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Spot Problem Loans Now - Before It's Too Late

After several years of ideal economic conditions - healthy GDP growth, historically low (if rising) interest rates, low inflation, and unemployment - that have led to a robust expansion, signs are appearing that the economy may finally be starting to lose some steam.

A combination of unwelcome signs led to a steep sell-off on Wall Street in late February and early March, including a significant downward revision of fourth quarter GDP. Of course, interest rates rose steadily for nearly two years between 2004 and 2006 as the Federal Reserve embarked on its campaign to bring rates up to a "neutral" level from the 40-year lows they reached three years ago.

The Housing Slump

All of this comes amidst a slowdown in rising home values, or outright decreases in home values in many of the nation's super-charged housing markets. As much as 15 percent to 20 percent of GDP is attributed to homebuilding, which is one reason why the housing slump has so much potential to affect the economy as a whole.

The other reason is the impact the slowdown has on consumer spending (which accounts for up to 70 percent of GDP) as the ability of homeowners to tap into rising home equity via home equity loans and HELOCs is restricted.

What does all this mean to banks and commercial lenders? Simple: If the economy experiences a significant slowdown or recession, problem loans are sure to follow. This makes now the time to identify potential problem loans and begin to take concrete steps for dealing with them.

Early Identification is Critical

There's no question the key to problem loan management is early identification. If caught early, you're likely to still have a viable core business, a reasonably cooperative borrower, a decent collateral position and, if necessary, the opportunity to ease the borrower out the door before things actually get bad.

However, the longer problem (or potential problem) loans fester, the more likely it is the company's financial condition will deteriorate. If you wait until the borrower is past due on loan payments or overdrawing the business checking account, it may be too late to do anything to salvage the credit - and the opportunity to "find a greater fool" may have passed as well.

Steps to Take

The first step in your search for potential problem loans is to identify industries in which problem loans have historically appeared during economic slowdowns, and then determine your portfolio's concentration in these industries. High-risk industries include those with:

• High levels of fixed costs due to heavy investments in fixed assets (equipment, machinery, buildings, etc.)
• Significant fixed labor expenses (e.g., labor contracts, skilled craftspeople, multiple layers of management)
• Post-retirement healthcare benefits and defined benefit pension plans
• Excessive debt relative to equity (especially short-term debt)

In today's environment, some obvious industries that bear close scrutiny include airlines and automakers and any companies that supply them; any industry heavily dependent on fuel (like trucking or agriculture); residential construction; and commercial real estate. Be sure you're lending only to the strongest borrowers in these industries, and begin taking steps now to prune marginal borrowers.

Finding Problem Loans

Next, carefully examine your loan portfolio in search of individual companies that might be headed for trouble.

Companies that are most vulnerable will be those that have not aggressively cut expenses, have not invested in good inventory and receivables management systems, do not have a good handle on their costs, and whose owners have built lavish lifestyles but are unwilling to scale back. A few questions to ask as you examine your current borrowers:

• Are sales flat or declining, or are sales growing while earnings are declining
• Are gross margins shrinking
• Is overhead rising as a percentage of sales
• Does the borrower have systems in place that enable the business to provide quality and timely financial information
• Does the borrower have a good handle on costs
• Is financial leverage increasing, especially short-term debt and lines of credit
• Has the borrower invested heavily in non-productive fixed assets - like fancy gadgets, cars, private jets or office space - that don't significantly add to the bottom line
• Is the owner continuing to draw a large salary and/or take large distributions even if earnings are flat or declining
• Are receivable and inventory turns lengthening, or are they longer than industry norms for no good reason
• Has the owner grown the business too fast and beyond the ability of current management to handle the growth
• Are the borrower's trade payables lengthening

The fact is, many borrowers (and some lenders) simply got sloppy back when the Prime rate was under 4 percent, because carrying excess inventory and receivables was relatively inexpensive. Now that Prime has more than doubled, this isn't the case anymore.

Be Proactive

In the months to come, you should be especially proactive in your loan tracking and monitoring efforts. This means staying current with loan documentation and scrutinizing borrower performance in the areas listed above more carefully than you may have in the past, focusing especially on loans that have the potential to go bad.

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