Dear Prudence
by Paul J. Thompson
In the past year and a half, the lending envir-onment for underwriting of commercial and com- mercial real estate loans has become markedly
more difficult. I think you’ll agree that this is an understatement!
What got us into this mess? In large part, it
was the proliferation of loans—now beginning to reverse—made with lax or loosened underwriting practices. Surprisingly, in the time leading up to August 2007, as much as two-thirds of the com-mercial real estate loans were originated by Wall Street investment banks and other lending entities operating outside the regulatory framework of a commercial bank. They generated mortgage-backed securities (MBS) that were assigned a rating and then sold to the market.
As the market grew hung-rier for more MBS deals (and more income), lenders began to waive prudent underwriting standards in order to make or get the deal. This securitization process occurred with residential real estate loans as well—with further depart-ures from sound underwriting practices—through the now infamous sub-prime loans.
Commercial banks, including many that had developed a niche in commercial real estate (CRE) lending, were left with the choice of standing on the sideline and watching their market share and profitability dissipate—or entering the game by adjusting their own underwriting practices. Bowing to market pressures, some banks compromised their underwriting practices by making loans with high loan-to-value ratios, low debt-service coverage ratios and collateral values based on unreasonably high valuations.
Now, as the economy has slowed, most of these unregulated and/or imprudent debt suppliers have either taken themselves out of the game or have otherwise been “ejected” from it. Their absence has created further downward pressure on real estate prices, commercial and CRE lending, and the eco-nomy as a whole. So, if you are a business owner who relies on a reasonable level of debt to run your business, what trends in commercial lending underwriting practices can you now expect in the coming months and years?
The main trend we are already seeing is toward a return to lending basics. That isn’t entirely a bad thing since the ubiquitous availability of debt resulted in unrealistic and unsustainable growth rates in asset values, creating the infamous economic bubble.
The problem is that because of that lack of debt discipline, our economy is fiscally out of shape. Now it’s like we’re trying to get back into shape by completing a marathon when we haven’t run in years. That’s painful!
As a result, we are now seeing a greater emphasis by lenders to ensure that they are fully apprised of borrowing needs in an effort to structure a sound debt-repayment program. Lenders are focusing on the business’s cash flow and profitability, and are seeking many sources of information and copious financial documentation—including, yes, tax returns. Lenders are also focusing on the personal debt in order to understand what cash flow the owner will need from the business to handle other personal debts. This is referred to as a “global cash flow analysis.”
Another trend affecting un-derwriting standards involves working capital financing or lines of credit secured by a company’s accounts receivables and inventory. In today’s bank-ing environment there are more reporting requirements and fin-ancial-performance covenants
in this type of financing vehicle. Maximum advance rates may be reduced from
80 percent on eligible accounts receivable to, say, 70 percent.
Advances on inventory have also been reduced significantly. As a business owner, be prepared to complete monthly reports so that the bank fully understands your company’s position concerning the assets being financed. More than ever, frequent and honest communication is the key to maintaining an ongoing working relationship with your banker and to obtaining access to capital. Communicate all relevant aspects of your business and industry to your banker—good and bad. This helps ensure that your lender understands these issues and, maybe more importantly, demonstrates that YOU have a handle on what is required to not only survive, but also thrive!
As underwriting standards return to—I would argue—a more prudent level, traditional banks con-tinue to be in the business of lending money to assist the growth of small and medium-sized businesses. We’re one of those banks, and we’re still lending money. Even during these challenging times, we remain optimistic about the long-term future growth and prosperity of Kansas City and its businesses. 
Return to Ingram's April 2009
Paul J. Thompson President and CEO, Country Club Bank Chairman, Missouri Bankers Association