I found this old credit memorandum that I wrote many years ago in the late 2000s as the market was crashing. It was an excerpt of an internal memo where I was driving home the fact that our fund needed to mitigate risk. I thought it would be interesting to share it with our members.
Managing portfolio risk is critical to the success of any loan-based fund. It is important to understand that there are many types of risk associated with lending that differ from other types of investing. The mitigation of portfolio risks and the maximization of investment returns are the primary goals of the fund.
Credit/Default Risk: The most obvious type of loan risk is Credit or Default Risk. This type of risk has to do with the borrower being unable to repay its obligation. Failure to make timely loan payments means that interest is not being collected. This translates to lower yields to the portfolio as revenue is decreased. It is also the danger that the principal laid out by the fund will be lost. This sort of risk is mitigated in several ways.
By having a consistent, written credit policy, emotional decisions are removed from the mix. Many of the issues banking is experiencing today stem from Chief Credit Officers deviating from sound lending policy to make loans to people because “He’s a good guy.” By following a disciplined approach to credit decision making, the likelihood of taking credit losses are dramatically minimized. A copy of current credit policy is in the appendix to this plan. The “Three Cs of Credit” that mitigate this risk are:
- Capacity:
It was once said that the three most important things in lending are ability,
ability, and ability. If a client lacks the capacity, or cash flow, to meet the
payment requirements of the loan, then a default is almost assured. A 1:1 or
100 debt service coverage will be required to borrow money. This means that a
borrower must show the capacity to pay all of its expenses, including the
requested loan payments, before they receive money for the loan.
- Character: Sometimes known as “Credit”, Character is the measure of one’s moral attitude for following through on an obligation. Perfect credit will not be a requirement of doing business with our fund, but we must be reasonably assured that the client currently and in the future will be committed to making good on their loan obligation. A borrower with a propensity to shirk their commitments is not a good credit risk.
- Collateral: Key to our success is the notion that our loans must be adequately secured. Each loan must have a “Secondary Source of Repayment” that ensures that, if the borrower defaults on their obligation, that the loan will be paid off in some other way. The collateral will most likely be real estate or securities. In some cases, such as in the case of a franchise, it might be the guarantee of a corporate franchisor to purchase back the franchise and pay off the loan to the fund in the event of franchisee/borrower default. Our Loan to Value ratios (LTV) will be considerably lower than the industry average to allow us to assume slightly more Capacity and Character risk than a traditional bank might accept. This concession allows us to make a considerably higher yield on the loan portfolio while still mitigating risk to the portfolio. Our target for commercial real estate LTVs will be no more than 60%.
Interest Rate Risk: When dealing with fixed rate loans, a real risk to a loan portfolio occurs in a rising interest rate environment when a loan is locked in for a low interest rate while market rates continue to climb. Investors looking for strong terms will no longer wish to invest their money in a fund with locked in lower rates if they can get better returns elsewhere. Does anyone remember 20% mortgage rate at the beginning of the 1980s?
The opposite is also true of variable rates. Over the past several years, most banks offered home equity lines of credit at Prime minus ½% to 1%. With Prime standing at 3.25 throughout the Spring and Summer of 2009, many of these rates currently stand at 2.25%. This puts the interest income of the financial institution below its cost of funds meaning that the institution is losing money on tens of millions of dollars in loans. This is a major reason for the inability of banks to be profitable in this day and age.
To minimize this risk, there are several measures that the fund will take. Among them are:
- Shorter-Terms: By keeping fixed rate terms short (5 years or less), the impact of increasing interest rates on the fund’s portfolio is minimized.
- Floors on Variable Rates: If a variable rate loan was issued at Prime plus 6% when Prime was at 8.5%, the return would be reasonable to the fund. Now that Prime has dropped to 3.25%, however, the return is now in the single-digits, well below what the fund has targeted for a return. Adding a minimum interest rate to variable rate loans mitigates the impact of any dramatic drops in rates.
Market Risk: Market risk occurs when the market for your product dries up.
- Speed of Execution: Many times, a borrower may find an opportunity that they must move quickly on. They also might get backed into a corner and need money right away. Traditional financing outlets generally can not accommodate these borrowers. We can. If the deal is very lucrative for the borrower, they will pay our rates and fees. They may refinance the loan at a later date with a traditional lending institution, but we can collect the interest in the interim.
- Out-of-the-Box Thinking: FDIC insured banks are very limited in the types of loans they can make. Currently, for instance, it is difficult to find an institution that will lend on a non-owner occupied strip center regardless of the loan to value. Unlike banks, we have the ability to make good, makes-sense loans to borrowers who will pay us back. Federal restrictions on banks are traditionally written by bureaucrats and politicians, not professional lenders. There is a huge segment of the borrowing public that does not fit into the box.
- Expected vs. Historical Earnings: Let’s say that a barber has worked in a large shop in a town for years. He inherits a commercial lot and wishes to build a building to house his own shop on the lot. Because his new business is not 2 years old, many banks will not lend to him. They require at least 2 years of tax returns from the business showing an average income large enough to support a 1.25X debt service coverage in order to qualify for the loan. The client does not have the time nor wishes to deal with the SBA. Provided the loan amount versus the value of the property is 60% or less and we can be reasonably assured that the business will be able to make the loan payments (1.00X debt service coverage based on reasonable projections), we would probably make the loan.
- Federal Lending Restrictions on Banks: President Obama often publicly asks why more people don’t refinance their mortgages when rates are so low. The answer is that government has placed draconian restrictions on FDIC-insurance lending institutions making it much more difficult for people to meet their qualifications for loans. The commercial lending industry is particularly hard hit. If a loan is remotely “outside-the-box”, banks can not make the loan. There are many good loans that can not get traditional bank financing. That is where we come in.
Economic Risk: As we are finding out now, the economy is cyclical. Hard economic times can negatively impact a lender that is not prepared to weather a storm. Conversely, it can be fortuitous for an experienced lender that can move quickly and professionally to make opportunities happen for those who need money. If banks can’t move quickly enough, are having liquidity problems (a majority are), or the client does not “fit the box”, hard economic times can be a blessing for a lender like us.
Valuation Risk: In the mid-2000s, everyone wanted to invest in real estate because they believed that people would always need land and the asset class would never go down in value. Even when reminded that real estate is, itself, an asset class and like all asset classes goes in cycles, they would often answer “This time it’s different.” We all discovered that it was not different. The real estate building led to over-building and over-speculation which caused the crash to be devastating to the economy. With so many people up-side-down on their property, they would simply walk away from it further driving the market lower. Lenders, for the most part, were lending at 90 – 100% of the value of the properties expecting the market to continue to rise. Building a buffer zone is critical to avoiding this risk. There must be a strong secondary source of repayment for the loans made by the fund. For real estate backed loans, the fund will lend no more than 60% of the verifiable value of the property.
Environmental Risk: Let’s say that a borrower wishes to purchase a fully-rented strip center for $500,000. They wish to put down $200,000 and have requested a $300,000. They will have no problem paying the loan back and we are well collateralized. There could be a pitfall here. Let’s say that next door to the center is an old gas station that has buried, leaky tanks. The current owner of the station owes nothing on the building and disappears to Mongolia when the EPA requires him to clean up the plume that extends 5 miles including the land that your borrower wishes to purchase. We’ve already lent the money to the borrower. The EPA comes to the borrower and says that the property must be cleaned up and our borrower is responsible for the $1 million bill for cleaning up the property. They only owe $300,000, so the logical business decision they make is to hand us the deed to the property and file bankruptcy. We now, as owners of the property, must pay the bill. That’s not a good investment. To mitigate this risk, clients will be required to purchase environmental insurance policies to indemnify the lender should a scenario like this occur. The policies are not expensive and most lenders require them.