September 2011 The RMA Journal58

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From Me to You

Reflections on a Career in Lending

••In this article, which first appeared in the December 2004–January 2005 issue, a banking veteran offers advice to help young lenders find their way, while also striking chords with bankers who have been through the decades and cycles.

When you’ve been around, and around, the block, you learn a few things. One is that others who have been around that block even more have experiences to share that can help you develop that all-important, but some-times neglected, area of loan decisioning: sound judgment.

In this article, I’m pleased to share a num-ber of experiences that have helped me build sound judgment in my various roles. Banks want to use money to make money, not lose it. As exciting as it may be to employ all the lat-est quantitative tools, I’ve learned that these tools are an adjunct to a banker’s judgment and not an end in themselves. So here are my thoughts on building the better banker.

Many problems can be avoided at the outset if the banker begins with the proper skills. You might assume that an “experienced” hire is well versed in best practices in lending and documentation. But this assumption may cost the bank tens of thousands of dollars in loan

by Tom D. Vance

The RMA Journal September 2011 59

losses if the manager doesn’t make sure the employee knows what the heck he or she is doing. Those few hundreds of dollars saved by not investing in a formal lending school may snowball into enough dollars in losses to afford a Harvard MBA. Make sure everyone knows his or her job well, and never assume folks know how critically important their role might be in lending.

Also, never assume young lenders know what to do or say in problem-loan situations. Leadership must get involved, show the way, set expectations, and direct how to get there. Employees do not like to admit they don’t know, so don’t wait for them to tell you. The worst documentation clerk I ever had was a legal secretary, and the most pitiful credit analyst I ever saw was a CPA. Go figure.

Another no-brainer should be for the lender to get be-hind the numbers, but we know better. I was trained to always read the “accountant’s opinion statement” first to see how much reliance to place in the numbers. In my day, the balance sheet and income statement were “spread” by hand, complete with the reconciliation of net worth and calculation of key financial ratios to be compared to RMA industry standards. As antiquated as this process seems today, the “painful” procedure of spreading each line of the accountant’s report by hand forces the lender to think about the relationship between the numbers and to see if the numbers make sense.

There is something about looking at financials on a slick, computer-generated report that tends to give them a false sense of credibility. Give me some old-fashioned, smeared-red-ink, white-out-covered spreadsheets, and I will know someone has really analyzed the numbers. In a way, it’s harder now to “get behind the numbers,” which makes it even more important.

Meanwhile, asking penetrating questions will result in a deeper level of information. For many years, I was exposed weekly to the dreaded “loan committee,” that subcommit-tee of the board of directors charged with the review and approval of loans. We had a very successful, shrewd, but not highly educated businessman who served for many terms as one of three outside directors on that loan com-mittee. Despite his lack of knowledge, or even interest, in

the financial spreadsheet and formal credit write-up, this director would always ask the most penetrating questions that the presenting loan officers could never anticipate or answer. His years in business and his diploma from the school of hard knocks prompted suspicion when things just didn’t smell right. I never appreciated the wisdom and value afforded by this elderly director until many years later when the reality of common sense took equal billing with “book learning” in making credit decisions.

Did you know that the phrase “The more things change, the more they remain the same” originated with the French? Plus ça change, plus c’est la même chose. Well, here are some other things you may or may not know that remain as true today as ever. You’ll notice the recurrence of certain words, such as “common sense”!

Instinct versus Numbers Cash is king; you pay your bills with cash. You can’t keep your doors open without cash. Cash is as necessary to every business as blood is to the human body. The technical term that analysts like to use is liquidity. Having operating dollars for working capital is crucial. I have seen the temptation for both lenders and business owners to spend all their efforts on arranging term credit to finance the acquisition of a business or fixed asset with no plans whatsoever for a line of credit. I have told lenders on many occasions that we do our borrower a disservice if we make credit available to start a business, but fail to insist on an adequate cash budget to ensure the enterprise can operate on a daily basis.

It’s not your money you are lending—so follow policy. Travis Tritt has a song that includes the line “ten feet tall and

As exciting as it may be to employ all the latest quantitative tools, I’ve learned that these tools are an adjunct to a banker’s judgment and not an end in themselves.

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bullet proof.” I think this song expresses the feeling of many young lenders who have not yet been humbled by a charge-off. That invincible attitude, driven largely by sophisticated, computer-generated financial analysis, is very dangerous. I have had lenders argue with me that the numbers show there is no way a particular credit can tank based on net cash flow, debt coverage multiples, and abundant collateralization. I respond to this arrogant, “blinders on” rationale by warning these lenders to follow the loan policy approved by their “owners” and to use common sense. After all, the money you are lending belongs to your shareholders, and the board is charged with the prudent oversight of these dollars, often based on a written lending policy. In the event you own 100% of the bank, you may disregard this recommendation.

If it seems too good to be true, it most certainly is. This rule applies 100% of the time. If only lenders would use what little sense they have, this one statement could save banks millions of dollars in losses.

Get behind the numbers and use common sense. Years ago, when I worked with other young credit trainees, a loan officer brought us financials to spread for a new food ser-vices/vending company. Although on the surface everything appeared to be in good order, the numbers just didn’t make sense. After we completed the spreads, the calculation of key financial ratios followed. The “inventory turnover” ratio revealed more than 100 days in inventory and the “accounts receivable turnover” ratio indicated some slow collections. How does a vending operation specializing in sandwiches have over 100 days of inventory on hand, and how does a vending machine generate a receivable? Needless to say, the credit request was a scam against the bank, and the financials were a total fabrication.

Structuring If you want to see time fly, make a 90-day note. Examiners hate 90-day notes because they never seem to be secured or get reduced. As noted on the worksheet, the source

of repayment is “paid by renewal.” The best example of this ever-green situation is the poor farmer. I had the opportunity to oversee lending in a county that used the 90-day note as the gold standard of lending. Many farmers would use as many as a dozen short-term,

unsecured notes to put in “last year’s” crop. Well, guess what? Last year’s crop never did come in, so your source

of repayment just shifted from “crop income” to “paid by renewal.” The poor lender responsible for these hundreds of 90-day notes has passed on, but many small farmers in this same area have died financially as new lending policies have eliminated these open-ended lending practices.

In lending, there is never a dumb question. The only dumb question is the one that does not get asked. There is something about a young lender not wanting to appear “dumb” to his sophisticated borrower that prevents him or her from asking questions. I have worked with highly intelligent bankers with tons of formal education who refuse to ask a basic question, or to simply say, “I don’t know, but I will ask.” I’d rather be embarrassed by asking a dumb question now than by telling my board later how we missed something so basic or obvious.

Closely held business owners and spouses should always personally guarantee. I remember the suspicious death many years ago of a prominent businessman who had been under tremendous financial pressure due to a soft economy. Although suicide was the likely cause, it could never be proven, and the man’s spouse eventually received a very large life insurance settlement. Apparently, the bank was never concerned about the spouse guaranteeing the debts of her sole-proprietor husband. As a result, she felt no obligation to pay her deceased husband’s debts, so the bank had no choice but to charge off the credit. In contrast, I am aware of an elderly widow who is still working today to pay off the debts of her deceased husband even though she had never signed any loan documents. In fact, she was not even aware he had borrowed the money. To her credit, this fine lady feels the moral obligation to pay. This widow is truly one in a million and should be considered the exception rather than the rule.

Takeout commitments are often worthless. The only takeout commitment worth its salt is one that has “cash money” held on deposit on a nonrefundable basis. I can-not begin to count the number of problem loans that have been created by the false comfort level afforded by weak takeouts. Many builders know the game well and will produce “buyers” in an effort to stretch spec construction loans into presales. Another potential problem can be that the commitment is bogus from the get-go. Always require a written copy of the commitment and verify the terms and conditions to ensure you know what you really have and if the lender is for real. There are too many mortgage companies in the market today, and some will do almost anything to collect that origination fee. Don’t worry about making folks mad or upset; verify the source and stability of the takeout on the front end. After all, it’s mighty hard to change horses in midstream.

Always require a written copy of the commitment and verify the terms and conditions to ensure you know what you really have and if the lender is for real.

The RMA Journal September 2011 61

real job and my spouse leaves me in total disgust.” This type of loan should be avoided like the plague and is a lose-lose situation for everyone. If you made 100 of these loans, 99 would be on your watch list!

Physical-damage insurance is a good thing—a very good thing. Some years ago, while getting ready for bed, I was watching the local news. The lead story was about a major fire in my town, so I thought I would watch the full report. I almost fell off the bed when the news anchor reported that the local business on fire was my largest loan customer. As busy lenders, we don’t pay much at-tention to ensuring that hazard insurance is in the file naming us as “loss payee” or “mortgagee.” By midnight of that evening I was in the bank pulling the collateral file, praying current insurance was in force to protect our $2 million mortgage loan. I learned years ago that the definition of insurance is “exchanging the chance of loss for a certain cost.” I was really glad my borrower had made that exchange. (P.S. Business-interruption insurance is also a very good thing. Do your large borrowers have this coverage in place?)

Collateral Don’t take anything that eats as collateral. I always loved the expression, “Take a chattel on the cattle.” My heart goes out to the dairy farmer, who probably has one of the hardest, most demanding jobs known to man. Those dumb cows don’t recognize any federal holidays and expect to be fed and milked on a daily basis. If by chance you should find the need to take possession of your “cow collateral,” welcome to the farm. Oh, by the way, don’t worry about where you step, because you’ve already stepped in it up to your eyeballs.

Always have an agreement as to the lot release price before funds are dispersed. Have you ever run out of money before you’ve run out of month? The same can be true of real estate development loans. Without proper planning at the inception of the commitment, you may wind up with more loan than collateral as time passes. After all, the primary source of loan repayment on your credit is lot sales. You must adequately calculate the amount from the sale of each lot to retire principal, or your self-liquidating loan becomes a problem loan. The developer is entitled to a profit on the real estate venture, but his profit should come on the back end after the bank has been paid.

Just because you change jobs, the plaintiff ’s attorney can still track you down and have you served. You can run, but you can’t hide.

Documentation When in doubt, spell it out (get it in writing). Nearly every lawsuit I have ever been named in as defendant stems from something that was not in writing. For example, “I will release this guaranty after the debt is reduced to a certain level,” or “I will renew this loan in a year even though the note is due on demand.” Any type of forward commitment needs to be in writing and kept in the file for future refer-ence. After all, lenders do change employers from time to time, and a documented promise that is part of the credit file will certainly make your replacement’s job much easier. Also keep in mind that just because you change jobs, the plaintiff’s attorney can still track you down and have you served. You can run, but you can’t hide.

Always check the math—twice. More than 20 years ago, I had the opportunity to handle a very large, very complicated credit that involved multiple loans, massive collateral documents, and over 16 personal guaranties. I was really focused on getting everything right because this was my chance to impress some pretty powerful folks, some of whom were bank directors. All went well at the closing table until we got to the settlement sheet. The total closing fee was some ungodly figure that made no sense at all. I had not taken the time to check the math but had used the total spit out by the calculator, which had not been cleared. That embarrassing moment taught me two valuable lessons: 1) See if the numbers look right from a “ballpark” standpoint; and 2) always check the math twice. As the carpenter says, “measure twice, cut once.”

Never make draw advances on construction loans before inspections are completed. How many builders do you know who love to do paperwork? I dare say the last thing most builders do every day is put things down on paper or organize which bills to pay. It only stands to reason that most construction types are lousy on record keeping. That said, how in the world can you not inspect construction progress before extending additional funds? If you have a builder with multiple houses under construction at the same time, beware. What makes things even more interesting are builders with multiple projects borrowing from multiple banks. Rest assured that the bank making inspections will suffer the least loss if the builder is playing games with construction draws.

Famous last words:“I can be my own contractor and save thousands of dollars and do the job in half the time.” This phrase would be stated more accurately as, “I can be my own contractor and take twice as long to finish the project, not have a clue what needs to be done, spend 50% more money than if I had hired a professional to do it right the first time, and become a royal pain in your butt as I lose my

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If you want to know what something is really worth, have an auction. For all of you second-mortgage holders with loans in default, the decision to pay off the first mort-gage to protect your position is usually most difficult. You just never know with an auction. Who shows up for the sale, as well as the weather, advertising, the perceived market value, and a host of other factors beyond your control, will determine the ultimate sales price. The decision to put more money into the deal without some idea of auction value is quite a risk, unless the equity position of the borrower is substantial. If not, swallow hard and let it go.

Doing the Right Thing Never lend to family, friends, or members of your church. In lending, one must be totally objective. My experience

in making loans to relatives, neighbors, friends, or church as-sociates is that you lose your objectivity and tend to bend or even break the rules of prudent underwriting. I strongly believe the best way to handle these situations is to thank

your kinsmen for coming to your bank for help and then explain the need to hand them off to another lender to avoid a possible conflict or embarrassment for both parties. It’s hard to call a loan on your cousin, file suit against one of your church leaders, or foreclose on one of your neighbors. Believe me, as I have done so.

Economists can make mistakes. You can’t. Never pretend to be an economist and predict when interest rates will move up or down. Many times, customers will look to you for advice on when to lock in a rate or whether to take a variable-rate over a fixed-rate loan. Refrain from making the decision for the borrower; instead, point out the pros and cons of both types of pricing. Recently, I visited with a customer who had tried for years to get his elderly aunt to cash in all her low-yielding CDs and invest the money in a “can’t lose” stock. As you might guess, soon after following her nephew’s advice, her stock tanked and she lost most of her life’s savings. Don’t let your perceived expertise in financial matters and the economy be responsible for lead-ing your customer into a bad decision. After all, you and your bank may be sued for damages, and, at best, you will certainly lose the customer to another lender.

When the stuff in the vault begins to look like money, find something else to do. One of the hardest situations to address is employee dishonesty and theft. Tellers are espe-

cially tempted every day to have cash stick to their fingers. Having dealt with these types of issues in the past, I’ve found that the employees who make these huge mistakes are not bad people. The reason most often given for the theft is, “I just got behind on my bills.” Given that we are all human, bank management must put in place strict audit and security procedures to help keep folks honest. A failure on management’s part to adequately police cash-handling practices invites the vulnerable to make the biggest mistake of their lives. Seeing and hearing the gut-wrenching cries of good employees who have made bad mistakes is not something I ever care to revisit.

Bad Loans I don’t want any more cheese, I just want out of the trap. A market president reporting to me had taken over a loan portfolio that was riddled with problem credits. Every time he was asked how his cleanup of the bad loans was going, he would say, “I don’t want any more cheese, I just want out of the trap.” Upon reflection, this person’s description of how you feel with a boatload of dog credits is pretty accurate. Just like the mouse who wanted more cheese, the bank’s previous president had received accolades for the rapid growth of his portfolio and the tremendous amount of credit life and accident-and-health insurance he had written. Only after an external loan review team examined the portfolio did every-one realize the bank was already in the trap, as loan growth and other income had driven “the mouse to the cheese.” If you have ever seen a mouse that’s been in a trap for a long period, you can imagine how the new president felt walking into that unpleasant situation. In a word, it stinks.

If “ifs” and “buts” were candy and nuts, we would all have a happy holiday. Have you ever had a problem loan that is constantly on your mind? This credit is the first thing you think about when you get up and your last thought when you go to bed. As you contemplate how you can get out of this dismal situation, you start to use if-and-but reasoning. For example, if only the company can be sold, or if those new investors will put in some needed capital, everything will be okay. After going through the “ifs,” you shift to the “buts,” as in “I need to call this loan, but maybe if I give them some more time things will get better.” Perhaps the “ifs” and “buts” are truly the candy and nuts lenders use to make things look sweeter than reality.

Bad loans only get worse. This concept is perhaps the hardest reality for lenders to learn. Fear of embarrassment or of job loss, or just not caring, are all reasons why lenders tend not to acknowledge southbound credits. Management must create an environment of trust that does not punish lenders for raising their hands early if they sense a potential problem loan. Much discussion has been given to incentive programs to increase loan production. Perhaps an incentive

A failure on management’s part to adequately police cash-handling practices invites the vulnerable to make the biggest mistake of their lives.

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• I don’t want you to see how bad things really are. • My records are so bad my accountant doesn’t have a

clue. • I am so broke I can’t afford a CPA. • I am not finished with altering my numbers yet. • Go ahead and renew my past-due loan now because you

would not if you saw these numbers. • What I have sent to the IRS is not what I want you to

see. • You don’t look at the financials after I give them to you,

so why should I bother? • Can you use the same attachment I am sending in with

my petition for relief?

Past-due loans are always worse than you expect. If you have ever attended an officers’ meeting to discuss past-due loans, you may feel like you need hip waders to navigate through all the bull emissions. Most lenders will paint a rosy picture even if they know the borrower is about to go belly-up. It is not our nature as lenders to be totally honest about anticipated loan losses. Perhaps ego, fear, lack of attention, or even stupidity all play a role in not being forthright with senior management. How many times have you underestimated collateral value as opposed to overestimating it? How often has an examiner told you to remove a borrower from the watch list? If all of your loan officers were really honest, would your loan loss reserve really be adequate?

The borrowers with the most flash have the least cash. My dad, who is now in his mid-80s, has always used the expression “nickel millionaire” to describe folks with “cham-pagne taste on a beer budget.” You often see them hanging around the country club or at the 19th hole of any golf course. These individuals represent a challenge, especially to a young lender, as they exude an image of wealth and social status. If you ever make them a loan, however, be prepared for years of “paid by renewal.” Bankers are better served by making loans to someone unassuming, often referred to as “the millionaire next door.” My best example of this point is a recent-ly deceased couple who left their estate valued at near $10 million to various charities. These folks had lived in the same small home since the 1950s and had a 1978 Ford LTD sitting in the driveway. Never make a judgment as to financial condition based on outward appearance or perceived high-society standing.

Overdrafts and past-due loans are always warning signs of problem customers. Watch out for the icebergs. As the

for the early detection of a credit “with hair on it” might make even more sense, given the dollars that will be saved in charge-offs.

First loss is least loss. How many times have you heard this saying? Well, believe it or not, it is true. I remember a loan situation involving a “good ol’ boy” contractor who knew how to build but not how to manage. I had every sign in the world that a problem was brewing—delinquent inter-est, overdrafts, unreturned phone calls, a pending divorce, notes past due for maturity, and so forth. Instead of calling a stop to the bleeding, I agreed to extend yet another loan to cover “cost overruns.” The old adage of “throwing good money after bad” certainly applied in this case, as the new funds did nothing to get my unfinished houses finished. As a result, a $50,000 loss turned into more than $100,000 in charge-offs. It still bothers me to drive by those spec houses, which serve as monuments to my stupidity. As the comedian who pokes fun at folks doing stupid things says, “Here’s your sign!”

Overdrafts are unauthorized, unsecured loans. A boss told me that years ago after I had made a mess of approv-ing insufficient checks for one customer, which resulted in a huge overdraft total. I didn’t understand what went wrong, as I had watched my boss approve bad checks for his customer on a daily basis. It was no big deal, and my boss’s customer always covered the overdrafts without a problem. The huge difference between his customer and mine was that his customer was generating daily sales and the collection of receivables, while my guy was just plain losing his shirt—and mine. The reality that overdrafts are unauthorized, unsecured loans took on a whole new mean-ing for me as a young lender when I sat in bankruptcy court and watched my “position” as a creditor disappear. Some lessons you never forget.

The Three Ds of Lending. We have all been taught the Five Cs of Credit—character, capacity, collateral, capital, and cash flow. Not as well known are the Three Ds of Lending—death, divorce, and dumbness. In my years of banking, I suspect the D that has given me the most problem on a recurring basis is divorce. Given that 50% of marriages end in divorce while 100% of all lives end in death, one would expect death to be the bigger problem for lenders. This has not been my experience, as in death the assets are still there, along with willing co-makers and maybe even some life insurance. In divorce, all Five Cs of Credit are more often than not wiped out. Maybe that’s why D comes after C in the alphabet.

My financial statements aren’t ready yet. Allow me to translate this sentence:

It is not our nature as lenders to be totally honest about anticipated loan losses.

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captain of the Titanic said when asked what he wanted to drink with his last meal, “Sweet tea and hold the ice.” Like the good captain, we have conditions that can warn us of impending danger. Overdrafts and past-dues are certainly two huge chunks of ice that shouldn’t be ignored. Be alert to all early indicators of dangerous waters ahead. The captain of the Titanic went down with the ship. What are your travel plans?

Portfolio Management It’s not what you expect; it’s what you inspect. I don’t think anyone looks forward to an inspection, but there is no bet-ter way to ensure that expectations are being met. Surprise audits of teller cash, a mid-month review of past-due credits, and a rigid program to review documentation and policy exceptions all fall into the “inspection” category. It’s sad to say, but lenders often do just enough to get a loan booked and leave all the details to a processor or, worse, just let unrecorded documents pile up over time. These problems will not surface until a loan has headed south and then it’s too late to perfect a lien, obtain insurance, or record a deed of trust or financing statement. Inspect beats expect any day of the week. Young lenders will never fully appreciate the importance of getting the details done until they see a loan charge-off with their initials next to it because a car title lien was not perfected or hazard insurance had lapsed.

If I had known I was going to live this long, I would have made better loans. I recently turned 50 and can attest firsthand that time really does fly. All of a sudden, a 30-year mortgage seems not to be such a long period. Loans that you thought you made just last year are hitting the maturity report, and it’s hard to remember what promises were made five years ago. The importance of keeping accurate notes

in the credit file is critically important unless you have a photographic memory. The better the credit file, the better the loan.

Don’t make too many big loans, don’t make too many bad loans, and do not make any big, bad loans. This saying continues to ring in my ears and is profoundly true. I had just asked a very knowledgeable investor to buy stock in our new bank offering, and he said yes right after giving me this exhortation. I didn’t think too much of his comment at the time, but as credit decisions were made in the years to follow, his words became like a prophecy. In any bank, too many big loans constitute a threat to your capital, too many bad loans will kill your earnings, and even one big, bad loan can eventually close your doors. The temptation to grow rapidly by making very large loans can be extremely enticing, but a healthy reality check is to look at the size of your total capital and loan loss reserve before you “bet the ranch” on a handful of mega relationships.

Pigs get fat and hogs get slaughtered. This old saying is a warning against excess. It has applications in all walks of life and is very important for lenders to heed. For example, overdraft protection with an option for the customer to write his or her own loan is a very profitable banking product. Given the tremendous return on this line of business, the tendency is to “load the boat.” Similarly, spec construction loans turn over quickly, generate fee income, and afford mortgage loan opportunities for new banking relationships. The issue of credit concentration certainly applies in both of these examples. It is wise for the bank to grow its profits using an appropriate mix of these assets, but to put all your eggs in a single product invites disaster.

What you make on popcorn you lose on peanuts. Do you know how much you charge off annually in overdrafts and uncollected service charges? How about dollars lost in failing to write credit life insurance or to collect loan-origination fees on commercial loans? Which of your loan relationships are profitable? The point to these questions is to look for income sources that may be considered peanuts individually, but that collectively may add up to what you pay today at the movies for popcorn—and that is plenty. Shrinking net margins demand better management of other income sources.

Legal lending limits exist for a good reason. Don’t bet the ranch on any one customer. Enron, WorldCom, Adelphia, Tyco, Martha Stewart Living, etc. You get the point. v

••Tom D. Vance is president and CEO of First National Bank, McMinnville, Tennessee, one of the state’s oldest community banks. He can be reached at tvance@fnbmt.com.