Jeff Judy

Jeff's Thoughts - December 10, 2008


Challenges To Repayment

In a recent issue, I talked about "covariance," the notion that you may have a "hidden concentration" in your portfolio because you are lending to major economic drivers in your market, and also working with businesses (and consumers) dependent on those drivers.

For example, in many more rural markets, agriculture would be a typical driver of the local economy. While lending to farmers on the one hand, and to retail shops in town on the other, may look like a diversified approach, the truth is that when the ag part of your portfolio takes a downturn, the retail businesses in your market will follow. The two go together -- what I mean by "covariance" -- and that doesn't mean you don't make those loans, it just means you go into them with your eyes open.

So let's open your eyes a little wider and get to specific "challenges to repayment." (For convenience, I will stick with the ag-based example, but you can easily extend this thinking to any other market dependent on a major manufacturer, single large employer, or the like.)

Typical risk management thinking identifies risk as events that are close to the borrower, and couched in the language of lending. For our retail shops, mentioned above, you think about the risk of default. You might go farther to think about what drives default, and decide that the underlying reason they don't repay your loan is because they experience a drop in sales.

Based on that thinking, you monitor their sales figures. You expect to pick up early signs of trouble, a possible "threat" or "challenge" to repayment of the credit you have extended, in the sales trends for the store.

But if you did the homework we discussed in my earlier article and looked for sources of covariance, you're in a position to detect challenges to the borrower's ability to repay much earlier in a downturn. You can look for two additional sources of difficulty, farther up the chain of events, if you will:

  1. If the main economic driver falters, that will act to dry up sales for your local store, and
  2. If you can identify the challenges faced by that economic driver, those challenges apply to your retail businesses as well.

Back to agriculture, in some regions farmers turned massively to corn to take advantage of the demand for ethanol. As ethanol plants popped up very rapidly, corn prices rocketed, and some observers even worried about the impact of this corn-for-fuel movement on the basic food chain.

But, at least in some markets, whether temporarily or not, ethanol has suddenly lost its bloom. Some major players are looking at bankruptcy, demand for corn is greatly reduced, and prices are collapsing.

In that situation, what is the "challenge to repayment" for your local hardware store? A drop in demand for ethanol!

I am always amazed, when I'm in my car, at the drivers who never look more than ten feet in front of them. Those are the ones who drive right up to a stopped car, or other obstacle, slamming on their brakes at the last minute.

The safest drivers are looking as far ahead as they can, anticipating conditions while there is still plenty of time to react. Extend your detection of "challenges to repayment" as far through the chain of cause-and-effect as you can. Put on your high beams, peer far ahead into the night, and you will be anticipating, and mitigating, risks in your portfolio long before your competitors even realize they are there.