Jeff Judy

Jeff's Thoughts - October 10, 2012

Collateral Is Nice To Have, But ...

In this issue of Jeff's Thoughts, I've invited guest columnist Charlie Dickerson to share his suggestions for how bankers should think about collateral. More about Charlie below.

When somebody starts a new employee on a path leading to commercial lending responsibility, one of the first things that enters the teacher's mind is the "Five C's of Credit." It's a good place to start because it affords the beginner a "quick screen" of very basic requirements that must be met if an application is to be approved. If any of these five requirements isn't met, the possibility of payback on an agreed-upon schedule can be severely diminished. And one of these requirements, you will remember, is Collateral.

We teach our commercial lending tyros that it's necessary to "put yourself in the shoes of the borrower", and this makes great sense. Because, once the loan proceeds change hands, the borrower's strengths and weaknesses become the lender's strengths and weaknesses also. Until the application is approved, the banker can analyze it for forever and a day, but no amount of wishing will imbue the borrower with strengths it doesn't already have or eliminate some innate weakness. That is why the need arises for one of these C's of Credit: Collateral.

Collateral is taken as extra protection in case the lender should misvalue some other aspect to the loan application - particularly Capacity - the ability of the borrowing business entity to repay the loan according to the established schedule. It's a front-line defense against a lender's failure to properly assess the potential borrower's relative strengths against its weaknesses.

And collateral has a habit of not ultimately providing as much protection as we bankers think (perhaps "wish" is a more appropriate word) it will be worth. A general rule of thumb might be, "If there's a difference between the borrower and the lender as to how much loan protection an item of collateral might provide in a forced-sale environment, always assume the lower of the two amounts." Not only is this a conservative approach, but it's likely the borrower is closer to a potential buyer for the collateral than the banker is and possibly even has a private offer already in hand. It takes a lot of ego on the banker's part to believe that he/she knows more about the industry involved than the borrower. Ego should never be confused with experience.

Success in the lending game isn't about what you know--it's about what you don't know. Even the most successful lenders would admit that their knowledge of law, finance and psychology, as examples, is passable, at best, but their knowledge of a borrower's industry peculiarities is much weaker.

The biggest shortcoming of many newly-minted lenders is a firm belief that what they know gives them an advantage in determining a borrower's ability to repay on a timely basis. Lenders sometimes forget the reason they were selected in the first place - they were hired because they can think, dispassionately weighing the strengths and weaknesses of an applicant. And that presumes an ability to admit openly what they don't know.

That's why we take collateral. But collateral should be reserved to address the unexpected. It isn't a cure-all. It is only first aid, not life-saving (or "loan-saving") surgery.

About Charlie Dickerson

Charlie Dickerson began in commercial banking in Pittsburgh after graduating from Dartmouth College. Later he moved to Philadelphia to work for the First Pennsylvania Banking and Trust Company. While at First Pennsylvania, he managed the Credit Department and supervised the bank's Management Training Program. Later, he was active in the Loan Review and Correspondent Banking Departments. After leaving First Pennsylvania, he became responsible for all lending activities for two smaller banks in neighboring states. Charlie was also President of Crossing Financial Consultants for many years and has taught for major trade groups, state banking associations, and CPA firms.