Jeff Judy

Jeff's Thoughts - June 5, 2013

Do "Air Bags" Make You Drive Recklessly?

As a credit trainer, I spend a lot of time teaching people how to do a better job of mitigating the risks associated with the credit decisions they make. I am a firm believer that "credit risk management" is our job, as lenders. Armed with a deep understanding of alternative sources of repayment, of loan covenants and guarantees and sound structuring practices, we can do a lot to reduce the impact of a problem loan or default.

Notice that I said "reduce," not "eliminate."

We all know that the recovery is still moving slowly, and that good prospects for our credit business are hard to find. That increases the pressure to "make the deal work" when it walks in the door. And that means that some loans that should go in the "decline" bin instead get stamped, "accept and mitigate the daylights out of it."

No amount of mitigation will turn a bad credit decision into a good one. But the belief that "we can mitigate any risk" may lead you to take on borrowers who are not really up to your standards. Lay on as many ways to mitigate the risk as you want, they will never make you whole.

In my classes, I harp on the fact that collateral never completely pays you back. And sometimes the more collateral you take, the more work you have to do, when the credit goes belly up, the more staff time you invest, for the most meager results.

And I am bewildered when someone goes through tough negotiations to get a small business owner's personal guarantee, just so the "Guarantee Taken" box can be checked in the process, without looking more closely. If all your guarantor's assets are tied up in the business, and if all of the guarantor's income comes from the business, when the business tanks, your guarantee won't get you much.

Don't even get me started on loan covenants that will prove impossible to enforce when trouble comes, or how often those disputes lead to lender liability issues.

In spite of all the shortcomings of mitigation, some loan officers decide that poor risks become good ones with sufficient mitigation. But they probably don't think that way when they are driving to and from the bank.

After all, compared to when I was a lad, your chances of surviving a serious car accident are much better these days than they used to be. And most of that is through "accident mitigation," we might say. That is, under the same conditions, an accident in a modern vehicle is much less likely to kill you, and any injuries are likely to be much less severe than they would have been back in the day. Today's standard safety equipment like seat belts and air bags greatly reduces the impact of a crash -- but only after the fact, of course.

Does that mean you can drive more recklessly, knowing that you'll probably survive an accident? Or is the best "safety equipment" avoiding accidents in the first place?

When your car crashes, you're probably going to lose a lot of time, and perhaps some money. You are certainly going to have an unpleasant, stressful experience. Nobody who has a serious accident says, "Oh, it didn't bother me at all, because the air bags saved me!" An accident is a loss, even if it isn't a loss of life and limb.

Mitigation and risk management are there to protect the bank from surprises. They are there to make sure that when a good credit goes bad, you can minimize the damage. But you cannot eliminate it.

You cannot mitigate a bad loan into a good one. Do not make credit decisions as if you could.