We asked three credit and risk executives to weigh in on what they’ve learned and their plans for moving forward. Eric McGriff is chief risk officer at EverBank Commercial Finance, Inc. in Parsippany, NJ. Frank Namdar is executive vice president and chief credit officer at U.S. Bancorp in Portland, OR. Kenneth G. Sullivan is senior vice president and chief risk officer at Fifth Third Commercial Leasing in Cincinnati, OH.
Equipment financing companies have a bird’s-eye view of industries across the country and thus were able to watch the rapid segment-by-segment decline. Lessors began to tighten credit and look more closely at risk factors as the economic indicators slowed, but what they saw didn’t seem to make sense. “It was odd, to say the least,” recalls McGriff. “Everything was the opposite of what had been normal. Higher volumes were bad, lower approval rates were good. The focus on delinquency and charge-offs was intense.
“Rather than tightening credit across the board, we approached it in a more precise way,” continues McGriff. “We analyzed past downturns to get a good profile of which industries tend to be hardest hit at various points in a recession. With additional data obtained from PayNet, we made targeted adjustments in our lending posture, both within credit scoring and on a manual adjudication basis. We will continue to approach credit in a similar fashion: compiling industry performance statistics, monitoring the macroeconomic trends and adjusting our lending posture as appropriate.”
“The reality as a credit process manager is that we must continue to maintain a long-term view of the consequences of our underwriting strategies,” says Sullivan. “The balancing act is maintaining the integrity of the review process while being cognizant of the goals and objectives of the business unit. With greater limitations placed on the number of deals at hand, the credit manager must ensure that each new opportunity is treated like an oyster with a pearl in it.”
Balancing risk with business generation was always important, but as the downturn continued, the focus shifted more toward risk management and mitigation. In many cases, the competition stepped back to tend to their portfolio and cash-flow problems. This allowed a certain measure of opportunity for those that were still in a position to lend, but with an added degree of caution.
“Based on U.S. Bank’s balance sheet and capital strength, we were able to continue to lend during the downturn, which enabled us to grow market share,” says Namdar. “Now we are seeing more liquidity in the marketplace, and our competition is returning. We conduct sensitivity analysis in our risk assessment process to make sure we ask the what-ifs. We’ve always had this focus, and it served us well during the economic downturn.”
The what-if’s became and remain critically important. What happens if a client has variable rate debt and experiences a 200 basis point rise in interest rates? How much cushion does a company have in the event of a slow down or downturn? Just how strong is their balance sheet?
“Much of what we do in credit is based on lessons learned and past experiences,” remarks McGriff, “but you must also be mindful of the unforeseen and think through worst-case scenarios. In this downturn, many individual concentration risks, which were understood, suddenly proved highly correlated to other concentrations risks, the combination of which was perhaps not fully understood. If you were concentrated in a hard-hit geography with a concentration in industries that were also hard hit, the impact was devastating. Going forward we must consider the possibility that seemingly unconnected risks may combine and add up to a much bigger problem.”
“During these times, more than ever, the credit process manager must foster an environment with the relationship managers where communication and execution are intensified and prioritized,” Sullivan states. “Greater onus is placed on the development of opportunity memorandums. Deal huddles between all constituents involved in the underwriting should be more frequent, and integration of cash flow and collateral-based underwriting strategies becomes more prevalent.”
EverBank has learned to be less reliant on credit scoring. “While there is a role for scoring, we believe it will be one of guidance for the analyst rather than relying on a fully automated scoring environment,” says McGriff.
Namdar’s team keeps an eye on exceptions: “We routinely monitor exceptions to our credit policy and criteria. When we see increasing exception trends, we evaluate this carefully as this could be a predictor of future downturns, delinquencies or other credit issues.”
Documentation bears re-examination, too. “The desire for one page, snap-out leases has resulted in some provisions being excised or reduced,” McGriff explains. “While enforceability of these documents held up reasonably well, there is no question that documents could be improved.”
The New Reality
Some generally accepted myths were shattered over the past few years, too. Relying on past performance as sole predictor of future performance is one guideline that fell by the wayside. “If the customer maintained a fixed-charge coverage of 1.75 to 1 for the past three fiscal years, we should not assume that there will be no problems servicing debt going forward,” says Sullivan.
The notion that a long-tenured company that survived prior economic downturns was likely to survive a future downturn rang false for McGriff. “Surviving a past downturn is a good sign, but it is far from a lock on a company’s ability to manage through a future downturn. We saw many long-established businesses closing their doors or filing bankruptcy, often without showing a pattern of delinquency. This downturn was unique in that it was led by a real estate bubble and accompanied by a credit crunch. That combination of factors painted a very different picture for many businesses.”
Collaboration between front and back ends of the business became paramount as lessors tried to bring in new business while balancing a seemingly new world of credit and risk. To avoid layoffs or make good use of existing personnel, manpower was reallocated. In some cases, the slow down in volume allowed credit officers to catch up in portfolios, analyzing different segments they might not normally have time for. At EverBank, credit people moved to collections and portfolio management. “Some have moved back, and I see obvious growth in them, with new insights,” says McGriff.
“We increased staff in areas such as collections and risk management” Namdar notes. “Based on additional staffing, we were able to increase proactive focus on our portfolio to be sure we served our clients in an effective manner.” At Fifth Third Commercial Leasing, documentation and operational staff, once dedicated solely to booking new business, were given checklists and processes for re-auditing booked transactions with deteriorating credit risk scores.
Other strategies included EverBank’s alignment of credit with collections and recovery, encouraging the groups to meet on a monthly basis to review individual delinquent and workout accounts. “When managing a diverse small-ticket portfolio, if you want to understand what is happening in the economy and how it is affecting small businesses, just ask a collector!” exclaims McGriff. “Our collectors were the best window into the economy we had, and their input was extremely valuable in ensuring that our credit approach was appropriate.”
Fifth Third created a portfolio review team consisting of leaders in credit, asset management, portfolio management and documentation. “They met as needed to discuss account management strategies and to hold folks to targeted action plans,” Sullivan explains. “They looked at how we would manage the risk as a back-end deal team while also assessing and refining their individual processes to ensure that we had access to staffing and resources.”
Knowing what your strengths are on the front end can help balance the risk management and profile on the back end. “In 2009 and 2010, we refocused our target markets,” says Namdar. “These target markets represent our new strategic focus.”
Managing the Human Factor
Given the uncertainty of the markets and organizational changes, in addition to daily news reports expressing dismay over the declining economy, it would not be a surprise to hear that employees were anxious or disheartened during the decline.
Sullivan strives to maintain a can-do attitude at Fifth Third. “As business leaders, we tried to create an environment that said, ‘We are talented, and it’s time to step up and make adjustments’ rather than ‘It’s time to panic.’ We benefited from the extra time that came from having fewer new business originations. This allowed us to take a deep breath, make adjustments and forge ahead.”
With the focus on portfolio and credit quality, important areas like employee development and training took a back seat in most companies. “We need to invest in these areas again, especially since we have new learnings to share,” says McGriff.
If good things come from bad, the career experience gained by credit analysts could be seen as a silver lining. Having gone through good times and bad, newly seasoned analysts are better prepared to think abstractly about the types of risk that can impact a company or industry. The days of “elevator analysis” — where analysts examine the metrics only in terms of their movement rather than in terms of what the changes mean — are gone. Today’s analysts now know they need to get in deeper to see what is behind the numbers.
“After experiencing a downturn or two, one cannot help but have a healthy respect for the unknown. For my grandparents’ generation, memories of the Great Depression influenced their thinking. I think the Great Recession will have a similar effect. Valuable lessons have been learned that will guide us in managing risk throughout our careers,” says McGriff.
The overarching principles of good credit management are often referred to as the Five Cs of Credit: Character, Capacity, Capital, Collateral and Conditions. Having survived the downturn with newfound knowledge, we asked our credit managers to prioritize the Cs.
“I’d rate them Capital, Capacity, Character, Collateral and Conditions,” answers Namdar. “If you assess the first three properly, you’ll have less need to rely on an exit strategy for the collateral. Collateral is critical, of course, but you would need to rely less on its strength. If capital and capacity are strong, they can mitigate negative conditions.”
“They all have to work together to get you to a better place,” Sullivan adds, “but I would rate Character first. For me, the integrity of the organizations and individuals with whom you work has the highest priority. The other four Cs, melded together, would form a close second.”
Character also stands out for McGriff. “For me, it’s the pass/fail gate to the other Cs. In the small-ticket market especially, you are doing business on an application-only basis, so character becomes important because you don’t have a lot of other information to rely on. But they are all important. It really depends on the type of business you are doing and market you are in.”
“Going forward, we must not take our eye off the ball in terms of the economic cycle,” concludes Sullivan. “The U.S. has encountered 32 cycles of expansion and contraction since the late 1800s. Contractions, on average have lasted 17 months, and expansions 38 months. Four of those cycles have occurred since 1981. In granting credit we must emphasize stress testing, sensitivity analysis of P&L statements, and use of projections and modeling. It is critical to understand macro-economic trends and where specific industries are positioned.
“I remember the days of going to the library to read value line reports and Moody’s or S&P’s industry studies,” he adds. “Now we have to do much, much more!”
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