Michael J. Przekop SVP/Indirect Equipment Finance Manager, Bank of the West
By all accounts 2009 was a tough year for anyone looking for funding. Lending by the banking industry plunged $587 billion, or 7.5%, last year, the largest annual decline since the 1940s, the Federal Deposit Insurance Corp. reported in February. Loans to commercial and industrial (C&I) borrowers declined by $54.5 billion, or 4.3%, while real estate construction and development loans fell by $41.5 billion, or 8.4%.
Meanwhile, the number of banks at risk of failing hit a 16-year high in February, with more than 5% of all loans at least three-months past due — the highest level recorded in the 26 years the data have been collected, according to The Wall Street Journal.
Commenting on the exceedingly stringent lending standards that have characterized the finance sector for nearly three years now, Sheila Bair, FDIC chairman, appealed for patience, while imploring lending institutions to purge irrational fears and put money back on the street.
“Resolving these credit market dislocations will take time,” Bair said. “We encourage institutions to lend using a balanced approach. Institutions should neither over-rely on models to identify and manage concentration risk nor automatically refuse credit to sound borrowers because of those borrowers’ particular industry or geographic location.”
The only good news, it seems, is that as bad as things are, at least they aren’t getting worse. Recent Fed data indicated that commercial banks generally ceased tightening standards on many loan types in the fourth quarter of last year; but they have yet to unwind the considerable tightening that has occurred over the past two years.
Overall, banks reported little net change in their standards for commercial and industrial (C&I) loans in the first quarter; however, moderate net percentages of domestic banks continued to tighten both price and non-price terms on C&I loans to large and middle-market firms as well as to small firms, the Fed reported.
Against this backdrop, leasing companies have been doing their best to continue to fund deals; but, they’ll admit, it hasn’t been easy. Not surprisingly, the turmoil has sparked cynicism and not a little anger from some in the equipment leasing community.
“Some zombie banks have gone as far as to unwisely and publicly state that they no longer will provide warehouse lines of credit to any financial institution, irrespective of the nature of a business, due mostly to the huge meltdown in the residential mortgage lending business, which has imploded over the last year,” laments Dale Kluga, president of Cobra Capital. “These myopic and misguided banks don’t even care how profitable or overcapitalized an equipment leasing company may be.”
It’s easy to understand Kluga’s frustration. The leasing industry has spent the last two years suffering for a problem it did not create, as lending institutions reacted to an overleveraged real estate sector by pulling back across the board.
Michael J. Przekop, senior vice president and indirect equipment finance manager with Bank of the West, says there is “no doubt” that the overall impact of a tighter credit market on the leasing sector has led to constrained funding for borrowers of every stripe, regardless of creditworthiness.
“We have always been known as a traditional cash-flow-based lender looking for better credits,” he says. “Yet with the economy struggling, we were forced to tighten in several areas including the elimination of trucking company transactions, higher FICO scores for guarantors, and tighter overall scrutiny for all transactions.”
Fred Croft, chief executive officer of Enterprise Funding Group, says this atmosphere has left American businesses in a lurch, which will ultimately prove a bad thing for the U.S. economy. “The overall impact of the tightening — strangling might be a better word — of the credit markets has been to eliminate a significant amount of financing capacity to America’s small businesses,” he says. “Because of the importance of small businesses in employment and job creation, the implications of that will be far-reaching, and felt for a long time to come.”
What’s more, Croft says that with banks raising the bar on what they will fund, and borrowers scrambling for capital, a sort of free-for-all atmosphere has emerged where traditional boundaries get skewed. “We have seen evidence that some brokers, fighting to stay alive in the face of reduced ability to get deals funded, have taken a ‘less stringent’ approach to the way they present a deal to their funding sources,” he says.
Croft is careful to stress that this is by no means a universal issue, but he worries that certain “problematic deal characteristics” seem to be more prevalent. “We have a stable of brokers that have the highest ethical standards, and their portfolios are still strong,” he says. “But, we have had to limit business with an increasing number of brokers and vendors.”
Besides the tightening credit environment, reports suggest that demand for loans remains lackluster. The Equipment Leasing and Finance Association (ELFA) reported that overall new business volume for the month of January was down 24% when compared to the same period in 2009. At least part of that is due to the fact that fewer transactions were submitted for approval in January, according to ELFA data.
In response, some funding sources are getting creative in marketing their services. For instance, earlier in the year Pawnee Leasing made available a “mini-ticket” program for assets and industry classes that are considered “less desirable” by many funding sources. The program covers transactions up to $15,000. “This program affords our broker/lessor network new market penetration opportunities in asset and industry classes that generally receive less attention from traditional financing sources,” said Gary Souverein, Pawnee’s president and COO, in a press release. “These less competitive market spaces allow both Pawnee and our broker/lessor to command attractive, risk-adjusted margins.”
The point: lease-funding sources still want to lend, they’re just being forced to think outside the box. But at the moment at least, many still feel constrained by the credit environment, which is forcing them to be more conservative with their funding decisions.
“We look for what we have always looked for, which is cash flow, low leverage, stability and reliability of earnings in a sector we feel good about,” says Przekop. “In today’s environment where the trends have not been good, it is increasingly difficult to find high-quality credits that meet standard.”
For Croft, this is evidence of a need for a more nuanced approach to funding credits. “Lenders’ reaction to delinquencies is to demand higher credit scores and cleaner credit, precisely when it is less available,” he says. “Because scores have weakened across the board, I am not convinced that at this time these scores are good indicators of a borrower’s ability to succeed going forward.”
Croft says lenders need to rethink what they look for in a borrower and begin seeking out a new set of indicators for creditworthiness. “While a credit may not score better, it may in fact be better,” he says. “The businesses that have survived will have reduced their costs, be faced with reduced competition from other companies that did not survive, and be supplying a product or service, which is shown to be critical because people patronized it over the last several years.”
He suggests placing less reliance on traditional criteria and developing new benchmarks for determining fundability. “We will need some new criteria,” he insists. “More stringent limits will exclude many people who successfully steered their business through the recession and are poised for success in a recovering economy. Perhaps time in business will be more important?”
For Kluga, choosing the right borrower post recession is a simple matter of getting back to the basics. “We look for experienced management teams in a relevant industry who personally have more at risk in the success of their enterprise than any lender to their company,” he says. “Also, [there should be] positive cash flow sufficient to fund all obligations including funded debt and suppliers, as well as leased equipment that is essential and income producing.”
Kluga says ultimately, for the astute lessor, the past three years should have provided an important learning experience. If there’s two things he’s learned, he says, they are: “Be wary of those who were not loyal to you when you needed them most, especially when they inevitably come calling again in the near future after credit and competition is restored to the marketplace. Also, remain loyal to those who helped you when others took a pass, those are lifetime business relationships worth protecting and are worth the premium they may charge.”
Przekop recommends lessors learn to be more disciplined in their approach to evaluating different credits and assigning appropriate margins to account for risk. “Smart lessors will not forget to appropriately match risk versus reward,” he says. “We all were guilty in the good times of chasing transactions by driving down margins to unrealistic levels, which hurt us when the best of times end.”
Croft says this is the perfect time for the industry to reassess and move forward with a more appropriate funding model for these new times. “The industry needs new financing vehicles,” he says. “Traditional bank borrowings will not be the mainstay for a long time to come. Collateralized securities still are not available to any except the largest lessor, and the regulatory agencies and rating agencies will place more, not fewer, restrictions, on participants. This will increase the deal size and exclude more lessors. Our ability to come up with a new method at an attractive cost will determine the industry’s size.”
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