IN TODAY’S POST-COVIDeconomic world, bankers have the unenviable task of trying to grow and maintain their book of business in a highly volatile and uncertain environment. Bankers are bombarded by contradictory data such as low unemployment and high inflation, or high reported revenue growth offset by compressing margins and supply chain issues, all of which are compounded by the ongoing pandemic, recession fears, and geopolitical risks. In this era of increased uncertainty and volatility, bankers and credit officers must remain vigilant to maintain the credit quality of their portfolio.
Of course, not all borrowers are forthcoming in sharing bad news with their banker due to fear, ignorance, or arrogance, leaving lenders to determine the true nature of the loan through their own powers of observation. Fortunately, bankers don’t need to look into the future a la Nostradamus to mitigate loan distress and default risk. By being aware of early warning signs, they can get ahead of loan performance problems by recognizing deviations in a borrower’s behavioral patterns or business operations.
The Three Types of Early Warning Signs
Early warning signs can generally be categorized into three main types—contractual, financial, and relational—with nuances associated with the different types of changes in behavior and operations. Regardless of the type of early warning sign(s), once the banker takes notice, it is imperative to elevate the situation, document the issue, and implement an action plan. Additionally, the banker needs to address the situation professionally with the borrower, which will allow the borrower the opportunity to explain and provide more information or proffer potential resolutions. However, sometimes the conversation (or lack thereof) is confirmation that the loan is distressed and needs to be managed by the workout department.
Contractual Early Warning Signs
The most obvious early warning sign of a distressed borrower is a contractual breach of the loan documents, typically represented by late or missed loan payments; consistent overdrafts; and failure to pay taxes, insurance, or maintenance expenses on collateral. These items are mandatory obligations of the borrower, and only a desperate or struggling one would dare to violate them given the serious repercussions that could be incurred. Failing to make loan payments or pay mandatory taxes and insurance premiums is symptomatic of a borrower experiencing severe cash flow or liquidity issues. These contractual costs should be some of the highest priority spending, given that default could put the enterprise and property at risk. Most jurisdictions would consider missed loan payments a sufficient basis to start foreclosure proceedings, while missed tax payments can prompt a super priority lien ahead of a bank mortgage. Inability to pay insurance premiums also puts the property at risk in the event of a claim. If a borrower has missed these crucial payments, it is critical that the bank follow through to determine the root cause. If necessary, the bank may need to pay the taxes via protective advance or force place insurance to protect the collateral.
Likewise, consistent overdrafts from a customer’s checking account are indicative of a borrower experiencing cash flow issues and not managing its cash needs. Bankers should be very cautious about approving overdrafts, as they are tantamount to a short-term, unsecured loan to the borrower (especially since most overdrafts cannot accrue interest or earn enough fees to justify the true risk). Even if the overdrafts are rejected by the bank (negating the risk of holding the “unsecured loan”), consistent overdrafts can put other obligations at risk if the borrower suffers reputational and transactional impacts regarding its suppliers or work force that imperil the firm’s general operations.
Finally, a company’s failure to spend on necessary maintenance such as upkeep of real estate, periodic equipment servicing, or even funding required replacement reserve accounts are also red flags. Most loan documents require the borrower to maintain the collateral in good condition and not allow its “waste.” However, monitoring collateral preservation is not easy and requires an especially vigilant or inquisitive banker. The best proxy to determine if the customer is maintaining collateral is to conduct old-fashioned property inspections. These will detect any apparent deferred maintenance, or if the property looks “old and tired.” Additionally, the bank may request equipment- servicing invoices of collateral to verify if the customer is conducting routine maintenance. Finally, a common form of monitoring is comparing maintenance expenses year over year as reported in the financial statements. A large decrease in that spending category should warrant a question—one that hopefully sheds light on a reasonable business justification that is not indicative of a potential operating problem.
Financial Early Warning Signs
The second category of early warning signs relates to the financial information and comparative analysis conducted by banks when they receive financial reporting from the borrower. When underwriting and structuring a loan, banks include financial reporting requirements and covenants specifically to monitor and assess the risk of the asset during the life of the loan. During the bank’s periodic review process of the company, the analysis derived from the financial statements includes a wealth of information that indicates the health of the company. Similar to other early warning signs, negative reports or information contained in the financials need to be explored with the borrower and documented in the bank’s system for review and consideration. The most basic early warning sign that can be gleaned from the financial statements is a report of declining trends or deteriorating operational performance. For instance, a banker noticing that revenue or EBITDA decreased year over year would obviously ask the borrower about what was driving the change and how the situation will be remedied. In today’s environment, bankers may notice compressing margins due to supply chain issues or increased costs due to high inflation. While these issues are being experienced by many companies across numerous industries, it is imperative that the bank understands the borrower’s plan to adjust to the rapidly changing conditions, assesses feasibility, and determines if the plan impairs or improves the bank’s loan position.
On the balance sheet side, early warning signs manifest in the form of rapidly declining liquidity, stretch and expansion of trade credit, and current asset/liability growth—in other words, extension of the cash conversion cycle beyond historical norms for the company or industry. First and foremost, a rapid depletion of a firm’s liquidity is obviously a cause for concern and should be discussed immediately with the customer (even if there is not a liquidity covenant in the loan documents). The borrower may be drawing down cash to cover losses from deteriorating operations or to fund an unforeseen expense, capital improvement, or unannounced expansion or asset purchase. In any event, the customer will need to explain how it will replenish liquidity to adequate levels. The situation may warrant the development of a cash budget showing cash burn.
Additionally, a large, unexpected increase in accounts payable warrants discussion with the borrower. It could indicate cash flow issues and a reliance on stretching trade to fund the shortfalls. Accounts payable as a liability is a type of leverage that the borrower should treat carefully. Failure to adhere to the terms or repay promptly may result in suppliers cutting off the company or requiring cash on delivery. These actions, in turn, may trigger the customer to scramble to source other, more expensive or lower-quality suppliers, or resort to more expensive means of financing for payables.
REGARDLESS OF THE TYPE OF EARLY WARNING SIGN(S), ONCE THE BANKER TAKES NOTICE, IT IS IMPERATIVE TO ELEVATE THE SITUATION, DOCUMENT THE ISSUE, AND IMPLEMENT AN ACTION PLAN.
Finally, current asset and liability growth as represented by an extension of a company’s cash conversion cycle may indicate operating problems within the company and demand more pressure on the company’s capital base. Slower account receivable collections, longer inventory hold periods, and/or the aforementioned stretch of trade may lengthen the company’s cash conversion cycle. Each component should be analyzed in the context of the company’s historical norms as well as that of industry peers. Significant variations should be explored with the firm to determine if it is a short-term issue or a longer-term problem. For example, slower accounts receivable turns may be due to recessionary pressures felt by the company’s customers or a change in the accounting department that is making the company less efficient in its collections. Likewise, longer inventory hold periods may imply the company’s products are obsolete or no longer in demand, requiring it to lower prices to move inventory—which could impact cash flow and profitability. In any event, significant deviations or outliers need to be explored with the company. Its management should have a plan to resolve and eliminate the inefficacies over the long term.
The last subcategory of financial early warning signs includes the most severe: financial covenant violations, over-advances on the borrowing base, and stale/fully drawn revolving lines. While it is true that a financial covenant violation or over-advance on a borrowing base are both already technical defaults, they are also the strongest indicators of a company’s distress absent a hard-money payment default. A financial covenant violation represents a serious adverse change in the borrower’s financial capacity from the initial underwriting of the loan and needs to be addressed immediately by the bank and the customer. Banks get themselves into trouble when servicing loans if they uncover a financial covenant default, but then take no action or continually waive the violation if it occurs over several testing periods. Habitually waiving the default or ignoring the violation entirely can put the bank in jeopardy by establishing a “course of dealing” issue with the borrower; in short, the bank’s actions may speak louder than the words of its loan documents. A borrower may claim a “course of dealing” defense when the bank seeks to enforce the default at a later date, as the borrower has relied on the bank’s lackadaisical enforcement of that condition previously. The best way to deal with a financial covenant default is to work with the borrower and bank management to determine if the loan terms and covenant should be revised based on the borrower’s current reported financial condition. To cure the default, both parties need to return to the table and negotiate an appropriate alternative, as the initial covenant was bargained when the loan was structured and priced, and should be re-examined given the changed risk profile. If the bank determines that the default is an isolated occurrence and, for relationship preservation reasons, determines not to enforce it, the bank should nevertheless issue a “Reservation of Rights” letter, acknowledging the default and preserving its rights to enforce in the future.
Over-advances on borrowing base components and failure of an unmonitored line of credit to properly revolve are both examples of a line of credit not being used appropriately. The former indicates that a bank is undercollateralized with its outstanding loan. The latter represents the outstanding loan’s conversion from operating to permanent working capital (which is repaid from profits—not conversion of current assets to cash). In either event, the bank needs to engage the borrower to fix the credit facility, especially in the case of an over-advanced borrowing base where the bank must get the borrower to remedy the collateral gap immediately either by re-margining the loan or by obtaining additional collateral.
Relational Early Warning Signs
Relational early warning signs can be detected in how a borrower interacts with the bank or a negative shift of the relationship profile. They include of lack of communication, failure of the borrower to meet deliverable deadlines, notice of liens or lawsuits involving the borrower, and what can be represented as the “Five D’s” of distress: death, disability, drugs, divorce, and disagreements.
A change in the communication pattern with a customer is a common relational early warning sign because it is human nature to avoid difficult conversations or delay the disclosure of information that may result in adverse actions against the business. However, this early warning sign should be taken with a grain of salt, as there could be a variety of reasons why the level of communication has changed. A more serious relational red flag is when a borrower begins to miss informational deadlines, especially when required under the loan documents. Failure to provide financials when due or various certifications should be treated seriously. They are technical defaults and, if necessary, appropriate violation letters should be sent to put the borrower on notice as soon as possible. While there may be perfectly reasonable explanations for the tardiness of the documents, the failure at best represents some level of disorganization by the borrower. At worst, it represents obfuscation and potential fraud on the part of the borrower by withholding critical information from the bank.
Another relational early warning sign is when the borrower becomes embroiled in legal matters, such as having liens filed against collateral, or is being sued for a material reason that is not readily covered by insurance (such as a slip and fall or car accident). The former can be indicative of cash flow issues or inability to resolve debt, which affects the bank’s collateral, while the latter represents a serious situation for the borrower that could drain its time, resources, and focus—and ultimately result in a large judgment liability. When informed of a lien, the bank should obtain a title update on its collateral to verify the scope of the problem and work with the borrower to determine how it plans to clear the title. If the lienor is about to take adverse action or the borrower cannot resolve, the bank should send the asset to the workout department for resolution. If the bank is made aware that the borrower is named in significant litigation, the bank should obtain as much detail as possible about the nature of the suit. In the event the litigation is an existential threat to the company—for example, a substantial monetary judgment or the loss of key intellectual property are possible—the bank should elevate to the internal legal and credit teams to determine if the company has a going concern problem. Less-threatening litigation should be analyzed in the context of the litigation’s potential drain on the resources and focus of the firm and its owners, and if they are willing and able to fund any judgment or settlements.
That leaves the final relational early warning signs to be discussed: the Five D’s of distress. Death, disability, drugs, divorce, and disagreements are highly impactful and damaging changes to the people who are critical in a borrower’s operations. If these extremely stressful events are observed in a borrower’s key personnel, the matter should be escalated to bank management—and the potential impact on loan repayment should be quantified. A quick summary of the potential impacts of each of the Five D’s follows:
“The Five D’s of Distress Death, disability, drugs, divorce, and disagreements are highly impactful and damaging changes to the people who are critical in a borrower’s operations. If these extremely stressful events are observed in a borrower’s key personnel, the matter should be escalated to bank management.”
Conclusion
Bankers are constantly inundated with information and are often challenged to make the best decisions in a dynamic, competitive, and disruptive environment. Knowing the customer and being perceptive to changes and deviations from the norm are critical in identifying and acting on early warning signs. As Ben Franklin stated, “An ounce of prevention is worth a pound of cure.” Being inquisitive and proactive when alerted to these red flags can limit the damage and loss incurred by the bank through early treatment of the potential problem. Conversely, ignoring or dismissing early warning signs can allow the problems experienced by the borrower to fester, limiting the bank’s ability to help borrowers resolve the issues. Even if the message and the medicine are not what the customer wants to receive, it is always best for the bank to address problems timely to avoid potential credit impairment.
JASON ALPERT, CRC, is Senior Vice President at a commercial bank with over 17 years experience and is a member of the Editorial Advisory Board of the RMA Journal. The views expressed are the author’s alone and do not necessarily reflect the views of any other entity or organization. He is an adjunct professor at the University of Tampa and is active with several non-profits. He can be reached atjason.p.alpert@gmail.com.
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