Collateral in the 21st Century: What Every Small Business Lender Needs to Know: This Article Shows How to Deal with Unusual Collateral Situations, Think outside the Box, and Ensure a Sound Credit Decision. to Help Lenders Avoid Taking Excessive Risks While Not Turning Away Good Loans, the Author Examines the Issues They Face and Offers Possible Resources

Article excerpt

I was caught off guard when my senior lending officer asked me to research mortgage servicing rights as potential collateral for a loan. I'd never dealt with this asset as collateral before. However, it was not the first time I was working with a company that was willing to offer collateral I didn't know anything about. As I soon learned, mortgage servicing rights have a rather liquid market, and I had a short list of companies able to trade them and even provide a valuation. In about an hour, I had all the information required to proceed. Ultimately, my bank opted to use the owner's ample equity in a personal residence instead, because the high cost of getting a valuation and collateralizing our loan with servicing rights was not in the best interest of our customer. What matters is that we were willing and able to accommodate an unusual loan request and give it fair consideration.

I'm sure that many of you have borrowers whose unusual collateral eclipses anything you had seen previously. As the business environment continues to evolve, this trend is only likely to increase. Cash flow certainly overshadows collateral at the time of loan approval, but collateral is arguably the second most important element, especially when viewed in a fallback scenario. In the present lending environment, competition leaves few available borrowers with strong cash flow, collateral, and other characteristics, and those customers are zealously guarded by their lenders. In fact, lenders at times defy prudent lending practices for those customers and set loan pricing and structure below sensible levels just to retain the relationship. Thus, collateral plays an even stronger role today.

The present-day average borrower is a business with tight or even marginal cash flow, and that's when collateral becomes an important element of sound loan structure. Throughout my career and from conversations with my peers, I observed that, unfortunately, more and more lenders are using the same approach to evaluate collateral from different borrowers: One hat fits all. As a result, loan approval becomes riskier for commercial lending institutions, and some creditworthy customers are turned down.

Here are the most common issues:

1. Collateral is not actually understood, and approved loans are in reality undercollateralized.

2. Advance or discount rates for collateral are applied at liberty and without proper justification to ensure loan approval.

3. Loans that can be made are being declined.

Is Lending Based on Cash Flow Alone?

Think about small, unsecured loans that are approved through scored underwriting methods. How about the ones that were approved despite substantial collateral shortfall? How about the ones for which collateral is unlikely to be available in a default scenario? Last but not least, how about the ones based mainly on the exceptional wealth of guarantors, many of whom tend to shift their wealth to their family members (in which case you are unlikely to reach those assets in a default situation)?

Cash-flow-only lending is more widespread than we think. Why? Take a look at the continuing shift from producing industries to service-oriented industries. Many manufacturing companies have disappeared due to lower-cost competition from overseas, and businesses in the U.S. have become service and retail oriented. For example, the number of all employees involved in manufacturing declined from 18.5 million in 1977 to 13.4 million in 2004. Employees in retail trade between 1992 and 1997 increased from 18.2 million to 21.2 million. (1) In addition, the number of employees in business services grew from 5.5 to 8.1 million during the 1992-97 period. (2) As a result, collateral choices also have changed.

Physical collateral (such as inventory and equipment) is becoming a thing of the past. An increasing number of loans are secured by collateral appearing only on a company's books, ranging from accounts receivable of varying quality to marketable papers (such as a liquor license or sellable service contracts that can be assigned value). …