Watch out for those collateral constraints

Lack of foresight and diligence concerning locating, laying legal claim to, taking possession of, and selling the collateral can result in a scenario similar to the spilled milk offered here.

Traditional underwriting dictates that loans be both safe and sound. A sound transaction is supported by cash flow that is reliable and sufficient to service the needs of the borrower. A safe transaction provides a second source of repayment--typically, collateral--for the loan.

In a softening economy, reduced cash flows create a decline in soundness, and defaults rise. Many of these credits require the expertise of workout or Special Credits officers to facilitate satisfactory repayment of the debt.

Upon transfer of the weak credits to special credit, it is not uncommon for the transferor to note the cash flow problems of the borrower but to take comfort in the fact that the loan is "well secured." This scenario is especially true in a weak economy.

In light of this increased dependence on collateral, it is important for all bankers to recognize the difficulty in getting full value from the collateral. The most visible shortfalls are seen in such public enterprises as Winstar Communications Inc., whose nearly $5 billion in assets recently liquidated for less than $40 million. Even more recently, Global Crossing Ltd. hopes to liquidate its assets for 10% of book value.

Results like these are not limited to large public companies; they occur in most forced liquidation situations. Thus, financial institutions avoid liquidating an obligor's assets unless the borrower is either dishonest or incompetent. In either of these instances, the institution's first loss is its least loss!

Historically, with the exception of asset-based lending, banks have not been strong in monitoring collateral. This lack of close attention contributes to a false sense of security, leading to the "well secured" perception upon transfer of an account to the collection professionals.

All secured creditors need to be aware of the collateral constraints. Knowledge of these constraints will enhance the decision making during the workout process as well as assist the bank in setting aside the proper level of reserves. As always, information is power--in this instance, the power to make the right decisions.

The primary collateral constraints are as follows:

* Locate the collateral.

* Lay legal claim to the collateral.

* Take possession of the collateral.

* Sell the collateral for value.

Although these constraints seem logical, they are often taken for granted and are not assumed to represent a large cost. It is on this last point that creditors need to focus most. Collateral constraints often lead to the dismal liquidation results referred to earlier.

Locating the collateral appears to be simple and straightforward. Yet, bankers must remember that troubled borrowers are prone to move often. As they move, so does the bank's collateral.

Although these moves by the borrower may be supported by the needs of the business to do such things as reduce costs (rent) or improve efficiency of production with better space, the borrowers are not always forthcoming about these changes. This information and its timely disclosure may be critical to maintaining the lender's perfected lien position. It certainly is essential if the hank seeks to repossess its collateral.

Bear in mind that as the credit situation deteriorates, the communication between the bank and the borrower often declines. This puts added pressure on the lender to stay abreast of the debtor's activity.

Perhaps the best way to illustrate this point is by example. Several years ago, my bank had a cement contractor, Belt Inc., who was experiencing difficulties. As conditions worsened for the contractor, he decided to go out of business, In the process he met with the Special Credits account officer, Sam Jones, and handed him the keys to the nine cement trucks, in which the bank had a security interest. Sam was not surprised that Belt Inc. decided to shut down, but was surprised that Mr. Belt handed over the keys to the collateral. The cement contractor was in terrible financial condition, with large and rising losses reducing equity and liquidity to below-minimum levels. Also not unexpectedly, Mr. Belt blamed everyone else, including the bank, for his business failure.

Prior to organizing the effort to repossess the cement trucks, Sam drove out to Belt's place of business. Much to his dismay, the facility was vacant. There were no trucks. There was nothing but open space.

Sam immediately tried to contact Mr. Belt, but without results. He returned to the bank office and reviewed the Belt Inc. file. The most current job status report was a couple of months old. Despite the age of the report, Sam decided to check out the job sites to see if the cement trucks were there. It took Sam two business days to go by all of the sites and confirm that the trucks were not there either.

After talking with management, Sam hired Travis Corp. to find and repossess the trucks. The nine trucks had a book value of more than $300,000--slightly less than what Belt owed the bank. All of Belt's other assets (receivables, inventory, and other equipment) had evaporated. Travis wanted a $10,000 minimum finder's fee or $3,000 per truck, whichever was greater. A month later, the bank had possession of the nine trucks at a cost of $27,000. Now it had to sell them in a commercially reasonable fashion.

A special auction was held to sell the trucks. Although there was some interest, the nine cement trucks were, at best, in fair condition. The auction yielded about $100,000 and the bank took a loss.

At the time Belt Inc. was transferred to Special Credits, the book value of the collateral, including the trucks, was 150% of the loan outstanding. The transfer sheet reflected the loan as well secured.

Fortunately, the bank was able to find its primary collateral asset, the trucks. Unfortunately, the demand for this equipment was not strong. In a weak market, assets sold under duress often produce low returns, as was the case here.

In liquidating assets, banks must look at the liquidation value of the asset when assessing loan to value positions. The proper way to examine value before considering the collateral constraints is:

* Forced liquidation value--what the bank can get.

* Orderly liquidation value--what the borrower can get.

* Cost or book value--what is reflected on the balance sheet.

* Market value--what a buyer would pay in good times.

* Enterprise value--what a going concern might fetch.

* Value in use--what the asset is worth to the borrower.

* Replacement value-what it will cost to replace.

A close look at these valuations reveals a pattern with the lowest value at the top of the list and the highest at the bottom. This observation, together with the cost associated with the collateral constraints, needs to be evaluated in determining if a loan is well secured.

Contact May by e-mail at jecdm@aol.com

May is retired from his position as executive vice president of Whitney National Bank and lives in University Park, Florida. He served as president of RMA (a title now known as chairman) from 1993 to 1994 and continues to serve as a member of the Editorial Advisory Board of The RMA Journal.

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