Financing the Winning Bid Can Be a Losing Deal

When a good customer lacks the right experience, he may not be able to meet his expectations or those of the bank. By knowing his customer, one banker knew to reject a loan request. His competitor approved the loan and was later forced to take a whopping charge-off.

A commercial tile subcontractor approached my bank for a $12 million loan. The tile company had successfully bid $15 million to install tile in a traffic tunnel that was soon to be constructed. The loan amount represented 80% of the subcontractor's billings on this short-term contract. The subcontractor expected to make an 8% profit.

Although the company was a regular customer of the bank, I was wary. In reviewing the request, I was concerned that this job was four times bigger than any job the contractor had ever done. Contrary to my instincts, his anticipated profit margin was higher than any of his other work. The tile company normally generated an operating profit margin of 6%. This concerned me as contractor margins typically decline as the size of the project increases. Thus, I declined the loan request and the tile company sought financing elsewhere.

As circumstances would have it, we also did business with the general contractor for the entire project. I asked the general contractor about the subcontract bids he had received for the tile work, and learned that there were 12 bidders; all in the $18 million range except my previous customer who had come in at only $15 million. As the low bidder, he got the job. Right away I felt vindicated in my decision. The tile subcontractor was Johnny-Out-of Step compared to the others, and I believed he made a mistake somewhere.

Many months went by before they started work and began gluing the tiles to the sides and ceiling of the tunnel. About one-third of the way through the project, the tile company realized they were using the wrong glue. They had to stop work and rip out all of the tile they had installed. In addition they needed to purchase the correct glue and more tile, and then redo the entire job.

The account officer from our competing bank continued to believe the loan was safe. As a result of the error with the glue, the tile company told their loan officer that they expected to break even on the job--despite the fact that they were more than a month behind in completing the work.

When the tile company completed the job, it invoiced the general contractor for $15 million. The general contractor thanked the tile company, but told them there would be no payment against the invoice because the delays in the tile subcontractor's work increased the costs to complete the entire job. As a result of the delays caused by the tile subcontractor, the general contractor had to rewrite other subcontractor contracts and lost timely completion bonuses. In all, the general contractor listed over $20 million in costs and damages that were accrued as the direct result of the untimely performance of the tile company. These expenses and lost revenue more than offset the $15 million that the tile company sought for its work.

The nonpayment forced the tile company into bankruptcy. It then sued the general contractor with the concurrence of the bankruptcy court for payment against the tile work completed. The litigation carried on for many months, but the general contractor prevailed and was not obligated to remit anything to the tile company. The bank of account supported the tile company in appealing the initial decision, but lost the appeal as well.

Lessons Learned

You really need to know your customer. Watch out when a customer takes on projects larger than it has handled before, especially if the owners or managers think they're going to be generating margins higher than they normally generate. The original plan of the tile subcontractor was too good to be true. Instead of being the best job they ever had, it turned out to be a disaster. And for the bank, that meant a charge-off of $12 million.

COPYRIGHT 2001 The Risk Management Association
COPYRIGHT 2005 Gale Group