Navigating a New Era in Commercial Lending

Raja Sengupta, Executive Vice President, Wolters Kluwer Lien Solutions

United States lenders are bracing for a wave of defaults by business borrowers. Many of these borrowers have been granted temporary reprieves via a combination of widespread deferrals on debt payments and various grants/loan support that were quickly implemented at the federal government level. Similar to past deep recessions, this wave has the potential to quickly wipe out a number of lenders from the scene as capital is eroded, originations dry up and liquidity becomes much tighter. FinTechs and other alternative lenders that emerged in recent years are the most vulnerable, especially those who targeted the marginal end of the credit spectrum. But despite the potential for loss, reacting with overly onerous customer actions could erode a lender’s brand, reputation and customer base over an even longer period.

While survival is paramount, setting the stage for long-term growth should also be top of mind for every lender. Those who successfully balance surviving the next 3-6 months with making the right longer-term decisions for their shareholders, employees and customers will be well-positioned to benefit from the subsequent recovery and growth phases, which could last several years. Balancing these objectives is difficult and this article will examine some of the risks and opportunities presented by COVID-19 when managing your existing loan books, new loan issuance and federal lending programs.

Managing Your Existing Loan Books

Step one for each of these objectives is to critically reassess your primary scoring engine. A challenge lenders face early in a downturn is that the default risk of all customers has suddenly changed from the period prior to the recession. Of course, the probability of default is almost always higher – but, it likely does not increase uniformly for all borrowers. That is, the discrimination power of your core risk model is about to deteriorate, as the economic stress will vary along some new dimensions. Your past data will lack relevance and will not be sufficient to re-tune the model.

For instance, prior to 2007, presence of a mortgage on a consumer credit report was a strong indicator of lower probability of default. However, in the peak of the Great Recession, that conventional wisdom did not hold, if that mortgage had been written in the 2-3 years prior or for a non-primary residence. A likely suspect for a sudden jump in default risk this time is the bar and restaurant segment. The industry has always had above average failure rates (source) but they are now being hit particularly hard by lockdown orders and tight capacity restrictions upon reopening. Lenders must assume that the default risk has spiked much more than their models (built in an extended benign period) indicate. In addition, movie theatres, gyms, sports/concert venues, and hair salons are also vulnerable to disproportionate financial stress from extended social-distancing constraints – whether government-imposed or from organic consumer caution.

This potential change in risk-ranking must be acknowledged and incorporated by lenders as they execute on their new plans – starting with triage of their existing book of business.  

The sudden scale of the financial stress from the combination of the pandemic and the lockdown orders presents a nearly unprecedented challenge to lenders trying to manage their existing customer base. Many lenders followed the government and industry lead and granted quickly-executed deferrals or accepted partial payments over the past 2-3 months in hopes that this virus and economic contraction could quickly pass. It is now clear that the financial stress will persist for longer – especially for specific industries and geographies. All indications now are that the number of businesses and borrowers facing an extended period with substantially lower revenue and income is exponentially higher than the number who faced failure the past few years. According to the American Bankruptcy Institute, commercial bankruptcy filings in the US jumped by 48% in May as compared to May 2019 and 28% as compared to April. [1] Looking ahead, S&P Global Ratings is forecasting that the U.S. trailing 12-month speculative-grade corporate default rate will reach 12.5% by March 2021. [2] Internal collection teams and the outside agencies that service lenders distressed debt are about to be overwhelmed, as the deferrals stop and the temporary government support dries up.

The opportunity is to decide who to work first and how to work them. One of the best things a lender can do to strengthen their book is to use a deferral extension to renegotiate terms on an existing loan – for instance, add cross-default language across subsidiaries, secure the loan with additional collateral, improve lien position on any collateral, add personal guarantees, ensure signatories/legal names/DBAs are all properly documented, etc. Borrowers can, for instance, pledge real estate or equipment in order to secure a lower interest rate. These efforts are especially important for a business with short-term reduced revenues, but still reasonable prospects of return to near normal in the next few months. A workout for these businesses could mean the difference between another default on the books and a long-term borrower. One important caveat is to ensure any increase in required payments is in line with the borrower’s revenue stream. In this case, prematurely attempting to terminate a deferral can be as damaging as waiting too long.

At the other end are businesses with poor prospects over an extended period. Unfortunately, the best bet here may likely be to route for early legal action. In other words, seize collateral before the value drops further, cement your position as a creditor. Early review of loans is key to implementing these decisions, as a failure to perfect a security interest may necessitate alternative solutions. Pursuing legal action without a perfected lien may ultimately result in lengthy court proceedings that end without the claim being granted.For example, in 2006, in Tyringham Holdings Inc. v. Suna Bros. Inc., the court found that, due to a missing corporate ending on a filing, the creditor was unable to collect upon $310,000 of assets post-default. This is especially important for secured lenders where the validity of valuation assumptions over time is in question, as the pandemic may have long-lasting repercussions on certain asset types.

Collections should be the last resort option, but court closures may delay the process. As of July 21, 2020, 34 states had suspended in-person proceedings statewide and 16 states had suspended in-person proceedings at the local level. Lenders seizing collateral must also be aware of the various state guidelines that temporarily halt actions such as foreclosure, evictions and utility shutoffs to prevent themselves from unnecessary legal actions.

Regardless of the route taken, working with the borrowers is a critical opportunity to reduce risk on existing loans by way of increasing underlying collateral and also to strengthen customer relationships. Customers remember businesses that helped them in times of need.

Issuing New Loans

While growing ever more sophisticated and complex, credit risk models are built upon a set of assumptions and boundaries. While models may be able to tackle a wide variety of situations, there will be scenarios that models cannot accommodate, whether it be due to issues with data or with assumptions.

Usually, credit risk models use historical data and do not have access to the higher frequency data necessary to recalibrate. While the models could, theoretically, access alternative data to cope with the situation, reorienting them requires flexible infrastructure and systems. However, looking to the future, alternative data could prove to be critical. Current models, for instance, generally do not account for whether a restaurant has access to outdoor seating, which may make or break a borrower.

While quick action is key, any updates or changes to existing models and implementation of new models should be done prudently, as stricter deadlines typically lead to a higher risk of failure. The payoff from getting these forward-looking adjustments has the potential to be large, as many other lenders are already pulling back on originations in most loan types so there is a more wide-open field for an aggressive – and sure-footed – lender.

Federal Lending Programs

Fortunately, for that aggressive and sure-footed lender, there is a safety net. The U.S. government has allocated significant funding to three lending programs designed to mitigate the economic impact of the pandemic and shutdown. These programs – Paycheck Protection Program (PPP), Main Street Lending Program and Economic Injury Disaster Assistance Loans (EIDL) – each have their own nuances and the benefits and drawbacks of participation should be considered. An important consideration is whether borrowers taking on these new credit facilities will trigger contractual defaults or otherwise cause issues down the line The borrower could potentially default due to loan covenants regarding how much debt they can take on, for example.

For lenders who participate, the opportunities are enormous. Loans issued under PPP are 100% guaranteed by the SBA, while those issued under Main Street will have 95% purchased by the Fed, leaving only 5% exposure. Compensation for lenders under PPP is based upon the size of the loan originated – the SBA will compensate lenders 5% of the loan amount disbursed for loans up to $350,000, 3% for loans between $350,001 and $1,999,999, and 1% for loans greater than $2,000,000. Compensation for lenders under Main Street lending program is a combination of origination fees and servicing fees – between 75-100 bps of the principal amount of the loan as an origination fee and a servicing fee of 25 bps of the principal amount of the Federal Reserve’s participation in the loan as well as net interest revenue.

So long as strict compliance with federal guidelines is achieved, loans made under these programs could potentially be leveraged to expand a lender’s customer base. Low exposure means that, for the moment, loans could potentially be given to borrowers who may not have been considered due to the ongoing situation but would have been an approved applicant otherwise, it could also mean ensuring existing borrowers can stay afloat long enough for revenues to return. Further, this may be used to aggregate data, develop new models and explore strategies that may have been unattractive prior to the pandemic.

Distressed opportunities are also aplenty, offering a short window within which lenders may pursue competitors with attractive customer bases or companies that could bring underdeveloped capabilities to the forefront of the lending space. Of course, low risk does not mean no risk. It is a given that losses will occur for every lender. However, the potential long-term brand, customer relationship and government relationship impact of taking on “borderline” loans that may not have been funded under current circumstances may well outweigh the risks and contribute to the health of the borrower base and the economy as a whole.

Ultimately, the COVID-19 pandemic is an opportunity for lenders to differentiate themselves from the pack. The health of the borrower base, critical flaws in existing infrastructure and the ability to maintain compliance have been exposed, yet with careful planning, weaknesses can be shored up and the stage can be set for long term growth with access to guaranteed loans and potentially weaker competition. Careful balancing of short-term survival and a long-term outlook could prove to be a windfall in the years ahead.

About Wolters Kluwer Lien Solutions

Wolters Kluwer Lien Solutions, part of Wolters Kluwer’s Governance, Risk & Compliance (GRC) division, is the leading technology and service provider of comprehensive lien management, debtor due diligence, monitoring and risk management solutions to financial professionals. The award-winning iLien suite of products addresses solutions for asset-backed loans, property and vehicle title processing and management to help simplify complexity in lien lifecycle management, resulting in more confident lending decisions. In July 2020 the company launched iLien for Main Street, a technology solution devoted to helping U.S. lenders optimise their due diligence and lien management efforts when securing loans for small and medium-sized businesses under the Main Street Lending Program.

[1] https://www.reuters.com/article/us-health-coronavirus-bankruptcy/u-s-chapter-11-bankruptcy-filings-surge-in-may-idUSKBN23B2K3

[2] https://www.wsj.com/articles/wave-of-corporate-failures-stays-at-bayfor-now-11593509402