Verifying Borrower Liquidity Helps Avoid Problem Loans

4/14/2011

The phrase “Cash is King” has never been more true than in today’s lending. One action often recommended in the marketplace is the verification of liquid assets for borrowers. This is particularly true if liquidity is the primary, or one of the primary, strengths of the credit. Liquidity is also a key component when a bank is looking for ways to upgrade problem loans.

There has been a significant shift in loan structuring for all types of loans, particularly as it relates to commercial real estate lending. This is specifically true in relation to the ability for properties to provide positive cash flow or to show evidence of the borrower’s ability to fund any potential cash flow shortfall.

As banks continue to regain their footing and reduce the high classified loan levels, one way of upgrading a loan is through guaranteed payments in a bank-controlled account with funds deposited from the borrower’s own resources. If a loan is re-structured at a market interest rate and terms (i.e. amortizing basis), but the borrower does not reflect the ability to make the payments, depositing funds into a bank-controlled account is a way to potentially eliminate any criticism or well defined weakness within the credit. These funds should be deposited into the bank-controlled account, with no less than six months of payments on deposit at a time.

Also, it is a good credit administration practice to obtain verification of liquid assets on an ongoing basis. The verification should be completed no less than annually, which would support the financial statement balances. Furthermore, we have seen banks require a minimum amount be maintained on a regular basis, which is to be supported with bank/brokerage statements. However, make sure to distinguish between true liquid assets such as cash in bank or marketable securities versus cash value of life insurance and/or retirement accounts. File documentation is important when it comes to supporting true liquid assets. Banks have provided information that shows more than $1 million in liquid assets reported on a personal financial statement. However, when asked for verification, the reality is 70% of those dollars are in some sort of retirement account (and only available with penalty), and another 10% is cash value of life insurance (with a loan against it), meaning only the remaining 20% is truly liquid. If the borrower reports over $10 million in loans, the ratio of liquidity to total loans drops significantly from 10% to 2%. It is important to know what the true financial picture of your borrowers is and have documentation to give credibility to their stated liquidity.

We make the recommendation on a regular basis for banks to provide documented support when it comes to their borrower’s cash on hand. It is much better to have this liquidity detail on the front end of a good loan, rather than attempting to provide evidence on the back end of a bad loan.