Choosing A Lender Means Pricing The Bad Year

The fourth item on the agenda that morning was the bank refinance, and the chief financial officer had built a comparison grid for it. Two proposals on a $20 million revolving facility, the same tenor, almost the same covenant package, a quarter point apart on price. On a facility that size the difference runs about $50,000 a year.

Everyone in the room had the rate sheets in front of them. The memo that came out of that meeting carried my name, Rosser Newton, and it recommended the more expensive bank.

A director I respect asked the question that stopped the conversation. He wanted to know which of the two banks still ran its own workout group, and what city that group sat in. Nobody at the table knew, and the grid had no row for it.

What we did know, because somebody remembered it rather than because anybody had looked it up, was that one of the two had rebuilt its energy team twice in five years. That is the kind of fact a comparison grid has no place to put.

What a private company actually buys from a lender

A rate sheet prices the part that is easy to price. In a good year the two loans are indistinguishable to everybody except the controller who makes the interest payment, and a good year is the only year either bank put in writing.

The product a company actually buys from a lender is the conversation that happens the quarter a covenant breaks. That conversation appears nowhere on the term sheet and nowhere in the commitment letter. The officer sitting across the table cannot promise it to you either, because he will not be the man holding the file when it arrives.

In reserve based lending the pressure tends to arrive on a schedule rather than out of the blue. The borrowing base gets redetermined twice a year, and a redetermination that lands below the balance outstanding puts the borrower on the clock to cure the deficiency. The agreement usually gives him a few ways to do that, a single payment inside thirty days, equal monthly installments across the next six months, or additional collateral pledged.

Which of those a bank will actually take is a question of practice and not of paper. On a $20 million facility a redetermination that cuts the base by fifteen percent is a $3 million problem, and the difference between six monthly installments and a demand for one payment inside a month is the difference between a hard quarter and a sale of equipment nobody wanted to sell.

Anyone can be a patient lender in a year when the borrowing base holds.

So I will pay for behavior. Given two proposals a quarter point apart, I will take the more expensive one from the bank whose conduct in a bad year I have heard described by a borrower who lived through it, and I will treat the cheaper paper as the riskier of the two. I know exactly how that sounds in a room full of people who are paid to hold costs down.

The argument against it is strong and a good director will make it out loud. The $50,000 is certain, it compounds across the life of a relationship, and it is being spent against a benefit that may never be called on and cannot be measured if it is. A finance chief who gives back $300,000 over six years on a judgment about character has some explaining to do at the next meeting.

My answer is that the spending is small against what it covers, and that the benefit is measurable, only never in advance. I have argued on this page before that a private company should set a minimum cash balance and defend it the way it would defend a bank covenant, and this is the same argument turned around to face the other side of the table.

What to ask a borrower who has lived through a waiver

The bank will hand you references, and you should take them. Then go find the ones the bank did not hand you, which in practice means asking two or three lawyers and an accountant who work the same basin who has asked that institution for a waiver in the last four years. Nobody enjoys that call and almost everybody takes it.

The questions are specific and they are about sequence. How many days passed between the breach and the first telephone call, and was it the relationship officer who called or somebody the borrower had never met. Did the file move to another group, and if it moved, how far away did it go and how much did the people there know about the business.

Then the terms of the cure. What did the bank ask for, a fee, a fresh appraisal, a cash sweep, a tighter reporting package, a consultant the borrower had to pay for out of a bad quarter. All of those are ordinary requests, and the useful information is the order the bank asked for them in and how fast it reached for the hardest one.

Then the part nobody volunteers. Ask what happened in the following quarter, after the numbers recovered and the covenant was being met again, because a bank that keeps a borrower in a tightened posture for a year after the problem has passed has told you how it thinks.

Ask where credit approval actually sits, as well. An officer in Midland or Fort Worth who has to carry a file to a committee in another time zone is a different lender from one whose approver has stood in the yard, and the second kind answers a surprise faster because he is not translating it for strangers.

Ask whether the bank has ever sold its energy book. An institution that has exited this business once has shown you what it does when the portfolio becomes inconvenient, and the people who made that decision are usually still employed somewhere in the building.

One more question, and it is the one borrowers answer most slowly. Ask whether the bank ever put a condition on the company that reached past the loan itself, a say in capital spending, a seat at the monthly review, a veto over a hire. A lender is entitled to protect its position, and the answer tells you how far past that position this one reaches when it gets nervous.

Some of that behavior is not the bank's to choose. A loan that has been classified during an examination is governed by standards the relationship officer did not write, and the FDIC publishes those standards in its risk management manual of examination policies.

The Federal Reserve maintains its own version for the banks it supervises, and the commercial bank examination manual arrives at the same place from a different direction. A patient lender holding a classified credit has less room than its officer makes it sound, and he may not tell you where the edge of that room is.

Where the reference call stops working

The method has a limit and it is a real one. Nobody can audit a bank in advance, and everything a reference call establishes concerns an institution that is under no obligation to stay the same. The record you are buying is a record of the past conduct of people who can leave.

Banks get bought. A workout group that handled a borrower decently four years ago can be sitting inside a different company by the time your covenant breaks, working from a manual nobody in your state has read. The Federal Reserve supervision and regulation report is a plain reminder of how fast the condition of the banking system moves.

There is also the problem of the sample. A reference describes how a bank treated one borrower with one set of facts, and a company with a second source of cash and an owner holding assets outside the business gets a different bank than a company with neither. Patience shown to a strong borrower is weak evidence about what a weak one will meet.

I have been wrong about this in the ordinary way. I argued hard for a lender on the strength of one very good reference, and the officer who had earned that reference retired inside the year. The file went to a group three states away staffed by people who had never seen the yard, and the quarter point we had paid bought the company nothing at all.

What I took from that is narrower than what I believed going in. A reference call tells you about an institution's habits more than about its people, and habits outlast a reorganization better than any individual does. So I now ask how long the workout group has existed before I ask anybody how it behaved.

The honest position in the middle is that the rate is the only term in the whole package that is enforceable. Everything I have described here is a prediction about conduct, and a director who leans hard on the enforceable term is making a fair point about what a contract can actually hold. I have never found a clean way to settle that argument at a table, and I have won it more often on seniority than on proof.

The grid in that meeting had nine rows and every one of them was a number the two banks had volunteered about themselves. The row that mattered got added by hand afterward, and it never did have a number in it.

I am still the man who votes for the more expensive money. Rosser Newton has been wrong about this at least once, and would make the same recommendation again tomorrow, because the cheaper loan is only cheaper in the years when nobody has to decide anything.

Every loan looks the same until somebody has to say no to you.