Tough Financial Terms Getting Personal
Many elected officials subscribe to the credo that no good crisis should go to waste, and they wasted little time enacting landmark financial reform earlier this year. The Dodd-Frank legislation will impact many areas of bank lending and credit card use, but as regulators busy themselves with writing the rules, bankers aren't yet sure what to make of it.
The credit market remains in a state of flux as community banks report ample money to lend, but with more stringent terms than existed before the national's financial collapse. Only the worthiest of deals are getting done, and borrowers not only must have more skin in the game, they have to demonstrate sufficient cash flow to pay back loans and, in an increasing number of cases, they are required to provide a personal guarantee.
Banks have been directed by federal bank examiners to reduce their concentrations of loans in various capital piles, commercial real estate among them, so their underwriting standards are more buttoned down and they are more selective in lending. Conversely, the appetite for bank lending has ebbed, as some small business owners consider alternatives like borrowing off their 401(k)s.
Due to these concentration issues, community banks are more interested in strong commercial-industrial types of loans, which are typical working capital lines of credit, according to Brian Fisher, senior vice president and chief lending officer of WPS Community Bank. "Overall, many banks are looking for commercial-industrial types of loans, and many businesses have been waiting on the sidelines to see improvement in the economy," Fisher said. "Both borrowers and banks are being more cautious."
Paul Hoffmann, president and CEO of Monona State Bank, said most banks are still willing to lend when they can find good projects, but customers are holding off on expansions and other capital expenditures due to economic uncertainty. "I think we're all looking a little tighter at things because of that uncertainty," Hoffmann said. "When there is uncertainty, things just tighten up because you don't know what's coming."
While every deal is different, the terms for commercial real estate loans involving new multi-tenant construction almost ensure such deals cannot get done in an environment with high office vacancy. Whereas lenders once expected a 20% down payment, they now demand 25% or 30%. They once were satisfied if 40% of the space was pre-leased, but they now expect 75% to 80% or more. They once loaned money to projects with a loan-to-value ratio of 80% to 85%, but they now expect 70% to 75% loan-to-value. Loan-to-value is the ratio between the outstanding loan balance and the market value of a property, which is typically determined by an appraisal.
"I think office space in particular is one of those weaker asset classes along with retail space," said John Hecht, president and CEO of WPS Community Bank. "Those two have not fared very well with the high levels of vacancy in the current market, and so any bank willing to look at a retail or office project is going to insist upon a minimum of probably 75-80% pre-leasing before they would make a financing commitment."
With federal bank examiners telling commercial banks to reduce their concentrations in commercial real estate, there was concern that expiring loans for multi-tenant commercial structures would not be renewed, further damaging the market. Jim Hartlieb, senior vice president of First Business Bank, said banks took a different tone in a commercial real estate market that is "kind of bumping along the bottom right now."
"I think it's going through a cycle where that was the tone a year ago, and then bankers tried to execute on that and realized that, 'If I don't renew this loan, there isn't another bank that is going to come in and take me out, so I have to be prepared to liquidate the collateral,'" he explained. "This is the worst market, collateral market value-wise, that we've seen in decades, so what is happening now is banks are coming full circle back to saying, 'We've got to do everything we can to keep this alive.'"
"Every bank is dealing with its own issues because nobody wants to take them out," he continued. "You don't want to liquidate because you will need to take a huge charge-off on that loan, and so now you're just kind of pulling any string you can to keep the loan alive, keep the borrower alive while the market hopefully comes back. Some of those [loans] are working, some of them aren't. The longer it goes, the better the chance you have."
Even for non real estate loans, however, the borrowing terms are more demanding. More skin (cash) in the game, alternative collateral requirements, tighter loan covenants, including net worth covenants and liquidity requirements on small business balance sheets, and cash flow covenants all serve to help banks monitor the performance of the borrower and evaluate their ability to service the debt.
This increased level of documentation into company operations is probably here to stay. "I would say one of the things that has changed recently, and I doubt that it's a trend that will be reversing soon, is that the level of documentation that lenders are requesting, and in many cases requiring, is more expensive than what many borrowers who have had long-term relationships are used to," acknowledged Jim Bradley, president of Home Savings Bank. "I think that's been a real challenge for successful businesses that have a long-term relationship with their banks."
More lenders also demand personal guarantees from business owners who are negotiating or renewing bank debt or lines of credit. Attorneys Gregory Monday and Timothy Crisp, both of Foley & Lardner, caution against accepting the lender's standard provisions because it could include unfavorable features. Before providing a personal guarantee, they recommend negotiating with the lender to ensure the guarantee is only as broad as it needs to be and will not undermine the business upon your death or exit from the company.
In addition, they say business owners should execute a detailed indemnification agreement with the company and the other guarantors to recover any losses incurred under the guarantee and ensure their personal financial and estate plans account for the guarantee and provide adequate personal and family protection if the loan goes into default.
Each feature of a standard personal guarantee can be modified and should be negotiated and tailored to specific circumstances. Among the modifications the lender should seek are a collection or "last-out" guarantee, where the lender must exhaust its remedies against the company or its assets before pursing payment from the guarantor, and limit the guarantee to specific obligations so that it only covers specifically identified loans or credit lines, and not other obligations incurred with the lender.
Monday and Crisp have several more negotiating points for both the personal guarantee and the indemnification agreement, but the key is to have some kind of exit strategy from the personal guarantee, especially when there are other owners of the business involved. "Anticipate that you're going to, at some point, retire, sell the business, or die," Monday counseled. "That personal guarantee does not terminate upon one of those events unless you negotiate that with the lender, which is often difficult. Therefore, you may need to instead negotiate with the other business owners, with the business itself, or have other arrangements in place that are consistent with an exit strategy."
Crisp said a guarantor should come in expecting the bank to either ask, or press very hard, for a guarantee. "The days are several years gone by when banks would routinely do deals, or consider deals, without a personal guarantee," he said.
The business impacts of Dodd-Frank will become clearer with the passage of time, but one section that bears watching contains restrictions on interchange fees that larger banks can charge for processing debit or credit card transactions. Attorney Amy Salberg, a shareholder with Whyte Hirschboeck Dudek, said the fees will have to be reasonable, meaning they must reflect the costs of providing the service. The Federal Reserve has been charged with reviewing those fees for reasonableness, a process that will take several months.
In addition, she said large credit card issuers, those with assets in excess of $10 billion, can no longer prohibit merchants from setting minimum dollar value requirements for card purchases, or from giving an incentive for the use of cash over the use of credit.
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