‘The difference between genius and stupidity is that genius has its limits.’ – Albert Einstein
I was giving a presentation at an ILAG seminar and whilst talking to one of the attendees, I was struck by the fact that she was saying that there was some ‘good news’ about the current crisis! Her point was that it should bring an end to the stupid lending policies that resulted in 125% LTVs and income multiples that could never be sensibly justified. I agreed that this was a desirable objective, but that we should not forget that we had seen precisely the same ‘irresponsibility’ in the 1980s. Sadly, she then informed me, she was not old enough to remember those days! But, whilst it is true that Turner’s proposals should help to avoid such behaviour, the reality is that we will still face future risks once people’s memories have faded and ‘unjustifiable euphoria’ resurfaces with new ideas of how to lose money, or maybe even a few of the old ones too!
As I said in a previous blog, Turner has explained very well how the current crisis came to a head. In reading the report, it brought back memories of the five ‘C’s that used to form the basis of lending policy (for individuals and/or businesses) and which are as relevant today as they were in the ‘good old days’ of sensible [boring] lending. The reality is that some of our ‘highly skilled lenders’ deviated from the ‘basics’ of lending. Instead, trying to impress each other with their ‘sophisticated thinking’ that then got a lot of lenders in trouble. Regardless of the complexity of the credit, the basics still apply – ‘Cash Pays Debt’! It is worth remembering that statement and not confuse the cause of repossessions as being upon falling house prices – foreclosures happen because people are not able to meet the monthly repayment commitments.
So what are the five ‘C’s?
1. Character – how has the person (or business) viewed their previous credit obligations? Have they paid as agreed? If there have been issues, how have they responded – did they bury their head in the sand, or make proactive proposals. How do you feel about them? It had become unfashionable to expect a deposit, but there was a time (and we are seeing a return) when a deposit showed that the individuals could put money aside regularly and in so doing reduce the exposure of the credit.
2. Capacity (Primary source of repayment) – the ability of the individual (or business) to pay their debt – that is total debt, not just yours but any others they may have – according to the obligations of the loans, now and in the future? Look at net income after normal expenditure commitments… remember also that wealthy people can and do spend beyond their means! Shock tests should be applied to determine the ability to repay debt if rates were to increase. This used to be referred to as ‘lending 101’ where a test of what would happen if rates went up say by 1% increments.
3. Collateral (Secondary Source of Repayment) – this is usually the property against which the loan is secured and can be the ‘back door’ to recover debt if unforeseen problems occur. However, don’t be ‘utopian’ or ignore looking at the future for potential for economic downturns! We are not all as young as the lady I was talking to and many of us have seen property prices fall and the spectre of negative equity cannot be ruled out! Interestingly, although the value of the property [security] is assessed at the time of the loan, it is rarely reassessed unless it is linked to a further transaction. Given that one of my harbinger of doom statements is that ‘prices can plummet as well as fall’ lenders may want to consider obtaining a regular or time specific revaluation. Given the availability of electronic valuations, it is maybe surprising that this is not more widely used.
4. Capital – does the individual (or business) have the ability to sustain a downturn in the economy? Whilst it may be argued that any capital should be applied to minimise the loan, access to capital or savings could provide a buffer if income – primary source of repayment – is temporarily reduced.
5. Conditions – these can be various and include economic, employment, demographic, or political conditions. Considering the conditions prevalent at the time the credit is initiated is only part of the task to determine the viability of the credit risk. What are the terms of the credit and what could happen to the conditions during the duration of the credit? It is very difficult to foresee all potential problems, but it is unlikely that all the conditions will remain positive or consistent – as witnessed by the recent experience.
The five “C’s” of lending should never be thought of as ‘old fashioned’. They may not be as sophisticated as some clever algorithm, but, if properly applied along with practical judgment, they are ‘common sense’… the problem is that ‘common sense’ is NOT that common and being ‘too smart’ may not be smart at all!
