Lenders are not very hard to understand. Like other business people, we hate losing money. We are not in the risk capital game. If a borrower is interested in risk capital, they should ask rich Aunt Edna for an investment, or Mark Cuban, if they can get on “Shark Tank.” Is it any wonder that investors expect big returns on investment while most lenders expect modest returns? The smaller the risk involved, the smaller the return.
Let me get all nerdy here for a minute to explain the basics of risk management and credit underwriting. Since many banks are now offering interest rates between 4% and 5%, they obviously want deals that are relatively safe. Saying “no” to a deal is not at all personal, it is about where that deal fits into the risk-reward continuum. For example, if someone walks into the office with a great idea, but maybe lacks experience, I might get nervous at the lack of actual operational history. I feel confident they have a good chance of succeeding. Let’s say this imaginary business has a 75% chance of success. However, my 5% return does not give me a big enough reward to compensate for the 25% chance of a major crash and burn. A 15% return on the loan might make me more comfortable, but I am prohibited to charge what might be considered usury interest rates. So, even if this deal has a 75% chance of success, I would still decline the loan.
Based on the sure thing policy, how do lenders help ensure they get there investment back? Two words that every borrower hates to hear (ominous background music (maybe “Paint it Black” by the Stones)…lighting flashes and thunder crashes)…the “personal guarantee.” Almost every deal requires a personal guarantee. Refusing to give a personal guarantee is like refusing to acknowledge a basket in basketball behind the arc counts as three points. You can say it counts as ten, but it counts as three. These are the rules. As a lender, I am not going to shoulder all of the risk. Great gamblers are not the ones who win when there is no real money changing hands. I am a great poker player when I am not playing with my own money. When I have to pop out my own wallet, I stink. The same theory goes with lending. Lenders never want the borrower only playing with the house’s money.
Policies can also get in the way of lending. Most lenders like to keep balanced portfolios. No one wants a portfolio top heavy in real estate or restaurants or potato farms. A portfolio too heavy in any sector can bring down a lender if that sector crashes. For example, I might turn down a perfect deal…one that smells like honeysuckle on a dewy spring morning, if I have too many similar businesses already in my portfolio. Though that portfolio sector might smell like honeysuckle now, it can smell, well, like a field of cow patties on a 105-degree day in a few years. Portfolio management and diversification is critical from a lending perspective.
Pleased to meet you
Hope you guess my name
What's puzzling you
Is the nature of my game