Hard Lessons in Modern Lending
Joe Bliss thought the worst was over. Revenue at JBC Technologies--a Cleveland-based die cutter that makes products as diverse as materials used in electronics and small components for automobiles--had plunged 40 percent when the recession hit. Bliss had dismissed half of his 96 employees, cut wages across the board, and slashed his own salary to almost nothing.
Now, in the summer of 2010, sales were finally back. Bliss had restored his employees' salaries, repaid lost wages, and begun hiring again. He also resumed planning the expansion he had envisioned for the company--which included 40,000 square feet of additional manufacturing space and new corporate offices.
Then, on August 17, the men from Charter One bank came to visit.
Bliss, who had been banking with Charter One for five years, had $6 million worth of commercial loans outstanding. He says he never missed a payment or, as far as he knew, violated any of the covenants, the financial metrics that banks mandate to ensure the health of their borrowers. But the Charter One reps told him the bank wanted the 22-year-old company's loans off its balance sheet, part of a retrenchment that would affect billions of dollars' worth of loans in the bank's commercial portfolio.
It didn't matter that JBC's business had recovered; the decision had been made months before. The men recognized the irony. Under different circumstances, "we'd be aggressively pursuing you as a customer," one of them told Bliss. But JBC had been deemed, in the oblique vocabulary of Charter One and its parent companies, Citizens Bank and the Royal Bank of Scotland, noncore.
The problem was not Bliss's company but his industry and region--both of which, in an effort to stem future losses, his bank had essentially written off. Charter One, like other banks across the country, was using a sort of predictive math to sever ties with struggling borrowers before they stopped making payments. In the process, banks were abandoning businesses that were recovering, too. "It was a bizarre situation," Bliss says. "We were successful. It was so frustrating."
Charter One's divorce from Joe Bliss was just a tiny part of a precipitous pullback by the banking industry. From 2008 to 2010, the volume of business loans dropped some 22 percent. In cash terms, commercial lending experienced a $325 billion decline over those two years; the volume of small-business loans (generally defined as loans of less than $1 million) fell by $26 billion, and then kept falling: By June 2012, small-business loans were down $56 billion from their June 2008 peak of $336.4 billion.
Of course, it helps to remember what banks were going through at the time. Once the financial crisis was in motion, banks faced tremendous pressures. Government regulators introduced capital requirements that compelled banks to reduce their exposure to risk--mandates that often meant shifting more risk onto the borrower in the form of larger down payments, more collateral, and more onerous personal guarantees. Given that banks have watched hundreds of their peers struggle with insolvency, it's not surprising that banks began enforcing their covenants more strictly than they had in years.
Lending is finally beginning to crawl back, though the emphasis should be put on crawl--the stats would qualify as bad news if the past few years hadn't been so grim. Most banks are no longer tightening credit standards for small businesses, according to the Federal Reserve. And the volume of small-business loans fell just 1 percent from June 2011 to June 2012, compared with an 8.5 percent drop during the corresponding period 12 months earlier. Part of the reason for the slow recovery is that businesses remain too spooked to borrow. "Demand is down," says Jordan Peterson, senior vice president for business banking at PNC Financial Services Group. "We're seeing small businesses deleveraging, taking cash to pay down debt. But we're anxious to lend money."
Still, many entrepreneurs remain more than a little traumatized. "We're terrified of what a bank will do now," says Lowell Jaeger, owner of Jaeger Lumber, a Union, New Jersey-based chain of seven lumberyards. In 2011, after the chain posted its first annual loss in more than four decades, PNC abruptly canceled its $4 million line of credit--despite the fact that Jaeger Lumber expected to be back in the black and had banked with PNC for about 20 years. Jaeger managed to get credit from TD Bank. Still, he has been shaken up. In the past, his inclination was to pounce on an economic recovery, acquiring distressed competitors and upgrading facilities. Not this time. "I'm not going to take a chance on expanding and have another bank pull out," he says.
For anyone with a stake in the U.S. economy, that's the last thing you want to hear. Although the financial crisis was (one hopes) a once-in-a-generation disaster, there will always be business downturns. And in a dynamic economy, some industries will inevitably end up on the wrong side of new technology or shifting consumer tastes. But the latest crisis made clear that the era of personal banking is over--indeed, that it had been for years. The scale of modern banking has made the relationship between banks and small businesses more remote, more mathematical, and less personal. In the next downturn, you can't assume that a warm relationship with your loan officer will protect you.
It's also clear that as the economy recovers, entrepreneurs and banks will need one another again. The question business owners should be asking isn't whether the system will go back to the old ways--it won't--but whether they have taken the right steps to protect themselves and borrow prudently in this new world.
To understand how we got to this point, consider how different banking was a mere 30 years ago. Before ATMs sat on every street corner and sports arenas had names like Citi Field and Bank of America Stadium, U.S. banks were far smaller and far more numerous; in fact, there were about 10,000 more of them. They were, on average, a tenth the size of an average bank today. They were prohibited from operating across state lines, and most states capped the number of branches they could have.
Corporate lending worked differently, too. Companies and banks tended to pair off by size. The community banks that did the bulk of small-business lending tended to make subjective judgments, relying on personal knowledge of the local economy and the character of the local business owners. "You'd go to a loan committee, and there'd be six or eight people who knew the market and probably knew you," says William Dunkelberg, chief economist at the National Federation of Independent Business, or NFIB, since 1973.
Even by 1993, 55 percent of small-business loans (in dollar terms) were held by banks with less than $1 billion in assets; the largest 25 held less than 9 percent of such loans. The merger wave of the 1980s and '90s upended this model. As regulations were scaled back, banks joined forces and expanded nationally, and small banks got gobbled up by bigger and bigger ones. This was bad news for entrepreneurs: From 1989 to 1994, the number of small-business loans fell 34 percent, and many economists worried that big banks might stop troubling with them altogether.
Lending eventually came back--thanks to technology. As more data went online, a bank could access a potential borrower's payment history, compare a company's financials with industry averages and the finances of competitors, and use economic projections to assess prospects. When companies such as Fair Isaac and Dun & Bradstreet began offering business credit-scoring software online, a large bank's credit department no longer needed local experts with local expertise; an analyst with a computer and an Internet connection could make decisions from hundreds of miles away, and small businesses could get cheaper rates and approvals without knowing the local bankers. By 2007, the 25 largest banks were nearly six times larger than they had been in 1993 and held 32 percent of all small-business loans.
Then came the financial crisis, which flipped the hard-data model on its head. Banks had used data mainly to identify prospects and turn them into customers. Now Big Data went to work--in a real-life version of the science-fiction film Minority Report--identifying which paying customers were riskiest, so banks could quickly turn them into ex-customers.
On February 26, 2009, Stephen Hester, CEO of Royal Bank of Scotland, told analysts how he planned to defuse what he later termed "the biggest balance-sheet time bomb in history." The year before, the Edinburgh-based bank had lost $34.2 billion--the biggest loss in British corporate history--leading to a government bailout and the departure of the bank's then-CEO.
Hester stepped in and within three months identified about $612 billion worth of assets to be sold or dumped altogether. Next, he turned to the assets the bank planned to keep, including its U.S. subsidiaries: Citizens Bank and Charter One. In addition to cutting jobs and closing branches, the bank would look to eliminate individual credit lines, credit cards, and loans. The retreat would begin in the company's backwaters, where Citizens and Charter One lagged the market leaders, he said.
In the greater Cleveland area, where Joe Bliss and JBC Technologies had Charter One loans, the bank ranked fourth.
Cheryl-Ann Madsen, Bliss's relationship manager at Charter One, had worked as a banker in Cleveland for decades, starting at Charter One in 2005, shortly after it was acquired by RBS. When the bank moved underwriting to Pittsburgh in 2007, she had adapted; in fact, she planned to retire at the bank. So in July 2009, when the Cleveland relationship managers were told to prepare their loan portfolios for review by a visiting RBS executive from Michigan, she dutifully complied. The review would determine which loans would go into a new noncore group--assets the bank decided were either "high risk or not a strategic fit," says RBS spokesman Jim Hughes. "In a time in which banks have been forced to make tough choices," says Hughes, "relationships with some customers have had to change."
When the noncore list was announced to staff, Madsen was stunned. A third of the companies in her portfolio were on it--including nearly every auto-parts supplier she had. "They were all people who worked diligently and lived up to their loan agreements," Madsen says. She understood that the bank had to shore up its balance sheet. Still, she says, "it was very difficult to justify it to myself. I felt personally responsible." Madsen asked the head of the Ohio region to reconsider severing the relationship with Joe Bliss. He tried to help but couldn't. She then wrote an e-mail to the CFO of RBS, pleading for JBC specifically. She got no response.
Then, about a month after Bliss's loans had been pulled, Madsen was driving back from a client call with an out-of-state colleague toward Charter One's offices in downtown Cleveland. As they passed by shuttered stores and half-filled parking garages on 12th Street, her co-worker sighed. "Ohio--it's just a black hole," he said. The bank wasn't just writing off her clients now. She felt it was writing off her hometown. That was it, Madsen says. "I knew northeast Ohio would rebound. I have a lot of faith in the Joe Blisses of the world. I didn't see a black hole. I saw a storm we needed to get through together." She resigned a month later.
When banks move to stem problem loans, they follow a standard procedure, says Mitchell D. Weiss, a consultant who ran financing subsidiaries at Webster Bank and SunTrust. Underwriters are always looking for patterns in the numbers. Once they identify a problem group ("You might notice that real estate developers in Florida are having a higher instance of write-offs," Weiss says, by way of example), they put those companies on a watch list. Then, the bank starts looking for red flags: a late payment, a missed financial covenant, or a sudden drop in business.
During normal times, banks can be flexible. After a crisis, however, the stakes are much higher. When banks are under pressure from shareholders and regulators, there is little room for subjective judgments, exceptions, or forgiveness. If a "watched" company's credit agreement is subject to annual renewal, Weiss says, it may not be renewed. "It's not personal," says Weiss. "In these meetings--and I've been in these meetings--lenders will say, 'These are really nice people. It's really too bad what's happening to them. Move them out of the bank.' " During the recession, contractors, lumberyards, printers, and other companies tied to struggling industries came up again and again in these analyses.
When a bank decides to sever ties, a ticking clock starts for the business owner. He or she must find a new bank to refinance the loan or pick up the balance of the credit line, typically within 90 days, at which point the full balance "balloons" and becomes due immediately. Money that might have gone to purchase inventory, pay staff, or keep the lights on must go to cover the principal, or the company will default and go out of business.
When a large bank decides to retreat from an entire industry, it can have seismic effects. On October 24, 2008, the day PNC announced it would acquire National City, becoming the fifth-largest bank in the U.S., CEO James Rohr identified a $20 billion distressed-assets portfolio of bad residential real estate development loans, subprime residential mortgages, and brokered home equity loans. He also went a step further, saying the bank would begin "accelerating efforts to exit their noncore loans." Bank spokeswoman Amy Vargo specifically cited "equine lending" (loans to horse farms), payday lenders, and some mortgage lenders. PNC wound up shrinking its commercial loan portfolio of the newly combined banks by $21 billion, or 21 percent, over the next two years. Loans to manufacturers alone decreased by $3.9 billion--the equivalent of 30 percent of its manufacturing portfolio in 2008.
The moves reverberated among customers, many of them legacy National City clients in its Rust Belt footprint across Michigan, Ohio, and Illinois. In Mentor, Ohio, Brendan Anderson, chief financial officer and co-owner of Stam, got a call from his new PNC loan officer on June 8, 2009. Revenue at Stam, which makes air-intake and exhaust lines for heavy machinery, had fallen steeply. But Anderson had kept up the company's loan payments. Still, the rep told him that PNC now took issue with the way Stam calculated its net worth. As the bank saw it, the company's value had fallen below a mandated level, which put Stam in violation of its loan agreement. Anderson quickly dug up an e-mail from his old National City loan officer spelling out how the two sides agreed to calculate net worth. The dispute continued for weeks. Finally, the PNC rep was blunt: "You've been designated an exit credit. My goal is to get you out of the bank." (PNC declined to comment on specific clients.)
After the PNC breakup, Stam managed to move its equipment loan and revolving line of credit over to Park View Federal Savings, but CEO Kent Marvin says he's no longer interested in expanding. He will keep the 50 employees he has and cap hiring there. "It's just not worth it," he says. Demand is increasing, but the investment required to add another shift wouldn't pay off for at least two to three years, estimates Anderson, the CFO. That's too long, he says, and cash is too tight. "Heaven forbid there's another recession."
Business owners who decide to fight their banks hit a different set of challenges. David Moyal runs one of the last privately held printing operations in New York City, churning out programs and fliers for Broadway shows and the fine print for prescription drugs like Lipitor. Over the years, as demand for paper products declined and larger competitors hammered down prices, Moyal managed to stay competitive by using the latest, fastest presses.
In 2005, he expanded to New Jersey, opening a larger facility just on the other side of the Holland Tunnel, using equipment loans from People's Capital and Leasing Corporation, a subsidiary of People's United Bank. On July 24, 2008, Moyal purchased a custom-made, state-of-the-art, $3.8 million Mitsubishi sheet-fed printing press, capable of printing 10,000 two-sided pages an hour. As it had in 2005, People's provided him with a down payment for the new press (in this case, $200,000) and made a written offer to finance the rest. But in January 2009, after the press had been assembled and shipped and was ready for delivery, People's refused to make the loan.
The bank, Moyal learned, was in the midst of a rapid retrenchment. Rather than increasing equipment financing 20 percent in 2009, as it had expected before the crisis, People's CEO Philip Sherringham had told analysts that the bank planned to "put the brakes" on the portfolio. Loans to printers would fall 32 percent.
Moyal called the bank "9, 10, 15 times" to see what could be worked out. Meanwhile, as he was stuck with his old presses and unable to match competitors' prices, sales cratered. When he called People's to see if he could extend his payment schedule, his loan officer told him that the bank had decided not to change loan terms for printers unless they were already defaulting.
In September 2011, People's United sued Moyal to get back the $200,000. Moyal, incensed, is now countersuing the bank for breach of contract and fraud. (People's United did not return numerous phone calls for this story.)
Suits like Moyal's face steep odds, says John McFarland, a partner at Houston-based Joyce, McFarland & McFarland who represents banks in lending-litigation cases. Loan contracts often provide outs for lenders, including "material adverse change" clauses that can cover a sudden drop in sales. Even the most bitter breakups between borrowers and lenders rarely end up in court. "There's a lot of gnashing of teeth and some really badly damaged long-term relationships," says Buzz Trafford, a managing partner at Porter Wright in Columbus, Ohio, who has represented both sides on debt issues. "But there's not a lot of litigation."
So what should entrepreneurs do? Weiss, who now is a finance professor at the University of Hartford in Connecticut, advises entrepreneurs to seek loans from community banks rather than large institutions, at least when your borrowing needs are relatively small. "Your deal is more important to them, and there's more negotiating room," he says. "It's a better deal." And Ami Kassar, founder of Multifunding, a start-up that helps businesses find financing, pursues only deals in which the business owner can work directly with the people who approve the loan. "At a big bank, the underwriter and the loan officer working on it are often in different states and don't even know each other," Kassar says. "If we're not dealing with the decision makers, we won't go there."
Still, many entrepreneurs are drawn to the wider array of services and more advanced technology offered by big banks. Since 2008, the 25 largest banks' share of small-business loans has grown 5 percentage points. Regardless of the size of the bank, borrowers need to read the terms of their contracts carefully. "It baffles me," says Todd Massas, a manager at Plaza Bank, a community bank in Irvine, California. "Clients are hypnotized by interest rates even when they're getting pummeled by a baseball bat."
It's worth noting that all but one of the entrepreneurs profiled in this story found new banks. Still, the credit squeeze remains fresh in the minds of many business owners. In January 2011, JBC's Joe Bliss moved his equipment loan and credit revolver to FirstMerit Bank, a regional bank in Akron. After sales grew fast enough that he believed he could double his manufacturing capacity, he decided to put the experience behind him and take out a new loan. Banks made offers. Even Charter One. But when JBC heard the bank's presentation, the company's controller, Rick Gucwa, cut the conversation short. "How do I know you're not going to screw me again?" Gucwa asked Charter One's rep.
That's something all banks, as they attempt to rebuild their small-business portfolios, should keep in mind. For entrepreneurs business is, almost by definition, personal. Some will have a harder time than others with accepting the new nature of lending. In April, Moyal laid off all 120 employees at his New Jersey facility. In July, he auctioned off his old presses. Since he retrenched in his smaller Manhattan operation, sales have dwindled from $17 million at their 2007 peak to a projected $9 million in 2012. The Mitsubishi press remains in storage. Moyal sounds as much like a spurned lover as a businessman. "I want to hurt them really bad," he says. "I am dying to know who forgot about all the years of relationships and said, 'You know what? The guy never defaulted on a payment or anything. But too bad.'"