Wednesday, July 29, 2009

Borrower Risk, Net Worth, and Liquidity

You are considering making a $10,000,000 loan to one of two borrowers. Both borrowers have a $10,000,000 net worth and $1,000,000 in cash. Your astrologer has told you one borrower will default and the other won’t, but she can’t tell you which one. You are allowed to ask each borrower three questions. What do you ask?

Here are my questions:

What are your total liabilities (contingent and non-contingent)? A borrower with $10,000,000 in net worth with $20,000,000 in assets, $10,000,000 in liabilities and $1,000,000 in cash is a great risk. A borrower with the same net worth and liquidity comprised of $100,000,000 in assets and $90,000,000 in liabilities is toast in a significant downturn.

How did you make your money? If the answer is investing in the same market and kind of real estate as the loan you are considering (for example, multifamily in Dallas), the borrower is a good risk. Any other answer (selling a software company, dentistry, UPS driver, playing poker, aerospace engineer) is a problem. I know this from personal experience because I’ve approved and subsequently regretted making loans to borrowers with these former occupations. Each time I thought we had mitigated the risk – I now believe you can’t mitigate inexperience.

What was the value of CRE assets you owned in 2001? The answer should be at least $2,000,000 – enough to tell you they had some holdings in the last downturn. If the answer is less than that it means they made all their money in easy times. Ideally, a borrower would have been through the 1989-1994 trough, but those guys all have a net worth a lot bigger than $10,000,000.

I believe the answer to these three questions tells you pretty much everything you need to know about a borrower.