The Four Seasons of loan documentation

RMA Journal, The, May, 2004 by Bruce Bates

"One season following another...." This article may be focused on the economics, not meteorology. Yet like the seasons, the economy shifts from hot to cold. Unlike the seasons, there's no fool-proof predictability as to when the economic cycle will change. Good loan documentation, however, serves as down comforter and air conditioner and is assurance for all seasons.

No one is particularly surprised to learn in early October that the chill is ushering in winter. There may be warm days that follow, yet tee shirrs make way for sweaters and sandals move aside for boots. We plant bulbs in anticipation of daffodils in March, and we bring delicate plants inside.

We know a thing or two about seasons: We anticipate and act accordingly. It shouldn't be that different for lenders' approach to the economy--and the businesses making it run or falter. Somehow, though, we're not quite as good at dealing with this cycle.

The business cycle is not an evil thing and serves the purpose of purging weakness and preparing for new growth. Thus Adam Smith's "invisible hand" describes the cyclic change that promotes ultimate health in the financial ecosystem. Experienced lenders anticipate the approach of each season's change and prepare, while the inexperienced lenders hope summer will last forever and are totally unprepared for that first freeze.

Documentation should be adapted to current market realities, but they also should retain sufficient bite to hold up in any season. Let's use the seasonal metaphor to learn more. (Imagine Vivaldi's "The Four Seasons" playing in the background.)

Winter. The cold slows the movement of many things, some to dormancy. This is when the lender's volume of financing is down, and therefore the lender can tighten standards to reflect an increased choiceness. Documentation win be most favorable to the lender during this season. The lender may be bold with both rates and covenants.

Spring. When the economy's sun shines, rain Ellis, and temperature moderates, new growth begins to appear. Opportunity is the watchword for this season. Relationships begin expanding, and lending activity increases. Longer days encourage even more growth. Yet in this time of transition, a sudden freeze can make us wonder if we had been fooled by a false springtime or a temporary mid-winter thaw. In this season the pendulum is swinging from a lender's market toward that of a borrower's market, and previous wintertime documentary requirements are increasingly difficult to maintain.

Summer. Temperate predictability marks this growing season. There is plenty to be done, and competition among lenders becomes keen. Winter is a distant memory, and the opportunities stretch endlessly ahead. Too many financing dollars are chasing too few good new deals. Loan documentation becomes more borrower friendly as the power shift reflects that it is a borrower's market.

Fall. The growing cycle has passed and the harvest is in full swing. Indian summer days, however, mask winter's return. "Just one more" is the challenge of this season, much like the gleaner's search for the last good morsels. Smart lenders recognize that the balance of power is shifting back in their direction during this season, and there should be less negotiation relating to the documents.

The strongest (and most adaptable) survive. Documentation adapts to fit the realities of the negotiations through the seasonal progression. Bargaining in its broadest terms focuses on three main areas:

1. Loan amount.

2. Interest rate.

3. Loan terms and covenants.

Simple as this appears, it's difficult to think "ahead of the herd." The lending herd tends to react somewhat after-the-fact when the economic cycle changes. For example, in the early spring of lending, most lenders are hopeful but timid, and it is during this time that the bold lender increases loan yields. A limited number of lenders are actively financing; borrowers, sensing the growing economy, are less interest-rate sensitive.

During lending's summer, improving market share places significant pressure on lenders, and they become more aggressive. The pendulum swings from being a lender's to a borrower's market. Borrowers recognize the change and begin to exploit the circumstances. The borrowing client is able to shop among multiple lenders vying for the relationship and to use the competitive environment to pit lenders against one another.

During the past 25 years, there probably have been three full seasonal cycles. Late summer and early fall are the times in the cycle that are most hurtful to the documentation and, by extension, to problem loan resolutions. Documentation is paramount for each problem loan resolution, and it's at the latter part of the summer lending cycle, when lender competition is keenest, that documents may be most watered down.

When a relationship is transferred to me for resolution, I take a blank tablet of paper and give the files a quick read to achieve a high-level understanding of the credit structure and intent. I generally read the promissory note, security agreement, and collateral perfecting documents first to find out my rights. By deliberately not contacting the previous assigned officer, my blank pages are filled only with my questions, impressions, and interpretation of entity structure. With increasing lender consolidation and portfolio purchases, documents are not always consistent. Even seemingly standard provisions are sometimes missing. It doesn't matter how much a lender may hope for a particular right or treatment; if it is not in the document, the right doesn't exist.