Back In My Day: Civilized War -White Knuckle Time

It’s time to move this story forward toward its conclusion, especially with “banking” and an economy that is spiraling downward in the news.

My world was becoming one big adrenaline rush at work every week. The weekends with family, friends and church were all that kept me grounded. Over fifteen years later I still hate phones and frequently cringe when I have to use one. Being tethered to a Blackberry was just the worst. I also grew to despise flying. It had nothing to do with the act itself; when I relaxed enough it brought peace and beautiful views of our country from above. It was the airport experiences, TSA screenings, cancelled and delayed flights, taxis and rental cars, and so on that I disliked. Staying in hotel rooms during business travel is not enjoyable when you would rather be with family at home. I had rolled over the mid-century mark in age and was just not all that enamored with what the world says is the pinnacle of life.

I have linked this song before. However, it reflects what I was feeling at that point in life.

Small Business Banking Unleashed

Our division was blowing the doors off financially. From start up to $270 million in annual small business loan production in a little over two years with projected growth of over $75 M annually for the next two years. We had grown from a group of twenty to around seventy employees during the period. We needed to stay ahead of the growth curve with our staff training and preparation. We were active in all fifty states and a national preferred lender with SBA. Customers were served well, audits were excellent, profit was well above budget, owners were happy and employees were generally well paid and with upside to their roles.

There was a really important reason for our success. We had a sincere desire to take care of our customers, who were people a lot like us. No elites, no easy streets, very little generational wealth to invest, no big business, more at risk personally. Our division staffing was a mixture of races and cultures that reflected our great country. Customers could easily identify with and relate to us.

I had spotted an opportunity for a new product with the recent resolution of the SBA appropriation and operational issues. My thoughts were centered around doing conventional first mortgage commercial real estate loans associated with the other SBA (504) program in a manner that involved pools that were converted to securitizations like currently utilized in the 7(a) loan program.

In the process our bank could share a relatively small tranche loan loss risk for any projected loan losses beyond the historical average for the industry. The investors would probably want our expertise with loan sub-servicing rights. We knew we could not be the master servicer in the Wall Street game, but we could still strip up to .25% from the interest rate and give the master servicer a share to front our operation. In essence this senior servicer would take over should we default on our responsibilities. We could then capitalize our portion of the servicing asset, take a gain into current income, and amortize it over the course of expected life of the loan as we did our 7(a) loan program accounts. All of it involved standard accounting practices for that type financing.

So, before I dig a little deeper into this subject and to assist those who either want to learn more to understand better, the following link may be helpful. There are other descriptive links into the specifics also provided within.

https://www.investopedia.com/ask/answers/07/securitization.asp

Just know that when I reference “tranche”, it is a level or portion of investment into the broader securitization. Tranches can have different maturities, credit ratings, and yields (or interest rates) within the securitization. The investors take various levels of risk and the return corresponds with the risk of potential loss they are willing to accept.

During our internal review we determined the potential tranche risk from loan defaults in the 504 program were minimal. The loans were made to small business customers for commercial real estate purchase and construction of facilities. The loans would be for a maximum of 55% of appraised market value. A SBA guaranteed second mortgage fixed rated debenture was behind us bringing total project financing into the 80-90% range. Should a default occur, the SBA would be likely to pay the holder out of our first mortgage position to gain control of the asset to reduce their losses. Even if the SBA passed on doing so, all parties involved knew it would be hard to lose money at the low first mortgage loan to value. Regulators and ownership of the bank also had the ability to reserve for unlikely tranche losses from defaults above the reserve rate baked into the transaction by using a portion of the premium income we received when we sold the loans. Again, banks who sell their loans typically do not receive premium as high as we did or accept any limited risk in the securitization to secure greater income. With our strong underwriting skills in credit decision-making we felt secure. This point will be one to remember for a future story.

Folks with knowledge of such financial activities may think that it was not an overly innovative process. However, for that loan program up to that point it had never been done that way by any lender. There had not been enough industry loan volume to justify the exclusive use of that loan type in a pool and securitization had they even thought to consider it. Historically over a couple of decades, purchasers of those loans placed them in conventional commercial real estate loan pools of mixed use and type for securitization, gave up servicing rights and assumed no tranche risk. As a result the profitability of what they did was hammered. They had to do very large volumes to make decent money at it. That meant only the larger institutions with excess funding could and would participate.

Since I firmly believed then and now in working smarter, not harder, I felt that we either needed to dig deeper into this hybrid proposal or not participate in the 504 loan program at all. Our investment banking loan buyer from a respected regional investment banking firm loved the idea. He immediately set up meetings with the brass at his company and they started analytical work to see if it was viable and how there could be a win-win for all parties. We were a national small business loan origination machine, they could be a significant back end profit contributor for us if this worked as designed. They could then sell the program to other lenders nationwide as well as into other business segments and do well. All of it would enhance the overall viability of the endeavor in a growing niche.

The need to do this to grow our operation was fueled by necessity. When we compromised in our industry appropriation negotiations, we gave up a profitable method of financing commercial real estate through our bell cow 7(a) program. It was inevitable it would happen eventually, so giving on the issue at some point was expected industrywide. As things stood we were just brokering the 504 conventional loans to pooling banks for a 1% origination fee, who in turn sold the pools to Wall Street brokerage firms for securitizations where the big money was made.

We needed a replacement for the no longer available income stream or else we needed to slow our expansion and sell the owners on being satisfied with how things were. We knew they had big dreams of bank expansion statewide and were pushing for even more income. So, I involved them in the hybrid discussions with the regional brokerage firm to get their support should it come to fruition. As it all developed and began to make sense, the owners and their CPA green lighted it. Under current market conditions in early 2006, we all agreed our bank would receive a premium of 3-4% from typical loan pools plus the sub-servicing rights. This was about half of what we were receiving on 7(a) loan program premiums, however, we would be selling 100% of each loan into $50-100 million pools and not retaining 20% of the loan on our books that the 7(a) program required. The loans were much larger than the 7(a) program average as well. So we could make more loans to help more customers with the same funding and capital allocation using existing staff. It now made sense.

Our systems could handle such a move. We had previously moved well beyond the traditional bank’s abilities to deliver assistance other than funding and HR. The owners had authorized us to contract FiServe and their bank operations platform for our staff to book, bill and service the loans. We had built our own legal, accounting, audit, compliance, programming, etc, departments in addition to regular operations relating to delivery of loan products to customers. We were ready for this launch.

We could meet the needs of our customers, our owners, our loan buyers, the SBA’s initiatives, regulators, and ourselves. Win-win-win-win-win-win.

One of the conditions of the program’s launch was that our division’s operations would need to be examined by one of the three primary rating agencies; S&P, Moody’s, or Fitch. In addition we would need to have an initial review of operations and the bank by a prominent bank consulting firm noted for their expertise in the industry.

We accomplished all of that over about six months and through the process learned that Fitch was the most engaged in learning what we did and how we did it. So our prospective pool buyers were informed and accepted them. We provided all of the third party findings and reports to the state banking regulators, FDIC and SBA. They all approved. Our sales force was excited to have something no competitor could sell at that point.

It was “go” time.

Opportunity Knocks Once…

And then it moves on. We answered the door, invited Opportunity to come in, and now it was our job to help it bring rewards.

However, in business there is one very important truth to always remember. Opportunity can make for a wonderful visitor. It also should remain a visitor. Once you allow it to become a member of the family it can make a mess if not handled well. There are times you embrace it and make it comfortable to stay longer. There are other times you have to be willing to kick its azz out the door.

As an example the successful real estate investor knows to never fall in love with a piece of real estate. If your propensity is to do that, to not be ready and willing to part with something you have purchased at a moment’s notice; you should find another endeavor. It is the same principle that should be applied in nearly every business.

Our loan buyer dropped a bomb on me about the time we were finalizing the program with all of the related parties. He stated that he had a unique “opportunity” to join Bear Stearns in NYC and open a national small business loan program purchase desk. This would be the first time a Wall Street firm had been directly involved in loan purchases from lenders in the SBA loan programs in its history. The global loan volume was projected to grow exponentially over the years since the industry’s appropriation resolution with government, which made it more attractive on the Street. First, he wanted to know if we would sell our 7(a) loans to him there instead of to his soon to be former employer. Since he treated us well for a few years, was a noted expert in the industry, and we were not contractually linked to his former employer; that was an easy one to affirm. The second request was that he be allowed to pursue our hybrid program at Bear. It had not been legally “protected” at this point in the process by either us or his soon to be former employer. He stated he would modify it a bit that did not affect our return or risk while providing us higher premiums. He advised me to wait awhile before notifying his former employer until he had time to get it done at Bear. He let me know what this former employer was planning to pay us as the premium and that we needed to see that was true for ourselves by pricing our first $50 M pool with them. If true, it would prove they had been baiting us with one estimate and then planning to offer a lesser premium than we had originally determined was on the table when it became time to close the first transaction. He wanted to prove to us we could trust him.

He had one final request. If the Bear Stearns move did not work out as he envisioned, he wanted to retain our business at his next stop or go to work for us. Always looking for talented people to build our business, I agreed and informed the owners, who concurred. In addition to handling our division’s loan sales desk, he could also handle the overall bank’s treasury investments if he needed a home. I saw a need for our organization as well as the bank itself to mature as we grew and become more professional in a wild, wild west industry, which he could assist in accomplishing.

We all began to play our parts. The buyer’s former employer did exactly as he said they would, breaking the bond of trust that had been built. I guess they thought they had us over a barrel with no other options in selling the first pool. Of course, they were dead wrong. They not only lost over $100 M of annual 7(a) loan purchases, they lost the hybrid opportunity by doing so.

Meanwhile…

The nagging management headaches continued which extended to dealing with the owners as well. Personal egos and excesses would replace reason and respect at times. These and other situations were unneeded distractions. It was also obvious that it was becoming time to thin the herd. I asked department heads to formulate plans to trim the payroll of non-productive staff as well as make-work type job functions.

Our Bear loan buyer was busy setting up his operation and kept me informed of his progress. We completed our first two pools of loans for securitization over the next few months and sold them to Bear at a good premium. The owners were so proud to be doing business on the Street they bragged about it everywhere they went.

One day that year the buyer called to ask if I thought it would be possible for Bear to buy our division. It appeared he had been very busy selling us as well as the hybrid program internally and wanted to expand his kingdom. I would report to him if they got it done and would be contracted to operate the division autonomously. They did not want to buy the bank itself as they already owned one. I thought it would be worth pursuing to give the owners an option to cash out on our success as well as increase our unit’s ability to serve our growing customer base. I had detected the beginning of unreasonable profit expectations for the market by the owners as had occurred with other employers over the years. Greed was rearing its ugly head – again. I asked the buyer to directly approach the owners and see if they had an interest in talking.

Operationally, I had long desired to move the art of credit decision making of yesteryear into more of an analytics based method using historical statistics and data tied to proven credit parameters. Due to federal banking records retention and safety requirements, I had already compelled the credit, loan closing, and servicing areas to incorporate electronic document scanning into their operations. However, resistance to change slowed production. Eventually that would need to change as programming work for the new operations platform involving underwriting would inevitably lead to doing things differently.

Despite all of our discussions internally with some key mangers, they were still not fully grasping where all finance related businesses were headed with technology. The old school thinking in our ranks was still strong even with the younger employees, while this old guy had gone new age. Our division’s CPA/Controller was totally supportive of the move, so when it became time there would be very little defense for staying the same when the data and analysis was presented.

Conclusion

The owners gave permission for us to explore conversations with Bear about an acquisition of the division. The next step would be for me to visit with the Bear execs in NYC. At this point everything appeared to be flying high on Wall Street and the nation economically. It was time to see if there was a fit. So the flight and lodging was booked on Bear’s dime and my time allocated. Our loan buyer would be there to greet me at the airport.

We will pick up at that point in the next part. My world was about to take an interesting turn. I will also begin inserting parallel stories. I sincerely hope this is providing insight into some of the business world you hear and read about as we go. For example you can insert billions of dollars, instead of millions that ours covered, into a multitude of securitizations and industries in the debt markets that are just routine business on Wall Street.

Of course, the spoiler alert is that Bear was the first on Wall Street to fall in the economic and debt markets collapse of 2008, so stay tuned.