The 3 Ps of Credit

ImageNontraditional alternative bank financing has been around for thousands of years and has proved to be a great business and investment for lenders and an even greater benefit for borrowers and commerce. The advantages to borrowers is their ability to sell their goods and services and get immediate cash from a lender to repeat the process. The more access to capital, the more he or she can grow a thriving business. This non-bank lending arrangement allows a lender to invest liquid capital so lenders can make a return on their capital by way of fees and interest and putting additional liquidity into local commerce. For the system to work successfully requires that the lender understand and mitigate the risk and the borrower has to have the ability to pay back the loans. A win, win for both.

From the lender’s perspective, they have to decide what is fair to charge for their capital in order to cover costs and risk. For centuries, lenders have relied on some age-old principles to make that determination. Lenders evaluate risk, collateral, reputation of the borrower, past payment history, availability of capital, and the amount of time required to complete and manage the transaction. Modern lenders simply sum these up as the 3 Cs of credit: Credit, Collateral and Character.

As simple as the 3Cs are, how each is evaluated and what weight is put on each, varies from lender to lender. JP Morgan, one of the world’s most famous bankers of the 19th century is known to have had his 3Cs. He summed them up as Character, Character, Character. He felt Character was the most important element in lending.

The 3 Cs of credit fit most traditional bank lending arrangements. It’s the other nontraditional sources that make lending interesting, what we have come to call alternative financing or non-bank financing. In this group you have factors, hard money lenders, trade financing, P.O. financing, bridge loans, mezzanine lending, seconds, thirds and even fourth mortgages on real estate just to name a few. If there is collateral out there, someone it trying to finance it. Many of the loans in this grouping put little focus on the character and the credit components of the 3Cs and instead focus more heavily on collateral. Collateral is important in a lending transaction, but as every lender knows it’s the ability to turn that collateral back into liquid cash quickly that’s the tricky part.

Alternative lenders over time have developed an elaborate set of controls and requirements to make sure loans are paid back and they are not playing Larry the Liquidator each and every day. Even with an arsenal of controls, collateral lenders find themselves front and center in a cat and mouse game of deceit. When credit and character are pushed far to the bottom of the decision- making process, the propensity for a borrower to commit fraud is very tempting. Only holding to your core discipline can prevent lenders from inviting bad deals through your doors.

If there are proven systems to analyze loan applications, why do lenders find themselves on the losing end of loans? The financial meltdown of 2008 is a prime example. U.S. Banks, who have some of the most restrictive regulations, underwriting standers and oversight made some of the worst loans in the history of finance. The answer to this question lies in the over supply of money looking for return on capital. There was just too much money chasing too few deals. Money is money. There is no competitive advantage between yours, mine or ours. Being there is no differentiation of product and an abundance of the supply, lenders are left to alter the terms of the lending arrangement. First goes credit standards, then goes character, followed closely by controls and, finally, the perceived value of the collateral.

You would think that lenders learned something from the 2008 financial fiasco that almost brought down the world’s financial system. In the immediate aftermath of the meltdown, they had. Credit tightened, controls went into place and only AAA borrows with the best character could receive a loan. Why? The easy supply of money disappeared as investors tightened their collective purse strings.

Move forward to 2013 and it looks like deja vu all over again. The Sodom and Gomorrah of easy money is flowing again and controls, credit and discipline is once again taking a backseat in lending. More and more fraud is being seen and it’s only a matter of time loans start defaulting or prove to have too little collateral backing them up. The floodgates aren’t open quite yet, but if the trend continues we could again be in for a nasty surprise in the coming years. We have talked about the 3 Cs of lending, so what about the 3Ps? What are they? They are: Will they Pay, can they Pay, can you make them Pay?

What’s the take away from all of this? You might want to think about the 3Ps before it’s too late. Then again, JP Morgan might have had it right, when he said Character, Character, Character.

Author: Stephen Troy is an accomplished business executive, lecturer, author and founder & CEO of AeroFund Financial, Inc.. As Chief Executive Officer of Aerofund, Troy has established AeroFund as a prominent national finance company, which provides secured loans to small and medium-sized businesses. Troy is the founder and chairman of AeroBank.com. AeroBank is the first national business bank to be approved by United States government Office of the Comptroller of the Currency to operate solely on the internet. Troy is the author of two bestselling books, “Business Biographies, Shaken Not Stirred….With a Twist, about famous business leaders and “Would a Maharajah Sleep Here?” chronicling 5 star luxury travel around the world.

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