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Commentary: Lessons in Lending: Are banks changing their views on equity?

ROCHESTER, NY — Down payment or equity is a term that has been thrown around a lot in the banking industry over the past couple of years. As the credit markets have changed over the past three years, have banks changed their attitudes about equity?

First, we should probably try to define what the equity requirement for financing is. The generally accepted requirement for commercial real estate at community banks has been that we will finance a project at 75 percent of value but no more than 85 percent of cost.

For example, if the real estate purchase cost is $100,000 and the independent appraisal supported the value of $100,000 than the bank would be comfortable lending $75,000, if all other credit criteria were met. In another example, if the same property was purchased for $100,000 but for some reason (possibly a distress sale) was valued at $120,000 by an independent appraiser then the bank might feel comfortable lending more at 85 percent of cost, $85,000.

Every financial institution has its own comfort level or policy usually adopted by its board of directors and monitored by the regulatory agencies that examine them whether it is the OCC or the FDIC. Most banks have policies for all kinds of commercial lending.

For first-time commercial borrowers, that is one of the questions you should ask each bank you talk to because it can vary from bank to bank, depending upon how much risk a bank is willing to take on every deal.

Equity is commonly defined as the value of an ownership interest in property, also including shareholder’s equity in business. In simple accounting, this is the difference between assets less liabilities. If a company has been profitable it adds to equity by increased retained earnings, which come from net profit.

All bankers will tell you that loans are repaid from profits. If a company has lots of equity it shows a couple of things to the banker: Historical operations have been successful and management has made good business decisions, and that in case things go bad, a cushion has been developed that can help the company through rough times.

That cushion or excess is also helpful to understand if the bank and the company ever have to go through the liquidation process. Most assets in a bank liquidation go for a large discount and the more equity built in means the bank has a greater chance at getting back its principal loan and any costs associated with liquidation.

When the market is competitive and banks are trying to increase market share they will sometimes relax typical standards for equity down payments. As soon as the economy softens or lags this is an area that can then hurt a bank if the values change drastically.

As seen in the Florida, Arizona and Las Vegas residential real estate markets, dramatic changes in value and amount to plenty of loans that are no longer acceptable and large write-downs and charge-offs.

The banking problems that can be related to low “money down” products and large changes in portfolio values because of dropping real estate prices will be felt in the banking community for some time. National and state bank examiners have spent the past two years trying to make sure that banks don’t suffer the same consequences again.

Any banker will tell you that any exceptions to policy must be clearly stated and defended through internal review, external audit and with bank examiners. It is probably going to be some time before these standards get relaxed.

This column was written by Jeff Barker, vice president, commercial services, Canandaigua National Bank & Trust. He can be reached at jbarker@cnbank.com or (585) 419-0670, ext. 50646.

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