Inspections Are Good. Repeat.

by Regional Examiner Jeff Bagby, Oklahoma State Banking Department

Inspections are necessary. Inspections are good. Inspections keep the borrower honest. That mantra may need to be repeated on occasion when the loan has rocked along for a while and the only contact you've had with him or her is the monthly, or worse - annual, payment sent to the bank. It's also reasonable to consider that once the loan goes past due, it is too late. By then, inspections take on a forensic flavor suitable for determining how much to charge off. The next thing you know, you are being contacted by the producers of "The Worst Loan I Ever Made."

Inspections should start early and go late. I understand that not many loan officers have the latitude to make sizable loans without collateral evaluations in hand. With this said, you would be crazy to make a loan without a solid idea of what is supporting the credit if the cash flow comes to a screeching halt. The challenging part is forcing yourself or a colleague to go to the borrower's business and perform inspections during the interim. That is, after they get the money and before you file foreclosure.

Some officers need an excuse to inflict their presence on the customer, so they set the loan up on fairly short terms. That gives them the opportunity to reevaluate the borrower and his collateral at reasonable intervals. Others use the time-honored strategy of "the examiners are coming" to get the needed information. I still remember the letter I found in a loan file years ago that stated in no uncertain terms "The regulators will force us (the bank) to foreclose on your property if you don't bring in the needed documents." Nice. Now that banks are notified well in advance of our impending arrival for an examination, the deluge of fresh inspections in file is a little unsettling, but helpful in the end. There is, however, only one thing worse than an inspection done for no other reason than to appease examiners: No inspection at all.

Some bankers complain that they don't have time to make frequent inspections of far-flung collateral. They begin to "monitor" collateral by noting changes in the borrower's financial data. Assuming they even send the statements to the bank, this is tantamount to surrendering all control over the credit arrangement to the borrower. How do you know the information on the financial statement is accurate? There is a simple solution to this dilemma. Hire someone to do the inspections for the bank. Especially for livestock or equipment, there are inevitably retired individuals that spent a lifetime in the industry in question that have the time and experience to give a reasonable evaluation. And you don't have to pay them a king's ransom to do it.

There are times when a local guy can't get it done, though. Consider the bank that made a loan collateralled by international shipping containers. When questions arose whether cash flow was sufficient to service the debt, there was renewed interest in the actual value of the containers. They are very durable units, but no one was completely sure where all of them were located. That made for a nearly impossible scenario when the examiners stopped by and reviewed the loan. You thought driving out to Farmer Larry's spread to count cows was difficult. Not only did they have trouble finding the containers, finding someone to do the evaluations was even harder. Here's hoping they don't have to repossess the collateral. From international shipping containers to Chevrolet pickups, if you question whether the collateral can be monitored effectively over the life of the loan, maybe the loan is not worth making.

Inspections are also necessary in real estate construction loans. Making advances based on work completed is the standard approach to controlling a construction loan. Loan officers will occasionally track progress by simply watching the invoices rolling in. This results in less effort expended, but the strategy is somewhat flawed. Again, there is no better way to verify that the work is indeed being performed than to go to the construction site and inspect the progress. Take some pictures. Examiners love to look at pictures. And for the loan officers that continue to fully advance construction loans at the outset of the credit, well, good luck to you. Inspections may or may not help.

For bankers that finance cattle operations in our region, there are added benefits to having current inspections in file. Besides all the wildly positive results of inspections that have been discussed above, if that relationship ever deteriorates to the point that adverse >
The overriding benefit of periodic inspections may not be the actual document itself, but the simple act of showing the borrower that you the banker are interested in the condition of the collateral and the status of the business or project. It lends itself to the premise of human nature. Refer to "the examiners are coming" comment above. A local banker lives by the adage, "People don't do what's expected, they do what's INSPECTED." Curiously, his bank is one of the best in the state.

Jeff Bagby is a Regional Examiner with the Oklahoma State Banking Department. He has spent 17 years in bank regulation which includes a wide spectrum of knowledge and experience. In the early part of his career, the banking industry in the central region of the United States endured its most devastating era since the FDIC was established bringing with it numerous bank closures. In addition to writing examination reports and working with bank management, Jeff teaches Loan Officer Seminars aimed at revealing to bank lenders how and what an examiner looks for when reviewing loans.

Jeff received a B.B.A. from the University of Oklahoma in 1985 and is a graduate of the Conn Graduate School of Community Banking.

First published on BankersOnline.com 2/08/06