FIVE Ps OF CREDIT REQUIRED FOR CREDIT RISK EVALUATION.

This course uses Five Ps of Credit – a variation on the “Three Cs of Credit”

(character, capacity, collateral) – as a way to help you determine whether you think
a loan represents excess credit risk.

People – Does the borrower have a history of being honest, reputable and timely in
honoring his or her financial obligations? If not, go no further. This is the area where
you may make your greatest contribution. You may know something about the
borrower that no one else knows that could be critical to the lending decision.

Purpose – There should be a specific explanation of how the borrower is going to

use the funds. Don’t settle for a simple description such as “working capital.” For
example, a farm operator may borrow funds for working capital purposes that
include fuel, seed and fertilizer for a new crop. Or, it could be used to cover living
expenses until the next harvest. These are two very different purposes with
significantly different implications for loan repayment.

Payment – Knowing the purpose helps identify sources of repayment and aids in
structuring the loan’s repayment schedule based on the timing of the borrower’s
receipt of funds (cash flow). For example, if you loan money to a farm operator who
receives most of his income in the fall after harvest, a monthly payment schedule is
inappropriate. Rather, loan payments should be scheduled beginning in the fall after
the operator has harvested and marketed his crop.

Knowing the sources of repayment is important because that shows how the bank
will receive its principal and interest. The primary source of repayment typically
comes from the borrower’s cash flow. Secondary payment sources can be likened to
insurance policies. If the unexpected occurs, the bank looks to secondary payment
sources for the principal and interest it is owed. Some examples of secondary
payment sources are third party guarantees and sales of collateral supporting the
loan.

Plan – How will the loan be supervised and, in the case of borrower default, what
will the bank do? The plan to supervise should specify how the loan will be
monitored, including financial reporting by the borrower, and periodic inspections of
the borrower’s operations. The plan should also include the bank’s exit strategy for
the loan if something goes wrong. Will the bank foreclose on the collateral, collect
from guarantors, pursue collection through the courts or seek garnishment of wages?

Protection – This is collateral and other secondary sources of loan repayment.

Protection is last on the list of Ps for good reason. Except for some types of asset-
based lending, collateral should not be relied upon as a primary source of
repayment. The reason is that the value of the collateral rarely equals the full
repayment amount. For example, during the oil boom of the late ‘70s and early ‘80s,
one bank made a $1 million loan on an oil drilling rig that cost the borrower $2
million to build. This gave the bank a $1 million collateral cushion on the loan.
However, during the oil bust that followed, the borrower defaulted on the loan
leaving the bank with a rig that sold for $250,000.
Problems with collateral versus repayment amounts were prevalent in the ‘80s when
collateral values supported real estate loans. During this time, abusive practices led
to unrealistic appraisals on real estate that justified loans to borrowers with little or
no ability to repay.

Today, there are specific appraisal requirements for real estate taken as collateral on
a loan. Federal banking agencies now require that a real estate appraisal be
completed by a licensed, certified appraiser, except for:

• Residential loans with a value less than $250,000.

• Business loans of $1 million or less which don’t depend upon the real estate
(sale, lease or rental) as a primary source of repayment.
• Loan renewals where there is no material change in the asset’s collateral
value or the borrower’s financial condition.

If the bank does not receive a real estate appraisal, it must obtain a written
evaluation. If you were to look over the content in an appraisal and evaluation you
would notice only minor differences. That’s because the content of evaluations, as
specified in policy guidance from the federal banking agencies, is largely taken from
that for appraisals. Despite their similarities, there is one notable difference. State
licensed or certified appraisers, in accordance with Uniform Standards of Professional
Appraisal Practice, do appraisals. Anyone with real estate-related experience that is
independent of the transaction (for example, bank officers, directors and real estate
agents or brokers) can prepare evaluations. Because of this, they can be scheduled
more quickly and are less expensive to the bank and the borrower than an appraisal.

The Credit Checklist is a tool you can use to organize your loan review and assist you
in spotting sources of credit risk in requests that deserve further attention. By
answering the four questions included on the checklist you should be able to identify
basic credit risk issues that exist in a loan proposal.

Does the loan exceed the bank’s legal or internal lending limits?

Consider:

• What is the bank’s current lending limit?

• Is the total lending relationship to a borrower within the limit after granting
the latest loan request?

Does the loan present an excessive credit risk? ( The “5 Ps” of Credit can
help you make this determination.)

Consider:

• Is the borrower of good character?

• Is the purpose of the loan specific enough to indicate how loan proceeds will
be used?
• Is payment of the loan consistent with availability of sources of repayment?
• Is there a plan for administering the credit?
• Is collateral being taken as a secondary source of repayment?
 • If the collateral is real estate, does the bank have an appraisal or evaluation
to support the value given to the collateral?

Does the loan present legal or regulatory issues? (The Sam Wilson loan
presents more information on regulatory issues in lending.)

Consider:

• Is the loan to an insider or affiliate of the bank? If so, consider Regulation O

regarding insiders and Regulation W regarding bank affiliates.
• Have spousal guarantees been requested? If so, consider Regulation B.

Is the loan consistent with the bank’s loan policy?

Consider:

• Does the proposal fall within the bounds established by the bank’s loan policy
or is it an exception to policy?
• If the loan request is an exception to the bank’s policy, what is the exception?
Is the exception great enough to warrant not extending credit?