Ode to the C-Words

I’ve been writing this column for over a decade, and early on I promised myself I would never devote a column to those annoying Five Cs of Credit. Few bankers grow up in our industry without pledging allegiance to them. For you directors who missed the lecture on the subject, bankers have forever examined credits on the basis of Character, Capacity, Conditions, Collateral, and Capital. If a loan didn’t measure up in all five categories, bankers were trained to turn it down.

What’s made me change my mind has been the rogue’s gallery of CEOs who, in the old days, would have exemplified the borrower whose sterling personal life would have satisfied the Character requirement with room to spareu00e2u20ac”leaders with character so exemplary as to overcome shortcomings in the other Cs. Some of the biggest banks in the country have been snookered by Sunday school teachers (Worldcom’s Bernie Evers), civic-minded philanthropists (Enron’s Kenneth Lay), champions of small-town values (Adelphia’s John Rigas), and a parade of other virtuous men whose moral rectitude has resulted in a human tragedy of lost jobs, depleted retirement funds, and embarrassment and shame.

So something obviously happened to the standard by which we judge Character. Smart peopleu00e2u20ac”bankers, analysts, savvy investorsu00e2u20ac”have been judging character by a media-fed public relations persona. Maybe teaching Sunday school or saving the hometown lumber company or financing the local community theater group isn’t enough. If you’re also building 30,000 square-foot homes and keeping legions of relatives on the payroll and “investing” in assets that look suspiciously like leisure activities or personal ego-trips, maybe those things reflect on your character, too.

What about the other “Cs?” Nothing is more basic to lending than a borrower’s “Capacity” to repay the loanu00e2u20ac”to have sufficient cash flow, and the probability of it continuing, to give the lender a high level of confidence that the loan will be repaid. But when Capacity depends on a booming economy and a soaring stock market, lenders aren’t betting on the borrower’s capacity at all, but on the environment in which the borrower operates.

Which leads us to “Conditions.” Credit grantors are trained to be conservative, to assume that the worst-case economic scenario will prevail. But wait a minute, conditions were greatu00e2u20ac”the greatest bull market of all time and a “new economy” where the old rules of business cycles and value based on profits seemed not to apply anymore. Again, the sophisticated bankers that got burned the worst tried to re-define “Conditions,” only to find that the original definition was the right one after all.

What about “Collateral”? Hard to believe as it is, several of the fallen stars had massive personal loans collateralized by stock in their own high-flying and wildly overvalued companies. The stock tanks, the collateral shrinks, the loans are called. Then the CEO bankrupts, right? Nope. The company’s board calls a meeting and votes to lend money to CEO so he won’t sell his stock, which might lead the market to panic and the company’s market cap to further erode.

And, finally, “Capital.” Any small-town banker knows that you don’t lend money to an entrepreneur who doesn’t have his own capital invested right along with the bank’s money. Yet the sophisticated lenders of the new economy forgot that one, too, lending personally to CEOs whose entire net worths were often stock options and who’d never bought a share of stock or invested a nickel in the companies they led.

All of which is to say that the Five Cs of credit are alive and well. It may be time for a whole new generation of bankers to recite them frequently and write them on the blackboardu00e2u20ac”excuse me, their Palm Pilotsu00e2u20ac”a hundred times.