Know Your Collateral

The idea of lending money at a bank is conceptually simple: You lend money to people and businesses that will pay it back. If everyone paid you back without any problems, banks would lend money to everyone. However, some people and businesses, for whatever reason, do not pay the bank back. When the borrower doesn’t pay you back, you have to take the collateral and/or sue the borrower.

This may sound simple, but in practice it can get very interesting. One such example came to my attention in the early 1990s. I was a junior member of a loan committee and the following loan was presented:

Borrower: Remote Johnnys Inc. (RJI)
Loan Amount: $800,000
Collateral: All the equipment that the company owned

During the loan discussion, the loan officer, Bill, told the committee that RJI had been a customer of the bank for 10 years, had always been profitable and had always paid its loans on time. RJI had substantial deposits with the bank, which is always a great start to getting a loan approved. The owner of the business, Johnny Sample, had excellent credit and a strong financial statement. The cash flow of the business was 1.5 times debt coverage. The loan committee reviewed the company and personal financials—and you could tell the loan was about to be approved.

One of my weaknesses—or strengths, depending on how you look at it—is that I always look at things a little differently than other bankers. Many years ago, one of my mentors told me that I should always look at a bank loan as a transaction where the bank was buying the collateral for the amount of the loan and the borrower had two options as time went along. Option one was when everything went as planned and the borrower paid the loan and kept the collateral. Option two was when things did not work as planned and the borrower “let” the bank keep the collateral.

So, as I looked at the proposed RJI loan, a question arose in my mind. Here is how the discussion proceeded.

Me: “Bill, tell me more about what RJI does.”

Bill: “They provide equipment for the construction industry, like I wrote in the loan memo.” (Bill was not happy to have me asking questions just as his loan was about to be approved.)

Me: “What kind of equipment does RJI provide? What will our collateral be?”

Bill (unhappier still): “We will have all the assets of the business.”

Me: “Tell me what those assets are, please.”

Bill: “RJI provides remote johnny’s [porta potties] to construction sites.”

Me: “So, our collateral on this loan is primarily porta potties?”

Bill (really not happy): “Yes, but I want you to remember that this is a good business that has proven its ability to cash flow its debt.”

Me: “Bill, I understand that RJI is a good customer, but what would happen if he could not pay the loan? Would we even know where all these porta potties were located?”

Bill: “Well, ah, I think we would have a list of where they are located.”

Me: “How many porta potties does it take to be collateral on an $800,000 loan?”

Bill: (no answer).

Me: “OK, let’s say RJI does not pay us and we find all these porta potties all over Dallas and Fort Worth. Where do we store them once we get them in our possession?”

Bill: (no answer).

Me: “Finally, let’s assume we have the porta potties in our possession. Who is going to buy them from us so that we can get our money back?”

From there, it was all downhill. There was no chance that RJI’s loan was going to be approved. I had taken back enough collateral on loans at that point in my career to always be thinking about how we would get our hands on the collateral and how we would sell it. The loan was declined.

A year later, the economy bottomed out (pun intended), nearly all construction stopped, and another bank that made the loan took a giant loss. I have never forgotten the porta potty loan discussion.

As one may imagine, I was not always the most popular guy with other lenders due to my questions in the loan committee.


Ken Mixon is president and CEO of City National Bank in Corsicana. Prior to 2012, he worked at banks in Richardson and Plano. Mixon is a big fan of the Dallas Mavericks, Dallas Cowboys and Oklahoma Sooners. He enjoys hunting and fishing, as well as being with family and friends. His book, Texas Banker/Oklahoma Hunter: A Mostly True Story is available at KenMixonTexasBanker.com, Amazon and other booksellers.