A loan to a local grocery/retailer would involve more credit risk. A small local retailer will more than likely only have company prepared financials and tax return. Company prepared financials can be less reliable for the obvious reason that the company prepares them with no review. Tax returns are typically vague when it comes to balance sheet. Local retailers that have only been in business for a few years don’t have much of a track record. They are still trying to lay down the foundation of the business and gain a strong customer base. Lending to a new local retailer town can be risky even though the business owner may have been successful while managing another retailer that successfully. On the other hand large companies typically have a history of success and have grown to their size through years of profitability. They also have audited financials, which have been checked by a CPA. Audited financials can be reviewed by analyst in more detail.

Often times when you see banks that offer high CD rates they will often have higher loan rates also.

The best way to lower the average cost of funds for a bank is to gain non-interest bearing checking accounts.  Growing these kinds of accounts can help increase a banks net interest margin.  With more deposit in checking accounts and savings accounts banks don’t have to pay a premium for CD’s.  Being able to get lower cost of funds gives the bank more flexibility with loan pricing and they are able to offer lower rates to attract more customers who could be cross sold on other bank products.

You can see there are four phases, 1) Introduction, 2) Growth, 3) Maturity, 4) Decline. A product can be in the growth stage for one bank, but in the maturity stage for another bank. Lets look at them a little closer.

Introduction – A new product enters the market. The sales are slow and the bank actually usually loses money from set-up cost and marketing the product to “catch on” with it’s customers.

Growth -Sales of the product start growing as customers become more aware of the product. As a product catches on and sales grow more competitors join to take a bite of the action.

Maturity – Sales growth slows as new competitors join the game and most purchasers already have the product that need it. Heavy advertising & sales expenses are needed to maintain sales and profit starts dropping off.

Decline - Sales start to slowdown. Fewer banks offer the product. A newer and better product is offered that the customers needs in the place of the current product. Promotion of the product falls off and the product dies.

Here are a few examples I can think of by looking that the products offered by my bank.

Introduction – Ready Reserve Protection. We’ve had this product a few years now, but it hasn’t been promoted until the past 6 months.

Growth – Home Equity Line of Credit. Even though this product has been around a while it is really starting to be applied for more often and creating more buzz in town.

Maturity – Auto loans have hit maturity because of indirect lenders being able to offer lower rates.

Decline – Variable rate loans on the consumer side are in decline. We haven’t done adjustable rate mortgages in years, but we still have customers that still have them.

Another reason banks are not lending so easily is because of cash flow reasons.  Believe it or not some banks are actually wanting you to pay the loan you have with them off to assist in cash flow problems. The diagram below shows how this works.

Banks have loans that are in their pipeline and they are working on closing. They need money to fund those loans so they need to either 1) raise deposits or 2) have some loans paid off to free up cash to fund the loans in the pipeline. If you look in the diagram you see a “clog” and the money cant flow as fast to fund future loans in the pipeline. That clog is from loans in the portfolio not making payments. Loans that are not being paid are Non-Performing Assets (NPA). A good number of problems are coming form aquistion and development loans that are starting to default. With home sales slumping developers are falling behind on payments and defaulting.

Now you know why banks are so desperate for your deposits and are tighter when giving a loan to you and ok with you paying off your loan early. They need money to fund future loans that are meeting their strict criteria.

Here is what I look for when investing in notes on Lending Club.

1. A credit score of 720 or higher. It is ok to venture with borrowers that have a score as low as 680, but know there is more risk coming when you drop below the 720 mark.

2. Length of employment more than 24 months. You need to be able to see that the borrower has good stable job employment. I know no job is guaranteed, but it may help weed out borrowers that are possibly job hoppers or who recently took a job on a short-term contract basis.

3. No delinquencies in the past 24 months. A good pay history is a strong plus for a borrower. It shows that they manage their cash flow well and care about paying all of their bills on time. Sure slip ups happen with some people, but sticking with someone with a clear history is the way to go.

4. Debt-to-income below 25%. A borrower with a DTI of 25% or less shows that they have the ability to take on new debt and still are able to meet their current debt obligations.

5. Length of credit experience. Borrowers with credit lines open for long periods shows that they have experience with handling credit. You want your borrowers to know how to handle debt. I don’t have a certain # in years as far as how long they should have before I will lend, but the longer the better. you don’t want someone with a year or two of experience taking out a $10k loan. They need to start smaller and build a good payment history. Even with 20 years of experience you still have to watch out for how much of their lines they use. Refer to step 6

6. Revolving line usage of less than 50%. You want to make sure that your borrowers are not maxed out on their available credit lines. Someone with a high utilization is a red flag that the borrower could possible be headed down a road of taking on too much debt and no be able to make future payments.

Here are a few tips to remember when deciding also. Remember not to be greedy. The people that are complaining about the low returns is because of their default rates and lending to pretty much anyone with a good story as to why they need the money.

Also be VERY cautious of lending for debt consolidations. Debt consolidation within itself is a good thing, but if they payoff credit cards then max them out again next year then they are in deeper then when you helped them a year earlier. There is no way to make sure they cut their credit cards up.

Finally Stay away from student loans. The source of repayment is low if they are going to school then their isn’t as much income to pay living expenses. Unsecured loans are last on the list to pay… which is what your loan would be. Lending to someone who has a full time career and paying for a masters degree is ok as long as the they meet all of the other criteria. IE a teacher going back for a masters degree.

Character – Character assesses the consumer’s willingness and desire to repay a loan on time. This idea goes along with the “know your customer” concept. With previous experiences with an applicant you can make judgment on their character and if they actually care about paying you back.

Capacity – Capacity measures the applicant’s ability to repay the loan when it is due. Does the applicant have the cash flow and income to repay the new debt they are applying for?

Capital - Capital is the net value of a consumer’s assets. This helps lenders know if applicants have sufficient assets available to repay a loan to the bank if unfavorable situations arise. This has a bigger impact with larger loans.

Collateral – Collateral is an asset pledged by a borrower to a lender to guarantee a loan. The asset becomes property of the bank if the borrower fails to repay the loan.

Conditions – Conditions are external variables that will affect the risk of the loan, such as the economy, social and political environment, government regulations, or competition, or changes in the bank’s goals and objectives.

A method of exchange – Consumers want products that make it easy for them to make purchases, such as checking accounts, debit cards, and credit cards. They also want access to technologies that deliver services, such as telephone banking, secured Internet Banking and retail websites. Consumers also want alternative methods of payment available.

A means of preserving and accumulating wealth – Consumers want financial products that give them the ability to save and grow their money, such as savings accounts, CD’s, money market accounts. Also mutual funds and other investment vehicles fall into this category as more and more banks start offering investments that are not FDIC insured.Since the Gramm-Leach-Bliley Act in late 1999 was passed banks can now create subsidiaries to sell mutual funds, other investments, and insurance.

A way to increase their purchasing power – Consumers want credit products that enable them to make a large purchase without having to save the full amount before purchasing. They enjoy the convenience of being able to paying for the goods or services over time.

Assurance of security and safety – Consumers want peace of mind that their money is safe during economic downturn, theft, and mismanagement. They take their peace of mind when they deposit into an FDIC insured institution. The funds are insured bye the Federal Deposit Insurance Corporation (FDIC).

A – Extensions of Credit by Federal Reserve Banks
B – Equal Credit Opportunity
C – Home Mortgage Disclosure
D – Reserve Requirements of Depository Institutions
E – Electronic Funds Transfer
F – Limitations on Interbank Liabilities
G – Disclosure and Reporting of CRA-Related Agreements
H – Membership of State Banking Institutions
I – Issue and Cancellation of Federal Reserve Bank Capital Stock
J – Collection of Checks and Other Items by Federal Reserve Banks and Funds Transfers through Fedwire
K – International Banking Operations
L – Management Official Interlocks
M – Consumer Leasing
N – Relations with Foreign Banks and Bankers
O – Loans to Executive Officers, Directors, and Principal Shareholders and Member Banks
P – Privacy of Consumer Financial Information
Q – Prohibition Against Payment of Interest on Demand Deposits
R – (Regulation R was withdrawn in 1996
S – Reimbursement to Financial Institutions for Providing Financial Records; Recordkeeping, Requirements for Certain Financial Records
T – Credit by Brokers and Dealers
U – Credit by Banks and Persons Other than Brokers or Dealers for the Purpose of Purchasing or Carring Margin Stocks
V – Fair Credit Reporting
W – Transactions Between Member Banks and Their Affiliates
X – Borrowers of Securities Credit
Y – Bank Holding Companies and Change in Bank Control
Z – Truth in Lending
AA – Unfair or Deceptive Acts or Practices
BB – Community Reinvestment
CC – Availability of Funds and Collection of Checks
DD – Truth in Savings
EE – Netting Eligibility for Financial Institutions
FF – Obtaining and Using Medical Information in Connection with Credit

Source: The Federal Reserve Board, www.federalreserve.gov/bankinforeg/reglisting.htm