Inventory Lending: Anticipating Adverse Changes
Advance rates are set, ideally, based on the expected value of the collateral in liquidation, when a loan has defaulted. It is therefore direly important to understand the changes that can occur to collateral in a distress situation. Conversely, basing lending decisions on inventory conditions today, can prompt big losses down the road.
Although loan customers may get in trouble for a variety of reasons, the ultimate manifestation is usually tight cash flow. The absence of cash may cause management to sell-off prime inventory at a discounted price to alleviate the pressure. This leaves the collateral mix highly impaired. Typical situations where this can happen include lumber companies and wholesale suppliers. Many suppliers are further exacerbated by faddish or seasonal impacts on their product mix. In distress, the borrowers usually purchased too much special inventory in anticipation of orders that never come. It's easy to say that the quality or mix of inventory didn't look that way when the lender made the loan, [The old horse and barn door adage], but it is not difficult to anticipate what may be the likely cause of default based on a borrower's business type. Advance rates are then set based on those risks.
Another important cause of inventory losses is shrinkage. In many companies this may mean damage occurring in the warehouse, but in liquidation it is commonly collateral going out the back door. Inventory tests at pre-loan will always show better results than in liquidation. However, some industries require greater care to control collateral such as food manufacturers and wholesalers and consumer product firms. This is especially true where collateral consists of high-value, small size products such as meat or high-end electronics. Some items may have increased risks due to potential black markets such as in compact disks, computer memory chips and appliances. Unfortunately, when warehouse personnel realize that they will lose their jobs, inventory usually is taken with them. Furthermore, record keeping systems typically breakdown in distress. Although these issues can be mitigated through periodic reviews of client inventory systems and warehouse management, advance rates should also be adjusted if the borrower's industry has these potential risks.
Anticipating pricing of inventory in distress can be difficult (basically when considering the added costs of outside inventory management, auction and legal costs). Products that may be subject to wide swings should have close monitoring. While many of these items are commodity in nature, a quick drop in prices when debt remains static can immediately bring a borrower out of formula with its lending institution. Risks can be mitigated by matched hedging by the client and inventory advance rates pegged to market prices versus average costs. Many banks lent 85% against petroleum products and found trouble during the oil crisis. Similar bank losses have occurred with lending against copper and other metals.
Many other significant factors govern the lending against inventory such as obsolescence, perishability, quality, logistics and turnover. Fortunately, we will have numerous other banking experts to focus on such issues in future articles. We look forward to presenting them to you.