What Would Ernest Hemingway Say About Your Borrowers? Published April 23, 2019
Sometimes what’s not revealed by the storyteller is the most important part of a story.
Ernest Hemingway, the great American author, made famous what he called the “Iceberg Theory”, also known as the “Theory of Omission”. It’s the idea that a writer can strengthen the story by omitting selected details, thereby forcing the reader to fill in the gaps.
He named it the “Iceberg Theory” because getting the whole story mirrors how an iceberg actually works—the part of the story we see is supported by the majority of the story we don’t see.
For credit risk professionals, inferring the unknown gaps in a borrower’s financial story is dangerous. Without the proper tools to uncover a borrower’s hidden tax debts, determining which loans will be repaid or default becomes rife with uncertainty.
TAX DATA ABOVE THE SURFACE
For decades, commercial lenders have utilized federal tax liens as a strong risk indicator of a business’ ability to repay a loan. Credit risk professionals care if a prospective commercial borrower is paying their taxes or not, since nonpayment of taxes indicates everything from cash flow issues to impending business failure.
However, public record searches for tax liens present a mere glimpse of a borrower’s financial health story—just the tip of the iceberg. The problem is that this type of public record data only reports whether or not the IRS has filed a tax lien, not whether the borrower has paid all their taxes in full and on time. In fact, according to our research on over 50 million IRS tax transcripts, nearly 1-in-5 businesses have a hidden tax debt with no federal tax lien filed.
This problem is only getting worse.
Credit bureaus no longer include federal tax lien data on credit reports. As a result, credit scores are predicted to rise 20–40 points. In addition, according to the IRS Data Book, delinquent federal tax debt accounts are at a 15-year high while federal tax lien filings have declined to a 15-year low, further widening the gap of what commercial lenders are able to see when making credit decisions.
Calculating the risk lurking below the surface of the iceberg is crucial, but only if it can somehow be seen. There just hasn’t been a complete credit risk tool available to uncover all hidden tax debts.
GOING DEEPER BELOW THE SURFACE
The solution begins with a new understanding: credit risk is created at the moment of nonpayment of taxes, not when a lien is filed. When a business has a cash flow problem, payments are typically made to vendors, employees, landlords before the IRS. Consequently, tax liens become a symptom of a business’ cash flow problems, NOT THE actual credit risk problem.
Credit risk professionals must be able to look below the surface of tax liens for the complete story of financial health. But how?
Start by capturing the complete story of a borrowers’ financial health. Credit risk teams that use a comprehensive tax data solution to identify hidden tax debts, including missing tax returns and a history of tax deposits, can see the true risk. As a result, their organization will make more confident decisions, produce better-performing loans, and increase profitability.
I’m sure if the great Hemingway was a credit risk professional, he’d bring the details of hidden tax debt to the surface. Some parts of the story are just too important to leave out.
[Originally written for The Risk Management Association blog: https://www.rmahq.org/what-would-ernest-hemingway-say-about-your-borrowers/]