A Storm on the Horizon for Banks

During all the junk, we have watched about Matt Lauer, John Conyers, Al Franken, and others, a warning has come from Wall Street.  Ironically, this warning is coming from a man about to depart as the head of one of America’s largest companies.  But he is leaving on his own will, with no scandals in tow. 

Ken Chenault took the helm of American Express in 2001.  He is the third black CEO of a Fortune 500 company.  He navigated the company through the market crash in 2008.  As he is leaving, he is issuing a warning for his industry at his last investor conference. 

This all started a decade ago when some of the largest banks decided to cash out of their ownership of Visa, Inc. and Mastercard, Inc. through initial public offerings.  Before the sale, banks controlled the piping system of payments across the country. 

 But now with those entities outside the banking industry, they will have a hard time fending off new entrants that offer consumers innovative ways to move and spend their money.  This will blend finance with commerce. 

Chenault said that breaking off the card networks “was one of the biggest strategic blunders of the last 20 years.  They didn’t understand what they were giving up, and they lost sight of where the puck was going.  Along with yielding pricing poser to the network, the banks also limited their access to data and merchant relationships at a critical time.”

Take China, where payments are rapidly shifting from cash to apps and mobile devices, vaulting over the traditional banking industry.  Jack Ma’s Alipay and Tencent Holdings Ltd.’s WeChat Pay now handle 90 percent of these transactions, creating a vast system of e-commerce and finance.  Whoever controls the point of payments, commerce, and other services is at a “major advantage,” according to Chenault. 

A decade ago, lenders like JP Morgan Chase, Citigroup, Bank of America, Wells Fargo, and HSBC Holdings broke off their jointly owned credit card networks.  Mastercard had an IPO in 2006 and Visa in 2008.  Both stocks have soared since their introduction into the market. 

“They gave it up on the cheap, and now the roles are totally reversed,” Chenault stated that it is one of the most amazing business stories of the past 20 years.  “An industry literally transferred wealth over to two associations.  They were nonprofits.  That’s unbelievable.” 

Chenault thinks China’s payment model is coming to the U.S.  When it does banks may be the ones holding the bag to traditional non-bank companies who will take market share from the finance industry.  It creates a different model to be concerned about.  No longer is the small community institution focused on what bank or credit union will pop up down the street from them.  Now they will be concerned if Amazon becomes the financial house of choice for their customers.

The payment transfer industry will become even more important over time as there is a move to eliminate cash from our society.  If all transactions can be handled with an app or software, the place banks once held in society may not be there.  We need to realize these trends and prepare to meet them head on if we are to thrive in the future.

The Case of the Missing Credit Policy

Last week, a chief lending officer from a credit union we work with sauntered into our office and sank down in a chair across from my desk.  I had seen Bob (names have been changed to protect the guilty) many times before, but never this distraught.  He held his head in his hands for a good five minutes before looking up at me and crying, “I need help.  We have lost our loan policy!”

Now such a statement is quite surprising, but I have learned over the years to not show any surprise, no matter what outlandish claim is uttered by anyone sitting across from my chair.  After all, this is what a good credit sleuth does.  Before I could utter a word, Bob cried, “Our regulator friends have shut us down until we find our policy!”

The regulators!  For some these folks cause much pain and heartbreak.  Many times, the regulators are simply doing their job and trying to guide the wayward sheep back to the right path.  This situation does warrant further investigation to the cause behind the shutdown.

“So, to start, we should retrace your steps and see what you were doing when you last saw it” I replied.

Bob scratched his head in deep thought as he picked up my deerstalker hat and ran his fingers across the seams on my calabash pipe.  Finally, in a moment of discovery, his eyes lit up.  “I remember seeing it five years ago when it was approved by the board.”

My eyes widened.  “Five years is quite a long time,” I stated.  “Hasn’t the board reviewed the policy since that time?” 

“Never.  We never saw any reason to bring it back before the board.”

“Well,” I asked, “what about the requirements with the new regulation that went in place January 1, 2017?”

Bob thought and then replied, “We never saw any reason to change how we do things.”  

The situation was beginning to become crystal clear, as the clues pointed me toward the source of the trouble.  “There is much additional freedom in the regulation granted to MBL departments.  However, with much freedom, comes much individual responsibility on the individual institution.  The reg basically requires all institutions to rewrite their loan policy.”

Bob sat the pipe down on the edge of my desk and stood up.  He sauntered to the window and looked longingly outside.  “But why do we need to constantly change our loan policy?” he asked.

“Well for one thing, if you worked with the policy a lot, you would not lose it to begin with!” I chuckled, but held any other sarcasm as I saw the annoyance in Bob’s furrowed brow.  Besides, I needed a payday and would take the case.  “It is very elementary, Bob.  The freedom granted you requires more oversight by your board and staff leadership.  Your MBL policy should be reviewed at least annually, just like other policies that govern your credit union should be.”

“Annually?”  Bob shrieked.  “This seems quite excessive.”

I calmly replied, “It is not, if you realize it is part of your responsibility to have your leadership manage the department well.  Reviewing policy and procedures is just one piece of a properly executed credit department.  We can help you draft, structure, and set up the policies and procedures to make sure you are back in business.”

Bob appeared relieved for the first time since he slumped into my office.  “I will take you up on the offer!” he exclaimed.

“The case of the lost loan policy has been closed successfully,” I stated.  “We will begin the process of drafting your new policy.” 

If you have not reviewed your loan policy and procedures, we are here to help.  Reach out to us!

 

 

Make or Break Retail

The weekend before last, my wife and I ran an errand that took us to our local mall.  We were surprised at what we saw.  Here we were, a week before Thanksgiving, and one of every four small store spaces was empty.  Foot traffic was also light and you could shoot a cannon down most halls and not hit anyone.  Of anytime, I would expect the mall to have its shops full, at this time of the year. 

Now not every place in our town has retail that suffers.  One of the newer shopping areas with an attractive outdoor mall continues to grow with new stores, restaurants, and hotels going up there.  But malls seem to be suffering.  Ours has two large walking dead retailers of JC Penney and Sears that are anchor tenants.  A large space has been taken up by a franchised gym.  A church rents mall space as does some federal government offices. 

Times are changing.  We have looked at three different malls so far, this year and passed on all three.  There is a so-called retail apocalypse concept that now even has its own Wikipedia entry!  The industry’s response to this is typical media fearmongering that stresses only the troubles in the industry and not the good. 

There are some bright spots in retail.  In the first three quarters of 2017, retailers announced 3,044 more openings.  Twenty seven of the 50 states have more retail jobs today than they did in January 2007.  Four of those states, North Dakota, Texas, Washington, and Utah, even have double digit increases in retail employment.  And if you have a strong online presence, more people are shopping that way every day.  Personally, our family used to run out during the Thanksgiving weekend to do Christmas shopping.  It was an event where we used to get up early on Black Friday to hit the stores.  Now most of our shopping for Christmas is done on line.  I would guess many others are this way as well.

Bloomberg posted an interesting article earlier this month on America’s Retail Apocalypse.  There appear to be more dark clouds on the horizon for retail.  Compared to the 3,044 new store openings, 6,752 stores (excluding grocery and restaurants) announced closings in 2017.  This also comes at a time of high consumer confidence, unemployment at tremendously low levels, and strong hope for future economic growth.  These are historically times when retail will boom.  And yet, we see more closings, chains filing for bankruptcy, and stressed retail debt than during the financial crisis.  In metro areas like Reno, Phoenix, inland Southern California, Denver, Kansas City, St Louis, Detroit, and southern Louisiana, retail restate loans have delinquency rates exceeding 10%.  Pittsburgh leads the nation with 26.8% of all retail real estate loans late. 

The root cause is not as easy as blaming Amazon or other online marketers.  It is not 20-40 year olds spending more money on experiences than things.  Bloomberg puts the root cause as high debt.  Many of these long-standing companies are overloaded with debt.  Many of these are from leveraged buy outs from private equity firms.  These billions of dollars of debt are going to be harder for even healthy chains to sustain. 

What even makes this harder is that much of this debt is coming due.  This year, only around $100 million of high-yield retail debt came due.  This will increase to $1.9 billion in 2018 according to Fitch Ratings.  From 2019 to 2025, each year, the retail debt balloon will average $5 billion each year.  Even worse is the market for high yield debt will hit a record $1 trillion for all industries over the next five years.  So, the retail debt balloons will come in a time when demand for high yield money is high.  Also, don’t forget that with the Fed raising interest rates, some high yield seeking investors will gravitate toward lower risk alternatives that now pay more.

A canary in the coal mine may be Toys “R” Us who surprised investors by filing for bankruptcy in September 2017.  Typically, one would think you would wait until the Christmas season is complete, but Toys was struggling to refinance just $400 million of its $5 billion of debt, even though the company had stable results with increasing profits during a time when there was a small drop in sales.  Another testament to the negative aura of retail was earlier this year when Nordstrom’s founding family tried to take the department store private.  They gave up because lenders were asking for 13% interest was the best deal they could come up with. 

Note that on this retail real estate debt, an entire third is financed with local and regional banks.  Nearly a quarter is in the CMBS market, 15% is with national banks and 13% is with insurance companies.  Any amount of tremendous stress will hit smaller banks hard. 

The ripple impact of the stressed debt will hit employment as retail is the largest employer of Americans at the low end of the income scale.  Salespeople and cashiers make up 8 million jobs in the U.S.  During the financial crisis, 1.2 million retail jobs disappeared from 2008 to 2009.  Since 2010 employment in retail has grown each year except this one when 101,000 jobs were lost.  Low end retail jobs often provided a starting point where workers could move up to managerial positions and make an entire career in retail.  My father was one of those who did this. 

This drop in employment matches an acceleration of store closings with bankruptcies and larger retailers deciding they have too much space.  This is the position of Wal Mart and Target.  Note that the drop of 6,752 stores in 2017 is close to the all-time high of 6,900 in 2008, during the financial crisis.  Apparel chains have taken the largest hit with 2,500 locations closing.  Department stores of Macy’s. Sears, and JC Penney have downsized to around half of their total space of a few years ago.  The decrease in retail real estate has been stronger in rust belt and New England states. 

We all see the negative state of retail today, just as my wife and I did walking through our local mall.  Today will be good times in retail as we remember them, if the coming retail catastrophe hits. 

The Mother of Thanksgiving

The time was September in the year 1863.  Our country was ravaged by the Civil War and most recent in the minds of Americans was the bloody struggle in a small farming community in Southern Pennsylvania called Gettysburg.  Every person and community had been touched with a loss of family or friends in the war.

A prominent women’s magazine editor, Sarah Josepha Hale, sat down to write again about the need for a national day of thanks.  Sarah’s magazine, Godley’s Lady’s Book, was the most well know at the time.  Sarah, born in 1788 in Newport, New Hampshire, went into publishing after the death of her husband in 1822.  She wrote novels on the side of editing the magazine and even had time to write a little children’s poem you may have heard of: “Mary Had a Little Lamb.”  She was an ardent supporter of girls receiving an education.

Sarah worked for the magazine for 40 years and seeing the publication grow to a circulation of 150,000.  The periodical published works of prominent writers like Harriet Beecher Stowe, Edgar Allen Poe, and Nathaniel Hawthorne.  She was well known for her persistence. 

In 1827, she began a campaign to establish a national day of thanks.  Her writing went on for decades without the fruit she had desired.  Oh, there were and had been Thanksgiving celebrations throughout the United States.  Some special days of thanks had been declared by presidents and other leaders of states and before that, the colonies.   But no, consistent, national holiday that was set on the calendar each year had been established.  That was until her editorial in September 1863.

The subject struck a chord with President Lincoln and the people of the North.  Her editorial was published in the wake of the Union victory at Gettysburg.  The moment was ripe as the victory had a huge effect on the public sentiment regarding the war.  In October 1863, Lincoln established a permanent day of thanksgiving on our calendar.  His proclamation stated:

“It has seemed to me fit and proper that God’s gifts of prosperity and freedom, should be solemnly, reverent, and gratefully acknowledged as with one heart and one voice by the whole American people.  I do, therefore, invite my fellow citizens in every part of the United States, and also those who are at sea and the those sojourning in foreign lands, to set apart and observe the last Thursday of November next as a day of thanksgiving and praise to our beneficent Father who dwelleth in the heavens.”

Sarah’s long, 36-year campaign had become a reality.  Since that time, apart from moving the date during the Great Depression, the last Thursday in November has been our national Thanksgiving holiday.  In many ways, she is the mother of our Thanksgiving Day we have today. 

Thanksgiving has always been a special holiday for me.  It represented times when our family would get together and we celebrated with extended family and had reunions around that time as well on both my father and mother’s sides of the family.  It was wonderful to spend times with cousins, watch football, and enjoy the huge spread of food.  A tradition my wife and I started in our family is to cut down the Christmas tree the day after Thanksgiving and decorate the house that weekend. 

Thanksgiving embodies a spirit that we should have every day.  A failure to be grateful, reveals a prideful heart, one that does not recognize the blessings God or the help that others around you provide every day.  Ingratitude advance a lie that we think we can make it on our own. 

In addition to the many blessings of faith, family, and friends, we at Pactola are thankful to every person and institution we work with.  Perhaps you have been a part of a large commercial loan, or maybe you have a small credit your local plumber needed.  Maybe you have attended one of our classes, read an article, or had us help write your MBL policy.  In some cases, you have provided us lessons to make us better, as we are always seeking to improve.  In any of these situations and more, we thank you for your support.  We would not be where we are without each and every one of you. 

When I think of Pactola, I am also thankful to God, who gives me far more than I deserve.  In addition to all of you we work with or who have touched our lives, we have a tremendous staff who bring credit smarts and creativity to the office each day.  We have also grown and touched lives across the country and we look forward to the future with great expectation of new blessings we will be thankful for then.

 

The Quest for Perfect Underwriting Knowledge

There is an old Chinese proverb saying, “It is better to light a candle than to curse the darkness.”  I realized this earlier this morning as I attempted to maneuver around out dark house in the wee hours of the morning without turning on lights.  I ended up stubbing my toe on a large box of books we have left out the night before that was to be taken into storage.

I am sure my experience is something that everyone has had at one time or another.  When we look at a request for a business or farm loan, many times, it is like fumbling around in the dark.  Some borrowers assume that we know what is going on in their business and provide us with just enough information to keep us in the dark.  Other borrowers, are so far into the dark themselves they don’t have a clue about the financials of their firm.  Some clients may get quite frustrated when they provide you with what you have asked, only to hear the information provided has generated new questions to get you out of the darkness.  The scariest borrowers may be those to deliberately keep the lender in the dark and feed them just enough to help get the loan closed. 

In any case, it is easy for the analyst to become frustrated, throw up his hands, and call it quits until every single bit of information necessary to understand the company is provided.  It is then we curse at the darkness and refuse to light the candles that we have at our disposal. 

One of these candles is backwards math.  I came across the importance of this in a file for a manufacturing firm. Note that all numbers are changed to protect the identity of the guilty.  At our request, the sponsor had provided us three years of tax returns, interim financials, and a listing of all company debts and payments.  The list showed annual debt service requirements of around $100,000.  The cash flow for the business easily serviced this at over a 2:1 ratio. 

Using a little backwards math tells a different story.  The tax return showed about $80,000 of interest expense.  This seems pretty high for a company with debt service of only $100,000.  When you take the interest expense and use backwards math, imputing an interest rate of 5%, you get $1.6MM of debt.  Take that over 5 years, as most of their debt is on equipment, and you get over $360,000 of annual debt service.  The higher debt balances and payments were further verified by the tax return.

Now my 2:1 debt ratio is at 0.55.  The backwards math candle revealed how ugly these financials truly were. 

Another candle is the resources from the Internet.  I can’t begin to count the number of times one of our fine analysts has uncovered concerning information about the industry or the business itself on a borrower.  We had one deal several years ago that with a simple Internet search and a review from LexisNexis, showed that our sponsor had spent several years in prison for bank fraud! 

Searches need to go beyond just your typical credit report.  Searches for lawsuits, environmental issues, real estate market conditions, industry trends, or news can be a candle to help you understand exactly what lurks in the darkness that you are looking at.  We have uncovered items such as projects that have no chance of cash flowing in the market, collateral next to known leaky underground tanks, business that are becoming obsolete with new technology, and real estate that is located near areas where there may be high crime or questionable enterprises. 

A third candle is the light that a fresh set of eyes can put on your deal.  Let’s face it, when you get into underwriting a credit, often your emotion can cast darkness over an objective review of the company.  Sometimes, the analysts get so far into the weeds that they fail to look above and see the overall conditions of the credit.  It is at those times that a second set of seasoned eyes that are not clouded with the deal can cut through the issues and provide a different prospective. 

A final candle is using ratio and cash flow analysis.  Dicing up the income statement and balance sheet with various ratio analysis tools and comparing the performance and leverage of the company to others in the industry will often show areas of strength and weakness.  Not only is this good for credit analysis, but showing the ratio results to the company may be beneficial in them understanding how to perform better. 

There are more candles than these four that are useful in credit analysis. The next time, instead of sitting in the dark and refusing to do anything until every possible piece of information is provided to you on the company since the beginning of its existence, take what you have a light a few candles.  You may be surprised at the clues you can unlock with what you have!

When EBIDTA is Leaky

In my days as a young pup commercial lender, I first learned of EBIDTA.  To those of you in rural Missouri (where I came from) this stands for Earnings Before Interest expense, Depreciation, Taxes, and Amortization.  It may also be known as Traditional Cash Flow (TCF).  Basically, the thought here is, how much money does the company generate after paying all its operating expenses?  That is the amount you have left over to satisfy debt payments, make capital improvements, and reward the owners. 

To the lender, understanding this concept is incredible.  Now you have a tangible method to see if a business generates sufficient funds historically, or in projections, to make the debt payments required on the loan you are underwriting.  When I first discovered this, I thought I found the golden key that would unlock the mysteries of commercial underwriting.

The problem is that it only unlocked some of those doors and often, as in credit analysis, the answer may not indicate something good or bad, but point to further digging that needs to be completed.  One of the first examples of how wrong relying on EBIDTA came with the WT Grant bankruptcy in 1974.  Grant was a large retail chain with a long history of impressive earnings growth.  They had a strong TCF or EBIDTA.  To creditors it looks like they could easily handle the debt payments that they were required to make.

The bankruptcy caught a lot of creditors by surprise and this generated a large leveraged buyout.  What happened?   Almost all the TCF was eaten by increases in accounts receivable.  This left a fraction of the cash that was needed for debt service, instead of a multiple thereof.  Unfortunately, A/R does not pay the loans; cash does.

In this case, EBIDTA measurement failed to identify the leaks that drained cash from a business that looks outwardly profitable.  This set off alarm bells in the banking community and identified the need for a deeper dive in the analysis of the company.  Accountants went to work and began to create what became the statement of cash flows to help capture what is happening with the company cash from both a direct and indirect method.  Bankers created the Uniform Credit Analysis (UCA) method to analyze sources and uses of cash.  This has become a standard of spreading software that is used every day by lenders. 

TCF works generally well when you have a loan on commercial real estate, where the amount left over after EBIDTA is usually free of leakage and can be used for payments, CAPEX, and owner distributions.  But absent of that type of credit, your solid boat of EBIDTA, may end up being as porous as your kitchen strainer.  Consider these leakages:

Accounts Receivable may increase to levels where they use up cash and leave none available for loan payments.  A/R is not cash, but the sales do go into the top line of gross income and, if sold with a positive margin, will increase the EBIDTA.

Inventory is another use of cash.  I once looked at a retail business that continued to borrow repeatedly as they poured all profits back to getting more stuff they could sell.  Their inventory levels were so high that at then current levels of sales, it would take 2 ½ years just to sell through the stuff.

Accounts payable that are paid quickly are a use of cash.  Many times, generous terms with suppliers may help the company avoid the need of an operating line.  Having A/P turns that are much shorter than others in the industry may keep you on great terms with the suppliers, but also increases the need for borrowing.  I once studied an ice cream shop that had no debt, real estate of over $3MM in value, and took care of all their financing with 45 day terms with all their suppliers.

Capital expenditures, or CAPEX, can be a huge drain on EBIDTA.  If you have a business that requires the purchases of new equipment or long-term capital improvements to real estate for the business to continue to generate positive cash flow.  An example here would be a manufacturer who must replace machinery that normally wears out with use.  Another example is a hotel that has to replace case goods and floor coverings in a room.  In either case, large sums of money need to be spent to continue generating the top line revenue.

Owner dividends or distributions are also another leak of TCF.  Now people go into a business or purchase a piece of real estate, to receive some personal reward after satisfying all debt and operational expenses.  A challenge here is if the business owner or farmer drains off excessive amount of profit in good years, they may not have resources in the poor years to take care of your debt. 

So, is the EBIDTA or TCF that you are looking at subject to leakages?  This is an important analysis as you consider your possibility for repayment of your loan.

$666 Billion in the Hole

News came out this week that the U.S. Budget deficit for fiscal year 2017 came end at 3.5% of GDP or $666 billion.  Sounds like a scary number right before Halloween!  The biggest drivers of spending increases are government programs of Social Security, Medicare, and Medicaid—large entitlement programs that budget watchdogs say will eventually break the budget.  Spending on Obamacare’s subsidies for health plans purchased on the exchanges jumped 27% as taxpayers continue to bail out insurance company losses.  There are also large spikes in loan guarantee costs at Education and HUD.  Interest on the debt jumped 10%.

Increases in defense spending, often a punching bag for some who want to cut the military size, only increased a modest 1%. 

So many will look at this and conclude that we need additional taxes to drive down the deficit and get our fiscal house under control.  But for this fiscal year, the U.S. government took in over $3.3 trillion in tax revenues.  One would expect that should be plenty of money to satisfy all needs of government spending and even have some left over to pay down our over $20 trillion deficit.

I think the largest problem we have is with leaders who have abandoned any shred of personal responsibility and a moral compass to treat public funds with good stewardship.  We have bureaucrats who believe their job is to spend money on whatever just to keep their budget growing each year.  This past year we spent money on items like:  $174,792 in taking pictures of food, $2.4MM in Medicare payments to dead people, $429,220 in tracking eye movements of Latinos at grocery stores, $300,000 for Chinese fighting dog art, $686,350 to pay fat kids to not eat, $200,000 on a study on how meditation improves the lives of older women, and a total of $4.1 billion in improper Medicaid payments.  The Citizens Against Government Waste, believe that the Federal budget can be brought into balance within three years just by cutting all the waste. 

Government spending per capital has risen seven-fold since fiscal year 1941.  In 1941, per capital spending was $1,718 (in inflation adjusted 2017 numbers).  The entire federal budget was only $13.7 billion in 1941 dollars.  Now this was a $4.6 billion increase from 1933 when Roosevelt took office.  At the height of WWII, federal spending hit $92.7 billion with per capita spending at $9,035 in 2017 dollars.  After the war, in 1948, spending had dropped to a per capita of $2,079. 

In fiscal 2017, the federal government spent about $12,239 per capita.  Compared to the last year before our full entry into WWII, this means that our government is now seven times bigger than it was in FDR’s third term.  The question is, are we seven times better today?

In 1940, we spent 43.7% of government spending on human resources—items like education, training, employment, social services, health, social security.  Only 17.5% went to national defense. 

These numbers flipped in 1945 as we spent 89.5% on national defense as we fought WWII and only 2% to human resources. 

In 2016, we spent 15.4% of the budget on national defense and 73.2% on human resources.  FDR’s spending in 1940 on human resources, accounted for 4.2% of GDP.  Obamas 2016 spending on human resources equals 15.3% of GDP. 

So how can this be turned around?  How can we again begin to have financial responsibility in our government, just as we must have in our families and personal budgets?  Many ideas can show marked improvements.  We can eliminate baseline budgeting, the tool that automatically increases the base of each line item on the budget for inflation.  We could tie the salary of Congress and the President to their fiscal performance like many top corporate executives are.  We could do all we can to eliminate all wasteful spending, get rid of agencies that are not needed, stop all duplications, for starters.

But all of this will come from a change in attitude.  We were founded with a limited federal government whose role was to protect the liberty and freedoms of the people.  Our founding fathers had a healthy skepticism toward a large bureaucracy.  Thomas Jefferson once said, “A government big enough to give you everything you want, is strong enough to take everything you have.” 

We have changed to a society where one of the primary activities of the federal government is to make more people dependent upon it.  For as more are reliant, there is more need and power ceded to the state from individuals.  We need people to begin to love liberty, value self-sufficiency, and be unfettered in their pursuit of excellence in their lives.  We need leaders who will adhere to these principles and seek to limit the overarching reach of the state, in exchange for individual freedom.  We also need these leaders to not change their minds once they have tasted the drugs of power and control that is available to them in government, once citizens have entrusted them with this power.   

Direction of Interest Rates

As a lender, you are often asked about interest rates and the level of rates in the future.  I always would joke and tell a junior lender if he wanted to be right with 100% certainty about where interest rates will be, just answer the borrower that “rates will fluctuate.” 

Sometimes, rate swings come as a complete surprise, like the announcement in early October 1979 made by then Federal Reserve Chair Paul Volcker.  Volcker in a rare Saturday news conference, said the Fed would switch to managing bank reserves instead of managing the Fed Funds Rate, which he admitted, will result in greater fluctuations in rates.  Boy did it!  By late 1980 the overnight Fed Funds Rate hit 20%.  Volcker’s goal was to wring runaway inflation out of the economy.  The actions did stop inflation, but it also threw the country to a recession and drove up interest rates to levels where many farmers and businesses were forced to close. 

We have the luxury today of not being blindsided by what we expect to occur.  The Fed pumped large amounts of liquidity into the banking system after the 2008 crash.  The economy has grown since then, albeit at a much slower rate than we have experienced in many other expansions.  Inflation has remained in check within a range set by the Fed.  Commodity prices have dropped from highs we saw five years ago. Unemployment is low and we are starting to see improvements in the labor force participation rate. 

So, with all this good news of slow growth while having a lack of inflation, usually the Fed will move toward a policy of allowing the economy to grow if their concerns about price stability is minimal.  But now we have a Fed who remembers that pre-crash they had around $780 billion of US debt on their balance sheet.  Today that level is at nearly $2.5 trillion.  The record level of US debt on the Fed’s balance sheet hinders them from purchasing more bonds to inject cash into the economy when that may be needed to stop a downturn.  Couple this with already low interest rates, that have stayed low for a long period of time, and if an interest rate drop is needed to stimulate the economy, there is no level to drop the rate from to create new excitement.

We are left with a Fed who does not have the reason to increase rates to keep prices stable, but who finds it must do so anyway.  For months, the Fed has looked for any new sign of significant inflation with none to be found.  The economy of the world is quite a bit weaker than we saw 3-4 years ago.  Even though there are none, Fed Chairwoman Janet Yellen, has stated in several comments that the Fed sees no reason to back off their plan to increase the Fed Funds Rate and begin selling its US Government debt portfolio at a measured pace. 

Such actions will increase both the short-term end of the yield curve, with Federal Funds Rates, and the long term, with the sale of bonds.   That strategy from the Fed is creating their desired results.  We have seen secondary farm lending rates rise around 50 bps on the three-month end of the scale to around 70 bps on the 30-year end in the year ending late August 2017.  This appears to be the trend going into the near future as more rate hikes and bond sales are on the horizon. 

What does that mean for a lender?  First, now is the time for producers who can, to lock into long term, secondary market fixed rates on their land, and eliminate the interest rate risk if rates increase in the future.  This will often help the farmer better manage his cash flow.  We have several products that can help move the land loan off your institution’s balance sheet.  Now many CUs may not want to offer such a product, but doing so is a way to save the relationship.  If you do not offer it and entity like FCS will, and they will take the entire relationship away on your good producers.  Contact us at Pactola for help!

Next, watch your pricing strategy.  Remember you have an environment where borrowers have been expecting and getting very low interest rates.  They will push you for the same rate they may have nabbed on the last deal they closed a year ago.  But to keep the same margin from last year, that rate will have to be another 50-70 bps higher today.  This may mean that you lose some deals to the lender down the street who is not as astute as you are.  Use prudence, and allow the weaker ones to go if need be. By the time reality sits in, that lender will have marginal credits priced at low levels which will impact his margin negatively.

If possible, show the client how you will price their loan and leave it open during underwriting to be locked a week or so before closing.  That is the method we prefer since it preserves the margin of the loan for the lender if interest rates have moved higher during the analysis time. 

The easiest time to be a lender is when interest rates are steady.  The most profitable time could be when your cost of funds is dropping and the overall lending market has not caught up with those decreases.  Margins can grow quite fat in those times.  The most challenging is the one we are in, where interest rates are increasing and oftentimes many of your competitors are blind that their cost of doing business has been climbing.

The Growth of Robotics in Agriculture

Earlier this week, a story came out of the United Kingdom, of the first farm to successfully produce a crop without a human ever stepping onto a field.  The Hands-Free Hectare project, harvested 4 ½ tons of barley with robots doing everything from planting, pesticide and fertilizer application, and harvesting.  Farmers managed the crop through control panels and computers that controlled customized tractors and drones. 

In central California near Silicon Valley, farmers are reducing their need for field labor by using robots to harvest lettuce.  The robot is complete with a water knife that will cut and place the produce in a bin as it moves along a field.  Already 10% of the lettuce crop in the United States is harvested by robot. 

Welcome to the new world of agriculture.  Using all forms of robotics, drones, and computers, may usher in the next wave of agriculture that may make as big a difference than the last wave with the introduction in the 1970s of the 4-wheel drive tractor.

One of the big drivers is the increasing cost of labor.  Technology has improved in its efficiency and is coming down in price when compared to the cost of labor.  The producer does not have to worry if workers will show up for the day, or if there is adequate daylight to finish the daily tasks.  Things like the rising cost of healthcare and other benefits for workers are replaced with repair and maintenance costs on the technology.  Improvements in the operating systems are often down with open architecture that allows for various producers to adjust and improve features on the robots. 

But other expenses for the farmer will also drop with this new technology.  Robot tractors combined with drones are shown to reduce pesticide use by 75% while treating 90% of the weeds in a field.  This alone would represent a huge decrease in application costs which will help the profitability of the producer.

Robotics are also being used with farm animals.  Drones are used in some large ranches to monitor cattle or sheep.  A company in the Netherlands called Lely, has created and installed over 20,000 milking robots around the world.  The Lely Astronaut A4 box allows cows to be milked when they want to, compared to when the farmer has time.  The robot attaches teat cups to incoming cows and then takes them off when the milking is done.  The system also allows for better pasture management as cows can be rotated every 8-12 hours to a different pasture to prevent overgrazing.  The cows simply just move to the dairy barn when milking time is near and then move out to the pasture when complete.  Lely also makes autonomous robots to feed cows and clean the barn.

A dairy I visited in Colorado uses each milking to monitor production and health of each cow.  It is like each cow seeing a vet twice a day!  RFID chips in the cow’s ear tag will open a gate to a different corral that leads to the vet if illness is detected.   Each time a cow was milked the protein and butterfat content is measured. 

Safety is also an issue with robots having the ability to detect hazards of other robots, animals, or people in their path.  Drones are equipped with sensors that can help avoid hitting different objects and creating damage to themselves and to other property. 

So, the new wave of robots and drones appear to lower costs of labor, seed, fertilizer, and pesticides.  They also will improve the output of the producer.  What this could mean is a large shift in the type of skills needed to run a farm successfully and a new generation of people who will be inclined to look at a career in this field.  More technology skills are demanded to keep up with the ever-improving ag infrastructure.  The day may come where the next strategic hires for a farm are a computer programmer and drone flyer rather than someone to physically hop into a combine cab.  At the same time, these changes may also allow farmers to begin to have more free time.

The Successful Functioning Loan Department

We completed our agricultural and rural business class in Miles City, Montana last week with twenty students.  It was a great class and we had good interaction with the students.  The theme was very timely as we focused on working with loan management and working with troubled credits.  This year there is a substantial amount of these as we have a drought in the Dakotas and Montana coupled with lower commodity prices.  On the price front, we expect another 3-5 years of dismal prices.

The Kansas City Fed surveyed a group of bankers in their region.  Depending upon the state, between 18-40% of these lenders expected some level of carry over debt after the end of 2016.  The Minneapolis Fed expects 96% of lenders to be dealing with levels of carryover debt.  As an aside, I want to explain what is meant by carry over debt.  This is money still owed on an operating line, after all the agricultural product is sold that said line funded in this operating cycle.  If a farmer ends the year with a balance on the operating line of $100,000, but he has wheat in the bin worth $500,000, you do not have carryover debt.  You now have an inventory loan.

The question came up several times dealing with department structure for a business and agriculture department.  Whenever times are tough, as they are in the agriculture sector, credit managers tend to assess if they have the right people fulfilling the proper roles in their institution.  This question popped up several times in our class in different ways.

Sometimes, when it comes to dealing with a problem portfolio, having a different officer manage the collection process may be beneficial as the field officer may be too close to the borrower.  This may be very true in a tight knit community where you may see your borrower at the store, church function, kids’ baseball games, or school events.  In some rural banks, they may switch loan officers to different branches that may be a hundred miles from their hometown.  Sometimes that geographical break is all it takes to manage the problem credits.  When the crisis is over, they often move back to their home area. 

Adding managers and when need be attorneys is another strategy that is important as we work with problem credits.  Sometimes, having the other person there can also help the officer from saying something they shouldn’t.  Two sets of eyes will get different views on the condition.  Remember once the visit is completed, pull off the road and collaborate on a memo that describes what was observed. 

Many larger institutions will have their own special asset group (SAG).  SAG will work with the field lenders but will take over the main responsibilities of interacting with the borrower in most cases.  Sometimes, some SAG duties may be outsourced to a contract loan manager or resource like Pactola, to assist in the workout.  Having an outside set of eyes may shed a quite a bit of value to the situation.

We also had some discussion with the role of field officers and analysts.  There seems to have been a push in the examiner world to want to separate these tasks completely and never shall the two encounter each other.  Now, in some smaller institutions, this is impossible where the commercial lender may also fill in as a consumer officer, mortgage producer, and mow the lawn when needed.

For institutions that are large enough to operate with a complete division of field people and analysts, to do so makes your team weaker overall.  If a field officer does not understand the ins and outs of judging credit, you will end up with field people who find any opportunity and throw it against the wall to see if it will stick.  This wastes time and resources.  It also weakens your status in the community as your CU will be known as one who cannot provide substantial value to their business because of a perceived lack of competence among your team.  The field officers need to be so well versed in understanding credit that they can spot strengths, weaknesses, and trends in the business.  They are often your first line of defense on the credit. 

If you chain the analyst to the desk and all they understand are the numbers, they will be paralyzed in working with the people who actually own and operate the business.  Generic suggestions like you need to decrease your inventory on hand or speed up your receivables collection time, while good on paper and necessary, are much harder to implement.  Seeing the business firsthand by the analyst is a key to making sense of the numbers.  Also, if you keep your analysts in the office, they may never understand what the equipment looks like, if they have the inventory they claim they do, or the condition of the growing crops. 

When the time for managing problems in the credit, it is important that officers have good analyst skills and analysts have good officer skills as well for the best well rounded approach to working through challenges.  One CU mentioned they have a team approach where officers and analysts are forced to work together, see customers together, and analyze credit together.  This is a good team strategy. 

Commercial Loan Management Responsibilities

We recently had the pleasure of having an outside entity review some of our operations, underwriting, and file management.  During this event, we always are curious with what is going on out in the field in terms of credit administration.  It is always good to visit with others as it helps you learn how to better add value to the industry.  My blog this week will hit on a few of these items.

Perhaps the biggest curse with credit unions and commercial lending is the typical CU has such a strong consumer bend.  Credit unions do a great job in serving the member and often offer better terms for the borrower than many counterparts in the industry.  There is a focus on making the dream of the member come true.  And often, I do see the expectations of the customer are often met and exceeded by the service in the credit union.

In commercial lending, and any lending for that matter, at times the best thing you can do is to say “no”.  When the farmer comes in to borrow on another piece of machinery that will sit idle along with the rest of most of his equipment, we focus too often on how we can help they purchase this to help save some income tax expense when the overall cost of the tractor may exceed the value received.  Maybe the manufacturer can only afford a $50,000 piece of equipment, but he wants the new $120,000 model.  We focus too much on giving them what the member wants instead of what is a sound credit decision for both the CU and the borrower.

Next, there seems to be an absence of critical analysis regarding documents.  If we have underwritten a loan with the member reporting $100,000 in the bank and we suggest verifying that with statements, when the statements come in, do you just check it off the list or do you inspect to see how much money is there.  If the borrower only has $100 in the account, perhaps the credit is riskier than what we originally thought.  Maybe this becomes a credit that you do not want to pursue. 

We refer to the earlier practice as “check the box” lending.  It is a situation where there is no critical analysis completed on the information that is present in the loan file but all the boxes are checked to say you received the information.  What good does that do in helping you identify and manage the credit risk if you only check the box.

We still hear a lot about character lending.  I am aware that there are circumstances where this is applicable and necessary.  But an over reliance on character lending assumes that all other factors that go into financial behavior will remain the same.  You really do not know at what time the company will have a loss too large in a year, or a farmer has one too many years of poorly executed crops that will push the individual who would never miss a payment into handing you the keys to the business.  It could also be factors like sickness, divorce, family stress, loss of a key customer, to name a few other factors. 

If you originally closed a loan with poor fundamentals and a lack of company cash flow, to a person with stellar character, when the storm clouds roll in, you may be stuck with a loss.  If you relied on the character too heavily to fail to adequately collateralize the loan, the loss will be bigger. 

Another item that came up is a lack of investing in training and education for your commercial and agriculture team.  We do have some great classes that we provide.  But we look for other sources for us to learn better and to sharpen our skills.  You should as well.  Too many CUs will skimp on good credit training which will lead to poor performance in the lending department in the future.  As an aside here, if you have a topic that you want to learn more about in the commercial and agricultural area, let us know and we will get it on our radar.

We still hear about and have seen poor file management.  In some cases, following up with borrower and guarantor financial statements are not tracked and the data is several years old.  Stale data hinders you from fully understanding the current state of the credit today. 

There are other items like complete global cash flow analysis, identifying all the factors of the credit during the review time, and strengthening the credit write ups that we can point to as well.  We are all working on our end at Pactola to improve each day.  Are you working to be better or are you satisfied with where you are?

The Annual Rush to buy Farm Equipment

As we approach the fourth quarter of the year, and especially after harvest, there is an annual event in the farm sector.  This is often driven by accountants who are being asked by a producer how they can avoid paying any income taxes on this year’s profitable production (if we are in a year where there is a profit).  One of the first suggestions is to purchase farm machinery.  This idea has gained in popularity with the bonus depreciation in place with the current tax law. 

In addition to the standard depreciation schedules established by the IRS, there is Section 179 depreciation and bonus depreciation.  Section 179 allows to depreciate the entire purchase price of equipment up to $500,000.  For businesses that spend over $2 million in equipment, there is a phase out provision that eliminates the deduction once the new equipment costs exceed $2.5 million.  Bonus depreciation allows for 50% of the equipment cost to be depreciated in in 2017 for equipment purchases that are put into service.  This amount drops to 40% in 2018 and 30% in 2019.  The accountant is eager to point out the tax savings that can occur once equipment is purchased and the current tax laws are very favorable.  But the question remains, is it the right thing to do?

The proper way to assess the new purchase opportunity is to look at the costs associated with the existing equipment, amount of cash on hand, availability of borrowing, possible returns on alternative investments, and a review of other options to achieve the same goals.  The various options to consider are the equipment purchase (cash outlay or credit), leasing the equipment, custom hire for the same work, and short-term rental.  Each of these should be viewed according to the factors of capital needed to acquire, ongoing cash flow requirements, repair and maintenance costs, income tax deductions, operating labor needs, and risk of obsolescence.  I will focus on the final three options before going back to the ownership strategy.

Equipment leasing may require no investment or capital to be paid upon acquiring.  The ongoing cash flow needs will be all operating expenses plus any lease payments.  Repairs and maintenance are typically at the cost of the lessee, but these costs need to be considered in light of the repair costs on the existing equipment that is being replaced and any warranties on the new should be factored in.  Operating leases allow for the full lease payment and operating costs to be deducted from income tax and the risk of obsolescence is low.  If the lease is a finance lease, the farmer can deduct the depreciation, interest (not the full lease payment) and operating costs from taxes and is fully at risk for any obsolescence risk.  The farmer must supply labor to operate the machinery.  The farmer remains in total control over the use and timeliness of operation.

In a short-term rental, no capital outlay is required.  All operating costs and rental fees are required to be paid by the farmer.  The lessee may have to pay some of the repair and maintenance costs, depending on the lease covenants.  All rental fees are deductible as a business expense.  Labor is supplied by the farm operator.  The farmer has limited control over the timeliness and use of the equipment.   Also, since the equipment is now owned, there is no risk of owning obsolete equipment.

Custom hire is a typical option we see.  This does not require any capital outlay and only taxes the cash flow on the custom hire cost.  Repair and maintenance is the responsibility of the person you are hiring.  All custom charges are deductible from income for tax purposes.  Ongoing labor is provided by the custom owner, but the farmer is at risk and has no control over the timeliness and use.  The risk for obsolescence is borne by the custom worker and not the farmer.

The last option is for the producer to purchase and own the equipment.  This is done with either a full cash outlay for the cost or a loan on all or part of the purchase price, less any trade-in.  Ongoing cash flow will satisfy all operating costs and any loan payments.  It is also important to look at the opportunity costs associated with this strategy as the purchase may tax the ability of the farmer’s cash flow to meet other needs of the operation and may increase the need for operating loans.  Another factor is additional cash may be earned if the farmer rents his equipment out for custom work.  Repair and maintenance costs are the responsibility of the farmer, but these need to be looked at considering any R&M costs on the machinery this is replacing.  Taxes allow for depreciating the equipment and also any interest paid on the loan.  Labor is supplied by the farmer and he remains in control of the use and timeliness of operating.  The farmer also bears risk of anything going obsolete. 

So, as you see, there are more factors to consider in purchasing equipment than just the tax implications.  Making purchases just to save money on taxes can lead to poor investment choices.  The return on the equipment should be considered with the return on other forms of investment such as securities.  These are often more liquid and can be sold for cash quicker in times of financial stress. 

One metric that should be used to quantify investment results is the Internal Rate of Return (IRR).  This is calculated by first finding a discount rate that sets the present value of an investment’s cash flows to zero.  When the IRR of cash flows is considered from an expected machinery purchase in light of the risk, the farmer can determine if they are better off upgrading to the new tractor or keeping the old one while investing their money into the financial market. 

These calculations are often complex.  Fortunately, there are some pretty good resources out there to help make this simpler.  I found some great resources from Iowa State University at https://www.extension.iastate.edu/agdm/decisionaidscd.html This provides several excel sheets that allow the producer and lender to determine which option may be the best for equipment.  Using tools such as this should be a requirement of the producer as he weighs the equipment purchase decision.

An example of the required hurdle return that new equipment requires was found in studies by the University of Illinois.  Using all the variables in this study concluded that a rate or return of 5% of the purchase prices is required to breakeven on an IRR basis.  So, a farmer who purchases a tractor for $200,000 would need to see at least $10,000 improvement in after tax productivity in order to classify this as a wise investment.  This also shows the returns of a productive asset vs and idle one.  Purchasing a new tractor to save on taxes when it is used primarily as a front yard ornament or pulling a float in a local parade is a poor use of money.

The purpose of these studies is to try to quantify most of the drivers of financial performance a farmer needs to view considering a machinery purchase.  Many times, the investment decision is driven only by the tax savings. In most cases the focus should be on the gains in productivity, future resale value, and overall impact on cash flow as deciding factors for the equipment purchase.  This principal should be used and applied not only to farmers but also to other businesses in their weighing of equipment purchases. 

Constitution Day

Everyone knows the significance of July 4 when we celebrate the signing of the Declaration of Independence in 1776.  This formed the basis of principles for the Constitution, which was signed on September 17, 1787.  I will speak to that more later in this post.  But first, I want to bring out the significance of the Declaration.  First, realize that the Declaration was written in a time when it was widely believed that the only way to have governmental stability was to have family appointed rule.  When the son of King George III wanted to marry a lady of lower station, he was forbidden.  This was happening the time of the Revolution.

Next, consider that the signers of the Declaration were marked men.  General Gage had an order to find and detain them as traitors.  Many of them paid the price they had outlined in the last clause of the Declaration, “we mutually pledge to each other our Lives, our Fortunes and our sacred Honor.”

Finally, note that the Declaration opens by speaking of universal principles.  It does not portray the Founding era, people, or law as unique.  “When in the course of human events” means any time.  The phrase “it becomes necessary for one people to dissolve the political bands” means any people.  The Declaration appeals to a law that is beyond English law.  It cites obedience to the “Laws of Nature and Nature’s God” and certain principles that “all men are created equal with certain unalienable Rights.” 

Now the Constitution does not represent a break from the Declaration or a second founding of the United States.  If the founders had decided those principles in the Declaration were not needed anymore, they would have noted that.  So, the Constitution is a continuation, a building on those ideas.

And the Constitution has lasted.  Do you know what is the oldest government that is based upon a constitution?  Ours is! 

The Constitution begins with an acknowledgement that the ultimate source of power is not with the government, it is with the people.  It starts with “We the people”.  Nowhere does it cede all power to rule to a government.  It places limits on what the federal government can do.  The founders knew that without these limits, people are subject to their own passions which will eventually lead them to make rule over others for their own benefit.  The Constitution outlines powers that are allowed by the Federal Government and the Tenth Amendment leaves all other powers not delegated to the United States nor expressively prohibited by the States, is reserved for the States respectively, or to the people.  The Bill of Rights (Amendments 1-10) is also sets important boundaries of areas that the government cannot infringe upon certain individual rights.

Representation is another important guide the Constitution establishes.  This is who or how government officials are chosen.  House of Representatives and Senators are selected by popular vote (thought the Senate was originally chosen by State legislatures until the 17th Amendment).  The President is selected by the Electoral College which electors are chosen by popular votes.  Federal judges are appointed by the President with the consent of the Senate. 

The third principle is the separation of powers.  The Constitution is not set up where the President can make laws that stand beyond his administration without Congress, or the Supreme Court can legislate from the bench.  Article 1 outlines the legislative branch.  Article 2 outlines the executive branch.  Article 3 outlines the judiciary.  Each of these outlines what the branches can and cannot do. 

The separation also comes with a series of checks and balances.  The president can veto a bill from the legislature and the legislature can override the veto.  The legislature can impeach a president or judge and remove them from office for certain crimes.  The judiciary can declare laws as unconstitutional.  The president appoints judges with the consent of the Senate.  Each of these are designed again, to prohibit an amassing of power with one branch or individual.  If that were to occur, based upon human nature, it would eventually lead to tyranny. 

In my opinion, Constitution Day should be celebrated as much as Independence Day.  At a minimum, all citizens should be required to read the Constitution annually.  This should cause all of us to be thankful we live in our country. 

Ideas on Fixing the Student Loan Mess

August signals another return of many back to the halls of higher education.  It has also been that way in our household, as we currently have three currently in classes for a bachelor’s degree and beyond currently.  Thankfully, we have one who graduated with his bachelors this summer.

Higher education has become ingrained in our culture as a necessity to achieve in life.  Statistics shows us that on average those with a bachelor’s degree will earn more than those with a high school diploma, those with is masters earn more than a bachelor’s, and so on.  So, we push those in our society to seek more education to achieve more in life.

The only problem with this is that it costs money to do so.  Lots of money.  This is met with sacrifice in the family to pay for the education and when there is not enough savings to do so, it requires student and parent loans.  Personally, I think this is a factor that hits the middle class, those who make too much money for the student to qualify for grants and needs based scholarships but do not make enough to outright write a check for college.

The Federal Reserve Bank of New York now states that student loan debt has surpassed consumer debt in our country.  It was the only form of consumer debt that has grown significantly since the crash in ’08.  Americans owe $1.4 trillion in student loan debt; $620 billion more than credit card debt.  The average graduate in 2017 will have $37,172 in student loan debt to pay.  This number is up 6% from last year.  The repayment on these debts is a problem.  The average 90-day delinquency rates among the different age groups ranged from 8 to 16% in 2012.  The Fed also believes this rate is understated as much of the loans are in deferral.  Now as a lender, I know that to be successful, I need to be right 99 1/2 % of the time.  With such a high percent as a problem student loans, it seems this lending is very risky.

So how did we get here?  There are several factors.  First, college costs seem to have consistently risen faster than overall inflation and real wages.  So, if someone is going to college, they must borrow more today than they would in the past, since family wages are not keeping up with tuition increases.  In society, there seems to be little to allow for market forces to begin to check the rapid growth of tuition. 

This seems to have accelerated since 2010 when the Federal Government took over the student loan program, which for 45 years had been run in the private sector with government guarantees.  Couple this with additional governmental spending on education and we have large sums of money that are thrown at the feet of institutions.  Education costs are pushed up and those in the middle class suffer the most. 

So, what are some solutions to the problem?  One is we need to embrace the fact that we need people in our country who enter the workforce without any sort of higher education.  Skilled trades are sometimes looked down upon by those in the ivory tower of education.  Yet their contribution to the economy and raising a family without a large student loan debt of the primary breadwinner should be celebrated. 

Another possibility is to get the Federal Government out of the direct business of student lending.  Again, we know that a lack of efficiency here will just continue to have student debt grow exponentially.  Perhaps some of this should be taken on by the institutions of higher education themselves.  This could provide ongoing interest income for the institution.  It also ties the college into making sure the graduated student remains successful in their field to better insure the payback of their loans to the school. 

Schools need to become more efficient and governed by the market.  Students should have a rating of different classes and degree programs as how these will translate into projected future income.  If this income is not as great as the required debt to achieve the education, then perhaps a student loan should not be granted.  This is a hard topic to come to grasp with, as everyone will have different value of different fields of education.  But, simply if you want to have people pay back their student loans, they need to be in a field that provides enough income to do so.  This may help eliminate classes and courses of study that do not seem to directly benefit the student economically from the ability to have said class paid with a student loan.

Every college should provide a required course of study in personal finance and the relation of student loans to budgets, future income, and savings.  This should start early in college to help the student make decisions on fields of study.

Many universities are beginning to embrace various distance learning models that allow for the students to attend class and save money on room and board costs that would be found in a traditional college setting.  This also may allow students to continue to work in their present job while using spare time for classes.  This model of education should be able to be delivered at a lower cost than traditional class settings.  Everyone in my family has used distance learning for a portion or for all a degree program.

Innovative ways to pay for college should be explored by institutions.  At College of the Ozarks in Branson, Missouri, students work one of hundreds of jobs on campus to help pay for their education.  Classes and campus jobs are scheduled to avoid conflicts.  The school also operates with less employee costs as it gets much of the labor from the students.  This work, in combination with scholarships has students graduating with no student loan debt.  The college has a 64% graduation rate and students who enter the workforce at the national average for wages.  Again, all this is completed with no federal student loan debt at “Hard Work U” and the college ranks high among several independent university rankings and as a great place to work.

 

Thoughts from the Road

We recently took an extended vacation-son moving-business trip cross country.  We moved my oldest son to Florida, where his fiancée is working on her graduate school work at U of Florida.  Then my wife and I traveled down the Atlantic Coast, to the Keys, and up the Gulf Coast, staying several nights in each place.  We then went back to Gainesville and met my son’s fiancée, who was coming to the U.S. for her first time.  We then went to the panhandle and Alabama to visit some key CU partners.  Next we stopped in central Tennessee to visit my brother.  Then we went to Louisville, where I saw my younger son and my wife met a long lost relative.  The final leg of the trip was back to Missouri to see friends and my dad, and then the long trip back home. 

While along on the trip, I had several random thoughts…

There is something right in the world when you are laying on the beach and looking up at blue skies and palm trees.

There is something seriously wrong with me when I ignored my wife’s counsel to put on more sunscreen.  Heck, I am in the shade, what could go wrong?  I was pretty out of commission for a day with part of my body the same color as a lobster.

Everyone needs some time to unplug and enjoy things in life you normally would not do.  For my wife and I, this was the longest vacation with the two of us since our honeymoon, 25 years ago.  We were able to snorkel in reefs, see dolphins in the wild, go to the southernmost geographic point in the continental U.S., and see the sunrise and sunset over the ocean on the same island. 

The best places for smoked meat have large smokers inside or outside the restaurant.  Also, if the staff can tell you what kind of wood they smoke with, you are probably guaranteed it is good.  We had some BBQ at a dive in Fort Myers, which had none of those characteristics.  Consequently, it was a failure.  We hit a home run with Mission BBQ in Louisville.  The owners proudly announced he only uses red oak seasoned for at least one year and then took me back to see his twin smokers—Myrtle and Enda—named after his grandmothers.  This was very emotionally touching.

Take time to enjoy the joys of others.  My son’s fiancée is from China and she had the first opportunity to experience American things for the first time.  In each case, her enthusiasm was infectious and caused us to seek out other new experiences for her.  She was able to experience good smoked meat, root beer, a real burger (not from McDonalds), onion rings, trips to an American mall, trip to the ocean, and ability to see hundreds of stars for the first time.  Her joy and laugh was infectious.

Any trip that you take where you can spend time with all your kids after they have moved out of the house, is a really good trip.  Bonuses are when you spend time with your brother and get to hug your dad.

When all comes down to it, what matters are the relationships that you have in life.

If you have an intensive planner combined with a go-with-the-flow guy on a trip, the best result will be a mixture of well-planned events and spontaneous activities.

A successful trip seeing your older brother is one where you discover another thing to irritate him with.  Now that we have a family member who is a Florida Gator, I have to show him how they are superior to the Tennessee Volunteers!

It is always great to visit fellow CU brethren in their communities.  I was able to see some CUs in small rural towns all the way up to visiting the fine folks at Navy Federal at their complex.  In each case, there was a strong commitment to make their small corner of the world better. 

As I write this I have on the news about the devastation in Texas from the hurricane and its aftermath.  It breaks my heart across the country but is nothing compared to the pain those who are there experience.  Our hearts and prayers go out to these folks.

It is also encouraging to see people helping their neighbors, rescuing the stranded, getting folks to safety.  Their compassion and action shows one of the greatest sides of America.

 

 

The Problems with Character Lending

Recently, we have worked with some loans that seem to make little sense economically or in the credit sense.  In some cases, the collateral is weak, advance rates are too high, or there may even be no collateral to speak of.  Collateral is what you are left with whenever the payments cannot be made anymore from the borrower or guarantor. 

Some have no history of being able to support the debt but the projections look good.  Well, I have never seen any projection that does not look attractive.  If a projection is much different than the history, there needs to be a logical reason. 

Some had a lack of personal reserves to fall back on, either in liquidity or in guarantor cash flow outside of the company.  This, coupled with any weakness in the company, and lack of adequate collateral is a reciepe for a loss. 

In many cases, the reason for considering the request is the character of the applicant.  Maybe he is well known in the community.  Perhaps she has been a member of the credit union for decades.  The borrower may also have a long term roots across multi-generations in the community.  Maybe she has never ever missed a payment in the past.

While character is important.  You would not want to lend to someone who you think is not trustworthy and who has a history of following through on their promises.   But an over-reliance upon character as the sole positive reason to do the loan is dangerous. 

It is dangerous because the lender is making assumptions that the circumstances which the borrower has acted upon, showing honorable character, in the past, may not continue in the future.  This overlooks the importance of external forces upon the actions of the borrower. 

How do you know what level of pain the borrower will experience before they cease providing payment support for a business that is failing?  At what time does hope for the better future become replaced with fear and the guarantor just gives up?  When is the point when the sponsor can’t economically support the deal anymore? 

How many years of crop failure or low prices can the farmer survive?  How much negative cash flow can the manufacturer absorb until they are forced to shut down?  How long can the apartment building stay empty before the lender has to take it back. 

Oh, character is important, but there is a level of pain where the sponsor cannot economically support the project or there is a time when the willingness of the sponsor to provide financial support is overtaken by the fear and loss of hope for a better future.  It is at that point that the lender will be forced to close the business down. 

So when looking at a credit request if you find the only reason for you to grant the loan is because of character, consider what may happen if the pressure of the outside overcomes the good character inside the applicant.

Don't Focus on the How

My wife, at times, has accurately pointed out that I can become the killjoy of ideas in our family by focusing on the obstacles that must be overcome to complete the idea.  Sometimes I view life as a series of obstacles to overcome and in doing so, can take the wind out of the sails for a great idea.  I have had several instances when the people around me needed encouragement to go for it, rather than a picture of all the mountains that need to be scaled. 

Many who see all the obstacles just give up.  The world does not belong to those who are the brightest and smartest who can sit and analyze everything.  No, the world belongs to the C and B students, who have an idea and are dumb enough to try it because they do not see the obstacles.  Andy Stanley once said that when ideas are presented in our family or organization, we need to stop saying “How?” and start saying “Wow!” as our first response.

In 1971, Starbucks was founded with a passion for good coffee.  It remained a small store that caught the eye of its current CEO, Howard Schultz.  Schultz joined the company in 1982 to direct retail operations and marketing.  In 1983, Schultz travelled to Italy, and became inspired by the coffeehouse atmosphere there.  He came back to Seattle and tried to convince the owners that Starbucks should not just be about good roasted coffee, but that it should sell the social experience of a coffeehouse.  The board put up a resistance with the questions of “How?” but allowed the first Starbucks coffee house to be opened in downtown Seattle in 1984.

This coffeehouse was a success and Schultz founded a new company called II Gironale in 1985 to make drinks from the Starbucks coffee beans and sell them in the coffeehouses.  The original owners of Starbucks focused on bean roasting. 

In 1987, Schultz bought all the assets of the original Starbucks, changed the name to Starbucks Corporation, and opened stores in Vancouver and Chicago.  By the end of the year there were 17 Starbucks coffeehouses. 

We all know what has happened to the company since then and all of us have been in a Starbucks at least once.  For some reading it is a daily visit.  Why?  The atmosphere and good drinks.  But in case you did not realize, here are some of Starbucks accomplishments in 2015.

Launches Cold Brew iced coffee and Evolution Fresh™ handcrafted smoothies.

Announces sixth two-for-one stock split.

Commits to hiring 10,000 opportunity youth by 2018.

Expands Starbucks College Achievement Plan to offer full tuition coverage for all four years of an undergraduate degree for qualifying U.S. Starbucks partners. Commits to 25,000 partners graduating by 2025.

Reaches 99% ethically sourced coffee milestone.

Opens stores in: Panama (now, this was the 68th different country where a Starbucks was located)

Total stores:  22,519 (as of June 28, 2015).

Cleary Schultz was one who did not let the “How?” take the wind out of the sails.  Most landmark changes in an industry begin with understanding what are the one or two things that if mastered, will result in a complete paradigm shift in the industry.

So how many of you have heard of Handy Dan Hardware Stores?  In 1978, the CEO and CFO of Handy Dan tried to convince the rest of the leadership that they needed to abandon the small mom-and-pop hardware store concept and create a big box hardware store to grow the company.  This had not been really tried on a grand scale and the rest of the board focused on “How?” to the extent that they fired the two leaders, Bernard Marcus and Arthur Blank. 

Marcus and Blank were undeterred by the firing and kept focusing on their idea as they started up a new company.  Today that company, housed in Atlanta, now has 2,274 locations in the U.S., Canada, and Mexico.  The company now has 385,000 employees and had revenues over $88 billion in 2016.  You probably have not seen Handy Dan, but you probably have been in at least one of Marcus and Blank’s stores, The Home Depot.  Oh, and Blank also owns a little professional team called the Atlanta Falcons. 

Again, this is another case of a clear dream that focused on a key obstacle, that once overcome, would create a paradigm shift in the industry.  Personally, when I have to go to the hardware store, I will visit a large box store 95 out of 100 times.  These guys were dumb enough to ignore the obstacles the Handy Dan owners saw, and just focused on the “Wow!” of the idea.

So, the take-a-ways here are to identify the key obstacles in your industry and know if these are overcome will result in a paradigm shift like Starbucks and The Home Depot.  Encourage ideas.  When the ideas come, have your first response be a “Wow!” and not a “How?”.

The Need for Fiscal Policy Reform

We have just finished the past eight years with no one single year posting a growth in GDP over 3%.  This is the only time in U.S. history that this feat has been achieved by a president.  The funny thing, is that this occurred during a time of historically low interest rates.  The Federal Reserve has been doing all it could to stimulate the economy with favorable monetary policy.

The other type of policy is fiscal policy.  You will remember from your basis economics class, that this is a combination of tax, government spending, and regulation.  These combined can provide either a stimulus to or a brake on economic growth.  For the past half-decade, the actions or inactions of the federal government has served to stimulate the economy like an anchor impacts the speed of a boat.

Jamie Dimon, CEO of JP Morgan Chase Bank, echoed some of these concerns in mid-July when he said to his shareholders, “It is almost embarrassing being an American citizen … and listening to the stupid s— we have to deal with in this country, the inability to make headway on significant legislation is holding us back and it is hurting the average American. It isn’t a Republican issue; it is not a Democratic issue.” 

Our government was created to be a servant of the people, not the ultimate ruler over everyone.  Our founding fathers bowed their knees to God and not the government as the ultimate Source of law.  Whenever that principal is lost, the moral compass that guides us is lost as well. 

So, what are some practical things that can be done to correct fiscal policy?  First on taxes, lower the corporate tax rate.  We have the third highest corporate tax rate in the world behind the United Arab Emirates and Chad.  A significant lowering of the rate would encourage more business to house more of their productive capabilities within the U.S.  A lowering, and simplification, of the personal tax is needed as well.

Next, government spending should be looked at in terms of efficiency.  Most government programs begin with a good idea to help people, but within a few years the goal of the program is to perpetuate and grow the program, not help the people.  Any organization conspires against the mission of said organization unless it is checked constantly. 

One example of this comes from England.  Someone in the 1990s asked why the British government was using resources to paint smokestacks dark.  This was a constant process that went on and on.  Well, it originated in WW2 when the dark smokestacks made it harder for German bombers to find and destroy factories.  This work was still being performed fifty years later!

A very sad example in our own country came on June 15, 2017.  President Trump ordered the government to stop work on the Y2K bug.  This eliminated dozens of requirements for different agencies, including one alone that consumed over 1,200 man hours annually.  This is utterly ridiculous that an event that occurred over 17 years ago, and had no impact after that was still consuming government time and resources another 17 years later.  It was not sad that Trump stopped the Y2K work, it was just sad that no one before him had done this.

The last area is to reduce regulations.  CUNA has a campaign to eliminate red tape in favor of common sense regulation.  Take banking for an example.  Have you ever stopped to think of the number of regulations and agencies that impact banking?  You have the CFPB, OCC, SEC, FDIC, NCUA, Federal Reserve, FCA, USDA, SBA, FHFA, FSOC, Treasury Department, Fair Labor, and state regulators, to name a few.  These folks have created more FED regulations than there are letters in the alphabet for more rules than one can easily count all in the name of protecting the consumer and making banking safe.  I do agree that a safe banking system is important.  But, most of these have the tendency to drive up the cost of banking services to the customer and make it harder to work with credit unions and banks.  In some cases, this is again the impact of the organization conspiring against the very mission of the organization.

These actions have created a large nexus of power and money in Washington DC.  In 2012, five of the six wealthiest counties in terms of average wage were located around our capitol.  I don’t this this was what was in the minds of the founders.  All this occurs while it seems impossible to get major legislation completed that will actually help move fiscal policy forward. 

Term limits may help as it is necessary to have fresh faces with different ideas in Congress.  The current turnover rate in the legislature is less than the Soviets had in their Politburo.  Also, I favor tying their salaries to a combination of performance in the U.S. economy and the federal budget.  Maybe a performance based system will create the proper motivation we need to kick start economic fiscal policy.

A Plan to Fail is a Failure to Plan

From time to time as lenders, you will have a face-to-face meeting with a borrower who is in trouble.  If you have not had this opportunity, it is because you have not been in the industry long enough or you have not lent enough.  This will also be a requirement that many lenders will have soon, especially those in post boom oil regions or those in troubled ag areas. 

I recently had one of these meetings.  Basically, the meetings are made up of three things: (1) what has happened to get the company to where you are now, (2) where are you at now, and (3) what is the plan to move forward?  I find that utilizing financial analysis tools available to the lender can help with the process, especially parts 1 and 2.  Many problem business owners need some assistance to show exactly where they are currently and how they got there.

It is amazing how many firms have not had a full written down business plan that they refer to on a consistent basis and update as often as necessary.  When your economy is booming, planning is often thrown out the window.  All the focus is on how to handle the mass of business that is coming in today.  There is no strategy for the future.  Each day is an exciting journey as the rudderless ship is blown to and fro as the strong winds of customer business push the sails as they want. 

But when the economy turns, a multitude of weaknesses will show up.  Warren Buffett once said, “When the tide goes out, you can see who was swimming naked!”  Well, when the business goes out, you get to see which owners are exposed!  Hopefully it is not ones you have lent to, but as luck will have it, you may undoubtedly have a few bare bottoms showing up in the sand that are your borrowers.  I believe the biggest single item that causes this exposure, is a lack of an executable plan for the firm.

So, it was with my borrower.  They had a great idea of what caused the problem and where they were currently.  They had even made some positive changes with restructuring debts, lowering supply and labor costs, and beginning to find new lines of business.  Good, good, good.  But when asked about what the plan was, the owners had some ideas, but nothing written down and nothing established that they were following.  They were in a lot of ways, the rudderless ship. 

Undoubtedly you will face this circumstance in lending.  It is up to you to provide guidance, but it must be done without directing the borrower into actions that can cause you lender liability.  You need to carefully lay out some options and allow the borrower to select.  This plan must be theirs, it cannot be yours.  However, if the plan requires debt restructuring, it must have the lender buy-in as well. 

The business required a shift from customers from one industry to customers who are not dominated by that one industry.  This way, any industrial downturn will insulate the company if they are diversified.  Our goal was to help identify factors that would be required to put in place to begin to put a rudder on the ship and steer the company forward.  We left the borrower with several questions and ideas to follow up on.

Eventually, we hope this will be the impetus for a workable business plan that can be shared among the organization and will help steer the company out of their problems. 

About ten years ago, I had a similar discussion with another problem borrower.  We showed our financial spreads to the company with industry averages.  In the meeting, we identified three problems, low gross margins, inadequate capital, and too much debt.  That borrower took all we had to heart.  They installed better bidding software and set a more realistic threshold for profit margin.  Then they brought in money from family to help recapitalize the company.  The final piece was to sell off a division of the company that was profitable, but kept them from their core business.  These proceeds were used to retire debt. 

In my last meeting with the owners, they informed me of a new problem.  They did not know what to do with all the extra money they had!  The company had reinstalled their employer match to the 401k and made up for some of the lean years.  They also began some strategic expansion in areas that made sense with their business plan. 

A failure to plan is a plan to fail.  I do not know of many people who wake up and say, “Today, I am really going to fall flat on my face!”  But I do know of many who have no direction as to where they are going.  It goes back to the old adage, if you aim at nothing, you will surely hit your target!

When Leaders Must Challenge the Process

In 1987, Kouzes and Posner published the book The Leadership Challenge.  It is still a classic today for leaders and continues to be republished.  The book is not an individual leader giving their ideas, this is two researchers who interviewed a lot of leaders to reach the conclusions in the book with results that are data based.

In the early part of the book, they bring up the idea of challenging the status quo or challenging the process as key to growth in any organization.  The writers argue that this is part of the leaders mandate for successful organizations.  Progress is always proceeded by change.  Change is always proceeded by challenge.  If something is going to get better, someone must come along and say, “Hey we have to make this better” before improvement. 

Now for young leaders, the execution on challenging the status quo may not always be completed tactfully and thus may not be welcome.  In my first managerial job in banking, I ran a branch that the proceeding branch manager retired after twenty years of service.  Our branch was one of the smallest in the organization and I wanted the branch to grow.  So, I came in all guns-a-blazing with all sorts of new changes to make us better.  I also submitted great ideas that would change the savings and loan as a whole. 

About two months into my tenure, my boss sat me down and showed me how for my leadership to be effective, I had to watch and listen to those longstanding employees under me and expect a slower pace of change.  I also had to challenge those things that were in my sphere of influence as giving ideas for other areas was not always welcome. 

Challenging the process must be linked to a picture of a preferred future.  The leader must cast a vision of what the future needs to be to have folks agree and decide to achieve that desired goal.  Challenging the status quo is not comfortable.  One thing we often fear more than being wrong is being irrelevant.  When a young leader begins to challenge the status quo of an organization that older leaders have been a part of for a while, it does feel personal as many times the status quo may be the older leader.  Also the older leaders have brought the organization to the current place. 

The task for older leaders is to listen to the new ideas objectively and without fear of personal assault.  Everything that is good has a shelf life and the great ideas of the past will probably not be the great ideas of the future.  Take music for example.  I remember the great improvement in music when I was a kid, moving from 8-trac tapes to cassette tapes.  Then when the Sony Walkman came around where you could take your music with you on a hike or run, wow I thought we had reached nirvana.  But then cassettes gave way to CDs.  CDs gave way to I-Pods.  I-Pods to now streaming music from your phone.  When I want to listen to music when I work out or a podcast, I just call it up from my smartphone.

We would be still using the cassette Sony Walkmans today if no one had challenged the status quo.  And many of those ideas had to come from the next generation of leaders.  Leaders can get stuck in “happy-dance land” where we are fixated on the past successes without looking to the future improvements.  The truth is also that the next generation leaders will probably come up with solutions for the next generation problems.  I want to be in an organization that is open to these ideas and older leaders need to not be threatened when these ideas come up and provide support for the younger ones.

This does not mean a complete abandonment of the path that has been taken to get us to the present place, as experience is invaluable and can avoid mistakes and pitfalls of youth.  But this process of mixing the inexperienced, fresh ideas with the old, established ones is more of an art than a science as the mixing of predictable systems and new ideas must mix carefully like a fine dance.  Much of this success comes from the culture we create of listening.  It will require leaders to go through a lot of bad ideas until we reach the good ones.  We can only benefit from these new ideas or we won’t.  The only way to benefit from them is if we know what the new ideas are.  The only way for us to know what they are is in an environment where the new ideas are free to rise to the surface easily and avoid creating an atmosphere where next generation leaders feel they are not listened to.

Andy Stanley once said, “Leaders must challenge the process, precisely because any system will unconsciously conspire to maintain the status quo and prevent change.”  If we are not careful, we will wake up one day and find out that the firm we have created is set to sabotage the reasons we created it in the first place.  Have you ever felt you had to work around your company to get your job done?  Andy Grove, former CEO of Intel said, “Success breeds complacency, and complacency breeds failure.”  So, the worst thing we can do is to remain in happy dance land as that will lead to future failure.

If this is the responsibility of the leader to initiate, what are some ways this can be done?  First, ask newer employees to rate the company.  This should be done at regular intervals during the first two years of tenure.  It is easier for a new set of eyes to look at the organization objectively, than it is for a seasoned staffer.  Also, find ways to see how your organization is seen by the outside world.  One of the vendors we use does not exercise this strategy and causes massive frustration for the Pactola team.

Next, create a culture where ideas can be freely advanced, debated, the good ones kept, and the bad ones shot down.  This requires mutual respect of all parties.  The young ones in the company must be OK with advancing the idea without fear of reprisal.  They also must learn to accept that the denial of their idea is not a denial of them.  Seasoned veterans must be open to new way of doing things that may bump them outside the status quo they created.  They also must not take new ideas that may contradict what has been done in the past as a personal attack.

These healthy debates must be kept within the confines of the organization.  Everyone needs to feel free to be critical of the processes if that criticism stays within the lines of healthy debate inside the company.  Also, this must not turn into factions or backbiting.  Once you get outside the four walls, everyone needs to be a raving fan. 

Creating this culture is easier said than done.  It is up to the leader to set the tone and often requires the leader to move off their own status quo.