The 6 D's of Distortion of Credit

In the last two regional institutions I had the privilege of working for, loans that failed were inspected closely.  Now if the credit failed in the first year or so of the loan, much scrutiny, as is warranted, was placed upon the credit analyst and field lender for not picking up on the inherent credit weakness during underwriting.  After that time, more emphasis came on the ongoing management of the credit as opposed to the original underwriting.  Years ago, a competitor banker in my hometown told me, “You can’t always underwrite and identify every future problem.” 

Which is completely true.  No credit professional is a perfect prophet, though many may call us to be so.  The presence of problem loans, if these problems have arisen from unforeseen events or things occurring after the first year or so of the credit, do not point to a weakness in underwriting.  These problems are an opportunity to identify and best manage the relationship.  If not completed properly, this points to losses and possibly, an unhealthy credit management function.

In the last bank I worked for, we were required to do the “spilt milk” report when a credit failed or was in terminal health.  The adage was to not “cry over spilt milk”, but to use this as a tool to learn how to better analyze the risk inherent in the credit.  We recognized there are several things which could impair a business, which underwriters may never see.

Divorce can cause a huge disruption to a small, closely held business, especially if the two getting divorced are the active owners.  Anyone seasoned in the commercial area has a few stories with this disrupter.  The effects can cause immense hurt financially, managerially, as well as personally.  I once had a very successful transportation company which failed after one of the owners had an affair.  Though it may be rare when the lender sees possible problems on the home front, when they do arise, notice should be taken.

Drugs is another disrupter of a business.  It was also involved in my example above.  This could be either prescription or illegal drug abuse.  One may also include any type of addictive behavior.  Addictions often push a person to pursue that appetite instead of fulfilling responsibilities with their business.  Note that an addictive behavior that causes a business to fail may not be from your business owner, but also someone in his family.  I once knew of a retail store which closed due to employee embezzlement.  The owner became absent when dealing with a substance abuse problem with his son, and the untrustworthy employees took advantage of not being watched.

Disability is the third disruptor of credit.  I watched a small family manufacturer sell at a fraction of its value.  The owner was absent and had a key employee who was the brains behind the business.  That leader suffered a stroke.  Unfortunately, the employee tended to micro manage every function of the business and did not train others in how to successfully run the operation.  When he was unable to function completely, no one else knew how to keep the business open.  The company liquidated its assets and closed.

Disagreement among the owners or management team is our next disruptor.  A hotel operated very well in the good times, but failed to break even when visits dropped off because of the local economy.  At first, the owners pulled together and worked on a plan to move forward.  Soon, individual owners began scrutinizing the past track record and squabbles broke out in the group as more checks were written each month from a collective group which intended to reap profits from the business as mailbox money.  Discussions among the owners now went through attorneys, and the lender sat on the sidelines watching this train wreck happen.  Differences of opinions will come when you have more than one person involved in a business.  Those differences can strengthen the company.  But if no one overall plan is found for all to get behind and move forward, and especially if communication has disintegrated among the owners, watch out!

Death of an owner, key player, or manager can kill a business.  This is especially true in companies where key leaders who do not raise up others to operate the business.  Maybe this is due to a lack of time, leadership ability, or fear that someone will take over their importance.  Some of this risk can be overcome with key man life insurance.  In the end, such insurance may help retire debt and help the business continue for a while, but without additional leadership, the business will close.

Disaster is the final disrupter of credit that I will address.  This is a large category and items like hurricanes, tornadoes, blizzards, drought, and other “acts of God” as often put in insurance policies.  Other items in this category may be a commodity price crash, like agriculture prices in the past three years.  Some factors of the interest rate hike in the late 1970s may be put here.  These are unforeseen “black swan” events which can sink a business and pull down your loan.  Asking if your client has a contingency plan and what events are covered in those plans is helpful.

While it is true that loan failures many times are not seen at the time of underwriting and may occur years later, it is still important to carefully analyze every credit failure as a teachable moment to help manage risk better in the future.  The best lenders are not those who never make a bad loan; the best lenders are those who know what to do when a loan weakens. 

Quick Bites:  As I write early this rainy morning, it is Father’s Day.  I pause to honor my dad, who taught me the value of persistence, hard work, virtue, faith, and honor.  I can never thank him enough.

Elimination of Entry Level Jobs

News on the employment front this past week was remarkable.  There are more posted job openings than there are people actively searching for jobs.  This is a first in the record keeping from the Bureau of Labor Statistics.  It also highlighted that there are many positions requiring skilled labor and higher education that are unfilled. 

The challenge is with jobs at the beginning of the employment ladder.  Many of these entry level positions are gained by teens looking for summer or after school work.  These provide a great entry and learning experiences into the job market.  A large challenge to the entry level positions is the $15/hour minimum wage movement. 

I began my career in banking as a part time teller when I was in high school at a wage of $3.25/hour.  I worked through college at that position.  Doing an internet search, that $3.25/hour equals $7.67 in 2017 to have the same purchasing power.  This is around half of the current push for the higher minimum wage. 

I know that many of you feel the pressure of higher entry level wages in your CUs.  This has a direct impact on your profitability.  It is important to understand these same wage pressures, whether driven by supply/demand forces or regulation, impact your borrower.  I watched a segment on CNBC a couple of weeks ago featuring two business owners in Williston, North Dakota.  Both stressed challenges they face with finding and keeping employees.  Employee cost is often the costliest of any operational expenses for an organization.  Business disruption because of a lack of employees can be even more dangerous.

The push for the higher wage is also accelerating a drive toward technology.  I know that every financial institution operates with a fraction of the teller staff that it did when I entered the workforce.  My wife started working in fast food at In-N-Out and Carl’s Jr.  The staff needed to run a fast food restaurant is shrinking rapidly.

This past week, McDonalds announced it will be replacing all its cashiers in American restaurants in two years.  CNBC reported they will roll out 1,000 kiosks per quarter to stores.  These kiosks are already fully integrated in McDonalds in Canada, the U.K. and Australia.  A patron will be able to custom order his meal at the kiosk or through mobile app.  Payment will be handled there which will lower the need for cashiers.  The other benefit is customers tend to browse the menu longer with a kiosk and order more.

McDonalds is feeling the pinch of the rising labor cost as payroll rose from 30.2% of sales in Q1 2018, up from 27.8% in the previous year.  Some of the cashiers will still be able to stay there as new positions of delivering food on Uber Eats and jobs doing table service will open up.  The main drivers for the kiosks are increased employee costs and the improvements in technology which allow this to occur.

A comparison between Minnesota and Wisconsin shows the results of forced minimum wage increases and not.  In 2014, Minnesota started phased-in hourly increases for each year through 2016.  By the beginning of 2018, Minnesota’s minimum wage was $9.65 for large employers and $7.87 for small employers. 

Wisconsin did not follow Minnesota’s example.

From 2010-2014, fast food employment grew at the same rate in Minnesota and Wisconsin.  After 2014, fast food employment has grown 4.1 percentage points more in Wisconsin.  A 2017 paper released by the National Bureau of Economic Research pointed out how minimum wage increases reduced in the hours working in low-wage jobs.  The paper studied he impacts of the steep minimum wage increases in Seattle’s market and found that the jump to $13/hour wage reduced hours in low wage jobs by 6-7%.

The concern is with the push for a higher minimum wage, and the increases in technology, where will the youth of tomorrow find that important entry level position to get them involved in the work place?  Many of these are important to gain initial workplace skills such as scheduling, responsibility, and the work ethic that is needed in all careers no matter what level they are at. 

Quick Bite:  The stronger than expected May employment report released on June 1, showed an increase in non-farm payrolls by 223,000 in May.  This increases the likelihood that we will see a Fed funds rate increase at their June 12-13 meeting from 1.75% to 2.00%.  Lenders should be aware of these possible changes in rates as they price loans to better keep their margins intact.  If you have questions, please reach out to us.


Last week, some on our Pactola team were invited by a company who sells software for loan analysis, to attend a presentation on their product.  Now we are in the process of analyzing our current system, tools, and spreadsheets to see if we can find better tools in the market at a reasonable price which will make us more efficient and thorough in our work.  Efficiency has been a large focus of our group and we made two major computer system changes in the past two years to move us in a positive manner forward.

So back to the story.  In the introduction to the Webinar, I shared who we are, what we do, and what we were looking for.  This was the second time this group has heard our story so I expected the presentation to be tailored to the features in the system which applied to our direct need and wants. 

The presenters seemed to have some canned steps they went through to show off their product.  And it was a nice product and would have much appeal to some credit unions or community banks.  The product had features for deposits and treasury management, two areas we do not get into.  They spent time on their file management system, even after we told them we had a significant investment in our PacPortal and their system was not set up to replace the needs that are met with that product. 

As the presentation droned on, I attempted to steer it back on course to the items which we needed to see with spreading financials, industry averages, global cash flows, and the like.  But in each case, after answering the question quickly, they veered off the road of our needs and into the ditch of the canned presentation.  Within the first 15 minutes of the presentation, I was getting messages from others on my team listening and watching this train wreck about how this product would not work. 

At the end of the hour, they were successfully able to cover the “canned” portion of their presentation and we felt as though we each had an hour of our lives stolen away from a group which did not listen to our needs.  

Listening is a tough topic to write about.  I have had the honor of being married for 26 years to the most wonderful woman I know.  I still see how inadequate I am in this field.  My younger son who is engaged, has recently discovered in premarital counseling just how bad he is at listening.  We tend to think too much about what we want to say next and how important that is, instead of simply absorbing what is being said to us.  Or like our loan management software company, we have a presentation we feel we need to give and do not fully care about what the other person has to say.

This is not a conversation and an attempt to understand the other person, this is a speech.  It is seeking for others to understand you at the expense of not taking time to truly understand them.  When I was young I had an aunt, who told me if I was only concerned with talking and not listening, to just go talk up a storm to the barn and when I was ready to listen to come back.  “God gave you two ears and one mouth for a reason” she would say.

My hope is that the hour of life that I lost in the presentation will come to my mind the next time I fail to listen to someone else and am only concerned with what I think I need to say.  To be an effective listener is to listen to others the same way you want them to listen to you.

Quick Bites:  By the time this goes out the holiday that kicks off summer, Memorial Day, will have passed.  My hope is that you take time to think about what the holiday is truly about, remembering those who have sacrificed for our liberty.  I had the privilege of spending time with my dad recently, who was a veteran of the Korean War.  Take time to thank those who have sacrificed for us. 

The Tax Cuts and Jobs Act Impact on 1031 Exchanges

The impact of the new tax law on 1031 like-kind exchanges was a major topic last year as the bill was in process of being created and debated.  In the end, like-kind exchanges for real estate property was preserved.  This has been a major tool since its inception in 1921 that is used by real estate investors to defer any tax gain on a sale. 

Tax-deferred exchanges for personal property, intangibles, and collectables were cut.  These types of assets no longer qualify for a 1031 exchange.  One unique beneficiary of like-kind exchanges with the old law was the sale of race-horses.  Some 1031 intermediaries made a career as owners bought and sold prized equines.

But just because you are only involved in real estate only and have no desire to send the old mare to your neighbor down the road for his kids, does not mean that you should ignore the impact of the new tax law on 1031s as this will impact certain real estate transactions.  Consider the issue of selling a piece of real estate that has a valuable franchise license attached to it, like a McDonald’s.  In many transactions, the ownership of the franchise license is being sold apart from the underlying real estate.  In some cases, the value of the entire transaction is heavily weighted upon the franchise value.  Because the franchise license is considered an intangible, it is not eligible for the 1031. 

Another issue is when real estate and personal property are sold together.  Personal property may include equipment, machinery, furniture, and fixtures.  Like real estate, a taxable gain can be triggered when personal property is sold.  To avoid the gain, the FF&E component should be structured as a separate exchange since it is not like-kind real property.  This can impact certain transactions involving items like restaurants, hotels, medical facilities, and factories that will contain a large amount of FF&E.  Previously, a multi-asset exchange structure allowed investors to allocate values to the different components of the exchange like the real estate, FF&E, and goodwill.  The client will seek replacement property that has similar like-kind characteristics, giving an opportunity to align values for favorable tax treatment. 

This allocation is the heart of the new challenge.  The federal capital gains tax rate on real estate is 15 and 20 percent, while the tax rate on a gain of personal property is 35 percent.  Since the gain on the sale of FF&E cannot be deferred any longer, sellers will want to try to maximize the real estate value allocation and minimize the FF&E.  The buyers will want to have the highest possible value to FF&E, since they receive a larger depreciation for write off benefits. 

In a perfect world, FF&E would be valued at or below its current adjusted basis, resulting in no taxable gain.  This assumes an objective market appraisal will justify the valuation.  If not, it may be more beneficial to consider shifting more value to goodwill as the tax rate on goodwill capital gains is lower than the tax rate on FF&E capital gains. 

The new law opens up the importance for realtors to not only negotiate the price for the transaction but to also negotiate the various components within that price.  Sellers will find it to their advantage to have more of the purchase price allocated to real estate while the buyers will want more allocated toward the FF&E. 

It is important for the lender or real estate professional to not give tax advice.  But it is important to have knowledge of the new law and understand how this may impact the tax situation of the buyers and sellers.  Assuming they can have appropriate tax counsel, which supplies the transaction parties with maximum real property values that can be determined, the buyer and seller will be able to make their best decision as they negotiate the sales contract.  As a lender, understanding how a transaction will impact your borrower or guarantor with future tax liabilities, is important in judging their ability to support the credit. 

Quick Bites:  Illinois is the second highest property taxed state in the country, behind New Jersey.  However even with all these taxes, and other forms of state revenue, the Illinois News Network reports each Illinois taxpayer is on the hook for $50,000 in unpaid pension and other liabilities. 

To combat the problem the Chicago Federal Reserve has published a formal proposal that real estate is taxed an additional 1% annually per year for the next 30 years.  The challenge with property taxes is they will reduce the value of real estate and increase the tax burden for those left in the state who do not migrate out.  Plus it does nothing to correct the ongoing spending problem evident there.

Will Trade Create Trouble or Treasure for the American Farmer?

A ripple in world trade could cause tsunami impact on the U.S. farmer.  In 2017, U.S. agricultural exports totaled $140.5 billion, as reported by the USDA, to the third highest year on record.  It is one area of our economy that boasts a trade surplus of over $21 billion.  Exports are responsible for 20 percent of U.S. farm income and drives rural economies which support over a million jobs on and off the farm. 

China is the largest buyer of U.S. farm products, with shipments totaling over $22 billion.  Canada was a close second with $20.4 billion, Mexico third with $18.6 billion, and Japan with $11.8 billion.  By far the largest export was soybeans at $24 billion.  Other products of corn ($9.7B), tree nuts ($8.1B), beef ($7.1B) and pork ($6.4B) are dwarfed by the mighty soybean. 

The largest customer for U.S. soybeans is China with $14 billion in sales.  Mexico imported $1.5 billion of our bean crop.  Bloomberg reports that China picked up a third of the entire U.S. crop last year, which it uses to fee 400 million pigs.  The land is not very favorable for soybean growth and pork is a huge part of the Chinese diet. 

President Xi Jinping is studying the impact of restricting soybean imports to retaliate for U.S. tariffs on washing machines and solar panels.  Potential tariffs on foreign steel and aluminum are also a concern.  Any sort of Chinese action against soybeans would have a dramatic impact on American producers.  These concerns are echoed in rural America which has seen an erosion of commodity prices in the past four years. 

But one also needs to see the impact on the Chinese hog farmer.  China will not easily replace U.S. supply, even Beijing has sought to diversify.  Last year, China imported 51 million metric tons of beans, a 33% increase from Brazil, and another 33 million metric tons, a 3.8% increase from the U.S.  Other factors that complicate a switch away from the U.S. would be weather which has not always been kind this year to the South American farmer.  The fact remains that the American soybean farmer and Chinese hog producer have strong ties to each other that are not easily broken.

Large increases in pork prices in China are sensitive to the Communist Party, which came to power in 1949 partially in the wake of hyperinflation.  Strong price increases in the late 1980s also lead to unrest in the run-up to the Tiananmen Square protests.  Yet, there have been some reports that China has stopped purchasing U.S. soybeans but most of this is a result of seasonal factors.  Very little soybeans are shipped between April-August.

Trade concerns do hit both ways.  U.S. producers may not be as willing to ship beans to China if they fear a serious trade war, even if there are willing buyers on the other end.  Last year, many U.S. shipments of sorghum were turned away at Chinese ports or rerouted at sea.  Sorghum now has a 178.6% tariff in China. 

The key here as a lender is to keep an eye on international trade as ripples here can create giant income swings to your producers.  Remember the impact of the U.S. wheat embargo to the Soviets during the Carter Administration.

But non-ag lenders need to have their eyes opened as well.  We recently had a commercial construction project that went back to the architect’s board because of huge differences in the original estimate and the final contract price.  One of the culprits was a strong increase in steel prices with the extra cost of steel in the U.S. market after announcement of possible tariffs.  That combined with an increase in labor primarily associated with the steel has the sponsors looking at different configurations to lower the cost. 

Quick Bite:  Financials Institutions Looking at Robots:  A Swiss bank was forced with the choice to have seven employees work for three days on a project to transfer 5,000 securities positions to a different IT system or use five software robots to do the job.  They chose the latter in a pilot program with a cost of around 25,000 Swiss francs.  A bank VP noted the cost will go down if the bank opts to use this for other projects.  Much of the original cost was one-time in nature.  He thinks the use of robots can be used to forgo costly and expensive software interfaces for communication between the two systems which can cost millions of francs. 

A 2017 study by GFT Technologies SE showed that technologies and artificial intelligence have the potential to revolutionize the financial sector.  Nearly 300 retail bank leaders in eight European countries were interviewed by market researcher Frost & Sullivan.  Around 94% of participants saw direct added value in employing artificial intelligence solutions as a replacement for tasks once completed by humans. 

Robots are also being used for customer facing jobs.  In Japan, several branches of the Bank of Tokyo are using a two-foot tall robot named Nao as a concierge at the bank.  The red and white humanoid answers questions about bank services in several different languages. 

Customers gawk at Nao as it introduces itself, gestures, blinks its eyes, dances, and does tai chi.  Tokyo is hosting the 2020 Summer Olympics and the bank plans on using the multilingual robot to serve a growing number of foreign customers coming to the games.

Small Business Week and Commercial Lending Approvals

President Trump proclaimed this week Small Business Week.  The Small Business Administration (SBA) Administrator Linda McMahon has been working to expand opportunity for entrepreneurs and job creators around the country.  SBA is hosting a 3-day virtual conference starting on Tuesday.

Trump wrote in his Proclamation, “Small businesses are at the heart of our Nation.  Our country’s 30 million small businesses employ nearly 58 million Americans—48 percent of the labor force.  Each year, small businesses create tow-out-of-three net new, private-sector jobs in the United States.”   In addition to ongoing regulatory rollback across the Federal government, the U.S. now operates under a globally competitive tax system for the first time in decades, according to Commerce Secretary Wilbur Ross.

Clearly, one of the largest players on the field of small business success are lenders.  Have you ever wondered of all the business loan applications given to financial institutions, how many are approved?  Biz2Credit keeps a Small Business Lending IndexTM.  This is a monthly survey of more than 1,000 credit applications from small businesses on

In the category of large banks with assets exceeding $10 billion, approval rates for March 2018 reached 25.5% of applications, which happens to be a high point.  One big factor here is an increasing direction of interest rates.  As rates increase, small business loans are much more profitable to a big bank since their cost of capital has not changed.  A small rate hike could mean multi-millions more for the bottom line.  Expect big banks with a large deposit base to be more aggressive in lending in the face of a strengthening economy and rising interest rates.

Small banks commercial approval rates held at 49% in March 2018, a slight decrease from the previous month.  Small banks tend to do more government guaranteed financing which stresses analysis of the previous year’s tax returns.  There is typically a bit of a seasonal dip at this time of year when tax returns are due.

Institutional lenders like pension funds, insurance companies and CMBS lenders, reached a record 64.5% approval rate in March 2018.  Institutionals have made a strong foray into the commercial lending market as they found the credit defaults are low and the rates profitable.  One reason the approval rate is so high is that many requests are screened out before an application is made as the requirements are well established and easily made know to the prospect. 

Alternative, non-financial institution lenders play an increasing role in business finance.  The approval rate in March was 56.5% of applications, slightly down from the 58.4% approval in the previous year.  Approval percentages here have dropped every month for the past two years.  The cost of capital for an alternative lender is high and the rates are often high.  If a business is in a cash crunch, this may be one of the only options they have.

Credit unions approved 40.1% of the commercial loan applications they reviewed.  This is a 1/10% drop and a new record low on the Biz2Credit Small Business Lending Index.  This is also a drop of 60 bps from the previous year.  The analysis from the study is that much of the loans that went to credit unions in the past are now being funded by non-bank lenders.  The credit union industry needs to invest more into financial technology to become stronger in the commercial market. 

I think some of the issue here in our industry is the new regulations that require credit unions to “grow up” in their commercial lending with policies, procedures, technology, and talent to adequately mange the ongoing risk of a commercial lending department.  As you grow, we can be a valuable resource for your credit administration needs.

Quick Bite:  On April 28, NPR reported that Penn State University found that the 98-year-old Outing Club’s activities—hiking, backpacking, biking—to be too risky.  Other clubs that were shut down were the caving and scuba diving club.  In each case, the clubs were deemed to have an unacceptable level or risk in their current operating model. 

When asked more about this decision, the school cited concerns over students going to areas where cell service is not available in the case of an emergency.  Heck, for some of us in the rural areas, we can find cell phone dead zones wherever we go!  Sometimes even in our own homes!  Seems like to me that our universities should be focused on moving students into adulthood instead of coddling them in a safety net as we would children.

Inflation and Rising Rates

Harry Truman once asked for a one-handed economist.  When asked why, he said because every economist he talks to gives an opinion and then says, “on the other hand”.  He also commented that you could add up all the economists in the world and never reach a conclusion!

I have enjoyed economics as it was my undergraduate major in college.  I love looking at charts and graphs and trying to dissect what happened and what is going to happen in the future.  The field is quite humbling.  I once sat in a meeting with our bank economist in 2004.  He stated that the entire field of economics can be boiled down to four words, “people respond to incentive”. That is so true and very profound.  At the same time, it made me wonder what all four years of undergraduate work was for if I could have just had the summary from the get-go.

This piece will examine a little of the “on the other hand” and “people respond to incentive”.  It is a commonly accepted axiom in economics that the Federal Reserve Bank attempts to balance price stability (or low inflation) with employment growth.  If there is no sign of inflation, the Fed will spur on economic growth with lowering interest rates or other accommodating monetary policy.  If the economy is hot and prices are spiking up, they will try to cool off the economy with rising rates.  So, the principal is rising rates suppress inflation.

But what if that is not the case?  What if once the Fed begins to rise rates, what if people change their behavior to try to get ahead of the cycle by increasing their borrowing and spending.  These actions will accelerate inflation.

To the charts, Batman!  On the first one, note the Fed began to increase rates in the middle of 1977.  The Consumer Price Index (CPI) was at a hot 6.5-7%.  As the Fed increased rates from 7.5% to 17.5%, the CPI increased from 6.5% to 14.75%.


In this case the CPI did not drop until mid-1980 when the Fed cut rates from 17.5% to 9%.  In the next one, note that bank lending was strong at a growth rate of 8-9% annually.  CPI rose with every fed funds increase.  Fed increases started in March and the CPI shot up in June. 


In this case, the increase in the CPI ran alongside the fed funds increases.  The next one is from 1994-1995. Here increases in interest rates followed again with the increases in the CPI and also increased bank lending, substantially.


The next interest rate increase cycle was in 1999 to 2000.  In this case both CPI and bank lending followed the fed funds increase.  This is exactly opposite of what typical economics professors tell you will happen. 


The last case is from the interest rate increase from 2003-2006.  Here bank lending followed the rate rise and the CPI did increase but then ran out of steam.  After this chart we had the great recession and housing collapse. 


After the collapse, in 2009 the Fed took rates to zero and kept them there until 2015.  Lenders and borrowers became accustomed to these low rates.  Since 2016 tightening on rates started. 

The other major change over the past few decades, is the Fed now tends to flash bold signs as to their next moves.  This is amplified with Wall Street.  The Fed has stated “we are going to raise rates since there is going to be inflation.”  Once this is telegraphed the public believes that yes, indeed inflation is coming.  So, we should see CPI heat up but Fed increases have a bit to go before these become punitive.  The Fed is also going to work to tighten money by taking out $30 billion per month from the system.  In July this goes to $40 billion and in October this goes to $50 billion.  Taking these funds out of the market will create some headwinds for the market. 

It will be interesting to see if people think inflation is coming, how will they respond?  Will they jump in to spend and borrow more before things get worse as they have in the past?  Or will they follow the standard economic textbook? 

Quick Bite:  One of the areas that is hurting in the economy today is farming.  Most of us who are in ag lending know that prices spiked around five years ago and family farm income has dropped severely.  This bonus chart is from the FINBIN database of median net farm income in Minnesota.  If this continues, we will begin to see weaker farmers get out.


10 Commandments for Loan Pricing

At times, one item that we often question is how commercial and agricultural loans are priced in the credit union world.  The level of sophistication varies from none to those that have highly complex models to forecast the impact of a new lending relationship on return on assets (ROA) and in the banking world, return on equity (ROE).  In my past commercial positions at banks, I had to review the performance of the credit using complex models.  If certain targets were not hit, then there must be some good explaining on why we should do the deal.

It is in this spirit that I offer these:

1.       Thou shalt not publish commercial lending rates in a matrix as you publish consumer lending rates, unless your pricing risk is taken over by a secondary market sale.  There is no way that any matrix can adequately capture the variations in risk, duration, and relationship from one deal to another. 

2.       Thou shalt realize that commercial and agricultural loans are not under the same regulations for fair lending as consumer loans are.

3.       Thou shalt understand how booking a loan will impact your credit union’s balance sheet.  Booking a loan will increase your earning assets.  It will also require that funds are set aside in a loan loss reserve account.  The loan will have to be funded with either deposits or borrowings.  This will impact your required price you want for the loan.  If your institution has a very high loan to share ratio, you may want to charge a higher price for the new loan.

4.      Thou shalt understand how booking a loan will impact your credit union’s income statement.  The new loan will be an earning asset, hopefully without much trouble.  MBLs do require quite a bit of management so you will experience cost of monitoring and reviewing the risk of even the best of credits.  Understand that cost and the cost of capital associated with the loan.  Will the price that you are booking the loan at provide an increase in your ROA or will it drag it down?

5.       Thou shalt understand duration risk.  Duration is the risk that the margin you book the loan for today will not be available tomorrow.  A loan that reprices every time Prime moves, has a short duration and low risk.  A 15-year fixed has a long duration.  There may be a high chance that at some time during the life of the loan, the margin that you originally booked the loan at will be compressed or even worse, negative.

6.       Thou shalt understand margin.  Margin is the difference between the interest rate you are earning on the loan and what you must pay for the deposits to fund the loan.  You need to understand what is an acceptable margin to your institution.

7.       Thou shalt match fund as much as possible.  This is where you pretend that every loan you book requires that you must borrow those funds whether you must or not.  Use a yield curve of interest rates like the US Treasury rate or the Federal Home Loan Bank’s advance rate.  Pick a maturity that matches the reprice period of your loan.  E.g. use a 3-year UST to be your cost of funds for a MBL that reprices every 3 years. 

This does not always work.  You may have some government guaranteed programs that use Prime or some other index to price loans of any repricing maturity.  But as much as you can, match fund your loan pricing to the underlying cost of funds index.

8.       Thou shalt not lower an interest rate solely because a competitor is doing it.  This is the same as sticking your head out the window of your car as you drive down a one lane country road.  Sooner or later you are going to get smacked by a mailbox!  Figure out what you need to price and why.  Then use some discipline to follow your game plan.  There will be some cases that you will be more competitive, but do so on your terms, not because the borrower is asking for it.

9.       Thou shalt understand the present condition of the yield curve, direction of interest rates, and availability of alternative places to invest the institutions money.  A loan is an investment and you ae a steward of the capital entrusted you.  Understand the environment around you before pricing a loan.  We have seen many credit unions who are still pricing loans at rates that were fair last August.  Well, US Treasury rates have risen over 100 basis points since then.  So that same rate will not be very fair to your institution today.

10.   Thou shalt not lead off a conversation with a prospective borrowing relationship with price.  Putting price out on the table in the early part of a discovery period for a new or expanding credit relationship will doom you.  You become a slave to offering a low price since the only way you can set yourself apart from the competition is with a low price.  You either have low price or differentiation.

You must work with the member so they believe they are better when they are with you as their lender than when they are with someone else.  Create value in their mind.  Talk about what this new project will do for them.  Discuss their plans and dreams.  Give yourself time to look through the credit request, assess the environment, and know your institution before you commit to the price.  If you are not strong in this relational area, commit to developing this relational skill.  You will be wiser in your pricing and your institution will perform better.


Quick Bite:  From the Washington Post:  “More Retailers are Going Bankrupt Than Ever”.  Bankruptcies in the retail sector, reached a record high during the first quarter of 2016.  Nine companies reported defaults, including Sears and Claire’s during the period ending March 31, 2018.  Tops Friendly Markets, a supermarket chain and Bon-Ton department stores also filed for bankruptcy.  Defaults on corporate debt from the retail sector make up 1/3 of all defaults by corporations in all industries.  Moody’s predicts that their expected future default rate among retailers will decline next year.

Uncovering the Credit Worthiness of Non-Rated Tenants

Many office and retail commercial real estate deals you will review will involve some sort of rental income that is the main, or in some cases, the only source of income for the building.  If you are analyzing this type of credit, how can you determine the ability of the tenant to continue paying the rent?  This is a very important factor to weigh, especially if your guarantor is a weak secondary source of repayment.

If you are dealing with a publicly traded company as a tenant, finding their financial strength can be obtained by searching for corporate reports or bond ratings.  Note that just because a tenant is public, it does not mean that the tenet is financially strong.  We looked at a single tenant retail building late last year which we turned down due to the poor finances of the company that leased the building.

In most cases, you will not have tenants which are publicly traded and their financials are not public.  The lessee may be small or privately held.  This poses a question on the future income stream of the company and its ability to satisfy rent requirements.  What are some things that could be reviewed in your analysis?

First, in some cases you may actually be able to review the finances of the tenant.  Usually this would only be available if it is spelled out in the lease or if the landlord is vetting a new tenant.  Some leases are graduated with a base and then overages based upon certain sales levels of the tenant.  In those cases, the sales information must be shown to the landlord.

Second, inspect if the tenant pays its rent and other bills in full and on time.  Late payments on the rent may indicate further weakness financially in the future.  How does the tenant keep up their place?  Is it neat and clean?  Are they good neighbors to others around them?  Do they have a good relationship with others in the area? 

Third, look at the industry.  Tenants that are in industries that are thriving or in areas of high demand for the services will more likely be financially successful than those in struggling sectors. 

Fourth, are there any guarantors on the lease? A weak tenant that is backed by a strong personal guarantee or the backing of a large company, increases the continuation of rent payments.

Fifth, are there possible landmines inside the lease that could blow up and allow the tenant to easily leave.  One landmine may be a provision to allow the tenant to leave if certain amounts of sales are not obtained.  Another lease may be based upon the access to their shop from customers.  I once knew of a lease that stopped because a road was rerouted which made the access to the retailer difficult. 

Sixth, how easy is it to replace the tenant if they leave?  If the property is in high demand, perhaps less emphasis needs to be viewed on a tenant as they may be able to be replaced easily. 

Finally, consider paying a visit to the property.  If you can chat with some of the tenants you may gain an understanding of why they chose the rental spot and how successful the location has been for their business.  It may also give you a clue into the business acumen of the tenant and provide an opening to develop another business relationship.

Retail and office rentals may provide great opportunities for your borrower to add a good earning asset to their real estate portfolio.  It also may be a good loan on your books.  Consider a deeper dive on some of the tenants to make sure the income stream will continue.

Current Trade Conditions and Agriculture

In the past couple of weeks, President Trump has announced new tariffs on imports.  In early March, new tariffs of up to 25% on steel and 10% on aluminum were put in place to protect and revive American factories.  Within a few days, U.S. Steel announced bringing back workers in Illinois plants because of the expected need for more domestically produced steel. 

The impact should help producers of the metals, but could raise prices on manufacturers who use the metals and ultimately, the consumers who buy the products.  Last time I checked, there seems to be quite a bit of metal that is used on farm equipment, so expect some higher prices there.

The tariff announcements continued.  On March 20, President Trump announced as much as $60 billion in tariffs on Chinese goods.  These are a response to the $500 billion trade deficit we have with China and the theft of intellectual property has occurred from one of our largest trading partners.  The move sparked concerns of a possible trade war.  Some news outlets believe that if there is a response from China that it will be “targeted”.

One major concern is the impact any trade disruption will have on agriculture.  Foreign markets are important to keep open as viable places to sell the products farmers and ranchers produce.  The USDA reports that in 2017, the top ten food and ag products accounted for 58% of all U.S. ag exports. King of the list by far was soybeans at $21.6 billion.  This was followed by corn at $9.1 billion, tree nuts at $8.5 billion, beef at $7.3 billion, and pork at $6.5 billion.  Rounding out the bottom five are wheat, prepared food, cotton, dairy, and fresh fruit. 

China is expected to import nearly 3.5 billion bushels of soybeans in 2018 and this is expected to increase by around 140 million bushels annually for the next five years.  This growth is partially because of a decrease in Chinese domestic soybean production as profits have been higher for crops like corn and rice.  Soybean demand is high and China is the largest soybean importer in the world. 

But even before the recent tariff announcements, there was already some hostile moves by China against U.S. bean producers.  On December 20, 2017, Bloomberg reported the USDA agreed with a request from China to impose stricter standards on U.S. soybean shipments to China, while these same standards were not placed on Chinese imports from other countries, like Brazil.  At the same time, China increased its soybean purchases from Brazil in the first quarter of 2017-18 by over 7 million metric tons while cutting purchases from the U.S. by 5.37 million metric tons.  So even before the tariff announcements, it appears that China had begun making steps against U.S. producers. 

So as a lender, what should you watch out for to protect your institution and your producer?  First, watch the position of international trade and its impact on the U.S. farmer.  Agriculture is dependent heavily upon the world market demand to purchase a large portion of supply that is grown in our country.  Tariffs from other countries against U.S. products, or as in China’s case, additional requirements that are placed upon imports from the U.S. will have a negative impact on prices, which decreases the top line revenue to your producer.  Also, understand that these principles impact all commodities and not just soybeans which have been discussed here.

Secondly, watch the weather.  Several decades ago, the farmer was only concerned if there was good growing conditions in his area.  Since agricultural products have grown into worldwide commodities, there is concern for growing conditions around the globe and, in turn, the impact on supply.  A drought in Argentina that lessens the soybean crop while our crop is not impacted will drive overall prices higher.  At the same time, if the Brazil crop is extremely plentiful due to good growing conditions, and the Chinese see Brazil beans as a good substitute for buying U.S. soybeans, demand and the price for U.S. beans will fall.

The third factor is interest rates.  It appears that the Chinese and other countries may be curbing their appetite to purchase U.S. government debt.  Lowering the demand for U.S. debt will result in the debt needing to be sold at a higher interest rate.  This will impact the interest rate to your producers.  Also note that the new supply of government debt is plentiful as displayed in recent Congressional spending bills. 

Most news articles I read from experts believe that we are at a lower part of the price cycle for many agricultural commodities and will continue there for the next few years.  The impact of trade and tariffs from all sides, could produce stronger headwinds the farmer and rancher will have to face. 

Importance of a Contingent Liability Inspection

Years ago, at one of the banks I worked at, we had financed a business which suffered a severe downturn in its performance.  The company no longer generated enough revenue after operating expenses to satisfy all its debt obligations.  Consequently, we downgraded the credit appropriately and began closer monitoring of the situation. 

We followed the correct procedure with obtaining all updated financials and liquidity verification with all the guarantors for the credit.  We were provided a new business plan and budget for the business.  At first, there was little worry among our lending team as the pockets of the guarantors were deep and it initially looked like they could weather many years of losses at the level the company was experiencing.  The guarantors also appeared willing to support their obligation.

At first, all seemed to go well. Payments were kept current even though the company continued to struggle.  About six months into the plan, things began to go sideways.  Business continued to be poor and the sponsors behind the credit now were having problems with making the payments.  But how could that be?  The guarantors had shown they had multiple accounts that could support the deficiency in the credit for what seemed years.

We asked the guarantors for updated financial statements and discovered a large portion of the cash they held did not show up in what they now provided us.  So, what had happened?  Where had the money evaporated to?

The answer came from the performance of the other business ventures they were involved in.  Most were marginally profitable.  Several, including an investment in a closely held airline required capital injections of tens of thousands of dollars monthly.  The answer to the missing cash was in their contingent liabilities.

Contingent liabilities are loans with other entities as the borrower, but your sponsor on the credit may have signed a personal guarantee on it.  In some cases, this may be something minor, like signing a guarantee to make payments on a car loan if you son fails to.

At times, these guarantees can be quite major and potentially require large outlays of resources to support the credit.  Since we failed to ask this information, we were caught blindsided when our strong guarantors now were too weak to continue supporting the debt.  Ignoring your borrower’s or guarantor’s other contingent liabilities, is to ignore what may be the major source of personal financial success or failure.  This can have a huge impact on your sponsor.

So what things are needed to look at any contingent liability exposure?  A good start is to obtain financials and tax returns on any entity that your borrower has signed for.   This will give the analyst some historic basis for the performance of the companies your borrower/guarantor may have obligated himself/herself for. 

More information is helpful.  Understanding the relationship that your sponsor must the entity they have signed for is necessary.  The analyst will also need to know the outstanding balance or commitment, the type of credit, and the amount or percentage of the loan guaranteed.  Is the credit open-ended or closed?  Is the borrower that your sponsor has a contingent liability for, in compliance of all covenants or are they in default?  What are the penalties for default?  What is the annual cash flow from the company?  How does that compare to the annual debt service requirements for the company?

All these questions are valid when understanding the potential exposure your borrower/guarantor may have with obligations they are not directly responsible for.  In each case, these items may make a huge impact on their ability to successful support your credit.

If you have questions, let us know.  We also have a good contingent liability sheet that is in the loan application package that is on our website at

Bureaucracy or Accomplishment

This past week has been yet another incredible experience at the CUNA GAC.  Some of our Pactola team members went there to reconnect with some of our CU friends and meet new ones.  We also take time to visit with our Senators and Representative to help advance issues which will help our industry grow.  Here are a few pictures from the week.  


One part that I always enjoy, though sometimes I find it frustrating, is the time when we hike Capitol Hill to visit with our Senators and Representative.  It can be a great opportunity to share concern for issues and thanks for supporting credit unions.  The meeting this year caused me to think a bit.  But the thinking did not occur as we spoke to our legislators; it came in the traditional debrief afterwards.

A traditional debrief is held at a Washington DC establishment called Clyde’s, over Yuengling and oysters.  One of my fellow “hikers” commented on the meeting we had with one of our senators.  We had expressed concern over recent data breaches and instead of the senator giving a clear path of action, he tended to outline several roadblocks that had to be overcome in order to get anything done. 

A comment was made on how high up in the Senate this gentleman was, and yet he acted like he could not do anything more.  This is an example of bureaucracy winning over accomplishment. 

My mind drifted back to one community bank I worked for had a phrase of “serving our community” in what we would call a mission statement today.  When I first started, I thought it was neat that a bank had the focus on making their community grow and prosper.  It is something that as credit unions we all see the betterment of the lives of those in our membership area. 

The misconception I faced was based upon the word “community”.  Most of us think of egalitarian and noble ideas of improving the lives of all around us.  I soon learned their version of community was much different than yours or mine.

After I was there for a month, I discovered the main manual that was used by retail folks was horribly weak.  New employees often fended for themselves and were thrown to the wolves when it came to some tasks to serve the customers.  This took unnecessary time for file management tasks that should easily be handled by a knowledge employee within a few minutes.  Yet those in the know did not want to teach those who did not know as they felt it lowered their importance to the organization.

I had a friend who found himself in a similar situation.  He saw the inefficiencies and took time to create a new help manual that could be used for front line account staff.  The manual covered most of the challenges front line staff would come across with screen shots and detailed instructions on how to better serve the customer.  This work would save so much time and needless hassle.  So, he presented his work at the next staff meeting, fully expecting to be hailed a hero for his initiative.

But the opposite happened!  The CEO rejected the manual, even though it would help both the bank and the customers.  He wanted to form a committee to review the work and make necessary additions or deletions as they saw fit.  Consequently, nothing came of my friends work except for a few pirated copies used extensively by smart front-line staff.

Another case where bureaucracy wins!  The community that was improved was the little turf of some working inside the bank itself.  Those in the know continued to be important and others were left on the outside.  Several years later when my friend left the bank, his manual had still not made it past the committee.  It would forever be a casualty to their bureaucratic kingdom. 

Bureaucracies can flourish anywhere.  I grew up in a Southern Baptist church where once an idea came forth, a committee was typically formed.  And there were committees to nominate those to be on other committees.  Often, this created a lot of activity, but not much accomplishment.  Real ministry came when individuals or groups just went and did.  We would often joke that we were thankful that God so loved the world that He sent His Son, and not formed a committee!

Now this is not to say that there is no place for governance and order in your company.  But committees, departments, and divisions may often lose track of the overall goal of the organization and begin to act in ways that just advances their own small piece of the group.  At this point the bureaucracy thrives and the overall mission is lost. 

The bank I was at should have asked if each of these departments were set up to serve the community.  In areas where they did not, a decision needs to be made between the bureaucracy and accomplishment of their stated mission.  Bureaucracy and accomplishment are often polar opposites of each other.

What can be done to change your situation?  First, observe. Observe your organization. Is your mission and vision in line with what you want to accomplish?  If not change them!  If so, are your various sections and divisions of your company contributing to the overall direction or are they each in their own bureaucratic kingdom?

Next change what you value.  Place high emphasis on actions and attitudes that meet the mission of the organization.  Value mission over meetings, accomplishment over activity, and breakthroughs over bureaucratic castles.  Change departments if they do not support your overall mission and character.

Next, act.  Empower your team to make as many decisions on the front line and to execute them.  Educate your entire team so the attitudes you wish to see in them are evident.  Reward actions that are in line with the mission.

Finally, guard.  Guard your corporate culture.  There is a tendency for every good idea of service to erode into an organization whose goal becomes the furtherance of the organization.  That is a definition of bureaucracy and not accomplishment.


Business Strategies of a Fighter Pilot

During the Korean War, John Boyd was a young airman flying F-86 Sabre fighters.  John noticed that American pilots were downing Soviet MIG-18s with greater frequency than the Soviets were destroying U.S. fighters.  This intrigued John as the MIGs were known to be technically superior to the F-86s in most categories and the fighter pilot training on both sides was similar. 

John studied this phenomenon and discovered there were two slight advantages the F-86 had.  First, F-86s had a bubbled canopy for the cockpit that allowed pilots a larger field of vision that the MIG flyers.  Second, the F-86 had better hydraulic controls; this allowed our pilots to not exert themselves physically when flying the jets.  The combination of increased vision and better handling in combat gave the Americans a 10-1 kill advantage over the MIG pilots!

After the war, John continued serving our country in the Pentagon.  There, he expanded on his insights he made during the Korean War by crafting the OODA Loop.  OODA stands for Observe, Orient, Decide, and Act.  Boyd’s purpose in the OODA Loop is to create the ability to unraveling one’s opponent by acting in the least-expected way possible.  This keeps the opponent off-balance and keeps them from mustering an effective defense.  Think of those who are successful in a football game.  Many times, the difference may come from an unexpected play or two that give the advantage to the team that executes the play better. Think of the pass from Trey Bolton to quarterback Nick Foles in the recent super bowl. 

A great example of the OODA Loop embodied is in President Donald Trump.  Whether you are a Trumpster or don’t care for him, you must admit that Trump moves much differently from career politicians that we have been accustomed to.  In his first year we have seen the largest reform to the tax code in the past 30 years, major proposals to change Obamacare, slashing of 22 regulations for every new one implemented, and the proposal for a major private-public partnership for major infrastructure improvements, just to name a few items of what is happening. 

The discussion here is not to tout or criticize the accomplishments; it is to just compare the speed of action to those career politicians in Washington DC, where accomplishments are celebrated when the snail moves an inch.  It is because Trump moves at such breakneck speed that leaves his opponents and the media in the dust, wondering what has happened to them while Trump has moved way past them.  I am reminded of a neighbor I had in Missouri who ran a computer company that had a large contract with the State to monitor road conditions.  He once told me the biggest difference in the corporate vs government world is simply this.  In business you have a field to play on and the goal is to get to the end zone in whatever way you can, as quick as you can.  In government, they don’t focus on the outcome, they stress the process.  He told me of meetings he sat in on where the subject was literally how to have meetings!

The OODA Loop begins with Observe.  This is taking account of circumstances, outside information, implicit guidance and control, and unfolding interaction with the environment.  Think of the pilot who is constantly assessing the skies or the quarterback sizing up the defense.

Observation leads to the next step, which is to Orient.  This step mixes cultural traditions, heritage, past experiences, and new information together to analyze and synthesize the observation through these filters.  Here think of the fighter pilot moving into position behind an enemy or the quarterback dropping back for a pass.

The first two steps feed forward to the next one which is Decide.  Here using the observations and orientation, under the governance of implicit guidance and control, a decision is made.  This decision is feed back to the original observation.  At this point, the fighter pilot has the bogy in his crosshairs or the quarterback sees his slot receiver has a step on the opposing quarterback. 

The OOD steps feed forward to the final step, Act.  Action has feedback immediately with the observation when the action is executed and after the action occurs once unfolding interaction with the environment from the action occurs.  In this step, our pilot has fired on the enemy or the quarterback has hurled a pass to the wide open receiver. 

But this does not end after action, the process is a loop and it continues to turn again and again through the OODA process.  Companies and leaders who accomplish much at breakneck speed will use the OODA Loop again and again. 

There is danger in stopping at various points in the loop and not moving forward.  Staying in the observation and orientation stages too long can lead to analysis paralysis.  Have you ever seen someone who is very comfortable looking and studying the data and never deciding?  Analysis paralysis may come with a perfectionist attitude or the fear of failure that prohibits decisions.

Some may get stuck in the decision stage without action.  The circumstances are analyzed and a conclusion is made, but no real action is completed.  Another problem is completing the OODA loop in one cycle but not repeating it to see the changes in the environment with your action.  It is like leadership where you must inspire and walk ahead of the follower, but you also must look back for feedback and to make sure that you are being followed.  Abraham Lincoln once said, “He who thinks he is leading and has no one following, is only out for a walk”

Now the OODA Loop in your business may not require as quick of decisions as the fighter pilot or a professional quarterback. But the process needs to be completed and repeated to accomplish real changes in your world.  Also, this Loop should be studied whenever we see good examples of it.

Interest Rates on the Rise

Have you ever had the sinking feeling when you missed a plane, bus, or a train?  I remember that well when I was in elementary school and I messed around getting ready one morning.  The bus stopped at the end of my driveway and I walked by our living room window just in time to see it pass by.  I hurried to get my books and sprinted out of the house and up the street toward the speeding bus.  I just had one problem, my top speed could not match the rate that the bus was travelling. 

Finally, I wised up and lurched down the hill to our house.  My mom had to take me into school that day and I had to pay the punishment for the next two weeks for dilly-dallying around instead of being on time. 

I am sure that everyone has experienced missing a bus, connecting flight, or carpool ride.  The feeling in the pit of your stomach is awful.  We have something occurring right now that can do more damage to your profitability than re-booking the flight; the low interest rate train is leaving the station!

This is a classic where the borrowers are scrambling to get deals with interest rates like they did 6-12 months ago.  It is also the time when some lenders who are not looking at the world around them, will be silly enough to grant the terms that the borrower wants.  The result is maddening enough to make the CFO and Asset-Liability Committee comatose.

Last week, we received in two new participation projects.  Both are asking for 10-year rates at 4.25%.  Both should have had their projects ready to be funded last June if they wanted to be in this ballpark.  The sad thing is, there is probably some banker out there who will give this to them.

We have seen the 5-year U.S. Treasury increase from 1.73% late in August 2017 to 2.57% at the end of last week.  The 10-year U.S. Treasury was close to 2.00% at the same time and has jumped to 2.857% on Friday.  Each of these is an 80+ basis points increase in the interest rate compared to a mere 5 months ago. 

It also looks like interest rate increases may continue.  The Federal Reserve has indicated they may increase the Fed Funds rate three times this year (March, June, and December).  This would put the shortest-term rate at 2.25% heading into 2019.  The Fed is concerned with very low unemployment and rising wage growth that will light the fuse for inflation.  The Fed counteracts inflation with rising the level of interest rates to cool off the economy.

Economic growth is also strong and leads to possible higher interest rates.  The Federal Reserve Bank in Atlanta, forecasted GDP growth at 5.4% for the first quarter of 2018.  We will see if we hit this, but this is a level that we have not seen in a decade.  People are feeling better about themselves with additional money in their pocket from the Trump tax cut and extra bonus money from corporations who are sharing their tax savings with their teams. 

Consumer spending is up.  Business investment is increasing.  The optimism index of the NFIB is increasing from an all-time average high in 2017.  All economic indicators are pointing to a great year.  Couple this growth with upward pressure from the Fed and increased demand for credit if we run high deficits and you have the recipe for rates to be a full percentage above where they are today, at this time next year. 

At this point in the cycle, it is important to realize where we are and take appropriate action.  First, realize that you will have to pass on some deals if the borrower continues to be stuck in last summer’s interest rates.  Learn to price loans where the market is today and considering the direction in the future. 

Next, increase your hurdle rate you use to underwrite deals.  We underwrite to a higher interest rate to see how the deal will “act” when rates are at higher levels than they are today.  Last year our rate was at 6% to test deals at.  We are moving it to 6.5-7% for underwriting purposes.  Also, look at lower rate credits that are coming up for a reprice.  How will that impact the business performance?

Finally, pay close attention to areas in your portfolio that are in trouble.  Higher rates will not make the borrower any more successful than he was with the lower rates.  It will make things worse.  Watch out for your problem loans that are not performing now, regional areas that are struggling, or sectors of the economy, like agriculture, that are unable to generate high enough prices to keep their margins strong. 

So, the interest rate train has left the platform.  Are you on board with the current market conditions, or are you still chasing the caboose as you run behind the train?

New Tax Law Changes and Housing

Existing single-family home sales increased by around 1% in 2017 compared to the year earlier.  Housing inventory that was for sale kept the market from gaining more traction.  New home construction is rising, but the levels we saw before the 2008 crash have not been achieved. 

Many of the factors that have contributed to a lack of accelerating sales remain the same, two factors may result in a suppression of the market.  The first is the changes in the tax code.  Now while the recent tax law will mean that 90% of Americans taxpayers will see more money in their paycheck, the downer to the housing market is the increase in the standard deduction. 

The standard deduction increases to $12,000 for single files and $24,000 for couples means that fewer homeowners will realize the benefit from itemizing their interest expense as a deduction on their taxes.  There are also some limitations on interest deductions which will exclude mortgages of over $750,000, if the mortgage was taken out after December 15, 2017.  There are also some limitations with some deductibility of home equity interest.  The increase in the standard deduction means at current interest rates and with no other deductions, the mortgage threshold has grown from around $200,000 to above $400,000.  This is above the median home price in many areas.  The average median priced home in the U.S. was at $248,100 in December 2017.  The median new home price ended the year at $331,400.  The change in the tax code, while great for putting more money in people’s pockets, may provide a slight disincentive to purchasing a house.

The next factor is the strong economy.  As I write today, the Dow is down over 665 points.  The catalyst for the drop is the growing concern that the economy is heating up and the Federal Reserve may step in to increase rates.  The projection from the Atlanta Federal Reserve for GDP growth in the first quarter of 2018 is a high 5.4%.  This news was coupled with the increase in hiring and wage growth that was the strongest since 2009. 

If interest rates do increase, this will make home mortgages less affordable as interest rates climb, thus making payments higher.  Last year, sales of new homes rose 14.1% from 2016.  Many of these homes that have yet to start construction continue to rise, reaching 32.6% of new home sales in December.  The construction backlog may benefit rental markets in the short term as people who are purchasing new homes must stay in apartments longer, waiting for the home to be completed.

First time home buyer demand will probably be more muted with these factors.  In December 2017, Marcus & Millichap reported that first time buyers accounted for 32% of all purchases.  This rate has bounced from the high 20% to low 30% range since 2010 and will likely stay there in 2018.  This is well below the 41% long term average.

These factors should benefit apartments and other housing rental demand.  In 2018 new apartment completions will ease from the 380,000 units delivered in 2017 to 335,000 apartments.  Half of all additions are concentrated in a limited number of markets and vacancy will remain tight in much of the country throughout the year. 

These factors should all combine to increase the demand for rental housing.  In commercial lending we should understand the current drivers of the demand for these loans and this should continue to be strong all throughout this year.  We also should be aware that the cost of money is rising and increase our interest rates accordingly.

More Business Tax Changes

In the last blog, I looked at the impact of depreciation and the 1031 exchange in the recent Tax Cuts and Jobs Act, signed by President Trump last month.  There are some other changes that impact business that should be noted as well.  Note this blog and the others on tax changes, are designed to bring some awareness to the new changes.   You should consult with your tax professional on how these will impact your business.

Meals and Entertainment expenses have undergone a significant change.  Entertainment expenses that are incurred or paid beginning this year are no longer deductible.  Meals are still 50% deductible.  Meals that are provided by an in-house cafeteria are now 50% deductible.  After the end of 2025, the meals expense for clients will not be deductible at all.  So, the moral here is if you take clients to a sporting event, buy cheap tickets, but spend lavishly on the meal beforehand.  And if you are overly concerned with tax liability, stop all client meals in 2026! 

Interest expenses now have a limitation for large businesses with average gross receipts of over $25 million.   Net interest expense is capped at 30% of the business adjusted taxable income.  Between 2018-2021, adjusted taxable income does not include depreciation and amortization.  The adjusted tax income is determined at the tax filer levels and unused amounts are carried forward to be used as expense deductions in future tax years.  These do not run out.  There is a carve out for floor plan interest, which is not subject to the 30% limit. 

Research and Development costs spent after 2021 must be capitalized and amortized over five years or 15 years if done outside of the U.S.  This includes software development.  This change is not in favor of the tax payer as R&D costs are now written off immediately.

Businesses have new tax credits for employer paid family and medical leave.  This starts in tax years 2018 and 2019.  General Business Credit that is equal to 12.5% of the qualifying wages paid to employers on the Family Medical Leave Act if the rate of payment is at least 50% of the normal wages paid.   The credit will increase to a max of 25%, as the wages increase compared to the percentage of total paid. 

On rehabilitation of old buildings, the 10% tax credit for qualified rehab expenses on a building originally built before 1936 has been repealed.  A 20% credit is available for qualified rehab expenses with respect to certain historic structures.  This must be claimed over 5 years.

Remember that tax credits go directly against your tax liability as a dollar for dollar reduction.

Net Operating Losses (NOL) now have some new restrictions.  There is an excess business loss rule for a single tax payer of $250,000 or married at $500,000.  In the past if you had a farmer with $500,000 of W2 income and a $500,000 farm loss and $100,000 profit from another business, the net taxable income from those two is at $100,000.   Now the profit and losses from all the businesses are added together to and compared to the limitations.  A farm loss of $500,000 and business profit of $100,000 are subject to the single limit of $250,000.  This would reduce the taxable income in this example to $750,000 and have a carry forward of $150,000. 

Before 2017, NOLs were carried back 2 years and forward 20 years.  Now NOLs cannot be carried back, except for some farm losses.  The carryover is limited to 80% of taxable income and there is no expiration on the time frame for a carry forward. 

So overall, some of these changes are in favor and others are not for the business tax payer.  It is important to gain a full understanding of the new tax law considering how this will impact your situation.

Impact of the New Tax Cuts on Business

President Trump signed the Tax Cuts & Jobs Act into law on December 22, 2017.  This is one of the largest tax reforms since 1986.  Nearly all the provisions will go into effect starting January 1, 2018.  Some of the provisions are permanent, while others will sunset on December 31, 2025.  This law has the potential to ignite a boom into our economy.  This blog will look at the impact on depreciation and on like-kind exchanges. 

Depreciation Changes:  IRS Section 179 depreciation for equipment increases from $510,000 in 2017 to $1,000,000 in 2018.  There is a phase out for business entities that purchase over $2.5MM of equipment in a year.  Another big change is to now allow Section 179 is now available for non-residential real property assets.  This could allow for items like roofs, HVAC, fire protection, and alarm systems may qualify for Section 179 depreciation. 

Bonus depreciation rules have changed.  Prior to September 27, 2017, bonus depreciation was limited to 50% on eligible new property.  After September 27 through December 31, 2022, the bonus depreciation was increased to 100% and is now available for both new and used property purchased for business. 

Luxury automobile depreciation is loosened.  In 2017 this was capped at $3,160 in the first year, $5,100 in year 2, $3,050 in year 3, and $1,875 every year after.  The new tax law changes the limits to $10,000 in the first year, $16,000 in year 2, $9,600 in year 3, and $5,760 each year thereafter.  There is an additional bonus of $8,000 available for luxury autos in 2018. 

New agricultural equipment (other than grain bins, fences, and land improvements) is now on a shorter recovery period in the tax law is now recovered over 5 years instead of 7.  This will increase the depreciation deduction and lower the tax liability for the farmer. 

The law changed qualified improvement property by eliminating qualifications of leaseholds, restaurants, and retail establishments.  The tax life has been lowered from 39 years to 15 years for interior improvements made to a non-residential building after the property is first placed in service.  Elevators and escalators are excluded. 

Overall depreciation of residential real estate has increased from 27.5 years to 30 years if the taxpayer opts out of limits on interest deductibility and increases from 39 to 40 years on non-residential structures.  The old time-frame stays the same if the taxpayer agrees to the limits on the interest deductibility in the new tax law.  This is one area with the extended term which will increase the tax liability of the taxpayer.  Note, though, that the property owner can still use cost segregation to carve out improvements on property such as floor or wall coverings, to 5-year and 15-year property. 

Section 1031 Changes:  The new Tax Cuts & Jobs Act has eliminated the Section 1031 like-kind exchanges for all property except for real estate.  So, you can still complete a 1031 for deferring the gain of a commercial piece of real estate to another piece of commercial real estate.  Note that real estate is broadly defined and not classified by property type.  Thus, you can defer your tax gain on a hotel you sell and take that basis into an apartment, retail building, or office. 

The elimination of 1031 for non-real estate has eliminated deferring the taxable gain you have report upon sale of a piece of equipment, or other non-real estate asset used in business.  One large source of non-realty 1031 exchanges was with race horses.  Those will no longer be eligible. 

Overall, the new Tax Cuts & Jobs Act will have a positive impact on the deductibility of capital expenses made in real estate and equipment.  This increase in the deductions will lower the tax liability of the property owners.  The impact would logically have a stimulus effect on the economy. 

2018 Will Be a Banner Year for Small Business, Is Your CU Ready?

The National Federation of Independent Business (NFIB) collects trends on small businesses through surveys it completes monthly.  They have cone this with quarterly surveys since 1973 and monthly ones since 1986.  For 2017, the NFIB Index posted the highest yearly average that the Index has ever had in its history at 104.8. 

This Index surveys small businesses on items such as their view of labor markets, credit, sales and inventories, compensation and earnings, capital spending plans, and inflation.  Fifty-nine percent of owners reported attempting to hire new workers, 84% reported their credit needs were met or they were not seeking new credit, a net 28% of owners are experiencing higher sales, and 61% are planning new capital outlays. 

We have recently seen companies such as American Airlines, AT&T, Bank of America, Nationwide, Comcast, just to name a few, that have announced new bonuses for employees.  Other companies have announced major capital outlays.  Fred Smith, CEO of FedEx stated on Fox Business that “The key to take the risk out of expanding is the new tax policy.” 

The stock market is hitting new highs, again, today as I write this.  In 2017, the market was up over $7 trillion in value.  At the same time, over two million new jobs were created, capital spending is taking off, and housing is running quite strong. 

The NFIB cites the recent improvement in the economy as from the recent tax legislation combined with a cut in regulations from the Trump administration.  The new tax law is heavily weighted toward business compared to the Regan cuts.  The U.S. economy is on track to have 12 months of growth in excess of 3% by the end of the first quarter of 2018.  This is the first time we have experienced such growth in the past eight years. 

All these actions have helped create new hope and optimism for the economy, especially among the business community.  With this optimism for business, the plans for companies to make capital outlays and expand, the question to ask is, “Is my credit union ready?” 

At the start of the year, this is a wonderful time to review your structure of your MBL department and to make sure you are prepared for the heavy year of lending I believe we may see in 2018.  There are several items to put on your to do list.

First, are your policies and procedures revised to meet current regulations and your business environment?  Believe it or not, we still see MBL departments which have not upgraded their policies with the major regulation changes that hit at the beginning of last year.  Prudent lending dictates that all policies and procedures be reviewed annually. 

Next, have you set up a third-party loan review for your loan portfolio?  This is a strategy we use on our company to look at how we do business and what we can do to improve.  A third-party review can see how you apply your policy and procedures.  The ones which are valuable will help you see structural areas where you can improve and those sectors where you are already strong.

Third, what sort of training requirements have you set up for your commercial team and what sources are you using for ongoing training?  It is very dangerous to think that you are beyond any ongoing education as we all must learn continuously.  If you have not, set a minimum number of hours each year that every staff member needs to meet.   We started our group at 40 annually.  Last year every person on the Pactola team completed over twice this amount.

Fourth, what work have you done to establish a resource for funding large loans through participations and purchasing loan opportunities?  If you open your eyes to the possibilities, you will have the ability to fund larger businesses than what you believed could be completed.  There will also be great opportunities to purchase into good loan participations that offer diversity for your portfolio.

Finally, what is your strategic plan to grow this year?  Do you plan to expand your presence with medical professionals?  Maybe you want to fund more manufacturers?  Perhaps you know the top ten small businesses in your community and want to bank each of them.  January is a great time to dream with your team and set some real goals to achieve this year.

2018 is shaping up to be a banner year for business.  It is now time to make sure your framework is ready to take care of this increased business.  If you need help with your policies and procedures, file auditing, lender education, participations, and strategic planning, contact Pactola.  We exist to help you succeed with commercial and agricultural lending.

Public Speaking is Not About You

We had my oldest son and his fiancée visiting over Christmas and the New Years. She is working on her graduate degree in English and is always interested in communication in the US, especially since she is from another country. 

Our family attended Christmas Eve services at our church. After the service, she remarked that she was impressed with the sermon and the communication skills of our pastor, David. Her comments began to make me think about what makes a good speaker. 

Public speaking is a huge influence on your success. We have told our kids if you can learn to communicate well through speech and in writing, research effectively, lead others, and focus your time and energy, you will accomplish great things. So, what makes me hang on all of David’s sermons when there are others who would put me to sleep? The question is worth a blog. 

David connects with his audience, where other speakers may not. One of the first things you notice is an absence of a pulpit. He will have a large screen TV for PowerPoint slides and a tall table to put his iPad and other notes on. The absence of a pulpit, apart from giving the speaker something to hide behind, is removing a barrier between the preacher and the congregation. Now, I don’t think that every speaker needs to abandon a podium, but if that is removed, it does take away a barrier between you and the audience. 

David will allow his mind to wander a bit during the sermon. Some of this may be planned. It has the effect of making the listener realize that he has a lot of similarities as David. This helps build a connection. I watched John Maxwell, who is an incredible leader and speaker, spill water down his shirt during a talk. Instead of trying to hide it, John stopped his talk and exaggerated cleaning up the mess, while making a self-deprecating comment about his clumsiness. To a person whose family often jokes about my propensity for stupid head injuries, I can relate to that easily. 

The ability to laugh at yourself in public is a skill that brings down walls between you and those you are speaking with.  Now some may think this is not very dignified; at times dignity needs to be sacrificed for connection. Anyway, realize that as my Aunt Lil told me, “You better go ahead and laugh at yourself, because everyone else already is!”

Perhaps the biggest lesson in public speaking is one that is often overlooked. Speaking is not about you!  Now let that sink in for a bit.

If speaking were all about you, why go through the potential embarrassment of talking in public at all? Why not just practice watching yourself in a mirror in the bedroom? When you speak in public, you are trying to communicate an idea to motivate the listener to take action. Yet, many speakers are only focused on the items on their outline with no concern if the audience actually understands the message. 

George Bernhard Shaw outlined this problem when he said, “The single biggest problem with communication is the illusion that it has taken place.” Have you ever been the giver or receiver of a speech where you thought actual communication was happening but only discovered later that it was not? Everyone attempts to communicate, but very few people really connect to their audience. Connecting is the real goal of communication. 

The first obstacle to real connections when you communicate is that you want to look good as a speaker. My wife attended a speaking club event last year. During the meeting, each person had to get up, stand behind a podium and speak about the chosen topic of the meeting. Each speaker was judged on the number of “ums”, repetitive words, and unintended pauses. The focus of the meeting was how good the speaker looked. 

The challenge here is the more perfect a speaker looks, the bigger the gap is between them and the audience. People are not looking for perfection, they are looking for a connection. When you speak, remember it is not about you, it is about the audience. You have to lose yourself to the people you are talking to. Try to use humor, especially laughing at yourself to put your ego in check and focus on them. People will respect you for your strength and weaknesses, but they will love you for your failures.

The next time you speak, remember this: Time you have in front of an audience is about them, not you. In the words of John Maxwell, “Connecting is all about others: Whenever people take action, they do so for their own reasons, not yours or mine.”

Bar Napkin Analysis for Member Business Loans

As a CUSO that helps smaller Credit Unions with the startup of their Member Business Lending departments, after drafting a loan policy, the next thing I hear is ‘What now?’ This is a loaded question, because every member and his or her request is going to be different, but there are some basic steps that you can follow to help you determine the credit worthiness of a member’s request before too much time is wasted.

Step 1: Don’t start out quoting rates!! Starting out quoting rates before you know the details of the loan request is setting yourself up for failure. First, a member that is shopping for the best rate isn’t likely to be with your Credit Union for the long haul. Smart business owners know that there is value to a good relationship with their lenders, and if that comes down to an extra .5% on a loan, they will be willing to pay it. If they walk, you will likely see them back in a year when they find out their bargain basement interest rate wasn’t all it cracked up to be. Second, interest rates should be reflective of the structure and general risk of the loan. Quoting the same interest rate for a 5-year single family residential rental loan as a 12-month term line of credit that is tied to a borrowing base makes no sense. The latter is going to require significantly more time to monitor and service, and inherently carries more risk.

Step 2: Have your member complete an application. Pactola’s website,, has applications available to download for both commercial and agricultural loans, and each include a complete checklist of the items that your member will need to provide. These items will get you started on your bar napkin analysis of the credit request. If your credit union is a subscriber of Pactola, shoot us an email with your logo and we can get these applications customized for your Credit Union as well.

Step 3: Evaluate the collateral. Depending on your Credit Union’s loan policy, you will want to evaluate the collateral to make sure it is within your loan policy’s limits and is readily marketable. If it is equipment, do you need to discount the estimated value due to age or condition? You will then want to look at the maximum loan term, amortization, and LTV your policy will allow. Let your member know these terms so they know how much equity they will need to bring to the deal, and that those terms are how you will initially analyze the loan, but are not guaranteed. These terms are relatively fluid until closing.

Step 4: Time to analyze. Now that you have received the historical (or proforma, if a start-up) financials on the business, it’s time to analyze. Ideally, the primary source of cash flow is going to come from the gross revenues of the business. This can be rental income, sales of goods, cattle sales, etc., but this is how we want our debt to get repaid. Starting with the Net Income, add back any Depreciation expense, Interest expense, and Amortization expense. You have now calculated the business’s Net Operating Income (NOI), or EBIDA. This is the cash the business has to service its debt. Again, this is a bar napkin analysis just for you to see if there is merit to the request; these calculations can get much more complicated depending on the business. You will then calculate the estimated Debt Service Coverage Ratio, or DSCR, which is the NOI divided by the proposed debt service. Ideally, you want to see this above a 1.20x. If they are in that gray area of 1.10x and 1.20x, it may be worth looking at further; however, if it is below the 1.10x level the primary source of cash flow starts to be put into question.

Step 5: Look at the Guarantor’s resources. The secondary source of cash flow after the business revenue is likely going to be your guarantors’ cash flow and resources. Do they have a strong equity position or are they highly leveraged? Do they have liquidity to help supplement any cash flow shortages? What are their assets? Do they have diverse income sources, or are they solely reliant on the business for cash flow? Although a full personal tax return spread is not necessary at this stage of evaluation, you can usually get a good feel of the guarantor strength by answering these questions. Having a strong guarantor to backstop a loan is especially important when the cash flow from the business is weak or erratic.

Step 6: Underwriting. Once you have a signed term sheet and all of the necessary items from your borrower, it’s time to dive into underwriting. Business loans are evaluated based on the 5 C’s of Credit: Character, Capacity, Capital, Collateral, and Conditions. If you have a new business lending department or just don’t have enough staff resources to do underwriting in house, Pactola can act as your third-party underwriter.

Whether your Credit Union is just starting its member business lending department or you have found yourself struggling with initially evaluating a loan request, these steps can help get a good conversation going with your member and prevent wasted time on poor requests. Pactola is here to help in making your lending department great!