Direction of Interest Rates

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

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

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

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

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

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

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

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

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

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

The Growth of Robotics in Agriculture

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

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

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

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

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

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

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

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

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

The Successful Functioning Loan Department

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

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

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

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

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

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

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

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

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

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

Commercial Loan Management Responsibilities

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

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

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

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

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

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

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

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

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

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

The Annual Rush to buy Farm Equipment

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

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

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

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

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

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

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

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

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

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

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

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

Constitution Day

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

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

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

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

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

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

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

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

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

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

Ideas on Fixing the Student Loan Mess

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

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

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

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

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

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

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

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

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

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

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

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

 

Thoughts from the Road

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

The Problems with Character Lending

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

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

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

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

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

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

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

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

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

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

Don't Focus on the How

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

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

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

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

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

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

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

Announces sixth two-for-one stock split.

Commits to hiring 10,000 opportunity youth by 2018.

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

Reaches 99% ethically sourced coffee milestone.

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

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

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

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

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

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

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

The Need for Fiscal Policy Reform

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

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

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

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

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

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

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

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

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

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

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

A Plan to Fail is a Failure to Plan

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

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

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

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

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

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

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

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

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

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

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

When Leaders Must Challenge the Process

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

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

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

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

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

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

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

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

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

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

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

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

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

Agriculture News from Washington

This articles highlights some of the legislation and regulations in the past few months that will impact our farmers, ranchers and rural communities.  As I am live in the Dakotas and we are in the throes of a drought, the USDA has opened up grazing for livestock on CRP land in the Dakotas and Montana.  This is welcome news and hopefully will help ease some of the stress ranchers have seen as many are taking more cattle to the market as they cannot find enough food for them. 

Another big potential impact for ranchers is the opening of the Chinese market for American beef on June 30.  This comes a week after announcing the halting of the imports of Brazilian beef because of safety concerns.  China has closed its doors to U.S. beef imports since 2004.  The reopening of the market of the most populated country on the earth will create more demand for ranchers. 

Agricultural trade is critical for both farmers and the U.S. economy as a whole.  One fifth of all agricultural production is exported and every dollar of exports brings in $1.27 of economic activity.  Each billion dollars of ag exports supports 8,000 jobs in the U.S. economy as well.  It is essential to find ways to be competitive on the world stage with our agricultural products.  The current administration appears to be focused on expanding American exports and opening up new markets. 

The EPA and the U.S. Army moved on June 27 to rescind the 2015 ruling on the Waters of the U.S. (WOTUS).  The old ruling had some possibly onerous consequences for farmers with possible federal regulation of water on their land that would not have been considered under federal regulation prior to the 2015 ruling.  Hopefully, this will eliminate more potential federal government red tape to the farm. The new WOTUS will set standards back to those traditionally set by court decisions, agency guidelines, and longstanding practice.

"We are taking significant action to return power to the states and provide regulatory certainty to our nation's farmers and businesses," said Administrator Scott Pruitt. "This is the first step in the two-step process to redefine 'waters of the U.S.' and we are committed to moving through this re-evaluation to quickly provide regulatory certainty, in a way that is thoughtful, transparent and collaborative with other agencies and the public."

Agricultural Secretary Sonny Purdue named Anne Hazlett to lead the Rural Development Agencies in the USDA.  This includes the Rural Housing Authority, Rural Business Service, and Rural Utilities Service.  Her appointment indicates a more important role that Rural Development will play.  She reports directly to Secretary Purdue.  Previously, Rural Development leaders reported to an undersecretary who then reported to the Secretary of Agriculture.

President Trump also created an interagency task force overseen by the Secretary of Agriculture that has heads of 21 different federal agencies involved.  The Interagency Task Force on Agriculture and Rural Prosperity will identify legislative, regulatory, and policy changes to promote in rural America agriculture, economic development, job growth, infrastructure improvements, technological innovation, energy security, and quality of life.  Hopefully, positive changes for rural America will result from this cooperation between agencies. 

Bigger is Not Always Better

The scene is a board room in Atlanta, Georgia in the mid to late 1990s.  Around a long board room sit various executives of Chick-Fil-A who are involved in a long debate about the future of the company.  At that time, Chick-Fil-A’s main competitor, as viewed by the top leadership, was Boston Market.  The companies both had similar products at that time.  Boston Market had also announced a major expansion plan where their goal was to top a billion in sales by the year 2000.

This expansion caused great consternation among the leadership at Chick-Fil-A.  The debate that day was how to be bigger, how to grow.  If their main competitor was targeting sales so lofty, would they become a distant memory in the minds of the fast-casual diner?  So many different strategies were presented and discussed in that meeting.

At the end of the table sat S. Truett Cathy, the founder and CEO of Chick-Fil-A.  He seemed disengaged through most of the meeting.  Then suddenly, he began to bang his fist on the table and continued to do so until the room was quiet.  All eyes were on him as he spoke.

“You have been consumed with how to make Chick-Fil-A bigger, how to grow.  You are focusing on the wrong goal.  You need to focus on how can we make our company better.  If we are better, then our customers will demand we for us to be bigger and growth will come naturally.” 

These comments framed the direction of the company from that time on.  Chick-Fil-A became focused on how to measure their restaurants and how to improve on all areas of their business.  The obsession with growth faded away and a new focus on quality emerged.  Oh and by the way, in the year 2000, Boston Market filed for bankruptcy, and, Chick-Fil-A topped a billion dollars in sales!

Cathy’s goal established a culture of continual improvement.  What we are doing today may be fine, but I must be willing to sacrifice the sacred cows of today to be better tomorrow.  Programs, processes, and procedures that we follow religiously today, will have to change in the future.  This corporate culture has the characteristic that permeates everyone on the team to “make it better”.

Chick-Fil-A began a passion to pursue quality, from the single customer experience to larger decisions of opening stores.  At the single customer level, phrases for a team member to express thanks to a customer like “my pleasure” were initiated.  This customer focus is not lost in any restaurant.  To keep quality control, Chick-Fil-A owns every one of its restaurants and is very selective about who can open a new store. 

To keep the culture of “make it better” means that everything must be continually evaluated.  Andy Stanley once said, “only what is worth doing is worth evaluating.”  A process of continual critical evaluation in what we do is necessary to determine what steps to take to improve and what changes must be made. 

Most leaders find evaluation easy when failure hits or when the wheels fall off the wagon.  Those are the times the emergency staff meetings are called to triage the problem and find the source and solutions to fix the issue going forward.  Most leaders find it less intuitive to evaluate what is going right.  This leaves leaders’ attention to all the squeaky wheels and totally ignores things that run smoothly.  If you ignore those items that work well, you will not know how to build on the successes that you have achieved. 

If you want to establish a culture of “make it better” you need to have an open forum that allows team members to be free to express critical ideas about the organization.  Extra emphasis should be placed on new employees as once folks are part of the team for a couple of years, they become ingrained into the culture.  One idea is to have your employees do evaluations on your organization every six months for the first two years. 

Another is to look critically at both successes and failures.  If you have activities that are not worth evaluating, then perhaps you should not be doing them.  Take time to evaluate to make changes where necessary and duplicate the success where there is some.  Chick-Fil-A discovered how positive customers felt about their experiences at the restaurant when they were treated with extra kindness compared to other eateries.  As they built on this, more people brought in more revenue, which created more growth. 

Better before bigger may require the sacred cows of today to be in the BBQ tomorrow.  Encourage critical assessment of your programs and processes while embracing the mission and vision of the organization.  If there is a better way to execute on your overall mission than what you are doing now, don’t be afraid to change. 

Rain, Rain, Come Again

My oldest made the trip home this weekend from his job in north central South Dakota.  Along the way he noted that he was seeing fewer cattle than he normally observed along the way.  He also noted that some fields that a month ago were full of wheat are now being baled into hay.  It is a sign of the times.

The latest US Drought Monitor has all of North Dakota, almost all of South Dakota, and the eastern third of Montana in a drought as of June 20, 2017.  A big portion in east Montana is rated as extreme, as spots in the Dakotas are.  Most of the rest is in the moderate to severe drought area.  The drought is beginning to move wheat prices higher, as the crop yields and quality is expected to suffer. 

Drought is a win-lose situation, if you are in an area not impacted by the drought, you will have a higher price for your commodity.  If you are in the drought area, you don’t have the commodity to take advantage of the higher price.  The other problem with this drought now for the Dakotas is that it comes after we are a few years into this commodity super-cycle of lower prices.  The days of high wheat prices in 2012 and 13 are but a memory now.  So, farmers have been dealing with much lower gross and net revenue streams over the past several years.  Many of you are now dealing with maybe the second year of how to deal with carryover debt that has not been resolved yet.

This will have a negative impact on the lenders in the area as well.  Note that not only the producers of grain and cattle, but also small town businesses are also going to be negatively impacted.   Dr. Kohl of Virginia Tech, believes that these factors will cause up to 30% of operators to liquidate in the next few years.  I think in areas where the weather is not favorable, that number will be even higher. 

Now is the time, and for many of the lenders, you have already been assessing this, to identify additional risk you may be prone to and seek to exit relationships where you can.  Kohl outlined ten credit risks in a recent article and believes that if you have seven of them present and can exit the relationship, you should.  With the drought, that number may be lower.

1.        Trade volatility-movements in the commodities markets can easily cause an operator to sell for a lower than break-even price.  Your producers need to know where their break-even price is at and what protections they are undertaking to protect them from operational losses.

2.       Living expenses-we often come across lenders who want us to underwrite deals with lower living expense factors.  These rose rapidly during the good price times and take longer to come back down.  The ND Ag farm record reports the median family living costs at $72,000 annually.  If the farm operation is too small and the only source of income is from the farm, it is likely not profitable enough to cover family living expenses. 

a.       Here also watch off-farm sources of income.  Before the price peak, spouses would often have jobs off the farm to provide extra income and also cover insurance costs.  When the prices rose to the stratosphere, some quit their day job since the farm was able to take care of their family expenses and more.  Now that pattern has flipped.

3.       Non-farm capital expenses-watch out for the new toys, personal vehicles, high end vacation homes, boats, retirement houses in Florida.

4.       Cash flow margins and taxes-poor cash flow margins and poor tax planning may result in too much taxable income.  Also watch managing from tax records without factoring in accrual adjustments. 

5.       Debt concentration-if you have too many loans to small operators with too much debt or too many loans to operators in poor producing areas, these both cause problems.

6.       Collateral complacency-the lender who thinks they are so well secured that they can lend without covenants or proper controls may face losses that devalue their collateral position.  Always focus on cash flow and look at collateral value with suspicion. 

7.       Regulator overreaction-regulators have acted moderately so far.  They have provided warnings but have not brought down the hammer yet.  When that does change, there has been a tendency in the past to overreact and force the lender to push out too many loans quickly with will result in excessive legal costs and more losses.  Take time now to cull out the portfolio in a sound manner.  Also make a practice to not go into collection on a credit where you have not warned the borrower at some point in writing if they do not perform, that you will request to be paid off.

8.       Alpha pups and dogs-Alpha pups expand just for the sake of expanding without considering the need for profits and capital.  Alpha dogs expand wisely and strategically to cover these bases.  Are you dealing with a borrower who has either of these tendencies?

9.       Fraud-watch out for this as the time gets worse.  Grain checks do not show up at the lender’s door or farm critters may disappear.  Equipment may also be an issue.  Farmers may trade in your collateral for something else without telling you. 

10.   Next generation-changing the farm operations and ownership from one generation to another can be a challenge.  If the farm is too small to successfully produce sufficient net revenue for the family or if the young farmer is too leveraged, it will set up the farm to fail. 

Kohl said that if you have 7 or more of the above present, you need to exit the relationship.  This may be too lenient.  If you see 3-4 of these characteristics, it is time to begin planning to move the relationship or to at least begin using strong controls to manage the farmer.  The presence of any one of them warrants a discussion with the borrower. 

The last significant ag downturn we had lasted for 7 years.  We are sitting in year 3 or maybe 4 in the present challenging times.  I don’t see the issue of the low prices ending soon.  Couple this with some poor weather and you have a formula for disaster for marginal producers.  Only the ones large enough and who have enough price and operational expense controls will survive. 

When the producer is hurt, the next one hurt is the lender.  Now is the time for a more aggressive stance to managing your farm credits.

Do You Have a Culture of Continual Improvement?

There are a couple of things I know that are true about change.  First, for us to improve in life, it requires change.  Second, what is very good today may not cut the mustard tomorrow.  Third, if you do not improve, someone else will leave you in the dust.

We see these characteristics in finance all the time.  Think about all the different changes to the delivery of financial services that have hit over the past decade—internet banking, using an app to bank on your phone, online mortgage and loan products, texting payment, crowdfunding—just to name a few.  Now would any of these items ever come up if credit union and banking folks decided in the year 2000 that what we have now is all OK and there is nothing ever more in the future that is needed to improve the communication of delivery channels between the client and finance professionals.

We must hoist the sacred cow upon the alter of improvement and start the bar-be-que if we are to ever grow as a company.  For this to work best in an organization, it requires a culture of continual improvement.  This concept is so important to some companies that you can find it as one of their core values.  But even if it is not identified as a core value, you still need a heart seeking attitude of how we can do better.  How can you grow?  If you don’t it is like my Aunt Lil used to say, “Once you have fully ripened, the next step is that you start to rot!  So, stay green and learning in life!”

This desired culture requires that you take time to inspect everything that you do to see what can be done better.  Many times, it is easy to do what we call the “spilt milk” analysis on something that went wrong.  In my last banking job, we took time periodically to do this with loans that went bad.  Sometimes, we could identify things that we failed to do at underwriting that would have mitigated some of the loss.  It is easier to look at a failure and analyze what could be done better.

We don’t often think about inspecting the times we succeed.  Often that time is spent on celebrating.  But with every win, there are key actions that should be repeated for the next success.  There are also those areas where further improvement can be made.  Recently, Bill Belichick, coach of the New England Patriots, was asked what other things he would want to accomplish in his coaching career before he retires, as he is already one of the most successful coaches in professional football history. 

“Well I just want to have a good practice tomorrow.”  was his reply.  This shows a commitment to continual improvement.   It also shows a method to break down what needs to be done in small steps.  It is easy to make today better than yesterday.  It is nearly impossible to make this year better than last.  But if you work on making each day better, you will accomplish the latter goal. 

Continual improvement creates momentum in the organization.  Momentum for items that are new or improving, can be one of the best friends of a leader.  A leader who is trying to swim upstream against a tide of negative momentum in the company, often fights losing battles.  I found this out years ago when doing martial arts.  If you can use the momentum of your attacker, it is much easier to get him to fall.

So, once your organization has decided that you will be committed to continual improvement, your next step is to brand that.  You may not want to just call it “a commitment to continual improvement.”  Maybe terms like “make it better”, “finding new solutions”, “grow outside your confines of yesterday”, or “do more today than yesterday” express continual improvement in a catchy way that the team can latch onto.  This language is important as you can drop it in your conversations with others in your company.

After branding it, the next step is for the leader to model continual improvement.  A leader must show that he/she is getting better personally to motivate the team to do the same.  The question here is if everyone in your area is doing the same things you are doing to get better, are you improving or are you just keeping busy each day.  If you want continual improvement as part of your culture, you must show it intentionally each day. 

The next step toward making continual improvement a part of your culture is to teach it.  Teaching a concept always helps you master that concept or skill.  We see that on our end when we teach lender classes.  This does not necessarily mean that each leader must get up and give sermons on continual improvement, but it needs to be sprinkled in normal conversations and may include an occasional sermon.

Andy Stanley gives five different questions that need to be answered when you teach a behavioral concept that you want in your organization.  You need to wrap your culture characteristic around each of these questions on a continual basis. 

·         What it is?

·         Why is the characteristic important?

·         What will it require of us?

·         What does it feel like once we have that?

·         What is at stake if we have it and if we do not?

After continual improvement is taught, the next step is to institutionalize it.  Now this is different for different companies.  It may include items like allowing your new employees to evaluate the company once or twice in their first year of work.  Another idea is to do a review of every major event once an event is complete.  We eliminated the traditional employee review process for a quarterly check-up that has many ways a team member can judge what is working and what it needs to be changed.

The final step is to recognize or reward continual improvement.  People will repeat those items they are rewarded for.  So, this can be publicly rewarding things that team members do to improve.  This encourages further innovation and initiative.  These items can be small or they can be large. 

You can probably guess now that this process is one that requires it to all be repeated, over and over again, in a company if they are committed to getting better each day.  Sometimes, a good place to start is to see what are you doing that is old and tired with your staff or clients.  Sometimes seeing that will help put ideas in your mind of where to begin the path of continual improvement.

 

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In other news, do you know who has silently become a giant bank that you do not think of as a bank?  Amazon!  Amazon reported that Amazon Lending Service has surpassed $3 billion in loans to small businesses since it started in 2011.  In the last 12 months alone, Amazon has loaned over $1 billion to businesses.  This helps the business expand and hikes up sales for third party merchants, which provides another Amazon revenue stream. 

Amazon Marketplace VP Peeyush Nahar stated, “We created Amazon Lending to make it simple for up-and-coming small businesses to efficiently get a business loan, because we know that an infusion of capital at the right moment can put a small business on the path to even greater success.”

The rate of repeat business is high as over 50% of the 20,000 small businesses that use Amazon Lending, end up taking additional loans.

So the lesson here is if you only think your main competitors for lending will always be banks, you are wrong.

 

Similarities and Differences in Consumer and Commercial Sales

Credit Unions tend to do quite well with serving their membership.  This service involves expanding the share of wallet of the member, whereby more of the financial services used by a member is supplied by the credit union.  Many CUs have a strong sales cultures that raise the awareness of their membership for the various consumer services they offer.  Some even go as far as measuring and rewarding successful efforts on the sales front, in a healthy sales culture.  We saw last year the results from an unhealthy sales culture with Wells Fargo!

But can a consumer sales culture be transformed to a commercial one?   Before leaders implement this change, it is good that similarities and differences between the two marketplaces are explored. 

A big similarity is that both areas require a command of the products by the loan officer.  In consumer, you must understand the different loan types, pricing matrix, and parameters that you will do loans in.   Commercial requires the ability to assess, manage, and get paid for the risk in the credit.  The discovery period for commercial risk is much longer than consumer risk and often involves assessment of several additional factors.  In the end, members on both sides enjoy working with people they view as competent and knowledgeable. 

One big difference is the sales conversion cycle is much different in consumer and commercial.  The consumer cycle is often shorter and is transaction oriented.  The member comes into the credit union needing to finance a new car or to open a checking account after they have moved to a new city.  Typically, this occurs after the individual has already researched and made their decision on what they need and which institution they want to use.  The transaction becomes the springboard into building a relationship and the initial cycle is short.

In commercial, the sales cycle is quite varied and can be very long at times.  Relationship building begins well before the loan is closed and often may take years to develop.  Often, showing that you are competent and can deliver for the business over a period of time, is what is needed for the business borrower to open up to you when a request with the primary institution has been delayed or denied.  The “no” answer in many cases is really “not now” or “not in the way you presented it to me”.

A commercial loan creates a bonding relationship between the company and lender, whereas many consumer activities are more transactional in nature.  Once the MBL is closed, ongoing check-ups are required to monitor the health of the business and assess if there are any changes to the risk profile for the borrower.  Most consumer transactions do not require frequent check-ups on the borrower if the payments are made timely. 

One key to success on both sides is having various folks that send business to you.  We call those centers of influence or referral sources.  On the consumer side this could be car dealers or residential realtors.  Commercial centers are often commercial or land realtors, economic development entities, attorneys, and accountants.  Developing relationships with these folks can help to drive commercial business your way.  It also requires getting out of the office.  I believe that much of the consumer side is reactionary to a member coming in, while the commercial side has success based on going out. 

Advertising is also different between the two lines of business.  Consumer advertising is often dominated by a special rate or program.  Commercial marketing is creating more top of mind market awareness in the community.  Rate cannot be decided upon until the financing request and risk inherent is known.  Also, starting out the MBL conversation with rate, places the lender at a huge disadvantage in the negotiation.  It also makes you gain business by often being the low-cost leader.  That is not a position that most smaller and many larger institutions want to get into. 

Both sides will require lenders who are great listeners, highly skilled in their field, and creative in order to long term success.  My hope is whatever area, consumer or commercial, you will win on the field that you play on.

Estoppels and SNDAs, Which to Use for Lending?

At times when financing real estate with commercial tenants, lenders will use legal forms called Estoppels or Subordination, Non-Disturbance, and Attornment forms.  Now I have never seen these for a residential rental and I have not seen them for smaller commercial deals or small leases. 

The most common document for a lease administrator is the estoppel.  This document is usually sent by the property owner or management company to a tenant, whenever the owner is refinancing or may be selling the property.  Either way, the estoppel is to find the executing party to specific statements of fact.  These may include certain details about the lease terms, rental rates, maturity, and status of any breaches of the lease contract from the landlord or the tenant. 

The purpose of the estoppel is to benefit third parties, like lenders, who may not understand the details of the landlord-tenant relationship.  Courts have held that a landlord can’t use the estoppel against a tenant.  An example her may be if the tenant has “agreed” that the landlord has not overcharged for common area maintenance charges.  But care must be given by the tenant when asked to execute the estoppel.

A more detailed form is the SNDA.  Actually, this is three agreements in one.  The first is subordination.  This permits the lender whose lien is junior to the lease (usually because the lease was recorded before the mortgage was recorded), to be recognized as superior to the lien of the lease.  Once the lender’s lien is superior, in the event of foreclosure, the lender can eliminate all junior liens.  Most lenders will insist their loan is in a first lien position.  Most property owners recognize their property is more valuable and attractive to a lender if the lease is subordinate to subsequent mortgages.  Most landlords will have leases that frequently include provisions that declare the lease is subordinate to the mortgage.

The next part of the SNDA is the non-disturbance section.  This section protects the tenant and allows the lease to stay in force if the tenant is not in default.  A tenant who has a long-term lease or who has spent a large sum of money for their custom tenant improvements, has a big vested interest in having this section in place.  This section may need to be added to the lease, as many of them may not include an adequate provision here.  For the lender, the SNDA means that if the tenant is not in default, the lease remains in place, even after foreclosure.

The final section is attornment.  This section protects the lender and it binds the tenant to fulfilling the lease terms, even after the lender forecloses on the property.  This is necessary in some states where lease agreements are extinguished during foreclosure.  This creates a bond between the tenant and the third-party mortgage holder. 

Many of the SNDA agreements also have a survivorship clause where the agreement will continue if the lender on the property changes due to refinance, lender merger, or loan sale to a third party. 

It is also worth noting another document here that is executed with the mortgage or deed of trust, and may be included inside that document.  This is an assignment of rents.  It allows the lender to step between the landlord and tenant to collect rents in the event the property owner fails to make payments in a timely manner, yet continues to receive rent payments from the tenants. 

It is important for the commercial lender to have knowledge of these forms--estoppels, SNDAs, and assignment of rents—when working with commercial tenants on a property you are financing. 

Graduation Thoughts

May is the time of year that we see many completing degrees or finishing high school.  My oldest son, Zach, just completed his bachelor’s degree.  One of our team members, Trevor, finished his MBA. 

One thing that is typical of graduation are graduation speeches.  Typical themes in these oratories are often like these: “the world is waiting for your talents”, “you are entitled to great things”, or “what you have completed today is your first step to lifelong success”.  Often, these speeches are filled with clichés and ideas that just are not true with real life.  So, in the effort of being realistic, I offer some of the following.

The world is not waiting for your talents and does not care who you are.  Once you begin a new job, you always begin as the new guy.  Your boss and co-workers already have a set way of doing things and often the new folks on the team will take more time and energy and may be viewed as a distraction by some in getting their work complete.  You must go out there and prove yourself.  Even if you are the number one draft pick on a professional sports team, you still have to prove yourself. 

You are not entitled to anything.  This is the unfortunate carry over of how we have coddled children throughout their lives.  We do whatever we can to insulate them from hardship and disappointment.  We now have snowflakes who think they have a right not to be disappointed, offended, or hurt.  About the only thing I can guaranteed that you will have are problems and obstacles.  It is how you approach those that will refine your character.

You will experience failure and success, not only success.  I have always learned more from my losses than I have from my wins.  Take to heart Winston Churchill’s thoughts, “Success is going from failure to failure with great optimism.” 

Learn persistence to stick through the tough times.  Quitters will never make it to the finish line.  Often the true people who finish the race may not be the smartest or most talented.  They are the ones who want to finish it, more than the others around them.  They decide to push forward, no matter how bad they may want to quit and lie down.

You have only started to learn what you need to know.  Completing a degree is wonderful, but you have barely started to learn what you need to succeed in life.  Commit to life-long learning.  Realize that your best education will happen outside of the classroom.  Treat every day as a new entrance into the school of life and learn all that you can.

Never forget to be full of gratitude.  Take time each day and set aside special time at the end of the week to thank those who have given to you of their time, talent, and treasure.  Never allow yourself to become so important that you lose sight of being thankful.  It helps you to stay grounded.

Find out who you are and your purpose, then live it out.  We all struggle with these questions.  You need to discover the answers and then orient your life to fulfilling your missions.

Never lose sight of the power of one individual.  A single person can have incredible power to make a difference in the world, once they out their mind to it and devote their energies to the cause.  Don’t just settle for what can be done in the group.  Work to excel in whatever roles you have personally and those in the group.  So, go make a real difference.