Importance of a Contingent Liability Inspection

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

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

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

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

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

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

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

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

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

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

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

Bureaucracy or Accomplishment

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


Business Strategies of a Fighter Pilot

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

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

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

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

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

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

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

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

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

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

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

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

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

Interest Rates on the Rise

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

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

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

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

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

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

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

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

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

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

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

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

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

New Tax Law Changes and Housing

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

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

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

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

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

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

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

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

More Business Tax Changes

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

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

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

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

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

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

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

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

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

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

Impact of the New Tax Cuts on Business

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Public Speaking is Not About You

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

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

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

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

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

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

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

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

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

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

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

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

Bar Napkin Analysis for Member Business Loans

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

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

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

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

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

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

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

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

MBL Resolutions

As we ring in the new year, it is often a time for reflection of both the good and bad from the past twelve months.  Often, this leads us to making resolutions that will have us eating healthier, spending more quality time with family, losing that extra ten pounds, or maybe finishing the half marathon.  It is in this spirit, I offer some business lending resolutions for your institutions.

I am resolved to review and change my loan policy and procedures this year.  Believe it or not, we still see CUs who have not made changes to their MBL policy for several years.  The changes in the regulations that went into effect last January, require a universal rewrite of all policies and procedures.  If you have rewritten your policy, then you still need to review this annually for changes.  If you need help, contact us. 

I am resolved to set goals for my business lending department that is in alignment with the overall direction of my CU.  Some institutions operate without any concrete goals or vision for their business lending department, choosing to allow that area of the CU just take care of small requests that come in from the membership.  As such, the MBL departments do not exist as a primary driver of relationships and revenue.  Set an overall vision for what you want commercial and agricultural lending to do for you and set some reasonable and some “stretch” goals for the year.

I am resolved that once my goals are set and communicated throughout my team, that I will not deviate from them unless there is a strong, compelling reason that will be communicated.  I once worked in the bank that was notorious for changing the incentive plan each quarter.  It became a joke as we knew we would do our best and could reach the goals that were in place for the last quarter, just to find the bar moved for this quarter.  Actions like this cause distrust and do not encourage team members to excel. 

There are circumstances where goals need to be moved considering a more pressing goal.  I experienced this with the crash of 2008.  Our commercial team moved from aggressive pursuance of new deals and relationships to managing and monitoring all credits.  We have seen this with some of our CUs that have members who have been racked with the crash of commodity prices in the past few years as they turn inward to help the relationships they have march through these times as opposed to adding new business. 

I am resolved to make sure any incentive program I have for my lenders lines up with the overall goals for the CU.  If you have your number one focus as asset quality, then incentive plans need to have some measurement of that.  If you want growth, do how you reward your team members reflect those goals?

I am resolved to not turn away large deals just because it is over my lending limit or comfort zone.  We see CUs who have great opportunities dropped in their lap who will pass on it because of the size or complexity.  A few years ago, we had a small CU we work with turn down a request from a member to finance a newly built Dollar General store because of the size.  This would have been a great opportunity with a credit tenant as the primary source of revenue behind the project.  This is a participation we could have managed which would give other CUs an opportunity to take a part in.

I am resolved to make sure all farm operational loans contain a thorough budget.  I once financed a rancher who would sit at my desk and write out his annual budget on a piece of notebook paper each year.  Most of the time, he was pretty spot on with his projections.  Though I would have preferred something on a spreadsheet, I did appreciate the accuracy.  Too many times, we see an operating farm loan, or even a C&I loan, that does not have any budget behind it.  This makes it hard to know if the operating loan is sufficient for the needs of the farm.  Operating budgets also show the management ability of the farmer.  If you need help, we have a budget template on our website.

I am resolved to review financial information the customer gives me instead of just sticking it in the file.  Are you just checking off the box when you receive something or are you reviewing this to see what the financial information tells you?  Commercial lending requires that you exercise thought and judgement whenever you receive anything that needs to go in the loan file. 

I am resolved to clean out my files and get rid of old, obsolete information.  First, make sure that you are following all guidelines for file retainage.  I had a wonderful president of a bank I worked for who required everyone to take a half day to a day every January to organize and purge files from unnecessary information.  I have found that practice valuable as we work to stay organized. 

I am resolved that everyone on my team has appropriate training and education.  Learning is continuous; you never reach full knowledge.  We set a minimum number of education hours for each Pactola team member at forty.  Each of us, including myself, will exceed this by at least two times.  Start a log of staff training and then look for opportunities, schools, continuing education, seminars, webexes, or classes we hold, to meet that ongoing need.

I am resolved to work hard on loans at the first stage of problems instead of burying my head in the sand.  I have been guilty of the situation as described in a Peanuts cartoon.  Linus asked, “Charlie Brown, when you have a problem do you think you should fix it right away or spend time thinking about it?”

“Oh, thinking about it, definitely” replied Charlie Brown.

Linus pressed in further, “To give you time to make the best decision on how to fix the problem?”

“No to give it time to go away!”  Too often I have become as Charlie Brown and hoped the problem would disappear.  Sometimes it does, but more than often it does not.  It only gets worse.  Arrest problems in the early stages, even if these are painful to deal with and you will be rewarded.

I am resolved to make sure my loan files are all up to date.  This is a struggle when you have non-cooperative borrowers.  But a lack of information in the file equals not fully understanding what is going on with the borrower.  Serious problems may be occurring and you have no knowledge of these until it is too late.  Resolve to correct this problem even if you think all is OK and that you have a “great member who has high standing in the community” as the borrower or guarantor.

I am resolved to grow.  It is time that CUs who have business departments to become known as a resource for commercial and agricultural lending in their communities.  You want to become the first choice of a business borrower and not the last. 

So, there are twelve resolutions worth making for the new year.  Find ways to reward yourself and your team for little accomplishments along the way.  Develop a strategy to help you move from where you are today to where you want to be.  And, contact us to help you excel in your resolutions.


Racing to the End of the Year

So as of today, we have two weeks until the new year!  The season is sure busy!  We had the Pactola team Christmas supper last night.  I have only one week to Christmas shop and I have not started.  We are also trying to squeeze in the last closing participation of the year.  And, oh yeah, we have that year end closing the books thing to do.  It is truly crazy.

Despite all this business, I find it often easy to overlook giving gratitude and praise for those around us.  Perhaps you are better at this than I am, or maybe, you get caught up, from time to time, in the busyness of life.  I listened to a sermon today that reminded me the importance of gratitude.

Thanks to all the various credit unions that have allowed Pactola to help make you a better institution with your commercial and agriculture lending.  Thanks to each participant who has decided to help fund parts of our loans.  Others have decided to trust us with underwriting, file auditing, creating loan documents, or perhaps completing an annual review on a credit relationship.  Some of you have attended one of our educational seminars.  Thanks for allowing us to help you as we learn from you when we get the pleasure of working with you.

Thanks goes to our dedicated Board who took time this year to travel to the Black Hills and attend a strategic planning retreat.  The commitment of our present and past Board members has provided talent and vision for our team.  Thanks again for allowing me to be a part of crafting the vision.

Thanks goes to CUAD, our partner who helps us in so many ways.  The support and promotion you give us with the credit unions in the Dakotas and elsewhere is incredible.

We are thankful to all the borrowers we have had the pleasure to serve.  Many of these borrowers have become repeat clients for us and we are so appreciative for that.  Also, third party vendors we use are essential to Pactola and we are grateful for the talented IT, loan processing, insurance, accounting, trade groups, repairmen, cleaning crew, landlord, and auditors we have the pleasure of working with.

Now, when it comes to our staff, I cannot say enough great things, because we have an awesome staff.  Each one of our team members comes in with a commitment to excellence.  They each bring in their ideas, critical analytical skills, and communication talents every day to our group.  Their devotion to helping Pactola grow and their time commitment is amazing and it shows in so many ways.  Each one of our team is also devoted to growing personally so they can have more skills and experience to share with our clients.

I would be missing if I did not express my thanks for my family.  My wife and kids have been so supportive of my work.  At times, this means business trips away from home, or dinners that must be reheated, or maybe a phone call on the weekend.  Their support means the world to me. 

My final thanks is to God, who makes all this possible.   In this time of the year, let us stop the racing, to focus on the birth of our Savior amid all the hustle and bustle of the season. 

A Storm on the Horizon for Banks

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

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

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

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

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

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

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

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

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

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

The Case of the Missing Credit Policy

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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



Make or Break Retail

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

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

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

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

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

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

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

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

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

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

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

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

The Mother of Thanksgiving

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

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

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

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

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

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

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

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

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

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

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


The Quest for Perfect Underwriting Knowledge

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

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

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

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

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

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

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

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

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

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

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

When EBIDTA is Leaky

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

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

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

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

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

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

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

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

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

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

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

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

$666 Billion in the Hole

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

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

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

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

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

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

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

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

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

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

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

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

Direction of Interest Rates

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

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

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

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

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

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

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

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

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

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