Yield Curve 101

Working at a credit union, you are well aware of how an interest rate can be different for each person based on their credit score. A person with a bad credit score will be expected to pay higher interest rates to try and compensate for the risk of lending to them. And of course, people with the best credit scores get the lowest rates. But have you ever thought that there are other factors that can impact the interest rate?

You know that home loan rates differ from auto rates. And, unsecured loans or personal loans can have very high rates. That is because the type of underlying collateral (or lack thereof) drives the risk of lending too. Another thing you may have not considered is the term of a loan also affects whether a rate will be higher or lower. This is because of uncertainty. If we make a loan for 15 years, we don’t know if someone will continue to have the same ability to pay for all of those 15 years into the future. So, the longer we make a loan for, the more risk we need to price into the interest rate, and generally the interest rate will be higher.

Long-term loans also present a unique risk to the credit union in terms of interest rate risk. If a credit union makes a loan for 15 years, and then interest rates move up, the money in that 15-year loan will be stuck receiving a lower interest rate until the loan pays off.  The credit union then loses out on the chase to make money at a higher interest rate.

This opportunity cost of being stuck with a lower interest rate into the future is something studied heavily in finance. We can actually map out what interest rates look like from today, if we make a short-term loan or a long-term loan. This graph is typically referred to as the Yield Curve. And as you might expect, the longer the interest is fixed for, the higher the rate usually is. Below, you will see a graph I have made using interest rates from 2005, 2007 and 2016.

As you can see, the interest rates for all of 2016 have pretty much followed a similar pattern. The line on the very top of the 2016 bundle is actually our current yield curve for the end of October 2016. The yield curve for May 2005 (when I graduated college) has a similar shape, but is notably adjusted considerably higher than current rates. So overall, in the past 11 years, rates have come down considerably. And lastly, the 2007 yield curve actually slopes downwards. Why is that?!

What is particularly fascinating about the yield curve is that it can be a predictor for the economy too. If investors suspect a recession is about to occur, they expect the Fed will lower rates, thus we will see lower rates in the future. This will cause the yield curve to actually slope downwards or flatten out. Clearly, in 2007, investors expected a recession, which surely followed in 2008.

You can likely assume the opposite is true, which is when the yield curve slopes upwards, investors are more optimistic about the future and are expecting the Fed to potentially raise rates in the future. And what is notable about October 2016 is the yield curve has a stronger upward slope than the immediately preceding months in 2016. Perhaps this is because the economy is showing more strength, and a Fed rate hike is becoming more likely.

Buying a Business

If you have been in commercial lending or finance for any period of time, you probably have fielded a question regarding how to buy an existing business.  Now if you have not had this question, some day you will.   This is a common request as there are many reasons for business owners to sell and for future business owners to buy a firm.  Typically, the second question after they ask if you can help finance a business purchase is how much they should pay for the business.

There are several methods in determining the value of a business.  The easiest way occurs if you have a business that derives all of its income from a single tangible asset.  Examples here are an apartment building, office park, or a hotel.  In each of these cases, one tangible asset provides the revenue stream for the business.  In these cases, revenue comes from apartment rents, office tenant leases, or hotel guests.  Value can be determined by utilizing some method like a market cap rate or discounted cash flow analysis. 

But what do you do if there is a mixture of tangible capital assets and also non-tangible assets?  One method would be to assign values to both the tangible and intangible assets in figuring value.  If a manufacturer has real estate and heavy equipment, part of the purchase price can be comprised of the market value of these assets.  The remaining value can take into account intangible assets such as the business name, client list, or goodwill. 

A second method looks at the tangible net worth of the business and figures a value based upon the owner’s equity in the business.  This method may be applicable if the buyer is assuming the existing debts of the company in a stock or ownership purchase.  Most business buyouts I have seen, tend to be a bulk asset purchase of all the assets of the company and assuming none of the existing debts of the selling owner. 

Typically, with the tangible net worth method, the seller still will want some amount of goodwill for the intrinsic value of the business that is provided to the buyer over and above the market value of the tangible assets. 

Another method, the capitalized earnings approach, looks at the value of an investment that is expected by an investor.  This strategy seems to be geared more toward buyer than the seller.  An example here would be if a buyer of an ice cream shop would expect a rate of return, or cap rate, of 12% on his investment.  The overall net operating income, or stabilized version thereof, would be divided by the rate of return to create a price for the business.  A variation of this method is the excess earnings method, where a return on assets is separated from other earnings. 

A gross income multiple may be used to figure value by using some multiple or fraction of the top line revenue the company produces in a given year.  I have seen this done with some medical practices, where this factor is used in determining a portion or all of the price. 

Financing a business with large amounts of intangibles can be challenging.  Any financing of goodwill would not be able to be collateralized.  Some options would be to have the buyer provide additional tangible collateral, allow the seller to carry back junior debt that would carry the intangible value, or utilize some guarantee program like the SBA to help lessen the risk of the collateral shortfall. 

A seller carry may be used without or with a guarantee program.  The carry must be in a junior position to your loan and may have to satisfy some requirements of the lender or government guarantee.  Typically, the business would need to be able to cash flow all the debts.  Repayment of the seller carry in some cases may be required to be on some form of standby to the lender debt and may also be required to amortize at a slower pace than the senior lender debt. 

We can help you when the business buyout question comes across your desk.  We also work with different government guaranteed programs to help better manage the risk in the business purchase.  These loan requests can open up new doors of wonderful business for your credit union.  

The Cost of Doing Nothing

Doing nothing is doing something. When faced with a hard or complicated decision, some people feel it is better not to make decision or wait until the facts become more clear. However, waiting can cost you.

In the broadest sense, we call this cost an opportunity cost. If you are putting off the decision to build a new branch, then you are forgoing any future income you could earn from the new location until you finally go through with the project. If you are waiting to move the credit union’s excess cash into investments, your opportunity cost is the interest income you could have earned on those investments in the meantime.

In a more direct sense, we call the cost of waiting a holding cost. This is the cost you incur waiting to achieve your objective. An example of this can be seen with the Deepwater Horizon drilling platform that blew up in 2010, which resulted from BP pressuring its workers to take safety short cuts. Every day the platform wasn’t producing money came at an extraordinary cost to the company, so they wanted the well drilled as fast as possible. Drilling platforms can cost over $500,000 a day to operate. That is a serious holding cost if you are not producing anything!

 For a credit union, a holding cost could be the money you are losing after you opened your new branch while waiting for it to generate enough income to break-even. If that branch will never be profitable, then you need to consider if that loss justifies furthering your mission.

There is another way doing nothing can cost you by failing to fix problems. By allowing a problem to persist, your decision to do nothing has measurable costs as well. If you have bad computer systems or slow computer systems, doing nothing about it has an increased labor cost since your employees can’t work as fast. Not having enough computerized systems is an even better example of this.

I also often see the costs of doing nothing manifested as a desire not to know. Some businesses or operations lack good reporting or proper reporting. If you are a business with poor bookkeeping, then you wouldn’t even know if you are losing money. If a company produces multiple goods or services but doesn’t track each activity individually, how would they know the profitability of one isn’t masking the poor performance of another?

If you are a credit union, and if you don’t track the profit and loss of each branch individually, how else would you know if some of your branches are unprofitable? And even if you believe your mission doesn’t mean every location must be profitable, it would still behoove you to know how much any location loses so you can properly tailor services and costs. In this sense, there is a cost to not knowing your true cost.

Doing nothing is a real business decision with costs if you are a manager or executive. Doing nothing because of ignorance is truly equivalent to burying your head in the sand. Of course, doing nothing could make sense, when you know it costs less than doing something. But, that argument only makes sense when you perfectly understand both the cost of doing something and nothing.

Could Automation Lead to More Job Opportunities in the Future?

This last weekend I wasn’t able to catch much of the Sunday political talk shows, and maybe that is because I’m beginning to tune out further election coverage to save my sanity. But I briefly caught a blurb on one show about universal basic income, which is something I had wrote about before in a previous post I made here: http://pactola.com/blog/2016/7/1/how-many-jobs-will-be-lost-to-automation

The idea behind universal basic income is that it provides guaranteed payments to everyone, to protect against large-scale social strife that may result from people losing their jobs to automation. I feel this is a grandiose idea that could have only been hatched in the 21st century, and in way it is socialism reinvented. I can say that, because I spent time in the former Soviet Union and I’m not casting political aspersions.

I understand the intentions are well meant, but does the mere fact you exist entitle you to a basic level of income, for not even working?! I strongly believe in assisting those who have lost their jobs, but I’m not sure handing everyone a free paycheck is the best way to wash our hands of the problem of a changing job market. I wonder what our ancestors would say. Imagine the immigrants that poured through Ellis Island, the homesteaders who constructed sod houses on the barren prairie, or the families who built businesses from the ground-up. None of these people felt they were owed a paycheck just for existing, and all they wanted was a chance. What happened to that sense of seeking out opportunity?

It’s not that we shouldn’t dream about a more comfortable and easier future, but the idea of universal basic income makes the assumption that people aren’t seeking opportunity or they simply can’t. It also seems to make the assumption that people cannot adapt. It basically assumes that if someone is a teller at a credit union or bank, that they will be fired if their job is automated. And worse, they will no longer be able to do anything else, because all they have come to know is life as a teller.

We can already see how these assumptions will not hold true. I think it is unlikely institutions would fire tellers, but rather move them to other tasks that need done, and even finding more valuable tasks the institution wants to address. And even if larger, less caring institutions did layoff tellers, surely they will be able to find other jobs that may or may not be related to banking. This is what automation has always effectively done in society; free up people from less productive activities so they can occupy themselves with more productive actives for society.

This talk show had someone providing an astute counterargument to universal basic income. When we were an agrarian society, we had over 60% of our workforce devoted to agriculture. Now, we have 2% or less. Talk about massive job losses, right? And yet, that isn’t what happened at all. All of these people who were engaged in farming had their time freed up to find different jobs. And the same technologies that improved agriculture also created additional jobs for those people.

In the long-run, I don’t think automation will lead to any serious shift in unemployment, but rather continue to contribute to “natural unemployment.” This is a phenomenon largely attributed to the disappearance of old jobs that are no longer needed, and we believe it holds relatively steady around 3-4%. Of course nobody likes to see job losses in the short-run, but holding onto the old way of doing this is not healthy for the economy in long run. Should we really have fought to keep manufacturers of buggies and buggy whips? The workers today who will have their jobs automated will be working in positions that don’t even exist yet, but I think ingenuity will likely give them something even better to do.

Getting Up After Being Knocked Down

One of the movies I loved growing up was Chariots of Fire.  It is the story of two athletes in the 1924 Olympics: Eric Liddell, a devout Scottish Christian who runs for the glory of God, and Harold Abrahams, an English Jew who runs to overcome prejudice. 

A scene in the movie reveals a lot about grit, determination, and never giving up in the face of adversity.  Liddell is in a race and he is pushed to the infield and off the track.  It would have been quite easy to just wallow around in the cool grass, but that was not what Liddell did.  He sprung to his feet and sped through the track like a man possessed.  Soon he caught up with the last runner in the pack and then began one by one to pass each of them on his way to the finish.  He wins the race after unbelievable odds stacked against him. 

History is full of stories of those overcome their odds, those who fail and continue to move forward.  They are in inspiration to each of us when we experience our own failures.  It allows us to move forward and make progress when the everything else around us seems to tell us to stop, that we have made a good effort and no one would fault us from quitting.  In the spirit of growing after failure, I have compiled some quotes on the subject which are as follows.  I hope you enjoy.

1. “If you’re not prepared to be wrong, you’ll never come up with anything original.” – Ken Robinson

2. “Do one thing every day that scares you.” – Eleanor Roosevelt

3. “Everything you want is on the other side of fear.” – Jack Canfield

4. “Failure should be our teacher, not our undertaker. Failure is delay, not defeat. It is a temporary detour, not a dead end. Failure is something we can avoid only by saying nothing, doing nothing, and being nothing.” – Denis Waitley

5. “Forget about the consequences of failure. Failure is only a temporary change in direction to set you straight for your next success.” – Denis Waitley

6. “I have not failed. I’ve just found 10,000 ways that won’t work.” – Thomas A. Edison

7. “When we give ourselves permission to fail, we, at the same time, give ourselves permission to excel.” – Eloise Ristad

8. “What is the point of being alive if you don’t at least try to do something remarkable?” – John Green

9. Failure is part of the process of success. People who avoid failure also avoid success.” – Robert T. Kiyosaki

10. “Giving up is the only sure way to fail.” – Gena Showalter

11. “Everything you want is on the other side of fear.”  – Jack Canfield

12. “There is only one thing that makes a dream impossible to achieve: the fear of failure.” – Paulo Coelho

13. “Develop success from failures. Discouragement and failure are two of the surest stepping stones to success.” – Dale Carnegie

14. “Success is stumbling from failure to failure with no loss of enthusiasm.” – Winston Churchill

15. “Don’t be afraid to fail. Don’t waste energy trying to cover up failure. Learn from your failures and go on to the next challenge. It’s ok to fail. If you’re not failing, you’re not growing.” – H. Stanley Judd

16. “We are all failures – at least the best of us are.” – J.M. Barrie

17. “You’ll always miss 100% of the shots you don’t take.” –  Wayne Gretzky

18. “Only those who dare to fail greatly can ever achieve greatly.” – Robert F. Kennedy

19. “Failure is the key to success; each mistake teaches us something.” – Morihei Ueshiba

20. “Never let the fear of striking out get in your way.” George Herman “- Babe” Ruth

21. “If you want to conquer fear, do not sit home and think about it. Go out and get busy.” – Dale Carnegie

22. “There are no secrets to success. It is the result of preparation, hard work and learning from failure.” – Colin Powel

Ethics in Business Lending

In the past year, I’ve made several trips across North Dakota on I-94. I usually drive past a particular interstate exit to a small town on the western side of the state. There are no businesses on this exit. This exit, in this small town, was a proposed location for a hotel. At the time this hotel was proposed, it only made sense to do because of the oil boom in western North Dakota. While I didn’t question that the hotel could be profitable in the short-run, I seriously questioned the continued feasibility in a downturn. At this time, the price of oil still remained above $80 a barrel, but this town played no central role in providing oil related services. Any demand for a hotel would only come fromthe overflow of the housing shortage.

The proposed hotel project had an adequate down payment. The guarantor had ample financial strength to make the loan payments if the hotel project flopped. Yet, I declined to pursue the loan, because the hotel was sure to flop in the long-run. Hotels were being used as temporary housing, and it would only be a matter of time before permanent housing caught up to demand. And in the short-run, the project was still susceptible to any downturn in oil prices.

An aggressive lender could have argued that this was a bankable loan. If the guarantor could make the payments regardless of what happened to the hotel, why not give it the green light? In this situation, we would just be giving the borrower a rope to hang himself with. While our focus as lenders is rightly squared on getting repaid, there is clearly more that should be considered than just repayment. Is it wrong to give someone a loan if they will use it to fund a project that we know will be a failure? I would argue there is an ethical problem with this. In a fairly clear way, you are helping this borrower lose money. And while it may be in our best business interest to do the loan to earn interest income and fees, it is clearly not in the borrower’s best interest that the loan be made. 

I know we wade into murky waters when we start talking about what are right and wrong loans to do ethically. But, I feel when the facts are relatively straightforward, it is appropriate to throw up the ethics flag. It is like when an alcoholic is hitting you up for spare change in front of the liquor store. Sure, there is an outside chance he isn’t going to buy a drink, but we can reasonably assume we are fueling his destructive habit. 

It feels strange to feel good when I drive by this interstate exit and see there is nothing there. It makes me feel good that nobody else gave the borrower the loan to do this project. It makes me feel especially good this late in 2016 that the hotel doesn’t exist, because it would surely be losing money, and causing stress and heartache for the owner. Luckily, it never got built and the interstate exit remains barren and boring.

Create Your Own Member Destiny

Our team always enjoys teaching our fall classes with lenders.  It is also a good time to learn more of what is happening in various markets.  This helps us to be more relevant in the various areas where we help credit unions.

One theme I have noticed, is that there are many new projects and growth in the communities that are served by the CUs that we serve.  Now some CUs are involved in many new projects that create economic growth, jobs, and wealth for their area.  Sometimes, the CUs we work with seem to be content to sit on the sidelines and allow the economic growth to be funded by other institutions.  They are happy to received whatever person comes in to their office and works to serve that member well.

A lender who follows this strategy will usually be provided the leftovers as other banks will get the main business opportunities for their market.  But that is not what CUs are created for.  We are not built to be on the sidelines, we are built to serve our membership and grow our membership in ways that help our community grow. 

Successful lenders will not only work on the member in front of them, but they will have a strategy to build future business by developing long-term relationships.  Eventually, these will result in new members and new business opportunities for your CU.

Patience is a key virtue to have here.  One of the largest relationships I built took five years of calling and relationship building before I was able to land the client.   Now every lender does need the shorter term customers who will come to you in the near future.  But it is also important to have a strategic calling plan to develop relationships that may not bear fruit for one, three, or even five years or longer. 

Developing an expertise is also key to your business strategy.  One CU that I have worked with has a focus on medical professionals.  They want to not only have the personal accounts, but also retirement funds and business lending needs as well.  Another one, has a focus on small manufacturing firms and serving needs they have.  Within your market area, there are smaller sub-markets that you can gain an expertise in and become known for.

This strategy may require that you develop friendships with your target audience and may need to even hit some networking events that center around the target group.  Some of these groups may also become good pipelines of business for you.  In my career, I have built deep relationships with commercial Realtors, medical professionals in the town I was located, and land Realtors.  These have provided large amounts of loans and deposits over the year.

Some CUs will also shy away from projects because they are too large and complicated.  That is what we are here for.  We help with the complicated and as long as you can keep only 10% of the loan on your balance sheet, it is not too large.

My encouragement here is that you begin to create your own destiny in your CU.  Work on identifying the businesses in your community and determine what is your target audience.  Network with various industry or trade groups that can introduce you to other new sources of desirable business members.  Create your own “hunting list” of those in your communities that you want to bring in your membership.  Be patient in building the relationships with them.  You can build your destiny, or just take what comes to you.  

Is Your Credit Union Banking Non-Profits?

I recently read a newspaper article about a local non-profit that is undertaking a $14 million project to redevelop a 100,000 square foot facility to carry out their mission of helping children and families in the area. It is an impressive project and will make the community a better place. Surprisingly, they are doing it all with special grants, donations and funding from the city. No banks or credit unions loaned money to the project. Could it have commenced sooner if that funding source was available? For me, this reinforces something I have explained to business lenders several times: non-profits are a good source of business loans too.

 When we think of a non-profit, you might have an archaic vision in your head of what sustains these organizations. You may think of them as small operations heavily dependent on the charity of others. You may also think they are run by poorly paid people, who chose to take up that work because they are extremely mission-oriented. I would say that is hardly typical of a non-profit in the twenty-first century, and we all need to open our minds a bit more.

 Non-profits can largely do anything a for-profit business can do. Sure, just like some small businesses struggle and barely make it, that too can be the case with small non-profits. But other businesses flourish, scale-up and have billions of dollars at their disposal. There are non-profits like this too. The Bill and Melinda Gates Foundation has an endowment of $44 billion. The John D. and Catherine T. MacArthur Foundation has a $6 billion endowment. You are thinking these are exceptions, and local non-profits hardly have these resources, right? The John T. Vucurevich Foundation, based right here in Rapid City, has a net worth greater than $100 million and the South Dakota Wheat Growers Cooperative, based in Aberdeen, has $247 million in equity. Even local non-profits can be heavy hitters.

 Of course, you don’t need to look any further than your own credit union to make this very point. A credit union can provide banking services, and yet they do it all as a non-profit. And how big is your credit union? $25 million in total assets? $100 million? $1 billion in total assets? Non-profits like our credit unions have grown to become powerful organizations in our community. And that means they have large organizational needs too. They need to purchase capital assets, they need to buy buildings, and they need lines of credit. Just like any for-profit organization that would like to preserve their cash, non-profits may also prefer to borrow for some of their needs.

  I want to believe that credit unions should also have the inside track when it comes to lending to non-profits. When a credit union helps a non-profit, it is really a non-profit helping another non-profit. We know that successful lending sometimes means exploiting a niche or presenting a compelling story of why to work with you. I think credit unions providing MBLs to non-profits competes in both of these areas. Unless you have local banks trying to corner all the non-profit MBL transactions locally, I think credit unions could be doing much more to take advantage of these opportunities.

Where are Oil Prices Going?

In the upper Midwest and Plains States, oil plays a large role in the economy.  It certainly changed sleepy little towns in North Dakota that had not seen significant economic growth for decades into expanding communities with new businesses, houses, and public facilities.  And then, after several years of crazy expansion, growth slowed significantly with drops in oil prices that started in late 2015. 

The economy of the area has since then cooled from the red hot growth of the past few years and has struggled in some areas to find a new normal.  Not only has a decline in oil prices hit, but also lower commodity prices and a low Canadian Dollar has also impacted area demand.  These can mislead the analyst. 

Commodity driven markets can create struggles for the lender in trying to find what is normal.  Often, one who is looking at a company or an area, will attempt to think to the extremes.  When prices are high, there is a temptation to believe that the high prices will last forever.  We certainly saw this in the farm economy from 2010-2013 where producers added more debt with the assumption the high commodity prices would continue their contango.  On the other side, when prices are low, fear can make one believe that the area will only grow worse and worse.  The extremes can cause you to not understand where reality is. 

Now absent an accurate crystal ball, any explanation of future prices is merely a guess.  However, it is possible to look at the history and present factors in the market and find some facts.  The first is that oil prices have climbed nearly 80% since the low in February 2016.  What is also important is that the low dips in the market have consistently been higher than the earlier lows since this winter. 

The low prices have not only hurt U.S. producers, they have also cut deeply into the revenue of all OPEC producers and major non-OPEC producers.  Venezuela has been an abysmal failure with the low oil prices and the socialist government.  Saudi Arabia has sold nearly 30% of foreign assets in an attempt to try to balance its budget.  As a major producer, Russia has experienced severe headwinds to their economy from drops in oil.

OPEC announced this past week that they were going to begin to cap production.  Instantly, U.S. oil prices shot up 6%.  But as with all things, the devil is in the details.  OPEC had to move to change from increasing market share to capping production to halt an increasing financial mess.    Increasing prices indicate the market thinks there will be a balance between expected supply and demand.  This happens even though there has been a current glut in oil supply worldwide. 

The projected cap for OPEC will limit production between 32-33 million barrels a day.  This would put OPEN production at a level that cannot be sustained over any moderate period of time without significantly damaging oil fields and future revenue flow in many companies.  The first challenge to the cap is dividing it among the member countries. 

This will be a problem with Iran and Iraq, who have not had a monthly production quote for years.  In the OPEC meeting in early April, Iran did not even attend the meeting.  Last week they did, indicating they are moving toward agreeing to production limits.

Once the OPEC countries are all on board with production caps, a group of non-OPEC producers, led by Russia, would have to curb their output to do their part to stabilize oil prices.  Russia is producing around 11.5 million barrels a day.  But most of Russia’s fields are mature and are questionable if this level of output can be sustained far into the future.  Moscow has indicated they would support the proposed OPEC caps as proposed in the last two cartel meetings.  At this time, it is hard to tell if Russia will decide to limit production or just pay lip service to OPEC’s attempt to curb production.  So watch for strong negotiations between Russian and OPEC this fall.

The next hurdle that OPEC has in raising oil prices is the volume from U.S. producers.  The bulk of shale and tight oil reserves are right here in the U.S., but, unlike other major oil countries, the U.S. has no national oil company or centrally controlled oil production.  So, the U.S. government cannot commit to a national position on oil production.  The impact the U.S. has on global oil prices is primarily on crude import levels.  It is only recently, that American drillers have been allowed to export oil.  Any supply of American oil on the world market will take time before it is felt.  OPEC wants to raise prices to a level that keeps American shale producers sitting on the sidelines. 

The election could play a role here as there is one of the presidential candidates has indicated a commitment to U.S. energy independence.  This would use whatever resources we have here in the U.S. to keep us from imports.  Also, some local oil regions have recently experienced more opposition to fracking.  Oklahoma has seen a rise in earthquakes that some believe is a direct result from fracking.

The other factor is that innovations in technology have driven down the up-front cost of shale wells.  So now these producers can be profitable at lower levels of oil prices.  There are also large numbers of partially completed wells that are not producing.  Completion of those wells will be at an even still lower cost.  In North Dakota alone, there are over 1,900 partially completed wells. 

So take all these factors together, thrown in a wild card of any major political instability in oil producing countries like Venezuela or Nigeria, add some overall growth headwinds to global economic growth, and the crystal ball begins to get pretty murky.  Overall my guess is we will see prices continue to rise gradually but not reach the high levels we saw a few years ago.  This will bring production back to U.S. shale producer, but not at the same torrid pace we saw a few years ago.  

Assessing a Business Construction Budget: How Much Construction Experience is Needed?

As someone engaged in business lending, I must be an armchair expert on a wide array of topics. How can someone like myself feel comfortable reviewing loans related to agriculture, hotels and cinderblock manufacturing when I’ve never farmed, made a bed, or operated any heavy machinery in my life? It takes years of experience, but a solid knowledge of economics and finance can help you predict how these operations should behave, and then astute observation of past performance can help you corroborate those expectations.

Construction projects can be especially risky, because of the prospect of cost overruns and the fact we have no initial collateral in place. So, if you have never swung a hammer on a job site, how do you know if the construction request in front of you has any merit? Some common sense details can help us cut through most of the uncertainty.

First, you need a project budget, which we refer to as a “sources and uses” budget. In other words, we want a budget that shows all the project related expenses, and then a list of all resources provided to pay those expenses, such as personal cash, loans, etc. Sources must equal uses.  And there are some common expenses we know to check for on the “uses” side that are often overlooked and can materially affect the lender.

I particularly check for whether interest expense is budgeted to pay for the subject construction loan. The longer construction takes, the bigger this will be and more burdensome to boot. So, we need to make sure there is enough interest to pay for the loan until the project begins to produce cash flow.

Another item we need to check for is “contingency.” This is a catchall for unforeseen expenses. If it is small relative to the entire budget, it means there is little room for error. If it is particularly large, it may be treated as a slush fund for nonessential items. Generally, contingency should be between 5-15% of the construction budget. It may be okay if there is little or no contingency, so long as your guarantors have substantial personal liquidity reserves that can easily meet the same 5-15% test.

How do you know if everything in the construction budget has been estimated correctly and captures all necessary items? We will require a bid from the contractor(s) to corroborate the actual cost. If our sponsor is the GC, we may have a third party contractor or engineer evaluate the budget provided to get an expert opinion regarding the accuracy of all the expenses. A good appraisal should help corroborate this information as well.

If a third party contractor is utilized, it is also common to ask that the contractors be “bonded” or carry insurance to make sure their work is completed with an expected level of quality. Sometimes, general contractors are even expected to provide a “completion guarantee” to assure the project gets done.

There are additional underwriting details to evaluate when looking at a construction project, but look at how much risk we have already started to get our arms around. While we may have no personal experience at a construction site, we have already assessed what resources are available and where additional resources can come from. We can also make sure the contractor has the ability to deliver and verify their estimates and assumptions. In doing this, we show risk management isn’t about having deep knowledge about a specific topic, but rather having framework for dealing with unpredictable events and different kinds of uncertainty.

Three Failures in the Wells Fargo Fiasco

Wells Fargo was named by Global Finance and The Banker in 2016 as the best U.S. bank.  Brand Finance calls it the most valuable bank brand on earth.  CEO John Stumpf was named 2015 CEO of the year by Morningstar. 

Wells media accolades are known far and wide.  It was broadly admired by the American public even though this is a big bank.  Wells has $1.9 trillion in assets, 269,000 employees, 70 million customers in 8,800 locations.  Wells also has the highest cross selling ratio in the industry with an average customer using 6.15 different services. 

By now we all are aware of the fraudulent accounts at Wells that were made public recently.  Wells, once one of the most admired companies, now sits in the gutter with other entities that are known to milk revenues from the customer.  Fines from the Federal Government and testimony in front of Congress are now the headlines for the bank.

But there are three entities that have failed in this situation.  The first is the leadership at Wells, itself.  The records show that Wells was aware of the fraudulent accounts dating back to 2011.  In the five years since then, Wells has terminated 5,300 employees during this time, who were involved in this scheme to pad their own salaries, or in some cases, making goals just to save their jobs. 

Five years is a very long time for this to continue.

But this was not just a get rich quick scheme.  This lasted for years and probably even years prior to 2011.  This was ingrained in the culture of Wells and praised by the shareholders of the bank.  The head of retail banking at Wells was praised as one of the most powerful women in banking.  She oversaw the growth of Wells into a retail powerhouse.  She also left the bank in July with a $125MM bonus. 

Maybe this is the old bank culture that is rearing its ugly head again.  Maybe it is the same disease that brought us Enron, the subprime mortgage bubble, the financial crisis, and all angst associated with it.

The second failure is the media.  The Los Angeles Times reported in an article on December 21, 2013 titled “Wells Fargo’s Pressure-Cooker Culture Comes at a Cost.”  This outlined the aggressive tactics pushing banker sales teams and cross selling products.  In the article, the writer states, “The relentless pressure to sell has battered employee morale and led to ethical breeches, customer complaints, and labor lawsuits.”  Employees were forced to work after hours to make up for missed sales quotas.  The Times reported one branch manager was constantly told that she would “end up working for McDonald’s” during the hourly browbeatings, otherwise known as sales coaching calls. 

So the question to the media here is how does the Wells go from a pressure-cooker to the most respected bank brand in the U.S. when nothing changes with its sales culture?

The third entity who failed is the U.S. Government, specifically the Consumer Financial Protection Bureau (CFPB).  Many of you know that this agency was formed unconstitutionally with no congressional budgetary oversight.  Discussion of that is for another time.  This agency is supposed to protect the little consumer against the large corporation.  Now they hail this finding as a positive to their very existence.  But the question is, did they really do their job. 

The evidence will lie in two areas, time and money.  First is time.  The CFPB knew about these practices since 2011.  It was widely known in the industry.  Now in 2016, just before an election, the findings become public.  The long time this has taken also allowed Wells to continue to open bogus accounts, continue to make money, and even allow some of its key people who oversaw the fraud to retire wealthy. 

The second is the money.  The CFPB will assess a record $100 million fine.  Wells will pay another $35 million to the Comptroller of the Currency and $50 million in penalties to the Los Angeles city attorney’s office, for a grand total of $185 million.  To most of us, this seems like a lot of money.  But how does it look to Wells?

In 2015 Wells earned top line revenue of $86,057,000,000.  This comes down to $235.8 million in revenue a day or $9.82 million in revenue per hour.  So the fine of $185MM is less than a full day’s worth of top line revenue to Wells.  It comes down to only 18.8 hours of time.  Do you think that penalizing a company for 18.8 hours of earnings is enough to cause them to realize the gravity of the fine?  The next time some money making scam is created by the bank leadership that will generate billions in revenue but only cost a penalty of 18.8 hours’ worth of earnings, do you think that penalty will be severe enough to deter future wrongdoings?

It all points to governmental ineptness.   All I can say is time to move to another place to bank.  Credit unions are the place to be. 

By the time you are reading this, we will have finished our Agricultural Education Forum in Miles City.  We appreciate having the opportunity to visit with each student in the class.  Please take advantage of our Small Business Lending Class in Fargo on October 5-6 and our Intermediate Agricultural Finance Class in Fargo on October 6-7.  Come to the New Ideas Conference and stay for some good business lending education. 

We also have our Commercial Real Estate Lending class in Deadwood on October 17 and 18.  We have quite a bit of space available in that class.  We will be holding this at the Tin Lizzie Gaming Resort and will also have our first blackjack tournament during the social hour on the 17th.  We look forward to seeing you there! 

Skin in the Game

What is skin in the game? That sounds horrific, doesn’t it? It sounds like somebody lost skin doing something painful, like sliding into second base. Another way to phrase this is “to share in the risk.” Someone who has “skin in the game” is someone who is “sharing in the risk” of a transaction.

Why is it important that someone share in the risk? When making a business loan, we feel someone is more motivated to operate their business successfully, if they are exposed to the risk of losing their own money. That is why we want them to have some skin in the game. If the borrower does not have their own money at stake, they do not suffer if they give up and walk away, or they may not feel as motivated to turn things around when bad times hit.

Lately, I have had to explain to a handful of lenders (across several institutions) the issues related to financing 100% of a business borrower’s purchase. In other words, the borrower has no skin in the game. This presents a great risk in business lending, even though 100% financing is common in consumer lending. Consumer loans are relatively small in dollar amount, especially when they aren’t for a home. And it should not come as a surprise that buying a home requires a down payment since it is a big purchase, and we want to make sure the borrower has skin in the game.

Financing business loans at 100% carries considerably more risk, because of both the high dollar amounts and the nature of the collateral. There are less buyers in the market for an office building or stamping machine than there are for cars and RVs. That means if we foreclose on business assets, we may have to accept a much bigger discount on the value to sell the asset. An office building might sell for 80-90% of its appraised value. And then consider, we will have a lot of legal costs in foreclosing on something that big and have to pay a large commission to a real estate agent. When all is said and done, we might get proceeds equal to 75% or less of the appraised value of the building. Why then, would we ever want to finance more than 75% of the building? Usually, we don’t.

So by now, you can see there are actually two major issues that arise when someone has no skin in the game. First, the borrower has no exposure to losses, which could affect their motivations; and second, there are no ways to offset costs related to foreclosing and selling collateral. Therefore, sharing in the risk doesn’t just keep the borrower motivated to stick with business, but their equity in a project also helps absorb some of the losses the lender faces.

On the surface, these seem like tempting transactions to do when there is significant cash flow that can easily make the loan payments. But we have to bear in mind, we are observing the best-case scenario when everything is going right. We have to ask ourselves, what could transpire in a worst-case scenario? What could happen is cash flow could no longer service the debt. And if someone has not invested any of their own money, what incentive would they have to stick with the project then?

When Sales and Credit Management Do Not Mix

One bank I worked at had a division between management over sales and those over credit administration.  The bank had a strong credit culture, so, usually the will of the credit administration folks would shape any sort of program that those whose bonuses were tied directly to the growth of the bank’s branches they ruled over.

But this was not always the case.  One fine spring day, managers and lenders met with the senior vice presidents over the bank branches.  It was a typical meeting held in the spring or early summer when the bank’s upper leaders announced our goals for the year.  I always thought it kind of funny that in some cases half of the year had passed before you actually knew what the new “flavor of the year” was.

Something unique happened in this meeting.  It became evident that the SVPs of sales and SVPs of credit administration were not in the same universe, even though they sat in the same room!  Anyone who has been in lending long enough has experienced this.  Probably one of the most famous examples is the mortgage crisis.  I will digress a few minutes here to discuss that. 

When I started doing residential mortgages in my career, everything was underwritten by hand, verified, and presented to a loan committee that met daily for a loan approval.  This process was rather long (but not as long as some of the runaround a mortgage applicant gets today!  Anyway, to remedy the problem, folks at Freddie Mac and Fannie Mae whose bonuses were tied up to the production of mortgages, derived a system where everything was underwritten by computer algorithms.  The parameters of underwriting were stretched to a point where we began to see exotic products with no down payment, financing of closing costs, interest only, etc. 

This created a huge demand for housing and we saw house prices triple in the 1990s at a time when real wages increased around 3% annually.  Of course, the system crashed down and one of the biggest causes was the lax and insane underwriting standards.  The movie The Big Short does a wonderful job explaining the mortgage mess.

Anyway, back to my bank story.  A new product was announced for that year.  It was called the “Business Streamline Line of Credit.”  It was designed to be a small line of credit, usually no more than $50,000, that would be sold to business owners.  The line had no maturity; it was based on a demand note.  Payments were interest only, with no plan to amortize and retire the balance.  The loan was also unsecured.  The product would also be primarily administered by front line branch managers and consumer lenders, and not seasoned commercial lenders.

So after ten minutes into the presentation touting how great this product was, the time for questions from the audience began.  One of the first ones was what about underwriting?  All this was done on some business credit score system based entirely on a two-page application the borrower would fill out.  We were told that because these loans were so small, that the money spent on full underwriting would make them unprofitable. 

Next who was the target market?  Anyone, as this product was designed to be a gateway product into new clients we had not worked with, not existing companies that we had a relationship with already and also understood. 

Generous incentives were provided front line people who sold “Streamlines”.  Goals were established for each market.  For the next few months, anytime anyone opened a “Streamline” everyone received an email as to what a great job they had done.  It was not long that we had amassed over $50MM of these loans on our balance sheet.  What could possibly go wrong?

I have learned when that last question is asked, it usually is just before something bad hits.  The program began to unravel.  First, leaving this to people who had absolutely no business lending experience was a problem.  We began to attract the unbankable customer others had turned down.  And, we did it with an unsecured line of credit. 

Next, since all standard underwriting went out the window, since it was “too expensive”, proper due diligence was also ignored as many of these lines were closed with companies that did not actively operate or with individuals who were not authorized to act on behalf of the company. 

Most of these lines were maxed out quickly with no ability to repay the loan.  When the crash hit, most lines in those situations were frozen and some sort of repayment plan had to be worked out.   By the time I had left the bank. Nearly $10MM of the $50MM portfolio was charged off.  Imagine what a 20% charge off rate with no collateral to recover would do to your balance sheet.  Fortunately, they were large enough to weather it.

The geniuses who hatched the plan, left the bank for a new opportunity to screw up another financial institution, while credit administration stepped in to clean up the mess. 

The lesson here is in commercial lending, niche products need to be analyzed and implemented carefully.  If no one at all is doing this in your market area, you may become the lender of last resort, attracting relationships that will cost you a lot of money and staff time to manage. 

Next, you cannot abandon sound underwriting principles.  We come across that now with some CUs we work with who have such a product.  They become obsessed with selling the loan without any strong consideration if the product makes credit sense.  Less growth today with marginal clients will give you much more time with the good ones. 

I want to end with a plug for our fall classes.  Our annual Agricultural Education Forum in Miles City is on September 26 and 27th.  At the time I write, we have 23 students signed up for that one.  After going to the New Ideas Conference in Fargo, stay over later and attend our Small Business/Commercial & Industrial Lending all day October 5th and the morning of October 6th.  Intermediate Agriculture Finance will be held the rest of October 6 and all of October 7th in Fargo.  We have discounts for those who want to attend both of those classes.  We end our fall classes with a session on Commercial Real Estate Lending at the Tin Lizzie Gaming Resort in Deadwood, South Dakota on October 17 and 18th.  Come join us and you can participate in our first Blackjack Tournament. 

Every year we are humbled and honored to be able to help our CU family grow in their knowledge and skills in the area we live in each day.  We look forward to seeing people on your team this fall. 

Don't Wait Until Election Day!

You are likely reading this on a Friday morning and you may be somewhat preoccupied with what you are planning on doing this weekend, like have a cold beer after work or sleeping in on Saturday. I have small children, so neither of those things are likely to make my “to do” list, but best of luck to the rest of you.

But if you are taking a five-minute mental break from work right now, why not take this brief moment to become a more informed citizen? Oh no, I’m not going to rack your brain. I just want to take this time to remind you that November election is about so much more than candidates trying to become president. You will also have a chance to vote on some ballot “measures,” which are proposed laws or constitutional changes brought to the voters to decide!

In North Dakota, you will have 5 ballot measures this fall.

·         Measure 1 : Residency requirement for state legislators
·         Measure 2 : Allocation of some extraction tax revenue to schools
·         Measure 3 : Expand the rights of crime victims
·         Measure 4 : Increase the tax on tobacco products
·         Measure 5 : Allow individuals to use medical marijuana

You can find the details about these ballot measures at: https://ballotpedia.org/North_Dakota_2016_ballot_measures

In South Dakota, you will have 10 ballot measures this fall to consider.

·         Amendment R : Governance of post-secondary technical education institutes
·         Amendment S : Expands crime victims' rights
·         Amendment T : Redistricting commission created to make redistricting decisions
·         Amendment U : Statutory interest rates for loans
·         Amendment V : Establish nonpartisan elections
·         Referred Law 19 : Regulations on who may sign petitions for independent candidates
·         Referred Law 20 : Decrease the minimum wage for those under age 18
·         Measure 21 : Cap interest rates for short-term loans at 36 percent
·         Measure 22 : Revise campaign finance and lobbying laws
·         Measure 23 : Nonprofit organizations allowed to charge a fee for services

You can find more details about these ballot measures at: https://ballotpedia.org/South_Dakota_2016_ballot_measures and https://sdsos.gov/elections-voting/upcoming-elections/general-information/2016-ballot-questions.aspx

As far as the presidential election goes, the South Dakota ballot will have four candidate tickets:

·         Donald Trump/Mike Pence (Republican)
·         Gary Johnson/Bill Weld (Libertarian)
·         Hillary Clinton/Tim Kaine (Democratic)
·         Darrell Lane Castle/Scott Bradley (Constitution)

On the other hand, North Dakota will have the following presidential candidate tickets on their ballot:

·         Darrell Lane Castle/Scott Bradley (Constitution)
·         Hillary Clinton/Tim Kaine (Democratic)
·         Rocky De La Fuente/Michael Alan Steinberg (American Delta)
·         Gary Johnson/Bill Weld (Libertarian)
·         Jill Stein/Ajamu Baraka (Green)
·         Donald Trump/Mike Pence (Republican)

As you can see, North Dakota has two additional candidate tickets on their ballots from the Green Party and the American Delta party. South Dakota notoriously has more restrictions for getting on the ballot and voting than North Dakota does.

Speaking of access, South Dakotans need to be registered to vote by October 24th if they wish to vote in the election on November 8th.  Interestingly, North Dakota does not have voter registration on the state level for presidential candidates. But, cities may require a city level registration to vote in city elections. Although, without a state registration system, you will be required to provide a government issued ID showing you reside in North Dakota.

If you are looking for information about where to vote, what will be on your specific district ballots, etc., then try starting with http://www.vote411.org/enter-your-address#.V9lixSgrKUl or for South Dakota go to https://sdsos.gov/ , and for North Dakota go to http://sos.nd.gov/ .

Please vote. If you don’t vote, your voice is literally not heard. But also, please read about what you are voting for too. Some measures may seem like a good idea on the surface, but can have greater negative consequences once enacted.

Incentive Programs Gone Awry

Last week, news broke of a large fine of $185 million assessed against Wells Fargo.  The bank’s employees had opened 1.5 million in bank accounts and applied for 565,000 in credit cards that were not authorized by customers.  This practice dates back to 2011.  Wells is refunding $2.6 million in illegal fees to customers and fired 5,300 employees over this incident.  Wells has 40 million retail customers. 

Richard Cordray, head of the Consumer Finance Protection Bureau, stated, “Unchecked incentives can lead to serious customer harm, and that is what happened here.”  For those who are familiar with Wells in the industry, what came out in the news this week has been going on for a long time.  This is no surprise to anyone. 

Wells is known as having a strong culture that promotes sales and cross-selling.  I have known many former Wells employees who are well trained and smart, but who left the bank because of the high pressure environment.  I know of bankers who would get multiple calls from supervisors during the day to track sales efforts and results.  The sales culture went into overdrive here and it makes me wonder how many phony accounts were done from greed and how many from an attempt just to keep one’s job. 

Clearly, this also shows a banking culture that is not serving its customer base and is only concerned for profits.  It also shows a lack of commitment to the communities they are in and an attempt to pad the pockets of the shareholders and leaders of the company.  I am a little happier every time I drive by the vacant Wells building in my rural South Dakota community.

The real issue here is not just with the employees who opened the accounts, it is the actual system, the sales culture, that was set up and firmly established at the bank that encouraged and rewarded these actions.  In many positions at Wells, if you wanted to get your boss off your back, get promoted, and also receive bonuses, finding ways to open new accounts is the key.  The other issue with Wells is that many of these accounts remained open when a cursory review of the activity in the account, would indicate that something is wrong. 

A much more dangerous threat to the US economy than the fraudulent customer accounts, is the huge amount of derivative holdings by the largest banks in the country.  Derivatives played a big part of the financial meltdown in 2007-08 and subsequent freezing of the credit market.  As long as we have a stable market, derivative holdings should not be a concern.  But the real concern is when there is mass instability, when the counter party risk holders cannot fulfill their role, that derivatives become a “weapon of financial mass destruction” as Warren Buffet puts it.

So why should banks traffic in this?  The simple answer is money.  According to the Office of the Comptroller of the Currency’s 1st Quarter 2016 report on derivative holdings of banks, banks made nearly $5.8 billion in revenue just in the first quarter in their derivative trading.  Wells clocks in at the 5th largest derivative holding bank with just under $6 trillion of contracts held by a bank with total assets of $1.7 trillion.  The other four largest bank derivative holdings are with JP Morgan Chase, Citibank, Goldman Sacs, and Bank of America.  The top five banks hold a tidy $182 trillion in derivatives while they have total assets of $6.8 trillion.  In this quarter Goldman Sacs earned over 33% of its gross revenue from derivative trading.  The total credit exposure of the derivative holdings of the top four banks in the first quarter 2016, is listed at 482% of their total risk based capital.

To put some of these numbers in perspective, the Gross Domestic Product of the U.S. economy last year was $17.9 trillion.  The entire world GDP is estimated to be $73 to $78 trillion in 2016.  So the holdings of the just the top five U.S. banks is over 2.3x the entire world economy?  At what point does “too big to fail” become “too big to bail?”  The next major bailout will not only come from the government, but also from bank depositors. 

It is sad to say, but we have learned no lessons in the financial crisis as shown with the derivative holdings to be higher now than it was at that time.  There seems to have been no concerted effort to stem this tide.  In fact, it seems there is an effort among some of our politicians to cozy up to the big banks by receiving millions of dollars to give short speeches to banking officials. 

So large banks and their trade associations will point the flaw in the system at the credit unions who do not pay taxes.  But of the $16.122 trillion of assets held at financial institutions, only 7.5% of that is held at banks.  17% at banks other than the largest 100, while the top 100 hold over 75% of the banking system assets.  The total $1.2 trillion in credit union holdings is less than the $1.7 trillion asset size of Wells Fargo! 

Clearly the “credit unions are the problem with the banking system” argument is the magician’s sleight of hand, designed to take your focus off real systemic risks in the financial system.    Real solutions need to be put in place to prevent another meltdown.  At the rate we are going, I would expect another one to occur that will make the last financial crisis appear to be a walk in the park.

Real reform needs to be accomplished.  Perhaps issuing a tax on speculative derivative trading with portfolios that have over $1 million could be implemented.  New rules that prohibit financial institutions, that are under the government’s insurance funds, limitations to the size of their derivative holdings may help. 

With the election coming up this fall, it is important for the voter to understand who owns the ear of the candidates.  Who or what industry group has given the most money in contributions or paid for speeches?  It is most likely that they will control the agenda of any candidate from the highest office in the land all the way down to the local level.  

Credit Scores: Do They Matter in Business Lending?

Business lending covers a pretty large gambit. It encompasses a small business that may need some credit to purchase a vehicle or equipment, up to large private companies who manage vast portfolios of commercial real estate. When I am looking at a multimillion dollar request, I sometimes crack a smile when someone asks about the credit score of one of the project owners. Could a credit score really make or break the success of an office building, hotel, or manufacturing facility?

I don’t see this question as purely rhetorical, and there may be instances when it is arguably important. But first, we need to understand what a credit score is before we speculate how it affects business lending. A credit score is an attempt to understand the risk of lending to you by using standardized information about you, and comparing it to the same set of information that can be applied to everyone else. When we say everyone else, we should pay special attention to what that indicates.

Everyone, in an American sense, means most of us who probably own a car, probably have a credit card, usually have a job that pays us twice a month, and have likely graduated high school. Most of us share these common characteristics, so it is easy to anticipate the likelihood of a loan getting repaid when we look at how everyone else might have fared in the same situation. But, people borrowing for business purposes are different, and that fact alone distinguishes them. How many people do you know own a restaurant? How many people do you know own an apartment building? You might know one or two people like that, but they are not representative of everyone.

So, a credit score generally assesses the likelihood of a loan getting repaid, if the loan is for a standard reason we all borrow. In other words, it is a measure of our ability to repay consumer credit. But for people who are not borrowing for an ordinary consumer purpose, it doesn’t factor in other valuable information. The credit score cannot give us an idea of how much equity someone has in a real estate investment, or how much cash savings someone has to fall back on in hard times. Rather, a credit score is a narrow assessment of how many people can do one thing, which is repay a consumer loan.

Then if a credit score is consumer measurement, how relevant is a credit score in business lending? For small business owners who need credit for purchases like vehicles and equipment, a credit score might actually be a reasonable indicator of repayment, because small business purchases are more akin to consumer credit needs. But the larger the request becomes, and the more removed from consumer credit the request becomes, and then the score itself may have little importance on its own. But, there might be a reason to have concern if someone has a poor credit score and he/she wants to borrow millions.

If someone has a poor credit score, it might give us some insight into their character. No matter how large their borrowing need is, it is a bit concerning that someone may not be paying their small bills. It may be the case they really don’t have the extra money, or they simply don’t care to. Sometimes, the score is low because of a tax lien or judgement, which is a serious concern. However, sometimes there isn’t much cause for concern. Even I irrationally had a lower credit score once, simply because I had medical bill fall into collection, because they never sent the bill to my address so I knew to pay it! Borrowers might have a low score, but for explainable or immaterial reasons.

So, is a credit score relevant in business lending? For small businesses, yes, it tells us something about repaying small loans. For large business loans, the score alone is much less significant. But if there is an adverse score, generally a reason should be provided as to why this is the case. But ultimately, a credit score cannot give me meaningful feedback about whether an apartment building will lease up, whether the demand for widgets will go up or down, or whether 2016 will be a good year for crops. To determine these things, we need a more detailed underwriting process, and a credit score is a small item to consider in a much greater picture.

Labor Day and America’s Idle

Today is Labor Day; a time that we typically celebrate the end of summer and the beginning of fall and back to school.  In the Love house, it means that all the kids are in college classes and my wife is working on her doctorate.  I am the only one not attending class.  But Labor Day is typically a time when we honor work.

An article by Nicholas Eberstadt in the Wall Street Journal entitled The Idle Army:  America’s Unworking Men was published last week.  It is very appropriate as we ponder the value of work today.  Eberstadt speaks of a quiet catastrophe—a collapse of work for American men.  Over the past fifty years, the work rates of U.S. men have dropped substantially.  We are now the home of around seven million men between the ages of 25 to 54, in the traditional prime of their working life, who are not working and are no longer looking for work. 

Now this issue is rarely discussed in the public square.  In fact, common wisdom holds that a sub 5% unemployment rate in the U.S. is considered to be at full-employment.  This was touted in a speech by the vice chairman of the Federal Reserve last week as he praised the accomplishments of that body. 

But near full term employment?  The current labor force participation rate is at 62.8% with 94,391,000 American’s out of the labor force.  This is the lowest percentage level since the Carter Administration.  This paltry statistic also goes hand in hand with the anemic economic growth as Obama will be the first president since the Great Depression to not have one year when he was in office with economic growth that was above 3%.

In 2015, the ratio of employment to the population of American males ages 25 to 54 was 84.4%.  This is slightly lower than the 86.4% rate that it was at the end of the Great Depression in 1940.  When compared to the last time we were at genuine full employment in 1965, the male job deficit in 2015 would be nearly ten million, even after taking account of an older population and more adults in college.  When looking at this, it is hard to tout our current time as outstandingly robust in terms of economic growth. 

Another transformation over the past fifty years is how we measure unemployment.  It used to be there were two classes of workers:  those who held a job and those who were unemployed.  Now there is a third way, those who are not working and are not seeking a job at all.  These people are considered outside the labor force altogether and fall into those not participation in the labor force. 

Eberstadt cites a key difference now than in the past is that the U.S. is now rich enough to carry the non-working men.  In many cases, the non-working life does not consign a man to complete destitution as it would have decades ago.  An interesting paradox is American workers are among the rich world’s hardest working people.  No other developed society puts in such long hours of work, while supporting a large share of working age men who do not have a job, are not seeking a job, or are not building skills to have a career. 

So what do these idle men do with all their free time?  About a tenth are students who are trying to improve their lives.  The overwhelming majority fall into a category the British call NEET: “neither employed nor in education or training.”  For the NEET, activities such as socializing, relaxing and leisure are full time pursuits.  This accounts for 3,000 hours a year with much in front of a TV or computer screen. If you have ever commented that your cousin or friend who seems to have too much time on their hands and is always on some form of social media, they may well be a NEET.  My parent’s generation would just label these folks as “lazy.”

There are big changes in the U.S. economy that do play a role here.  Manufacturing is in a state of requiring less workers with the rise of robotics and computers.  This will cause a major shift in jobs in the future as many positions we know of now will simply go away to automation.  It is also unclear if, or what, the new jobs in the future will be for those who are displaced by technological advances. 

There has been a general slowing of the economy since the last crash.  There is uncertainty where investors are unsure of putting money into a new business venture or expansion.  Increasing employee costs are also driving firms to use more technology and less employees.  But there is a male flight from work that has been linear over the past two generations in spite of any economic cycle. 

Another evidence of this is the rise in disability.  In the 1990s, 1 in 40 workers in the U.S. were on Social Security Disability.  Today that is closer to 1 in 20.  Nearly 1/3 of the total drop in the labor force participation from 2007 to 2015 can be traced to more people going on disability.  Today over a third of all disability claims come from back pain or other musculoskeletal issue. 

So regardless of these causes, this paradigm shift in working is very important to America’s national interests.  Declining labor force participation and falling work rates lead to slower economic growth and wider gaps in income and wealth.  Slower growth means less tax revenues and more government expenditures, producing higher deficits and a larger national debt.  Unworking men increase the poverty in the U.S., especially among children whose fathers are without a job.

The social effects are great as well.  We are all designed to work and create great things.  Take that away, begins to take away part of the human soul.  This male retreat from the workforce has also accelerated family breakdown, promoted welfare dependence, and recast disability into a viable lifestyle.  That lifestyle also comes with a drop in civic engagement and community participation.  Skills and talents that could be used to benefit the whole of our country are kept to one’s self or are never developed in a meaningful manner. 

Yet, today this tragedy is overlooked by the media, politicians, and business leaders.  I believe, as Eberstadt does, that it is time this issue come out of the shadows and begin to be dealt with as part of our national interest.  Imagine what our country would look like if an additional ten million men held paying jobs.  We would see more economic growth.  There would be more involvement in communities.  Families would benefit by being supported economically and also socially better.  There also would be more satisfaction individually, as work is one of the highest callings that we ever will undertake in life.  

Who is Financing Your Politician’s Campaign? Hint: Probably Not You!

If you have never visited OpenSecrets.org, I highly encourage you to check it out. Our politicians are required to disclose the source of their campaign contributions, and opensecrets.org summarizes this information for voters. OpenScrets.org is a non-partisan group that is simply consolidating information that each politician is required to report.

Starting with North Dakota, you will find Senator Hoven is running for re-election, and has acquired $2.3 million in contributions since his last election in 2010. Hoven’s top three contributors were Westport Properties for $27,875, Murray Energy for $27,373 and Jennmar Corp for $25,750. The top industries that contributed were oil and gas, leadership PACs and electric utilities. While Fargo and Bismarck accounted for the largest single source of most of his contributions, 68% of his total campaign contributions have come from out of state. In other words, most of his money to run his election campaign does not come from North Dakotans.

Senator Heitkamp’s last election was in 2012, and she raised $5.6 million for her campaign. Her top contributors were Motley Rice, LLC for $46,750, Council for a Livable World for $31,095 and Berkshire Hathaway for $29,500. The top industries that contributed were lawyers/law firms, leadership PACs and organizations promoting women’s issues. The single largest community to give to her campaign was the Washington DC area, with Bismarck coming in 4th on that list. With 81% of her total contributions coming from out of state, it is clear little of her campaign money came from North Dakotans.

North Dakota’s at-large representative, Kevin Cramer, has received roughly $1 million in this election cycle. His top contributors are Northrop Grumman for $12,500, Xcel Energy for $12,000 and AT&T Inc. for $11,000. The top industries contributing to his campaign are oil and gas, electric utilities, and agricultural services. The top communities giving to Cramer’s campaign were Fargo and Bismarck, and 78% of all his contributions came from within North Dakota. Most of his money to get elected actually came from North Dakota!

Moving on to South Dakota, Senator John Thune is facing election this year and has raised $9.7 million since his last election. His top contributors were Blackstone Group for $53,097, Sanford Health for $37,946 and Sinclair Broadcast Group for $31,250. The top industries who gave were the retired, insurance, and securities and investments. Sioux Falls was the single largest community contributing to Thune, but 72% of his contributions came from out of state. Rapid City came in 5th place, behind Washington DC, Los Angeles and New York. Most of Thune’s campaign money did not come from South Dakotans.

Senator Rounds’ last election was in 2014, and for that campaign he raised $5.5 million. Since Rounds began his first run for senate, his largest contributors have been Citigroup Inc. for $40,700, Avera Health Systems for $29,004 and Verizon Communications for $27,000. The top industries contributing to his campaign were the retired, securities and investments, and leadership PACs. The largest single community that contributed to Rounds was Minneapolis-St. Paul, with no single South Dakota community being recognized in the top five. His contributions were 47% in state and 53% out of state. Most of his campaign money did not come from South Dakota, although almost half of it did.

Lastly, South Dakota’s at-large representative Kristi Noem has raised $1.8 million since her last election. Her major contributors were Blackstone Group for $18,300, First Premier Bank for $16,200 and Automotive Free International Trade PAC for $15,000. The top industries contributing were insurance, the retired, and securities and investment firms. Sioux Falls and Rapid City were the top sources of her campaign contributions, and 70% of her contributions came from within South Dakota. Most of the money for her campaign actually comes from South Dakota.

And just for fun, let’s look at what OpenSecrets.org reports on the presidential candidates. Money raised for Hillary Clinton’s campaign currently totals $435 million. Her top contributors are Saban Capital Group for $10 million, Renaissance Technologies for $9.5 million and Pritzker Group for $7.8 million. We can also see that California and New York total 45% of all contributions, with New York City and Los Angeles as the most giving communities.

On the other hand, money raised for Donald Trump’s campaign currently totals $137 million. His top contributors are himself with $52 million, followed by John Powers Middleton Companies giving $150,000, Philips International Realty for $100,000 and Kushner Companies also gave $100,000. California and Texas were the top sources of his contributions, totaling 26% of all contributions. Yet, New York City and Los Angeles were also the top communities that are giving Trump.

Business Lessons at In-N-Out Burger

My wife, Angela, and my daughter, Hannah, and I recently took a trip to southern California.  My wife was celebrating a class reunion and also visited the University where she begins her doctoral work.  One of my joys in going to southern California is to experience multiple times stops at the restaurant In-N-Out Burger. 

I am a burger connoisseur and believe that a restaurant is worth its weight in salt if it can consistently produce on an excellent burger.  Few fast food chains cut the mustard on this task.  But In-N-Out is quite different.  The chain was started in 1948 by Harry and Esther Snyder in southern California.  Today, their granddaughter, Lynsi, leads over 300 restaurants that are located in California, Nevada, Utah, Oregon, Arizona, and Texas.  Lynsi was once the youngest woman billionaire in the US. 

We always welcomed the opportunity to visit In-N-Out.  Their menu is simple but offers gluten free options which we always look for as a family.  In one of our several visits to their restaurants, I had some time to reflect and observe why this chain is so successful.  We stopped at one of their locations in San Diego a little after 11 AM, which is prime lunch rush time for an In-N-Out.  All tables inside and outside were filled and after our order, we found three seats on barstools at a counter that looked directly into the kitchen area.  We waited in line to get our food, which is typical of an In-N-Out.  I have not gone to one at any time of the day where I did not wait in line.  So why was is this restaurant so successful?

They know their identity and focus on that.  The In-N-Out menu is very simple:  burgers, shakes, fries, cold drinks.  Their mission is to “give customers the freshest, highest quality foods possible and provide friendly service in a sparkling clean environment.”  They have resisted the temptation to expand their menu over the years.  Also, all their ingredients are fresh from their beef and fresh vegetables, to the potatoes they wash and cut on site for their fries.  Also, I always see at least a couple employees who are cleaning counters, floors, the outside areas, every time I have walked into a store.  Their passion for cleanliness is hospital like as you see the light glisten off their steel counter.

They treat customers special.  One of my sons worked in fast food this summer and he equated their attitude toward customers as a cattle herder.  Just get them in and out as quick as you can.  This is not the case for In-N-Out.  The iconic arrow was an indication that “quality is served here”.  Customers are referred to as “guests”.  The attitude is similar to southern hospitality that I grew up with. 

They engage their insanely loyal guests.  Their Facebook page boasts nearly 3 million likes and usually responds to messages within a few hours.  They sell all sorts of In-N-Out logo merchandise at stores and on their website.  In-N-Out fans also can order with the secret menu and ask for items like a double-double (double cheeseburger), protein style (lettuce wrap burger), animal style (add grilled onions and In-N-Out secret sauce), or the Flying Dutchman (double cheeseburger with no contaminants).  In-N-Out is also one of the few burger places that I don’t mind having 10 other people in front of me in line.

They treat their team well.  My wife, who grew up in southern California, said that In-N-Out was the toughest fast food job you could get but also the most rewarding.  One restaurant we stopped at had a help wanted sign that touted their starting pay of several dollars above minimum, 401k plan, beginning with 2 weeks of paid vacation, and free meals.  These are all items not seen in other chains.  They also have their own management training school called In-N-Out University.  Several of their top level executives began their career behind the counter.  Managers average 14 years with the company and part-time employees stay over 2 years. 

Their team executes on the mission.  I paid attention to the time we were at the store.  We were there a total of 25 minutes and in that time, the store served 50 guests inside the store, not to mention those who were passing through the drive through.  That is a rate of a guest served in less than 30 seconds.  The kitchen area, which can be viewed by the public, had 14 different workers throughout the time we were there.  The work area is also logistically laid out where the team members do not bump into each other. 

They are a proficient user of technology.  Many In-N-Out locations have team members carrying around wireless handheld computers to take your order.  This is similar to what you experience when you enter an Apple Store.  This provides a personal service at the drive through and also gets you your order quicker. 

They provide great value for the price.  We had supper one evening at SmashBurger, which was the burger joint closest to our hotel.  We all were disappointed as we paid twice the amount than what we paid at In-N-Out and enjoyed the food half as much.  Getting a great price on fresh ingredients for a burger is definitely worth the wait in line!

What Are My Odds of Getting a Business Loan?

While I’m sure everyone around me enjoys how I can drone on and on about technical minutia that affects repayment, I can appreciate there is great value in being concise. I had a regional manager in Washington DC, who provided the most concise explanation I have ever heard on how anybody off the street can assess their likelihood of qualifying for a business loan.

My manager started from the obvious touchstone of the 5 Cs of credit. Except, he explained them in a way people outside the industry could easily grasp. The 5 Cs of credit are Character, Capital, Capacity, Collateral and Conditions.

1)      Lenders look at your Character, which means, can you be trusted based on your background and experience? Do you have a history of paying loans back? Are you qualified to be doing what you are doing?

2)      Next, lenders look at Capital. Lenders want to know you have something personally invested in this too. Do you have money saved that you can contribute? Do you have resources to fall back on in hard times?

3)      Lenders will examine your Capacity to repay the loan. How profitable will your business need to be to repay the loan? Is your idea feasible?

4)      Lenders need Collateral. Is there something of value that can always be sold to repay the loan? If the loan goes into default, will you sell something to make the lender whole?

5)      Lenders always pay attention to Conditions. Is there demand for the product or service? Is the industry on its way up or on the way down?

On a scale of 1 to 100, you can assign a score to each of those five things. A 1 means the category is weak or there is simply nothing there, and a 100 means the category is unquestionably strong.

Then, you can assume that each category contributes to roughly 20% of the decision on whether or not you will get the loan. You can apply your 1 to 100 rating for each category, and multiply each category by 20%. Then add up the results from all categories, and you will have a percentage that reflects the overall chance you will get the loan!

Just for example, say you had a business idea you wanted to borrow money for, and you assigned Character 80, Capital 50, Capacity 75, Collateral 50 and Conditions 90. Now we can work through the simple calculation.

Character : 80 X 20% = 16%  ; Capital: 50 X 20% = 10% ; Capacity: 75 X 20% = 15%; Collateral: 50 X 20% = 10% ; Conditions : 90 X 20% = 18%

Then we have 16% + 10% + 15% +10% +18% = 69% chance of gaining approval. And you can even clearly see what areas need to improve if you want to increase your chances! While this isn’t the assessment that will be done by the lender, it is a very helpful tool for the borrower to consider before approaching a lender with an idea.