A Bloodhound’s Guide Identifying Foul-Smelling Loans

In my last blog, I identified several structural items necessary for a lending institution to identify and manage problem credits.  This blog will point out several factors that may indicate problems with your corporate borrower.  Like a good bloodhound, you must be able to sniff each of these and determine when there is a problem involved that will impact your ability to be repaid.

New Borrowings from Other Creditors may be a clue of problems.  I once had a car dealer who said he believed in spreading business around town with loans at several institutions.  Over the period of a couple of years, he added five new lenders who advanced funds for real estate, equipment, inventory, and working capital.  When the business imploded, no lender had adequate knowledge of the business and control of the lending to enforce their position, so we all were comrades in misery as we took losses across the board. 

New credit that pops up is especially problematic when it is a surprise to the lender.  Often, we have seen this in ag lending when a new filing by John Deere pops up on a UCC search when the operating lender had no knowledge of any planned capital purchases.  It is really a problem if you have a “no new borrowing without lender approval” covenant which is violated. 

A new loan made by someone else when you turned down the request because of financial issues with the company may be a sign.  On some of the marginal companies we bank, we often hope there will be a greater fool out there who will close the next credit for them.  This is a real problem if the greater fool does not pay off the existing debt with us in the process. 

Tax Liens may signal a problem.  This can come in many forms:  property taxes, sales taxes, income taxes, withholding taxes, to name a few.  Of these, a failure to pay withholding taxes to the IRS is very egregious since most of these funds come from the employee.  Missing any required taxes is a sign of cash flow problems in the company and must be addressed.  Also, tax liens of the business owners may show the company is not producing enough cash to provide distributions to the owners to pay for their tax liability from tax profits generated by the company.

Delinquency and Overdrawn Deposit Accounts are obvious signs of cash flow problems.  Unfortunately, these are often signs that occur very late in the problem cycle and may indicate problem issues are exacerbating.    Now these may be caused by poor loan structuring, and in those cases, the lender may be able to help solve the problem with a proper structure.  We had a loan on a seasonal hotel which had problems making payments in the off-season, especially close to the time toward the end of the off-season when expenses to reopen the hotel were high.  This was solved simply by a seasonal payment structure that matched the business cash flow.

Concentrations of Business may indicate a serious problem in a business.  This can come from over-reliance on one customer in terms of sales or receivables.  I once worked with a horizontal contractor who had a large multi-year contract in a large subdivision.  The developer overextended himself and sales stalled.  Consequently, the contractor suffered a large loss which took several years to recover from.  Another case I know comes from a manufacturer of perfumes who had their main account, over 75% of their sales, to Wal Mart.  When Wal Mart found a cheaper source of product, the business scrambled to downsize because of the lost business.  In each of these cases, greater diversification could have staved off some cash flow issues.

Violation of Loan Covenants may be a strong indication of a foul smell coming from your borrower.  This is assuming that you have well-structured loan covenants in place to begin with.  Covenants are like good medical equipment to check the overall health of the company.  The lender needs to identify when one is broken, what caused the problem, and what possible solutions may be.  You should also look at the negative side to see what future problems may occur if the covenant remains broken or the company’s performance weakens further.

Expansion may be a problem, especially if it is completed too rapidly or made in an unrelated business line or market area.  Bigger does not always mean better, it just means bigger.  Many companies have failed as a result of growing quicker than their ability to service that growth.  Also, large spikes in revenues may present a problem when income drops.  We saw this recently with grain prices when farmers became comfortable with high prices earlier in this decade and began to make purchase decisions based upon those prices continuing into the foreseeable future.  Growth into a new market may not present the same revenues and net profit as the company experienced in the current establishments.

Failure to Pay Off Lines of Credit will show cash flow issues in the company.  In agricultural lending, we refer this as carry-over debt, or a short-term line of credit that the producer failed to generate sufficient revenues to retire.  Any operating line of credit that cannot be retired in an operating cycle must be sniffed out to see the cause.  Did the company use it for purchasing fixed assets?  Is there a deterioration of business that is causing the company cash flow problems?  Often this may give the lender one of the early whiffs of foul credit.

Withholding Information is a huge sign that something is rotten with your borrower.  This is often the worst position a lender can be in, not knowing what they do not know.  Have you ever had a borrower who refused to answer detailed questions we had regarding their finances?  If you do, this may be the sign that something rotten is being covered up.

Change may be a sign that something is smelly in your credit.  The change may be in the accountant, bookkeeper, management, leadership, industry, environment, or other factors.  Sometimes, these changes may signal a problem.  The lender should consider if any of these issues should require the loan to be watched more closely to see if what you smell is passing or is an indication of rottenness.

These are some factors that the credit bloodhound must sniff through as they manage their portfolio.  Identification of the problem is the first step in proper credit management. 

Something Smells in Here : Problem Loan Identification

Have you ever opened your refrigerator and were greeted with a smell that would knock out a horse?  A couple of years ago, we had something that had either died or was a growing scientific experiment in our fridge.  The smell was incredible.  Knowing that the only solution was to remove all items and totally clean the icebox, we put it off for a few days as we did not have time.  Soon, everything that was removed from the fridge had a stench and taste of the something between old sweat socks and dead raw maggot infested meat.  The only solution was a thorough cleaning complete with mask and gloves. 

Similarities may exist between the foul appliance and problem loans.  Everyone knows something smells rotten.  At first, no one wants to dig far enough to identify the problem.  Some shops are led by folks who want no bad news.  The messenger is shot, giving the message to avoid and push away anything credit that is beginning to be ripe.  Others refuse to spend time and money training their team members.  When problems occur, they can’t quickly identify them.  Still others continue to only harp on sales and production goals at the expense of credit quality. 

All these approaches gloss over the upcoming problems and are as effective in just adding a few boxes of Arm & Hammer as eliminating the rot.  Things may smell OK for a time, but eventually the dead body must be removed.

If you want to manage the smell, the first place to start is with the leadership.  An open, communicative culture must permeate throughout the organization.  This means that all news, no matter if it is good or bad, is welcome to be advanced.  In some institutions, weakening financial performance or negative headlines of a borrower is not welcomed.  Some shops have pushed production to the extreme that field lenders are either too busy to monitor their credits or they deny any issues as they push for the next closing. 

Credit leadership must also promote quality assets compared to just pushing more loans.  The leadership should also set up systems of internal and external loan review, periodic analysis on each credit, and establishment and maintenance of watch lists.  Watch lists should be expanded not only to cover substandard and worse credits, but also those which show weakness that may lead the borrower into a negative status.  Discussion of credits should involve the entire department to get input of everyone.  Different points of view are valuable in finding the best solution to manage the challenging credit.  Also, this discussion will provide good training to the less experienced credit team members. 

Solid portfolio management requires you to constantly survey the market area and look for possible pitfalls that can impact a large swath of borrowers.  Perhaps this is a dominance of a key industry or employer.  Many smaller institutions in a rural area may have an economy dominated by farming or ranching.  A severe downturn in prices or a widespread hail storm may impact many other businesses other than those directly involved in ag production. 

You should know any concentrations or granulations in your loan portfolio.  Granulation asks how diversified are your loans?  Concentrations of credit may be in an industry, borrower, company, region, or guarantor.  For many smaller lenders, it may be hard to have a well-diversified portfolio as this is not common in their market area.  Also, note that concentrations may mean that your shop has an expertise in managing and underwriting a particular type of credit.  I once ran across a bank that did a tremendous amount of loans in the trucking industry.  They had nearly 50% of their commercial loans to companies in those industries.  When I asked them about losses, the only significant loss they took was when they reached for diversity by lending on an office building.  They had decided to become more granular in an area they did not fully understand. 

A good example of a concentration risk that killed an institution would be the failure of LOMTO Federal Credit Union which lost $51.2MM on bad taxi cab medallion loans when it had only $185.5MM in assets.  The value of these assets plummeted after the popularity of Uber and Lyft.

Problem loan management starts with an assessment of your institution.  What resources do you have available?  Do you have staff with experience in working out problem loans?  What legal resources do you have at your disposal?  Do you have any third-party resources like Pactola to help?  Do you have the ability to have a dedicated department of talented people to handle workouts?  What time resources do you have available at your disposal?  Do you have any training that is available to develop your team members?

All these are items that leadership must be aware of in order to better identify and manage any foul- smelling credits instead of just pushing it to the back of the fridge.  In my next blog, we will look at direct warning signs that may train your bad credit blood hound nose to identify problems. 

Thanksgiving Day in the United States

Thursday is Thanksgiving Day in the U.S.  A few years back, my middle son asked how Thanksgiving was started in our country.  While we trace the origins back to the Pilgrims and have history of this celebration prior to the Revolution, these occurred when we were still a colony of the British Empire. 

The first official Thanksgiving in our country was proclaimed by President George Washington in 1789.  Washington proclaimed a “day of public thanksgiving and prayer” which was overwhelmingly agreed to by Congress.  But the holiday did not become an annual event.  Thanksgiving proclamations were made at different times by different presidents until 1814.  Also, some communities and states celebrated the day as well. 

In 1863, after the Union victory at Gettysburg, Sarah Josepha Hale, a 74-year old magazine editor, wrote to President Abraham Lincoln urging him to establish a national day of Thanksgiving on an annual basis.  Hale had written repeatedly to other presidents concerning this topic but with no success.  The national mood was of humble thankfulness as our country was ravaged by the Civil War.   She wrote, “You may have observed that, for some years past, there has been an increasing interest felt in our land to have the Thanksgiving held on the same day, in all States; it now needs National recognition and authoritative fixation, only, to become permanently an American custom and institution.” 

Lincoln responded to Hale’s request immediately and on October 3, 1863, exactly 74 years after George Washington’s first Thanksgiving Proclamation, Thanksgiving was established as we celebrate it today.  The text of Lincoln’s announcement follows:

“The year that is drawing towards its close, has been filled with the blessings of fruitful fields and healthful skies. To these bounties, which are so constantly enjoyed that we are prone to forget the source from which they come, others have been added, which are of so extraordinary a nature, that they cannot fail to penetrate and soften even the heart which is habitually insensible to the ever watchful providence of Almighty God. In the midst of a civil war of unequalled magnitude and severity, which has sometimes seemed to foreign States to invite and to provoke their aggression, peace has been preserved with all nations, order has been maintained, the laws have been respected and obeyed, and harmony has prevailed everywhere except in the theatre of military conflict; while that theatre has been greatly contracted by the advancing armies and navies of the Union. Needful diversions of wealth and of strength from the fields of peaceful industry to the national defense, have not arrested the plough, the shuttle or the ship; the axe has enlarged the borders of our settlements, and the mines, as well of iron and coal as of the precious metals, have yielded even more abundantly than heretofore. Population has steadily increased, notwithstanding the waste that has been made in the camp, the siege and the battle-field; and the country, rejoicing in the consciousness of augmented strength and vigor, is permitted to expect continuance of years with large increase of freedom. No human counsel hath devised nor hath any mortal hand worked out these great things. They are the gracious gifts of the Most High God, who, while dealing with us in anger for our sins, hath nevertheless remembered mercy. It has seemed to me fit and proper that they should be solemnly, reverently 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 those who are 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. And I recommend to them that while offering up the ascriptions justly due to Him for such singular deliverances and blessings, they do also, with humble penitence for our national perverseness and disobedience, commend to His tender care all those who have become widows, orphans, mourners or sufferers in the lamentable civil strife in which we are unavoidably engaged, and fervently implore the interposition of the Almighty Hand to heal the wounds of the nation and to restore it as soon as may be consistent with the Divine purposes to the full enjoyment of peace, harmony, tranquility and Union.”

The current Thanksgiving draws its roots from the trial of the Civil War.  Many years have passed since then and we are a most blessed people with many things to be grateful for.  We are thankful here at Pactola, for each of you and the opportunity we have to serve you and be served by you.

The day after Thanksgiving is Black Friday, the start of the Christmas shopping season.  We expect Christmas to cost a bit more this year.  PNC creates an annual “12 Days of Christmas Price Index”.  This sets the prices of the various gift items in the song “The 12 Days of Christmas”.  The current price for the items in the song is $39,094.93, a 1.2% increase over last year’s cost.  The index was started in 1984 when the cost was $20,069.58.  The biggest drop in the list is a 9.1% decrease in the five golden rings.  The highest increases are the ten lords-a-leaping, eleven pipers piping, and twelve drummers drumming.  All indictive of a tighter labor market!

ABCDs for a Beginning Lender

Last week, we held our first small class at the Pactola mothership.  Our topic was “Beginning Business Lending”.  We had the honor of spending a day and a half with ten fine lending professionals.  We plan on holding more of these classes in 2019 and are interested in hearing from you regarding any topics that would be of an interest to you.

As we worked through the class, we had a question pole where any question that may be not related directly to the subject matter at hand was placed.  We would spend time answering some of these questions throughout the class.  One question made me ponder for a long time after folks were on their way back to their respective homes.  It was, “What advice would you give to a beginning commercial lender?”

I thought back to one of my first training sessions I sat in after I left the retail and mortgage sides of the bank.  I took copious notes as I learned concepts like debt service, cap rates, and margin.  If older me, were to travel back and sit down with younger me, what would I say? 

I think I would keep it rather simple, like learning your ABCDs.

Always be learning.  Commercial and agricultural lending is something that you will never be able to reach the apex of knowledge.  That is one of the most wonderful things about this industry.  There are also so many sources to learn from each day.  Industry resources, peers, others in your institutions, and your customers can all be great teachers if you listen and read.  I remember the first time I learned how to calculate a property value using the discounted cash flow model.  Another time, I learned from a lender to the furniture industry, features to determine a good quality chair from a bad one.  Another example was when I finally understood what basis is in commodity prices.  Each of these are small samples that can add up to a lifetime of knowledge you can gain if you humbly commit to learn.  Ask great questions and then be prepared to listen. 

Believe you can do it.  Doubt is a powerful killer of dreams.  You must believe that your customer knows he is better because he is working with you.  This starts with a quiet confidence in your skills and knowledge.  I contend this also goes beyond yourself and requires faith because no matter how much you know, you will never have a full command of all the answers. 

Commit to the right things.  Sometimes, success comes from what we can say no to, in order to select something that is best.  Learn to stick to your core values and principles.  Then commit to going to the correct circles where your skills as a person and a lender can make a difference.  And while you are at it, don’t forget to commit to excellence each day.

Don’t give up.  This is perhaps the most important lesson.  Success is a walk it is not a flight.  It requires putting taking one step at a time, putting one foot in front of the other.  At times, the temptation of discouragement will be great.  You may find it easy to give up.  It is during those times that continuing to move forward is necessary if you want to enjoy future successes as a lender.

One of my favorite quotes on persistence was taught to me in my freshman year in college. Calvin Coolidge was a member of the same fraternity I was a part of.  Coolidge stated this about persistence.  “Nothing in this world can take the place of persistence. Talent will not: nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not: the world is full of educated derelicts. Persistence and determination alone are omnipotent.”

Sometimes the best pieces of advice are simple.Mastering these simple concepts can lead to great rewards in lending.

Could FASB Be a Major Game Changer in 2019?

Professionals who used to make leasing decisions, may soon be subject to the decisions of the chief financial officer.  New accounting standards from the Financial Accounting Standards Board (FASB) regarding changes to lease-accounting methodologies will begin at the end of this year for public companies and a year later for all other organizations.  These changes may make FASB the projected major disruption agent of typical methods to assess commercial real estate. 

The new lease standards came from a decade of study by FASB and its sister organization, the International Accounting Standards Board.  Both entities were requested by the Securities and Exchange Commission (SEC) in 2006 to look at this issue.  Currently, operating leases are noted as footnotes in the financial statements.  The SEC believed that operating leases should be recognized as a liability on the balance sheet of the tenant.  If a company signs up for a ten-year lease, they have a ten-year obligation for the right to use the subject space which requires ten-years of payments.

A white paper by the Industrial Asset Management Council states, “The intent of the new standards…was to improve financial reporting about lease transactions and, in doing do, gain that transparency for investors and other stakeholders…A major portion of this process will be the review and categorization of all leases, as well as their terms and options to ensure that all appropriate information is collected, a coordinated effort must be mounted internally, including accounting, finance, purchasing, operations, and of course, real estate.” 

K.C. Conway, director of research and corporate engagement at the University of Alabama’s Center for Real Estate, notes in the past, the decision for a company’s real estate department was relatively simple.  All that had to be completed was to align a targeted return on capital with the economics and project cost.  Now this process will move to a new committee level inside these companies.  The focus will change to what is the result on the balance sheet.  This will cause a clash “between the CFO’s objective view of the numbers and a very subjective nature of lease negotiations.” 

These upgrades are not simple.  Deloitte outlined 12 essential points governing the new standards.  These all can be reduced to one question.  What is considered balance sheet and what is not?  The new lease accounting standards will impact how a lease is recorded.  More CFOs will want to book shorter term leases with options than to put a 25-year lease on the books.  This will play havoc to lenders who would prefer to finance the building with a long term corporate lease backing the cash flow. 

Since the entire term of the lease obligation must be booked as a contingent liability, the balance sheets of companies who lease will be greatly impacted.  Current and long-term liability numbers will explode, in some cases up to ten times what was previously reported on the balance sheet.  This change could cause the lender to pull his hair out as he looks at a company who months before was financially well, that now looks insolvent due to the FASB changes. 

The lease accounting change could make owning your buildings more attractive than renting space.  This will impact companies looking to build and occupy single-tenant assets that are essential to their operation.  If the asset of a new headquarters building will be on the balance sheet for a long time, they may as well own it.  But for a retailer who has a spot in a strip center, this will probably not impact the decision to lease or not.  Most multitenant landlords are not going to reshuffle the structure of the strip center into individual condos as occupancies change.

There may be a decrease in the build-to-suit-then-leaseback activity.  Companies like Dollar General, Walgreens, and Panera Bread have used this model to obtain off balance sheet, long-term lease financing with the leaseback model.  As the new rules are implemented, they may elect to own the property.  Their cost of capital as a direct owner may be less than if they must deal with lenders.  Financing the individual owner with the long-term credit tenant lease has been a plum of a loan to have.  These will become rarer in the future. 

It is unclear the impact the new FASB changes will have on the commercial real estate market.  Could this be a major disruption like what the financial crisis did for home building?  Or could this represent a slight shift in larger companies keeping more real estate on the books and the overall impact not being felt?  On the lending side, there could be some major surprises in the financials this year and next as these new standards are implemented and more companies are reporting with the new rules. 

Building Efficiency in Your Files

This topic may seem quite simple for a blog, but it has been near the top of my mind as we are in process of implementing a new tickler system to help manage our credit files.  It surprises me at times, how disorganized files become.  I have seen instances where loan file contents may be found in a physical loan file, in items on the computer, with the loan secretary, and in the loan officer’s possession all at once!  I have also seen some more technology-savvy institutions which have different parts of the same file spread on different computer platforms. 

In each case, this promotes inefficiency.  One of the things that bugs me the most is when I cannot find an item I am looking for when I know I am looking in the correct location!  Yet, I know at times that in the busyness of the day, it is easy to misfile an item to go on to the next task.  The first problem is failing to realize that file inefficiency is a silent stealer of time.  This time can be used for anything else in life, increased productivity, serving others more, or devoting more time to family.  It is along these lines I offer a few tips on what we have discovered at Pactola.  This does not mean we are perfect, by any means, but we are pursuing excellence.

If your institution operates in various locations, and you find that folks in those locations need access to the same file, consider moving as much as you can to a digital file.  This greatly saves time in accessing file items.  We found this essential in our shop as we work with participants and staff that are spread throughout the country.  We eliminated paper files completely, only keeping a copy of the closing documents (which are digitized as well) in a paper file.  Also, strong backups are very important to put in place. 

Now if you are in the computer file world, it is important to set up a standard set of file folders within a loan file where items can be organized.  It makes it much quicker to go into the “appraisal” folder to find the appraisal or into the “title insurance” folder to find the final title commitment and all items associated with that.  Your standard set of sub folders may change some with the particular loan type, e.g. a SBA loan may need different folders than a construction loan.  The file folder standards should be determined by the team which will be touching the files the most. 

Next is how to name items that go into the folder.  Just scanning documents into a file and having your printer associate a random file name to it will still cause you to go through multiple files to find what you are missing.  Our team came up with a naming procedure that has the date, borrower or guarantor, and document description in the file name.  Whatever you do, again, have this created by those who touch the files the most. 

The next step is to create a tickler system or to use a program that accomplishes this.  Ticklers are important to help manage your time and make sure all items are requested and received to keep the commercial or agricultural file current.  There are several programs to do this or simple ones can be created using programs in Microsoft Office.  Without this tool, it is nearly impossible to best manage ongoing file needs and activities. 

A quality control process should also be instilled.  Perhaps this can be completed when one team member builds a loan file and tickler and a different person reviews the file for completeness.  It never hurts to have other eyes reviewing the file contents for accuracy. 

These standards should then be reviewed periodically by your team and taught to new members.  The organization and file naming structure can apply to files that are not directly related to a loan.  Every institution will have files for resources, economic information, and program manuals, to name a few.  Keeping these organized and easily accessible saves valuable time. 

Keeping files organized and clean is an ongoing task.  I once had a boss who required everyone to take a week in January to clean out any personal computer and paper files.  In today’s information age, data builds up.  Some of it becomes useless or irrelevant over time.  It is like the story of the doctor who refused to clean out old magazines in his waiting room.  Instead he set up a sign for “historical periodical reference material”.    Some of the items you are holding onto may be useful in the future, but many items require timely purging to avoid wading through the data to find what you need.

Efficiency or Effectiveness?

In my first banking job out of college, I was often tasked with odd jobs.  During my first summer there, we foreclosed on a small house located in a remote area of the county.  I was ordered to clean up trash in the house, remove old wallpaper, and paint the inside as we decided these acts would help bring a higher price when we sell the house. The job also had to be completed in the day as there were no utilities on in the place.

I traveled down some windy country roads to the house.  My first day of work was miserable.  Missouri is known for its heat and humidity in the summer.  I spent the day hauling trash the previous owner had left in the house out to a large pile to be hauled away later.  My boss told me he thought the cleaning itself, would take a week.  After the end of the first day, I had drug all the junk out of the house and was feeling great about how efficient I had completed a week’s worth of work into one day!

The next day, I went back to the office since I had no equipment for the prep and painting.  My boss was surprised at how quick I had completed the job.  He asked if I had pulled all the junk out of the basement.  This took me by surprise since the house I went to, had no basement.  Upon further quizzing, he discovered that I had gone to the wrong house to clean up.  All my efficiency was lost for nothing. 

Have you ever completed some task quickly, only to realize that you did the wrong thing?  This happens to me a lot with house chores.  I end up in the same position I was in at the house, very efficient in my work but not very effective.  It is like running on the hamster wheel fast but not going anywhere. 

Today, being efficient in the wrong things is easy to do.  We have moved from an industrial economy to one based upon knowledge.  When we were industrial, many jobs were based upon performing certain tasks well.  Tasks were laid out easily like a football field.  Efficiency and effectiveness was about getting to the goal quickest.

In today’s world, the goal is to still get to the goal the quickest, but the field has not been defined.  The first challenge is to take all the data that is available to you, sift through it, prioritize it, and come up with an action plan on the data you have remaining.  Then this info is constantly viewed considering other information to see if changes in the plan should be made.  Information is constantly being bombarded at you every minute. 

Consider email.  Over 4.3 billion folks on earth use email.  The average office workers received 121 emails per day in 2015.  Each of these represents something that must be viewed, and a decision must be made regarding action or tossing the email aside.  Then some priority of actions need to be set.  Look at the information on the internet.  In 2015, it was estimated the amount of information on the internet would pass a zettabyte.  To put that in prospective, if the cup of coffee on your desk equaled one gigabyte of data, a zettabyte has the same volume as the Great Wall of China!  Each day when we turn on the computer, we have access to so much raw information. 

Since we are limited by time, the first challenge we have in the knowledge economy is to define the field, obstacles, and goals we need to aim for.  The second goal is the need to prioritize the data we receive and act or not act where need be.  Otherwise, we may be very efficient in what we do, but not very effective in getting the right things done. 

Oh, and the wrong house I went to was actually foreclosed by another institution.  In the grand scheme of things, someone benefitted from my work, it just was not me or my employer!

The Net Interest Margin Squeeze

Most of us are aware that interest rates have risen a lot in the past few years.  I know you may not be aware of this if you live in a cave or are completely unaware of the world of finance around you.  But for those of us who live and breathe in this realm, the changes of interest rates are a daily factor on our minds. 

The rate changes are across the board.  Ten-year U.S. Treasuries were at a low of 1.4% last July and are now bumping the 3.2% yield.  On the shorter end of the spectrum, the Fed Funds Rate, which was at 0.07% in October 2015 is now at 2.18%.  Thirty-year fixed mortgages recently hit 4.72%, representing a sharp increase from the 3.42% two Septembers ago. 

For the borrower, this means that they will pay higher interest rates for loans, that is unless they are doing business with a financial institution which is still living in 2016.  If you are in credit, you should be aware of this as you look at budgets and stress test interest expenses that a company may have on those credits which are not fixed rates. 

Some borrowers still live in yesterday’s land of interest rates.  I recently was shown a term sheet for a project promising an interest rate of 5% for 5 years.  The institution we were working with was seeing what sort of deal they could do since the project was attractive to them.  The letter, which was by now over a month old, was dated and made in a different rate environment which was not applicable to the cost of funds today.  Term sheets should have short times for the borrower to act and as much as possible be based upon a variable rate that will be determined based upon market conditions closer to the time of closing. 

Savers can find better rates at financial institutions and in the bond market with the increase in rates.  These higher rates may move money back into these markets and away from stocks or other business investment if they believe the premium is not substantial enough to pay them for their risk.

Financial institutions are often those where rising interest rates can create substantial stress.  In most cases, the main driver of credit union and bank income is the net interest margin, that is the difference between the interest earned on loans and the interest paid on deposits.  If your shop has a lot of fixed rate loans on the books and lots of short term deposits that will come up for repricing before any interest changes in the loans, you will see your net interest margin shrink. 

I recently heard this lament from the leadership at a credit union.  This shop had done a great job in booking lots of 4 and 5-year new auto loans at rates between 1.99% - 3.99% with promotions they ran.  This brought in a lot of small loans, which have costs associated with managing and processing each loan.  The CU has deposits which will reprice at higher rates as demanded now by the market.  This will squeeze their net interest margin. 

The leadership mentioned how their main source of their new accounts started from small car loans in their community.  Many of these accounts have a very small deposit account, in some cases just the bare minimum to become a member, in their new deposit accounts.  So, the overall result of the campaign was locking in a lot of low interest, small balance loans that will probably not run off for several years, combined with a lack of new deposits balances from these new members. 

Today, is a good time to look at the benefits of sound business lending.  This strategy can help deploy larger amounts of capital at higher market rates than your typical new car loan.  If the loan is structured well, duration risk can be reduced by tying the rate to an outside index, such as U.S. Treasuries. 

Developing strong business relationships can also bring in larger deposit balances into your institution.  Plus, you can serve the business owners with their personal accounts and may be able to gain access to converting many of their employees to your institution as well. 

In many ways, one of the biggest ways you can make an impact in your community is with sound business lending.  These loans help provide the necessary capital for companies to grow, providing new jobs and helping other businesses increase sales. 

Impact of New USMCA Trade Agreement

One of the areas that has caused great concern for many areas of the economy is trade.  President Trump came into office promising to renegotiate existing trade agreements which he believed were often slanted against American companies and workers.  He began to use his authority to start trade negotiations with our trade partners and use the power of tariffs on imported goods as a weapon to enforce trade practices that were fairer to the U.S.

These actions caused a lot of fear among those who believed that there would be negative reactions for U.S. exporters, farmers, and for the economy, as a whole.  Some areas such as the steel industry cheered the actions as it began to provide protections with domestic steel, producing more jobs. 

Several trade deals have been stuck since this summer.  In July, the European Union struck a deal with the U.S. to avoid a trade war by decreasing tariffs.  The EU will also import more American soybeans and natural gas.  Both sides were also working toward no tariffs, no barriers, and no subsidies on non-auto industrial goods. 

In September, Trump met with South Korean President Moon and finalized a trade agreement with this country.  The deal expands opportunities to export American products in South Korea, including automobiles, medicine, and agricultural products. 

On October 1, the Trump administration announced that the old North American Free Trade Agreement (NAFTA) has now been replaced with a new U.S.-Mexico-Canada (USMCA) trade agreement.  The purpose of this was to benefit American workers and businesses in areas where NAFTA has failed. 

American auto manufacturers and workers will benefit from new rules of origin requiring 75% of auto content to be produced in North America.  Workers will also benefit from the rules that incentivize high-wage manufacturing labor in the auto sector, thus supporting better jobs for American workers.  The USMCA labor section is the strongest labor provisions of any trade agreement.  This is a core part of the agreement and makes labor provisions enforceable. 

NAFTA rules helped incentivize offshoring and took many manufacturing jobs out of the U.S.  USMCA also includes a strong protection and enforcement of intellectual property rights.  It also has a strong measure of digital trade of any agreement. 

Farmers, ranchers, and agribusiness in America will win as the agreement includes provisions that will benefit agri-trade more fairly.  Canada agreed to eliminate its “Class 7” program that allows low-priced dairy ingredients to undersell American dairy products.  Canada also agreed to provide new access for U.S. dairy products, eggs, and poultry. 

So, what is the impact on the farm economy?  Soybeans have shot up nearly 60 cents since their low in mid-September.  Corn prices have rallied by 7%.  Canola has shot up 3%.  Cattle is up by 7.5% since summer.  Milk so far has been flat.  Hogs have shot up 36% but most of this is a result of the recent Hurricane Florence. 

What will be the impact of these agreements?  First, I believe that these will be ratified by the Senate when Trump takes these to Capitol Hill.  Senator Chuck Schumer has already mentioned his interest in a better trade agreement than NAFTA. 

How will these agreements impact commodity prices?  There will be some increase in commodity prices as more fair markets will be open for agriculture.  However, I would not expect a huge increase in prices as better trade agreements do not change the current over-supply situation the world finds itself in. 

For U.S. manufacturers this can be a mixed blessing.  Some raw material prices may increase.  On the other hand, this should increase employment which has currently been at levels not seen since the 1960s.  Fair and favorable trade deals for our country will be a win for all of us. 

A Victory for Main Street Retail

A recent Supreme Court decision in the South Dakota v. Wayfair, Inc. is a possible win for main street brick-and-motor retail, commercial real estate and state and local governments.  In June the Court issued a decision in the case deciding that states have the authority to tax online purchase even if the retailer does not have a presence in the state.  The South Dakota law allows state sales tax to apply to online transactions from retailers with more than 200 annual transactions or $100,000 in sales per year in the state. 

The majority opinion, authored by Justice Kennedy, and joined by justices Alito, Ginsburg, Gorsuch, and Thomas, overturned a 1992 decision in Quill corp. v. North Dakota, requiring retailers to have a physical presence in a state to mandate the collection of state sales taxes on purchases.  When Quill was decided, the Supreme Court was not even addressing online sales, as these were still not even in the mind of most Americans’.  In 1992, less than 2 percent of Americans had internet access and very few could project how quickly our lives would be changed with digital purchases.  The revolution in e-commerce, the challenge by Wayfair, Overstock, and Newegg to the South Dakota law provided a timely opportunity for the court to revisit the physical presence requirements. 

In 1992, Quill exempted merchants from paying sales tax in a state when they did not have a physical location.  The case, addressing mail-order purchases, did not think that sending goods across state lines was significant enough to create a nexus under the Commerce Clause, to allow taxation without a physical location. 

Now in the Wayfair opinion, Kennedy used the example of two different online furniture businesses.  The first one may have a small warehouse in South Dakota with a limited selection of inventory.  A second business, may have a huge warehouse, just over the state line in Nebraska, with a fancy virtual showroom and first-rate online presence. Before this decision, a South Dakota resident would pay sales tax on the first purchase but not the second.  The court found this distinction unfair and not in line with the realities of today’s on-line economy. 

Justice Kennedy noted the physical presence rule “produces an incentive to avoid physical presence in multiple States.  Distortions caused by the desire of businesses to avoid tax collection mean that the market may currently lack storefronts, distribution points, and employment centers that otherwise would be efficient or desirable.”  The distinction created an unfair advantage for online purchases compared to the local storefront which may be already struggling to compete with their digital counterparts. 

Opponents of the decision contend that taxing online sales places an undue burden on small internet retailers, who may struggle to administer tax collection in various locations with different tax state and local tax rates.  The Court’s dissenting opinion argues that Congress should have legislated an appropriate online sales taxation standard and not the judicial branch.  Several bills have been introduced in Congress to address this issue, but none have been enacted. 

The South Dakota law addresses the undue burden concern by exempting small businesses with few sales and transactions from the law.  While software can facilitate gathering sales taxes in multiple jurisdictions, the court agreed the South Dakota law as adequately addressing this logistical burden for small online retailers.  Other states are expected to follow suit, and 20 states have passed legislation requiring only an economic nexus and not a physical presence, to collect sales taxes. 

It is easy to see the favorable possibility of more local sales with this new ruling that attempts to level the playing field between main street and online retailers.  But there is also a big windfall for state and local governments.  A 2016 study from the National Conference of State Legislators in conjunction with the International Council of Shopping Centers, estimates that states lose nearly $26 billion annually in sales tax revenue from remote purchases.  The Court cited a different study estimating closer to $33 billion in lost revenue.  The loss of this revenue could be felt with higher taxes in other areas or a reduced funding for other services provided by governments. 

Another area that is expected to benefit from this ruling is commercial real estate.  Now that the Supreme Court has eliminated the physical presence standard, businesses might be more inclined to open a physical retail location to add to their internet presence.  A decision to close or not to open a physical location in a town may have a large impact on the community.  Not only does the town lose tax revenue, but the lack of local sales may drive retailers out and have empty storefronts, driving down real estate values. 

Jennifer Platt, vice president of Federal Operations for the International Council of Shopping Centers in New York lists two impacts of the ruling to retail.  “First, is the psychological impact on consumers no longer being led to believe that shopping online is tax-free.  Second, is the functional impact on online retailers who have not wanted to create a physical nexus by building out a brick-and-motor presence.  That dynamic has been wiped away with the Wayfair decision.” 

This ruling should provide benefits to local retailers, local and state jurisdictions, and retail commercial real estate.  Hopefully, some of these favorable factors may keep more local retailers open, instead of seeing more businesses dark and boarded up.

View from the Agriculture Class

Last week we hosted our fifth annual agriculture lending class.  This one was in Bismarck and we had 47 students; a new record for us!  The class ranged from field lenders, analysts, and managers.  Experience levels were from brand new to those who can tout decades of agriculture lending experience.  This blog will review some of the highlights we took away from the lenders in the class.

Stress is quite present with the producers in the areas represented in the class.  We hosted students from Montana, the Dakotas, Minnesota, and Wisconsin.  There are producers who have no or very little debt.  The ones which keep our class up at night are those who are highly leveraged for the current prices we are experiencing currently.  The challenges that face producers who have leveraged their operation up with loans on new equipment or land when prices were much higher 4-5 years ago is again taking a toll on the farmer. 

We had several lenders who reported that they are now in the third or fourth year of some carryover debt on the operating lines.  This presents a double challenge with not only having to deal with the financing carryover of the past year and must work on the need to finance this year’s operation.  Some wonder what is the magic formula that can be used to determine when to cut off the producer.  There is no magic formula available and each situation is looked at differently. 

Most students believe we are in the winter season of the ag economy and that we face another 3 years or so of low prices which will weigh heavy on the producers.  Trade issues are on the mind of many as looming trade wars with countries that import U.S. agricultural products are starting to curb their purchases from us.  Some were heartened with the recent one on one work that is being done in negotiating with the Eurozone and Mexico.  Overall, even if trade issues disappear overnight, there is still downward pressure on prices with the oversupply of commodities present in the world. 

Assessing management skills of the producer was a topic mentioned by several lenders.  It seems that there needs to be a method to better understand the ability of the farm borrower these days, especially now that we are facing yet another year of low prices and possible thin margins.  If you understand the skills of those running the farm, you have a better idea of who has the highest probability of succeeding in the present price environment.  We discussed some ideas on how to turn a very subjective rating on the management skills of the farmer into a more detailed quantitative analysis.  The operators who will thrive in this environment are those who can win at the 5% rule.  They can find ways to increase their production or get a better price by 5% and find methods to decrease their costs by 5% compared to their neighbors. 

Some lenders spoke about the risks of generational changes in the farm.  Some aging producers do not have a solid plan on how the farm will continue when they decide to retire.  Plans seem to be in the head of the producer and are not written down.  These are also not reviewed by their accountant and attorney for any tax issues. 

Divorce is probably the biggest risk to upset the family farm.  Lenders spoke of the necessity to understand which role each spouse plays in the operation.  If marital problems appear and the wife is the manager of the operation while the husband is the tractor driver and field worker, you will end up lending differently to the remaining spouse if you are working with the manager compared to the laborer. 

Some in the group who had experienced the ag crisis of the early 1980’s commented on the differences today compared to then.  Farmers overall tend to be less leveraged today.  There is more discipline regarding financing reporting and better overall understanding of the producers in how finances play a role in the farm operation. 

One of the biggest challenges is the marketing plan of the producer or how the farmer decides to sell his product.  Too many farmers have grown a crop and had a large portion of this exposed to market prices without any sort of contracting, price protection insurance, or commodity market hedging.  One dire situation this year is for North Dakota soybean producers.  It has been reported that elevators are only going to take the crop that they have already contracted for and are not taking any additional crop.  So, the soybean farmer who is exposed to the market will have to deal with storage costs, shrinkage, and further price exposure as they hope to have this year’s crop sold middle to late 2019.

We expanded our office space and added a conference room that we did not have before.  This allows us to have small classes on business or agricultural lending that we had no place to host before.  If you have some interest in making a trip to the Black Hills this fall for some quality commercial education as you enjoy some of the sights of the area, please reach out and let us know. 

Financial Stress Management

During a time of financial stress for a business, it is often hard to determine what the problem actually is, and what the proper strategy that can be implemented to reduce the stress.  What makes this even more challenging is that there is no one-size fits all solution that will positively change each incident of financial stress. 

The first step when a company has a loss is to divide the costs associated with generating revenue into fixed and variable costs.  Fixed costs remain the same no matter how many items are produced or sold.  In a business some examples of fixed costs would be rent, salary levels required to keep the doors open, and utilities.  Variable costs change with sales or production.  Examples of variable costs would be supplies, raw materials, and wages that are based upon production.  Charting the revenue line against the fixed and variable costs provides a useful picture of what is happening in the company and what may be a proper strategy.

I once had some used car dealers financed who were successful until the “cash for clunkers” program hit a few years back.  Sales plummeted for both dealers; one dropped much lower than the other dealer due to the rural market they were located.  In fact, revenues dropped to under 50% of fixed costs for the next six months.  In this case the first strategy was to reduce fixed costs or for the sponsor to have a large pile of cash personally to fund losses.  Since the second option was not available, the business owner shut down two locations and consolidated all lots into one location.  This saved additional costs of rent, utilities, and some management staff at the closed locations. 

A contractor I worked was saddled with a couple of years of losses from failed subdivisions after the crash in 2008.  Their situation was not as dire as the car dealer as they were close to being profitable but were not quite there.  Their strategy involved changing their pricing of their work after they studied what a minimum profit margin would need to be in order to be above breakeven.  This increase lowered the revenue but made each revenue dollar more profitable.  They also decided to sell a marginally profitable line of business and use the funds to reduce debt and lower fixed costs.  These two strategies together made a huge difference in the performance of the firm.  It also shows that at times, more than one strategy is needed to manage the financial stress. 

At times, the answer to financial stress lies in better management of variable costs or just increasing production.  A small fragrance manufacturer was bouncing between a small profit and small loss for several years.  Their solution was two-fold. First, they discovered that the containers they were packing the product in, could be outsourced to another manufacturer at a 33% cost reduction than their in-house costs.  This created a large reduction in variable costs with the removal of this production line.  They even reduced some fixed costs by selling some machinery that was used to create the containers. 

The company did not want to reduce staff, so they switched the staff working on the containers to producing more fragrances.  This increased throughput, combined with lower variable costs, caused profits to soar.  In this case, the answer to leaving the financial doldrums was selling assets to lower fixed costs, reducing variable costs, and increasing production.

A normal operating corridor for a business is when each dollar of revenue is able to produce some cents for profit, and also taking care of fixed and variable costs associated to generate that dollar.  In the case of a business that is operating above breakeven, the answer to raise profitability is to increase sales. Each new dollar will increase profits and will tend to increase profits at a larger rate with fixed costs staying the same. 

When a company is in financial stress, once you determine the various fixed and variable costs of revenue, there are several answers to alleviating the pressure.  This may involve reducing fixed costs by asset sales, refinancing, or reducing fixed staff.  It may also involve increasing profits by better pricing, reducing variable costs, or increasing the output.  It may also require multiple strategies to achieve success.  It is important to understand what strategy to take and what is the end goal of the action.

Judging Repayment Capacity for Agricultural Borrowers

Years ago, when I was a young commercial lender, still wet behind the ears, I learned how to judge if a borrower has the ability to repay the loan.  This was by using the debt service coverage ratio (DSCR) calculation.  Basically, this takes gross income and deducts all operating expenses to reach a net operating income line.  This amount is divided by the annual debt service requirements to get a ratio.  If the ratio is at 1:1 then the business just makes enough money to pay all operating expenses and debt payments but has nothing else left over for owner payments or capital improvements.

Once I learned this, I thought I had found the holy grail of lending!

But just like the cave began to crumble around Indiana Jones when he picked up the sacred cup, I soon found times when my analysis would crumble around me if I was to base my review upon the DSCR.  One area where this really comes to light is with agricultural lending, especially when the producer is providing cash-based income statements. 

Consider the issues of the timing of when crop is raised compared to when it is sold and when cash is received.  I once had a potato farmer who showed massive cash losses in his tax return.  This was enough to raise the hair on the back of your neck, until I learned that a large payment for that year’s crop by Frito-Lay was not received until the following year.  When the financials were adjusted from a cash to an accrual basis, they easily met our DSCR standard.

Another issue is when a rancher increases his cash income by selling breeding stock.  One cow-calf operator usually ran 100 heifers as breeding stock.  One year we saw a spike in cash income which looked great until we discovered that they now had only 59 heifers instead of the usual 100.  Now their ability to keep production at previous year’s levels was in question. 

Other factors are when expenses are prepaid for future years or may be incurred but not paid until another period.  This also must be watched for supplies and inventory levels.  Any expansion or contraction on these away from previous year’s levels may skew the cash, based borrower’s income statement, and thus your analysis.

This is one of the topics that we will be covering in our upcoming class on September 19-20 in Bismarck.  Sign up today as our class is filling up fast!

The Importance of Assessing Farm Management

Five years ago, the farm economy looked much different.  Prices for wheat exceeded $8/bushel.  Corn prices were near $7/bushel.  New calves are at $200/cwt.  It looked as though prices would continue to increase for years to come.  Producers were looking for ways to expand their farms, purchase more and better equipment, and expand their herd. 

Fast forward to today.  We are now 4-5 years into the commodity super cycle turning from the past years of the peak.  We may have another 4-5 years in this portion of the cycle before commodity prices turn up.  Lenders are dealing with producers who cannot pay off their operating lines.  Perhaps this has now happened 3-4 times.  Some farmers are contemplating if they should consider leaving the industry and some lenders are wondering if they will ever be paid off. 

We are at a time in the cycle when a proper assessment of producer management is essential to understanding which borrowers are the ones you want to stick with and which ones you need to take a different approach.  A good economy can hide a multitude of management errors.  A producer lacking management skills will tend to see larger losses and bigger problems in bad agriculture times. 

There are four areas that I suggest agricultural management be looked at.  I will touch on these in this blog but note that we will go more in detail in our Managing the Agriculture Loan in Good Times and Bad class.  We are holding this in Bismarck on September 19 and 20.  You need to contact us to get signed up.

The first area is financial management.  One of the best questions to ask is if the producer truly understands his cost of production.  What is even more impressive is if this is written down or on computer, and if this is also divided up by each crop or ag enterprise.  If your producer does not truly understand this, how will you the lender understand?  Also, if they have no idea on their costs, why would you want to lend with them?  A borrower with a strong, written command of their input costs will outperform the farmer who is winging it.

Another one of the eight financial factors we have deals with capital spending.  Does your producer have a capital spending plan?  How many years out does it cover?  Is the budget geared toward increasing the farm efficiency and income or is it based around shiny new iron in the barn?  Is the budget followed? 

The second area of management is production.  If you have a farmer, how does his production per acre compare with the county averages?   How does the rancher’s herd in sale weights compare to peers?  Is there a pride of ownership with the farm?  Is the farm well-kept or does it look like a junkyard? 

The third area is marketing and risk management.  One of the most important factors here is if there is a solid marketing plan that is written and executed.  Is there a plan that may involve forward contracting or hedging to secure prices or are the prices solely at the whim of the market?  We all have seen some clients who refuse to sell crop in hope of a better price in the future with no solid plan.  All this revolves around is a wish. 

The fourth area, I title as other factors.  One of these factors is a transition plan.  What plan does the farmer have for the next generation?  Is this plan well developed with key advisors like attorneys, accountants, and lenders?  What key skills are needed to keep the farm successful in the next generation?  Is there a plan to make sure these skills and resources are available to the next generation?

These questions are some that are key to understanding the management skills of your producer.  This is perhaps one of the most important time in the farm cycle to be accurate on how well the producer will be able to improve their current condition.  We will be reviewing these factors in our class in our section to assess agricultural management.  We look forward to seeing you in Bismarck.  Use this link to get more info and to sign up.  https://pactola.com/education-opportunities/

Is the Fed Ready to Stop Spiking the Economic Growth Punch?

In the latest testimony by Jay Powell, chair of the Federal Reserve to Congress, he praised the current condition of the U.S. economy.  “Robust job gains, rising after-tax incomes and optimism among households have lifted consumer spending in recent months.”  Clearly, the fiscal policy has advanced economic growth with the recent tax cuts.  Optimism in the business community has taken hold with a growth-friendly leadership and lowering regulations. 

The Fed has hiked short-term rates by 1.50% since the end of 2016 and has indicated we may see several more 25 basis point hikes this year and next.  Increasing rates make borrowing cost higher and will tend to slow down growth.

The classic balance with monetary policy, the actions taken by the Fed, is to maintain price stability with a small level of inflation on one side and full employment on the other side.  This lesson was taught to me early in my first macroeconomics class.  So, the Fed is to act as some monetary thermostat, heating up the economy when activity is too cool and cooling it down when it is too hot.  Ideally, changing the thermostat is to make the economy move along at a very comfortable level, not growing too fast and never falling into a recession.

But, just as an old thermostat may not work to keep your house comfortable, the Fed’s actions are never perfect.  Furthermore, there are other motivations of the Fed.  Remember the Fed is the bank of banks.  Powell, as with most other Fed leaders, spent decades working for investment banks.  The Fed was created by our nation’s top bankers over a century ago and there is motivation to keep the financial industry happy even if these actions may cause some pain to the rest of the economy.

At times, banks love when rates rise.  This comes when repricing earning assets widens the margin more than the need to reprice bank deposits.  Forbes discussed this in mid-July when analyzing the second quarter earnings reports from our nation’s big banks.  “What really stands out is how well JP Morgan and Citigroup performed in Q2 despite 10-year yields remaining so low.  It’s arguable that few analysts (and probably few of the economists at banks themselves) would have thought 10-year yields would be in the 2.85% range this far into the year, but here we are in mid-July, and that’s basically where the yield sits.  Thought shares of the financials have been punished as rates remain stubbornly low, it’s possible bank stocks could get rewarded if yields start to find more traction and revisit the 3% level.  That’s where yields were briefly in May, and with the Fed still in a hiking cycle, it’s not necessarily too aggressive to think yields could potentially make it back to that level sometime in the coming months.” 

So as rates shoot up, bank profits follow.  The real risk comes if the Fed increases short term rates to a level where they are higher than longer term interest rates.  Almost every time in the past century when this has happened, a recession has followed.  The chart below, from the St. Louis Fed, shows the differential between the 10-year and 2-year U.S. Treasury rates. The gray columns are recessions, or downturns in economic growth for two quarters or more.

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Note that each time the yield curve has inverted, or short-term rates have risen higher than long-term ones, a recession has followed. We are currently getting close to a level of the yield curve flattening and turning negative.

There is another factor in play.  Rates have dropped to levels so low after the Great Recession, that rates need to be at a higher level if the Fed needs to act to stimulate the economy again.  There is more simulative power in a Fed Funds drop from 3% to 1% than from 1.5% to 1%.  In other words, the Fed needs rates to be higher in order to give it ammo to fight the next recession more effectively.  If rates continue in super low historic territory, the impact of lowering rates to grow the economy is muted. 

The Fed could take rates negative, a move that European central bankers have done, but that tends to not have good results for the banks or the economy. 

One takeaway from the chart above is to note how much of the chart is above the horizontal black line.  It shows it is normal for someone lending money for a longer term would receive a higher interest rate than someone lending for a shorter term.  We refer to this a duration risk, or the risk of losing purchasing power the longer you peer into the unseen future. 

But note how the line snaps back quickly into the positive after dipping negative.  The risk in institution profits is for a lender or CFO to have a large portion of outstanding loans locked for long term fixed rates on their balance sheet during the times the rate is negative.  The curve will normalize and your cost of funds will tend to rise.  This has the potential to squeeze net interest margins.   It is smarter in times like these, to not commit to low long term fixed rates on loans or to find a way to hedge against the duration risk if you do.

Challenges at the Dairy

This spring, dairy farmers were surprised when Dean foods cancelled their contracts to purchase milk.  When one follows the money, the trail leads back to Walmart.  For decades, Dean has bottled milk under the Great Value name and they continue to do so.  But in areas where these contracts have been lost, like Pennsylvania, Indiana, Kentucky, Tennessee, North Carolina, and Ohio, are areas where Walmart has built its own bottling plant. 

Dean does not place the blame on the new Walmart plants but they do state “the introduction of new plants at a time when there is an industry-wide surplus of fluid milk processing capacity” and losing milk volumes during a time of increased volume competition as reasons for ending dairy contracts.  Dean expects to continue to shrink production over the next two years in various phases, which could mean more cancelled contracts with dairies who supply to Dean. 

Walmart has just found a way to increase its margin in milk sales by eliminating the Dean processor.  It brings to mind the quote from Jeff Bezos, head of Amazon, “Your margin, is my opportunity.” 

But we cannot place the blame on Walmart for all the ills on the dairy farm.  The supply of dairy cattle in the U.S. dropped substantially from 2008-2010, ending at just over 9.1MM head.  Since that time, milk cows have risen to 9.4MM head.  At the same time, production by cow has risen by 12% over the past decade.  This has led to a larger glut of milk in the market. 

These two factors have shrunk the number of dairy operations from over 70,000 in 03 down to around 40,000 in 2017.  The average herd size has jumped from 129 in 2003 to 234 at the end of 2017. 

This is coupled with a drop in domestic demand for milk and milk products.  The average person in the U.S. drinks here gallons less of milk per year than they did in 2010.  Go to the grocery store and you will find a wide variety of nut and soy based milks.  In our house, milk was always in high supply.  Now with some of the kids emancipated and the remaining one with dairy intolerance, it is more common to find no or very little milk at the Love household. 

The other strong demand for dairy is international trade.  Mexico, Canada, and China combine to purchase $2.5 billion of U.S. dairy products.  These are the three largest buyers for U.S. dairy.  Concerns with trade may temper some of these numbers in the future. 

Overall, the world is awash in milk and the supply is increasing quicker than demand.  This is classic economics when we would expect prices to drop further until the supply/demand balances out.  Overall the problem cannot be blamed on Walmart. 

The dairy producer should review their milk contracts with legal counsel to see how easy it is for the buyer to exit the relationship and how much notice must be granted the producer.  A secondary market should be sought in case the first contract ends.  In other words, it never hurts to pack a backup parachute. 

Next, producers need to find some way to squeeze out some more margin from their dairy.  At this time, this could be the difference between living to milk another day and hanging it up.  We have seen some dairies invest capital in robots that milk and feed the cows.  Others are utilizing drones to watch over the herd or the condition of their crops they may be growing for silage.  The investments in technology may be huge, but the payoff can greatly increase margins as fewer workers are needed.  Also, human labor can be used to review the health of the herd instead of much of the traditional dairy labor.  This also allows the farmer to expand easier. 

These trends will tend to push out the smaller and less efficient dairy operator as those who can find ways to squeeze out another 5-10% profit from more efficiency.  Unfortunately, this will tend to put more milk in the market, which will have a downward pressure on prices.

Temporary Loans, A Bridge to Nowhere?

Sometimes, a business will request a short-term note to get them by from today until a certain event occurs in the not-too-distant future.  These are often called bridge loans.  These are designed to bridge the gap between when cash is needed and the known event that provides the repayment on the debt. 

The most common type I have come across is a construction loan where another institution has committed to financing the finished product.  The borrower will need funds to have the product built and obtain the local authority’s stamp of approval, before the permanent lender is willing to take over.  If you have ever financed a construction loan portion of a SBA 504 take out commitment, you have done a bridge loan.  In fact, any temporary financing of the SBA 504 loan, construction involved or not, could be through of as a bridge loan. 

The loan should be underwritten assuming if the backside financing does not materialize.   Can the lender be comfortable in financing the entire project?  What happens if the 504 loan does not fund?  The lender should underwrite this as a backup plan.

The second type usually involves an order a company has received which is out of the ordinary.  There is typically enough profit margin or other future value for the business owner to consider the request.  Completing the order will require extra cost for material, labor, and overhead the company would not incur and may not have now, if they elected to not complete the order.  I worked with a road contractor who landed a large project with the state for highway work.  The work required additional resources outside of their existing operating line to complete the work. 

This required several points to analyze that one typically does not see with a standard loan.  First, can the company execute on the contract?  Does the company have a history of past experience with this type of work?  What if the contractor could not get necessary materials to complete the job?  What about work stoppages?  Proper permitting?  Could the lender have funds outstanding on the bridge loan when the company is not able to finish?

Next, can the customer, in this case the state, are they able to provide timely payment on the contract once completed?  The state may be certain to pay, though it may be slow.  A buyer in a weaker financial position may not be able to fulfill his obligations on the order. 

If the product is not produced or payment is not made, what other impacts will there be on your client operationally, financially, or reputation-wise? 

Each case requires the analyst to assess the back-up plan and underwrite that to terms of an acceptable loan in terms of structure, guarantees, and collateral.  If you cannot create a reasonable structure if the event does not occur, then you will have a problem loan if things do not materialize as planned.  If you cannot create a fall back financing plan that works, perhaps it is best to pass on the opportunity. 

The maturity of the loan should match the expected time of payment.  Don’t just look at a 3 or 6-month term.  If the payment is supposed to hit 101 days from the day of closing, select a term to match that to help the line police itself.  Since these terms are short and there may be a higher risk to the credit, the lender should charge a larger fee.  The interest should be on a variable rate to keep the margin intact.

Don’t go into a bridge loan without collateral.  Consider taking a negative pledge on the asset involved in the event.  Take additional collateral to shore up the risk and help prevent the borrower from leveraging other assets if the cash flow gets tight. 

When it comes to a bridge loan, the lender should remember Murphy’s Law, “If something goes wrong, it usually will, and at the most inopportune time.”  Given this, understand your backup lending plan, structure the loan correctly, get substantial collateral, and get paid for your risk.  In the end, you will be pleasantly surprised if things work according to plan and adequately protected if your bridge loan turns into a permanent financing vehicle.

Challenges with Seasonal Lines of Credit

Many businesses have seasonal variations in sales.  The firm may be characterized by building up a lot of inventory during the non-peak season, followed by high cash flow when this inventory sells.  One example of this is a retailer who builds up inventory to sell during the Christmas season.  This is why “Black Friday” is so termed because some retailers continued in a negative profit state the entire year only to turn profitable during Christmas sales, or moving into the “black”.

One example in the area we currently live is during the summer tourism season.  We have some businesses that are closed during the winter as tourism drops off substantially in the Black Hills as there are less winter activities to draw folks here.  We have some businesses which make all their revenue in a three-week period surrounding the Sturgis Motorcycle Rally!  Farmers and ranchers may also fall into this seasonal situation. 

Whatever the case that causes drags on the cash conversion cycle—from raw material to inventory to A/R to collections of accounts, or in service related firms where work is completed, operating expenses paid, and then receivables collected—a seasonal business may be best analyzed by focusing on the peaks and troughs of current assets and liabilities.  The cash conversion cycle does not matter as much for seasonal loans and the business may not even need to be profitable to repay a properly structured seasonal credit. 

Analysis of the seasonal credit requires a historical view of monthly cash flow, in addition to the standard annual financial statements.  A monthly budget is also required to determine appropriate line size and repayment time.  Therefore, we ask agricultural producers to provide us with monthly cash budgets.  Watch the levels of accounts receivable and inventory, key clients, marketing plans, and accounts payable levels and terms. 

In some cases, the appropriate structure may be to adjust the term credit to take advantage of high revenue seasons and have lower payments, or even no payment at all, during times when revenues are low or the business is closed.  This adjustment itself, may eliminate the need for a seasonal line.  If this will not meet the business needs, a non-revolving line of credit would be a good structure.  The maximum amount is determined by the peak borrowing need, plus a cushion for some unexpected operational expenses.  Maturity is tied to the point when the borrowing need is the lowest.  A retailer may have peak revenues during the Christmas season.  A farmer would have his peak cash revenue when he delivers his grain to the market.  By setting up the line maturity to match this event instead of just making it for a 12-month cycle, allows for the line maturity instead of the lender notes on his calendar to make sure the line is paid down.

If the borrower has other financing needs, such as equipment purchases or capital improvements, it makes sense to finance these outside the line or term out the purchases with a typical amortizing note.  Line advances may be based upon submission of invoices if you want to make sure the line funds are used for the proper purposes. 

The collateral should include all accounts receivable and inventory with further support from equity in fixed assets.  Monitoring inventory, work-in-process, and accounts receivable during the tenure of the line is good, but tying this to a borrowing base may be problematic.  In a typical seasonal line there are times stages when the amounts of inventory and receivables will not support the amount that is outstanding, even when the credit may be otherwise solid. 

The biggest problem occurs if the borrower is unable to fully repay the loan at maturity. This will require the lender to re-risk the credit as the assumptions used in underwriting the deal did not materialize.  It is important to not allow the borrower to remain in control at this point.  An example would be a farmer who refuses to sell his grain in hopes of getting a better price in the future.  Another is a retailer who uses funds that should have gone to the line, to open a new location that was not specified in the original plan. 

After the rating downgrade, options should be explored on how to handle the carryover portion.  This may include some or all the following: (1) liquidate the collateral, (2) sell other assets to retire the remaining debt, (3) convert the remaining portion to a term note, consummate with the collateral support, (4) move the debt from your institution, typically one that may be more asset-based, (5) infusion of additional cash into the business, and (6) guarantor support. 

It is important to look at other factors that may have caused or have a lasting influence on the business from the carry-over.  Were trade creditors paid timely?  If not, there may be a need for a larger seasonal line in the upcoming year if trade credit is curtailed.  When was the product liquidated?  Sales that occur during the end of a season may be discounted.  If the borrower cannot sell the product, how much better will the lender be at this?  Were there issues like machinery breakdowns, labor issues, or raw material costs hikes that prevented the repayment?  Were receivables collected from purchasers and do they remain collectable?  Was the loan used for non-seasonal operating expenses like asset purchases, repayment of other debt, or distributions to owners? 

The close examination of the reasons behind the failure to repay the seasonal line will assist the lender in a path to correct the situation. This must be fixed as the borrower may need another seasonal line to operate in the upcoming year. 

Challenges with Operating Lines

One of the most common causes of borrowing for a business is an operating line of credit.  Here, a company or farm will borrow money to continue business while time passes in the cash conversion cycle from the time a product is created, through the sales cycle, and to the time that cash is received from the company.  Often, this cycle can have times when the cycle “sticks”.  Perhaps this may come from waiting for the crop to mature or for the collection department to get payment on an outstanding invoice. 

In a perfect world, these operating lines are paid down to zero at some time during the cycle.  Maybe this is after the crop is sold or during a slow time of sales but high time of cash collection.  Many times, this is not paid completely to zero but is paid down to a certain level.  Operating a business creates a level of operating cash that is just needed for the day to day activities.  Expenses occur each day and do not always match up with the timing of cash received. 

If you were to graph your client’s operating line usage, you would be able to tell where is an average minimum usage.  This level can be considered as permanent working capital.  The business needs this money to operating no matter what happens.  It may be desirous of the lender to eventually have the borrower wean out of needing the permanent working capital over time.  Perhaps this is done with an amortizing note. 

The fluctuating usage of credit over the permanent working capital is the temporary working capital.  This will go up and down over time and ideally it would get paid down to zero.  But what happens if it does not?  This may be an event that happens in the real world. 

One analysis that is done is to assume the unpaid line of credit is fully advanced and termed out.  The debt service on the line is run through the normal debt service calculation as shown below in the companies below.

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In this case, Barely Alive will make their debt payments, but not be able to meet a standard 1.25 debt service coverage ratio (DSCR).  Now there is a temptation for the lender to extend the amortization on the line of credit to make the ratio better, but that is not always the wisest move.  Also, some of you will note the 6% interest expense and think that is too high.  It is time to realize that interest rates are marching upward.  Prime interest rate, which is defined as the base interest rate for short term lending to the strongest bank customers, is currently at 5%.

Another method to look at the line is to figure how long of a repayment period would be needed to retire the debt completely and stay within proper DSCR thresholds.  Consider our example:

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In this example, it will take Barely Alive 8.33 years to retire the principal on the line of credit, while Living Large will have this completed before a year cycle is over.  This calculation can be looked at over several cycles to get an average performance.

The answer here is not to just extend an amortized line to keep DSCR acceptable for Barely Alive.  It may be very possible that in the next 8 years, they will need another operating line, or several to continue.  I would say that it may be time to become defensive in lending and find ways to take additional collateral for the line or get the owners to put in more equity into the company to retire the outstanding line.  In some cases, you need to just ask Barely Alive to find another lender while they are still alive.  Sometimes that lender in your community who is very hungry to build new business, may be your best friend as you refer your future problem to him. 

Doing a rough calculation on the repayment period contrasted with the current or average performance of a company may help provide some prospective when stronger covenants, more collateral, or a more disciplined approach should be applied.

Keeping Up with Ag Credit Risks

One of my commercial lending buddies had an interesting side hobby.  He set up giant fireworks displays for communities and commercial use.  He was part of a larger team that you would see the incredible results over displays on July 4th. 

He did take his job seriously and detested telling people that he set up fireworks.  He preferred the term “pyrotechnic engineer”.  He had a tennis ball yellow shirt that had on the front, “Pyrotechnic Engineer”.  The back read, “If you see me running, you’d better keep up!”

Today in our agricultural market, there are several credit risks that we must keep up with.  They are as dangerous as the man streaking by you in the yellow t-shirt and if not managed, could result in the detonation of your producer or serious explosive damage to your institution.

One of the most dangerous areas is international trade.  Today, 20% of our farm income is driven by exports.  As the U.S. seeks to obtain fairer trade deals, we tend to expose one area where we are a net exporter, agricultural products.  NAFTA represents 28% of the entire world economy and many people who have money.  We have $20 billion of exports to Canada.  Mexico has $18 billion of exports last year in a country that has 47% of its population under 25 years old.  China is another key ag trading partner with $30 billion in potential. 

In each case, we should expect volatility, possibly extreme at times as new talk of tariffs and trade deals are announced.  It is important for the lender to preform sensitivity analysis on their ag and commercial loans to see how far prices may fall and keep the farm above water. 

The next roman candle of risk is with the oil and energy markets.  The 9/11 tragedy set in motion the wheels of the U.S. becoming more energy independent.  This began a drive toward more efficiency, exploring new energy sources, and a growth in alternative energy as well.  Today the U.S. is the number one energy producer in the world.  Canada ranks #6 and Mexico is eighth.  We also sense trends on the horizon to move away from the internal combustion engine and to electric vehicles.  This move will cause areas that have rare earth metals used in batteries, such as Central Africa, to become the new Saudi Arabia.

In agriculture, nearly 80% of all production expenses are impacted by energy.  Every recession since the 1960s has started off with a spike in oil prices.  This risk may be a bit muted now as we have seen a sharp increase in oil prices since 2016 and yet we do not see a huge increase at the gas pump.  Oil price increases may not create the negative impact it used to as we are now able to export oil.

The U.S. economy is another risk.  We are currently in an expansion that is over 100 months and is nearing the all-time record in length.  At some time, we would begin to expect a correction and the Fed is certainly concerned with possible inflation, low unemployment, strong consumer sentiment, and the overall strong growth in the economy.  Some major factors impacting this are the renewed enthusiasm in business with the recent Trump cuts in taxes and governmental regulation.  People are more hopeful today overall.  This leads people to feeling better about themselves financially and this leads to more consumer spending. 

The strong economy leads to a strong dollar and add in trade issues, leads to low commodity prices.  Also watch future rate hikes that are based upon more urban and costal economies, but do not look fully at the impact of the rural producer.  As I write today, Prime is at 5%.  This is 1.25% higher than what it was just 18 months ago.  Consensus is that rates will go up another 50-75 bps this year. 

The average of Prime is at 6.5%.  If Prime just goes to the average from where we are today, operating lines will cost 30% more in interest than they do today and about 73% more than what they did 18 months ago.  This may be disastrous for a producer who is at best marginally profitable.  The guy in the yellow shirt is streaking by financial institutions who fail to recognize the impact that increasing rates have on their balance sheet as their net interest margin will be sorely compressed.

The final keg of TNT to be careful of is land values.  Years ago, I heard an examiner, of all folks stated, “if you have the dirt, you can’t get hurt.”  Clearly today, this complacent attitude toward land prices is like ignoring a lit fuse.  Land prices have historically showed resilience.  We are seeing a trend that land valuation will be more based upon productivity, availability of water and minerals, technological compatibility, and the impact of organic, local, and natural markets.  Other factors are the increasing aging of the producer and lack of generational transition, availability of affordable operating and equipment financing, and cyclical downturn in land prices, which may occur.

As you lend to farmers and ranchers today, the yellow man is racing by you.  The question is how can you keep up? Closing your eyes as you feel the breeze after he runs past is not a viable option.