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.

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.   

The 6 D's of Distortion of Credit

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

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

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

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

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

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

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

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

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

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

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

Elimination of Entry Level Jobs

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

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

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

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

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

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

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

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

Wisconsin did not follow Minnesota’s example.

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

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

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


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

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

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

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

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

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

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

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

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

The Tax Cuts and Jobs Act Impact on 1031 Exchanges

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

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

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

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

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

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

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

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

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

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

Will Trade Create Trouble or Treasure for the American Farmer?

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

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

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

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

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

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

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

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

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

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

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

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

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

Small Business Week and Commercial Lending Approvals

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

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

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

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

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

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

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

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

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

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

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

Inflation and Rising Rates

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

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

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

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

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


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


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


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


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


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

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

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

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