Is Development Slowing on the Horizon?

In most core and secondary U.S. real estate markets, new development and leasing activity growth is slowing due to factors like stock market volatility, uncertain interest rates with a slightly inverted yield curve, the waning impact of tax cuts, rising wages, labor supply shortage, and fatigue after a record-setting period of economic expansion.  Globally, economies have stagnated in Europe and even China is showing signs of slowing. 

One factor is companies seeking new locations.  We see this with Amazon and Apple expansions that impact Northern Virginia, Nashville, and Austin, Texas.  The massive growth effects here will be localized to areas where there is large company and government growth.  We expect to see some growth in the Black Hills area with the new B21 bomber moving to Ellsworth AFB.

Another factor are companies moving from higher tax and regulated states to those where it is more affordable to live and easier to operate.  McKesson Corp. recently announced it was moving its headquarters from San Francisco to Dallas.  The company cited low taxes, affordable housing, good schools, and a business-friendly environment as reasons for the move.  With the new tax laws in place, residents of high tax states like New York, California, and Massachusetts are considering relocating to states like Texas, Florida, Tennessee, and the Carolinas where taxes are lower.  Since as a country we are at full employment and have the lowest unemployment in two decades, companies may select areas where it is easier to retain employees.  Low taxes and regulations and good community amenities are factors.

When considering various sectors of commercial real estate, industrial, senior housing, and manufactured housing are going strong.  Most of the primary industrial markets in the U.S. have vacancy rates under 5%.  In all the port cities and large metros like Atlanta, vacancies are under 2%.  Low vacancy rates are driven by a revitalizing of manufacturing and consumer spending and e-commerce.  Retailers reported e-commerce sales jumped 26.4% around the 2018 Thanksgiving holiday compared to the previous year.  As e-commerce continues to grow, strong demand in industrial will come from the need to warehouse products. 

Multifamily and hospitality are seeing rising construction costs.  Currently, some of these are hitting 12% annually.  Office markets are mostly flat nationally with some markets like Houston, New York, and San Francisco as exceptions.  Companies that are adding office related jobs are also shrinking space needs per person.  Work benches, open cubicles, creative spaces, and in some cases the ability to work remotely using a VPN network are all lessening the office demand space per person. 

Nationally, retail development has stopped.  Malls are experiencing large vacancy rates and bankruptcies.  In recent years hundreds of malls have closed as major retailers have closed with a combination of changing purchase habits and high debt loads.  Some retail areas that are doing well are smaller neighborhood, food-anchored shopping centers, home improvement stores, furnishings, and off-price stores like TJ Maxx and Ross Dress for Less. 

Self-storage real estate sector rebounded in 2013 and is breaking record valuations in 2015.  This type of property is seeing strong demand among lenders with a new national increase of 8.7% over existing supply according to MJ Partners Real Estate.  Some areas are seeing double digit increases so there may be some concern with overbuilding.

Some secondary and tertiary markets are seeing strong growth.  Salt Lake City, Orlando, and Central areas in Florida and Wisconsin are all strong demand with interest that has not been seen in years.  So as the old adage for success in real estate is based on location, location, location continues to be true.   Other factors, as they always do, impacting commercial real estate, are the availability of equity and debt capital, and inflation of material prices.  A new issue this year is if the accounting regulation changes for handling of leases will have an impact on demand. 

The lender and investor should understand the current forces in the market nationally but really needs to understand the local trends in his own area.

5G Technology, the Next Industrial Revolution

Most of us have heard of the upcoming advance of the 5G network that is touted by cell phone providers.  But do you know what this is and how this could change our everyday lives? 

The “G” in 5G stands for generation.  The first generation was the ability to have sound on cell phones.  Some of you may remember your first cell phone.  Mine was in a bag the size of a small suitcase, with an attached antenna that went on top of my car attached with a 10-foot long cord to the carry-on bag.  Those were the days!  The second generation gave us the ability to do texts.  Third generation gave us the internet on our phones and surfing the web.  The fourth generation took all the previous three and made the system around 10 times faster. 

5G takes the 4G data and now accelerates the speed by ten-fold.  4G can download info at around 2 gigabytes/second.  5G can download data by 20gb/second or quicker.  The Chinese company Huawei claims that an 8gb movie that took 7 minutes to download, can be downloaded in 6 seconds in a 5G environment.  Basically, 5G communicates in real time with a lag of one millisecond.  The ability to transmit and receive data live and in real time provides huge opportunities.  Driverless cars would have the ability to know what all other vehicles on the road are doing.  Remote doctors could consult real time with medical specialists all around the world as they work on a patient.  Remote rural communities can have the same access to information as those in large, well-wired cities.  The possibilities with transmitting data immediately are endless.  Some have called this the next industrial revolution. 

5G technology requires an entirely new infrastructure.  The signal connects with computers with more of a line-of-site and has a much shorter distance than what we have with 4G.  As such, more 5G transmitters, which are about the size of a notebook, would have to be installed every few hundred yards or so to have a solid network.  The large US cell carriers are expecting to have 5G networks available in large scale by 2020.  Samsung is seeking to open 5G throughout South Korea later this year.

This industry is huge and could eclipse $1.26 trillion in size by 2026.  China is the fastest growing country in implementing 5G.  GSMA estimates that by 2025, China will have 40% of all global 5G connections which could be up to 3.2% of China’s entire GDP, 8 million jobs, and 2.9 trillion in yuan by 2030.  Spending in R&D by Huawei on 5G is more than 3 times the combined 5G R&D spending of the three major US equipment manufacturers.  China’s spending on 5G is a large part of their “Belt and Road” initiative to link China with various countries throughout Asia, Africa, and Latin America.  China is also providing equipment to 60 different countries. 

Newt Gingrich has a wonderful podcast called “Newt’s World” which I would encourage you to listen.  In one of his latest episodes, he had General Robert Spaulding, a former Senior Director of Strategic Planning for the National Security Council.  One concern that was brought up is the impact of big data and technology privacy.  5G will provide data that anticipates what you want and need.  Some may think it would be OK for their connected refrigerator to send a message to your phone to pick up eggs since you are low.  Personally, I still think that is a bit weird.  Next my fridge will criticize me if I sneak down for a midnight snack!

But, what do you do when a totalitarian regime with control of some 5G network uses data available on you to influence people around you in ways that you did not intend?  What if various “artifacts” could be left on the web that could cause a breakdown of social order?  If nefarious people control the data, they may be able to have the same impact as weapons of war have without ever firing a weapon.  What if the manufacturer of your equipment refuses to allow you access to your money unless you agree to their views on things? 

True, there are security and privacy risks that must be mastered.  5G has the potential of revolutionizing our lives.  The challenge is how do we get a network developed when private sector companies still have 4G tech investments to work through.  They also are subject to the shareholders and the performance quarter by quarter.  In the past, the government sometimes sees this as the responsibility of the private sector.  Yet, we are in a tech race that rivals the space race that started when Sputnik went into orbit.  The country that dominates 5G technology and prepares for the next generation after that, can dominate militarily, economically, and in sheer knowledge.

Opportunity Zones vs. 1031 Exchanges

For years real estate investors have enjoyed and understand the benefits of the Section 1031 Exchange program.  This allows the capital gain from a sale of business or investment real estate to be deferred with the reinvestment of proceeds into another like-kind property.  Like-kind is very broad when it comes to real estate, as this means any other piece of real estate used for production of income. E.g.  an apartment sale can 1031 into a track of vacant land or an office can 1031 into an apartment. 

In the Tax Cuts and Jobs Act of 2017, code 1400Z-1 and 1400Z-2 created qualified opportunity zones to encourage investors to move money into economically distressed areas of the U.S.  This investment may allow taxpayers to defer or even possible exclude any capital gains from taxation.  The opportunity zone refers to investments in a Qualified Opportunity Fund (QOF), which has been established under the code and regulations. 

There are several differences with the 1031 and QOF in terms of the investment characteristics.  The QOF can defer capital gains from any assets, can use any funds, and only are required to invest the gain amount.  The 1031 requires the exchange must be like kind in nature, funds must be tracked to purchase the new property, and the new property must be equal, or more than the value of the property being sold.  The QOF allows you to invest only the gain you have on stock into an approved fund without any capital gains.  The 1031 would require you to reinvest the $1MM of value you sold the office building for to another piece of real estate of $1MM or higher in value. 

The QOF Investment (QOFI) can be into any qualified QOF.  The 1031 has strict rules such as the 200% rule, three property rule, and 95% rule.  The QOFI allows for capital gain reduction of up to 15% after a 5-7-year hold and 100% after a 10-year hold.  This effectively makes the capital gains on the investment tax free.  The 1031 has no capital gains reduction, only a deferment of taxes due to a later date. 

The 1031 has 180 days to identify and close on replacement property.  Advance notification must be made for replacement property prior to closing.  The QOFI does not have the same limits.  The 180-day period may be just the beginning for the QOF to invest funds and even longer for electing partners in a partnership that did not make such an election.  The QOF also requires no advance notice prior to investing.

The 1031 allows you to defer the gain on the sold property indefinitely.  The QOF deferral is only until 2026.  In that year, investors will have tax on corresponding income.  The 1031 is broad in allowing you to invest in any other real estate used for income, while the QOF must be in an approved QOFI.  The 1031 investment may not require additional investments while the QOF may need more improvements on the property. 

The 1031 provides great flexibility to finance, sell, or exchange the replacement property after purchase, whereas the QOF may have some lost benefits if not held for 10 years.  The QOF starts the 180-day clock when capital gains would otherwise be recognized and there is no indication that an investment be entered into before that time would benefit from this election.  The 1031 allows more flexibility here with the possibility of a reverse 1031 exchange, which allows the investor to purchase the replacement property first and then sell the disposition property, while still enjoying the deferral. 

These outline just a few differences between the 1031 and the QOFI.  The real estate investor should consult with tax advisors and other professionals to see which one would sever him best in the current situation when considering some deferral of capital gains taxes.  The analyst should have a knowledge of both programs when completing analysis on these types of properties. 

What Sport is Your Business Playing?

One of the fundamental needs of a business is for all to understand and buy-in to a common goal.  That is why organizational planners have companies set out a common mission, vision, and values.  It is crucial for success to have everyone understand these, or else, it is like aiming at whatever target the team member thinks is best at the time. 

But even when there is commonality of mission, vision, values, and goals, undue friction and conflict may crop up.  Some of this is due to the normal growth patterns of a business, organization, or a church.  As growth increases, complexity increases and the rules of the game change even though the goals may stay the same.  To illustrate, I will use the analogy of sports.

Track is a sport where you practice with others, but you perform alone on most events.  Your goal is to beat your personal best every time you are there.  Sole entrepreneurs are like decathletes.   They may go to conferences and seek advice of others, but ultimately, they are the ones selling the product, answering phones, completing orders, administrative work, and dealing with customer complaints.  Here the limit is how good you can perform each event of the decathlon.   When I first started with Pactola, I was the only person here.  I looked for loans, developed new business, was the IT department, web designer, main underwriter, policy drafter, and HR department.  I was a jack of all trades, but a master of none.

As a business grows, it will move from a decathlon to golf.  Golf is often practiced alone but played in a foursome.  It is highly relational but is performed alone.  The relational factor is why so many business meetings are held on a golf course.  Your performance, though alone, is seen by everyone in your group.  These events are often recounted back at the clubhouse where all the good and bad shots are replayed over refreshments.  A golf organization is one where everyone knows about everyone else’s life. 

As business grows, it will move from golf to baseball.  Baseball is highly relational but begins to have a division of roles or positions.  You have pitchers (starters, middle relievers, closers), infielders, outfielders, utility players, designated hitters, and coaches.  Each of the roles are unique but are highly dependent on each other.  While everyone knows what everyone is doing on the field, not everyone sees everything about each fellow teammate’s life.  Organizations will grow beyond the baseball stage, but players may get stuck and complain that they don’t know everything anymore that they used to.

The next stage of organizational growth is football.  Here the team is so large it may not travel in the same bus together.  Football is divided between offense, defense, and special teams.  Only one of those divisions is representative of a team on the field at any one time.  Each of these divisions also have their own coaches and then assistant coaches for various positions, such as a quarterback coach, receivers’ coach, and offensive line coach.  All the coaches report up to one head coach.

Here not all people know what the others are doing.  The special teams do not get upset when the offense sets up a new pass play.  The quarterback should not be tweaked when a defensive coach shows a new technique to the linebacker and does not include the QB in the training.  Large organizations are like a football team where players may have a general knowledge of the execution of plays of all areas of the team but not a highly specific understanding.  And that level of understanding is OK.

Undue friction may come when a group moves from one sport to another, or where some players on the football team may still be back at the golf stage in the business execution and may yearn for the good ole days when the group was small, and everyone was a close friend.  Maybe you are a small business who is trying to divide up as a football team, when you really need more relational interaction and team execution as a baseball team.  The leader needs to watch for and be aware of players who may be stuck in one sport when the organization has grown in complexity beyond the sport stage they are stuck in.

Look for a sudden increase in low-level frustration.  Maybe Linus in accounting, was upset that Sally did not tell him when she finished the website changes, when all this used to be discussed in the past.  When people who once knew all are now not knowing all, they may feel left behind.  This may just be a part of the natural growth of a business.

Next watch out for meetings that go to long.  People often are getting involved in things they don’t need to be a part of and which are not part of their roles.  I often joke that I have two rules for meetings that come from my Southern Baptist roots.  (1) all meetings should be 20 minutes or less and (2) if you violate rule #1, bring food!  The corporate meeting is often the main roadblock to productivity.  Treat the minutes spent there as precious knowing you will never get any of them back.

Lastly, watch out for an increase in a team-members hurt that results from mis-communication.  As a company grows, especially from the highly relational stages to those which are not as relational, the lack of sharing in some areas which used to be common, may be only because the group has grown to the next sport level where roles take you away from the intimate golf stage. 

The highest performing organizations have shared missions, vision, values, and goals.  They also have team members all playing the same game. Leaders need to be aware when the complexity in the company has caused the game to change and help bring along those who may be stuck playing an old game.

The Power of Collaboration

Today as I write, is the first day of Spring, my younger son Josh’s birthday, and a mere 8 days away from the opening day for baseball season.  These events that mark spring are much anticipated by me and many others.  I thought about these events a lot while trapped in an airport because of a blizzard.  My only hope now is that we have seen the last winter storm of the season!

As I, along with many others were able to experience more of the amenities at the Minneapolis airport on this last trip—more than I ever cared to—it did give time to ponder the credit union industry after the recent conference I had attended.  One theme that is evident in this industry more than others in the financial arena is collaboration.  In my career in finance, I have worked for savings and loans, banks, insurance agencies, and now for credit unions.  Of all of these, I have found credit unions to work together the most for common goals. 

I think much of that is ingrained in the credit union DNA.  From the beginning, credit unions that started in factories realized they would be stronger if more worker-families used the credit union for their financial needs.  Community-based credit unions realized they could server more people when more people in the community joined.  With this natural bend toward financial services that benefit the entire group rather than those driven by profit to the shareholder, it seems natural that credit unions would join with other credit unions to conquer common problems.

This is quite evident in our institution, a credit union service organization or CUSO.  From what I know, there are no banking service organizations or insurance collaborative companies.  Yes, all financial sectors do have common trade groups or user groups with different vendors, but none have groups like a CUSO, where its credit union owners have vested ownership and a stake in making the CUSO successful, which in turn will help make the owner credit unions more successful in one area or another. 

The CUSO model also embodies the spirit of collaboration.  Individual CU owners who are vested with the CUSO will make decisions that may not be the best decision for their individual CU but will benefit the CUSO.  The short-term sacrifice will turn into better long- term gains for the industry and for the individual CUs.

We see this a lot as we work with the collaborative power of funding large commercial loans.  Some of these could not be individually funded by one institution and they need the help of others in the funding.  The institution that purchases a portion of a commercial or agricultural participation will receive a higher yield than other alternative investments.  This provides more earning benefits to their individual membership. 

But the purchaser provides much more benefit than just higher earnings.  They help the selling institution win the deal.  This makes the seller a more viable financing option for future business loans by others in their community.  Helping here strengthens and builds up that credit union.  This helps to strengthen and builds up credit unions as a whole.  More business owners and farmers will see working with a credit union for their financial needs as a viable option when they hear of fellow businessmen who have gained financing for their building expansion or new land purchase through a credit union.

The loan buyer benefits from this increased awareness of the credit union option.  They also could benefit from the present CU seller helping them when they have a large project that needs to be funded.  This collaboration is shown when we help our brother and sister institutions.

The collaborative benefits extend to the CUSO which can provide and service more accounts and help facilitate more loans with servicing income earned from managing each credit.  The income also allows the CUSO to expand its services in its support of credit unions.  Again, the power of collaboration is evident throughout this model.

As an individual CU, how have you reached out beyond your group and collaborated with others?  This brings the possibility of new ideas, new members, and new business for all of the group which will allow your individual CU to grow beyond all efforts solely done on your own.

Business Owners:  Open Your Eyes to Business Lending at a CU!  CUs:  Open Your Eyes to a CUSO!

This week, I had the opportunity to attend the Credit Union National Association’s annual Governmental Affairs Conference.  One of the themes this year is to improve the credit union brand across the nation.  Many people know that we exist, but 72% of those who know about CUs and do not use our financial services, would not consider a CU to be an option for them. 

I bet the percentage would be even higher if you asked the general public about if they would consider their business needs with a credit union.  That number of those who would not consider a business loan at a credit union as an option would be even higher still.  Unfortunately, many in the CU industry also don’t realize that the CU can be a resource to help small businesses and agricultural producers.  Too many times I have heard CUs turn down good business opportunities because they don’t do commercial loans, or the loan is too big, or the business is too hard to understand.

It is time for credit unions, members, and those-who- are-not-members-yet-but-can-be to open their eyes to the possibility of a business relationship with a credit union! 

It is also time for credit unions to open their eyes for the collaborative resources of a business CUSO!

Let’s say you have no business department but want to begin to serve small businesses in you community.  Perhaps you want to help business owners employ more people, make more products, and create wealth—but you don’t know where to start.  Open your eyes to Pactola, as we can help create the structure for a business department with policies, procedures, and best practices. 

Perhaps you already have a business department but are short on staff.  Maybe it is for a short season or perhaps it is a longer season of time as you have good field lenders but not enough back office support.  Open your eyes to Pactola as we can help with underwriting, document preparation, risk reviews, and government guaranteed lending. 

Maybe your department is very good at either commercial or agricultural lending, but not at both.  Your community and membership base are in need of you servicing both areas well.  Open your eyes to Pactola as we work with both credits to finance farms and businesses.

Another scenario is that your CU has decided that utilizing governmental guaranteed lending is a good option to increase your reach, while managing your risk.  Open your eyes to Pactola as we can help with SBA, FSA, and USDA Rural Development guaranteed lending.

Your biggest business member just got too big for you to handle.  The company brings in the opportunity to finance a $25MM commercial real estate project and you have only the capability of taking 10%.  The project is strong and has great cash flow.  Don’t turn them away!  Open your eyes to allowing Pactola to underwrite, syndicate, and manage the credit on our participation platform for you!

Loan demand may be slow for you.  Don’t worry!  Open your eyes to the possibility of helping your CU brothers and sisters finance projects they are part of by taking part of one of our loan participations. 

Financing businesses, farms, and ranches is a great way to impact your community by creating jobs, growing wealth, and making the dreams come true for the owners.  It is time for the CU to open their eyes to making a difference and for members and future members to open their eyes toward a CU as their trusted business financial partner.  Our CUSO, Pactola, can help get you there.

A Closer Look at Profitability of Loan Types

Auto loans across all credit unions totaled $30.4 billion, compared to $7.2 billion in commercial loans in the third quarter of 2018.   One of the most popular loan investments among credit unions for years has been the auto loan obtained through indirect lending.  For those of you not familiar how this works, a lender will set rates for new and used auto loans.  These rates and terms are provided to car dealers, who are hungry for outlets to finance their vehicle sales.  Many CUs have used this as a strategy to gain higher earnings than other options.

The process may vary a from institution to institution.  Typically, the buyer will complete an application at the dealer’s desk and the finance manager at the dealer will review multiple options of lenders who provide their interest rates to the dealer.  These usually will come with some form of incentive from the lender to send the paper to them.  The interest rate the borrower will receive is usually based on their credit score, LTV on the vehicle, and debt ratios.  Competition for this credit is fierce, with at times the major auto producers offering 0% finance rates, from time to time, when they need to move inventory.

Let’s look at an example from a CU in the Midwest. We will call them Car CU.   As of early 2019, they were offering interest rates of 3.75% fixed for a five year fully amortized auto loan for their highest credit rated customer.  To get this loan with the dealer, they must provide a benefit of 0.50% back to the auto seller. Now we have a net rate to the lender of 3.25%.   Most of these people also have no relationship with the Car, or they may have gone to their Car first, as we hope.  So, these loans will come with a typical nominal account to obtain membership.  Car also has little control over the interest rate as all members who fall in a certain profile get a certain interest rate.  So no differential can be made for differences in market areas and other factors. 

Let’s assume the Car writes $1,000,000 of these loans at an average loan of $40,000, which would give us 25 loans.  Over the first 12 months, this package of loans will have an average outstanding balance of $900,198, assuming a 5-year term.  Loan serving expenses and loan losses from auto loans averaged 30 and 60 bps in Q3 2018.  Multiplying this by the average balance gives expenses of $8,281. 

Car CU lines up with the median cost of funds in the industry of 0.30%.  Now, this issue is another blog as I contend that an accurate measure of loan profitability is not using the cost of funds for the CU but using an index like U.S. Treasuries or FHLB Advance rates.  This view assumes the CU must go out into the market to fund the loan with borrowing the funds from at the market.  This helps focus on the net spread using a matched fund principle.

For this example, we will go with Car CUs cost of funds.  Now we have a net interest rate of 2.95%.  Over the first year, Car will earn a net interest of $28,966, after factoring out the cost of funds.  Taking out the loan management costs of 30 bps and loan loss of 60 bps will produce a net income of $20,685.  These new loans will produce a ROA of 2.30% ($20,685/$900,198) from this loan package. (Note the loan servicing expense and loss provision are averages for the industry in the third quarter.)

Let’s consider other loans.  Since we work with commercial loans, I will use Business CU lending $1,000,000 on an equipment loan with the same 5-year term and amortization.  We recently looked at a new loan on a highly qualified credit at a net rate of 5.33%, after our servicing expense.  This is around 2.8% over the current 5- year UST rate.  Now after the average cost of funds, Business CU has a net interest margin of 5.03%.   The average balance on the loans in year one will be $904,310.

Servicing expenses are very small since most of the loan servicing tasks of credit review and payment processing has been handled at the CUSO level.  In this case we will assume 10 bps.  Loan loss risk is higher and averaged 75 bps for commercial loans in the CU industry for 3rd QTR 2018.    This gives us 85 bps of servicing and loan loss expenses or $7,681.

This credit will produce net interest for Business CU at $48,961.  After the cost to manage the credit, the net income is $41,280.  This gives a ROA of 4.6% ($41,280/$904,310).  If Business CU had the relationship and required deposits which averaged $50,000, the ROA on the relationship would increase around another 100 bps.  This is because these deposits represent free money to the CU.

Clearly, the higher yield is with the commercial loan.  The ROA from those relationships of 4.6% compared to 2.95% is a no-brainer.  Now there are higher risks with more funds concentrated into one commercial loan than 25 vehicle loans.  But, the business loan borrower would be better known to the CU compared to the vehicle loans where the application is filled out in the finance department of the dealer.  A finance department that has a vested interest in, at times, in putting down what is needed to have the loan approved. 

Now actual ROA calculations on these loans will vary from institution to institution.  My figures here are based solely on call reporting averages and there may be other factors or costs involved in your shop.  But basically, the NIM and ROA on a commercial loan are much greater than what you pay for indirect auto.  If you want a higher yield on the indirect, you would increase the risk in the loans by going to C paper or lower. 

Also, note that I made a comparison between two loans of the same amortization.  The larger balances for Business CU will probably be in commercial real estate.  Here the rates will be lower, but will still be much higher than Car.  Also, the amortization will be longer, so the interest earned will not take as much of a hit.  The average car loan has a 3 year term and an average business loan has a 5-7 year term in the credit union world.

There may be a place for both indirect and business loans in the CU world.  But if you are thinking that indirect auto lending is the ultimate salvation to a sagging ROA, think again.  The results are dwarfed by a good commercial loan.  Indirect lending should be used as a gateway to get a bigger share of the banking wallet for those 25 new members, instead of just the $25 share membership.   A good business lending program must be added to increase yield while deploying capital in larger pieces which will make a bigger impact in their communities, providing increased employment and helping people achieve their dreams. 

Our CUSO has a mission to make those CUs we work with successful in the commercial and agricultural lending arenas.  Let us help boost your ROA and success.

Creating a Good Team by Watching the Door

A good friend of mine was appointed to a board position for a charity.  At the time he joined the board, two other members left due to term limits.  These folks were replaced by two gentlemen who each represented small fund-raisers that was held annually for the charity.  The new members and my friend settled into their new roles. 

Within six months, the board had turned to a complete state of incompetence.  One of the new members, who was an absolute rock star with the yearly gala that he ran, made everything about his annual fund raiser which provided about 10% of the annual revenue.  The other gentlemen spent most of his time fighting any new idea that came before the board since it was unfamiliar with how things were run in the past.  Others on the board ran with their own ideas and promoted those to the extent that no unifying mission could be executed by the board.

The problem began with the two new individuals who were allowed into the leadership group, not because of their ability to add to the team mission but because they successfully ran a fund raiser or had history with the charity.  This shows how you must watch the door because if you allow the wrong person into the room, it is very hard to get them to exit. 

The first step to watching the door is to speak up on the front end.  When you are afraid that a new potential team member will not work out and you can speak up, do so.  If you don’t speak up on the front end, you do not have a right to complain on the back side.  My friend knew the gent who was encased in the past.  He should have trusted his gut when it came to his analysis of people.  Watching the door involves courage.

Next, pick leaders and not representatives for to get into the room.  Remember you want a leaders on the team that work together toward common goals and not a just a house of representatives.   Have you ever been part of a group charged with oversight on an organization that had leaders made up totally of representatives?  Representatives tend to break into their own silo to serve their own constituency, instead of the good of the organization.

People should be let into the room because they fit the needs of the team.  You may have absolute stars that you are bringing in who may be just like people you already have in the group.  A baseball team does not win with a full roster of 25 great first baseman and no other infielders, outfields, or pitchers!  So, how do you determine who will be a good fit for the team.

First, consider character.  Avoid people with poor character, or who are untrustworthy.  Also, how well does the candidate work with others?  They will need to pull together as part of a team.  How flexible are they?  Moving for the good of an organization may require the ability to change when change is needed.  Can they do that?

Next, does the potential leader have philosophical unity with the organization?  All need to understand their role and execute in that direction.  If you want to form a restaurant that can provide an excellent five-course dinner, you don’t hire three bakers who can produce the best desserts.  What about the rest of the meal?  The philosophy and core value need to be the same.  There needs to also be a passion for unity.

Lastly, consider what personality or roles you need now in the group when figuring if you need to allow someone new in the door.  If you have a lot of high performers who are very vocal and highly execute on the mission, perhaps you need a quiet person who is a high-level thinker and can plan efficiently.  If your team needs someone who is great in Excel to complete analysis, consider a spreadsheet expert.  If you need new ideas that are outside of your industry to reach new folks, consider a skilled outsider to enter the room.

Much pain can be avoided on the team for months and years ahead if the door is guarded and admittance is allowed in a well-thought and strategic way.  Allowing the wrong person in can cause a tremendous amount of problems.

Why Your Cost of Funds is Not Your Cost of Funds

Accounting tells us that any asset is funded by a combinations of liabilities and/or equity.   If you ask any CEO or CFO of an institution they can usually cite their current average cost of funds of their institution.  This would be the average cost paid on deposits and capital that are then used to fund those assets or loans. 

For the past decade or so, with both short term and longer-term interest rates being low compared to levels seen in the 1970s-early 2000s.  Rates have been comparatively stable.  These stable low rates result in a very low cost of funds when looked at on a snapshot basis.  The question is if this is a correct manner to view your cost of funds.  After all, understanding your cost of funds is the first step in building the interest rates that will be charged on the loans.  The loan rate should be figured by taking the cost of funds, figuring an adequate margin which considers loan interest rate duration, loan loss reserves, and management costs.  I have seen some shops that subscribe to a logic of identifying the static net interest margin as they compete for loan deals with super-low interest rates.  This is often done without any consideration of the cost of managing the credit, booking and maintaining the loan, and loan loss reserve expenses. 

I argue that a simple snapshot view of your current cost of funds is not the best way to form the basis of your institutions cost of funds when forming the basis for the interest rate you will charge on your loans, today.  The global interest rate environment has been so low for so long could deceive you to understanding the cost of funds in the future.  One problem with history is that we tend to stay in our short attention span and make decisions in that scope without considering a longer-term view of where rates have been in the past.  As rates increase and the overall cost of funds rises, looking at your static cost of funds which have been so low for so long, will miss the expected future increases in the near term.  Even if rates stay where they are now, your cost of funds will increase as many non-bank and non-traditional banking sources will become an attractive alternative for many of your customers to move some of the 0% earning deposits that you have enjoyed for so long.  This may force you to begin to compete on rate for deposits, which raises your cost of funds.

Early in my commercial career, I learned the concept of pricing using a “matched fund” method.  This strategy assumes that you have no money on your own to loan.  You must reach out to some source like the US Treasury or FHLB in order to fund the loan.  The loan funding term will match the term of the pricing on the loan, i.e. a three-year ARM would be tied to a 3-year US Treasury, a five-year balloon would be tied to the 5-year FHLB rate.  The net interest margin (NIM) spread is the difference between the interest rate on the loan and the underlying cost of funds. 

Pricing loan using matched funds to determine the NIM gives a truer picture of the actual cost you would incur to fund the loan.  Tying adjustable rate loans to a similar index in maturity also give you a picture of your cost if you were forced to borrow funds when the loan matures or adjusts to re-fund the credit facility.  This is basically focusing on the margin pricing. 

This pricing strategy may increase your overall yield on the loans if you are currently figuring NIM on a very low static cost of funds.  It should help your earnings comparably to the static view, especially when involved in a low interest environment with possible increasing interest rates, such as we are now.  If interest rates and your cost of funds is very high at the top end of an interest rate cycle, adjustments to this strategy should be considered to maintain strong NIM profitability.

When Teams go Bad

If you have ever been part of a team, department, board, or church group, you may have been in the situation when the team was bad.  The result here may be infighting, incompetence, and inability to accomplish anything meaningful.  It is often quite painful to be a part of a dysfunctional team, especially when we realize how much we could accomplish but are unable to execute on.  I think it useful to find possible sources of what has spoiled the team when you are in this situation or when you want to avoid ever getting there. 

The first factor to consider is if the team members are all aligned toward the same common goals.  Years ago, I was part of a non-profit board which had almost as many goals as we had board members.  The only item that was accomplished was that of the strongest board member, and this was at the expense of all the other members.  Until we got together and figured out the direction of the organization, we accomplished nothing else. 

Alignment is also required in the large overall methods used to reach the goals.  My wife and I were part of a canoe race.  The first few minutes of the race actually had us rowing against each other!  We then began to move toward the goal in a large zig zag formation.  We lost the race, but if we had been in harmony on our method to reaching the goal, energy used to paddle against each other and in any path other than a straight line could have pushed us over the finish line.

Sometimes just the place where the group meets may be a deterrent to the team coherency.  One department team I was part of had weekly meetings every Monday morning.  We sat around the table and did deal with the critical issues of the week.  But no large, strategic goals were ever discussed there.  We met around dinner tables and on couches at coffee houses when we discussed the large issues that set the framework of the organization for years to come.  Had we stayed in the board room and not been in a relaxed environment to develop relationships where we felt comfortable sharing any idea, we would have never grown.  If your board is stuck in neutral, consider a change of scenery.

The next spoiler of team is the tendency to ignore relationships and concentrate only on the task.  But you can’t presume that people who share the same mission would naturally get along.  Relationships must be fostered instead of just assuming the work will bring people together.  Unity does not come from a shared mission; it comes from deepening relational connections.  What are you doing to bring the team together?

Sometimes, a problem with the team is not meeting enough.  Now I am not a huge fan of meetings, especially those which are without food!  But if you are meeting so rarely and whenever you meet large decisions must be made immediately, you may find the team stalled in neutral and people feeling pressured to make decisions without having time to think and talk through them.  A solution may be to add another meeting to discuss issues and advance any solution without making any decisions.  This, more relaxed meeting, will help strengthen relationships and advance great ideas that would not have been shared in a typical stressed meeting. 

Turnover is another struggle to trip up teams.  Turnover requires balance.  If you have too much turnover on your board, you spend a lot of time rehashing the organization history and bringing the newbies up to speed on where the group has come from and where we are going.  If you do not have any new members on your board, you run the risk that no new ideas will ever come into the group which could make a huge impact on the company.

Complexity can be a challenge for team success.  More people on the team mean more possibilities, ideas, and work capacity.  But this also means challenges among the relationships as more numbers of people are involved.  Consider if you have two members on a team, you have two lines of communication between person one and the person two.  When the next person is added, now you have six lines of communication among the three people.  Add a fourth person, you now have 12 lines of communication.  If you have five people, like our group, 20 lines of communication are in place.  If your group grows to 20, you have 380 lines of communication among one individual to another individual. 

Great teams are made up of strong relationships among the team members.  Huge accomplishments are made by strong teams.  If you want your team to win and avoid going bad, this requires cultivation and commitment toward developing the relationships among individuals in the group with each other.  If your team has turned bad, perhaps some of these items may point to source issues which need to be corrected.

The Debt Yield Ratio in Commercial Real Estate

In commercial real estate lending (CRE), we often use several calculations to measure the leverage and risk of the transaction.  One of the most common is a simple loan to value (LTV) calculation where the loan is divided by the value to get a percentage.  A 50% LTV would mean that half of the CRE is funded by debt and the other half by equity.  Another measurement is the debt service coverage ratio (DSCR).  Here the annual net operating income (NOI) is divided by annual debt payments.  If you had a company with a DSCR of 1.00, indicates that the company just earns enough NOI to cover its debt payments.  This company will have nothing left over in the year after all expenses and debt payments are made.

Another measurement of leverage on a property is the debt yield.  This is not as well known as a typical LTV or DSCR.  The Debt Yield Ratio is calculated by taking the NOI and dividing it into the first mortgage debt balance.  As an example, let’s say you have an office building with a NOI of $500,000 and the borrower wants to finance a loan of $6,000,000 on it.  The transaction will have a Debt Yield Ratio of 8.33%.  What is a way to think of what this means?  Basically, if you were to foreclose on the property on day one of the loan, you would earn 8.33% annually as a cash-on-cash return on its money.

Now it is important to see what items are not include in the Debt Yield.  Items like the cap rate or discounted cash flow analysis which would be used to establish value in the LTV ratio is not a factor here.  The lender’s interest rate and loan amortization used to calculate the annual debt service is also not used here as it would be in the DSCR.  The only factor here is the principal balance of the debt compared to the NOI of the property.  This calculation helps take out the factor that a low cap rate, low interest rate, and high leverage would play in the analysis.  At times in the market when these factors were present, real estate values were pushed to the stratosphere.

Most money center banks and CMBS lenders that are originating some form of longer-term fixed rate, conduit-style commercial loans are using the Debt Yield in their analysis. Few credit unions and community banks originating for their own portfolio look at this ratio.  This does not mean that the ratio has no significance; it can be used as an important tool in measuring the leverage on a property. 

There are some weaknesses in the ratio.  Widely fluctuating NOI would be one factor.  If you sized a loan based upon one-year analysis of NOI which spiked, you could be over-leveraging the property.  It is also better used for CRE than a C&I or agricultural loan. Also note that acceptable Debt Yields will increase as the rate on alternative investments rise.  Finally, just as no ratio should be used in a vacuum, neither should the Debt Yield. 

What is a good Debt Yield?  Like all other answers in lending, it depends.  Acceptable Debt Yields will fluctuate between the property type and tenant.  A good multi-tenant apartment or strong NNN leased credit tenant property in good market may have a debt yield as low as 9% and in some very rare cases, in the mid 8% range.  Most other common types of CRE would have a Debt Yield of 10% that is acceptable.  Some types of real estate that are more labor intensive if the lender were to take them back and operate them may have a higher threshold for the ratio. 

If we use the example above and target a Debt Yield of 10%, the loan would need to be lowered to $5,000,000.  If your institution were happy with a minimum threshold of 9%, the loan would be $5,550,000.  A DY of 10% will produce an LTV in the 63-70% range.  Pushing the DY down to 9% would raise the LTV to 69-77%. 

The Debt Yield became more popular in the past decade.  For over 50 years, CRE lenders used the DSCR as the main determining factor to size the loan.  In the mid 2000’s, problems started to develop, bond investors had a strong appetite for CMBS, driving yields down.  The result was CRE owners could obtain long-term fixed rate conduit loans in the 6% range.  Dozens of conduits battled each other to win conduit loan business.  Each promised to advance more money than their competitor, driving up LTV ratios into the low 80%.  The CRE investor could achieve a historically high amount of leverage with a long-term fixed rate that was very low.  Demand for this money skyrocketed as did demand for CRE.  Cap rates on CRE plummeted. 

When the crash hit, conduit lenders found that many of their loans were significantly upside down.  Lenders began using the Debt Yield ratio to determine the correct size of a loan.  This ratio can be a good tool in analyzing the risk of a loan request and the risk of a particular loan in your portfolio.

Pitfalls of Critical Thinking

Once you have mastered the skill of critical thinking, the road ahead is a smooth drive for logical interpretation of issues, right?  Well, that may not always be the case.  Large potholes may lurk in your path and the road may lead to nowhere or lead you to a place you do not want to go.  There are several traps the critical thinker can get themselves into.

First, is jumping to answers too quickly.  I used to be horrible at giving answers before I fully understood the question.  This made the person on the other side, usually my wife, frustrated.  Finding the answer to the wrong problem is still the wrong answer no matter how right it may be.  Much of this can be avoided if you fully understand the problem statement.  What are the issues behind the problem?  Who are the people asking and what interest do they have in the problem?  Getting a clear scope of the problem and all the issues and players will frame the issues and start you off on the right path in thinking critically.

The next pothole is not breaking down a large problem down into smaller pieces.  Staring at a huge problem can lead to fearful intimidation of the vast size of the issue.  Thus, it is also important many times to take a large problem and break this down into small pieces by asking focusing questions.  Evaluating past efforts and problems will help understand the possible causality of the present problem and other past problems and circumstances.   Looking at the problems from different points of view will also help to understand the problem and its impact on others.  The problem will look very different from the CEO view compared to the front-line teller.  Breaking all this down may help refine the problem’s scope and reveal some areas that immediate solutions may be applied.

Another pitfall is to refuse to expand the problem space.  This may have you solving a symptom instead of getting to the root problem.  I once met with a business client who accurately identified that the company was having problems financially.  Sales were down substantially.  But the owner only wanted the magic pill, the silver bullet to fix the problem immediately.  I began to drill down into the root cause by asking several layers of “why” questions.  Another thing that helped was to have the owner figure what they would do differently if they closed the business and started from scratch.  These helped the owner see problems in bidding, sales commission structure, and inventory buying present in the company.

The next roadblock is to focus on what is unimportant.  An Italian economist, Pareto, once stated that 80% of the results comes from 20% of the effort.  Hence, it is important to find the 20% and focus on that to get maximum results.  Years ago, I had an analyst who spent weeks trying to figure out what amounted to 2% of a construction budget, at a time, when the borrower had over 50% of the budget in liquidity.  We lost the deal because of a focus on the wrong 20%!  The question needs to be asked, “If I solve this will it move the needle?”

Another detour happens when you take analytical results at face value.  Failing to ask what the analysis means can lead you to incorrect answers.  It is also important to understand any relationship between this problem and others.  Years ago, on the farm, we had an electric fence that would not work.  Figuring that this was a problem with the wiring since a portion of the fence was cut, we proceeded to rewire hundreds of yards of fencing.  Hours later, we discovered we did not have to do all this work.  We only had to fix the one connection and then plug the fence in!

The final pitfall is to not think through future consequences of your answer.  This is like driving down the road without a map, compass, or road signs to make a trip from Texas to Indiana.  Solutions need to be thought through to what results of the actions and responses to those actions as well.  This is when we need to ask several “so what” questions to figure out what can happen when you put your answers in action. 

It can be easy for good critical thinking can go off the rails.  Using some discipline and being aware of these pitfalls can help make this a fruitful endeavor to getting our hands around problems and fixing them.



In other things, we are working on our lender education plans for 2019 and want to hear from you.  What sort of topics are you interested in learning to add to your toolbox for commercial or agricultural lending?  Reach out to us with your ideas.

The High and Low of Critical Thinking

If you have a problem to conquer, the first step is to define or frame the problem.  This leads to generating recommendation for solution, conducting analysis, and finally coming to an executable solution.  It sounds like a really simple 1-2-3-4 step from problem to solution. 

But we all know, if all were this simple, we would not have nearly the number of problems that are evident today.  Problems would not last long and would be always in process of discovering an answer and working through to resolution. 

Many times, problems are never solved as we spin out of control during the analysis phase.   Mike Figliuolo notes a good analysis requires both a high road and low road approach.  The high road is like soaring above the issue to see the overall goals, problems, and obstacles.  The low road involves the hard analysis crunching to validate the answer and direction.  There are dangers in not achieving a balance between the two and it can get easy to be trapped in one or the other. 

I once worked for a bank that stayed exclusively on the high road to long when it created a new program for a business line of credit with immediate underwriting.  The leadership thought adding lots of small balance business lines of credit would be a good introductory product to gain more customers.  They desired to get this out to a broader audience, so they allowed retail employees to sell business products which they had no experience in.  When asked about underwriting standards, leadership commented that using disciplined standards to review requests would make the product unprofitable due to the high cost to underwrite the credit.  Time and effort were put into the selling of the product with new contests, incentives, and goals for all front-line personnel. 

The lack of diving down into the low road kept the bank from detailed study of loss rates compared to various underwriting standards.  A few years into the program, the bank abandoned it as they experienced millions of dollars of loss from poor underwriting and fraudulent borrowers.

On the other hand, one can get caught up in the fun of crunching numbers, excel spreadsheets, charts and graphs that never reach a decision point save for one item, more data is needed.  This analysis paralysis results in extreme amounts of busywork without any solid recommendations for action.  Another bank I worked for decided to take any analysis from the field officer’s duties and place it in centralized underwriting pods with analysts who had no physical contact with borrowers or even the field lenders themselves.  Our analysts were located a mere three-hour drive time away.  Analysts were hired and promoted n their ability to generate questions and research no matter if any new credits were actually produced. 

I had an established borrower that we had financed nearly twenty different condominium construction projects.  Each one was successfully built on time and in budget, and units were sold as quick as they were finished.  A new request came for the next building which was sent, for the first time, to the credit analyst in the newly restructured division.  After a month of providing various items to review, our construction inspector approving the budget, and the appraisal, I finally received a lengthy and detailed analysis of the request that arrived at no conclusions, but requests for more data.  Most of the questions revolved around items in the construction budget which aggregated to 1.5% of the overall total.  This was after our construction engineer had approved the budget and we had verifiable cash from the sponsor for nearly 75% of the loan request.  Yet no decision could be reached from the analyst as she stayed stuck in the low road.  The customer went to another bank and received approval within a couple of days. 

Successful execution of the high road analysis involves the following:

·         Have a clear definition of the problem.
·         What is the analysis telling you about the problem?  What is being proved or refuted?
·         Estimate the benefit of doing analysis before pulling lots of data.  Try to rank possible solutions and pull data in order of your rankings.
·         Think of the Pareto Principle:  20% of the efforts usually result in 80% of the results.  Focus on those items most important.
·         Short bar-napkin analysis can frame issues.
·         Constantly think your thinking.  Do the answers you see, support or refute your recommendation?·         Look for similarities and differences in other problems in the past that may offer clues to a solution for the current problem.

The low road or “getting deep in the weeds” analysis, needs to be successful as well.  Some suggestions to do this are:

·         Only run the numbers and look at the data you need to run.  Time is precious and do not waste it.
·         Don’t stay buried in the data for too long.
·         Pop back up to the high road every so often.  What are the data teaching you?
·         Don’t try to polish dirt.  This is when you continue to look at more information that wastes time and does not give you more clarity on the credit risk or problem than you already have.
·         Don’t try to push a rope uphill.  This is when you preestablish the outcome and force data into supporting your decision when the data does not support it.
·         Focus your attention on answers that really matter.


Successful critical analysis requires a balance between both the high road and low road approaches.  An imbalance between the two may result in wasted time, errant conclusions, and poor direction.  Strive to use both well for greater efficiency as you solve complex issues. 

The Importance of Asking “So What?” When Looking for Solutions to Problems

Once you can clearly identify the root causes of a problem, you are now in a place to think about solutions.  But many companies think of solutions in a vacuum, without considering the actual impact and influence it may have on others outside of the problem.  That is why it is first important to identify consequences when you solve a problem.  These consequences may be with your business, team, customers, stakeholders, competitors, or the general market.

As I write, it is the morning before the playoff game between my beloved Kansas City Chiefs and the Indianapolis Colts.  Thoughts on my mind turn to football.  When a defensive coordinator sees the team is having problems guarding the tight end on the slant route in the middle of the field, he devises adjustments.  He also asks what adjustments the offense will make on the other side.  Will his changes make the offense able to run the ball better?  Will the wideouts be open for big plays? 

When devising solutions, it is important to ask the question “so what?” as you analyze possible results.  In my second banking job after college, I took over managing a branch of a savings and loan located in my home town.  Our branch was the smallest in terms of loans of all the eight branches of the company.  When I left that branch it was the second largest.  I knew and implemented strategies to make the branch grow but failed to see the negative impacts of my changes.

I replaced a branch manager who had retired after twenty years.  He had a long-time staff.  Changes I made helped us grow, but I failed to get the buy-in from the other long-time staffers.  I was young and arrogant and if I had asked the “so what?” question, I would have responded, “I don’t care, follow me since I have the answers!”  The resistance of the staff and counsel of leaders above me caused me to stop and rethink how to implement the growth strategies. 

Often the “what if?” questions need to go several layers deep to get to other changes that need to be made.  Mike Figliuolo, in his course on critical thinking gives the example of a company that identifies the root problem of needing to change the incentive plan which was broken.

So what?

We must change the incentive plan.

So what if you do that?

We don’t know how to do this.

So what do you do when you don’t know how to change it?

We need to find someone who knows how to do this.

So what does that mean?

We must find a new VP over compensation.

So what do you do?

We need to prioritize our search for a compensation VP and de-prioritize other recruiting efforts.

So what impact does this have?

Our search for a new supply chain VP will be delayed.

So what impact will that have?

Without a new supply chain VP, we will not be able to make the goals we have for our supply chain.  In this case it took seven “so what” questions to get to the basis that if we began to look for a new VP of compensation, we need to lower the supply chain goals we have for the year.  On the surface, these two items appear to be independent.  It took several “so what” questions to show how they are actually connected together.

In credit, you will often have clients who come to you who are in trouble who have think their only solution is for you to rescue them with another loan.  Sometimes, instead of running to open the vault for them, some “so what” questions need to be asked to determine the actual outcomes of their choices.  I once had this with a client who was made the final cut on a project with a large general contractor that he had tried to get in with for years.  The conversation started with the loan request.

So what if you get this project?

It is large and will be equal to 30% of our annual revenues.

So what sort of demands on resources do you think such a large project with short time demands will have on your business?

If we get this, we it will put us behind on other projects.

So what do you need to do to keep up with all your projects and add this one?

We must hire a new foreman for our other projects and put our most experienced one on this project.

So what will happen to the other project if you move your best foreman from it?

The project will not be run as efficiently.

So what does that mean?

It will probably cost us more time and we may not be able to utilize the relationships with suppliers and subs that our best foreman has in that community.

So what?

We will need to hire an additional foreman and some additional workers and must make extra efforts to build the relationships with our subs and suppliers in that community to keep that job profitable.  In this case the “so what” questions showed the impact in two unrelated jobs.  The contractor made adjustments to keep his existing job and made some pricing adjustments in his bid on the new one to keep his margins acceptable. 

A third example was with a full-service hotel which was remodeling to join a well-known chain.  The chain was only requiring the rooms and common areas to be redone.   The restaurants were already remodeled but the kitchen which served the restaurant was old and inefficient.  I knew of some of the problems with the kitchen with long delays in food service when I dined there.  We started with the loan request for remodel of the rooms. 

So what if you do not remodel the kitchen?

We can do that that at a later date.

So what will be the impact if you do all the other remodel now and then must shut down restaurants in the future to fix that problem?

It will be more convenient to do all the remodel of the hotel and kitchen at once.  To do these in pieces will look bad to our customers. 

So what if you do this now?

We will have to delay another project and focus more energy here.

So what if you do that?

We think the return is higher to spend more energy and money on the kitchen remodel now.

So what impact will the remodel have on your existing business?

We will have to shut down the restaurant at certain times in the remodel.

So how can you serve your customers?

We can go to a limited menu and use a food truck to feed the patrons during this time.  In this case the “so whats” helped the client change the timing of the kitchen remodel, delay another project which was not as profitable, save face in the community, avoid future grief by putting the remodel off, figure a logistic plan to manage the timing of various parts of the remodel, and keep the restaurants open during the kitchen makeover.  They also discovered the remodel built in huge efficiencies they did not have before, allowed the menu to be improved, and generated enough net profits to pay for itself in a few years. 

Asking “so what?” may help you see possible impacts with your solution on areas which are unrelated on the surface level.  Good critical thinking to solve problems requires a deep dive into the possible solutions and their impacts.

 

 

Good Critical Thinking Requires Knowing Why

One of the most needed skills in analyzing a credit request is good critical thinking.  This skill is hard to develop, and many analysts will often take the easy road in reporting what is obviously apparent in the numbers.  Stand-alone comments like “sales went up by 10%” or “net profits were down by 4%” is what we call elevator analysis.  The write up that is filled only with this offers no real value over just a mere presentation of the financials spread in multiple columns for the reader. 

One of the best ways lenders can show real value is not only to use good critical thinking tools in the analyzing of a credit, but to also share these questions with the client to help them to better understand and improve their business.  Often, the business owner gets stuck in all the day-to-day minutia of opening the doors, making sure the equipment is running, keeping adequate staff, or responding to emails.  Staying in this low road every day, prohibits the business owner from rising above to get a critical look at their company.  Even the best run companies often fail to rise above and study.

Steven Covey categorized time spent in good critical thinking as that in Quadrant II of a four-part time division.  Quadrant II represents things that are very important but are not often urgent.  We tend to spend more time on the urgent flashing light in front of us since that must be accomplished now.  At times, when the urgent has passed, we may gravitate to things which are not important and not urgent since completing those items give us a sense of accomplishment.  But those items do not move the needle of true value. 

Since most business owners or employees in a company have a hard time practicing good critical thinking on their own firm, the lender can add real value with sincere questions to help understand what is driving the business.  Now these questions should be tempered with an honest desire to lean about the business and its owners.  It is essential to understand both to have an accurate credit recommendation for approval or proper management strategy for an existing loan.

Whenever you are presented with a company’s financial status, you need to understand why things are the way they are.  Mike Figliuolo believes that the question “Why?” must be asked at least five times in order to gain true insight into the root cause of the problem and gain real insight.  Sometimes these questions may help the business owner know what items are needed to make good decisions to positively change the business direction.

One example I can cite is a horizontal contractor who experienced large losses in some subdivision work during the economic crash.  The request came in for an additional loan or some payment relief to help them through this problem.  But to grant that without fully understanding why would be of no service to the bank or the customer.  I armed myself with the initial financial spreads of the company as I sought to learn more.  Our conversation went something like this.

Customer: “We need payment relief since we took losses on these three subdivisions.’

Me: “Why did you take the losses?”

Customer: “Because we did not get paid fully for our work.”

Me: “If you have the ability to bill during the project, why weren’t you able to recoup more of your costs?”

Customer: “Because the job had such a low margin and we also had to make concessions on payment terms in order to get it.”  Here was insight number one, the company needed to change the way they progress billed for construction work.  I had this nugget after the second why!

Me: “Why did you take a job with such low margins?

Customer: “We need to discount to get the job.”

Me: “Why is it important to bid a job that is not profitable just to get it?”

Customer: “We need to continue to keep our employees busy or they will go to work for someone else.”

Me: “Why can your company be viable in the long term if you bid projects cheaply that will not cover costs if there is a payment hiccup?”

By this time, we uncovered the following:  1.  They needed to change how they billed for jobs and try to at least recapture their costs sooner in the job.  2.  They were chasing after low margin work, when they had higher margin corporate and government jobs waiting for them.  3.  Keeping a large staff busy may not be the best option to maintain the company into the future.  None of these insights would have been discovered if I stayed at the top request for payment relief or a new loan and did not do the deep dive into why.

The owner took these suggestions to heart.   They purchased new bidding software, set a minimum profit threshold and began to pass up jobs that were not up to their profit standards.  They changed their progress billing methods to recapture more of their costs earlier in the job.  Then they began to look at idle workers and shrunk their workforce because of less work they were doing, and they also sold a division of the company which diverted their time and attention from their core business.  Slowly, the business returned to sound financial footing.

Often, when you are first presented with a credit request or the need to understand a business financials you are seeing a symptom and not understanding the real cause.  Diving down into multiple layers of “Why?” will help you uncover the truth behind the initial statement.  Using this skill can also help you immensely in your own business and life.

The Burnt Man in the Shower

I once spent the night at a resort in Estes Park, Colorado.  Our bank was looking at financing a purchase on the resort.  After my morning workout, I retired to my room for a shower in the short window of time I had before a morning meeting. 

The problem I encountered was the water never warmed up.  Even though I turned up the water as hot as it could go, the shower did not get much warmer than the Fall River was outside on this January morning!  Judging that I had to take a shower before the meeting, I proceeded to jump in for what seemed an eternity of time that was punctuated by my constant swearing, “Oh Lord”, and “you gotta be kidding” until the end of the most painful event.  The walls were thin and the other gent I was travelling with in the other room said he got the best laugh that he had in years.

Have you ever been in a shower that was not warming up as quick as you desire so you blast the hot water?  In some of these, the water heat is building up slow and finally comes in a scalding batch that suddenly burns the person in the shower.  OK, so next time, you would hope to remember what happened and turn up the hot water more slowly or just wait until the water gets warmed up.  The problem with the burnt man in the shower scenario is that the man continues to do the same actions each time he gets in the shower with the same result—a burn from the hot water.

I once heard the Federal Reserve as compared to the burnt man in the shower.  The Fed tries to set monetary policy as a balance between full employment and price stability.  When Alan Greenspan was Fed chair, he once defined price stability as “the state in which expected changes in the general price level do not effectively alter business and household decisions.”  Greenspan kept a targeted inflation rate of 2%, though he insisted that no actual amount should ever be made public.  When Ben Bernake was chair, he formally announced in 2012 the targeted inflation rate was 2%.

Incidentally, this targeted rate came in 1988 from a TV interview with New Zealand Reserve Bank chair Roger Douglas, in seeking to dissuade New Zealanders from thinking the central bank would be content with high inflation.  He stated the bank was targeting an inflation rate between 0 and 1 percent.  In the next year, Don Brash, Reserve Bank Chair, and Finance Minister David Caygill set a targeted range of 0 to 2% to achieve price stability.  Inflation in the island country dropped from 7.6% in 1989 to 2% in 1991 after the enactment of this monetary policy shift.  As Brash shared his story with other central bankers at a conference in Jackson Hole, Wyoming, one by one other central bank heads began the 2% inflation target which has reigned as a norm in monetary policy for nearly 30 years now. 

A problem with monetary policy changes is often those who pull the levers are not patient to see what impact their changes accomplish prior to making the next move.  In 2018, we saw four—quarter point increases in the Fed Funds Rate.  At the end of the year we sit with a very flat yield curve.  As I write this the 2-year Treasury is only 17 basis points lower than the 10-year U.S. Treasury. 

Each recession since the 1970s has been marked with an inversion of the yield curve, a point where 2-year notes are at a higher rate from the 10-year notes.  This is out of the ordinary since a 10-year note would require a higher rate due to its duration risk.  We are very close to this going negative and one additional quarter point bump coupled with stable prices on 10-year notes will push the curve there. 

So, is the economy overheating?  Inflation in November ended at 2.2%, which was in the Fed’s target range.  Unemployment sat at 3.7% with more job openings than people searching for employment.  This was a little below the Fed’s long-term goal from 4 to 4.6%.  Things don’t seem that out of control and yet the Fed still chooses to increase rates. 

Some will argue that the Fed’s inflation target is arbitrarily too low and a rate of 3 or maybe even 4% is more normal.  If that were the case, we would not have seen the interest rate increases in the past year.  The question is if the Fed under Chairman Powell will act like Chairwoman Yellen.  Yellen followed a pattern of making a small change and then taking time to observe what was happening before the next move.  One may question if Powell will follow the same course.  Four rate increases in a year, even though they are small, causes one to wonder. 

Will the burnt man in the shower learn his lesson?  Or will we see hot increases in interest rates until the economy goes to into a recession, thus forcing a quick reversal in policy to get things going again?  Only time will tell.  If past history tells us anything, there is a good chance the burnt man will be burnt again.

How Economically Competitive is Your State?

Each year the various 50 states are rated in the Alec-Laffer State Economic Competitiveness Index.  Information can be found at alec.org.  The Economic Outlook Ranking is based on a state’s current standing in 15 different policy variables.  These factors measure income tax rates, other tax burdens, recent tax changes, debt service compared to tax revenue, public employees per 10,000 residents, state liability systems, minimum wage, average workers compensation costs, number of tax expenditure limits, and if the state is a right-to-work state.  Generally, states that spend less (on income transfer programs) and states that tax less (on productive activities like work and investment) experience higher growth rates than states that tax and spend more money.

The survey also looks backward on each state’s performance in gross domestic product, domestic migration, and non-farm payroll employment.  Each of these are influenced greatly by state policy.  These are measured and ranked looking at the past ten years.  Looking backwards, the top five states are:   Texas, Washington, North Dakota, Utah, and Colorado.  The states ranking 46-50 are:   Illinois, Michigan, Rhode Island, New Jersey, and Connecticut. 

The forward looking economic outlook is based upon an equal-weighting of each state’s rank in 15 different policy variables.  The top five states are:  Utah, Idaho, Indiana, North Dakota, and Arizona.  The bottom five are:  New Jersey, California, Illinois, Vermont, and New York.  Below is a quick view of how the states in the upper plains rank and what factors are strong for growth and which factors are hinderances to growth.

Iowa ranked 18th on the past economic history coming in at 7th in GDP growth, 30th in domestic migration, and 29th in non-farm payroll growth.   Future economic outlook has ranked Iowa at 29th among the states.  Iowa has a low minimum wage and is a right-to-work state.  Negatives are the Hawkeye State ranks 47th in corporate income tax, taxes estates, and ranks 41st in public employees.

Minnesota ranked 22 in economic performance with 19th in GDP growth, 37th in domestic migration, and 18th in non-farm payroll growth.  The future looks worse competitively with a ranking of 44.  Positives are the state has a good liability system and has enacted some personal income tax cuts in 2016 and 2017.  Negatives are the high personal and corporate income taxes, high remaining tax burden, taxes on estates, and North Star State is not a right-to-work state. 

Montana ranked 9th in economic growth in the past decade.  This was raking 8th in GDP growth, 18th in domestic migration, and 11th in growth in employment.  The projection is worse with Big Sky Country coming in one slot higher than Minnesota at number 43.  Positives are a no state sales or estate taxes.  Negatives are personal income taxes are progressively bad, they have a high tax burden personally, and the state is not a right-to-work state. 

Nebraska ranked 13th in the past decade with a 2nd ranking in GDP growth, 29th in domestic migration, and 13th in non-farm payroll growth.  Future growth ranks Nebraska at 28th.  Positives are that the Cornhusker State is a right-to-work state, the liability system is managed well, and the state has cut personal income taxes. Negatives are Nebraska has one of the higher progressive income taxes, a high number of public employees, and a taxing of estates. 

North Dakota emerged as the star of the group with a ranking of 3rd in past decade.  They had the highest GDP growth of any state, 16th in domestic migration, and 1st in non-farm payroll employment.  The economic outlook ranks the Peace Garden State at 4th for growth.  Positives are the state is a right-to-work state, has low workers’ compensation costs, a low minimum wage, implemented a tax cut in 2016 and 2017, and has the second lowest debt service compared to revenue.  Negatives are that North Dakota has the 3rd highest sales tax burden and has a high number of public employees per population.

South Dakota ranked 8th in the past decade with a ranking of 4th on the GDP growth, 22nd in domestic migration, and 9th in non-farm payroll growth.  The Mount Rushmore State ranks 9th in future growth.  The state is a right to work state, has a well-managed liability system, has no estate, personal, or corporate income taxes.  The worse negative is the state has the 43rd in terms of sales taxes per $1,000 of personal income. 

Wyoming ranked 43rd in the past decade of economic growth with a 47th rank of GDP growth, 21 in domestic migration and dead last at 50 in non-farm payroll growth. The Equality State has an economic outlook ranking 8th among the states.  Positives for the future are the 0% corporate, personal, and estate tax rates.  Wyoming also has the lowest state debt service at 2% of tax revenues.  The state is a right-to-work state and has well managed liability system.  Negatives are that Wyoming has the highest proportion of public employees to population and has a higher property tax burden. 

The ALEC-Laffer study is viewed with other factors such as demographics by companies who are searching for good growth states that are business friendly.  The study is a good read to understand more about how each of the states are their own little experiment of democracy and policy.  It will be interesting to see how the various states’ growth progresses in the future.



As we approach the end of the 2018, we extend our gratitude for each of you that we have worked with.  Perhaps we helped close a new loan for your institution or maybe you attended one of our classes.  Maybe you called with a loan question or used our servicing platform to manage a credit.  We appreciate each of you and look forward to serving you in the new year and beyond.  My wish is for new successes for you next year and a very merry Christmas in this year.  May you know the good news that was first shared with a small group of shepherds long ago, “unto you is born this day in the city of David, a Savior, who is Christ the Lord.”

Surprises in the Lender's Stocking

Opening a Christmas gift is risky.  You don’t know if this is something that you really want or if it is something that will be sent to the goodwill box within a week.  We have all experienced this.  It may be an ugly sweater, a necktie that is not meant to ever be in public, or some item there is no way that you will ever use.  It is the same as finding a big lump of coal in your stocking from Santa.

This time of year, we tend to look back at the past and look forward to the future.  When one considers the challenges and possibilities for the new year, it is like receiving presents that you have no idea if they will be absolutely fantastic, or if they turn into the lump of coal.  Here are a few of the mystery presents that lenders find under their tree this year.

I will start with the economy.  We are already nearing record time for an economic expansion.  There continues to be good economic news—strong employment, expanding companies, inflation that is reasonable.  Yet, we just don’t know when the party will end or what will make it end.  Will it slowly fade, or will some violent change cause the growth to come to a screeching halt?  Then what impact will it have on your borrowers?  What sectors of the economy are already showing stress?  We are already seeing quite a bit of stress in agriculture.

Could a debt crisis that is triggered from emerging markets or a financial crisis from uncontrollable deficit government spending, bring the economy to its knees?  If there is a debt crisis, will it reduce the supply of possible funding for new projects?

Interest rates are another mystery.  It is expected we will see another Fed increase this month, but after that, what will be the attitude of the Fed?  Will the yield curve invert?  This is a sign that a recession is coming and would be a large lump of coal in the stocking!  Our recent recessions have been rather severe in nature. 

Will commercial real estate (CRE) lending slow down?  Starting on December 15, 2019 the new Current Expected Credit Loss (CECL) model for allocating loan losses, goes into effect for institutions that file with the Securities and Exchange Commission.  By the end of 2021, all lending institutions will be using this.  This will replace the current Financial Accounting Standards 5 and 114 for allocating credit losses and now require lenders to estimate a loss over the entire life of the loan.  It is expected this will require additional capital reserves due to the increased credit loss estimates.  Will this slow down CRE lending?

Another possible slow down for CRE is the new lease accounting standards for public companies that will begin at the end of this year.  What impact will lease accounting have on long term lease structures that are key to the current triple-net (NNN) lease market?  What happens with permanent debt investors that rely on matching longer-term liabilities to assets with long duration cash-flowing assets?  Will companies that engage in long term sale-leaseback CRE, now relay on holding those assets, thus effectively shrinking the supply of good NNN deals for CRE investors?

This change is a material occurrence.  Moody’s estimates this new Financial Accounting Standards Board lease accounting change may add as much as $1 trillion in liabilities to corporate balance sheets.  This becomes even more complicated with the right-of-use asset calculations that can mitigate this additional liability.  In these figures, the asset value is not determined on the market value, but on the use.  This could result in a decline in assets and correspondingly the company’s net worth.  This possible disruption in longer-term leases could leave the NNN lease market exposed and would be a present no lender wants to see.

Another possible lump of coal is with employment.  This fall, we have more posted jobs than folks who are on unemployment.  As I write, the unemployment rate is at 3.7% and real wage growth is increasing by 3.1% annually.  Employment growth is averaging 170,000 jobs a month.  Many highly skilled jobs are also going unfilled.  Will companies be able to find the labor they need in a tight job market?

A final mystery present that I will mention, but definitely not the last, is the future of regulations.  2019 will mark a time when we have a House leadership that has been historically for increased government oversight, contrasted with a Senate and President who have sought to cut regulations.  The other players are the actual folks who implement the regulations themselves.  Will there be a continued move to unshackle the economy or will this change to a focus for more oversight? 

Each of these mysteries will be wonderful opportunities for some and could be devastating to others.  Our goal for the new year is to be highly aware of what could lie in each stocking and present; then be adaptive quickly to the changes.

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.