Judging Repayment Capacity for Agricultural Borrowers

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

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

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

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

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

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

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

The Importance of Assessing Farm Management

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Challenges at the Dairy

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

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

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

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

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

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

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

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

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

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

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

Temporary Loans, A Bridge to Nowhere?

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

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

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

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

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

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

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

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

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

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

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

Challenges with Seasonal Lines of Credit

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

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

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

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

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

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

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

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

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

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

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

Challenges with Operating Lines

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

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

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

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

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

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

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

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

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

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

Keeping Up with Ag Credit Risks

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

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

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

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

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

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

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

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

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

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

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

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

The 6 D's of Distortion of Credit

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

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

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

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

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

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

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

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

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

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

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

Elimination of Entry Level Jobs

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

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

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

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

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

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

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

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

Wisconsin did not follow Minnesota’s example.

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

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

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


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

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

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

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

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

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

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

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

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

The Tax Cuts and Jobs Act Impact on 1031 Exchanges

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

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

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

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

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

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

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

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

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

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

Will Trade Create Trouble or Treasure for the American Farmer?

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

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

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

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

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

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

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

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

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

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

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

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

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

Small Business Week and Commercial Lending Approvals

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

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

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

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

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

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

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

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

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

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

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

Inflation and Rising Rates

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

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

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

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

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


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


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


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


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


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

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

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

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


10 Commandments for Loan Pricing

At times, one item that we often question is how commercial and agricultural loans are priced in the credit union world.  The level of sophistication varies from none to those that have highly complex models to forecast the impact of a new lending relationship on return on assets (ROA) and in the banking world, return on equity (ROE).  In my past commercial positions at banks, I had to review the performance of the credit using complex models.  If certain targets were not hit, then there must be some good explaining on why we should do the deal.

It is in this spirit that I offer these:

1.       Thou shalt not publish commercial lending rates in a matrix as you publish consumer lending rates, unless your pricing risk is taken over by a secondary market sale.  There is no way that any matrix can adequately capture the variations in risk, duration, and relationship from one deal to another. 

2.       Thou shalt realize that commercial and agricultural loans are not under the same regulations for fair lending as consumer loans are.

3.       Thou shalt understand how booking a loan will impact your credit union’s balance sheet.  Booking a loan will increase your earning assets.  It will also require that funds are set aside in a loan loss reserve account.  The loan will have to be funded with either deposits or borrowings.  This will impact your required price you want for the loan.  If your institution has a very high loan to share ratio, you may want to charge a higher price for the new loan.

4.      Thou shalt understand how booking a loan will impact your credit union’s income statement.  The new loan will be an earning asset, hopefully without much trouble.  MBLs do require quite a bit of management so you will experience cost of monitoring and reviewing the risk of even the best of credits.  Understand that cost and the cost of capital associated with the loan.  Will the price that you are booking the loan at provide an increase in your ROA or will it drag it down?

5.       Thou shalt understand duration risk.  Duration is the risk that the margin you book the loan for today will not be available tomorrow.  A loan that reprices every time Prime moves, has a short duration and low risk.  A 15-year fixed has a long duration.  There may be a high chance that at some time during the life of the loan, the margin that you originally booked the loan at will be compressed or even worse, negative.

6.       Thou shalt understand margin.  Margin is the difference between the interest rate you are earning on the loan and what you must pay for the deposits to fund the loan.  You need to understand what is an acceptable margin to your institution.

7.       Thou shalt match fund as much as possible.  This is where you pretend that every loan you book requires that you must borrow those funds whether you must or not.  Use a yield curve of interest rates like the US Treasury rate or the Federal Home Loan Bank’s advance rate.  Pick a maturity that matches the reprice period of your loan.  E.g. use a 3-year UST to be your cost of funds for a MBL that reprices every 3 years. 

This does not always work.  You may have some government guaranteed programs that use Prime or some other index to price loans of any repricing maturity.  But as much as you can, match fund your loan pricing to the underlying cost of funds index.

8.       Thou shalt not lower an interest rate solely because a competitor is doing it.  This is the same as sticking your head out the window of your car as you drive down a one lane country road.  Sooner or later you are going to get smacked by a mailbox!  Figure out what you need to price and why.  Then use some discipline to follow your game plan.  There will be some cases that you will be more competitive, but do so on your terms, not because the borrower is asking for it.

9.       Thou shalt understand the present condition of the yield curve, direction of interest rates, and availability of alternative places to invest the institutions money.  A loan is an investment and you ae a steward of the capital entrusted you.  Understand the environment around you before pricing a loan.  We have seen many credit unions who are still pricing loans at rates that were fair last August.  Well, US Treasury rates have risen over 100 basis points since then.  So that same rate will not be very fair to your institution today.

10.   Thou shalt not lead off a conversation with a prospective borrowing relationship with price.  Putting price out on the table in the early part of a discovery period for a new or expanding credit relationship will doom you.  You become a slave to offering a low price since the only way you can set yourself apart from the competition is with a low price.  You either have low price or differentiation.

You must work with the member so they believe they are better when they are with you as their lender than when they are with someone else.  Create value in their mind.  Talk about what this new project will do for them.  Discuss their plans and dreams.  Give yourself time to look through the credit request, assess the environment, and know your institution before you commit to the price.  If you are not strong in this relational area, commit to developing this relational skill.  You will be wiser in your pricing and your institution will perform better.


Quick Bite:  From the Washington Post:  “More Retailers are Going Bankrupt Than Ever”.  Bankruptcies in the retail sector, reached a record high during the first quarter of 2016.  Nine companies reported defaults, including Sears and Claire’s during the period ending March 31, 2018.  Tops Friendly Markets, a supermarket chain and Bon-Ton department stores also filed for bankruptcy.  Defaults on corporate debt from the retail sector make up 1/3 of all defaults by corporations in all industries.  Moody’s predicts that their expected future default rate among retailers will decline next year.

Uncovering the Credit Worthiness of Non-Rated Tenants

Many office and retail commercial real estate deals you will review will involve some sort of rental income that is the main, or in some cases, the only source of income for the building.  If you are analyzing this type of credit, how can you determine the ability of the tenant to continue paying the rent?  This is a very important factor to weigh, especially if your guarantor is a weak secondary source of repayment.

If you are dealing with a publicly traded company as a tenant, finding their financial strength can be obtained by searching for corporate reports or bond ratings.  Note that just because a tenant is public, it does not mean that the tenet is financially strong.  We looked at a single tenant retail building late last year which we turned down due to the poor finances of the company that leased the building.

In most cases, you will not have tenants which are publicly traded and their financials are not public.  The lessee may be small or privately held.  This poses a question on the future income stream of the company and its ability to satisfy rent requirements.  What are some things that could be reviewed in your analysis?

First, in some cases you may actually be able to review the finances of the tenant.  Usually this would only be available if it is spelled out in the lease or if the landlord is vetting a new tenant.  Some leases are graduated with a base and then overages based upon certain sales levels of the tenant.  In those cases, the sales information must be shown to the landlord.

Second, inspect if the tenant pays its rent and other bills in full and on time.  Late payments on the rent may indicate further weakness financially in the future.  How does the tenant keep up their place?  Is it neat and clean?  Are they good neighbors to others around them?  Do they have a good relationship with others in the area? 

Third, look at the industry.  Tenants that are in industries that are thriving or in areas of high demand for the services will more likely be financially successful than those in struggling sectors. 

Fourth, are there any guarantors on the lease? A weak tenant that is backed by a strong personal guarantee or the backing of a large company, increases the continuation of rent payments.

Fifth, are there possible landmines inside the lease that could blow up and allow the tenant to easily leave.  One landmine may be a provision to allow the tenant to leave if certain amounts of sales are not obtained.  Another lease may be based upon the access to their shop from customers.  I once knew of a lease that stopped because a road was rerouted which made the access to the retailer difficult. 

Sixth, how easy is it to replace the tenant if they leave?  If the property is in high demand, perhaps less emphasis needs to be viewed on a tenant as they may be able to be replaced easily. 

Finally, consider paying a visit to the property.  If you can chat with some of the tenants you may gain an understanding of why they chose the rental spot and how successful the location has been for their business.  It may also give you a clue into the business acumen of the tenant and provide an opening to develop another business relationship.

Retail and office rentals may provide great opportunities for your borrower to add a good earning asset to their real estate portfolio.  It also may be a good loan on your books.  Consider a deeper dive on some of the tenants to make sure the income stream will continue.

Current Trade Conditions and Agriculture

In the past couple of weeks, President Trump has announced new tariffs on imports.  In early March, new tariffs of up to 25% on steel and 10% on aluminum were put in place to protect and revive American factories.  Within a few days, U.S. Steel announced bringing back workers in Illinois plants because of the expected need for more domestically produced steel. 

The impact should help producers of the metals, but could raise prices on manufacturers who use the metals and ultimately, the consumers who buy the products.  Last time I checked, there seems to be quite a bit of metal that is used on farm equipment, so expect some higher prices there.

The tariff announcements continued.  On March 20, President Trump announced as much as $60 billion in tariffs on Chinese goods.  These are a response to the $500 billion trade deficit we have with China and the theft of intellectual property has occurred from one of our largest trading partners.  The move sparked concerns of a possible trade war.  Some news outlets believe that if there is a response from China that it will be “targeted”.

One major concern is the impact any trade disruption will have on agriculture.  Foreign markets are important to keep open as viable places to sell the products farmers and ranchers produce.  The USDA reports that in 2017, the top ten food and ag products accounted for 58% of all U.S. ag exports. King of the list by far was soybeans at $21.6 billion.  This was followed by corn at $9.1 billion, tree nuts at $8.5 billion, beef at $7.3 billion, and pork at $6.5 billion.  Rounding out the bottom five are wheat, prepared food, cotton, dairy, and fresh fruit. 

China is expected to import nearly 3.5 billion bushels of soybeans in 2018 and this is expected to increase by around 140 million bushels annually for the next five years.  This growth is partially because of a decrease in Chinese domestic soybean production as profits have been higher for crops like corn and rice.  Soybean demand is high and China is the largest soybean importer in the world. 

But even before the recent tariff announcements, there was already some hostile moves by China against U.S. bean producers.  On December 20, 2017, Bloomberg reported the USDA agreed with a request from China to impose stricter standards on U.S. soybean shipments to China, while these same standards were not placed on Chinese imports from other countries, like Brazil.  At the same time, China increased its soybean purchases from Brazil in the first quarter of 2017-18 by over 7 million metric tons while cutting purchases from the U.S. by 5.37 million metric tons.  So even before the tariff announcements, it appears that China had begun making steps against U.S. producers. 

So as a lender, what should you watch out for to protect your institution and your producer?  First, watch the position of international trade and its impact on the U.S. farmer.  Agriculture is dependent heavily upon the world market demand to purchase a large portion of supply that is grown in our country.  Tariffs from other countries against U.S. products, or as in China’s case, additional requirements that are placed upon imports from the U.S. will have a negative impact on prices, which decreases the top line revenue to your producer.  Also, understand that these principles impact all commodities and not just soybeans which have been discussed here.

Secondly, watch the weather.  Several decades ago, the farmer was only concerned if there was good growing conditions in his area.  Since agricultural products have grown into worldwide commodities, there is concern for growing conditions around the globe and, in turn, the impact on supply.  A drought in Argentina that lessens the soybean crop while our crop is not impacted will drive overall prices higher.  At the same time, if the Brazil crop is extremely plentiful due to good growing conditions, and the Chinese see Brazil beans as a good substitute for buying U.S. soybeans, demand and the price for U.S. beans will fall.

The third factor is interest rates.  It appears that the Chinese and other countries may be curbing their appetite to purchase U.S. government debt.  Lowering the demand for U.S. debt will result in the debt needing to be sold at a higher interest rate.  This will impact the interest rate to your producers.  Also note that the new supply of government debt is plentiful as displayed in recent Congressional spending bills. 

Most news articles I read from experts believe that we are at a lower part of the price cycle for many agricultural commodities and will continue there for the next few years.  The impact of trade and tariffs from all sides, could produce stronger headwinds the farmer and rancher will have to face. 

Importance of a Contingent Liability Inspection

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

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

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

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

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

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

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

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

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

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

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

Bureaucracy or Accomplishment

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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