2013 Mid-Year Financing Report

The most recent edition of Commercial Investment Real Estate included a recap of commercial real estate financing for the first six months of this year.  The Mortgage Bankers Association has an optimistic forecast with commercial mortgage originations growing by 11% in 2013.  The only thing they see that could dampen the growth is a rise in interest rates.  The market today looks quite different than it did several years ago.  In addition to the opportunistic borrowers, new government regulations and a lender emphasis on limiting risk and maximizing yield dominate.  Note that this overview is on a national level and different regions of the US may fare better or worse. 

Commercial Mortgage Backed Securities (CMBS) rose by 48% last year and is expected to rise between 40-50% this year to $55 billion. CMBS have been limiting LTVs to 70-75% and have recently been focusing on a project’s debt yield.  Debt yield is the net operating income divided by the proposed loan amount.  A lender looks at this as a cash-on-cash return on money lent if the commercial property is foreclosed on day 1 of the loan.  The market is targeting an overall debt yield of 9-10%, but these numbers are beginning to drop with competition.  Debt yields will also differ depending on the type and location of the property.  The top CMBS players this year are Deutsche Bank, J.P. Morgan, Wells Fargo, Goldman Scahs, UBS and Bank of America. 

Life Insurance Companies closed 18.1% of the 2012 commercial real estate loans according to Marcus & Millichap.  They are expected to increase their CRE by 15% this year.  Typical LTV maximums are 65% and 10 year fixed pricing can be found in the 3-4% range with yield maintenance clauses.  While they are very conservative, some life companies like StanCorp, Symetra, and Ohio National are looking to pick up market share by offering smaller loan amounts.

Banks have emerged from the credit crisis, but the local and regional banks still fighting to comply with new regulations.  The rules require larger capital reserves, which may affect the amount of CRE banks choose to hold.  Regulators are also watching concentration levels in the portfolio.  National, international and regional banks funded 25.5% of CRE loans last year.  Banks still remain conservative with their underwriting and are often more eager to expand the bank relationship with sale of ancillary services than the stand alone real estate transaction. 

Government-Sponsored Enterprises impact will drop in 2013 by $6.4B to $56.9B under the Federal Housing Finance Agency’s 2013 directive.  This news may have little impact on existing GSE borrowers, and other lenders may see an opportunity to expand market share in the healthy apartment sector, especially in secondary and tertiary markets.

The Small Business Administration (SBA) is expected to remain on pace with its 2012 originations, which were only a small dip from the record year of 2011 that was marked with reduced fees, expanded loan guarantees and raised loan amounts.  The SBA 504 program offers lenders the opportunity to make a 50% leveraged loan.  The SBA makes a second mortgage between 30-40% of the project cost.  These second mortgage rates have remained below 5% for most of this year on a 20 year fixed basis.  The SBA’s 7(a) program enables lenders to provide a small business a 90% leveraged first mortgage on real estate up to $5MM with a guarantee of 75% of the loan balance.  The guarantee is important, as the guaranteed portion can be sold into the secondary market to replenish the lender capital or can be held for earnings and not counted against concentration and cap limits. 

Bridge Loans are being offered by many lenders with somewhat aggressive terms for empty buildings, unseasoned properties, discounted note payoffs, and buildings needing improvements.  Terms typically are for 2-3 years at a 65-75% LTV.  Some large Fannie Mae lenders like Wells Fargo may offer aggressive bridge loans to get the final take out financing. 

In summary, the financing outlook for the remainder of 2013 is mixed.  There is significant capital in the market for projects.  Increasing interest rates may dampen demand.  Credit is still tight for projects that are too small or weak.  Credit will be more open in areas with strong economic growth such as what we experience in the Dakotas. 

A side note:  here at Midwest Business Solutions we are pleased to have Trevor Plett on our team.  Trevor comes to us with a background as a bank examiner and was most recently in credit administration for a large regional bank out east.  Trevor will be writing articles for the Credit Union Association of the Dakota’s Memo on Friday for those of you who receive this email publication.  --Phil Love

Corn and Wheat Price Outlook

Last year, those farmers who had enough moisture to have a corn crop enjoyed some high prices as the drought gripped its hand across most of the corn producing region of the US.  In some areas of the Dakotas, corn was ground up into silage as a lack of moisture caused the crop to not mature. 

Wheat prices also increased with prices began to be tied to the performance of the corn market.  Some think the correlation in prices is from wheat being used as a substitute for corn in animal feed.  This gained some popularity last year after corn prices reached record levels. 

What a difference a year makes.  Weather forecasts are calling for cooler temperatures in the Midwest for the next few weeks.  This is during a key time for corn as the crop moves into the pollination phase.  Hot and dry conditions during pollination can lower corn yields as this is the critical time when kernel formation is determined.  There are still parts of the Midwest with a moisture deficit but increased chances of rain are on the forecast for the next two weeks.  I can attest that the fields I have seen in this area of the country are lush and green compared to the brown and dry conditions last year.  Bottom line is the cooler and wetter year increases chances for a record corn crop this year.

Corn prices are also depressed from strong increases in supply from other corn producing countries.  Argentina announced an increase of 6 million tons of corn production.  Most of the additional production is available for export, which will push down corn prices further.  Currently, large speculators and funds tend to hold net-long positions on corn futures while the small speculators are bearish on the future of corn prices.   The prices tend to favor the bearish position with prices falling from over 650 for December corn in September 2012 down to 487 where it is now.  But note, that any change in the weather conditions could cause a spike in prices as short position holders seek to cover themselves.   

Wheat is in a similar trend.  Note that September Wheat has dropped from over 900 last fall to 640 where it is today.  Now going into the fall, traders will watch with keen interest the Spring Wheat crop performance.  Average yields are expected to fall below last year’s levels due to late plantings this season.  The Wheat Quality Council in North Dakota has estimated a Spring Wheat yield at just under 45 bushels per acre. 

Wheat prices are being depressed with the strong corn crop, as many will switch back to corn instead of using wheat for animal feed.  Lower wheat prices will help US Exports but abundant global wheat supplies are sending Middle Eastern and North African buyers to purchase wheat from the Black Sea region where cash prices are the lowest among major exporters. 

The Sep/Dec Wheat spreads in Chicago and Kansas City are turning bullish, indicating that commercial buying and increased exports could be emerging.  This can add some support to prices. 

The bottom line is that both corn and wheat prices will be lower than last year.  But a careful eye will be kept on these markets for the next few weeks by traders and farmers to determine where the price level will be.

Leadership is...

Try asking people this question.  The answers you will get are as varied as the folks you are asking.  Often I will hear of someone who says, “If I only was in control or had that position, I could really make a difference.”  To these people, leadership is a position, a title, a name on the door.  They think that whoever is in that position is a leader. 

But that is not true.  In 1994, institutional investors of Saatchi & Saatchi forced the board of directors to dismiss Maurice Saatchi, the CEO.  As a result of this, several key executives left as well and many of the advertising firm’s largest clients like British Airways and Mars.  Saatchi’s influence was so great that the company’s stock fell by 50% immediately.  Even though Saatchi lost his title and position, he continued to be the leader.  Stanley Huffty quoted, “It’s not the position that makes the leader; it’s the leader that makes the position.”

Some may think that leadership is management and many books have been written that say so.  The difference is that leadership is influencing people to follow in a certain direction, while management focuses on maintaining systems and processes.  Organizations need both leaders and managers.  The best way to tell if a manager is a leader is to ask him to create positive change.  Managers can maintain a system and direction, but they cannot always create change for the better.

Some will say that an entrepreneur is a leader but that is not always the case.  Entrepreneurs are skilled at recognizing opportunities and seizing them.  But they are not always skilled at leading others to achieve the goal with them.

One answer you may have is knowledge is leadership.  That is not the case.  We all know of people who are brilliant and are considered by all to be the smartest person in the room, yet who do not have the ability to lead others.

For me the true measure of leadership is influence.  It does not matter what the title, knowledge, or skill may be.  All leadership boils down to influence.  Margaret Thatcher once said, “Being in power is like being a lady.  If you have to tell people you are, you aren’t.”  If you watch people interact with each other, you will notice some leading and others following.  This often has nothing to do with position or title. 

So why do some people emerge as leaders and others do not?  John Maxwell identified several factors that cause the leadership cream to rise to the top.  First is character, who they are.  True leadership always begins with the inner person.  Second are relationships, who they know.  Any leader has to have an understanding of facts, factors, timing and a vision for the future.  Third is intuition, what they feel.  Leadership is more than a command of the data; it demands the ability to deal with numerous intangibles.  This is often a main difference between a manager and a leader.  Fourth is experience, where they’ve been.  The greater the challenge a leader has faced in the past and has overcome the more credibility they have for the present.  Fifth is past success, what they have done.  Nothing speaks louder to followers than putting some wins under their belt.  Last is their ability, what they can do. The bottom line for a follower is what a leader is capable of doing.  People gravitate toward those who can deliver a victory. 

An incident in the life of Abraham Lincoln illustrates the influence principle well.  In 1832, Lincoln gathered together a group of men to fight in the Black Hawk War.  In those days, the person who put together the group often became the leader.  He was given the title of captain.  But Lincoln had a problem.  He did not know anything about being a soldier, had no prior military experience and did not understand military strategy.

One day, Lincoln was marching several men across a field and needed to guide them through a gate into another field.  But Lincoln could not remember the proper command words to get the company to go edgewise.  He finally shouted, “This company is dismissed for two minutes, when it will fall in again on the other side of the gate.”  Lincoln started out as a captain, but earned his rightful leadership place as a private by the end of the war. 

Lincoln had a leadership proverb, “He who thinks he leads, but has no one following, is only out for a walk.”  If you can’t influence people, they will not follow.  If people will not follow you, you are not the leader.  Leadership boils down to influence, nothing more and nothing less.

The NCUA's Construction and Development Limits

The NCUA has set standard limits on all Construction and Development (C&D) Loans at 15% of capital of a credit union.  The goal of the limits is to help manage the risk of construction lending.  It seems that the regulators attempt to treat all construction with the same level of risk with this broad stoke approach to construction lending.  The question is, “Do all construction loans have the same risk?” 

I will contend the answer is no.  My years of commercial lending have taught me that each construction project has its own unique risk.  It would be impossible to create separate regulations for each loan.  However, there are some characteristics of different types of construction lending that tend to have greater or less risk than the other.  Consider the differences among these various construction projects.

Spec Construction vs. Owner Build:  A project that is built with the intent to sell all or parts of the construction is more risky than a construction project built for the use of the owner or one that has a committed quality tenant who has the capacity to handle fulfillment of the rental agreement.  A subdivision lot development or a large condominium development where the repayment is the successful sale of the lots or units is a higher risk than the construction of a building for the use in the operation of a business.  A manufacturer building a factory, an hotelier constructing a new hotel, or a developer building a retail building that has established credit tenant support will be a lower risk than spec construction of a subdivision.

Credit Union Managed Construction vs. Qualified Third Party Managed:  In many cases, credit unions do not have the staff talent and experience to properly manage larger construction projects.  This poses a higher risk than a construction loan that has disbursements managed with a third party title company or attorney firm.  In general, the construction inspection process is also better with a qualified third party architect or building inspector instead of utilizing the field lender.

Construction without Permanent Financing vs. End Loans in Place: Here any construction project that has permanent financing in place at the onset of the construction is less risky than a construction loan with no end loan in place. 

Repayment from the Sale of the Development vs. Debt Servicing from Other Sources:  If the repayment of the principal of the construction loan is based upon the sale of the development or building, it is considered speculative.  This is a higher risk than construction that will eventually have the principal serviced with non-speculative sources.  These could include regular P&I payments that are supported by a lease on the property or an owner use property where the amortized payments are supported by the positive net operating income of the business. 

The spirit of the NCUA limits is to help manage the risk of construction projects.  However, as shown above, some projects pose more of a risk than others and should be subject to appropriate limits.  Using the low limits may be appropriate in limiting construction that is spec, credit union managed, and has no end loan in place.  The current low limit is not applicable for owner or tenant built, qualified third party managed, and projects that have a final loan in place that is supported from historical net operating income.  I would contend that construction loans with the latter characteristics should not be subject to the 15% limit.  Such limits hinder credit unions from supporting its membership base with lower risk construction loans, which in turn, hinders economic growth in the market area.  It also causes credit unions to turn down lower-risked construction loans that will turn into good earning assets to help the credit union’s earnings and equity grow.  But whether or not the NCUA agrees with me, it is still the lender’s responsibility to recognize the variations of construction risk and act appropriately.

The Card in My Briefcase

I keep a card in my briefcase that is a folded piece of red construction paper from my son Josh.  I think of it as one of those items that help keep me grounded.  Josh was about 7 at the time and I was working for a large regional bank.  We had a management change.   The old group that left was very seasoned in commercial lending and also excellent in developing staff.  It was under their tutelage that I began to grow my commercial skills with both experience of working on over $100MM in credits and the classroom knowledge of obtaining my graduate degree from the Graduate School of Banking at University of Wisconsin.  They were also very good at developing relationships with people. 

At this time, several of these key leaders left and began working at other banks.  We had new leaders come in.  This group was not interested in establishing relationships and did not accept the lengthy sales cycle in commercial lending.  They only focused on the bottom line results from what they saw each month in the bank.  They were only interested in immediate good results to impress their next level of management.  This was often done while sacrificing the best for the bank on the altar of quarterly results.

Our entire team groaned under the new leadership.  It was at this time, when struggling to keep my job and hating every minute under the oppressive thumb of the new team, that Josh handed me the handmade card one day after work.  The outside reads:

I love you

From:  Josh

To: Dad

It continues on the inside:

Daddy I hope that those people at the bank gets nice to you

The back cover has a hand drawn heart.  It choked me up and gave me hope realizing that no matter what happened my family and I were going to be OK.  Nine years have passed and I still have the card in my briefcase.  I believe the card has valuable lessons for today.

1.  People are more important than quarterly profits.  At the end of your life, if the only thing you are proud of is how many consecutive quarters of profitable ROE you produced at your job, you have lived an incredibly empty life.  Yet this is the focus of many in the banking world, especially managers who could not keep a customer relationship if it was handed to them.

In the credit union world, we speak of our clients as “members”.  A member is not just another account measured on a spreadsheet for its profit or loss to the institution.  These are real people that have real hopes, dreams, fears, and goals.  They each have a past, present, and a future.  They each also choose to work with you because they trust you.

2.  Good long-term relationships will grow your shop better than flashy short-term achievements.  Those who love to “stack-rank” the spreadsheet results deny this principle.  Yet it is true.  The goal each of us should have is to be a trusted financial advisor to our members.  This means they will come to you because they believe your counsel is valuable and that you have their best interest in mind.  I have often said you know when you win at the relationship battle when a client comes to you for strategic financial advice that does not involve the immediate need for a loan. 

When you get to that point, if you are lucky enough, you have made a true business friend.  Your member will also begin to introduce you as his “banker”.  This is a term that is not politically correct on the credit union side of the fence.  But if someone calls you his banker, you have won the relationship war. 

I was once at a bank where the spreadsheet geniuses came up with this new “streamlined line of credit” for business customers.  This was an business unsecured line of credit that was only credit scored in its underwriting.  This product was pushed out to the front line customer service reps who had no knowledge of business lending.  The leadership in our local market did not use the product as most of the rest of the branches pushed the product on customers like a drug dealer does to a heroin addict. 

Our market never achieved the applause of senior management during that two year stretch for selling the product.  We did continue to develop relationships and put good loans on the books in that period.  We also did not experience any of the $4MM of losses the program had with fraud and unsecured lending; things that could have been stopped with proper underwriting.

3.  At the end of the day, remember what is important.  No matter how long and hard you work, you always need to remember what is most important.  Relationships and not results always trump, especially those relationships with our friends, family and Creator.  These will outlast any position you hold, any achievements you reach, or any failures you earn. 

Each time when I come across the handmade card, I thank God for the wisdom shown to me by a little 7 year old boy.

Independence Day

I have always been fascinated with U.S. history and minored in it at college.  Of all the periods that intrigue me, perhaps the one that fascinates me the most is the period of the American Revolution.  It is amazing the character and fortitude of the men and women who founded our country and fought against the world superpower of their day.  As we come upon the fourth of July, we often will have a day filled with family, BBQ and fireworks.  I have plans that involve each of those items on that day and will begin marinating the pork shoulder for the smoker on Tuesday evening.  I do think it is valuable to pause, and take time to reflect on the significance of the day.

This year, I took some time to reread the Declaration of Independence.  Some today will scoff at the Declaration or the Constitution, saying that these are overly simplistic frameworks for government in such a complex society that we have today.  I strongly disagree.  Our founders realized certain truths that are built inside of all people, regardless if they live in the horse-and-buggy or the space shuttle era.  They considered these truths to be “self-evident”, meaning that they did not require a lawyer or philosopher to argue their merit. 

“…all men are created equal…” This flew into the face of a society that was based on a hierarchical structure of a royal, ruling class and the rest of us.  Everyone is equal under the sun.  In the credit union world, we count every member the same.  It does not matter if it is a struggling college student or the successful, wealthy business owner.  All are members and are entitled to the same representation.

“…that they are endowed by their Creator with certain unalienable Rights, that among these are Life…”  The founders acknowledge everyone has the same right to live: the young and the old, the sick and the healthy, the rich and the poor, those who have made their mark in the world and those who are anonymous.

“…Liberty…”  All people are born to be free.  Our founders threw off the oppressive government of Great Britain.  This was not an easy decision, for they had to give up the security of being under the world’s most powerful nation to being on their own.  This is a struggle we see today with some wanting to live in the safety of a strong government.  Benjamin Franklin saw it different when he said, “Those who would give up essential Liberty to purchase a little Temporary Safety, deserve neither Liberty nor Safety.”  Thomas Jefferson, the writer of the Declaration said, “A government big enough to give you everything you want, is a government big enough to take away everything that you have.”

“…the Pursuit of Happiness.”  The founders state here that people are allowed to follow their dreams.  This is one of the principles that has made our country achieve more than any other country in history.  Think of the things we have each day because people have refused to accept the normal status quo and have achieved their dreams.  We take for granted things like the light bulb, computers, cars, air conditioning, baseball and good BBQ.   All these came because people followed their dreams.

The Declaration ends stating the signers were pledging their “lives, fortunes and sacred honor”.  Many of them and countless others have sacrificed so much in order for us to be free.  So on this Independence Day, before you take time to light fireworks or sink your teeth into the smoked pulled pork, take some time to reflect and be thankful for our country and those who have sacrificed so much for it.

Is EBIDTA the Holy Grail of Understanding a Company?

I remember the first time I was in a classroom at the bank I worked for in Jefferson City, Missouri.  I was a seasoned banker, but quite a young pup when it came to the commercial and agriculture side.  One of my banking mentors taught a short class on how to figure the Debt Service Coverage Ratio (DSCR).  This is figured by taking EBIDTA (Earnings Before Interest Depreciation Taxes and Amortization) divided by the annual debt service requirements for the firm. 

I was amazed.  I was looking for the holy grail, the excalibur that I could use to dissect the financials of a farmer or a business and gain clarity of whether the company could manage the proposed debt requirements for the loan request.  I thought I had just conquered commercial lending.

EBIDTA or another similar term, Net Operating Income, is not only used in calculating the DSCR but is also used in figuring value by using Cap Rates.  So now I was even more excited that I could not only see if the company could service its debt, but I could get a value of the company or the collateral as well.  Now the conquering of commercial lending turned into a mastery of the subject.   High fives all around.

My mom always warned me about getting "too big for my britches”.  That is good advice, as life is a constant learning experience, and just when you think you are really solid, get ready for a fall.  This was the case with my supposed mastery of the subject.  I quickly learned there is no holy grail, only road signs to help you determine the health of a firm.

It all came clear with a manufacturing company who wanted to acquire a new machine.  I did all the due diligence and determined that the customer could historically service his existing and proposed debt based upon my EBIDTA and DSCR calculations.   I completed my write-up and sent it to my boss.  The wise sage requested to see a detailed depreciation schedule.  I wondered why, since you could get the whole depreciation figure from the income statement without looking at the schedule. 

The sage called me in the next day and said, "Young grasshopper, the company has three pieces of machinery that will need to be replaced next year according to their history and depreciation schedule.  Where will the capital come from for the machinery?"  The manufacturer had equipment or parts that went on larger pieces of equipment which would wear out every two years and need to be replaced.  Since the replacement would be completed and benefit the company beyond this fiscal year, they capitalized and depreciated the asset instead of expensing it as a repair item. 

So, I had failed to account for that planned expense.  Calculating it in took my slam dunk deal into questionable territory or maybe a denial.  I trudged back to the company's CFO to get more answers. 

An important factor in analyzing a company is to look at required and necessary capital expenses that will be required to maintain the current level of production.  For my firm, the $150K for machinery press and drill parts was necessary for keeping three key machines running to continue production of granite countertops; otherwise, the company could not machine cut the countertops and would have to cut all by hand.  This would either require more staff or less production, either of which would drop the NOI substantially.  We had to uncover how those items would be paid for.  In this case, the company had set aside most of the money and was planning to pay for the last 1/4 with cash from several large sales they were to get in the next two months. 

This was a case in which only looking at the EBIDTA or NOI to figure the DSCR was not enough.  It required a further look into the planned capital expenses to determine the adequacy of cash in the company.

It is possible that the EBIDTA number can be understated.  I have banked with some hotel operators, who will expense any repair or improvement item for the hotel:  light bulbs, replacing broken furniture, new carpet, or repaving the parking lot.  All of these have different treatment accounting-wise.  The light bulb is a consumable item that should be run through the repair expense.  Replacing broken furniture can either have an expense for the broken piece depreciated out and the new one capitalized, or one could just expense the new one in the repair line.  The carpet should be depreciated over the expected life of the carpet.  In the case of this hotel, it was around 5 years.  The parking lot had an expected life of 15 years. 

If all of these items were in the repair expense, it would be counting repair items that would not necessarily be occurring every year.  Perhaps you may want to do that if you have a property that is requiring large amounts of ongoing capital investment year after year.  But in most cases, the one-time expenses should be pulled out, and a capital expense allowance can be used.  This is an estimate that on an average given year, some percent of gross income (usually 3-5%) will be spent on capital improvements for the property.  Using this method will help average out the EBIDTA in years when improvements are made and expensed, and in those years when no additions are done.

The Commandments of Borrowing

1.  Asking “How?” and “What are the proceeds used for?” is just as important as asking “How much?”  In the majority of borrowing situations, the business owner focuses only on how much money they need as their primary concern.  But understanding what the proceeds will be used for and how the loan will be repaid is equally important, because ignoring these issues could lead to borrowing wrong.

“Is borrowing wrong even possible?” you may ask.  It is not only possible, but it is probably likely, unless both the debtor and the lender approach each borrowing situation armed with a firm understanding of the basic financing patterns and the lending requirements for the correct structuring of liabilities.  Improper financing can be the death to a business. 

2.  Growing businesses and farms will often require an increased investment in both current and fixed assets.  It is incorrect to assume that growth in revenues will occur without any required growth in assets.  The only case where this is not true is if there is gap of unused capacity within the growing company and an increase in efficiency where the result is an increase in sales. But in most cases, if your borrower expects to double his sales, it will require an increase in resources to accomplish that.

3.  Fluctuating current assets should be financed by cash or short-term debt and paid off by cash flow.  Recently, I saw a financial statement from a company that had a large debt to a supplier that was over six years old!  This is a situation where the borrowing was improper.  If you borrow money from a lender or a vendor to get supplies that you need to manufacture your product, that debt should be paid off when you sell the product and are paid.  It should not be paid off from net profits after all other operating expenses are taken care of. 

Lenders can help manage this structure with using borrowing bases and other controls to force the business to pay back the operating lines in a timely manner.  This also requires understanding how and when cash flows through the business for proper structuring.  Lines should be reviewed at least annually and should be monitored at least monthly.

4.  Permanent current assets are financed by equity, permanent current liabilities or intermediate term debt and are paid off by net profits.  Any seasoned lender has been in a place where a line of credit becomes “evergreen,” in that it does not get paid off or reduced in outstanding balance.  This is a clue that the line is improperly structured.  These debts should be placed on an amortized payment and paid off by the net profits of the business over a reasonable period of time, perhaps up to 5-7 years.  The struggle here for the lender is how to properly collateralize this loan, since assets such as real estate, buildings and equipment may already be pledged.  Use of a government guarantee like the SBA may be a nice alternative to mitigate the risk. 

Permanent current assets are the base levels of cash, accounts receivable and inventory that these items never drop below.  If a company has an accounts receivable level of $50,000 and inventory of $50,000 with sales of $1MM, then it is expected that the company would need to have receivables of $100,000 and inventory of $100,000 to reach sales of $2MM.  This is assuming the accounts and inventory receivable turnover ratios remain constant. 

Of all the needs for lending, the most difficult may be the permanent current asset financing.  When a company has real growth, as opposed to a seasonal fluctuation, that represents a permanent increase in current assets, these will behave like a fixed asset.  This should be financed with equity, permanent current liabilities, expanded terms from suppliers, or intermediate term debt. 

5. Fixed assets are financed by equity and long-term debt and are paid by net profits of the business.  Most of these assets are capitalized and depreciated.  Fixed assets usually relate to fixed costs, those that do not change relative to sales over a reasonable range.  Increases in fixed assets should lead to greater capacity for the business to increase revenues. 

These are generally the easiest to finance.  The amortization term should not exceed the useful life of the asset.  Proper LTV, LTC, and terms are usually spelled out in your loan policy. 

6.  Ignoring these principles will lead to friction between the borrower and the lender.  It could lead to a business that fails and a lack of sleep as the loan officer worries about the customer.   Proper adherence to these ideas will give the business or farmer the best chances for success and also grant adequate cash flow to sustain the business.

A Company Gone Under

The last stage of company growth after Wonder, Blunder, and Thunder, is the Under stage.  This is the time when the company’s effectiveness wanes and many firms just go out of business completely.  A company can fail for many reasons.  It can fail to recognize new trends that make their product irrelevant.  It can fail due to poor financial management.  Its leadership can also fail to plan for the future.  Consequently, many companies die and are buried each year.

When dealing with this stage, it is important to realize that sometimes it is healthy for a company to be allowed to die; in some cases it is planned.  A case may be a small one-accountant CPA firm with no future succession plan.  In that case, it would be wise to sell the business and close shop when possible.  Some companies may exist to complete a particular task, and when the job is done, the company needs to end.  In each of these cases, it is important to make adequate plans to close the business.

Some companies do not adapt to changes in the world around them.  Just think of the changes in how music is delivered.  When I was born, records were the rage.  Then came the 8-track tape.  This was improved with the cassette tape.  The first stereo I bought could play records, 8-tracks, and cassettes.  I thought that I would never need another system as long as I lived. 

But then came the CD.  The sound quality was so much better and I thought that this was where all music was going.  Now we have iPods and downloadable music that is more convenient and sounds better than any other in the past.  Music can be downloaded any time from multiple sources on the Internet, and trips to the record store are obsolete.  My kids have more music on their devices today than I ever dreamed could be possible. 

If you had a company that just made records or just made cassette tapes and never adapted to new ways to deliver music, you would already have closed your doors by now.  Avoiding the “under” stage requires vision and foresight to keep the company out of the graveyard. 

Avoiding this stage also requires the company to have some of the characteristics of the other three stages.  The firm needs the excitement of the wonder stage and the desire to understand the world around it.   They also need to be willing to take the chances and overcome the failures evident in the blunder stage.  The company must also capitalize on the victories and make a real difference in their market area. 

With proper planning and work, a company can maintain its status as live and vibrant instead of being six feet under and pushing up daisies.

The Thunder Stage - Making Real Noise in the World

If a business is able to grow beyond the Wonder and Blunder stages in its life-cycle, it will next come to the Thunder stage.  The impact companies have in this stage is similar to a Midwestern thunderstorm, with its flashes, crashes, wind, and rain.  The impact may be felt worldwide or may be on a local basis.  No matter what the scope of the market area is, the company does make a difference, and cannot be ignored.

Many of these companies are ones that are studied, benchmarked, and copied by others.  Larger ones may become household names like Apple, Microsoft, Toyota, Lowes, or Exxon. Large or small, the businesses make a lasting impact in the world around them.  They may even change how people live and the products they demand.  The explosion of personal computers, tablets, and smartphones are good examples of this. 

Companies in this stage are defined with a strong culture.  They have strong demand for their product and can command a good price for it.  They may be able to determine what customers they want to work with.  They also may be able to make a difference for the long-term and become a wonderful place to work for their employees.

The challenge to a company in this stage is how do they remain a “Thunder” force?  Just like a thunderstorm will dissipate when the conditions are not conducive, companies or products can also fade away.  In the past three years consider some of the large companies that have gone out of business:  Hollywood Video, Circuit City, Borders Book Stores, Ultimate Electronics, Fashion Bug, and Hostess.  These are all companies that we all assumed would always be there. 

Navigation in the Thunder stage is just as important as it is in any other business growth stage.  There is a tendency to become complacent in this stage since the company has “arrived;” however, that is just the recipe for failure.  The best companies that stay a Thunder force will spend a lot of resources improving existing products or delivery service methods, or expanding into new ones that fit their business model.  A good example is the constant improvement Apple makes with its products.  We have watched a company once irrelevant, and noted for its school computers; expand its reach into a high quality product that competes with personal computers in many homes.  They have begun the use of Apps instead of programs and have established the tablet and smartphone benchmarks with their iPad and iPhone.  Now, Apple is setting its sights on TV and changing the way you receive your cable or satellite channels. 

Succession planning of key personnel and products is also important.  A law firm may be one of the best in its area, but if they have key attorneys who leave or pass away, it can devastate a firm who has not properly planned.  If a manufacturer like Hostess does not place its company on firm financial footing, it may not have the resources to continue in the future.  If a company, who may be at the top of their class, fails to recognize a trend that is moving away from the industry, they will not remain a force for long.  Note how many blacksmiths and buggy whip manufacturers are around today.  Long-term vision is important to remaining in this stage.

It takes proper navigation, succession planning, and continual development for a company to continue to make a lot of thunder for the long-term.

The Blunder Stage—Going from Mistake to Mistake with Great Enthusiasm

The second stage of a four-stage business life-cycle is the blunder stage.  This stage is marked with flashes of brilliance among a sea of blunders, much like one will find in adolescence.  In this stage, the wonder of the early stages of the business has worn off and actual executable plans find mixed results of successes and failures. 

The challenge here is to not make mistakes serious enough to kill the business and also, to not get so discouraged that the business owner gives up.  Endurance and persistence are keys for a business to get through this stage. 

Winston Churchill said, “Success consists of going from failure to failure without loss of enthusiasm.”  Clearly these words must have rung in the ears of Englishmen while they endured some of the darkest days of WWII.  Churchill also realized that the journey is more important than success or failure when he said, “Success is not final, failure is not fatal; it is the courage to continue that counts.” 

The business leaders in this stage should remember the early wonder years of the company.  Why did you get into business to begin with?  What opportunities were you hoping to capture?  What was your business plan?  When you are in the thick of long work days, unending deadlines and a string of mistakes, it is easy to call it quits.   That is why it is important to review the vision and mission of the firm and relive why you started.

Not only is it helpful to remember the wonder years, it is helpful to look forward to the future to the next business stage, the thunder years.  These are the times when the company really becomes profitable and effective in its mission.  The mistaken laden times the business owner is in now will eventually pass.  Failure is not fatal, it is important to learn to fail forward. 

Some of the most successful businesses came from failing forward.  Henry Ford went bankrupt seven times before he landed on the Model T.  Dave Anderson bounced from job to job and city to city as a travelling salesman.  When he failed at that business, he opened up Famous Dave’s BBQ, his real love and passion, and became a millionaire.  Fred Astaire had his first rejection letter hung above his fireplace.  The director who turned him down for a part said he could not act, was a bad singer and was even worse as a dancer.  Astaire went on to become a household name with his dancing and acting with Ginger Rogers.

Flexibility and wisdom are important in this stage.  Leaders need to be flexible enough to change direction, abandon a product, or revise a strategy when necessary.  But they also need the wisdom and insight necessary to know when to stay the course and push through the failures, knowing they are on the right path.

Unfortunately, some businesses never move out of this stage, just like some people never seem to grow up.   But for the ones that push through, the glory years are just ahead.

The Life Cycle of a Business-Wonder

I once worked for a boss who believed that any business goes through four distinct phases in its existence, from its beginning to when the doors close down.  The overall success of the business will be determined on how well the leadership navigates through these stages and continues to remain relevant to its revenue source.  The ultimate challenge is for a business to avoid the last stage and to continue into stage three.  The four stages are: wonder, blunder, thunder and under.

Wonder:  Have you ever watched a young baby or toddler explore the world around them?  Have you ever gone on a trip to a new place that you always wanted to go?  In either case, you can see the wonder that surrounds the person as they explore their world.  The explorer’s eyes are big, and they tackle assessing every detail possible about their environment with inexhaustible zeal.  It has always fascinated me to watch people passionately exploring the world around them. 

This stage applies to businesses as well.  In many ways, MBS is in the wonder stage.  There are so many opportunities for a well-run business and agriculture CUSO.  We are located in the strongest economic growth area of the country that is being driven by multiple industries, a business friendly state and local government (compare that to much of the rest of the nation), a desirable place to live, and wonderful, hospitable people.  The demand for our services is off-the-chart as we are swamped with new deals, even when we have not actively solicited new business.  We are also gaining new, experienced people, who are excited about the possibility of building a company and making their mark on it.  Every day when I come to work, I am excited and amazed with the possibilities set before MBS.  We are truly blessed.

All start-up businesses go through this stage.  But not only start-ups, this stage can also apply to an existing business introducing a new product or service as well.  This stage is marked by characteristics that are necessary for a business in any stage to have, if it is to grow.  Any firm who wants to be better cannot just be satisfied by the status quo.  They must desire to achieve greatness.  The leadership must be willing to explore the world around them and discover ways they can become relevant with a new product, service, or a new way to make something existing better.  This is why large companies have strong research and development departments. 

My oldest son is interested in pursuing a major in game design in college.  We recently visited with a professor at an institution that offers a degree in this area.  As he spoke, you could see the wonder that he had for his field.  And as he spoke, his passion also transformed his wonder into actual wonder owned by my wife, son and myself.  You see, wonder is transferrable, and the passion of an executive can be shared among an entire team.  Someone once said that you can gain an audience if you set yourself ablaze first. 

 In that meeting, I learned that game design is not just about a nerd in his parent’s basement building some shoot-em-up game to be stocked at the local Game Stop.  Design involves an intricate team of professionals working together as one.  You have a story-teller who writes and designs the script of the game.  Graphic designers turn the written idea into pictures.  Three dimensional graphic artists make the game appear to be in the real world.  Scientists help keep the game grounded, using natural laws of physics or creating the game to defy those laws.  Computer programmers turn all this work into an actual game on some sort of platform.  Marketing professionals take the game and figure out how to distribute and sell the game.  They also get feedback from the market for improvements or for the next game.  It also takes leadership to make sure all these areas work together at once for one goal.

As the professor’s eyes sparkled while he described the process, I realized that successful companies in this industry are built upon a collaborative company model.  In many ways, these companies are textbook examples of how a business can run and work as a team.  Communication between the different players is important to achieve the final goal.

The industry is not just about what you buy your kid at the game store for his X-Box.  Games are being used for medicine, in rehabilitation of patients with brain injuries and training students.  Companies are beginning to use games to train their employees as the employee will retain more knowledge in an interactive environment that involves more senses rather than just reading or listening to a lecture.  Even large financial companies like Wells Fargo are looking to gaming as a way to train staff. 

The degree is challenging, with students taking classes such as physics and calculus.  Graduates compete for jobs with students from MIT.  Starting salaries are often above $80K annually.  But the possibilities are endless.  This is an industry in a wonder stage.

Some companies never leave this stage.  Now it is great for companies to always have some wonder in them, for that keeps them growing.  But to never leave the wonder stage is like always remaining a toddler.  A problem in this stage is focus and long-term planning.  It is easy to become so enamored with your surroundings that you go nowhere and are constantly running from one opportunity to another.  Strategic planning is essential. 

MWBS Can Help Increase Your CUs Earnings with Farmer Mac

Midwest Business Solutions is excited to add another tool that can help make your credit union money—Farmer Mac loans.  MWBS is now a direct seller to Farmer Mac.  FM offers a variety of fixed and variable rate financing on farmland, ranch land and farm facilities.  Leased farm ground may also be eligible.  Variable rates can fluctuate monthly, or on a one, three, five, ten, 7/1, or 10/1 year basis.  Fixed rates can be locked up to 25 years.  Amortizations on these loans can run up to 30 years.  The property must be involved in production of an eligible commodity as those listed by the USDA and must have at least $5,000 of annual gross agricultural sales.

FM also offers an AgEquity Line of Credit that gives the farmer a 5 or 10 year draw period followed by a repayment period of up to another 25 years.  The payments during the revolving draw period are interest only and will fluctuate monthly. 

Mortgage amounts are typically up to $11 million, and the maximum loan request for any one borrower is up to $30 million.  Payments can be set up monthly, semi-annually or annually for your borrower’s convenience.  The interest rates will be directly competitive with those at FSA or with an insurance company who finances farm ground.

These loans also represent no risk to you, as they are all sold into the secondary market.  You can think of it as a FannieMae or FreddieMac loan for farmers.  Since this is the case, your institution does not need to have an experienced ag or business lender on staff.  Any institution could participate in this loan.  Those CUs who have ag loans on their books, may find this product valuable to manage your balance sheet exposure.  You can move the term debt on the land to a FM product while you keep the equipment and operating line debt.  This can also help manage duration risk of placing a large fixed interest rate loan on your books while giving your farmer a product he wants.

The best thing is that even though this product is sold into the secondary market, you still have an opportunity to make money.  You can make money at origination and also can make servicing income throughout the life of the loan, even though it is not on your books.  If you had a FM loan with an average balance of $1 million and were making 50 basis points on the servicing side, this would translate into another $5,000 of non-interest income for your credit union. 

You can find out more about our FM loans at www.mwb-s.com/farmer-mac.   Our site also has information on the different FM loan types, an underwriting grid for various FM loans and a series of questions to help you talk about this product to your customer. 

We will be sending out rate sheets on a weekly basis for the Farmer Mac products.  If you want to get on our rate sheet email list, email me at phil.love@mwb-s.com.

How MWBS Manages a Participation Loan

Do Participation Loans Scare You?

The proper answer here is:  “They should!”  Especially if you do not have a clear idea at any time how the file is being managed.  Concerns over what information is or is not present in a file and if the risk profile has changed from what you know will keep you awake at night.  Thinking about how an examiner will treat a participation that lacks proper loan documentation is downright a nightmare!

 Recently, we closed a major participation loan.  Even after the closing, there exists some confusion among the participants as to what role MBS plays in the transaction and what role the credit union plays.  In this blog, I thaought it valuable to provide an overview of what each stakeholder does in a MBS participation.

Pre-Underwriting to Term Sheet

The interaction between MWBS and the member is determined by the lead credit union.  In the most recent loan we closed, the lead was not familiar with lending in the borrower’s industry.  They provided us the contact information, and we met directly with the partnership group to discuss the project and gather all necessary documents to underwrite the loan.  We also met directly with the general contractor and the developer of the retail/office development.  After these meetings and our collection of information, we worked with the lead credit union as to acceptable terms for the loan.  These terms were documented to the client in a term sheet.

Each interaction with a commercial or agricultural member is different.  It is the responsibility of the lead credit union to determine when and to what extent to involve MWBS directly with the client.  I have spent over 20 years in the field.  I hated when my relationship with the client was usurped by a manager who had nothing better to do than to meddle.  Sometimes I had to apologize to the client after the meeting just to keep the relationship going.  At other times, directly bringing in an expert from the credit side of the shop helped strengthen the customer relationship and navigate the credit request into a closed loan. 

So it is my belief and also the position we take at MWBS, that the level of direct interaction between MWBS and your customer is determined by you as the lead.

Underwriting to Loan Sale

Once the borrower approved the terms, we then continued the underwriting process by analyzing all relevant information and preparing a comprehensive write-up.  The lead credit union reviewed both the write-up and all source documents, made suggestions for improvements on the credit analysis and then approved the deal.  In this case, the credit union did not want to own the entire credit, so a participation sale was needed.  MWBS revised the write-up for the sale and began to market the opportunity, first to MWBS members, then MWBS subscribers, and finally to any other interested funding source.  In each presentation, the interested loan buyer had access to both the credit presentation and all source documents to make their own judgment about the appropriateness of the credit for their portfolio.

At the same time, all other things necessary to complete the underwriting, such as the appraisal, environmental report and title work, were all ordered and reviewed by MWBS.  These documents, along with MBS reviews, were presented to the participants.  

Closing

Closing documents were prepared by MWBS.  We have a loan document system that allows us to prepare appropriate closing documents, applicable in any state.  In this case, we had participants in North and South Dakota, a borrower in North Dakota and a project in Minnesota.  The document set was sent to all participants and borrowers for review prior to closing. 

MWBS worked directly with the title company to arrange the closing and utilized the title company to close the transaction and handle the filing of all appropriate lien documents. 

Construction Management

MWBS will manage the construction process on this loan.  We have contracted with a title company to handle all disbursements and lien waiver collection.  We also have a third party architect that will provide percentage of completion inspections throughout the process.  This is in addition to the general contractor and architect of the borrower signing off on each draw request. 

Draw requests and inspections will be presented to the participants when funds are needed.  Each participant will be able to review the request and will then electronically transmit the funds to MWBS’ account.  MWBS will then directly pay the title company, who will pay the construction bills.

Loan Servicing

MWBS services its own participations.  All bills and statements are generated by MWBS and sent to the customer.  Any other customer communication, such as sending tax statements, comes from MWBS.  Payments are sent to MWBS and applied to the loan, utilizing the core processing system of MWBS.  Monies are distributed to each participant, along with a detailed breakdown of how they should be applied.  It is the job of the lead and its participants to apply their payment appropriately.

Loan File Management

It is my belief that if you are the participant on a loan file, you should have access to whatever is in the file.  We provide that through a secure electronic file that can be accessed on-line.  Each credit union participant has its own folder set up on our servers and its own unique password.  A credit union can log in and view its loan files in an indexed fashion whenever it wants. 

File management is ongoing, and MBS utilizes an electronic tickler system to track when information is required to be placed in the file according to the loan covenants.  Notifications can be sent directly to the borrower and communicated to the lead credit union, if assistance is needed to collect documents.  MWBS reviews these loans in light of the current financial information on an annual basis.  A term loan review is prepared, along with a new risk grade, reflecting the current condition of the credit.  All this information is placed in the electronic file.  Loan owners can access current information that has been processed by MBS inside the file.

The Role of the Credit Unions

The loan owners may find this structure is different than other participations they are involved in.  The lead credit union helps determine the direct level of involvement MWBS has with the client.  The lead may assist MWBS in obtaining all the necessary documents for underwriting, but the lead does not produce the loan documents, close the loan, accept payments from the customer and pay all participants directly.  All this is handled by MWBS. 

I would like to say the participants can just sit back and relax after the loan is closed, but I would be lying if I told you all you had to do was to clip payment coupons that we send you.  The loan participation is still an asset on your books, and as with any asset, you must watch and monitor it as if this were money from your own grandmother.  The MWBS structure gives you the proper tools to do that.

Selling from the Front Porch

I used to love going with my parents to my Aunt Betty and Uncle Andy’s house when I was young.  They lived on a farm in the country.  We would usually get there in the late afternoon and begin to spend some time fishing or picking fruit and vegetables from their large garden and orchard.  The work was followed by a hearty supper, which always included some form of meat.  Andy was a hunter, and you were never told what you were eating until after the meal. 

We typically would retire on the warm Missouri summer nights to the front porch, where we would work on processing the garden produce.  Oftentimes, we would have a glass of sweet tea or some homemade ice cream.  We would sit together, talk and share our lives with each other.  It was what happened after supper that taught me some of the best lessons on sales that I have ever learned in my life. 

Saying you were sold something is always a negative, saying you bought something is always a positive.  Jeffrey Gitomer says it like this, “People hate to be sold something but they love to buy.”  I first learned this one night when a neighbor of my uncle’s dropped by to complain about the “lemon of the truck he was sold.”  The salesman had “sold him a bill of goods” about the truck’s ability.  My uncle, who has always been a proud GM owner, began to rave about the Chevy truck he recently bought. 

If you listen to yourself and to other people, you will find this principal to be true.  Every time you have a bad experience with something you bought, you never want to take ownership that you actually made the decision to buy it, but that you were “tricked” into acquiring the item by a salesperson.  When you make a purchase you are proud of, you tend to puff out your chest and announce to the world how smart you are.

People don’t care how much you know until they know how much you care.  I saw this with a few salesmen who would wander up the driveway when we were snapping beans.  One guy, who was selling encyclopedias, was interested in only finishing his well-rehearsed sales speech and ignored some of the questions my aunt had.  He was only interested in getting to the close.  He ended without any sale, because he did not care about the customer. 

The knowledgeable salesman was in stark contrast to a fuel salesman. My uncle used a bit of fuel around the farm in his equipment.  One evening Joe, the fuel salesman, came by.  He did not have a well-rehearsed sales speech and was not in a hurry.  Instead, he sat down in a chair on the front porch and began to shell peas with the rest of us.  He was genuinely interested in my family as we shared life together.  He did not get the sale that evening.  It did take several more evenings of snapping beans and shucking corn on the porch, but eventually, he did get my uncle’s business, the business of the rest of his family and also the majority of the neighbors.

People find it easier to buy from people they know and like than from strangers.  Not only that, but if they know and like you, they will refer other people they know to you.  The adults in my family would frequently recommend mechanics, butchers, ag suppliers and anything else that they had a good relationship with and they trusted.  They were also not afraid to tell about those they wouldn’t touch with a ten-foot pole.

In order to sell, you must first come up to the porch.  No matter if you like it or not, we all must sell to survive.  Even though credit unions tend to be more relational than our banking brethren, we still must sell ourselves and our institution.  The most successful sales people are those who are wise enough to take the time to join your members and future members on the front porch or the back deck.

These are two places where life slows down.  Everyone on the porch is a real person who has hopes, dreams, history, fears, successes and things that keep them up at night.  You can be successful on the porch if you show interest and are genuinely curious about other people.  It is in the sharing of life that relationships are built.  As those relationships are built, your credit union will grow as more members come into your group.  They will not do so because you had the best rate or the best product.  They will do so, because they believe you are the best one to meet their financial needs.

Someone once asked me how I could so naturally visit with business owners and walk away with loans and deposit accounts.  I smiled and said if I ever lose my bearings, I just close my eyes briefly and step onto their porch.  If you want to be successful, sit down and pour a glass of tea.  You may find the pace a little slower than the telemarketer, but you will find some friendships that will last a lifetime.

Coverage Ratios: Is Your Company a Little Exposed?

Coverage ratios are designed to measure how well a company is able to meet the demands of its operational expenses and debt requirements. They are similar yet different from leverage ratios. In leverage ratios, we measure the lender’s margin of comfort in the event of liquidation. Coverage ratios indicate the cash flow margin of the company as a going concern. Highly leveraged companies or businesses with high debt requirements are vulnerable to an economic downturn or a drop in top line sales, because the fixed payments from the debts may conflict with the reduced cash flow from the falling sales. The company will have to do whatever they can to provide cash to satisfy their obligations. Ultimately, an answer will be to find a way to de-lever the company and reduce its obligations.

Times Interest Earned Ratio (Interest Coverage) is used to show the ability of the company to meet its interest obligations. It is used a lot by public bond rating agencies and banks monitoring revolving lines of credit, revealing the amount of company earnings needed to pay interest on its debt. The reason for the focus on just the interest rate exposure is that many bonds and lines of credit do not require any amortization.

Since it does not take into account the principal portion of payments, the ratio will have its shortcomings. But it is a valuable picture of what impact an increase in borrowing rates will have on the company’s cash flow and the extent which earnings pay the financing requirements of the firm. The ratio must be at least greater than one, since a ratio below one will indicate the company does not make enough net cash flow to pay its interest requirements. This is the case in several European countries now.

The ratio is as follows:  (Net Income Before Taxes + Interest Expense) / Interest Expense

Debt Service Coverage Ratio is the granddaddy of the coverage ratios in the eyes of the lender. This measures the ability of the company to perform on its debt obligations. In simple terms, it is defined as:  Earnings Before Interest, Taxes, Depreciation and Amortization (EBIDTA) / (Interest Expense + Current Portion of Long Term Debt (CPLTD))

This is designed to show, after paying all the operational expenses of the business, how does the debt requirements compare with the EBIDTA. A ratio of 1:1 would indicate that the company is able to pay all its obligations but has no money for anything else. Lenders will often use this as a loan covenant or measuring tool to assess the health of the business. They will also have different thresholds for different industries, ages of collateral and types of collateral.

There are some concerns with this ratio. If a company makes large capital improvements and then expenses them, this could lower their EBIDTA to a point where they may be in violation of their loan covenant. A prudent solution is to keep separate financials according to GAAP while having another set that complies with the tax law. An example here would be a manufacturer who is able to fully expense $200K in capital improvements to their plant under repair and maintenance in the year the work was completed. This reduction in EBIDTA may put the company in violation of the DSCR requirement.

A shortcoming with using the DSCR is that the expenses for taxes are real cash expenses. Using the DSCR they are not regarded at all. Another problem with using EBIDTA is if a business has regular ongoing capital expenses each year, necessary to continue operations. Ignoring those expenses may show an adequate DSCR, but miss the overall shortfalls of cash needs the company may have in order to keep operations intact.

Another issue with DSCR is how to treat large salaries or personal expenses of the owners. These would be treated as ongoing operational expenses, but if excessive, may show the company in a worse light than what it is. If the excessive salaries are added back, then a look at the global picture of the owners, the subject company and their other businesses may be appropriate in judging the financial ability of the company.

Funded Debt/EBIDTA Ratio and the Debt Yield are used by some banks to see a comparison of the balance of all funded debts to EBIDTA. The ratio for Funded Debt/EBIDTA is:  Balance of all Funded Debt / EBIDTA = Funded Debt to EBIDTA ratio.

If you have a company with a ratio of 2, this would mean that the entire balance of all funded debt is only twice the amount of EBIDTA. The reciprocal of this is the Debt Yield which is figured by:

EBIDTA / Funded Debt = Debt Yield and is usually expressed as a percentage. So if we have a ratio of 2:1 in the above ratio, this one would be 50%. These ratios are used by some lenders to judge the amount of leverage compared to the net operating income of the company.

Challenges with Available Collateral and SBA Loans

Small Business Administrative (SBA) loan requests are not to be declined solely on the basis of inadequate collateral.  Lenders can use the SBA program for borrowers that can show they have an adequate repayment ability and cash flow but have inadequate collateral to fully secure and repay the loan if it defaults. 

SBA will require that the loan must be “fully secured”.  This means that the loan must have a security interest in all available assets with a combined liquidation value up to the loan amount.  “Liquidation value” is the net amount expected to be received after the asset is sold.  This net amount considers all care and preservation expenses and existing liens have been taken care of. 

As a lender, the SBA requires you to identify all available collateral and determine the liquidation value of each one.  The liquidation value may be determined by the lender based upon their conventional or SBA lending policies. These must be consistently applied from loan to loan.  The SBA does not define exactly how a borrower’s personal residence should be valued.

In the SBA Standard Operating Procedure (SOP) 50 10 5(E), Chapter 4, the SBA does require that lenders secure each loan to the “maximum extent possible up to the loan amount”, utilizing the assets tied to the borrowing business as well as the personal assets of each principal.  It does not matter if those personal assets are owned individually or jointly.

If the loan is not fully secured, the lender should determine and certify that no additional collateral is available.  This should be documented in the file.  If there is a collateral shortfall, this should be mitigated by the other strengths in the file.  If other assets are available, they should be taken as collateral.

In the SBA 7(a) loan, it is a common practice to take the borrower’s primary residence as additional collateral for the loan to prevent a shortfall or impairment to an SBA Guaranty, in the event of liquidation or default at a later date.  There are two exceptions to this rule:

1.  A personal residence that has equity less than 25% of the property’s fair market value.

2.  When there is a legal impediment, such as an irrevocable trust or a prenuptial agreement, that prevents the borrower from using a spouse’s individually-owned property to secure a loan.

In the SBA 504 loan, it is extremely rare for a Borrower’s personal residence to be taken as additional collateral.  This may be more desirable to the member.

Proper handling and securing of collateral when using an SBA loan will provide protection for your Guarantee.  The SBA program should not be used to place a marginal loan on your books.  A problem loan that has an SBA guarantee will require a lot of your time and effort to manage the credit.  The SBA program should be viewed as a way to help mitigate the risks for a good credit that may have some weaknesses in the collateral coverage.  

The Power of Persistence

In college, most fraternities and sororities tend to headline some of their most successful members:  CEOs, athletes, celebrities, great scientists and presidents.  It was during my freshman year that I became acquainted with Calvin Coolidge, the only US President who came out of my fraternity.  Coolidge is not as well-known as many other Presidents.  He was known as a man of few words.  One time, at a party, a lady guest bet the President that she could make him say more than three words.  Coolidge calmly replied, “You lose!” and walked away.

When Coolidge spoke, his words were very pithy.  It is his comment on persistence that has made an impact on my life.

“Nothing in the world can take the place of Persistence.  Talent will not; nothing is more common than unsuccessful men with talent.  Genius will not; unrewarded genius is almost a proverb.  Education will not; the world is full of educated derelicts.  Persistence and determination alone are omnipotent.  The slogan ‘Press On’ has solved and will always solve all the problems of the human race.”

The wise commercial or agricultural lender knows that persistence is very important in the sales process.  True, it is good to have some easy deals that can be done quickly, but the real “golden members” often take months and years to cultivate.  These are not transactions, but long-term relationships with people who own and run the businesses.  These people are the same as you and I, in that we all have hopes, dreams, ideas and things that will keep us up at night.  We all aspire to do great things beyond ourselves, for that is how we are made.

After being on both sides of the credit union/banking fence, I think that the relationship building aspect comes easier to the credit union folks.  I may be wrong on this, but I feel the credit union culture is more focused on people and relationships than profits and bottom lines.  Relationships take time to build, sometimes years, but the outcome can be rewarding.

When I was banking in Missouri, one of the clients I was handed had a $500K loan with our bank and was a large developer.  The client had a small group of financial savvy individuals he would work with on large condominium projects.  My first strategy was not to ask for more business, but to learn more about them and their company.  I grew to know all the players and their families over several years of meetings, lunches and site visits.  When I left that bank, we had over $12MM of various projects and term notes that we financed for them.

My longest persistence story came when I was in Colorado.  About a year after I began banking there, I was introduced to a small company that was growing rapidly.  They were in a segment of the construction industry that did not experience the economic slowdown and was the recipient of large sums of Federal, State and bond funding.  I met and began to get to know the CFO and one of the owners. 

I spent time with them and learned about their industry, their company and developed a relationship with them personally.  After a couple of years, we closed a large construction crane lease of over $1MM.  We still had no deposit accounts nor did we have their main lending relationship.  My strategy was to continue to get to know them.  I made office visits, had lunch and breakfast appointments and took them to sporting events.  Around 4 ½ years into the relationship building, the main partner completed a large job in Missouri and Australia and moved back to Colorado.  We opened personal accounts and closed on a mortgage and equity line for his new house.  We also began to discuss moving the main source of financing to my bank. 

Eventually, after 5 years of developing a relationship, we established a relationship with over $15MM of loans and another $20MM of deposits.  It was one of the largest new deals our bank did that year.  This was done with a combination of genuine interest in the people and the company, willingness to invest time with them (even sometimes investing your time for the long haul instead of the quick easy deal that comes in the door), and persistence.  The commercial and agricultural sales cycle is sometimes quite long.  But if you are persistent, it is rewarding.

Labor Market Outlook

Look at the pictures below.  The picture on the left is a lettuce robot.  It travels down the rows and picks heads of lettuce.  The picture in the middle is a strawberry robot.  The robot travels around the strawberry plants and gently picks ripe strawberries with it foam fingers.  The picture on the right is a GPS in a combine harvester.  This is used to drive the combine down the rows to maximize the harvest in the most efficient manner.​​

So what is in common with these three items?  They all do work and reduce the number of workers needed to complete tasks that used to be completed by people.  Today in agriculture and business, more and more tasks are being accomplished using technology, which requires fewer workers.  The architect may have ¼ of the staff he had in the past, as he relies on CAD equipment instead of a large group of draftsmen.  Factories are now staffed with robots, where they used to be filled with people to complete tasks.  Credit Unions operate with less tellers and staff, as more people use other ways like online banking and ATMs to access their money. 

This is both a blessing and a curse on the US Economy.  The blessing is that we are the most productive country in the world.  The curse is that it will continue to take fewer workers to create the same economic output.  Note the chart below of industrial production and employment.

Note in 2009, the US had $600B of labor costs for $2.4T of industrial output.  This is by far the most productive economy in the world.  This trend has been continuing for years, as is shown in the next chart.

More and more GDP goes to capital and less and less to labor.  So when you hear about manufacturing returning to the US, which it is, that may not translate into the same increase in labor as it did in 1970 or even a decade ago.  In the 1950s, a young man could get a job in Detroit, attaching the rear wheel to cars as they go down the assembly line.  He could make a career with that job and make a nice living for his family by just doing that one task.  Now, that same job is handled by robots, which do not require all the costs of benefits and salary the worker does.  The economy has changed.

We now live in a world economy where globalization and high technology will leverage top talent.  The talented can now be seen and demanded by a world audience instead of a smaller local or regional one. Areas that were completely closed to capitalism in 1980, like the old Soviet Bloc, China and India, have now embraced it.  This has created a larger supply of labor around the world and has also created many more customers. Highly demanded processes can reproduce at a breakneck rate like Amazon, Starbucks, Wal-Mart and Apple apps.  Top CEOs and professionals will use the world market to bid up their income.  This equates into a growing gap between those in demand and the ordinary worker. 

Today, it is important to grow and acquire skills that are in high demand.  This could make the difference between financial struggle and success.  I would encourage everyone to study the chart below.  Note the difference in wages between changes in wages among the highly educated and those with the least.

We all know a graduate degree will not guarantee success, and there are those dropouts that occasionally end up on top; nevertheless, it is still important to gain as much training and skill sharpening as you can to develop talents that will be in high demand in the coming years.

The US Economy: A Good Future?

Despite all the problems with the US Economy after the crash in 2008, we are still the only developed economy to have a higher GDP than what it had prior to the crash.  In some ways, we are the best house in a bad neighborhood.  Here are some positives and negatives in the US:

+ We have an energy bonanza fueled by hydraulic shale fracturing (“fracking”) which will continue for decades.  This has provided an abundant low-cost energy resource.  There is a wide gap between the price of natural gas compared to the price of oil.  Gas prices are 4xs more expensive in Europe and 5xs more expensive in China than they are in the US.  This provides low cost energy to fuel our economy.  Natural gas provides some cleaner environmental benefits compared to other hydrocarbons.  Fracking is also friendlier to the environment than traditional drilling as there are less holes drilled in the ground.  An interesting aside is the only place in the world where there is not the presence of shale gas is in the Middle East. 

+  The US has the world’s most innovative and productive economy.  We have the highest gap between what industrial workers are paid ($600B) and industrial production ($2.4T) of any country in the world.  We are still the place of great innovation and new ideas that fuel new industries.

+  The US banking and credit union system has been largely repaired and is well-capitalized.  There is a slow renewed growth in lending. 

+  There is a slowly accelerating business formation and job growth, but this is primarily in several areas or regions of the economy, as opposed to being all across the country.

+  The housing market appears to have bottomed in many areas and is moving up.

+  The US has decent private-sector growth and has some government shrinkage, especially at the state and local level.

-   There is a lot of uncertainty in a “fiscal cliff” deal and how that will actually impact the economy.  We need a strong and stable plan to work through the issues now and not just push this into the future.  If a decent deal is done, the economy could surprise to the upside.

-  The US has a large growth of entitlement spending with a record number of people on food stamps, unemployment compensation, Social Security Disability, and now healthcare.  We simply can’t afford this.

-   There is an uncertainty in the private sector, with a tsunami of government rules and regulations.  This is increasing the cost of doing business and will lessen productivity.  It will also force some companies to cut back or close altogether.

-   By far, the largest threat to the US economy is the large amount of domestic debt we have in our country.  This is at a level that we have never been at in the history of our country.  Highly encumbered households do not spend.  Governments at all levels will cut back.  Companies lack the top line growth and don’t expand capacity, and political games will paralyze decision making.  This will hamper growth for years to come.

Take a look at the chart below.  This measures total debt in our economy as a percent of GDP.

Total Domestic Non-financial Debt as a % of GDP

Source:  Ned Davis Research, March 2012

Note the drop that shows up around 2009.  This is not from retiring debt.  It is from mortgage defaults and the reduction of debt that came from foreclosures.  One thing to note is that we have had huge debt bubbles in the past.  Note the following chart that has tracked Federal Debt since 1791.

Source:  Blanco Research

Note that the federal debt from WWII was higher than it is today.  One difference today is that a greater percentage of Federal Debt is not held by the public.  How did we drop from the high after WWII to a low of 28.9% in 1975?  Did the government pay off that debt?  The next chart shows the key.

See, there is no way to pay down the debt without inflating the currency and retiring a fixed amount of debt with inflated dollars.  Note this happened after WWII with an inflation rate that reached 20%.  It is possible, but I don’t think that we will have that high of inflation.  If the inflation rate rises to 4-5% per year over a 10 year period, you will get rid of the majority of the debt if you are not incurring new trillion dollar deficits each year.  So the take away here is to expect higher inflation in the future.