A Happy New Year in Commercial Finance

Most people use the New Year to reflect upon what was accomplished the last year and what we hope to accomplish in the coming year.  We should be doing this in credit administration as well. Here are some thoughts about what needs to be accomplished annually with your business loans:

Annual Reviews  Every significant relationship needs to be reviewed annually. By relationship, we mean all loans related to a particular borrower or principal. The entire relationship needs to be reviewed, because each loan and business venture will impact the overall financial condition of the borrower or principal. The annual review can be done any time of the year, but should be consistently done at the same time of the year every year. Often, annual reviews coincide with receiving major documentation for that review, such as, an annual audit or tax returns. The annual review for your loan relationships is like getting an annual physical. You will recalculate the risk rating and provide a brief summary of what good and concerning events have transpired for the relationship.

Annual Reporting  Some relationships require the regular collection of documents, perhaps even on a monthly basis. But, once a year you should expect to receive a comprehensive report of financial condition prepared by an accountant or bookkeeping professional. These financial statements usually have more disclosure and organization than typical “interim” statements. These more comprehensive financial reports can be received anytime. Often they report a fiscal year-end of December 31st, but the fiscal year-end can be in any month. And despite what fiscal year-end the financials report, the report may not be prepared and ready for circulation for months after that date.

Tax Returns and Personal Financials  In addition to receiving comprehensive business financials on an annual basis, we need to collect personal financials for guarantors. A signed personal financial statement should be collected annually, and it is good practice to annually pull a personal credit report for each guarantor too. It is necessary to collect personal tax returns as well. We know tax returns must be filed by April 15th; but often, business operators seek an extension to October 15th. If an extension has been filed, a copy of that extension receipt should be kept on file. And just because an extension has been filed, doesn’t mean the guarantor does not know anything about how their tax return will look until October 15th. Estimates of the guarantor’s tax liability must be made at the time of the extension. I find it is good practice to ask if a draft of the tax return or if any pertinent personal filing information can be provided. While this is not considered finalized until taxes are filed, it is better than not having any estimate before October 15th.

Policies  Internal policies should be reviewed and updated on an annual basis as well. The new year is a good time to consider necessary changes to your loan policy so that your Board of Directors can approve it in their annual meeting that approves polices. This would also be a good time to have a meeting to address any misunderstandings with policy to make sure everyone is interpreting policy the correct way. These practices will make your institution more robust by adapting and improving your lending practices.

Staying on top of your annual duties is critical to the health of your institution. Regular servicing through review and collecting updated financials keeps the risk in your loan portfolio well-identified. Assuring your institution has the proper policies to identify risk will keep your organization happy and healthy in the New Year!

After Failure, Then What?

My son returned home for Christmas break from his studies and was greeted a few days later with his semester grades.  The greeting was not full of cheer of the season and brought back memories of the first few years of my own college experience.  I think that in life, we may experience more losses than wins.  Our attitude toward failure is what that will determine our ultimate success.

In failure we have many companions.  In May 1851 a large publishing house in England sent a rejection letter to a writer for a manuscript that was described as lacking “an antagonist with a more popular visage among younger readers” and asked that “the employment of ‘thou’ and ‘thee’ as it will put the reader too much in the mind of the Vicar’s sermon”.  The author was Herman Melville and the book was Moby Dick.

This man failed as an art dealer, flunked the entrance exam to theology school, and was fired by the church after failing at missionary work.  Although only one painting was sold by Vincent Van Gogh prior to his death, some of his pictures today will sell for over $100 million.

This famous scientist was expelled from school, failed his entrance exam into college, and was predicted that he would not amount to anything.  This was Albert Einstein’s life before he developed the theory of relativity.

Failure did not stop any of these people, but it has paralyzed countless leaders from reaching their potential.  At some point, all great achievers are tempted to believe they are failures.  In spite of this, they persevere.  There are some characteristics that I believe are a part of their success.

People who grow from failure will accept their mistakes and not blame others.  Pointing fingers gives people or circumstances power over you and will cause you to sink into a victim mentality.  Playing the blame game robs you of learning from failure and can push others away from you by refusing to take responsibility for your mistakes.  There was once a basketball player who was cut from his high school sophomore basketball team.  Over his career he missed over 12,000 shots, lost nearly 400 games and missed 25 would-be game-winning baskets.  But, Michael Jordan did win six championships and is considered by many to be the best to have played the game.  Jordan did not focus on blaming his teammates, the coach, or the officiating for those losses.  He concentrated on elevating the performance of the entire team by being the best he could be.  Imagine what little he would have accomplished if he spent all his time blaming others.

People who personalize failure see problems as large holes they are permanently stuck in, while achievers see any predicament as temporary.  One mindset wallows in failure of the past, others look toward the successes of the future.  Thomas Edison showed this trait when he was inventing the light bulb.  When he was in the throes of figuring out what would work for the light bulb, a reporter asked him if he was discouraged with the lack of results from his experiments.  Edison replied, “Results?  Why, man, I have gotten lots of results!  If I find 10,000 ways something won’t work, I haven’t failed.  I am not discouraged, because every wrong attempt discarded is often a step forward.”

People who fail forward learn to vary approaches to achievement.  In the Psychology of Achievement, writer Brian Tracy tells the story of four millionaires who made their fortunes by age 35.  On average, these people were involved in 17 different businesses before they found the one that took off.  They kept trying and changing until they found what worked. 

Those who grow from their failures will not waste time shoring up non-character flaws at the exclusion of their strengths.  People operating from a position of strength enjoy a far lower rate of failure than those laboring in areas of weakness.  Dave Anderson was a travelling salesman who failed at everything he tried to sell.  He was horrible at presenting his products and could not articulate his message. But as he travelled, he followed his passion, barbeque.  He visited thousands of restaurants and BBQ shacks across the country, got to know the owners, and learned what he could.  That knowledge was used to create the Famous Dave’s Restaurants we have today.

Spending energy focusing on past failures sabotages concentration and eats away at self-confidence.  When dealing with failure, achievers have short memories.  They quickly forget the negative emotions of mistakes and press forward resiliently. John Creasey did this.  He was a famous crime novelist who has sold over 60 million books, yet he received 743 rejection slips in a row before his first book was published.  The other thing high achievers will do with past failure is use the experience as a springboard to become great.  One famous Hollywood actor kept a rejection letter above his mantle.  It described him as “balding, skinny, can dance a little.”  The dancer was Fred Astaire.

The book of Proverbs tells us that as a person thinks in his heart, so is he.  It is nearly impossible for a person to believe is a failure and yet achieve greatness.  There is a great temptation to internalize failure for those who have failed at business, school, or in a relationship.  Failure offers us an incredible opportunity when it occurs.  Will we review our present position and grow, realizing that a failure is to be separated from one’s self-worth?  Or will we pursue the other option and wallow in a pit of despair.  Our choice on how we respond to failure holds the key to our success.

O’ Christmas Tree…

The Christmas tree is a fascinating symbol that has transcended religion and culture. What led to the creation of the Christmas tree is full of speculation, but scholars feel it is likely linked to pagan traditions centered on the winter solstice, which is the shortest day of the year that occurs December 21st or 22nd. For centuries, evergreens have inspired people by their ability to remain full of life, despite the world around them succumbing to winter’s frost. Naturally, people brought them into their homes in these cold months as a symbol of perseverance and hope.

Christmas trees have never really served a functional purpose throughout history other than for decoration, yet their acceptance has become infectious. The tradition of the “Christmas tree” appears to have started in Germany around the time of the Protestant Reformation, and at that time, it appeared to have become a Protestant custom. The custom gained momentum and was becoming commonplace amongst many Christian societies by the middle of the 19th century.  By 1986, Pope John Paul II introduced the Christmas tree to the Vatican, cementing its acceptance by Roman Catholics, who surely were observing the practice well before 1986!

Amongst the Orthodox Christian community, Peter the Great of Russia adopted a “New Year’s Tree” in the 17th century, which was later banned in Imperial Russia in 1916 due to its association with Germany, an enemy of Russia at the time. It wasn’t until after the installation of the Soviet Union that the ban was lifted in 1935, and these endearing conifers once again became commonplace in Russian homes and public squares.

By the 20th century, a phenomenon known as the Hanukkah bush had infiltrated some sects of Judaism. These bushes were no doubt nothing more than a scaled down version of the Christmas tree, which allowed Jewish families to partake in the same festive decorative practice. This practice is controversial and really only found amongst liberal Jewish communities.

It is believed that the Europeans, who settled the Great Plains, brought the practice of the Christmas tree with them to the frontier. As we know, the plains of the Dakotas are largely devoid of trees, and because of this, many pioneers constructed their homes from sod bricks cut from the ground. It’s rumored these hearty settlers used tumbleweeds, in lieu of trees, for the festive Christmas custom and decorated them as Christmas trees for the holidays.

In contemporary times, Christmas trees are cultivated as a cash crop. The Economist estimates this to be a $1 billion industry.  And, no industry is complete without its own trade association. The National Christmas Tree Association (NCTA) was started in 1995 to advocate for those growing Christmas trees. Christmas trees take 8 to 12 years to grow, which is no doubt a serious investment that needs to be protected.

In 2008, a new trade association appeared, known as the American Christmas Tree Association (ACTA), which claims to support the industry as whole, inclusive of artificial Christmas trees. This has led the NCTA to make strong efforts to lobby consumers to purchase natural Christmas trees over fake trees.

Statistics indicate that sales for real Christmas trees in 2012 totaled 25 million trees and sales of fake trees came to around 11 million trees. Keep in mind, fake Christmas trees can be used more than one time, and most statistics indicate fake trees are now used more often than real trees, despite having less number of sales per year.

The Economist also estimates there will be nearly 250 Christmas tree fires this season, which will include both real and fake trees.

Despite your religion, culture or propensity to purchase real or artificial trees, the Christmas tree continues to be a symbol widely recognized throughout the world, and it will no doubt continue to evolve in ways that brings warmth and spirit into homes to help us get through the winter months.

Financial Covenants: Profitability and Liquidity Covenants

Loan covenants that are based upon profitability of the company can be based upon a net profit or operating profit margin, a percentage of sales, or a minimum dollar amount.  Baselines for these ratios can come from RMA or Moody’s averages of companies in the same SIC or NAICS codes for appropriate minimums on the company.

The first profitability covenant is the Net Profit Margin.  This covenant measures the borrower’s ability to earn income on each dollar of sales.  It can be measured before or after taxes.  Again, industry averages or breaks in the industry quartiles may be applicable to use.  Historic results are an indication of what to expect in the future, unless there are major changes in the company.

Gross Margin Covenant measures how profitable sales are, considering only the cost of production or services.  A gross margin covenant is preferable to a net profit margin covenant where the primary credit concern involves the efficiency of the borrower in converting revenues to cash before looking at interest, depreciation, or selling, general and administrative (SG&A) expenses.

In my time as a lender, I have never seen the above ratios used as loan covenants.  What I have seen in loan covenants, is a minimum dollar amount of net profit required by a company.  I have also only seen that used once.  As with any covenant, the profitability covenants are possible tools to use, but it is not required that each loan would have this type of monitoring placed upon it.

On a multi-year loan, you may want to require an increase in the net profit or the profit margin over time.  This can be based upon the borrower’s expectation that their profitability will increase during this period, as a result of new capital expenditures placed in a business or other changes in the firm.

Liquidity or Working Capital Covenants are quite useful in measuring the borrower’s liquidity and equity position.  Use these covenants to determine if the borrower has sufficient working capital to operate comfortably when compared to industry averages or to the borrower’s historical needs. 

The timing of judging these covenants is crucial.  A company’s liquidity can change dramatically during the course of an operating cycle due to seasonal fluctuations and normal expansions, or contractions of receivable and inventory accounts.  So, when this is measured, it can be a crucial factor to either a passing or failing covenant test.  The timing can also give a false sense of hope or concern to the company’s true financial picture.

The Minimum Working Capital Covenant measures either a dollar amount or a minimum working capital ratio.  It requires an understanding of the borrower’s cash flow cycle.  Since each company has a unique working capital situation, industry averages can be used to determine appropriate minimums.

A Current Ratio Covenant requires the relationship between current assets and current liabilities to be greater than a set ratio.  A ratio threshold of 1.25:1 means that there must be $1.25 of current assets for every $1.00 in current liabilities.  Industry averages and historic company figures can be used to determine what is appropriate. 

The Liquid Asset Test Covenant requires a borrower to maintain a minimum dollar amount of cash and marketable securities.  This can be placed upon the borrower, or I have also seen this as a combination between the borrower and guarantors.  This covenant is applicable when the borrower must maintain a liquid reserve to either meet a forthcoming obligation, such as a large debt payment for capital expenditures, or to cover a likely or anticipated temporary downturn in cash flow.  It would be appropriate to not only see this information on the financial statements for the company, but to also provide liquidity verifications in the form of copies of the actual bank or brokerage statements.  This covenant is also useful where there may be some weaknesses in other ratios like the DSCR.  A liquidity verification will show additional money that is available to provide coverage of debt and expenses in case of a downturn. 

Where Does Business Lending Training Come From?

When I was working for a bank in Washington DC, I had co-workers come to me and ask where they could go to get business lending training. They also wanted to know how I learned to analyze business loans. You would think those would be easy questions to answer, but unfortunately, they are convoluted.

Where I received my training was mostly on the job. I did attend some classes with the FDIC, but those were restricted primarily to regulators. My co-workers complained that on-the-job experience wasn’t a luxury they had, and that they needed some sort of outside training. Since the classes I took were off-limits to the general public, where could they go?

There are some classes out there, but they are few and far between. And, the classes tend to take the “kitchen sink” approach; that is, they throw everything at you, including the kitchen sink, and do not leave you with much context to sort out how to apply the methods they teach. The reality is, most people learn from seasoned coworkers or in larger institutions that have specialized departments. If your institution has access to neither, you are in a tough spot.

I think the lack of access to training on business loan principles is a problem for all financial institutions. When the staff at an institution does not have adequate training, but engage in business lending, two outcomes usually result. Lenders usually extend credit on the basis of having collateral or the basis of having good character. Could either of these situations result in adverse problems?

Collateral-dependent loans, or collateral lending, are the idea that so long as collateral is present, then risk is seriously mitigated. This approach is problematic, because liquidating collateral should only be a means of last resort. There will be no emphasis placed on understanding cash flow, the primary source of repayment, and an institution will find it is expensive and burdensome to liquidate collateral. Furthermore, these types of lending decisions may overly rely upon what an appraiser’s opined value is, which can often differ drastically from the actual value the institution will receive from a sale. In short, collateral lending seriously underestimates the risk and costs of the transaction.

Character loans also lead to faulty judgments. In these decisions, the borrower is trusted that he will repay whatever he asks for, and would only ask for credit if he was sure he was able to repay. Thus, the lender does not put much analysis into repayment, given the customer will understand the repayment better than the lender. There often appears to be the belief that a customer better understands what he is capable of than the lender.

While the lender may not know the borrower’s business as well as the borrower, it behooves the lender to verify that the borrower’s cash flow can repay the debt. Often, borrowers need assistance in getting the correct credit facility, and borrowers may be lack an understanding cash flow and credit which has led to the customer requesting a new business loan. Character lending may appear to be helping someone out, but it could be a short term fix and could ultimately cause the borrower more harm in the future with bigger losses.

Most institutions understand the dangers of character lending and collateral lending, and know it is no substitute for sound credit principles. We recognize that access to training for these sound credit principles is a problem, and we are taking steps to mitigate this. In the near future, we hope to further our mission as a business lending CUSO by providing our area CUs with credit classes, and ones that will be well-reasoned without using the kitchen sink approach. 

Cash Flow Covenants On a Loan

A financial covenant restricts the amount of financial risk that the client can take on during the term of the loan.  These are based on information contained in the borrower’s historic financial statements, projections, the borrower’s written and verbal representation, and the condition of the guarantors. 

Determine the need for financial covenants based upon the size, term, and the borrower’s potential financial deterioration during that term.  Loans that you do not anticipate the borrower to pay back during the term of the loan, (i.e. you expect to extend the loan upon maturity), generally require financial covenants, due to the potential risk.  Smaller and short-term loans with a well-established source of repayment generally do not require covenants. 

Financial covenants can be expressed in terms of dollar limitations, minimums, or in terms of ratios.  Stating covenants in dollar amounts creates an agreement that is restrictive in structuring.  Ratio covenants offer more flexibility, allowing the borrower to grow, as long as the covenants are maintained. 

Examples of common categories of financial covenants are:  Cash Flow Coverage Covenants, Profitability Covenants, Liquidity/Working Capital Covenants, Leverage Covenants, and Turnover Covenants.

Cash Flow Covenants

Perhaps one of the most used covenants is the Debt Service Coverage Ratio covenant.  It is defined as net operating income (NOI) divided by annual debt payments.   This measures the borrower’s ability to generate cash from operations in order to cover debt obligations.  It also measures what is left over after all operating and debt obligations are met.  Minimums on this can be set at the loan policy thresholds or can be increased if there are other risk factors present that must be mitigated. 

This ratio is used a lot with rental property.  The property should produce adequate income to pay all the operational expenses, satisfy debt obligations, and still have some funds left over. 

One issue here is what to do with capital expenditures when the borrower elects to treat as an expense on the income statement, as opposed to treating as the addition of an asset and capitalized.  I often see this issue with hotels, where the owner elects to aggressively expense one-time capital improvements.  This could abnormally reduce the numerator of net operating income, thus making the company appear in a worse position than it actually is.  A possible solution is to have the business owner identify all the capital expenditures made in a year that were expensed.  These can be added back to NOI to create a more accurate picture of the operating performance.  I would also suggest that a capital expense allowance be deducted from NOI to allocate for an average amount of capital expenditures that would be spent in an average year.

Another issue is that the DSCR does not take into account any equity draws that are paid to the owner, since these come out after the NOI calculation.  Here, if it is necessary for the owner of the entity to take money from the company in order to live, it may be proper to treat this as a salary expense; this comes out prior to NOI.  Another option would be to place a leverage covenant that limits the amount of money the owner can withdraw from the company.

Interest Coverage measures a company’s earnings before interest, taxes, depreciation, and amortization (EBIDTA) to interest expense.  Another method is to compare EBIT to interest expense.  In each case, there is no consideration given to the principal portion of the loan payments. 

The Fixed Charge Coverage measures either EBIT or EBIDTA compared to interest, principal, and lease obligations.  This covenant may be applicable when the borrower has substantial rental or lease payments each year, in addition to loan payments.

Utilizing cash flow covenants is a good way to gauge if your borrower is generating sufficient cash from obligations to satisfy all loan and lease obligations.  It also answers the question of how much is left over for regular and unexpected repairs, and also payments that will be made to the owners.

How Big Should a Line of Credit Be?

How big should a line of credit be?  This is a question I’ve toiled with a lot in underwriting, and to be honest, there really isn’t a hard and fast rule which governs this idea. I would love to tell you it is a tightly managed equation that depends on the cash conversion cycle, but the truth is, that all gets thrown out the window once we start evaluating the underlying financial strength of a business.

When I look at a line of credit, I care most about being repaid. For me, the appropriate size for a line of credit is one which can assuredly be repaid. To determine the true capacity for repayment, it helps to look at multiple repayment sources. Oddly enough, I think it helps to start by looking at traditional real estate finance to wrap our minds around this.

How big should a real estate loan be? Well, that’s simple.  There is an acceptable loan-to-value ratio, which restricts how large your real estate loan should be.  Generally speaking, 70-75% of the value of your real estate is the size of loan you would expect to see. But wait one second, there is another important concept we first must consider. Is the sale of the real estate going to repay this loan? No, but it could as a means of last resort. The rent collected from that real estate will be the primary source of repayment.

For a real estate loan to be of appropriate size, it must actually meet two criteria: 1) It must have an adequate loan-to-value, and 2) it must generate adequate rent to regularly pay the loan. This actually places two constraints on the size of the loan, and really assures we have, at a minimum, two sources of repayment.

Now, let’s attempt to apply these constraints to a line of credit. When we have a line of credit secured by an account receivable, we will probably also take some collateral margin near 75%. Is the collection of that receivable going to repay the line of credit? Yes, and this is a major departure in most peoples’ understanding of its role as collateral. Remember, we generally don’t sell real estate to repay our loan. That is our collateral; our back-up plan. An account receivable should not be forced into this dual role of both being our primary source of repayment and our secondary source of repayment, i.e. collateral.

What I am suggesting is an account receivable should probably be viewed as our primary source of repayment, and we should look for an independent, secondary source of repayment. Perhaps that is additional cash reserves, or real estate, or a guarantor’s personal resources.  In this respect, now the proper size for a line of credit will begin to emerge. The line should generally be no more than 75% of your expected A/R and limited to the availability of your secondary source of repayment. In this way, your line of credit will have A/R as the primary source of repayment, and there will be secondary source to fall back on which could also extinguish the debt. Feel free to add a covenant or put a lien on your secondary source of repayment as well to protect your position. After all, you file a mortgage on real estate, don’t you?

So, if a borrower wants an exceptionally large line of credit, having sufficient A/R is really only proving the primary source of repayment exists. The size of the line should equally be tailored to the secondary source of repayment as well, just as we may do in a real estate loan.-

Loan Covenants: A Better Way to Manage the Credit

Over the next few weeks, I will address the issue of loan covenants.  Covenants are promises by a party to take or not to take certain actions.  These are utilized as a means of gauging a borrower’s financial health.  Covenants do not restrict the normal operation of a business, but set limits on how much risk is acceptable before the lender has the right to be concerned about the borrower’s future and ability to repay the debt. 

I do realize that many smaller business loans do not require the covenant and covenant monitoring as the larger ones do.  But I also have seen loans that could have used better covenants and monitoring in order to keep the borrower on the right track and protect the lender.  The covenant will either require or prohibit certain actions on the part of the borrower, depending on the wording.  Affirmative covenants require actions by the borrower during the term of the loan.  Negative covenants ban certain actions that would negatively impact the borrower’s financial condition, their ability to repay, or the collateral. 

The lender should always analyze the financial risks and design covenants to protect the lender against such risks. The following are some items to keep in mind when creating a covenant:

·         *Covenants should be precisely defined, measurable, and directed at specific credit quality goals.

·         *Covenants should be reasonable and enforceable.  Do not place nonessential covenants in the loan agreement.

·         *Avoid covenants that are too restrictive or give the lender control over the borrower.  Those may present lender liability issues. 

·         *Design covenants that will alert you when the credit grows riskier than a level the lender is comfortable with.

·         *Design covenants that will alert you when the credit changes significantly from what initially existed when the loan was underwritten.

·         *Be careful in establishing covenants on existing business entities where the business does not historically meet the covenant thresholds.  These must be reviewed and explained thoroughly in detail in the credit write-up.

Covenants can be divided up into three different categories:  financial covenants, non-financial covenants and reporting covenants.  A financial covenant restricts the amount of financial risk a borrower can incur during the loan.  These are based on information contained in the borrower’s historic financial statements, projections, and the borrower’s oral and written presentation.  Non-financial covenants are not usually expressed in ratios or dollars, but still place restrictions on the borrower’s activity to protect the lender.  Reporting covenants identify what type and amount of information must be supplied by the borrower and/or guarantors and when it is required.  In future posts, I will cover the financial and non-financial covenants.  This post will focus on the reporting requirements.

Reporting requirements will focus on what information is required by the borrower/guarantor and when it is required to be presented to the lender.  Quite often, these will include tax returns, personal and corporate financial statements, rent rolls, aging reports for receivables, payables, or inventory, or a listing of capital expenditures.  When creating a reporting covenant, consideration must be given to frequency, quantity, and quality of documents.  Frequency should be such that it provides the lender current information regarding the financial condition of the firm, yet gives the firm enough time to prepare accurate financials. A commercial real estate borrower will probably not be able to present your year-end financials by January 2nd, but they should be able to have it completed prior to the end of March.  If the lender sets reporting covenants so far into the year, the information may be “stale” considering the present condition of the company.  Also, on frequency, it may be good to bunch some of the reporting covenants together. An example of this would be requiring a signed personal financial statement and personal signed tax return by May 15th of the year.

The quality of the documents should match the required quality of documents in your loan policy and write-up.  An example is if your loan policy requires audited financials for all relationships over $3MM, you should identify this as a policy exception, if you are only requiring a compilation for a loan you have over $3MM.  The quality of the financials should provide the lender with accurate information they can trust to give them the current picture of the company.

With quality of information, you should require as much as you need to see the current condition.  An example of this is on a guarantor - requiring only a personal tax return may not provide you with adequate information on the guarantor cash flow as would requiring a signed personal complete federal income tax return with all schedule K1s and W2s.  The latter will provide the credit analyst with sufficient information to determine personal cash flow.

The final thought I will make on reporting covenants is, what sort of penalty is there for the borrower who refuses to turn in the required information in a timely manner?  All seasoned lenders have stories of these “Late Larrys” or “No-Report Noels”; it means you have a credit that you really may not know what is happening.  One remedy we use is to make any missed reporting covenant as a covenant violation.  One of the remedies we reserve for a covenant violation is to increase the interest rate on the loan up to the legal limit.  The possibility of jacking up the interest rate several points seems to motivate the slow borrower into turning in information in a timely manner.

Thanksgiving Remembered

Here is a trivia question for you:  Who was the first US President to make a Thanksgiving Proclamation, and when was this done?  I am ashamed to admit, that even with my minor in US History, I missed this question when I was first given it.  The correct answer is George Washington and this was done in 1789, the first year of our nation.  It was the first official proclamation issued by the President of the United States.  It reads:

“Whereas it is the duty of all nations to acknowledge the providence of Almighty God, to obey His will, to be grateful for His benefits, and humbly to implore His protection and favor; and Whereas both Houses of Congress have, by their joint committee, requested me to ‘recommend to the people of the United States a day of public thanksgiving and prayer, to be observed by acknowledging with grateful hearts the many and signal favors of Almighty God, especially by affording them an opportunity peaceably to establish a form of government for their safety and happiness:’

“Now, therefore, I do recommend and assign Thursday, the 26th day of November next, to be devoted by the people of these States to the service of that great and glorious Being who is the beneficent author of all the good that was, that is, or that will be; that we may then all unite in rendering unto Him our sincere and humble thanks for His kind care and protection of the people of this country previous to their becoming a nation; for the signal and manifold mercies and the favorable interpositions of His providence in the course and conclusion of the late war; for the great degree of tranquility, union, and plenty which we have since enjoyed; for the peaceable and rational manner in which we have been enabled to establish constitutions of government for our safety and happiness, and particularly the national one now lately instituted for the civil and religious liberty with which we are blessed, and the means we have of acquiring and diffusing useful knowledge; and, in general, for all the great and various favors which He has been pleased to confer upon us.

“And also that we may then unite in most humbly offering our prayers and supplications to the great Lord and Ruler of Nations and beseech Him to pardon our national and other transgressions; to enable us all, whether in public or private stations, to perform our several and relative duties properly and punctually; to render our National Government a blessing to all the people by constantly being a Government of wise, just, and constitutional laws, discreetly and faithfully executed and obeyed; to protect and guide all sovereigns and nations (especially such as have shown kindness to us), and to bless them with good governments, peace, and concord; to promote the knowledge and practice of true religion and virtue, and the increase of science among them and us; and, generally to grant unto all mankind such a degree of temporal prosperity as He alone knows to be best.

“Given under my hand, at the city of New York, the 3d day of October, A.D. 1789.” 

This Thursday, we will all be busy with turkey, football, and family.  I would encourage you to pause to give thanks for the many blessings that you have been given.  We at MWBS are thankful for each and every client we have had the opportunity to work with in the past year.  Our lives and our company are richer because of these relationships we have formed.   We are thankful each day for each and every one of you.

Happy Thanksgiving!

Managing Construction Risk

Most commercial loans have collateral which provides for a last means of repayment should the borrower default. The risk in a construction loan is the collateral could potentially be incomplete if the borrower were to default during the construction. For the sake of this article, I am considering a construction loan as one that vertically builds a structure from the ground up. Loans that horizontally develop land for development are also lumped into the same category as construction, but I consider those projects “development” with a different category of risk factors.

Nonetheless, having an incomplete building as collateral is an issue and a serious risk! How can an institution possibly control this risk? Naturally, the institution can put mechanisms in place to assure the building is completed. It is common practice for the institution to require the construction contract with the general contractor be assigned to the lender. In this way, if the borrower were to default, the lender can take over that project by working directly with the contractor to finish the construction.

Lenders can also obtain special guarantees and bonds that assure the project gets finished. A “completion guarantee” may be obtained from a third party, who will be a source of funding or labor should the borrower or contractor run into financial difficulties. A similar, but more formal, solution would be requiring a “completion bond” which is, in effect, buying insurance that guarantees the project will be completed.

Of course, having to take special efforts to complete the project is not ideal, but rather, a means of a last resort to shore-up a project. A strong level of due diligence before commencing on a construction project should do a lot to prevent the reliance contract assignments and completion guarantees. Due diligence will start with evaluating the borrower’s previous experience in managing past projects of similar complexity, but that is only the beginning. Due diligence should also be done to determine the contractor’s ability and history of completing past projects of similar complexity. Having a borrower and contractor that have proven track records reduces the likelihood the lender will have to take measures to complete an unfinished project.

Making sure the project is structured and administered correctly is also vital. In banking, a project must have a loan-to-cost of 80%, but will ideally be 75% or below. In the credit union realm, a project cannot exceed 75% loan-to-cost. These metrics are in place to assure the borrower has equity at stake and is sharing in the risk of the project.  In this way, the borrower has incentive to see the project through to completion too.

Also, the lender should assure the borrower has some padding in their budget in the event of cost overruns and unforeseen events. This padding is usually referred to as “contingency,” and ideally, this should be 10%-15% of the total project cost.

The proper way to administer the project is to only fund work that has been completed, and to verify the completeness with an inspection. For example, say a borrower wants to draw on a construction line of credit to finance pouring the foundation on a commercial building. The lender will not advance money to the borrower and then later inspect that the foundation has been poured; but rather, the lender will make sure the foundation is already poured and complete, and only at that time will he advance funds to pay for the work done. And for good measure, the lender should also assure the subcontractor who poured the foundation does not have a lien on the property for the work performed, so the lender can keep a clear first lien position on the entire property under construction.

Monitoring construction projects can be time consuming and require attention to detail. Large institutions will have an entire department devoted to administering construction loans. If an institution is not capable of managing the construction monitoring process, there are third parties who specialize in providing these services. Of course, this will be another party the lender will have to perform due diligence on.

To summarize, a “vertical” construction loan has an additional level of risk than a typical real estate loan, but “horizontal” development construction is far riskier. The risk that needs to be managed in vertical construction is assuring the project is completed, so the lender is not left with an unfinished building as collateral. This can be done by taking an assignment of contracts or seeking a completion guarantee or bond. Before commencing the project, make sure the borrower has sufficient equity, contingency and experience. Make sure the contractor has experience, and experienced people are monitoring the construction administration process as well. With all these mitigating factors in place, the construction loan should only provide little additional risk to your portfolio.

Were the Pilgrims Socialists?

This time of year our thoughts turn to Thanksgiving.  I will spend hours smoking a turkey and enjoying lots of football with my family.  But, we also take some time at our house to reflect on the First Thanksgiving in America with the Pilgrims.  Who were these people who endured such a harsh land with the desire to be free?

Most Americans know the Pilgrims, or the Puritan Separatists, landed in what is now Massachusetts in 1620.  Many of us do not realize that their original economic system of their colony, Plymouth Plantation, was a form of communism or collectivism.  True, the Pilgrims could elect their leaders.  But, there was neither private property nor a division of labor.  All food and supplies that were grown or created in the town was taken to a general storehouse and then distributed equally among all.  This was according to the original contract between the Pilgrims and their merchant-sponsors in England.  The women, who washed clothes and dressed meat, did so for everyone and not just for their own families.   The men, who raised crops and hunted, brought all their products to the storehouse.  This sounds like the perfect agrarian utopia of Marx and Lenin.  But what happened to it?  The answer can be found in William Bradford’s account, Of Plymouth Plantation. 

Bradford served as Governor of the colony from 1620 to 1647 and recorded the events in the colony in detail. In the first spring after the harsh winter of 1620, Indians taught settlers how to plant corn, fish for cod, and skin beavers for coats.  This is typically the part where the Thanksgiving story ends, with the Pilgrims thanking the Indians for saving their lives, rather than an expression of gratitude rooted in the traditions of the Old and New Testaments.

Yet, the colony did not flourish, even after the Indian help.   By 1623, it was obvious the colony was barely producing enough corn to keep everyone alive.  Supplies from Europe were few and far between.  Without major changes, the colony would face starvation. Bradford described what was going wrong and how it was fixed.  

“The experience that was had in this common course and condition, tried sundry years…that by taking away property, and bringing community into a common wealth, would make them happy and flourishing—as if they were wiser than God.  For this community (so far as it was) was found to breed much confusion and discontent, and retard much employment that would have been to their benefit and comfort.  For young men that were most able and fit for labor and service did repine that they should spend their time for labor and strength to work for other men’s wives and children without any recompense…that was thought injustice…At length, after much debate of things…that they should set corn every man for his own particular, and in that regard trust to themselves; in all other things to go in the general way as before.  And so assigned to every family a parcel of land, according to the proportion of the number, for that end, only for present use and ranged all boys and youth under some family.  This had very good success, for it made all hands industrious, so as much more corn was planted than otherwise would have been by any means the Governor or any other could use, and saved him a great deal of trouble, and gave far better content.  The women now went willingly into the field, and took their little ones with them to set corn, which before would allege weakness and inability; whom to have compelled would have been thought great tyranny and oppression.”

So, the Pilgrims decided to abandon their original socialist experiment and allowed each family to own their own parcel of land and to make their own decisions on what to do with it. Whatever yield they produced from their own hard labor, belonged to that family and was not transferred to a community storehouse.  There is a basic law of economics that can be summed up in four words:  People respond to incentive.  Now that the incentives were in place, those who would not work before, now went to the fields gladly. 

The colony produced an abundance of food and began to thrive.  The Pilgrims found they had much more food than they could use.  So, they set up trading posts and exchanged goods with the Indians.  The profits they made allowed them to retire their debts with their lenders.  Their success and prosperity attracted more Europeans and began what is known as the “Great Puritan Migration.”

Bradford attributed the ultimate failure of the “common cause” to something deeper when he wrote, “Upon the point all being to have alike and to do alike, they thought themselves in the like conditions and one as good as another; and so, if it did not cut off those relations that God hath set amongst men, yet it die at least much diminish and take off the mutual respects that should be preserved amongst them.  And would have been worse if they had been men of another condition.  Let none object this is men’s corruption, and nothing to the course itself.  I answer, seeing all men have this corruption in them; God in His wisdom saw another course fitter for them.” 

Bradford is saying the socialist system is doomed for failure, because people are not wired in this way.  Moving to a capitalist system that allows people to take risks and keep what they earn provided the proper incentives to allow the colony to thrive.  It is this system that has also contributed to much of the success of our country and is a part of American excellence. 

Real Estate Appraisals: What is Your Property Really Worth?

A real estate appraisal provides an expert opinion on the value of the property.  If an expert tells you a property is worth $X, does that mean you can expect to receive exactly $X when it is sold?  I had an old boss who once said, "I haven't had one appraiser buy a foreclosed property for what they said it was worth!"  This brings up an interesting point to consider, which is, an appraiser can be wrong because it is not him who must buy or sell the property.  The reasons the sale price of a property and the appraised value differ have to do with several factors.

Instead of blindly accepting the value of an appraisal, a good lender must understand what an appraisal represents and how it should be used.  An appraisal for commercial real estate property will usually include three different methods for evaluating the property-cost approach, sales approach, and income approach.  The appraiser will either use one approach and explain why he didn't use the other two; or the appraiser will use multiple approaches and try to reconcile them.

Perhaps the easiest method to understand is the sales approach.  In this method, the appraiser finds comparable properties that have recently been sold, and evaluates how those properties are similar and different compared to the property he is appraising.  The appraiser attempts to adjust for differing characteristics in the set of comparables and explains whether the subject property's value should be higher or lower based on these differing characteristics.  This method works well when there are several similar properties that have recently been sold nearby, because this indicates a market for the property is established.  The use of this method becomes less valuable when comparable properties reside outside of the subject market or there are simply no similar properties being sold.

The cost approach is a method often used when it is challenging to find comparable properties.  The cost approach generally evaluates the cost of replacing the subject property.  This will include the cost of acquiring the land at market value and including materials and contruction costs necessary.  You should note this approach has little to do with market value, since the cost of improvements will likely exceed the cost of the land.  A value determined by the cost approach is more of less telling you the cost of the project, and not the price of similar projects that are being bought and sold.

The income approach evaluates a commercial property based on how much income it generates.  In this method, the appraiser treats the property like an investment that will yield an expected rate of return.  The value is usually determined by the way of a "cap rate", which is a relationship described as the property's income divided by its market value.  A good appraisal will seek out similar properties and adjust for differing characteristics, much like the sales approach; although the adjustments are made to reflect the expected income stream.  Then the appraiser looks at what the local cap rates are, by looking at the relation to income and value for similar properties.  With a market cap rate, and market adjusted income stream, solving for value is a simple algebra equation.

Often, I see appraisals that the cap rate is not derived by observing local market conditions; but rather, by looking at national investment trends.  Much like the sales approach, I feel considering data outside the local market weakens the appraiser's conclusion, since we expect the buyer is likely local, not a faceless, national investor.  It's not that the buyer couldn't come from outside the local market; it just isn't reasonable to assume this will be the most likely case.

I think the key to understanding the resale value of any property is to ask yourself who the potential buyers will be if the property needs to be sold.  The buyers will likely be local investors interested in marketable properties.  If a property is not readily marketable, i.e., can only be used for a special purpose, then the price will likely need to be discounted to attract potential buyers.

The appraisal is a tool which gives you some basis for understanding the value of the property, but it is still an opinion.  It is a mistake to use the appraiser's opined value without understanding the assumptions and methods he used to determine that value.  An institution should provide analysis with the appraisal which addresses whether potential buyers exist in the market and what the prevailing market conditions look like.  Know that if there are not easily identifiable buyers or an established market, it will likely take large discounts to attract potential buyers, rendering the appraised value moot.--Trevor Plett

Judging Farm Performance

For some farm producers, winter often allows a time of reflection of the performance of the harvest and planning for the next year.  For others where the work continues throughout the season, the close of one year and the beginning of another is a good time to perform some planning tasks.  There is value in that as my mom used to say, "Prior planning prevents poor performance."  Those words rang true in my ears as I finished a test in school.  How well I was prepared, often resulted in how well or poorly I did on the test.  But as I look at my career in finance, that saying applies to your farm producer as well.  It is a fearful situation when the farmer is just "winging it" and hoping for the best.  Oftentimes, the result is like my results on the test that I did not prepare for.

So what are some of the better ways to judge farm performance?  Clearly, one way is to focus on the revenue per acre or revenue per head.  But this can skew acutal performance as it does not take into account any input costs.  A farm with a $150 revenue per acre with cost of $50 is better than one with $200 revenue per acre with costs of $125.

I would suggest that some of the financial ratios we utilize in company analysis can also be useful here with farm analysis.  But a warning here is that just like when reviewing a company, none of these ratios should be used in a vacuum.

The first measure is Return on Equity = (Net Farm Income from Operations less Value of Unpaid Operator and Family Labor ) divided by Average Total Farm Equity.  This ratio measures the rate of return on the owner's equity capital used in the agricultural operation.  In high profit years the top third producers had ROEs as follows:  pork 23%, grain 18%, dairy 6%, and beef 12%.  The worst third had ROEs that averaged from 4.5% to -5%.

Focusing on ROE alone can overstate the performance of a highly leveraged producer.  This is since the denominator is abnormally low with the lack of equity in the farm.  So it is useful to also consider Return on Assets = (Net Farm Income from Operations less Value of Unpaid Operator and Family Labor) divided by Average Total Assets.  Here it may be good to have both a market valued balance sheet (which is useful in comparing one farm ot another) and a cost valued balance sheet (useful in comparing a farm to itself over time).

The Operating Profit Margin Ratio = (Net Farm Income From Operations + Farm Interest Expense - Value of Unpaid Operator and Family Labor) divided by Gross Farm Revenues.  The OPM measures the return on capital per dollar of gross farm income.  A farm can increase profits by increasing the profit per unit produced (with higher revenue or lower unit costs) or by increasing the production volume while mantaining the profit per unit.  OPM focuses on the first factor while Asset Turnover Ratio will focus on the later one.  Asset Turnover = Gross Farm Revenue divided by Average Total Farm Assets.  It is important in both these ratios to use the accrual basis. Some producers may deliberately hold back product from the market in seeking a better price or for tax planning.  The cash basis can provide some skewed numbers.

Another measure is change in earned net worth.  This is the accrual net income after taxes, less owner withdrawals.  In the business world it is the change in retained earnings.  This shows how the owners use their net income.  It will equal the change in retained earnings.  This shows how the owners use net income.  It will equal the change in the cost basis of net worth, with the exception of any capital contributions or distributions.

Sometimes, the profitable producer will go down the slippery slope of financial trouble when they extract more money from the farm than what it produces.  In these cases, it is important to note the "toy factor" or new cars, planes, tractors, etc. that lie around the ranch and have been purchased from the farm assets.  While there is nothing wrong with toys, there is a problem if the earnings do not support them.

There is also the trap of the farmer or rancher only looking at changes in market value net worth without questioning the actual change in owner equity of the farm.  Is the increase in equity from a windfall in land prices, which would have no relations to operating earnings?  Is your client a good or poor operator, a good or poor farm asset investor, both, or none?--Phil Love

Income: Is It Cash Flow?

In finance, we constantly hear about “cash flow.” This has to do with one particular reason, which is, only cash can repay debt. Therefore, we are preoccupied with tracing where the borrower’s cash is coming from, since the ability to pay debt will depend on the recurring nature of that source of cash.

So how hard is it to determine cash flow? That is basically income, right? Not necessarily. There are a couple of principles to bear in mind that distinguishes what we call income from cash flow. First, you have the Generally Accepted Accounting Principles (GAAP) which requires capital assets to be depreciated or amortized. Ignoring the reasons for this, what you should understand is the income statement of a business can contain several non-cash expenses that make income appear less than the actual cash flowing through the company.

The opposite can also be true when a large capital purchase is made. The income statement will not reflect the large cash expense to acquire a capital asset in the same year that expense occurred. Rather, only a fraction of that expense will actually be represented on the income statement as depreciation.

Because of GAAP, the income statement may not accurately reflect the true cash flow of the company. It is the duty of the underwriter to uncover which expenses were not actual cash expenses, and which expenses actually occurred that were not necessarily reflected on the income statement.

The other significant reason income cannot be equated to cash flow has to do with our tax system. Taxable income is not necessarily cash income. Individuals must pay taxes on their business income, which we already know is not cash flow because of GAAP. The individuals must pay taxes on that income even if they did not take any cash out of the company, and the individuals must pay taxes on that income even if the owners put money into the company!

Also, keep in mind other unique events happen as well. If people receive non-cash gifts, they must report that as income. If they sell assets at a gain or loss, only the gain or loss is reflected as taxable income, when in fact the cash proceeds from the sale were the actual cash flow. Certain forms of retirement income are not taxed. The list goes on. Just because income is taxable doesn’t mean it is cash in hand.

For these reasons, the underwriting process is not as simple as looking at an individual tax return or a business P&L. Rather, the underwriter uses these tools as a basis for analysis, and will likely formulate questions to be asked to the borrower to determine which sources of income can be counted as cash and which can’t. This may involve requesting K-1s for partnerships, which disclose cash exchanged between owners and their businesses. The underwriter will need to ask questions clarifying how cash moves to and from the individual from their accounts or other individuals, or how cash moves in and out of the business for operating purposes. This is because income, not cash, is what is being explained on income statements and tax returns.

In short, it would be easy and a luxury to be able to build a cash flow simply by using a tax return, or by assuming reported net profits are cash available for debt service. Unfortunately, the world we live in is full of caveats and special considerations. GAAP is not concerned with reflecting actual cash on income statements, and the IRS does not tax on a cash basis alone. It takes an understanding of both GAAP, IRS rules, the unique circumstances affecting the individual, and the operations of each business to truly determine what is occurring on an actual cash basis. --Trevor Plett

Cash Flow: A Good Predictive Indicator

One of the most overlooked accounting statements is the Statement of Cash Flows.  Using this can help transform a static balance sheet and accrual based income statement into a dynamic assessment of the company’s health.  An analysis of cash flow helps you know who did what to whom in the financial sense and an accurate cash budget is a good roadmap for what will occur in the future.

The reason behind looking at cash flows is simple, as net income is a creation of accrual accounting.  While this is subject to well defined rules, which are sometimes violated by the small business, accrual accounting is open to interpretation by those that use it in company financial reporting.  The primary purpose of the statement is to provide relevant information regarding cash receipts and cash payments for a certain period of time.  The user can see the ability of the company to generate cash flow, both now and in the future with the use of a cash budget.  Cash is important to understand since obligations are paid for with cash.

The Statement of Cash Flows is divided up into three sections each focusing on a different classification of a source and use of cash:  operations, investing, and financing activities.  Cash flow from operations shows the receipt and disbursement of cash from items that occur in the course of business.  It will reconcile to net operating income once changes in receivables, inventories and payables are taken into account.  

The second section covers cash flows from investing activities. This would cover monies the company pays to purchase equipment, assets, or property.  Purchases are shown as a use of cash and receipts from sale of assets are shown as a source of cash.  It is valuable for the lender to inspect several years of cash flow statements to uncover reoccurring cash expenses for assets used in the production of income. A good example here would be a hotel.  The hotel would have a lot of items like beds, desks, chairs, dressers, carpet, and tables that are necessary in the production of income.  These items need to be replaced every so often.  Understanding when these cash expenditures are needed will help the lender see future cash requirements of the business.

The last section covers cash flows from financing activities.  Here cash paid out for loan payments, dividends, or owner distributions are shown as a use of cash while new borrowings and capital injections are a source of cash.  Understanding if a company requires a constant injection of cash from financing activities will lead the lender to analyze the probability of those funds continuing in the future. 

There are several different ratios that can be derived from the statement to give a picture of the health of the company:

Cash Power of Sales = Cash Flow from Operations / Sales.  This indicates how changes in sales impact cash flow and how much of each sales dollar is available to management.

Quality of Income = Cash Flow from Operations / Net Income.  Determines how much cash flow is represented by each dollar of net income.

Interest Coverage = (Cash Flow from Operations + Interest Paid + Taxes Paid) / Interest Paid.  This assesses a firm’s ability to keep its interest requirements current.

Comfort Level = Cash Flow from Operations / Financing & Investing Outflows.  This shows the borrower’s ability to meet its financing and investment commitments from cash generated internally.

Management Factor = (Cash Flow from Operations – Debt Repayment) / Cash Flow from Operations.  This determines just how much internal cash flow is left to management discretion. 

High cash flows and earnings are characteristic of financially strong companies.  On the other hand, weak earnings reports and miserable cash flow are symptoms of a weak company.  Young, fast growing profitable companies may tend to realize sizeable costs in order to keep receivables and inventory growing.  Cash flows from operations may fall short of net income in their start-up years.  Well-established companies may periodically encounter the same situation when experiencing a growth spurt, but it could show the potential for bankruptcy if this becomes an ongoing trend.  Measuring the strength in cash flow is the most effective means of using financial statements as a predictive tool of future performance and must be used by the lender in making the credit decision.--Phil Love

Risk Rating Jargon for Business Lenders

When an institution decides it will engage in commercial/business lending, it is required they have a firm grasp of the risk involved in this type of lending. How the risk in these loans is classified is unique, but universally applied throughout the commercial lending world.

When a loan has manageable risk and is generally considered an acceptable asset, the loan has a risk classification of “Pass.” A loan classified as Pass is one which is structured appropriately, pays on time, and likely has acceptable collateral margins. Often institutions will have several subcategories within their Pass classification to indicate a more precise amount of risk. These will range from a high Pass rating, which could be an excellent or superb loan to have, down to low Pass which is fair or minimally adequate.

The next classification of risk is the Watch List. These are loans that require continual monitoring, because there are problems that have arisen or foreseeable problems which may impact the loan’s ability to be repaid appropriately. Generally speaking, a Watch List loan is not a loan the institution would originate under the prevailing conditions. These loans will be reviewed every quarter, unless they are upgraded to Pass because conditions improve.

If a loan suffers deterioration in quality, it may be labeled Substandard. A Substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. In this way, a Substandard loan does not mean a loss will occur, but the likelihood is substantially elevated.

If a loan does deteriorate to the point where a loss is imminent, the loan will be classified as Doubtful. Loans classified Doubtful have all the weaknesses inherent in those classified Substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions and values, highly questionable and improbable. Simply put, a loss will occur, but the magnitude of the loss is generally unknown.

The last and worst classification a business loan can have is a Loss classification. Loans classified Loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value; but rather, it is not practical or desirable to defer writing off this basically worthless asset, even though partial recovery may be possible in the future. Any loan or portion of a loan classified as Loss must be charged down to $0 within 90 days.

When a loan is classified Watch List or worse, an institution needs to reserve additional capital in a special Loan Loss Reserve. This capital must be set aside to absorb potential losses and cannot be used to leverage new loans. An institution needs to carry enough capital to remain both adequately capitalized based on its leverage, and have enough capital set aside in reserves to protect against loan losses. Regulators check both capital requirements, and they also check the risk rating classifications to see if the institution is accounting for their risk accurately.

As with any business decision, balancing risk is both an art and a science. Every institution wants as many high Pass loans as possible, and nobody wants Watch List loans or worse. Often the challenge is to grasp how strong the Pass loan can remain in stressed conditions, so that it won’t deteriorate to a point where the loan would ever slip below the Watch List rating.--Trevor Plett

The Six C's of Bad Credit

All experienced lenders have heard of the Five C's of Lending:  Character, Capacity, Conditions, Capital and Collateral.  Each of these is a factor, necessary factors in good loans and a lack of them can be a harbinger of problems to come.  But not as many people have heard of the Six C's of Bad Credit.  Avoiding these will help insure a higher probability of repayment.  In this post I will attempt to review these factors.

Complacency is the first factor.  It stems from the attitude, “I don’t need to watch this borrower; they have always paid on time.”  This blinds lenders from seeing the need to monitor the company which may end up with a nasty surprise when the default comes.  Complacency can come from an overreliance on past performance of the company, guarantors, or the economy.  Some may also look at the net worth of the sponsors of the credit and think there is no need to monitor the credit. 

Lenders tend to forget hard times of the past, in light of a good economy of the present.  Forgetting past losses and problems may cause the officer to be complacent in setting standards to properly monitor the credit.  A scarier factor is the lenders who have never seen hard economic times or had the privilege of working through a problem credit.  Without these experiences, the lender may not have a healthy degree of skepticism necessary to ask the tough questions to judge the merits and flaws of the credit request. 

Carelessness is the second factor.  One of the most popular forms of carelessness is sloppy, unorganized loan files with inadequate documentation.  In some cases, collateral is not properly perfected, resulting in the lender’s collateral position being compromised.  Sometimes, loan officers will fail to document conversations with borrowers and then are caught reconstructing the file at the last minute as the bank is taking the customer to court to recover the loan.  Or they may leave items out of loan documents that should have been in there to protect the lender.

Another popular form of carelessness is a failure to establish thoughtful, adequate covenants to monitor the company’s performance through the life of the loan.  Some lenders will treat a commercial loan just like a consumer loan, and that may be fine in the cases of smaller credits.  They may not worry about the file as long as payments are made.  Then when they finally get financials from the company, they are surprised the company has a debt coverage ratio below 1:1 and the company’s net worth has been drained from operational losses and owner withdrawals. Yet, with no covenants to enforce, the lender cannot take appropriate action to enforce the bank position. 

A Communication breakdown may be a simple problem, or it can bring down an entire institution.  The first breakdown may be between the officer and the borrower.  This can lead to a startled lender, when a seemingly good credit all of the sudden is incapable of making payments.  It is important to have good relationships with the borrower that fosters communication between your borrower and you as the officer.  Remember, you should have a commanding and current knowledge of your borrower.

But there can be a breakdown of communication within your credit union or bank as well.  There can be unclear credit quality objectives and desirable lines of business from the leadership to the front line lenders.  The organization may be plagued with an attitude by top management of “shoot the messenger” if any problems are reported from the field.  Thus issues may be covered up until the time to effectively deal with the problem is past and a real loss is staring the institution in the face.  All communication should be clear, concise, and yet comprehensive to include all pertinent information.

Contingencies are the next factor.  Lenders have one of the hardest jobs as they need to be correct 99.5% of the time.  Once your losses begin to creep up over that ½% level, it could begin to impair your capital.  Truly, commercial lending has one of the smallest margins of error of any profession.  Imagine what would happen in baseball if you had to get a hit that often to be successful! 

Lending is risk analysis.  We are to look at every bad thing that could occur and then decide on how likely any of those things can happen.  A lack of attention to a downside risk can hurt the ability of the loan to get repaid if the economy slows down, occupancy drops or company revenues fall.  This is why it is important to stress test the credit at underwriting in applying breakeven analysis, increase the loan interest rate, raise the cap rate, and also reduce company revenues to see how the credit will perform.

A focus on how to make the deal work is another way contingencies are avoided.  Instead of worrying about getting the principal paid back, bankers have worried about finding a way to get the money out the door.  Sales goals should never trump credit quality goals.  Also, the pricing for risk philosophy often times causes the lender to ignore if the risk is higher, so is the chance of default.

Competition causes lenders to do strange things.  Too often, credit decisions are based upon what the institution down the street is doing rather than concentrating on the merits and risks of the loan in front of them.  Unfortunately, this often leads to loosening credit standards down to the lowest common denominator.  When the losses begin to roll in, at least you will have company with other lenders who are in the same boat. 

Competition causes lenders to do strange things.  A competitive euphoria is a sickness that may cause the institution to lower the price or seek a reduced covenant or collateral position just to get the deal.  Oftentimes, the results of these closings are touted as the credit union having a stronger market share than its peers.  But higher market share with poor credits is not a way to build your shop.  The key here is the command, “Thou shalt not book loans just because the other CU does.”

Strong revenue growth objectives may cause the lender to be tempted to cut corners in order to get the deal on the books.  This is why attention also needs to be paid to the quality of the credit.  If you are operating on a 3% margin, just one $50,000 loss means another $1.67MM of good loans needs to be closed to make up for the loss. 

Cluelessness is the final factor.  What is most scary is when either a borrower or worse, the lender does not even know what they do not know.  This can come from inexperienced staff taking on lending functions in a vacuum, without additional outside support. 

If these six factors are minimized—Complacency, Carelessness, Communication, Contingencies, Competition, and Cluelessness—the lender can hope for above average results with managing their credits.--Phil Love

Feasibility Studies: Do They Help in Underwriting?

A common theme I hit on when addressing commercial lending is more analysis is not always better analysis. Time and time again, I have stressed you shouldn’t use every tool in your toolbox just because it is there, because a one-size-fits-all approach will always result in white noise. Recently, the question has arisen whether we should be using a certain tool in our toolbox more often, that being the use of feasibility studies. Does it make sense to get a feasibility study for each construction project?

I strongly support any method that helps us understand and reduce risk. The question at hand is will a feasibility study help us assess, understand, and minimize risk? To answer that question, we need to understand what a feasibility study is. Note, “feasibility study” is not in the dictionary, so there isn’t a hard and fast definition of what one is. From context, we can assume it is a study or investigation into whether something is feasible, which is synonymous with “capable” “reasonable,” and “successful.”

Feasibility is not really a concrete idea, so it will mean something different to each person. To one person, a feasible project simply reflects the cost of accomplishing a project.  Another person may view a project as feasible if it meets certain goals, which may be unrelated to profit motive. Perhaps an investor will only view a project as feasible if it meets a certain benchmark for return on equity, and lower levels of profitability will not be deemed satisfactory. Determining feasibility is truly a subjective task.

I think it is not coincidental that there are not industry standards on feasibility studies, because the concept of feasibility in itself is subjective. Feasibility studies will need to employ whatever methods and whatever data they need to meet the request of the party that commissions the study. Because of this, there will not be methods or data that will necessarily be repeated in each study.

A feasibility study for a gas station will employ entirely different methods than a study that investigates low-income housing, and for good reason. A gas station needs to be profitable; whereas, low-income housing needs to meet the needs of a specific population, and perhaps only needs to break-even or may be allowed to operate at less than break-even to meet its goals. 

Note that this is unlike appraisals, which will have to conform to a cost approach, sales approach, or income approach; and there is an attempt to reconcile each method in the appraisal. Feasibility studies do not have to conform to a certain method. Like I mentioned, there simply won’t be a method that can universally conform to each feasibility study.

So, can a feasibility study help us assess risk? They may, and they may not. The feasibility study helps assess whether a goal will be met, which may or may not tell us something about risk. If we were to engage a third party to specifically assess the financial feasibility of a project, this would present a challenging obstacle. In the absence of standards, how do we determine who is qualified to undertake the task? If a report is prepared by somebody not qualified to assess the project, now the feasibility study is introducing additional risk into the decision making process, rather than mitigating risk.

To me, it is clear a feasibility study is not a tool that will regularly inform us about the risk, so to seek one out for every project would be cumbersome and pointless. It is a tool, however, that has a special purpose and is useful in sampling markets for which little is known or helping understand atypical requests. In this way, they will gather data that is not readily available and show how it could support a request. But, in this way, feasibility studies are reserved for special circumstances.

For established markets and standard requests, an appraiser will employ standard methods that show how markets are establishing the value of a project, which is far more practical for underwriting purposes. A feasibility study tries to project what will be, and trying to underwrite to a subjective projection is risky and should not be done.

Checking in on your Non-Profit

Many of our institutions provide financial services for various non-profit organizations.  Most of the time, this comes in the form of deposit accounts.  But it we may also have loans or even may serve on a board or committee for a non-profit. 

I once served as a treasurer for a non-profit that was recovering from an ex-president who had embezzled tens of thousands of dollars from the organization.  This soiled the reputation of the charity among its givers and also in the community.  The group went through a forensic audit to uncover how much was lost, why it was lost, and what could be recovered.  The group leadership learned quickly that a fun way of contributing back to the community soon became a serious drudgery as they worked to figure out how to survive. 

Dangers exist from many sources for non-profits.  Embezzlement and waste of funds from within can drain off precious contributions from where they should go and drive donors away.  Poor leadership can fail to rally adequate support and energy to keep the organization growing.  Reliance upon a small group of large donors can be painful if one decides not to contribute.  A lack of fresh volunteers can also doom the organization into failing to innovate and reach out to new people.  And for those who serve in leadership, board liability is real.  If liability is not there, then a poor reputation for the organization and its leaders may arise in the community.

Insist on top-notch financial reporting.  I fired the existing accountant when they could not explain the financials.  I also thought that whether or not the bookkeeper was involved in the embezzlement, the fact that it happened on their watch was enough to let them go.  We recruited and hired one of the best firms in town and also set up an audit, something I recommend for any non-profit, especially those with revenues over $200,000.  Your donors want to make sure their money is spent wisely.  Why would you give money to a group that was wasting it?

The financial reporting should include a monthly income statement with a comparison to budget and the past year.  If the revenue or expenses fluctuate, looking at the performance of this year’s period to previous years is valuable.  A balance sheet prepared according to GAAP should also be presented.  Finally, a statement of cash flows is also useful.  It is not only necessary to present these to the board, but they must be broken down and explained in terms that the board members can make educated decisions for the group.

Use top-shelf leadership talent.  I always think non-profit leaders have often one of the hardest tasks as they do not have the power of the wage to hold over the workers.  Since there are also so many good causes around, it is easy for people to leave one group and go work for another.   This makes it even more important for the successful non-profit to have excellent leadership.  An organization will not grow beyond the leadership capability of its head.  If your non-profit or church cannot grow or is losing lots of members, you need to look at the leadership capability. 

I once attended a church that suffered from a vacuum of good leadership at the top.  In the space of several months, the 1/3 of the other leaders left, the youth group went from over 60 to the single digits, and offerings dropped in half.  The worship team left and the attendance dropped by 2/3.  In this case, the inability of the leaders at the top were driving the organization into the ground.

Now if you are a leader or volunteer for a non-profit, find a cause or organization you can work passionately in.  Life is too short to live half-heartedly.

Keep the cause at the top of your mind.  I worked on a board that raised money for college scholarships for needy students.  We increased our donations and workers when we began to let our students become our best advertising piece.  They were at our telethon, golf tournament, banquet, and other fund-raising events.  We had some of them work in the office.  We put their stories on our website.  The story moved from the “traditions” of the institution to the needy kids.  Donations began to pour in.  Emotions and belief in causes will often cause people to open their hearts, and give their time, talent, and treasure. 

Member Business Lending--From Scratch

Working for a CUSO that specializes in Member Business Lending is an exciting opportunity. On an average day, I can work with credit unions that have decades of commercial lending experience and credit unions with little or no business lending experience. Fulfilling a unique role for each credit union’s level of experience is challenging, but fun and rewarding.

I am surprised that both our experienced and inexperienced credit unions are asking for training on commercial lending. The experienced credit unions want to further develop their staff and make sure all people involved in commercial lending understand how the loans are structured and managed. The credit unions that are inexperienced with commercial lending want to develop a new line of business to better serve their members while benefiting from better earning assets. This has also prompted a unique question for these credit unions new to commercial lending, which is, how does a credit union start a business lending program?

We had talked with one credit union that asked if we would help them advertise and do other things to attract new business, once we help them put a member business loan policy in place. This was an interesting question, and it really highlights the difference between consumer lending and commercial lending. While advertising and putting a banner up is a good way to attract new consumer borrowers, it would actually do the opposite for attracting commercial borrowers. The commercial borrowers you will likely attract are the types who were unable to get a loan at any other financial institution. Why is this?

Commercial lending requires a lot of work and understanding on the lender’s behalf, and a good commercial borrower knows this very well. To change relationships is to take a big risk and could lead to access to credit on different terms with a different lender. Commercial borrowers don’t like uncertainty, and going to a new institution brings uncertainty.

While occasionally a good commercial borrower will have a relationship soured by a bad lender, it is more often the case the relationship is soured by a bad borrower; thus, it is often the bad borrower on the hunt for a new lender. How is a credit union new to commercial lending supposed to weed out the bad borrowers from the good borrowers?

Really the answer is already right under your nose, and that is the credit union may already have good relationships with depositors or consumer borrowers who now have commercial borrowing requests. To their credit, I think most of our credit unions new to commercial lending already realize this. But still, the question remains as to how to attract new commercial borrowers.

I can really think of two primary ways to find new borrowers, and they both require patience. First, providing exemplary service to a borrower can often lead to additional business. When a borrower is happy, they are likely to do additional business with you and tell others about the great service you provide.

The second way to find quality borrowers is to get involved in the community. Serve on boards, join trade associations, and volunteer in community projects. This really ties back to providing quality service, but for your community. This is a good way to meet new people, and good borrowers will know who you are and take note. You will build relationships with them through work outside of the institution, and they will feel comfortable coming to you with their commercial requests in the future.

This is probably the best advice I can give as to how to grow your MBL portfolio organically, although it is always possible to hire seasoned commercial lenders or purchase participations as well. The key concept to understand is growing a strong MBL portfolio takes patience, because advertising commercial loans like consumer loans will often attract borrowers who were shunned by other institutions.--Trevor Plett