Being Teachable

My Great Aunt Lil was a gardener.  Every year she would have a wonderful garden full of all sorts of vegetables that sprung like magic from the black dirt.  She would tell me that in life you have to stay “green like tomatoes, because once you have ripened, the next stage is to begin to rot!”   This is an interesting saying from a short 4’10” woman who was over 90 years old at the time.  But she modeled it in her life.  Her house was full of books which she read constantly in her attempt to learn more.

Keeping that humble attitude on learning is quite healthy.  Former UCLA basketball coach John Wooden is an inspiring model of personal growth.  He continually developed himself, and pushed his players to do the same, in order for them to reach their potential.  One of his sayings was, “It’s what you learn after you know it all that counts.”  Wooden recognized that the greatest obstacle to growth isn’t ignorance, it’s knowledge.  The more you learn, the easier it is to have an attitude that you know it all, that you have arrived.  If that happens, you will begin to rot like my Aunt Lil said.  You will stop learning and become unteachable. You will not improve.

Wooden kept learning and growing, even while he was at the top of his profession.  After he had already won the NCAA championship, an accomplishment most college coaches never will achieve, he scrapped the offense he used for years and learned a completely new one in order to maximize the potential talents of one player, Lewis Alcindor, now known as Kareem Abdul-Jabbar.  The result was the Bruins won three consecutive national championships.  Wooden holds the record for the most national championships in college basketball and was one of the greatest coaches to have ever lived.

It’s true that when you remain teachable, your potential is limitless.  This also requires that you also never stay satisfied with your current accomplishments or “rest on your laurels” as we would say in Missouri.  Rick Warren said, “The greatest enemy of tomorrow’s success is today’s success.”  Thinking you have finally arrived, when you accomplish a goal has the same effect as believing you know it all.  It’s another characteristic of destination disease. 

Successful people know that wins, like losses are only temporary.  You have to keep growing if you want to experience a continual string of successes.  Charles Handy once said, “It is one of all paradoxes of success that the things and ways which got you there are seldom those that keep you there.”  So while it is great to celebrate a success, it is wrong to cease growing and stay in celebration mode all the time. 

My encouragement to you today is to always seek to stay a little green in life, because once you ripen all the way, you will begin to rot!

Real Estate Helps Teach About Financing Contractors

Real estate is usually the most straightforward asset to finance. We know the collateral is in a fixed place and where to find it. We know there is an established real estate market to evaluate the property and dispose of the property. We expect that rent will usually be the source of cash flow that will repay the debt. Most real estate loans are repaid over several years, usually through regular payments that will include principal and interest.

Financing a service provider is an entirely different animal. A doctor, lawyer, engineer, architect, general contractor, etc. has different financing needs outside the realm of real estate. Service providers (or contractors for short) perform a service and then bill for that service. When the service is billed, the contractor records an account receivable as an asset on their balance sheet. If a contractor has a need for cash before they can collect on the account receivable, they may need a line of credit so they can access working capital. Once cash for the receivable is collected, they will use the proceeds to repay the outstanding balance on the line of credit.

It’s interesting how some real estate fundamentals can help us understand underwriting for contractors as well. For example, an ideal real estate project has a tenant identified before the loan is funded. This is so a future source of cash flow for repayment is secured. Ideally, we would like to see a similar situation for the contractor before making a line of credit available. Much like a real estate project needs a tenant with a lease, we would like to see a contractor with a signed contract for a customer. This way, we know the contractor has secured future cash flow. Good practice dictates the underwriter ask for a list of contracts to see how much work is left to be completed, which is an indication of future cash flow for the contractor.

Another useful feature of a real estate lease has to do with determining the price of rent.  The lease will state what the required rent is each year as a fixed price. A contractor’s contracts should be evaluated for pricing too. Some contracts are “cost plus,” meaning the customer agrees up front to pay a certain percentage of profit based on the cost of materials. Other contracts are “hard bid” or “fixed cost,” meaning they will only receive a set amount of money, regardless of the cost to complete the service. Fixed cost contracts have more risk, and require the contractor use great judgment in estimation and cost control to ensure a profit can be earned.

The issue of collateral is generally more difficult when dealing with a contractor’s line of credit. In real estate, cash flow from rent collection is the primary source of repayment, and the sale of the real estate asset is the secondary source of repayment. With contracting, the accounts receivable should regulate the size of the line of credit as if they are collateral, but they are truly the primary source of cash flow for the repayment once cash is collected. If accounts receivable are the primary source of repayment, a secondary source of repayment will need to be identified.

And lastly, with an accounts receivable being a primary source of repayment, it is necessary for a lender to consider the counter party risk of those receivables. The lender should identify any concentrations of receivables, and know the credit risk of those concentrations. A contractor with a high concentration of work done for one customer will be in dire straits, if that customer fails to pay or fails to renew a contract in the future. This is just like in real estate when a project is dependent on a single tenant. The underwriter must assess that tenant’s ability to pay as part of financing the real estate.

To summarize, when evaluating a contractor’s creditworthiness, it is ideal that a contractor has existing contracts. The underwriter should review those contracts to evaluate to determine future cash flow. The underwriter should determine if the contracts are “cost plus” or “fixed cost,” and if they are fixed cost, understand the bidding and estimation process is very important. The receivables for work performed on contracts should regulate the size of borrowings, but shouldn’t be confused as a secondary source of repayment. And, it is necessary to understand the underlying credit risk of those receivables, if the contractor is highly dependent on a particular customer or contract.

Covenant Monitoring, Violations, and Waivers

Once the loan is closed and the covenants have been established, the credit officer is responsible for regular monitoring of the loan covenant.  Here, I will first assume the loan covenants have been well- written and clearly outline what is measured, how it is measured, and when it will be measured. 

Typically, covenant monitoring occurs during the annual term loan review, after year-end financials have been received and reviewed by the lender.  Some covenants may require a more frequent review or may also be done at a time other than at the term loan review.  The term review analysis should cover the required loan covenants and a comparison of the actual performance of the company in relationship to those covenants.  Further explanation should be given as to why the company performed or failed to perform in line with the covenant thresholds. 

Covenant Violations occur when a borrower fails to meet the threshold stated in the loan covenant.  The first rule is “do not panic, yet.”   In the event of a covenant violation, the lender should have the right to take remedial action under the terms of the loan agreement.  Circumstances and the materiality of the violation should dictate the lender’s course of action. The degree of materiality is measured by the extent to which a violation indicates deterioration in the borrower’s ability to repay the debt.   I once had a hotel owner who failed to meet his debt service coverage threshold; yet, he was current and also paid ahead on his loan every month.  His cash reserves were increasing.  Clearly, nothing else indicated the repayment ability of the borrower was impaired.  When I looked closer, I found the owner had bought new furniture and elected to expense these items instead of capitalizing and depreciating them.  This decreased his net operating income to a point of breaking the covenant.  This violation was not very material since it was one time in nature, the borrower had not missed a payment, and the borrower had increasing cash reserves.

The lending officer or credit administrator is responsible for investigating and evaluating information that supports a recommended course of action given the default.  A memo or section of the term loan review should identify the specific covenant violation, effective date of the violation, rationale for the action taken, and the appropriate approval for the action that is taken.  Next, notification should be given to both the borrower and also, the guarantors on the note.  The lender has one of four possible actions to take.

A Written Response to Reserve provides the borrower with a written notification of a covenant violation and reserves the lender’s rights under the agreement.  This can be used for more significant defaults or when minor violations repeatedly occur.  The communication should include the covenant violated, the lender is aware of it, the lender does not intend to waive or take any action at this time, and the lender reserves its rights and remedies to act at a future time.

A Written Unconditional Waiver is on a one-time basis and provides a borrower with a waiver of a covenant, yet reaffirms the covenant waiver does not apply to future violations.  This may be appropriate to use when a borrower is financially stable, but has a good reason for the one-time violation (as with my hotel owner above).  The letter to the borrower should identify the violation, list the date of the infraction, and specify the time period for which the waiver is in effect.

A Written Amendment is used when the borrower’s circumstance has changed, and they are unable to comply with an original covenant going forward.  This involves a modification to the original loan agreement and should not be to bring a loan into covenant compliance when a serious weakness in the credit is evident.  In some cases, an alternative covenant may be established.  Using my hotel owner as an example, a proper amendment may be to clearly define how net operating income will be calculated.  We could state we will add back all one-time capital purchases that were expensed and then deduct a factor of x% of gross income, figuring that some money each year will have to be spent on improving the property. 

Acceleration is a viable option when a material covenant violation is accompanied by payment defaults and/or a decline in collateral value.  All notices of acceleration need to be prepared by appropriate Legal Counsel to assure the lender takes appropriate steps and includes the proper language in the document. 

Rewarding Positive Covenant Trends

One tool at the lender’s disposal when working with a complex credit is to create incentives that reward positive performance in the company.  Most lenders do not realize this, but any lender who sets up a revolving line of credit tied to a borrowing base has set up a loan that rewards good performance and punishes bad performance.  If a line is tied to receivables, perhaps you allow the company to borrow 75% of any receivable that is under 90 days old, but you exclude receivables that are over 90 days old.  In this case, as long as the company is collecting their receivables at a reasonable pace, they are rewarded with a larger amount of money they can borrow on the line.  If their receivables begin to get rather old in the tooth, their borrowing ability on that line is cut off.

Rewarding positive covenant trends can also extend further than the limitations on a borrowing base tied line.  These can also be structured in such a way as to increase or decrease the interest rate, given changes in the performance of the company.  This can be tied to a ratio or a combination of ratios that the lender finds most useful in judging the company’s performance.  A company performing well indicates a less risky credit and should require less cost in time, loan loss allocation, and energy to manage, rather than a company that is barely making its debt coverage requirements. 

Consider the following covenant, “The interest rate shall be determined on a quarterly basis in accordance with a matrix on the borrower’s leverage, current ratio, and minimum debt service coverage ratio as described in the pricing grid below:

Max Leverage Ratio    Min Debt Service                  Min Current Ratio              Loan Rate at                                            Coverage Ratio                                                                 LIBOR +bps <=0.50                                   > 2.00                                         >1.75                                        250

> 0.50 ≤ 0.625                 >1.60 ≤ 2.00                             >1.30 ≤ 1.75                                   275

>0.625 ≤ 0.75                   >1.30 ≤ 1.60                             >1.10 ≤ 1.30                                    325

>0.75                                      ≤1.30                                         ≤1.10                                         350

In this example, the income statement and balance sheet are reviewed quarterly and three ratios are tested.  The result of those ratios determines the interest margin above LIBOR for that loan for the next quarter.  Here, you are rewarding lower leverage, higher debt service and a higher current ratio and are punishing higher company leverage, lower DSCR and a lower current ratio with a higher loan interest rate. 

The question arises as to what will be done if you have three different loan rate results from the readings of these ratios at one time?  This needs to be determined by your loan structure and defined in the note and loan agreement.  It is easier to concentrate on flexible margin pricing on a smaller number of variables than a larger group of indicators.

Another variation of performance pricing may deal with a specific action that you want the borrower to complete.  I once had a loan that we decided to increase the interest rate in six months if easement issues of the property were not properly corrected.  The borrower could continue to enjoy a lower interest rate, provided he fixed the problems with the collateral.

Rewarding positive covenant trends with risk-adjusted pricing can be done on as many factors as there are different ratios and methods to measure company performance.  However, these must be set up in a thoughtful manner, to help control behavior you do not want to see and encourage performance you want the company to do.

Dakota Economics

When we hear reports on how the national economy is struggling, we know that in many ways it impacts every American. However, when these reports discuss specific topics, like unemployment, we understand some Americans are severely impacted by unemployment, yet places like the Dakotas are effectively not impacted by unemployment at all. Really, the national economic data is an aggregate of all states, but it will not necessarily paint a picture for each region.

The preliminary estimate for the national unemployment rate in November is 6.6%, according to the Bureau of Labor and Statistics. However, locally, unemployment is much lower. Bismarck, ND sits at 2.3%, Fargo reports 2.6%, Sioux Falls is 2.9% and Rapid City reports 3.6%. Regionally speaking, our unemployment is impressively low. If we look to some of our larger urban neighbors, we see Minneapolis reports 4.0% unemployment, Denver sits at 5.8% and Omaha reports 3.6%. All in all, our nearest urban centers aren’t fairing too bad either.

With the Dakotas posting notably low unemployment, we would naturally wonder what is driving the economy in our area. The Bureau of Economic Analysis in 2012 reports South Dakota’s economic output is $42.5 billion and North Dakota’s economic output is 8% greater at $46.0 billion. We know the oil boom in North Dakota is a major driver of the economy. Natural resource exploitation comprises $8.1 billion of North Dakota’s economy, or roughly 17.5% of the total North Dakota economic output! By contrast, natural resource exploitation in South Dakota totals $4.5 billion, which is 10.6% of total South Dakota economic output.

Diving further into the economic profiles of the Dakotas, we know South Dakota has intentionally created a particularly favorable climate for the financial services industry. Core financial services in South Dakota produced $6.7 billion in output, which equals 15.9% of South Dakota’s economy. By comparison, North Dakota’s financial services output was $2.9 billion, which equals 6.3% of the North Dakota economy.

Lastly, we can’t help but think about how much agriculture is a major contributor to the economy. In North Dakota, ag output totals $3.6 billion or 7.9% of the economy, and in South Dakota, ag output totals $4.4 billion or 10.3% of the economy. While these figures seem surprisingly small, we need to keep in mind the ag economy serves as a lynch pin to several other aspects of our regional economy. Without agriculture, there likely would be less demand for financial services, retail, and wholesale activity that supports farm operations.

When comparing these statistics to national averages, we can see just how different a regional economy can be. National unemployment is 6.6%, but North Dakota unemployment is 2.6% and South Dakota unemployment is 3.6%.  Development of natural resources is 2.9% of the national economy, but 10.6% of the South Dakota economy and 17.5% for North Dakota. Financial services are 8.0% of the national economy, but 15.9% for South Dakota and 6.3% for North Dakota. Agriculture represents only 1.1% of our national economy, but 10.3% for South Dakota and 7.9% for North Dakota.

It is interesting to see that unemployment in the Dakota’s is roughly half the national average, and our regional economy relies upon natural resources by nearly 4 to 6 times as much as the national economy. Our economy is also roughly 8 to 10 times more reliant on agriculture! And as for South Dakota, the economy records roughly twice the amount of financial services activity compared to the average national economic output. Without further analysis, it is easy to conclude that ag, natural resources, and financial services are likely related to our overall prosperity in the Dakotas.

Non Financial Covenants

All commercial loans have some form of non-financial covenants contained in the loan agreement and the note.  These are often found in all the small print and were devised by legal minds that either draw up your loan papers personally or through your document preparation system.

The most popular are commitments a borrower makes to continue to pay any property taxes and satisfy any mechanic liens associated with the collateral property.  The client agrees to continue to pay all taxes and liens as they come due, since these would constitute a superior claim on the property than the mortgage.  Another common covenant is for the borrower to keep the property insured with coverage that names the lender as a lienholder or mortgage interest in the property.  All lenders consider these covenants important to protecting their interest in the collateral. 

The sky’s the limit on the number and type of non-financial covenants that are available for the lender to use.  A good place to begin to get introduced to a sampling of these covenants can be found in a reading of a loan document set.  What follows are some examples of various non-financial covenants and what they do.

Corporate Existence and Qualifications requires the borrower’s legal corporate existence and qualifications be maintained throughout the term of the loan. 

Change in Ownership covenant requires the borrower request permission from the lender when the entity is considering some form of change of ownership.  A change in ownership, resulting in a key guarantor giving up his ownership in the operation, may make said guarantor less likely to provide secondary support for the debt in case of a payment default. 

Limiting or Prohibiting Mergers, Acquisitions, and Consolidations assures the lender that material changes in the firm and the structure of the business cannot occur without the lender’s consent.

Restrictions on Substantial Changes in the Borrower’s Business require the borrower to continue to engage in the same business or with the same franchise as he is a part of on the date of the loan.  This is often used in franchised hotels or restaurants, where it is required no cancellation or change of the franchise is allowable without the lender’s approval first. 

Limitations on Sale of Assets covenant prevent the borrower from jeopardizing the earning power of the business by transferring or selling off a substantial part of their earning assets.  This covenant can also allow for sale of assets, but require proceeds are used to pay down indebtedness to the lender.  It would be good to shore up this covenant with perfecting collateral interests in the assets you want the borrower to maintain.

Limitations on Up Streaming Funds places limits on the payments of dividends, owner’s draws, shareholder advances, and loans to affiliates.  This is used to preserve capital in the company.

Capital Expense Limitations states the borrower will not spend beyond a certain amount on capital expenses until the lender approves, or the loan has been paid down to a certain level.  This covenant may be appropriate in a highly leveraged situation, where the officer feels it is appropriate for the company to pay down debt prior to spending money on items that will expand their business base or scope.

A Reimbursement Covenant can be used to require the borrower to repay the lender for any funds the lender may have spent in paying taxes, insurance, attorney, or any inspection fees necessary to protect the lender’s collateral position.  Usually the required reimbursement period is outlined in this covenant. 

These are a few examples of non-financial covenants.  Many more are possible.  The additional ones that are appropriate to use should be determined prudently by the lender, and structured in a way that helps mitigate the risk in the credit.

It's All Relative in Commercial Finance

A few years back when I was living in the Washington DC area, my wife and I attended a Christmas party for the company she worked for. The CEO of the company proudly announced that his company had grown by over 20% that year. Everybody applauded, and he seemed pleased with himself. But as an analyst, I wondered what exactly he meant.

I turned to my wife and asked, “Does he mean profits increased by 20% or revenue increased by 20%?” My wife just shrugged. The more I thought about it, he could have also meant his balance sheet grew by 20%, or he had secured 20% more contracts to do business. I knew it was a moot point, so I didn’t question it further. But, it exemplifies how information needs context so we can determine how relevant that information is.

J.P. Morgan is one of the biggest banks in the country and has over $2 trillion of assets on their balance sheet. In 2011, the bank had a net profit of $18 billion dollars. It was later discovered in 2012 that the bank had made a hedging error and would be exposed to an $8 billion loss. Reporters and pundits were outraged at the thought of a bank experiencing an $8 billion loss. But, relative to 2011 profits, it wasn’t even half of the profits the bank realized. Despite the loss, J.P. Morgan finished 2012 with a net profit of $20.5 billion. This was equivalent to a return on assets (ROA) of 0.87%, which is relatively normal for a financial institution, and indicates it is likely not under any serious financial distress. An $8 billion loss seems large to us, but relative to a multi-trillion dollar corporation, it is an easily survivable loss.

Common issues with relativity I see on a daily basis have to do with the nature of interest rates and how they reflect risk. All institutions acknowledge that financing construction is more risky than financing an existing building. Often, a person’s intuitive response to this is, “if construction is more risky, then interest rates should be higher than what I charge on an existing building.” This is true, when you are comparing two like projects and terms, but we have to keep in mind an interest rate not only reflects your risk, but also your cost of funding.

When we finance commercial real estate, we typically make a loan for five years that doesn’t fully amortize and has a balloon payment at maturity. Say we make a loan for five years.  Then we will try to find deposits or other funding sources that don’t mature for five years. Our interest rate will be based on the cost of securing that funding for five years. If a five-year deposit costs 1.50%, and we think the risk in the loan is small and only seek a 3.50% margin, then we will price the loan as 1.50% (cost of funds) plus 3.50% (margin for risk) which will equal 5.00% interest rate.

Construction will be funded differently. A construction loan may mature after only one year, and the balance of that loan will be different every month. In this case, we assume each month the loan will be funded at the cost of holding a deposit for one month. One month deposits may have an annual interest rate of 0.05%; therefore, we will change the interest rate on the construction loan, every month, to equal the cost of funds plus some margin for our risk. We know construction is risky, so our margin will be greater than the 3.50% for pre-existing buildings; let’s assume it will be 4.50%. In this case, our interest rate will be calculated as 0.05% (cost of funds) plus 4.50% (margin for risk) which will equal 4.55%.

In the above example, the financing on the permanent building is done at a 5.00% interest rate, but the financing for the construction is done at 4.55%. Why isn’t the interest rate higher on the construction loan? Technically, the return on the construction loan is higher, even though the overall rate is lower. That is because there is a higher margin in the construction loan. The institution will be compensated for more risk, even though the rate is lower. It isn’t necessary to make the construction loan higher than 5.00% to reflect the risk, because the interest rate is also a relative observation. Interest rates are also relative to the cost of funding, not just the risk of the project!

America's Regulatory System: Another Labratory for Democracy

The American government is a federalist system, in which power is shared with a national government and individual states. While for some this seems confusing, we are repeatedly taught there is great advantage to this division of power. The tenth amendment to the Constitution allows for the states to govern in areas not discussed in the Constitution. Scholars note this creates a laboratory for democracy, since each state can take a different approach towards handling its own affairs, especially since our Constitution leaves a significant amount of space for states to make laws.

Often the public and politicians complain that regulation of our financial system is complicated and argue it would be better if it were centralized and managed by a single regulator. Little do they understand that our seemingly strange regulatory framework is a direct result of a federal system, and the same advantages of having shared powers allow the states to have their own regulators as well.

A financial institution can be chartered (licensed) by either a national authority or state authority. The Office of the Comptroller of the Currency (OCC) charters national banks, and the National Credit Union Administration (NCUA) charters national (“federal”) credit unions. Each state can also charter banks and credit unions.  Delaware, Wyoming, and South Dakota do not provide charters for state credit unions. North Dakota is the only state to charter, own, and operate its own bank - the Bank of North Dakota.

What is the advantage of selecting a state charter over a national charter? Again, it has to do with our federal system. In theory, state chartered institutions will obey state banking laws and state credit union laws, and national charters will follow national banking laws and national credit union laws. Now it is virtually universal that financial institutions are required to carry deposit insurance if they wish to keep their state or national charter. These most popular insurance programs, run by the FDIC for banks and NCUA for credit unions, will demand federal oversight for all participants. In this way, federal agencies maintain certain de facto oversight of state chartered institutions that must carry nationally managed deposit insurance.

In this unique situation where state chartered institutions have national oversight, often national and state regulators work together to regulate state institutions; whereas, national chartered institutions only have one direct regulator. State institutions can benefit from the diversity of opinion from having dual regulators. While some contradictions may exist, the state regulators usually have an interest in doing what is best for the local communities; whereas, national regulators are viewed as taking a standardized approach towards enforcement for all institutions.

Other peculiarities that arise have to do with resources. State regulators have the benefit of understanding the local economy better, but national regulators have greater resources at their disposal to train regulators and enforce laws. Unique solutions to these problems exist. National regulators often open their training programs to state regulators, and national regulators make efforts to provide field offices to be closer to the communities in which their regulated institutions reside.

The result of all these quirks leads to a democratic approach towards licensing and regulating a financial institution. Owners or members of these institutions can select either a national or state charter, depending on their preferences. They can even choose amongst different states to take advantage of different laws. If a national charter is selected, they will have one regulator; but if they are state chartered, they will likely have some national oversight with regulatory duties being shared with state authorities as well.

This is another example of how the federal system creates a laboratory that can provide for several approaches and unique solutions. Fifty different states mean fifty different jurisdictions can have different regulations, and local laws can be tailored to local needs. This shows that a single regulator for all institution types would undermine the federal system and force states to give up their authority, leading to a more centralized government. While a single regulator would appear to simplify the system, it is an example of how simpler is not always better, and how it can lead to a loss of local control.

Leverage Covenants

Leverage covenants are some of the most critical covenants in properly structuring a term credit agreement.  They warn the lender when debts or liabilities of a company are disproportionate with the company’s equity base.  One of the frequent reasons a lender charges off a loan is because the borrower has incurred excessive debt.  When debt is too high, there are fewer cushions to fall back on during a downturn.   These covenants are mandated in some government-backed lending programs, such as Rural Development. 

The leverage covenant can be especially useful when used in conjunction with Debt Service Coverage Monitoring, in making sure the company can (1) satisfy its debt obligations, and (2) in making sure the owners are not draining out too much equity from the company.  But the nature of the covenants and the quality of financial statements that a lender will see may raise some problems.

The first is, what items are really equity, and what is truly debt on the balance sheet of the company?  It is not often clear with a cursory review of the statements.  The first place to look is on the asset side.  What items are truly assets?  I would suggest that receivables from related parties or owners should be discounted from the asset base, and at the same time, the corresponding entry would be to reduce this company’s equity.  (The equation assets = liabilities + equity must remain in balance.)  Another place to look is intangible assets.  Do they really provide value?  What about obsolete assets like inventory?  These may be discounted as well. 

The next place to look is on the liability side.  If there are debts owed to company owners and the lender has subordination agreements in place that place the debt junior to the lender’s, these may be treated as a subordinated equity.  Intercompany liabilities should also be looked at.  Next, equity should be inspected.  Are there any equity classes that have a superior claim to the company assets than what the lender does?  If so, these should be treated as debt.  These adjustments to the financial statement should give a truer version of the debt and equity position of the company.  Note that if there are any qualifiers that will be placed on how the debt and equity is calculated, these should be defined in the covenants. 

If the company’s current leverage is high relative to industry averages or higher than the lender’s preference, you can structure the leverage covenant to require the leverage decrease over time in order to decrease the risk during future periods. 

Total Liabilities to (Tangible) Net Worth limits the ratios of total liabilities to net worth or tangible net worth.  This limits the overall leverage of the company.  A possible problem is using this test with a company that has large fluctuations of payables or operating lines of credit.  These swings can have a negative impact on the ratio.  A liability to net worth ratio of 4:1 is required by Rural Development backed financing. 

Total Borrowed Money Debt to (Tangible) Net Worth focuses only on debt obligations and not on other types of liabilities.  If your primary objective is to control the amount of debt a borrower can incur and you want to apply a fairly tight test, a borrowed debt to net worth ratio is more effective than a liabilities to net worth ratio.

Total Debt Limitations is a covenant with an absolute hard number and does not fluctuate.  In order to deal with leverage issues, while allowing the borrower to avoid incurring considerable debt, you should establish an absolute dollar limit on the amount of debt the company can have outstanding. 

Contingent Liability Limitations limits a borrower’s ability to incur contingent types of liability.  The lender can limit liability by including, in the definition of liabilities, all guarantees and other contingent liabilities.  Normally, you should set an absolute limit on contingent liabilities by stating “none are permitted” or that “only guarantee A and B are permitted but no others.” 

 Generally, these leverage covenants can be effective tools to cause the borrower to maintain certain amounts of equity in the company and/or to make sure company debt does not grow beyond the capability of the company to manage it.

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.