Stealing Capital from the Mouths of Business

Much ado has recently been made about the National Credit Union Administration’s proposed risk-based capital rules.  The issue is very confusing, as many government regulations are. It also appears to be a knee-jerk reaction to the troubles from the financial crisis.  This crisis did not seem to impact credit unions as severely as some of the “too big to fail” banks. 

The question is, how will these proposed changes impact the credit unions’ ability to lend?  If there is a change in the amount of lending, how will it impact businesses and consumers?  What will be the impact on the economy as a whole?  What will happen to the long-term financial stability of the industry?

In my last blog post, Did Someone Forget to Tell Lenders the US is in a Recovery?, posted on March 30, 2014, I outlined a rather weird issue that we now face in our economy.  The Commerce Department has reported 11 straight quarters of economic growth in US GDP.  Yet the loan-to-deposit ratio is hitting record lows.  There is currently a gap of $2.4 trillion between the amounts of deposits to the amount of loans held by banks.  Interestingly, this amount is close to the additional reserves banks are leaving with the Fed. 

This divergence is not normal.  What we have seen time after time in our economy is, as we see growth and expect future growth, lenders will lend money to individuals and businesses to grow and expand.  Capital is needed to fuel consumer purchases, which provides sales to companies.  Companies also need capital to expand their operations, which in turn, will provide more jobs for individuals. 

Yet today, we see the loan to deposit ratio and the labor participation rate at lows we have not seen since the economic malaise of the Carter Administration.  This economic recovery has not been the rising tide that has pushed all boats higher, as many are left by the wayside. 

Now, it is true that some of the lackluster loan demand has come from borrowers who are not wanting to go into more debt because of an uncertain economic future.  But another large factor is lenders are not willing to lend as much due to uncertainty in their regulatory and economic future.  Why would we see $2.4 trillion kept as excess reserves with the Fed?  Bankers can enjoy their 0.25% return on risk-free money. 

Economics 101 teaches us that increasing the minimum reserve requirements is a monetary policy available to the Fed to help slow down the economy.  The new risk-based capital rules would require many credit unions to keep more money in reserves and thus have less money to lend out to members and member-businesses.  So these rules will negatively impact the credit unions’ ability to lend.  It will also create competitive disadvantages between credit unions and banks as the proposed capital requirements for credit unions are more stringent than those imposed upon banks.

The second question is how will the decreased lending impact consumers and businesses?  While a good case can be made that less leverage is good for a person or an entity, strategic leveraging is necessary for economic growth.  If one wishes to see an example of out-of-control borrowing, they need to look no further than our own US Government’s $17+ trillion debt.  So, some businesses will not be able to borrow to acquire that new piece of machinery, move to a new location or even begin to start up, as lending requirements tighten due to increased capital requirements.  This will lead to less jobs and less demand for goods and services. 

This will impact the credit union members even more, whether the credit union is involved in business lending or not.  What happens to your credit union if your primary employer in town downsizes due to lack of demand for their product?  What impact would this have on your members and institution if you had multiple consumer loans go on your watch list because of a lack of income from the members to satisfy debt service? One has to conclude that the rules will be a negative for the credit union lending.

On the economy as a whole, if funds are not available for consumers and the private sector to grow, then this is a method to slow down the economy.  The largest segment of the economy comes from the private sector.  If you make it harder on the private sector to grow, the economy will slow down.  This will continue to have the loan to deposit ratio fall.  If economic growth continues forward, it will continue to benefit the large and wealthy, while leaving the small behind.

So what could be the long-term impact for the credit union industry?  Fewer loans.  Fewer business loans as a percent of total loans.  The loans that will be put on the books will tend to have a lower margin over cost of funds, as consumer loans tend to have smaller margins than business loans.  Lower margin will result in lower income.  Lower income also results in lower profits, and lower profits lead to less additional capital.  Less additional capital leads to further lowering of possible lending, as more money must be kept in institution capital. 

The impact on credit unions can be greater than the impact on banks as the proposed credit union capital is more onerous than bank capital requirements.  I would counsel my banking friends to not rejoice at this point.  Having our government pick winners and losers in such a way that benefits you, will someday result in you ending out on the short end of the stick.  Besides, both banks and credit unions could get further ahead if they would focus on common issues that impact both of them, such as increased regulatory items with Dodd-Frank.

I am not an advocate for poorly executed lending or undercapitalized institutions.  Credit Unions need to be smart in how they operate. Capital requirements that place the CU at a competitive disadvantage to the bank is not fair.  These increased requirements will also slow down vital funds needed in our communities and our economy as a whole.

Sources and Uses: Project Economics

We expect a balance sheet to “balance” with total assets equaling total liabilities plus net worth. This same principle holds true with project economics. Total uses of funds must equal total sources of funds.

For example, say a construction project costs $1 million. The construction is a use of funds; therefore, total sources of funds through loans and capital must equal $1 million. If sources total less than $1 million, the sponsor needs either a bigger loan or more capital. If total sources exceed $1 million, then the project may be unnecessarily giving a cash surplus to the sponsor beyond what construction is funded.

There are a few key items that should be checked for on all sources and uses. In construction, the loan as a source of funds should not exceed 75% of total project cost for credit unions, or 80% of total project cost for banks. Also, when a sponsor lists cash equity as a source, you should verify if the sponsor has that cash or how and when the sponsor expects to provide that to the project. Ideally, the sponsor’s cash is the first resource consumed to assure they are fully invested in the risk of undertaking the project.

When examining the uses of funds, you should verify it includes common closing costs, such as origination fees, legal fees, appraisal costs, etc. When dealing with construction, the uses of funds should also include “carrying costs.” The most common example is an interest reserve to pay for interest until the project generates cash flow to pay debt service. Other carrying costs may include real estate taxes and condo fees.

Another item that should be identified in construction uses of funds is “contingency.” Contingency is surplus funds to deal with unforeseen costs or changes in costs. Ideally, uses of funds should comprise 10% contingency. Any contingency less than 5% suggests the project would have a difficult time dealing with unforeseen changes, and any contingency above 15% becomes notably ample, allowing for large deviations from the planned budget, which may be undesirable.

An additional use of funds you must come to understand is the developer fee. This is the fee a developer receives for seeing the project through to completion. Traditionally, a developer fee hovers around 10% of total project cost. Developer fees that exceed 10% should be questioned, and no matter the amount of developer fees, they should be funded last so they don’t compete with other project resources.

A project with no developer fees should also raise a red flag. With no developer incentivized to drive a project to completion, the project may twist in the wind without leadership, slowly driving transaction costs higher as time is needlessly consumed.

Deferred developer fees are an item that may be found in the source of funds. This suggests the developer is allowing for their fee to be used as capital, but this needs to be approached cautiously. The deferred developer fee is not hard equity, but it is really more akin to “sweat equity.” The extent to which this should be considered a valid form of equity investment is debatable. The closer the operating relationship between the developer and sponsor (perhaps they are the same entity), the better the argument holds water, but ideally there should not be an overly significant reliance on this source of equity.

When presented with a project budget, it is crucial to have it broken down into sources and uses. The project must “balance” with sources equaling uses. No matter the complexity of the project, there are common items to check for, such as loan-to-cost, carrying costs, contingency, and developer fees. Sources of equity should be well understood, especially in determining whether they provide hard cash or provide for proper risk sharing. Pursuing these simple checks will help you quickly identify problems that can occur with common project financing.

Did Someone Forget to Tell Lenders the US is in a Recovery?

According to the US Department of Commerce’s Bureau of Economic Analysis, the last quarter of 2013 represented the 11th straight quarter-to-quarter growth in US Gross Domestic Product (GDP).  The latest increase for 4th quarter 2013 was originally reported at 2.6%.  Yet, when we look at this “recovery”, it seems to be marked with a large number of unemployed, a record low labor participation rate, and small business failures.  Another characteristic I will focus on here is that the recovery still remains a secret to lenders. 

Fortune reported early this year that JPMorgan achieved strong earnings in 2013 with profits of $18 billion.  One item in Morgan’s year ending 2013 financials stands out; the bank’s loan-to-deposit ratio hit a new low.  In 2013, the bank lent out an average of 57% of its deposits; down from 61% a year earlier.  This trend is not only true of Morgan, it is common across the entire economy. 

So, what if the loan to deposit ratio is low and falling during an economic expansion?  While this may be expected during a recession for banks to reduce lending and keep more reserves on hand, it is not as common this late in an expansion.  It also indicates the availability of credit for businesses to expand is limited, which can hinder future economic growth as firms need capital to expand.  It may also mean that demand for loans is lower as borrowers are less likely to borrow in the future because of uncertainty, or their belief that the reward from the borrowing is less than the risk associated with the loan.  It may also mean that firms are stockpiling their own cash and not borrowing.  Forbes indicated on its website that American companies are holding onto over $5 trillion dollars of cash.  We also have reports of the wealthy hoarding cash as well.

The following chart is from the Federal Reserve Bank’s FRED data.  Note that the gap between loans to deposits is at $2.4 trillion and growing.  This divergence seems to be unique to the post financial crisis environment.

One wonders just how strong the US economy would be if the loan to deposit ratio were closer to norms?  Demand for credit is weak due to economic uncertainty, large amounts of cash on company’s balance sheets, jittery labor markets, poor wage growth expectations, general unease of taking on debt, and governmental uncertainty.

On the supply side, lenders are less willing to lend money due to tighter credit standards.  Another huge factor is the regulatory uncertainty; a good example is the proposed new capital rules for credit unions.  The excess of supply of funds to demand for loans has also pushed rates down to levels where some loans are unprofitable, given the amount of risk in the transaction.  This pricing challenge is what we currently deal with in the lending world. 

Another factor on the supply side is the ability of banks to keep large reserve positions with the Fed.  These reserves are placed at the Fed instead of lending out to borrowers.  The Fed is paying 25 bps, and these are funded with deposits that pay near 0%.  This creates riskless profits with no regulatory capital requirements.  The excess reserves in the banking system is now about $2.4 trillion, the same amount as the gap between a traditional loan to deposit ratio and what we see today.   The following chart shows the loan to deposit ratio which is at a 30 year low.  Note the tick up in 2010 is due to an accounting adjustment and not a true trend.

One day, when we look back at this time, we will wonder what sort of economic growth we might have witnessed if a normal loan to deposit ratio were in place.  This truly is a “what-if” economy that continues to keep us dreaming about what could have been if we would see a normal loan to deposit ratio.

K-1 Cash Distributions: Is It the Right Cash Flow?

We should all understand by now that income is not cash flow. We understand the income statement captures non-cash income and expenses, and we need to subtract out or add back these items accordingly to find the true cash impact to the company.

 Moreover, just because a company has a positive cash flow position doesn’t mean it is actually paying cash out to its owners. The way we verify whether cash is paid out to owners of partnerships, S-corps or trusts is by reading the K-1 filed with the respective tax return. The K-1 will report the taxable income to the respective owner, as well as any distributions paid or contributions made by that owner.

 Now to put this idea together, a company’s net income is not the same as cash flow, and a company’s cash flow is not automatically distributed to the owner. The K-1 will report what proceeds were distributed to the owner, which may be different than actual cash flow. Many people request K-1s so they may see what cash was distributed, and they will use K-1 distributions to measure cash available for debt service, not the actual cash flow of the company.

 I think this is well-intentioned, but I have an interesting true example that calls into question this practice. Once I had to underwrite a borrower who owned several apartment buildings. Most of her properties failed to achieve break-even cash flow. Even though most properties lost money on an annual basis, she had ample K-1 distributions every year. How was this possible?

 She had owned many properties for a long time, which meant she had a lot of equity in these properties after paying down debt for several years. Each year, she seemed to take out a large new loan against a property with accumulated equity. This loan was not used to renovate the property, but rather used to pay her a cash distribution. Now the old property would have substantially higher debt service and a substantially high cash flow deficit since rents couldn’t be reasonably increased to match the new debt service.

 Each year there was a new loan and a big distribution on the K-1, but effectively larger cash flow deficits on a global level as more leverage was taken on by the sponsor. I had to explain to the lender that even though her K-1 cash flow looked great, the loan was substandard because the actual global cash flow had gotten very bad. Also, she was running out of properties to secure new debt!

 I have come to believe that distributions and contributions from K-1s need to be taken with a grain of salt. A company does not have to be profitable to distribute cash, nor do I think lack of cash distributions should be a sign of poor global cash flow. I think what ultimately matters is the cash flow of the company, not whether the owners chose to pay themselves with the cash flow.

 If a company shows positive cash flow, I think it is cash flow that should be counted towards global debt service, whether or not it is distributed. This is because cash flow is available, regardless of whether or not it is used.  The opposite holds true as well. If a company is experiencing negative cash flow, it should be reflected as a burden, regardless of whether K-1 distributions are made. If distributions are made, they should not be regarded as an available source of cash flow.

 This means instead of collecting K-1s, it makes better sense to collect P&Ls or tax returns to accurately measure global cash flow available for debt service. While this may seem cumbersome to the borrower, I doubt it is any more cumbersome than having to isolate and send just the K-1 from the very same tax return.

Why "Giving Away the Store" is a Poor Strategy for Business Development

Sometimes an institution will get into the habit of doing whatever is necessary to bring in the business.  This is most often seen with loan officers who are on an incentive program that has no qualifier for credit quality or loan profitability.  It is also common with financial institutions that are opening up new business lines and believe they need to “buy” the business.  The areas that are most often compromised are (1) price and (2) loan covenants and structure.

The price issue can come with an abnormally low rate inherent to the risk associated with the credit.  An example is taking a higher risk credit facility, such as a revolving line of credit for a manufacturer, and pricing it similar to what you may an auto loan, which traditionally has a lower amount of risk.  It can also come in the form of locking in a rate for a longer time frame than the risk associated with the cost of funds.  An example of this would be locking in a rate for a year on a revolving line of credit.  The cost of funds on those draws can change every day, and you do not know if your margin will remain intact.  Other concessions on prices come with closing loans with no financial compensation to the institution for its time in underwriting, documenting, and booking the loan.  In some cases, institutions may even pay for third party costs associated with the loan on behalf of the borrower. 

So is there any case that justifies a price concession?  Sure there is.  But the lender should go into the situation with a strong case as to why prices were lowered to do the loan, and make sure the concession makes financial sense.

Covenant concessions can be even more dangerous than price concessions.  This is where the lender will deviate from standard covenants on a loan in order to just get the deal.  Some examples of compromised covenants could be accepting a DSCR that is below your standards for the type of credit, allowing collateral (such as in a line of credit) to be sold and not require funds repaid to the loan, or accepting a highly leveraged company as an acceptable credit when this would not normally be done so.  I would contend that each covenant concession should have a mitigating factor defined that explains why the increased risk for the covenant waiver is OK. 

It is also a double-whammy when both price and covenant concessions are done only to win the business.  If that is the only way you can win the business, why would you want to do that?  It does give you the reputation of being both cheap and easy.  Last time I checked, those are not good qualities to look for in people!  The problem with being cheap is that there will eventually be some fool who will undercut your rate.  If your borrower is willing to leave for 0.005% of savings, just how loyal is he to you?  The problem with covenant concessions occurs if the performance of the company or farmer deteriorates into a problem credit status.  The first question that would be asked by an auditor or regulator is why such low credit standards were accepted and championed in the requirements just to get the business?  In this case, the deal may become so bad that a “greater fool” may not be able to be found to offload the loan. 

I contend that a long term strategy of price and covenant concessions is not the way to grow your commercial portfolio.  You must move to a place where these issues can be taken off the negotiation table.  You cannot beat Walmart, nor do I know many institutions whose goal is to become Walmart and compete solely on price.  Some bank that is bigger will eventually beat you.

When I think of good covenants, I think of my Aunt Lill.  Lill was a gardener.  Once, when I was just a lad, I asked her why she took so much time putting stakes and cages around her tomatoes.  It seemed like such a waste of time to me.  She showed me that if she just left the tomatoes grow on the ground, she could only plant one plant in the same space that she could plant five with good cages.  The tomatoes on the ground also grew wild and tended to rot easier, and more of the critters under the ground would get to them.  Her tomato yields were down substantially.

In the same way, good covenants are just like tomato cages, allowing the company to grow with structure and understand how the lender views and manages risk.  This also allows the institution to grow with more loans to more institutions.  The large loan that is un-covenanted is like the un-caged tomatoes.  They will cost more time and money, hindering you from growing your portfolio.

I always say that you know you have won the relationship when the borrower comes to you for advice that does not immediately involve a financing request.  The time this happens is when the borrower views you as what your goal is to become, a trusted financial advisor.  Again, the ultimate goal for the lender is to become the trusted financial advisor to the client. 

When you look for an attorney, doctor, accountant, or investment broker, you do not look for the cheapest and easiest.  You want the best.  You want someone who will make you better.  In the same way, once you become a trusted financial advisor, your good clients will come back to you, because they realize you make them better by being your member or customer.

Prepayment Penalties and Business Loans

Prepayment penalties are a way for a financial institution to recover income in the event a loan is repaid early and will not continue to pay interest income. Some may feel this is a penalty for successfully attaining a stronger financial standing, and for that reason specifically, I think the NCUA has prohibited prepayment penalties on loans. It seems to go against the spirit of the credit union movement to have members penalized for trying to better their financial position by accelerating repayment.

Generally, I don’t see an issue with the lack of prepayment penalties for consumer loans. However, prepayment penalties can serve a special purpose to discourage early loan repayment when that loan is matched with a funding source of similar maturity.  From a safety and soundness perspective, I fear interest rate risk when long-term assets payoff but long-term funding remains fixed; but this likely has negligible effects in the consumer lending arena.

I think the interest rate risk is more substantial in business lending because of the sheer size of the assets that can reprice instantaneously. To illustrate this point, consider the following example: Say an average car loan is $10,000. Now say the credit union makes 50 car loans which leads to $500,000 in outstanding debt. No doubt, some of those loans will be prepaid by accelerated payments or be refinanced with newer purchases; but it is unlikely all will prepay, and those that do prepay will not all prepay at once.

Now consider making one business loan for $500,000. If the loan is refinanced at a different institution, immediately the entire $500,000 loan fails to provide any interest income to the original institution, and this leaves $500,000 in exposure to funding source of matching maturity. This would have far greater consequences to income and interest rate risk than the example of auto loans prepaying. Without a prepay penalty, the credit union is not penalizing the member for refinancing at a different institution, but this comes at the cost of significant interest rate risk to the credit union’s balance sheet.

I would advocate that the NCUA should allow for prepayment penalties on business loans, because it is critical for the credit union to manage its interest rate risk and other funds management objectives. However, in the spirit of the credit union movement, I think the prepayment should only be permissible if the business loan is refinanced at a different institution. If the loan repayment is accelerated with the member’s own resources, or the loan is refinanced with the same credit union; it would seem fair that a prepayment penalty should not be applied.

Prepayment penalties should not be an ugly concept when they are a tool that helps preserve the strength of the credit union. I would not advocate for prepayment penalties on consumer loans, because the interest rate risk associated with prepayment is more manageable. However, I would advocate prepayment penalties for large business loans that are refinanced at different institutions, because the instant repayment of large assets can seriously affect funds management strategies. By disallowing prepayment penalties on large business loans, members’ deposits are placed at greater risk at the expense of one member benefiting from an easy exit to a different institution.

Interpertation of the Current Ratio

One of the most common measures of a company’s or farm’s financial short term ability to pay its obligations is the use of the current ratio.  Theoretically, if an entity entirely ceased to generate income and if it were able to use all of its short term assets that can be turned into cash within the next 12 months to pay its entire short term obligations that are due within the next 12 months.  Of course, this does not include any ongoing operational expenses.  A ratio that is above 1.0 indicates that there are more current assets than current liabilities; the ratio below 1.0 indicates current liabilities are greater. 

The larger question here is what is actually considered a current asset and what is actually a current liability.  Just because it is listed on your client’s balance sheet does not really mean it fits the definition.  One can see that if these numbers on either side a skewed, the ratio will not tell the correct short term position of the company.  This post will look at several issues to consider when inspecting a current ratio.

First, consider the asset side of the equation.  When you are looking at current assets, which ones are really current?  Are there any items that are listed as a current asset that have a high probability of not being turned into cash in the foreseeable future?  Are there any accounts that are uncollectable?  Is there inventory or work in process that is stale and not marketable?  Are any of the bank deposits pledged against other obligations that could not be used to satisfy any payables?  Are there amounts due from the owners that will really not be paid back within the next year?  It may be prudent to judge the current ratio after removing these items from the current assets.

There may also be intermediate term assets that could be turned into cash rather quickly in the case of a cash pinch.  In farming, one item that could be considered is breeding stock or seed from harvested crops.  In one bank I worked at, we would add to current assets either the extra amounts over the historical averages the customer would typically keep on hand.  Another method may be to include a percentage of these intermediate term assets as current when running the current ratio.  Clearly, items should not be added in here that if sold, would have a serious strain on the ability of the firm to generate income from its operations, such as selling equipment that is used in production.

On the liability side, one item that seems to be missed is the current portion of long term debt.  I have seen many balance sheets that do not split the required principal payments due in the next 12 months from the long term debt balances.  This understates the liabilities. 

Some ways current liabilities may be overstated are when amounts due to the owners are listed as current, when the company has neither the will or ability to satisfy those debts in the next year.  One option would be to treat this as equity, especially if you can get a subordination agreement to your loan.  Other potential overstatements may be when debt that will not be paid in a year is stuck in the current side.  This can happen with a line of credit a company has that it historically only can pay down to a certain level and no more.  Sometimes, it may be wise to do a short term note with an amortized repayment to retire that form of permanent working capital. 

The current ratio, as with all others, should never be used in a vacuum.  There is no “holy grail” to be found that will give the lender a perfect method of monitoring and managing the performance of the company.  All ratios are only clues to be followed to find the true reality of your company’s or farmer’s financial position.

Funds Management: Have Your Cake and Eat It Too

Financial institutions are constantly faced with balancing the risk and reward of different business decisions. Should a business loan be funded or is it too risky? Should a new product line be adopted, or will it result in more expenses than revenue?

When it comes to funds management, the balance also comes with the need for liquidity and the need for earnings. What should the institution do with the funds on hand? Invest in consumer loans? Invest in business loans? Invest in securities? Do nothing and hold cash? I think it is important to understand that doing nothing and holding cash is a decision that also has serious consequences, because it will have an effect on the long-term cash flow of the institution.

The goal of funds management is unique. The institution must manage its need for liquidity to pay obligations, while also balancing the need for earning assets to fund operations. An institution needs to develop a funds management policy, which determines where they will place the fulcrum to balance these needs. Ultimately, it will boil down to how much liquidity is necessary, and how the institution will go about accessing it.

A strong funds management policy will allow for efficient use of available funds without the need to wonder how much liquidity is too little or too much. When excess liquidity is identified, it can be put to use. Excess liquidity should be put to use, because the rate of return on holding cash is 0%. In an odd turn of the phrase, having too much cash is literally leaving money on the table! Those funds could even be deployed into CDs with correspondent accounts or low-yield securities that at least pay something above 0%.

Many institutions currently possess too much liquidity. I believe this is the result of three major factors. The first factor is the concern over low interest rates. Institutions don’t want to risk investing in long-term assets only to have their cost of funds increase. This can be overcome by smart asset-liability management.

The second issue has to do with a fear of running out of liquidity in the event of an economic downturn. This is a legitimate concern to a point, but smart funds management can easily preserve liquidity. In modern times, institutions have great access to multiple lines of credit through the FHLB, Fed Funds, etc. Also, if liquidity is invested in available-for-sale (AFS) securities, those investments can easily be converted back to cash.

The third reason I think institutions hold on to too much liquidity is they simply are not sure where and how to invest it. They don’t want to invest in securities only to realize losses if interest rates rise, and they don’t want to invest in complicated loans only to have them default. They may be constrained by their market area and simply have no other way to build consumer loan volume.

The only way to overcome the last concern is by strong management and foresight. An institution needs to find innovative ways to overcome barriers, and those who are willing to innovate will win. There may be costs associated with employing expertise to help with funds management, analyzing securities or buying into participation loans; but ultimately, the cost will be more than recovered in the long run.

Those who will not effectively use a funds management policy or innovate will retain their liquidity, at an opportunity cost. While holding onto cash may seem prudent in the short-term, it is not a profitable decision, and an institution needs profits to keep the lights on and continue to grow its capital. An institution that fails to grow to meet increased customers’ and members’ needs risk losing their competitive edge and may need to merge with a larger institution in the long run.

The Timing Risk of Loans and Deposits

A common challenge financial institutions often find themselves in is centered on interest rates.  I can accurately predict what will happen to interest rates—they will fluctuate!  These rate changes can cause fits for the CFO as they attempt to adequately fund the balance sheet and earn the highest amount of Net Interest Margin (NIM) as possible.

 If rates did not fluctuate, how much easier asset/liability management would be!  The marginal cost of funding would be constant with the only variations occurring with the timing of the term of the deposits or the loans.  The CFO could prop his feet up on his desk, set a standard margin, choose a index of interest rates to go by, and set prices across the institution for both loans and deposits for the best risks.  Higher rates on loans and lower ones on deposits can deviate from the best rate in order to price for the risk.  I believe if rates did not fluctuate, we may find more financial CFOs spending time on the golf course.

 But alas, fluctuations have been here since the dawn of the market and will continue into the future.  Because of that fact, wise CFOs must engage in a diligent study of the interest rate sensitivity analysis of their institution and also watch for the trends in the market as a whole in relation to how that will impact them.  In interest rate sensitivity analysis, an institution will have a positive gap, negative gap, or no gap.

 A positive gap occurs when the amount of interest earning assets exceeds the amount of interest paying liabilities.  This is beneficial to an institution in a rising rate environment.  The CU or bank would be able to move rates higher with the market on its loans while enjoying the locked in rates on the deposits for a season.  Note that a positive gap in a decreasing rate time will cause NIM to fall.

 A negative gap occurs when the amount of interest paying liabilities exceeds the amount of interest earning assets.  In this case, a declining rate environment where the liabilities are repricing at lower rates while assets remain fixed at higher rates will benefit the firm.  A rising rate environment will hurt a firm that is negatively gapped. 

 Financial institutions with no gap or a neutral gap will have an equal amount of interest earning assets and interest paying liabilities reprice at the same time.  Theoretically in this case, the NIM will remain constant.

 Mismanaging the interest rate gap can kill an institution.  Around ten years ago, as I banked in Colorado, we learned of an agricultural-focused bank in the northeast corner of the state.  That bank had a strong desire to grow and began to become quite aggressive with their Ag lending portfolio, offering terms of 90-95% financing on land and requiring very little equity or reserves from the farmers.  They also locked in interest rates on these loans for long terms.  It was not uncommon to see 10 or even 15 years on a fixed rate before the loan would reprice. 

 Soon, borrowers flocked to the bank, quicker than politicians to campaign contributors.  The bank began to experience phenomenal rates of growth.  The growth ate up all the funds they had available to lend so they turned to the Internet to acquire “hot” CD money.  They generated deposits that would reprice quicker than a lot of their heavily margined loans would.  They also had to pay higher rates to attract the money, which squeezed their NIM.

 A dip in some commodity prices coupled with a couple of dry years in that area hurt the farmers.  Those who were highly leveraged, did not survive.  This resulted in several farms from earning some interest to earning no money at all as they were transferred to the bank’s other real estate.  The 2008 crash also took its toll.

 The next whammy that hit was the loss of the hot CD money.  The deposits time came to reprice and the new rates were not as competitive as the prior ones so much of the funding left.  Other deposits were pulled out as depositors began to look at the bank’s financial position and rightly judged the bank was unsound.  A small run ensued.  The bank was insolvent and the regulators took it over.

 There are several lessons to learn here. First, uncontrollable growth funded unwisely can kill an institution.  The bank should have increased their underwriting standards to slow down the rate of growth to level that matched their ability to organically develop deposits.

 Second, risk should be priced for.  If you are going to do 90% farmland loans, a practice I would strongly advise to not enter into, you had better increase the rate to adequately compensation you for the increased cost of delinquency and default in the portfolio.

 Third, as much as possible, the duration risk in the portfolio, should be minimized.  Duration risk is the sensitivity of your NIM to a change in interest rates.  So if you locked a loan in a rate for 15 years and left it on your books, you would experience a higher amount of duration risk than if it was locked for 3 years.  The larger the duration number, the greater the interest rate should be on the credit facility.

 Duration risk can be minimized by matching the timing of repricing of assets to when liabilities reprice.  NIM usually greatest at the onset of a loan if the interest rate is fixed for a long term and it is funded by very short-term liabilities. The risk here lies that if rates rise, the wonderful NIM you enjoyed at the start will not continue.  I was with a bank once that eliminated much duration risk by requiring no loans over $1MM could have an interest rate locked for longer than a year.  If a customer wanted a locked rate, the customer would have to enter into an interest rate swap contract.  This effectively transferred the duration risk from the lender to the borrower. 

 So the next time you see your CFO ask him if he is keeping his eye on the balls, both the little white golf ball and also the funding ball of his NIM.

The Next Banking Crisis: Interest Rate Risk?

We all remember the last recession as a very messy time in finance that was accompanied with an unseen number of bank and credit union failures since the Great Depression.  We know the cause of that mess was poor credit quality. People were given loans which they could not repay, and when loans don’t get repaid, bank/CU capital gets depleted. If there isn’t enough capital, the institution gets shut down.

 When most people hear of bank failure, they probably think the institution made too many bad loans, or, the institution became insolvent and ran out of cash to pay deposits. These are both certainly causes of bank failure, with insolvency being less of a concern in modern time. There is another unique way an institution can fail, which is the same manner in which any business can fail: the inability to operate profitably!  In this case, the institution fails to make enough interest income to pay both deposit interest and overhead, such as salaries, utilities, etc.

 When the spread between the interest earned on assets and interest paid on liabilities is susceptible to change, we say the institution is exposed to interest rate risk. The spread between those interest rates is how profit is earned, which pays for overhead and dividends. If that spread is too thin, an institution may fail due to lack of profitability.

 Failure due to interest rate risk can occur in two primary ways. The first way is when the institution carries long-term deposits and borrowings, and uses those funds to finance short-term assets. When interest rates decline, the spread will be squeezed by short-term assets repricing to lower interest rates and long –term deposits remaining at their current levels.

 Imagine taking in a 10-year deposit priced at 5.00% and using it to fund a home equity line of credit at 7.00%. In this case, the institution has a 2% spread (7% less 5%), which are profits used to pay overhead and dividends.  Say the line of credit reprices monthly. Now assume in one year the interest rate on the line falls to 5.00%. That means now the spread is 0%. The deposit will remain fixed at 5.00%, despite the line of credit dropping to 5.00%. There is no spread now to pay overhead or dividends!

 The other primary way interest rate risk causes failure is the complete opposite of the example above. Imagine you fund a 10-year fixed rate loan at 7.00% using deposits from a money market account that adjusts price monthly, and has a current interest rate of 5.00%. If short-term interest rates move up on the money market account, there will be less spread with the 10-year loan. If rates increase by more than 2.00%, there will be no more spread remaining, and the institution will be unprofitable.

 As demonstrated, interest rate risk can be a problem when interest rates rise or when they fall. It all depends on how your institution structures its interest rates.

 My present concern is I see banks and credit unions funding loans for long-term fixed rates of 10 years, 15 years, and even 20 years! The problem is they are not obtaining deposits or borrowings that also have a fixed rate for the equal period of time. This means these long-term fixed rate loans are being funded with short-term liabilities. If interest rates rise, their spread will quickly deteriorate. Also, take into consideration, interest rates persist at historical lows, which suggests they have nowhere to go but up.

The Pricing Challenge

A common question that you hear revolves around how to price a loan.  Now some loans do have limitations placed on their pricing if they are tied to some government program such as SBA.  But the general attitude in far too many cases when the lender has the ability to set a rate is to see what the competition is doing and then either match or slightly beat that rate. 

It is a dangerous thing to run your institution by sticking your head out the door and looking at your neighbor.  His shop is different from yours and what works for him may not work for you.  Besides, if he is the stupid one, why do you want to follow? 

Now I will concede that there are clients who are bringing you a substantial amount of business which you are forced to concede on the price.  I am not suggesting that the lender abandon this practice altogether; I am suggesting that you keep your eyes wide open when pricing.

An institution should consider a minimum threshold when considering pricing.  The threshold should account for the amounts needed to cover operational costs of the CU plus a targeted profit margin and reserve increase.  Non-interest income is then deducted from those costs.  The remainder is what needs to be earned by the net interest margin between the costs of deposits and borrowings and the earnings on loans and investments. 

This may lead the institution to attempt to move as much funds from investments to loans since the average yield on loans is higher.  That is true, but the average yield assumption fails to consider a few items.  First, typically the cost to service a loan is usually higher than the cost to service an investment.  Second, the risk in servicing loans is usually higher than investments.  We call this the risk of default or charge off.  Third, the cost of dropping rates on existing loans to attract new loans will lower your marginal yield. 

To make an apples to apples comparison between investments and loans, the costs of servicing and default need to be added to the yield on the investment.  This will give an adjusted yield that will compare to the loan rate. Servicing costs can be figured in your shop with the incremental cost of support staff, computer systems, and other items that will be used to service the new loan.  Credit risk can be calculated by looking at a stratification of the evidences of default and delinquency among various risk rates of loans in the portfolio.  Those figures, along with an analysis of the adequacy or lack thereof in your allowance accounts, will help determine the premium factor that the new loan would cost compared to the investment. 

To make the comparison the same, similar maturities or repricing periods should be considered for both. It does not make sense to compare a 2 year Treasury to a 5 year fixed loan rate or a Prime tied loan to a 5 year US Government agency.  In the same way, how a loan adjusts should be tied to a similar term index whenever possible.  So this would tie an adjustable rate for 5 years to a 5 year index, which could be a US Treasury, LIBOR or FHLB.  Matching this term will help determine the spread compared to the alternative investment or may help you more fully identify your cost of funds for that loan.  In the end, even after these adjustments, many will find the loan offers a better net yield, even after consideration of the alternative investment’s adjusted rate.  But a strategy of pricing should consider these costs.

Projections and Pro-Forma : Why We Can and Can’t Rely on Them

Sometimes I receive a request to prequalify a customer for a loan. My first question is naturally, “What is the project?” I am then frequently told there is no “project,” but simply, the member wants to know how much they can borrow based on their income and net worth. Unfortunately, business lending doesn’t follow the same patterns as consumer lending, and it isn’t as simple as collecting basic personal data and calculating a few metrics to establish approval.

 In business lending, project matters in everything. A member’s net worth, income and experience may be adequate for $1 million real estate request, but may be inadequate for a $1 million line of credit. Business requests aren’t straightforward for preapprovals, because each business has different ways of generating revenue, different expenses, and different cost structures in general. Simply put, each business loan request will require different personal resources to support the credit risk.

 One tool that can aid in evaluating a business loan request is projections or a pro-forma. A pro-forma is synonymous to projections. While I don’t think there is much of a difference, I tend to personally think of a projection or budget as an annual summarized estimate, and I tend to think of a pro-forma as a month-to-month budget estimate. In most (but not all) real estate requests, generally an annual projection is adequate, but for commercial, industrial, and agriculture requests; having monthly projections are important.

 When a request is vetted with a specific project and a projection/pro-forma in-hand, it becomes much easier to provide advice as to whether the request is likely creditworthy. But, one should always take projections and pro-formas with a grain of salt, and always keep in mind, it is a projection at best, and not a guarantee the estimated performance will result. I cringe when I see credit officers sign approvals for troubled borrowers, simply because they provided a new budget that suggested this year they will finally be profitable!

 A projection or pro-forma should be accompanied with assumptions of how they arrived at the resulting revenue and expenses. Assumptions are necessary so the logic behind the projections can be assessed.

 Once I was given a request for a restaurant, and this borrower had operated several other successful restaurants in the area. He gave me a pro-forma for a new restaurant he wanted to start, but it didn’t explain to me how he arrived at his revenue projections. I asked him, “What is the average charge for a lunch meal? What is the average charge for a dinner meal? How many tables? How much turnover per table?”  He urged me to take faith in his projections based on his past performance, but I explained to him why I needed that to review the request.  He kindly agreed to try and fill in the additional details for me. When he came back, he said it wasn’t economical for him to start the restaurant! It turns out he couldn’t fit enough tables into the building he wanted to buy; thus, he would be unable to generate the revenue he was projecting!

 To get started with a business request, having some sort of projections are key to initially assess underwriting. Each business request has unique risks, which is why we can’t really underwrite a borrower for a preapproved amount of money. The projections will help us understand that risk, and whether the borrower can backstop those risks. But, we need to take those projections with a grain of salt and understand the assumptions used in the projections.

SBA Program Changes

The start of this year is also marked the beginning of a new SBA Standard Operating Procedure with SOP 50 10 5(F).  The new SOP allows all loans up to and including $350,000 to be processed like the “Small Loan Advantage” (SLA) Loans.  The standards of the SLA program are now applicable to all loans up to $350,000, whether the loan was an Express loan or a 7(a). These smaller loans require a credit memo that outlines the pre-screened credit score, shows a DSCR of 1:1 or greater, a global cash flow of 1:1 and also has verification of tax returns through the 4506-T.  The credit memo should show a determination that if the equity and proforma debt-to-worth are acceptable based on its policies and procedures for its similarly-sized, non-SBA guaranteed commercial loans.  If the lender requires an equity injection as part of its policies it must also do so for SBA loans.

All new SBA Guaranty request must be submitted via SBA’s E-Tran system.  Lenders can no longer submit their requests to the SBA by fax, email, or mail.  The E-Tran system also has to be used to develop a pre-screen credit score.  If the score is below 140, the only options are to request an Express loan guarantee, which has a lower guaranteed amount, or to provide documentation to the SBA for them to underwrite the loan and make their determination regarding the guarantee percentage they are willing to commit to. 

Larger loans over $350,000 must have a DSCR of at least 1.15:1 using EBIDTA.  Any debts that are refinanced must have a justification reason.  These must also include transcripts for each of the refinanced accounts that stretches back for the prior 24 months if the debt is not at your financial institution or 36 months if it is at your credit union. 

Collateral requirements for SBA loans have changed a little.  You must use commercial reasonable and prudent practices to identify collateral items.  The collateral should include a first security interest in the assets you are financing.  If you are refinancing existing debt, the loan should be secured with the same security and lien priority as the debt being refinanced. 

Loans under $25,000 are not required to have collateral.  Loans between $25,000 - $350,000 should follow the same collateral policies and procedures the lender has in place for its loans.  At a minimum, a lien on fixed assets should be taken.  Loans over $350,000 should be collateralized up to the maximum extent possible up to the loan amount.  If there is a collateral shortfall, the lender must take any available equity in personal real estate of the principals as collateral.  Available equity excludes personal residence with equity of less than 25%.  Any liens on personal real estate may be limited to the amount of the collateral shortfall. 

A loan is deemed fully secured if the adjusted net book values equal the assets original prices less any depreciation.  New machinery and equipment (M&E) maximum is 75% of cost.  Used M&E is 50% of Net Book Value or 80% of Orderly Liquidation Appraised Value.  Commercial real estate is limited to 85% of value.  Any residential or investment real estate is valued as the lender normally would if the loan was not guaranteed by SBA.  If there is a collateral shortfall, the lender must include any trading assets of the firm. 

The application process has changed slightly.  All business and personal financials can be dated within 180 days of the lender application or SBA Guaranty.  Personal financial statements still must be dated within 90 days. The applicant must complete SBA Form 1919 and the Lender completes Form 1920.  Form 4 and 4-I are not used.  Lenders have the option of using their own note and guarantee agreements rather than the SBA versions (SBA Forms 147, 148, and 148L). 

The pilot program of the Patriot Express has been deleted.  Fees have changed slightly with all loans of $150,000 and below having no up-front fee or on-going servicing fee.  Loans over $150,000 have no change in their up-front fee to the SBA and the on-going fee is reduced to 0.52%.  

If you have any questions, please contact us.  We have several helps for lenders on our website under the “commercial” tab with the SBA Program Overview and the SBA One Overview. 

Is Strategic Planning Worthless?

It is that time of the year when everyone is scheduling annual meetings and planning sessions. Review, revision, or development of a strategic plan will no doubt be the task of several organizations. Many question whether the strategic planning process actually provides any useful planning. In my experience, I believe strategic planning is a powerful tool, but it is worthless for most organizations. Why the ambivalence? Simply put, most teams do strategic planning incorrectly.

Cutting through all the fluff and dressing of what most people think strategic planning is, the truth is one key element separates all good plans from bad plans. The key element is accountability. That is not to say all plans that have accountability are good, but certainly any plan that lacks accountability is dead on arrival. Without accountability, most strategic plans read like communist propaganda, which is inspirational at inception, but never results in effective execution of goals.

An accountability plan is measurable. Think of a strategic plan like a road map, and it should clearly define where you currently are and where you hope to be. The vaguer you make it, the more you whittle away at accountability. Are you in South Dakota and want to get to North Dakota? Or, are you in Rapid City, SD and want to get to Grand Forks, ND in no less than eight hours, and by no later than Friday? Both plans are measurable, but the latter is more defined and therefore easier to measure whether it is successful.

I think many plans are not accountable, because it is convenient for people not to be held accountable for their actions. This is an unfortunate reality of the human experience, but nobody wants to be held accountable for a plan coming up short. People fear negative repercussions for failing to carry through. Management should address that people need to be held accountable, but failing isn’t necessarily going to reflect poorly on them, because there are always factors outside of everyone’s control, and sometimes plans are unrealistic. A plan that cannot be executed still helps management pin point where plans are weak and create more realistic forecasts going forward.

Most strategic plans are broken from the beginning, because they lack anything to be accountable to. Consider these two mission statements:

1)     GE under the management of Jack Welch "To be the most competitive enterprise in the world by being No. 1 or No. 2 in every market - fixing, selling, or closing every underperforming business that couldn't get there.

2)     Citigroup “Our goal for Citigroup is to be the most respected global financial services company. Like any other public company, we're obligated to deliver profits and growth to our shareholders. Of equal importance is to deliver those profits and generate growth responsibly.”

With GE, the direction the mission statement adds to the strategic plan is obvious. GE can measure whether they rank #1 or #2 in a market, and if they don’t, they will have a plan to fix, sell or close a lagging division. With Citigroup, the mission gives little direction to strategic planning. What does it mean to be the most respected company? How will they get there? What does it mean to generate growth responsibly?

A good strategic plan is accountable; and to be held accountable, performance must be measurable. A strategic plan should provide specific direction and have goals that can be measured. A plan that lacks these features is little more than propaganda that won’t effectively guide institutional growth. Most plans lack accountability and measurable goals, which is why these plans add no value to the organizations they are designed for. Strategic planning is only useful when done right, which is why few organizations find they have strategic plans that are actually useful.

Demographics and the Economy

One of the more interesting studies is to parallel demographics and economic growth.  There are some logical reasons to look at these two in tandem.  First, the largest segment of our economy is consumer spending - what you and I spend on food, clothes, gas, and our houses - just to name a few items.  There are typical patterns of consumer spending that are evident for the average person in a certain demographic group.  An example is you usually do not have retired people buying a larger or new house or making major consumer purchases, since they tend to have a smaller disposable income than people, say, in their 40s.  If the trends in spending continue, one could predict the expansion or contraction of consumer spending, accounting for around 70% of economic activity, based upon demographic changes.

Young people tend to cause inflation as they produce little and cost a lot.  As young people grow up, they enter the workforce and become productive new workers; thus, increasing labor supply and also higher spending consumers creating more consumer demand.  As one goes through life, the consumer demand tends to increase with purchasing a house and raising children.  As a person grows in their career, their income tends to increase and demand grows as well.  At some time, people begin to switch from being a consumer to being more of a saver as they look toward retirement.  Expenditures are reduced as their home mortgage is retired.  Further cuts are being made as the person approaches retirement in expectation of a reduced level of income.  Expenses in other areas, such as healthcare and long-term care, increase.  As a general rule, those who are in the retirement age category create less demand than those that are younger. 

So how does this impact an economy?  A good example is Japan.  Japan had its baby boom prior to the US and is between 25-40 years ahead of us on the demographic curve.  Throughout the 1980’s, Japan’s economy and stock market soared.  In early 1990, the Nikkei 225 Index was over 35,000 yen.  Then the economy began to slow down, as the aging population demanded less.  Japan had eight major monetary expansions in the 1990s.  This kind of reminds one of the Fed’s Quantitative Easing. In Japan, none of that easy money policy expanded the economy, and prices began to deflate.  The overnight interest rate fell to a fraction above 0%, which is where it remains today.  The Nikkei is sitting around 15,000 yen today, a third of the level it once was. 

Japan is still in a comatose economy with little growth and a deflation of prices with the lack of demand.  The major monetary expansions and government borrowing have continued, and the debt bubble in Japan has never been de-leveraged.  Prices do not change, even though the government is printing money at a rapid rate.  Is this starting to sound familiar?

Harry Dent’s new book, Demographic Cliff:  How to Survive and Prosper During the Great Deflation of 2014-2019, is an interesting read on this subject.  He believes “demographics are the ultimate indicator that allows you to see around corners and predict the most fundamental economic trends…decades in advance.”  He contends that the demographic tide is turning against the aging US.  As Boomers retire, more deflation will occur and weaken the economy. 

The US reached its current demographic peak spending level between 2003-2007 and is headed for the demographic cliff. Germany, England, Switzerland, China are all headed there too.  China is a few decades away from the fate of the others.  The stock market will crash as the worse economic trends hit in the next 5 years.  The US economy should also experience another major slowdown in this period and will be unable to expand because of the increased amount of Fed intervention. 

This impact will hit the everyday consumer more, who never came out of the last recession.  The true winners of the Fed’s monetary expansions are the rich, as asset prices are aided by monetary stimulus.  If the population changes, in which people dying outweigh new consumers, there will be fewer spenders, borrowers, and investors to participate. 

Our country has debt at insane levels, and it keeps increasing as politicians act like we can continue with endless monetary injections and bailouts to get over what they think is a short-term crisis.  Or they may think a short-term boost is all they need to buy them enough time to reach the next election.  The underlying problem is a long-term structural problem in nature and has implications we cannot run away from.

A business will have to become lean, focus on cash flow, defer major capital expenditures until they are absolutely necessary and sell non-producing assets to continue to be a factor in the years to come.  Dent argues some of the biggest challenges in the coming years are private and public debt, health care and entitlements, and authoritarian governments around the world. 

If Dent’s predictions come true, we are in for a real struggle.  We already have signs of weakness in the economy on the horizon.  We currently have 15% of the US population on food stamps.  MSN Money reported recently that 43% of American families spend more each year than they make.  The labor force participation rate is at its lowest level since the Carter Administration.  A question is that as boomers retire, will companies replace them with younger workers, or will they seek to generate more productivity with the remaining staff?  This would further reduce employment and income, and subsequently, reduce economic activity. 

Can You Take That to the Bank?

As we all know, risk is part of our daily life. We all take a risk just by getting into our cars in the morning and driving to work. We know that the odds are in our favor that we will make it to work alright, if we drive responsibly and watch out for other drivers. I started driving when I was 15 years old and have only been in one accident, and it was when someone hit me from behind while I was waiting at a stoplight!

All business we engage in also have risks that must be navigated, and banks and credit unions spend a significant amount of time trying to understand their risk profile. When lending money, the main risk we are concerned with is not getting repaid. How much risk is acceptable? If our odds of getting repaid are 50%, is this a good risk to take? If our odds of getting repaid are 75%, is this a good risk to take?

To answer how much risk is acceptable, we need to understand the ability to absorb our risk of default. What a financial institution falls back on is capital. If a loan goes bad, the institution will have to record the loss as a loss to capital, and it cannot record it as a loss to depositors. When capital runs out, the regulators shut down the institution.  So, it is capital that ultimately limits how much loss or risk of loss an institution can take.

Consider that most financial institutions have a capital ratio of around 10% of total assets. That means, even if the odds of getting repaid by loans were 90%, the risk of 10% of loans going bad would deplete the entire capital of the institution! That means an institution has to do better than a 90% chance of getting repaid.

A healthy bank or credit union can grow its capital at a rate of 1% of assets per year.  That means, if losses were to be any greater than 1% a year, then an institution is losing capital at a rate faster than it can replenish. That also means a healthy institution could hypothetically see 1% of loans go bad in a year, indicating they must be right 99% of the time!

Of course, institutions would like to grow and need capital to do so. If their capital growth was constantly offset with losses, they wouldn’t grow at all. So realistically, an institution would like to get it right greater than 99% of the time.

This means banks and credit unions rely on loans that have a 99% chance or greater of getting repaid. We refer to these loans as “bankable” assets. When there is sufficient cash flow, collateral, and a high probability of repayment, we say that the loan is a “bankable” asset.

A misunderstanding I often run across is lenders or small business owners see great potential for their business, but they don’t understand why an institution will not readily finance their business. I would agree that a business that has a 90% chance of repayment sounds promising, but unfortunately, it isn’t bankable. That isn’t to say it’s a bad business venture. Many of these businesses are worthy of investment from some other source, but it simply is too risky to be funded by depositor money.

To summarize, the odds of repayment must be exceptionally high for a loan to be considered “bankable.” Even if odds of repayment are high, the loan request may still not be bankable. The loan must demonstrate enough collateral, cash flow, and positive business conditions that it is a 99% or greater chance repayment will occur. This means even a good business isn’t always a bankable business, and sometimes a good business will need to seek a different form of investment other than debt from banks or credit unions.

A Case for Repealing Dodd-Frank

I apologize up front, but this post is a bit longer than a typical one.  I do think the subject involves some thought.  The 2008 financial crisis was a major event, causing many at the time to equate its impact with the early days of the Great Depression.  Many commentators and other self-proclaimed experts stated we were witnessing a crisis of capitalism, proof that our free market system was inherently unstable.  The only calming influence could come from government, and these officials claim their efforts prevented a complete meltdown of the world’s financial system.  This idea has won popular acceptance among those in academia and the media.  The crowning achievement of this regulatory effort was the Dodd-Frank Act.  This is founded on the notion that the only solution for the unstable financial system is government regulation. 

Of course, we will never know what would have happened if no government intervention occurred.  But it is possible to understand what some of the causes of the crisis were, and if those line up with the reasons behind enacting the regulation.

These new government regulations have slowed economic growth and increased the cost and decreased the availability of capital for business expansion, which they will in the future.  This may be a legitimate trade-off, in which we sacrifice economic freedom and growth for stability.  But if the crisis did not stem from a lack of regulation, we may have needlessly restricted the growth that most Americans want. 

It is still not clear if a lack of regulation was a factor in the 2008 crisis, but there is compelling evidence that the financial crisis was a result of the government’s own housing policies.  These policies were based on an idea, which is still very popular among some, that underwriting standards in housing finance are discriminatory and unnecessary.  Of course, this idea runs contrary to the idea of the mortgage investor who wants a surety of repayment of his principal with some interest, and thus, wishes to divide up good credit risks from poor ones.  This reckless attitude toward the rapid expansion of credit, without regard to eligibility, is what caused the insolvency of Fannie Mae and Freddie Mac.

The Federal Government’s foray into housing began in 1934, with the establishment of the Federal Housing Administration (FHA).  It insured mortgages up to 100%, but it also required a down payment of at least 20% or more.  The FHA operated with very few delinquencies for 25 years.  But during a serious recession in 1957, Congress began to loosen the standards to increase housing’s growth.  Down payments were lowered to just 3% between 1957 and 1961.  This resulted in a boom in FHA insured mortgages, followed by a bust in the late 1960s.  This pattern keeps recurring, and no politician tends to remember the past mistakes.  Mortgage standards are loosened, prices bubble, followed by a crash.  The taxpayers cover the government’s losses, and most of the people who are hurt are those who purchased houses in the bubble years.  They find when the bubble deflated, they could not afford their homes or, as in the most recent crisis, the drop in value was too great, and this exceeded the obligation to continue making payments, so they walked away. 

In the 1970s and 80s, Freddie and Fannie learned from experience what underwriting standards kept delinquency and default low.  They generally required down payments of 10-20%, good credit histories from borrowers and low debt-to-income ratios for the new mortgages.  Mortgage defaults stayed less than 1% in normal times and slightly higher in a recession.  Homeownership remained around 64% despite those higher standards. 

This changed in 1992 when Congress enacted “affordable housing” goals for Freddie and Fannie.  Before 1992, these firms dominated the housing finance market, especially after the savings and loan industry failure.  Freddie and Fannie’s role, as originally envisioned and as developed until 1992, was to conduct secondary market operations to create a liquid market for mortgages.  They could not directly make mortgages, but could buy them from direct lenders.  This provided cash for lenders and encouraged home ownership by making more funds available for mortgages.  Even though these entities were shareholder owned, they were chartered by Congress and granted government privileges, such as exemptions from state and federal taxes and from SEC rules.  The president appointed members to their board of directors and they had a $2.25 billion line of credit from the US Treasury.  Investors began to believe Fannie and Freddie were government-backed and would be rescued by the government if they ever encountered financial hardship.  These entities also dominated the housing finance market with their ability to borrow at rates slightly higher than the US Treasury.  From this position, they set underwriting standards for the entire industry, and few lenders would make mortgages that could not qualify for sale to Freddie and Fannie.

Community activists for years had hounded these firms, arguing that their underwriting standards were so restrictive, they were keeping many low and moderate income families from buying houses.  Since these Government Sponsored Enterprises (GSEs) had government support, this gave Congress a basis for intervention, and in 1992, quotas were established for Freddie and Fannie to meet regarding loans to low and moderate income borrowers.  The initial quota was 30%.  These totals increased to a high of 56% in 2008. 

Now in order to meet these quotas, the GSEs had to reduce their underwriting standards.  As early as 1995, they were buying mortgages with as little as 3% down, and in 2000, they were buying mortgages with nothing down.  At the same time, other standards were loosened, such as taking on riskier borrowers with poor credit in order to find the subprime and other non-traditional mortgages necessary to make the affordable housing quotas.  Cash-out refinances sprung up as housing prices soared in the wake of the money that was being pumped into the housing market.  As a result of loosening the credit standards, by 2008, just prior to the crisis, 56% of all mortgages in the US, 32 million loans, were subprime or otherwise low quality.  Of all these loans, 76% were on the books of government agencies.  At the same time, demand for Freddie and Fannie securities remained strong, as the investors believed purchasing one of their mortgage backed bonds was as safe as a US Treasury note. 

Again, all this cash began to flood into the housing market and pushed prices up at abnormal rates.  Before the 1990s, housing prices tended to follow the rate of inflation and a rate of increases in real wages.  As people had more money at their disposal, they could afford a more expensive house.  Yet, once the loosening of underwriting standards began in the 1990s, housing prices increased three-fold until the crash.  During this same period, real wages increased at a modest 2% annually.  Clearly, this created a bubble in the market. 

Weaknesses in the housing market are hidden when the bubble is inflating.  As housing prices rise, it is possible for borrowers who have high amounts of debt service in relation to their income to either refinance or sell their home for more than the existing principal amount owed on the mortgage.  Potential mortgage investors see nice yielding loans, with delinquencies and defaults at levels depressed beyond norms.  Many begin to discount the risks of investing in subprime mortgages, and more money pours into the system. 

As with any bubble that feeds on itself when it inflates, it also exacerbates the problem when the bubble implodes.  Housing prices began to fall rapidly, making it impossible to refinance to get out of debt payment trouble, or sell the house and retire the principal owed on the mortgage.  Underwriting standards are raised, as losses cause creditors to not lend to riskier applicants.  Many borrowers just walk away from the mortgage, knowing that in many states the lender has recourse only to the home itself.  So, delinquencies and defaults shot up to unprecedented levels.  Investors fled the mortgage-backed market, which drove prices on these securities down and interest rates up. 

Since mortgage-backed securities were held by many financial institutions, the drop in value of these securities was disastrous to their capital and earnings.  Since 1994, banks were required to use a “fair value accounting” in establishing the balance sheet value of their assets and liabilities.  This required investments to be marked-to-market and reflected at current market values instead of the historical cost.  So a credit union may have a mortgage-backed issuance that was still making interest payments regularly, in which they were forced to reduce the value of the asset in order to follow GAAP.  The reduction in the asset value is countered by investment losses, which eats away at capital levels.  This began to hinder financial institutions’ ability to lend money.  Investment firms also had to write down significant portions of their private mortgage-backed securities portfolios, creating large drops in earnings.  When Lehman Brothers declared bankruptcy, a panic ensued, where financial institutions would not even lend to each other on an overnight basis, for fear they would not have adequate cash for panicky deposits when they came to get it. 

So, to summarize, the most recent financial crisis was not caused by insufficient regulation or by an unstable financial system.  It was precipitated by the government tinkering with housing policies that caused the dominant institutions in the trillion dollar housing market, namely Fannie Mae and Freddie Mac, to reduce underwriting standards.  The lax standards spread to the market and created an enormous bubble, where more than half of the mortgages were subprime or weak.  When the bubble popped, mortgages failed in record numbers, driving down housing prices and the values of mortgage-backed securities, which caused some financial institutions to be unstable and possibly insolvent. 

So what would be a proper response to the crisis?  The answer would be to change the direction of the US housing finance system away from the kind of government control that lent on quotas, instead of lending based upon prudent underwriting standards.  Blame should be removed on the Realtors, appraisers, lenders, title companies, and mortgage brokers from causing the crisis and placed directly where it needs to be, on the government.  As long as control of the housing finance market is subjected to the whims of narrow political imperatives, instead of sound underwriting and the efficiency of the free market, we will continue to have the potential for future housing bubbles and subsequent busts. 

Given these facts that the government was a main cause in the financial crisis, further regulation by the same government is not the salvation the economy needs.  The Dodd-Frank Act has created vast new regulatory restrictions.  This has created uncertainty and drained the appetite for well-thought out risk-taking that once made the US financial system the most successful in the world.  It has also increased the cost of a financial institution to operate.  Economic growth will continue to be restricted, and capital will be restrained until the American people realize the financial crisis did not occur because of insufficient regulation.  Only then can adequate steps be taken to remove the draconian restrictions present in laws such as Dodd-Frank.

The Power of Our Words

Several years ago, (I will not reveal the number of years to protect the writer), my wife and I were teaching Sunday School for second graders.  The lesson we had that week was on the power of words from the book of James.  The passages spoke of how our tongues can set off all kinds of trouble or how our words can speak life to others.  It is amazing how with one small part of our body, we can create and yet, destroy ourselves and those around us.

To illustrate the point, we gave each kid a tube of toothpaste, a stick, and a plate.  We had them perform “toothpaste art”.  So for about 15 minutes the kids smeared toothpaste all around the plate and just had a ball.  I then took out a new $20 bill and told the kids, whoever could put all the toothpaste back into the tube would get the money.  It was fun seeing kids scramble to try to get the paste back in, but all soon realized it was impossible.  The lesson was this is like our words.  When we say something careless, we can ask for forgiveness, but it would have been better if we had not said it in the first place.

These are lessons I am still learning.  Do I speak encouragement and help others achieve more with my words, or do I cut down and destroy folks?  Mark Twain once said, “I can live for two months on one good compliment.”  Think of the last time you received a great compliment and how it impacted your life.  Those are times that we will never forget.  I can close my eyes and still hear my dad telling me how proud he was of me when I graduated college, or hear my wife tell me what great things I would accomplish when I took over the helm at Midwest Business. 

As much as I enjoy and relish in those words, it also forces me to see what impact my words are having on others.  Do my family, friends, co-workers, members, clients, and acquaintances find my words life-giving, or am I a downer?  Do people want to be around me to find encouragement, or do they avoid me, thinking that what I will say is always critical and hurtful?  Are you one of those people who others gravitate toward because you lift them up?

If you are unsure if your words are beneficial, you may want to think about the “4 Way Test”, authored by Herbert J. Taylor and used by Rotary Clubs. Ask yourself the following:

1.      Is it the TRUTH?

2.      Is it FAIR to all concerned?

3.      Will it build GOODWILL and better friendships?

4.      Will it be BENEFICIAL to all concerned?

Compliance vs. Safety and Soundness

When people hear I once worked as a bank examiner, I think there is an immediate association they draw in their mind. They think of a guy, combing through documents, making sure the “i’s” are dotted and the “t’s” are crossed. Surprisingly, that is only half of the job. What is the other half? The other half is making sure the institution is managing risk appropriately, and that job isn’t black and white like following regulations.

Making sure an institution (credit union, bank, or any business really) follows the laws is a concept called “compliance.” Compliance involves making sure state laws and federal laws are being followed, and contracts are executed correctly. When people think of bank examiners, I think they envision examiners doing compliance work only.

Following laws and entering into contracts may not be enough to ensure an institution stays out of trouble. A bank or credit union can make a lot of bad loans, which may follow all laws and regulations, but were still given to borrowers that had no reasonable prospect of repaying. A financial institution can fail to manage its liquidity appropriately to pay deposits on demand. An institution may charge too low of interest rates on loans and too high of rates on deposits, thus failing to make enough profit to pay salaries or operating expenses. These sets of risks are safety and soundness risks, and can arise regardless of following the laws. Examiners need to assess these risks as well, so their jobs are not strictly compliance.

Safety and soundness regulation tends to be a subjective task, so it requires sound reasoning. Examiners will interview management to understand how they manage various risks. An examiner will seek to understand what management is doing to maintain access to liquidity sources, how they are monitoring interest rate changes, and how they plan to react to foreseeable problems that are known to arise. Examiners will also review underwriting criteria for loans, review loans to see if the criteria are being used, and assess whether those loans have a reasonable chance of repaying.

Examiners will discuss their findings with management, and this should differ with compliance as well as safety and soundness. With compliance, it is relatively straightforward as to whether regulations are met. Safety and soundness, on the other hand, tends to be a matter of opinion, since there are not hard and fast rules as to how risk should be managed. In this respect, examiner findings should be approached as a discussion on how management perceives its risk and how examiners perceive their risk.

It may come as a surprise that examiners are not solely preoccupied with reconciling account balances and verifying laws are being followed, but also, assessing risk management practices on an institutional level and critiquing specific loan requests. But, it may also come as a surprise that management does not have to wait passively for the examiners to present a scorecard based on findings. Managers also have an opportunity to help examiners understand how the mangers see the risk and what they are doing to mitigate it. In this respect, management and examiners together can teach each other about risk management.

Often, it is through discussion that examiners come to understand how risk is being managed. It is management’s responsibility to openly discuss their understanding of risk and loans and not simply take criticism as though safety and soundness were approached the same way as compliance. And management must understand that there are two components to examination; compliance and safety and soundness.

Bringing the CU Member Service Model to Commercial Lending

The competitive advantage credit unions have over banks is an ability to provide a superior level of customer service. Providing customer service in retail financial services is fairly straightforward: be polite to the customer, and try to help them within the maximum extent of your ability.

How this customer service model translates into the commercial lending world can be problematic. Commercial borrowers certainly deserve politeness and a helpful attitude, but CU staff must understand that backstops that exist in consumer lending don’t necessarily exist in commercial lending. Commercial borrowing requests don’t readily offer a concrete set of metrics that can have a computer model score the loan as good or bad; rather, commercial loans require a lot of human judgment to subjectively evaluate factors a computer cannot account for.

The factor of human judgment in commercial lending often leads to two interesting problems. The first being a CU rejects doing business loans because they feel incapable of underwriting the risks involved. This is a conservative approach, and it is understandable. Why take a risk you don’t understand? Fortunately, CUs can help members with business loans by referring the lending request to a business lending CUSO. Even if the CU does not wish to participate in the lending request, or find that a borrower will not qualify as a member, a business lending CUSO can solve these problems. In this way, your members and non-members can receive superior customer service from the CU and still have access to business lending services.

The second and more concerning issue is when a CU decides to takes on a commercial lending request, but treats it like a consumer loan. Because a credit union wants to provide superior customer service, they feel it is acceptable to extend credit, so long as a customer maintains a decent credit score and good reputation.

It has been my experience that while business owners have great products and services, their expertise doesn’t always translate into a strong understanding of financing. This puts the loan officer into a role of having to help the member understand what they can and cannot do with debt financing. An inexperienced loan officer may believe that a business owner would not request a loan unless he could assuredly repay the loan. This is often not the case. The business owner may not understand how financing works and need a loan officer’s expertise to help understand their financing needs and limitations.

If a loan officer feels that superior customer service means finding any way to give a business owner a loan which they request, the business owner may take on more debt than they can handle. Because there are not metrics like debt-to-income or credit score to indicate the member is in over their head, an inexperienced lender may not realize the potential harm the additional debt can create. While it may seem counterintuitive, sometimes the best decision for the member is not to take on additional debt. It is challenging to say “no” to a member, when saying “yes” seems like better customer service. But helping the member understand “no” is the better decision can lead to your member finding ways to better structure their business for longer term success.

Credit unions are in a unique position to help members that are business owners. They can refer business to a business lending CUSO if they are uncomfortable doing business lending, or they can consult with a CUSO if they want to make sure they are underwriting a business loan correctly. The important issue at hand is delivering superior service. Superior service doesn’t mean the member has to go to a different institution for a business loan, but superior service also isn’t about giving a member a business loan that can ultimately harm them. Customer service isn’t giving the member everything they want, but helping the member find what’s best for them, and that is a tough balancing act no matter what industry you work in.