Think Tax Credits are Useless to a Credit Union? Think Again!

Credit unions are member owned financial cooperatives, and their member-owners pay taxes on dividends they receive from their deposits. Much like a bank that elects S-corp status, the profits are not taxed at a corporate level since they will already be taxed at the ownership level. Then for what reason would a credit union pursue tax credits?

Tax credits have two sides- a buy side and a sell side. While the credit union does not need to purchase tax credits, there may be a tremendous opportunity in selling or allocating tax credits.

To make use of these tax credits, a credit union must apply to become a certified development entity (CDE). Once they are a CDE, they can apply for tax credits awarded through the CDFI Fund, managed under the US Treasury. These specific tax credits are known as New Markets Tax Credits, and the CDE (the credit union) effectively allocates the tax credits to business projects. Those tax credits are then sold to raise capital for qualified businesses in low income communities.

Credit unions can help support qualified businesses in low income communities through the use of tax credits. No, the credit union will not receive tax benefits, but they can help make businesses a more attractive lending opportunity. When a business lacks equity, the credit union will be hesitant to extend a business loan to a member. The tax credits can be used to raise capital on the businesses’ behalf, making the business a safer lending opportunity for the credit union.

Aside from New Markets Tax Credits, there are also Historic Tax Credits for rehabilitating historic properties and Low Income Tax Credits to support affordable housing. All tax credits can effectively provide the same benefit to the borrowers. The sale of the tax credits raises additional equity for a project, which generally improves the credit worthiness of the member.

If a member proposes using tax credits to help fund a project, listen closely. They are likely not suggesting that your credit union will receive some sort of tax benefit, but rather they are using an innovative way to raise equity for their project.

Failing Forward Again

One of my favorite books is John Maxwell’s Failing Forward.  Truly in life, it is not the successes but the failures and our response to them that shape us.  I have my own stories about how I have failed, dusted myself off and moved on.  It is a humbling experience.  When I was in my junior year at college, I had an upper level economics class with a term paper.  This was the days when word processors were just catching on and I had several graphs to do so I decided to use the good old typewriter to write my paper.  When I received it back from my professor, it read, “A-.  Great paper.  But I think someone interested in pursuing a career on Wall Street or banking should know how to spell the word ‘interest”.”  I had misspelled interest throughout the entire document.  I am so thankful today for spell-checking. 

What follows are some examples of people who failed and got up, dusted themselves off and pressed ahead.  It is also a strong example of how to not listen to the “experts”.

Abraham Lincoln went to war a captain and ended his military career as a private. He then opened a business that failed. As a lawyer in Springfield, he was too impractical and temperamental to be a success. He turned to politics and was defeated in his first try for the legislature, again defeated in his first attempt to be nominated for congress, defeated in his application to be commissioner of the General Land Office, defeated in the senate election of 1854, defeated in his efforts for the vice-presidency in 1856, and defeated in the senate election of 1858.

Winston Churchill repeated a grade during elementary school. He twice failed the entrance exam to the Royal Military Academy at Sandhurst. He was defeated in his first effort to serve in Parliament. He became Prime Minister at the age of 62. He later wrote, "Never give in, never give in, never, never, never, never - in nothing, great or small, large or petty - never give in except to convictions of honor and good sense. Never, Never, Never, Never give up."  Churchill also said, “Success is going from failure to failure with great optimism.”

Albert Einstein did not speak until he was 4-years-old and did not read until he was 7. His parents thought he was "sub-normal," and one of his teachers described him as "mentally slow, unsociable, and adrift forever in foolish dreams." He was expelled from school and was refused admittance to the Zurich Polytechnic School.  He did eventually learn to speak, read, and even did a little math.

Louis Pasteur was only a mediocre pupil in undergraduate studies and ranked 15th out of 22 students in chemistry. In 1872, Pierre Pachet, Professor of Physiology at Toulouse, wrote that "Louis Pasteur's theory of germs is ridiculous fiction."

Henry Ford failed and went broke five times before he succeeded.

R. H. Macy failed seven times before his store in New York City finally caught on.

Fred Smith, the founder of Federal Express, received a "C" on his college paper detailing his idea for a reliable overnight delivery service. His professor at Yale told him, "Well, Fred, the concept is interesting and well formed, but in order to earn better than a "C" grade, your ideas also have to be feasible.

F. W. Woolworth was not allowed to wait on customers when he worked in a dry goods store because, his boss said, "he didn't have enough sense."

When Bell Telephone was struggling to get started, its owners offered all their patent rights to Western Union for $100,000. The offer was disdainfully rejected with the pronouncement, "What use could this company to make an electrical toy of this product."

"So we went to Atari and said, 'Hey, we've got this amazing thing, even built with some of your parts, and what do you think about funding us? Or we'll give it to you. We just want to do it. Pay our salary, we'll come work for you.' And they said, 'No.' So then we went to Hewlett-Packard, and they said, 'Hey, we don't need you. You haven't got through college yet.'" ~ Apple Computer founder Steve Jobs on attempts to get Atari and HP interested in his and Steve Wozniak's personal computer.

Rocket scientist Robert Goddard found his ideas bitterly rejected by his scientific peers on the grounds that rocket propulsion would not work in the rarefied atmosphere of outer space.

An expert said of Vince Lombardi: "He possesses minimal football knowledge and lacks motivation." Lombardi would later write, "It's not whether you get knocked down; it's whether you get back up."

Michael Jordan was cut from his high school basketball teams. Jordan once observed, "I've failed over and over again in my life. That is why I succeed. I've missed more than 9000 shots in my career, I've lost almost 300 games, 26 times I've been trusted to take the game winning shot ... and missed. I've failed over and over and over again in my life. That is why I succeed."

Tom Landry, Chuck Noll, Bill Walsh, and Jimmy Johnson accounted for 11 of the 19 Super Bowl victories from 1974 to 1993. They also share the distinction of having the worst records of first-season head coaches in NFL history - they didn't win a single game.

Johnny Unitas's first pass in the NFL was intercepted and returned for a touchdown. Joe Montana's first pass was also intercepted. And while we're on quarterbacks, during his first season Troy Aikman threw twice as many interceptions (18) as touchdowns (9) . . . oh, and he didn't win a single game.

Oftentimes it is not how we deal with success but how we respond to failure that shapes us.  Will failure master your life, or will you learn from it, rise from the ashes, and press on?

Commercial Real Estate Basics

The first question that must be asked in commercial real estate is whether or not the property is leased. Ideally, leased real estate provides a consistent source of income to repay debt financing. This suggests that real estate which is not leased is speculative, or for short, we say “spec.” If the real estate will be mostly leased by the property owner, we then refer to the real estate as “owner occupied.”

Spec properties are considered some of the most risky projects to finance. The project owner will need to make debt payments from their own personal resources until they find tenants to lease the property. Finding tenants will also come with costs, which include paying agents commission to find tenants, and possibly even building out the space for the tenant to operate.

Leased properties are considered lower risk, but they are still not without potential issues. Simply because a space is leased does not mean the tenant will have the ongoing ability to pay. It is not uncommon for a tenant to default on their lease. This means the project should be underwritten as if a new tenant could possibly release the space. This is done mostly by examining market rents and vacancy. Operating expenses of the property are generally unimportant, as tenants will likely be expected to pay their own maintenance, insurance, and their equivalent real estate tax for the space rented. This is usually agreed to in a triple net lease.

An additional risk to leased real estate is the timing of the leases. If leases expire before the debt matures, then some of the previous stated risks of spec real estate begin to become a concern. If an owner must find a new tenant, new expenses may be incurred. Also, the contents of each lease should also be examined. Leases may give the landlord or tenant special rights to demand higher or lower rent, or terminate the lease prematurely.

Owner occupied real estate has its own set of risks, although it’s generally considered the least risky real estate to finance. Risk is considered lower, because the owner doesn’t have to find or secure a tenant. This means the risk of repayment depends on the successful operation of the owner’s business. In a sense, this puts all the eggs in one basket, so the failure of the borrower’s business will lead to an immediate deterioration in the first source of repayment of the debt. This means even with owner occupied real estate, the project should still not be financed unless market conditions show a different tenant could support the property.

To summarize, leased real estate is preferred over vacant or “spec” properties. But, financing a leased property still requires analysis. The tenant’s ability to pay ongoing rent should be considered, as well as the type of lease the tenant has entered into. While owner occupied real estate mitigates some of these risks, it places all the credit risk onto one business or operator. Even with owner occupied real estate, market analysis is required to make certain the property could be remarketed.

Business Lending as a Social Good

What comes to your mind when I mention how a credit union improves the social well-being of a community?  Perhaps you think of how you are able to pass on lower rate loans or pay more to members than your banking counterparts.  Maybe you think of a member who relied on the CU to help get him through a tough time when he was down on his luck.  It kind of reminds you of Jimmy Stewart’s character, George Bailey, in It’s a Wonderful Life and how he made a difference in people’s lives compared to the Mr. Potter, who hoarded his wealth.  Another thought may be a donation to some facility or charity that makes an impact in your community.

One item I rarely hear mentioned is how business lending from a credit union improves the social good of a community.  I believe that commercial and agricultural lending provide one of the best methods a CU has to impact its territory.   I’m sure I will have some naysayers who dispute my claim, but indulge me for a bit while I make my point.

Some will view the business owner as a greedy, profit-driven person whose only concern is improving his own station in life.  But these same greedy, profit-driven people provide demand for loans and supply deposits for your institution.  Often the loans are priced with a higher spread over your cost of funds than a normal consumer loan would be.  This allows for increased earnings for the CU which benefits the members.

Consider the business owner or farmer’s family.  The successful operation of the business allows a family to be supported. Personal items like a house, cars and college tuition can be borrowed from you, thus increasing the business at your CU.  The successful owner generates additional cash that allows him to give back to the community.  Some of the most generous people I know are business owners.

Consider the impact of the employees of the business.  They are able to fund their lifestyle which will include houses, cars and tuition for their kids.  The successful business will provide a living for many people.  This makes these people better citizens, better neighbors, and better people.  This is improving the society as a whole.  And this occurs over and over again not just one time like a donation to a local charity.

In an age where class warfare is preached from some of our leaders and a record number of Americans have left the labor force, I contend that the business owner should be celebrated. The Non-Farm Payrolls data released on May 2, 2014, show the US workforce shed 806,000 jobs in April. This is a stunning drop that cannot be blamed solely on the weather.  Both wage growth and hours worked were flat.  This follows news earlier in the week that the economy is growing at a rate of 0.1%.  The headline unemployment rate fell to 6.3%, but this is only since the labor participation rate is down to 62.8%, a rate that was last seen in the abysmal Carter Administration when there were far fewer women in the workforce.  The rate for males in job participation is at an all-time low of 69.1%.  The data is warning that any US economic expansion is in danger of halting.  This is also coming at a time when the Federal Reserve is adopting a tighter money policy by trimming its bond-buying each month. 

A friend of mine said he had an economics professor in college who told the class on the first day, “You should be thankful for the rich, because everyone who hires you for a job is richer than you.  You should want to be taken advantage of by the rich, because if they do not, you will not have a job.”  That is true.  These people who have risked a lot in life have made our world a better place for all of us. 

Every commercial or agricultural loan we have closed at MWBS has either added or retained jobs from the business client.  The impact we have is families being started on sound financial footings, allowed houses and other items to be purchased,  or sent kids to college.  Many times, the greatest social good can be accomplished through your activities with your business or farm client.

Franchising: When Reinventing the Wheel is Risky

The media is awash with news about how new businesses have a high rate of failure. Why do new businesses fail so often? There are several reasons, but it usually boils down to lack of experience and not offering a product or service that is desired. The idea of franchising can help mitigate both of these business killers. A franchise can provide both proven operating methods, as well as proven products and services.

A franchise is a right to use someone else’s successful business model. The idea behind franchising is someone else has already found a business model that works, and they will sell that model to you. The benefits include use of a recognized brand, training on how to operate the franchised business, and access to standardized inputs to produce standardized products or services. The ability to produce something standardized is important for offering a recognizable and successful product.

Some popular franchise restaurants in our area include McDonalds, Taco Johns, Buffalo Wild Wings, Perkins, Little Caesars, Subway, and Pizza Ranch. Restaurants aren’t the only franchised businesses. Franchised businesses can include hotels, like Hilton or Ramada. Fitness centers can be franchised, like Anytime Fitness or Snap Fitness. Cleaning companies can be franchised like ServiceMaster Clean. Even shipping services like UPS Stores are franchised. Any business can be franchised.

Franchises are usually independently owned and operated. This means while the franchising company sells the business model, they do not share in the risk of running the business concept they are selling. To outline what franchisor (the seller of the franchised model) will do, and what the franchisee (the purchaser of the franchised model) is expected to do; the two parties will enter into a franchise agreement. This agreement stipulates what each party must provide to each other in exchange for the franchise.

The seller of the franchise usually receives an upfront franchise fee for the purchase. This is usually a fee for simply entering into a franchise agreement, and does not provide anything else to the purchaser. The franchisee is solely responsible for purchasing all the necessary assets to start the businesses in addition to paying the franchise fee. Once the business is operating, it will then typically pay a royalty fee to the franchising company. The royalty fee is commonly a fixed percentage of gross revenue.

In return for paying franchise and royalty fees, the franchisor maintains the brand. They help give the franchisee access (but not financial support) to all the assets they need to operate their franchised business. The franchisor may advertise nationally, which is not a cost any one franchisee could support on their own. The franchisor will also conduct quality assurance reports (QAR) to make certain people adhere to franchise standards, and force franchisees to continually undertake product improvement plans (PIP). All of these activities reinforce the brand recognition of the franchise, adding continued value and desirability to both consumers and future franchise owners.

Acquiring a franchise may be expensive, but the alternative is to take a bigger risk with an unknown business with an unproven product. But, a franchise does not guarantee success, and will still require hard work and discipline from the business operator. The franchise is intended to give someone with the resources to operate a business an advantage by letting them buy into a brand and proven method. In this respect, the franchise helps mitigate some of the risks that lead to business failure, but it is still the entrepreneur’s skills and experience that are required to operate the franchise successfully.

Senior Housing Demand is Strong

A few years ago, my wife listed and sold an assisted living facility through her real estate company.  Around the same time, I helped finance construction of a new Alzheimer’s facility.  It was these two projects where I learned about senior housing.  Senior housing demand will continue in the future and is fueled because of several reasons.  Some of these factors are: an attractive spread between borrowing rates and capitalization rates, resurgence of the housing market, improvement of the stock market, and strong tenant demand as more people retire and need these services.  There is an increase in funds from both institution buyers and non-traded REITs that has increased prices for top quality stabilized senior housing.

In 2013, a sharp increase in home prices on a national scale fueled by low interest rates and boosted confidence, significantly reduced the number of homeowners that owe more on their mortgage than their house is worth.  Zillow reports this dropped 6% on the year over year numbers to 25.4%.  This change represents over two million homeowners who have escaped negative equity, which has provided reason for seniors to sell and relocate into independent living facilities. 

Both independent living and continuing care retirement facilities both expect increased occupancy this year.  Assisted living will also show an increase, though a wave of construction in some areas of the country, such as the Southeast and Texas, will cause the national vacancy to decrease only slightly.  It is expected that a greater number of listings will hit the market in the coming months, thus lifting transaction velocity.  Strong gains in rents have occurred since the second quarter of 2012.  Owners interested in divesting should be able to show a good recent operating history and list their property for a higher price.

Investor demand for assisted living properties, which make up for nearly ½ of the seniors in the housing market, is greater than the present number of available properties for sale.  Currently, assisted living and dementia care properties have cap rates that dip into the low 8% range on a national basis.  This is partially due to demographic trends.  Currently, 40% of the US population over the age of 85 has Alzheimer’s or related diseases.  This age group is expected to expand by 4% by 2017.  At these projected growth rates, 90,000 more seniors will be living with dementia in 2017, thus increasing the demand for these facilities. 

Development in assisted living is robust, especially for units with a dementia care unit.  There was a 2.3% increase in units over the past year alone as 6,800 units came on line.  Another 14,700 units are under construction which may put some temporary pressure on occupancy.  By the end of 2013, national occupancy rates are at 90% for assisted living, 89.8% for independent living, and 87.8% for skilled nursing units.  During the first half of 2013 demand for these units rose another 0.7%. 

New facilities coming on line coupled with strong demand has allowed operators to increase asking rents by 2.3% over the past year.  Buyers, who are seeing these favorable lease rates, are increasing their presence in the assisted living market by 72% during the 12 month period ending second quarter 2013.  The national average of asking rents stood at $4,180/month at the end of last year.

New independent living units inventory growth reached 3,900 units for the TTM ending June 30, 2013.  This was an increase of 0.8%.  An additional 78 properties with 8,500 units are under construction in the nation’s 100 largest metros.  Developers have also increased the average number of units for a property by 32% in anticipation of the new demand.  Asking rents climbed 2.5% to 42,810/month.

Skilled nursing inventory dropped 0.3% in 2013.  In the middle of 2013, only 81 properties were under construction, down 24% from the prior year.  Occupancy fell to a new cyclical low and the bed count of the new facilities is 10% lower than the new units that were completed in 2012.  Rents averaged $273/day for skilled nursing facilities. 

Overall the median prices per unit in assisted living averaged $163,000 per unit in 2013.  Independent living’s median sales price was $139,200 per unit and skilled nursing traded at $63,000 per bed in 2013.  Cap rates for independent living ranged from 6 - 9.25% with the median in the 8% range.  Assisted living caps traded between 7-10% with the mid to upper 8% range as median.  Skilled nursing sold for 10-15% cap rates with the median slightly below 12%. 

All in all, as these properties tend to grow just with the sheer force of demographics of the aging baby boomers, we will see more of them and higher returns for operators in the long haul. 

Covenants: Why Do Business Loans Have Them?

Business loans have typical documentation you will find with all loans: promissory note, agreement to provide insurance, title insurance, etc. But, often the loan will be accompanied with additional documentation that is not common with consumer lending. The “loan agreement” is probably the single most unusual document that tends to accompany business loan requests.

A loan agreement is an agreement between the borrower and the lender that certain provisions will be met as part of the ongoing extension of credit. This is necessary, because in business loans we want to identify potential issues in advance before they affect repayment so we have time to prepare, restructure, or reconsider our decision to provide credit.

If the nature of the business changes, repayment can be greatly affected. The loan agreement helps us reach an understanding with the borrower, in which we expect them to operate their business in a certain way.  We don’t want them to change things so much that it may affect how we originally understood their plan for repaying the loan. We may be asking the borrower to agree not to take on other debt without first consulting with us, or make certain they maintain base level of operating income that can satisfy the required payments on the loan.

The agreement can also specify conditions unrelated to payment. If the borrower is a hotel, we may ask they do not change their franchised name, so they don’t become an unknown hotel that has difficulty attracting customers. It is also common that the borrower agrees to regularly supply us with financial information, so we can monitor their financial condition.

These different deal points come to be known as loan covenants. If the borrower fails to meet a covenant, they have technically defaulted on their loan. If a customer is still paying as agreed, but has broken a covenant, we say they are in “technical default.” An event of default usually allows the lender to exercise certain decisions to better protect their odds of repayment, including forcing immediate repayment of the loan.

What decisions the lender choses to exercise with a covenant violation often depends on the seriousness of the violation. If the borrower has engaged in a risky behavior, which has led to the covenant violation, perhaps it makes sense for a lender to call the loan due. On the other hand, if a covenant is broken because the borrower is slow to produce financial statements, but there is otherwise no cause for concern, there may be little or nothing done or said.

If a covenant is violated because the borrower has failed to meet certain financial benchmarks, the lender has a lot to consider. Perhaps the benchmarks were not set correctly in the first place. Maybe the financial condition of the borrower has deteriorated, but they are still viable and capable of repaying the loan. It is in these situations that a lender must chose to restructure the loan, waive the violation, or even start charging penalties for the added risk or work required to monitor the situation.

It is for these reasons that having loan covenants is a good idea. The borrower and the lender are able to layout expectation upfront through a loan agreement, and then the lender has options and recourse should the borrower fail to meet provisions in the loan agreement. It is important that the lender does not overreact when a covenant is broken, but rather consider the seriousness of the specific covenant and what a measured approach going forward should be.

Could the Biggest Competitor to Banks and Credit Unions Come From the Outside?

Whether you are on the banking side of the fence or over on the credit union side, you will often hear that all the ills of the industry are from those people on the other side.  But as we look at the financial industry landscape today and trends going forward, will a large competitor for banking services come from outside these groups? 

Consider Facebook.  It is estimated that 20% of time Americans spend on their smartphone is on Facebook.  The social media juggernaut is now weeks away from regulatory approval it needs to launch an e-payments service in Europe.  Facebook has its European headquarters in Ireland and that country’s central bank is pondering approval of Facebook as an electronic money institution.  Zuckerberg’s firm is seeking approval for a service that would allow users to store money on Facebook, use the funds to pay for goods and services, and exchange money with others. 

Consider how this compares to PayPal, which is owned by eBay.  It offers money transfers and merchant services.  It should also be a wake-up call to financial institutions.  I do know that both PayPal, banks, and CUs have been around much longer but they lack a critical ingredient that can make Facebook a dominant player of the future, the mass eyeballs of people.  Many rely on social media sites for events like sports to social gatherings.  Imagine the power if you can see an event for your kid’s little league tournament on Facebook and then hit a button to submit your entrance fee to the parent who is organizing the event.  Or what if you saw a friend’s birthday announcement on Facebook and used the site to send her some money?

The current age group that is joining Facebook at the fastest rate are those from 35-60. This is also the age with the most earning power.  Facebook recognizes this and is seeking ways to have us spend money on things and give the company a cut as we do.  Facebook’s power is ubiquity:  It is routine to check your page, converse with friends over the messaging service and even text when you are overseas. 

In contrast most conventional banks do not offer any particular benefits that make one want to stay with them.  Security is now often suspect, with recent hacking.  Could Facebook be any less secure?  Also, relationship banking with big banks is non-existent as the 12 largest banks in the US hold 69% of all the banking system assets.  Clearly, these accounts may be at risk.

Consider if just 10% of Facebook’s would use the bank for banking services.  It would be the largest bank in the world in terms of number of clients.  A banker may say he is not worried about this threat.  But if I can now store and use money to pay for my kids’ little league game through Facebook, that is less money banks will hold.    

The payments area, which has been a source of up to ¼ of some traditionally bank revenue, is highly contested.  Paypal is the number one online payment method in some countries.  New payments methods like Square and Stripe are becoming more popular.  Retailers are becoming a popular method to handle payments.  It is estimated that 1/3 of Starbucks revenues now come through its own loyalty cards. 

Non-banks are beginning to branch into checking and savings.  Google introduced a debit card for the Google wallet.  T-Mobile started a new checking service with a smartphone app and ATM card.  Wal Mart has teamed up with American Express to start a prepaid card that functions like a debit account. They have had over a million customers in the past year. 

All these new competitors that have entered into area that has belonged to banks and credit unions present new and interesting challenges for the financial industry.  It will be interesting to see how these financials will respond to these challenges and what opportunities they will capitalize on.  

Boom, Bust and Bubbles: Managing the Business Cycle

The business cycle is a precarious phenomenon that is not fully understood. The business cycle is the concept used to describe the fluctuation of economic output. When economic expansion is robust, we refer to it as a “boom” time. When the economy shrinks, resulting in negative economic growth, we refer to this as a recession, or the “bust.” Why economic activity goes through boom and bust cycles is subject to great debate.

While it would be ideal to have predictable and steady economic growth, it simply isn’t feasible. This would require strong government intervention in the market place and would result in a command economy. This economic control is effectively communist macroeconomic policy, which fails to effectively deliver goods and services in response to demand. This means the boom and bust cycle is a byproduct to the capitalist system, where firms freely compete against each other. Why does free competition lead to boom and bust cycles?

One theory suggests the problem is the “bubble.” A bubble occurs when production expands rapidly in one industry to try and satisfy a strong level of demand. Increasingly more and more firms jump into the marketplace to try and capitalize on the demand, and eventually, overproduction results, with more goods or services provided than what is demanded. At this point, many of the firms stop production, meaning economic output suddenly slows or stops. This is effectively how the bubble “bursts,” and often ancillary industries feel the effect by also slowing or stopping production, causing economic recession.

In the spirit of remediating the effects of recession, some economists believe that government spending can replace the hole left by receding industrial output. The first problem with this idea is that government spending is a much smaller part of the economy than business and consumer spending. This would require enormous increases in government spending. This is often widely unpopular, because it must be achieved by higher taxation or borrowing money. A second issue is when funds are borrowed to prop up economic output, then borrowings should be repaid in boom times, but rarely does this occur.

The focus then shifts to avoiding bubbles, or overproduction, if they are indeed the reasons for the boom and bust cycle. The challenge with avoiding bubbles is often we aren’t quite sure what a bubble looks like. The rise of personal computers in the 1980’s and 1990’s could have been construed as a bubble, but it was clearly a justified increase in societal demand. The rapid expansion of internet firms in the late 1990’s and early 2000’s also seemed like a bubble at the time, and in fact it was. Too much capital and production had been allocated to the industry too soon. This resulted in a recession when the bubble burst when supply exceeded demand.

If there was a way to identify bubbles, that would only lead to another big debate. Is it the government’s responsibility to prevent, stop, slow, or manage the bubble? And if so, what tools should they use? How much government intervention are we willing to tolerate, if any? These debates may not be far off, but as for now, we still aren’t sure when we have a bubble on our hands.

It should also be noted that there is plenty of evidence that bubbles alone don’t cause every recession. Recessions can arise for several different reasons, including government policy or a rapid increase in production cost. With bubbles and other recession drivers being hard to predict, the business cycle of boom and bust is likely to continue.

Happy Resurrection Day!

This time of year fills us all with hope, especially here in the Dakotas, for a global warming phenomena we call “spring”.  After the long winter we have experienced, we all look forward to the decreased possibility of snow storms and the increased probability of sunny days and warm showers.  Yet as I write this, a new, light blanket of snow has covered the woods outside of my house.

 This time of year also begins to fill us with thoughts of new life.  It is time for many crops to be planted.  Grass and trees begin to spring to green life.  At the Love household, we have two new puppies, a beagle and terrier-schnauzer mix, for my younger two kids.  We also have eight baby chicks.  I am quite partial to farm fresh eggs in the morning.  Spring also marks my kids counting down the days until they are out of school and another important beginning, the start of baseball season.  It gives me hope that my beloved St. Louis Cardinals will fare better than in the previous year.

 On the work front, those of us in agriculture realize this is the renewal season for ag lines of credit.  It is planning time for the farmer and rancher.  On the commercial side, it is also time for many annual reviews as we begin to get tax returns in on some of our clients.  We also are experiencing new loan demand as new projects and developments are beginning.  This time is exciting as entrepreneurs have awakened from their winter hibernation, which has seemed especially long this year.

 Spring is also the time for Easter.  Now some will think of this as only a time of new beginnings, bunnies, and eggs.  But the true meaning of this holiday is the celebration of the death and resurrection of Jesus Christ.  Whether one believes it happened or not, indisputably the first Holy Week fundamentally transformed civilization and helped establish many of the basic values that our country was founded upon.  Since that time, countless people believe that Jesus died for them, rose again from the dead, ascended into heaven and will return again some day.  It is my hope that the resurrection will not just be a historical event or just another holiday, but will actually produce hope for you as it has in my life.  

What Is It Really Worth?

How much can an appraiser’s opinion be trusted?  If an appraiser says a property is worth $10 million, what reason do you have to distrust him/her?

 Commercial real estate appraisers have national and state standards which they must meet, much of which includes several hours of work experience. Because of these standards, most appraisers can provide a report with valuable insight and information; however, it should be noted that the appraiser is giving his/her opinion. This should be taken into context of why we require real estate appraisals.

 When financing commercial real estate, naturally it makes sense to have a third party evaluate the property, so the borrower or lender is not being overly optimistic and over-leveraging the asset. While this puts the appraiser in the position of having nothing to gain, this also puts the appraiser in the position of having nothing to lose.

 As mentioned, the appraiser’s value is an opinion. That does not mean the property will sell for the appraised value. In all likelihood, it will sell for a price above or below the appraised value. This occurs for a host of reasons related to the negotiation process. But, a property can sell for a value substantially higher or lower than the appraised value, because the buying and selling parties have an entirely different opinion of what the true value of the property is worth.

 I think it is key to remember that a property’s true value is what someone is willing to buy it for. That value is not necessarily the appraised value. The appraisal report is informational and often a good reference point, but it does not command market values. And because it is truly an independent report, the appraiser suffers no recourse for having an opinion that does not materialize.

 To best understand how the appraiser arrived at his/her opinion, it is important to read the report and understand the assumptions the appraiser is using. And, you may find you disagree with some of the appraiser’s assumptions. The assumptions drive the entire evaluation process, and I often disagree with some of the assumptions I find. That does not mean the appraiser is wrong, but it means we have a difference of opinion.

 I feel the real task for financial institutions is to read the appraisal, understand the assumptions, and then decide whether the reviewer concurs with the assumptions. If the reviewer does not concur with the assumptions, then the reviewer should indicate how this could potentially change the value of the property.

 To summarize, the appraiser’s evaluation is not a guarantee. The appraiser’s evaluation is an opinion based on a set of assumptions. The lending institution must review those assumptions and determine if they agree with them. Disagreement with the assumptions has serious impact on the assumed value of the property. And most importantly, the appraiser has nothing to gain in the transaction, but also nothing to lose by formulating an errant value or assumption.

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.