Rethinking Commercial Prepayment Penalties

I see very few prepayment penalties on commercial and agricultural loans throughout credit unions.  Part of this is from the NCUA regulations, which prohibit federally chartered credit unions (FCUs) in the majority of the cases to charge them to clients, or if they are charged, they must be forgiven.  I think the idea is prevalent in our industry that a prepayment penalty hurts the member and therefore, we do not want to do that.  But have you considered how the lack of a commercial prepayment penalty hurts the credit union?

Whenever you make a loan and lock in the interest rate, unless you just have some unlimited source of free capital or do not care, you should be concerned with the cost of your funding to make that loan.  In many banks I worked at, we used some index such as the US Treasury Curve or LIBOR Swap Curve to understand what the underlying cost of those funds were, for say, a three year locked rate, if we had to go into the market and borrow those funds.  That would provide us with a base cost of funding for the loan with a three year fixed rate. 

A prepayment penalty came in as an asset-liability management tool to help keep the assets we put on the books in place for the duration we expected them to be there, before we would see the loan re-price.  I would contend that the current regulation restriction on prepayments hinders the Federally chartered credit union from using the best practices in the industry in regards to balance sheet management.  The challenge here is that all the large loans booked are at risk of leaving.  This is especially true when rates are higher, and we begin to see a decrease in interest rates.  Everyone is ready to refinance from their higher rate loans.  Prepayment penalties help those loans stay on the books.

It is also interesting to note that other funding sources like banks, insurance companies, and conduits all use prepayment penalties to manage their balance sheets.  While the lack of a prepay may make you more customer friendly, it does have the potential of hurting the financial stability and earnings potential of your credit union.

So should every commercial or agricultural loan have a prepayment penalty?  No.  I can think of several cases when, for a business reason, you would not want a prepayment, or you would want to waive a prepayment.  Some examples of these would be church loans, a problem loan that you need to get out of, or a loan that has an interest rate below the market rate you could replace that loan with.  There will also be cases when you want to have a prepayment penalty but will allow the borrower to pay off an additional amount of principal, say no more than 5 or 10% of the loan amount. 

There are provisions allowed in the regulations for an FCU to charge a prepayment.  This is outlined in §701.21(e), which allows for prepayments for a business loan that is made under a government insured or guaranteed loan program, where said program allows for a prepayment penalty.  An example of this would be the SBA subsidy recoupment fee or prepayment penalty, which is part of the 7(a) program.  Another example would be on a guaranteed FSA loan that allows for a prepayment penalty.

This is also outlined in a letter dated May 20, 2004 from Sheila Albin, Associate General Counsel to James Hammersley, Director of the U.S. Small Business Administration.  Other regulations that apply here are 12 U.S.C. §1757(5)(A)(m) and (viii), 12 C.F.R. §§701.21(c)(6) and (e), and 723.4.

So to conclude here, if a prepayment penalty is allowed, it is wise to charge it.  For now, on commercial loans that are owned by an FCU that do not have a government guarantee, no prepayment may be charged.  State Chartered Credit Unions may charge a prepayment.  But if any portion of that loan is participated out to an FCU, it would need to be refunded.

Is Your Institution Structured Correctly? Effectively Running a Business Loan Program

You want to offer business loans, so you write the necessary policy, get it approved and go out and hire the right people. Great, where do you go from there? Now the trick is making sure the right business loans get booked, and the bad ones are warded off. This will require structuring management.

First, you need to ask yourself what type of lending you are engaged in. Business lending will likely fall in to one of two broad categories: small business lending and middle market lending.

Small business lending is usually to people that are characteristically sole proprietors or to small trade companies which are owned by a small group of individuals. They probably need equipment financing up to a couple $100,000, and/or a line of credit of similar size. These relationships are likely under $1 million when all requests are aggregated together, and the individuals probably don’t have a net worth much greater than $1 million either. Small business requests will likely require a small group of individuals tasked with agreeing on and approving the business loan request.

A small business lending department, if in a small institution, will likely be its own department with a manager that directly reports to the CEO/President. A small business lending department, if in a large institution, is often rolled into a larger lending division and reports to the chief lender, or it may even be rolled into retail services or administration and report to either of those heads.

Middle market lending is often characterized by lending requests of business owners or companies that have strong net worth, probably well over $1 million, but are still too small to raise capital through issuing bonds into the secondary market. These borrowers seek to finance investment real estate, have a need for large equipment requests, may need lines of credit of $500,000 or greater, or they have special requests like leveraged buy-outs and special bridge loan needs. In general, the entire relationship is likely no smaller than $1 million.

Middle market lending shouldn’t be treated as a department within the institution, but should really be considered a full scale division. This will require a chief lending officer directly reporting to the CEO/President and a chief credit officer also reporting to the CEO/President. Having only one or the other report to the CEO presents issues, because the top lender will be incentivized to book as many loans as possible, and the top credit officer can be overly conservative and pass up good business opportunities that are worth taking risks. Both heads need a space where they can present their arguments and have others assist with the decision.

This usually leads to a loan committee, which ideally is balanced with lenders and credit officers, but may also include the CEO and CFO. It is a good idea to keep minutes of the loan committee and have a secretary, who has the power to execute approvals or withhold approvals until conditions required by loan committee are met. It is also good practice to have an expiration date for each approval granted by loan committee.

Like all things in life, there are nuances to the product or services offered, and they aren’t always uniform. A business loan isn’t simply lending to a business, but needs to be separated out as small business or middle market. Likewise, you will need different management structures to execute either lending type if you hope to be successful.

True Advertising Power

The business owner often wonders, “What is the actual return on my advertising dollars?”  I would contend that if you expect your average advertising to bring in customers, with the exception of when you are paying the highest deposit rate or charging the lowest loan rate, you will be disappointed at your return on investment, unless you find a more effective way to market your services. 

One of my favorite business pioneers is James Patterson, the founder of NCR.  Patterson was a genius.  He invented a cash register at a time when no one else had or used one.  So, not only did he have to convince the business owner to purchase this new piece of equipment, he had to create a consumer market that would demand it as well.  How did he do that?  He spent advertising dollars on convincing the public the need to “get a receipt” with their purchase.  And what was one thing the cash register did?  It produced a receipt.  Now all of a sudden, retail shops were banging on Patterson’s door to get a cash register, because their customers wanted a receipt. 

He knew how to create excitement about his product.  In the 1904 World’s Fair, when most of the other exhibitors had booths with lots of items people could not touch, NCR had a booth that invited people to come in and touch and play with whatever they wanted.  It was the forerunner to the modern Apple Store.  If you have ever been in one of those, you can play with any sort of Apple product that you want while you are in the store.  It does not matter your age or computer abilities (although the young may have more computer ability than the old!), anyone can use a Mac, IPhone or IPod there.

Patterson had a quote about advertising, “Advertising brings awareness, but testimonials bring customers.”  The more I think about that, the truer it seems to me.  Jeffrey Gitomer, writer of some of the finest sales books that I have ever read, said, “Testimonials are the most powerful form of advertising.”  I have personally experienced that in my career, the most powerful drivers of business have come from customers and third parties that have recommended a business owner to come to me because of what I have done for them.

The testimonial that comes as a referral is the most powerful business generation possible. In my finance career, I have been a part of numerous service clubs and eaten more Chamber of Commerce rubber chicken dinners than you can shake a stick at.  Yet these did not bring me significant business. It did get me recognition.

What got me the most business was a club I joined that dealt with property exchanges and networking among Realtors.  All I did was do a good job for whoever brought me a deal, showed up at meetings, and added as much value to the organization as I possibly could.  Before I knew it, people were bringing deals to me.  People who I did business with were sending their business friends to me, and my customers wanted to do more and more business with me, because they believed their business was better when I was involved in financing it.

So, if you actually can be lucky enough to get a testimonial, what do you need it to say?  First, it needs to be in the words of the business owner and not a script that you hand him to perform in front of a camera.  It must be authentic and genuine.  The second thing it needs to do is to spurn the listener into action.  When you think about this, you do this all the time.  Last year, a buddy of mine bought one of these ceramic smokers for BBQ-ing and smoking meat.  I had heard about them but never was interested because of the price.  After I heard his testimony of how this worked, the quality of the meat that came out of the smoker, how little fuel it used, etc., I was finally sold on the product.  There was no amount of ads, commercials, or reviews I could read that mattered to me.  It was not until my friend told me about his experience with the product that I began to look at it.  Sampling the finished product also was convincing.

Now guess what?  Because of my lovely wife hearing about my thoughts on the product from my friend, I now have a ceramic smoker on my patio.  I would have never done this, if it were not for the testimony of a friend.

On the business side, what needs to be in testimonials about your financial institution?  You want your customers to tell how they have been able to start a successful business, increase their profits, move to a new location, or achieve their financial business dreams because of your services.  The testimonial needs to be in such a way that takes away the risk in doing business with you in the mind of the hearer and establishes the expectation for a happy ending.  All you have to do is deliver on it, and get another testimonial for your arsenal of advertising. 

The Path Forward: New Lending Opportunities are Necessary for Survival

Change, for better or worse, is always happening. I can’t help but think I am part of the last generation that will have grown up without a cell phone or the internet constantly at my fingertips, and how strange it will be for me to explain to my children that we managed to live happy lives without those amenities. But there is value and a need for these inventions, which is why we have all permanently embraced them and incorporated them into our lives.

This got me thinking about a business meeting I recently had, where CEO shared with us a story of change his father experienced. His father was a banker, and decades ago he thought the idea of drive-up service at a bank was ridiculous. He thought it was a waste to knockout a bank wall to put in a drive-up window, but realized afterwards how wrong he was. When the next innovation came, the ATM, his father was one of the first bankers to have one installed!

I think we tend to view our field of financial services as a mature industry, and I agree that it is, but mature industries are still strongly shaped by technological advancement. Arguably, mature industries have to adapt faster to technological advances because they face greater competition in their field. If you manage your institution in the manner of “I’m going to stick with what I have always done because it has always worked,” you are ironically facing an existential threat. The world of finance today is not like it was decades ago for several reasons.

One major change is the role of the community bank is in decline. Many banks have been swallowed up into larger enterprises that no longer will find it cost effective to handle small business lending. While I lived in Washington DC, I witnessed banks that would refuse to look at loan requests less than $1 million, $5 million, or even $10 million simply because it wasn’t worth their time! While some community banks will continue to provide services to smaller businesses, the number of these banks is shrinking every day.

I see this as a tremendous opportunity for the credit union industry to fill the community banking role that banks are leaving behind. Credit unions’ mission has always been rooted in empowering members, and business lending can be another way to directly support members and the community.

While many CUs have seen themselves traditionally as consumer lenders, this lending is becoming an increasingly low yield product that covers less and less overhead. The yields are low and demand is not experiencing strong growth. It is the CUs that embrace business lending that will continue to survive - both by garnering better yielding assets and by providing services that their members are demanding and fewer banks are providing.

Business lending is a big change, but it is a necessary change for credit unions. Small business is the engine that drives the US economy, and CUs can be there to feed that engine in place of consolidating banks that pass over small business needs. Best of all, business lending is one more service that several members need, which makes it a perfect fit for CUs trying to empower their members.

Why We Sometimes Say "No"

A few weeks ago, a credit union sent us a loan to underwrite.  There were several risks associated with the loan that they did not identify.  Once we identified them, and suggested this credit was not a good fit for their portfolio, we were met with the comment, “All you guys do is to say ‘No’.”

It is true that we either turn down or suggest changes on deals more often that come into the MWBS office than those we just approve.  Our overall goal is for institutions to put good earning assets on their books.  These assets have had their risk analyzed and mitigated where possible.  We also contend that covering up systematic weaknesses in the credit with a government guarantee is not the preferred method for doing business. 

When looking at a risky asset, the first thing I contend to do is to “do the math."   Let’s say you booked a marginal deal for $1,000,000 that had a 90% government guarantee on it. You were able to get a point on the deal.  Oftentimes, we see CUs giving away the store for a marginal deal, but that is another blog discussion.  Let’s say the deal goes bad and the governmental agency pays on their portion of the guarantee, leaving you with a loss of $50,000 after all is said and done..  Well you think, "I cleared $10,000 at closing so my loss was only $40,000."  But, the issue here is the opportunity cost in loan volume necessary to make up the $40,000 loss. 

The $40,000 loss must be considered.  Let’s say that you have figured out you operate your credit union with a net interest margin of 3%.  In order to make up the loss you would need a spread of 3% on a loan with an average balance of $1,000,000 over the course of a year to make up the loss.. 

It does make the lender want to stick his head in the sand and have his investment officer buy government securities.  Truly, we are in an industry where we need to be right 99.5% of the time.  A few years ago, when our banking brethren were seeing charge offs approach the 2% level, the Federal Government was inventing TARP and other sort of bailout plans.  We must focus on safe assets, as Will Rogers once put it, “I am more concerned with the return of my asset than the return on my asset.”

Hiding in laddered CDs or government agencies is also not an answer as a viable institution is a growing institution.  Growth in earnings means prudent booking of good earning assets, which in our case is lending.  So when we say “no”, it is because of our analysis of the loan has a greater chance for loss or problems based upon inherent weaknesses in the credit that we see. 

In a totally unrelated item, this week I will celebrate my wedding anniversary of 22 years to my wonderful wife, Angela.  It is rare when you find someone who believes in you more than you do in yourself and also makes you a better person.  Whenever you find someone like that, you should hold on to them.  My dad had a saying to don’t marry the person you can live with, marry the person that you cannot live without.  That is who Ang is to me.  It has been a great ride so far and I am truly blessed by God. 

Spreadsheet Error Potentially Debunks Another Study: Who is Holding Academia Accountable?

I am no stranger to deadlines and know how challenging it is to work through sets of numbers and assumptions to present findings in a clear manner to decision makers. I think it is important to get it right, no matter the cost. Sometimes I need to ask for extra time after promising I would finish earlier, and other times I have to stay up all night working to make certain analysis was done correctly. While I don’t like to admit these things, people are counting on me to be as accurate as possible, and I need to make sure I can stand behind that accuracy. To me, nothing feels more damaging professionally than presenting hasty analysis, laden with mistakes; especially if it appears to have been done under the auspice of bias.

And yet, even in the ivory towers of higher thought and research, there appears to be a problem with a lack of professionalism coming to light. Last summer, it came to light that Harvard economists Carmen Reinhart and Kenneth Rogoff had errors in their study that concluded there was a link between governments who borrow heavily and sluggish economic growth. When a college student sought to use their work, he asked for the source data and found their spreadsheet had unexplainably excluded a number of data points, which would have weakened their conclusions. The research, which was conducted in 2010, was not found to have these errors until 2013. How come no one caught it sooner? The main criticism is the research was not published in a peer reviewed journal, so basically nobody was expected to check their work. It would seem prudent for policy makers to check the veracity of the research before using it in decision making, but unfortunately they didn’t.

It appears now another spreadsheet conundrum has come to light to cast doubt on more hot-button research findings. Just a few days ago, on May 23, 2014, Chris Giles, an editor for the Financial Times, boldly came out to mention inconsistent findings he has discovered in Thomas Piketty’s work Capital in the Twenty-First Century. Picketty’s research suggests that wealth inequality is increasing and will lead to economic instability. Giles claims after reviewing some of Picketty’s spreadsheets that “some numbers appear simply to be constructed out of thin air” and “that some of the data are cherry-picked or constructed without an original source.” The research was not peer reviewed in a proper sense, but published by Harvard in a book written by Picketty. Giles points out that when adjusting for what sees as Picketty’s errors, the growth in wealth inequality doesn’t appear to be as extreme nor as concerning.

The clear issue that needs to be addressed is how come nobody is reviewing the work of these world class economists? No matter someone’s title and prestige, that does not put them above peer review. Not surprisingly, I am not a world class economist, and my work is reviewed thoroughly by several people. That is okay, because I welcome this and stand behind my work. However, a more concerning question arises as to whether these economists are manipulating their work to prove a political agenda. We simply don’t know, but why risk the accusations? One should take the time to do the analysis correctly to alleviate any doubt. This is not only an onus on the researchers, but the publishers as well.

I can’t help but point out that John Maynard Keynes understood economists were fallible, and despite this, major policy makers would rely upon their opinion and research. Keynes famously stated in The General Theory of Employment, Interest and Money (1936) that, “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”

 I think there is nothing more powerful than your ability to think independently, and ask questions based on your own unbiased observation. Never be afraid of asking questions about what you don’t understand, or how an analysis was prepared. That includes anything we may provide to you here at Midwest Business Solutions.

New Risk Based Capital Rules

Recently, many comments have been made regarding some of the proposed rules by the NCUA for changes in reserves due to proposed risk based capital requirements.  Why any regulatory body would propose such drastic changes would be because they believe that additional reserves need to be set aside in case of another downturn as we saw in 2008 with the last collapse.  The question is will these new rules be effective and what possible impact will they have on the rest of the core mission of the credit unions, which is to serve their membership.

It is also important to note that at the same time these proposed rules are on display, additional reserve requirements are also on the table for our banking brethren.  In a blog I had several weeks ago, I identified that this current recovery is already marked by a record low loan-to-deposit ratio as financial institutions continue to hoard capital.  In fact, the amount of excess reserves over what is a normal level at this time in the economic cycle adds up to over $2 trillion dollars.  This is also at a time when labor force participation is at an all time low, a record number of Americans have decided to live on government disability, we have a government that borrows nearly 40 cents of every dollar it spends, and more companies are actually closing for business than new companies are opening up. 

It is also interesting the same government, who arguably pressed rules and regulations that caused the mortgage meltdown in the first place is now the one attempting to prevent any collapse from reoccurring in the future.

It would seem that we are also suffering under the burden of over-regulation.  A recent Forbes article outlines the amount of money that is spent on compliance to various regulations in the US each year is greater than the entire GDP of Canada.  We also are living in a time when a record number of rules, regulations, and executive orders are levied against business as if it is the evil one here.  The last time that I checked, no government program created wealth, it only transfers it from one person to another.

Back to the new proposed risk based capital requirements.  Is it good to adjust reserves for additional risk that may be inherent within the asset?  That would seem wise.  What about adjusting for duration risk when either assets or liabilities are locked into rates and duration risk is evident?  Again, not a bad idea. 

One of the problems here is that risk needs to be identified and managed with a targeted approach and not a broad nuclear approach.  There is a tendency among the regulatory crowd to paint in broad strokes certain assets or liabilities as always bad.  A fine example here as I have pointed out in the past is the construction and development rules for credit unions.  All C&D is painted equally in the same risk classification.  In reality, there is a wide divergence of risk in C&D from spec to a project that has an established end business user, from horizontal development to vertical development, from construction with no permanent take out to those projects that have a perm funding source.

The new risk based capital rules are yet another example of a nuclear option when a sniper is needed. 

The new rules paint all business loans as equally bad compared to consumer lending.  It is done solely on the premise that a large business loan if it fails, could take down an institution.  True, there have been some mismanaged institutions that have seen such loans destroy a credit union.  But equally as true is the credit union that is slowly eaten away by multiple consumer loans going bad when a large employer which formed the base of membership, is forced to shut down.  Now instead of chasing one large business loan, there may be hundreds of smaller loans which require more time and resources to manage and oftentimes are not as well collateralized as a well structure business loan.  Yet these consumer loans are deemed less risky just on the mere fact that they are consumer in nature.  Perhaps studies on both consumer and business delinquency and default rates are in order, and not in a general sense, but divided up by credit score or industry type, to gain a true propensity for future problems.

The new proposed risk based capital rules will lower earnings as CUs will be forced to leave well structured and priced business loans in exchange for traditionally lower earning assets.  Reduced earnings will have a negative impact on the long-term viability of the firm as it is earnings that continue keep the institution going in the future.  We have seen the ROA of instutions that leave the majority of their resources in held-to-maturity securities and it is not a long term model for business growth. 

Another issue in the proposal that I take offense to is the negative impact on CUSOs.  It would appear that we are viewed as all the source of risk for any institution that does business with us.  Yet the fact of the matter is, a well run business CUSO can be an excellent source of knowledge and resources for the credit union to identify and manage credit risk.  At MWBS, we turn down far more deals than we do.  Now why would we do that when we should be trying to help the member?  Because a loan loss hurts the institution’s ability to help good credit risk members in the future.  Do we turn down everything?  Heck no, we understand that good assets need to be on your balance sheet for your future viability.

Another problem with the propose regulations is that it will slow down the economy. Part of economic growth requires the free flow of capital and credit.  As businesses are ready to grow, they require debt or equity to fund their expansion.  These rules will make it harder for companies to borrow, thus forcing them to stop growing and employing more people.  With more unemployment, more individuals will be facing a tougher time to meet their obligations, resulting in more losses for the credit union.  The RBC rules tend to favor the large companies that are stockpiling cash instead of the small companies that need well structured borrowing in order to go to the next level.  On that fact alone, it would seem that the government is taking the side of the big company as opposed to the small one. 

Opportunity: Where Have the Pioneers Gone?

Today we often hear about the stagnating economy in which incomes are not making gains and recent college graduates have trouble finding jobs. Many people argue that there is a lack of opportunities today, but I have to wonder if our attitudes towards life and work are really to blame.

My great-great grandparents were pioneers on the plains of North Dakota. They came out to the frontier with nothing and built a house out of sod. That was their version of opportunity - a house made of dirt without running water or electricity. I can’t think of anyone I know today that would consider that an opportunity, yet my predecessors saw an opportunity to build a life for themselves and decedents through backbreaking labor, while lacking any technological frills we take for granted.

When I hear that there are less jobs for college graduates these days, to me it appears people are blaming a faceless system. The blame seems to be either the college is not doing enough to bring employer job searches to campus or the government isn’t doing enough to generate jobs. I wonder where the pioneering spirit has gone. Surely the pioneers didn’t complain about not being handed an opportunity, but rather they were ready to leave family and friends permanently to chase down their dream of self-reliance, no matter how much discomfort it would bring to their lives.

I had a teacher that once told me that opportunity favors the prepared mind. That has always stuck with me because it makes so much sense. If a person is never looking for opportunity, how will they ever discover it? I think people too easily blame others or society for lack of opportunity, when in fact personal success is not a right, but something only earned through hard work and perseverance. Simply put, we make our own opportunities in life, and only through rare coincidence is an opportunity readily handed to you with a bow on top.

There is an infinite number of opportunities waiting for any individual to capitalize on. The only way to truly turn your back on opportunity is to say “no.” Many people feel like they have to say no because of limitations, but what they forget is limitations don’t apply to all people equally. Often by working with others to overcome limitations, we discover new opportunities. People that find ways to overcome limitations are the modern pioneers, and they will benefit by playing in a field with less competition.

Opportunity favors the prepared mind, which means we must conditions ourselves to accept opportunity. Before rejecting a new idea or accepting our limitations, it is beneficial to take a step back and ask if there is possibly a path we haven’t thought of yet. Trying a new path, although uncomfortable and frustrating at times, is how opportunity is born. To relate this to finance, sometimes superior customer service isn’t telling the member what is and isn’t possible, but going out of your way to get the member what they need even if it isn’t a standard service offered.

We think of pioneers belonging to a certain time period and set of circumstances, but the truth is they still exist today. They are inventing things like the Internet and wireless devices. Modern pioneers are building telescopes to study the edge of the known universe or applying new technologies to agriculture. Often pioneers in finance are those that can reform old processes, and they understand that the old ways of doing things are now broken or growing obsolete. Becoming an agent of change will be the way forward.

How will you find a way to be a pioneer in your job the next time a member asks for a service your credit union doesn’t readily offer?

Balance Sheet Management Styles

The task of balance sheet management involves, well…balance.  You must have the right type and amount of earning assets to provide as much income as possible with enough assets that are safe to avoid losses and also keep the regulators happy, while keeping enough liquidity to take handle operational needs and take advantage of new earning asset opportunities.  This has to be accomplished while you have enough of your assets in items to run your business like buildings, computers, and equipment, while keeping as many assets as possible as earning assets. Successful execution is not unlike the tightrope walker across Niagara Falls.

 The balancing act can cause even the best CFO to go crazy at times.  It can also be maddening since different stakeholders all have different goals on how your balance sheet should look.  The head of investments would like a large emphasis in investments.  A chief loan officer wants a well-managed loan portfolio and enough liquidity to seize new opportunities.  The personal loan manager may measure success by how many people they can give loans to without much thought of the overall rate.  The head of facilities wants a large devotion of assets to buildings and equipment.  Your customers want the highest rates on their deposits and the lowest rates on their loans.  All these goals are also different from how your regulators want your balance sheet to look like.  Many times their position is one that has minimal risk, according to their definition, while making sure a plethora of their rules are followed.

 In my position, I see a lot of balance sheets of different credit unions.  It is interesting to see such variation in managing them.  Each management strategy has different consequences and results.

 Some institution are run by Linus Liquidity.  Keeping cash and short term assets that can be turned to cash quickly are the ultimate goals in managing the sheet.  Even when prime earning opportunities avail themselves, concern comes over the CFO in how much liquidity will be eaten up with the new loan.  This will typically result in low risk, but also low earnings and ROA.  Great improvement here can come with using some of that equity to add some good earning assets.  The good earnings will ultimately increase liquid assets with earnings.

 I have seen those CUs managed by Gus Gunslinger.  These guys will take advantage of every high earnings opportunity possible.  Loan growth can shoot off like a rocket.  Earnings also rise to stratospheric heights, until, the liquidity runs out.  Then, the growth plateaus and earnings tend to flatline as new loans cannot be added.  A possible cure here is to sell off loans, either all or parts of them, to free up more liquidity.  This can be accomplished through well-managed participations or selling off guaranteed portion of any government guaranteed loan.  Midwest Business can assist you with either of these actions.

Some institutions are run by Seth Security.  This gent believes that a well-managed security portfolio is the sacred key to success.  Many have run their institutions quite successfully using this strategy during a decreasing rate environment when the value of the securities increase as the interest rates decrease.  But Seth’s strength may also become his weakness when the rate environment changes and rises.  Then the value of the portfolio drops and must be reported if these are all available for sale securities.  ROA could increase with the sale of some of the securities and addition of prudent loans. 

 The institutions that will survive and thrive over the long haul are those that are run by a Barbara Balance. Her approach is to provide a mixed balance sheet that allows the CU to take advantage of adding earning assets in a smart way, while maintaining liquidity.  The balance sheet is balanced in terms of duration of assets and liabilities.  All stakeholders are satisfied with no one group overly ecstatic. 

 Midwest Business can be the missing piece to your balance sheet management challenges.  For those institutions that are swimming in a mass of cash, we have opportunities to put some of that to work with well underwritten and managed loan participations that may help diversify your lending by geography and industry.  Solid earnings are required to keep your institution in a position of serving your members for the future or you will become a target for a merger with a higher-earning asset institution. 

 For some of you on the other end of the scale with challenges with liquidity, MWBS can help free up some of that by selling off loans with participation lending or into the secondary market that takes government guaranteed loans and long term farm land loans.  These CUs have tasted success of a high performing institution and understand how that allows for a greater reach of services to be provided for their members.  We can help that institution continue to grow.

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.