Management: The Secret Ingredient

When evaluating the repayment of a commercial loan, we examine several factors. Cash flow and collateral tend to dominate discussion, but I often feel management is an overlooked component which is just as important.

Management, as a risk factor, was something I first learned about as a regulator. The FDIC Risk Management Manual explains management risk as “The capability of the board of directors and management, in their respective roles, to identify, measure, monitor, and control the risks of an institution’s activities and to ensure a financial institution’s safe, sound, and efficient operation in compliance with applicable laws and regulations…” I think key amongst that quote is “identify, measure, and control risks” and “ensure safe, sound, and efficient operation.”

A profitable business does not necessarily signify good management. The question arises, does the current management have the ability to remain profitable or find repayment when times get tough?

A good idea or a profitable business on their own are not acceptable lending opportunities. A business may be profitable because it is in the right place at the right time, but change in technology or the economy may quickly lead to financial distress. To quote a popular phrase, “A rising tide floats all boats.”  The ability to navigate those risks and deal with change is the management risk component. To quote Warren Buffet “Only when the tide goes out do you discover who’s been swimming naked.”

Strong management may make some marginal lending requests better, and weak management might make strong lending requests appear more risky.

I once worked on a lending request for an industrial operator in Washington DC. His core business was successful and in demand. This business would have been quite lucrative if expenses were tightly controlled and marketing opportunities for the product were expanded. The problem was, this core business bored the owner. Instead, he was trying to open new businesses and unproven product lines, which would struggle and lose money. In pursuit of another get-rich-quick idea, he used his core business to guarantee a risky lending venture in a very corrupt country abroad. This shows how poor management can put a good business in serious peril.

On the other hand, dealing with good managers can be a delight. They are organized, involved, and know their operating numbers like the back of their hand. Good management is never a substitute for credit basics, such as collateral and cash flow, but strong managers are good at mitigating risks. When a strong manager has a loan request that pushes the limits of policy, it may not feel like a stretch to grant credit, because the manager is capable. But still, it is not acceptable to throw out policy completely, simply because of good management.

The best way to evaluate management is to first do your own homework. You need to understand the business’s financials and read about the specific industry. Do this, so you can talk to the managers intelligently about their business, and then you can ask them about the good and the bad you see in their financial performance and address any industry specific risks you see.

Strong managers love to talk about these concerns, because they are constantly thinking about them. On the other hand, weak managers tend to be dismissive, and may not be willing to explain the items you have questions about. Weak managers may be unconcerned because they have a lack of focus, or perhaps a lack of understanding. Either case is reason for the lender to be concerned.

Will Utility Rates Squeeze Your Customer's Cash Flow?

Ronald Reagan once quipped, “The nine scariest words in the English language are ‘I’m from the government and I’m here to help.’”  Though many government programs start out as good ideas to help the citizens and much good is done, sometimes parts of the bureaucracy can hurt or even outright kill businesses.

 I witnessed this first hand several years ago when the infamous “Cash for Clunkers” program was enacted.  The plan was to take older, less fuel-efficient cars off the road and allow newer models to replace them.  The program created a spike in new car sales, but it had bad consequences as well.

 One of these was a used car dealer I had financed.  The company provided low priced used cars that were primarily bought by lower income folks who needed a car for essential transportation.  Cash for Clunkers provided money for those who turned in their old car.  These cars were then junked and added to the landfills of our country.  Over 600,000 used cars were taken from the road with the program. 

 The program raised the price of used cars with the decrease in supply.  Soon my dealer was paying 50-100% more for the same used car that he did prior to the program staring.  Margins were squeezed.  I watched as the dealer closed down one of his locations after the other, until both he and his brother, who was also in the same business, eventually filed bankruptcy.

 Today, a recent ruling by the EPA is mandating that carbon emissions be cut by 30% in fossil fuel burning plants by 2030.  This seems to impact the coal industry the most, which supplies around 35% of all the electricity in the US.  States have to come up with plans to make plants more efficient or to change to other forms of power generation.  This mandate, if it is allowed to continue, will create winners and losers.

 Winners can be any electrical generation that produces less carbon.  Some examples are solar, natural gas, and nuclear.  Companies that produce power inn these ways or new technological achievements that can lower the production price per kilowatt hour can achieve superior financial results.  Also conservation methods and companies that assist clients to conserve or produce their own energy can also see increased demand.

 Losers start with coal producing states.  If no other market is found for the coal, they will see a severe drop in economic activity and jobs.  Other losers can be businesses and consumers that use electricity.  If no other alternative source of affordable energy is found, these users can expect to see an increase in their utility rates.  Higher utility rates could cause prices to increase. If no other dependable alternatives are found, then some areas could be burdened with interrupted electrical supply.

 If these utility rates do increase substantially, the credit analyst must ask if the business has the ability to weather increased utility and other costs or if the company can pass on those costs and keep their margins in place.  Is it possible this could become a new risk that must be underwritten for?  If the company uses a lot of electricity, this cost factor should be considered.  We often stress test for increased interest rates; we may need to stress test for increased utility costs. 

 What if a company invests substantial capital into some form of alternative energy like solar to combat the higher energy costs?  I had banker friends who financed a large solar installation on the roof of a cold storage warehouse of a food service company.  The firm expected to see a reduction in its electrical bill by nearly 75%.  The actual results were less than 10%.  The firm failed to realize that if their electricity usage spiked over a certain threshold, a demand rate would kick in from the utility for the remainder of the billing period.  So one really hot day in an otherwise mild summer month would wipe out the cost savings from the solar. 

 Now we are in a time where solar cells are coming down quickly in price and also are gaining efficiency.  If the same company were to install the solar system today, perhaps they would begin to see greater gains in their savings.  These advances in technology are sometimes hard for a credit analyst, and even a business to understand exactly what the economic benefit would be for an alternative energy system.  It becomes a problem in a company where cash flow is already tight and the system requires loan financing.  Any way you look at it, the advances in technology and changes from governmental laws and regulations present large challenges to the lender.

Cash Flow Confusions: What K-1 Distributions Don't Tell You

In credit analysis, we obtain peoples’ tax returns to evaluate their income. However, we know that the tax return fails to tell us everything we need to know about someone’s cash flow to repay debt, because the IRS taxable income does not necessarily tax income on a cash basis.

For starters, we need to understand that taxable income is not necessarily cash income. Therefore, many taxable sources of income that appear on the first page of a tax return do not indicate with certainty that the person received cash from that source. Whether the source of income is business related, interest income, farm income, etc., the amount reported is simply the “taxable” part of their income and not the actual cash received, which may vary greatly.

For people who own companies and partnerships (for which this income is reported on Schedule E of the tax return), they will annually receive a K-1 form that tells the individual how much taxable income to report. A unique feature of these K-1s is that they also include distributions and contributions made from/to the company, regardless of taxable income. Because of this, it has become industry practice to ignore the taxable income, but to focus on whether money was received via a distribution, or lost via a contribution.

While this would seem a good way to evaluate cash flow, there is still information not being conveyed on K-1s, and distributions and contributions can still oversimplify cash flow in many ways.

First, consider that all distributions and contributions are not necessarily cash. If a person transfers property to or from a company, that too will be counted as a contribution or distribution. If I own a piece of land and transfer that to the company’s name, I have just made a contribution. This did not impact my cash position, so it would be wrong to count this as a cash event, but my K-1 may not reflect the type of contribution made. Likewise, if I transfer the company’s private jet to my personal name, the company has just made a distribution to me, but again my cash position was unaffected.

Now, consider if we knew whether a contribution or distribution is actually cash, the K-1 still does not indicate other key information needed for analysis. A distribution can be made, even if a company had negative income or negative cash flow. A company does not need to be profitable or strong to make distributions. A company can borrow money and then distribute those borrowings to owners.

Likewise, a cash contribution isn’t necessarily the sign of a weak company. A company with strong profitability and cash flow may still receive a cash contribution for a variety of reasons. If the company doesn’t need the cash and has a cash surplus, does it make sense to penalize someone’s personal cash flow for having moved cash into that company?

The point I’m driving at is the K-1 tends to be a red herring of sorts. While at first it seems a tool that captures the actual movement of cash to and from a company, it really may not be capturing cash events at all. And, in the cases where we can definitively demonstrate cash was distributed or contributed, it is still unclear what the actual cash flow of the company was.

Really, the only way to tell whether a company truly had recurring cash flow to distribute would be to obtain a P&L and evaluate how much cash flow is remaining after all of that company’s debt service was paid. And, if there is a cash flow shortage, it would seem logical to reflect that as negative cash flow when evaluating global cash flow.

K-1s ignore the internal cash flow and debt service of each company, so to only track distributions and contributions treats each company like a black box and misses the key details that indicate how dependable the company is as a source of income.

Farm Accounting: Where Have the Intermediate Assets and Liabilities Gone?

One popular method of balance sheet reporting format for agriculture is to break up assets into current, intermediate, and long term categories.  Current assets are those items that will be turned into cash in the next 12 months, like grain inventory for sale or actual cash in a bank account.  Intermediate assets are those items that will be turned into cash in the time frame of 13-120 months.  Long term assets are those that are more permanent in nature and generally will not be turned into cash until after 10 years.  Liabilities are judged in the same manner with short term liabilities-those items that are paid within the next 12 months, intermediate liabilities are debts that are paid between 12-120 months, and long term liabilities are those with longer maturities.

Oftentimes the purpose of dividing up the balance sheet in these parts is to see if the debt structure lines up with the term of the asset.  I.e. you would not want to fund farm ground on a note with a maturity of under a year!  Many analysts will find it useful to comparing short, intermediate, and long term assets with liabilities of the same maturity to see if the financing structure is correct.

There has always been some challenges with determining what is “intermediate”.  Many will put equipment in the intermediate category. Yet most farmers I grew up with owned the same tractor for decades!  I can attest to an affinity I had with my old 1940s Ford 8 N.  What a piece of machinery!  Anyway, the ag credit departments I have worked in took a more conservative approach and only left items such as breeding stock or seed that was used for the next year’s crop in the intermediate category.

The Farm Financial Standards Council (FFSC) sets the standard for accounting principles for farm and ranch accounting.  In their January 2014 update of the Financial Guidelines for Agriculture, the FFSC sets standards for balance sheet formats.  At a minimum they recommend both assets and liabilities be divided into current and non-current categories.  The non-current balance sheet assets should contain at a minimum divisions by machinery and equipment, breeding livestock, buildings and improvements, and land.  Other non-current asset accounts such as investments in capital leases, cooperatives, or other entities may also be used.  With smaller farmers, we often see personal assets on this side of the sheet.  At a minimum, the liability side should be split between real estate debt and other notes payable that are non-real estate related. 

The new FFSC standards advise the removal of the intermediate asset and liability category, thus leaving the only division among assets and liabilities as short and long term.  The Council does recommend that a structure of overall financial analysis should include a study of the current and proposed farm debt structure to see if it is applicable to the assets being funded.  The intermediate/long term categories do not add substantively to an analyst’s ability to perform their analysis.  FFSC also contends that as diversification in the types of holdings and financing terms grows, it is difficult to accurately determine what is intermediate and what is long.  An example here is a real estate loan with a balloon in five years.  Should that be classified as intermediate because of the maturity or long term because of the asset?  The intermediate/long term classification also forces certain liabilities such as deferred taxes and personal liabilities into categories that are not meaningful.

Because of these reasons, the FFSC believes that moving away from the popular three category sheet is necessary.  They do believe that going back to the three category sheet is acceptable in cases where the preparer believes the categories are very well defined and that the division provides meaningful information.  In the majority of other cases, the current/non-current split with the proper divisions among non-current assets as mentioned above is most appropriate. 

Participate, with Due Diligence

Participation loans are heavily criticized, and this has to do with risks that are often uniquely associated with participations, which credit unions will not typically encounter with other loans.

A major risk to consider with participations is out-of-territory lending. Lenders are assumed to have a strong command of their local market, but they are unsure what constitutes an acceptable risk 100 miles down the interstate highway. The truth is, the same tools can generally be used to underwrite a loan in a different market. This may include reports concerning occupancy and rental rates in real estate, or reports that show trend and level for prices in commercial or industrial loans. The key is establishing the condition and direction of the market.

 Another risk which tends to be cited with participation loans is the lack of experience in the lending type.  NCUA regulations concerning MBL types notoriously require two years experience in a specific lending type. But, guidance for participations also notes that a credit union may purchase a participation that is not within a defined lending type of a credit union’s loan policy. This seems to run counter to the intention of the two-year experience requirement.

 The participation guidance does require that a credit union establish underwriting procedures for loan types that fall outside normal loan policy for the credit union. The only two logical ways to deal with non-conforming MBL participations would seem to be through either education and research on the proposed lending type, or contract with an independent party which has expertise on the loan type.

 While education and research on a new proposed lending type may seem cumbersome, it actually brings attention to another risk credit unions are often cited for - which is lack of analysis of loan participations. Even if the participation is within a defined lending type the credit union permits, the onus is still upon the purchasing credit union to analyze the participation to see if it fits policy and underwriting standards

 When a credit union purchases a participation, it must complete and document its own analysis of the participation. Since this is already a requirement no matter the lending type, the desire to participate in a non-conforming lending type may seem like less work since the burden of analysis will always be required.

 Credit union staff may be concerned they have a lack of experience with a lending type, and be unable to successfully or comfortably produce their own analysis. In this case, we have found credit unions can solicit help from a different credit union which may have experience in the area. The experienced CU can act as a consultant and advise on key risks and benchmarks, and even give their own opinion as to the level of risk present. In this way, a credit union can purchase a participation, for which they do not have experience in the lending type, without having to contract with a third party for underwriting.

 Participations do have added risks, but like many risks, they are manageable if you are willing to take steps to mitigate them. In other words, participations are really like any other loan a credit union will make; they simply require an appropriate level of due diligence.

The Power of Shared Risk

Much of our financial and banking system is based on the concept of shared risk.  If a person comes into a credit union to get a home mortgage, the duration risk of a 30 year loan is shared by passing it on to the secondary market.  If a business loan is short on adequate history or collateral, that risk may be shared with the SBA or a USDA government agency.  When a young farmer wishes to purchase land, equipment, or livestock, that risk may be shared between the lender and the FSA.

For years, credit unions and banks have been able to share risk between each other with the use of participating portions of loans to the others.  This participating of credit has provided great benefit to the participating institution.  If they are in a growing area, they are able to serve larger numbers of customers than they would otherwise.  They are also able to avoid concentration risks easier with one borrower, a set of borrowers, a geographic area, or within an industry.  This is done while the institution keeps its relationships and earnings with valuable clients.

There is also benefit to the institution with excess capital that wishes to increase its yield on good earning assets that may not be adequately available within its trade area.  They may seek a higher rate than one can find on Treasury or Agency issues.  After all, strong, adequate earnings are essential to the long term success of an institution.  I think all of us are aware that the margin on auto loans is not very conducive to producing even average earnings in today’s world.  And while placing funds in safer investments like Treasuries may make you sleep well at night, the lack of solid earnings and interest rate risk associated with long term bonds could be problematic.

I am not advocating placing all your institution’s assets into participation loans.  But, I do think a balanced diet with some of these is beneficial to the health of the institution, just like a balanced diet is good for your personal health.  But there are several things the buyer should know before plunging right in.

Know your lead institution and servicer.  You should have adequate knowledge of the lead lender in the deal and also who will be servicing the credit.  This will start with a good loan file that is well documented and explained.  Watch how the files are managed to gauge the comfort level of the servicer.  If you have a lender or a servicer who cannot defend their loan that is probably not the loan seller you want to be with.  I often request that the investors on the loans we service, contact us with any questions they have with the credit.

Know your industry.  You should have a good knowledge of the company’s industry.  This should be something that is defensible if you decide to invest your money into.  A danger here would be to invest into an industry that you have no knowledge of, like a taxi cab medallion or loan to an oil service company if you have no understanding of the industry.

Know you have to underwrite the loan as if it were originated by you.  This is necessary to fully understand the credit, company, collateral, and sponsors.  If you can’t underwrite it; you probably should not do it.

Know you will face greater scrutiny with participation loans.  It is a fact that a participation loan to a regulator is like a red cape to a bull.  Investing in these will invite greater scrutiny even though the use of participating lending is advocated by regulations as a way to help manage risks.  This forces the buyer to understand the credit and be able to defend why it is prudent to invest in it. 

Shared risk with participation lending is a challenge but also can be quite rewarding if handled correctly by all parties involved.  The loan buyer has the ability to reap great results for the furtherance of their institution with good participations.

Pricing Your Loans II: The Risk Premium

In my last post, we examined how setting an interest rate must start with observing your cost of funds, because the first goal is to maintain a loan with a higher interest rate than an interest rate you are paying on deposits.

The next question is, how far above your cost of funds should you price a loan? Well, that all depends on the risk, and different risks have different premiums associated with them. Common risks to consider are the risk of default, interest rate risk (often referred to as duration risk), and liquidity risk.

The risk of default is probably the most common risk people think of, and of course the higher the chances of default, the higher the interest rate should be. Although, in the field of banking (which includes credit unions), you will not see a particularly large band of interest rate variance for default risk, because there is only so much risk of default the industry is willing to tolerate. Remember, depository institutions need to be right 99% of the time for fear of rapidly depleting capital. An extraordinarily above-market interest rate on a commercial loan may indicate the default risk is too high for the loan to be considered a bankable asset.

Interest rate risk or duration risk is another consideration, and it harkens back to the discussion on match-funding. If an institution will deploy a significant amount of loan proceeds fixed for 5 years or 10 years, it may be unable to match-fund all loans appropriately. The institution may then demand a higher interest rate in order to be compensated for the amount of risk they are taking on. Take note, pricing this risk only makes sense if you know the interest rate risk profile of the institution, and institutions that can do the best job at match-funding should be able to price more competitively.

Liquidity risk has to do with the rate at which your principal is returned and interest is received. Your institution needs funds to not only make new loans to match prevailing market conditions, but also payoff liabilities (such as deposits) as they mature or are withdrawn. The longer it takes to have your principal returned, the more liquidity risk you are taking. That is why loans that amortize over a longer period of time will command a higher interest rate.

There is also a market risk component to the loan collateral as well, in which the longer collateral secures a loan into the future, the harder it is to predict an adequate market value for the collateral in real terms today. Also, if the collateral is not easily marketable, that is an additional risk that may warrant higher pricing as well.

To summarize, many people are preoccupied with pricing for the risk of default, but truthfully that is only a small piece of the puzzle. Any pricing decision should start with considering the cost of funds first, with the intent to match-fund the loan. A margin is then placed on top of the cost of funds, which is not only driven by default risk, but also by liquidity risk, duration risk, and even inherent risk in the collateral. Interest rates are not driven by default alone, but should be a systematic construction based on cost of funds, with adding a premium to compensate for several potential risks.

A New Country

This week, we celebrate Independence Day.  To many, it is just another day off and/or a long weekend.  I believe that it is important to take a look back and see how our country was founded, and remember the beginnings of our nation.  America is unique in human history.  It is one of the few countries created where government is set up to be subservient to the people.  Our country’s founding was nothing short of miraculous.  Many of the stories of the revolution prove this.

In the early period of the revolution, the rebels suffered defeat after defeat at the hands of the British.  The small continental army was outgunned, out supplied, and outmanned compared to the British Army, which was the most powerful fighting force on earth.  Washington was trapped in New York and barely escaped under a thick fog. 

The continentals needed a victory desperately.  Congress had fled Philadelphia and given Washington complete control.  Many of the remaining 2,000-3,000 US soldiers were nearing the end of their enlistment at the end of the year.  To make matters worse, they were not getting paid.  Supplies were low, and the army was ill-equipped for the winter.

It was with this backdrop that Washington convened a council of his military leaders to plan a surprise attack on Trenton.  The British had a group of 15,000 elite Hessian soldiers there.  Hessians were German mercenaries.  They were very well trained and drilled under Colonel Raul, who got them up at sunrise every morning.  Yet, Raul did not drill his troops on Christmas, and he also gave them the next day off.

The attack began with a crossing of the Delaware River on Christmas night.  A severe winter storm had set in.  Visibility was near zero.  Heavy snow and participation hampered the already dangerous crossing, as the army had to master the swift current and dodge chunks of ice in the water.  Washington split up the army into three parts.  Only one actually made it across.  The crossing, which started at midnight, was supposed to be completed and have the continentals in Trenton by 3 AM.

Unknown to Washington, while the crossing was going on, a small group of 50 New Jersey militia decided to raid some of the outskirts of the Hessians.  This got the entire Hessians out looking for the attackers.  The winter storm was so severe the Hessians decided that no one would be able to attack during the weather, so they went back to bed and called off the standard morning exercises.

Washington’s army trudged on.  They faced crossing a 4-foot wide creek, which was usually fairly easy.  The winter storm had now caused a torrent of water that was 6 feet deep.  General Knox had to dismantle cannon and heavy artillery, and use ropes to lower them down and across the creek.  After the crossing, General Sullivan informed Washington that their gunpowder had gotten wet and they may not be able to fire.  Several military leaders urged Washington to use the cover of the storm to retreat.  Washington ordered the troops to fix bayonets and proceed to take Trenton.

At 8 a.m., Knox’s division fired their cannon and the Hessians were in disarray.  About 30 Hessians were killed, another 900 captured and the continentals seized a treasure trove of supplies and ammunition.  This represented one of the turning points in the war.  The continentals had lost 3 men to hypothermia during the crossing, but none during the battle. 

Some today will try to tell you that our nation was not founded in a just way, that the founders exploited those around them, and that there is nothing true about American exceptionalism.  True, the founders were not perfect.  But they did create the foundation for the most powerful country on earth.  They knew the basis was freedom.  Freedom to worship God as one wanted.  Freedom of speech.  Freedom to choose one’s own course in life.  Ability to pursue happiness.  It was those ideas that our founders fought for.  Today, as we tend to have our personal liberties eroded with the promise of greater security, let us not forget our beginnings.

Freedom that we have goes against the natural tendency and desire of man.  Human nature desires to control, dominate, and enrich one’s self.  These forces are arrayed against liberty. We must never stop fighting for this.

Pricing Your Loans I: Understanding the Cost of Funds

What should you charge for a business loan? Well, that all depends, but it depends mostly on your cost of funding as well as a risk premium.

The first thing anyone should understand about pricing a loan is that a financial institution accepts deposits and loans out those funds. For the institution to pay overhead and make any profit, it must charge a higher interest rate on the loans than the interest rate it pays on deposits. Therefore, it is the interest rates you charge on deposits that will serve as the basis for pricing a loan.

Deposits are the funding source for loans, and the interest rate we pay on those deposits is the cost of those funds. There are other ways to fund loans too, such as borrowing from Fed funds, Federal Home Loan Bank (FHLB), etc. The price you have to pay for any funding source is what we consider the cost of funds.

In a perfect world, you would “match-fund” all loans, meaning 5-year deposits would be used to fund 5-year loans. No matter how you choose to fund the loans, the loan should be priced off the cost to match-fund the loan. Interest rates fixed for 5 years should use 5-year funding sources as a basis to start pricing, just like a rate fixed for 10 years should use a 10-year funding source cost basis to guide pricing.

 By not match-funding a loan, you expose yourself to interest rate risk. If a 5-year loan is funded with a 10-year deposit, the institution benefits when interest rates rise but is harmed when interest rates fall. If rates fall, and loan reprices after 5 years to a lower rate, but the rate on the deposit will remained fixed!

 Likewise, when a loan is not match-funded in the opposite circumstance, interest rate risk persists. If a 10-year loan is funded with a 5-year deposit, the institution will be harmed if interest rates rise and will benefit if interest rates fall. When rates rise, the institution will have to pay a higher rate on the deposit when it matures in 5 years, but the loan will not be repriced.

Now imagine an institution makes a fixed rate loan for 15 years, the NCUA maximum term. Would you be able to match fund that with a 15-year deposit? If not, you will face interest rate risk if rates rise in the next 15 years!

Match-funding is an ideal circumstance, and an institution’s balance sheet will likely be exposed to interest rate risk in some direction. When, on an aggregate basis, more assets (loans) are likely to reprice than liabilities (deposits) in a given period, we say the balance sheet is asset/rate sensitive. When more liabilities are likely to reprice than assets in a given period, we say the balance sheet is liability/rate sensitive. At any given time, the aggregate difference between the rates charged on assets and the rates charged on liabilities is known as the net interest margin.

The cost of funds is the basis to begin pricing a loan so you preserve your net interest margin, but then a risk premium needs to be added on top of that. I will address that next week in Pricing Your Loans II: The Risk Premium.

The Search for Reality

I have always maintained that commercial underwriting is like being a private investigator.  You are sifting through clues in order to determine the financial health of the company regarding the loan request, or to gauge how the company is performing now that the loan has closed. 

Financial statements help to reveal the clues.  But, an inaccurate understanding of the basis of the reporting on the financials, can lead to conclusions based upon errors.  One of the best ways to provide yourself with adequate clues is to obtain the following statements from your commercial or farm customer on a regular basis:  balance sheet, income statement, statement of cash flows, statement of changes in owner equity, and cash budget.  Are these necessary in all lending cases?  No.  Larger and more complex credit customers should provide this information, as it also can be a planning and benchmark tool for the company.

The financials also lead the prudent analyst to ask several questions.  The first would be, is the accounting system cash or accrual based?  Or is it a mix of the two?  Typical cash based systems do not recognize income unless it has been received.  The company carries no receivables on its balance sheet.  This can cause some challenges in determining the financial result for a certain time period.  A company could have made a large sale on account at the end of the year, and may not receive payment until next year.  Under a cash based system, the sale would not be posted until the following year, and expenses associated with the sale would be posted when they are incurred.  This would tend to understate the performance in the first year and overstate it in the next. 

Another question is, how are items, purchased for the production of a good, treated?  An example here would be the hog farmer.  When the farmer purchases a pig, is that treated as livestock inventory on the asset side of the balance sheet or as a cash expense?  When the pig is fed, is the feed expensed on the income statement, or is it added into the pig inventory side of the balance sheet?  And, if the feed is added to the balance sheet side, one may miss the cash implications of that, if they do not have an accurate statement of cash flows.

The valuation of assets is another example with wide variations.  According to Generally Accepted Accounting Principals (GAAP) and the Farm Financial Standards Council (FFSC), the following methods are acceptable to value assets:

1.      Historical cost.  This lists the cost paid for the asset and possibly the cost of production that was added to the raw material to get the ending inventory.  GAAP wants things valued on the balance sheet at the lower of cost or market.  An example here is a hog that cost $750 would be reported on the balance sheet at $750.  Now, if it cost another $100 in feed and vet bills, the cost could be reported at $850.

2.      Current market values.  This is done a lot in ag and is useful to lenders to ascertain the true liquid value of the farm inventory (crops or animals), in order to get a truer picture of the cash value of the assets, if they were sold today.  There are different value methods for the market. A farmer could just pull the ending price on heifers and use that to determine his breeding stock’s value.  A company could look at an orderly liquidation value to determine the value of its inventory that it would need to sell in an orderly, discounted sale. The market value for the same heifer here is now at $1,000.  So that is how the bovine is valued.

3.      Net realizable value method.  This takes the net expected value after any closing, sales, and transportation costs are taken from the proceeds.  To sell the heifer will cost $50 in sale and transportation costs.  This results in a value of $950.

4.      Discounted cash flows method.  This is done some in commercial real estate. The value becomes the sum of the Present Value of all future stream of net cash inflows over the life of the asset.  Usually a residual value at the time of disposition is also used.  This amount is usually discounted with a discount rate that represents the cost of funds for the client.  The example here is the same heifer that cost $750 costs $100 per year to feed and keep healthy.  The animal is expected to produce calves in years 2 and 3 and then be sold for $1,000 at the end of year 3.  The cost of funds for the farmer is 6%.  This results in a value of $687.13 on the same heifer.

So, any of these methods could be used to determine values; and in some cases, multiple methods are used within one set of financials.  Yet, the amounts range from $687.13-$1,000.  When multiplied over a large number of cattle, the amount can vary widely.  You may also see the “whatever value I can pull from my head” method on a balance sheet.  Who knows what sort of value will show up under your cattle when that method is used.  Differences in the valuation methods can result in different variations in the actual values.  Unlocking the clues that are hidden within the financial statements are required in order to determine the financial health of the business. 

How the NCUA Should Approach MBL Participations

Albert Einstein famously noted that insanity is doing the same thing over and over again and expecting different results. In other words, it makes no sense to constantly repeat a process if you are already certain what the outcome will be.

 When banking regulators began encountering participations that were in several institutions, it became clear that it didn’t make sense to review the same participation over and over again in each bank; but rather, review the participated loan once and have the conclusion apply to all institutions that hold a piece of that participation. This resulted in the creation of a Shared National Credit Program, often referred to as an abbreviated acronym, SNC, pronounced “snick.”

 The Shared National Credit Program was established in 1977 by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency to provide an efficient and consistent review and classification of any large syndicated loan. Today, the program covers any loan or loan commitment of at least $20 million that is shared by three or more supervised institutions. The agencies' review is conducted annually. This program is logical and efficient, because it saves several regulators time by not having to review the same loan over and over again. But more importantly, it keeps regulators’ findings and conclusions consistent, and it prevents them from dictating opposing opinions to different institutions.

 The NCUA does not participate in the Shared National Credit Program, nor do they maintain their own program to handle syndicated loans.  Not only could the NCUA save precious manpower by establishing such a program, they could devote special expertise to an area where they are concerned there is greater risk.

 I would propose the NCUA setup a single committee to review loan participations, with those findings and conclusions applying to all institutions holding part of the participated loan. I think the dollar amount of the participation is irrelevant, and really, any loan shared by three or more institutions should be subject to review by this committee.

 Next, I would propose that any participation review committee be staffed by both members of the NCUA and State regulators; perhaps appointed by the National Association of State Credit Union Supervisors (NASCUS).

 I would also propose the review committee engage with the principal underwriter and/or servicer to carryout its review. For example, if a CUSO is underwriting and servicing the participation, the regulators would work with the CUSO to complete the review and address their concerns to the CUSO. The goal is to regulate the risk at its source and not by proxy.

 This in no way removes the responsibility of a credit union to maintain a participation policy and complete its own analysis before purchasing a participation. Any credit union that purchases participations should demonstrate a sound understanding of the activity they are engaging in.

 The NCUA could learn from their bank regulator counterparts, and reduce redundancy by only having to review a participated loan once. Moreover, the NCUA can assure an examiner, with the right set of skills, is reviewing the loan. By mimicking the Shared National Credit Program, the NCUA would have a way to consistently communicate their findings and engage directly with the originator or custodian of the participations. This would ease the burden of regulation on both the NCUA and all the institutions holding a participation, so it seems to be a win-win strategy.

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.