Green Commercial Buildings

Much ado has been made about residences and businesses going green.  Proponents state it is environmentally responsible and is necessary to save the planet.  Because of that we have seen numerous strategies crop up in the past decade like carbon credits, tax incentives, and utility rebates to begin to bring green buildings more affordable. 

So what is a green building?  A green building will consume less energy, water, and waste than other properties.  Green buildings may also be made with recycled or use environmentally friendly materials that provide a healthier environment for its inhabitants.  There are also various shades of green.  One building may just elect to change all its lighting to LEDs, while another one utilizes renewable energy to go completely off the grid. 

While I am not a tree hugger by any means, I am interested in something else that is green—money.  Does adding green features or making a building more environmentally sustainable worth the money? Efficient buildings may reduce ongoing operating costs compared to non-green properties.  This will result in a higher NOI and therefore will be worth more than a similar building with a lower NOI. 

Studies by the Institute for Building Efficiency show that green buildings have higher asset values than their conventional counterparts.  On average the differential in asset values is proven by a 6 to 35% increase in higher resale values, 2 to 17% higher rental rate, 30% lower operating costs, and a 1 to 18% higher occupancy rate.  One of the main drivers of the increased value is lower operating costs.  Green properties are cheaper to operate due to lower utility costs, less water usage and reduced maintenance costs. 

Energy costs are important to manage, since that cost can comprise up to 30% of the building’s operating cost.  The Environmental Protection Agency estimates that owners can increase their property value by $3 for every $1 invested in energy efficiency technologies.  This figure reflects the net present value of future energy savings added to the property’s resale value.  One example is a 50,000 sf building that pays $2/sf in energy costs, a 10% reduction in energy use adds up to an additional $10,000 annually in NOI.  Using a capitalization rate of 8%, this translates into a $125,000 increase in the asset value, according to Energy Star. 

A second major driver is marketability.  As green buildings become more in vogue, investors and tenants will continue to recognize the green building label.  Sustainable multifamily buildings may have improved air-quality, lighting, and thermal comfort.  CoStar recently published a study that stated LEED-certified apartments command an average rent premium of 25% over non LEED properties.  Sustainable buildings tend to offer a more comfortable workspace, leading to increased productivity by employees, resulting in an increased bottom line for the business. 

Green buildings may also be less impacted by increasing energy prices.  Possible upcoming regulations by communities, such as mandatory disclosures, building codes, and laws banning inefficient equipment, may have adverse impacts on rental income and thus the future value of non-green real estate. 

But green does not always provide an adequate return.  I know of a large refrigerated warehouse that spent over $500,000 after rebates on a photovoltaic solar system for their building.  They initially expected energy savings of nearly 75%.  What actually occurred was savings of 5%.  They failed to realize a factor in their commercial utility billing was the demand charge.  On a hot day, their electrical usage would spike, kicking them into a higher charge per kilowatt hour that impacted the entire billing period.  The result was a system that they expected to payback in 5-8 years now took 40 years.  A lender who may have leveraged up the company for the solar install, while projecting a large decrease in utility costs may find this credit to be on the watch list with the company not realizing the projected savings.

With any energy improvements, analysis should be completed in the fashion known in the CCIM industry as a “T-Bar Analysis”.  This simply takes into account the various cash outflows for the costs of the green system and any ongoing maintenance, and looks at any inflows such as higher rental income, utility rebates, tax credits, and lower utility and water cost.  This is good to determine a breakeven time frame for the green investment and a rate of return utilizing a discount interest rate.  If the plan is to market the property at some specific time in the future, the net projected sale price should be considered. 

Going green is a worthwhile endeavor for the commercial or agricultural building owner at times.  But the ultimate judgment of the value is how much additional green it will put into the wallet of the owner. 

On another note, I would encourage those interested to contact us about our upcoming “Basics of Agricultural Lending” course held on October 8-9 in Miles City, Montana.  At the time of this writing we already have 17 students.  We look forward to seeing you there.

The Wrath of Grapes: America's Migration Inland

Earlier this month, I read an article on CNBC.com reporting Americans are increasingly leaving large costly coastal cities for affordable small cities in the country's interior. This seemed surprising to me, but I dismissed the article as a small news blurb on a slow news day, until I heard some additional reports also came out about this phenomenon.

The idea goes like this: The cost of living in major American cities is on the rise, and Millennials are flocking to city centers. I have witnessed this first hand. One of the last projects I underwrote in Washington DC was for condominiums that would sell for over $750,000 for 1,000 s.f. with two bedrooms and two bathrooms. How could anyone young trying to start a family begin to afford something like that?

The other option is to live out in the suburbs, which are an increasingly painful commute into the city. An average commute in a big city could easily be 45 minutes to an hour each way. For those without the means to live downtown, and for those with the desire to have children and own a home, the big city is making less and less sense.

The southern United States is seeing the effect of this migration. The South is known for more affordable real estate, and now its small cities are teaming with more amenities and jobs to draw people away from large northern cities. Likewise, we see plenty of growth in the upper Midwest. Des Moines and Omaha have successfully developed strong financial services sectors, and even small cities like Sioux Falls, Fargo and Rapid City are seeing strong growth not witnessed since before the Dust Bowl.

The South and the Midwest may be winners, but who are the losers? The Northeast is seeing many people migrating particularly to the South. California is known to be another big loser, with many of their residents packing up and leaving for a variety of destinations throughout the US, but especially Texas. The migration has led to the phrase “the wrath of grapes,” suggesting it is the reverse of what Steinbeck witnessed. Now people are leaving the big cities on the coasts to seek better lives where their predecessors may have originally come from.

Despite this phenomenon, it is also worth noting that migration in the United States is at an all-time low. While Americans are still much more likely than their European counterparts to move for work, they are doing so with less frequency.

This has brought about debates as to whether that is part of the current economic drag. If people are unwilling to move for better jobs, will this result in a more stagnant GDP? Some question whether people can afford to move, due to moving costs or the fear of selling a home that is underwater on its mortgage. Whether it is a matter of affordability or a change in culture won’t be clear until more time reveals the trend of the future.

As for me, I feel like I am living like a king in South Dakota after having lived in Washington DC. I can afford three times the amount of housing here and several other extra amenities, which would have been money spent on taxes and commuting in DC!

http://hereandnow.wbur.org/2014/08/18/south-migration-america

http://www.cnbc.com/id/101891238

Drowning In a Sea of Corn

This summer has been next to wonderful out here in the Dakotas.  We have had only a handful of days over 90 degrees, abundant moisture, and cool evenings.  It has been this way throughout most of the Midwest.  It has been nearly perfect if you are a corn plant.  The weather has expectations of a corn crop so large that we may see piles of grain after the harvest across the Midwest.  The US Agriculture Department projected the production will exceed 14 billion bushels, more than last year’s historic harvest.

The excess supply will cause a drop in corn prices.  Indeed prices have fallen 13% this year and were down 40% last year.  Corn, which was near $8 in late 2012 is now down to $3.66/bushel on the September futures.  A new record crop could push prices even lower. 

The price declines result in winners and losers.  Winners will be livestock producers.  Farm animals are the biggest consumers of US corn, eating around 34% of the supply.  The plunge in prices has increased the profits for beef, pork and poultry.  Growers will add more corn to their fed mixes in lieu of other ingredients like hay or alfalfa.  But the increased demand will be tempered.  The nation’s livestock herd is at its lowest level in 60 years.  The porcine epidemic diarrhea virus has cut the nation’s hog supply by 5% of 3 million animals from last year.  The chicken flock is roughly the same.  The USDA expects corn fed to animals will only increase a measly 1% in the year starting September 1 since there are fewer livestock mouths to feed.

Another third of the US corn crop goes to make ethanol.  Additional consumption of ethanol is held up by the so called “blend wall”.  Most vehicles can’t handle gasoline that is more than 10% ethanol and the US gasoline supply is already nearly at that level.  So any increases in ethanol consumption will come from increased demand from additional driving.  There is a trend to look at more fuel efficient cars, which will decrease fuel demand.  The US Department of Energy expects fuel demand to increase slightly in 2014, then decline in 2015.

The next demand for US corn is exports.  While some countries have increased US corn demand like Peru and Columbia, others like China, one of the largest buyers have stopped.  China has rejected US shipments because the genetically modified strains of corn have not been approved to sell in China.  Shipments of corn to China fell 86% in the first six months of 2014 from their levels a year ago. 

A surplus of ears in the bin will probably create a “corn hangover” with other grains such as wheat or soybeans.  As more people go to the lower priced corn, they will go away from other grains, thus decreasing their demand and lowering prices.

This depression in grain prices will result in lower revenues for farmers.  Many planters who leveraged up their farm based on the high prices that hit in 2011-12 may be in a situation where debt service requirements will be hard to meet.  The lesson here is to be wary of when prices are high and seem like they will never come down in the commodity realm. 

We will see several loans to grain farmers come into stress this year and next.  As an agriculture lender, it is important to not leverage up your farm client based on today’s prices with the assumption that those prices will continue forever.  When prices turn, revenues may not be sufficient to support all operating costs and debt service.  Today, we are seeing record prices for cattle and hogs.  Though it seems that there is quite a bit of room for the bull rally to continue with these commodities, and they may will, it is still important to provide conservative lending structures and also to encourage producers to retire more debt in good times so they can make it through the lean ones.

Red Flags: Save Time and Energy by Identifying Major Problems Immediately

My earliest memory of a “red flag” was in elementary school. When the school bus would drop us off in front of the school, if there was a red flag outside, it meant it was too cold to be on the playground, and we needed to come wait inside for school to start.

I’m not sure how the idea of a red flag came to be, but it now universally seems to mean there is a big problem that deserves attention. In finance, we talk about red flags all the time, as though they are hidden deal breakers and non-starters; and often, they are!

Red flags we often see in spreading financials are when someone has judgments or bankruptcies on their credit report. We immediately know the borrower may have financial management issues. Another red flag is when we see a business borrower collecting unemployment benefits. If a borrower depends on direct government assistance for persona cash flow, it suggests the borrower cannot depend on their business investment or other sources of income. This likely indicates a poor business lending prospect.

Some character red flags we will look for in finance are any evidence of a criminal history. If the borrower has been to jail or convicted of financial malfeasance, this may clearly indicate a bad lending prospect. Your borrower will likely not pay you if they are in jail, so it is better not to risk doing business with someone who may wind up there.

Another red flag we search for is past litigation. If a borrower has a history of being sued, it may indicate potential recurring problems the lender will be exposed to. If a contractor is continually sued for not doing an adequate job, it may be a poor decision to extend credit to that contractor or to lend money to someone who will use that contractor.

Financial red flags, as you may suspect, are a little more obvious. A balance sheet that does not balance is a red flag. Financial statements that cannot be reconciled year-to-year can often be a red flag. Assets and liabilities which we know the borrower owns but are not being reported on financial statements are a red flag.

To expand on that point, a borrower willfully withholding financial information is also a red flag. One year, a borrower refused to provide me with his tax return. I requested his line of credit be shut down until he did provide it. I couldn’t be sure of his financial situation and didn’t feel comfortable extending him credit. He argued I knew his financial position was bad, but I tried to explain to him I didn’t know just how bad it was until I had more information.

When it boils down to it, most red flags are quite obvious. They mostly result when someone is breaking the rules or hiding something. When a loan is requested that has obvious financial problems, we don’t tend to think of that as a red flag, because weeding out bad decisions is a normal part of business. Really, a red flag results when we believe we have an understanding of a request or borrower, and it turns out information had been misrepresented, or a piece of information obtained came as a serious surprise.

While reason for pause when finding red flags may be obvious, how one proceeds with the information is also equally important as identifying the issue. It is important to make sure all decision makers are aware of the red flag, so if the issues are a non-starter for someone, they can incorporate that into their decision. Sometimes people can get comfortable, mitigate, or suggest a way to rehabilitate a red flag. But, this only makes sense if everyone understands the red flag exists and have agreed on how to handle it going forward.

We are also hosting a Basics of Agriculture Lending Class in Miles City, Montana on October 8-9, 2014.  Please contact us for more information.

Similarities Between Zip Lining and Commercial Lending

Our family took a vacation recently to Big Sky, Montana and Yellowstone National Park.  My wife had planned each day of the trip and loaded it with various activities.  The trip provided a wonderful and much-needed break for our family.

One day my wife planned for us to do zip lining on a course over the Gallatin River.  The plan was to have out two teenagers to participate in the three hour course and my wife and I would spend some time relaxing on the porch of the business with each other.  I enjoy taking time just to visit with her. 

On this day, my son was not feeling well and we had already paid for two people to zip-line.  My daughter begged me to go with her.  I reluctantly agreed to go.  I don’t really have a fear of heights; I have a fear of falling from heights.  Gravity can be a real bummer!  But one thing I learned is how much zip lining is like good commercial lending.

After fixing us up in harnesses, helmets, and cables, we piled in a van to make the three mile trek to the course.  The course had six lines with two of them travelling right over the Gallatin.  I wished that I was in the river with my fly rod rather than flying through the air above it.

The guides first gave us a lesson about the quality of the safety gear we would be using.  It made me feel very confident in the quality of the gear as long as I had both feet solidly on the ground!  The main part of the gear was a harness that went around both legs, your waist, chest, and shoulders.  The harness had a main carabiner that was hooked to a trolley which went rode on the line.  Two additional lines were also hooked to the trolley, each with their own carabiners attached.  Each carabiner was strong enough to handle over 600 pounds of weight. 

We climbed up to the first zip line platform and the first guide gave us some final instructions and then plunged down the 600 foot line to the platform on the other side.  As I waited in line, I had one overriding thought that I must maintain bladder control.  I worked so hard to learn this as a toddler and avoid putting myself in situations where I may lose it. 

The time finally came for my turn.  The guide hooked up the trolley and the main carabiner.  Next the first safety carabiner was attached.  The guide radioed on a walkie-talkie to the receiving guide to see if it was clear to zip.  Once the OK was given, the second safety carabiner was attached and it was time to take the jump.  I must admit that my screams were manlier then they sounded as I plunged into the air.

As we progressed through the course, each time it was to take a jump, the same process was followed.  Hook the main and first safety carabiner, radio for clearance, hook up the backup secondary carabiner, give the OK for the jump, step off, scream, and pray for bladder control.

I found that zip lining is a lot like commercial lending.  In commercial lending we try to figure out what will be the primary source of repayment for the loan.  A hotel would be net operating income from room nights, a cattle farmer would be proceeds from the sale of cattle, and a rental office building would be net revenue from the rents.  But what happens if the first carabiner fails?

That is when the second carabiner kicks in.  We refer it to the secondary source of repayment.  This could be the guarantors’ financial strength, sale of breeding stock, or re-rental of a marketable building.  But what could happen if both the first and second sources of repayment fail?

That is when the third carabiner kicks in.  This is the tertiary source of repayment.  Some possibilities here may be the strength of the guarantor or sale of the asset that is being financed. 

Oftentimes, the officer will not look hard enough to accurately identify what are the second and third sources of repayment.  Heck, I have even seen loans where the primary source of repayment is not clearly outlined in the write up.  I have also seen some where repayment sources as weak as “additional borrowing”, “speculative land sales”, or “possible future income” in write ups.

Sometimes it appears the first repayment source appears to be strong enough.  Maybe it is a credit tenant or government contract.  I have seen cases where credit tenants like Circuit City have fallen or where US Government contracts have gone away.  It is important to consider alternative repayment sources even when the primary source seems extremely strong.

The goal of giving any loan is to get repaid.  The saying that the best loans are the ones that payoff is true.  The analyst must identify what each of these repayment sources are in order to best insure the loan will be repaid.  It is also important for the borrower to relate his plan for his second and third carabiner to gauge his ability to manage the business in times of trouble to put you in the best position for repayment.  Commercial lending is a humbling occupation and at the end of the day if you have minimal losses and no soiled underwear, you have really accomplished something great.

We are also hosting a Basics of Agriculture Lending Class on October 8-9 in Miles City, Montana.  Please contact us with more details.

Dimensions of Credit Analysis: Cross Sectional Analysis vs. Time Series Analysis

Credit analysis is done to determine the likelihood a debt can be repaid. Often, you will hear about how analysts concern themselves with the 5 Cs of Credit, or particularly the level of cash flow. No matter what analysts focus on, it all seems highly analytical.

While there is no doubt a method to the madness, there is much more method than one may realize. All analysis can be broken down into two realms: cross sectional analysis and time series analysis.

Cross sectional analysis is the study of a particular aspect in a single point in time. For example, say you are concerned with the market rent for an apartment building, and you go out and gather information on what other apartments are renting for. That is cross sectional analysis. When you spread a guarantor’s personal financial statement, which is also cross sectional analysis. The key here is we are not examining how the details change over time, we are only examining the details at hand today.

Time series analysis, on the other hand, examines how a particular aspect changes over time. If you want to know how average rent for an apartment in a city has changed over the past three years, which is time series analysis. When you spread a guarantor’s tax returns for the past three years to examine the consistency of their income; you are conducting time series analysis.

Time series analysis tends to be more challenging, because it is the responsibility of the analyst to create standard time periods, and then the analyst is further tasked with determining which events belong in each time period. Often people struggle to keep it all sorted out.

For example, we may look at a credit report and find a monthly car payment, and habitually, we create an annualized required payment by multiplying by 12 months. But, if a car loan pays off in 6 months, it should not be counted as a recurring debt service requirement for years into the future. And in the present year, it should only be counted as payment for 6 months and not 12.

In many cases, the application of both time series and cross sectional analysis is well warranted. Take for example average hotel revenue per room (RevPAR). First, it is prudent to examine the RevPAR of a similar class of properties (e.g. budget hotel RevPAR if a budget hotel) to determine if projections reflect the current market conditions. This is cross sectional analysis.

But then, you will want to check if RevPAR has been increasing or decreasing year over year. That is time series analysis. And, you may find that RevPAR is higher in summer and lower in winter, making monthly comparison of RevPAR troublesome. An analyst would be wise to create an annualized average RevPAR, which can then be compared to annualized projections or to historical annual tax returns.

When to use cross sectional analysis and when to use time series analysis is a tough call, but for the most part, it is best to use both if at all possible. For example, cash flow is often looked at as a time series, with historical financials compared to debt service. But equally important is where that cash flow is coming from. If cash flow depends on a single source or payer, there is concentration risk which must be investigated. The analysis should shift to a cross sectional understanding of who that payer is, rather than a time series of how successful debt service coverage has been in the past.

Instead of asking yourself whether it makes more sense to apply time series analysis rather than cross sectional analysis, I think ultimately you must ask whether it is okay not to do one or the other. If you cannot produce a defensible answer as to why to ignore using one method, then there is probably a need to do it!

NCUA's Requirements for Commercial Guarantees Part 2

So what does a “guarantee” actually mean?  The guarantor must provide a payment guarantee, meaning they will make the entire payment under the terms of the note.  The guarantee should be full, meaning it applies to all the amount of the borrower’s indebtedness, past, present, and future, to the lender.   It should be joint and several, so the lender can pursue one or all guarantors for the payment or full amount of the loan. 

With some cases, it is my opinion that you should always require a guarantee on the loan.  An example would be a construction loan.  Construction loans typically have more risk.  If you have a small company that wants to avoid guarantees on this type of loan and have you bear all the risk, you should be extremely careful.  It would be as if the customer is expecting you to bear the risk as a general contractor.

If you want to deviate from the guidelines, you will need approval from the NCUA.  The reasoning should represent sound credit underwriting and not just, “I have to do it to get the deal.”  The guidance letter lists the following factors that should be in place for all guarantee waivers:

·         Creditworthy borrower

·         Superior DSCR

·         Positive income and profit trends

·         Strong balance sheet and conservative debt-to-worth ratio of borrower

·         Easily marketable collateral

·         Low LTV

·         Long relationship with the customer (5+ years)

Note that often waiving a guarantee will require additional monitoring going forward.  The minimum additional steps you must take are:

·         Well defined financial loan covenants

·         Increased regular financial reporting that include:  annual tax returns, quarterly management-prepared financials, annual GAAP prepared financial.  The frequency can increase if necessary

·         Well defined reporting covenants that outline penalties if the financial reporting is not done promptly

·         Site visits at least yearly and more often if needed

If you are considering waiving a guarantee, consider some alternatives like requiring limited guarantees.  Some deals I have been a part of had pro-rata guarantees that were limited to a certain multiple of a percent of the ownership the individual had.  An example would be with a 150% of ownership guarantee, an owner of 25% of a company would provide a guarantee of 37.5% of the debt.  As an aggregate, you would have total guarantees equal to 150% of the debt, though you would not be able to collect that entire amount from any one guarantor. 

Releasing guarantors should also be done with care.  The lender should make sure that a release does not violate any terms of the loan type, like SBA, and that the release will not produce a violation to any regulations.  In my career, I have only seen releases occur with two different circumstances.  The first occurred to release a spouse of a deceased partner.  The company had buy-sell agreements in place to take care of the estate and the wife transferred any ownership she had to the remaining partners.  The second occurred after a property was built and stabilized that had a long term credit tenant in the property with a lease term that exceeded the amortization on the loan.

Billions of Barrels in the Bakken

The North Dakota Department of Mineral Resources (DMR) keeps track of oil production in the Bakken oil patch of western North Dakota. The first month of recorded well production was December 1953. Between 1953 and 1982, the highest number of oil wells in production at any one time was 38.

In the early 1980s, the price of oil per barrel spiked to nearly $40/barrel, which adjusting for inflation is more like $100/barrel today. This represented nearly a 3-4 times increase over what oil had cost a decade before. The higher cost of oil justified more expensive means to extract it. The sleepy oil fields of North Dakota, with their more challenging to find reserves, began to seem more attractive and the oil boom of the 1980s was born.

By December of 1989, the DMR reported 131 wells in operation. The anticipated expansion wasn’t quite as large as some had hoped, because oil prices tumbled from their peak highs shortly after the spike. By 1989, oil prices were $24/barrel. Promising new technology, like horizontal drilling, fueled further expansion into the early 1990s. By 1991, there were 229 wells in operation, but one critical problem was looming: productivity. The wells in the 1980s produced 30-40 barrels a day, and the wells drilled in the early 1990s peaked at 60 barrels a day. But then suddenly, productivity sank. By the end of the 1990s, productivity dropped to 10 barrels a day per well. The boom had gone bust.

Around that same time, Leigh Price, a researcher from the USGS, had started to compile information in the 1990s about oil in the Bakken formation, estimating it could hold between 271 billion to 503 billion barrels of oil. Price suggested that potentially 50% of this oil could be recoverable. Despite this, the Bakken had not been developed as a major energy producer until hydraulic fracturing technology (fracking) finally proved to be the missing link to the recovering of the oil.

With the existing technology and proven resources, the USGS officially estimates recoverable barrels to be 7.4 billion; only 1.5%-2.7% of the estimated total reserves. Even though the total recoverable amount seems a small overall percentage, the billions of recoverable barrels have still led to the fracking induced boom we see today. For North Dakota in 2005, there were only 220 oil wells in production. As of May 2014, there are now 7,687 wells in production; which is 35 times as many wells! In the same period, production per well went from roughly 15 barrels per day to 127 barrels per day.

North Dakota is now the only state, other than Texas, which produces more than 1 million barrels of oil per day. At a rate of 1 million barrels per day, the Bakken’s 7.4 billion barrels could be exhausted in a little over 20 years. Analysts believe Bakken production will top out at 2 million barrels per day. At that rate, 7.4 billion barrels would be exhausted in roughly 10 years. Of course, production isn’t uniform, and there is no accounting for advances in technology or additional oil exploration. Technology and exploration may yield more recoverable oil yet.

No matter if advances in technology or exploration are realized, the next 5-10 years looks to be a relatively strong certainty for continued oil production in the Bakken formation.

NCUA's Requirements for Commercial Guarantees Part 1

One of the differences I had to get accustomed to when I came to credit union land were requirements for guarantors.  On the banking side of the fence, guarantees were not a regulatory issue.  Oh, we almost always got them and the only way we would look at a deal non-recourse would be if it went to the secondary market or if we received other concessions to entice us to not require a guarantor on a loan.  Another time we would look at non-recourse lending was if we had a project that had very strong cash flow that would exceed the loan term or amortization.

At that time in my career, guarantees on a loan seemed more common loan sense than a matter of regulation.  Credit union regulations have a clearly defined set of requirements for loan guarantees.  These are required, unless you have other guarantee stipulations with certain government guaranteed loans.  Section 723.7(b) states principals, other than those in a not-for-profit organization as defined by the IRS Code or where the Regional Director grants a waiver, must provide personal liability guarantees for the commercial loan.  Some have read this to mean that any natural person with ownership in a company, no matter how small that ownership portion may be, must provide a personal guarantee. 

But a reading of that one sentence in the regulation and guidance, without an understanding of the whole regulation is “lucky-dipping”.  This is a Missouri term we used to use when someone picks out one sentence or item in a much larger document and bases an opinion on that one item, even though it may contradict the whole.  Whatever you come up by sticking your hand at the bottom of the lake, no matter if it a catfish or a handful of mud, you cannot assume the entire lake consists of whatever you pull up.

A Supervisory Letter titled, Evaluation Credit Union Requests for Waivers of Provisions in NCUA Rules and Regulations Part 723, Member Busienss Loans (MBLs) provides further clarity on the subject.  In reading on page 10 of that document the definition of who has to guarantee is outlined as “one or more natural persons who have a majority ownership interest in the business organization (borrower) receiving the loan.  For a corporation, this will be one or more shareholders having a majority ownership of the organization.  Natural person partners having a majority ownership in the partnership must each guarantee the full amount of a loan to a partnership.” 

The next key is to define what is a majority?  This is necessary to find out who will have to guarantee.  Majority is a majority of all classes of ownership.  This could be general and limited partners in a partnership, or common and preferred stockholders in a corporation.  So you have to have at least 50.1% of the people in ownership provide a full guarantee on the loan.  This can get more complicated if a part of your ownership group is a company or a series of nested entities.  Then you need to drill down through the different layers of ownership in the company to determine exactly who will need to provide a personal guarantee.  Also you should be getting corporate guarantees for each level of ownership as well.  Page 11 of the document is a wonderful resource and provides an example in a chart of who and what entities need to sign. 

I would add that as a practical matter, even if the controlling partner or stockholder has a minority ownership percentage, the officer should get the guarantee from that person.  It only make sense to have guarantees from those that control the entity.  Another idea is to get a guarantee from anyone who has 20%+ ownership; this follows rules found with the SBA and Rural Development.  A final practical idea here I will advance is to get the guarantee of those strongest financially, even if they have a minority of ownership.  At the end of the day, you want your loan to be paid.

In the next post, I will look at more guarantor issues.

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.