Too Big to Fail a Farce

Since 2009, our economy has improved moderately and we continue to limp forward economically as a nation. But sooner or later, another recession will happen, and another banking crises is sure to occur.

 What I’m interested to see is how far the “too big to fail” doctrine will go in providing reckless companies assistance the next time around, and how the government will defend their action then. Roughly $100 million a year was spent by banks lobbying in both 2011 and 2012, even though the last banking crises is in the rear view mirror and another one cannot be seen on the horizon yet. I suspect this has a lot to do with “paying it forward.”

 The idea behind “too big to fail” is that some banks are far too systemically entrenched in our financial system, that their failure to exist or operate would result in economic disruption across our entire society. Even the politically liberal economist Paul Krugman defends this idea and feels more regulation is the answer, so we can allow these large institutions to persist.

 What I never hear in the “too big to fail” debate is how to allow a bank to fail, or how to unwind such a large company. Perhaps that is why people believe in “too big to fail,” because they don’t understand that you can break a bank apart and still wake up tomorrow without total economic destruction.

 Step 1: Tell the shareholders to take a hike, and tell senior management to stay put. Sorry shareholders, you invested in a business that went bankrupt and you must suffer the consequences of that risk. Senior management needs to stick around to keep the lights on while we get this big boy diced up. Don’t worry, they’ll just be happy to have a job at this point.

 Step 2: Bring out the dead! Take all the bad loans and sell them off to various debt collectors and distressed asset buyers. There are plenty out there, trust me.

 Step 3: Bust it up trust-busting style. In each part of the country, there will be regions or large branches of this failed bank which have good loans and deposits. Those can be marketed to local institutions in that market. You mean banks/CUs will buy loans from other institutions? Yep, this isn’t uncommon. You mean banks/CUs will buy deposits from another bank/CU? You bet!  This is done all the time when one institution disposes a branch, or an institution is merged or bought-out by another.

 Step 4: Spin-off those systems which are the glue holding everything together. If they have a very effective payment system, treasury management, or other client services, then why couldn’t those business lines be packaged as a business by itself and sold to the highest bidder? Companies sell divisions all the time.

 Voila! You just managed a bank failure in a fair way that didn’t destroy the American economy. So realistically, why didn’t this happen with very large banks? Manpower has a lot to do with it. There simply wasn’t enough regulators at that point in time to do all the slicing and dicing. I would still contend that is not an adequate reason to pursue “too big to fail.” I would argue the government could step in and keep the doors open while they went out and hired or contracted the help they needed.

 Politically, “too big to fail” is expedient. Managing a bank failure could take years. Telling people they won’t allow a big bank to fail seems to clear up uncertainty rather quickly and ease fears. But the truth is, it is the easy way out. It favors the large institutions over the small, it encourages reckless risk-taking for the powerful, punishes the disenfranchised for being prudent, and it protects shareholder equity at the expense of all taxpayers. Yes, it is an easy patch in scary times; but in the long run, it is unjust and harmful to the economy.

https://www.opensecrets.org

http://www.nytimes.com/2010/04/02/opinion/02krugman.html

Checking in on the Congregation

There is an old adage in lending to do no loans to professions that begin with the letter “P”.  Among these are plumbers, prostitutes, preachers, and politicians.  Among this group, the only one I have seen a problem with an institution I have worked for is the politicians, thought I also have no knowledge of a bank lending to a prostitute, but I do hear it is the oldest profession. 

Some of the loans that paid down their principal the quickest in my career were loans made to churches.  Sometimes lenders shy away from these because all their income is from donations.  They argue that people do not have to give money.  That is true, but I will point out that people do not have to buy from the particular retail store you are lending to or stay in the particular hotel that you have financed as well.  Real estate loans to finance religious buildings such as classrooms, auditoriums, and meeting halls can be an acceptable risk to the institution. 

These require a proper understanding of cash inflows and outflows of the church.  A close inspection should also be made of the history and growth characteristics of the church as well.  Traditionally, loans to established churches in mainline denominations are often less risky as many denominations offer support in areas of doctrine, pledge support, material, personnel, accountability, and in some cases financial support.  Loans to non-denominational churches are often more risky and loans to start-up churches should be avoided unless some other strong compensating factor is present like the presence of deep personnel guarantees.

Different churches have different organizational structures, forms of property ownership, and procedures that must be followed in order to borrow money and pledge collateral.  It is important for the lender to get a proper understanding of these items.  Also, the quality of the financial statements must not be overlooked.  A church that has an annual outside audit and excellent internal tracking where the accounting department can tell you statistics like average giving per family, shows a church that has a superior control on its finances.  Better control, often leads to a higher probability of loan repayment, which is always our goal.

One challenge is that an effective church ministry often seeks to give away as much of the money as it takes in to various ministries and love offerings.  On the surface, the church may look like it is not reaching an adequate cushion after debt service.  The lender must learn what are discretionary and non-discretionary expenses, i.e. in times of tight finances, what expenses can be foregone without substantial deterioration in the church’s ministries to ensure debt service is made.

Proper church underwriting requires the analysis of different ratios than the lender would look at for other commercial loans.  Some good thresholds are to have the loan amount/gross annual receipts at 3x or less.  Another is to cap the loan at $3,500-4,000 per giving unit.  You want to lend to a church with some size so a minimum number of giving units of 100 is good.  You also do not want the annual debt service to exceed 33% of the total annual receipts.  What is important here, is if you have questions, contact us at Midwest Business.  We have experience with church lending and can help.

Church lending can be a rewarding relationship to the credit union.  After all, we always say that we are part of a movement that is larger than ourselves. Perhaps this is one way that we can.  A proper church loan will also build good deposit accounts.  It will also build a good relationship among the folks in the congregation.

Monetary Policy vs. Fiscal Policy: Why the Fed Can't Fix the Economy Alone

Everyone hears on a regular basis about how committee members of the Federal Reserve Bank meet to discuss economics and whether to change the inter-bank lending rate. It would seem media commentators wait with baited breath to see what the Fed will do and what that will mean for the greater economy. I think people tend to assume the Fed is responsible for the economic well-being of our country, but that is only partly true.

The Federal Reserve principally exists to soundly manage the money supply, which is what we refer to as monetary policy. However, over time, the Fed’s mission has been tweaked, and now they are also tasked with trying to keep the economy at full employment.

To understand how the Fed has some, but not all, responsibility for the economy, starts with the study of macroeconomics. This branch of econ concerns itself with three economic measures: unemployment, inflation, and “output” better known as GDP. The issue is, these three indicators don’t move in harmony. If GDP growth is high and unemployment are low, inflation tends to be high. If inflation is kept low, that tends to keep unemployment high. So the Fed has this interesting task of trying to manage the money supply (keep inflation low), but also trying to keep unemployment low at the same time.

While this all sounds complex and like the work of highly educated central bankers, it really boils down to a simple idea. The Fed is there to manage, not so much to lead; and yet people bemoan when the Fed isn’t doing more or can’t do more to spur on economic growth. We must step back and ask ourselves, is it really their responsibility to generate economic growth in the first place?

If it is not the Fed’s responsibility, then whose could it possibly be? Another thing you must understand about macroeconomics is GDP = Consumer Spending + Investment + Government Spending + Net Exports. It is hard to imagine the Fed is somehow responsible for consumer spending patterns, people’s decisions to invest, how taxes are spent or the export/import environment. There is, however, a body of government that concerns itself with all of these things, and it’s called the US Congress.

How money is spent is fiscal policy, and that is the responsibility of Congress. The real challenge with economic growth is if there is no plan on how money is spent by the government nor what can be done to increase consumption in certain industries. Because of this general uncertainty and malaise over laws that govern business, GDP remains stuck in the mud. The Fed, on the other hand, is trying to do what it can with monetary policy, but it is fiscal policy that will bring any sort of real change to the economic environment.

The gridlock in Congress, leading to a complete lack of fiscal policy, is far more likely to blame for the mismanagement of the economy. In fact, it is leading people to pressure the Fed to do more. Then the Fed gets blamed for engaging in risky new policies out of pressure to create economic growth, but the blame should lie in the lack of any fiscal help, which is what is needed most at this time. If Congress could do more to encourage economic growth, the Fed could stop trying unproven methods in the hopes of not causing more harm than good.

Understanding the Unemployment Rate

One of the most widely published measures of the health of the economy is the unemployment rate.  In August, 2014, the published unemployment rate for the US was at 6.1%, according to the Bureau of Labor Statistics (BLS).  So what exactly does this measure mean and how does it determine the health of the economy?  As analysts we have learned that taking statistic at face value can lead to a skewed version of reality.

Did you know the government tracks six different versions of the unemployment rate?  They range from “People unemployed 15 weeks or longer” for U-1, to “Total unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons” for the U-6 measure.  The typical published unemployment rate is known as the U-3 measurement by the BLS.  It is defined as total unemployed as a percent of the civilian work force.  Unemployed means the worker is not working but is actively looking for a job. 

U-3 does not include those who have been discouraged about their job prospects and have stopped looking.  Much of the improvement in the widely published U-3 rate comes from individuals who have left the job market.  This is shown by the shrinking labor force participation rate.  According to the BLS, as of August 2014, the labor force participation rate of people over 16 stood at 62.8%.  The civilian labor force is the sum of all employed and unemployed persons (note that unemployed is defined by U-3).  It does not include those in the US Armed Forces. 

At the end of August, the BLS estimated the number of available workers who are not in the labor force totaled 91.8 million.  That number has risen by nearly 2 million people in the past year.  The estimated US population of people over 16 from the Census Bureau as of July 1, 2013 was 250.9 million.  This means that nearly 37% of people over 16 are not in working or looking for a job.  Some of those people who are not in the labor force are students and some may be retired.  But still, the labor force participation rate is at the lowest level it has been since the Carter administration.  The Census Bureau projects the labor force participation rate to decrease over the next decade as the population ages and more people retire from the work force.

The largest level of unemployment measure, the U-6, has the numerator as all unemployed, part time employed who want to be employed full time, plus those marginally attached to the labor force.  Marginally attached laborers are those who cannot find a job and have decided to just stop looking for a job.  These people would be actively looking for a job if they believed they had opportunity to find a job.  These people have given up hope to find employment.  The total of U-6 for the US stood at 12.0% as of the end of August.  Clearly, the U-6 number does not paint as pretty of a picture of unemployment as the U-3 does.

Over the past year, U-3 has dropped from 7.2% to 6.1% and U-6 has dropped from 13.6% to 12.0% on a national basis.  This may lead on to believe that the economy is getting better.  At the same time, the civilian labor force participation has dropped from 64.3% to 62.8%.  As people leave the labor force who were unemployed, it reduces both the numerator and denominator of the unemployment rate calculation by the same number.  This will cause the unemployment rate to decrease without actually creating more employment. 

Unemployment rates also vary greatly by states.  The lowest rates for both U-3 and U-6 is in North Dakota, where the rate is at 2.8% and 5.5%, respectively.  The highest U-3 rate is Rhode Island at 8.9%, while both California and Nevada had the highest U-6 rates at 16.2%.  The states that MWBS owners are located in have U-3 that ranges from 2.8-3.6% and U-6 rates of 5.5-7.3%.  These are some of the lowest unemployment rates in the country.  We have heard of businesses in this area that have experienced labor shortages and others, especially in the oil patch, that have to pay high rates just to get workers. 

One interesting thing about unemployment is that even though the rate appears to be decreasing, partly from new job growth and partly from people just leaving the work force, there still is a need for skilled workers in this country that are not being filled at the present time.  If you have a skill that is in demand in the economy, you can find a position.

A World of Infinite Risk

The goal of extending any credit is to get repaid timely, with an adequate amount of interest earned for the risk taken. The less risk you take, the less interest you will receive. To take no risk is to sit on top of a pile of cash and not lend it out. While that is the surest way to guarantee money won’t be lost, no income will be earned either, which will inevitably create problems in funding salaries and keeping the lights on.

 And yet, I hear people comment that they are passing up on loan opportunities because risk is present.  I understand that some loans can be too risky, but no loan will be risk-free. Lenders will never find risk-free loans, and loans with minimal risk will have terrible yield. I’m not advocating chasing yield and accepting a high level of risk; but rather, I believe a lender should focus on how to mitigate risk.

 Mitigating risk means minimizing the likelihood and adverse effects of that risk. For example, if a borrower opens a restaurant, the lender expects to be repaid from the profit of that restaurant. However, the restaurant may fail. How then will the lender be repaid? The lender mitigates this risk by taking the restaurant property as collateral, and hopes, in a worst case scenario, to sell the property and use the proceeds to retire the loan. Taking collateral is probably one of the most common ways lenders mitigate risk.

 Mitigating risk takes on all sorts of interesting practices. For example, the NCUA limits how many participations you may purchase from one lender to mitigate the risk of poor underwriting and servicing from an uncontrolled source. Making loans that amortize before the end of the useful life of an asset is also a common way to mitigate the risk of the collateral resale value. Lenders may try to limit how many loans they have made to a particular industry to mitigate the risk they are exposed to in the case of a slow-down in that area. Lenders are faced with a wide variety of risks, but instead of avoiding them, good lenders try to live with them by mitigating them.

 I recently heard a lender was disinterested in funding one of our loans, because they were concerned the economy in the subject community was driven too much by a single industry. The fact of the matter is, this is simply another request which needs to be mitigated. The very nature of communities is they tend to exist or are founded for an express purpose, and they tend to be heavily invested in a particular industry. In Rapid City, it tends to be tourism. In Pierre, SD it tends to be State government. In Washington DC, it tends to be national government. Omaha and Des Moines are heavily concentrated in the insurance industry.

 Yes, a slow-down or change in any of these industries would definitely impact the well-being of these communities. But, do these industry concentrations mean they are bad communities to lend in? Definitely not, if you are mitigating the industry risk. If you can test how well the loan repayment would hold up in those communities based on potential downturns, or if the loan is structured in a way that increases the likelihood of repayment regardless of downturns, then proper mitigation is being enacted.

 And ultimately, the best way to mitigate the risk in the circumstance above is to make sure you don’t invest too heavily in that specific community! Perhaps one or two large business loans makes sense, but if 3x your net worth is invested in that community, which is dependent on a single industry, it may be a wakeup call that diversification is needed.

The bottom line is, if lenders refuse to lend simply due to the presence of risk, then a lender will always find a reason not to fund a loan. A good lender assesses whether the risk can be mitigated, or whether the risk is acceptable to bear.

Weeding the Loan Portfolio

One reason we have a house in the woods with a little land is that I hate yard work.  I am a big fan if I can do all of it sitting on a tractor.  In fact, the time I enjoyed mowing the most was when I had my Ford 8N with a six foot grooming mower.  Now yard work is a balancing act between how long I can let the yard get and yet be able to see any snakes from the woods. 

Last week, as I was walking through the yard with my dogs, I noticed a healthy crop of weeds, lush and green, from two to six inches high.  I had attempted to use some herbicide, but it seemed to make the weeds grow faster.  No, the only way to get rid of these pesky foliage is to grab them at the root, give a slight twist, and yank them, root and all, out of the ground.  So I began to pull weeds and after 40 or so, determined the yard was at least tolerable to my lax yard standards.

As I pulled weed after weed, I began to think about how a well-managed loan portfolio often requires a lot of constant weeding.  But I would not treat the loan portfolio as easy as I do my yard.  Portfolio management requires constant and consistent maintenance. 

Many lenders have the tendency to concentrate on new opportunities and often neglect the actual performance of the existing clients they have lent to.  Financial statements and tax returns become more items to stick in the file rather than tools that reveal the performance of the organization.  Oftentimes, a good study of the financials may show you the roots of weeds growing inside your client’s company before they get out of control.

Another possible weed is the company that is growing too quickly for its capital base.  If you have one of these in your loan portfolio, you can see there may be a tendency from the company owners to focus only on the future growth without any concern about having the necessary resources to continue the growth.  Additional leverage does not scare them as they believe sales will constantly provide more revenues than the additional debt requirements.  They also make no provisions for a decrease in revenues.  These companies are a fast growing weed with little root to them. 

Some loan officers may be in the habit of not requesting adequate financial information in order to accurately assess the risk of the company.  They may think that since the credit is performing as agreed, there is no need to inspect the firm.  This habit can be ignoring the possible hidden weeds that may be in the portfolio.  By the time, they are dealt with, they may be in a critical stage that could have been avoided with early intervention.

One thing about weeds, if they are addressed early, a lot of time and energy can be saved.  Allowing the weeds to grow will mean they will thrive and choke out the remaining time that you have for new productive business.  If you have not experienced the time drain from poor credits, ask someone who has worked through a problem credit or worse, a problem portfolio. 

As we are getting into the season of getting updated tax returns from our clients, I would encourage each credit officer to take some time to inspect and pull a few weeds.  The time you invest now, can save you a lot of effort in the future.

Different Types of Banking: Where Does Your CU Fit In?

“Bankers” are not a well-liked group, or so the media would lead you to believe. But, what a banker is varies greatly. For some, a banker is someone who may help you with a checking account or a car loan, and for others, a banker is someone who buys and sells stocks and bonds. So which is it? Well, like all things in life, the world of banking is far from monolithic.

Banking, at its core, is about accepting deposits from savers, and lending those deposits to borrowers. This is often a highly regulated activity, because the savers want assurance their deposits will be returned. If you want to accept deposits from anyone so that you may lend them out, you will need to obtain a charter (license) from a state government or the national government. This activity is called commercial banking.

In commercial banking, you may accept deposits and lend them out as funds so that people can obtain consumer goods; like cars, campers, furniture, etc. These types of loans are known as consumer loans. The people needing consumer loans may have a need for deposit accounts and other savings products as well. Managing these deposit accounts and consumer loans is often referred to as retail banking. Just like a retailer targets most anyone in the general public, most banks are offering “retail” deposit accounts and consumer loans to the public.

Retail banking is a volume business. To be successful, you need to do a lot of it. Often, a more efficient way to generate interest income on loans is to focus on making only big loans. Less work will go into making one $1 million loan than 50 car loans for $20,000. But, consumers will not have a need for large $1 million loans. Businesses tend to have more of a need for these types of loans, and this banking is appropriately called business banking.

When a business loan is relatively small, say to purchase some equipment or small piece of real estate, the lending need usually falls into the category of small business lending. When a company wants to borrow a large sum of money, often several million dollars, but it is not big enough to do so by issuing stocks or bonds, this is considered a middle-market request. It is middle-market, because it is not small business; but also, not large enough to justify the involvement of an investment bank.

When a large recognized company can raise funding by selling stocks or bonds to the public, an investment bank is enlisted. These banks underwrite the financial instruments sold and find buyers for them. However, investment banks often do not raise money through accepting traditional retail deposits, nor do they often fund much of what they underwrite. For these reasons, investment banks are much less regulated.

Investment banks may offer private banking services to wealthy clients, in which the private banker will assist clients (for a fee) in finding high yielding investments for their savings; however, they will not provide any protection nor guarantee to return all the money invested. For these reasons, investment banks gain a reputation for being risk takers. Investment banks are not like commercial banks that strive to connect savers with borrowers, but rather, their goal is to make as much money as possible, often by being as innovative as possible with financial instruments sold, and with clients’ money being invested.

Credit unions engage in banking; of course, they are not privately owned, but collectively shared by all those who provide deposits. Credit unions have traditionally provided retail banking products and occasionally small business products. Credit unions have an opportunity to fill in more of middle-market lending going forward, simply because there are less banks every year that engage in this due to mergers and acquisitions. Credit unions have a niche to fill, because these middle-market companies are owned by local individuals and provide good local jobs too. People should not confuse business lending with “bad” banking or investment banking when a credit union is scaling up its business lending. It doesn’t mean it is catering to wealthy clients or engaging in more risk-taking like investment banks do.

Making Long Term Decision on Short Term Factors

Many times in life, we are faced with decisions that will impact us for years or even decades into the future.  In those cases, it is always good to try to “count the cost”, or look at the impact over the long term when making such a decision.  I once knew a man who decided that get to some point in your life when you are ready to marry and whatever woman you are with at that time will be the one you marry.  It sounds like making a life-long decision based upon what is happening in the short term.  It kind of reminds me of a man who fell in love with a lady who was a wonderful singer. He was completely enthralled with her voice, which as like an angel.  They married after a month of whirlwind courtship.  On their wedding night the lady proceeded to take off her makeup, pulled off her wig, and removed her girdle revealing a much different looking lady than what he married.  He looked at her and replied in horror, “For God’s sake woman, SING!”

Lenders can often get into the trap of listening to the credit applicant and looking at his short term situation in making long term financial decisions.  It makes it easy to leverage up a hotel based on the revenue in a hot market without consideration of what happens when normal times return.  While it is truly unknown what will be the new normal in the future, there may be a tendency to leverage up the client based upon today’s revenue without asking if what is going on today would be considered normal.

Many times it is hard to consider what normal is.  A few years ago, some agricultural lenders got into this trap a with grain farmers.  The lenders looked at the current escalating grain prices and considered this would become the new normal for prices in the future.  They then gave credit based upon consideration that these prices would continue and even climb further from where they were at.  Some farms were sold and lent upon at inflated prices.  Other farmers purchased new equipment, storage facilities, and made improvements based upon these high prices.

So what has happened in the past two years?  Corn prices have dropped 50%.  Wheat has fallen as well.  Cool weather and ideal growing conditions have made this a bumper year for some of the grains.  Add in a decrease in supply from some countries like China, who do not like our GMO corn and you have a perfect storm of falling prices.  The price drop will impact the top line of many farmers.  High input costs will erode profits on the bottom line.  This may lead to problem loans that just two years ago were good solid credits.

We may be facing the same issue with the livestock sector.  True, when one looks at supply and demand with the cattle population at its lowest in 60 years, the swine population is down by 5% due to the disease that is impacting the young porkers, and chicken supply is also trailing demand; all factors seem to point to higher prices for the foreseeable future.  But remember, the prices will change at some time.  The herd will eventually increase, pigs get healthier, and supply/demand factors balance out in the poultry arena.  What we don’t know is when.  It would be foolish to load up the rancher on long term debt for the next 20 years on prices that are high today, but may not last the next 5 years.

Using historical averages is a tool to help even out the dips and spikes in revenues and prices of a business.  This may help the lender approach the borrower with a more realistic approach to expected earnings for a company.  Basing a more conservative loan that can be serviced on that revenue stream will help ensure the lender reaches his ultimate goal of having the loan repaid.  Another strategy may be to shorten up the amortization in order to gain more principal reduction quicker in the early years when abnormally high revenues or prices are expected. 

On another note, contact us for more information about our agricultural finance training in Miles City, Montana on October 8-9, 2014.  We look forward to seeing you there.

How Should You Stress Test a Loan?

We live in a dynamic world and we all understand that. I can’t think of one tax return or P&L that looked exactly the same from one year to the next. We understand that a whole host of factors change every year, and it is a poor assumption to believe that present conditions will remain constant throughout the life of the loan. Therefore, it is important for us to test just how much stress the borrower can endure until the likelihood of default becomes too high.

Where to begin? The most common way you may see a loan stress tested is by shocking the interest rate. The underwriter will examine how the debt service coverage ratio (DSCR) is affected by increasing and decreasing interest rates. The results of this are not surprising, as you would imagine DSCR improves when rates are lowered and deteriorates when rates are increased.

Lowering a rate will never hurt a loan, and testing a loan in this manner is mistakenly a practice that is only meaningful when looking at a bank or CU balance sheet as it relates to cost of funds. Increasing the rate is often arbitrarily done by 1-4%, although again, the results are predictable. A higher rate will result in lower DSCR. A more precise method is simply to solve for the break-even interest rate, which will give you the absolute threshold at which DSCR would slip below 1.00x if all else remained constant.

However, it is a poor assumption that all else will remain constant. The lender should be well aware that sales could drop, cost of materials could increase, and operating expenses could increase too. Realistically, changes in these factors are far more likely to pose a threat to repayment than an increase in interest rates. Therefore, a lender should calculate the maximum decrease in sales, maximum increase in cost of materials, and maximum increase in operating expenses; all as a percentage of gross revenue. Again, these are all break-even indicators and tell us more than providing arbitrary 5%-10%-15% increases or decreases.

For reasons noted above, it becomes clear that break-even analysis provides much more information than stress shocks. Shock analysis, while better than nothing, is sort of a one-size-fits-all approach to stress testing. On the other hand, break-even analysis provides maximum thresholds for all factors examined.

Most importantly, interest rate stress testing should not be the only stress test examined. Revenue, COGS, and operating expenses should also be examined because they are far more likely to impact repayment. Those tests should also be reflected as a percentage of revenue to put into context the size of the overall maximum stress tolerance.

When we can observe there is ample buffers before break-even is reached, we can feel much more comfortable about the ability of the loan to handle changing conditions. When break-even marks are less than 5% in any area, it is a point of concern that needs to be monitored.

One other thing, for those in a reasonable driving distance to Miles City, Montana, do not forget about our upcoming "Basics of Agriculture Lending" on October 8-9.  Please contact us for more details.

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.