Fall 2014 Commercial Real Estate Review

On a national scale, money from both equity and lending sources are pumping more liquidity into commercial real estate market.  Equity capital has come from local investors, 1031s, REITs, private equity, and sovereign wealth funds.  Commercial mortgages, which dropped over 10% during the credit crisis, reached a new high in mid-2014.  Credit unions and banks have picked up more fixed and floating rate loans, Commercial Mortgage Backed Security volume is strong; insurance and government sponsored agency lenders are active as well as mezzanine funds.

This reflects a positive outlook for CRE and an economy that has been strengthening has supported the momentum.  New additional hiring has passed the number of jobs lost during the recession while the number of people underemployed or leaving the work force have tempered growth and allowed the Fed to hold rates steady.  The job gains have been matched with very limited income growth.  But in many ways, the slow growth has been good for CRE performance.  The incremental growth has kept construction from roaring back during a recovery cycle, as is often typical.  This has prevented over-building and is pushing up values and lowering cap rates.

Apartments are the overall star among property types.  Demographics are favorable for more apartment demand as the growing echo-boomer generation is set to expand by 2.1 million over the next six years.  This could support demand for another 1.4 million apartment units.  The recent poor economy has also pushed 3.3 million echo boomers living with family.  As job creation accelerates, many of these young adults will have no choice but to move into apartments with high levels of student debt keeping them from house ownership.  In some areas of the Dakotas, new apartments cannot be brought on line fast enough.

Vacancy rates on a national basis dropped to 4.4%.  Rents have risen and are now 18% higher than the dip in 2010. Developers have taken notice and another 238,000 units are expected to come on line in 2014, the highest level recorded.  National average cap rates for high quality apartments have dropped below 6%.

Retail has been a slower performer with needs-based anchored centers with national retailers outperforming local retailer centers.  Retail sales have averaged a 4.3% annual growth since the recession, which is in line with long term averages.  Typically, retail space will change as retail sales change.  But space and sales will not track exactly in tandem in the future as more people gravitate to on-line shopping.  A small amount of new supply has come on line in 2014 quarter 2, representing only ½% of the national total retail space.  Prices per square foot have reached new highs at around $180/sf and cap rates have hit new lows at around 7%.  Even with this performance, there are still vacant retail spaces in various markets. 

Office hiring has increased demand for office locations on a national basis.  It is estimated another 2 million office jobs will be created in 2014-15 and much of the vacated space left from corporate layoffs will begin to be filled.  New office space coming on line is at historic lows.  The national office vacancy rate stands at 15.6%, currently, and may only drop another 30 bps by the end of the year. 

Industrial space demand is strong with much coming from the e-commerce sector and other demand from housing, auto sales, and international trade.  Nearly 380 million sf will be absorbed in 2013-14.  This pushed the vacancy rate down to 7.1%.  Cap rates tend to be tightening across the industrial space sector with warehouses making the largest gains. 

The expansion of the US economy is also creating a growth in hotel room demand.  National occupancy has risen 220 bps to 66%.  Higher group demand accounts for some of the growth as hotels recorded another 2.1 million additional group rooms in the first half of 2014 compared to the same period in the prior year.  Supply growth has stayed slow with available rooms up only 0.8% from last year.  Spending on hotel construction has not been at the same level as it was during the peak of the last building surge and is now expected to even out.

With the increase in demand outpacing supply, hotel operators are enjoying a 4.4% rise in average daily rates for the first eight months of 2014.  The increase in both occupancy and ADR has risen revenue per available room (RevPAR) by 8%.  RevPAR growth is continuing to pick up with nearly half of the nation’s largest 25 markets experiencing double digit gains this year. 

These trends are on a national basis and the local market are that you operate in may, or may not, track with the national trends.  It is important to understand the factors in your area as you judge the market conditions for the existing and new loan requests you have.

Insider Loans and Conflicts of Interest

A conflict of interest arises when someone is not in a position to independently carry out their role or function.  Independence is a necessary element in finance to prevent fraud or maintain credit quality. When someone cannot be independent in their role as an underwriter or lender, there is no telling what can happen.

In finance, you may see this manifested when a manager may be especially close with the loan applicant (perhaps a friend or family member).  The applicant may expect the loan to be approved because of this close relationship, and the underwriter may fear they will upset their manager by not approving the loan. In this situation, the underwriter cannot make an independent decision. Or, even if he/she did make the decision independently, that independence is called into question.                                                                                          

Another way conflicts of interest come about is when a person has multiple roles to fulfill. For example, a bank or CU manager may also find themselves investing in commercial real estate. If that manager tries to get a real estate loan at the bank or CU he manages, what are the odds he will turn down his own loan? Here the manager is playing both the role as manager and borrower, calling into question whether he can truly make an objective decision keeping the institution’s best interest in mind over his own personal gain.

In banking, this conflict of interest is the basis for Regulation O, or Reg O for short. The Regulation limits how much a banking executive may borrower from the bank they supervise. This is done so the managers and board members don’t treat the bank as their personal funding source to finance projects, which may not have been adequately reviewed for credit risk.

The NCUA does limit some insider borrowing, but mostly stipulates they cannot get preferential treatment when borrowing. Reg O has similar provisions, which mostly state that insiders must pay the same interest rates and fees as everyone else.

Like all regulations, there gets to be a gray area with interpretation. Often, it isn’t clear if a board member or their businesses should be treated as insiders. However, the same conflict of interest issues arise. How would it look if a director of an institution has a business loan at that institution? Did the managers make that decision independently? Can they make that decision without fearing negative consequences professionally?

While there aren’t rules and regulations for every ethical dilemma, it is often best to simply avoid entangling your staff and managers in the debate. If the practice seems questionable, or there is clearly an area where independence can be debatable, often it is easier to make it internal policy to bow out.

While nobody likes to pass up good business opportunities, it is far more unpleasant to foreclose on directors or friends and families of managers. This will do more to damage relationships in the long run than any short-term decision to avoid insider issues.

The Power of Listening to the Right Questions

Have you ever experienced a sales person who constantly tries to push a product or service on you that you do not want?  Doesn’t it make you feel like running the other way?  My wife sums up sales well when with her saying, “People don’t care how much you know, until they know how much you care.”

I once violated this rule early in my finance career when I primarily did real estate mortgages.  I had a realtor bring a buyer to me who wanted a loan to purchase a house.  He knew exactly what he wanted, a 3 year adjustable rate mortgage, since the rate was lower and he had another property that would close within the three years so he planned on retiring the debt.  I told him about the benefit of a fixed 30 year mortgage, as I could not understand why anyone would want an adjustable rate loan.  It just seemed too risky in the event that he could not pay off the loan and if rates shot up.

The guy went to the bank down the street to get the loan to my surprise.  When I asked the realtor why, he told me that I did not listen to him and was offering something that he did not want.  He then said that I had two ears and one mouth and I should spend more time using the organ I had more of.

We experienced someone really caring in sales with a car dealer.  We purchased three vehicles from the same salesman over the past year (I have teenagers at home).  This gent asks the right questions and listens.  He then finds the vehicle that fits what we want.

So how does this apply to commercial lending?  Whether you like it or not, you are in sales.  You are never the only game in town as there are others who are vying to become the trusted financial advisor for your client.  This involves you asking pertinent questions to learn about the customer’s business and then listening intently with the intent to learn.  One thing that is really cool about commercial and ag lending is that you can never cease to learn.  If you think you have learned it all, then it’s time to retire.

Active listening requires asking insightful questions that will draw out a thoughtful response from the client.  You need answers that are more detailed than “yes” or “no”.  The questions also need to be asked in a sincere and non-threatening way.  The client can sniff out if you really want to understand his situation just like a hound dog can sniff out a rabbit.

One way to find good questions is to do some research on the industry and the market area.  What are overall trends?  Then asking what trends the client sees and compare if the industry and the client are experiencing the same things.  These questions will differ greatly between various types of businesses.

There are other questions you can ask that can be used universally to engage the client.  Asking “what was your biggest successes last year” may shed light on what the owner thinks is most important and what he devotes the most time to.  If you have an owner who is really into the financials, he may cite a certain product or division that had the largest profit margin. 

A question like “what things keep you up at night” will help you see the biggest concerns the owner may have.  If you cannot get a thoughtful response here, you either have an owner who does not trust you to share the information or who ignores any risk that is present in the business.  The former requires you to build a stronger relationship, the latter requires you run and avoid the prospect. 

Asking “where do you plan to be in 5 years” will help you understand the long term goals of the business.  The question of “what are your plans in the next 6-12 months” can give reveal the short term plans.  Learning about the history of the business or owners is key in understanding how the firm got to the place they are in today. 

One of the worst mistakes is to fail to listen and learn about your customer.  If you are suggesting financing options without listening to the client first, you are degrading your professional skills to that of taking an order over the phone. If you get the transaction, you are not getting the relationship as a trusted advisor.  This is your goal as a business or farm lender.  You want your clients to come to you over and over again, because the owner believes he is better banking with you than he is with anyone else. 

True, there are times when you cannot give the customer what he wants since it conflicts with your guidelines or prudent underwriting practices.  At those times, it is important to explain why you cannot give him what he wants and if possible, offer an alternative.  But listening to the customer is the first step in building the relationship.  Otherwise, making suggestions to the business customer on financing options for his business is like throwing ideas against a wall and hoping something sticks.  That is an inefficient way to build your portfolio.

The Business Cycle Does Not Have the Same Impact on All Business

On my drive to work early this week, I heard on the radio that McDonalds reported a decline in earnings. Analysts noted that more people are employed now than 5 years ago, and these people have more money to spend on better fast food options. Chipotle was specifically cited, but here in Rapid City it is clear Five Guys Burgers and Fries would also serve as a good step-up competitor.

It seems to go against what we typically believe, which is the rising economic tide tends to float all boats. But the truth is, when income or employment improves, people give up cheaper products and services for higher quality ones.

Industries that do well when the economy is doing well are known as “cyclical” industries. This harkens back to the business cycle, in which industry as a whole expands to generate positive economic output, and when aggregate output decreases, a recession results.

Some industries can be “more” cyclical than others. Highly cyclical industries include housing, new automobiles, and luxury items. When times are good and people feel they have stable work, they are more willing to spend on big ticket items. Likewise, these industries suffer in a recession since more people find themselves out of work or are less certain about their future.

For other industries, say the sit-down restaurant industry, you will likely see less business, but not as steep of a drop off in demand. People still might find $50 or $60 in their budget to dine out even if the future is murky.

Other industries are described as “non-cyclical.” Take for example healthcare or utilities. While people would wish they could cut the expenses of these items when the economy takes a downturn, the reality is their consumption will likely remain at a relatively steady rate. Most of us will forego several other items before we refuse to pay the heating bill in winter, or before we refuse to get a broken arm fixed.

Then there is the concept of “counter-cyclical” industries. These are businesses which may see additional revenue because of a contracting economy. Think discount retailers and cheap fast food. People will readily buy these products and services in a recession when they can afford less and forego Chipotle or Five Guys. Another good example of a counter-cyclical industry is the foreclosure processing industry. As unfortunate as reality is, when people lose their homes in a recession, more people need to be employed to foreclose on properties.

Knowing how your business member tracts with the economy is important. Cyclical businesses should not struggle during an economic expansion. A cyclical business that is operating marginally during an expanding economy may not be a “going concern” in a recession. On the other hand, if they are struggling because of a recession, there may be reason to believe their performance will improve as the economy improves. Of course, all of this is vice versa for counter-cyclical business.

Understanding the risk of the business cycle requires lenders to know two things: first, where the economy is in the business cycle, and second, how businesses in their portfolio track with the business cycle.

Risk Rating and Loan-to-Value Migration

A couple of new items that many of you, in credit union commercial lending departments, will hear from the examiners this year is Risk Rating Migration and Loan to Value Migration.  These things sound like the annual trek of birds or animals to warmer or more inviting lands as winter begins to break onto the horizon.  But it has nothing to do with that.

The migration is simply keeping a historical record of any changes in the risk rating or the LTV over the life of the loan.  This could simply be done on an excel sheet or if you are utilizing a file management program (we use Suntell in our shop) you can track those changes inside the program.  The purpose of this is to show that you are managing the credit file properly. 

The best time to record any change in the risk rating is at the annual risk review time.  But, this should not be the only time, if new major information comes to your attention that can dramatically change the risk rate either up or down, the loan needs to be re-risk rated.  The goal of a risk rate is to accurately show the risk of a commercial or agricultural credit on a pre-determined scale.  If you need help on creating a scale, call us.

It would be a best practice to find several different financial performance indicators that can be used to accurately gauge the risk in a credit.   Now these factors will not be the same for all credits.  A rented office building has different applicable risk indicators than an operating line on cattle.  So, different risk models would be most applicable for different types of credit.  As a general rule, one could use three model groups:   Commercial Real Estate, Commercial and Industrial, and Agriculture. 

It is also important once the indicators are checked, that they are reviewed and the ranges of the indicators are reviewed to make sure they are accurately displaying the risk.  Also, do not be afraid to override the risk model if outside information comes to light that could harm the company.  An example here may be a company that is performing well but has litigation that will have a major negative impact on the financials.

So back to the risk rating migration.  The practice here is to keep a historical log of the risk rating.  The log should be backed up with your annual risk review and the log should also indicate when the risk rating was last reviewed and by whom.  It should include thoughtful analysis on the true risk, instead of being like a bank I once worked for.  Everything was rated at the average pass grade despite any other performance measures that may indicate another grade is applicable.

The LTV migration is a bit trickier.  The first fear is that you have to order an appraisal or get some form of evaluation from a third party on the property each year to determine value.  Requiring new appraisals each year would put the credit union in an enormous competitive disadvantage with other lending sources.    

One method is to figure a new value for the real estate using the cap rate that was provided by the appraiser.  A cap rate is calculated by dividing the net operating income of the property by the property value.  So if you know the current NOI and also the cap rate, you can calculate the value by dividing the NOI by the cap rate.  My suggestion would be to run this calculation when you do your annual risk review.  This makes the assumption that the cap rate will be constant from the original appraisal.  If you have knowledge of market cap rates changing on the type of property that you have lent on (as they will do), then you can change the rate.  Just provide some narrative as to how and why you calculated the new LTV in your risk review.

The overall lesson here is the officer needs to stay on top of the credits in his portfolio.  Tracking changes in risk rating and also tracking potential LTV changes are just two tools that are used in managing the credit risk.

Subordinated Debt: Not All Liens Are Created Equally

Recently we have received feedback from the NCUA regarding our interpretation of the common ratio Loan-to-Value. I think we first need to ask ourselves what this tool is used for in underwriting. While this seems obvious, it bears stating that we use loan-to-value to measure our collateral position.

NCUA Rules and Regulations 723.21 defines loan-to-value (LTV) as the aggregate amount of all sums borrowed including outstanding balances from all sources on an item of collateral, divided by the market value of the collateral. According to this interpretation, the NCUA is not using LTV as a measurement of collateral, but a measurement of project leverage. Why is that significant?

LTV as a collateral measure tells us how much cushion we have in the event of foreclosure. Our cushion remains unaffected if there are liens behind our senior lien. Say we have a $1 million piece of real estate and a $500,000 first mortgage. Our LTV is $500k/$1 mil. = 50%. Now say there are four additional $500,000 mortgages behind our first, creating a second, third, fourth, and fifth mortgage! No matter what subordinated liens exist, that $1 million property will first serve as collateral for our first $500,000 mortgage, and therefore our LTV position will always be 50%.

However, the NCUA argues all of those liens should be included in the LTV ratio. In this case, if there is actually $2.5 million in debt secured with a $1 million piece of property, it will bring LTV to $2.5 mil / $1 mil = 250%! Yes, the total project has debt of $2.5 million, and the collateral is leveraged 2.5 to 1, but that doesn’t tell us anything about our specific collateral position. Is there danger in a project being overleveraged? Yes, both from a cash flow standpoint and an equity standpoint. But, LTV is not the most effective tool in limiting leverage.

Traditionally, we employ a different ratio to measure project leverage, which is loan-to-cost (LTC). In this case, it is common to lump all the aggregate amount of all sums borrowed including outstanding balances from all sources on an item of collateral. But in this case, you don’t divide by collateral value, but divide by total project cost. I would argue the NCUA would be correct in adding all debt, including subordinated debt, in determining a project’s total LTC.

Why does this matter? Credit analysis is fraught with people using the wrong tool for the wrong purpose, and we need to be careful in understanding what LTV is and isn’t. LTV is the tool we use to measure collateral, but not necessarily the tool we use to measure equity. For this reason, we only care about the LTV of our specific debt. LTC is the tool we use to measure equity, therefore LTC should account for total debt and not just specific debt.

By adding all debt into the LTV calculation, the ratio is misstating what the true collateral position is for specific debt, and it will also misjudge equity in the project. In effect, the present definition fails to characterize both collateral and equity in a meaningful way.

Red Flags for Examiners

As I begin to get into this blog post, I first want to thank all 24 students who attended our Agricultural Finance Training in Miles City, Montana last week. It was a great class and we look forward to hosting more of these events in the future.

We also completed our annual NCUA exam.  We had a great group of examiners and were able to talk to them about current issues they are running into as they look at business loan portfolios of credit unions.  I like to think of them as “red flags”. 

No Monitoring of the Business Credit After the Closing:  This is one that is still out there in some institutions.  Any type of commercial or agricultural lending requires not only obtaining new financial information to keep the file current, but analyzing that information to make sure the risk profile that you have is accurate.  Other problems here is a lack of organized file management.  This sloppiness makes it hard to figure out what is happening with the credit. If someone else had to take over managing that credit, how easy would they find that task, given your file?

Site Inspections:  A lack of documentation of site inspections is found throughout CUs.  We are guilty of this as we have been on site to every loan we have closed, yet I had no documentation in the file of the visit.  The inspection should be dated, signed, have a listing of the collateral condition, have photos, etc.  If you do not have a standard collateral form for inspections, make one up!

Poorly Managed Risk Ratings:  We hear of institutions that risk grade all their credits the highest rating they can and then do not change this over the life of the loan.  The best practices for risk grading is to have a model that uses several applicable tools of measurement, to make the grading more objective than the officer’s subjective analysis.  Risk ratings need to be redone during annual review time and may need to be redone more often should the conditions of the credit deem necessary.  A coming trend among the examiners is for you to be able to show the history of the risk grade through the life of the credit.  Putting those tracking tools in place now will help you in the future.

Lack of Interim Statements:  This hits especially when they are required in the loan covenants.  Interims should be used with companies that have not reached stability, complex industries or businesses, or problem credits. 

Ignoring or Not Having Covenants:  This is when the lender has no follow up on loan covenants.  They are not tracked after the closing.  There also is ignorance of how to handle a broken covenant and what do you do when you have a broken covenant but decide to waive your rights to penalize the customer or accelerate the note.  Generally, there is a lack of covenants, what they do, what to covenant for, and why to use them.  The examiners view the institution that avoids the covenant issue completely as laziness.

Poor Loan Structure:  This plagues some institutions that think of every commercial loan like a regularly amortizing auto loan.  In commercial, there may be instances when creating structures to better capture the business cash flow or requiring curtailments, required principal pay downs, or funding payment reserves may be the best option.  A word of caution here is to make sure your core processor can handle a loan with an irregular payment.  Better yet, if you can’t do this with your core, we can process the loan with the exotic payment structure at MWBS.

Credit Presentations that Receive a Failing Grade:  Too many credit presentations when millions of dollars are being sent out the door do not have adequate content to warrant the loan.  A credit write up should be written to the extent that if an auditor, examiner, or loan buyer from another state were to come in to fund the loan, they could read it and understand the deal.  Poor or no definition of the loan structure is often found in the write ups.  A lack of narrative that explains what is going on, the collateral, market area, or guarantors is evident in a lot of files. 

Our deals at MWBS tend to be more complex, so we typically have write ups that begin at 30 pages and go upward from there. But even in our write ups, we still found some ideas to provide additional thoughtful analysis and better cover a few areas where we are a little light on our information.  I am not saying that every write up needs to be the size of a good short story, but if you have a large credit, you should have a thorough analysis.

It is my hope that you can understand some of these red flags and avoid them.  If you need help, get in touch with us.  It is our hope we can help take down some of those warning signs the examiner may find.

Contract Enforcement is a Cornerstone of Economic Development

Often we hear about how uncertainty prevents businesses from expanding or hiring new people. Why is that? Any time a business decides to do something new, they are taking a risk. Business owners know they must take risks to increase profits, but they are not willing to take a risk unless they understand the risk they are taking.

When the government is unclear about the future of taxation, regulation or spending; businesses hesitate to take a risk since they don’t understand how those changes may impact them. Still, this doesn’t halt business activity altogether, it just impedes growth. Surprisingly, our system operates with a fairly high degree of efficiency because businesses are fairly confident they can enforce contracts that are needed to buy, sell and trade products and services.

A large reason businesses tend to flourish better in developed economies is the certainty of contract enforcement. While we may feel our malaise of fiscal policy slows down economic growth, our economic system still manages to operate more efficiently than others because businesses and financial institutions can enforce contracts. Do you think banks and credit unions would lend money if they couldn’t use the court systems to take collateral or hold people accountable for debts?

And yet, this is exactly the problem many people face in several countries throughout the world. When a business is unable to enforce a contract, then the business will only engage in activities with people they deeply trust, and they will not be willing to take risks with people they do not know. It is not hard to see how this limits economic activity, since it greatly reduces the number of opportunities a business has.

It’s not that these countries don’t have laws in place, but their enforcement becomes highly questionable. Often, public officials can be bribed to ignore laws or to apply laws unfairly to competitors. If the judicial system cannot be relied upon to be fair, or if the law only works for the biggest briber, it becomes clear why contracts cannot be relied upon and economic development is stifled.

Uncertainty regarding contract enforcement is also an obstacle towards economic development on the Native American reservations throughout the Dakotas. Often the uncertainty of how contracts and laws will be applied, or how this may change with the election of new leadership, creates an uncertain business environment.  For this reason, many businesses are hesitant to invest in these areas.

It is surprising how much we take for granted because our contracts and laws can be easily enforced. People buy and sell real estate all the time without fear of public records being tampered with. People can apply for business licenses without passing money underneath the table, and most people fear breaking laws believing it will be highly unlikely that police officers and regulators can be readily bribed. We may not think about it often, but our ability to enforce contracts is truly a cornerstone to a strong functioning economy.

Organizational Chart for the Status Quo

Too often, the Leader of New Growth Ideas, is often an empty position in so many organizations.  But the organization that is happy with the same old same old things and getting the same results often has several other layers of upper management over the new ideas leader that hinder his or her effectiveness.

Usually, the direct report for the new ideas leader in such an organization is the Director of Analysis Paralysis.  These people have to have endless reports, statistics, charts, graphs, an data that must be painstakingly reviewed in order to make the decision to get even more information to do more analysis.  These folks are more interested in scurrying from one piece of data to the other, and are happy if nothing consequential never gets done.  After all the analysis keeps them employed.

This individual is usually led by the VP of Stay the Course.  For this manager, making sure that nothing ever makes it beyond the director of analysis is his number one goal.  This guy will talk incessantly about the good old days and how we just need to imitate what happened then to gain the same results today when the entire landscape around him has changed.  Any new idea is deemed too risky and a threat to the established way of leadership of this VP.

The VP of Stay the Course, often has a valuable consultant that he employs whenever an idea is so good that he needs extra energy to kill it.  We Have Not Done It That Way Before, LLC if often the consulting firm that is used.  The firm will charge a colossal amount of money just to warn the institution of the dangers of the unknown, which the company will gladly pay in order to stay safe.

Across the organizational chart for the VP of Stay the Course is the VP of Status Quo.  This individual is happy with how things are and often consults with his colleague, Stay the Course.  You can often see the two of them plotting together on the golf course on how to keep things exactly as they are.  Status Quo manages two different individuals.  The Director of Bureaucracy reports to him with different rules and regulations that must be followed, forms filled out in triplicate, submissions of requests that have to pass through five different levels of management, and rulebooks that are measured in feet of thickness.  The Bureaucrat has a co-director who enforces the rules called the Director of Rigidity.  This individual is one who will enforce every rule possible with what employees wear, where they park, what can be and cannot be on their office wall, to how the walk, talk, eat, chew and breathe.

Stay the Course and Status Quo also have another co-vice president, the VP of No.  In order to make sure that he has adequate information in order to kill an idea he uses information from his subordinate, the Director of Onerous Reporting.  This guy’s office is next door to the Director of Analysis Paralysis as he often supplies information and reports to him.  Often the mountains of information provided by Onerous Reporting do not matter.  Yet they are provided to keep him employed. Any good idea from the staff will get buried in the reporting, only to be stopped by No.

Overall the leader of the VPs is the leader of the entire organization, the Chief Idea Killer.  This individual’s goal is to eliminate any really good new idea that slips through the cracks of No, Status Quo, and Stay the Course.  Sometimes, this leader will wonder why no new results are reached by the organization when the same things are tried over and over and over.  This is the definition of insanity. 

So are any of these people running your organization?  Perhaps you see yourself in some of these positions.  How can you best position yourself and your organization to take on the growth potential that comes from new ideas?

Live by the Concentration, Die by the Concentration

I once had to review a line of credit renewal for a business that manufactured home improvement materials (siding, gutters, weather stripping, etc.). The business was doing very well and then tanked, and the previous underwriter said the recession was to blame. Upon reviewing the financials, it was obvious to me the company saw a slow-down during the recession but continued to operate profitably. Later on, an extreme drop in revenue came well after the recession.

I had an opportunity to sit down with the company officers and talk to them about this phenomenon. As they explained it, they had one major corporate buyer for nearly all their products, and that company decided to switch suppliers. And just like that, the borrower lost the majority of its business overnight and failed to operate profitably since.

When we look at financing businesses, it is not enough to know how effectively the business operates; we also need to understand who they are selling to. If a business has a concentration of sales to a single customer, then that customer presents a unique credit risk to the business, which means it becomes a credit risk to the credit union as well.

Part of the underwriting process should be to check for customer concentrations. Generally, a concentration is usually any customer that makes up 10% of sales or more. A customer concentration alone is not necessarily a bad thing, but it means that further underwriting considerations are needed. The big question we must ask is, whether the business could reasonably deal with a loss of one or more of their customers with whom they have a concentration? And, is there any information we have that speaks to the financial wherewithal or credit worthiness of that customer?

Red flags arise when the business is overly reliant on the concentration of sales, especially when the business is providing a specialized product or service for which there would be no other demand outside of the customer with the concentration. Take, for example, someone doing consulting for NASA that specializes in the space shuttle. When NASA no longer has use for the space shuttle, that consultant will not have a use either, and the consultant will have nobody else to provide that specialized support to.

The most common way to check for customer concentrations is to request an accounts receivable aging report. This will provide a list of customers, how much they owe, and when the customer was billed. From this list, you can see if one customer’s billings tends to comprise a significant amount of total billings, which would indicate a concentration. Another way is to obtain a backlog report of work orders or contracts to see what works.

Just like most underwriting, the question that needs to be answered is what will happen in the worst case scenario. If the borrower loses a customer concentration or fails to collect from that customer, what will ultimately happen? Can the business remain profitable without the concentration? Does the business have the equity to absorb the loss? Does the guarantor have the personal resources to prop up the business if need be? If the answer to all of those questions is “no”, then your ultimate source of repayment is too heavily dependent on a customer concentration.

How Successful is the War on Poverty?

The US Census Bureau released its annual poverty report last week.  The report marks the 50th anniversary of President Lyndon Johnson’s War on Poverty.  Since the beginning of those government programs, US taxpayers have spent over $22 trillion, in constant 2012 dollars, on anti-poverty programs.  Adjusted for inflation, this spending, which does not include Social Security or Medicare, is three times the cost of all military wars in US history since the Revolution.  Note this amount is also greater than the total national debt.

The official poverty rate was reported for 2013 as 14.5% of the population.  It is interesting to note that this rate was virtually the same in 1966, two years after Johnson launched his programs.  Since the mid 1960s, poverty has ranged from a low of around 12% to a high of 15%.  It seems to rise by a few percentage points when the economy slows and drop by a few when the economy increases. 

Robert Rector and Rachel Sheffield of the Heritage Foundation, point out in a recent report that the static nature of poverty is perplexing because the poverty rate fell dramatically before the War on Poverty began.  In 1950, the poverty rate was 32.2%.  By 1965, the first year the programs started, the rate had already fallen to 17.3%.  The puzzling fact is that the rate has not changed while means tested welfare spending has soared.  In 2013 the federal government ran over 80 different welfare programs that provided cash, food, housing, and medical care among other services to low income Americans.  Over 100 million people, nearly one in three Americans, received benefits from at least one of the programs.  Poverty spending totaled $943 billion in 2013 at an average cost of $9,000 per recipient. 

Today, adjusting for inflation, 16 times more money is spent on poverty programs than when the War on Poverty started.  As the spending has soared progress in reducing the poverty rate has stopped.  Part of this is because of how the Census Bureau counts poverty.  A family is poor if income is below a certain threshold.  But the Census Bureau leaves out nearly all government means-tested spending on the poor as income.  This trick makes it so welfare programs could grow infinitely while poverty remains unchanged. 

But this also understates the living condition of people in poverty in the US.  According to the Federal Government, 80% of poor households have air conditioning; before 1963 only 12% of the entire US population had AC.  Almost 75% of the poor have a vehicle and 31% have two or more.  66% have at least one DVD player.  Over 50% of poor families with children have a video game system.  The average living space of a poor person in the US, exceeds the average space for the average income person in Sweden, France, Germany, and the United Kingdom. 

According to figures from the USDA, America’s poor and middle class children consume virtually the same amount of protein, vitamins, and minerals.  Most poor teenagers today are one inch taller and 10 pounds heavier than the average GI who stormed the beaches of Normandy in WWII. 

I don’t think the results from Johnson’s War are what he anticipated.  He stated, “We want to give the forgotten fifth of our people opportunity, not doles.”  He said the war would make “important reductions” in future welfare spending.  The goal was to make “taxpayers out of taxeaters”.  Basically, the percentage of Americans that are not self-sufficient has not changed over the past 50 years in spite of large amounts of government spending that was designed to eliminate poverty.

So what happened for us to spend all this money and yet not be able to move the needle toward more self-sufficiency?  Education has played a role.  High school graduation rates have largely plateaued after 1970.  This is during a time when most careers require more education and training.  For example, a person could make a decent living ratcheting lug nuts on tires as the cars traveled down a Detroit assembly line in 1970. Today, that job has been replaced by robots.  There is a growing divergence between the rich and poor in the world economy today.  Those with the skills and education in demand will succeed.

During this time, there has also been a slowdown of wage growth among low-skilled male workers but there has also been an increase in wages among women.  Another factor that has seemed to contribute to increased poverty has been a decline of the American family unit.  In 1965, only 7% of children were born outside of marriage, today that number is over 40%.  As the welfare state has expanded, marriage has stagnated and single parenthood has soared.

Now, I realize that any single parent run household has their own path of how they came to the place where they are at today.  Single parents have one of the toughest jobs there is.  (I realize how tough it is to manage kids with two parents!)  These comments are not designed to criticize any person’s position in life.  This is just to make some general overview comments.  According to the Census Bureau, single parent families are twice as likely to be in poverty as families with married couples.  One may conclude that the growth of single parent households has contributed to the stagnation of improvements we have hoped to see in the poverty rate. Also, as means-tested welfare benefits were expanded, in some communities, welfare became a substitute for having a husband at home, according to the Heritage Foundation.

The church we go to have a lot of programs to help people in our community that are struggling.  These deal from helping them break addictions, to fixing cars of single parent and poor families, to working with those incarcerated.  One thing that is mentioned is to avoid giving “toxic charity”.  Constantly giving someone a handout where they are dependent upon you is toxic.  Teaching that person a skill so they can eventually become self-sufficient, as President Johnson envisioned, is truly helping.

At the 50th anniversary of the War on Poverty, it appears a lot of the money we have spent as a country could be categorized as toxic charity.  The benefits have moved from becoming a safety net to a hammock for some people.  Many of the programs have discouraged work.  They have also taken away the core desire in each of us to work, create, and achieve great things. 

There is no denying that we need to have ways to help those in our country who are in need.  There is also no denying that things are tough in our economy as the median family income is lower today than it was before the recession.  The questions are how should we change these government programs so they are more effective.  Finding ways to unshackle businesses from the burdensome government taxes and regulation so more productivity will occur and people will get jobs is a start.  Welfare programs for able-bodied recipients should require education to move them off the program and also require work.  Anti-marriage penalties should be removed from welfare.  We also need more non-profits, churches, and communities to step-up as assistance at the local levels is more efficient than Washington mandates.  The success of the program should be defined by how many people move off the welfare system to self-sufficiency, as Ronald Reagan once said.

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.