New Year's Resolutions

The New Year is right around the corner, and no doubt many of us are wondering how to make 2015 better than past years. Many of us pledge we will make improvements to help better our quality of life.

Losing weight is the most common resolution, followed closely by managing money better and improving relationships with others.

A study and statistics compiled by University of Scranton Journal of Clinical Psychology recorded the following Top 10 resolutions:

1. Lose Weight
2. Getting Organized
3. Spend Less, Save More
4. Enjoy Life to the Fullest
5. Staying Fit and Healthy
6. Learn Something Exciting
7. Quit Smoking
8. Help Others in Their Dreams
9. Fall in Love
10. Spend More Time with Family

http://www.statisticbrain.com/new-years-resolution-statistics/

How successful will people be with their New Year’s resolutions? The University of Scranton indicated 75% are able to maintain their resolution through the first week of the year, and that will fall to 71% by the second week of the year. By the six-month mark, 46% are still keeping with their resolution. Ultimately, only about 8% of people actually report success with achieving their resolution.

Age apparently has a bearing on your success in achieving your resolution too. The report also finds 39% of people in their twenties report achieving their resolution each year, and people over 50 years report a 14% success rate.

New Year’s resolutions aren’t for everyone though. Only about 45% report making resolutions regularly as part of their New Year’s tradition. Actually 38% of people report that they never make a New Year’s resolution!

Lastly, the same report also indicated that people who make resolutions are 10 times more likely to attain their goals than people who don’t make resolutions. This would seem to indicate that the practice of making a resolution does serve an important purpose, because it helps people set goals and gives them starting motivation to go after them!

A Different Christmas Poem

A Different Christmas Poem

We at Midwest Business Solutions wish you a Merry Christmas and a Blessed New Year!  This season of the year is exciting as we celebrate the birth of our Savior and prepare for the adventures that await in the coming year.

A friend of mine shared this poem with me that I am now passing on to you.  This is in honor of our Military, who provided us the liberties and luxuries we currently experience at this time.  The poem was originally written by LCDR Jeff Giles, SC, of the USN, 30th Naval Construction Regiment.

The embers glowed softly, and in their dim light,
 I gazed round the room and I cherished the sight.
 My wife was asleep, her head on my chest,
 My daughter beside me, angelic in rest.
 Outside the snow fell, a blanket of white,
 Transforming the yard to a winter delight.

 The sparkling lights in the tree I believe,
 Completed the magic that was Christmas Eve.
 My eyelids were heavy, my breathing was deep,
 Secure and surrounded by love I would sleep.
 In perfect contentment, or so it would seem,
 So I slumbered, perhaps I started to dream.

 The sound wasn't loud, and it wasn't too near,
 But I opened my eyes when it tickled my ear.
 Perhaps just a cough, I didn't quite know, Then the
 sure sound of footsteps outside in the snow.
 My soul gave a tremble, I struggled to hear,
 And I crept to the door just to see who was near.

 Standing out in the cold and the dark of the night,
 A lone figure stood, his face weary and tight.
 A soldier, I puzzled, some twenty years old,
 Perhaps a Marine, huddled here in the cold.
 Alone in the dark, he looked up and smiled,
 Standing watch over me, and my wife and my child.

 "What are you doing?" I asked without fear,
 "Come in this moment, it's freezing out here!
 Put down your pack, brush the snow from your sleeve,
 You should be at home on a cold Christmas Eve!"
 For barely a moment I saw his eyes shift,
 Away from the cold and the snow blown in drifts..

 To the window that danced with a warm fire's light
 Then he sighed and he said "It’s really all right,
 I'm out here by choice. I'm here every night."
 "It's my duty to stand at the front of the line,
 That separates you from the darkest of times.

 No one had to ask or beg or implore me,
 I'm proud to stand here like my fathers before me.
 My Gramps died at ' Pearl on a day in December,"
 Then he sighed, "That's a Christmas 'Gram always remembers."
 My dad stood his watch in the jungles of ' Nam ',
 And now it is my turn and so, here I am.

 I've not seen my own son in more than a while,
 But my wife sends me pictures, he's sure got her smile.
 Then he bent and he carefully pulled from his bag,
 The red, white, and blue... an American flag.
 I can live through the cold and the being alone,
 Away from my family, my house and my home.

 I can stand at my post through the rain and the sleet,
 I can sleep in a foxhole with little to eat.
 I can carry the weight of killing another,
 Or lay down my life with my sister and brother..
 Who stand at the front against any and all,
 To ensure for all time that this flag will not fall."

 "  So go back inside," he said, "harbor no fright,
 Your family is waiting and I'll be all right."
 "But isn't there something I can do, at the least,
 "Give you money," I asked, "or prepare you a feast?
 It seems all too little for all that you've done,
 For being away from your wife and your son."

 Then his eye welled a tear that held no regret,
 "Just tell us you love us, and never forget.
 To fight for our rights back at home while we're gone,
 To stand your own watch, no matter how long.
 For when we come home, either standing or dead,
 To know you remember we fought and we bled.
 Is payment enough, and with that we will trust,
 That we mattered to you as you mattered to us."

As we spend time this year warm with family and friends, remember those who have chosen to be away from the comforts of home and serve to protect us.  We owe them a debt of gratitude. 

Blue Sky and Goodwill

Christmas is almost here, and it is that time of year where we hear a lot about goodwill and giving. You may have come across goodwill as an asset on a balance sheet before, and often wondered what it meant. Has the CU or business done something good for someone that it can count as an asset? That all depends on how you look at it.

In the world of finance, goodwill is an accounting term. We need to remember that Assets = Liabilities + Net Worth. Goodwill results when more money is exchanged than the total assets being purchased. In other words, say a company has $3 million in assets, but somebody buys that company for $4 million. The company will then report $1 million of its assets as goodwill. Sometimes, that $1 million is also referred to as “blue sky” above the book value. But, what was technically purchased for $1 million, or why would someone want to pay more than what actually exists?

We know that a company is not simply a balance sheet alone. A company has the ability to generate income. That income stream may be more desirable than the actual book value of assets. A company may also have recognized brand or a strategic market position. Or, a company may own a patent, a client list or rights to services or products. These are challenging items to put a price on, and often, their value isn’t readily reflected on a balance sheet. They could all be reasons why someone may want to pay more for a company than its actual book value.

But, we need to be careful about how much value is assigned to goodwill. Just because someone is willing to pay above book value for a business may not mean another person is willing to do the same. A frequent criticism is the current owner is usually the added value behind the business, and when that owner sells, often that added value is lost. Does that mean if a business starts to perform poorly after it is purchased with goodwill, that the goodwill should be charged down? Well, that depends.

It used to be the case that goodwill was expensed through amortization, just like how capital assets are expensed through depreciation. However, accounting rules have more recently changed so that goodwill can only be expensed if there is a measurable impairment in the value of that business. For financial institutions and regularly audited companies, it is best practice to have this impairment test done annually. Various accounting firms can be charged with this task.

The NCUA has weighed in on the matter, noting that goodwill cannot be considered as an acceptable form of collateral. Goodwill does not necessarily mean the business itself is marketable collateral, and so no matter the perceived value of the business, credit unions must demonstrate there is other tangible collateral securing any business loan request.

So does goodwill mean that something good was done?  Perhaps. The seller certainly benefits from the transaction, but they have to consider whether what was sold was worth cashing out from. But, whether someone can capitalize charitable giving, contributions, or acts of kindness; sorry, those are expenses that must run through your P&L!

What is Going on with Oil Prices?!

As you might expect, it’s complicated. Oil is a global commodity, and the price of it affects nearly everything we purchase and consume. And you have probably heard that it is dropping like a sky diver whose shoot won’t open. Is this true, how bad is it, and most importantly, why?

First, I should state I am not a commodities analyst, but today I will pretend to play one. Let’s first consider where the price of oil has been, and where it is now. Most oil in the US is tracked by the index for West Texas Intermediate (WTI) oil. In the last twelve months, WTI peaked at nearly $100/barrel and has since fallen into the mid $50/barrel. While swings like this are not unheard of, the last time WTI was around $50/barrel was back during 2009 in the depths of the recession. Also, this really hasn’t been so much a price swing as it has been a gradual 6-month decline.

The decline in price, as far as I can tell, can be tied to three things: Supply, Demand, and Currency. The supply of oil right now is ample, and this has much to do with fracking revolution. Now that many new oil fields in North Dakota and Texas have been developed due to fracking, there is more oil production in the world. This comes at a time when demand is pulling back, because globally, most of the world’s countries are not growing as much as previously anticipated. China, Japan, and the European Union are all experiencing sub-par growth, so their energy needs are not growing as rapidly as forecasted.

That leaves us with the last issue, currency. The one major piece of the global economy that is growing is us! The United States is finally realizing nominal growth, not seen since 2009. This is impacting our currency, in particularly, driving up the price of the dollar. The dollar is currently crushing the other major world currencies, and the strength of the dollar is returning to a pre-2009 level when compared against the Euro or the Yen. Why does this impact oil prices? Oil is priced in dollars, and so when the dollar is strong, it buys more oil!

Fear mongers are abound, screaming the price of oil may hit $40, no $30, no $25 dollars a barrel! While they have no evidence to support their claims, they sure get plenty of attention, like someone shouting “fire!” in a crowded movie theater. The facts are, the price of oil seemed to be quite expensive in the past 5 years as it hovered around $100/barrel. Fracking technology supplied the world with additional oil, and yes, there was great incentive to do so at $100/barrel. And as we know in economics, more supply will push down prices.

But, logic would also seem to indicate that fracking isn’t going to oversupply the market until fracking isn’t feasible. Rather than seeing fracking disappear, the price will balance out fracking production so it is done efficiently and deliver oil at a price the market will tolerate. This isn’t a bust in the traditional sense, because the oil isn’t drying up; there is just too much of it all of a sudden.

This is bad news to weak companies who were only in the game because of the high prices and could only live off their cash flow and not their own equity. Other companies, which have made more wise investments, will still be able to produce at some price between $50 to $100 a barrel, and they have the financial strength to sit back and wait for the market to figure it out.

It appears the “rush” may be coming to a close, but the fracking and oil production is here to stay. Now the maturing Bakken oil fields will come to settle into their niche in the global market, and this market correction may give wary North Dakota and Montana communities a little time to catch up with their growth.

The High Bar of Client Expectations

This Christmas season, as you are in line at the Starbucks or waiting on the clerk at the department store, think for a minute as how demanding you are as a customer.  Typically I am usually happy-go-lucky but there are times when I am in a hurry or am having a bad day that I can be a real pill of a customer.  I also can get testy if the person serving me just is not giving the effort for good service that I expect. 

That is the same way your clients and members are toward you as a financial institution.  We all know that no matter how hard we try, at times, events happen, whether in or out of our control, where we fail to meet the high bar of customer expectations.  So what happens then?

Leo Colborne, VP of EMC Corporation quoted, “Customers with problems have to go through a healing process before they can move on.  The goal is to get the customer to say, ‘I’m really not happy about what happened, but I can’t thank you enough for the support you provided to get me through it.”  This is an interesting and true way of what happens when one of your member is let down.  It will happen.  The important thing is what actions you take when this happens.

Clients have certain expectations of customer service.  A study by Cooper and Associates, came up with the top ten expectations of bank retail customers.  Even if you are not in the retail side, these will still apply to you.

1.       Being called back when promised
2.       Receiving an explanation of how a problem happened
3.       Knowing who to contact with a problem
4.       Being contacted promptly when a problem is resolved
5.       Being allowed to talk to someone in authority
6.       Being told how long it will take to resolve a problem
7.       Being given useful alternatives if a problem can’t be solved
8.       Being treated like a person, not an account number
9.       Being told about ways to prevent a future problem
10.   Being given progress reports if a problem can’t be solved immediately

A few of these stick out to me.  Knowing who to contact and being allowed to talk to someone in authority is important.  When you call your office, are you greeted with a person or some system that requires 10-20 different entries on your phone to finally get to a voicemail box and having to leave a message for someone deep in the bowels of the organization?  Another thing is if you are dealing with a problem, take responsibility to fix it as much as you can.  Don’t shift blame to someone or something else.  Truitt Cathy, CEO of Chick-Fil-A has a sign in his office that says, “If it’s meant to be, it’s up to me.” 

Successful repair of the relationship requires that you fix the person first, and then fix the problem.  If your folk focus quietly on correcting the problem without dealing with any emotional damage to the person, you are leaving the message that your product is not reliable, but it can be fixed if one gripes about it.  People lose a little faith in your company when there is a problem that is not addressed.  It is also important to allow the customer to vent and explain his frustration before beginning to fix the problem will go a long way in repairing the emotional relationship.

Your work should always be done in the spirit of partnership.  Those of us in credit unions have a leg up on this if we view our institution as a partnership between members and employees.  We are all in this together.  When there is a problem, if there are actions the member could take to avoid parts of the problem in the future, share that with them.  This should never be done in an accusatory sort of way but with a spirit of we are all on the same team.

Recovering from a service failure is a planned process.  You should have steps in place that are created and agreed upon by your team on how to respond when there is a failure.  Performance Research Associates book, Delivering Knock Your Socks Off Service, list two big benefits to a well-planned and well-implemented recovery process:  the quality of the solutions offered and the skill of the people offering it.  Of these, people remember the people more than they do the solution. 

Jeff Bezos, founder of Amazon.com said “You can’t guarantee that you will never make mistakes. You can guarantee that you will fix them.”  It is important to realize that any encounter with a disgruntled client is an opportunity to deepen the relationship.  The next move is up to you.

Pricing to Meet Your NIM Threshold

We get a lot of questions about how to determine the price on a loan.  One of the easy places to start is to price a loan to meet or exceed your Net Interest Margin of your institution.  This method is simplistic, and does not account for operational expenses or provision for loan loss reserve, but it does provide a starting point to provide some discipline to your loan pricing.

Net interest margin (NIM) is simply the average interest rate you receive on your assets less the average interest rate you pay on your liabilities.  Assets include both loans and investments for your institution.  Liabilities include deposits and any borrowings.  If your institution is heavy into investments like government securities and agencies, your income on earning assets is probably low since these items are viewed as less risky than loans.  Once you have your NIM, you know a target threshold for your institution needs to meet on a loan in order for an incremental NIM improvement to occur as a result of the new loan.

The next step is to consider the cost of funds.  You may already know this for your institution, but I would suggest that a better method is to pretend that you have to borrow the money for that loan and then are making money on the spread between what you borrow the money for and what you lend it at.  I had a boss once who said that we make money by borrowing and renting out small pieces of paper with pictures of dead presidents and founding fathers on them.  The success you will have is tied directly to the spread.

There are several different measures you can use for calculating a cost of funds.  I would suggest using an index that can correspond to your cost of funds.  Some possibilities are the US Treasury rate, Federal Home Loan Bank’s Cost of Funds or London Interbank Offered Rate (LIBOR).  Of these three indexes, it seems that US Treasuries have depressed rates in times when demand for US Debt is high.  This may artificially lower the rate and show a lower cost of funds than what you experience in your institution.  The following is a current listing of the variations in the interest rates among these three as of December 8, 2014:

Note that of the three, currently the FHLB is currently at the higher one.  I would suggest if you insist of using a US Treasury then you may want to look at a higher margin.  So select a maturity that matches the repricing term of your loan.  An example is if you have a loan that will reprice in 5 years, you will select a cost of funds rate that has the same maturity, i.e. 5 year Treasury, LIBOR or FHLB.  This becomes your cost of funds. 

If your institution has a NIM of 3% now, your 5 year loan, based upon LIBOR as cost of funds, needs to be at 4.73% or higher to create an improvement to your NIM.  So is there any reason to close a loan that has lower NIM than your current one?  In some cases yes.  Perhaps you have a borrower who keeps an average of $250K in a deposit account that pays no interest and this customer is borrowing a $1MM for 5 years.  You could think of this as having $750K at your 5 year COF base and the remaining $250K at a COF of 0%.  Using the LIBOR index, you would have a blended COF of 1.30% on the loan. You could effectively price the loan lower and still maintain profitability due to the increased business you have with the client.  Remember, your goal is relationships, not just transactions.

Again, this method is very simplistic and does not take into account many other factors.  If your NIM is adequate but you are paying another $10,000 of third party costs, your profitability will suffer.  If your NIM is slightly below the threshold but you are getting some hefty origination fees, you may have more net income.  The purpose of the NIM pricing is to instill some discipline in pricing to make your institution more successful.

Dealing with the Unpredictable

As some of you may have heard, famed statistician Nate Silver released an analysis last week titled “Which City Has the Most Unpredictable Weather?” which can be found at http://fivethirtyeight.com/features/which-city-has-the-most-unpredictable-weather/ .

The study revealed information most of us long knew. “Among the cities we tested, the one with the most unpredictable weather is … Rapid City, South Dakota. Congratulations, Rapid City! The ICAO code for Rapid City Regional Airport is KRAP. That’s also a good description of Rapid City’s weather. Its temperature might be 30 degrees in January — or just as easily -12. It’s snowy and windy and prone to big, unexpected winter storms. And it has a thunderstorm on almost 25 percent of days from July through September, more than the national average.”

While Silver may describe Rapid City’s weather as “krap,” its residents readily point out the location enjoys the mildest winters of all the Dakotas. While the Black Hills can make the weather a crap shoot, (an appropriate pun given the passage of Amendment Q?), it does make the city’s climate generally warmer in the winter.

Among the other top ten cities with the most unpredictable weather were Sioux Falls, Fargo, Bismarck, and Aberdeen.

While the rest of the country wonders how we do it, for most of us, it has just always been a way of life. While the weather can be downright dangerous at times, it can be managed around or managed with, by employing common sense.

While living in Pierre, one year I had to fly out to Washington DC in February as part of work. At the time, it was cold in Pierre, but there was no snow cover. Before I went to the airport, I grabbed a snow shovel and put it in my trunk, just in case things changed. When I flew back into Pierre later in the week, the area had been hit by a snow storm, and my car was snowed in at the Pierre airport. I was prepared, as all I had to do was open up my trunk, and I had access to a snow shovel so I could dig myself out!

This reminds me of what Lloyd Blankfein, the CEO of Goldman Sachs once said, "Most risk management is really just advanced contingency planning and disciplining yourself to realize that, given enough time, very low probability events not only can happen, but they absolutely will happen."

Of course, that is all most business lending turns out to be, which is advanced contingency planning. Plan A is getting repaid the way you expect if everything works out as planned, but it behooves you to have a Plan B if something unexpected happens. Almost no business loan makes sense to do, unless you have a snow shovel in your trunk in case the “krap” hits.

Business Loans Are Not Only for Businesses

We tend to think of business lending (or commercial lending) as providing loans to finance a business or a farming operation. While anything having to do with business and agriculture is quite broad, it is still somewhat limiting.

I tend to think of business lending as any type of lending that is not consumer lending. This makes the concept of business lending broader and doesn’t just stop with businesses and farming. This can include governments, non-profits, co-ops, etc. If a consumer loan won’t work, there is probably a business loan solution to it, even if it isn’t technically a business.

Co-ops may not seem like business lending targets, but you should seriously reconsider your thinking. In the Dakotas particularly, many co-ops are large with healthy balance sheets and ample liquidity. These same co-ops may also want to finance large capital expenditures or even want an operating line of credit. And best of all, they tend to be better governed than typical businesses, since the shareholder base is diverse.

Much like co-ops, non-profits can have strong financials as well. What you will find with non-profits and co-ops is that their financial reporting and business cycle may be somewhat unfamiliar. They will abide by different accounting standards, which are driven by what their charter will and won’t allow them to do. Many assets may be restricted, temporarily restricted, or unrestricted for certain purposes. And on the income side, you will see a similar delineation of accounts. Also, income may be “lumpy,” meaning it tends to be inconsistently timed. Non-profits, engaged in direct charity, may show a net income loss for most of the year, and then an enormous revenue spike in December during the “giving season”.

In my career, I’ve helped non-profits finance great real estate assets, which represented acceptable lending risks that were “no-brainers”. And some were great guarantors as well, with good balance sheets and income statements. On the C&I side of lending, I helped underwrite a loan to the airline trade association to help modernize the national airline reservation system. Again, based on the financials, it was no-brainer, but not the type of request that first comes to mind when you’re thinking of business loan opportunities.

Financing government can be another great opportunity. Again, broaden your thinking. Even local government can be quite diverse. This may include loans directly to specific city departments, or to the entire city, or county, or even the State. Sometimes, these governments help create economic development authorities, in which the government may or may not have an obligation to help repay any borrowings. And, the financial accounting will be different for governments too. Despite the special considerations, there can be great lending opportunities if the obligor has strong financials and a project that makes sense.

A credit union should never have to send a member or a community organization down the street to the local bank. If the credit union encounters a loan request they are unfamiliar with, talk to us, because our CUSO was founded to address these kinds of problems. And don’t be afraid to broaden your lending opportunities too, because non-profits, co-ops and governments can be great business lending targets.

The Do's and Don'ts of Financial Spreading

A major part of credit analysis is reviewing financial information. Many businesses will provide information from their own personal bookkeeping, while others may enlist accountants to produce highly refined statements and audits. No matter the quality of these statements, decision makers want to be able to quickly identify the risk and act decisively.

Financial spreading is the most common way an organization relays the risk to a decision maker efficiently. Spreading is an organization’s process of standardizing the presentation of financials, while also identifying major risks apparent in those statements. The “spreads” can be done on vendor software or on an internally designed system, such as a spreadsheet. Major spreading goals often include segregating current assets and liabilities from their non-current counterparts, segregating tangible assets from intangible assets, and identifying significant accounts that aren’t readily understood. On the P&L side, spreading aims to segregate gross profit activity from operating profit activity, cash events from non-cash events, and also identifying significant income sources and expenses that are not readily understood.

The aim of spreading financials should not be to alter the statement in any material matter, but restate the financials in a more useful format. Thus, all financial spreads should “foot” to their original documents. Total assets, liabilities, and net worth should be the same on the spreads as they are on the provided statements. If any significant adjustment is required, it should be well-documented.

The income statement should also foot to the original statements. And, the income statement should be reconciled to the balance sheet. If a business yielded a $1 million net profit, then the net worth of the business should have increased by $1 million. If net worth does not reconcile, an explanation should be sought. It is not uncommon for a business to make distributions or receive contributions, which directly impact net worth and are reasonable adjustments to make to net worth. If net worth cannot be reconciled to the income statement with a reasonable explanation, then there is unexplained balance sheet activity, and a red flag should be raised.

Like all analysis tools, spreads are not a one-size-fits-all tool. Financial spreads are commonly used to evaluate commercial and industrial activity, more commonly referred to as C&I. In these spreads, the aim is to understand leverage, liquidity and profit margins. These spreads will be unhelpful in evaluating commercial real estate (CRE) loans, in which we are more concerned with loan-to-value, net operating income and changes in market rents. While less common, there is special software that spreads real estate financial information. Even agriculture will likely have special spreading considerations, because it is important the decision maker understands the quantity and price of the current marketable assets on the balance sheet for the spreads to be of any use. This would suggest C&I and CRE spreads wouldn’t be adequate in analyzing agriculture.

To summarize, spreading is done to standardize how an organization tracks and reads financial statements. Spreading may involve re-categorizing accounts, so a business can be more easily evaluated, but spreads should still foot to their original source documentation. Reconciling income statements to the balance sheet are especially important, because it is an indicator of whether all financial activities are accounted for. And lastly, it is important to know not all spreading software will be useful for all financial statements reviewed. Most software is built for C&I information; whereas, CRE and agriculture will have their own special spreading requirements.

Washington's Thanksgiving Proclamation

Our country has a rich heritage of the Thanksgiving holiday, which we will celebrate this week.  Most of us know of the first Thanksgiving, which happened with the Pilgrims in Plymouth Colony.  After that event, Thanksgivings were pronounced throughout the colonies by local and individual colonial-level officials.  These usually were done after a victory in a battle or the harvest season.  Thanksgivings were marked by feasting, worship services, and a spirit of acknowledgement of God as the source of all blessings.

Thanksgiving proclamations started with our very first president, George Washington, in the very first year of his presidency.  The president set a non-sectarian tone for these devotions and stressed political, moral, and intellectual blessings that make self-government possible, in addition to persona and national repentance.  Below is the text of his proclamation what was issued at the request of Congress on October 3, 1789.

“By the President of the United States of America, a Proclamation.

“Whereas it is the duty of all nations to acknowledge the providence of Almighty God, to obey His will, to be grateful for His benefits, and humbly to implore His protection and favor; and—Whereas both Houses of Congress have, by their joint committee, requested me “to recommend to the people of the United States a day of public thanksgiving and prayer, to be observed by acknowledging with grateful hearts the many and signal favors of Almighty God, especially by affording them an opportunity peaceably to establish a form of government for their safety and happiness:”

“Now, therefore, I do recommend and assign Thursday, the 26th day of November next, to be devoted by the people of these States to the service of that great and glorious Being who is the beneficent author of all the good that was, that is, or that will be; that we may then all unite in rendering unto Him our sincere and humble thanks for His kind care and protection of the people of this country previous to their becoming a nation; for the signal and manifold mercies and the favor, able interpositions of His providence in the course and conclusion of the late war; for the great degree of tranquility, union, and plenty which we have since enjoyed; for the peaceable and rational manner in which we have been enabled to establish constitutions of government for our safety and happiness, and particularly the national one now lately instituted; for the civil and religious liberty with which we are blessed, and the means we have of acquiring and diffusing useful knowledge; and, in general, for all the great and various favors which He has been pleased to confer upon us.

“And also that we may then unite in most humbly offering our prayers and supplications to the great Lord and Ruler of Nations, and beseech Him to pardon our national and other transgressions; to enable us all, whether in public or private stations, to perform our several and relative duties properly and punctually; to render our National Government a blessing to all the people by constantly being a Government of wise, just, and constitutional laws, discreetly and faithfully executed and obeyed; to protect and guide all sovereigns and nations (especially such as have shown kindness to us), and to bless them with good governments, peace, and concord; to promote the knowledge and practice of true religion and virtue, and the increase of science among them and us; and, generally, to grant unto all mankind such a degree of temporal prosperity as He alone knows to be best.

“Given under my hand at the City of New York the third day of October in the year of our Lord 1789.-- Go. Washington”

We at Midwest Business wish you a happy Thanksgiving. 

Return on Assets : How Well Does Your Institution Fare?

One of the standard methods of measuring financial institution performance is using the return on asset ratio.  This is an easy calculation made by dividing net income into total assets.  Net income starts with net interest income, or all interest income less interest expenses.  Non-interest income is added and non-interest expenses are taken out to reach a net income figure.  On the banking side, this number is calculated before income tax expenses. 

Net income is then divided into average total assets to reach a return on assets or ROA.  Basically, this tells the net return you make on your assets.  Credit Unions nationally average a ROA of 0.77%, according to the NCUA.  Banks had an average ROA of 1.44%, according to the FDIC website.  In our area of the country, some of the highest performing credit unions have ROAs that reach 1.60%. 

So why should you be concerned with the ROA of your institution?  After all, aren’t credit unions supposed to be not-for-profit?  True, but not-for-profit does not mean “no profit”.  Successful net earnings performance allows the institution to grow its capital base and also return more net profits back to the members.   A successful capital base and net earnings also allow the credit union to better serve its community and membership as well. 

So what should be a good target for ROA?  I would start with shooting for at least a 1% return on assets.  If you are already above 1%, aim to improve your ROA.  You should be cognizant of the factors that go into the calculation and understand how each item is impacted with the existing and new business that is added to the books. 

If your ROA is low, what is the cause?  There could be many factors to consider and to properly diagnose is similar to a financial institution check-up.  Start first with looking at the net interest margin of the institution.  How does the spread on what is earned on loans and what is paid on deposits compare to the industry and market area?  Could a problem be that there are too many low earning assets on the books?  Perhaps your firm has too much in non-earning assets like buildings and real estate in proportion to its loan portfolio.  Maybe you are known as being the cheapest place in the market to get a loan.  Maybe you are giving away the store to the point that the earning assets are not profitable. 

As a side note, I actually saw this on two different credit union’s websites in the past month.  They were advertising a deposit interest rate special that was higher than the rate they were touting for a new loan product.  Fund enough business on both sides of that equation will lead to insolvency.

Another balance sheet issue is how will your institution perform if there is a change in the rate environment?  If rates go up in 2015, how will it impact your net interest margin and profitability?  So when considering the balance sheet the level, rate, and duration of your earning assets and funding liabilities all come into play.

Other factors to consider are the non-interest income earned and non-interest expenses paid as the final components to reach the net income number.  Are you not only the cheapest place to get a loan in terms of interest rate but are you also paying all third party costs for the loan and not charging any fees to originate the transaction?  Do you not receive fees when they are expected in the market for your services?  Do you have higher than normal non-interest expenses? 

So as you see, finding the source of the problem for poor performance often leads back to low cash, low net interest margin, and low net profits.  There can be a multitude of causes for each of these items that must be researched and understood to accurately assess and also improve your shop.  Once you understand the performance of your CU, you can also determine the profitability, or lack thereof, of a new transaction.  That information can be used to see if there will be an incremental increase or decrease in ROA once the transaction is booked.  If you have questions, ask us.  We are here to help.

Leadership Starts with How you Put on your Socks

One of the greatest college basketball coaches was John Wooden of UCLA.  Wooden amassed 10 national championships, including 7 in a row; 88 consecutive victories; 38 straight playoff wins; 4 perfect seasons with only one loosing year - his first, in 41 years of coaching.  Wooden summed up his 10 championships in the formula 10 = C + F + U (Conditioning + Fundamentals + Unity).

Wooden was known for his attention to detail.  His leadership notes stated: “Leave nothing to chance.  The difference in the championship and merely a good team is often the perfection of minor details.”  Denny Crum told of his first day of practice with Wooden sat down all the players and had them take off their shoes and socks.  He did the same.  He then went through a careful demonstration of how to put on the socks, correctly to squeeze out the wrinkles and folds.  He wanted the socks to be smoothed out all the way to the calves.  He knew that socks that were not put on incorrectly could create blisters and blisters could hinder the performance of the player. 

For shoes, he had the trainer measure each athlete’s foot—right and left—to ensure the sneakers fit properly with no slippage.  On shoestrings, he showed players how to lace and tie them correctly so they would not come undone during a practice or a game.  When he arrived at UCLA, the school had no practice uniforms.  He had new practice uniforms ordered so players did not see sloppiness in themselves or each other.  Whenever they travelled as a team they would always wear a shirt and tie, coat, and slacks.  He not only wanted them to realize they were representing the university but also that being a UCLA Bruin was something special and they should conduct themselves accordingly. 

He stopped providing bits of chocolate at halftime to players because he determined it left phlegm in their windpipes.  He used orange slices which provided the same energy boost without the phlegm.  Phlegm, like shoestrings that come undone or lumpy socks, can cause a distraction, which leads to errors that can lead to losses.  At team meals, water was served at room temperature rather than ice cold to avoid the possibility of stomach cramps.  All these items add up.  It is not about being a perfectionist but being determined to constantly improve. 

The relevant details vary between sports, just like they do in business or in different organizations.  Wooden said the basics of success in leadership do not change much when it comes to the identification and perfection of little things and achievement of the big things we strive for.  Effective leaders find ways to identify pertinent details that may give an incremental advantage.  Success and not the devil, is in the details. 

The detail oriented focus must come with balance as it is easy to become over focused on one item at the expense of those that are truly important.  It is possible to focus so much on one small thing and perfecting it, that other more important items are missed completely.

For Wooden, success began with socks.  Make sure you teach your team to do the little things right.  There are no big things, only an accumulation of many little things.  Remove a rivet and it may not impact an airplane.  Remove enough of them and the wing will come off.  As a leader you have to identify the correct rivets and determine how much attention has to be given to each.  Once you have figured that out, seek to nourish the talent of your staff in the environment of perfected details.  It is then that new heights can be reached.  Always insist on doing things right as sloppiness breeds sloppiness.  A casual approach to executing the job details will make sure a job is done poorly.  Once one job is done poorly, it makes it easier to do the next job half-heartedly as well.

Wooden exemplified tremendous leadership and accomplished things in college basketball that we may never see duplicated.  He shows that leadership starts with how you put on your socks.

Is the Fed the Cause of High Stock Prices?

As the stock market continues to push to all-time highs, it is natural to wonder if stocks are in a price bubble. You may hear a lot of people point to the Federal Reserve as the cause of this bubble. Why is that?

The Federal Reserve has the ability to influence interest rates, which is how they try to regulate growth in the economy. Most people, governments and businesses borrow money, so interest rates touch all parts of the economy. When interest rates are low, we can afford to borrow more, which leads to more consumption and economic activity. When rates are high, we can’t borrow as much, so we buy less on credit and the economy slows down.

Since the last recession, the Fed has tried to keep interest rates as low as possible to spur economic growth. The Fed traditionally sets short-term rates for which banks and credit unions can borrow from the central bank. If financial institutions can borrow more cheaply, then they can charge lower interest rates to their borrowers.

The Fed even recently undertook an ambitious attempt to lower long-term rates by purchasing large volumes of long-term bonds, which was referred to as quantitative easing. When the Fed was willing to buy long-term bonds for cheap, it made interest rates for other long-term debt (like home mortgages) lower and more competitive; thereby, decreasing the cost of long-term borrowing in the hopes of making even more credit for big-ticket items cheaper.

Of course, the economy has not improved by leaps and bounds despite the Fed lowering interest rates. I like to use the following proverb to sum up the situation: You can lead a horse to water but you can’t make it drink! By making it cheaper to borrow, that still doesn’t mean people will borrow. The Fed cannot control how people spend money, it can only control how people borrow money (see http://www.mwb-s.com/blog/2014/9/18/monetary-policy-vs-fiscal-policy-why-the-fed-cant-fix-the-economy-alone).

Low interest rates is what investors fear are driving up the stock market. If debt (which includes bonds) have low interest rates, then their yield is unattractive. Worse, if interest rates rise, the value of fixed-interest rate bonds and debt will decrease further. Investors will wait until debt with higher interest rates are issued, and then lend their money. If investors dislike low yield and fear the price of bonds will decrease if interest rates move, then they are going to park their money in the next best thing: stocks!

The belief is investors are biding their time by investing in the stock market until interest rates rise. If inflation were to pick up because of the liquidity from the Fed buying all the long term bonds, then stock prices would go up too. If inflation picks up, interest rates will rise, and the value of existing bonds and debt will get worse. Now it is easy to see why the stock market looks like a pretty attractive place to put your money right now, and if everyone wants to put money there, the value of those stocks will increase because of that.

The real question to consider is what will happen to stock prices when the Fed finally takes action to increase interest rates? The Fed started to slow its last round of quantitative easing starting in June 2013 and finally stopped purchasing long-term bonds in October 2014. The stock market grew throughout that whole time, but people are still concerned what will happen when short-term rates rise.

How Long does it Take to Fund a Commercial Loan?

Often, we are asked how long it will take to close a loan. Like all things in life, it depends. If your member asks you this, it is a great opportunity to educate them on the process, so they understand what pitfalls may create hang-ups in getting to the finish line.

First, terms of the loan need to be agreed to. If terms have not been agreed to, the best answer as to when we can close may be never! Simply put, we aren’t even sure if we have a loan we want to close on, until the borrower and lender are in agreement with things like interest rate, maturity, amortization, etc. Then, how long will it take to close on a loan after terms have been agreed to? Well, it depends!

The next hurdle to get over is underwriting. The agreed upon terms are used to process the request and make sure the request is possible, given the proposed terms. In a perfect world, underwriting would only take a couple days, but rarely does. Why is that?

One issue tends to be availability of information. If the underwriter needs to wait on the borrower to provide info, then the underwriting process gets stretched out. Another issue has to do with the experience of the underwriter. If the request is for something the underwriter has little expertise, then the underwriter will need time to research and educate himself or herself. That could take several weeks. And then, there is always the issue of the availability of the underwriter, who may have other requests to complete first.

Now, assume terms have been agreed to and the underwriting has been completed. How long will it take to close? Well, that all depends! The good news is, the finish line is now in sight. If it is a simple real estate loan, it may get wrapped up in a week from now. If the loan has special considerations, perhaps a lawyer will need to prepare loan docs, which will increase the time needed before closing. If the transaction requires some government funding, a government guarantee, or other special sources of funding, that can also delay closing. Again, it all depends on the complexity of the transaction.

As you can see, there is a big window of variability in closing any transaction. I think the quickest I’ve ever seen a large commercial loan closed is in about a month, which was the time it took for the appraisal to be completed. On the other hand, the longest I’ve seen has been over a year. That transaction involved the use of tax credit and government grants.

Ultimately, it is hard to say when a loan will close, but there are things that can be done to speed up the process. Terms can be agreed upon upfront, information for underwriting can be provided in a timely manner, and an experienced underwriter with availability will all help greatly in speeding up the process.

What to do with Covenant Violations

Well-managed commercial loans will use reporting and financial covenants to establish standards on how the borrower needs to perform.  So what should be done if a covenant is violated?  Too many lenders either ignore the violation or write about it in an annual internal review and not communicate with the customer.  Is this the proper way to handle when a covenant is broken? 

In order to answer this, we must first look at your loan closing paperwork.  In the commercial or agricultural loan agreement, covenants should be clearly defined.  Each covenant should identify what is to be reported to the lender, when it is reported, how covenant ratios are calculated, and also remedies the lender has when a covenant is broken.  If you state the covenant but do not have a list of what can happen if it is broken, then there is no way to enforce the covenant in the lending contract.   

The loan agreement should identify a covenant violation as a condition of default on the loan.  The remedies provided to the lender will include everything from doing nothing to foreclosing on the collateral and calling the entire loan due.  A variety of options should be available to the lender, allowing various actions to get the loan back on the right track.  An example here is to use the right to place a default rate on the loan when financial statements are not provided in a timely manner.   

When a covenant is violated, it is important to notify the borrower of what the covenant is and what the violation is even if no action will be taken by the borrower.  This is best done with a covenant default letter, which shows not only the violation and the covenant standard, but also what actions will be taken right away from the lender.  If actions are not taken or certain acts are not taken, then language needs to be in the letter that acknowledges the lender’s continued right to treat future covenant defaults differently than the current one.   

A failure to notify the customer of a covenant default raises the risk that a court will nullify the lender’s right to enforce a covenant in the future, if the lender desires to do so.  This could severely restrict the remedy options available to the lender after a default, causing the credit union or bank to live with a substandard loan than using their using covenants to make it better.  The court’s logic has been if the lender allows the substandard loan to continue year after year and now wants to enforce a covenant that has been violated but never shown to the borrower, it cannot be done, since the lender has set a precedent by its actions.  The actions will supersede what is in the written loan agreements. 

The lesson here is not to ignore covenants altogether, as good covenants provide a valuable communication tool between the borrower and the lender.  The lesson here is to follow through on covenants and notify the borrower when they are violated, what actions you are taking, and how you reserve and all future actions at the lender’s disposal to those which are included in the note and loan agreement.  The covenant violation letter becomes an important tool in proper management of the credit. 

Why is Growth Important to Your Credit Union?

How do you accomplish growth? Why do you want growth? What IS growth?

I think when we talk about growth, we are mostly talking about growing the balance sheet. We tend to think of growing asset size, but these assets will need to be funded with deposits and retained earnings, so really growth comes on both sides of the balance sheet. But why is growth a goal?

When an institution is larger, ideally it can offer more to its members. More capital allows for offering bigger loans and attracting larger relationships. Also, more earning assets should generate more income, which in turn, can be used to fund more member services.

Credit unions that remain small will only be able to serve a limited role in their members’ financial needs; whereas, growing CUs will more easily provide a wide variety of services and update services to meet changing demands and needs.

I’ve seen in my career how small institutions struggle to meet larger and larger loan requests, and lack money and resources to update technology. While some fear that growth will make them more corporate and less personal, too little growth can result in an existential threat. An institution that fails to grow fast enough will not be able to adequately serve members, and those members may no longer seek services from the CU.

Now, we have looked at what is growth and why it is beneficial, but how do you accomplish it? Like we said, growth in balance sheet requires both a growth in assets and a growth in liabilities. You need to identify both loan and investment opportunities to grow assets, while at the same time identifying deposit opportunities too.

Uneven growth will come at an expense. If you grow loans and not deposits, you will be faced with a potential liquidity problem or have to pay to borrow from other institutions. If you grow deposits and not loans, you will be left with too much cash that pays no interest, or invest in CDs or government securities with low yields.

Accomplishing loan growth also presents challenges. Too many consumer loans may have too low a yield. Business loans have higher yield but higher risk. Attracting new business loans takes time to develop relationships with the right people. Rapidly growing a business department by compromising credit standards will greatly increase the chance of losses.

There is, on the other hand, such a thing as too much growth or too fast of growth. As mentioned earlier, uneven growth is expensive and rapid loan growth poses credit issues. And then on the operational side, too many new services, locations and products coming online at the same time will have your own CU competing for resources. If your CU’s operations are disorganized, you will not be providing any real quality services to anyone. Here is where you risk taking on that cold corporate feel and will lack the ability to personally connect with members.

Growth is important and necessary too, to keep up with members’ needs. However, it needs to be managed smartly, which includes not growing too fast in any way that can invite issues. Finding the right balance comes from experience and good strategic planning.

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.