What the Slowdown in Money Velocity Could Mean

OK, it is time to put on your “economic geek” hat.  The velocity of money is the rate which money is exchanged from one transaction to another and how much a given unit of currency is used in a given period of time.  Money velocity is usually measured as a ratio of Gross National Product (GNP) to a country’s total money supply.  This concept helps tell how healthy the economy is, and it is also a key input in determining inflation in the economy.  A country with a higher money velocity compared to another tends to be further along in the business cycle and should have a higher rate of inflation.

As an example, this morning I dropped off my son’s car to be serviced.  When I pick it up later today I will pay for the work completed.  If that is the only place where the money goes within a given period of time, and the shop owner puts it in his savings account, it would have a velocity of one.

Now say the shop owner takes the money and goes to the store to buy groceries.  The grocer then spends that money on wages for a clerk and the clerk pays his rent.  In this case the money velocity has risen to 4.  When an economy is healthy, lots of buying and selling exists and money moves quickly.  Unfortunately, the US economy is in the exact opposite state right now and indicates we may enter into a deflationary state even though the Federal Reserve has been turning on the faucet by flooding the system with more money.  Some will argue this is creating a financial bubble, like the dot.com and housing market bubbles we have seen since the turn of this century.

When you look at the velocity of money supply as defined by M1, you will see that velocity declines during a recession, as you can tell with the shaded areas of the chart below.  Now M1 is includes all physical money, demand deposits, and NOW accounts.  The odd circumstance is that M1 has continued to fall since the last recession and is now at a near 20 year low.

Even if you look at the M2 money supply, the news is not good.  M2 includes all of M1 plus savings deposits, money market mutual funds, and other time deposits.  The velocity of M2 has now dropped to the lowest level ever recorded.
 

According to the velocity of money indicators, we should be in the throes of a recession.  In some ways we are.  Even though the unemployment rate is low, a record number of Americans are now out of the work force.  The labor force participation rate is the lowest it has been since the Carter years.  One in 8 men in their working years of 25-54 are not in the labor force at all.   This ratio is at an all-time high since records were kept in 1955.  An additional 2.9 million men are classified as unemployed and in the labor force calculation.  This leaves a total of 10.2 million men not employed out of a census of 61.1 million American men in the work-force, which equates into a 16.7% unemployment rate for men.  It is not a pretty picture for women workers as well.

As the Fed meets this week, everyone is questioning if they will raise interest rates.  Though one can never guess what the Fed will do, there seem to be enough economic headwinds here and also in other foreign countries which are experiencing economic recessions and slowing growth, for no increase in rates.

We will just have to see if the slowdown of money velocity is another predictor of a recession and deflation.

Does the Stock Market Tell Us About the Economy? Yes, No, Maybe..

I was listening to an interview on NPR last week in which, the interviewer remarked the economy was falling apart once more, because the stock market was declining. This frustrated me some, because it is a broad oversimplification of the economy, the stock market, and how they are related. But, even common sense should help us understand that the stock market is not the principle indicator of our economy. When the stock market crashes, as it recently has, there isn’t mass layoffs or a huge disruption to our way of lives. Likewise, when the stock market soars, we don’t instantly see a strong upward pressure on our wages or a lot of new job opportunities.

Then why do people look at the stock market as an indicator of the economy? First, we need to understand what the stock market is. The stock market is a place where shares, which represent ownership in a company, are bought and sold. The stock market is arguably any and all stock/share transactions, although there are notable “exchanges” that initially created these markets, such as the New York Stock Exchange (NYSE).

An exchange is different than an index. You may hear about the Dow Jones Industrial Average (DJIA), which is a sampling of 30 companies, or the S&P 500, which is a sampling of 500 companies. There are thousands of companies, many of which are small and thinly traded, so less attention is generally given to them. The major indices (plural form of “index”) try to capture the share prices of the biggest and most important companies.

When we hear that the stock market finished up or down, they are generally referring to an index; most commonly, the DJIA or S&P 500. When these indices move, is it because of the economy? There is a timing mismatch that comes into play when answering that question. Stock prices are quoted daily, and economic output is quoted every 3 months (quarterly). In this sense, it doesn’t make much sense to tie the everyday movement of the stock market to the overall trend of the economy.

However, if companies are doing well for a sustained period of time, then it may well be because the economy is strong. And if companies are struggling with stagnant sales for several quarters, causing a decline in their stock price, then it may be because the economy as a whole is slumping.  Thus, over the long run, the stock market trends and economic output show a relationship. However, the daily movement in the stock market is only one small data point in those overall trends, so it may not make sense to compare the everyday closing price of an index with the everyday condition of the economy.

Large companies now have such a large international presence, that their overall performance is growing more dependent on the global economy, and not just the US economy. While the indices generally increased with growth in the American economy, their long-term trends will continue to be more representative of the global economy. As we have seen with the latest stock market crash, the panic was due to slowdown in the Chinese economy, not the American economy.

So is it correct to think that the stock market is an indicator of the overall economy? When put properly into the context of long-term trends, there may be some accuracy in doing this; however, the stock market indices are starting to reflect the global economy more than the American economy. But, you shouldn’t try to correlate the daily stock market numbers with daily economic conditions. This just results in speculation and panic!

Is There a Bubble In Auto Lending on the Horizon?

We are all familiar with different bubbles over the past two decades:  the dot.com bubble, the real estate bubble, the stock market bubble, and the mortgage debt bubble.  One can read of several new bubbles in the future like the student loan and sovereign debt bubbles.  The term bubble identifies an asset that has grown up to an unsustainable level.  The real problem is that when the bubble ends, it tends to pop, as compared to a slow deflation.

One possible asset bubble are auto loans.  We all see ads from auto dealers touting 0% interest deals in order to move slower selling vehicles.  Of course the 0% deals seems to be reserved for the best credit scored people.  Experian reports the average interest rate on new auto loans is around 4.7% in the first quarter of 2015.

But several alarming vehicle financing trends indicate we may be in the middle of an auto loan bubble.  Outstanding auto loans in the US have increased by 435 since quarter two of 2010.  Now auto debt has exceeded $1 trillion for the first time ever.  The 2nd quarter of 2015 had the fastest aggregate auto loan growth since 2005.

New loans have increased in duration as well.  Loan terms from 73-84 months now account for nearly 30% of all financings.  This seems concerning since there are weaknesses in the US economy with slow growth and nearly 94 million Americans out of the workforce.  If the US economy were doing so well, why are so many choosing a longer term loan so they can afford the car?  And what will happen if we experience a severe recession?

Another concern is the liberal credit standards.  Experian reports 28% of new loans are rated subprime or worse.  This is up 3.4% from 2013.  Subprime auto loans allow over-indebted consumers to buy a car they can’t otherwise afford.  If you wondered why auto sales are at 10 years highs, you only need the ability to fog a mirror to receive financing.  Can any say mortgage crisis?

Institutional investors are also buying some of these risky debts in order to find some yield.  Now the auto loan market is nowhere close to the size of the mortgage market.  So we probably are not dealing with a problem that will threaten systemic collapse.  Delinquency rates are also low with only 3.4% of auto loans currently at over 90 days late.  Compare this to student loan debt, which passed $1 trillion in debt in 2013, has a much higher delinquency rate at 11.5%.

The growing reliance on auto debt shows the debt addiction of US consumers continues.  Now household debt-to-GDP is around 77%.  This is down from a high of 96%, but is still above the 45% level in the early 1980s.

Many CUs tend to hold a healthy portfolio of auto loans.  Many of these are lower yielding assets which could result in much more maintenance in another economic downturn.  It may be good asset/liability management to look at your underwriting standards and exposure to auto loans.  If there is an auto debt bubble, when it pops, you will want to be prepared.

Deflation: Is it Bad When Things Get Cheaper?

When I was a college student in economics, I remember what a big focus inflation was in my classes. Inflation was generally considered bad, because it eroded away the value of one’s savings who could not invest at a rate equal to or greater than the inflation rate. In other words, inflation penalizes people who hold on to cash, because that cash will continue to afford less and less.

However, it was always generally accepted that a little inflation was better than deflation. Deflation occurs when prices fall, making goods and services cheaper. Why is that such a bad thing?

Deflation poses two significant risks to the way our economy works. First, deflation puts downward pressure on wages. If cost of living goes down, your employer may argue there is no need to provide you with a wage increase. Or, new workers will be hired on at lower wages, because they arguably need less to live. This is especially tough on people who have debt or loans, because their wages may effectively decline, but the amount of debt they owe does not decline with deflation. All of a sudden, it becomes much harder to repay loans.

The second big issue with deflation is it restricts credit. If you are a lender, you need collateral to secure your loan. Take home mortgages for example. If you know the home prices are declining, and you aren’t sure how much the price will continue to decline, you will be scared to make a loan. A home that may adequately collateralize you loan today may not be worth enough tomorrow to collateralize that same loan. What is a lender likely to do? Nothing! The lender is scared and will not make loans, so the flow of money in the economy slows due to less credit being available.

My economics professors knew deflation was bad, but said it would never be a concern, because the Federal Reserve Bank could always print money to spur inflation. This was put to the test with “quantitative easing” orchestrated by the Federal Reserve Bank. The central bank created more money for banks to lend, so they would turn around and lend that money out to consumers and businesses. Of course, the deflationary environment meant banks didn’t want to lend the money out. And worse, with so many people losing their jobs, there were less creditworthy people to lend money to. While the central bank created more money to fight deflation, that money never reached ordinary people to actually cause inflation.

Deflation is in the news again as the economies of Europe limp along, and real estate values are declining in China. Much like our central bankers, they are concerned with how to combat deflation. This brings us back to classroom economics. Our professors focused greatly on how to combat inflation, and it appears we are well equipped to control inflation in the 21st century. They never assumed deflation could ever become a problem, and now it is becoming a persistent problem worldwide for which we lack a good solution!

Contact the Professional or Figure It Out on Your Own?

Recently, my wife and I decided to replace our water softener that had gone out a year ago. After a couple of weeks of research, mainly to find one that would fit into the small closet space where it is located, we headed to Menards to pick up the equipment and all the other items for the install.

My wife asked if we should contact a plumber for the install.  I disagreed with the idea as in the last month I had replaced our kitchen faucet.  It had only taken me six hours, but in the end I had it completed with no leaks!  So if I could do a kitchen faucet, surely a water softener could not be difficult.

The problem, not known to me at the time, started when I removed the old water softener.  There were two different small hoses which I yanked off and did not pay attention to what their purpose was.  I just pushed them to the corner of the closet, assuming they connected somehow to our whole house humidifier which we rarely use.

So my wife and I worked through the several issues on the install and conquered problems that would make any redneck proud.  We finally had the softener hooked up and had to connect a drainage hose.  Well, it was next to the water heater which sat in a large pan for overflow, so I figured we should just drain it there.  This is my second problem when my wife asked if I was sure that was right.  After over two decades of marriage, you would think I would learn that when my wife asks this question, I should reverse direction.

We finished the install and programmed the softener.  It worked like a charm for a couple of weeks.  Then this past week, when I was on a trip in another state, I received a text from my wife that we had no hot water.  I scrambled to find contact information for a plumber and gave it to her.  After hours of work, the plumber discovered my redneck drainage method for the water softener had shorted out a sensor in the water heater which eliminated our possibility of enjoying hot water.  So after, fixing the water heater and properly installing the drain hose, I probably spent an extra $200 over what I would have if I called the plumber in the first place!

One of the most valuable services we provide is counseling.  We often have CUs call us on a commercial deal or on a farm financing situation.  I always enjoy visiting with lenders as I think we have a wealth of experience across many different types of industries and loan types.  Often we can provide a different prospective than what the front line person is seeing.

On my travel back from North Dakota last week, I received a call from a credit union in the South.  The officer was getting ready to do their largest commercial loan they would handle in house.  It involved a construction project in another state with a long-time member.  I was able to walk him through the process of utilizing a third party architect or engineer to inspect the progress and using a title company or attorney to disburse funds.   We discussed proper pricing of the credit and what structure would be best for the CU.  At the end of the conversation, the officer thanked me as I had brought up several issues that he had not thought of.

Sometimes, we find CUs who will bring a deal to us that is in serious trouble.  The loan is already on their books and it is a problem.  How I wished that we could have assisted from the beginning, as it may have prevented a problem loan and provided a structure that would have benefited the borrower’s cash flow.  But if need be, we are here to help pick up the pieces.

The book of Proverbs tells us that a wise man seeks counsel.  I find that commercial lending is a constant learning experience and I am always growing as is the rest of the MWBS team.  Even as we are learning, we still have a lot to offer.  Please reach out and contact us when you are financing a new project you may be unsure of.  We are here to help.

The Three Pillars of Commercial Real Estate

I have written numerous times on using the right tool for the right job. In this article, I want to focus on what that looks like in the realm of commercial real estate.

The creditworthiness of commercial real estate rests upon three pillars: rental cash flow, loan-to-value and the sponsors. Knowing this, you put away several of your credit analysis tools immediately. Put away your liquidity tools, put away your leverage tools, put away your UCA cash flow, and put away all your tools for analyzing receivables, payables, and inventory.

To assess cash flow, you need to concern yourself with two things: 1) What type of real estate are we dealing with, and 2) What is going on with market rents?

Different real estate types have different expense structures. Office, retail, and industrial real estate have relatively low expense because the tenants are expected to pay for most things, including maintenance, taxes and insurance. Residential rental real estate has moderate levels of expenses, since they are typically shared between the owners and renters. And special purpose properties, such as hotels, have high expense ratios since the owner is expected to pay for virtually everything.

Understanding rental markets is also key, because the demand for each real estate type is different. In this case, market reports are your best friend. Use a market report to establish what the market rate rent is for your piece of real estate. Then apply the appropriate cost structure, and see if there is enough pro-forma income left over to meet debt service payments. If there is, then you have one of your pillars in place!

Next, we have to concern ourselves with loan-to-value. This measure is unique, because it simultaneously tells us about our collateral position, as well as the equity in the transaction. As a rule of thumb, the riskier the real estate type, the more equity we want to see in the property. In other words, special purpose properties will have low loan-to-values, more marketable office and retail will have moderate loan-to-value ratios, and very marketable residential real estate will have high loan-to-value ratios.

Lastly, we look at the existing or proposed owners or principal operator. Generally, whoever will be responsible for overseeing repayment, we call them the sponsor. We assess their willingness and ability to repay, as well as their experience with real estate type. Willingness and ability to repay the loan matters, because if a tenant vacates the real estate, the sponsor may need to pay the loan for some time from their personal account until a new tenant can be identified. Experience matters, because that tells us how good they are at keeping paying tenants and how much they reinvest in necessary maintenance.

And that is how you underwrite commercial real estate, in a nut shell. When people start pursuing other items and measurements, they may find themselves lost in tall weeds. What people tend to focus on the least is usually what matters the most: local market conditions. The demand for a specific real estate type will affect what can be charged for rent (cash flow), which drives its value (loan-to-value ratio), and ultimately, affects the sponsor if he or she has similar investments in this type of real estate.

Participation Trophies or Championship Rings

James Harrison is one of the most feared outside linebackers in the NFL.  He plays in the Pittsburgh Steelers 3-4 Defense, so his task is often to rush the quarterback.  He has a monumental career of accomplishments that follow his work.  The man has been through a success track that is like the myths you hear except it is true.  His dad was a truck driver.  He wanted to play football and went to tiny Kent State.  He shows up to the Steelers as a free agent and was cut twice.  He finally gets his chance as a backup and has a monumental breakout game against Buffalo.

If you remember the Pittsburgh-Arizona Super Bowl, you will remember his 99-yard return for a touchdown interception of Kurt Warner.  Well, last week he made news when his sons came home with “participation trophies” for a sport they played.  He flipped out.  In his world you don’t get a trophy for showing up.  You don’t get a trophy for trying hard.

In his world, you only get a trophy when you succeed.  When you succeed at the very top, it is rare and you become a champion.  They only give out one Lombardi Trophy to the NFL champion each year, not one to each team that participated.  So he posted a picture of the trophies on Instagram and wrote, “I come home to find out that my boys received two trophies for nothing, participation trophies.  While I’m very proud of my boys for everything they do and I’ll encourage them to the day I die, these trophies will be given back until they earn a real trophy.  I’m not sorry for believing that everything in life should be earned, and I’m not about to raise two boys to be men by making them believe they’re entitle to something just because they tried their best, because sometimes your best isn’t enough, and that should drive you to want to do even better, not cry and whine until somebody gives you something to shut you up and keep you happy.”

There is only one Lombardi Trophy, one World Series Ring, and one Stanley Cup given out each year.  None of these professional sports give a trophy for just showing up.  So the next question is are you giving participation trophies to your people or are you really celebrating true accomplishments with your team?

In the high-performing financial institutions that I have worked in, all have had different ways to measure the performance of their commercial people, their branches, and their divisions. Goals are set and then various measures of production, productivity, credit quality, income maximization, and expense control are looked at and measured.

The goals and results are shared throughout the organization from the leadership down to what is applicable on the front line.  This gives an opportunity for each employee to take ownership for their work and to realize that what how their actions can impact the overall organization.  Employees begin to have more of a purpose and pride in their job as they understand that their work matters to the overall outcome.  There is something innate inside each of us to achieve great things.  Giving folks on your team great things they can achieve will cause them to improve their daily performance.

So do you reward everyone on your team the same?  Of course there are rewards for the group performance, but there also should be rewards for your top performers.  Earlier this year, Gravity Payments decided to raise the minimum wage for everyone in the company to $70,000/year.  What ensued is several of the top performers in the company left, thinking it was unfair to more than double the salary of some of the weakest company performers while the top performers received no increase at all.  If you want your institution to perform at a high level, top performers should be recognized and rewarded.

Maybe you don’t even think that sharing goals and performance standards to people in your organization such as your lenders, branch managers, or front line staff is important.  I spoke to someone at a bank in my home state that followed this course of action.  My friend wondered why they were so mediocre and how to make his shop better.  I said to begin with, you need to share the goals and performance among the entire bank tem.  If the people you hire are valuable enough to bring on your team, they are valuable enough to share the goals.  Otherwise you run the risk of not aligning your team to meet your common goal.  How can they meet it if they do not know what it even is in the first place?

So to conclude, set goals for your CU and the different branches, divisions, and employees.  Share those goals with team members to get buy-in.  Track the performance to goal.  Reward those who achieve great things, and not just give a trophy for showing up.  These are steps in reaching beyond the present level you are at now.

Things to Watch for in the New Member Business Regulations

The NCUA has put forth a proposal of new regulations for business loans.  This will totally change the existing regulations that are currently in place.  In many ways, this will give CUs more flexibility in their business loan decisions.  More freedom also requires more responsibility as CUs will be required to have stronger loan policies, underwriting standards, and credit management practices.  I would encourage everyone to read the policy changes and provide comments which are due by August 31.

There are several items that I see in the new regs that raise questions for me.  First, the regulation creates a new class of loans called “commercial loans”.  Now some loans that are currently considered Member Business Loans for statutory purposes are not commercial loans and vice-versa.  While I do think it is wise to extract some of the items currently carried in the MBL limits, the reg did not state what would be done with the commercial totals.  Will these loans also be subject to an overall portfolio scrutiny?  If so what are the levels?  Who determines this, the CU or the NCUA?

The associated borrower and single borrower limits also cause me some concern.  The reg seems to cast a broad net over what constitutes an associated borrower and seems to leave some vagueness in areas where one sponsor who has control over a certain amount of another’s company stock is counted or not.  It also removes the guarantor criteria in calculating limits to one customer as now any associated borrower would count toward the limit.  This is good, as it would encourage limited use of not requiring guarantors on credits.

But I contend that many times with good solid sponsors who may have multiple profitable companies, the associated borrower rule may prevent the CU from entering into a new transaction that would be profitable and a prudent credit.  Perhaps using a proportion of the credit in calculating associated borrower limits may be applicable when dealing with companies where the owner has less than 20% ownership, where the company’s debt is not guarantor reliant, where the owner does not derive more than 20% of his personal income form the company, where the company has historic income to satisfy all expenses, debt, and dividends paid to owners, and where the debt is adequately collateralized.

The regulation outlines several different reporting requirements which need to be identified from the reg and then monitored by the board and credit management.  Much of the reporting goes under the heading of tracking exceptions to your loan policy.  I find this category too broad, since you can have an exception to policy for almost anything.  It would be wiser to create categories within loan policy of what exceptions will be tracked.  This forces the tracking into broad categories such as exceeding LTV, inadequate quality of financial statements per policy, guaranty not provided per policy, or DSCR below minimum threshold.  Such tracking will be more meaningful in managing these credits and also it will not create a minutia of information that fails to track what are important risk factors.

The policy now requires a substantial commercial loan policy that is reviewed and updated at least annually.  In the requirements for policy inclusion items, it seems that some of the items in the proposed regulation may fall under procedure rather than policy.  In either case, these items should be present and forcing CUs to create a substantial commercial loan policy is needed.  Once the regulation is in place, if you need help, contact us.

Another item in the regulation is the use of a risk rating system to gauge the risk of the credit.  This should be established at closing and also tracked during the life of the loan.  The risk rating model should help move a subjective guess of the credit’s risk into something that is more objective.  I would add that multiple risk models should be utilized as the risk inherent in an ag loan is much different than what is found in a rental office building.  Again, if you need help here, ask us.

The reg removes unsecured lending limits.  While that opens up business possibilities, it is also quite risky.  Each loan policy should have different measurements and thresholds of performance where an unsecured loan should meet before entering into one.  These tests should be spelled out in loan policy.  Some of these would be DSCR thresholds, current ratio minimum, debt/asset limits, etc.

The proposal removes the waiver process as most items that are currently waiver items, become issues of loan policy, underwriting, and credit structure.  CUs will find less reasons to structure credits around regulatory constraints and more reasons to formulate loans around sound credit practices and policies.  This feature is a positive change.

Once the regulation is in force, there will be an implementation period of 18 months.  While the time may be good, sub-timeframes should be used to help CUs along the way.  Some of these may be to establish a date when loan policies should be completed by, another date for the start of exception reporting, etc.  This would ensure a smoother start up into the new policy.

The new regulation will require a lot more work to shops that are weaker on their current credit policy and management.  For many, it will not be much of a change from their present operation.  The proposed changes in the regulations is needed to improve the overall credit management in the industry.  I suggest that everyone read the new regulation, ask questions, and prepare comment letters to outline what you like and what sections can be a hindrance to your CU.

Margins for Error

I was training a new hire one day, and it immediately became apparent to me how sharp he was and how lucky my company was to hire him. He was underwriting a loan for a contractor who was buying a building, after having rented a different building for several years.

The analyst was quick to understand that rent would no longer be an expense to this contractor, so it made sense to add the rent expense back to income since that would now be money available to pay debt. He then got to thinking about other factors too. He could see the contractor was moving to a space 25% bigger, so he figured the utilities would cost more, and there would be even more real estate taxes that would need to be paid. Then he realized the building was in a different part of the city that would have different utility rates, since they were provided by a different company. His head began to spin! How could he possibly come to understand all the changes about to happen in the borrower’s expenses?

We want to see borrowers succeed, and we also want to incorporate all available data into making a decision. Alas, it is impossible to account for every penny, and our own analysis reaches a diminishing rate of return the more we dig into the numbers. Does it make sense for a salaried person to spend hours of their time trying to account for an immaterial amount of money? Sometimes we need to pull back and assume, all things equal, our borrowers are competent enough to manage the fine details of how they spend their money. Often, we will be happy and sane not knowing how much it costs our borrower to take out the garbage or to buy cleaning supplies.

Underwriting isn’t about turning over every rock to make sure every dollar is accounted for, but rather making sure your borrower can handle unforeseen events. I feel far more comfortable knowing someone can handle unexpected expenses, than knowing every exact expense they realized.

How we assess whether someone is prepared to handle unforeseen events is by making sure there is a “cushion” to protect them. For example, it is not enough to have cash profits to pay your loan, but rather, we would like to see enough profits to pay your loan by a factor of 125% or greater. Or consider someone’s liquidity, we like to see they have enough short term assets to cover short term liabilities by a factor of 125% or more. Even with real estate, we like to see loan-to-value no greater than 75%, so there is some room for the property to change in value, or equity to pay for costs to sale, or even equity that can be financed out to pay for other bills.

A borrower that operates with good, consistent cushions is usually a borrower that knows what they are doing. In doing our assessment to make sure the cushions are in place, we relieve ourselves of having to be a secondary bookkeeper for the borrower, and graduate into asking higher order questions. Questions, such as, is this an acceptable lending risk, and can the borrower still pay the loan if something unusual arises? Probably the type of questions we should be concerning ourselves with!

The Board of Directors

I read an interesting article in the Wall Street Journal this week regarding activist investors. Investors who only have a small interest in an underperforming companies have found a unique way to get their voices heard. They have been working with the larger, typically silent investors, to demand seats on company boards to have their interests represented. You see, typically mutual funds or other large institutional investors would buy large stakes in companies, but didn’t actively concern themselves with how the company was governed. These small activist investors have convinced them to suddenly take a more active role!

I find this exciting and interesting, because the Board of Directors for any organization will tell you a lot about how the organization is governed. And, as a bank examiner, I meet several boards of directors.

With community banks, there is typically a single family that owns a majority of the bank. Thus, the Board of Directors is usually their family, and might include a friend or important community leader. Needless to say, there isn’t much debate over operations or where the institution is headed. It is the same principals who pretty much control everything from top to bottom.

Regional banks tend to have a different flavor. Often, a regional bank has become a regional institution by swallowing several smaller institutions. It is not uncommon for former owners or executive management to be placed on the Board of the new, bigger institution. Not only do these directors have some important insight into how the bank should be run, but also they serve as a magnet for business opportunities. Often these directors are used to attract new business lending relationships to the bank, although that is not the director’s formal role.

The boards for credit unions also seem unique in their own rite too. To me, it seems these boards serve the purpose of a board better than any organization I’ve seen. Credit union boards are typically made up of competent community leaders that show a genuine concern in how the institution is run and whether it is property serving its membership base. While this shouldn’t seem surprising, note how much this differs from the community bank and regional bank commentary I provided above!

And no matter in what capacity a person may come to serve on a board of directors, it is much more than just an honor, it is actually a big responsibility. Directors can be held criminally liable if their organization operates outside the law or in an unethical manner. This means a board member should not expect to only provide wisdom and guidance, but they should be well educated about the industry their organization belongs to. This will also mean ongoing education and keeping up with current events is likely expected of you, if you become a director.

The general idea of a board of directors is to provide oversight, guidance, and representation to the organization on behalf of shareholders. So ultimately, the best thing a director can do is be involved, and a major stakeholders should care about directors being involved too!

The NCUA's Proposed Change to MBL Regulations : Policy Issues

The proposed Member Business Lending (MBL) regulations do move from one that is prescriptive to one that is principal based.  This gives more freedom, but the principles that must be used are sound lending guidelines and practices.  The first place this must be used is in your loan policy.

Policy must be approved by you Board and must be examined at least annually and more often as necessary changes are required.  They must provide for control, management, and measuring the commercial lending activities of the CU.  The policies must make sure the CUs business lending is safe, that risks are assessed timely, and that operations are set up to properly monitor the portfolio.  The new regulations also suggest a separation of duties between underwriting, portfolio monitoring, and collections when possible.

Each CU should have a comprehensive risk rating system to identify the risk to the borrower, the relationship, and the overall lending portfolio.  We suggest that multiple risk rating models are needed, as it is next to impossible to use one model to capture relevant factors that are present in different types of commercial real estate, C&I, and agriculture loans.  Also, the factors used in each model should be examined and changes made, when and indicator loses its effectiveness in identifying the credit risk or when a stricter or looser judgement is warranted.

The risk rating system also becomes a living history of the credit and there should be a way to monitor the rating from closing to payoff.  It also can be used to gauge the risk in the commercial department.  This, combined with an analysis of rate exposure, provide a good way to help determine possible upcoming issues to the CU’s assets.

Loan policy should identify the types of loans permitted, trade area, maximum loans amounts for loan category and borrowing group, qualifications of the lending staff (now this is an area that you can determine), the loan approval process, and underwriting standards.  Underwriting should culminate in a loan write up that contains all relevant information of the credit and analysis of the borrower, guarantor, industry, and collateral in a logical format.  The analysis should look at income and expense trends, debt service ability, balance sheet changes, and how these impact the ability to service debt.

All related parties should be looked at in order to determine if they provide additional strength to the credit or could be a possible drain on company liquidity.  Global cash flow and stress testing are quite applicable here.

Due diligence requirements should be set forth in analyzing the loan.  Requirements for financial reporting should also be established in order to make an informed credit decision.  Policy minimums for financial reporting will differ depending upon the size, complexity, collateral, and repayment source of the loan.  Requiring an audit for a single tenant office building may be overkill but an audit would be appropriate for a large manufacturing firm.

Next, LTV thresholds should be set based upon the type of collateral offered.  An example here is the LTV with an asset with changing values, such as accounts receivable and inventory, should be lower than one with a more stable value, such as equipment or real estate.  But even within more stable collateral, there will be variations.  We will contend that all other things being equal, the prudent lender will be more comfortable with a higher LTV on an apartment building than on a specialized single-purpose property.  Also, concern should be paid to real estate values in areas that are subject to sharp price increases.

The proposed policy also identifies different risk management processes that should be used to monitor the credit.  The ones listed are using loan covenants, periodic reviews of the credit, using a risk rating system, and the approval and monitoring of loan exceptions.  We contend that these are all valuable methods and are all used together to watch credit performance.  The result of certain covenants, such as a Debt Service Coverage Ratio, or Debt to Asset Ratio, will be used as factors to assess the risk ratings.  This way moves the often subjective method of risk rating to an objective measurement.

All of these items in the proposed loan regulations require that the CU grow up in its commercial loan policy, the handling of credit management, underwriting, and portfolio review.  Gone will be the days that you can run a business department on a policy that can be read and digested within 10 minutes.  And you also cannot just fall back on the regulations for your policy specifications.  It requires the institution to come up with strong, thoughtful tools to manage and underwrite loans.

I would encourage everyone to read the proposed policy changes and make comments.  There are a lot of items that should improve the commercial credit management over present regulations.  Comments are due by August 31st.  Also, we are Midwest Business are here to help.  We have written policy, created risk rating systems, helped instill sound credit practices in institutions, and also serve as a backup piece for your credit administration.  Contact us for help.

What is a Trust?

The concept of a “trust” is not well understood by most in finance, yet most people will encounter these oddities a few times in their career. So what exactly is a trust?

A trust typically comes into existence by means of a trust agreement. The trust is formed for several reasons, but they are generally created so one person’s assets can be protected or managed by a third party. Why would someone want that arrangement?

Imagine your parents hit the lottery, and they wish to share the wealth with the entire family. But, we all have that one family member who is financially inept. We know if he/she got a cut of the winnings, they would manage to spend it all within a year, and not on wise investments either.

Just for example, let’s say we have a sibling named Jack. Here a trust becomes very useful for taking care of Jack. The money due to Jack can be put in a trust, but then be managed by mom and dad, another sibling, or even a family friend. The person who transfers money into the trust is called the grantor. The person responsible for managing Jack’s money in the trust is called a trustee; whereas, Jack is considered the beneficiary. No matter what crazy scheme Jack may come up with to spend the money, he won’t be able to do so without the trustee agreeing to it, and the trustee will follow the terms laid out in the trust agreement.

Trust agreements exist for several reasons. They are not just a tool to protect the financially irresponsible from themselves. The principle reason a person establishes a trust is because he/she has specific wishes or desired outcomes. Perhaps they want the money in the trust only to be used for education of their children or to help them buy a home. Another reason people form trusts is to grant their children an inheritance at a lower tax rate, or with no taxes; which is the case in South Dakota. When someone is elected the President of the United States, they are expected to turn over all their assets to a trust, so that any of their actions cannot be seen as a deliberate effort to enrich themselves.

In the examples above, we are discussing situations in which the beneficiary does not have control of the assets, because a trustee has independent control. This is what is typically referred to as an irrevocable trust. In this arrangement, the beneficiary does not control the assets, and they don’t have the ability to pledge or manage the assets. When doing credit analysis, this means the trust does not really contribute to the net worth of the beneficiary, unless the trustee is willing to allow the trust to guarantee the loan too.

In contrast, a revocable trust is a situation in which the grantor retains control of the assets in the trust, and they are the beneficiary, so long as they are living. Therefore, creditors have full recourse to assets in a revocable trust, although it is still beneficial to review the trust document to make sure it is, indeed, a revocable trust. The typical purpose for establishing a revocable trust is to avoid probate, thereby keeping details about grantors’ estate confidential when he/she passes away.

Trusts can be borrowers and guarantors, but you do need to be careful with the documentation. It is important you understand the difference between a revocable trust and irrevocable trust, and how that indicates who should be signing on behalf of the trust!

The Social Security Asterisk

Every now and then I get some sort of statement of my benefits from Social Security that says how much I would receive once I retire.  Typically, I throw these away and do not pay much attention to them.  I am like a lot of folks in my generation who don’t think Social Security will be around by the time I get to retirement.  I once read a study where younger folks believed that there is more of a chance in getting abducted by aliens than ever collecting a Social Security (SS) check?

I had a friend who received his statement and noticed an asterisk.  When you followed down to the bottom of the page, it mentions the actuaries’ current projections of income and expenses for the program would only generate benefits of 70% of the projected amount as stated above.  Well that really is a kick in the rear!

When the program was started in the 1935, there were nearly 13 workers for each retiree.  Now we are closer to a ratio of 3 workers for each retiree.  That ratio has to be dropping quickly with a combination of the baby boomers starting to retire and a labor force participation rate in free fall and in the low 60% range with over 94 million Americans out of work.  That means a lot less people there to pay into the plan.

So statistically, the program can’t work unless you bring in a lot more workers to pay into the system, cut the benefits paid, increase SS taxes, or a combination thereof.

Recently, SS actuaries predict that the program’s “trust fund” won’t be exhausted until 2034.  This is a whole year longer than their original estimate.  But David Stockman, the former White House Budget Director during the Reagan administration has dug into the numbers and finds other disturbing problems.  He wrote, “On a cash basis, the OASDI (retirement and disability) funds spent $859 billion during 2014 but took in only $786 billion of taxes, thereby generating $73 billion of red ink.  The trustees’ own reckoning, the OASDI funds will spew a cumulative cash deficit of $1.6 trillion during the 12 years covering 2015-2026.  The OASDI trust fund could be empty as soon as 2026.”

Wow, that is another 8 years before the trustees’ estimate that the fund will run dry!  The difference is the actuaries’ project nominal GDP grows at a 5.1% annual rate in the next 12 years.  Yet we have come anywhere close to half that amount.

Of course for this to run out of money assumes there are funds inside there to begin with.  The problem here is Congress began borrowing from the trust fund in the 1980s to pay for many things that are not dealing with retirement.  So the trust fund is filled with a bunch of IOUs from the US Government.  That is not something to give one any warm fuzzies for anyone who will be relying on SSI funds for part of their retirement.

So at the end of the day, I suppose I will be working as long as possible, relying on my own savings for retirement, and looking forward to meeting E.T. before I collect any SSI.  I suppose this is the same approach most folks in my age group have.  Unless something different changes, imagine how this can impact your members.

The Price of Stocks in China

Perhaps you have heard, and maybe you haven’t, that the Chinese stock market is in a free fall. If your first reaction is, “why does a communist country have a stock market?,” then I’ll give you a moment to come to your senses and join the 21st century, where China is now only “Communist in name only.”

And yet, despite this fall in the stock market, many of us haven’t heard about it here. And, frankly, it doesn’t really appear to be affecting us much either; thus, discussing the price of stocks in China have no more relevance to us than the price of tea in China. But, there are some interesting parallels to China’s situation, which follows some of our own history.

A notable similarity is the stock market in China now and our stock market in the roaring 20s. Private individuals and households are the main investors in the Chinese stock market. This is unlike the United States today, where most investors are large actors like pension funds, mutual funds, or generally what we refer to as institutional investors. This wasn’t always the case in the United States. In the 1920s, more individuals took it upon themselves to invest in the stock market, and many small banks were also taking peoples’ deposits and also, investing as individuals in the stock market. The issue that comes to bear with individual investors is they tend to invest for much more speculative reasons; whereas, institutional investors tend to invest more for the long haul. Thus, when millions upon millions of people act speculatively, the market will experience dramatic swings up and down.

Many interesting laws came about as a result of the Great Depression and many people losing their pants, when the stock market rally in the 1920s tanked. For example, now if you want to sell your stock to the general public, you must be regulated by the US Securities and Exchange Commission (SEC). The SEC requires a high standard of financial reporting, so companies must have great transparency to the public. And, if the company is not publicly traded, then the stock can only be marketed to “accredited investors.” The SEC considers accredited investors to be individuals who make more than $200,000 a year, or $300,000 with joint income from a spouse; or someone who individually or jointly has $1 million in net worth. It is not clear if China has any of these restrictions, which could be further fuel for a stock market bubble.

Of course, understanding the crash of the Chinese stock market isn’t a matter of using hard economic analysis to dissect what is really happening. In a matter of one year, the market has gone from a 52 week low of 2,135 points to 5,178 points. The market more recently closed at 3,726 points. It seems like a simple case of the market overheating due to speculation. Observers believe that the Chinese stopped investing in real estate and piled into the stock market suddenly. And now the market needs to find a new normal, which is probably around the 2,000 level, which is where the Shanghai Composite has floated for most of the past 10 years.

While the price of stocks in China may not affect much our daily business here, it is interesting to see if China may come to struggle with some of the reforms our own country had to deal with. And more interestingly, it is fascinating that the group calling themselves the Communist Party are struggling to deal with free market forces they have created!

Liquidity Examined

A lender can look at the current portion of a balance sheet, which tells us assets that are cash or will be turned into cash in the next year and liabilities that must be paid within the next 12 months with cash.  Lenders also can run the current ratio that compares current assets to current liabilities to tell if the company has cash resources to satisfy its short term obligations.

This review is good to do, but it is possible for the lender to think the company is in good shape, when actually there is a liquidity crisis at hand.  Thus, liquidity must be inspected further to make sure that the liquidity is true and not an illusion.

One area is concentration risk.  Receivables should be reviewed for any concentrations to one or a small group of buyers.  If a customer were to fail while owing a lot of money to your borrower, it could have a disastrous impact and the company may see current assets vanish before their eyes.  Also, inventories should be looked at.  If there are products that are stockpiled and do not have a ready market, turning those products into cash may be impaired or the item may have to be discounted to move it.

Verifying inventory or accounts receivable are is also important.  Just because your auto dealer says he has a certain inventory of cars or your farmer says the grain is in the bin, is that actually true?  Inspections are a must if you have a substantial loan that is based upon inventory as the source of repayment.

Another factor that will impact liquidity is what methods of risk management are your customers using?  If you have a farmer with crops of livestock, are these subject to a contract price or are these items subject to market volatility?  How stable are the inventory prices?  Can you take the figure to the bank or is there a possibility that when the inventory is sold, less cash will be realized than what is reported on the balance sheet as inventories?

Timing is an important factor for current assets.  When will the receivables become cash?  Are any taking longer to collect than usual?  If that trend continues, there is more of a need of working capital to support operations.  One possible strategy is to look at a month by month projected budget or statement of cash flows to see when cash expenditures will be paid and when cash revenues will be received.  This is necessary when determining what an appropriate level is for a line of credit.

The quality of inventory is also a key factor to watch.  Crops will command a premium or be subject to a discount based upon items like the moisture content.  Organic crop may be sold at a higher price than a conventionally grown crop.  Also what does your producer do with a GMO crop if China places a ban on buying GMOs?  This can push down the market price of the grain your farmer has.

Insurance is an important factor to consider.  If the borrower is under-insured, a catastrophe could be a severe drain to the cash available for operations if inventory is ruined.  Another factor to consider is does the company have adequate insurance to overcome a peril and continue operations or will there be a business disruption?

Looking at the level of the line of credit is an important judge of liquidity.  Is adequate inventory or receivables available to retire the LOC?  If not, how much will be left over and how much additional drain on cash will the remaining balance cause?  This is a reason to manage a LOC with a borrowing base.

The level of cash is a final determination in figuring the true liquidity.  Cash does pay the bills but the question is how much cash is necessary for the company to operate.  How does the balance in the bank compare to the requirements for operations, major expenses, and debt service?  Comparing cash to these expenses can determine the burn rate of cash.  This calculation can be essential to seeing how long a company can weather a downturn.

So all liquidity is not created equal.  Some items don’t turn into cash as quickly as the company may need this for operations.  A closer inspection will help the lender understand how solid the liquidity numbers actually are.

Breaking Away from Herd Mentality

There is unquestionably an advantage to belonging to a group, and we all know how there is a “safety in numbers” for personal and professional survival. However, there can be disadvantages to following the herd everywhere it roams.  If resources are lean, you will compete against the entire herd, and cannibalism may arise.

I visited the Minneapolis-St. Paul area last week, and had an opportunity to visit with CU business lenders in that market. They echoed a stressful sentiment about competition that I was accustomed to hearing in Washington DC. In major urban markets, all banks, big and small, are attracted to do business there, and the competition gets to be quite brutal. Terms of lending get loose, interest rates get low, all to win the deal, leaving prudent lenders with few opportunities that make sense. In this situation, what could one possibly do to be competitive, but not stupid?

I have always been an advocate of abandoning the herd and going off the beaten path. While this is not for everyone, it can be fruitful for hardworking people willing to educate themselves in new markets, industries and practices.

For example, every business expo in the Washington DC market was packed full of bankers. I would meet more bankers at these meetings than actual business leads! It was far from an effective way to land new business. I decided it would be better instead to branch out into a different industry, the non-profit industry, where bankers were not falling over each other to win business. Why weren’t bankers vying for non-profit accounts? I think most didn’t realize that they had similar needs as other businesses, like the desire to purchase or construct facilities. Since nobody thinks about non-profits when they think about banking, it wasn’t a competitive field. The herd wasn’t ever at that watering hole, so it never got much attention.

I also convinced my colleagues that perhaps it didn’t make much sense to chase our business in a crowded field, but rather, have the business chase us. We decided to have an exclusive, by invitation only, meeting at our bank for various businessmen and developers. In this case, we were the only bankers at the meeting, and the clients felt special by attending the event. Other banks were not doing these types of events, so we definitely stood out in their minds as unique.

Another way in which I tried to break from the herd was by exploring new markets. Again, every banker was trying to do business in Washington DC, but none of them were looking at opportunities outside of the city. I looked at government data that tracked the economic output of the surrounding communities, and I could see Baltimore was experiencing an upswing in growth. Despite the recent negative news surrounding the city, the community is poised for great redevelopment. I attended a couple of business expos there, and often found I was the only banker in attendance! This gave me easier access to developers and other professionals too.

There is a reason why many bankers were not trying what I did, and it boils down to risk. It is a risk to enter a new industry, enter a new market, or adopt a new pattern of doing business. But when you have to compete in your existing market with extraordinary low rates or bad terms, then how much additional risk is it to explore new options elsewhere? Trying to win a giant race is exhausting, and sometimes it is easier and no more risky to try something new.

Sacred Cows Make Great Steak

There are two things that make a cow one of the greatest animals ever.  First, there is an active market where you can turn your bovine into cash.  The price you will receive from your beef critter is subject to market forces, but you can still turn it into cash.  In recent years, with the historically low numbers in the US cattle herd, prices have been good.

The second factor is greater than the first in my mind, since it creates the reason for the market.  Your cow can be turned into wonderful cuts of meat:  hamburger, ribs, and steak.  This meat can be turned into edible wonderfulness via the addition of heat in the form of baking, frying, or my favorites, smoking and grilling.  The thought of 10 hour slow smoked brisket over hickory and cherry woods makes my mouth water.

Now, in each of our organizations, we all have sacred cows.  These are things that we would never dare give up and are held in higher esteem than cattle are to some Hindus.  Some of these items may be the standard Monday morning meeting, the Tuesday sales report, or the Friday wrap-up.  Other sacred cows could be a process, spreadsheet, form, or workflow that is followed to a “T” every time.  These are things that are never abandoned, for if they were, we would be afraid the company would collapse.

Now you may be thinking, “But there are certain tasks that have to be done a specific way.  I have found out the most effective way to execute this job.”  In some cases, this is not a sacred cow, this is an ox.  An ox is a strong critter you can use alone or in teams to really do tough work like plowing a field or moving heavy objects.  Oxen love to work and can really accomplish great things.  One ox that I tend to do when I analyze a credit is to first focus on the cash flow of the company.  I want to understand how cash moves and how I will be repaid.  I don’t have to always do this first, but I have found it tends to weed out more problem deals if I start there. You have to first ask if the item under scrutiny is an ox or a sacred cow.  If it is an ox, realize that even that can become more efficient.

Sacred cows, on the other hand, are there to just eat and look pretty. Sacred cows consume a lot of energy and resources and don’t give you any results other than something to look at.  But we don’t realize that the best thing about the sacred cow is also the best characteristic about real cattle, they can be turned into steak!

This requires critical thinking that is often done best by someone who is not ingrained into the corporate culture.  Is the Monday meeting valuable or is this just a waste of time?  Could the same thing be accomplished by an email or an internal wiki?  The old spreadsheet you are using to accomplish a task-is is really necessary and is it efficient?  Does it need to be upgraded to include formulas and shared with those who will input the data?  Is the process the most efficient way to work?

Never discount the ideas from the new person.  Lots of times they may be able to find ways to improve your company since they are not steeped in the culture and the “way we do things”.  If someone was important enough to hire, they should be important enough to listen to their ideas.  A good leader will learn to stop what he is doing and listen whenever a team member starts out with, “You may think I am crazy, but I had this idea….”

Slaughtering the sacred cows will not only provide great enjoyment from the entire team as they consume the steak, but it will also make you more money by increasing the efficiency of the organization and saving time for tasks that are important to generating income and increasing the service provided by your company.

Consumer Lending vs. Business Lending : Like Comparing Apples to Oranges

Credit unions fill a niche that banks often overlook. Sometimes people in great need don’t underwrite for loans, perhaps due to mistakes they made in the past or because of unfortunate life events. Here is where credit unions shine. Just because a member was overwhelmed with medical debt in the past, or they were never given a good opportunity to build credit, the local CU will not turn their back on their members. They understand character and work ethic can be bankable, and they can help with financing a used car to help someone get to work or help with replacing a furnace in the middle of winter.

Mathematically speaking, these aren’t terrible risks to take. While credit scores can help us assess some risk, a score hardly tells the whole story. Personal, in-depth knowledge about a person’s life situation and character is always a better tool for decision making. And realistically, any able-bodied human being has the capacity to repay a loan for a few thousand dollars. Any honest, working person should always have access to some credit for life’s necessities. C’mon, it’s just a few thousand bucks!

So what about credit to fund a business? Now we are playing in a different ballpark. First, a business venture is a risk an individual takes to be profitable. Business lending differs from consumer lending, because repayment hinges upon the profitability of an enterprise, and not someone’s wages.

When someone buys real estate as an investment, it is a business loan. When someone needs a line of credit to bridge the collection of receivables, it is a business loan. When there is a need to purchase equipment so work can be done to fulfill a contract, you are dealing with a business loan. Note that this is far removed from the member that is down on their luck that just needs a little understanding to gain access to necessities.

Understanding the risk in lending to a business is much different than understanding the risk in lending to an individual. Because the repayment means is much different, the math and statistics are entirely different. Business loans tend to deal with larger sums of money, which means larger potential losses. This leads to business lending being given more serious treatment overall, and thus, CUs must engage in business lending with the same standards that any bank would. In this case, we see less flexibility to help the member at any cost, because simply put, the cost becomes so much greater.

Character of the business owners matter, but now, risk to an institution’s capital matters much more. This creates the major rift on how CUs can approach business lending and consumer lending.  And for these reasons, financial institutions separate out the business lending from consumer lending completely. The consumer lenders report to a retail operations specialist, and the business lenders report to a chief credit officer. While it all may seem like lending money, they are different like apples and oranges.

A credit union should help honest members going through challenging times, because that is part of the credit union mission. And, credit unions should provide business loans, because it helps support jobs and economic development in the community. However, a credit union shouldn’t always exhibit the same flexibility in making business loans like it would in consumer lending. Believing in a member and their character is important, but giving them credit for a risky business proposition is like giving them rope to hang themselves. In this case, the CUs need to be on par with bank lending standards in the field of business lending.

New CU Business Regulations, Time to Grow Up!

When I was in junior high and high school, I had a curfew to meet.  I also had to report where I was at and where I was going.  My parents were concerned about me and wanted to know how to keep me safe, just as all good parents.

After high school, I ended up attending a college in my hometown.  After one year of living on campus, I quickly learned the benefit of living at home and commuting to college.  I could save money on room and board.  Going home also helped get away from the campus.  If I wanted to get away from home, I could always crash at the fraternity house on campus.  It was the best of both worlds.

When I was in college, my parents did not impose a curfew or require me to report where I was at.  If I stayed up till the wee hours of the morning, they did not care as long as I was mindful and respectful of them when I came home.  But this freedom also came with more responsibility.  If I stayed out too long and was dog tired the next day it would impact my grades.  My actions would impact my grades and future opportunities in life.

This year, as credit unions, we are on the edge of a major change in business lending regulations from the National Credit Union Administration.  The main spirt of the change is to move from a proscriptive regulation that defines inside the regs what is permitted and what is not, to a regulation that has more freedom and where the CU is reliant upon sound credit lending policies and practices.  The former is much like my life in high school at home.  I had to let my parents know where I was and ask permission for what I wanted to do.  The latter is like my college years at home.

While the new regs will be a welcome relief for many commercial and agricultural lenders, it also requires greater responsibility and restraint.  Items that CUs for years have wanted such as the ability to decide when to get a guarantee and when to not, will be present in the new regs.  However, this “gift” also increases the responsibility of the credit department in making sure that sound lending judgement and credit structure is put in place.

The new regs will increase the credit expertise that the CU will have to exhibit.  Credit administration folks will have to justify their decisions and will not be able to go back to the proscriptive regulation of the past.  Commercial lenders will have to answer to the NCUA for their decisions.  What may be worse is the commercial lender answering to their board for a loss sustained from a poorly structured business credit.

In many ways, the changes in business regs from the NCUA will be like my growing from a high school student to a college student.  There will be more freedom, but with more freedom, comes more responsibility.  If anything, the changes will create more demand for sound internal credit departments and experienced business CUSOs to properly manage these loan assets.

Candor

If you met the man who built one of the most successful companies in the world, you probably wouldn’t think he was the guy behind it all. Under Jack Welch’s management, General Electric’s value rose by 4,000%, and it was a top company worldwide in all its business lines by the time Welch left in 2001. Jack Welch only stands 5 feet, 7 inches, and he doesn’t have thick luxurious hair. In fact, he is bald, and even speaks with a bit of a stutter. Not having a natural born leader look or charisma, why was he able to get so many people to follow him and believe in him? Jack attributes it to “candor.”

Welch wrote in his book, Winning, that candor is a necessary element to any successful business. In fact, Welch has even gone on to say that lack of candor is the biggest dirty secret in business. Welch noted, “Lack of candor basically blocks smart ideas, fast action, and good people contributing all the stuff they’ve got. It’s a killer.” In other words, when people don’t speak up, any organization is worse off for it.

Speaking from a personal experience, some people view candor as something radioactive, which you should avoid and shield yourself from. Working at a bank in Washington DC, I had a precarious situation as a senior underwriter, because I believed my job was to shepherd through good loans and stop bad loans from being made. To my surprise, the bank had staunch factions that made this difficult to accomplish.

Lenders felt anytime someone stopped one of their loans, it was a malicious act by an enemy. On the other hand, the credit department counted their wins in how many loans they could decline. In my attempt to see good loans get made, my credit team thought I was working against them. But when I tried to stop bad loans from being made, the lenders thought I was working against their team.  It left both sides wondering whose side I was really on, even though I thought I was ultimately trying to be on the “bank’s” side! It appeared that facts were inconveniently getting in the way of feuding departments trying to vie for greater control within the bank, and profitable decision making had taken a backseat.

In a more interesting situation, I was a Peace Corps’ volunteer in the former Soviet Republic of Ukraine. I was invited to speak at a university, and told I could speak about anything I wanted. While still being young and naïve, I thought it would be a great opportunity to discuss how to reform education in Ukraine to reduce corruption. In fact, my whole argument was they needed to pay educators much more, so they can hold them more accountable and make the bribes seem petty and not worth the risk. After that event, I was blacklisted by the university. When I found this out, I naturally wanted to know why. I was informed it was because I acknowledged that corruption may exist in their institution.

Candor, which is defined as “the quality of being open and honest in expression,” is a tough quality to have. Candor might hurt someone’s emotions, or is unpleasant to hear. And, it isn’t uncommon for people to shoot the messenger, so nobody wants to be the bearer of bad news. But, good organizations value candor and encourage it. Welch knew this, and used his own candor and solicited the candor of others to transform GE into one of the best company’s in its day. Welch understood that all the facts can’t be dealt with unless they are all put on the table. Only in an environment where anything can be honestly discussed can the best decisions be made to build better companies.