Successful Business Lending: Pay Attention to the M&Ms

Now I know that someone will say, “Ah!  Finally someone has found the secret of lending in chocolate candy!”  Now this is not about that kind of M&Ms.  But understanding commercial lending can be boiled down into getting a good understanding of the math and management of a company.

A few weeks ago, as I was helping my daughter with her algebra, she asked me, “Dad, how much do you use math in your work each day?”  Her question caused me to realize just how much my job is based upon math.  We look at all kinds of ratios:  Loan-to-Values, Debt Service Coverage Ratios, Current Ratios, Debt/Assets, just to name a few.  Some of these same principles and ratios are used to judge a company to determine if it is a good investment.  In the case of either lending or investing, once you gain a commanding review of the math and all the factors that drive the numbers, decisions can be made to the credit or investment worthiness of the company.

I once had a loan on a used car dealer who had created one of these buy-here, pay-here car lots.  They catered to people who needed a vehicle and who could not handle the payment of a new vehicle.  The company utilized quite a few different banks to fund all their inventory and loan paper.  Looking back, the company was too leveraged, and we had problems historically with the debt to assets and the DSCR, was acceptable, though it was thin.  We did the loan with a SBA guarantee on it to help facilitate a new car lot.

Well, in this case, my violation of the key math ratios proved deadly to the credit.  The company failed to make it in a downturn in the used car market and we were forced to liquidate what we could get our hands on and file a claim for the remainder.  In this case and in nearly every other case in commercial and agricultural lending, if the math does not work, the credit will not work.

The second “m” is management.  Even if the ratios work well and the deal passes muster with all the empirical credit analysis, it still takes good management to execute acceptable performance in the company.  I once had a high-performing hotel in a resort community in my portfolio.  The owner wanted to sell and I financed the new buyer.  The borrower had an adequate down payment, good reserves, and had even owned and run a successful restaurant in the same community.  So surely, this was an easy credit, especially since the math works, right?

Wrong!  The success of the restaurant was largely due to good people that he had hired.  When he purchased the small hotel, in order to save money, he moved into the manager’s quarters on site instead of using an experienced general manager.  Then, he decided to cut housekeeping staff and do most of the work by himself and his wife. 

The challenge here is that he did not have or develop the skill set to keep the hotel desirable and also to relate to the customers.  An example was his solution to deal with a noisy customer was to post laminated sheets of paper throughout this beautiful, rustic hotel, telling the clients to be quiet.  These stuck out like a sore thumb.  His interaction with the customers was as abrasive as well.

Then, to save more expenses, he attempted to cut down on ongoing maintenance items on the property.  The hotel, once a desirable place to stay, had become a place where people would avoid.  The credit that worked so well with the math, had failed with the management execution.  It had become a problem credit. 

So a violation of the empirical math or the ability of the owners to execute on the mission, can each quickly become the death knell of the company, and unfortunately, your credit.  The best management skills can rarely overcome bad financial ratios.  And the best performing companies can fall into disarray if the leadership is not able to perform.  

Lines of Credit

A line of credit is an interesting credit facility. Basically, it is like having a credit card with a high credit limit for business purposes. The institution preapproves you for a set limit of money you can borrow. Then, you can submit a request to draw on that money and have it paid to a vendor, or deposited into your business account, or it might even be linked to an actual credit card.

It used to drive me crazy when someone would request a line of credit and say the purpose was for “working capital.” Well sure, that much is obvious. With small businesses, it tends to be a matter of having a way to separate business expenses from personal expenses. In this situation, the line of credit will not be particularly large; probably under $100,000. In this case, the line of credit is not necessarily for “working capital,” but more for documenting business expenditures.

For larger businesses, which we tend to call “commercial and industrial” or “C&I” operations, a line of credit does fulfill a distinct need of providing working capital. However, why that line of credit needs to be a source of working capital should be clearer in the request or the underwriting. Most often, these lines are used to bridge the collection of accounts receivable. In other words, a contractor has billed someone he/she provided services to, and is waiting for that bill to get paid. In the meantime, the contractor needs to start work on another contract, as well as pay their own bills for keeping the lights on. The contractor will then draw on the line of credit to pay for the things that need to be paid for today, and then pay back that line of credit when the account receivable is collected.

Another way in which a C&I operator may use a line of credit for working capital is to finance inventory. In other words, they will draw on the line to buy raw materials or wholesale products, and then pay back the draw after they have sold that inventory. This poses a much greater risk than financing receivables. An account receivable represents a completed sale; whereas, inventory is really a sale waiting to happen. There is no assured time in which it may be sold. It may never be sold. Then how would the line be repaid? This is why financing inventory is more challenging!

To make sure that lines are only drawn for the purposes of accounts receivable or inventory, the borrower must submit a borrowing base to prove these assets are present on their balance sheet. This also helps prevent the line from being used for non-working capital purposes. If a borrower has a need to have funds available like a line of credit, but will use it to purchase vehicles, equipment or machinery, we instead setup a guidance line that will convert to a term-out of the principal after a specified time. Otherwise, we would have a line of credit with a balance that never gets repaid from the sale of an asset. In this case, we say the line has permanent working capital, or is “evergreen,” since it is always outstanding.

To summarize, all lines of credit are not necessarily for the same purpose. Be sure to find the underlying need for the line of credit so you can structure it accordingly.

Judging Relationship Profitability

One item that has amazed me in the credit union industry is there seems to be no push to gauge the profitability of the member to the credit union.  Now I do know that we are here to serve the member, but if you are not making what you can, then there are less members you can serve, and if it gets to the point of serious losses, you will go out of existence! 

So if finding a way to hit a target profit level is essential in making our institution viable for the long run, then we must have some manner to figure out the profit from our loans and deposits.  If we set targets for a desired return on assets, we can create a pricing model that will be used to determine thresholds that need to be hit as we price loans and deposits.  This can be used for an individual relationship or for an entire division of your shop, such as auto loans. 

The methodology can become quite complex but it the concept is relatively simple.  Let’s look at a business customer seeking a new loan to purchase a building.  The client already has deposit accounts with you and some other ancillary services.  Your institution decides it has a goal of hitting a 0.80% ROA.  How would you go about figuring where to price the relationship?

In this case, you decide you want to lock the rate for 5 years. Now even though your CU may be flush with deposits, the prudent method of judging the profitability is using a matched-funds principle.  This assumes that every dollar you lend out has to be funded with dollars borrowed for the same maturity as you are locking the interest rate for.  In this case, a 5 year loan is funded with dollars borrowed for 5 years.  Typical indexes used may be US Treasury Notes, LIBOR, or FHLB Advance Rates.  So your cost of funds for that loan will be the underlying index.

On the income side, you have figured that your CU makes an average of $1,000 off other products they purchase from you.  You are also charging fees on the loan, since you don’t work for free.  Points will be amortized over the life of the loan.  Your client also keeps an average balance of around 10% of the requested loan amount with you in accounts that do not pay interest.  These deposits can be treated as a source of “free funding” for that portion of the relationship. All these items are factored in.

On the expense side, you have ongoing costs associated with the loan.  Your CU leadership should have an estimate of how many man hours maintaining that relationship will require each year.  In our case it is a real estate loan that requires annual reporting and annual risk reviews.   An annual total of this price should be considered an expense that comes out of your spread income.  Another expense would be for a loan loss reserve, which can be assigned on a sliding scale based upon the risk rating of the credit. 

In the end, the net income for a year from that loan can then be divided by the expected average balance for the year on the loan, to reach a ROA for that credit.  So what can you do if the ROA does not meet your threshold?  The various factors you can play with are the interest rate, doing things that will lower the risk on the loan, increasing deposits, or adding more services that generate fees. 

I am not saying that you should never enter into a loan where the ROA is below your threshold.  There are business reasons to do that from time to time.  What is more alarming is not even realizing how the rate for a loan has an impact on your ROA in the first place.  Not knowing your cost, may tempt you to price loans as your neighbor does down the street.  Unless he knows what he is doing and has the exact same funding structure as you do, that can be a recipe for disaster.  Also, not taking time to figure out where you are at is sticking your head in the sand and ignoring upcoming problems or actual areas where are excelling.

Another problem is judging long term loan money against a short term index, such as Prime.  This may inflate your earnings spread, but is not a true measure of the true cost of funds associated with that loan. 

So with a little work, you can create pricing models for your CU, to gauge the profitability of individual relationships or even entire divisions of your shop.  Contact us for more ideas.  

The Balance Sheets: Different Strokes for Different Folks?

If you want to borrow money to fund a business or a farm, you will need to provide financial statements to the lender. When we say “financial statements,” we usually mean income statements (or “profit and loss” statements) and balance sheets.

An income statement tracks revenue and expenses. Sometimes, a business tax return makes for an acceptable substitute because an accountant has made a professional effort to summarize these details appropriately. However, when it comes to the balance sheet, what this includes is much more nebulous.

A balance sheet reflects possessions as assets, what money is owed as liabilities, and the net worth as the difference between the assets and liabilities. While this sounds fairly easy to understand, you may quickly find that each business borrower has a different spin on what belongs on a balance sheet.

Most businesses now are incorporated, so they are technically a separate legal entity from their owner. This is done to give business owners legal protection from what happens at the business, and the separation protects their personal assets. But here is where the idea of balance sheets becomes fuzzy.

When you ask a business owner for their balance sheet, you might get something different depending on what type of business you are financing. A business owner that sells goods or provides services will have a balance sheet that reflects business assets and business liabilities. A farmer, on the other hand, will usually give you a balance sheet that reflects all his assets, both business and personal. And, a real estate investor, will probably just give you his personal financial statement showing all his personal assets and liabilities. When pressed for a business balance sheet, a real estate developer may have little or nothing to show you. Why do such differences exist?

A business owner that has a commercial or industrial (C&I) business, has a distinct difference between what assets are used for their business, and what assets are strictly personal. Likewise, it is easy to track which loans are personal and which loans are business related.

In agriculture, the difference between what is business related and personal are blurred. A farmer most likely regards all of his assets and liabilities as “farming “related. With farming not being just a profession, but a way of life, it is naturally difficult to disentangle what are personal and business assets, as well as respective liabilities.

And, why would a real estate developer have a challenging time producing a balance sheet? As it turns out, real estate financing is quite simplistic. If a business is nothing more than commercial real estate, then typically the only asset to that business is a single piece of real estate. And, the only liability in that company is the real estate mortgage. Knowing that, a real estate developer doesn’t see the need in maintaining and updating a balance sheet, when he/she already knows the value of the property and balance of the mortgage.

It is important to understand that not every business operates under the same set of assumptions. Depending on who your borrower is, you may be provided with a different type of balance sheet, or no balance sheet at all! Even with business lending, there is a fair amount of nuance that goes into reading and understanding financial statements, just like how any member at your credit union deserves some amount of personalized consideration.

Employment Becomes Rarer

The September employment report just came out today and the numbers are horrible.  The US added only 142,000 jobs last month.  This is much lower than the 200,000 jobs, which was the consensus estimate.  Also the August report was lowered to only 136,000 new jobs.  The monthly minimum number of new jobs that economists quote as necessary just to keep up with population growth is 150,000.  We did not even get that. 

The numbers of those Americans over age 16 and not in the labor force has reached a record high of 94.6 million.  Labor force participation has dropped to 62.4%, a level that we have not seen since October 1977.  The unemployment rate, U3, remained unchanged at 5.1%, but this was from another 350,000 Americans leaving the workforce.  If you look at the real-world unemployment rate as reported from Shadow Government Statistics, which uses the same methodology the Bureau of Labor Statistics used during the Carter Administration, the unemployment rate is flat at 22.9%.

The diffusion index, measures the number of industries that are adding jobs to those eliminating them.  The lower the number, the more weakness in the job market.  It ended September at 52.9, down from 61.4 a year ago.  This also was the worst reading since February 2010. 

Challenger, Gray & Christmas, Inc. is a staffing company that complies layoff statistics on a monthly basis.  The September numbers totaled 58,877, a 43% increase from the prior month. While this amount was down from July, the average trend is increasing, a phenomenon that has occurred for the last couple of years.  This past quarter was the second highest job cuts since the Great Recession. 

The cuts are also hitting across different segments of the economy.  A few months ago, energy was the sector that was hit the most.  Today, the computer industry (Hewlett-Packard), retail and automotive are the most hit.  The announced layoffs are indicators of future economic weakness.  Heck, even Wal-Mart announced it was cutting staff from its Bentonville, Arkansas headquarters as they also cut their outlook for the year.  Whole foods announced Monday it is laying off 1,500 people.  Sprint is looking at cutting $2.5 billion in expenses, which could impact some of their employees.  Target laid off 1,700 employees at its Minneapolis headquarters and plans to cut another 2,000 jobs in the next two years.

All this weakness in the job market does not bode well for raising interest rates.  The possibility of an increase in October is low, and this trend will continue throughout the end of the year and well into 2016. 

The interesting thing is if our economy is so healthy, why do we not see the job growth?

The Economy is Struggling: Blame Congress?

It is looking increasingly likely that the Federal Reserve will raise interest rates soon; however, inflation remains low and economic output remains below desired levels. Logic would seem to dictate that this is not the ideal time to raise interest rates to bring inflation or growth under control. Then why is the Fed under pressure to raise rates?

The Fed has run out of policy tools, and they are concerned they will have nothing with which to fight the next recession. They appear to believe that economic conditions will not improve much more significantly, and they are likely right. The Fed has done all it can to better the economic situation of the United States, and now they need to stop concentrating on the present and focus on future battles.

Has the Fed done a poor job at fostering an economic recovery and simply given up? Not at all. The Fed has done everything it could possibly do, and may have even gone beyond traditional measures with their quantitative easing program. The Fed is limited in what it can do. We forget that economic stewardship lies with two bodies, monetary policy (overseen by the Fed), and fiscal policy controlled by the Congress. If the economic recovery is still stuck in the mud, blame Congress!

Monetary policy is the control of the money supply. Fiscal policy is the control of the US budget and laws surrounding the economic policies of the United States. Does fiscal policy really make that much of an impact on the economic well-being of the country? We have several local examples that make this point clear. Take for example, Deadwood, SD. All the gaming, hotels and restaurants in this town exist purely from the fiscal decision of the SD legislature to allow gambling in this one community in the State. And, look at the oil boom in western North Dakota. The State of New York banned fracking, which will prevent any future oil boom in that State, but the State of North Dakota has chosen to allow and manage it, making such large infrastructure investments and job growth possible. Even the city of Sioux Falls, SD has seen enormous growth due to South Dakota’s unique banking laws.

On a national level, you can see the results of fiscal policies with such programs as “cash for clunkers” or tax breaks for energy efficient home purchases. These policies created large positive impacts on specific industries.

If we are not seeing more national economic growth, it is because Congress is failing to implement policies that foster economic expansion. And as we know, Congress has passed a record minimal amount of legislation in the past few years.

When we step back and compare monetary policy and fiscal policy, it appears fiscal policy makes much more impact in creating jobs and expanding businesses. Monetary policy (the Fed), is really more of a thermostat to the house where the economy lives, and it can turn on the air conditioner when it is hot, or turn on the furnace when it is cold. But, it is Congress who installs the air conditioner and the furnace. If these appliances are not working appropriately, there isn’t much more the Fed can do to regulate the temperature.

It seems strange the Fed wants to raise rates right now, but they have little choice. They can’t do anything more by themselves to improve the economy. The failure of Congress to act or do more to promote economic prosperity is the true reason behind our dull economic recovery. 

Dawn of the Next Generation of Agriculture

Some experts believe that by the year 2050, the Earth’s population will reach nine billion people.  This is up from the 7.3 billion in the world today.  Of course when you have more people, they all will demand more food than what we produce today.  Other demands on infrastructure from energy, transportation, and water will also increase.  This will require new solutions to satisfy demand.

Today, we are seeing new advances in technology that are pushing agriculture into the future. Lance Donny, founder of the start-up OnFarm Systems, an agriculture data company, divides up the history of Agriculture into 3 different periods.  First is Agriculture 1.0 from the beginning of the world until around 1920.  This period was marked with a lot of manual labor and some tools.  Agriculture 2.0 ran from 1920 to 2010.  This period was characterized by machines, fertilizers, improved seeds, and farming methods allowed farmers to produce more with less struggle.

Now we have entered into a new age, Agriculture 3.0.  This time is now marked when data is crucial and can become the most important resource.  Data will help a farmer understand how and when to use fertilizer, or insecticide.  Data can help know where the majority of the herd is located on a massive ranch. 

A few years ago, I visited a large dairy.  The technology in dairies today is amazing.  Every time a cow is milked, vitals of the cows are taken.  If the cow has a fever, then after the milking, the computer chip in the cow’s ear tag will open a gate that the cow will walk through to the vet.  If a cow is milked twice a day, that will also produce two check-ups each day for the cow. 

Technological advancements on the farm are huge.  In 2010, AgFunder, a crowdfunding platform for the agriculture industry, saw $400MM of deals.  In 2015, it will exceed $2.1B. The subsector of farming that is producing the most funding this year is in robotics and drones.  This can be expected.  The Association for Unmanned Vehicle Systems International cites a study that commercial drones will generate over $80 billion in economic impact over the next decade with agricultural drones providing the most benefits. 

Yamaha is heavily involved in producing drones and already sells these to Japan, South Korea, and Australia.  Now one in every three bowls of rice in Japan have been treated by a Yamaha drone.  Now Yamaha is looking at entering the US market.  This drone is rather large, and can be used for crop inspection, fertilizer application, or pesticide spray. 

Drone technology is only one of the new inventions in the world of Agriculture 3.0.  We are also seeing robotics for harvesting, GPS drivers of tractors, and various computer applications to monitor animals’ health.  Watch for other advances in technology and how these will play an important role in the future. 

Since we are talking about information, I will make a plug for our classes this fall.  Next week, on Monday and Tuesday, we are teaching Intermediate Ag Lending in Miles City, Montana.  We also have Commercial Real Estate Lending and Beginning Agriculture Lending in Fargo, North Dakota in the first week of November and also have Commercial and Industrial/Small Business Lending during the third week of November in Deadwood, South Dakota.  These are all great opportunities to meet other lenders and increase your knowledge and skill level in your field.  Please contact us for more info.  We would love to see you.

Fed Watching: No Interest Rate Hike on the Horizon

Well Fed watchers for the year have hyped up the possibility of an interest rate hike in September.  Last week, the Fed voted to hold rates where they are.  The last interest rate increase by the Federal Reserve was in 2006. So we have gone nearly a decade without any sort of increase in rates from the Federal Reserve.  We have lenders working today, who have not experienced any impact from increasing rates as a result of Fed policy action.  It kind of makes one wonder if this will be how things are for the foreseeable future.

Fed Chair Yellen cited that while the recovery from the Great Recession has advanced sufficiently, there were enough uncertainties in the world and a less inflation than the 2% range, which is where the Fed would like to see it.  Inflation was recently reported at 0.2%, and has not exceeded the 2% threshold since 2012.  She also mentioned weakness in the labor market as a factor to hold off on increasing rates.  There are high levels of part-time involuntary employment and a very low labor force participation rate in our economy.

Other factors are weakness in economies and markets throughout the world.  This has helped lower import prices and also risen the value of the dollar in comparison to other currencies.  A rate hike at this time will strengthen the dollar more, which will make US exports less competitive on the world stage. Yellen mentioned concerns about China 16 times during her press conference wrapping up the Fed meeting. 

The challenge with the Fed’s continued zero interest rate policy (ZIRP) is that it leaves very few monetary policy options available if there is some sort of severe downturn in the economy that could use some intervention from the Fed.  Also, would any rate hike result in a pullback in the markets and the economy, taking us past the point of slowing down economic growth to a full-fledged recession?  And would pumping additional money into the economy just swell the already bloated debt market?

But ZIRP can be here to stay for a while.  When Yellen was asked if the Fed could be locked into a box where rates never escape from zero, Yellen said she could not rule it out.  Former Fed Chair Ben Bernanke was reported by Reuters last year that he did not expect rates to normalize in his lifetime. 

One factor that is not often discussed in its role in our economy is the impact of demographics.  The Baby Boomer segment of our population control nearly 75% of the net worth of the country.  These folks have just begun entering into retirement in 2007.  Over the next 14 years they will retire at a rate of one in every eight seconds.  When folks retire, they tend to spend less on goods and services.  Consumer spending is the largest segment of our GDP.  As more and more of these people leave the workforce, economic activity will decrease and it will become harder and harder to see significant economic growth.

Japan is several decades ahead of us on this demographic curve.  Their baby boomer generation has already entered into retirement.  They have had overnight lending rates at zero for almost two decades.  Their government has been involved in several stimulus projects.  Yet, while sovereign Japanese debt has ballooned to 230% of GDP as the government continues to attempt to grow the economy, economic growth has remained anemic. 

So barring any other new developments, we may be in ZIRP land for quite a while.

The Recession Wall Street Isn't Talking About

In the years of 2008 and 2009, a crippling recession was sweeping the country. America was suffering a terrible hangover from a reckless construction boom. The overbuilding of homes drove down home values, mass mortgage defaults triggered defaults in mortgage backed bonds, and the commercial real estate sector was suffering many of the same ills. Several banks failed as a result of these events.

The year is now 2015, and the worst days appear to be behind us. While policy makers are not satisfied with the slow pace of growth, it is growth nonetheless. The latest economic fears in the news surround what the Federal Reserve will do with interest rates, and what direction the stock market is heading. There doesn’t appear to be much concern with a specific industry wreaking havoc.

But those of us in the upper Midwest have a dirty secret. While the rest of the country was experiencing the pains of recession, we saw record years in farming and oil development. Our economy experienced a slowdown, but we didn’t feel a largescale slide backwards. And now the shoe is on the other foot; agriculture is entering difficult times, while the rest of the country isn’t aware or concerned with this issue.

How did it happen that agriculture was strong in a recession, and now it is weakening in a time of growth? Some of it has to do with commodities. When people were scared during the recession, they pulled investments out of real estate and securities, and preferred to buy commodities. If you recall, we saw record prices in gold, oil, and even corn and wheat. This wasn’t entirely to blame for the run up of agricultural commodities, because there were drought stricken areas in other parts of the world at this time too, putting less affected American producers on top.

Values in ag land had already been on the rise. It was becoming clear that advances in farming and genetics allows higher yields on the same price of land. The rising commodity prices only threw fuel on the fire, and we saw continued strong growth in ag land values. But then, the economy started to mend, and commodity prices across the board fell, as people felt comfortable getting back into their traditional investments. And now, local farmers are feeling the pinch. When corn could be sold for $6 or $7 a bushel, it made sense to buy land at a premium. But, having to pay the debt service on that newly acquired land with corn at only $3.50 or $4 a bushel, the economics have become unfeasible.

Now, as the rest of the country sees a return to normal conditions, the ag economy is seeing prices fall for land used in corn production. This will no doubt lead to stress on area farmers and their financial institutions. There could be a recession brewing, but it is interesting, people aren’t discussing it. At the very least, we are in for some significant turbulence in the ag economy.

With respect to beef production, we have also seen record run up in the price of pasture, due to a recent spike in beef prices. Hopefully ranchers and lenders are taking note of the emerging farmland issue, and not allowing ranchers to assume current prices will remain where they are at. Likewise, one day the price of beef will fall, bringing the price of pastureland down with it too.

FinTech : Will Technology Replace Banking Jobs?

I can remember back when my family first got “the internet.” I was probably around the age of 12, and we had a modem that dinged, donged, dialed and made all sorts of white noise to connect to the internet via America Online or AOL for short. It is hard to believe that was only 20 years ago, and now the internet is far more integrated into our everyday life.

Despite the internet being a household presence for 20 years, we continue to find new innovative ways to use it. The internet, for better or for worse, wreaked havoc on many traditional businesses. Take print media for example. The decline of the newspaper industry and major book retailers is directly linked to the rise of the internet. We have also seen the internet profoundly reshape the music industry, and now it is even challenging the television industry!

What about those of us in banking? I think we acknowledge that changes brought on by the internet have resulted in quieter branch offices and teller lines. Now people can monitor transactions online, wire money online, and pay bills and loans online. Also, there is even remote capture of deposits, so there is no need to bring checks to a teller to deposit. When was the last time you visited a local bank or credit union branch? There are still people there, but perhaps fewer. And now, they are more skilled generalists, who need to be skilled to handle a wide variety of problems that can’t readily be solved on the internet.

So what next? Can the internet start to replace other jobs further up the management chain? Crowdfunding has begun to show us that entrepreneurs may no longer need to go to the bank to get a loan. Crowdfunding, the phenomenon that allows an online platform to aggregate several small investments from a large group of people, is already being used to finance several small business ventures. By the end of 2013, the crowdfunding industry was only $5.1 billion, which is relatively small. But, it has seen explosive growth, since it was a $1.2 billion industry in 2011 and $2.7 billion industry in 2012.

Now, larger lending opportunities are attracting crowdfunding too. A notable example in recent news was the crowdfunding purchase of a $26.8 million office building in Washington DC, known as Georgetown Plaza. Companies like Realty Mogul and Fundrise are challenging how real estate transactions have traditionally been funded. If millions can be raised to fund traditional real estate purchases, then what can’t crowdfunding provide capital to? It would appear a new source of funding is on the horizon, and depository institutions should take notice!

It is hard to say if crowdfunding will replace commercial lending in any meaningful way, but it is likely to affect the course of business somehow. Other industries affected by the internet likely felt impervious to information technology too, but they have since faced their day of reckoning. What traditional banks and credit unions should start to do is evaluate crowdfunding to see if there isn’t a way to differentiate their products or incorporate crowdfunding  into their traditional lending practices, say through a CUSO or other subsidiary, instead of waiting until it is too big of a revolution to catch up to.
 

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!