How Millennials Will Change Christmas Shopping

The largest segment of the economic growth in the US is from personal consumption.  It is important to look at the individuals behind consumption to find clues into buying habits that may impact the economy.

Demographically, the baby boomers are the largest group and most powerful in terms of net worth and wealth.  As boomers retire, they will have less income and their spending, or personal consumption, will decrease.  Since my generation, the gen-Xers, is much smaller, we will not be able to counter the drop in consumption from boomers.  The next largest demographic group is the Millennials.  What will be happen to their spending habits?

While gen-Xers, grew up in an environment where there is strong belief in that the future will be better, Millennials may have the belief that the best days of our country are behind us.  As such, Millennials are less likely to spend their way into debt as past generations may have.  While probably most gen-Xers have credit cards a recent study cited 63% of millennials not owing a credit card.

The Global Economic Analysis blog “Mish Quotes” from “MarketWatch”, states that, “Most holiday shoppers plan to pay in cash.  Younger shoppers were especially unlikely to use credit cards; 48% of millennials said they would do most of their shopping with debit cards, and 36% said they preferred cash.  Millennials in general tend to avoid credit cards more than previous generations have done; 63% of millennials do not own a single credit card according to a separate Bankrate survey in 2014.  They grew up in the Great Recession and saw what happened to their parents.  They don’t want to ever be in a situation where they’re in debt.  They’re shying away from high-interest loans essentially.”

So while it is good to not plunge into consumer debt, without using credit the millennials will not sustain the consumer spending which so many retailers depend upon.  Economists can’t think of a world that is dominated by consumer spending, and subsequently debt.  The Christmas season economics news is dominated by spending habits of consumers.  Past decades of economic history have shown growth from an increase in the middle class as technology progressed and a more efficient division of labor made goods more affordable.  Now the only way to increase prosperity is to spend more.  It appears this will not be sustained.

Millennials are also smarting from large student loan debt which tends to decrease their disposable income and alter their spending habits.  Younger folks who saw their parents destroyed by debt now, will keep these memories their entire life.  Spending attitudes are a key force for consumption.  It took two generations for memories of the Great Depression to go away and will take at least a generation for millennials to have their memories of money struggles of their parents to vanish.  This will mean less spending on Christmas for millennials.

On the positive side, these new spending habits may cause the next generation to escape the slavery of consumer debt.  They may be able to teach their kids how to avoid this debt trap as they rebuild the economy.  On a negative side, shopping and spending during this Christmas season, which drives much of the economy will once again suffer.

From Tops to Pyramids: Shifting Income Distribution

In South Dakota, 46% of voters are registered as Republicans, 34% are registered as Democrats, and roughly 16% are independent. And despite a strongly conservative ideology in the state, many were shocked when a 2014 ballot initiative to increase the minimum wage was successful. 55% of voters supported the proposed increase to $8.50 / hour. This gives South Dakota one of the highest minimum wages in the country. Only California, Connecticut, Oregon, Vermont, Washington, and the District of Columbia have higher minimum wages. Why would a conservative state like South Dakota support an increase in the minimum wage?

I feel the answer lies in the shifting socioeconomic status of many Americans. For a long time, we have heard about the “hollowing out” of the middle class, but perhaps we haven’t been particularly sure how much it is myth or reality. It is much more challenging to observe in the Dakotas, because we don’t have the same economy and lifestyle as our urban neighbors on the coasts. If you drive through any of the cities in the Dakotas, you would be convinced that the middle class is alive and well. And I think that is true, in the Dakotas. But if you have had an opportunity to live in a major city, you will experience how disorienting our economic system can be. There is extreme wealth, and extreme poverty, and services that cater to people on both ends of the spectrum. However, it is very challenging to be middle class in these environments, and to live with no support in the face of high rents, unsubsidized transportation, and high taxes at every government level.

The issue at hand is income in the United States used to have a unique distribution to it. Imagine a spinning top, the kind of top that spins on a tiny point but has a bulbous body on top. If you placed that top upside down so the point was sticking into the air, you would have a fairly good representation of what income distribution used to look like preceding World War II. Think of the volume of the top with respect to the height as a representation of incomes. Most of the volume or incomes were around the bulbous body on the bottom, and only a few were really high at the tiny point where the top would spin. With most of the incomes clustered around each other, people had a shared sense of what it is like to be American.

Now in recent decades, the shape of that top has disappeared. Instead, income distributions have taken on the shape more similar to a pyramid that has stretched out the bulbous body of the top, and pushed some incomes lower, and some incomes higher. The effect is a more disconnected vision of what it is to be American. For those who saw their incomes pushed higher, they are content with the system, and for those who saw incomes get pushed lower, there has been disenchantment. Now there is disagreement over what is fair, and less of a consensus on what is ordinarily normal or even affordable.

What has caused these shifts is subject to a lot of study and speculation. A heavy influx of college educated people into the economy following WWII is likely one reason, causing income disparity between those with college degrees and those without. This would also suggest that the “bulbous top” shaped income distribution could have been an anomaly, which largely resulted from the prosperity that immediately followed WWII. Income inequality is not something new in the United States. It was well documented and discussed during the Gilded Age from 1870-1900 and again, a hot topic in the 1920s.

These sociological shifts are likely the reason even a conservative state like South Dakota would adopt a higher minimum wage. While conservative ideology is a dominant force in the state, still many with those ideals may have been pushed downward on the pyramid, and are trying to create a back-stop from being pushed further.

https://ballotpedia.org/South_Dakota_Increased_Minimum_Wage,_Initiated_Measure_18_(2014)

http://www.cnbc.com/2015/10/21/american-wage-earners-became-more-unequal-last-year.html

http://www.cnbc.com/2015/12/10/middle-class-americans-no-longer-majority.html

Economics of the Christmas Tree Shortage

I once had a management professor tell me that economics isn’t a real science, after I told him I had a degree in economics. I was a little taken aback, because my first thought was “what makes management more of a science than economics?” I am always perplexed when somebody suggests economics isn’t a science. It isn’t a “natural” science, but it is a “social” science. And moreover, it is probably one of the most empirical of the social sciences. Supply and demand affects how much money people have in their pockets, and this couldn’t be clearer than with the Christmas tree shortage this year.

The United States Department of Agriculture (USDA) reports that Christmas tree production has decreased by 30% in the last decade.  Drought conditions in several Christmas tree farming regions seems to be further exacerbating the declining supply. Now many local newspapers and finance news outlets are reporting on Christmas tree shortages in portions of the United States.

I went to the website www.realchristmastree.org to find some statistics about Christmas tree sales and prices. I graphed the results below for your benefit. The blue line represents the average price paid for a Christmas tree, and it corresponds with the left scale of the graph. The orange line represents the number (in millions) of Christmas trees sold, and its scale is on the far right.

As you can see, the data may appear to be exhibiting a pattern. It looks as though in most years when the number of trees sold declines, the price goes up. If there is a fixed number of trees that is delivered to market each year, then it will make sense in scarce years prices will be higher, and in surplus years the price will be less.

I added some dotted trailing lines as a shear guess as to what the pattern may continue to look like. From the large number of media reports that there is a Christmas tree shortage, we can reasonably guess that supply for 2015 will be less than 2014. Average price is harder to predict, but I read a number of news stories that even small 3 foot trees in New York were selling for as high as $50. I made a guess that the average tree price would be $45 for 2015, which is a huge leap historically.

The National Christmas Tree Association provided the following comment with the data:

Many factors can influence total trees purchased, including trees available for harvest, harvest conditions, weather conditions, number of consumers traveling for the holidays, number of retail outlets offering trees for sale and even the number of days between Thanksgiving and Christmas.

There also appears to be another factor affecting the Christmas tree shortage, and that would be geography. Too often people forget, economics is regional. While you could haul a Christmas tree cross-country, why would you if the quality will deteriorate? Most tree sales are relatively local, with inventory probably not traveling from more than one state away. It appears to be California and the Carolinas this year that are being hit particularly hard by the shortage, because there have been drought conditions in their Christmas tree farming areas.

While the Christmas tree shortage doesn’t prove economics is a science, I believe economics helps us understand it. I am not going to comment whether management is a science, but economics is certainly no less scientific than management, as far as I’m concerned.

http://www.realchristmastrees.org/dnn/NewsMedia/IndustryStatistics/ConsumerSurvey.aspx​

Why the Grinch will Steal Christmas for Retailers Part 2

In the last blog, I identified one of the biggest reasons that big box retailers are behind the curve is because of technology.  The growth in retailing today is mainly from the online powerhouses like Amazon and Apple.  There is a trend is exemplified in my kids.  This trend desires to purchase as much online as possible—from Christmas gifts to toothpaste.  This makes shopping more of a social experience than one to actually acquire items.  Places that will appeal to the social need will be able to find a niche among this paradigm shift in shopping habits.

There is a second trend that will bring out the Grinch for retailers this Christmas and possible for many other Christmas shopping for some seasons to come.  It is because of a resource that is beginning to disappear and it will continue to disappear for years to come.  There is no way we can replace the resource quick enough to stem the tide.  The resource is not oil, water, gold, or any commodity.  This resource is people.  This will not only have an impact on Christmas sales, but also on the economy as a whole.

Economist Harry Dent spent considerable time studying spending and wealth trends of Americans.  On average we all act in a similar fashion.   We tend to enter the workforce in our early 20s.  We get married around age 26 and begin to have kids a few years later.  Most of us then buy starter homes in our early 30s, which are traded up for larger homes in our late 30s or early 40s.

We then enter in our peak spending phase, the time when we tend to have the most disposable income and purchase stuff like cars, technological gadgets, and various grown up toys.   This usually occurs from ages 39 to 55 but the average peak is around age 46 for an average household and 54 for those most affluent.

But after this peak, our spending habits change drastically.  We begin to look at the future and see retirement in the future.  Our kids begin to leave home and start their own families.  People begin to retire in their mid-60s and have their greatest net worth at age 64.

Take this information and look at the demographic condition of the US.  Births in the US saw sharp increases from the late 1930s to early 1960s.  Usually the time from after WWII to the early 60s is referred to as the baby boom generation.  After the mid-1960s, the birth rate dropped and did not pick up to a level close to the boomers until the millennials came on the scene.

Baby boomers represent around 35% of the total US population but they control 77% of all net worth in the US.  As boomers have moved into their peak spending and net worth years, the economy has grown and the stock market has taken off with it.

But since 2007, the boomers have begun to retire at a rate of one every eight seconds.  In the next 14 years we will see up to 50 million boomers leave the workforce.  But think of what this means, you have people who are not generating as much spending because they have less income.  When the largest component of your economy is consumer spending, this could mean that the largest part of our economy will shrink.

Not only that, but think of the skills and knowledge of those who are leaving the work force.  We will be losing much of our intellectual capital and experience.  And the generation that follows the baby boomers, the GenXers, of which I am a part of, is not nearly as large as the boomers.  We would have to greatly increase our spending in order to meet the deficit the boomers will leave.  This will not happen.

So think about what this means possibly for real estate prices.  If more and more folks are retiring and selling their homes, if the supply of houses exceeds the lower demand from future generations, we will see prices drop.  When you look at the stock market, Dent shows that you can overlay the inflation adjusted Dow over a population chart that adjusts births to match an average peak spending age, there is a close correlation between the two.  If the correlation continues, we could see a long time drop of 30-60% in the stock market before another bull market begins around 2020.

As affluent baby boomers grow older, their spending moves from the larger home to a vacation home around their mid-60s.  Then in our late 70s we tend to downsize, move into a condo and end up in a nursing home in our mid-80s.  So right now with the baby boomers retiring, we will begin to see them seek to sell their large homes in favor of smaller ones with less maintenance.  For the first time in modern history, America may have a shortage of home buyers.  What makes it worse is the millennials are waiting to purchase houses later because of preference or economic stress with high student loan debt.

This situation is exactly what Japan experienced in the mid-1990s when its own baby boomers were followed by a much smaller generation.  The property market has not recovered since that time.  The price per square foot of real estate in Tokyo’s Ginza district is worth less than a quarter of what it was in 1989.  If we see a massive retraction in real estate prices, it may put as many as half of the homeowners in a negative equity position.

But this blog was originally about Christmas shopping so let’s get back to that.  Imagine what will happen to retailers who rely on a strong Christmas season for a profitable year.  First, an overall decrease in demand would cause retailers on the whole to experience less revenue from January 1 to Black Friday.  Second, as so many boomers have less income and adjust their spending habits accordingly, we will see poorer results for Christmas shopping.  The demographic Grinch will have struck and will continue to until the millennials spending and wealth begin to kick in.

Thinking Inside the Box

I was listening to the radio this week, and the local disc jockey was talking about clichés he couldn’t stand anymore. One of the clichés was “thinking outside the box,” which I probably hear on a weekly basis, and it is probably me saying it half the time. Thinking outside the box is practically part of my job description, because our company is an intermediary for credit unions that often need to create new and unique solutions to solve problems. But, innovative thinking isn’t the solution to all problems. Sometimes having a strong command of the fundamentals of lending and operations is all that is really needed to solve some of your institution’s problems.

I suppose we can call it “thinking inside the box” when we use common sense and implement basic solutions that were simply missing to begin with. I can elaborate on how institutions are failing to incorporate the basics after having worked as a bank examiner who critiqued bank managers, and also working at the CUSO where I speak with many CU management teams. With both industries there are definitely recurring problems where people are failing to think inside the box.

The most common way I see people failing to think inside the box is when they blame the competition for their woes. When people blame others for their failures, they are failing to do their job. All organizations need to hold people accountable for their actions, and hire people who are not afraid to take responsibility. And yet, when people fail at business development or departments fail to be profitable, they point the finger at people outside the institution for the reason behind their incompetency.

The next issue I often see is the lack of profitability. This is either a revenue problem or an expense problem. With revenue, it may come from holding too much cash, and failing to deploy that cash into interest earning loans or investments. Or with expenses, it may be they complain about the high cost of compliance and overhead, but fail to recognize that their efficiency ratios fall far shorter than their peers. Every institution must generate enough interest income to pay for operating expenses, which is a basic function of all depository institutions, and a failure to do this indicates a problem with management, not the industry or local competition.

And with business lending, we see too many credit unions approach business loans the same way they approach consumer lending. Lenders want to help members out because they have great character, mistakenly lending large sums of money to fund business operations that have significantly more risk than a normal car loan or home loan. Also like consumer loans, some credit unions will not follow up with borrowers after they book the loan, failing to realize it is standard industry practice to continually update information in the file. These institutions fail to monitor risk by following widely known best practices.

As with any task with life, success is 10% innovation and 90% perspiration. In other words, thinking outside the box is important, but working hard to master your core business operations is truly the most important function your credit union should undertake. If your credit union is not operating effectively to begin with, then thinking outside the box may do little to improve the current situation.

Why the Grinch Will Steal Christmas for Retailers Part 1

The day after Thanksgiving is dubbed “Black Friday”.  This was traditionally recognized as the time when retailers would begin to go into the black in terms of accounting.  That is begin to be profitable.  And the better the Christmas season would be, the more profitable they would end the year.

Yet the days, when the big box retailers rule the Christmas season will fade away as major changes are on the horizon as shoppers are changing their preferences in shopping.  When I was a kid, one highlight was the arrival of the Sears Christmas Catalog.  My brother and I would spend hours poring through it as we made our “want” lists.  The catalogs would create some mail in ordering, but to send an order that way was risky as you may not receive your gifts by Christmas.  I think catalogs helped drive more people into the stores where they could pick up their merchandise.  Even if you were not a catalog shopper, you would probably be among the massive throng of shoppers rummaging through the local stuff-mart to fill your list.  Usually for me, this begins around December 20th!

But retailer stocks are taking a serious hit.  Sears is down over 35% since the first of the year.  Wal Mart fell 10% last month and others like Macy’s and Neiman Marcus have dropped farther.  Large retailers come and go.  I have seen the likes of Montgomery Ward and Circuit City disappear from their prominence.  Clearly the market does not have the usual rosy outlook for retail sales this time of year that you usually see.  Part is from a change in shopper habits.

Fast forward to today.  Shopper’s preferences in shopping has changed.  One of the beautiful things of the world we live in is that I can sit in my underwear at my computer and compare different items, read customer reviews, see which seller has the best price, and purchase items in the warm comfort of my own home away from the cold weather and insane crowds.  I think there are some days that if I could avoid going to another store and could purchase everything at home, I would.

My kids are all over this trend.  My daughter is always showing me something that she has found on Etsy and purchased most of her gifts last year from that site.  My oldest son talks of a day when you can have an automatic shopping list on your computer and get shipments for grocery, personal maintenance item, and cleaning supplies automatically.  I even have an app that I found where I can take a picture of myself and order a tailored dress shirt!

Services like Amazon and Apple are making a killing in retail as the new wave of retailer.  Imagine what would happen if everyone shopped for Christmas gifts from their home as I have.  Crowds and foot traffic at the stores would disappear in to ghost towns of warehoused merchandise.  This trend of shopping from your home is a new wave that big box retailers have to figure out or suffer the consequences.

Oh there will be some areas where it is harder to buy items from your chair.  I think it will take longer to purchase building supplies or groceries (though some stores are beginning on-line grocery services).  But it will also impact where you buy.  My trips to Wal Mart are a fraction of what they used to be as I will opt for a smaller grocery store or a convenience store for emergency essential items.

I think it will also make going to the store more of a social event than a chore to do.  There will be more leisure in shopping which will usually be accompanied by Starbucks and a nice lunch.  Stores will have to have a product that requires people to go to pick up or they will have to provide an experience where people will want to go to in order to shop.  The last option is they will have to successfully jump on the wave of online sales.

Until the big box retailers figure this out, they could experience the Grinch stealing their expected strong holiday sales.

Tis the Season to do Nothing? The Cycle of Commercial Finance

Every industry has its own unique seasonality to it. Out here in the Black Hills of South Dakota, tourism drives a lot of the economy. Therefore, we see hotels and restaurants swell with business between Memorial Day and Labor Day, and then they sustain with lighter local traffic in the colder months. We here at Midwest Business Solutions are not a tourism company, so we follow a different pattern.

Our CUSO operates like the back office of a regional bank (or a very large credit, I can only presume). Our busy season starts in February. Why February? It would seem there is a lot of planning and goal setting that occurs in January, and people hit the ground running in February. We start getting calls on almost a daily basis to look at various projects that people want to start this year. This is also the time of year a lot of existing business loans have their annual loan reviews that need to be done.

The calls and reviews start coming in February, which means underwriting of these projects start in March and April. All the while, more loan reviews are coming in. Life feels hectic and hard to keep up with until June. And all of a sudden, it is like you reach a plateau. The calls stop coming in, and the reviews stop coming in. Now we are making the calls, and nobody answers. Why not? It appears everyone has picked up and gone on vacation!

The entire summer feels like a bit of malaise in terms of getting projects complete. Projects move forward, albeit, slowly. It takes a lot of time for calls or e-mails to get returned, because there is always a key decision maker somewhere who is out. And say we do wrap up a project and have a call for that participation opportunity, the attendance on that call tends to be especially low since fewer people are around.

And then Labor Day hits and fall begins. Now we suddenly hit another busy season. Everyone gets back from vacation all at once, and they are pushing hard to get projects wrapped up before the end of the year. Again, it can be a bit overwhelming. And then October 15th rolls around, which is the drop-dead date for tax return extensions, and so we have another wave of loan renewals. All of this momentum starts to die out by Thanksgiving.

After Thanksgiving, the phones stop ringing, and business becomes relatively quiet until after the holiday season; or roughly speaking, until February. While this might be a good time to relax, the truth is, we identify projects throughout the year we need to tackle, and we are hoping we have enough time between Thanksgiving and February to get them complete. And, we may have been referred loan opportunities during the summer or fall that we may not be able to kick-off until after the New Year. In other words, we will still have underwriting work even when we are slow.

It is interesting that the busy seasons in finance are spring and fall, and the slow seasons are summer and winter. But just because there is a slowdown in communication doesn’t mean we experience a slowdown in work. 

Give Thanks

Our modern day Thanksgiving celebration on the fourth Thursday of November began by a law signed by President Franklin Roosevelt in 1941.  Prior to this, days of Thanksgiving were often announced by our leaders beginning with the first Thanksgiving of the Pilgrims.  Congress and various presidents set aside days of Thanksgiving not only in harvest time, but also after the nation had passed through a tough trial, such as a war.  Prior to Roosevelt, different states also celebrated Thanksgiving on different days.  It was Roosevelt who signed a law to standardize this celebration and our nation enjoyed the first Thanksgiving Day under this law in 1942, during the trial of WWII.

I am a huge fan of US History.  One thing I enjoy at this time of year is to read Thanksgiving Proclamations of past presidents.  Here is the Roosevelt’s from our first “standardized” Thanksgiving. 

“It is a good thing to give thanks unto the Lord." Across the uncertain ways of space and time our hearts echo those words, for the days are with us again when, at the gathering of the harvest, we solemnly express our dependence upon Almighty God.

“The final months of this year, now almost spent, find our Republic and the Nations joined with it waging a battle on many fronts for the preservation of liberty.

“In giving thanks for the greatest harvest in the history of our Nation, we who plant and reap can well resolve that in the year to come we will do all in our power to pass that milestone; for by our labors in the fields we can share some part of the sacrifice with our brothers and sons who wear the uniform of the United States.

“It is fitting that we recall now the reverent words of George Washington, "Almighty God, we make our earnest prayer that Thou wilt keep the United States in Thy holy Protection," and that every American in his own way lift his voice to heaven.

“I recommend that all of us bear in mind this great Psalm: "The Lord is my shepherd; I shall not want”….Inspired with faith and courage by these words, let us turn again to the work that confronts us in this time of national emergency: in the armed services and the merchant marine; in factories and offices; on farms and in the mines; on highways, railways, and airways; in other places of public service to the Nation; and in our homes.

“Now, Therefore, I, Franklin D. Roosevelt, President of the United States of America, do hereby invite the attention of the people to the joint resolution of Congress approved December 26, 1941, which designates the fourth Thursday in November of each year as Thanksgiving Day; and I request that both Thanksgiving Day, November 26, 1942, and New Year's Day, January 1, 1943, be observed in prayer, publicly and privately.”

We at Midwest Business Solutions have much to be thankful for this year.  I am first thankful for our team.  We have gathered together a group of very smart and talented people on our team.  Each of them goes above and beyond the normal call of duty and add so much value with their ideas and insight. 

We are thankful for our Board and the support they provide us.  Our Board has also excitedly captured the vision that we have, realizing that MWBS can be a national force among business CUSOs and not just an entity in the northern Midwest.  Just this past week we have talked to CUs located in or about projects located in the Dakotas, Nebraska, New York, Ohio, Virginia, Florida, and California.  We have worked with CUs in 18 different states so far.

A special thanks for CUAD.  They have provided so much support and the talented team under Jeff Olsen’s leadership has provided great service to the CUs in this area.  We also are thankful for the Montana League and their support of MWBS.

Thanks is necessary for all of our 21 of our CU equity members.  This year, so far, we have had the pleasure of welcoming the following CUs into our group:  United Savings in Fargo, McCone County in Circle, Montana, Med 5 in Rapid City, Sentinel in Box Elder, Northern Tier in Minot, and Healthcare Plus in Aberdeen.  We are thrilled to have the opportunity to serve each of the CUs in our equity group.

We are thankful for the growth in business we are experiencing.  We closed our first participation loan in April 2013.  When our final loan for 2015 closes in a couple of weeks, the portfolio of the loans we manage will reach around $100 million and will pay over $3.5MM in interest income to our loan investors.

We are thankful for the attendance at our classes this year.  We held five different classes on different facets of commercial or agricultural lending and taught over 120 students.  We value the education part of our business as it is a way we can give back and also connect more with fine CU folks.  Special thanks also go to Trevor, who spent tireless hours writing most of the materials.

Each day at MWBS is filled with excitement and opportunity.  I invite you to join us.  Perhaps this next year will provide you the opportunity to allow us to help you land a new commercial loan that you did not think you could do, maybe it is helping a large farmer in your area finance his land, perhaps it is spending time with us in one of our upcoming classes, or maybe even using us to provide structure to your MBL department.  Either way, we will be thankful for having an opportunity to serve you and also help you serve your members better. 

All Else Equal, A Recession in 2017?

If you read the daily finance news on the web, you know it is often just as sensational as the mainstream media. A big part of reading financial news is tracking forecasts and listening to the assumptions people make about their predictions. Some of these “experts” make wild predictions that never materialize. Maybe one of their predictions actually occurred once in the past 10 years, and since then, they have been considered experts every day of the week no matter if their predictions have always been incorrect. To me, this seems like a case of a broken clock being right just twice a day.

But, when I hear an expert make a prediction, and it is an expert I rarely hear from, I tend to listen much more closely. This happens to be the case with a Bloomberg article I recently read, where Tony James, President and COO of the Blackstone Group, said of a possible recession, “It wouldn’t surprise me if we had one in 2017.” James has a very successful track record as an investment banker, and is not frequently in the news making any bold predictions. In fact, he is hardly ever in the news at all! James notes there is already a recession in most of the US industrial sector, and recent terrorist attacks will slow down tourism.

This same article echoed concerns of the co-CEO of the Carlyle Group, David Rubenstein, who was quoted as saying, “At some point in the next year or two or three, you can expect a recession.” However, Rubenstein gave a more superstitious reason, citing that recessions on average occur every seven years in our modern economy.

But, all predictions come with a caveat. “All else equal,” this is what appears to be likely. Our world and the conditions in it are far from static. Going forward from today, events could change, leading to a much brighter economic forecast, or events could deteriorate and become much worse. And the reality is, we don’t know there is a recession until we are actually in one. And we know, we are not in a recession now.

All predictions need to be taken with a grain of salt. Even the brightest and best actors can’t predict technological breakthroughs, geopolitical conflict, or even what the weather will be like more than five days from now. And, all of these things will have enormous impacts on our economy that no one can control.

I think both James and Rubenstein have valid points. There is some resistance to economic growth, and our last recession was about 6 to 7 years ago. But, neither of those things assures a recession by 2017, although they may increase the likelihood of it. What I would worry about more is the continued mismanagement of our nation’s fiscal policy, for which the Congress and the President are both to blame. I would also worry about over-tampering by the Fed in a desperate attempt to make monetary policy do more than it was intended to do.

http://www.bloomberg.com/news/articles/2015-11-18/blackstone-president-james-sees-potential-u-s-recession-in-2017

http://www.bloomberg.com/news/articles/2015-10-09/carlyle-s-rubenstein-says-u-s-recession-inevitable-by-2018

Hands Off Me Brand, Matey!

Today I read on CNBC about a new start-up called DoorDash, which specializes in delivering food. The catch is, they don’t make the food. Instead, DoorDash will order what you want from your favorite local restaurant, and then go pick it up and deliver it straight to you.

As it turns out, one of these restaurants does not care for this arrangement. The popular fast food chain called “In-N-Out” is now suing DoorDash for improper use of their trademarks in a way that suggests a partnership exists between two companies. The general counsel for In-N-Out remarked, “"We have asked DoorDash several times to stop using our trademarks and to stop selling our food."

This reminded me of a similar news story with similar rhetoric from earlier this year. But this story was about a grocery store called Trader Joe’s. Someone was buying and reselling Trader Joe’s products in a store called Pirate Joe’s. There are no Trader Joe’s grocery stores in Canada, so a Canadian businessman was buying mass amounts of Trader Joe’s products in the US, driving them to Canada, and then reselling them in a Canadian shop. This upset Trader Joe’s for many of the same reasons In-N-Out was upset with DoorDash.

Trader Joe’s sued Pirate Joe’s for trademark infringement, but lost.  The legal battle upset the owner of Pirate Joe’s, and he conveyed this by temporarily dropping the P from the store name, leaving it to be called Irate Joe’s.

At first, these stories raised an interesting question. Why would a company be upset if someone was buying their products, and by doing so, to resell them? It would seem to me this is an opportunity for even more sales for Trader Joe’s and In-N-Out, which will lead to more profit. Why the big deal?

At the heart of these matters is actually trademark disputes. Companies have a lot invested in their brand, which includes the looks, as well as the experiences it produces. The last thing they want is someone to rip-off their brand and have a consumer confuse the two. If the consumer is unhappy with the fake brand, they may just as well associate that anger with the legitimate brand too. What if the In-N-Out delivered by DoorDash arrives cold or soggy? What if it makes someone sick? Sure, DoorDash gets the blame, but the consumer may have lost faith in the quality of In-N-Out too, even if they weren’t responsible for how the product got delivered.

While it may seem like an overreaction for Trader Joe’s and In-N-Out to sue, I think this reflects something positive about these companies. They have strong brands that they feel they need to protect. They want consumers to be able to distinguish their products from others, because they know consumers will remain loyal, if they can produce a consistent quality product. This has me thinking, if a company didn’t fight to defend its brand, I might wonder about the quality of things they are offering.

http://www.cnbc.com/2015/11/11/in-n-out-sues-startup-for-delivering-its-burgers.html

http://www.cnbc.com/2015/03/12/trader-joes-canadian-clone-grocer-plans-to-launch-second-store.html

Business Regulatory Changes

In our fall classes for Intermediate Agriculture Lending and Commercial Real Estate, we were fortunate to have a couple of examiners from the NCUA to take an hour and speak about their views on the state of business lending and what is upcoming for CUs in terms of business regulatory changes.

We all know that there will be a new business regulation soon.  We do not know what will all be in that ruling, but we do realize that it will be less proscriptive and more principle based.  Part of the delay is because the proposed changes generated more comment letters than any other regulation proposed by the NCUA.  Whenever the regulation is complete, expect for more responsibility to be placed upon the shoulders of the individual CU.

There is a move to better quantify risk in an individual credit, industry, and the entire portfolio.  The NCUA wants to see more objective measures of risk rating.  Subjective adjustments should be tracked and then when the next review of the credit is completed, an analysis of the subjective adjustment on the credit should be viewed to see if making that adjustment was a correct assessment of the risk in the credit.  As for the entire portfolio, the CU should be able to quickly identify where the risk issues are inside the portfolio.  This could be from loans to a certain industry, geographic area, or borrowing group.

There will also be a new focus on loan covenants.  Now we have seen many institutions who do not use covenants at all.  At a minimum, on nearly all business credits, reporting covenants should be stated.  These tell what ongoing information is required from the borrower or guarantors and when it is required.  Fresh information is required in order to monitor the financial health of the borrower.

Performance covenants are woefully missing from many loans that we see.  Now, I can see where this is not necessary for a small loan or a loan with an overly strong borrower, but would contend that every loan that is over $250,000, and many below that level, should have some form of performance covenant(s) tied to the loan.  Covenants should be meaningful to the specific credit, tied to a certain measurement, and also managed well on an ongoing basis.

We have found some institutions that avoid covenants because they are unsure of what to do when the covenant is broken.  A covenant violation does give you the option to call the loan, waive the covenant completely, or forebear the covenant to the next period.   In all cases, a covenant violation is a great opportunity to visit with the borrower to understand what exactly is occurring with the company.  The CU should also produce a covenant violation letter when a covenant is broken to outline where the failure is and what actions the CU is going to take.  Also, if a covenant violation is waived, language should be in the letter to reserve the rights of the CU for all actions that are available in the loan documents for future violations if they occur.

Covenant violations should be tracked for the entire portfolio.  Examples are what percentage of your portfolio has its DSCR below policy, LTV below policy, policy exceptions, or debt/asset ratio in violation?  Further tracking should be made to all loans where the DSCR is below 1 on the portfolio compared to the percentage of the total commitments.

Global cash flow analysis is important to review.  A big question is how re-occurring are the cash flows from the borrower and guarantor group?  Now on a seasoned business that cash flows extremely well, global cash flow analysis is still good to look at, but will not be as important as a business with a weak or unproven track record.

These are just some of the items that will be required when the new regulation goes into effect.  If you need assistance on a credit or your portfolio, contact us.  This review and analysis is what we end up doing each and every day in our group.  We would be glad to provide tools that will help increase your underwriting and credit management skills to not only please the examiners, but to also create a better performing portfolio.

Discounted Cash Flow: A Penny Not Saved is a Penny Lost

Working in finance, we all understand that a dollar today is not worth a dollar one year from now.

An easy way to understand this is with inflation. If inflation is occurring at a rate of 2% per year, then a year later a dollar is worth 2% less than a dollar today. Or in other words, a dollar tomorrow is only worth 98 cents today!

We also know there is an opportunity cost that comes in to play too. You can save that dollar, and put it into a savings account or certificate of deposit that pays annual interest. If that interest rate is 3%, then a dollar saved today is worth $1.03 next year. Benjamin Franklin famously summarized this as “a penny saved is a penny earned.”

But, just like inflation, this means the same dollar today is not equal to the same dollar amount in the future. In a way, $1.00 today is equal to having $1.03 a year from now. Which means, if you did not save that dollar, you lost 3% in interest. If you refuse to save your dollar, then you should discount it by the 3% interest it will not earn in the future. Economists call this “opportunity cost,” which is the highest cost of doing something different with your time or money. Finance people refer to this as the “time value of money,” which means money you hold today can be invested in helping you earn more money. And, if that money isn’t invested today, it will be worth less to you.

Say we are owed one dollar, but we won’t receive it for one year. If we had received that dollar today, we would have saved it at a 3% interest rate. Since we won’t receive that dollar for a whole year, it is basically worth 3% less to us since we couldn’t save it. That dollar one year from now, is really only worth 97 cents to us.

Say we are owed one dollar a year, for 10 years. Now we are going to miss several opportunities throughout the next ten years to save those dollars at a 3% rate. Our dollar in one year is only worth 97 cents. But our dollar in the second year will be worth even less. It will be worth not only 3% less, but 3% less than the 97 cents. One dollar two years from now will only be worth 94 cents to us. And a dollar in the third year will even be 3% less, which is 91 cents.

What we are effectively doing, is we are discounting our future expected dollars at a rate of 3% year over year. We can then sum up all our discounted dollars over 10 years to calculate what they are worth today. We take 97 cents, plus 94 cents, plus 91 cents etc. If we do that for dollar payments over ten years, our total discounted value of all ten dollars will equal $8.49 today.

This is the idea behind discounted cash flow. Because we can’t save or invest money we don’t have today, it is worth less to us in the future. If we have to wait 10 years to collect all $10 owed to us, then that payment stream is only worth $8.49 today.

What the 2015 Kansas City Royals Can Teach Us about Life

What the 2015 Kansas City Royals Can Teach Us about Life

Since I am from Central Missouri, I grew up as a fan of both baseball Missouri teams, the St. Louis Cardinals and the Kansas City Royals.  I grew up growing to both stadiums and seeing both teams.  Since I have left Missouri, over a decade ago, I have still maintained my affinity to those teams.  So you can imagine my elation when I watched the Royals defeat the Mets to win the World Series. 

What is even more exciting than celebrating the Royals victory is to take note of the life lessons we can learn from the team in persistence and endurance.  They provided a great lesson in never giving up, no matter how bleak the circumstances appear.  The team set a record in having seven victories in the post season, where they came from behind by being at least two runs behind in the seventh inning or later. 

This started in the American League Division Series with Houston.  The Astros held a 6-2 lead at the end of the 7th when the governor of Texas tweeted congratulations for the Astros for advancing to the next round of the playoffs.  The Royals scored 7 runs in the 8th and 9th on their way to winning the series.  I watched it continue in the first game of the World Series, when the scrappy Royals tied the game in the bottom of the 9th on their way to win the game in the 14th inning.

Last Sunday evening, I witnessed the Royals come through again.  In this case they were behind by two runs going into the 9th.  They then scored two runs using only one hit and then scored another 5 in the 12th to win the series.  The team never gave up, no matter how bleak the outcome appeared at the time.  They lived the mantra spoken by Winston Churchill during WWII as to “Never, never, never, never, never give up!”

What seemed more amazing to me is that the Royals just expected to win the game no matter how far down they were late in the game.  You could see a quiet confidence that they realized that someone(s)—a starter, bench player, or a pitcher from the bullpen—would pull through and contribute the runs or stop the other team and win the game.  In the last game the go-ahead run was driven in by a Royal who had not had an at-bat in the series up to that point!

The next attribute the Royals had was an excited expectation as to what they would experience after winning the game.  Even if they were behind late in the game, you would see the Royals in the dugout, get up and begin acting like a little league baseball team in their excitement.  They started jumping up and down, waving towels, and shouting as they encouraged the rest of their teammates as they began their way toward victory.

So the lessons here are to first never, ever, give up when things get tough.  Then have a quiet expectation that you will win in the end and create an expectation to win!  

Subordinated Debt

As lenders, we focus on having a first lien position on any collateral we take to secure a loan. In other words, if we are going to lend money for a house, a car, or a business asset; then we want to have the first right to foreclose and liquidate that collateral we have securing our loans.

When lenders have a first lien, it means they have priority over any other lender who may claim that asset as collateral. Sometimes, we call the loan with priority claim the “senior” debt, and any other loans secured by this collateral are considered “junior” debt, or it has a “junior” lien.

Think of a borrower who has a first mortgage on their house, and also has a second mortgage that is a home equity line of credit (HELOC). The HELOC is junior debt and has a junior lien on the house. That junior lien is “subordinate” to the senior lien. As you can probably infer, subordinate debt is synonymous to junior debt.

In the world of business lending, we see subordinated debt play a role in various situations. Just like a member might have a HELOC on their home, business owners might have a second mortgage on their commercial real estate to tap into equity for renovations or another big purchase.

Sometimes a potential real estate buyer does not have quite enough equity to purchase a property. Say the credit union will make 75% loan-to-value mortgage on a property purchase of $500,000. This means the credit union will provide a loan of $375,000, and the borrower is expected to come up with $125,000. Perhaps the member can only provide $80,000. If the seller is motivated or flexible, they may provide the remaining $45,000 in financing as subordinated debt. That debt is subordinated to the credit union’s first lien interest in the $375,000.

The arrangement described above can be both good and bad. It may be good, because it assures the credit union has a loan-to-value at or below 75%. Notice, the junior debt has an effective loan to value of ($45,000 + $375,000) / $500,000 equaling 84%. The junior lender (the seller in this case) will need to pay off the credit union’s mortgage before he can foreclose on his $45,000 second lien position. The bad part about this arrangement is now the effective debt on the property is $420,000. Now the borrower has two mortgages to pay, meaning less money is available should anything go wrong.

Subordinated debt can also play a positive role in a business buy-out situation. Sometimes a business is sold for its intangible worth, such as its reputation or client list. In this case, the credit union will probably take something outside the business as collateral; although, it may be desirable not to pay the seller 100% of the purchase price, but force them to provide some of the financing as subordinated debt. This is sometimes called seller financing or seller carryback. In this situation, the seller will only realize their full purchase price if the business continues to operate successfully into the future. In this case, the seller may be incentivized to stay involved in some way or leave the business in good operating condition to the benefit of themselves, and thus everyone else in the transaction.

Could a Drop in Junk Bonds be a Recession Sign?

Investors are happy we have passed through the third quarter of 2015.  It was quite a tough time for US companies who showed the weakest performance of the year.  Weak global demand and a lack of purchasing power hit these companies hard.  The easiest way to increase revenues is to raise prices, but this strategy does not work when consumers don’t have the additional income or the will to pay the higher prices.

We have the issue of the strong US dollar.  On Thursday the Europeans announced the next round of quantitative easing and more negative deposit rates.  This hit the euro and made the dollar even stronger.  The strength of the dollar is hitting US companies that export so many are now reporting declining revenues.  This is not just isolated to the energy sector.  Of the 142 non-energy companies that have reported Q3 earnings so far, revenues have dropped an average of 3%, when compared to last year, according to Moody’s Credit Markets Review.  In a time of declining revenues, companies try to maintain net profits by cutting costs.  Moody’s warns that “Results such as these weigh against expecting much of a pick-up by either hiring activity or capital expenditures.”  This is an omen of a downward economic cycle.

Even though rates have been historically low for some time now, cheap money is not readily available to riskier borrowers.  In Q3 2015, bond issuance by junk rated companies dropped 38% from a year ago.  The high yield bond market is sensitive to economic cycles.  Commonly referred to as junk bonds, these debt securities are issued by companies with lower quality credit ratings.  Because of the increased risk, they must offer higher interest rates than their lower risk peers.  When spreads widen between junk and stronger credit issuers, it costs junk companies more to borrow.

Morgan Stanley reports the US junk bond market has experienced its weakest four month stretch, from June-September 2015, since the end of 2008.  This return of -7.03% was a factor of weaker energy prices, decrease in commodity values, uncertainty of Fed rate increases, and a weakening overall global economy.  During this time, bond issuance by junk-rated companies and leveraged loans plunged 37% from the prior year.  For the 12 month period, total issuance is down 29% from the 12 month all-time record in 2013.  This phenomenon is also worldwide as high-yield corporate bonds are down 30%.  Oil and gas companies have plummeted their issuance by 83% and other companies have dropped 21.5%.

Yield spreads between junk bonds and treasuries have widened to 700 bps.  Now the past three recessions have started within eight months of the yield spread in junk bonds exceeding 700 bps and also within 15 months of a top in the junk bond market.  In 1989, the spread rose above the 700 bps level just eight months before the recession of ’90-’91.  In 2001, the gap hit just five months before the 2001 recession.  In 2008, the bond market had already topped and the yield gap hit one month after the financial meltdown occurred. 

The next troubling sign is a drop in the overall credit ratings.  High-grade borrowers have access to funds in difficult times, but the number of high grade borrowers is shrinking.  Companies have also mussed up their balance sheets for more M&A activity and also share repurchases.  Downgrades have pushed many of these companies into medium grade issuers.  From 1995 to 2012, bond issuance by high-grade companies was nearly double the issuance by medium grades.  But not anymore.  Since 2012, medium-grade offerings have outpaced higher grades by 24% annually.  In the past quarter, medium-grade issuance soared to 47% higher than the safest rated companies.  Many of these companies have been downgraded since they issued these bonds a few years ago.  If their ratings stay where they are now, if they have to refinance their bonds, they will be refinanced with lower-rated, more expensive debt. 

Moody’s sums up that the deterioration of credit indicates that companies are losing financial flexibility.  Lower rated borrowers are experiencing higher credit costs and access to credit is becoming difficult or even impossible.  Corporate outlays on staff and capital goods may be curbed more rapidly in response to a weaker business outlook.  In the past month, companies such as Wal Mart, Caterpillar, Target, and Hewlett-Packard have all announced cutbacks.  This trend has moved way beyond the energy sector. 

On the credit side, risks are building in the banking sector.  The Comptroller of the Currency recently quoted, “Reminds me of what happened in the mortgage backed securities in the run up to the crisis.”  

Untangling the Debt Limit Debate

I don’t know who first said it, but those who like laws and sausage should not observe how either are made. And to provide you a disclaimer, we are going to talk about one of these things right now.

As you might suspect, it is prudent for a government to have a budget. For the six years preceding 2015, Congress failed to pass any budget. Of course, this was largely because the Senate was controlled by Democrats and the House was controlled by Republicans, and they refused to agree on anything.

Republicans gained control of the Senate in 2015, thereby gaining entire control of Congress, and a budget was finally passed in 2015. However, just because the Republican controlled Congress passed a budget still didn’t mean a Democratic president would agree to it and sign it into law. And so, there is still no official budget for our government.

If we have no budget, then who decides how government money is spent? Well, it is still Congress and the President, but on an ad hoc basis. In other words, pieces and parts of the budget get negotiated only when they absolutely need to be done. There are 12 regular appropriation bills that need to be passed each year to fund the government, and these are taken up separately or in groups as part of an “omnibus” spending bill, instead of figuring it all out in one budget. It is when one of these omnibus spending bills expires and needs to be re-approved, we start to hear clamoring of government shutdowns.

But, a government shutdown is unrelated to the debt limit. You see, just because an omnibus bill is passed doesn’t mean there will be enough money to fund it. Our government operates at a loss, and passing an omnibus bill tells the Treasury how it must spend the money, but it does not empower the Treasury to go apply for an increase on its credit card to cover the operating loss. Congress and the President need to also agree to do that together. And so, Congress and the President will agree to a spending bill, while not necessarily agreeing to increase the debt limit to pay for that spending bill. It all seems a little crazy. Actually, given the size of our government and economy, it seems very crazy!

It would seem logical that a budget, spending bill, and debt limit would all be interconnected and dealt with at the same time. Instead, our politicians see it as an opportunity to have three different fights. All three items have been separated from each other, and nobody is trying to make it all fit together. It seems like a waste of time, it seems illogical, and it almost makes you sick to your stomach as if you were watching sausage being made.

As frustrating as this seems, I suppose it is democracy. I want to believe some of our founding fathers would be appalled by the gridlock, and yet others would be shocked we haven’t evolved a better process for getting this done. But I bet there would be some of them that believe this is exactly the way things are supposed to work. It is America’s unique way of having its cake, and eating it too.

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.