The CAPEX Conundrum

When business owners operate their businesses, they will collect money for selling a product or service. They will then take that money and pay for necessary expenses. The money left over is the money they have to take home or pay loans.

The expenses a business has to pay have some interesting categories. Consider a restaurant owner who serves food. She will need to purchase the ingredients to prepare meals. Those purchased items are an expense, or more specifically, the cost of materials or cost of goods sold.

That same restaurant owner will need to pay a staff for cooking and waiting on customers. She also needs to pay for lights, water, garbage, etc. These are what we call operating costs or operating expenses.

Then there is another kind of expense that may not seem readily obvious. What if the windows are old and need to be replaced? Or, what if the roof needs to be fixed or the parking lot needs to be repaved? Those types of expenses are called capital expenditures, or CAPEX for short.

Cost of materials and operating expenses may vary over time, but they are relatively predictable. If you are operating a restaurant, you will know how much food you will need to prepare orders and how many employees you need to hire as well. Capital expenditures, on the other hand, can be more challenging to predict. You may know that the building will need to be repaired, but you aren’t sure when.

As a lender, you can review the financial performance of the restaurant, and clearly see the cost of goods sold and operating costs. But, you may not see capital expenditures if they happened. A capital expenditure is not necessarily recorded as an expense! Instead, accounting rules require that capital assets be depreciated over their useful life. If a piece of $100,000 equipment was purchased, and it is expected to last 10 years, then the business owner might have to expense $10,000 a year as depreciation over 10 years, instead of showing the full expense in the first year.

How does a lender anticipate what capital expenses, or CAPEX, a business will be faced with? Even if equipment has a 10-year life, it might fail before 10 years or last well beyond 10 years. No matter what happens, you want your borrower to be prepared. Should the borrower be faced with an unanticipated capital expenditure, then the borrower will rely on her savings to pay a big ticket item, or need financing.

With large projects, we try to be proactive, and require the borrower to save some money every year in case an unexpected CAPEX item arises. But, the key issue is CAPEX is often unanticipated, so it is hard to say with any precision how much the borrower should be required to save on a regular basis. Therefore, the targeted savings is an estimate, or a best guess. In this case, the borrower has some ground to debate what may be an appropriate amount, and the lender will need to negotiate a practical solution where both parties can find some common ground.

Could We Be Facing a Dollar Shortage?

So we now face a possible interesting paradox in the world.  Since the crash of 2008, more dollars have been printed at a faster rate than any other time in history.  The Federal Reserve has printed around $3.5 trillion of dollars, raising the money supply us to over $4 trillion dollars in this time period.  This is the fastest rate of increase in the money supply since the start of the Fed. 

But, with all these new dollars in the circulation, is it possible that there is a possible shortage of dollars on the horizon? 

First, consider the high amount of dollars that corporations are holding on their balance sheets.  CNN Money estimated the amount of dollars held by Fortune 50 companies was at $1.4 trillion at the end of 2014 with the total continuing to climb.  Perhaps the biggest reason to keep more cash on the balance sheet is if the leadership of the company is uncertain or fearful about the future.  Companies may also think that even with the really low rate of return on cash, it still may seem to be better than to take a risk by investing the money into new equipment or a plant expansion. 

Next, even though the amount of dollars has increased substantially, the amount of dollar denominated debt has grown by nearly $57 trillion since the crash.  This is a growth rate of 20 times.  The greatest percentage of growth comes from sovereign debt.  Another $14 trillion comes from companies below investment grade, or considered to be in the junk bond status.  Most of this comes from companies in emerging economies that borrowed dollars.  Another big source of borrowing in the past 6 years has come from energy companies who borrowed expecting the price of oil to stay above $70 a barrel. 

All this extra borrowing is much more than the growth of dollars in the market.  This will increase the demand for dollars as a dollar based debt needs to have repayments in dollars.  The supply of dollars overseas is going down with the Fed’s recent bend toward interest rate hikes.  Increasing rates in the US causes capital flows to come into the US as investors will abandon foreign markets for the return and safety of the US.  This places a double whammy on the foreigner debtor who not only has to pay back the dollar debt, but now he pays a higher rate with the appreciating dollar compared to his local currency. 

So, the Fed appears to be bent this year on using whatever positive economic news as a reasoning behind a tightening program of interest rate hikes.  The most recent factor cited was the strong December employment number of 292,000 new jobs.  On the surface it appears to be a strong amount of growth.  Former White House budget director David Stockman, mentions the importance of looking at the seasonal adjustments.  When you take away the statistical voodoo, you are left with only 11,000 new jobs in December.  This is a pittance in a nation as large as ours.  It is also interesting to compare the nonseasonable adjusted job count today to the same point in other economic cycles.  In December 1999, around 140,000 new jobs were added and in December 2007, 212,000 new employment positions were gained. 

The lack of new jobs is downright scary.  What is worse is the number of new jobs that pay $50,000 or more a year remains below levels of both 1999 and 2007.  Labor force participation is at its lowest level since the Carter Administration.   A record number of people are now dependent upon government assistance for their survival.  This weakness in the job front is also pointing to another sign of economic weakness with Americans taking on less debt than they used to.  Growth in consumer credit has slowed to $14 billion in November, which is 22% lower than the consensus projections.  The news was enough to pull the Dow down another 130 points in the final hour of trading last Friday. 

So if the Fed uses any sort of economic surface news to continue its tightening, the higher rates will increase the supply of dollars back to the US and drive up the value of the dollar relative to other currencies.  Commodity prices will continue to weaken as a stronger dollar can acquire more goods.  US exports will weaken and other countries with weaker currencies will have products that are cheaper in the world market. 

The rate increases will slow down the US economy further.  Slower economic growth coupled with weaker commodity prices will have the possibility of causing downgrades and defaults in the bond area, especially with those borrowings tied to energy of emerging markets.  None of the solutions to the current economic situation are easy and most have side effects of deleveraging the system with defaults and restructuring on one side or inflation to pay off debt.  Either way indicates there may be warning signs up ahead as a dollar shortage takes hold.  

A Happy New Year of Quotas

A new year means reevaluating goals and setting new ones. For many in business lending, this means having a new amount of business you are expected to bring in by the end of 2016. To borrow a contemporary cliché, it is time to work smarter, not harder.

Instead of racking your brain on how to find the same competitive business that is harder to find every year, consider shaking it up and trying some new ways to book quality business loans. It is the 21st century, and it is time to start lending like it.

Your Maximum Loans to One Borrower Is No Longer a Problem

If you have good members that you can’t lend any more money to, consider participating out the next loan. You can even participate out existing loans, which may be even easier to participate, because they have proven performance. Not sure who to participate with? Contact your local MBL CUSO (that would be us, hint hint…).

And if a large request walks in your door, know you have 10 times the capacity to participate over your max loans to one borrower. If your limit is $300,000, then you can originate a loan of $3 million, and participate out the remaining $2.7 million!

Did I Mention It Is the 21st Century? Buy a Participation Already!

The worst thing your credit union can do is hoard cash. Your credit union needs to be earning interest to pay for overhead. If loan demand is weak in your territory or you have an undesirably large securities portfolio, it is probably time to start buying loan participations to help your income.

Loan officers bemoan participations as something that doesn’t count towards their quota. I think it should count toward their quotas, because managing a successful relationship with a CUSO can take a lot of work when it means making sure the CUSO loans are synching up with your internal loan policies.

Senior management may also have a dislike for CUSOs, thinking they are nothing more than loan brokers. While that may be true for some, it is not the case for all. Make sure you work with a CUSO that is part of the transaction long-term and is not just getting paid for closing the loan. Also, make sure the CUSO has strong oversight, say, from a local group of credit unions on their board (that would be us, hint hint…).

Consider Changing Your Attitude

Fatalism is a self-fulfilling prophecy. If you tell yourself there is too much competition, you will never try your hardest to find business. Dealing with rejection is unpleasant, but this is the world of sales. You will need to accept a lot of rejection before finding success. What separates good loan officers from bad loan officers, is the good ones continue to try hard with a smile on their face, even after being rejected several times.

Changing your attitude also means opening your mind to new lines of business. Learning how to lend in a new industry can open up a lot of business, as does learning to use new tools like SBA guarantees, USDA guarantees, tax credit equity, etc. Knowing something your competitors don’t know how to do gives you a distinct advantage. In fact, a local CUSO could probably help you with this.

No matter how you plan on meeting your quota or finding new business, you should be open to trying something new. You can do this on your own or with help, but the important thing to do is try. Whether or not you are an investor in our CUSO, we are here to help you.

Ringing in a New Year

We have now turned the corner from 2015 into 2016.  Anytime we enter into another year, it is time that economists study tea leaves, the position of the planets with the stars, or the spreads on the playoff football games in hopes of gathering useful data to forecast what lies ahead for business and the markets.  These forecasts vary greatly and often one individual will come up with multiple forecasts that often contradict each other. 

Such is the field of economics, where people can espouse multiple opinions and can make a pretty good living by being right only a fraction of the time.  Compare this to lending, where one needs to be right 99% of the time or credit losses will greatly exceed earnings.  The forecasts often do not lead to anything concrete.  The old story goes that you can line up all the economists in the world and never reach a conclusion!  The wiser economists tend to reveal what factors are happening today and allow the reader to come to their own conclusions for the future.  It is with this spirit, that I point out a few factors as we enter the year.

First, I must congratulate those few students we had the privilege of spending time with this fall, for their accurate prediction of a Federal Reserve rate increase in December.  Overall, less than 10% of our classes thought that economic forces indicate that now is the time for the Fed to begin to cool down the economy.  When one looks at some factors like deflationary pressures and falling labor force participation rates, the tailwinds propelling the economy appear as strong as a slight breeze.  But if one figures that the Fed has to put itself in a position where they can use fiscal policy to lower rates when the next economic crisis hits, then they have to begin to increase the rates.  If this is the mindset of the Fed, I would look for more rate increases this year, barring some disaster.

The next factor that increasing rates will impact is the strength of the US dollar.  For the past several years, we have been in a round of currency wars, where other countries have worked to weaken their home currency in an effort to make their exports attractive to the world market, thus stimulating economic growth at home.  Every time the Fed raises rates, this strengths the dollar.  If the dollar is strong, it will buy more goods and services.  Look for this spiral of the currency wars and the Fed increases to depress prices further and hold inflation in check.  This will be good news for consumers but anyone who produces commodities may see a challenge again this year.

Turmoil in the Middle East and a division in OPEC will play a greater role in the world oil markets this year than it did in the last.  The Saudi plan to break the back of the US fracking industry will take a back seat to their seeking to reduce their sky high budget deficit and preserve their home economy.  We enter this year with gasoline prices doubling inside Saudi Arabia as internal subsidies have been cut.  Also a 1400 year old rift in Islam has raised its head as Saudi Arabia and Iran begin to break off diplomatic ties.  When you throw in ISIS, Syria, Russia’s involvement, and an absence of any solid US foreign policy in the region, all this points toward a potentially volatile year in the oil market. 

Look for slowing economic growth around the world.   Brazil is forecast to have its worst economy in a century.  China has seen its purchasing manager index fall into a recession zone and also had a selloff in its stock market that was so great the exchange was closed, all within the first 4 days of the year.  None of the other economies around the world really stand out as a good possibility for on-fire growth.  Look for governments to engage in more stimulus measures as they try to push against the gravitational forces of a falling economy.

As this is an election year, expect for advertising to receive a shot in the arm with the billions that will be poured in from all the various campaigns.  This is something we all cringe at but has become a part of our American landscape.  Many wish for a change in our system.  Some prefer the intellectual stimulation of the Lincoln-Douglass debates while others may wish a return to colonial days when candidates spent their advertising money on beer and whiskey for the voters.  But we have developed a citizenry with the thought depth of a puddle and the attention of a gnat. 

All these factors and more will prove for an interesting year.  While we all may be tempted to run for the hills and hide out until the year is over, we will see a lot of good buying opportunities in the market.  Baron Rothschild said that “the best time to buy is when blood is running in the streets.”  This year may prove to be one of those opportunities.  

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.