Definitions, Not News, Should Define Loan Classifications

I have grown frustrated over the past couple weeks as I’ve heard loans related to the North Dakota oil boom are being viewed as substandard simply because they are in western North Dakota. Many are adversely classifying these loans despite no delinquencies or the strength of the guarantors. This begs the question, is it correct to adversely classify a loan because of fears induced by the media or because of personal prejudice towards certain industries?

I think it is important to examine loan classifications to understand whether loans are being classified appropriately. It should be pointed out that the NCUA does not require credit unions to adopt the uniform regulatory standard classifications of substandard, doubtful and loss. So what one credit union considers pass or watch-list, another credit union may consider substandard. Banks, on the other hand, have a more uniform standard of how these ratings are applied. This discussion will focus on the definitions as they apply to banks, since most sophisticated credit unions have an analogous system.

Loans that are classified substandard have a well-defined weakness that jeopardizes repayment. Symptoms of a substandard loan include delinquencies, collateral shortfalls, and diminishing prospects that outside sources of repayment exist. Therefore, if a loan does not have delinquencies, and there is little reason to believe a delinquency will result in the foreseeable future, it is challenging to understand why a loan would be adversely classified. Likewise, if the guarantor has ample resources despite a slowdown in the market, the argument that the market alone is a reason to adversely classify a loan seems like a hasty decision.

There is another regulatory peculiarity that may result when a classified loan is a participation. As a CUSO, we service loans that can hypothetically have inconsistent classifications depending on the institution. For credit unions outside of energy producing states, an energy exposed loan may swiftly be judged as substandard because of all the negative news about the energy sector. However, for those loan reviewers accustomed to seeing loans in the energy sector that are well acquainted with the facts, the same loan may be considered “pass” due to prevailing facts specific to that loan.

To prevent these inconsistencies, the NCUA and the institutions they regulate would be better served if the participation loan was only reviewed once at the level of the principle underwriter. The findings on that loan, as well as the classification, would be duly disseminated and uniformly applied in all institutions. The regulators would then only be concerned with whether a purchasing institution completed their due diligence when they run into that same loan again.

Returning to the point, it is important to know what a loan classification actually means, and institutions should be ready to justify their risk ratings based on those meanings. All business lending is an opinion that has different points that can be argued, and there is no black and white decision that a regulator or loan reviewer can outright impose without having to consider your argument or justification.

Ultimately, people who review loans are still people, and sometimes their personal biases can affect their decisions. It is tough to ignore the 24-hour news cycle that is constantly trumpeting anything of interest in economics and politics. But, we need to remember to evaluate loans based on their true definitions and based on the actual facts that pertain to each individual loan, and not based on ominous assumptions we render from the news.

Central Bankers are so Negative These Days!

A year ago, Sweden’s Risksbank, the oldest central bank in the world, became the first major monetary bank to move its core interest rate into sub-zero territory in an attempt to stimulate the Swedish economy.  Since that time, there have been three successive drops in their rate, even further below zero.  This represents a new paradigm shift in the philosophy of the bounds central bankers have in setting interest rates.

It was believed that the lowest limit for a central bank to set their overnight rate was at zero.  Who would chose to leave their money in the bank if they had to pay for the privilege of doing so?  It used to be thought that decreasing central bank interest rates would boost an economy.  Savings rates would naturally drop and people would choose to spend more money and save less.

Some economists warn that there is a limit to the economic benefits of stimulus from cutting rates.  This is called the “zero lower bound”.  If rates go too low, savers face negative returns, and this will encourage people to withdraw their savings and hoard cash.  This act will slow, rather than grow the economy.

Sweden is an interesting example.  It has the third highest savings rate in the developed world.  Instead of touching off a mass of economic growth with the rate cuts, expansion is slow.  The unemployment rate still above 7%, still well above the pre-crisis levels of 5%.  Sweden is actually experiencing deflation which is well below the central bank’s target inflation rate of 2%.  As the economy of other countries has weakened, the cost of importing goods into Sweden has fallen.

The central bankers in Sweden have been joined by all countries in the Eurozone, several in Eastern Europe, and now, Japan.  The Japanese shocked the world with its decision to go sub-zero last month in an attempt to drive down the value of its currency.  Since the interest rate drop, the Japanese Yen has actually risen by 9%.

Currently, over $8 trillion of sovereign debt is trading at a negative yield.  For those not in the negative yet, many countries are flirting with it.  Banks have also not been willing to pass on the negative deposit rates to their customers.  This increase in the banks’ cost will force them to make up the revenue somewhere else, such as higher lending costs or more fees.  Higher lending costs will have a counter effect to the goal of the central bankers’ of economic stimulus.

This leads a vicious cycle of slow or negative economic growth followed by the attempt by central bankers to devalue their currency, do a round of quantitative easing, or push rates into negative territory to stimulate the economy.  The economy does not improve and more money is parked on the sidelines as businesses and individuals believe the future is not bright.  This can lead the central bankers to do another round of stimulus.

Eight years have passed since the financial crisis.  Central banks around the world have cut core interest rates 637 times and injected another $12.3 trillion into the system. Yet, the current global recovery is one of the most deflationary in modern times with growth rates averaging 1.6% over the past six years.  It appears that rate of growth may be optimistic in the present world with a dangerous cocktail of low commodity prices, stagnant demand, and skyrocketing sovereign debt.  It also makes one wonder if the central bankers really have any grasp on what is going on to begin with.

Where is Oil Going?

Oil impacts directly or indirectly many of the businesses in our area of the country.  We have watched an incredible boom in North Dakota that seemed it would continue into the foreseeable future, followed by a severe slide of prices down to a level to areas where the 55 gallon barrel the oil comes in, has more value than the oil inside it!  We have also seen the number of drilling rigs fall and new exploration come to a halt as it is not economically feasible.

This blog is an attempt to show the various forces at play in the oil market today.  As for the direction of oil prices, my stab at it is as much of a guess as anyone else.

Bloomberg Business reported that the largest oil producing country in the world in 2015 was….the United States!  Second is Russia.  When we think of oil we begin to focus on OPEC countries, who collectively produce the largest amount of oil.   But one of the main reasons for the price drop has been the extra supply of oil produced right here in our own country.  We produce more oil that we consume.  Congress also reversed the ban on US oil exports recently.

The low price of oil by US companies was not felt as much in 2015 as most prices were hedged.  This year, most of those hedges will expire, making companies more exposed to the market prices.  Another issue with many US producers is the amount of leverage taken on by oil producers.  Most of this was given when it seemed prices would stay in the $60 range or higher.  Now, with prices half of that, we could see a rash of defaults and lender stress.

The low oil prices have devastated the economies and propelled sovereign debt higher in countries heavily dependent upon oil sales.  Most OPEC nations are running large deficits and are not producing enough revenue from oil to satisfy all their government budget.  So any attempt to bury the US frackers is also severely hurting oil dependent countries.

Saudi Arabia had a record budget deficit of $98B at the end of 2015.  This is 15% of their entire GDP.  The Saudi government slashed its 2016 budget by 14% and increased domestic fuel prices by 2/3, even though it is only around $0.20 per gallon.  The Saudi sovereign wealth fund began to repatriate funds from oversees money managers.  This has drained some liquidity from stock markets around the world.

Saudis are also issuing bonds for the first time since 2007 and plans another $32B in 2016.  They also are selling parts of their crown jewel, Saudi Aramco, in an IPO.  But all these acts will not dig it out of the oil price war.  Bank of America expects that $30/barrel oil will shoot the Saudi budget deficit up to $180B.

Global oil supply numbers look to increase once Iranian sanctions are removed and it comes back into full sales and production.  Of course, there is still severe tensions between Sunni and Shia, as there has been for over 1000 years.  The recent warming of US-Iranian relations has also pushed the Saudis and other OPEC countries in the region to seek help from Russia, in order to reduce worldwide production.  I would look for something to occur as neither OPEC nor Russia can afford the prices to stay down for an extended period of time.

On the demand side, worldwide economic growth has slowed and demand is down.  There has been more of a push for other non-fossil fuel sources, which has left large supplies unused.  Supply should also begin to stabilize as old wells experience lower production and there are not enough new wells to take their places.

One of the biggest events I expect to see is for the Saudis to break their riyal-dollar peg.  Saudi Arabia has had their currency tied to the dollar since 1986.  The 12 month forward contracts on the riyal-dollar rate are now trading at a 17 year high.  The peg to the dollar has caused the Saudis to blow through their reserves.  This sounds like the Chinese problem.  China has devalued its Yuan against the dollar several times in the past few months.  Saudi reserves have dropped by over $100B in the past year.

If the Saudis do not devalue their currency they will have to severely cut oil production to drive prices back up.  If they do devalue, they will cause some global upset to stock markets just as the recent slowdown in China has as well.  Khalid Alsweilem, the former head of asset management of the Saudi central bank, said that the dollar peg was the anchor of Saudi economic policy and global credibility for the past 30 years.  A change will stir up turmoil within the kingdom.

I would expect the Saudis to devalue their currency and also some accord to be reached with Russia and Middle Eastern OPEC countries to find a way to decrease production.  I also expect as some at Goldman Sachs have projected, that we will begin to see an increase in oil prices.  I would expect some increase to be modest, with slowing growth in the US and stagnant growth around the world.

In the end, my opinion is just a guess.  The only way I can be correct in my forecast is to say that prices will fluctuate!

Term Limits: An Unusual Plan for Economic Development

My frustration with the lack of fiscal policy in the USA has hit new highs this week as there has been some murmuring from the Federal Reserve about negative interest rates.

I’ve repeatedly written that monetary policy, which is control of the money supply by the Federal Reserve Bank, has been pushed to the limit in what it can accomplish for our economy. Our economy continues to underperform because of decisions related to fiscal policy, which is how Congress raises money, spends money, and legislates.

The Fed has taken some unusual means to try and spur the economy; most notably “quantitative easing.” Negative interest rates would be another untested experiment that they feel pressured to look at because economic growth is lagging. The Fed is resorting to these means (and they shouldn’t have to), because our Congress and President are failing to create an environment under which an economy can grow more robust.

Fiscal policy is vital to the prosperity of the American economy. If the government makes committed plans to develop infrastructure, foster new industries and create incentives to business owners, then the economy is well fertilized for long-term growth. Unfortunately, the fighting and partisanship has ground to a halt our fiscal policy, and businesses have been left with uncertainty in both the short-term and the long-term. As a result, businesses have tread lightly with future ambitions and growth opportunities.

As you can see, this has nothing to do with the Fed (monetary policy), and everything to do with Congress and the Prez (fiscal policy). With fiscal policy going nowhere, the Fed keeps feeling compelled to do something, even if it is untested or results are unpredictable.

Partisanship persists because so many political leaders are entrenched. Incumbents have some of the best job security of any Americans. Because of this, I don’t foresee a change in the lack of fiscal policy soon, since the same actors will remain in place. So, why not create a controversial way to assure the politicians churn out of Congress, so they aren’t incentivized to play up partisan bravado to continue to get elected? I would call this idea “term limits.”

With term limits in place, eventually new politicians will need to come to serve Congress. Old alliances will dissolve, new alliances will be formed, and there will be a continued need for people to find ways to work together to accomplish their goals. It will be much harder to foster gridlock with old faces constantly leaving and new leaders arriving. Without the gridlock, there is a greater chance real fiscal policy might be adopted, and the economy can start to forge ahead. Therefore, term limits may hypothetically be a plan for future economic development.

I cringe when I think what new thing the Fed will attempt to do next in an ill-fated attempt to spur the economy. It’s unfortunate they feel pressured, because it isn’t their fault. The politicians in Congress, who don’t have to leave, bear the responsibility for the stagnant economy. And what is more interesting, there is no discussion about Congressional term limits by either major political party this campaign season.

Analysis Paralysis

In the world of business lending, we tend to deal with loans that are bit more complex than consumer loans. Instead of having loan decisions that conform to a few basic loan details, e.g. debt-to-income, credit score etc., we need to look deeper into these requests. Particularly, we need to understand a business’s source of revenue well, the nature of their operating expenses, and if the owners have any resources to fall back on in hard times.

This means a request for a business loan will take more time to analyze than a loan request for a car or a home. But, how do you know when you have looked at enough information to approve the request for the business loan?

When a request for a business loan takes an extraordinary amount of time because the analysis is endless, we label the process as “analysis paralysis.” In other words, the analysis is bringing the entire request to a halt. This is generally considered a negative thing, implying that the process has seized-up because someone responsible for the analysis is hung up on something.

For what I label analysis paralysis, I tend to contribute mostly to lack of training or experience on the behalf of managers or analysts. The paralysis usually results because people are struggling to understand the request and don’t know how to look at it in the proper context. The belief is, if facts and all details are scrutinized, then they may be able to tease out minor errors or inconsistencies with how the loan is being presented. But, findings like these are immaterial, so they don’t usually provide meaningful guidance on making a final decision.

Another cause of analysis paralysis is the relentless pursuit of facts. This is a new concept I’ve come to call “check the box” lending, where there is a comprehensive list of documents that must be collected, and the request may hinge more upon the ability to complete the list than what the content of those documents convey.

This may result in an analyst’s desire to have all financial information regarding everything a business owner has done in the past few years. This may include tax returns from businesses that have little or no operations, leases for small amounts of rental space that won’t materially contribute to cash flow, or bank statements that need to verify to the penny what was reported somewhere else. While a good decision can be made without having 100% of the facts, the process will be held up until all insignificant facts are brought to light.

Business lending, more than consumer lending, is an argument that needs to be made. Each request has strengths and weaknesses, but few requests will conform tightly to a model that can be used to regularly approve or deny requests. It is the duty of managers to use experience and reasoning.  They need to know when to push forward with a request because the details overwhelmingly support a likely approval, or to slow down the process because more analysis is actually warranted. But if a manager fails to control the process or simply doesn’t know any better, then paralysis may result.

The Ire Against Member Business Lending

Last year, the NCUA proposed an overhaul of all the Member Business Lending (MBL) regulations.  We anticipate these will be in place sometime at the end of the first or beginning of the second quarter of this year.  I have been asked why the MBL change is taking so long compared to other regulatory changes.

One of the reasons, is the large number of comment letters.  The MBL change generated more comment letters than the popular risk based capital regulatory changes.  In fact, it is a record.  Many of these letters came from bankers as organized by the American Banker Association.  The tone of all those letters is to not allow MBL regs to change as the banks feel it will lead to an expansion of business lending from credit unions.

I have worked for both sides during my career.  Typically the grievance on the bank side comes from the credit unions tax exempt status.  They think this is an unfair advantage for the credit union.  Actually, credit union earnings are taxed once we pass these on to members in the form of dividends and interest.

But did you know that many banks are set up in the exact same tax structure, in effect, as credit unions?  In 1997, Clinton signed the Small Business Job Protection Act, which allowed commercial banks to become chartered as a Subchapter S Corporation.  The S Corporation has no taxation at the corporate level, but all profits are passed through to owners who then are taxed.  Sounds the same as the credit union tax structure, right?

By 2014, over 35% of all banks in the US were chartered as S Corps.  This represented around 5% of total bank assets, but it grows to 20% of total bank assets, when removing the top 50 banks.  So most of S Corps are smaller banks.

If the credit union tax advantage structure (and that of 35% of US banks) were a large advantage in obtaining lower costs of funds, one would expect this to equate into credit unions holding the lion’s share of assets in the industry.  But this is not the case.  In mid-2015, reports from the FDIC and NCUA show that large banks hold 74.8% of all banking assets, small banks hold 18.2% of the assets and credit unions hold 7%.  Total assets for CUs are around $1 trillion.  There are four banks in the US that each have asset sizes larger all combined CUs:  JP Morgan Chase, Bank of America, Wells Fargo, and Citibank.

What is even more interesting is the trend.  In 1992, the division between large bank, small bank and CU stood at 41.1%-53.3%-5.6%.  Now this stands at 74.8%-18.2%-7%.  The story is not how tax exempt status has helped CUs grow so unfairly large, as I was told two decades ago from banking brethren.  The story is how the small community banks have become rarer in their market share due to increasing regulatory cost, advances in technology, and other factors.  We have also seen the rise of the “too big to fail” banks that must be preserved to make sure the economy is progressing.

So now, enter the current resistance to MBL as portrayed by our banking brethren.  Changing MBL regulations to bring it more in line with other business lending regulations will not cause a massive land shift of business from the banks to CUs no more than a CU having a tax advantage against banks that are no chartered as an S Corp.  In my opinion, overt resistance from the ABA is a waste of energy.

First, on the commercial and agricultural lending side, banking is built on relationships.  Business owners want a trusted financial advisor with their banker, whether he work for a credit union or a bank.  Owners want to believe that their banker makes their business better and they don’t just want someone who can complete the next transaction for them.  The first place a bank should look if they lose a business client to a credit union is in the mirror.  A post-mortem is necessary to find out what they could have done better to keep the relationship.

What is in the best interest of the citizenry and the economy is to allow a wide range of choices for businesses to be able to obtain credit—whether a credit union, bank, or other lender.  A more level playing field should be in place, which is what the new regulation seeks to accomplish.

Next, the bank’s negative attitude toward credit union business lending, takes away focus on areas that cost banks far more money than the small 7% of the market held by credit unions.  This culprit is excessive regulations.  Not only do you have the general alphabet of regulations from the OCC, NCUA, and FDIC; add in RESPA, TIL, BSA, FRCA, FinCEN, FRB Regulations A-NN, just to name a few.  We even face a government department devoted to regulating anything that appears to harm the average consumer, in their eyes.  This institution also falls outside the constitutionally established structure to fund government agencies.  Perhaps if less focus were spent on the animosity between the bank-credit union camps and more energy were placed at the excessive high and burdensome cost from governmental regulation, both sides of the aisle would be more profitable.

Finally, the ABA’s errant focus, helps them ignore many other non-financial companies that are competing for banking services.  The 10 largest non-financial companies Forbes’ list, have assets exceeding $3 trillion.  Each of these companies, has at least one product that competes directly for financial services that are provided by banks.  Whether it is the bank inside Wal Mart, a Chevron credit card, or financing with GE Capital, all these companies and more, compete directly for business that exclusively belonged to banks and credit unions in the last century.

It is also easier for non-bank companies compete for business customers with the new delivery channels that do not require a large investment in brick and mortar.  Bankers should realize that to focus solely on the small 7% of the market held by credit unions may cause to miss more business that is being taken away every day from business loan advertisements at Office Depot, to equipment finance at GE Capital, to deposit dollars being placed on a Starbucks card.  In the end, the lack of good relationship building, excessive regulations, and non-bank (and non-CU) competition will do more damage to the bank’s balance sheet than the entire CU industry will.
 

A Hunch is Not a Fact

We, as people, are equipped with tools to sense the environment around us: ears to hear, eyes to see, and nerves to feel. These senses serve us well, allowing us to navigate obstacles and respond to the environment around us.

This does not separate us distinctly from several other vertebrates on this planet, yet we found a way to build cities, fly in airplanes and cure diseases. For this to happen, we had to use more than our natural senses. We had to learn how to reason, and learn that the world we live in was more than what we could see, hear or feel.

One of the challenging aspects of my job is to not accept a loan request based on what it “looks” like; but rather, based on what true facts are underlying the proposal. I need to provide a reasoned argument as to why it is or isn’t a good loan request. Sometimes people think I’m crazy, because what looks like a bad request on the surface may actually be a great opportunity when the facts are checked. Likewise, loan opportunities that look great may be quite weak when the facts are examined.

Our brains are wired to make snap decisions based on limited information. This is well intentioned, because it keeps us from running into walls, falling off cliffs, etc. But those kinds of snap decision didn’t create society as we know it today. That required a slower, more reasoned way of approaching the world. So, to make a loan decision based on snap judgment, would be like starting to impulsively build a home without first checking to make sure the soil was adequate for the project. The facts that are not readily seen still matter and can affect the outcome, so it is better to slowdown the decision making process and make sure all relevant facts are checked.

Television and the internet are pervasive forces in all of our lives, and we may not always realize how much these media sources appeal overwhelmingly to the short-term judgment aspect of our brain, and how they fail to present reasoned arguments. A major aim of most of this media is not necessarily to inform, but rather to sell advertising. Therefore, the main objective is to grab our attention by any means possible, so your attention can be immediately forwarded to the advertisements.

This is why most news headlines seem audacious and extreme, and why anyone who wants to get the attention of news sources must say or do something audacious and extreme. For the average media consumer, it is hard to sort out where the well-reasoned truth is, because every media source is using the same tactic to capture your attention. And they also know, starting a well engaged explanation of the facts detracts from advertising time and may not hold everyone’s attention, so usually that well-reasoned argument isn’t explored.

The other day I heard a comedian on satellite radio ask the question, “When was the last time you saw a real scientist on television?” He talked about how physicists found the subatomic “God Particle” or “Higgs Boson” which can begin to explain why everything in the universe exists. And yet, this discovery received very little, if any, mainstream press. The discovery was simply not provocative enough to compete with whatever sex scandal or outrageous political arguments that were dominating headlines.

The point I seek to address here is this: we need to be careful about what appeals to us emotionally, or what is dominating our senses when we have a serious decision to make. Whether we are making a decision about lending millions of dollars, electing our political leaders, or planning for retirement, we should not be sidetracked by what appears to be the truth based on loud and flashy details. Instead, we owe it to ourselves to calmly review the facts so we can continue to make rational decisions that helped create our impressive society, which will hopefully preserve it too.

Your Competition has Grown

Last night, I dropped by my local Office Max store to pick up my annual copies of Turbo Tax.  As much as I hate taxes, I have actually found TT to make preparation more enjoyable and have used the program for nearly a decade.

When I checked out, I had another encounter with yet another competitor for banking services.  This was a coupon I received for RapidAdvance.com, an online lending source for small business loans.  As a bonus the borrower would also get a gift card to Office Depot!

I decided to do a quick internet search on the company and came up with other business lenders like LendingClub, CanCapital, Kabbage, OnDeck, and others.  Some of these offer funds in as little as three days from application.  Now, I don’t know if these companies are good or bad.  I assume they have a market niche they fill.  Three days for funding is also quite short and I am sure this is some sort of credit scored decided product that anyone with a 6th grade education could read an approval or denial.  They probably deal with a short term cash need for a relatively easy credit, something that we do not handle at our company.  They are a lending source that competes against your business department.

Another good example is the Starbucks Card.  My wife has a gold one and she will continue to refill it when it gets low.  Those funds that sit on that card are funds that could be sitting in a deposit account in your institution and a few years ago they did.  I imagine if you added up all the funds held by Starbucks it would exceed the deposits of many of your institutions.

Facebook announced it was working on a way where you could send cash to another person.  In a way, Facebook is becoming a bank.  Wal Mart also has made big moves into the banking field.

Thirty years ago none of these bank competitors—RapidAdvance, Starbucks, Facebook or Wal Mart—did not exist.  The competition for deposits and loans was typically between credit unions and banks in a community.  Rates could be set over meetings on the golf course.  People adjusted their schedule to fit into the 9-3 hours of the institution.  Businesses owners adjusted their schedule in order to fit into that of where their accounts were.

The problem we have today is too many financial professionals fail to realize that their competition for deposits and loans has grown much larger than just the other banks and credit unions in their community.  Now not only does the competition extend throughout the country, it also encompasses firms that are not primarily financial in nature.  The delivery method has greatly changed as people may be just as comfortable using LendingTree or Quicken Rocket Mortgage to get a home mortgage than they are in stopping in your firm and setting down with a mortgage officer.

It forces people in the finance industry to develop strong relationships where the customer thinks of going to you first, instead of dropping by the bank section of Wal Mart or clicking on a website that is not yours.  It will require innovative methods to find solutions to their needs.  The finance professional who wins will also be one that can also suggest new ideas that make the customer better and more profitable.

In the end it is about delivering value so the customer knows he is better by being with you than he is by clicking the mouse to select some online lender or dropping by his local retailer who happens to also offer financing.  It is important to be aware that your field of competition is growing wider; this forces you to be better.

A New Year, A New Approach to Loan Covenants

I decided to take a break from reviewing some of the economic news in this blog even though the world and markets are rife with it, from one of the worse starts in the U.S. stock market in years, to the collapse of oil prices and impending defaults from oil companies, to stagnant wage growth, to increasing federal deficits.  Also, it does not matter how good the Federal Reserve tries to assure you the economy is expanding at a pace necessary to raise interest rates, the fact it, when Wal Mart begins closing stores, it is time to realize that something is amiss.

So this week, I want to spend some time on financial loan covenants.  Covenants are various performance standards that measure your borrower’s financial capabilities.  Many of these standards are viewed during underwriting and a covenant helps review the financial health of the borrower throughout the life of the loan.  Typically, these are thought of more after year end, as many companies have covenants that are measured after their fiscal year end which usually coincides with the calendar one.  When these covenants are viewed and tested, it is a good time to assess how well you have structured these guidelines and how to improve in the future.

The lender should embrace the use of covenants as this is a good tool to monitor the health of the company and manage the business credit.  No one should fear putting in a covenant because they are afraid to act if one if one is broken.

First, are the covenants clearly defined?  Covenants are clear when they describe what is measured and how it will exactly be measured.  This should be clear enough for any borrower to be able to look at their financials and figure out how they match up with the standards set out in the loan documents.  An example of a debt service coverage covenant for a hotel may read, “The numerator will be all normal income from operations less all operational expenses.  Any capital improvements that are expensed will be added back and a 3% CAPEX allowance will be deducted.  This number will be divided by all annual debt payments.”

Second, do the covenants tell when the measurement will take place?  Good covenants explain when a measurement will start, how frequently it will be measured thereafter, and if there are any performance benchmarks that may allow the measurements to become more or less frequent.  An example would be a loan for a business to expand by purchasing new equipment.  I may want to delay the first measurement of DSCR or to have the standard ramp up in order to allow the company to realize the additional net income from the expansion at a stabilized rate.  I may want to check the covenant more frequently, say on a quarterly basis, while the company is ramping up to reach its new stabilized revenues.

Third, note that covenants can be both positive and negative.  Some loans can be structured to reward the customer with a lower interest rate if certain thresholds in DSCR, deposits held at the institution, or debt/worth are reached.  In some of these ways, this can actually reward the client for good performance and create an incentive for the business to be run profitability in order to reach the reward.

Fourth, recognize that different ratios will apply to different companies in judging their financial health.  On a manufacturing company, I may want to measure items like the current ratio, debt/worth and free cash on hand after all obligations.  However, a rental apartment building mortgage, could have most of the risk analyzed with reviewing the debt service only.  Viewing a debt/worth ratio on this type of loan is not helpful in determining the risk.  Selecting the right measures to judge the health of a credit is also important with your risk rating model you use.

Finally, the options the lender has for a violated covenant should be varied.  Your loan agreement should have the option of doing nothing up to calling the entire loan due if a covenant is violated.  Monetary penalties, such as increasing the interest rate should also be an option.  The lender can then select what course of action is most appropriate when a loan covenant is violated.

Self-Driving Cars: Not If, But When

As you are reading this, a major winter storm is bearing down on the Washington D.C. metropolitan area. There are roughly 5 million people that live in that Census designation alone, and there will be millions more affected by this storm.

My wife and I used to be among those 5 million, and a few people asked me this week what it would be like commuting to work when it is snowing in the DC area. Of course, they knew it would invoke an extreme reaction. We know how many accidents happen in the Dakotas due to snowfall, so naturally that will be multiplied several times over when millions of more people enter the mix.

And my response, by the way, was that I simply didn’t go to work those days. Life is too short to fight congested traffic that isn’t budging because of icy accidents!

But living out there gave me an interesting perspective on the future of driving. Before moving out there, I had thought the idea of self-driving cars was mostly science fiction. I didn’t take the concept seriously, and I didn’t expect to see much of it in my lifetime. But through casual conversation with my DC area coworkers, I soon learned my view of this was a small-minded one.

People living in major cities not only expect self-driving cars to happen, they can’t wait for the technology to arrive. Traffic in cities is awful during a normal day, and life-crippling if it rains or snows. Automated cars that avoid accidents, or automated roadways that control the flow of traffic, can provide a large boost to the quality of life for urban dwellers. The average commuter will save many hours a week from not being stuck in traffic, while simultaneously reducing their stress. The thought of being stuck in traffic only once in a while, instead of almost every day, is a reality everyone is eager to accept.

This changed my opinion of self-driving cars completely. One of the greatest risks of any technological advancement is adoption. Some technology provides great value, but people may fail to recognize it immediately, leaving us to say “it was before its time.” But with self-driving cars, the public desperately wants it, leaving implementation simply a logistical issue. When enough people want something so bad in a free society like ours, there will be technologists that find a way to make it happen!

As for the Dakotas, here I can see adoption occurring somewhat slower due to lack of immediate necessity. Our problems are actually the opposite of our urban counterparts. Our cities are easily navigable, but the distances between our communities is vast and empty. Where we will benefit from self-driving cars are the long road trips. Here, self-driving cars will free us up for activities that require more concentration. Fifteen years from now, instead of having a driver focus on keeping the car pointed straight on the interstate, that same driver may be playing cards with his or her family, or completing a time-sensitive work project on their laptop.

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.