Why Bother?

This week we are wrapping up our visit with the Minnesota Credit Union Network (MnCUN). It is always interesting to meet new people who come from institutions that range from $5 million in total assets to over $1 billion. Some large credit unions are actively involved with business lending, and they can easily employ a full time staff to manage this product. Smaller credit unions may dabble in business lending and work with CUSOs like Pactola to support them. However, there are still credit unions that insist that they are too small to do any meaningful business lending.

Often times, the biggest challenges we face is ourselves because of the limits we impose upon ourselves. I have heard from credit unions of all sizes that they cannot compete in their respective markets because they are too small, or because nobody gives them a chance. This is a perspective that feeds upon itself. If you are convinced that you cannot compete, you will not compete, so you will never have a competitive edge.

I witnessed this vicious cycle often when I was a Peace Corps volunteer. In Ukraine, many people have fatalistic attitudes. When asked about why they don’t capitalize on opportunities or try to change society, the comment often made is “why bother?” If someone never tries, nothing ever changes, which reaffirms to them that nothing ever changes. After decades of Soviet bureaucracy, it has been tough for Ukrainians to come to terms with controlling their own destiny.

I don’t mean to pick on Ukraine alone, because we all know people like that here too. I’ve witnessed that this same fatalistic tendency exists amongst many in the credit union movement. And, I’ve heard people in credit unions say that they can’t compete in with business lending whether the CU has $20 million in total assets or $1 billion. Just like the phrase, “I think, therefore I am,” people can achieve great things, or achieve very little, if they chose to limit themselves respectively.

And much like I observed in Ukraine, these credit unions believe they cannot engage new activities like business lending, so they pass on good opportunities or don’t actively seek solutions to accommodate the request. The result is they don’t engage in business lending, which reaffirms their belief they cannot engage in business lending. Do you see the cycle?

Of course, the issue is greater than simply business lending, but a problem with people selling themselves short. If CU leaders believe they can’t provide competitive services, they won’t. This might apply to business lending, online banking, insurance services, brokerage services, trust services, etc. If leadership is convinced it cannot be done, they won’t find a way to do it. Which means, they won’t do it, which proves to them it can’t be done.

Credit unions have a phenomenal cooperative spirit which banks do not have. Credit unions are skilled at leveraging each other’s resources through working together. Fatalistic attitudes are at odds with credit union movement, because it means giving up instead of working together to find an answer. In this sense, credit union managers are not only selling themselves short with fatalism, but they are selling their members short too. 

Derivatives, a Ticking Time Bomb for the Economy?

In the height of the Great Depression, the Glass-Stegall Banking Act was passed in 1933.  This forced banks to separate themselves from brokerage houses and to not get involved in some of the risky transactions that caused the Depression to be as severe as it was.  In 1999, Glass-Stegall was repealed by the Gramm-Leech-Bliley Act, thus allowing investment and banking sides to intermingle effortlessly once again. 

This change led to the exponential growth of derivatives on the bank’s balance sheet.  Derivatives are an opaque financial vehicle that can encompass a wide range of financial products:  futures contracts, interest rate swaps, foreign exchange, credit default swaps, etc.  Derivatives are popular since they create a large portion of bank earnings.  But with any investment, there is a level of risk.

The Office of Comptroller of the Currency identifies some of these risks in their quarterly report on derivatives.  “Credit risk is a significant risk in bank derivatives trading activities. The face amount of a derivative contract is a reference amount that determines contractual payments, but it is generally not representative to the amount at risk. The credit risk in a derivative is based on a number of variables, such as whether counterparties exchange notional principal, the volatility of the underlying market factors (interest rate, currency, commodity, equity or corporate reference entity), the maturity and liquidity of the contract, and the creditworthiness of the counterparty.”

Credit risk in derivatives differs from credit risk in loans due to the more uncertain nature of the potential credit exposure. A loan has credit exposure from one source, the borrower.  The exposure is limited to the amount of the loan.  However, in most derivatives transactions, such as swaps (which make up the bulk of bank derivative contracts), the credit exposure is bilateral. Each party to the contract may have a current credit exposure to the other party at various points in time over the contract’s life. Now since the credit exposure is a function of movements in various market factors, banks do not know, and can only estimate, what will be the value and risk in a specific derivative contract might be at various points of time in the future.

So this makes measuring risk from derivatives a guess at best.  A bank has to identify derivatives receivable and net out any derivatives they have payable. Any derivative receivable represents credit risk that bank faces on the instrument, a derivative payable would show the risk that bank poses to the holder on the other side of the derivative counterparties.

The entire system works well as long as there remains trust in the system and the all parties to the derivative can perform their role.  But what happens when the glue of trust evaporates and one or multiple parties cannot perform their counterparty risk?  You begin to get meltdowns like we saw in 2007-8 with failures in the credit derivative market.

Credit derivatives split a bond, loan, or mortgage into pieces and then reassemble them into new configurations that are sold to different investors or speculators.  The problem with this is that the new derivative instrument is not related to the obligation it was based upon and also separates the lender from the borrower and vests economic power in the hands of a party that has little interest in the economic fate of the borrower.  Credit default swaps grew to over $60 trillion in size on the eve of the 2008 financial crisis.  This was far greater than the volume of the cash obligations it was insuring.  The sheer size of this market had a strong negative influence on the real world of cash credit obligations.  Values fell to levels that ridiculously low levels, unless you expected the world to end. 

For the first 9 months of 2015, derivative trading produced over $41 billion in revenue for our nation’s banks and holding companies.  This represents nearly half of the revenue earned by the holding company.  Clearly, there is a profit motive for these instruments.  At the end of September 2015, US banks held $192 trillion of derivatives, most of these being in the form of interest rate swaps.  The top five banks—JP Morgan Chase, Citibank, Goldman Sachs, Bank of America, and Wells Fargo, held $180 trillion at this time.  This amount is way more than the $6.4 trillion in assets held by the institutions and also much larger than their capital base.  This amount also dwarfs the GDP of the US, which was around $18 trillion in 2015 and the GDP of the entire world, which is around $75 trillion.  Sounds like another case of the “too big to fail” syndrome. 

Again, as long as trust and all parties can fulfill their roles, the system stays in place.  But what happens when that one event:  a sovereign debt downgrade, a default of a small insignificant country, or a large company failure—begins another 2008?  It could be like the one snowflake that starts an avalanche.

The Social Good Behind Lending to Small Businesses

I took a class in college called Regional Economics, and it explained how communities trade goods and services with each other in the same way we think of countries trading in international economics. Each community has something to offer to the rest of the country, or even the rest of the world. It also suggests that if a community lacks anything to export, it might die. Maybe.

The class also focused on an interesting argument that is analogous to the classic phrase “which came first, the chicken or the egg?” You see, economists couldn’t seem to figure out if jobs attracted people to communities, or if people attracted jobs to communities. It turns out, a lot of research indicates both are true. Jobs chase people, and people chase jobs. So economic development feeds on itself, which is also the idea behind the “multiplier” effect.

People working and earning money creates more jobs for other people. If someone is getting paid to work, that person will then want to spend their money at a restaurant or a retail shop, which means someone else will need to fill a job at a restaurant or department store.

These economic effects often depend very heavily on the assumption that people have access to credit. Those jobs at the restaurant or retail shop may never come to fruition unless there is a local lender who is willing to provide a loan to open these businesses. I am not suggesting lenders should lend money simply because people ask for it, but they may carry some responsibilities as trustees of their community by assuring credit is available.

Having examined banks in small towns across South Dakota, I can tell you that the local bank or credit union can have a huge impact on the vitality of their community. I have seen dying communities, and typically, there is a scrooge of a banker nearby. Bankers who refuse to take any risk will hoard deposits and always have any excuse on why they can’t lend to the local business owners. As a result, businesses don’t open, and the town struggles to keep people and services. Likewise, it is amazing to see a small community hold on to what it has, because an innovative lender has found a way to get credit to local businesses and co-ops.

This also provides a good outlet for a credit union’s liquidity as well. Many credit unions, especially in small communities, have too much liquidity. This surplus cash is often kept with correspondents or corporate credit unions, where they receive an exceptionally low interest rate. If these funds were instead lent to small businesses, the credit union might see a yield of 4% or greater on those funds.

Credit unions have done an excellent job at providing consumer loans to their members, but just like banks who accept deposits, they are also trustees who have a responsibility in making sure those deposits are reinvested in the community. That should include helping small businesses, who provide goods, services and jobs in the local community.

Be Extraordinary

So what does it mean to be extraordinary?  Extraordinary is an achievement of a level of accomplishment that becomes memorable because it is beyond the normal, the expected, and the usual.  Extraordinary sticks in the front of your mind, whether it is something personal—like graduation, marriage, or the birth of a child, or it may apply to a large number of people—like V-J Day, the Kennedy Assassination, or the day the Berlin Wall came down.

Extraordinary begins with the root word ordinary.  It starts with what is normal and expected.  Extraordinary events begin as the usual.  Extraordinary service begins with the normal service one expects—being greeted by name, having the transaction completed quickly, and being treated courteously.

But to be extraordinary you must go beyond.  This week marks the first two rounds of the NCAA Basketball Tournament.  This always shows up as an example of what is ordinary and what is above.  Ordinary is making it to the tournament.  Extraordinary begins with a team who is not supposed to win a game against a foe that is bigger, stronger, and overall better, beats that team.

In the first round of this year’s tournament, one of the best examples of extraordinary is the Middle Tennessee-Michigan State game.  The game began as a classic of a #2 seed, who many expected to win the entire tournament, playing the token game with a #15 seed.  Usually these games involve the lower seed making a good run and fading in the late in the first half or early in the second as the higher seed cruises to victory.

This game was different than the ordinary.  Middle Tennessee got ahead from the beginning and never trailed as they ended with a 90-81 victory.  Every time that Michigan State had a run and got closer, Middle Tennessee answered with a run of their own.  What was expected did not happen.  The extraordinary did.

Note that the first ingredient to change ordinary to extraordinary is effort.  It takes extra effort, more effort than what normally expected, to begin the move to what is memorable.  It also takes to never give up, even though there are obstacles that make us want to quit, and if we did quit, that would be acceptable in the normal of life.

A second round game I watched had 6th ranked Notre Dame playing 14th seed Stephen F Austin.  I watched the second half of the game and Austin was in complete control.  But in this case, the effort required to finish from SFA was not used as it appeared the team attempted to give up their dominance and play it safe, allowing the clock to run out while they had the lead.  They missed several scoring opportunities in the final minute that they seemed to have made before.  Notre Dame tapped in the winning basket with 2 seconds left for a one point win.  They did not complete the effort needed to be extraordinary.

Every day, we face many opportunities to be ordinary in our work, families, and those we come in contact with.  Many of these ordinary events can become extraordinary with increased effort on our part.  Go the extra mile and your efforts can become the start of something memorable.

Using Credit Scores, Betting Odds and Polls to Predict the 2016 Election

I think it is hard to deny that the 2016 United States Presidential election continues to be an unpredictable spectacle that is making history. I have been trying to follow it in terms of statistics, which leads me to regularly be directed to two interesting websites.

The first website is http://www.oddsshark.com/entertainment/us-presidential-odds-2016-futures where people can bet (albeit, technically off-limits to Americans) on the outcome of the election. A betting site like this is effectively a futures market, and I visit the site twice weekly to see what the odds are for people putting real money down on their bets. Since about January, the odds have consistently suggested a Clinton-Trump matchup, with Clinton carrying a respectable lead, but not an enormous one. This isn’t my opinion or spin on the facts; this is what real money is betting on. Check out the archived results, and you will see some interesting trends throughout the nomination season.

The other site I like to visit is http://fivethirtyeight.com/ which is a relatively new blog established by Nate Silver. Silver is respected for creating a way of coalescing an analysis of several polls to provide a strong consensus on election outcomes. He accurately predicted how 49 of 50 states voted in 2008, and how 50 of 50 states voted in 2012. Silver’s blog isn’t predicting the next president just yet, but it is closely following primary polls. They have great graphs showing how each candidate’s support has tracked over time, and shows how “on target” each candidate’s strategy is that would best secure their nomination. The most fascinating recent developments show Sanders is not too terribly off track to still have a chance at winning the nomination, and that Trump’s support may be waning enough to result in a brokered convention. Again, this isn’t my opinion, these are what the numbers and polls are actually saying.

I think the most interesting article I’ve read this week happened to come from CNBC: http://www.cnbc.com/2016/03/17/this-candidates-supporters-have-the-worst-credit-score.html . It appears CNBC tried to track how people will vote based on their credit scores. People with the worst credit scores, defined as 620 and below, were most likely to vote for Clinton, followed by Sanders, and then Trump. And people with the best credit scores, defined as 720 or greater, were most likely to vote for Kasich, followed by Rubio and then Cruz. The poll said it was conducted online and had 765 participants. Without more concrete information on how it was conducted and given the very small sample size, I don’t think this poll really tells us much of anything!

It is always important to remember that this data is simply a snapshot in time, and what truly matters more than anything is that every able, eligible voter makes it to the ballot box to support their desired candidate. The United States has some of the worst voter turnout of developed countries. In the 2012 election, only 53.6% of eligible people actually voted in the US, but 84.3% of people registered to vote did vote. It appears if we can convince people to register to vote, there is a good chance they will participate! http://www.pewresearch.org/fact-tank/2015/05/06/u-s-voter-turnout-trails-most-developed-countries/

Guarantees and the New MBL Regulations

Possibly the most heard requested change that I heard from credit unions for MBLs was to change the guarantor rule.  The current regulation requires a guarantee of the full loan by a majority of the ownership.  Exceptions are granted for any loan to a non-profit or a loan that is tied to a governmental guarantee that has different rules.

The new regulation allows the guarantee decision to be make at the lender level.  Lenders can decide when to require a guarantee or when to disregard the need for one.  This portion of the new MBL regulation goes into effect within 60 days after publication in the Federal Registry.

I do agree that the decision to require a guarantee or not should be a lender level decision.  But I do think that not requiring a guarantee from the sponsors should be rare and warranted in certain credit circumstances.  In one of the first loan committee meetings I attended as a young commercial lending pup, we were discussing a credit request for a small manufacturer.  The owner wanted the loan on a non-recourse basis.  Our head of commercial credit said something that has stuck with me since then, “If the borrower expects us to loan money and thinks the company is good enough to support the request, he should be willing to back it up personally.”  Since that time there have been a handful of times, that I have not had a guarantee on a loan.  The lender has little upside in a loan on a project that excels.  We only get our required payment but do not benefit in the wild profits when they come.  However, we do bear the risk on the downside with most loans putting more funds into the project than the borrower does.  Hence the need for a guarantee.

So what are some circumstances you should look for to waive a guarantee?  The first requirement is to find out if the business can historically and going forward support the debt request without any intervention from the sponsor.  This is why some projects like a construction loan that has the risk of completing the project, should always have guarantors backing the project.  I have also never seen a business credit that requires a lot of sponsor involvement to make the business perform as a candidate for non-recourse.

So this leaves projects that are somewhat passive in income in terms of sponsor involvement.  So a manufacturer or a hotel that has the main sponsor on site each day would not be a good non-recourse possibility.  Some options that may be options would be a financing a building with a long term lease to the US Government, an established apartment with management outside of the sponsor group, or a long term leased building with a strong credit tenant in an industry with a strong future.  The last one we have to be careful with as we can point to companies that were once strong like Circuit City or Kmart that used to be very stout but are gone or a shell of what they were in their heyday.  Consideration of the future use for the building outside of the present use should also be contemplated.

Non-recourse lending should also be more attractive to the lender than recourse lending.  Some ways to do this would be to require a lower LTV, underwrite to a higher debt service threshold, or shorten the term.  In banks I worked at, we would often require another 5-10% down to entertain the prospect of a non-recourse loan.  Strategies like this reserve non-recourse for stronger credits.

Some things to consider would be if the non-recourse loan request has a term that exceeds the lease term.  If it does, how easy is it and does the sponsor have any responsibility in finding new tenants?  If it is somewhat difficult and there is sponsor involvement, you probably want to tie them to the loan.

Other options may be to require limited guarantees.  An example of this if you have five owners of a company would be to require each of them to guarantee an amount slightly higher than their ownership percentage.  In this case we ask for each to provide a 25% guarantee of the total of the credit.  As a whole you have more than 100% of the credit guaranteed which allows the lender some space to deal with any costs to service and dispose of the property.

Whenever you do have the case with a non-recourse loan that you decide to do, you will have to establish a case of why this is acceptable and what steps were taken to mitigate the risk of leaving out the guarantor.  This will be required by the examiners but is also a good practice to manage the credit wisely.  Using the excuse, “We had to offer this because the competition did,” is not sufficient on either count.

Business Lending vs. Consumer Lending

I think most people understand quite well that business lending has a very different risk profile than consumer lending, but maybe it is not always readily obvious why that is.

Probably the biggest driver of consumer underwriting is wages or income, followed by someone’s overall debt load. People can borrower increasingly more consumer debt so long as they have the income to support it.

A person’s income is relatively easy to figure out, since for most people it is a recurring paycheck about every two weeks. And someone’s debt load is easy to figure out, since most consumer debt is reported to a credit bureau and that debt can be seen on a credit report. This commoditizes information on individuals, and makes it easy to create decision making criteria for a large population since we all share these similarities of a regular paycheck and a credit report.

Businesses differ greatly in all of these characteristics. While the revenue and net income of a business matter a lot, it is far harder to predict the recurring nature of that cash flow. Businesses don’t get a steady paycheck every 2 weeks like average wage earners. A hotel might see an enormous amount of revenue in the summer, and little revenue in the winter. On the other hand, a snow removal company will see a lot of revenue in the winter, and no revenue in the summer.

We can’t create a one-size-fits-all approach to business lending, because the source of revenue and recurring nature of it differs greatly from business to business. Comparing two different businesses isn’t like comparing two different people. It is like comparing two different species.

Businesses also don’t have a robust credit report. Some agencies attempt to create a credit report for businesses, but it is hard to commoditize this information for reasons we just discussed. This would also require all lenders to report business debt to these agencies, which isn’t something customary and it is a practice that would be subject to a lot of debate. Business borrowing often goes beyond simple bank-debt, so even knowing what bank-debt is outstanding still does not give us enough information to decide whether the business can handle another loan.

There are patterns and systems that can be used to underwrite businesses, but they aren’t as fine-tuned as the models used to underwrite consumer debt. And more importantly, in every circumstance of business lending, there is responsibility on the lender to understand the source of revenue for each business. This will require some research and special reporting tools.

Take for example the hotel operator. The lender will need to obtain a special market report for the area hotels to see what average room-night stay costs, and whether there is substantial seasonality. But for the snow removal business, a lender’s research will differ. Now the lender will need to be more concerned with what contracts the company has secured, and what the company has to fall back on if there is not much snow this season.

Because business revenue doesn’t have the same predictability as a wage earner collecting a paycheck, the underwriting differs and the structure of the loans will differ too. This is why a different set of specialists are required for business loan underwriting, and why it presents a uniquely different risk to the financial institution.

Decision Making in the Business World

Decisions, decisions, decisions.  Every day requires a lot of decisions, especially in the business world.  A requirement of good leadership is the ability to take in information, analyze it, and make decisions regarding the information received.  Sometimes those who rise the top in leadership are simply those who have the guts to make decisions and follow through better than those around them.

In our field of commercial and agricultural underwriting, it requires synthesizing a lot of information and making informed decisions based upon that information.  Simple right?  Well as simple as it is, there seems to be quite a few obstacles that prevent the proper execution of making and living with the decision.

One factor is the analysis paralysis.  This is the situation where there is a constant request for data, information, and forms, without any idea of what any of this information actually means.  Credit analysts can get into this trap.  We often can become more obsessed with checking the boxes on the list than we are with understanding what the information we have is telling us.  It leads to faulty loan underwriting where the risk in a credit is never fully understood.  My suggestion is if you are in the check the box trap, seek to get as much understanding as you can so you can execute proper risk analysis of the credit request.  Understand the credit so well that you can defend your analysis.

Corporate culture can either create an environment for all to take ownership and make decisions or where an endless stream of reviewing data continues with no real conclusions are ever reached.  Oftentimes these shops will be easy to condemn bad decisions.  This creates an environment where people are afraid to make a decision, because they think they will be punished if it goes wrong.  Inaction and constant analysis are valued higher in this arena than are actual action and accomplishment.

Companies in with this culture find employees swimming against a strong tide of criticism, with little or no achievement to show.  Oh, these entities may reach greater heights, but the opportunity to really reach their true potential never materializes.  Teddy Roosevelt once said, “It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.”

So back to decision making.  It has to be expected that sometimes when decisions are made, there will be some mistakes.  The real test is not to make the mistakes, but what your next move is after the mistake is made.  For the company, the culture will determine what happens when mistakes are made.

Decision making also comes with the time factor.  The wrong decision at the wrong time is a disaster.  The right decision at the wrong time, will not lead to the results desired.  The wrong decision at the right time, is a lost opportunity.  The right decision at the right time, now that leads to success.

Decision making is also required when negotiating.  The party you are working with does not want to constantly hear, “well I have to check with,”  “I don’t have the authority to say,” or “we have to get our committee’s approval”.  By now the other party is thinking they just want to talk to someone in authority or just take their deal to someone else.  I love negotiations and the interaction back and forth that occurs.  My goal is to have the playing field well-defined when entering into discussions.  Yes, in many instances there will be items that require the approval of some higher authority.   But, knowing and articulating what can and cannot be done increases your stature in the eyes of the client and will ultimately bring you more business.  People like doing business with people they view as an expert in their particular field.  Think to the last time when you dealt with a store clerk who did not have the authority on an item you are trying to return.  After the third “I will have to get that approved,” you tend to be ready to just speak with whoever is in authority.

So there you go.  A few thoughts from my porch on a Sunday afternoon.  Embrace the challenge of making decisions.  Avoid analysis paralysis.  Realize you will make mistakes. Empower your team and avoid the circular fire mentality.  Realize the critic is not the one in the arena who actually accomplishes great things.  Be aware of proper decision timing.  Learn to negotiate well.  At the end of the day, these skills will help you succeed in your decisiveness.

The Impact of China on the US Economy

I spent last week in Washington DC at CUNA’s Government Affairs Conference.  I always enjoy going there as I love US History.  However, sadly, I did not go to any museum or monument because of work.  This is your CUSO hard at work.

The day before we landed back in South Dakota, my oldest son returned from a month long trip to China.  This was his third trip to that country.  Since I am always interested in economics, I wanted to get his take on the status of the Chinese economy since I hear reports of a slowdown.  I found his take on the situation there interesting.

He showed me a shopping center that was full of a large variety of shops when he was there last year.  Now, there is only a Wal-Mart and a few clothing stores.  He said it was like a bomb went off in the place.

He has a friend over there whose mother lost her job at a retail store in a mall after working for years at the same place.  She has not been able to find another position yet.

On Sunday evening, the People’s bank of China reset the midpoint of the renminbi’s trading range to 6.5452 per US dollar.  This is the lowest fixing in nearly a month.  The Chinese have been devaluing their currency in an attempt to stimulate the export sector of their economy.  It is interesting that the drop came just days after China signed a pledge at the G-20 meeting to not resort to currency wars.  Then just a few days later, they devalue their currency by a larger than normal amount.

Additionally, the Chinese central bank cut its reserve requirement ratio by 0.5%.  Dropping the reserve requirement is a monetary stimulus tool aimed to get money back out into the economy and out of the bank vaults.

China does not control our economy but it is a huge influence on the overall world economy.  Most of the economic growth in the past decade has come from the BRICS-Brazil, Russia, India, China, and South Africa.  Now, most of these countries are languishing.  Their lack of economic growth hurts several areas in our economy.  One of the largest is agriculture.

Every devaluation of a currency compared to the US makes our exports more expensive.  This has a huge impact on our producers in the US.  If you have any doubt about this, ask any wheat farmer who lived through the Russian grain embargo.  The factors were different then, but it still caused the demand for US grain to drop sharply.

Meanwhile, we will still see moves in countries like China to prop up their economy.  Foreign reserves continue to flow from that country at record paces.  It would not surprise me to have a sharp decline of as much as 20% in the yuan in one day as an option to help stop the bleeding.  Each sharp drop there can send a ripple impact over here, especially in our ag sector.

Announcing a New Partnership with Conterra Asset Management

A partnership has formed with Conterra Asset Management & Pactola!  Conterra is one of the three master central servicers for Farmer Mac.  They also manage over $2 billion of USDA guaranteed loans.  Conterra also has an agricultural appraisal company called Contour Valuation Services, which has a network throughout 15 states to provide farm, ranch and agricultural facility appraisals. 

“The partnership with Conterra offers us several new and exciting products for our agricultural lenders” states Phil Love, Pactola’s President.  “Conterra has several alternative lending programs that can provide transitional financing, debt restructures, and bridge loans for special circumstances.  These programs may allow a credit union to move some farm loans that show stress but have ample equity off their balance sheet.  Conterra also has a program that allows for expanded eligibility over Farmer Mac standards.  This will allow us to provide additional agriculture financing options for the credit unions we work with.”
 

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.