Advantages of Adversity

One of the best ways to learn about yourself is through adversity.  Adversity always gets our attention.  When we are in the fires of the furnace of trials, it can help burn off the dross and leave the pure metal.  Former Egyptian President Anwar Sadat once said, “Great suffering builds up a human being and puts him in the range of self-knowledge.”

But too often, when the storm of adversity comes in, we have a tendency to hide.  We resist the pain and seek to hide.  We may build a fortress to prevent further adversity.  Our attitude is like that from Sargent Schultz in Hogan’s Heroes.  “I know nothing.  I see nothing.”  This is their response to hard times. 

Yet, adversity can be a huge teacher to us.  James Allen wrote in the book, As a Man Thinketh, “Circumstances do not make the man; it reveals him to himself.”  Novelist Samuel Lover once wrote, “Circumstances are the rulers of the weak; but they are the instrument of the wise.”  Yet, it is really easy to ignore adversity and fail to learn its lessons.

One of my fraternity brothers, Mark Taylor, used to love telling this story.  A wealthy man had two sons.  One was always sour on life, had a negative attitude, and complained about everything.  The other one was always thankful, looked at the positives, and found the best in everything around him. 

One Christmas, the father decided to do an experiment to see if he could change the attitude of either son by giving rewards or adversity.  He gave the son with a sour attitude a roomful of toys.  Every kind of neat toy, computer, and electronics device filled the room.  The son with the great attitude, he filled his room full of horse manure. 

On Christmas morning, the father told both sons that he had their presents in their rooms.  Both boys joyfully ran to their rooms.  After several hours, the father came up to the son’s room who always had the sour attitude.  To his surprise, the son was sitting in the middle of his room crying.  He was complaining about all the wonderful toys he was given and how he could not get everything to work.  He could not assemble the toys, computers were not working, and the iPads were frozen.  Even though he had all these wonderful gifts, still he continued to complain.

He went down the hall to the second son’s room.  To the father’s surprise, the son was joyfully shoveling manure as fast as he could out the window.  The father asked, “Why are you so happy?” 

The son answered, “Because dad, with all this manure here, there has to be a pony in here somewhere!”  Here is a picture of someone looking through the adversity to see the positive!

Adversary can teach you more than pleasure or success.  Robert Browning Hamilton wrote a poem once about this.

I walked a mile with pleasure,
She chatted all the way.
She left me none the wiser,
With all she had to say. 

I walked a mile with sorrow;
And never a word said she,
But oh the things I learned from her,
When sorrow walked with me. 

In the end, the trial can be the best teacher to better understand ourselves, if we will choose to be educated by adversity.

The Retail Breakup

With the economy recovering after the crash in 2008, many in the retail industry were hoping the mass of store closings would subside and become past history.  Even though retail appears to be much more solid than it was five years ago, store closings are going up.  In 2015, 5,866 stores were closed in the US, this is a 7% increase over the store closings in 2014.  Cushman & Wakefield estimates that store closings can surpass 6,200 units this year. 

Store closings run a variety from department stores, grocers, apparel, and electronics stores.  These include some major big box retailers like Office Depot, Macy’s, Sears, and Barnes & Noble.  Examples of this are Sports Authority, who filed Chapter 11 bankruptcy in March and announced it is thinking about closing 140 of its 450 stores.  Walmart is closing 154 stores in the US, most of these are the smaller Walmart Express format.  Best Buy is closing some stores as leases expire, including 30 stores last year.  North of the Border in Canada, Target closed 130 stores. 

There are several factors that are influencing the decline in retail.  Planners for retail companies are rethinking the old time brick-and-motor strategies now that there is such strong growth in online retailers and e-commerce.  Online now comprises of just under 8% of all retail sales.   Retailers are seeking to expand their on-line presence.  Underperforming stores are looked at with more scrutiny.  Retail companies are shrinking store footprints and looking for locations that are more favorable.  Basically, retailers are being much more selective on where and how to expand. 

Some may question the health of this recovery.  With nearly 94MM Americans out of the work force, there is less potential disposable income to be spent in stores.  Personal income has had anemic growth since 2008.  Less income creates stagnant growth for demand for goods and services.

Demographics also has an impact on demand for goods and services.  As Baby Boomers retire, they have less income and typically will purchase fewer goods.  The next demographic group, Generation X, is quite a bit smaller in numbers than the Boomers.  So as the Boomers retire and Gen X gains in assets and disposable income, their impact on demand will be less due to their lack of numbers.   Millennials have more numbers than Gen X, but their impact on demand for goods and services has not been felt as they tend to not have as much disposable income and assets as previous generations.  Also, their buying habits will change the landscape of retail.

Small shop space may often have a list of possible tenants; bigger box stores create a bigger challenge.  There are fewer possible tenants because of retail bankruptcies and consolidations, which have taken possible tenants out of the market.  Other big box retailers are actively looking to shrink their square footage footprint.  Even in areas where a big box retailer is expanding and there are often options from other open buildings, the empty building may not be suitable due to location or demographic concerns. 

One option for empty larger box stores is to divide the space.  In Pueblo, Colorado, the Walmart on the north side of town built a new supercenter, leaving an older Walmart building vacant.  The building owner was able to fill the space with putting in a Big Lots Stores in the majority of the space.  They then filled in the rest of the space with a restaurant, thrift store, and offices. 

Retail construction in the US has also fallen dramatically.  In 2005-2008, new retail space averaged around 250MM square feet.  This amount dropped to less than half of that in 2009 and has not come close to recovering from the pre-crash level.  New retail space last year ended around 80MM square feet. 

Overall, these factors present strong headwinds for the retail industry, especially in the big box area.  As large companies seek to find methods to increase profitability, they will focus on more efficient methods to deliver their goods to clients at lower prices or utilize more targeted methods to generate sales.  All of these may create more empty big box retail space. 

Can a Credit Union Serve Immigrants?

There are 42.4 million immigrants in the United States, which makes up 13.3% of our total population. If you include the children of those immigrants who were born in the United States, that totals 81 million people. This means that 26% of our total population are families with immigrants!

I feel this reinforces many facts we often forget. We are a nation of immigrants, immigrants have always been key to our population and economic growth, and a substantial part of our population continues to be first generation Americans.

I think sometimes the rhetoric in the news about immigrants tends to overwhelm people, and media consumers are encouraged to view the immigrant population with suspicion. We forget immigrants are really quite ordinary people who need ordinary services, like a place to deposit a paycheck or a place to get a car loan. When I was a bank examiner, I came across a bank that filed a Suspicious Activity Report (SAR) on a dentist, because he was foreign born. There were really no other factors that seemed suspicious or unusual about the man, other than he was from abroad, and now needed access to banking services as he practiced dentistry in the United States. To me, this seemed like a bit of an overreaction.

But for many of us who have lived our entire lives in the Dakotas and do not have frequent exposure to immigrants, how are we supposed to know when it is okay to bank with somebody who wasn’t born here? I think it is a legitimate question, so let’s look for some legitimate answers.

The key phrase you will usually encounter when dealing with government worded guidance is that someone must be a “lawfully admitted alien.”  The definition of “lawfully admitted” means an alien remains in status as a permanent resident, conditional permanent resident, or temporary resident.

The hardest status to understand is the category of temporary resident. A temporary resident has a visa to study or be employed in the United States, but cannot remain here as a permanent resident; whereas, a permanent resident can remain in the United States indefinitely and possesses a famed “green card.” Therefore, you may need to take into consideration the length of stay for a temporary resident, but a permanent resident shouldn’t be viewed any differently than an ordinary citizen. A permanent resident will have a social security number, driver’s license, and can work most jobs in the United States, but cannot engage in the political process.

If a permanent resident chooses to become a citizen and is successful in doing so, they become a “naturalized” citizen. Naturalized citizens are afforded all the same rights, responsibilities, and opportunities as a citizen, except they cannot be President of the United States. They can still engage in the political process and even hold elected office. An example would be Arnold Schwarzenegger, who was born in Austria, but became a naturalized citizen, and later became governor of California.

No matter someone’s legal status, you are always going to check the OFAC list before doing business with them, and collect the identifying information. Even if someone is an immigrant, any naturalized citizens or permanent residents will possess the same documents for identification as any natural born citizen. So in reality, having immigrants as members should be no different than members born in the US. And, I would argue that the fact they are immigrants alone shouldn’t raise suspicion or concern.

http://www.migrationpolicy.org/article/frequently-requested-statistics-immigrants-and-immigration-united-states

https://www.immigrationsupport.com

Leaders Help the Team to Enlarge

I have been on the road a bit lately.  One evening I found myself in the hotel flipping through channels and stopped at the movie Braveheart.  I love the movie and the story behind it.  In 1296, King Edward I of England crossed into Scotland with a large army.  Edward had just recently subdued the Welsh.  He set up a puppet king in Scotland and then bullied that king until he rebelled, giving Edward a reason to invade Scotland. 

King Edward sacked the castle of Berwick and killed all the inhabitants.  Other castles surrendered quickly.  Many believed that the Scots were destined for the same fate as the Welsh.  But they did not take into account the efforts of one man, Sir William Wallace.  Wallace is still revered as a hero in Scotland today.

In Braveheart, Wallace is shown as a fierce and determined fighter who valued freedom above everything else.  William was the second son and was originally groomed to be in the clergy.  He was taught the value of ideas, including freedom.  William grew to resent the oppressive English after his father was killed and his mother sent away to exile.  William became a fighter when a group of Englishmen tried to bully him and by the age of 20 he was a highly skilled warrior. 

During this time, warfare was usually conducted by highly trained knights and professional soldiers.  The larger and more skilled the army, the greater the power.  When mighty King Edward faced the smaller Welsh army, they did not stand a chance.  But the Scots were different.  Wallace had the unusual ability to draw people around him, and to make them believe in the cause of freedom.  He inspired and equipped them to fight against the seasoned worriers of England.  He caused them as a group to ban together and enlarge their abilities. 

Wallace was unable to defeat the English and gain the independence of Scotland.  When he was 33, he was executed.  But the legacy of enlargement, of having a group believe in something greater than themselves, carried on.  In the year after Wallace’s death, noblemen Robert Bruce claimed the throne of Scotland. He carried on Wallace’s example and the peasants and nobility banded together. Scotland gained its independence in 1314. 

Team members always admire a player who is able to help the team go to another level.  I always admired that about Michael Jordan.  He was able to help the level of everyone around him play beyond their talents.  By doing so, the Bulls were able to win six championships. 

John Maxwell writes about the characteristics of leaders who enlarge their team.  Enlargers first value their teammates.  Charles Schwab once stated, “I have yet to find the man, however exalted his station, who did not do better work and put forth greater effort under a spirit of approval than under a spirit of criticism.”  The approval we show helps others give and achieve more.

Enlargers also value what their teammate’s value.  Leaders who do so learn what things are important to their team members and understand it.  Their ability to relate to their fellow players creates a strong connection among the team.

Enlargers add value to the individuals on the team.  This is often finding ways to improve the individual team members’ gifts, attitudes, and abilities.  The mining of these skills, gives the individuals the ability to use their talents more freely, thus increasing the reach of the team.

Finally, an enlarger will add value to themselves by how they have added value to others.  You cannot give up what you do not have.  An example of this, now that we are in NBA playoff season, is a basketball great like Karl Malone is helped greatly by a great passer like John Stockton.  If you want to increase the value of your team, add value to yourself. 

As a leader the question here is if you help others on your team achieve more and enlarge them, or do they wither under your leadership.  For a team to accomplish great things, it starts with the leader believing, serving, and adding value to others on the team before they do the same for you.  

The Science of Management and Leadership

The many of the sciences not connected to the physical understanding of our world are often criticized for not being real sciences. These critics are incorrect with this complaint, as rigorous mathematics and statistics has been repeatedly applied in fields like economics and political science to demonstrate a very accurate understanding of society, people and their behavior. Moving further from the physical world, I had no appreciation for how much the fields of management and leadership had been developed into sciences. While it these fields may not easily lend themselves to experimentation, they have revolutionary theories that continue to affect our progress as people.

A key assumption that management science has debunked is the idea of the natural born leader. As it turns out, a person’s physical appearance or natural predisposition does not automatically make them naturally fit to lead people. Rather, leadership is a skill that is learned and can be taught. Research is beginning to reveal that the most successful people tend to be sociable, which is also a quality that can be learned and taught. But being sociable alone will not make someone a great leader, but it may be one of the most important prerequisites.

A successful leader is not necessarily someone who has been granted legitimate authority to tell people what to do, but rather one who can influence the way people think and motivate them. Here is where learning and studying leadership is important, because it is easy to be mistaken about what actually motivates people. Some leaders feel that pay and benefits motivates people, when in fact, these things can’t or won’t motivate people for any significant amount of time. Why not, since these are clearly things that people desire? As it turns out, research in management science has revealed that satisfaction and dissatisfaction are not two points on the same scale, but rather two completely different scales! This intuitively makes sense, when you consider that there are some jobs you may not be willing to work, no matter how high the pay is. Why? Because the dissatisfaction will overwhelm the satisfaction of receiving money.

Frederick Herzberg summarized this by introducing the “two-factor theory” to the field of management science. Herzberg explained there are two factors affecting people’s job satisfaction, which are motivators and hygiene factors. We understand that motivators motivate, but what do hygiene factors do? Hygiene factors are factors that will lead to dissatisfaction if they are not met. Hygiene factors include pay and benefits, but also include things like work conditions and vacation. Then what are actual motivators? Surprisingly, motivators correspond with higher order needs, and tend to be things like challenging work, recognition for one's achievement, responsibility, opportunity to do something meaningful, involvement in decision making, and a sense of importance to an organization.

As you can see, motivators correspond more with emotional needs, whereas hygiene factors correspond with basic psychological needs. Then it may not come as a surprise to learn that management science is finding most successful leaders are those that are empathetic, which means they are mindful of the thoughts and emotions of others. While this seems obvious, it runs counter to how many leaders manage. I speculate this is because satisfying emotional needs is difficult and time consuming, and altogether an issue that makes many leaders uncomfortable. A good leader must learn to overcome these uncomfortable conversations, and accept it is a natural part about understanding and motivating people.

https://en.wikipedia.org/wiki/Two-factor_theory

Building Business Relationships

It requires a different mindset and strategies to build a desirable commercial and business portfolio than it does to build consumer business.  On the consumer side, a financial institution prepares the product, produces advertising through a variety of media:  radio, internet, TV, billboards, statement stuffers, etc.  Once the marketing campaign is out in the public, the attitude is to sit back and see what the marketing will bring in the door for consumer business.

Once when I worked for a savings and loan, we had a promotion to give away a Rubbermaid stepstool that doubled as a tool box.  Each new deposit account would get one.  We stacked hundreds of these in our branch, put out the marketing and waited for the results.  People filed in to open an account and get a step stool.

Business development on the commercial or agricultural side does not work that way.  This presents a problem for credit unions who attempt to build a successful portfolio using the same tools that they do on the consumer side.  Marketing on the commercial side is more about raising brand awareness and is designed to get your foot inside the door of the companies you desire to service, not to bring those clients to your branch.

Commercial marketing is quite strategic.  It involves identifying the type or industry to target or even identifying businesses to bring into the credit union.  It requires that one join different groups or trade associations where your targets frequent.  Waiting for your desired clients to come to you will not produce the results that you want.  On the commercial and business side, people go where they already have a relationship.  If they don’t have a relationship with you, the walk in is usually someone who is just looking for some method to have his business financed.  Many times these folks have already been turned down somewhere else.  This is often not the recipe for a desired borrower.

The sales cycle for commercial is also very unpredictable.  It can be very short, if just happen to meet a business who is actively seeking to start a new banking relationship.  It can also be quite long.  One of the largest commercial relationships that I started when I was a commercial banker, took me five years of relationship building to win.  We ended up getting $17MM of loans and $20MM of deposits.  It was also one of the most financially sound companies in the entire portfolio of the bank.

So how do you handle commercial relationship development with such an unpredictable sales cycle?  First, realize that advertising is primarily for brand awareness on the commercial side.  Next, identify the businesses you want to target.  This can be by industry like family doctors, dentists, attorneys, or mom and pop shops.  It can also be a target business that you want to bank.  It can also be a mixture of both targeted businesses and industry.

These targeted entities should create a series of calls.  You need to build relationships and make friends.  If your portfolio is not as big as you want it, you need to go make more friends.  This will require that you work with some desired customers for years before you see the fruit from the tree that you have planted.  In some cases, it will come a lot sooner.

Find groups that you can belong to where your targets hang out.  This is the same as finding the right spot where the fish are biting on the river and getting your fly rod in that area on a regular basis.  Don’t seek to sell people there, seek to build relationships.  Remember people hate to be sold, but they love to buy.

Good commercial portfolios do require different tools and skills than most of the retail mindset that runs throughout the credit union industry.  But with the right tools, you can be successful.

The Economics of Leverage

Every individual has mixed feelings about debt. Some people refuse to borrow money, others think it’s okay to borrow responsibly. Yet, others borrow too much and live on the edge of bankruptcy. So from a purely economical point of view, how should a business view debt?

To answer this question, we need to consider the basic accounting equation, which is Assets = Liabilities + Net Worth. This means that everything a business owns (its assets), are funded with either debt (liabilities) or personal capital (net worth). Now consider you are a business owner who needs $100,000 to purchase equipment. That means the business owner will need to fund the $100,000 with his own capital, or debt, or some combination of both. If he pays for it all out of pocket, it costs him $100,000 immediately. But, the more he can borrow, the more he can save his own money. Say a lender will allow him to borrow 75% of the cost of the equipment, so the business owner will only need to invest $25,000 of his own money. With only needing to invest $25,000, a business owner could save $75,000 for other purposes.

If a business owner wanted to pay cash for a $100,000 purchase, and he didn’t have cash, then he would probably need to sell part of his business to raise the cash. You can see why this would be undesirable. If part of the business is sold, the original business owner will need to share profits and possibly even allow someone else to have a say in how things are run. Selling ownership is probably a last resort, and it creates incentive to borrow as much as possible. Really, it is in the business owner’s best interest to borrow as much as possible, so they don’t have to sell part of the business or use their own cash. Then why can’t a business owner borrow all the money he needs, and never have to sell or use his own cash?

While it would be ideal for a business owner to borrow 100%, it also makes it easy for them to walk away from the debt if the business isn’t working out. As we well know, lenders require a down payment for virtually all large purchases, thereby not allowing people to borrow 100% of the cost of the purchase. The reason a lender requires a down payment is so the borrower has something on the line to lose. So if a business owner wanted to purchase $100,000 in equipment, the most he could borrow is $75,000 if a lender requires a 25% down payment. With a down payment of $25,000, then the business owner stands to lose this and the equipment if he doesn’t repay the loan. This gives the business owner motivation to stick with making his business work, and making sure the loan gets repaid.

It may sound strange, but many successful businesses want to borrow as much as possible. This preserves cash and preserves ownership. Really the lender is the only person stopping the business owner from borrowing 100% for everything. Note, business leverage is very different than consumer debt. Consumers borrow to consume, or usually purchase things that rapidly depreciate. The more they borrow, the harder it will be to pay back their debt. Whereas, a business borrows to generate more income, so borrowing should lead to more profitability if done appropriately. This is another key reason why analysis of debt for businesses needs to be approached differently.

Can Too Big to Fail Actually be Kept from Failure?

An article in this morning’s Financial Times quotes Bill Dudley, the New York Federal Chief.  His concern is there may be ‘significant gaps’ in the central bank’s ability to provide emergency funds to help financial institutions in difficulties.  He wants to allow broader access to the Fed’s lending window. 

At a Fed function in Amelia Island, Florida Dudley stated, “In my view, an important issue is to identify and address gaps in the Fed’s lender-of-last-resort function.”  His concern is that only depository institutions like commercial banks have access to the Fed’s discount window, which is a source of emergency loans during a crisis.  “The law hampers the ability of a bank to pass along discount window funding to its securities unit” explains The Wall Street Journal. 

Dudley went further, “Now that all major securities firms in the U.S. are part of bank holding companies and are subjected to enhanced prudential standards as well as capital and liquidity stress tests, providing these firms with access to the discount window might be worth exploring.” 

I have blogged in the past about concerns I have with the sheer size of derivative holdings of banks.  US Banks held credit default swaps at a level of $60 trillion on the eve of the 2008 financial crisis.  This level was far greater than the volume of cash obligations it was insuring.  The real problem with the derivatives comes in a crisis when the counterparties are not able to fulfill their obligations on the contract.  Warren Buffet has called derivatives a financial weapon of mass destruction.

So fast forward to 2015.  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.

One who is skeptical might consider if such a move by the Fed would free up the trading units in these banks to take even bigger risks with more leverage, knowing that if things go haywire, the parent bank can always run to the discount window for a quick fix.  Smells like the seeds for another crisis are being sown.  Good thing that the credit union industry has not jumped onto the derivative bandwagon as we have seen with banks. 

Another banking story today comes as the biggest banks think they now have a constitutional right to risk free profit from the Fed.  In December, Congress took some of the Federal Reserve’s accounts to fund a new highway bill.  This was done by cutting the annual dividend on stock that big banks purchase to belong to the Federal Reserve System.  The stock is risk free, the dividend gets paid out even if a regional Federal Reserve Bank were to be disbanded. 

The dividend rate is also lucrative to the banks.  If a bank has over $10 billion in assets, the dividend was 6%.  Now the new legislation cut the rate to the yield on a 10 year Treasury note.  At the last auction this was 1.765%.

So the American Bankers Association claims this is not right.  Their claim is that the dividend rate has been the same for the past century and it was considered essential to the Fed to attract member banks.  Really, banks are required to join the Federal Reserve System.  This is from the Fed’s formation back in 1913.  Besides there are other benefits to banks to being a member such as access to the discount window. 

The ABA further claims that the “takings clause of the Fifth Amendment provides that private property shall not be taken for public use without just compensation.”  So the ABA believes the 6% dividend rate itself is constitutionally protected since it is bank property and has been around for a century.  The ABA’s comments came last week prior to the end of the public comment period on the dividend cut.  Look for a lawsuit next.  So in the meantime, will the new highway bill be funded?

Saudi Arabia: A Day Late and a Dollar Short?

Warren Buffet once disclosed his main investment strategy, which many people today struggle to fully understand. The Oracle of Omaha says to “buy low, and sell high.” And this has been the continued winning strategy of Buffet’s success.

With oil prices depressed, it wouldn’t seem like an ideal time to be selling oil related investments. And yet, that’s what is happening with the state-owned company Saudi Aramco. The company, which controls the largest amount of proven oil reserves in the world, announced its intention to have an IPO to sell roughly 5% of the company. This is seen as a move to raise cash, in light of depressed oil prices, and possibly part of a strategy to diversify investments into something other than oil.

It would seem like an unfavorable time to have an Aramco IPO. If the value of oil is depressed, naturally the company would be valued as less. It seems like it would have been better to consider this IPO while oil prices were much higher, but then I am sure they didn’t feel the pinch of lower revenue. I suppose hindsight is always 20/20.

Some spectators indicate it may be a symptom of long-term problems Aramco is starting to acknowledge. There is no shortage of news which suggests oil prices might remain low for some time, or at least not return to the $100/barrel level for several years. This is due to fracking technology making several oil reserves feasible, and the decreasing price of alternative fuels too.

I feel there is an irony about the energy situation in which we find ourselves. Once we were desperately concerned that we might run out of oil. I grew up with people talking about “peak oil,” which is a situation where people speculated we would realize a time of maximum oil output/extraction. After this point, it was feared we would be faced with a painful decline in oil usage, as we couldn’t find more oil and the known reserves would continue to dry up. As it turns out, the exact opposite transpired.

The reality is, we became so good at finding and extracting new sources of oil and other fossil fuels, that we flooded the market with supply and kept them cheaper for longer than we thought possible. And we were able to burn so much fossil fuels, that we contributed significantly to changing our climate. To this end, it is not “peak oil” that has come to give us heartburn over uncertainty, but the abundance of oil and what that means for future emissions. Now, scarcity is likely to have less influence over the future price of energy, and it may instead be the cost of regulation that will drive prices up while also driving down demand.

Now let’s look again at Aramco’s decision to sell part of the company. Sure, the price of oil is down, and so too the price of the company. But, the future uncertainty about demand and regulation could make for an even worse situation for Aramco than what it is experiencing now. If Aramco expects oil consumption will be more heavily regulated and taxed going forward into the future, then now might be a great time to start selling off after all.

http://oilprice.com/Energy/Energy-General/Why-The-Saudi-Aramco-IPO-Will-Not-Be-Enough.htm

How to Carve a Creative Channel on Your Team

Vince Lombardi said, “The joy is in creating, not maintaining.”  Yet, most of our organizations are geared to maintain rather than create.  Annette Moser-Wellman in her book The Five Faces of Genius claims, “The most valuable resource you bring to your work and your firm is your creativity.  More than what you get done, more than the role you play, more than your title, more than your ‘output’—it’s your ideas that matter.”  As important as creativity is, some studies suggest that less than 10% of adults are creative; that they have grown out of that area of their lives by adulthood.

Creative thinking is not necessary an original idea.  Often, it is being able to see an issue and connect the dots that were previously unconnected.  Creative thinkers value ideas and options.  Often when I am working to negotiate a deal, I want to understand the playing field I am allowed to be in.  Creative thinkers will embrace the uncertainty and offbeat.  They also will not fear failure.  There is a story of a reporter asking Thomas Edison if he was discouraged after 5,000 failed attempts to find a suitable filament for the incandescent light bulb.  Edison replied that he was 5,000 steps closer to finding something that works!  Creative people see failure as a learning point not an end destination.

John Maxwell asserts that creative thinking is a process.  It begins with a thinking, then collecting other material that relates to the thought.  Then other ideas are combined to make the thoughts better.  Next a refining process corrects problems and errors with the thoughts.  Lastly, the ideas are connected and positioned in the right context to make the idea powerful.

So as a leader, if creativity is important to your organization’s growth, how do you foster creativity, especially in the ordinary workplace of financial services?  First, you have to encourage creativity.  I love when one of the Pactola team will begin a thought with, “You may think this is crazy…” You know then it is time to put down your pen and listen.  Your team needs to know they have permission to be creative and that creativity is encouraged.  Creative people need to be embraced on your team.

Next, there needs to be trust among the team members.  Creativity always has a risk of failure.  Trust is important to foster more creativity.  Trust comes from people working together, knowing that teammates have experience launching successful ideas, and assurance that creative ideas will not go to waste. 

There must be a focus on innovation and not just invention.  The breakthrough product is great but just as valuable is finding new ways to deliver existing services in a better and more efficient manner.  Our newest experience at Pactola is our new PacPortal.  We have worked a more efficient and easier way for our loan investors and potential buyers to have access to their loan files.  It is even so easy that I can use it!  Not only will the investors be able to have better and timely access, Pactola will save valuable staff time that can be used to provide more help to our stakeholders.

A creative environment lets people go outside the lines.  Most of the boundaries we have are self-imposed.  The inventor Charles Kettering said, “All human development, no matter what form it takes, must be outside the rules; otherwise, we would never have anything new.” 

A creative environment also appreciates the power of a dream.  Encourage your team to start with a blank sheet of paper and ask, “If we could draw a picture of what we want to accomplish, what would it look like?”   You have to start with dreams if you want to accomplish great things.  Martin Luther King Jr. declared “I have a dream,” not “I have a goal.”  A goal may give us focus, but a dream gives power.  Also, when your staff is dreaming, do not let any naysayers pipe up with a “Well that will never work.”  A dream session is not a place to kill the creativity.  Dreams can be refined later. 

When I first came to this position, I visited with two dozen different CUSOs as I thought surely there was a pattern, a magic bullet, for success.  I soon learned there was none.  So then I had to begin to dream and get others around me to dream about how we wanted Pactola to be.  As we have grown in numbers of owners and employees, the dream is getting larger.  Far off accomplishments are becoming possibilities. All this is being fueled by creative people. 

Strategies for Riding a Dead Horse

Pegsus Company convened a meeting of their top brass.  “Folks,” the CEO began, “We have just discovered we have been riding a dead horse!  This emergency meeting of the executive team is convened to find a solution to this situation.  Each department is to study the problem and then come up with solutions in a week at the dead horse retreat.”

A week later the crack executive team met to discuss the situation.  The first team member to share ideas was VP of Human Resources.  Her first solution was to try changing riders on the dead horse.  Perhaps a rider that was more suited and had more experience with dead horse riding could get better results.  Another method for better results is a complete review of the performance requirements for horses of all types.  Perhaps if the live horses would not be expected to do so much, it would not make the dead horses feel any sort of discrimination. 

The Marketing Chief was next to offer her ideas.  This suggestion was to purchase a stronger whip and tout the strong whip on a massive advertising campaign that involves print, television, and social media.   A Tweet Army of dead horse fans would spend time telling the benefits of the dead horse to the community, and a website designer would create a stellar presentation on dead horses that would create Internet magic with the goal of thousands of “likes”.

The Chief Operating Officer struggled with the assignment since he believed that, “This is the way we’ve always ridden the horse, so what is the problem?”  But he assembled his team and came up with the idea to harness several dead horses together for increased speed.  If that does not work, then promoting the dead horse to a supervisory position would surely fix the problem.

The CEO had his doubts on adding additional deceased equines to the one for efficiency and believed that changing the requirements for dead horses by HR may have problems with actually coming to some sort of consensus on dead horse standards.  He then turned to the Dead Horse Consulting Group. 

DHCG was ready to arrange a committee to study dead horses.  The crack team of consultants had already spent time visiting other companies to study how they successfully rode dead horses.  They also had a quality circle of others in the industry to discuss uses for dead horses.  Any of these studies would take a considerable amount of time and money, but it would yield impressive PowerPoints and bound reports that would create a sense of “DHCG Wow” to the eyes of the reader.

The CFO was concerned with the costs of consultants and had not seen good results in spending money on outsiders in the past.  He suggested a better and more efficient use of funds would be to just increase funding for the dead horse to improve its performance.  This would result in a pay raise for the dead horse, the dead horse rider, and also more money for the department to allow for better performance.  The idea of buying a stronger whip also was valuable to the CFO. 

Legal had sat patiently and listened to all of the discussion.  The attorney stood to his feet and passionately stated that all which was required was to state “no horse is too dead to ride.”  This would result in a change to the by-laws, specifying that “horses shall not die”.  Using these two simple legal strategies would correct the problem. 

The head of facilities suggested that a new facility around the dead horse would change the results of the horse and rider.  If more dead horses were found, new and better facilities would be needed to change the results.  Perhaps even a monument would be in order.

It is a scary thing when a sacred cow of your organization turns into a dead horse.  We recently had that experience at Pactola.  We had a file sharing system for our participation files that was often confusing to the end user and took a lot of our staff time.  As the one who selected the original file sharing system to begin with, it was tempting as a leader to attempt to make the original system work, causing frustration on the part of the loan participant and also, a time drain on our team. 

So I went out and found a software engineer who could write a program that would meet our needs.  This week marks the launch of this program, our own “PacPortal”.  Equity members of Pactola and loan participants can go into our website, log in and see their loan files. We moved on, and buried the "dead horse". 

We have a tendency to stay with the normal, the usual, the status quo, and often fail to assess if what we have before us is really a benefit to our group or if it is a dead horse in our business.  Though the examples with Pegsus above seem absurd, each of us who has been in the workforce long enough, can cite examples that line up perfectly with the Pegsus leadership team. 

Facing a dead horse in your life or organization can be scary.  It is tempting to keep on the same path since that is what is comfortable.  But the correct method to approach this is found in the words of Abraham Lincoln.  “When you find you are riding a dead horse, dismount!”

Are We Overheating?

Competition keeps us all honest, and it is a cornerstone of a healthy capitalist system. Institutions need to compete for depositors or members, as well as loans. We compete for deposits by trying to charge more than our competitors, and we compete for loans by trying to charge less than our competitors. Here, we can begin to see one of the inherent boom and bust cycles a competitive capitalist system drives. Rates on deposits will go up and rates on loans will go down, until this creates a crisis where competitors struggle to exist. This makes institutions increasingly fragile, and the headwinds of a recession may lead to a series of failures, which then allows the survivors to reset the status quo with lower deposits and higher loan yields again.

What I experienced in Washington DC some three years ago, appears to be arriving in the Midwest with a vengeance. To beat competition, institutions are bidding increasingly low interest rates for increasingly longer terms. There are two key issues I worry may be overlooked in this race to provide the most competitive interest rates. These are two distinct issues, the first being that each institution has a different cost of funds and hedging profile, and the second issue has to do with the Federal Reserve’s desire to push interest rates upward.

Addressing the first issue of hedging and cost of funds, I think we need to acknowledge that not all banking balance sheets can be compared apples to apples. More institutions are increasingly purchasing derivatives, so they can convert the risk of fixed rates to be on par with that of variable rates. An institution that buys these derivatives can offer lower fixed rates because they will be less affected by rising rates. However, if your institution is not buying derivative hedges to mitigate rising rates, you are taking more risk by competing with lower interest rates.

The second substantial issue is the desire of the Federal Reserve to increase rates. They initially wanted to raise rates four times this year, which presumably means an annualized increase of 1.00%, since each increase is expected to be 0.25%. Although, where we are sitting in April, many have reason to believe they might realistically only try for two times, amounting to a 0.50% increase. Now, consider that your institution needs a 2.50% spread between loan rates and deposits to remain operational. If a loan is fixed for 5 years at 3.50%, then you are hoping that the cost of your deposits does not increase by more than 1.00% over the course of those 5 years. And note, the Federal Reserve wanted to raise rates by 1.00% in just 1 year alone! If the Federal Reserve raises rates any more for the remaining 4 years, that is arguably a loan you are losing money on.

I remember when reading Jack Welch’s book Winning, that he discussed “deal heat.” People get worked into a frenzy when they desperately want to make a deal happen, and they find themselves making compromises and concessions they later regret. I suspect right now there is a lot of “deal heat” seeping into all areas of business lending, and I worry it is starting to feel like the system is overheating a bit.

The Big Three Causes of Bank & Credit Union Failures

We all have a general idea of how a credit union or a bank functions. They accept deposits, and they turn around and lend those deposits out. It is a great model that transfers money from people who have extra funds to people who have a need for funds. But, this process has some unique risks associated with it. There are some common ways this process can go wrong, so credit union leaders should be aware of three key ways this can lead to total failure of an institution.

Probably the most common way banking institutions are known to fail is through a liquidity failure. History and old movies have depicted this problem as run on deposits. In other words, the institution has lent out deposits so people can buy cars and homes. But now, the depositors want to withdraw all their money, but all the money can’t be returned because all the loans haven’t been paid back yet. In this case, the institution is forced to close because it cannot return everyone’s money.

Various measures have been put in place to try and reduce liquidity failures. Now many deposits are insured up to the $250,000 level, so people feel assured that they don’t need to withdraw their funds hastily. There are also “reserve requirements,” which means each institution must carry a bare minimum amount of cash. Most institutions should also have lines of credit now with the Federal Reserve, FHLB, or some other correspondent, which mitigates any liquidity concerns.

The second major way banking failures happen is losses from bad loans. If too many bad loans are made which can’t be repaid, then depositor money cannot be paid back. This was what led to the banking crises of 2008-2009, and has repeatedly caused banking crises throughout history. Banks and credit unions are mostly made of deposits, with only about 10% of the money owned by the institution. When a loan loss occurs, the loss is charged against the 10% capital, not the 90% deposits. Once that 10% capital is gone, a banking failure has occurred. As you can imagine, it doesn’t take many bad loans to torpedo 10% of an institution. This continues to be the most common modern cause of failures.

The last major way an institution can fail has to do with interest rate mismatching. A credit union funds its operations by charging a higher rate on loans than the rate it charges on its deposits. If it has to charge more for deposits than it charges for loans, it will lose money and a failure will occur. In fact, deposit rates don’t need to be higher than loan rates. Even if deposit rates are 1-2% cheaper than loans, a failure can still occur, because the institution cannot earn enough money to fund operations. This is what happened in the Savings & Loan crises in the 1990s. Thrift-savings institutions made many long-term loans with short-term deposits. When interest rates moved up, the deposits became more expensive but the loan rates remained the same. As a result, many thrift-savings institutions couldn’t make enough money and failed.

These three ways to fail can easily be avoided through prudent management. This means keeping lines of credit at your disposal, having sound loan policy, and good credit union managers that understand asset-liability management. Some observers, which includes me, feel the greatest chance of failure in the near-term will be due to interest rate mismatching as the Federal Reserve starts to increase rates. 

Psyche of the Business Owner

Credit folks tend to focus on the financials, ratios, and number analysis in reviewing a business.  What there is a tendency to overlook is the people who run the company.  This plays an essential role into how well a business can grow, build efficiencies, or handle difficult problems.  Understanding what makes the business owner tick, is key in understanding the leadership ability behind the company.

We work to understand what makes our borrowers tick.  One construction company I worked with funded their crew with spec buildings that they built and then sold.  A problem hit when the housing and retail space market slowed down during the crash, yet their attitude was to continue building and hope that the market would take off again.  They did not have the financial staying power to weather the storm.  This client is contrasted with another developer who learned the business through one of the early developers of strip centers that were close to Wal Mart stores.   Understanding his thought process, shows us his depth of execution and experience in the property development arena.  You are more comfortable with the second member between these two.

One client I had had ownership into several different types of businesses that were not related at all.  The main sponsors had the attention span of a gnat.  Instead of seeking to run each company efficiently and profitability, they often left one company dangling on the verge of break even before running to the next shiny new thing.  This group is a polar opposite of another one that is very disciplined, focused, works on maximizing revenues and becoming more efficient, and is a leader in their area.  They don’t chase after the squirrels and have a strategic growth pattern that is well planned and executed.  So between the two groups, guess which one is a better credit risk?

Understanding psychology of the sponsors is important in any credit relationship.  Perhaps when a company or industry is experiencing stress, it is even more so.  Today, we are seeing challenges with agriculture producers, especially those in the grains who leveraged themselves up in the good times to acquire more land and equipment that have debt which cannot be serviced at today’s price levels.  We are also seeing this with some of the primary oil related and secondary oil impacted companies. 

In each case, the sponsor has experienced or will experience a loss.  It may or may not end up as a loss on the income statement, but it definitely is a loss of the potential revenues and with those, hopes, plans, and dreams.  The sponsor will go through the stages of grief, just as one would with a loss of a job, family member, or friend.  The successful sponsors are those who can work their way through the grieving process quickly and successfully.

In 2011, Wright outlined the seven stages of grief as:  (1) shock and denial, (2) pain and guilt, (3) anger and bargaining, (4) depression, reflection, and loneliness, (5) the upward turn, (6) reconstruction and working through, and finally (7) acceptance and hope. Studying and understanding each of these stages is important to identifying where the business owner is after a loss.  Also, how well they can work through these stages is key in how well the company can be turned around.

As an example, we have seen wheat farmers who are still today, in the denial that the prices they saw in 2013 are not in place today.  They still may rent ground out at rates that were acceptable in the market 3 years ago.  They think the present price levels are an aberration from the norm and we will see wheat double in its present price yet this year.  If they don’t verbalize this, this is how their actions are.  They may sit on large amounts of harvested grain, refusing to pay down operating lines, in hopes of getting a better price in the future.  These guys have a long way to go in the grieving process.

I had a client that killed their business by staying in the anger and bargaining stage too long.  This group worked well together in the good times, but when the times were tough, they broke apart and caused the business to fail.  If they would have continued to pool their talents and resources together, they would have made it through.  Instead, they turned on each other, turned on their banker, and turned on their suppliers.  They tried to bargain their way out of the present situation.  Failing to move past this stage led to their demise.

On the positive side, I worked with a company that experienced major losses on three projects.  This was a problem credit, but on the bright side, we had teachable owners.  They wanted to meet with us to understand how a creditor sees their business.  At the meeting we identified issues of low margin, too much leverage, and lack of operating capital.  Soon after this meeting, the family of owners moved quickly into stages 5, 6, and 7.  They sold a division of the company and recapitalized their core business, retired debt and injected much needed working capital into the company.  They also instituted a new computer pricing program and stuck with a minimum threshold of profitability on each job.  Now they were not as tempted to chase after the low margin projects.  They soon had a new problem, now they had too much money!

As a lender, you are a trusted financial advisor for your members.  When a loss occurs, you need to understand where they are in the grieving process and be aware if they are stuck in one of the stages and how that can negatively impact financial decisions they make.  You may need to help lead your borrower, through the stages of grief.  How well they navigate through these waters will often be the difference between a loss to the lender and a financially winning business.

How the Federal Reserve Impacts Credit Unions

Following financial news can feel like a deluge of information on a daily basis. Some want to hide their head under a pillow when the front page of CNBC.com delves into ag commodity prices, oil prices, Federal Reserve meetings and the stock market. What is a credit union in the Dakotas supposed to make of all these things going on?

My job is to filter out the noise surrounding extraneous information, so let me help you make sense of our dynamic world. One thing that will impact all credit unions is the Federal Reserve’s intention to raise interest rates.

What does the Fed raising rates even mean? The Federal Reserve, who lends money to credit unions and banks, can lend cheaper than everyone else in the country. If they increase the interest rate at which banks and credit unions borrow, then lenders will need to charge a higher rate on loans also to cover the increased cost. Even if your credit union doesn’t borrow money through the Fed, you could feel this impact of increasing rates. When banks and CUs rely less on the Fed, they rely more on depositors, and will try to fund more assets with deposits.  This gives depositors the ability to demand higher interest rates too. While we have not observed this yet, it is a real possibility as the Fed raises its rates higher.

Another situation you will witness with the Fed raising rates is how it will impact your securities portfolio. When interest rates go up, bond prices fall. This is because new bonds can be issued at better, higher rates, and old bonds are less desirable, since they are stuck at lower rates. The longer the term of your bonds, the greater you will see a devaluation of their price. Therefore, it may make sense to avoid buying bonds, especially long-term bonds, unless those bonds have some variable rate features that allow for the rate to adjust.

This brings us to the last important point to consider, which is the effect of having long-term fixed rate loans. Just like it is more desirable to have bonds that can adjust their rates, it is highly desirable to have long-term loans with adjustable rates too. Going back to the concern that deposits can become more expensive, this becomes a serious issue if you can’t change the interest rates on loans. Your credit union funds operations by charging more for loans than it has to pay for deposits. If the interest rate on loans and deposits become closer together, the credit union has less net income to fund operations.

To summarize, if the Fed is raising rates, you could eventually see your deposit rates rise, and you will see the value of your investments drop! Try to avoid investing in both bonds and loans in the long-term, unless the rates are adjustable. And be aware, the Fed wants to raise rates, and will do so if there is positive economic news. Be prepared!

http://www.forbes.com/sites/samanthasharf/2016/03/16/fed-officials-projecting-two-rate-hikes-in-2016-down-from-four/#2ffb75f56b02

The Fuel for the Stock Market

After a weak beginning to the year, the Dow has shot up 1,275 points of 7.7% during March.  Stocks are positive for 2016 and are trading above moving averages and key levels of support.  All these are great signs of celebration, right?

Well maybe.  A challenge is there is not a booming economy to support the market rise.  There is also quite a bit of uncertainty for the future with the election year, weakening world economy, threat of terrorism, and a $19 trillion debt at home.  It would seem in these times, we would not see a strong bull market.

Part of the reason for the market’s rise over the past decade is the huge amount of corporate stock buy backs.  Deutsche Bank reports that the total flows of money into the market has remained stable during a time that $2.7 trillion of shares of S&P 500 stocks have been retired.  The drop in the supply of stock and constant money in the market will cause prices to increase.  This capital could also be used for future R&D, capital improvements, or business expansion, but it is not. 

Since 2011, the number of companies in the S&P 500 that have purchased back shares totals between 360 and 390 each quarter.  In 2015 alone, the total of these buy-backs exceeded $568 billion, according to Factset.com.  The growth in the buy-back craze coincides with a steep rise in the market since 2009.  It is not the only reason for the market rise, but it is one strong influencer of prices. 

Since the fourth quarter of 2014, there has been a drop in corporate profits, while there is an uptrend in the percentage of corporate profits that are used for stock repurchases.  In the last quarter 2015, 75% of the profits of the S&P were used by companies to purchase their own stock.  Profits don’t seem to matter to the 140 companies of the S&P 500 who bought back more stock than their trailing twelve month (TTM) net income.  Also close to 150 of the 500 spent more on buying back stock than they had in TTM free cash flow. 

The drop in outstanding shares via the buy backs creates the temporary illusion that earnings per share are increasing.  In many cases this is not only because of increased profits but is also from a decrease in shares outstanding.  Increasing EPS is what investors want to see.  It also benefits corporate executives who can cash out on their fat option bonuses.

Another issue that goes even farther, is the earnings manipulation put forth from companies.  Companies have to report their earnings using GAAP.  But many also report non-GAAP earnings.  Non-GAAP accounting lets companies exclude certain losses from their accounting since they are supposed to be one-time charges by nature.  There is a problem though when one time charges continue to occur quarter after quarter. 

The S&P 500 non-GAAP earnings for 2015 was $118/share.  GAAP earnings ended at just $87/share, 26% lower than the non-GAAP earnings.  GAAP earnings in 2015 were only $5 higher than what they were in 2006 before the meltdown. 

So much for a healthy “recovery”. 

A group of analysts, like Societe Generale’s Andrew Lapthorne, Deutche Bank’s David Bianco, Capital Wave’s Shah Gilani, and Berkshire Hathaway’s own Warren Buffet, have all expressed concern about how the distorted view of earnings is impacting investors. 

It will be interesting to watch the earnings that are reported from companies with exposure to falling commodity prices and the banks that have financed them.  Will they resort to a lot of non-GAAP shennangians?  Will other companies continue to use excess cash to buy back shares instead of investing in their future growth? 

Be aware that the market can be manipulated, both with decreasing outstanding shares and also by manipulating earnings.  In such times like these, extra caution is warranted by the prudent investor. 

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.