Whiners and Winners

It is so easy to focus on the negative obstacles in life.  Some people make these challenges even bigger by digging a hole of deep self-pity.  They complain that they do not have the same education, privilege, money, opportunities, or whatever else that other people get.  Heck, it is easy for any of us to fall into this trap.  

When we do so, it is easy to fail to count the blessings that each of us has right now.  When I was a teenager, we had a pastor visit our church who had Down Syndrome.  The man hobbled up to the pulpit and in broken English would exclaim, “God don’t like no belly-aching, no complaining, no griping.”  Clearly when the congregation saw the condition that he was in, who really had a better reason to complain than any of us ever had, it put us to shame. 

My younger son is in college studying to be a pastor.  He is also interning at a church.  One of the pastors there was born with spina bifida.  He walks with a limp and tires out easy.  When he was young, he could not enjoy sports like the other kids, so he worked on training his mind.  He developed a tremendous memory and is very sound in his logic.  He also is a powerful preacher and very clear in his oratory.  Here is another case of someone who had a lot more reasons to complain than I ever will, but did not. 

Another example I think of is my mom.  She was diagnosed with Multiple Sclerosis when I was a freshman in college.  She lived with that disease that robbed little by little of her ability to control her muscles.  She lived with that disease for thirty years.  Yet she would sing as she went through the day and would smile and laugh a lot.  It could be convicting to be around her at times, especially when you were complaining about your lot in life.  

Complaining takes valuable energy and wastes time.  Have you ever spent more time complaining about work than it actually took to complete the task?  I did once in college with a surprise term paper that was sprung on us that was due in a week.  I spent the first five days griping about how unfair the exercise was only to finish the paper within a day once I started.  It took me more time to gripe than to finish the job!

Whining and quitting takes a lot of energy and time and robs it from productivity.  Whining never overcame the obstacles to create the light bulb, invent the airplane, or explore space.  All happened with continually chipping away at the obstacle until it was eventually overcome. 

Griping make us ungrateful, and focuses on the problem and not solutions.  If you ever want to conquer a complaining spirit, just be thankful.  Even be thankful for the challenges, as you learn more in struggle and failure than you ever will in success and ease. 

So this next part is an extra.  I know some of you tend to hate Mondays.  You may use it as a way to coast in a lower gear instead of really kicking it into high gear on your efforts.  I saw an interesting acrostic for Monday:

Make it happen because you

Only live once, and there is

No time for whining…

Don’t make excuses, just

Ask yourself, do

You want it bad enough?

Maybe that will make your Monday a bit more productive.  In a couple of other things, we will be at the CUNA Government Affairs Conference in Washington DC next week.  Stop by our booth #550 and see us!  Better than that, bring us one of your CU friends from around the country who would find it valuable to meet us.  We want more friends!

We are also hosting our MBL Boot Camp in Sioux Falls, South Dakota on March 20 and 21.  This is a great opportunity for business lenders who are starting out, or those with little experience, or business support staff to pick up some good skills and knowledge from some of our fabulous team members.  We look forward to seeing you there.  Contact us for reservations.

Are We in the Last Innings of the Real Estate Cycle?

On a national basis, the upward momentum for commercial real estate prices and values has slowed recently compared to the rate of increases we saw in the first few years after the credit crisis.  Now there are two things to keep in mind about this statement.  First, commercial real estate (CRE) values are still driven by the market area.  It is the old location, location, location thing.  Those in Williston, North Dakota, have not seen overall CRE increases in the past year with the decline in oil prices that hit the second half of 2015.  Also, we will begin to see ag land prices softening with lower commodity prices today than what was in place in 2013.  So the sector and location you are in will dictate if you are seeing upward growth in values like the national averages.

Second, the only time it is possible to time a peak in the market is in hindsight.  If you are able to forecast a market peak correctly, then you are pretty lucky.  So what we can understand is the influencers in CRE today and make preparations for the next steps of the CRE market.  In order to do this, we must try to figure out which innings of the market we are in today.  I use innings as we have spring training that is right around the corner for those baseball fans.

CRE has been an overall great investor performer and a preferred asset class since the end of the credit crisis.  Values were depressed in many areas, in some cases to the point of abnormality.  Investor confidence in CRE peaked in 2013 and has dropped since then.  In the third quarter 2016, CRE still remains slightly higher in investor confidence than stocks, with cash as a close third.  Confidence in bonds is relatively low as investors believe that higher rates are around the corner.  This drop in confidence indicates that we are entering into the later innings of the CRE uptick. 

A recent poll at the University of Chicago Booth School of Business Real Estate Confidence among real estate professionals asked where the industry is in the current cycle.  The professionals were asked to use a baseball analogy to characterize the inning of the CRE growth cycle we are in.  The result is we were in the bottom of the 8th inning in late 2016 and are entering in the 9th inning in 2017.  This year is expected to be much like 2016, with CRE prices and values on average increasing slowly and cap rate compression slowing down.  The questions are what are signs that we are getting close to the third out in the 9th and what are possible signs we can go into extra innings.

Interest rates are creeping up, which will curb the availability of loans for projects.  It is anticipated the Fed will continue on a course of slowly measured increases.   As rates do increase, we will see marginal financing projects become unaffordable.  Another factor to limit capital will be the new regulations in the CMBS market, with its billions of dollars of loans that will be maturing over the next few years.  Credit unions and banks will see an increased amount of refinance activity, but overall expect the supply of loans to slow with these changes.

Any possible black swan event could also lead to a major market correction and the end of the game.  This could be started from wide-scale terrorist attacks, a financial crash, or some other unforeseen event.  One would think that when such an event occurs, the market will act rationally.  However, with new players who have not experienced the Great Recession in the CRE realm and how irrational folks can get, it may not always have a smooth ride.

So what can take us into extra innings of CRE growth.  One large factor is the investor perception.  If people believe that things are improving in the future, they will be more apt to invest in CRE today.  We have seen an increase in the spirit in our country after the election which has been seen in major announcements of new offices and production facilities.  Another factor is the rise in the stock market.  Clearly, if a sizeable portion of the cash that has sat on the sidelines since the Great Recession begins to flow into the market, we will see extra innings. 

Another factor is fiscal policy reform.  This can come from both tax cuts and regulatory burden relief.  If Trump is successful in cutting corporate and personal taxes and also eliminating 2 regulations for every new one started, we will see the economy grow with the shackles of Washington loosened.  Accomplishing these things seem elementary simple to the average American in the heartland, but do represent a threat to the bureaucrat’s way of life.

Ken Riggs of Situs RERC Advisors sees industrial properties will still have the largest cap rates of any major property type.  We may see some price compression in offices and retail properties prices will slow.  Any property with a long term lease may look good to a lender, but will have more interest rate risk and lower values in a rising rate environment.  If the economy keeps growing, apartments and hospitality may be in the best position to take advantage to hedge out increasing rates. 

So back to our question, what inning of the CRE growth cycle are we in?  Are we in the latter innings?  And if so what factors could send us to extra innings and what means the game is over?  Unfortunately, this is not as clear as the third out in the bottom of the 9th is in a baseball game.  But we can see the influencers and make moves accordingly.

The People Factor in Business

We often focus on cash flow and collateral when analyzing loans.  Surely if the deal will produce adequate cash to satisfy all operational expenses, take care of all payments, and leave leftover money for the owners or for the future, that would be sufficient, right?  If a business has a strong equity position and may even have more of its own money invested into an asset than you do on the loan side, that would be sufficient as well, correct?  Both of these factors are important in assessing the credit, but perhaps the people factor can be the deciding issue of if a business will live or die.

I once financed a horizontal construction business who did amazingly well when the economy was going great in the early 2000s.  They went from one subdivision to another putting in streets, sewer, and water lines.  But then the crash in 2008 hits.  Three subdivisions are developed by them and the owners did not make the full payment.  In some they took property back as payment, but unfortunately, property does not pay the bills.  The company saw most of its equity erode away with the large losses. 

Throughout this entire time, the borrowers never missed a payment.  They held one of the first characteristics you want in a borrower, they did whatever necessary to fulfill their obligations, even when it meant the sacrifice of their comfort. 

The second characteristic is they had the ability to look at their business critically and make hard decisions which required a business mind to make with an absence of sentimentalism.  They assessed and sold off a line of business they were in, even when that line was profitable.  They realized the timing was good to sell and they also were able to get rid of a divided focus and concentrate on their core line of business.  A different result came from a custom countertop manufacturer I had financed.  When the economy turned and business dried up, he continued to promote granite countertops, even when the demand ended.  He refused to go to other countertops that were selling which were of lesser quality and also less expensive, even when those surfaces were selling.  Eventually, he closed down.

Another factor is the ability to be taught.  I met my horizontal contractor for lunch one day and shared with him how his business looked to a lender.  We identified three symptoms in the business financials and traced them back to their three root causes.  In addition to selling off a line of business, they brought in additional capital from the owner’s family, and established strong pricing discipline.  They stopped chasing any business that did not have at least a gross margin at a level they believed was necessary to operate the company.  This led to less business, but what they did do, they made money with. 

If these folks were not willing to learn, they would not have made the necessary changes and been able to survive.  When I visited with the countertop builder identifying some of the same issues, I was met with an explanation of how I did not understand the business and thus could not offer advice.  He would not look at the symptoms of his sick business and work to trace back to the root cause.  Eventually, he closed. 

Businesses that survive are also filled with leadership that can cast a vision and provide hope to others on the team.  Challenging financials, tight liquidity, shrinking margins—all of these can be horrible downers to their staff.  But somehow, these leaders were able to point toward the eventual goal and cast a vision in the mind of the workers.  It was essential during the three-year period that took them to claw out of their poor financial state. 

Character is developed during times of struggle.  We sit at a time with renewed excitement for business prospects since the election.  Also when Trump and Congress are able to achieve real tax cuts, healthcare reform, and regulatory relief, we will see our economy take off in ways we have not seen in years.  A lot of money has been sitting on the sidelines in the past decade, and those funds can really be put to work in the economy. 

But the challenge for a lender is to try to assess the character of your borrower.  A strong economy can hide a multitude of sins.  We have seen that in the Bakken area.  A few years ago, horribly performing businesses could still make a tremendous amount of cash.  When wheat was at $7/bushel, all wheat farmers were making money.  There was no push to become more efficient, putting money aside for a rainy day, or growing at a measured pace.  So when prices tumbled, the impact was greater. 

If your borrowers have a strong character, they will often be able to rise above the troubled waters.  The difference was worlds apart between the countertop manufacturer, which we foreclosed on, and the horizontal construction company.  The last problem I had to work with on the horizontal contractor was what to do with the excess cash that the company was generating.  They went back and made up their missed contributions to profit sharing plans for the employees and paid bonuses. 

Why Land Loans Can be Risky Real Estate Finance

Many people who like to invest in real estate say it is one of the best investments out there. Why is that? Because, they argue, they aren’t making any more of it! The amount of land in the world is fixed, right? I think that is a fact we can all accept. The occasional development of multistory buildings hardly adds to the additional inventory of real estate in the broader world.

Real estate is kind of funny though, because it tends to hold its value better if it has buildings and other improvements. This is because real estate that has been improved can usually be rented, which means an income stream is attached to it. So while the value of the underlying land might increase or decrease because of market conditions, improvements can still always be rented and provide more value over raw land.

To take this one step further, appraisals for commercial real estate are often heavily based on the income stream the rental real estate can generate. The more money you can rent an office building or apartments for, the more money someone else is willing to pay you for it when you sell.

The value of land is generally not determined by how much rental income it generates. Rather, the value is based on what other similar types of land are selling for. In other words, the value of land is more based on what people think it is worth, and not based on more scientific methods that can compare it to the income of other investments.

Because the value of land is determined by what people think it’s worth, it is subject to wide swings in value when the economy changes. When there is a recession and people feel gloomy about the future, they are not willing to pay much for land. The value of land will decline. When there is an economic boom, people get very excited about the future and can’t buy land fast enough. The value of land will increase.

How do lenders protect themselves from this uncertainty in values? First of all, land will require higher down payments than improved real estate. In other words, the buyer must have a high amount of equity invested to protect against the swings in the market. It is not uncommon for lenders to limit land loans to LTVs between 50% to 65%.

And then there will still be concerns about how and where repayment will come from. If that land is generating rent, then the land itself won’t help repay the loan. The borrower will need to use some other existing source of income. Because a land payment can be a real albatross around your neck, many lenders prefer to keep land on a shorter amortization; typically ranging from 3 years to 10 years.

Notice what a huge difference in lending standards this creates. A home residence can have an LTV of 97% and amortized over 30 years. An apartment building can have an LTV of 80% and amortized over 20 to 30 years. But, raw land might have an LTV of 65% and could be amortized over 5 years! When raw land serves no purpose but some future speculative purpose, lenders rightly hedge their bets to protect against the uncertainty.

Sometimes the Best “Yes” is a “No”, Taxi Cab Medallions, Secondary Market Multifamily

One of the standard documents we have in our SBA application kit is a personal family budget.  We think it is important when someone is buying or starting a business to see what their family expenses are in comparison to the income sources they will have from that business and other sources after they purchase the business. 

Recently, I met with the seller and potential buyer of a business to discuss the possible financing of the sale.  The transaction would also involve some additional expenses in relocating the existing business.  After meeting, I suggested they revise the operating budget for the business to realistic figures.

After that was completed, I told the buyers to then prepare an accurate family budget, not one that unrealistically cuts all expenses to the bone, but one that is representative of actual living expenses they have historically incurred.  I told them the budget needs to be realistic.  Don’t forget about the cost of fixing the car, buying clothes for the kids, or an occasional time to eat out. 

A week later I received a call from the potential buyers.  After they completed their budget, they discovered the business could not provide enough money to support their family.  The business would require that one would work full time and another at least part time in order to be successful.  They thanked me for helping them see the financial reality that was hidden by their excitement and dreams. 

I encourage everyone to complete a personal family budget who is purchasing or starting a business.  Sometimes the best positive answer you can get is to be able to say no to an opportunity.

Beware of Taxi Medallions

A story in Bloomberg today has a headline “Taxi Medallion Prices Are Plummeting, Endangering Loans.”  In a recent study by Capital One of its $690MM in taxi medallions, 81% are in risk of default.  Currently, more than half of these loans are non-performing. 

BankUnited told investors in November that 59% of its tax medallion loans are under collateralized.  Of these nearly 95% of the taxi loans were to New York City borrowers.  The distressed taxi industry is feeling the pressure of ride sharing services like Uber and Lyft.  Uber became the preferable mode of transportation for business travelers in the fourth quarter 2016, taking 52% of ground transportation business according to Certify.  Rental cars accounted for 33% of travel and taxis were below 15%.  Lyft doubled its share from 2 to 4% in the past year. 

On the last business trip I took, I took a taxi and also ordered an Uber.  I found the Uber was cheaper and the driver much more friendly.  She also waited for me when I ran to get food at In-N-Out!

For the lender, if you do not have taxi medallion loans in your portfolio, beware of any new medallion opportunity.  If you are unfortunately to have some of these, prepare for the possibility of some write downs and restructuring. 

Secondary Market Multi-Family Mortgages

Pactola has formed a partnership with one of the largest producers of secondary market mortgages on apartments and multi-family housing.  These are placed in the market with Freddie and Fannie.  Products offer locked rates for 5-10 years or longer. Rates are tied to the underlying US Treasury notes with a spread that varies with different thresholds for LTVs and DSCRs.  

Last week, a qualifying 10 year fixed rate conventional loan could yield 4.50% at an 80% LTV maximum with a minimum DSCR of 1.25x. This product may be able to help you provide some financing for your member or expand your horizon to other projects in your community.  Let us know if we can help.

The Confusing Issue of Free Trade

When I attended college in the early 2000s, the U.S. had just finished a decade of robust growth that had ended in the “dot com bubble” bursting. Alan Greenspan was still the Chairman of the Federal Reserve, and there was a lot of certainty (or maybe hubris) about economic thought at the time. As a student of economics, I was told deflation was never an issue we would have to worry about. That turned out to hugely false with crashing real estate during the recession we witnessed between 2008 and 2009. Another similar belief was that the world would continue to knock down trade barriers, and global free trade was imminent. I wonder what those same professors are thinking now?

The trading of goods and services is a cornerstone of civilization. None of us produce everything we need ourselves, and we need to trade the specialized goods and services we are skilled at producing for the other goods and services we want. Logically, the more of us we have trading, the more things we will have access to. But this leads to a competitive environment as well, where people producing the same things will need compete for business, and the producer with the lower costs can offer a lower competing price.

When this competition amongst producers happens within our own country, we tend to view it as healthy capitalism. The bad producers might be driven out of business and the better producers survive. But we tend to take a different view of this when we are faced with producers outside the borders of our country. Is it fair if producers from other countries drive ours out of business? Is it fair if our producers drive theirs out of business?  

This concept gets more complicated with the rise of transnational companies. Our producers might find it cheaper to manufacture in a different country and then import the products back to our country. This is great for our consumers, but not necessarily for the labor force. And then it gets more complicated, where maybe only certain parts or resources are imported, but then the entire product is assembled here. Would that technically make the finished good an import, in part?

Then there is the issue of national security. Is it prudent to rely on other countries for certain products that we deem essential? This has been one of the drivers in having an agriculture policy, so that we are assured a domestic supply of food. Some argue energy is also important to national security, but there has never been a real energy policy for the United States. No matter, these national security interests can clearly affect how international trade works too.

Proponents of free international trade argue it keeps products cheap and it keeps all industries competitive over the long run. They can point to Argentina who recently undertook protectionist trade policies, and it led to people having less choices and paying higher costs for domestically produced goods. Argentinians have also complained the goods are now inferior, because the local producers have less competition so they don’t have to worry about producing high quality goods.

Opponents argue free trade costs domestic jobs and devastate industry. A popular example is how a number of Asian countries prevented the importation of American electronics and cars in the 80s and 90s, so that they could protect their own electronics and automotive industries and give them time to develop. The result is now several of these companies are powerhouses globally, because they benefited from protectionist policies early on.  

There is really no way to fully predict how changing international trade agreements will affect the economy. Neither free trade nor protectionist policies yield a win-win solution. However, the only certainty one can predict is there will be a lot of uncertainty, if a country tries to switch from free trade to anti-trade policies or vice versa. 

Genius or Idiot?

The setting is in Port Huron, Michigan in 1854.  A school teacher, G.B. Engle, grew frustrated with one of his students and called a little seven-year old boy “addled”.  For those of you who do not want to consult a dictionary now, this word means mentally ill.  The young boy stormed home and told his mother, a young lady named Nancy, who returned to school the next day with her son in search of an apology. 

For a boy who enjoyed playing outside and exploring the world all day, sitting in a one-room school house was pure torture.  What made matters worse was that Engle and his wife made their students memorize their lessons and repeat them out loud.  When a child forgot part of a lesson, punishment ensued, often a whipping. 

The young boy did not get along with his teacher.  His mind was filled with questions and not with the memorized lessons.  Fear did not motivate him to learn.  The boy also suffered with dyslexia, which was not diagnosed or treated at this time.  So mother and son, marched to the school to get their apology.

“My son is not backward!” declared the Nancy, adding, “and I believe I ought to know. I taught children once myself!” Despite her efforts, neither the teacher nor his wife, would change their opinion of young boy. But the lady was equally strong in her opinion. Finally, she realized what she had to do. 

“All right, the Nancy said, “I am herby taking my son out of your school.” The young boy could hardly believe his ears! “I’ll instruct him at home myself,” he heard her say.

The young boy looked up at his mother, this wonderful woman who believed in him. He promised himself that he would make his mother proud of him.  The boy grew up, by learning at home and with little formal schooling as we commonly think of today.  Much of his education came from R.G. Parker’s School of Natural Philosophy, and the Cooper Union for the Advancement of Science and Art.

The boy also had developed hearing problems at an early age.  This may have come from a bout with scarlet fever and reoccurring ear infections.  His hearing may have been damaged when his chemical laboratory he had in a boxcar caught fire.  

The boy sold candy, newspapers, and vegetables on the train from Port Huron to Detroit.  When he was not supplementing his income, he was studying qualitative analysis and chemistry.  He began a streak of entrepreneurship when he obtained an exclusive right to sell newspapers and began publishing his own. 

At the age of 19, the boy, now a young man, moved to Louisville, Kentucky to work for Western Union on the Associated Press news wire.  He requested the night shift to give him time for his passions, reading and experimenting.  Eventually, this curiosity cost him his job as one night while working on a lead acid battery, he spilled sulfuric acid on the floor. It ran down to his boss’ desk below.  The next day he was fired. 

He made friends with another telegrapher named Franklin Pope.  Pope allowed the impoverished young man to live in his basement.  It was there that his passion for inventing flourished.  He created several inventions to improve the telegraph, including a stock ticker.  He obtained his first patent with an electric vote recorder in 1869. 

He eventually left the telegraph business and opened up his own laboratory in New Jersey.  Many of his inventions are still those we use today.  His accomplishments total 1,093 US Patents with his name.   He founded 14 different companies. One of them is one of the largest publically traded companies in the world, General Electric.

All this was started because a young mother, Nancy Edison, believed in her youngest son, a boy who suffered from partial deafness and dyslexia, who could not sit still in a school room, and who was labeled with mental problems.  His name was Thomas, Thomas Edison.

Later in life, Edison said, “My mother was the making of me. She was so true, so sure of me: and I felt I had something to live for, someone I must not disappoint.”

How would the world have been different if Nancy had labeled her son a failure just as his teacher did?   Do you have anyone in your family or friends who could accomplish great things in life if they only had you to believe in them, and then get them to believe in themselves? 

Does Strong Dollar = Strong Economy?

What is meant by the phrase “strong dollar”? Is it a dollar that cannot be broken? Is it when the dollar is a mean bully to the rest of the currencies? I think people intuitively associate a “strong dollar” or a “strong currency” with economic strength. But, it is really an objective term, not a subjective term.

A “strong dollar” is when a dollar can respectively buy more of another country’s currency, and therefore goods, with respect to some historical context. Complicated? Think of it this way: A few years ago, it cost around $1.30 to purchase 1 euro (€ 1). As time progressed to the present day, it has taken less and less dollars to purchase a euro. Today you can buy € 1 for $1.07. That means, the dollar has strengthened significantly against the euro.

What caused the dollar to strengthen in value? One possibility is demand for goods and services produced in the European Union declined, so people needed less euros to purchase those. Or, demand to purchase goods and services produced in the United States increased, and so more dollars were demanded. Just because demand for our exports increase, doesn’t mean our overall economy is doing better. Our GDP does increase when we export; however, exports are a relatively small part of our economy. In 2015, our exports totaled $1.51 trillion, while our total GDP was $17.91 trillion. Never mind that the US imported $2.31 million in 2015.

So, if the dollar is strong, it means we can purchase more foreign goods and services. That is good, right? It is, if you are heavily dependent on purchasing imports. We see that the United States purchases significantly more imports than exports, so it helps considerably when the dollar is strong. Our main imports are computers, electronics, crude oil, and cars. We buy all of these more easily when the dollar is strong.

What happens when the dollar is weak? Then it becomes easier for other people to buy exports from us. Our main exports are refined oil (especially gasoline), cars, aircrafts, electronics and industrial equipment. When the dollar is weak, it means other countries will buy more of these things from us. This is why China has long desired a weak currency, because it makes it easier for other countries to buy their exports.

Locally, we export things like beef, corn and soybeans. This means agricultural producers benefit more from a weak dollar than a strong dollar. Another local export, crude oil, is uniquely affected by currency changes too. Most oil throughout the world is priced in dollars. So when the dollar becomes weaker, but the demand for oil hasn’t changed, oil actually becomes more expensive. When the dollar becomes stronger, then it buys more oil, and the price of oil falls. This means, a weak dollar helps support higher prices on oil, which in turn creates more demand for oil.

Now you see, a “strong dollar” doesn’t necessarily mean good things for the economy and a “weak dollar” doesn’t necessarily mean bad things for the economy either. A strong or weak currency is really more of an unbiased idea that alone doesn’t mean anything good or bad in isolation. We need to consider the context of the greater economy, and who the winners and losers are with imports, exports and commodities.

The Power of Questions to a Leader

Too many times in my life and career, I have been consumed with how important it is to share my knowledge with others instead of learning to ask questions and listen.  This especially was true early in my financial career.  I was taught the skills of being able to condense the sales pitch of your institution into a thirty to sixty second sound bite.  Now this may have been effective in spewing my knowledge to the client, but it did not allow me to learn from the customer, nor build any sort of relationship. 

One of my uncles once told me, “Phil, the Good Lord gave you two ears and only one mouth.  So shut up and listen!”  His advice is so true.  I learned that I needed to have a natural curiosity about things and ask those questions.  Then I need to listen to the answers.  Sometimes, when I meet with someone I will ask a question I know they know the answer to, but I just want to hear them explain. 

Part of the power of questions comes from a humble realization that you can always learn something from someone else.  We rely on others as our teachers through life.  It is only by questions that you can actually unlock those gems of wisdom. 

Thomas J. Watson said, “The ability to ask the right questions is more than half the battle of finding the right answer.”  This is so true.  But it is only true if you are willing to ask the question in the first place.  Perhaps our jobs in credit, help us be more open to asking insightful questions that could be construed by others as intensively private.  Questions like “why have your accounts receivable grown so much?” “why is your top line room revenue down in your hotel?” or “what is your succession plan for your company?” do seem quite personal at times.  But these questions, if asked with genuine concern and the desire to learn, will help us unlock the inner ticking of the company and understand their risk.  So it is with questions that we have an effective way to connect with people. 

Communication comes from the Latin word communis, which means common.  Before we can communicate, we must establish commonality.  The more common ground we can find, the greater the chance for good and deep communication.  Effective communication prompts people to think, “Yes, I agree and understand!”  Too often communication is one way and will result in the listener saying “So what?”  The playwright George Bernard Shaw once said “The greatest problem with communication is the illusion that it has been accomplished.”  When you think your audience understands what you have said, watch out!  You may be on very vulnerable ground for a mutual understanding.

Of any question you can ask, perhaps “why” is the most important.  It helps unlock the true motives of a person’s heart and will require an explanation other than a yes or no.  Larry King, who made his living as a television talk show host, says that “Why” is his favorite question.  He calls “why” as “the greatest question ever asked and it always will be.  And it is certainly the surest way of keeping the conversation lively and interesting.” 

Asking good questions also require prior planning.  When you are preparing for a meeting with someone, think through the questions you want to ask.  You need to communicate that you value the people you are with and that, if it possible, you want to add value to them.  This process will require asking questions and being able to “shut up and listen!”

Understanding the Cash Conversion Cycle and How to Speed it Up

Have you ever encountered a business that is profitable, yet does not have the money it needs to pay its bills?  This is a plague for many small businesses and farms. You see, it takes cash to pay bills.  You cannot take an account receivable and give it to your utility company to satisfy your electric bill.  You also cannot give your bank excess inventory you have in order to make your mortgage payment.

The process of taking cash, turning it into a product, selling the product on account, and then collecting on that account is the cash conversion cycle. How many stops must cash take along the path from initial cash, then adding value of some form, and finally collecting cash at the end? This is important for a business to know since, after all, cash pays the bills. 

So let’s start the trip along the cash conversion cycle. Now every stop on the way may not apply to some businesses. Also, if the company does not have enough money to satisfy all debts at each point of the cycle, then it has a borrowing need to help fund inventory, receivables, or production. 

Stop 1:  Purchasing materials to create a product. This step will not happen with a company that does not make a product or grow a crop.  If the firm carries no inventory then there will be no funds that are spent here. Also, if a company provides a service, such as a computer repair company, and carries no inventory, no money will be spent here. 

The time spent here, from company to company, will also vary. A potato chip plant may have potatoes delivered and dumped into a bin at the start of a day, and bags of potato chips are shipped just hours later. A company that makes durable goods, such as aircraft, will take more time in this stage of the cycle. 

When cash is spent on material and labor to produce the product, it is not available for other operating expenses. Some tips to manage this stop are:

• Watch material and inventory levels and do not purchase more than what is needed. Doing so is a use of cash and can hamper profits.  I once saw a hardware store that would borrow money to purchase product for resale. When they sold that product, they would not pay off the bank loan, they used it to purchase more items to sell. 
• Note the average time frame that it takes inventory to turn over with other companies in your same industry. The hardware store I mentioned only turned their inventory over once a year, when the industry average was much quicker.  As such, they to continue to borrow money to operate, which left them with an unsustainable level of debt. 
• Suppliers can provide a source of cash if they provide you with generous terms.  I once studied a restaurant that had no debt on their building, fixtures, or operating line from their bank.  They sold over $3 million annually and supplied all their cash needs by paying for food on 45 day terms with their supplier. 

Stop 2:  Taking the product you produced to market.  This step happens once a company has completed creating the item and is taking it to market to sell.  Different industries have different time frames for this step in the cycle.  Also, sometimes, a firm may intentionally stay at stop two.  An example here is if a farmer harvests crop and waits to sell the product as he is expecting to get a better price in the future.  That may work, but there is also a carrying cost to holding onto an item instead of selling it. 
It is important here to not over produce your sales demand, as this will cost you money. Also, learn to be disciplined in your selling approach.  Always trying to grasp the brass ring of the highest possible price for your product often comes with a cost of capital. You may not be making as much profit in the long run as you think.

Stop 3:  Collecting money on an account receivable. This step does not apply to some firms. If you are a retailer and sell no items on account, this step does not apply.  But if you sell a product or complete a service and then create an invoice for the buyer, this step applies to you. 

It is important to see how your company stacks up against the industry. If it takes you much longer to collect your receivables, you will use more cash than similar companies. It is possible to run a profitable business but to be in need of cash. Many times this is because of a lack of collecting your accounts on a timely manner. 

Here some methods may be to offer a slight discount if an invoice is paid within 10 days.  You also may consider the extra cost on your business to collecting accounts slowly.  This may need to be built into your price.  If accounts cannot be collected quickly enough to satisfy cash needs, then the company may need to borrow on an account receivable loan or turn to factoring to receive cash quicker.

Managing the cash conversion cycle and minimizing the natural stops can make a huge difference in the cash needs a business has to have to operate.  Simple steps like paying suppliers slightly slower, managing inventory levels, and speeding up the collection process could minimize or eliminate the need for an operating line for the company.

Why Aren't Business Loans Priced Like Regular Mortgages?

The United States has a unique mortgage product that has helped tens of millions of Americans become homeowners. That is the 30-year fixed rate mortgage. From a banking perspective, that is a really impressive deal. A loan for 30 full years, and the interest rate never changes? Wow!

In reality, how does a bank or a credit union make a loan like that work? Consider that in banking, you fund loans with deposits. Do credit unions have deposits that will be left in place for 30 years? In all likelihood, probably not. That means if interest rates increased, the credit union would have to pay more for deposits to keep money at the institution, but it would be unable to increase the interest rate on the 30-year mortgage. It seems like making a loan with a fixed interest rate for 30 years could be risky business. What if over a 30-year period, the deposits became more expensive than the mortgage?!

The truth of the matter is, a 30-year loan is not really funded by deposits in the long run. What happens is the credit union makes the 30-year loan, and then it turns around, sells the loan to someone else, and the credit union then gets all its money back. Viola! The deposits are no longer tied up in a 30-year loan, and they now have more cash to make other loans with.

Who is buying these 30-year fixed rate loans? Investors, typically insurance companies and retirement funds. They need a predictable long-term stream of income, and what is more predictable than someone paying their mortgage every month? So what really determines the interest rate on a 30-year loan is what these investors want their return to be. This is usually a much lower interest rate than the rates a credit union would typically charge on a loan. But at the end of the day, it is not the credit union who will own the loan, so the credit union doesn’t have to worry about balancing this interest rate risk.

When a loan is underwritten to a standard which the investors are willing to buy it, we call it a “conforming” loan. A huge mistake credit unions might make is trying to price all their real estate loans like conforming loans, when they are not all conforming. A non-conforming loan is one that will not be purchased by investors, so why should they be priced low like investors are buying them?

Non-conforming loans should be priced based off the underlying deposits, not based on what secondary market investors want. The act of trying to match the price and term of deposits with the price and term of loans is called “asset-liability management” which is abbreviated as ALM. All non-conforming loans should be priced according to ALM principles, and not rates found in the secondary market.

We should consider that all business loans too, even those for commercial real estate, are non-conforming loans. There is a secondary market for commercial real estate loans, but those investors do their own underwriting and do not purchase loans from banks or credit unions. In light of these facts, that means a credit union should also price their commercial real estate loans according to ALM policies.

In other words, we should ask ourselves what is the cost of a five-year deposit, and then add a percentage on top of that to get our 5-year fixed loan rate. Even if someone is financing rental houses, they should be priced according to ALM and not what secondary market investors pay for home mortgages. This is, of course, because the business loan to finance rental houses can’t be sold, or won’t be purchased by those investors in the secondary market.

Your Business Lending CUSO in 2017

By the time you read this, you will be wrapping up the first week of 2017. Congratulations, only 51 more weeks to go!

With the start of the new year, I thought it might be helpful to remind everyone about who and what Pactola is. We are a one-stop-shop CUSO for everything related to business lending. CUAD actually owns 10% of Pactola and helped start the CUSO, so that all credit unions in the Dakotas would have access to local professionals who could help them with business lending. All together, we have eight senior equity owners and eighteen junior equity owners. Our ownership now includes credit unions from North Dakota, South Dakota, Nebraska, Montana, Minnesota and Ohio.

What does Pactola do in the business lending sphere? We have three main business lines. The principle reason we were established was to serve as a central servicer for participation loans. In other words, credit unions come to us because they need help participating out a loan, or because they want to buy a loan participation. We are in the middle, providing a standardized set of analysis, file management, documentation and reporting. If you need help selling or buying a loan participation, call us.

Our second largest business line is “consulting” or “in-house” services. Credit unions may want help with writing a business loan policy or participation policy. Or, they want help with underwriting, 3rd party reviews, file audits, documentation, etc. So if a credit union needs general assistance with a business loan they aren’t participating, we are here to help with that too. That includes special knowledge regarding government programs like the Small Business Administration (SBA), the USDA programs, or even things like Historic Tax Credits.

Our last business line is education. We see that credit unions want to learn more about business lending, and want to better understand the underwriting that goes into our loans, whether it is a participation or in-house loan. It used to be most of our sessions were held in the fall, but now we are spreading them out throughout the year in case people want to attend more than one. The schedule for this year is as follows:

·         MBL Boot Camp (Intro to Business Lending) : March 20-21 in Sioux Falls, SD
·         Commercial Real Estate Lending : May 22-23 in Minneapolis, MN
·         Commercial & Industrial / Small Business Lending : August 7-8 in Omaha, NE
·         Ag Lending Forum : September 25-26 in Miles City, MT

We should also mention that we’ll be helping our credit union partners at several CUAD and CUNA events throughout the year. Feel free to introduce yourself to us at any of these if you feel you could use some help. Here is a list of events we are sure to attend:

·         MonDak Roundtable : Jan 10-11
·         CUAD Hike the Hill in SD: Jan 25
·         CUNA Business Roundtable: Feb. 7-9
·         CUAD ND Legislative Reception : Feb. 21
·         CUNA GAC: Feb. 26 – March 2
·         CUAD Summit: April 10-12

If you hope to do more with business lending in 2017, please reach out to us. We love hearing from our old partners and new contacts alike. We care most about you succeeding, because that is the only way we can succeed.

Being Intentional

The start of a new year often marks the time for creating resolutions.  This may involve a long list of getting in shape, quit smoking, losing weight, or stopping bad habits.  Some people have items focused on making them a better person, like spending more time with family or learning to listen more.  Maybe your list includes giving more time to charity or community service.  In any case, the items on the list are designed to be a commitment to make us better.

Often these lists are onerous and unrealistic to keep for any long time.  We tend to be weak in our human resolve at times.  For those of us with the strongest determination, resolutions may last through the winter or even into spring.  I think many of us have too many items on the list that prohibit us from ever being successful.  Perhaps this involves a simpler goal of resolutions in order to be successful. 

The start of this new year also marks a much quieter house for our Love household.  Our two sons are now moved out and my wife and I only have our youngest daughter who is home with us.  At times, the silence can be deafening compared to what we have been used to. 

Beginning to empty out the nest makes one reflect on life.  Before this time, you have kids with you each and every day.  Evenings are spent with a houseful of kids and there is a lot of interaction with all the family members.  You may also have a lot of planned activity that surrounds our kids.  Now, you have to work with not seeing or visiting with your kids on a daily basis.  We had all of our kids at home for Christmas and wonder if this will be the same case when the holidays roll around this year.  So it makes that whenever you have time with them you want to make it count.  It also reminds you of all the times that you were with your family physically, but were not fully engaged. 

So what if we set a simpler goal for resolutions?  My challenge is to you is to be intentional this year.  What about your work?  Have you ever had days or even weeks when you just showed up at work and were not fully engaged with your job.  What things could we accomplish with our work if we gave a consistent focused effort, instead of just getting by? Imagine what goals could be reached by your business if all exhibited a razor sharp focus and effort. 

For those in school or higher education (which covers all of my family except me) what difference can focused, intentional effort make in your learning?  Could it be that your focus could make the difference in a positive way and something you pick up in class will make a difference in your life later on?  I think we are all created to accomplish great things in our lives. 

I don’t think we were designed to just float aimless through life.  Intentional focus may make the difference between mediocracy and greatness.  It does take effort.  Time must be well thought out instead of not planned.

Even more so than just in our jobs and education, being intentional is more important with the people we have in our lives.  In the end, the relationships you have will be more important than what your accomplishments or possessions are.  What difference could we make if we used our energy to really get involved in the lives of every person in our homes instead of just living in the same house?  What if we took time to really listen to our friends and get to know what makes them tick instead of keeping the conversation on the surface?  What changes could we see with our co-workers, members, or customers by being intentional?  What positive differences would we see in the lives of others? 

Intentionality does require prioritizing.  It may mean giving up time spent on the job to spend a little more time with your family.  It also takes effort.  It may be as simple as taking time to learn the name of the customer who always comes in at 9AM on Tuesday or turning off the football game to listen to your wife’s day. 

I challenge you this year to be intentional.  The investment will pay rich rewards in your accomplishments, but more importantly in your faith, your relationships, and your friendships.  Life is much richer and greater by being intentional, than if we just float through it.

How Jolly Are You?

“Tis the season to be jolly…” goes one of the favorite Christmas carols.  But is jolly just accompanied with holly and fa-la-las?  Is this just something for this time of the year?

My dictionary app defines the verb jolly as “in good spirits; lively; merry; cheerfully festive or convivial; joyous; happy; delightful; charming.”  That does seem to apply for some in this season of the year.  Many may feel this way as they are surrounded by family and friends.  Perhaps business success, great grades on finals, election results, or new opportunities in life can cause one to be jolly.  In Britain, it is also a slang term for one who is slightly drunk or tipsy.  That definitely applies to some folks! 

This season is painful for many as well.  We remember Christmases past and loved ones who are not at the table.  Some have passed on.  Some are off serving our country a long way from home.  Others may not be able to get home because of other commitments.  We hope to be together with them again.

For our house, it is full of excitement as my youngest son, who has been in Kentucky at college since August, is flying home.  Our oldest, who just took a job in a remote town in northern South Dakota, will be coming in as well.  We will have our family together, though our extended family will be several states away. In that sense, we will be jolly with our kids.  It also gives up hope for growth in the future.

This time marks the end of a year.  Most of us reflect on the wins and losses we have had throughout the year.  These can come in our business, school, or personally.  This year has been filled with both for our team at Pactola.  But I am joyful for our group and also the relationships we have established and have grown with those in this field.  We work with terrific people who are winners and who help those around them become winners.

Christmas Eve is also a special time for me as it was on that night, 25 years ago, that my wife accepted my proposal.  This event definitely makes us jolly and hopeful as we remember that night together as we opened gifts for the first time together and she put the ring on her finger!

Most importantly for this season of the year, amid all the parties, shopping, and events, I trust that you will remember the real reason this season is jolly and full of hope.  It is found in Luke where the writer pens, “a Savior is born, who is Christ the Lord.”  May your Christmas season be jolly and filled with hope this and each year.

Inflation Explained by the 12 Days of Christmas

In my data driven world, I’ve been pouring over information that I believe suggests that inflation is coming down the pike. I wanted to talk about these reports and provide different arguments about their results; but frankly, I think that would have bored you to pieces.

Instead, I thought I should play the role of a jovial analyst, and present to you some information about inflation in the context of one of our favorite carols, “The Twelve Days of Christmas.” Unless you’ve lived under a rock your entire life, you understand the song talks about 12 cumulative gifts one gives to their true love: 12 drummers drumming, 11 pipers piping, 10 lords a-leaping, 8 maids a-milking, 7 swans a-swimming, 6 geese a-laying, 5 gold rings, 4 calling birds, 3 French hens, 2 turtle doves and a partridge in a pear tree.

Why are there 12 days of Christmas? I have no clue.

PNC Bank has surmised a “Christmas Price Index” which tracks how much these 12 gifts cost and how their prices change throughout the year. It appears the “price of Christmas” per the 12 gifts has increased roughly 2.1% since last year. The year over year average increase for the past thirty years has been roughly 2.8% annually. Below a chart tracks these changes on an annual basis through 2009 to give you some idea of how it has changed:

So how does PNC determine the price of each of the 12 gifts? The price of each item is set as follows:

·         The pear tree comes from a local Philadelphia nursery.

·         The partridge, turtle dove, and French hen prices are determined by the Cincinnati Zoo and Botanical Garden.

·         The price of a canary at Petco is used for the calling bird, though the price of a blackbird (colly bird) may reflect the original version of the song.

·         Gordon Jewelers sets the cost of the gold rings, though the gold rings of the song may actually refer to ring-necked pheasants.

·         The maids are assumed to be unskilled laborers earning the federal minimum wage.

·         A Philadelphia dance company provides estimates for the salary of "ladies dancing.”

·         The Philadelphia Ballet estimates the salary for the "leaping lords.”

·         The going-rate for drummers and pipers is that of a Pennsylvania musicians' union.

And of course, like all fun things in life, there are people that just take it too seriously and find ways to be critical about how the index is contrived. Some have complained that the index falls short of good scientific analysis, despite it not being designed for any true scientific purpose.

Critics note that the “eight maids a-milking” isn’t well defined, so only the maids are counted; whereas, some might argue the cost of the cow should be included too. There is also the issue of prices of some gifts being provided by only one store, where a better way to do this is to look for similar product costs that should be averaged over many stores. And lastly, there is even a complaint that ballet dancers are not true substitutes for real lords a-leaping.

Whether or not you buy into the Christmas index, I think most of us agree these gifts would be somewhat unusual by 21st century standards. As for me, I would happily accept a little more peace on Earth. Or even, a little more peace at home, which itself is likely a tall and priceless order.

https://www.pncchristmaspriceindex.com/content/dam/pnc-com/pdf/aboutpnc/CPI/2016-CPI-Chart.pdf

https://en.wikipedia.org/wiki/Christmas_Price_Index

https://web.archive.org/web/20071229050601/http://www.pncchristmaspriceindex.com/mediaHistory.htm

New CMBS Bill May Make Financing Options Fewer

A new regulation for Commercial Mortgage Backed Securities, under the Dodd-Frank Wall Street Reform and Consumer Protection Act, is scheduled to go into effect in December.  The bill, is made up of a new set of risk retention rules, and will require CMBS lenders to retain a portion of the value of the loans they issue as opposed to selling all them off in bonds.  The risk retention rules were designed to protect issuers from risky lending, a factor which was evident in the crash in 2008. 

The new bill requires lenders to hold on to about 5 percent of the loans they issue, which will result in fewer CMBS lenders and an overall reduction in the amount of loans being originated.  This regulation requires issuers to use more of their own capital, driving down profit margins for lenders and increasing the total overall cost of capital.  Smaller CMBS lenders who do not have the capital resources or capability will likely be priced out of the market, leaving only larger CMBS lenders. 

Before the Great Recession, there were around 40 different CMBS lenders throughout the U.S.  After the crash, the number of lenders dropped down to 10 at one point.  As the market has recovered a bit, CMBS lenders number around 20.  The new bill will cause a similar impact on the number of CMBS lenders as smaller ones will leave the market and larger ones will become more selective in the projects they finance.  The timing of this new regulation is horrible for the CMBS community.

In 2017, over $145 billion of CMBS loans will mature.  Upwards to 45% of those loans will not be able to be paid off at maturity and will need to be refinanced.  Many of these matured loans will have to be refinanced with other sources.  This will drive the demand for financing from other capital sources, such as life insurance companies, credit unions, banks, and agencies.  As the CMBS lenders adjust to the new regulatory landscape, they will likely exercise greater caution in underwriting and originating loans, thus adopting a more conservative approach.  In the past, CMBS was an active option for higher leveraged loans, as other lenders shied away from those credits. 

Also, CMBS lenders were often the go-to source for larger deals in secondary and tertiary markets.  With these new changes, it may be tougher and cost more for investors to obtain financing in those markets.  This result may drive demand for properties in primary costal or gateway markets, where deals require less leverage and borrowers can turn to other lending options for lower interest rates.  We can expect the cost of loans in the non-primary markets to increase. 

One exception to the CMBS rule is for qualified loans.  Loans that meet a qualified status will not require the lender to hold 5 percent of the loan.  A qualified loan requires the amortization and loan to value lower.  An example would be a 10-year loan must have an amortization of 25 years or less.  Leverage cannot exceed 65 percent and a debt coverage ratio must be in the 1.5 to 1.7 range. 

The overall result is that we will see more demand for financing deals that credit unions would not normally see with a more active CMBS market.  We should also note that in many cases the other options for financing may have higher interest rates.  This may help us command a higher rate for these future deals.  

The Credit Union Part in the Greatness of America

There are a few beliefs that we hold as Americans that define us.  One is the exceptionalism of our country.  We have a fundamental value of liberty.  Most countries have constitutions that tell what limitations the citizenry have; ours places limitations on what the government can do.  We realize it is this freedom forms a basis for people to achieve great things.

Another value is we believe that our children will have a better life in the future than what we have experienced.  One large reason why elections move in the ways they do is that people will select leaders who they believe will offer a brighter future and deny those who say that our best days are behind us and we need to elect them to oversee the decline.  Our basis is one of optimism for the future and not that of pessimism. 

Today in America is not a time when we bask in the glory days of the past.  Our best days are before us and we all play a part in making them great.  Our new president said last week, “Now is not the time to downsize our dreams, but to set our sights higher than before for our country.”  This speech made me remember Ronald Reagan’s comments that it is now morning in America.  We are up for a new day with new opportunities.  We do not sit on the sunset of the American promise; we are at the sunrise of a better tomorrow. 

Each of us in our positions in credit unions play a part as agents of change to make our country great.  We do this with service to our fellow citizen.  This is done in many ways.  Some are helping a child begin a lifetime of thrift with their first savings account.  Some may be helping that teenager prepare a budget to help achieve the goal of their first car.  Some may be helping a young couple purchase their first house.  Some may be helping a business grow and expand, thus providing more jobs for our neighbors and wealth for our communities. 

The work you do to server others financially is important.  This field also offers great opportunities for growth and a true career for those who pursue it.  For those who do, you will have a lifetime of making a difference in the lives of people around you. 

Today is the day when we should recognize that we are all agents for positive growth and change in our communities.  We need to fulfill the important role we play as we continue to make our neighborhoods, communities, states, and country grow to reach new heights of potential.  Ideas that were only a dream, will become a goal and then achieved reality.  The work we do in our credit unions, play an important part in our country’s future. 

Each of us can make a difference.  One day this week as I left the credit union that we rent space from to go to lunch.  I had some member that I did not know, walk beside me on the sidewalk outside of the building.  “I love this place,” he said.  “I will never go to another bank because these people believe in me and help me.  I love these people.”

It is time to realize the potential that each of us have to change lives.  We can turn neighbors into members and members into raving fans as we help them achieve more than they thought they could.

A Rose by Any Other Name...the Perils of Naming

In consumer lending, it is relatively straightforward how a loan will get repaid. Someone has an income and a credit report that summarizes what other debts need to get paid. We compare how much income they have with how much debt they have, and make a decision whether they can afford the new loan.

Business lending has effectively the same method for determining repayment. We compare a business’s income with all the debts it has to determine if it can afford more debt. However, we know a business’s income differs from personal income in many ways. The income is likely to change up and down every year, and a business has different types of expenses to worry about. But, we are still focused on their income, which is what will repay the debt. Particularly, we focus on their cash income, which we call cash flow.

How we look at a business’s cash income can create some unique debates at times. Even personal income could be open to interpretation. Say someone has a salary of $40,000 a year. Okay, we can expect various taxes to take away about 1/3 of that income, so someone is actually left with $26,666 to live off and pay debts. But say the person also sells a used car for $5,000. Is the person’s cash income really $26,666 + $5,000 = $31,666? In that particular year, yes, they seem to have an extra $5,000. But that was an unusual situation. If the person is coming in to get a new loan, should we use the income of $26,666 or $31,666 to make the decision? I’m inclined to use the lower amount, unless the person can demonstrate they have a used car to sell for every year the loan is outstanding into the future.

For businesses, we can look at their regular income with a method we call EBIDA, which stands for Earnings Before Interest Depreciation and Amortization. In other words, how much cash income a business has before it pays any debts and ignoring non-cash expenses. We can then look at a business’s historical EBIDAs and reasonably project what income to expect in the future.

There is another method for counting a business’s cash income called UCA cash flow. The UCA stands for “Universal Credit Analysis.” This tries to capture all cash events related to the business. So if the business has an EBIDA of $26,666, and it sells a piece of equipment for $5,000, then the UCA cash flow is $31,666. Once again, which way of calculating income do you think makes more sense to evaluate when considering a loan?

In the past year, I’ve heard a lot of murmuring about the need to use UCA cash flow, and I think there is a belief it is superior based on its name alone. After all, it is the Universal Credit Analysis cash flow, right? Well, I would argue strongly that it is not “universal” in its application, nor should it be. Maybe it is called “universal” because it looks at all cash events? Maybe it should be renamed the “comprehensive” or “everything” cash flow?

Believe it or not, UCA cash flow is actually a copyrighted method of calculating cash flow created by RMA back in 1987. I believe they had the best intentions in trying to look at cash flow arising from changes in the balance sheet, which are undoubtedly important to how a business is run and managed.

But regardless of what moves on or off a business balance sheet, it’s sales that we ultimately care about, and whether those sales can cover operating expenses. UCA cash flow is important for large companies, like publicly traded companies that have a more unique balancing act that doesn’t just involve management of bank debt, but the expectations of shareholders and bondholders. As for small business and the middle market, EBIDA is a more powerful tool for predicting tomorrow, since we don’t expect rearranging the balance sheet will be integral to our repayment.

https://cms.rmau.org/uploadedFiles/Credit_Risk/Library/RMA_Journal/Cash_Flow_Analysis/Focusing%20The%20UCA%20Cash%20Flow%20Format%20On%20Lending%20Opportunities.pdf

Will Deregulation Really Bring Oil Jobs Back? Probably Not...

There is murmuring on Wall Street that a Trump presidency will lead to deregulation, and that it is a good thing for oil companies. We all know how the economy of western North Dakota has declined due to changes in the oil markets, so will deregulation really turn this situation around? To better understand, we need to drill down into the economics of the situation.

Let’s first examine the question about whether regulation is impacting oil production. We know that fracking is a hotly contested technology, because it involves injecting pressurized fluid into the ground to breakup formations that contain oil. A highly visible EPA study recently concluded that fracking poses no significant risk to contaminating ground water, which mitigates many reasons to strongly regulate fracking. What could be the major reason the EPA felt there was little concern for contamination? It turns out that fracking occurs far deeper than the water tables we rely on for drinking water, so it is relatively rare that a 10,000 ft. fracking well would impact a 1,000 foot reservoir for human drinking water.

Surprisingly, fracking has few regulations on the national level and is mostly left to the states to regulate. The result is some states shun the technology while others embrace it. The federal government only has strong regulation over wells drilled on federal land, and the states get the last word on any private land. Since a vast majority of wells exist on private land, it is unlikely that a change in federal policy will have much of an impact on all the current and future private wells.

But oil production has drastically decreased in recent years, right? Well, it is not the case that it has drastically reduced, but rather the case it is no longer drastically expanding. And the reason it is not expanding has nothing to do with regulation nor the fact they have failed to find oil. Rather, we became too good at finding the oil. The introduction of fracked oil, especially Bakken oil, to the world markets has led to an oil glut. This has significantly reduced the price of oil for the foreseeable future. As you can see on the graph below from cnbc.com, in 2014 the overall price level of WTI oil slumped. This had much to do with an enormous amount of North Dakota oil wells coming online and sustainably supplying the market with oil.

The oil “bust” in western North Dakota isn’t a “bust” in the traditional sense. It isn’t that the oil dried up or was found to be overexaggerated. Rather, there was so much oil there, it had an enormous impact on the world market and drug down the prevailing price level for oil. With an oversupply of oil, buyers would pay less, and producers had no more incentive to expand or work harder to supply the market.

In conclusion, it is unlikely that any deregulation of fracking on the federal level would have any measurable impact on the production of oil in the United States. However, it is still possible for prices to increase if one particular wild card were to occur. If the United States goes through a period of significant inflation, which we haven’t seen since the eighties, then naturally the price of oil will go up too. So in this case, it wouldn’t be the president-elect’s deregulation effort that lead to an increase in oil prices, but rather an unrelated event that caused the overall prices on everything else in the economy to increase.

http://www.nytimes.com/2015/03/21/us/politics/obama-administration-unveils-federal-fracking-regulations.html?_r=0

http://www.wsj.com/articles/fracking-has-had-no-widespread-impact-on-drinking-water-epa-finds-1433433850

Prospective on the Harvest

The fall harvest in the U.S. has been very bountiful, even reaching record levels with some commodities.  This oversupply has pushed wheat prices to a low for the decade, and corn is still at under 50% of what is was in 2012.  Cattle and hog prices have also dropped.  The low prices combined with higher input and finance costs are making some farmers wonder if they will be able to stay afloat. 

A lot of the farm economy may rest with President Trump and a new Congress, which will have the job of crafting a new farm bill.  These are trillion-dollar, twice-a-decade monster that will set subsidies and can broadly shape the life of the individual farmer.  For the producer, the margins can make a big difference to financial reality. 

Even with the rising costs and declining commodity sales, it was not long ago that farmers’ and ranchers’ wallets were fat.  We saw record profits in 2012 and 2013, exceeding $116 billion, in 2009 inflation adjusted dollars.   But the drop has not been as severe as drops in the 1930s and 1980s, but so far, it has been a return to the levels seen in the 1960s and 1990s, two relatively quiet times in American agriculture.  The challenge that we face now is that producers were getting used to prices that were too high for too long.

Input costs are starting to come down.  Fertilizer and fuel have dropped.  Seed and machinery are the two that resist coming down because of the infrastructure involved in those areas.  Seed costs will eat more revenue in an area of GMOs.  Since 1995 seed costs have increased by 87.5% with the GMO corn, soy, and cotton.  Now the average seed purchase exceeds 4.5% of the farmers’ gross income.  Equipment spending which was crucial to decades of farm mechanization, collapsed in the 1980 farm crisis from its high of 8% of farm gross income.  This has averaged around 4% of farm gross income over the past thirty years with an exception of a run up to 5% with the price peak in 2012-2013. 

Organic food spending is continuing to climb.  The Great Recession slowed annual sales growth from 19.2% to a low of 4.3%.  That level has risen to 10.6%.  The growth rate is phenomenal when total organic sales were under $10 billion in 2005 and sat at $39.75 billion last year.  Some of these smaller farms are making more profit than a non-organic farm that may be a hundred times their size.  Many organic farms also benefit from lower annual input costs once the initial infrastructure has been put in place.

A major push for the corn market came from the renewable fuel legislation passed in 2005 and 2007.  This dramatically increased the mandate for U.S. ethanol use.  In 1990, around 5% of the nation’s corn was used to make ethanol.  This peaked at just over 40% in 2012.  This has dropped to around 38% currently.  It is expected this level will remain constant at it is currently.  This will not provide the extra demand that helped run up corn prices in the past decade. 

Land prices increased with the rising commodity prices and inflation of the 1970s.  That increase is nothing compared to the ethanol fueled farmland boom of the 2000s.  Farm real estate in Iowa averaged around $4,000/acre, in 2009 adjusted dollars, in 1980.  In 2012, this average was up to $8,000/acre.  Land prices have dropped since that peak slightly. 

A combination of the lower commodity prices and higher operating costs are increasing some debt levels for the farmer.  We have seen farmers dip into equity or increase borrowing to continue operations.  This is causing debt to equity ratios to rise in the farm belt from the low ratios we saw in 2012.  There is a push to get bigger to cover the increased fixed costs. 

Exports and federal farm payments have helped the farmer’s income statements but both have limits.  Free trade can give access to new markets for farm products but it also exposes them to foreign competition.  Exports have risen substantially until a peak of 2009 inflation adjusted $140 billion in 2012.  This will drop to around $119 billion this year.  Much of the drop can be attributed to a drop in the commodity price and not a drop in the volume of product shipped abroad. 

Congress had received pressure to pass emergency farm aid in bad years from the 1980s to mid-2000s.  The new programs have made the subsidy payments more automatic.   Overall the subsidies will not prevent the producer from losing money but can help control the depth of the losses. 

Overall, in the next two to three years it may be a challenge for the farmer to break even.  It may not be a repeat of the farm crisis of the 1980s but it still will be a long way away from the days of lush profits we saw just a few years ago.  Producers who are able to smartly leverage technology, control input costs as much as possible, resist the temptation to leverage up, and who seek newer and smarter ways to farm, will be the ones who operate well in the current paradigm.