The High and Low of Critical Thinking

If you have a problem to conquer, the first step is to define or frame the problem.  This leads to generating recommendation for solution, conducting analysis, and finally coming to an executable solution.  It sounds like a really simple 1-2-3-4 step from problem to solution. 

But we all know, if all were this simple, we would not have nearly the number of problems that are evident today.  Problems would not last long and would be always in process of discovering an answer and working through to resolution. 

Many times, problems are never solved as we spin out of control during the analysis phase.   Mike Figliuolo notes a good analysis requires both a high road and low road approach.  The high road is like soaring above the issue to see the overall goals, problems, and obstacles.  The low road involves the hard analysis crunching to validate the answer and direction.  There are dangers in not achieving a balance between the two and it can get easy to be trapped in one or the other. 

I once worked for a bank that stayed exclusively on the high road to long when it created a new program for a business line of credit with immediate underwriting.  The leadership thought adding lots of small balance business lines of credit would be a good introductory product to gain more customers.  They desired to get this out to a broader audience, so they allowed retail employees to sell business products which they had no experience in.  When asked about underwriting standards, leadership commented that using disciplined standards to review requests would make the product unprofitable due to the high cost to underwrite the credit.  Time and effort were put into the selling of the product with new contests, incentives, and goals for all front-line personnel. 

The lack of diving down into the low road kept the bank from detailed study of loss rates compared to various underwriting standards.  A few years into the program, the bank abandoned it as they experienced millions of dollars of loss from poor underwriting and fraudulent borrowers.

On the other hand, one can get caught up in the fun of crunching numbers, excel spreadsheets, charts and graphs that never reach a decision point save for one item, more data is needed.  This analysis paralysis results in extreme amounts of busywork without any solid recommendations for action.  Another bank I worked for decided to take any analysis from the field officer’s duties and place it in centralized underwriting pods with analysts who had no physical contact with borrowers or even the field lenders themselves.  Our analysts were located a mere three-hour drive time away.  Analysts were hired and promoted n their ability to generate questions and research no matter if any new credits were actually produced. 

I had an established borrower that we had financed nearly twenty different condominium construction projects.  Each one was successfully built on time and in budget, and units were sold as quick as they were finished.  A new request came for the next building which was sent, for the first time, to the credit analyst in the newly restructured division.  After a month of providing various items to review, our construction inspector approving the budget, and the appraisal, I finally received a lengthy and detailed analysis of the request that arrived at no conclusions, but requests for more data.  Most of the questions revolved around items in the construction budget which aggregated to 1.5% of the overall total.  This was after our construction engineer had approved the budget and we had verifiable cash from the sponsor for nearly 75% of the loan request.  Yet no decision could be reached from the analyst as she stayed stuck in the low road.  The customer went to another bank and received approval within a couple of days. 

Successful execution of the high road analysis involves the following:

·         Have a clear definition of the problem.
·         What is the analysis telling you about the problem?  What is being proved or refuted?
·         Estimate the benefit of doing analysis before pulling lots of data.  Try to rank possible solutions and pull data in order of your rankings.
·         Think of the Pareto Principle:  20% of the efforts usually result in 80% of the results.  Focus on those items most important.
·         Short bar-napkin analysis can frame issues.
·         Constantly think your thinking.  Do the answers you see, support or refute your recommendation?·         Look for similarities and differences in other problems in the past that may offer clues to a solution for the current problem.

The low road or “getting deep in the weeds” analysis, needs to be successful as well.  Some suggestions to do this are:

·         Only run the numbers and look at the data you need to run.  Time is precious and do not waste it.
·         Don’t stay buried in the data for too long.
·         Pop back up to the high road every so often.  What are the data teaching you?
·         Don’t try to polish dirt.  This is when you continue to look at more information that wastes time and does not give you more clarity on the credit risk or problem than you already have.
·         Don’t try to push a rope uphill.  This is when you preestablish the outcome and force data into supporting your decision when the data does not support it.
·         Focus your attention on answers that really matter.

Successful critical analysis requires a balance between both the high road and low road approaches.  An imbalance between the two may result in wasted time, errant conclusions, and poor direction.  Strive to use both well for greater efficiency as you solve complex issues. 

The Importance of Asking “So What?” When Looking for Solutions to Problems

Once you can clearly identify the root causes of a problem, you are now in a place to think about solutions.  But many companies think of solutions in a vacuum, without considering the actual impact and influence it may have on others outside of the problem.  That is why it is first important to identify consequences when you solve a problem.  These consequences may be with your business, team, customers, stakeholders, competitors, or the general market.

As I write, it is the morning before the playoff game between my beloved Kansas City Chiefs and the Indianapolis Colts.  Thoughts on my mind turn to football.  When a defensive coordinator sees the team is having problems guarding the tight end on the slant route in the middle of the field, he devises adjustments.  He also asks what adjustments the offense will make on the other side.  Will his changes make the offense able to run the ball better?  Will the wideouts be open for big plays? 

When devising solutions, it is important to ask the question “so what?” as you analyze possible results.  In my second banking job after college, I took over managing a branch of a savings and loan located in my home town.  Our branch was the smallest in terms of loans of all the eight branches of the company.  When I left that branch it was the second largest.  I knew and implemented strategies to make the branch grow but failed to see the negative impacts of my changes.

I replaced a branch manager who had retired after twenty years.  He had a long-time staff.  Changes I made helped us grow, but I failed to get the buy-in from the other long-time staffers.  I was young and arrogant and if I had asked the “so what?” question, I would have responded, “I don’t care, follow me since I have the answers!”  The resistance of the staff and counsel of leaders above me caused me to stop and rethink how to implement the growth strategies. 

Often the “what if?” questions need to go several layers deep to get to other changes that need to be made.  Mike Figliuolo, in his course on critical thinking gives the example of a company that identifies the root problem of needing to change the incentive plan which was broken.

So what?

We must change the incentive plan.

So what if you do that?

We don’t know how to do this.

So what do you do when you don’t know how to change it?

We need to find someone who knows how to do this.

So what does that mean?

We must find a new VP over compensation.

So what do you do?

We need to prioritize our search for a compensation VP and de-prioritize other recruiting efforts.

So what impact does this have?

Our search for a new supply chain VP will be delayed.

So what impact will that have?

Without a new supply chain VP, we will not be able to make the goals we have for our supply chain.  In this case it took seven “so what” questions to get to the basis that if we began to look for a new VP of compensation, we need to lower the supply chain goals we have for the year.  On the surface, these two items appear to be independent.  It took several “so what” questions to show how they are actually connected together.

In credit, you will often have clients who come to you who are in trouble who have think their only solution is for you to rescue them with another loan.  Sometimes, instead of running to open the vault for them, some “so what” questions need to be asked to determine the actual outcomes of their choices.  I once had this with a client who was made the final cut on a project with a large general contractor that he had tried to get in with for years.  The conversation started with the loan request.

So what if you get this project?

It is large and will be equal to 30% of our annual revenues.

So what sort of demands on resources do you think such a large project with short time demands will have on your business?

If we get this, we it will put us behind on other projects.

So what do you need to do to keep up with all your projects and add this one?

We must hire a new foreman for our other projects and put our most experienced one on this project.

So what will happen to the other project if you move your best foreman from it?

The project will not be run as efficiently.

So what does that mean?

It will probably cost us more time and we may not be able to utilize the relationships with suppliers and subs that our best foreman has in that community.

So what?

We will need to hire an additional foreman and some additional workers and must make extra efforts to build the relationships with our subs and suppliers in that community to keep that job profitable.  In this case the “so what” questions showed the impact in two unrelated jobs.  The contractor made adjustments to keep his existing job and made some pricing adjustments in his bid on the new one to keep his margins acceptable. 

A third example was with a full-service hotel which was remodeling to join a well-known chain.  The chain was only requiring the rooms and common areas to be redone.   The restaurants were already remodeled but the kitchen which served the restaurant was old and inefficient.  I knew of some of the problems with the kitchen with long delays in food service when I dined there.  We started with the loan request for remodel of the rooms. 

So what if you do not remodel the kitchen?

We can do that that at a later date.

So what will be the impact if you do all the other remodel now and then must shut down restaurants in the future to fix that problem?

It will be more convenient to do all the remodel of the hotel and kitchen at once.  To do these in pieces will look bad to our customers. 

So what if you do this now?

We will have to delay another project and focus more energy here.

So what if you do that?

We think the return is higher to spend more energy and money on the kitchen remodel now.

So what impact will the remodel have on your existing business?

We will have to shut down the restaurant at certain times in the remodel.

So how can you serve your customers?

We can go to a limited menu and use a food truck to feed the patrons during this time.  In this case the “so whats” helped the client change the timing of the kitchen remodel, delay another project which was not as profitable, save face in the community, avoid future grief by putting the remodel off, figure a logistic plan to manage the timing of various parts of the remodel, and keep the restaurants open during the kitchen makeover.  They also discovered the remodel built in huge efficiencies they did not have before, allowed the menu to be improved, and generated enough net profits to pay for itself in a few years. 

Asking “so what?” may help you see possible impacts with your solution on areas which are unrelated on the surface level.  Good critical thinking to solve problems requires a deep dive into the possible solutions and their impacts.



Good Critical Thinking Requires Knowing Why

One of the most needed skills in analyzing a credit request is good critical thinking.  This skill is hard to develop, and many analysts will often take the easy road in reporting what is obviously apparent in the numbers.  Stand-alone comments like “sales went up by 10%” or “net profits were down by 4%” is what we call elevator analysis.  The write up that is filled only with this offers no real value over just a mere presentation of the financials spread in multiple columns for the reader. 

One of the best ways lenders can show real value is not only to use good critical thinking tools in the analyzing of a credit, but to also share these questions with the client to help them to better understand and improve their business.  Often, the business owner gets stuck in all the day-to-day minutia of opening the doors, making sure the equipment is running, keeping adequate staff, or responding to emails.  Staying in this low road every day, prohibits the business owner from rising above to get a critical look at their company.  Even the best run companies often fail to rise above and study.

Steven Covey categorized time spent in good critical thinking as that in Quadrant II of a four-part time division.  Quadrant II represents things that are very important but are not often urgent.  We tend to spend more time on the urgent flashing light in front of us since that must be accomplished now.  At times, when the urgent has passed, we may gravitate to things which are not important and not urgent since completing those items give us a sense of accomplishment.  But those items do not move the needle of true value. 

Since most business owners or employees in a company have a hard time practicing good critical thinking on their own firm, the lender can add real value with sincere questions to help understand what is driving the business.  Now these questions should be tempered with an honest desire to lean about the business and its owners.  It is essential to understand both to have an accurate credit recommendation for approval or proper management strategy for an existing loan.

Whenever you are presented with a company’s financial status, you need to understand why things are the way they are.  Mike Figliuolo believes that the question “Why?” must be asked at least five times in order to gain true insight into the root cause of the problem and gain real insight.  Sometimes these questions may help the business owner know what items are needed to make good decisions to positively change the business direction.

One example I can cite is a horizontal contractor who experienced large losses in some subdivision work during the economic crash.  The request came in for an additional loan or some payment relief to help them through this problem.  But to grant that without fully understanding why would be of no service to the bank or the customer.  I armed myself with the initial financial spreads of the company as I sought to learn more.  Our conversation went something like this.

Customer: “We need payment relief since we took losses on these three subdivisions.’

Me: “Why did you take the losses?”

Customer: “Because we did not get paid fully for our work.”

Me: “If you have the ability to bill during the project, why weren’t you able to recoup more of your costs?”

Customer: “Because the job had such a low margin and we also had to make concessions on payment terms in order to get it.”  Here was insight number one, the company needed to change the way they progress billed for construction work.  I had this nugget after the second why!

Me: “Why did you take a job with such low margins?

Customer: “We need to discount to get the job.”

Me: “Why is it important to bid a job that is not profitable just to get it?”

Customer: “We need to continue to keep our employees busy or they will go to work for someone else.”

Me: “Why can your company be viable in the long term if you bid projects cheaply that will not cover costs if there is a payment hiccup?”

By this time, we uncovered the following:  1.  They needed to change how they billed for jobs and try to at least recapture their costs sooner in the job.  2.  They were chasing after low margin work, when they had higher margin corporate and government jobs waiting for them.  3.  Keeping a large staff busy may not be the best option to maintain the company into the future.  None of these insights would have been discovered if I stayed at the top request for payment relief or a new loan and did not do the deep dive into why.

The owner took these suggestions to heart.   They purchased new bidding software, set a minimum profit threshold and began to pass up jobs that were not up to their profit standards.  They changed their progress billing methods to recapture more of their costs earlier in the job.  Then they began to look at idle workers and shrunk their workforce because of less work they were doing, and they also sold a division of the company which diverted their time and attention from their core business.  Slowly, the business returned to sound financial footing.

Often, when you are first presented with a credit request or the need to understand a business financials you are seeing a symptom and not understanding the real cause.  Diving down into multiple layers of “Why?” will help you uncover the truth behind the initial statement.  Using this skill can also help you immensely in your own business and life.

The Burnt Man in the Shower

I once spent the night at a resort in Estes Park, Colorado.  Our bank was looking at financing a purchase on the resort.  After my morning workout, I retired to my room for a shower in the short window of time I had before a morning meeting. 

The problem I encountered was the water never warmed up.  Even though I turned up the water as hot as it could go, the shower did not get much warmer than the Fall River was outside on this January morning!  Judging that I had to take a shower before the meeting, I proceeded to jump in for what seemed an eternity of time that was punctuated by my constant swearing, “Oh Lord”, and “you gotta be kidding” until the end of the most painful event.  The walls were thin and the other gent I was travelling with in the other room said he got the best laugh that he had in years.

Have you ever been in a shower that was not warming up as quick as you desire so you blast the hot water?  In some of these, the water heat is building up slow and finally comes in a scalding batch that suddenly burns the person in the shower.  OK, so next time, you would hope to remember what happened and turn up the hot water more slowly or just wait until the water gets warmed up.  The problem with the burnt man in the shower scenario is that the man continues to do the same actions each time he gets in the shower with the same result—a burn from the hot water.

I once heard the Federal Reserve as compared to the burnt man in the shower.  The Fed tries to set monetary policy as a balance between full employment and price stability.  When Alan Greenspan was Fed chair, he once defined price stability as “the state in which expected changes in the general price level do not effectively alter business and household decisions.”  Greenspan kept a targeted inflation rate of 2%, though he insisted that no actual amount should ever be made public.  When Ben Bernake was chair, he formally announced in 2012 the targeted inflation rate was 2%.

Incidentally, this targeted rate came in 1988 from a TV interview with New Zealand Reserve Bank chair Roger Douglas, in seeking to dissuade New Zealanders from thinking the central bank would be content with high inflation.  He stated the bank was targeting an inflation rate between 0 and 1 percent.  In the next year, Don Brash, Reserve Bank Chair, and Finance Minister David Caygill set a targeted range of 0 to 2% to achieve price stability.  Inflation in the island country dropped from 7.6% in 1989 to 2% in 1991 after the enactment of this monetary policy shift.  As Brash shared his story with other central bankers at a conference in Jackson Hole, Wyoming, one by one other central bank heads began the 2% inflation target which has reigned as a norm in monetary policy for nearly 30 years now. 

A problem with monetary policy changes is often those who pull the levers are not patient to see what impact their changes accomplish prior to making the next move.  In 2018, we saw four—quarter point increases in the Fed Funds Rate.  At the end of the year we sit with a very flat yield curve.  As I write this the 2-year Treasury is only 17 basis points lower than the 10-year U.S. Treasury. 

Each recession since the 1970s has been marked with an inversion of the yield curve, a point where 2-year notes are at a higher rate from the 10-year notes.  This is out of the ordinary since a 10-year note would require a higher rate due to its duration risk.  We are very close to this going negative and one additional quarter point bump coupled with stable prices on 10-year notes will push the curve there. 

So, is the economy overheating?  Inflation in November ended at 2.2%, which was in the Fed’s target range.  Unemployment sat at 3.7% with more job openings than people searching for employment.  This was a little below the Fed’s long-term goal from 4 to 4.6%.  Things don’t seem that out of control and yet the Fed still chooses to increase rates. 

Some will argue that the Fed’s inflation target is arbitrarily too low and a rate of 3 or maybe even 4% is more normal.  If that were the case, we would not have seen the interest rate increases in the past year.  The question is if the Fed under Chairman Powell will act like Chairwoman Yellen.  Yellen followed a pattern of making a small change and then taking time to observe what was happening before the next move.  One may question if Powell will follow the same course.  Four rate increases in a year, even though they are small, causes one to wonder. 

Will the burnt man in the shower learn his lesson?  Or will we see hot increases in interest rates until the economy goes to into a recession, thus forcing a quick reversal in policy to get things going again?  Only time will tell.  If past history tells us anything, there is a good chance the burnt man will be burnt again.

How Economically Competitive is Your State?

Each year the various 50 states are rated in the Alec-Laffer State Economic Competitiveness Index.  Information can be found at  The Economic Outlook Ranking is based on a state’s current standing in 15 different policy variables.  These factors measure income tax rates, other tax burdens, recent tax changes, debt service compared to tax revenue, public employees per 10,000 residents, state liability systems, minimum wage, average workers compensation costs, number of tax expenditure limits, and if the state is a right-to-work state.  Generally, states that spend less (on income transfer programs) and states that tax less (on productive activities like work and investment) experience higher growth rates than states that tax and spend more money.

The survey also looks backward on each state’s performance in gross domestic product, domestic migration, and non-farm payroll employment.  Each of these are influenced greatly by state policy.  These are measured and ranked looking at the past ten years.  Looking backwards, the top five states are:   Texas, Washington, North Dakota, Utah, and Colorado.  The states ranking 46-50 are:   Illinois, Michigan, Rhode Island, New Jersey, and Connecticut. 

The forward looking economic outlook is based upon an equal-weighting of each state’s rank in 15 different policy variables.  The top five states are:  Utah, Idaho, Indiana, North Dakota, and Arizona.  The bottom five are:  New Jersey, California, Illinois, Vermont, and New York.  Below is a quick view of how the states in the upper plains rank and what factors are strong for growth and which factors are hinderances to growth.

Iowa ranked 18th on the past economic history coming in at 7th in GDP growth, 30th in domestic migration, and 29th in non-farm payroll growth.   Future economic outlook has ranked Iowa at 29th among the states.  Iowa has a low minimum wage and is a right-to-work state.  Negatives are the Hawkeye State ranks 47th in corporate income tax, taxes estates, and ranks 41st in public employees.

Minnesota ranked 22 in economic performance with 19th in GDP growth, 37th in domestic migration, and 18th in non-farm payroll growth.  The future looks worse competitively with a ranking of 44.  Positives are the state has a good liability system and has enacted some personal income tax cuts in 2016 and 2017.  Negatives are the high personal and corporate income taxes, high remaining tax burden, taxes on estates, and North Star State is not a right-to-work state. 

Montana ranked 9th in economic growth in the past decade.  This was raking 8th in GDP growth, 18th in domestic migration, and 11th in growth in employment.  The projection is worse with Big Sky Country coming in one slot higher than Minnesota at number 43.  Positives are a no state sales or estate taxes.  Negatives are personal income taxes are progressively bad, they have a high tax burden personally, and the state is not a right-to-work state. 

Nebraska ranked 13th in the past decade with a 2nd ranking in GDP growth, 29th in domestic migration, and 13th in non-farm payroll growth.  Future growth ranks Nebraska at 28th.  Positives are that the Cornhusker State is a right-to-work state, the liability system is managed well, and the state has cut personal income taxes. Negatives are Nebraska has one of the higher progressive income taxes, a high number of public employees, and a taxing of estates. 

North Dakota emerged as the star of the group with a ranking of 3rd in past decade.  They had the highest GDP growth of any state, 16th in domestic migration, and 1st in non-farm payroll employment.  The economic outlook ranks the Peace Garden State at 4th for growth.  Positives are the state is a right-to-work state, has low workers’ compensation costs, a low minimum wage, implemented a tax cut in 2016 and 2017, and has the second lowest debt service compared to revenue.  Negatives are that North Dakota has the 3rd highest sales tax burden and has a high number of public employees per population.

South Dakota ranked 8th in the past decade with a ranking of 4th on the GDP growth, 22nd in domestic migration, and 9th in non-farm payroll growth.  The Mount Rushmore State ranks 9th in future growth.  The state is a right to work state, has a well-managed liability system, has no estate, personal, or corporate income taxes.  The worse negative is the state has the 43rd in terms of sales taxes per $1,000 of personal income. 

Wyoming ranked 43rd in the past decade of economic growth with a 47th rank of GDP growth, 21 in domestic migration and dead last at 50 in non-farm payroll growth. The Equality State has an economic outlook ranking 8th among the states.  Positives for the future are the 0% corporate, personal, and estate tax rates.  Wyoming also has the lowest state debt service at 2% of tax revenues.  The state is a right-to-work state and has well managed liability system.  Negatives are that Wyoming has the highest proportion of public employees to population and has a higher property tax burden. 

The ALEC-Laffer study is viewed with other factors such as demographics by companies who are searching for good growth states that are business friendly.  The study is a good read to understand more about how each of the states are their own little experiment of democracy and policy.  It will be interesting to see how the various states’ growth progresses in the future.

As we approach the end of the 2018, we extend our gratitude for each of you that we have worked with.  Perhaps we helped close a new loan for your institution or maybe you attended one of our classes.  Maybe you called with a loan question or used our servicing platform to manage a credit.  We appreciate each of you and look forward to serving you in the new year and beyond.  My wish is for new successes for you next year and a very merry Christmas in this year.  May you know the good news that was first shared with a small group of shepherds long ago, “unto you is born this day in the city of David, a Savior, who is Christ the Lord.”

Surprises in the Lender's Stocking

Opening a Christmas gift is risky.  You don’t know if this is something that you really want or if it is something that will be sent to the goodwill box within a week.  We have all experienced this.  It may be an ugly sweater, a necktie that is not meant to ever be in public, or some item there is no way that you will ever use.  It is the same as finding a big lump of coal in your stocking from Santa.

This time of year, we tend to look back at the past and look forward to the future.  When one considers the challenges and possibilities for the new year, it is like receiving presents that you have no idea if they will be absolutely fantastic, or if they turn into the lump of coal.  Here are a few of the mystery presents that lenders find under their tree this year.

I will start with the economy.  We are already nearing record time for an economic expansion.  There continues to be good economic news—strong employment, expanding companies, inflation that is reasonable.  Yet, we just don’t know when the party will end or what will make it end.  Will it slowly fade, or will some violent change cause the growth to come to a screeching halt?  Then what impact will it have on your borrowers?  What sectors of the economy are already showing stress?  We are already seeing quite a bit of stress in agriculture.

Could a debt crisis that is triggered from emerging markets or a financial crisis from uncontrollable deficit government spending, bring the economy to its knees?  If there is a debt crisis, will it reduce the supply of possible funding for new projects?

Interest rates are another mystery.  It is expected we will see another Fed increase this month, but after that, what will be the attitude of the Fed?  Will the yield curve invert?  This is a sign that a recession is coming and would be a large lump of coal in the stocking!  Our recent recessions have been rather severe in nature. 

Will commercial real estate (CRE) lending slow down?  Starting on December 15, 2019 the new Current Expected Credit Loss (CECL) model for allocating loan losses, goes into effect for institutions that file with the Securities and Exchange Commission.  By the end of 2021, all lending institutions will be using this.  This will replace the current Financial Accounting Standards 5 and 114 for allocating credit losses and now require lenders to estimate a loss over the entire life of the loan.  It is expected this will require additional capital reserves due to the increased credit loss estimates.  Will this slow down CRE lending?

Another possible slow down for CRE is the new lease accounting standards for public companies that will begin at the end of this year.  What impact will lease accounting have on long term lease structures that are key to the current triple-net (NNN) lease market?  What happens with permanent debt investors that rely on matching longer-term liabilities to assets with long duration cash-flowing assets?  Will companies that engage in long term sale-leaseback CRE, now relay on holding those assets, thus effectively shrinking the supply of good NNN deals for CRE investors?

This change is a material occurrence.  Moody’s estimates this new Financial Accounting Standards Board lease accounting change may add as much as $1 trillion in liabilities to corporate balance sheets.  This becomes even more complicated with the right-of-use asset calculations that can mitigate this additional liability.  In these figures, the asset value is not determined on the market value, but on the use.  This could result in a decline in assets and correspondingly the company’s net worth.  This possible disruption in longer-term leases could leave the NNN lease market exposed and would be a present no lender wants to see.

Another possible lump of coal is with employment.  This fall, we have more posted jobs than folks who are on unemployment.  As I write, the unemployment rate is at 3.7% and real wage growth is increasing by 3.1% annually.  Employment growth is averaging 170,000 jobs a month.  Many highly skilled jobs are also going unfilled.  Will companies be able to find the labor they need in a tight job market?

A final mystery present that I will mention, but definitely not the last, is the future of regulations.  2019 will mark a time when we have a House leadership that has been historically for increased government oversight, contrasted with a Senate and President who have sought to cut regulations.  The other players are the actual folks who implement the regulations themselves.  Will there be a continued move to unshackle the economy or will this change to a focus for more oversight? 

Each of these mysteries will be wonderful opportunities for some and could be devastating to others.  Our goal for the new year is to be highly aware of what could lie in each stocking and present; then be adaptive quickly to the changes.

A Bloodhound’s Guide Identifying Foul-Smelling Loans

In my last blog, I identified several structural items necessary for a lending institution to identify and manage problem credits.  This blog will point out several factors that may indicate problems with your corporate borrower.  Like a good bloodhound, you must be able to sniff each of these and determine when there is a problem involved that will impact your ability to be repaid.

New Borrowings from Other Creditors may be a clue of problems.  I once had a car dealer who said he believed in spreading business around town with loans at several institutions.  Over the period of a couple of years, he added five new lenders who advanced funds for real estate, equipment, inventory, and working capital.  When the business imploded, no lender had adequate knowledge of the business and control of the lending to enforce their position, so we all were comrades in misery as we took losses across the board. 

New credit that pops up is especially problematic when it is a surprise to the lender.  Often, we have seen this in ag lending when a new filing by John Deere pops up on a UCC search when the operating lender had no knowledge of any planned capital purchases.  It is really a problem if you have a “no new borrowing without lender approval” covenant which is violated. 

A new loan made by someone else when you turned down the request because of financial issues with the company may be a sign.  On some of the marginal companies we bank, we often hope there will be a greater fool out there who will close the next credit for them.  This is a real problem if the greater fool does not pay off the existing debt with us in the process. 

Tax Liens may signal a problem.  This can come in many forms:  property taxes, sales taxes, income taxes, withholding taxes, to name a few.  Of these, a failure to pay withholding taxes to the IRS is very egregious since most of these funds come from the employee.  Missing any required taxes is a sign of cash flow problems in the company and must be addressed.  Also, tax liens of the business owners may show the company is not producing enough cash to provide distributions to the owners to pay for their tax liability from tax profits generated by the company.

Delinquency and Overdrawn Deposit Accounts are obvious signs of cash flow problems.  Unfortunately, these are often signs that occur very late in the problem cycle and may indicate problem issues are exacerbating.    Now these may be caused by poor loan structuring, and in those cases, the lender may be able to help solve the problem with a proper structure.  We had a loan on a seasonal hotel which had problems making payments in the off-season, especially close to the time toward the end of the off-season when expenses to reopen the hotel were high.  This was solved simply by a seasonal payment structure that matched the business cash flow.

Concentrations of Business may indicate a serious problem in a business.  This can come from over-reliance on one customer in terms of sales or receivables.  I once worked with a horizontal contractor who had a large multi-year contract in a large subdivision.  The developer overextended himself and sales stalled.  Consequently, the contractor suffered a large loss which took several years to recover from.  Another case I know comes from a manufacturer of perfumes who had their main account, over 75% of their sales, to Wal Mart.  When Wal Mart found a cheaper source of product, the business scrambled to downsize because of the lost business.  In each of these cases, greater diversification could have staved off some cash flow issues.

Violation of Loan Covenants may be a strong indication of a foul smell coming from your borrower.  This is assuming that you have well-structured loan covenants in place to begin with.  Covenants are like good medical equipment to check the overall health of the company.  The lender needs to identify when one is broken, what caused the problem, and what possible solutions may be.  You should also look at the negative side to see what future problems may occur if the covenant remains broken or the company’s performance weakens further.

Expansion may be a problem, especially if it is completed too rapidly or made in an unrelated business line or market area.  Bigger does not always mean better, it just means bigger.  Many companies have failed as a result of growing quicker than their ability to service that growth.  Also, large spikes in revenues may present a problem when income drops.  We saw this recently with grain prices when farmers became comfortable with high prices earlier in this decade and began to make purchase decisions based upon those prices continuing into the foreseeable future.  Growth into a new market may not present the same revenues and net profit as the company experienced in the current establishments.

Failure to Pay Off Lines of Credit will show cash flow issues in the company.  In agricultural lending, we refer this as carry-over debt, or a short-term line of credit that the producer failed to generate sufficient revenues to retire.  Any operating line of credit that cannot be retired in an operating cycle must be sniffed out to see the cause.  Did the company use it for purchasing fixed assets?  Is there a deterioration of business that is causing the company cash flow problems?  Often this may give the lender one of the early whiffs of foul credit.

Withholding Information is a huge sign that something is rotten with your borrower.  This is often the worst position a lender can be in, not knowing what they do not know.  Have you ever had a borrower who refused to answer detailed questions we had regarding their finances?  If you do, this may be the sign that something rotten is being covered up.

Change may be a sign that something is smelly in your credit.  The change may be in the accountant, bookkeeper, management, leadership, industry, environment, or other factors.  Sometimes, these changes may signal a problem.  The lender should consider if any of these issues should require the loan to be watched more closely to see if what you smell is passing or is an indication of rottenness.

These are some factors that the credit bloodhound must sniff through as they manage their portfolio.  Identification of the problem is the first step in proper credit management. 

Something Smells in Here : Problem Loan Identification

Have you ever opened your refrigerator and were greeted with a smell that would knock out a horse?  A couple of years ago, we had something that had either died or was a growing scientific experiment in our fridge.  The smell was incredible.  Knowing that the only solution was to remove all items and totally clean the icebox, we put it off for a few days as we did not have time.  Soon, everything that was removed from the fridge had a stench and taste of the something between old sweat socks and dead raw maggot infested meat.  The only solution was a thorough cleaning complete with mask and gloves. 

Similarities may exist between the foul appliance and problem loans.  Everyone knows something smells rotten.  At first, no one wants to dig far enough to identify the problem.  Some shops are led by folks who want no bad news.  The messenger is shot, giving the message to avoid and push away anything credit that is beginning to be ripe.  Others refuse to spend time and money training their team members.  When problems occur, they can’t quickly identify them.  Still others continue to only harp on sales and production goals at the expense of credit quality. 

All these approaches gloss over the upcoming problems and are as effective in just adding a few boxes of Arm & Hammer as eliminating the rot.  Things may smell OK for a time, but eventually the dead body must be removed.

If you want to manage the smell, the first place to start is with the leadership.  An open, communicative culture must permeate throughout the organization.  This means that all news, no matter if it is good or bad, is welcome to be advanced.  In some institutions, weakening financial performance or negative headlines of a borrower is not welcomed.  Some shops have pushed production to the extreme that field lenders are either too busy to monitor their credits or they deny any issues as they push for the next closing. 

Credit leadership must also promote quality assets compared to just pushing more loans.  The leadership should also set up systems of internal and external loan review, periodic analysis on each credit, and establishment and maintenance of watch lists.  Watch lists should be expanded not only to cover substandard and worse credits, but also those which show weakness that may lead the borrower into a negative status.  Discussion of credits should involve the entire department to get input of everyone.  Different points of view are valuable in finding the best solution to manage the challenging credit.  Also, this discussion will provide good training to the less experienced credit team members. 

Solid portfolio management requires you to constantly survey the market area and look for possible pitfalls that can impact a large swath of borrowers.  Perhaps this is a dominance of a key industry or employer.  Many smaller institutions in a rural area may have an economy dominated by farming or ranching.  A severe downturn in prices or a widespread hail storm may impact many other businesses other than those directly involved in ag production. 

You should know any concentrations or granulations in your loan portfolio.  Granulation asks how diversified are your loans?  Concentrations of credit may be in an industry, borrower, company, region, or guarantor.  For many smaller lenders, it may be hard to have a well-diversified portfolio as this is not common in their market area.  Also, note that concentrations may mean that your shop has an expertise in managing and underwriting a particular type of credit.  I once ran across a bank that did a tremendous amount of loans in the trucking industry.  They had nearly 50% of their commercial loans to companies in those industries.  When I asked them about losses, the only significant loss they took was when they reached for diversity by lending on an office building.  They had decided to become more granular in an area they did not fully understand. 

A good example of a concentration risk that killed an institution would be the failure of LOMTO Federal Credit Union which lost $51.2MM on bad taxi cab medallion loans when it had only $185.5MM in assets.  The value of these assets plummeted after the popularity of Uber and Lyft.

Problem loan management starts with an assessment of your institution.  What resources do you have available?  Do you have staff with experience in working out problem loans?  What legal resources do you have at your disposal?  Do you have any third-party resources like Pactola to help?  Do you have the ability to have a dedicated department of talented people to handle workouts?  What time resources do you have available at your disposal?  Do you have any training that is available to develop your team members?

All these are items that leadership must be aware of in order to better identify and manage any foul- smelling credits instead of just pushing it to the back of the fridge.  In my next blog, we will look at direct warning signs that may train your bad credit blood hound nose to identify problems. 

Thanksgiving Day in the United States

Thursday is Thanksgiving Day in the U.S.  A few years back, my middle son asked how Thanksgiving was started in our country.  While we trace the origins back to the Pilgrims and have history of this celebration prior to the Revolution, these occurred when we were still a colony of the British Empire. 

The first official Thanksgiving in our country was proclaimed by President George Washington in 1789.  Washington proclaimed a “day of public thanksgiving and prayer” which was overwhelmingly agreed to by Congress.  But the holiday did not become an annual event.  Thanksgiving proclamations were made at different times by different presidents until 1814.  Also, some communities and states celebrated the day as well. 

In 1863, after the Union victory at Gettysburg, Sarah Josepha Hale, a 74-year old magazine editor, wrote to President Abraham Lincoln urging him to establish a national day of Thanksgiving on an annual basis.  Hale had written repeatedly to other presidents concerning this topic but with no success.  The national mood was of humble thankfulness as our country was ravaged by the Civil War.   She wrote, “You may have observed that, for some years past, there has been an increasing interest felt in our land to have the Thanksgiving held on the same day, in all States; it now needs National recognition and authoritative fixation, only, to become permanently an American custom and institution.” 

Lincoln responded to Hale’s request immediately and on October 3, 1863, exactly 74 years after George Washington’s first Thanksgiving Proclamation, Thanksgiving was established as we celebrate it today.  The text of Lincoln’s announcement follows:

“The year that is drawing towards its close, has been filled with the blessings of fruitful fields and healthful skies. To these bounties, which are so constantly enjoyed that we are prone to forget the source from which they come, others have been added, which are of so extraordinary a nature, that they cannot fail to penetrate and soften even the heart which is habitually insensible to the ever watchful providence of Almighty God. In the midst of a civil war of unequalled magnitude and severity, which has sometimes seemed to foreign States to invite and to provoke their aggression, peace has been preserved with all nations, order has been maintained, the laws have been respected and obeyed, and harmony has prevailed everywhere except in the theatre of military conflict; while that theatre has been greatly contracted by the advancing armies and navies of the Union. Needful diversions of wealth and of strength from the fields of peaceful industry to the national defense, have not arrested the plough, the shuttle or the ship; the axe has enlarged the borders of our settlements, and the mines, as well of iron and coal as of the precious metals, have yielded even more abundantly than heretofore. Population has steadily increased, notwithstanding the waste that has been made in the camp, the siege and the battle-field; and the country, rejoicing in the consciousness of augmented strength and vigor, is permitted to expect continuance of years with large increase of freedom. No human counsel hath devised nor hath any mortal hand worked out these great things. They are the gracious gifts of the Most High God, who, while dealing with us in anger for our sins, hath nevertheless remembered mercy. It has seemed to me fit and proper that they should be solemnly, reverently and gratefully acknowledged as with one heart and one voice by the whole American People. I do therefore invite my fellow citizens in every part of the United States, and also those who are at sea and those who are sojourning in foreign lands, to set apart and observe the last Thursday of November next, as a day of Thanksgiving and Praise to our beneficent Father who dwelleth in the Heavens. And I recommend to them that while offering up the ascriptions justly due to Him for such singular deliverances and blessings, they do also, with humble penitence for our national perverseness and disobedience, commend to His tender care all those who have become widows, orphans, mourners or sufferers in the lamentable civil strife in which we are unavoidably engaged, and fervently implore the interposition of the Almighty Hand to heal the wounds of the nation and to restore it as soon as may be consistent with the Divine purposes to the full enjoyment of peace, harmony, tranquility and Union.”

The current Thanksgiving draws its roots from the trial of the Civil War.  Many years have passed since then and we are a most blessed people with many things to be grateful for.  We are thankful here at Pactola, for each of you and the opportunity we have to serve you and be served by you.

The day after Thanksgiving is Black Friday, the start of the Christmas shopping season.  We expect Christmas to cost a bit more this year.  PNC creates an annual “12 Days of Christmas Price Index”.  This sets the prices of the various gift items in the song “The 12 Days of Christmas”.  The current price for the items in the song is $39,094.93, a 1.2% increase over last year’s cost.  The index was started in 1984 when the cost was $20,069.58.  The biggest drop in the list is a 9.1% decrease in the five golden rings.  The highest increases are the ten lords-a-leaping, eleven pipers piping, and twelve drummers drumming.  All indictive of a tighter labor market!

ABCDs for a Beginning Lender

Last week, we held our first small class at the Pactola mothership.  Our topic was “Beginning Business Lending”.  We had the honor of spending a day and a half with ten fine lending professionals.  We plan on holding more of these classes in 2019 and are interested in hearing from you regarding any topics that would be of an interest to you.

As we worked through the class, we had a question pole where any question that may be not related directly to the subject matter at hand was placed.  We would spend time answering some of these questions throughout the class.  One question made me ponder for a long time after folks were on their way back to their respective homes.  It was, “What advice would you give to a beginning commercial lender?”

I thought back to one of my first training sessions I sat in after I left the retail and mortgage sides of the bank.  I took copious notes as I learned concepts like debt service, cap rates, and margin.  If older me, were to travel back and sit down with younger me, what would I say? 

I think I would keep it rather simple, like learning your ABCDs.

Always be learning.  Commercial and agricultural lending is something that you will never be able to reach the apex of knowledge.  That is one of the most wonderful things about this industry.  There are also so many sources to learn from each day.  Industry resources, peers, others in your institutions, and your customers can all be great teachers if you listen and read.  I remember the first time I learned how to calculate a property value using the discounted cash flow model.  Another time, I learned from a lender to the furniture industry, features to determine a good quality chair from a bad one.  Another example was when I finally understood what basis is in commodity prices.  Each of these are small samples that can add up to a lifetime of knowledge you can gain if you humbly commit to learn.  Ask great questions and then be prepared to listen. 

Believe you can do it.  Doubt is a powerful killer of dreams.  You must believe that your customer knows he is better because he is working with you.  This starts with a quiet confidence in your skills and knowledge.  I contend this also goes beyond yourself and requires faith because no matter how much you know, you will never have a full command of all the answers. 

Commit to the right things.  Sometimes, success comes from what we can say no to, in order to select something that is best.  Learn to stick to your core values and principles.  Then commit to going to the correct circles where your skills as a person and a lender can make a difference.  And while you are at it, don’t forget to commit to excellence each day.

Don’t give up.  This is perhaps the most important lesson.  Success is a walk it is not a flight.  It requires putting taking one step at a time, putting one foot in front of the other.  At times, the temptation of discouragement will be great.  You may find it easy to give up.  It is during those times that continuing to move forward is necessary if you want to enjoy future successes as a lender.

One of my favorite quotes on persistence was taught to me in my freshman year in college. Calvin Coolidge was a member of the same fraternity I was a part of.  Coolidge stated this about persistence.  “Nothing in this world can take the place of persistence. Talent will not: nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not: the world is full of educated derelicts. Persistence and determination alone are omnipotent.”

Sometimes the best pieces of advice are simple.Mastering these simple concepts can lead to great rewards in lending.

Could FASB Be a Major Game Changer in 2019?

Professionals who used to make leasing decisions, may soon be subject to the decisions of the chief financial officer.  New accounting standards from the Financial Accounting Standards Board (FASB) regarding changes to lease-accounting methodologies will begin at the end of this year for public companies and a year later for all other organizations.  These changes may make FASB the projected major disruption agent of typical methods to assess commercial real estate. 

The new lease standards came from a decade of study by FASB and its sister organization, the International Accounting Standards Board.  Both entities were requested by the Securities and Exchange Commission (SEC) in 2006 to look at this issue.  Currently, operating leases are noted as footnotes in the financial statements.  The SEC believed that operating leases should be recognized as a liability on the balance sheet of the tenant.  If a company signs up for a ten-year lease, they have a ten-year obligation for the right to use the subject space which requires ten-years of payments.

A white paper by the Industrial Asset Management Council states, “The intent of the new standards…was to improve financial reporting about lease transactions and, in doing do, gain that transparency for investors and other stakeholders…A major portion of this process will be the review and categorization of all leases, as well as their terms and options to ensure that all appropriate information is collected, a coordinated effort must be mounted internally, including accounting, finance, purchasing, operations, and of course, real estate.” 

K.C. Conway, director of research and corporate engagement at the University of Alabama’s Center for Real Estate, notes in the past, the decision for a company’s real estate department was relatively simple.  All that had to be completed was to align a targeted return on capital with the economics and project cost.  Now this process will move to a new committee level inside these companies.  The focus will change to what is the result on the balance sheet.  This will cause a clash “between the CFO’s objective view of the numbers and a very subjective nature of lease negotiations.” 

These upgrades are not simple.  Deloitte outlined 12 essential points governing the new standards.  These all can be reduced to one question.  What is considered balance sheet and what is not?  The new lease accounting standards will impact how a lease is recorded.  More CFOs will want to book shorter term leases with options than to put a 25-year lease on the books.  This will play havoc to lenders who would prefer to finance the building with a long term corporate lease backing the cash flow. 

Since the entire term of the lease obligation must be booked as a contingent liability, the balance sheets of companies who lease will be greatly impacted.  Current and long-term liability numbers will explode, in some cases up to ten times what was previously reported on the balance sheet.  This change could cause the lender to pull his hair out as he looks at a company who months before was financially well, that now looks insolvent due to the FASB changes. 

The lease accounting change could make owning your buildings more attractive than renting space.  This will impact companies looking to build and occupy single-tenant assets that are essential to their operation.  If the asset of a new headquarters building will be on the balance sheet for a long time, they may as well own it.  But for a retailer who has a spot in a strip center, this will probably not impact the decision to lease or not.  Most multitenant landlords are not going to reshuffle the structure of the strip center into individual condos as occupancies change.

There may be a decrease in the build-to-suit-then-leaseback activity.  Companies like Dollar General, Walgreens, and Panera Bread have used this model to obtain off balance sheet, long-term lease financing with the leaseback model.  As the new rules are implemented, they may elect to own the property.  Their cost of capital as a direct owner may be less than if they must deal with lenders.  Financing the individual owner with the long-term credit tenant lease has been a plum of a loan to have.  These will become rarer in the future. 

It is unclear the impact the new FASB changes will have on the commercial real estate market.  Could this be a major disruption like what the financial crisis did for home building?  Or could this represent a slight shift in larger companies keeping more real estate on the books and the overall impact not being felt?  On the lending side, there could be some major surprises in the financials this year and next as these new standards are implemented and more companies are reporting with the new rules. 

Building Efficiency in Your Files

This topic may seem quite simple for a blog, but it has been near the top of my mind as we are in process of implementing a new tickler system to help manage our credit files.  It surprises me at times, how disorganized files become.  I have seen instances where loan file contents may be found in a physical loan file, in items on the computer, with the loan secretary, and in the loan officer’s possession all at once!  I have also seen some more technology-savvy institutions which have different parts of the same file spread on different computer platforms. 

In each case, this promotes inefficiency.  One of the things that bugs me the most is when I cannot find an item I am looking for when I know I am looking in the correct location!  Yet, I know at times that in the busyness of the day, it is easy to misfile an item to go on to the next task.  The first problem is failing to realize that file inefficiency is a silent stealer of time.  This time can be used for anything else in life, increased productivity, serving others more, or devoting more time to family.  It is along these lines I offer a few tips on what we have discovered at Pactola.  This does not mean we are perfect, by any means, but we are pursuing excellence.

If your institution operates in various locations, and you find that folks in those locations need access to the same file, consider moving as much as you can to a digital file.  This greatly saves time in accessing file items.  We found this essential in our shop as we work with participants and staff that are spread throughout the country.  We eliminated paper files completely, only keeping a copy of the closing documents (which are digitized as well) in a paper file.  Also, strong backups are very important to put in place. 

Now if you are in the computer file world, it is important to set up a standard set of file folders within a loan file where items can be organized.  It makes it much quicker to go into the “appraisal” folder to find the appraisal or into the “title insurance” folder to find the final title commitment and all items associated with that.  Your standard set of sub folders may change some with the particular loan type, e.g. a SBA loan may need different folders than a construction loan.  The file folder standards should be determined by the team which will be touching the files the most. 

Next is how to name items that go into the folder.  Just scanning documents into a file and having your printer associate a random file name to it will still cause you to go through multiple files to find what you are missing.  Our team came up with a naming procedure that has the date, borrower or guarantor, and document description in the file name.  Whatever you do, again, have this created by those who touch the files the most. 

The next step is to create a tickler system or to use a program that accomplishes this.  Ticklers are important to help manage your time and make sure all items are requested and received to keep the commercial or agricultural file current.  There are several programs to do this or simple ones can be created using programs in Microsoft Office.  Without this tool, it is nearly impossible to best manage ongoing file needs and activities. 

A quality control process should also be instilled.  Perhaps this can be completed when one team member builds a loan file and tickler and a different person reviews the file for completeness.  It never hurts to have other eyes reviewing the file contents for accuracy. 

These standards should then be reviewed periodically by your team and taught to new members.  The organization and file naming structure can apply to files that are not directly related to a loan.  Every institution will have files for resources, economic information, and program manuals, to name a few.  Keeping these organized and easily accessible saves valuable time. 

Keeping files organized and clean is an ongoing task.  I once had a boss who required everyone to take a week in January to clean out any personal computer and paper files.  In today’s information age, data builds up.  Some of it becomes useless or irrelevant over time.  It is like the story of the doctor who refused to clean out old magazines in his waiting room.  Instead he set up a sign for “historical periodical reference material”.    Some of the items you are holding onto may be useful in the future, but many items require timely purging to avoid wading through the data to find what you need.

Efficiency or Effectiveness?

In my first banking job out of college, I was often tasked with odd jobs.  During my first summer there, we foreclosed on a small house located in a remote area of the county.  I was ordered to clean up trash in the house, remove old wallpaper, and paint the inside as we decided these acts would help bring a higher price when we sell the house. The job also had to be completed in the day as there were no utilities on in the place.

I traveled down some windy country roads to the house.  My first day of work was miserable.  Missouri is known for its heat and humidity in the summer.  I spent the day hauling trash the previous owner had left in the house out to a large pile to be hauled away later.  My boss told me he thought the cleaning itself, would take a week.  After the end of the first day, I had drug all the junk out of the house and was feeling great about how efficient I had completed a week’s worth of work into one day!

The next day, I went back to the office since I had no equipment for the prep and painting.  My boss was surprised at how quick I had completed the job.  He asked if I had pulled all the junk out of the basement.  This took me by surprise since the house I went to, had no basement.  Upon further quizzing, he discovered that I had gone to the wrong house to clean up.  All my efficiency was lost for nothing. 

Have you ever completed some task quickly, only to realize that you did the wrong thing?  This happens to me a lot with house chores.  I end up in the same position I was in at the house, very efficient in my work but not very effective.  It is like running on the hamster wheel fast but not going anywhere. 

Today, being efficient in the wrong things is easy to do.  We have moved from an industrial economy to one based upon knowledge.  When we were industrial, many jobs were based upon performing certain tasks well.  Tasks were laid out easily like a football field.  Efficiency and effectiveness was about getting to the goal quickest.

In today’s world, the goal is to still get to the goal the quickest, but the field has not been defined.  The first challenge is to take all the data that is available to you, sift through it, prioritize it, and come up with an action plan on the data you have remaining.  Then this info is constantly viewed considering other information to see if changes in the plan should be made.  Information is constantly being bombarded at you every minute. 

Consider email.  Over 4.3 billion folks on earth use email.  The average office workers received 121 emails per day in 2015.  Each of these represents something that must be viewed, and a decision must be made regarding action or tossing the email aside.  Then some priority of actions need to be set.  Look at the information on the internet.  In 2015, it was estimated the amount of information on the internet would pass a zettabyte.  To put that in prospective, if the cup of coffee on your desk equaled one gigabyte of data, a zettabyte has the same volume as the Great Wall of China!  Each day when we turn on the computer, we have access to so much raw information. 

Since we are limited by time, the first challenge we have in the knowledge economy is to define the field, obstacles, and goals we need to aim for.  The second goal is the need to prioritize the data we receive and act or not act where need be.  Otherwise, we may be very efficient in what we do, but not very effective in getting the right things done. 

Oh, and the wrong house I went to was actually foreclosed by another institution.  In the grand scheme of things, someone benefitted from my work, it just was not me or my employer!

The Net Interest Margin Squeeze

Most of us are aware that interest rates have risen a lot in the past few years.  I know you may not be aware of this if you live in a cave or are completely unaware of the world of finance around you.  But for those of us who live and breathe in this realm, the changes of interest rates are a daily factor on our minds. 

The rate changes are across the board.  Ten-year U.S. Treasuries were at a low of 1.4% last July and are now bumping the 3.2% yield.  On the shorter end of the spectrum, the Fed Funds Rate, which was at 0.07% in October 2015 is now at 2.18%.  Thirty-year fixed mortgages recently hit 4.72%, representing a sharp increase from the 3.42% two Septembers ago. 

For the borrower, this means that they will pay higher interest rates for loans, that is unless they are doing business with a financial institution which is still living in 2016.  If you are in credit, you should be aware of this as you look at budgets and stress test interest expenses that a company may have on those credits which are not fixed rates. 

Some borrowers still live in yesterday’s land of interest rates.  I recently was shown a term sheet for a project promising an interest rate of 5% for 5 years.  The institution we were working with was seeing what sort of deal they could do since the project was attractive to them.  The letter, which was by now over a month old, was dated and made in a different rate environment which was not applicable to the cost of funds today.  Term sheets should have short times for the borrower to act and as much as possible be based upon a variable rate that will be determined based upon market conditions closer to the time of closing. 

Savers can find better rates at financial institutions and in the bond market with the increase in rates.  These higher rates may move money back into these markets and away from stocks or other business investment if they believe the premium is not substantial enough to pay them for their risk.

Financial institutions are often those where rising interest rates can create substantial stress.  In most cases, the main driver of credit union and bank income is the net interest margin, that is the difference between the interest earned on loans and the interest paid on deposits.  If your shop has a lot of fixed rate loans on the books and lots of short term deposits that will come up for repricing before any interest changes in the loans, you will see your net interest margin shrink. 

I recently heard this lament from the leadership at a credit union.  This shop had done a great job in booking lots of 4 and 5-year new auto loans at rates between 1.99% - 3.99% with promotions they ran.  This brought in a lot of small loans, which have costs associated with managing and processing each loan.  The CU has deposits which will reprice at higher rates as demanded now by the market.  This will squeeze their net interest margin. 

The leadership mentioned how their main source of their new accounts started from small car loans in their community.  Many of these accounts have a very small deposit account, in some cases just the bare minimum to become a member, in their new deposit accounts.  So, the overall result of the campaign was locking in a lot of low interest, small balance loans that will probably not run off for several years, combined with a lack of new deposits balances from these new members. 

Today, is a good time to look at the benefits of sound business lending.  This strategy can help deploy larger amounts of capital at higher market rates than your typical new car loan.  If the loan is structured well, duration risk can be reduced by tying the rate to an outside index, such as U.S. Treasuries. 

Developing strong business relationships can also bring in larger deposit balances into your institution.  Plus, you can serve the business owners with their personal accounts and may be able to gain access to converting many of their employees to your institution as well. 

In many ways, one of the biggest ways you can make an impact in your community is with sound business lending.  These loans help provide the necessary capital for companies to grow, providing new jobs and helping other businesses increase sales. 

Impact of New USMCA Trade Agreement

One of the areas that has caused great concern for many areas of the economy is trade.  President Trump came into office promising to renegotiate existing trade agreements which he believed were often slanted against American companies and workers.  He began to use his authority to start trade negotiations with our trade partners and use the power of tariffs on imported goods as a weapon to enforce trade practices that were fairer to the U.S.

These actions caused a lot of fear among those who believed that there would be negative reactions for U.S. exporters, farmers, and for the economy, as a whole.  Some areas such as the steel industry cheered the actions as it began to provide protections with domestic steel, producing more jobs. 

Several trade deals have been stuck since this summer.  In July, the European Union struck a deal with the U.S. to avoid a trade war by decreasing tariffs.  The EU will also import more American soybeans and natural gas.  Both sides were also working toward no tariffs, no barriers, and no subsidies on non-auto industrial goods. 

In September, Trump met with South Korean President Moon and finalized a trade agreement with this country.  The deal expands opportunities to export American products in South Korea, including automobiles, medicine, and agricultural products. 

On October 1, the Trump administration announced that the old North American Free Trade Agreement (NAFTA) has now been replaced with a new U.S.-Mexico-Canada (USMCA) trade agreement.  The purpose of this was to benefit American workers and businesses in areas where NAFTA has failed. 

American auto manufacturers and workers will benefit from new rules of origin requiring 75% of auto content to be produced in North America.  Workers will also benefit from the rules that incentivize high-wage manufacturing labor in the auto sector, thus supporting better jobs for American workers.  The USMCA labor section is the strongest labor provisions of any trade agreement.  This is a core part of the agreement and makes labor provisions enforceable. 

NAFTA rules helped incentivize offshoring and took many manufacturing jobs out of the U.S.  USMCA also includes a strong protection and enforcement of intellectual property rights.  It also has a strong measure of digital trade of any agreement. 

Farmers, ranchers, and agribusiness in America will win as the agreement includes provisions that will benefit agri-trade more fairly.  Canada agreed to eliminate its “Class 7” program that allows low-priced dairy ingredients to undersell American dairy products.  Canada also agreed to provide new access for U.S. dairy products, eggs, and poultry. 

So, what is the impact on the farm economy?  Soybeans have shot up nearly 60 cents since their low in mid-September.  Corn prices have rallied by 7%.  Canola has shot up 3%.  Cattle is up by 7.5% since summer.  Milk so far has been flat.  Hogs have shot up 36% but most of this is a result of the recent Hurricane Florence. 

What will be the impact of these agreements?  First, I believe that these will be ratified by the Senate when Trump takes these to Capitol Hill.  Senator Chuck Schumer has already mentioned his interest in a better trade agreement than NAFTA. 

How will these agreements impact commodity prices?  There will be some increase in commodity prices as more fair markets will be open for agriculture.  However, I would not expect a huge increase in prices as better trade agreements do not change the current over-supply situation the world finds itself in. 

For U.S. manufacturers this can be a mixed blessing.  Some raw material prices may increase.  On the other hand, this should increase employment which has currently been at levels not seen since the 1960s.  Fair and favorable trade deals for our country will be a win for all of us. 

A Victory for Main Street Retail

A recent Supreme Court decision in the South Dakota v. Wayfair, Inc. is a possible win for main street brick-and-motor retail, commercial real estate and state and local governments.  In June the Court issued a decision in the case deciding that states have the authority to tax online purchase even if the retailer does not have a presence in the state.  The South Dakota law allows state sales tax to apply to online transactions from retailers with more than 200 annual transactions or $100,000 in sales per year in the state. 

The majority opinion, authored by Justice Kennedy, and joined by justices Alito, Ginsburg, Gorsuch, and Thomas, overturned a 1992 decision in Quill corp. v. North Dakota, requiring retailers to have a physical presence in a state to mandate the collection of state sales taxes on purchases.  When Quill was decided, the Supreme Court was not even addressing online sales, as these were still not even in the mind of most Americans’.  In 1992, less than 2 percent of Americans had internet access and very few could project how quickly our lives would be changed with digital purchases.  The revolution in e-commerce, the challenge by Wayfair, Overstock, and Newegg to the South Dakota law provided a timely opportunity for the court to revisit the physical presence requirements. 

In 1992, Quill exempted merchants from paying sales tax in a state when they did not have a physical location.  The case, addressing mail-order purchases, did not think that sending goods across state lines was significant enough to create a nexus under the Commerce Clause, to allow taxation without a physical location. 

Now in the Wayfair opinion, Kennedy used the example of two different online furniture businesses.  The first one may have a small warehouse in South Dakota with a limited selection of inventory.  A second business, may have a huge warehouse, just over the state line in Nebraska, with a fancy virtual showroom and first-rate online presence. Before this decision, a South Dakota resident would pay sales tax on the first purchase but not the second.  The court found this distinction unfair and not in line with the realities of today’s on-line economy. 

Justice Kennedy noted the physical presence rule “produces an incentive to avoid physical presence in multiple States.  Distortions caused by the desire of businesses to avoid tax collection mean that the market may currently lack storefronts, distribution points, and employment centers that otherwise would be efficient or desirable.”  The distinction created an unfair advantage for online purchases compared to the local storefront which may be already struggling to compete with their digital counterparts. 

Opponents of the decision contend that taxing online sales places an undue burden on small internet retailers, who may struggle to administer tax collection in various locations with different tax state and local tax rates.  The Court’s dissenting opinion argues that Congress should have legislated an appropriate online sales taxation standard and not the judicial branch.  Several bills have been introduced in Congress to address this issue, but none have been enacted. 

The South Dakota law addresses the undue burden concern by exempting small businesses with few sales and transactions from the law.  While software can facilitate gathering sales taxes in multiple jurisdictions, the court agreed the South Dakota law as adequately addressing this logistical burden for small online retailers.  Other states are expected to follow suit, and 20 states have passed legislation requiring only an economic nexus and not a physical presence, to collect sales taxes. 

It is easy to see the favorable possibility of more local sales with this new ruling that attempts to level the playing field between main street and online retailers.  But there is also a big windfall for state and local governments.  A 2016 study from the National Conference of State Legislators in conjunction with the International Council of Shopping Centers, estimates that states lose nearly $26 billion annually in sales tax revenue from remote purchases.  The Court cited a different study estimating closer to $33 billion in lost revenue.  The loss of this revenue could be felt with higher taxes in other areas or a reduced funding for other services provided by governments. 

Another area that is expected to benefit from this ruling is commercial real estate.  Now that the Supreme Court has eliminated the physical presence standard, businesses might be more inclined to open a physical retail location to add to their internet presence.  A decision to close or not to open a physical location in a town may have a large impact on the community.  Not only does the town lose tax revenue, but the lack of local sales may drive retailers out and have empty storefronts, driving down real estate values. 

Jennifer Platt, vice president of Federal Operations for the International Council of Shopping Centers in New York lists two impacts of the ruling to retail.  “First, is the psychological impact on consumers no longer being led to believe that shopping online is tax-free.  Second, is the functional impact on online retailers who have not wanted to create a physical nexus by building out a brick-and-motor presence.  That dynamic has been wiped away with the Wayfair decision.” 

This ruling should provide benefits to local retailers, local and state jurisdictions, and retail commercial real estate.  Hopefully, some of these favorable factors may keep more local retailers open, instead of seeing more businesses dark and boarded up.

View from the Agriculture Class

Last week we hosted our fifth annual agriculture lending class.  This one was in Bismarck and we had 47 students; a new record for us!  The class ranged from field lenders, analysts, and managers.  Experience levels were from brand new to those who can tout decades of agriculture lending experience.  This blog will review some of the highlights we took away from the lenders in the class.

Stress is quite present with the producers in the areas represented in the class.  We hosted students from Montana, the Dakotas, Minnesota, and Wisconsin.  There are producers who have no or very little debt.  The ones which keep our class up at night are those who are highly leveraged for the current prices we are experiencing currently.  The challenges that face producers who have leveraged their operation up with loans on new equipment or land when prices were much higher 4-5 years ago is again taking a toll on the farmer. 

We had several lenders who reported that they are now in the third or fourth year of some carryover debt on the operating lines.  This presents a double challenge with not only having to deal with the financing carryover of the past year and must work on the need to finance this year’s operation.  Some wonder what is the magic formula that can be used to determine when to cut off the producer.  There is no magic formula available and each situation is looked at differently. 

Most students believe we are in the winter season of the ag economy and that we face another 3 years or so of low prices which will weigh heavy on the producers.  Trade issues are on the mind of many as looming trade wars with countries that import U.S. agricultural products are starting to curb their purchases from us.  Some were heartened with the recent one on one work that is being done in negotiating with the Eurozone and Mexico.  Overall, even if trade issues disappear overnight, there is still downward pressure on prices with the oversupply of commodities present in the world. 

Assessing management skills of the producer was a topic mentioned by several lenders.  It seems that there needs to be a method to better understand the ability of the farm borrower these days, especially now that we are facing yet another year of low prices and possible thin margins.  If you understand the skills of those running the farm, you have a better idea of who has the highest probability of succeeding in the present price environment.  We discussed some ideas on how to turn a very subjective rating on the management skills of the farmer into a more detailed quantitative analysis.  The operators who will thrive in this environment are those who can win at the 5% rule.  They can find ways to increase their production or get a better price by 5% and find methods to decrease their costs by 5% compared to their neighbors. 

Some lenders spoke about the risks of generational changes in the farm.  Some aging producers do not have a solid plan on how the farm will continue when they decide to retire.  Plans seem to be in the head of the producer and are not written down.  These are also not reviewed by their accountant and attorney for any tax issues. 

Divorce is probably the biggest risk to upset the family farm.  Lenders spoke of the necessity to understand which role each spouse plays in the operation.  If marital problems appear and the wife is the manager of the operation while the husband is the tractor driver and field worker, you will end up lending differently to the remaining spouse if you are working with the manager compared to the laborer. 

Some in the group who had experienced the ag crisis of the early 1980’s commented on the differences today compared to then.  Farmers overall tend to be less leveraged today.  There is more discipline regarding financing reporting and better overall understanding of the producers in how finances play a role in the farm operation. 

One of the biggest challenges is the marketing plan of the producer or how the farmer decides to sell his product.  Too many farmers have grown a crop and had a large portion of this exposed to market prices without any sort of contracting, price protection insurance, or commodity market hedging.  One dire situation this year is for North Dakota soybean producers.  It has been reported that elevators are only going to take the crop that they have already contracted for and are not taking any additional crop.  So, the soybean farmer who is exposed to the market will have to deal with storage costs, shrinkage, and further price exposure as they hope to have this year’s crop sold middle to late 2019.

We expanded our office space and added a conference room that we did not have before.  This allows us to have small classes on business or agricultural lending that we had no place to host before.  If you have some interest in making a trip to the Black Hills this fall for some quality commercial education as you enjoy some of the sights of the area, please reach out and let us know. 

Financial Stress Management

During a time of financial stress for a business, it is often hard to determine what the problem actually is, and what the proper strategy that can be implemented to reduce the stress.  What makes this even more challenging is that there is no one-size fits all solution that will positively change each incident of financial stress. 

The first step when a company has a loss is to divide the costs associated with generating revenue into fixed and variable costs.  Fixed costs remain the same no matter how many items are produced or sold.  In a business some examples of fixed costs would be rent, salary levels required to keep the doors open, and utilities.  Variable costs change with sales or production.  Examples of variable costs would be supplies, raw materials, and wages that are based upon production.  Charting the revenue line against the fixed and variable costs provides a useful picture of what is happening in the company and what may be a proper strategy.

I once had some used car dealers financed who were successful until the “cash for clunkers” program hit a few years back.  Sales plummeted for both dealers; one dropped much lower than the other dealer due to the rural market they were located.  In fact, revenues dropped to under 50% of fixed costs for the next six months.  In this case the first strategy was to reduce fixed costs or for the sponsor to have a large pile of cash personally to fund losses.  Since the second option was not available, the business owner shut down two locations and consolidated all lots into one location.  This saved additional costs of rent, utilities, and some management staff at the closed locations. 

A contractor I worked was saddled with a couple of years of losses from failed subdivisions after the crash in 2008.  Their situation was not as dire as the car dealer as they were close to being profitable but were not quite there.  Their strategy involved changing their pricing of their work after they studied what a minimum profit margin would need to be in order to be above breakeven.  This increase lowered the revenue but made each revenue dollar more profitable.  They also decided to sell a marginally profitable line of business and use the funds to reduce debt and lower fixed costs.  These two strategies together made a huge difference in the performance of the firm.  It also shows that at times, more than one strategy is needed to manage the financial stress. 

At times, the answer to financial stress lies in better management of variable costs or just increasing production.  A small fragrance manufacturer was bouncing between a small profit and small loss for several years.  Their solution was two-fold. First, they discovered that the containers they were packing the product in, could be outsourced to another manufacturer at a 33% cost reduction than their in-house costs.  This created a large reduction in variable costs with the removal of this production line.  They even reduced some fixed costs by selling some machinery that was used to create the containers. 

The company did not want to reduce staff, so they switched the staff working on the containers to producing more fragrances.  This increased throughput, combined with lower variable costs, caused profits to soar.  In this case, the answer to leaving the financial doldrums was selling assets to lower fixed costs, reducing variable costs, and increasing production.

A normal operating corridor for a business is when each dollar of revenue is able to produce some cents for profit, and also taking care of fixed and variable costs associated to generate that dollar.  In the case of a business that is operating above breakeven, the answer to raise profitability is to increase sales. Each new dollar will increase profits and will tend to increase profits at a larger rate with fixed costs staying the same. 

When a company is in financial stress, once you determine the various fixed and variable costs of revenue, there are several answers to alleviating the pressure.  This may involve reducing fixed costs by asset sales, refinancing, or reducing fixed staff.  It may also involve increasing profits by better pricing, reducing variable costs, or increasing the output.  It may also require multiple strategies to achieve success.  It is important to understand what strategy to take and what is the end goal of the action.

Judging Repayment Capacity for Agricultural Borrowers

Years ago, when I was a young commercial lender, still wet behind the ears, I learned how to judge if a borrower has the ability to repay the loan.  This was by using the debt service coverage ratio (DSCR) calculation.  Basically, this takes gross income and deducts all operating expenses to reach a net operating income line.  This amount is divided by the annual debt service requirements to get a ratio.  If the ratio is at 1:1 then the business just makes enough money to pay all operating expenses and debt payments but has nothing else left over for owner payments or capital improvements.

Once I learned this, I thought I had found the holy grail of lending!

But just like the cave began to crumble around Indiana Jones when he picked up the sacred cup, I soon found times when my analysis would crumble around me if I was to base my review upon the DSCR.  One area where this really comes to light is with agricultural lending, especially when the producer is providing cash-based income statements. 

Consider the issues of the timing of when crop is raised compared to when it is sold and when cash is received.  I once had a potato farmer who showed massive cash losses in his tax return.  This was enough to raise the hair on the back of your neck, until I learned that a large payment for that year’s crop by Frito-Lay was not received until the following year.  When the financials were adjusted from a cash to an accrual basis, they easily met our DSCR standard.

Another issue is when a rancher increases his cash income by selling breeding stock.  One cow-calf operator usually ran 100 heifers as breeding stock.  One year we saw a spike in cash income which looked great until we discovered that they now had only 59 heifers instead of the usual 100.  Now their ability to keep production at previous year’s levels was in question. 

Other factors are when expenses are prepaid for future years or may be incurred but not paid until another period.  This also must be watched for supplies and inventory levels.  Any expansion or contraction on these away from previous year’s levels may skew the cash, based borrower’s income statement, and thus your analysis.

This is one of the topics that we will be covering in our upcoming class on September 19-20 in Bismarck.  Sign up today as our class is filling up fast!

The Importance of Assessing Farm Management

Five years ago, the farm economy looked much different.  Prices for wheat exceeded $8/bushel.  Corn prices were near $7/bushel.  New calves are at $200/cwt.  It looked as though prices would continue to increase for years to come.  Producers were looking for ways to expand their farms, purchase more and better equipment, and expand their herd. 

Fast forward to today.  We are now 4-5 years into the commodity super cycle turning from the past years of the peak.  We may have another 4-5 years in this portion of the cycle before commodity prices turn up.  Lenders are dealing with producers who cannot pay off their operating lines.  Perhaps this has now happened 3-4 times.  Some farmers are contemplating if they should consider leaving the industry and some lenders are wondering if they will ever be paid off. 

We are at a time in the cycle when a proper assessment of producer management is essential to understanding which borrowers are the ones you want to stick with and which ones you need to take a different approach.  A good economy can hide a multitude of management errors.  A producer lacking management skills will tend to see larger losses and bigger problems in bad agriculture times. 

There are four areas that I suggest agricultural management be looked at.  I will touch on these in this blog but note that we will go more in detail in our Managing the Agriculture Loan in Good Times and Bad class.  We are holding this in Bismarck on September 19 and 20.  You need to contact us to get signed up.

The first area is financial management.  One of the best questions to ask is if the producer truly understands his cost of production.  What is even more impressive is if this is written down or on computer, and if this is also divided up by each crop or ag enterprise.  If your producer does not truly understand this, how will you the lender understand?  Also, if they have no idea on their costs, why would you want to lend with them?  A borrower with a strong, written command of their input costs will outperform the farmer who is winging it.

Another one of the eight financial factors we have deals with capital spending.  Does your producer have a capital spending plan?  How many years out does it cover?  Is the budget geared toward increasing the farm efficiency and income or is it based around shiny new iron in the barn?  Is the budget followed? 

The second area of management is production.  If you have a farmer, how does his production per acre compare with the county averages?   How does the rancher’s herd in sale weights compare to peers?  Is there a pride of ownership with the farm?  Is the farm well-kept or does it look like a junkyard? 

The third area is marketing and risk management.  One of the most important factors here is if there is a solid marketing plan that is written and executed.  Is there a plan that may involve forward contracting or hedging to secure prices or are the prices solely at the whim of the market?  We all have seen some clients who refuse to sell crop in hope of a better price in the future with no solid plan.  All this revolves around is a wish. 

The fourth area, I title as other factors.  One of these factors is a transition plan.  What plan does the farmer have for the next generation?  Is this plan well developed with key advisors like attorneys, accountants, and lenders?  What key skills are needed to keep the farm successful in the next generation?  Is there a plan to make sure these skills and resources are available to the next generation?

These questions are some that are key to understanding the management skills of your producer.  This is perhaps one of the most important time in the farm cycle to be accurate on how well the producer will be able to improve their current condition.  We will be reviewing these factors in our class in our section to assess agricultural management.  We look forward to seeing you in Bismarck.  Use this link to get more info and to sign up.