In Search of Normal

I have three different sports apps on my smartphone.  Normally, at this time of the year, I am checking NCAA basketball scores, getting updates from spring training with my beloved St. Louis Cardinals, and catching up with hockey games.  Now the only news on my apps are NFL trade rumors and notices that all sports seasons are on hold.  At this point one wonders if the football season will actually kick off later this year.

A week ago, I would have not thought twice about going out to a restaurant.  The only question would be what my family and I felt like eating.  This weekend, the planning went to give preference with smaller restaurants, where less than 50 people would be at based upon the recommendations of the CDC.  Last night, any dining decisions are based upon what drive through is open or what groceries we have on hand.  Several states and cities are now shutting down restaurants, gyms, bars, movie theaters, and non-essential events.  President Trump has stated that the next 15 days are key for us to get a hold of the virus by social distancing, washing hands, and staying at home. 

The strategy to combat plagues or viruses has not changed over the centuries.  Today we are told to avoid crowds, stay at home, stay out of the bars and restaurants, and stop public sporting events.  Daniel Defoe wrote a diary of the 1665 plague in London.  Then the solution was to have people stay home, shut down all the public entertainment, close down the pubs, and stop the main sport of the day—bear baiting!

It is amazing how what we normally expect has changed so much in just a few weeks.  We also now expect what normal has changed to today, to be possibly quite different tomorrow.  We may see all non-essential businesses and government agencies which would be shut down as people are told to shelter in place.  It may be easier to adjust some areas of our business for people to continue to be productive as they work from home in a way to avoid the virus. 

As much as a problem of the virus, a possible greater impact is with the economy.  Allow many service workers to stay home from jobs in the service industry and possibly millions of people will be unemployed.  Wall Street is feeling the pain with nearly a third of the value of the DJIA being erased in a few weeks.  Every major bank that had a stock buy-back strategy, cancelled the program.  This was after the Fed dropped rates substantially twice in March and also injected massive amount of money into the economy by buying government bonds. 

There are storm clouds appearing on the horizon and the question is what do we do now?  The writer of Proverbs tells us that “The prudent sees danger and hides himself, but the simple go on and suffer for it.”  To be prudent, the first thing we need to do is not deny the situation.  Today, that could be if we believe that the virus will not impact the economy, our members, or business model, would be a form of denial.  We really don’t know what will happen, but we do know the impact will be great. 

Note the simple also continue on the same path when danger is present.  It seems that this is without any consideration of the danger or risk.  There will be some cases when you assess the danger and stay on the same course, but you must review the current situation and see if any changes should be made.  The management principal of the OODA loop (observe, orient, decide, act, repeat) is applicable here. 

Based upon what I observe today, what are some possible actions to consider?  First, you should divide up your portfolio and identify those commercial or agricultural borrowers who are at the highest risk.  Go beyond the primary business as well.  You may not have a loan on a restaurant, but you may have a loan on the real estate retail center where the restaurant is a tenant.  In either case, there will be a huge drop in revenues and your payments are more at risk today than they were two weeks ago.  In California, the governor has stopped any evictions of tenants until the end of May.  If you have a loan on an apartment complex, the owner may see a drop in rental income which may impact his ability to pay.  Perhaps approaching your borrowers and suggesting a few months of interest only payments to the loan may be prudent. 

Consider areas where you need to change how you view risk among certain industries when underwriting.  Projects that are more speculative may be better to pass on or require a lot more equity or stronger sponsors to reduce the risk.  If there are other ways you can strengthen the credit, consider doing this today.

In every trouble there is always some opportunity.  Look for ways to help strong borrowers who may be left behind by other lenders who drop out of the market.  This may be a good time to approach some of the desired clients in your community that you have not been able to establish a relationship with, in the past.  People remember those who come around when everyone else is staying put.

Review your pricing at this time.  Yes, your cost of funds may be miniscule as the treasury market is very low.  But unless you can off-load the interest rate risk, you still need to have a fair rate that keeps you operational.  Realize that what your client tells you he was offered from the bank down the street, may not be available to them today when they are talking to you. 

Don’t be afraid to make plans in light of the current situation.  True, some of your plans may be different than they were a month ago, and your plans may also require that you make adjustments as time passes.  Consider new strategies and regularly assess the results of those actions.  Ask where your institution should invest funds and other resources in and do not be afraid to act.   As you move forward with your plans, you will begin to find a new normal that you control. 

What Else Can Change with Recent World Events? Consider Your Loan Portfolio

This morning as I write, major world events swirl around.  The Coronavirus’ impact seems to grow at exponential rates.  Yesterday, Italy decided to lock down their entire country and this morning was providing relief for those with mortgage payments.  I have friends who were to travel to Israel yesterday whose trip was cancelled with the new quarantine there.  The news is flooded with various health tips and suggested restrictions on travel, self-imposed or other-imposed quarantines, and suggestions to weather business disruptions.  Even a shopping trip this weekend in an area of the country that does not have one reported case, yet, revealed a run on various staple items, cleaning supplies, and sanitizer.  As a business, if you have not had a conversation on how you can operate with most of your employees at home, you better plan for this possibility.

Then on Sunday, we saw the world oil markets collapse over a dispute between Saudi Arabia and Russia on production limits.  The Saudis opened the spigots and we witnessed one of the largest drops in oil prices in a day in history.  We also saw the biggest point drop in the DJIA on Monday, falling over 2,000 points throughout the day.  The cattle and grain markets are showing substantial downward trends.  Consider what also is happening to the bond market.  The 30-year US Treasury opened and closed below 1% yesterday.  This has never happened in history!  This also is a major drop from the already low rate of 2.33% at the first of the year and shows just how fast markets can move. 

Time will only tell if the events we see now are a short term dip and things will bounce back to a more normal range, or if we are in a large crater which will take a long time to return to rates closer to what we thought as normal at the first of the year.  In any case, consider other things which could disappear: your net interest margin and  good commercial loans.

If you have not had borrowers request lower interest rates on their loans, expect it to happen soon.  We have been fielding requests on both performing and also non-performing loans to drop their rate to match what is happening in the market.  (It is interesting that the lender is not expected to go to the borrower and ask to raise their fixed rate when the market swings the other way!)  Commercial real estate conduit loans for office, retail, or industrial properties are priced at a margin of 140 to 290 bps over the 10-year SWAP or US Treasury.  With the current market, this would result in rates from 2.21% to 3.71% locked for 10 years to the borrower.  We don’t have many in the credit union and banking world who want to play in that rate sandbox, yet. 

This can make the most attractive loans in terms of performance and low risk in your portfolio, vulnerable to the refinance risk with another institution.  On the credit union side, this risk is more pronounced as there are very little prepayment penalties on loans—federally chartered CUs, by law,  can only charge these on a government guaranteed loan that allows for these, and generally these are extremely rare in the industry anyway—and there is very little use of interest rate swaps or caps to protect the interest rate margin of the lender.  Overall this law and industry practice has left institutions’ balance sheets in a very unstable position at times like this. 

As you look at new requests and protecting your lending assets, consideration should be given to the property type.  Multi-family lending is in very high demand, so good apartment loans may see spreads 10 bps lower.  Hospitality loans tend to start at 50 bps higher.  Also, the market will take a higher LTV on an apartment or office with strong credit tenant while wanting a lower LTV for properties which are riskier.  Multi-family may get you into the 75-80% range, while a hotel or property with riskier tenants may be closer to 65%.

Another risk to the lender is to rely on debt service coverage ratios at this time in underwriting.  With rates as low as they are, when you use a market rate, it is very easy for anyone to hit the 1.25 or higher threshold.  But if you leverage a deal at 4% for 5 years up to a level that matches a 1.25 threshold, if the rates rise higher after the five years and the performance has not improved, then you may have an underperforming credit.  One option is to underwrite the credit using a phantom rate.  An example of this may be 6.5% or 7% today as you properly size the debt.

When rates are this low, conduit lenders tend to throw the DSCR out the window and use a calculation called the debt yield.  This takes the net operating income divided by the loan amount.  What this tells the lender is if he is able to operate the real estate just as the borrower has operated it, this is the rate of return expected on the amount of debt.  The debt yield threshold will be lower on multifamily and office with a good credit tenant and higher on properties with weaker tenants or hotels.  Note that debt yield takes out the cap rate to figure a value for the property.  It also takes out the interest rate or amortization on the lender’s loan.  It only looks at how large the loan is compared to the NOI.  Astute commercial lenders want to make sure that low rates, low cap rates, and high leverage never push real estate valuations sky high and create another lending bubble. 

What is an appropriate debt yield?  I would start with something in the 9-10% range.  Some lenders will go to the lower end of the range or maybe even as low as 8% on very high-quality loans.  Loans in smaller rural areas or those with a higher risk profile will have a higher debt yield. 

At times like this, it is important to view the landscape and make wise lending decisions.  It is not a time to give away the store and you may have to let some credits go.  Hopefully, there are others out there who will take your riskier deals.  Perhaps when all the dust settles, you have a portfolio that is stronger.

Failure is Not Final

It was late in the year 1879.  A young man and his team huddled in a laboratory which they had spent nearly two years experimenting on the same invention.  The leader of the team may have been thought of as a failure compared to many others in his day.  Concerning education, other than being mostly self-taught,  he only had three formal years of school as a child and some classes in chemistry at New York City’s Cooper Union.  As a child, he was hyperactive, prone to distraction, and deemed difficult to be taught.  One of his teachers said he was “too stupid to learn anything.”

In the workforce, he was fired from his first two jobs for being “non-productive”.  As an inventor, he had a string of products that cost much precious time and money to create but were flops.  Among these were the automatic vote recorder, the electric pen, the home projecting kinetoscope, and ore mills and separators.  When asked by a reporter midway through this present development process as to what he received from the multiple failed attempts he replied, “Results!  Why, I have gotten a lot of results.  I know several thousand things that won’t work!” 

The invention the team pursued also had been worked on by various scientists for over 40 years up to this point.  Scientists knew that electric light was possible with an arc lamp. But all attempts proved to have extremely short lifespans or were too expensive to produce.  In October 1879, the boy who was branded a failure took a carbonized filament of uncoated cotton thread and created a light bulb that lasted 14 ½ hours.  Early the next year, Thomas Edison created a filament from bamboo fiber that gave Edison lamps a life of up to 1,200 hours.  Patent number 223,898 would forever change what we mean when we say, “turn the light on.” 

History is full of people who have failed and have started over again.  Abraham Lincoln lost every political race he ran with the exception of when he was elected president.  Imagine what would have happened if he would have quit prior to the last election.  Henry Ford went bankrupt five times before he built the Model T.  What would have happened if he hung it up after the fifth bankruptcy?  Babe Ruth amassed hundreds more strikeouts than he did home runs in his career. Do we look at his career as a failure because of this?  Winston Churchill was kicked out of his own political party and considered a pariah before he was the prime minister who lead England through World War II.  He was the only sound voice that kept the people of Britain inspired to continue to fight in the face of Nazi oppression. Michael Jordan missed over 9,000 shots and lost 300 games in his career.  Yet many consider him one of the greatest to play the game.

Failure can be our best teacher, if we let it.  We must face the reality and reasons behind our failure.   Athletes who are at the top of their game have coaches who help them identify where their failures are and make then make changes to address those.  Thomas Edison kept thousands of detailed records of his experiments and would often go back to them to see what things did not work.  This gives you a closer path to what will work. 

Another thing to consider is what we may think of success may actually be failure in other areas.  Consider the successful businessman who has sacrificed his family on the altar of accomplishment.  Another example is Kenneth Lay.  He ran the once successful company Enron but proved to be without a moral compass and was convicted on six counts of fraud.  Sometimes success may seem wonderful on the outside but is built upon internal failure which we cannot see. 

A problem we have with failure is that we hang a label around the neck of those who have failed as failures.  Zig Ziglar reminds us that, “Failure is an event, not a person.”  When we fail, some of us tend to wallow in self-pity than rise up and start again.  When we see others who we think are failures, some of us tend to judge those folks form our own self-righteous position.  Perhaps we do this to make ourselves feel better and ignore our own shortcomings.  But allowing ourselves to be a judger, jury, and executioner of another’s worth and character places us in a position that no human is qualified to perform.

Keeping failures as events in our lives and recognizing failure as an event in the lives of others  is a key step.  Next we assess what happened and adjust as needed.  Finally, rising from the dirt and trying again is the only way true success occurs.  After all, the expert, is only the person who has failed a lot and yet just continued to try and endure.  The first step on the journey to success is to take the first step for you will always fail at what you do not try.

Post-Closing Follow Up for Commercial Construction Loans

Once a construction loan is closed and the mortgages are filed, part of the lender’s due diligence has ended but an entirely new part of lender work has just started.  This adds a new layer of work for the lender, that if not followed, could result in a serious loss to the lender and pain to all those involved.

But first, we move back in time prior to our closing of the construction loan.  The lender should have received the complete set of plans prior to closing, or at least prior to the first draw request that will occur after closing.  The plans should be accompanied with a budget divided among the various divisions of construction as established by the American Institute of Architects.  The contract should be inspected with vetting of the general contractor and obtaining any necessary bonding, workers comp, liability insurances required for the project.  Any necessary permits should also be provided to the lender for the file. 

A qualified third party, like an architect or engineer the lender employs, should be hired to review the budget and also provide periodic inspections during the construction period to verify the funds spent are actually spent in this project.  I once had a house construction years ago that we had nearly 70% of the funds from the loan out when the project only had the foundation and first floor framing complete.  Your architect should also provide a judgement with each progress inspection,  if there are adequate funds remaining in the construction budget to complete the project. 

The title company should also provide survey coverage, verifying that the building is set on the actual lot which you have as collateral.  I once knew of a prominent realtor in a community who built his house over a property line boundary with his neighbor.  What a mess that was to fix!  The title company should also be lined up to handle disbursements and to provide a date down and lien search with each construction draw to make sure no supplier or labor liens are present.  In some states, these builder liens take precedent over the lender’s previously filed mortgage or deed of trust.  The title company should also oversee the lien waiver process and make sure that adequate lien waivers are executed and in their file. 

So fast forward to after closing when you are in the throes of the construction process.  Many of the commercial construction projects may require additional money to be put in from the borrower prior to the construction draw money from the lender.  This equity should be tracked and run through the title company, just like any other draw funds that the lender would provide.

In addition to each draw being run through a title company to make sure no liens have arisen; each draw should be monitored by your third-party inspection.  The inspection should also contain multiple picture of the property and a detailed inspection of the draw, funds spent to date, and funds remaining as lined up with the original budget.  Explanations of any change orders and the cost impact should be provided.  At times, these may require the borrower to bring additional equity into the project.  The worst case is when the borrower is out of resources and additional lending funds must be obtained to complete the project. 

Now there are some lenders who want to take on these roles that I suggest being completed by the title company and architect.  While a field lender may be fine in overseeing a small construction loan, larger, and complex commercial loans should utilize competent third parties for inspection, title work, and disbursements, unless the lender has a dedicated staff who can handle these duties.  Yes, there is a cost for these services, and this should be passed on to the borrower.  This is just part of the cost of doing business. 

Utilizing an outside architect should not be an excuse for the lender to not visit the project.  Borrowers love showing off what they are building.  A few inspections of the site with the borrower often yields invaluable insight into your client. 

Prior to the final draw, the lender should be provided the certificate of completion or occupancy for the project, and any business licenses for the company, if needed.  If the project is completed in the winter, this may be a temporary certificate in nature, often with the requirement of certain landscaping to be completed prior to the final certificate.  Any temporary certificate should be understood for what items are required for completion in the eyes of the jurisdiction, and, if necessary, funds should be held in escrow with the title company.  The amounts for any disputed bills with the contractor should also be held at the title company in escrow,  so you can obtain a title policy with all builder’s or mechanic’s lien coverages for your institution. 

Any commercial construction loan requires much work in monitoring prior to closing and during the construction process which requires the lender to adhere to best practices in proper management of the loan.  Deviations from these may expose the lender to additional risk.  If you need help, contact us.  We manage construction loans and can help.

Audit Committee Miscues on Third Party Loan Reviews

The audit committee of a credit union serves an important function of oversight.  In September 2019, the NCUA approved new guidelines in amending Part 715 governing the responsibilities of a federally insured credit union to obtain an annual supervisory committee audit for the institution.  These committees often employ different external or internal third parties to perform these functions. 

Many of these committees only interact with a third-party loan review company when they hire the company and when the report is delivered.  This weak audit committee oversight can lead to a significant amount of money spent on a report with little to show for it other than fulfilling one of the items on the examiners’ check list.

One symptom of this is allowing the third-party vendor to drive the loan review bus.  This starts with employing a vendor with no specified contract or a rather vague contract or maybe no contact at all.  The end result is the report matches the original goals the credit union had, since they had none at all!  It is important the committee have strong input on the scope of service they want to receive from the firm they hire.

Another issue is when unqualified internal staff are used to complete a third-party credit risk advisory review.  We once worked with an institution who used an internal auditor to complete a review of the risk of a handful of commercial credits.  The worker only completed audit work as a portion of her job function and also had no training in commercial credit.  The review ended up recounting consumer lending laws and how many of them were not followed for the commercial loans.  Also, the reviewer used various consumer lending ratios and guidelines when judging the risk in the commercial credit.  Consequently, the entire review was worthless and a waste of staff time to the CU.

Using a generic as compared to a risk-based approach for the review is another common shortcoming.  One institution called me about a third party review they received which the company took a sampling of various loans randomly and attempted to form overall opinions on the condition of the credit department.  The problem came with the random samples.  The CU had over 60% of their business portfolio in agricultural credits and another 20% in small business C&I lending.  Not one credit in either of these areas was pulled for review, so there was no inspection of the areas with the highest possible risk since they were the most active lines of business. 

The audit committee not asking tough questions during a review is also a shortcoming.  We have seen too many reviews completed which were blindly accepted by the audit committee without any serious questions asked to the vendor.  There are often some items in the review that individual committee members failed to understand, yet they kept silent during the presentation to their group by the vendor.  This dovetails into another quandary; do you have competent people on the committee to judge if your commercial staff is doing their job correctly?   Placing someone on that committee who has no business background or lending acumen is a sure bet to not receive the true value you desire. 

The final shortcoming to avoid is to only hire a third-party review just to fulfill the expectations of the regulators.  I know that some actions we complete in an institution is to keep the regulators happy.  The problem with only getting a third-party review to check the box is that there is considerable cost in this function and there is so much value available in a good review to help the institution understand their current status and also point a path toward future growth. 

Good reviews should identify systemic strengths and weaknesses in the institution now.  This should cover areas of credit risk analysis, policy review, staffing, technology, underwriting, file management, problem loan administration, and business line growth, to name a few.  The best reviews should offer actionable steps to make marked improvements in each area, improvements that either correct weaknesses in the department or build further on strengths that are already evident. 

These reviews can provide wonderful insight to improve and grow, yet many of these fall far short.  Much of this comes from the audit committee failing to do their job in selection, contract negotiation, and oversight into the process.  These shortcomings can be overcome, and good value can be achieved with these third-party reviews.  If you have questions, contact us and we can help!

Turning Your Third-Party Credit Risk Review into a Touchdown

As I write today, we are only two days removed from the tremendous victory of the Kansas City Chiefs in the Superbowl!  As a Missouri boy, this is such a tremendous accomplishment that is 50 years in the making.  My family and friends from the area had such excitement over the game!

This week our team completed a wrap up of a third-party credit risk review for a CU in the Midwest.  In our wrap up session, they cited several actions we completed that really made our work a scoring play in their eyes.  I thought this blog would be valuable to touch on a few of these items.

You see, many third-party credit reviews are a high expense to the institution.  Sometimes the money is spent on a file that is thrown into a file drawer just to be drawn out at exam or audit time.  The quality of many reviews is lacking as the worker may be only copying your data into their spreadsheet or program to compare their risk they find in the loan with what you say.  This may provide no actionable intel for how to properly assess and improve their department.  This is a sure way to fumble a lot of money and have no return on the expense.

They also may not test your systems.  As an example, I once saw a risk rating model that would still give a pass grade even if you took the debt service coverage ratio to zero.  The model had so much weight on collateral that it could not be broken.  This grossly understated the risk in the portfolio.

So back to our CU, when asked about what features we completed gave the most value to them, they listed several.  The first was an accurate assessment of the overall good and bad of their department’s credit management skills.  Multiple reviewed files reveal overall trends which can then show where the institution needs to improve.  The institution may have messed up on an individual file, but if this trend is not repeated over and over, it is truly an exception to their normal actions.  Figuring out how to improve the basic blocking and tackling skills of the group from where they are today is huge. 

Next is identifying missing training areas which need to be addressed.  Deficiencies can point to areas of ignorance or blind spots.  Strengths can show areas that they need to continue to go to the next level.  In either case, we identified areas of training and provided them with a day of training that was customized to their group.

The group liked our analysis on their staff set up and how they could improve in the future.  The group had two senior loan officers who were only a few years from retirement and had not started a mentoring program to bring younger officers up to speed.  This strategy could help avoid disruption or using a costly headhunter to land a person to move into the area. 

The biggest feature they liked was the Gantt chart we helped them create to identify areas they needed to improve, set individuals or teams who are primarily and secondarily responsible for completing the tasks and also setting up target dates for completion of each task.  Items on the chart of cause and effect were mentioned (for example, item G can’t be started until A and B are completed).  This management tool provided them with a game plan to go forward to improve their shop overall. 

All these are some features of credit risk advisory services which can score a touchdown compared to those who fumble.  Contact us if you are considering needing credit risk advisory services or a third-party loan review.  We look forward to creating a customized plan for you!

Common Shortcomings of Outsourced Risk Review

So, you have finally hired a company to provide an outside review of your credit department and all is wonderful!  Right?  Nothing now to worry about?  You can set back and coast as yet, another item is checked off the list in preparation of your upcoming exam! 

Perhaps.  But there are several possible pitfalls that an outsourced credit risk assessment can hit which derail the possible usefulness of such a study.  Avoidance of these can make the returns you will see on the outside review more effective.  After all, who wants to waste money?

The first assumption is not defining the value you want to receive.  If you desire to spend tens of thousands of dollars to receive a report that is tossed in the cabinet and only pulled out when the regulators show up, then you do not need to read the rest of this blog.  An outside credit review gives you a different prospective on how your shop operates which often can help you see strengths and weaknesses more clearly.  A good definition of the take-a-ways you want to receive from the process and final report is essential.  Some of these to consider are:  clear definition of risk deficiencies; actionable plan to correct problems and/or improve on strengths; opinions on staffing, technologies and other tools used every day in the department; and either education on sound credit or issues that your team should be educated on to make you better. 

The objectives should be defined clearly in a contract that defines the scope of services, cost, time frame, and deliverables.  This is the second pitfall, when the engagement contract is lacking.  I know of one bank who hired a credit risk review (CRR) company based on a contract that only stated the number of files they would review, the date, and the costs.  There was no clarity of what else would be reviewed, how opinions would be formed, or the ending deliverables.  Ultimately, you want this to be a tool which you can use to make your institution better.

Just because you hire someone, does not mean you will receive value.  Good vendors are moving away from a focus on file coverage numbers to a risk-based approach.  The latter focuses over depth of analysis to form sound opinions as opposed to checking off a review of 5-10 files per day per reviewer.  The approach should not be a one-sized-fits-all approach.  I once visited folks in a bank who specialized in tractor-trailer financing.  They built much of their portfolio around properly assessing and managing the credits in this area.  An examiner who does not dive deep into their management practices may just conclude that they lend to a risky segment of the economy with a high concentration in that area.  Yet, they consistently had delinquency and charge offs at levels below other peers in the area.

The actual report you receive can be a pitfall.  If the report is generic in nature and does not have properly supported systemic conclusions or if there is not a thorough analysis on items like appraisal management, documentation processes, credit analysis, underwriting, officer supervision, file documentation, and risk migration, then it lacks usefulness for use as a tool to grow on.  Some reviewers spend all their time transposing data like financial statements or loan data into vendor software, charge you for this, and then present this back to you as the meat of the report without any other actionable items.

Another pitfall can come when there is weak audit committee oversight into the process.  Now in many smaller credit unions and community banks, the competency of the audit committee is limited and is often below that of the credit department.  In a perfect world, there would be strong board, strong audit committee, and strong credit management.  But no matter, the vendor cannot fully drive the bus on the review.  Nor can this be left to unqualified internal staff who may be shuttled over to the credit review function just to allow them to complete their 40 hours each week. 

The wheels can come off with a review which is too easy and does not ask the hard questions of “why”.  Sometimes this must be asked several layers deep in order to come to the root issues.  A reviewer who only swims on the surface will often miss the root issues that the institution needs to understand.  There is no value in that.

A final pitfall is to have a review completed and have not one actionable item for improvement that you can implement.  Each review we have had I find at least five and maybe ten or more items which are then loaded into a Gantt Chart and set to be reviewed with the lending team. These changes not only helped up to be better at credit, but they also changed some of the fundamental ways we transact business to improve profitability.

The CRR can be so much more than something in a file cabinet.  Good ones are tools that actually make you better.   If you have questions on your current external or internal auditing process and want a fresh set of eyes to review, contact us.  If you need a third-party review, we offer those services in our Credit Risk Advisory Department.

2020 NCUA Examiner Focuses

The NCUA has released its examiner guide on January 8,  2020 which shows the priorities its examiners will focus on in 2020 for Supervisory Committee Audits and Minimum Procedures.  The entire guide can be found here:  https://www.ncua.gov/files/publications/guides-manuals/2020-supervisory-committee-audit-guide.pdf   Some of the details of the various hot topics for Supervisory Committee Audits and also for areas where CU examiners will focus on are as follows.  Note I will spend more time on the lending side.

Bank Secrecy Act and anti-money-laundering compliance:  Examiners will conduct a BSA/AML review during the exams.  There will be a focus on customer due diligence and beneficial ownership requirements that started May 11, 2018.  They will also look at the appropriate filing of SARs and CTRs.

Consumer Financial Protection:  Examiners will review compliance with the Electronic Funds Transfer Act (Regulation E), error resolution procedures; Fair Credit Reporting Act (FCRA), reviewing credit reporting procedures; Small dollar and payday alternative lending, including compliance with NCUA Payday Alternative Lending (PALs) rules; Truth in Lending Act (Regulation Z); Military Lending Act (MLA) and Serviceman Civil Relief Act (SCRA).

Cybersecurity:  The agency’s new security review program called the “Automated Cybersecurity Examination Tool (ACET)” will be in force this year.  This allows CUs to do a self-assessment through access to the program on the agency’s website early in the year. 

Loan Reconciliations:  As common with most exams, there will be a focus on the loan trail balance and subsidiary ledgers to insure their accuracy and that they are reconciled correctly to the general ledger.  Accrued interest receivable will also be reviewed. 

Loan Approvals and Processing:  Review a sample of at least 25 approved loans in the testing period.  This should be selected in proportion to the types of loans granted during the period.  A review should be done on the underwriting, supporting documents, and list any exceptions.  Loan functions of approval, disbursement, and processing should have a separation of duties among different workers.  All loan terms should on the closing documents should be compared with what was approved.  Approvals should be documented according to loan policy and exceptions mentioned where applicable.  Collateral perfection will be inspected.  The fair market value of the collateral will be reviewed to make sure it falls within CU guidelines.

Loan File Maintenance:  Obtain the list of individuals who have authority to approve loans, process loans, and complete file maintenance.  Are file maintenance items being reviewed by a different individual than those initiating the transaction?  Review at least 15 days of file maintenance change reports to verify the modification, extension, proper review, and accurate input on the system. 

Loan Delinquencies:  Look at two months of delinquency reports to identify a selected number of loans that appear on the delinquency reports.  Inspect charge offs, refinanced delinquent loans, and those which have had payments made on the loans. 

Charge Off Loans:  A review of the Board approved written charge off policy will be inspected and this will be reviewed compared to the actual practices of charge off and recovery of loans. 

Allowance for Loan and Lease Losses (ALLL):  The examiners will review ALLL policy and the actual practices of the reserve calculation considering all loan charge-offs and recoveries, management support of the ALLL calculation, testing of all schedules to insure mathematical accuracy and logical support of the ALLL methodology.  There will also be discussions on the upcoming Current Expected Credit Losses (CECL) in 2023 to see what work CUs are doing now to prepare to implement the new Financial Accounting Standards Board (FASB) standards.  Each institution should be making some steps now in preparation of these future changes. 

Control over Employee and Official (related party) Accounts:  Any special interest rates for employees, delinquent employee loans, reversed fees on employee loans, loans approved with terms not in line with board policy, and loans to officials in excess of $20,000 in aggregate will be subject to be reviewed. 

London Interbank Offered Rate (LIBOR) interest rate benchmark transition:  Examiners will look at a CU’s exposure and planning with the future discontinuance of LIBOR in 2021.  This will include loans, LIBOR related transactions on and off-balance sheet exposures, planning, governance, budgeting, and any other impact to the institution with the discontinuance of this index.

Investments:  A review of Held to Maturity (HTM), Available for Sale (AFS), or Trading Investments will be reviewed for all mathematical accuracy, policy compliance, accurate book keeping of accrued interest, discounts, gains, etc. 

Share Accounts:  Examiners will look at the reconciliation, overdrafts, accrued interest payable, closed, dormant accounts, and share file maintenance. 

Other Balance Sheet and Income Statement Items:  Examiners will look for the reconciliation and accurate reporting of all other items on the balance sheet and income statements. 

Board Minutes:  Review all Board of Directors board minutes for the testing period and make sure all items have been approved or reviewed by the board, as applicable for these items, unless delegated to management:  interest rate changes, dividends on share accounts, investment, A/L management, BSA, Loan policies, ALLL policy, delinquent loan reports, and charge offs. 

Liquidity Risk:  Credit unions with low levels of balance sheet liquidity will have their liquidity management reviewed by looking at the potential effects of changing interest rates on the market value of assets and borrowing capacity, risk modeling, changes in cash flow projections based on an appropriate range of relevant factors, and a review of contingency funding plans in the event of a liquidity shortfall.

The NCUA will also open up the Modern Examination and Risk Identification Tool (MERIT) in the second half of 2020.  Credit unions and examiner staff will be able to transfer documents and files needed for the examination securely, receive updates on changes for corrective actions and access completed examination reports securely. 

These are a few things to look forward to as audits for supervisory committees and examinations are gearing up for the current year.  As you make plans for 2020 for a third-party loan review, remember Pactola provides these credit risk advisory services.  We would love to discuss the range of services you need and provide a detailed scope of services we can perform. 

Why More Coverage May Leave you Exposed

This may seem a bit counterintuitive, but this statement could apply to your third-party credit risk review.  I once took part as a small crew of three in a portfolio credit loan review for a lender (note the overall items and dollars have been changed in this blog).  The institution had deficiencies in their commercial department as outlined by examiners.  Our contract included reviews of policy, procedures, people, technology, and loan files.  We were to draw up conclusions based upon what we saw, as to the risk identification and management ability of the group.  Much of our work was driven by requirements addressed by the officials. 

Of all the individual items that needed to be addressed, the biggest one the bank focused on was to have a third-party validation of the credit rating of every relationship over $50,000.  The bank was located in a rural community that served small businesses and farmers.  It was common for the institution to have quite a few relationships between the $50 - 250K range and the largest relationship was slightly over $3MM.  Our contract was to complete the on-site work in one week to limit the cost.  This also would limit travel expenses charged to the bank for our little crew.  As you may know, the travel expenses for the on-site credit review can be substantial once the bank pays for airline, gas, rental cars, hotel, and meals.

Some third-party firms will transcribe data like financial statements from the files onto their software to complete the analysis.  This process is very time consuming and provides little value to the institution.  To save time, we skipped this in order to just start writing about our findings.  This process allowed us to focus on the credits more and draft conclusions of our findings.  The next agreement between the bank and us was to eliminate looking at all relationships between $50K - $150K.  It was possible to do a sampling here instead of looking at all of them, but the lender was concerned with a review of as many files as possible.  If the bank took a complete loss on all of the relationships below $150K, the aggregate total would be only slightly above the size of their largest relationship. 

Even with limiting the number of relationships to review, we were tasked with reviewing around 300 files for this week.  The first day of any on-site review is a waste of a detailed look at the files as you deal with logistics, staff interviews, and high-level discussion of the portfolio, policies, and procedures.  Day two involved a deep dive of each of us into files, but by the time we had finished the day, we had finished only 9 relationships.  This did not give us much progress on the number of files to cover, but it did give us a detailed understanding of how the bank worked. 

We were left with 291 relationships divided between three days and three people per day.  Doing the math, shows you this divides down into 32 1/3 relationships to review per day per reviewer.   Considering we put in a good ten hours of work per day, this averaged 3.23 files per hour per person. 

Now if the files were completely in order and all info was easy to find, and if, we had very easy files with only one entity to review and simple amortized payments, perhaps this would be adequate time to render an informed judgement.  But if you add in disorganized files, borrowing bases, multiple borrowers/guarantors, missing site inspections, financial information, and other documentation, this greatly complicates the goal of completing a review of all the files. 

Note that I said a review of all the files, not “a thoughtful, thorough analysis of the credit risk of each relationship”.  This would be the overall goal of a third-party credit review.  The purpose is to provide an accurate analysis of the strengths and weaknesses in the bank and not just provide another opinion of the risk in the credit based upon a minimal amount of information reviewed.

This leaves the reviewer and lender with three choices.  First, make sure every file is touched, but sacrifice the quality of the review within the week time-frame.  Second would be to spend the required time on each loan to do an adequate review.  This would take several more weeks of time and expense to the institution.  A third choice would be to complete a detailed review of a sample of files that represent the complexity of the various relationships and their management and spend the remainder of the time quickly reviewing the remainder of the files in a summary format on or off site.  A final, and the best option, would be to thoroughly review a risk focused sample in collaboration with management.

We settled for option three.  Our overall goal was to provide feedback to the institution and where they needed to improve instead of the individual files.  The individual files provided mere symptoms that pointed to the overall problem.  We ended up with a pretty deep dive into around sixty of the files while doing a cursory review of the remainder.  This gave us a pretty good idea of many of the systemic weaknesses that needed to be addressed. 

Overall, our small team of three could have either easily spent another week there and completed a pretty deep dive into another 60 or so files.  In the end, a detailed look at all 300 relationships would reveal a redundancy of findings which were revealed in the smaller sample.  This would have come at much greater cost to the bank while not showing anything new.

But what, you ask, would come if there was a serious risk in a credit which was not part of the deep dive?  Of course, that is a risk possible in any review.  No matter how good the reviewer is, there is always the possibility that something would be missed.  After all, the reviewer is human.  A good review provides coachable material that can be used to make you better, not just a file to be put inside a drawer to satisfy the examiners. The review is not to provide you with a 100% guarantee that all deficiencies are adequately identified and provided to the institution. 

The problem here is if the primary focus is on looking at every file relationship, and if there are many of them to inspect in a short time, the quality of the work tends to not reveal deep issues with the credit union or bank.  The best practice is to not focus on 100%, or even 50%, coverage but to seek a thorough understanding of the depth of the practices, policies, and procedures of credit management.  Otherwise, more coverage may leave you exposed.

A Thoughtful Look at Third Party Loan Reviews

Over the past three decades, credit union and banking regulators have suggested, or even demanded, that institutions have an independent validation of their credit risk.  This third-party loan review has become a necessary expense to stay in the good graces of the examiners.  Many times, the accounting firm or loan review company completes the work at a significant expense, often one of the largest third-party expenses to the lending department.  Then there is the additional time expense you are paying for your staff to accommodate their requests, answer questions, and provide file access.  But is that the only purpose of this expense of credit risk review (CRR) to satisfy the examiners? 

If the only purpose of the CRR is to check the box for the examiners or satisfy the requirements of the audit committee, bonding insurer, or ratings agency, you are probably not receiving the value you need from this expense.  If you receive the same redundant report year after year which is filed away and only pulled out at when a regulator steps in the building, you may not be receiving the value you need.  If your reports do not identify root strengths and weaknesses and give you direction on improvements which could be made, you are not receiving the value you need.  Also, if you have the same company performing the CRR year after year, with no oversight to the reviewing company itself, you may not be receiving the value you need.  If the entire CRR is poorly managed and provides low value, it is one of the easiest costs to control and receive more bang for your buck! 

As we have worked with various institutions, we have seen the need for a good CRR process.  A good process is like a coach who can provide a different perspective on the risk landscape that is before you.  A coach can help you see flaws in your technique to fix, or strengths in your game that you should capitalize upon in order to succeed.  If you cannot view your current CRR provider as a coach to help you improve, you need to take another look at your review process. 

To meet this need, we at Pactola are opening up Pactola Credit Risk Advisory Services.  We can serve you with the actual external CRR process or provide services as an outside evaluator for your current internal and external auditing functions, to make sure you are receiving good value.   

If you want us to provide the service, we will create an agreement that outlines the scope of services and cost.  Our goal is to provide you with an overview and a deep dive into the various aspects of credit management, risk identification, staffing, technology usage, and portfolio performance.  We will provide you with actionable items and a roadmap that you can use to improve your shop.

If you want us to review the work your present CRR vendor completes, we will work to validate their conclusions on asset quality, compliance of the credit process, effectiveness of ongoing supervision of credits by loan officers, portfolio performance, management and board supervision, and adequacy and accuracy of management information systems. 

We have partnered with seasoned individuals who will provide much of the oversight and field work for Pactola Credit Risk Advisory Services.  The gentlemen who will head this for us, has four decades of industry experience with over thirty years with the Office of Comptroller of the Currency as an examiner.  We have other ex-lenders, ex-field and supervisory examiners, and ex-ag lenders who we are working with to provide these services.  We can also look beyond the commercial and agricultural credits, with expertise in other areas like indirect lending. 

Contact us as you make your plans for 2020 and beyond for your credit risk review needs.  Whether you use us for the actual CRR process or to provide analysis of your existing internal and external loan review process, our goal is to make you better and successful in your institution.

Tyranny of the Urgent-the Death of Progress

Recently, I spent a week at a rural CU helping them with their commercial and agriculture loan files. We went through scores of loan files and ended the week with a day and a half of good old-fashioned loan management training. After meeting the various relationship managers and looking at half a dozen files, it became clear to see the various strengths and weaknesses in the organization.

One of the overarching challenges is what I call the “tyranny of the urgent”. This happens when we let our lives be completely dominated by what is screaming the loudest in front of us. I admit that I have fallen into this trap and throughout my life have chosen tasks which are not important over those which demanded immediate attention. Sometimes, this has resulted in haphazard work by putting out the fires but never dealing with long term solutions to move the matches and gasoline in the first place! At times, to my shame, the tyranny of the urgent has reared its ugly head in putting out a fire at work while sacrificing time with my family. In either case, what time we spend in the wrong place, can never be bought back.

Steven Covey divides time management into four quadrants as follows:

• Quadrant 1: things that are important and urgent

• Quadrant 2: things that are important but not urgent

• Quadrant 3: things that are not important but are urgent

• Quadrant 4: things that are neither important nor urgent

You have probably seen these as you have studied leadership and management. Everyone seems to get to the quadrant 1 tasks. Dealing with a kitchen fire, a crying baby, or an irate customer in your lobby would fall into this category. Unfortunately, at times I have wallowed in quadrant 4, dealing with items which are great time wasters. We should strive to find items here that can be removed or minimized because they have little value. Sometimes we stay with the quadrant 4 tasks because they are familiar to us or we are avoiding the hard tasks of dealing with what is important. It could be an avoidance technique while you feel some form of accomplishment on things that really don’t matter at all, but it is accomplishment. If you can eliminate quadrant 4 time and move it to other quadrants, your effectiveness will go up exponentially.

One overriding problem with this CU is they were spending too much time in quadrant 4 which need to be moved. Simple things such as copying the same document to be placed in multiple loan files for the same borrower, instead of using a more effective file management technique, or better, moving this to an electronic format, can help move time out of quadrant 4.

I find that quadrant 3 activities are often great time sucks. The commercial department of the CU acted like the tellers, focusing immediate attention and time upon the person who walks into the door. Yes, this is urgent, but the officers were not taking adequate time and focus to properly manage the credit relationship. Things such as taking time to perform good farm inspections to see the operations and judge the management abilities, or using a well thought out agriculture renewal procedure, went by the wayside as they just oriented their efforts on who stood in front of them. Quadrant 3 time activities must be strongly managed, or they will override all things which are important.

The real jewel of time is quadrant 2. The problem here is these are very important things but are not urgent. On the CU side, this involved setting up good policy and procedures, mentoring younger credit officers, marketing for new borrowers (their largest credits are with producers who are in their 70s), creating a solid pricing strategy, and utilizing technology to manage repetitive tasks. Repeatedly we heard folks at the CU say that they know these items need to be done but they are taking care of urgent things. If this is continued, the very important things are never completed.

On the personal side, some quadrant 2 activities may be developing your spiritual life, personal exercise, adequate risk, proper nutrition, date nights with your spouse, spending good time with your children or grandchildren, journaling, or spending time giving thanks and appreciation to others. You can easily add more time activities to this list. It is easy to skip your workout to get in the office earlier to deal with urgent items or to stay late and miss family supper while you accomplish tasks which really do not move the needle.

The Apostle Paul says in his writings that whatever we sow we will also reap. This is important in time management. If we sow all of our seed in categories that are really not important, we will never accomplish great things which are important. What is important now, is to reflect on how you spend time and to move forward with resolve to invest your time into important things which will last.

Delivery Channels, Branch Sales - Leasebacks

I have travelled and visited with quite a few different CUs this year and have seen many different methods on how each is delivering services to their members. A few months back, I had a conversation with Joe Karlin on various delivery channels for our CUs and thought his ideas would be of interest to share in a guest blog. What follows are his thoughts on some ideas of delivery channels and extracting value from our branch networks.

We spend a great deal of time on our products and services, and rightly so. But do we spend the same amount of time on our delivery channels? Given changing technologies, consumer preferences and increasing competitions, our delivery channels are as important as the products and services we deliver. As well, one of our delivery channels – our branches – is ripe to extract value today while future delivery needs transform.

Delivery channels have changed drastically in the recent past. Just 35 years ago, online banking got its start. Within just the last decade, mobile banking was created, with adoption of that channel to the point where consumers now rank their mobile banking apps among their three most important apps.

As we look to the future of delivery channels, changes will continue, and will do so at an increasing pace. In the not-too-distant future, mobile interactions will be overshadowed by device-independent transactions, as we will leave our phones at home and use bio-authenticated public devices (e.g. a screen in the driverless Uber authenticates our identity via an eye scan or face scan, using that secure screen for activities now performed on our phone). And many transactions will move to what experts are calling the “invisible payments wave.” These are payments processed in the background without our specific, individual approval of each transaction (e.g. your smart-fridge ordering more milk when it sees you’re nearly out, without you specifically approving the individual transaction). At the same time, our virtual assistants will move from being reactive to our requests to serving in a proactive role (e.g. Alexa or Siri will learn our financial preferences and will automatically perform banking transactions on our behalf without our interaction).

As technologies improve and proliferate, our members’ preferences and their consumption habits will change. With attention to our membership’s future needs and preferences, we can be prepared to meet those needs. Two specific opportunities are 1) performing a product/services delivery analysis and 2) evaluating sales-leaseback on branch properties.

Delivery Analysis – Credit unions should undertake an analysis of delivery channels for its products and services. After this analysis, we can then develop a detailed plan for future delivery channels. The process starts with an analysis of members’ future needs, current and expected future products and services, and the channels to support those. Based on that analysis, we then develop the path from current configuration to the desired state.

Sale-Leaseback for Branches – Today, our branches play an important role. However, with evolving member needs and preference, branch volumes will continue to decline. And as we look out 10-15 years, the branches’ role will be significantly reduced. Given today’s strong commercial real estate market, we can extract value from our branches today by selling and leasing back those properties. Extracting value today allows us to invest that capital to benefit our members, while protecting ourselves from likely future property value declines (some investors have already started to demand increasing cap rates on branch properties due to long-term concerns about property uses/values). Current cap rates on most branches are very attractive, with cap rates typically in the 5.5% to 7.5% range. We have partnered with the nation’s largest CRE firm, combining our credit union expertise with their CRE expertise and connections, all while minimizing the credit union management’s time and effort.

Depending on a credit union’s preference, a sales-leaseback transaction can also provide the credit union with commercial loan volumes. While we have an established group of investors who invest in branch properties, we can also help find local or regional investor(s) and facilitate a sale-leaseback in which you (or other Pactola credit unions) serve as the loan originator.

Any time something is in flux, opportunities abound. We have a great opportunity to develop delivery channels that will set us up for success in the future. As well, that same change provides us the opportunity to extract value from our branch locations today. I would be happy to visit about either of these issues; please contact me and let’s schedule a quick call!

* * * * *

Joe Karlin is CEO of Karlin Consulting LLC. Joe has worked in the financial services industry his entire career. Joe started as a CPA at Deloitte & Touche, auditing for the financial services industry before moving to one of the largest credit unions in the nation where Joe worked in both operational and executive levels. He has spent the last 13 years providing consulting services for banks and credit unions. Joe’s experience and expertise includes all aspects of lending, strategy and execution. Joe can be reached at:

joekarlin@me.com / OR / karlinconsultingllc@gmail.com

913-909-0793

linkedin.com/in/joekarlin/

Strategies for Managing Business Loans Small in Size

One of the challenges of credit unions and community banks is how to effectively manage a business loan that is smaller in size.  Regulators on the NCUA side may tell you that any business loan below $50,000 is considered to not be a business loan.  Many institutions have set up systems to review and approve smaller dollar loans using less volume of information compared to the larger and more complex loan requests.

Once the smaller loan is approved, and I will note that the size is relative to the size of the institution, how is this effectively managed?  Are complex annual reviews required?  What about huge details of information that would be needed to judge the risk in a complex credit?  Why would I demand annual financial statements on a $51,000 loan to finance a small rental real estate and not require the same if not more information on the $75,000 vehicle loan?

I recently spent time in an institution who were told that intense reviews were required on all their business loans above $50,000.  The institution has a lot of smaller business loans as they are located and serve a small rural community.  Many of the smaller ones are tied to real estate or some equipment.  If you drew a line at relationships below $100,000, this would cover around a quarter of their business loans.  If they suffered a total loss on the entire aggregates of these credits, the total would not exceed $1,000,000.  Sure, it would hurt their return on assets, but not as much as if their largest relationship, over twice the size of the aggregate of these, were to suffer the same total loss.  Furthermore, experiencing a total loss on all the small loans would not be very realistic. 

This quandary forces us to think critically.  We live in an imperfect world where we all have tremendous demands on our time at work and less limited time resources available to give.  We must learn to prioritize our time and spend time focusing on larger credits, or problem credits that pose a more immediate risk to the institution’s capital. 

What is most effective is to set forth procedures for lower balance relationships that have less risk characteristics.  Limits should be set on loans that should be viewed in depth every one, two, or three years.  The following is a list of some characteristics to consider setting in policy that allow a loan to be viewed less frequently. 

·         All necessary documents to perfect the collateral are filed and valid.  Collateral should be a type which has stable value such as unimpaired commercial real estate

·         LTV must be within loan policy limits

·         Property taxes must be reviewed and current

·         Loan must have had no late payments in the past 12 months

·         Property insurance must be current with lender named as mortgage holder

·         Personal and business credit reports and legal check must show no late payments or problems

·         There must be no requirements for any government guaranteed organization to complete a risk review annually or more often

·         There has been no request for additional credit within the past 12 months

·         The loan must not have any requirements for annual covenant checks or these covenant check should be shelved and this action described in the review memo.

·         Loans that have owner-occupied real estate could be looked at less frequently than those are not owner occupied.

These are a few ideas to help manage your credits better.  Managing your portfolio requires some prioritizing of your time to those credits which require more efforts. 

Thanksgiving’s Beginnings in the United States

Thursday of this week is Thanksgiving.  Folks will gather to spend time with family, food, and football!  It is also a good time to remember how this holiday was started in our country.  We all realize the roots of thanksgiving in the New World began with the pilgrims in New England.   But this blog will focus on the start of the holiday in the United States of America.

The first thanksgiving after the start of our country was proclaimed by George Washington in October 1789,  which was the first year of our nation and a mere seven months after the seating of our first government.  It was the first official proclamation issued by the President of the United States.  The leaders of our young nation were extremely grateful for their new nation which was born defeating the most powerful empire on the planet.  Washington’s proclamation reads:

“Whereas it is the duty of all nations to acknowledge the providence of Almighty God, to obey His will, to be grateful for His benefits, and humbly to implore His protection and favor; and Whereas both Houses of Congress have, by their joint committee, requested me to ‘recommend to the people of the United States a day of public thanksgiving and prayer, to be observed by acknowledging with grateful hearts the many and signal favors of Almighty God, especially by affording them an opportunity peaceably to establish a form of government for their safety and happiness:’

“Now, therefore, I do recommend and assign Thursday, the 26th day of November next, to be devoted by the people of these States to the service of that great and glorious Being who is the beneficent author of all the good that was, that is, or that will be; that we may then all unite in rendering unto Him our sincere and humble thanks for His kind care and protection of the people of this country previous to their becoming a nation; for the signal and manifold mercies and the favorable interpositions of His providence in the course and conclusion of the late war; for the great degree of tranquility, union, and plenty which we have since enjoyed; for the peaceable and rational manner in which we have been enabled to establish constitutions of government for our safety and happiness, and particularly the national one now lately instituted for the civil and religious liberty with which we are blessed, and the means we have of acquiring and diffusing useful knowledge; and, in general, for all the great and various favors which He has been pleased to confer upon us.

“And also that we may then unite in most humbly offering our prayers and supplications to the great Lord and Ruler of Nations and beseech Him to pardon our national and other transgressions; to enable us all, whether in public or private stations, to perform our several and relative duties properly and punctually; to render our National Government a blessing to all the people by constantly being a Government of wise, just, and constitutional laws, discreetly and faithfully executed and obeyed; to protect and guide all sovereigns and nations (especially such as have shown kindness to us), and to bless them with good governments, peace, and concord; to promote the knowledge and practice of true religion and virtue, and the increase of science among them and us; and, generally to grant unto all mankind such a degree of temporal prosperity as He alone knows to be best.”

This Thursday, I would encourage you to pause to give thanks for the many blessings that you have been given.  Our hearts are also heavy for those friends and family who will not be at your celebration due to distance or passing on.  We at Pactola are thankful for each and every client we have had the opportunity to work with in the past year and look forward to deepening those relationships and growing new ones in the coming year.  Our lives and our company are richer because of these you.   We are thankful each day for each and every one of you.

Happy Thanksgiving!

USDA Guaranteed Loans for Rural Energy

The Rural Development (RD) division of the USDA has an exciting guaranteed loan and grant program for agricultural producers and rural small businesses to purchase or install renewable energy systems or make energy efficiency improvements.  The agricultural producer may be in a rural or non-rural area.  For businesses, RD defines rural as an area other than a city or town with a population of more than 50,000 inhabitants. 

The funds may be used to buy, install, or construct renewal energy systems for items such as:  biomass (biodiesel, ethanol, anaerobic digesters, and solid fuels), geothermal for electric generation or direct use, small hydropower below 30 megawatts, hydrogen, wind generation, or solar power generation. 

The program can also be used for the purchase, installation, and construction of energy efficiency improvements such as: high efficiency heating, ventilation, and air conditioning systems (HVAC), insulation, lighting, cooling or refrigeration units, doors and windows, electric, solar or gravity pumps for sprinkler pivots, changing from a diesel to electric irrigation motor, or replacement of energy-inefficient equipment.  On the agricultural side, some of the more popular uses are grain dryers, energy efficiency pumps, or LED lighting. 

The guarantee is up to 75% of the total eligible project costs.  Grants are available for up to 25% of the project costs but the combined grant and loan guarantee funding are limited with up to 75% of the total eligible project costs.  The grant requests are graded on a scoring basis set forth by RD.  Grant request which score higher on the RD scale, have a stronger chance for funding than those which do not. 

The loan guarantees range from a loan of $5,000 up to $25 million.  The RD guarantee is up to 85%.  The lender has the ability to negotiate terms with the borrower but are subject to approval by the RD.  No balloon features are acceptable.  The maximum term for real estate is up to 30 years.  Machinery and equipment loans are maxed at 15 years, or the useful life, of the machinery and equipment.  The initial guarantee fee is 1% with the renewals of 0.25% annually on the remaining outstanding balance of the loan at the end of the previous year.

In addition to the loan guarantee program, RD has an energy efficiency and renewable system grant program.  The renewable energy grants range from $2,500 to $500,000.  Energy efficiency grants range from $1,500 to $250,000.  If the applicant is only seeking a grant, they must provide 75% of the project cost on their own.  If there is a loan guarantee request or combined guarantee and grant request, the applicant must provide at least 25% of the project cost. 

If the project cost is over $200,000, a technical report from a qualified third party is required.  Energy efficient projects will require an energy audit or assessment.  Ultimately, there needs to be some validation that the extra expense for the efficiency or production equipment would produce the desired results.

So how are some practical uses for this program?  On the agricultural side, items such as energy efficient pivots, grain dryers, solar or wind power generators for remote equipment uses, or installation of LED lighting in an agricultural production facility are all possible uses. 

On the business side there are many possible applications to this program.  I once financed energy efficient refrigeration equipment for a food processing company.  Other options would be installation of new energy efficient HVAC and lighting with or without small solar or wind production would work.  Keep in mind this program can also be used in conjunction with other RD programs.  A possibility here would be if you have a new hotel construction and are able to obtain a RD Business and Industry guarantee on the project.  If a portion of the project could be for high efficiency HVAC, LED lighting, a small vertical wind turbine  on the roof and a covered parking by a solar cells, these items could fall under the RD Renewable Energy Program while the remainder of the project can be under a regular B&I guarantee.

If you have questions, reach out to us or your state USDA RD office.  We look forward to hearing from you.

Could Senior Housing be Facing a Downturn?

Over my career I have financed various types of senior housing, including assisted living, memory care, and intense nursing care.  My parents lived the final years of their life in a senior housing complex that combined apartments with more intense care needs.  This facility is one of thousands which have been developed over the past decade in the U.S.  These properties have been filling up with people born from before the Great Depression to the World War II era.  Real-estate investors are eyeing the massive baby boomer generation of 72 million people born between 1946 and 1964. 

Real estate investors are betting big on this.  In 2018, senior housing developer added 21,332 new units, over twice the amount added in 2014, according to the national Investment Center for Seniors Housing and Care (NIC).  This makes senior housing a faster growing commercial sector ahead of office, retail, hospitality, and apartments.  This development is expected to increase as within 10 years, the baby boomers will begin reaching their mid-80s, the average move-in age for senior housing.  The needs of this group would require thousands of new facilities if the current demand continues.

“If” is a big assumption.  Peter Grant in a recent Wall Street Journal article cites concerns that this bet on elder care could be one of the biggest real-estate miscalculations in recent history.  We are already beginning to see assisted living communities which are not filling up and performing as originally expected.  Overall occupancy is strong at 88%, but this is down from 90.2% just five years ago. 

Some companies specializing in senior housing are hurting.  Ventas Inc., a large health care REIT, fell by 9% in one day in October as it reported the occupancy rate of its senior housing communities declined for the 17th straight quarter.  The age that people consider entering into senior housing is increasing to 85 years old today, compared to 82 years a decade ago, according to Green Street analyst Lukas Hartwich.  This is partially due to improving health. 

Technology plays a role in this. In 2019, over $1 billion will be invested in “aging in place” technology to allow seniors to enjoy the living standard of their current residence while accessing care without moving to the senior care facility.  Some products include sensors that respond to a variety of medical conditions, facial recognition to identify visitors, and houses that can be easily changed as the resident ages to meet their needs. 

These technologies make it easier for seniors to live at home and be less dependent upon others.  One company is offering voice-recognition services that interacts with seniors about their health or plans for the day, makes suggestions, and then sends help based upon the responses. 

The design firm Gensler is developing houses with features like adjustable bathroom sinks, living rooms that can be converted into bedrooms, and cabinets which people can see what is inside of them when they touch them.  Who can forget items like the walk-in tub, stair chair lift, or Lifeline, which brings medical help at the touch of a button?

In England, the developer Tolent Construction is breaking ground on South Seaham Garden Village, a 1,500 home and mixed-use development in the Newcastle area. Homes will contain sensors and technology that will allow seniors to live next to families and younger single people.  One fifth of these homes are outlined for people over 55 years old.  The development will also have a village square, health center, and 20,000 sf of office space for startups and new technologies. 

Hugh Daglish, the urban designer working on South Seaham touts the project, “You’re discouraging social isolation because you’ve designed the development in a way that brings people together.”  This helps create a stronger community of people of all ages instead of quarantining the older folks to their own area. 

Another factor which creates headwinds to senior housing demand is the sheer demographics of our country.  After the huge influx of baby boomers, the Gen X group, my generation, is much smaller.  Birth rates do not match the Boomer rate until later in the Millennial and Gen Z eras.  So logically, if you build this to fit the Boomer needs, there will be a lot of empty units when the Gen X group comes around. 

Senior housing will not go away.  This remains a viable option for people with medical problems, loneliness, and the need for assistance with daily activities, like eating, dressing, bathing, and exercise.  But the new aging in place movement and changes in the attitudes of future prospects for senior housing, will keep more people from senior housing.  Clearly, the younger seniors will stay away, leaving the very, very old in housing and thus will be less attractive to younger seniors.  Based on these factors, we should still see a declining trend in occupied units.  These are factors the prudent lender should take into account. 

USDA vs. SBA Guaranteed Loans

Your institution may participate in the Small Business Administration’s express or 7a guaranteed loan programs or have worked with a Certified Development Corporation on an SBA 504 loan.  Your group may have also worked with the United States Department of Agriculture’s Business and Industry (B&I) loan program.  But what circumstances make it better to look at the SBA or the B&I guarantee?

The first item to consider is location.  SBA loans can be done nationwide, while B&I loans must be in cities and towns with a population of less than 50,000.  The intent of the B&I program is to assist credit-worthy rural businesses to obtain needed credit for qualified business purposes.  They focus on creating and saving jobs in rural America.

The next item is what will the loan proceeds be used for?  If the project is at least 51% owner occupied real estate, then the 7a, 504, or B&I program is usable.  B&I can be used for rental properties in Opportunity Zones, if these are creating jobs.  Large equipment loans can be guaranteed by the 7a or B&I program.  If you have a borrower needing working capital, company buy-outs, or loans without substantial real estate or large machinery collateral, then the 7a or express program is for you.

Loan amount is a consideration.  Most 7a loans have a max of around $5 million.  504 loans have a structure that may go up to $10 million between the 504 and underlying first loan.  B&I guaranteed loans can go up to $25 million and may be increased above this in some cases. 

Amortization is the next factor.  504 loans can have up to a 25-year amortization and the underlying first mortgage has to have a term of at least 10 years.  7a loans have a blended amortization depending upon the purpose of the funds with real estate having a term of 25-30 years, equipment is usually at 7 years, and working capital 5 years.  B&I loans can go up to 15 years on equipment and 30 years on real estate.  The longer amortization may help free up cash flow.

Balloons are another factor.  B&I guaranteed loans cannot have a balloon feature on them.  SBA 7a loan are also full term with no balloon.  The first mortgage in front of an SBA 504 loan will usually balloon in 10 years and must be refinanced. 

Prepayment considerations are important.  SBA 7a loans will have a prepayment in the first three years.  504 loans have a prepayment in the first 10 years.  B&I loans have no prepayment on them. 

The borrowing entity is also an issue.  SBA must have a for-profit operating company as a borrower.  B&I loan can have individual investors, non-profits, cooperatives, Federally-recognized tribes, and public bodies as eligible borrowing entities. 

Interest rates on the SBA guaranteed loans are highly regulated by the SBA.  504 loan rates are set by the bond debenture market.  The B&I lender has more power to negotiate a rate acceptable to both borrower and lender, assuming the rate is not uncommon with other credits the lender has. 

How much your institution wants to guarantee is important.  B&I loans can have a guarantee from 60-90%.  SBA express loans have a 50% guarantee.  Export express loans an international trade loans may go up to 90% as a guarantee.  7a loans will range from 75-85%.  The SBA 504 loan is not a guarantee but is a junior lien behind your first mortgage.

Each program does have its own quirks.  The SBA eligibility has a net worth threshold of the sponsors on the credit, which looks at affiliated owned entities.  A borrower who grows to a certain size may be too large for the Small Business Administration standards. 

The B&I program has a stringent tangible debt to net worth ratio requirement.  Some items on the company balance sheet may not be considered as assets or tangible equity which can push the ratio higher.  B&I also has a multi-agency checklist that can become squirrely if you have a project in a national historic district, wetland, or reservation. 

Either of these programs are wonderful ways to help mitigate the lender’s risk in the project and may help you win deals that are outside the comfort zone you have for these credits.  If you have questions on these, contact us.  We have worked with lenders on both the SBA and the USDA B&I program underwriting, syndication, and ongoing file management.

Don't Be So Negative!

In August of this year, Germany issued 30-year bonds with interest rates below 0%.  Yes, if you bought a $1,000 German bond with a rate of -0.11%, you would actually only receive back $998.90 on your investment.  Now Germany was only able to sell less than half or the €2 billion of bonds they offered. 

When you consider a negative interest rate, it stands for a value discount of the asset.  It is saying that the money today is more valuable than taking the duration risk of investing and receiving money tomorrow.  This is quite unnatural , as anyone would expect to be paid something for their foregoing the use of their money today in order to lend it to another to use.  Saying that the new natural interest rate has turned negative is wrong, as it defies the natural order.

Thorsten Polleit identifies this strategy has found its way into monetary policy around the world with now over $17 billion of sovereign debt in the negative territory.  These rates are “highly attractive to the state and those groups closely associated with it because if the central bank forces interest rates into negative territory, running debt becomes a profitable business, and financially ailing states and banks can reduce their debt burden at the expense of creditors.” 

Wonderful, let’s continue to encourage irresponsible behavior!

Central banks manipulate market interest rates on all ends of the spectrum.  They control the short term and impact longer term rates with the purchase and sales of debt securities.  In Europe, the trend to negative rates has not been natural, it has been orchestrated by the European Central Bank (ECB). 

It is conceivable that consumers and businesses could eventually see negative interest rate loans.  If a bank in Sweden borrows from the ECB at a -2% rate per year, it pays back 98 Euros for the 100 Euros it has borrowed.  If anyone could suddenly get a loan with a negative interest rate, it would be expected credit demand will skyrocket.  To prevent this, the ECB would have to resort to credit rationing.  The credit market will not determine who gets which loan and at what rates, the ECB would set guidelines for which loans and types of individuals and businesses would receive credit.  This becomes an ultimately planned economy.  Polleit paints an Orwellian picture where “the monetary policy of zero and negative interest rates—if it is consistently thought through—leads to the demise of (what little is left of) the free society as we know it in the Western world.”

If credit is not rationed while it is negative, it could reach levels of a speculative bubble which would eventually pop in a destructive debt deflation.  This may be possible, but some will point to Japan where rates have been below zero for decades and yet no bubble has appeared.  Maybe what is more plausible is the Larry Summers idea of a “Black Hole” monetary policy, when rates fall below zero, that the energy required to sustain the private sector economy cannot get out. 

This trend does not bode well for banking profits.  A study from the University of Bath, England over 7,359 banks from 33 countries between 2012-2016, found that bank margins and profits fell in those countries pursuing a negative interest rate policy compared to those who did not adopt the policy.  Loan growth was damaged by the squeeze on bank margins that negative rates produce.  The decline in profits for financial institutions, also erodes capital bases, which in turn, limits an institution’s ability to lend. 

Recent statements from the head of Financial Supervisory Authority in Denmark warns that negative rates are pushing the European banks to a tipping point.  Banks must change their basic business model or accept they will have to contract in size.  The evidence is showing that negative rates are deflationary. 

Currently, these phenomenons are happening to countries across the oceans from us.  But if negative rates appear on our shore, while it will help those in a lot of debt, it will likely stagnate and imprison the private economy. 

A Look at the Yield Curve and Recessions

The yield curve is a picture of interest rate yields of debt with different maturities.  Typically, one expects the longer the maturity, the higher the interest rate an investor would require since there is more uncertainty as time goes on. 

There are times when the yield curve will invert.  That means that shorter term rates will be higher than longer term ones.  We see this happening in the U.S. government debt market now. I pulled the October 10 close of the U.S. Treasury constant maturity market.  A one-month T-Bill was yielding 1.74%.  All maturities from the three-month to the 10-year debt were at lower rates than the one-month, with the 5-year at the lowest rate of all maturities at 1.48%.The 20 year and 30-year bonds were higher, with rates of 1.96% and 2.16%, respectively.  Overall, this gives more of a bowl-like shape to the yield curve.

The Federal Reserve Bank of St. Louis has tracked yield curve inversions with the difference between the 10-year Treasury less the 2-year Treasury.  When the difference is negative, they count this as a yield inversion.  At the time I write this, the difference between the two rates is a positive 14 basis points.  Pretty small indeed!

Since 1978, there have been five different recessions, that is two consecutive quarters of negative GDP growth.  All five of these have been predicted by an inverted yield curve which gave a warning light from 10 to 22 months prior to the recession.  As I look at these different inversions, my first question is why did the curve invert?

The first one comes in the fall of 1978.  The Federal Reserve manages the Fed Funds Rate, or the rate for overnight lending to banks.  In summer of this year, this rate stood around 8%.  By the end of the year, the rate had spiked to nearly 14% with some Fed tightening.  Recession started in January of 1980.  Later in 1980, the Fed eased a bit and Fed Funds dropped to 9.5%.  Then in the fall again, Fed Chair Volker determined to eliminate excess inflation from the economy, and we watched rates jump to over 20%.  It did help wring out inflation but threw the economy into a recession in mid-1981. 

Both these are times when the Fed increased rates which caused the inversion as short-term rates shot above longer-term ones.  The next inversion, in fall of 1989, came as the Fed was easing rates.  Fed Funds had bottomed out in the fall of 1986 at 5.75% to a peak around 10% in the spring of 1989.  Then the rates began to ease by a point before the curve inverted in August 1989.  Recession followed in summer of 1990.

We enjoyed a decade of growth in the 1990s.  Rates fell to around 3% in 1993 and rose to 6% in 1995.  Fed Funds rates stayed around the 5-6% range until rising to 6.5% in summer of 2000, giving us our 4th yield curve inversion.  Recession began in March 2001 with the dot com tech bust. 

Our final inverted curve hit in February 2006.  Fed Funds had sharply dropped after the 2001 recession and bottomed at 1% for most of 2003 to mid-2004.  The Fed began tightening in the summer of 2004 with a steady march up to 5.25% in July 2006.  The curve inverted in February 2006 and recession, now referred to as the “Great Recession”  began in December 2007 after the crash of the financial markets in the fall. 

The Fed reacted quickly during the crash and we saw the Fed Funds rate drop their target rate to 0.25%.  This rate stayed pretty much the same for over six years, until the Fed began to methodically raise rates in quarter point intervals until a peak around 2.25% in early 2019.  We have seen a few reductions in the rate to the current target rate of 1.75 to 2%. 

Back to the original issue, why is the yield curve inverting and does this mean a recession is on the horizon?  For that, I have a few take-a-ways.

All interest rates have a base in a normal positive yield curve on the Federal Reserve’s Fed Funds Rate.  It seems like most of the inversions happened during periods of Fed raising rates to slow down the economy.  A couple of inversions seemed to come as the Fed was attempting to reverse course after rate increases. 

The magnitude of the rate swings was also much greater.  The gaps ranged from an interest rate trough to peak from a minimum of 3.5% to over 10.5% before the recessions.  Our current interest trough to peak of Fed Funds was only about 2.5%.  It was not uncommon in the past to see 1% rate increases at Federal Reserve Open Market Committee meetings.  Now we only tend to se 0.25% changes.  The Fed has been more accommodating lately and it is hard to argue that as small of the magnitude of the rate increases, we have seen from 2016 to 2019 would trigger a recession, based on some of the past data. 

One reason to consider the current flattening of the yield curve may be the strength of our economy and the yield on our government bonds, which is low, but is still positive.  There is around $60 trillion dollars of government debt in the world.  Nearly $17 trillion is at negative interest rates.  If you bought a 10-year German bond today, your yield is -0.446%.  In this example you would receive less money when the bond matures than when you paid for it.  Our rates may be low, but at least they are positive!

The attraction of the largest economy with positive government debt rates is attracting others to buy our bonds.  This pushes the price of the bonds up and the interest rate lower.  Some are saying that we may have seen a peak in interest rates for a while.  Other mature economies in the world are stagnating.  Many have negative rates.  All this is a negative drag on our rates.  This has been one of the factors for the current yield curve.

Will the current inversion, flattening, or bowl in the rates point to a recession?  Only time will tell.  It does appear that there are arguments showing the factors we are currently experiencing seem different than the inversions of the past. 

The Construction Loan Net-Worth-to-Loan-Size Test

The other day we had a request for a new commercial construction request for an apartment.  The total project was around $10,000,000 with the borrower putting up the land, estimated to be worth $1,000,000 and then putting in another $1,500,000.  Things looked good until we got down to the net worth of the sponsors.

These gents were highly leveraged and only showed a net worth of $500,000.  What?  The sponsors want to borrower $7,500,000 and only have a net worth of a paltry $500,000?  When you dug down into their balance sheet, most of the equity was tied in an estimated equity of real estate.  Cash and investments were reported at less than $20,000.  Given these items, what financial strength does the sponsor have to support the deal?

An old rule that I learned when looking at construction projects is the sponsors on the project need to have a net worth at least as large as the construction loan they are requesting. This would especially apply in the case of a spec construction, but some other types such as an SBA guaranteed project would not necessarily apply.  In this case the $7.5MM loan would be matched with sponsors with at least $7.5MM of net worth, and not inflated equity net worth, but financials that are realistic. 

Now in times when lending is tight, some lenders want to see this ratio at 1.5 times or more.  In times when lending rules are easier, lenders rarely will go below a net worth to loan ratio of 0.75.  This project did not have sponsors substantial enough to pursue the deal further.  Now there may be a lender out there who is desperate to put loans on the books may close the loan.  We call that the greater fool theory.  You do not want to be the greater fool.

Back to our example, was the net worth only $500,000?  When one looks closer, if the land is free and clear, not listed on their personal balance sheet, and if their money they are putting into the deal as equity is not generated from other borrowers, that would be $2.5MM will be equity.  If we add that to the $500,000, they at least have $3MM of equity.  It still falls woefully short of the loan request, but at least it looks a little better.  We refer this to a case where this shade of lipstick looks better on the pig than it did in the beginning!  But it is still a pig.  The ratio is 0.40 and the request appears to be seriously flawed!

What does the ratio tell you?  If the sponsors do not have adequate net worth, or assuming the personal financials represent inflated equity numbers, the guarantors will not have adequate resources to help either with as cash from liquidity on the balance sheet, borrowing against an asset with equity, or cash from the equity of an asset that would be sold.  If something goes south on the project, the lender is stuck with finishing the project or foreclosing. 

Is this ratio set in stone?  Say you are close on a deal with a ratio of 0.85.  Perhaps most of the net worth is from unencumbered liquidity.  Maybe they have strong income, very low personal debt service, and a large amount of equity in marketable real estate with a very low leverage.  The lender should ask, “How easy is it for the sponsor to put more money into the project if necessary?” 

I have seen cases where the ratio is good, but the equity is from a large array of partial interests in other real estate projects that are all highly leveraged.  If this sponsor were required to bring more cash to the table, he would have had difficulty since he did not have the power to leverage the properties on his own and if he did, it would require quite a few properties to be pledged to generate any substantial amount of liquidity injection. 

Like all other ratios and guidelines in commercial lending, no one is the cure-all to answer all your risk questions.  Each one, when used appropriately, can offer insights into the financial situation of the various players in your credit.