Looking Ahead at 2015 and Beyond
By the end of 2014, many were left with optimistic spirits for what the future holds. This feeling is justified based on the numbers alone. The GDP displayed positive growth trends for both the second and third quarters at 4.6 percent and 3.5 percent, respectively. Even more impressive are the statistics revealing the unemployment rate is under 6 percent since the first time since before the recession.
Rightly so, this relief has led many small business owners to grow increasingly confident in their outlook for the future. The Small Business Optimism Index is a number calculated each month by the National Federation of Independent Business that rates just now optimistic small business owners are feeling. The most recent Index reading revealed a 96.1 which was the highest level for 2014.
All of these positive endings for 2014 are leading many small business owners to desire an increase in capital spending in the near-term. This is a good thing for community bankers as this reveals a potential increase in demand for small business loans in 2015. Having said all of that, it is important that we remember where we have been and how we got there.
Take Warning from the Past
The economy has experienced a handful of recessions to date and from this comes a warning list for lenders. Problem loans tend to arise in industries that share a few common characteristics:
- High levels of fixed costs
- Lots of debt layered in with the fixed costs
- Owners who tend to live extravagant lifestyles
- Vulnerability to drastic and often unforeseen changes, especially changes in the political and regulatory environments, tax laws, competition and technology.
If these characteristics are not warning enough, let’s take a look into some specific problem loan scenarios. In the late 1970s, the agriculture industry exhibited the aforementioned characteristics before a crash in prices led to a wave of bad Ag loans and numerous bank failures. The next problem child was in the 1980s when both the energy and commercial real estate industry experienced a lending crisis. Following in those footsteps was the technology and dot-com boom and bust of the late 1990s.
The 2000s carries memories that are all too fresh for some. Airlines and auto manufactures exhibited and dealt with problem loan characteristics on multiple occasions. Most recently is the Great Recession which was a result of the industries in residential and commercial construction, income property, and financial services which all experienced significant run-up. The Bureau of Labor Statistics published an article detailing the results of the most recent Recession which really sheds some light on the consequences of poor lending choices.
Red Flag Industries
A handful of industries have been selected as candidates for possible problem loans in the future.
Agriculture – Leased land from investors and higher fixed cost due to the increase of new equipment purchases and leases are a recipe for disaster. Land prices are climbing and with that so are rent prices. All of this is coming at a time when overseas demand for U.S. agriculture products is weakening and production is strengthening resulting in a surplus of agriculture goods and lower prices.
Coal – The Obama administration’s “war on coal” has created a situation where any number of changes, especially regulatory, could have damaging effects on the U.S. coal industry. The latest shots fired are the EPA’s Clean Power Plan and a new climate agreement with China announced late last year.
Healthcare – The Affordable Care Act (ACA) has created much frustration nationwide. Currently in the early stages of transformation, any legislation at this point will result in winners and losers. Presently, it is community hospitals and small, private-practice physicians who can barely keep their head above water in a post-ACA healthcare world.
Fracking – More properly known as Hydraulic Fracturing, is the reason many drilling companies have brought on a significant amount of debt. Fracking has transformed large players in the U.S. energy industry and revitalized entire regions where shale rock layers have been discovered deep underground. All this acquired debt is not a good thing as falling oil prices could be the cause for an early end to the fracking party. This sounds all too familiar to the time when many communities in Texas during the oil boom and bust days experienced falling oil prices. Businesses of all kinds shut down as a result of the drop in the oil economy.
Ethanol – In 2007, the Renewable Fuel Standard program increased the volume of required to be blended in to transportation fuel sold in the U.S. This explosion in ethanol means an explosion in the use of water and is it a main element of the fuel. Using a nonrenewable resource for a renewable objective is detrimental, not to mention fracking also includes large amounts of water. The aquifers that are being tapped for both purposes can only handle so many holes as they are a nonrenewable resource.
Municipalities – When you picture troubled cities think Detroit, the poster child. However it is not alone as several smaller cities in California and a few other states have declared Chapter 9 bankruptcy protection. Many economists believe this is only the beginning as more municipalities with have to deal with the high cost of providing defined benefit pension plans for employees and healthcare benefits for retirees. This process is hard to maintain without raising taxes or cutting services.
Lend with Caution
These warnings are not in place to completely discourage lending to these specific industries. In fact, they are all relatively healthy right and may offer good opportunities for you to grow your portfolio with profitable new lows. The warnings are in place as a reminder to practice due diligence.
Before lending, be selective on who you allow to borrow. Look for the strongest players that can demonstrate a long-term track record of success and that practice conservative financial management with modest levels of debt. It is also important that you go past the business side of the loan and look into the owner’s personal lifestyles as an indicator of how frugal they are living comparative to their business success.
A key factor in loaning to businesses in the identified red flag areas is your management and monitoring habits of concentration risk. It is important to limit total exposure to these industries along with making sure concentration limits are in place to help you track your portfolio.
If you are looking to further minimize your bank’s exposure to problem loans please give us a call at 417-881-0145 to schedule a meeting at your convenience.