An end to LOAN WINTER

Midwest bankers can expect credit markets to thaw in 2014 By Matt Doffing

SINCE 2008, two groups typically served by Midwest banks have shown less desire to borrow money: Farmers and small business owners.

Many farmers, with record earnings during the last five years, have their own cash for their liquidity needs. And many small business owners have shied away from borrowing for the opposite reason: Their operations struggled as client lists declined and remaining customers bought less.

In 2014, these headwinds in the Midwest are set to change, bringing with them a new season for loan demand.

A few more customers at the commercial loan officer's desk would be a welcome change for bankers. The years that followed the financial meltdown of 2008 brought bankers asset quality issues, tepid loan demand and low interest rates.

The first of these to improve was asset quality. In 2012 and through second quarter 2013, banks reported improved quarterto-quarter earnings because they reduced provisions for future loan losses, according to the FDIC. But now, with asset quality reaching historical norms, many banks have realized the gains to be had from reduced provisioning. The median bank in the Minneapolis Federal Reserve Bank district has less than 10 percent nonperforming loans to capital as of the end of the third quarter 2013. For banks in the region, that's a ratio lower than the 20-year average. Across banks in the region, provisioning is flat. The median district bank provisioned less than the 20-year median in the third quarter, according to Ron Feldman, executive vice president and senior policy adviser at the Minneapolis Fed.

To improve lending income in 2014, banks either need to make more loans or price their loans differently. Fortuitously, the improvement in asset quality for Midwest banks has also meant greater health among bank customers. In fact, declines in past-due loans generally trigger increased credit demand, according to Chris Kuehl, economist and managing director of Armada Corporate Intelligence, Lawrence, Kan.

And it's not just the banking industry that's reporting declines in past-due activity. Credit managers across the country in industries ranging from retail to construction to manufacturing have reported that negative indicators for loan demand are receding, said Kuehl who is the economist for the National Association of Credit Management. NACM polls approximately 900 credit managers throughout the country every month.

"Historically, credit managers report more accounts out for collection, slow paying customers and rejected credit applications when even good customers are protecting their cash flow," Kuehl said. "When a business knows it is 60 percent of its creditor's business, it can take advantage... The business tells its creditor that times are not so good, that it is going to take a while to send payment. Credit managers can only gnash their teeth at this."

Things change when a business wants to ask for more credit, Kuehl said. "You can stretch your creditors when you don't need to borrow from them," he said. "But if you are getting ready to ask for credit to expand your business, you bring yourself current."

Fewer businesses are keeping past-due accounts with their creditors, according to the latest credit managers' index published by NACM, Kuehl said. Credit managers also reported improvement in favorable conditions at the end of the 2013, Kuehl said. "There is a real sense that Jason Henderson credit is more available than it has been in some time and that bodes well for the coming year," he said. "Decent companies are asking for money and their applications are being granted."

Less cash flush

Notably, conditions in the agricultural economy are changing. Farm economists predict a plateau for the ag boom.

The United States Department of Agriculture predicts declines for corn, soybean and wheat prices until after 2015. USDA also predicts net farm income will decline in 2014 and 2015, but it will remain well above the average income seen from 2001 through 2010.

Farmers and investors polled by Purdue University, West Lafayette, Ind., expect the average price of com to be $5.20 a bushel in the next five years, according to Purdue economists Jason Henderson and Brent Gloy. In the worst case, those polled thought com prices could get below $4 a bushel in the next five years. In the best case, com prices could be more than $7 a bushel. The USDA's baseline 10-year forecast for com is $4.50 a bushel.

Farmers are not as flush as they once were, according to Purdue economist Michael Boehlje. Farmers who have expanded rapidly in recent years also have been aggressive bidders in the land rental market and have made fixed cash rental arrangements for three years to five years at relatively high fixed rates, Boehlji said. "These pseudo-debt obligations are similar to capital lease obligations which increase leverage and typically reduce the liquidity position of the business," he said.

Boehlji also said that farmers' strong cash positions coupled with their concerns about high tax liabilities have resulted in significant purchases of machinery and equipment, again reducing liquidity. "And, the higher prices of fertilizer, seed, chemicals and fuel have resulted in larger operating lines, which increases the leverage and reduces the liquidity position even further," he said.

These factors inform Jim Nowak's outlook on 2014 for the Midwest. "I am bearish on the United States for the first half of 2014, but I am bullish on the Midwest," said Nowak, who is assistant vice president of risk management at United Bankers' Bank, Bloomington, Minn. "I also am bullish for my ag-bank customers. Some of the positive factors that have driven the ag sector will change next year. I do not see a crash in farmland values but I do see more of a cash void for farmers next year. Farmers will have more need for credit. That's good news for bankers but for the wrong reasons; it means the farmers aren't doing as well."

Banks in the Kansas City Fed region already have seen a drop in farm income and corresponding increase in demand for credit. In the third quarter, U.S. crop prices dropped sharply as the national cash price for corn plunged to $4.19 at the end of September, down from $7.51 per bushel in March. Soybean prices dropped 11 percent in the same period, according to the Kansas City Fed.

The 219 bankers who responded to the Kansas City Fed's most recent survey of ag-credit conditions reported that shrinking farm incomes spurred demand for farm operating loans in the third quarter. Bankers reported no change in rates of loan repayment but said that they received more requests for loan renewals and extensions.

Short term opportunity

On Dec. 18, the Federal Open Market Committee voted to maintain its current target for interest rates until well past the time that the unemployment rate declines below 6.5 percent. The FOMC also voted to slow its program of asset purchases to $70 billion per month from $80 billion. "This was a nonevent from the bankers' perspective," Nowak said.

Although no one can predict with certainty what the FOMC will do or where yields on securities will be over the course of the coming year, Nowak said the current yield environment is an opportunity for banks. "The time is right to capture a lot more yield for less duration risk in the short term," he said. In May 2013, the rate of two-year Treasury securities was 0.19 percent. "Today, it has more than doubled to 0.4 percent," Nowak said. "You can double your yield on a two-year investment now. This steep of a curve has happened only six times in the last 20 years."

Nowak does not expect the Fed to raise its low rate policy in the foreseeable future. "In the Fed's statement, the words 'well past the time that the unemployment rate declines below 6.5 percent' are special in Fed speech," Nowak said. "For them to come out and say that the unemployment rate needs to be substantially below 6.5 percent means rates will stay put for quite some time. It means the unemployment rate needs to reach something like 5.5 percent. It will be 2016 before it's that low."

Nowak and Dimitri Delis, director of BMO Capital Markets Fixed Income Group, agreed the FOMC isn't looking at the survey-based unemployment rate reported by the Bureau of Labor Statistics to make its decisions. "The true unemployment rate is the employment-to-population ratio," Delis said. "This ratio has remained essentially flat at over 10 percent since 2008, while the unemployment rate has declined to 7 percent from over 10 percent." Nowak put the true unemployment rate at 10.7 percent.

Loan baffles will continue

Loan-to-deposit ratios are not what they once were for Midwest banks, said Nowak who serves some 260 bank customers in 14 states. Novak said that his average bank customer had a loan-todeposit ratio near 90 percent in 2007. Today, his average customer has a ratio in the 60 percent range, he said. "The difference between the ratio of2007 and that of today is the securities portfolio," Nowak said.

Most loan growth comes from banks stealing loans from each other, Nowak said. The environment creates a kind of double jeopardy for small banks. "Banks that have loan growth will see margins grow because they can shift into new loans, thus their interest rate risk exposure drops. But if you do not have loan growth, interest rate risk will remain elevated and margins will remain under pressure," he said.

Nowak said this is the reason regulators are focusing on small banks for interest rate risk. "Two of my bank customers have had directives from the FDIC on this. Both were smaller than $50 million in assets," he said. "It's too bad because those banks will be required to give up more earnings today than they would lose when the market shifts, based on my forecast models. The examiners are giving directives even though the Fed has extended low rates.

"Small banks are in a real pickle," Nowak continued. "Regulators appear to want bankers to shorten up and get used to profits being a secondary concern. This they cannot do. If the bank is inside their ALCO policy limits then bankers need to run their bank to meet their fiduciary responsibility for the benefit of the shareholders and the community."