Podcasts

162 Tede Forman Payments

April 2024

This transcript was generated by artificial intelligence. CUES accepts no responsibility for mistakes in this document.

Theresa Witham 00:03
You're listening to the CUES Podcast, episode 162. Welcome to the CUES podcast where leaders and experts discuss the top topics in credit unions today. I'm Theresa Witham, Vice President of publications and publisher of the CUES credit union management magazine. In this episode, we talk about real-time payments with our guests TD Forman, TD is president of payments solutions at CUES supplier member Jack Henry, he leads the company's strategy and solutions for payments. We had an interesting conversation about instant payments. And the work Jack Henry has done with FedNow, as well as how they are helping credit unions think about and be ready for real-time payments. TD joined Jack Henry in 2011. And he has more than 35 years of financial services and technology experience this expertise shows during our interview, so let's get started. We always like to start with a couple of questions that help listeners get to know you better. So do you have a leadership quote or mantra that you live by? Yeah,

Tede Forman 01:17
Theresa's Sure. I really believe strongly in collaboration, communication, and transparency. And making sure from a team perspective, we really have a diverse background of folks that are contributing. So you know, transparency, collaboration, communication, don't hide the elephant, let's you know, we can all figure out how to solve a problem. So really, really just being you know, very open and transparent, I think really helps lead constructive discussions and dialogue and help us get kind of where we need to go.

Theresa Witham 01:51
So I couldn't agree more. I love that. If we were honest, I think it'd be more out in the open. And I feel like we could solve a lot more problems.

Tede Forman 02:01
Absolutely. I mean, you know, there's not always any right or wrong answer to some, you know, so let's open up. Let's be fully transparent, because if we need to course correct, that's fine. Just be transparent, forthcoming.

Theresa Witham 02:14
Well, thank you for that. Why don't we start talking about the topic at hand and payments? Jack Henry actively participated with the Federal Reserve to help develop its real-time payments network now can you tell us why Jack Henry wanted to be on the leading edge of the FedNow launch? Yeah,

Tede Forman 02:34

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you know, we really wanted to offer this opportunity to all of our community FIs, you know, specifically credit unions right from the start, really to give them the horsepower to drive innovation. We also saw this as kind of the foundation for meeting kind of current needs, but also building future payment solutions. You know, there's going to be a lot of innovation and transformation with instant payments, you know, from P to P to business, and really felt like getting in on the front end would one you know, help the credit union understand operational processes as well, while volumes were low, and then also think through use cases that could be leveraged in the credit union space with instant payments. We basically if you think about FedNow, in specific, we probably have probably around 30-33% Of all the FIS that are live on the FedNow rail, or actually a Jack Henry

Theresa Witham 03:37
FYI. Oh, wow. That's great. I'm sure you're talking with credit unions about fat now a lot. What are some of the most common questions you're getting about that now? And how do you answer them?

Tede Forman 03:50
So two, probably the most common questions from credit unions basically are which network should I participate in? You know, FedNow, ACH, RTP? Why should I join FedNow, if I already have RTP. And we basically kind of informed them or tell them, you know, it's really, really important to have receive turned on for both networks, because the use cases are really different. That way, you know, no member is at a disadvantage to receive funds in real time if a merchant or a biller or whomever is connected to one rail versus another. So that's, you know, one of the big questions that we kind of walk through. And another one really is how difficult is it to implement FedNow, as a lot of the early adopters that we've turned on, there's really not a lot of lift for them from an implementation process, because it's pretty simple. The one thing we did at Jack Henry is we really built a repeatable process that allows us to basically bring on 20 fis in a single day, based on our turnkey approach to turning on instant payments. So those are probably two, probably two of the most more frequent questions we get asked.

Theresa Witham 05:05
And this may be more of a question for me to clarify. But is there anything that would stop a credit union from being on more than one, one of the different networks?

Tede Forman 05:15
No. And, you know, again, we really believe it's table stakes to make sure credit unions turn on receive only. And then as use cases get built, you can determine which network you want to go to, but receive shouldn't be table stakes, because really, they are different use cases. So if you think in terms of what the clearing house has done, they've got a lot of the gig economy workers, same day access to payroll as an example. So you know, as those gig economy workers are cashing out of those corporate apps, they're getting instant money moved down to the Community Bank space FedNow, you know, they're building some different use cases, there's going to be government payments that leverage that eventually, there are same day wage access. So again, their use cases are different. And we recommend turning both on specifically, little bit different ways on how liquidities managed between the two networks. But you know, it's easily managed. Plus coming on early also allows backroom operations to really understand the difference in how reconciliation works from your traditional three day ACH versus instant payment. And then reconciling with the liquidity processes that you've put in place.

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Theresa Witham 06:32
Thank you for that, that makes a lot of sense. There's really not a risk and turning on receive is what it sounds like, that would be correct. Speaking of risks, what are some of the common risks or barriers that make a credit unions hesitant implement instant payments, like bad now and other real time payments? And what you tell them?

Tede Forman 06:53
Yeah, I mean, the potential for fraud associated with instant payments is probably the largest risk making credit unions, you know, hesitant to implement them, we're, you know, what we're looking at. And what we suggest is having multiple layers of security within an application that's originating send payments, you know, and having a fraud solution really is key to reducing fraud in general. The other piece too, is really around education. And that can drive significant reduction in risk, because a lot of risks that we see with instant payment is account takeover, right where you were, I give away our credentials to someone else. And you know, at that point, you know, you've unlocked the doors. So really, education and continuing education is truly important. And it should be available to all credit union associates as well as their members. So, you know, understanding kind of what fraud is, what the different categories of fraud are, and then help for associates and members on how to mitigate that. You know, as far as barriers, many credit unions are really concerned about the opera realization to support instant payments, not the implementation. And, you know, we found institutions and credit unions, you know, really that are looking for operational guidance, you know, a jack Henry, we also come in and help set up and operational model, what to look for how to balance what reports but access to a portal that's available to do reconciliation, and then little shout out or can definitely share some appreciation for the work that's being done by the Faster Payments Council out there, right now, to address the needs, you know, in a series of their publications that they basically put together on operational considerations. There's a couple of links, I'm happy to share with you, Theresa, if you want is, you know, a link that kind of shows some guidance comes from the Faster Payments Council, and it's really guidance around things that financial institutions consider for instant payment receive. Yeah, that

Theresa Witham 09:03
would be wonderful. We will put that in the show notes. listeners can find them there. Do you have any data you can share about the use of and demand for instant payments?

Tede Forman 09:13
Yeah, no, good question. So I'll break it down into kind of the three different kinds of faster payment solutions that are really live today. You know, you've got Zell, you've got RTP. And you've got FedNow, we've got just north of 300 financial institutions that are live on the Zell network, and we're processing about just north of $14 billion in transaction volume. And as an example, between the end of September and the end of February, we saw a 44, almost 45% increase in dollars processed across the Zell network. If you look at RTP as an example, we have just north of two 160 financial institutions live. And that represents I think I mentioned earlier 60 65% of the FIS that are live on the RTP network, or Jack Henry F eyes, we've seen between September and February about a 40% increase in dollars processed. And we're processing about four and a half billion dollars worth through the network. And

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then specifically with FedNow, we're north of 160. Live, we've got over 265 contracts that are signed for FedNow rails. And this number is huge, because you got to think about the starting point. But we've seen a 15,000% increase in dollars processed on the FedNow rails, and we're processing over a million dollars a month in transaction volume for specifically for FedNow, knowing it's only been live since July and pilot mode. So again, the takeaway here is significant increase in transaction dollars and volume. And Zell is both send and receive, but RTP and FedNow right now these numbers only represent receive. So you can imagine, when use cases get developed around send and request for payment, the significant increase in adoption that you'll start seeing with those rails as well.

Theresa Witham 11:24
Absolutely, it really seems like there's no going back on this. It's too popular. It's certainly is very handy when you're trying to pay someone for yard work I had done last summer, right? It's so easy to just give them that payment directly instead of getting the cash or the cheque writing a

Tede Forman 11:45
check. Yep, exactly. But I think you'll see, you know, as use cases get developed around small business merchant apps that can leverage these faster payment rails to get paid immediately. So yeah, that's less risky for them.

Theresa Witham 11:59
What about, can you tell us how instant payments can help credit union members improve their financial health?

Tede Forman 12:08
So a couple things, one, think in terms of faster access to funds. So deposits, for gig economy workers or day to day workers, you're talking about earned wage access, where payroll companies or merchants are small businesses can push, you know, earn wages access immediately. So again, I think one big one is faster access to funds. I think the other piece that's still evolving, is really financial health management for members of a credit union. You know, if you start combining AI, or predictive analytics, with instant payments, members can really better manage their cash flow. So within an example of, you know, our money movement platform that we've built a jack Henry, we've got some predictive analytics baked in there where, you know, Theresa, if you had missed your paying your utility payment, or you had been paying your utility payment, all of a sudden you didn't make a payment, we have the ability to do a push notification to you, Hey, Theresa, do you want to go ahead and schedule and make that payment, you could do it. And then we're integrating Instant Payment rails basically into that money movement platform, so really gives a credit union's member better access to understand cash flow and financial health. So I think those are faster access to funds, as well, as you know, the ability to manage and improve financial health are two things that I think you could see a lot of use cases that are getting developed for instant payment.

Theresa Witham 13:41
Sure, absolutely. And having that access to the funds much more quickly, could hopefully help members resist the call of the payday lender or the predatory lenders that are taking advantage.

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Tede Forman 13:54
Exactly. No, you're exactly right. Exactly. Right.

Theresa Witham 13:57
What is your vision for the future of instant payments?

Tede Forman 14:03
A couple things,I think, instant payments as a foundation, on top of which, you know, we'll see kind of innovative solutions build up. I think this is just the beginning at this point. I think you'll see merchants, once really rails become hardened. And the security and fraud is in place. I think you'll see merchant apps pop up that allow consumers to pay for goods and services at those merchants and think in terms of you know, a merchant potentially then not having to pay as much interchange, if someone was using a card versus a merchant app that's got instant payment rails built into it. So you know, I think you'll see some of that. I think the ability to embed Payment Capabilities into value chains. I think these opportunities are going to grow. So think in terms of fintechs that you embed my gross payment, microservices in are going to grow. And then the other piece really I think that you'll see is, as the US moves ahead with our domestic adoption, I truly think you're going to see that set up the future. For more Global Payment Capabilities were instant payments, rails can connect to other regions countries with Instant Payment Capabilities. So instead of wiring somebody, you would probably leverage the ability to do instant payments as an example. So whether it's cross-border or international payment capabilities, as we become more of a global economy, I think these instant payment rails will basically set up the ability to move funds that way. Another example I like to use think in terms of the mortgage business today here in the US, right? Traditionally, you have to wire money by 10am. So you can close by two o'clock in the afternoon. If you think in terms of instant payments, it can really open up the opportunity to you could close any time, right, you could close on a weekend, because these rails are 24/7. You no clothes in the morning processes fraud have to be baked into that. But I truly think the mortgage industry is ripe for a use case developed around instant payments. Very cool. Sorry, I'm somewhat passionate about it.

Theresa Witham 16:30
So no need to apologize. That's it's good to have people like you who are passionate about these topics have such a profound impact on the industry. It's

Tede Forman 16:40
exciting. I mean, it's you know, I think there's a lot of exciting times ahead for us with instant payments as these continue to get hardened. But

Theresa Witham 16:49
the various payment channels being silos in most credit unions that inherently create disparate user experiences and operational burdens. What are the benefits to see with a true money movement platform?

Tede Forman 17:05

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Well, the biggest one, really, I see as a single platform that can provide consolidated data for analytics and fraud mitigation. I think that's huge. You know, if you think in terms of all the disparate systems that are out there today, and they're siloed, you know, if you have one portal, one pane of glass, that you can go in and be able to do analytics and look at fraud across your solutions. That's huge, seamless experience. So improving that user experience, not only for the end users, but the account holders, but also the f5 teams, right. So the credit union associates themselves easier for operational teams to have a single administrative tool as an example, for settlement and reconciliation, you know, managing and supporting the members across multiple payment channels. To me, that's huge in operational efficiency. Keeping

Theresa Witham 18:01
employees happier by making their jobs easier is certainly something that most credit unions would aspire to, I think we know that instant payments are a real game changer. But what other payments innovations, do you believe our current or emerging game changers? Gonna start with consumer payments? And then tell us about business payments?

Tede Forman 18:23
Yeah, you know, I think probably many of them apply to both. So I mean, if you start thinking about embedded Payment Capabilities, as an example, what we're calling and you know, Jack Henry, we built out payment as a service payment hub. But it really is the ability to have API micro services, and being able to embed them in both, whether it's a consumer or a small business solution for basically moving money faster. The other piece that I think, you know, inherently as an industry, we're going to be moving to a common data standard, you know, the ISO 222. That really simplifies the exchange of information between systems. I think that's huge. And then I think we'll see Gen AI applications, improve payment processes, and really enhance fraud and risk mitigation and management. So you know, probably three key things that I would see see out of that.

Theresa Witham 19:23
Can you tell us about the expected impact of a request for payment functionality for small or medium businesses?

Tede Forman 19:33
instant payment requests for payments functionality solves a lot of issues. You know, it offers speed, finality, and saves the SMB time and resources it really helps them manage their cash flow better. If you take a step back timely collection of payments is a challenge for many SMBs think in terms of streamlining their invoices and payments is a challenge today. Often payments are outstanding small business owners, you know, spend extra time tracking them, sending reminder emails, you know, every billing cycle. And even when their customers send payments, there could be uncertainty in exactly when those funds will be available to them, or the remittance process on how they're balanced. So really, the whole process could be tedious, and potentially negatively impacting their cash flow. So that's why I said at the beginning, you know, Instant Payment Request for Payment really solves these by speed, finality, and then time and resources, it really helps them improve their cash flow.

Theresa Witham 20:40

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absolutely, thinking about paying my cat sitter, when we go away, and how I don't get her invoice for sometimes up to a month, that must be a bit of a challenge, right?

Tede Forman 20:51
So to get it, did she send you electronic invoice and then want you to write a check and mail it to her normally? Yes,

Theresa Witham 20:59
that's how it usually works. But and by that point, I've forgotten all about the fact that we used her services. So and obviously, if I'm a little late getting it sent off to her, then that's not very helpful. So if I could just pay her right away, right, when I get home and see that my cat still healthy and happy and well fed, that would be wonderful. So as we, before we wrap up, what about a final question, what would you tell a credit union that does not have a formal, constantly evolving payment strategy?

Tede Forman 21:31
Well, first thing is, I tell all financial institutions, credit unions, it is very important that you develop a payment strategy. You know, I sometimes use the term death by 1000. Duck bites. I don't know, you might need to edit that out trees. I don't know. But I love that. If you think in terms of you know, one or two duck bites aren't going to, you know, really hurt. Yeah, but 1000s of duck bites. Yeah, they could take off an arm. So think of the fragmentation. And the displacement that's happening today in the payment world, as payments typically drive about a third of a financial institutions net income. When you start thinking about these duck bites, you know, one or two, probably you don't see the impact, but 1000s do. And as credit union members find other ways to conduct payment business, they may not come back to that credit union to do that. So really, one of the first steps we like to do would be to have a conversation on payments, you know, at the top of the organization, how can payments help achieve a credit union's missions and goals? Consider the segments you want to focus on, and then plan on addressing those segment needs, and really need to promote payments, education among the teams to learn about payment trends, keeping up with the industry. You know, Jack Henry, we do offer like some webinars and talks on the relative topics, plus we offer a payment strategy service. And this isn't a I walk into the credit union and hand you a white paper. It's really sitting down with leadership, and helping connect the dots on what's important to the credit union, how do you connect the dots between payments and income? What's important to you from a business driver perspective, and then really help formulate a strategy on solutions that help keep payments in that credit unions ecosystem. So members and small businesses continue to use the credit unions digital experience to do all their payment business. That to me is key. Absolutely.

Theresa Witham 23:40
That's wonderful. Is there anything that I didn't ask that you wish I had or anything you want to add? Before we wrap up?

Tede Forman 23:48
I think you covered the gamut very well, Theresa, I mean, I again, I appreciate the opportunity to spend some time with you and kind of share with you my passion on payments and how it can help credit unions so excited that we got the time to talk. Thank you,

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Theresa Witham 24:05
listeners. Thank you for taking time out of your busy schedules to listen to today's episode of the CUES podcast. Also, thank you to TD Forman of Jack Henry for sharing his vast knowledge about payments with us. You can learn more about today's guest and sponsor Jack Henry at Jack henry.com. You can also reach out to TD AT T Forman at Jack henry.com That's the letter t f o r m a n at Jack henry.com. The guide he mentioned about setting up receive for real time payments is linked in the show notes along with a full transcript of this episode at sea you management.com/podcast 162 You can also find more great credit union specific com tent at sea you management.com I'd love to hear from you. Send me questions that you'd like to hear answered on a future episode of the CUES podcast. My email is Theresa@cues.org That's Theresa with an h t h e r e s a at CUES dot o RG. Thanks again for listening CUES is an international credit union association that champions and delivers effective talent development solutions for executives, staff and boards to drive organizational success.

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In this episode we talk about human-centered leadership. Returning to the show as our guest is CUES’ own VP/Consulting Lesley Sears, who heads up our CUES Consulting offerings. She explains the difference between a business-centered culture and a human-centered one and shares why centering your people will ultimately be better for the business. “In business-centered leadership, you're primarily focused on the numbers. You're focused on the ways of business that are outside of the people,” Sears says. “Are we strategically aligned? Are we getting our numbers? What is the data showing? What's the profitability?” “Then the counter to that is digging into and aligning leadership with what's best for the people who are getting the business done,” she adds. “They're the ones that are making the credit union successful. How can we develop our organization to focus on them first, and then let the success of the credit union come from that people focus?” In the show Sears also discusses: the difference between human-centered and business-centered leadership; why a human-centered approach to leadership works; what human-centered leadership looks like in action; signs that your workplace is struggling to be human-centered; and ways to evolve your culture. Links for this show: Transcript

 Caveday.org: The resource that is saving Lesley’s life right now by helping her find time to focus on deep work. 

From Fast Company: 7 Qualities of the Human-Centric Workplace for Innovative Leaders

CUES Consulting
 
Purposeful Talent Development blogs by Sears: Purposeful Talent Development: Career Paths Are More Important Now Than Ever Purposeful Talent Development: How Employers Did on 3 Key 2023 People Goals Purposeful Talent Development: 4 Best Practices for the New Year Purposeful Talent Development: A Culture of Learning Builds Resilience  Past podcasts with Sears:  Mitigate the Flight Risk of Newly Promoted Employees  The Nine Dimensions of Climate  Align and Streamline Your Organization Using a Skills Focus  Videos with Sears: Tips for Making Your 2024 Talent Development Resolutions  How to Kick Start Your Managers' Development How Can Credit Unions Build a Balanced Bench of Talent?

 

Podcast 160 Jim Devine Business Lending

February 2024

By Jim Devine

 

Lisa Hochgraf  00:03

You're listening to the CUES Podcast, episode 160.

 

Lisa Hochgraf  00:08

Welcome to the CUES Podcast where leaders and experts discuss the top topics in credit unions today. I'm Lisa Hochgraf, senior editor at CUES. In this episode, we explore member business lending, both where it's been and where it could be headed.

 

Lisa Hochgraf  00:24

Our guest is Jim Devine, co-founder CEO and chairman of Hipereon, a financial training company based in Washington State. Jim is also a lead faculty member for CUES School of Business Lending, which starts its 2024 session on April 1.

 

Lisa Hochgraf  00:40

In this show, Jim talks about what has been happening with credit union business lending post-pandemic, and what may happen to it as the economy shifts again in 2024. He describes the school and how it helps credit union leaders learn foundational tenets of success in business lending, plus what he's doing that's new and cool with this year's school.

 

Lisa Hochgraf  01:01

I know you're going to learn a lot from what Jim has to say. So let's get started.

 

Lisa Hochgraf  01:08

Welcome to the show, Jim.

 

Jim Devine  01:10

Thanks. I appreciate the opportunity to talk with you.

 

Lisa Hochgraf  01:13

It's always good to talk with you. I feel like I know you pretty well since you've been teaching the School of Business Lending since like 2002, I think that's when the pilot was. But many of our listeners won't have met you yet. And I'd like to help them get to know you better. To that end, would you have a mantra or a quote that you live by that you would share?

 

Jim Devine  01:34

We do have, you know, a couple of things that we're well known for, as you well know. We've done a lot of commercial lending training over the years for both banks and credit unions. And we have kind of a battle cry that we created several years back. And so most of our students, over all the years we've been doing these schools, if we say this out loud, they all absolutely buy in, and we say, "If the cash don't flow, the loan don't go."

 

Jim Devine  01:57

And so it's just our way of telling them that when you make a credit decision on a business lending opportunity, people have to be worthy, you know. So you have to diagnostically assess their capabilities to repay you. Are they worthy to get the money because they have a an identified capacity to pay you back? And are you confident that the processes that you execute to determine that capability are processes that are valid, and you're not kidding yourself? And again, don't sell credit, grant credit, and realize that the money that you are making available to a prospective borrower isn't your money, it's your depositors’ money. So you have a fiduciary responsibility to, you know, to mother it and protect it.

 

Lisa Hochgraf  02:40

Yes, it's your members’ money, right? People would say, and I attended your School of Business Lending a few years back, and I still remember that mantra, "If the cash don't flow, the loan don't go," and you would say it over and over until people were saying it in the hallway because that was so foundational.

 

Lisa Hochgraf  02:59

So, Jim, I've been reading that 2023, this past year, was the first year since 2019, without some sort of pandemic-era-induced liquidity excess or low rates. In other words, we're slowly getting back to like a "normal" environment.

 

Jim Devine  03:16

Well, it's a normal environment. But again, you have to look back and see what happened in 2023 from an interest rate structure perspective, because the Fed, in its attempt to try and curb inflation that was happening rapidly out of the pandemic, started to raise the Fed funds rate, which is the rate that financial institutions borrow from the Fed. And it was, you know, at an almost zero level at the beginning of last year, and over the course of that year, it increased 500 basis points.

 

Jim Devine  03:46

So effectively, what happened is prime borrowing rates and banks went from around three, three and a half percent, at the beginning of 2023, to now eight and a half or 9%, depending on the institution you're dealing with. So you know, to put it in perspective, let's say you have a million-dollar loan. And that million-dollar loan is amortizing based on a 3.5% rate on a 20-year amortization schedule, that loan payment would be around $6,000 a month. If you take that same loan and put it in place today. And you say, "Okay, that's a prime rate borrower," so I'm going to apply an 8.5% rate; that payment all of a sudden jumps up. And so instead of paying $70,000 in annual payments, you're going to be spending $105,000 in annual payments. So it's going to literally go up by 50%.

 

Lisa Hochgraf  04:37

That's amazing. So what did this do? What What impact does this have on credit union business lending last year?

 

Jim Devine  04:43

Well, I mean, what it's done is again, what we talked about being creditworthy, right? And so you have to have the cash flow capacity to service the debt. And that cash flow capacity is going to link back to your underwriting policies and operational guidelines. And so typically, when you look at debt service coverage, you want a fudge factor in there. For a secondary source of repayment, you want a loan-to-value logic that has a fudge factor in it. And so here's the irony of what's happened.

 

Jim Devine  05:09

Let's suppose that you have a lending policy that says, "Okay, my debt service coverage requirements in the underwriting guidelines, I need $1.20 capacity to cover every dollar of principal and interest that needs to be repaid." Well, what happens if all of a sudden, you're hedging that and you're you say, "Okay, well, I'm going to approve this loan, even though it's not at my minimum requirement, I'm going to approve it. My analysis says it's $1.15 at capacity, not $1.20. But I'm going to do it."

 

Jim Devine  05:38

And so now interest rates go up, and I have to reevaluate this loan, probably reprice it, and commercial real estate, which really dominates. There's roughly $160 billion worth of commercial loans on the books of credit unions today, when you look at that pool, 80% plus of those are commercial real estate loans. And so we've gravitated to commercial real estate because there are less moving parts than there are in commercial and industrial loans and operating loans to a business. You got the tangible collateral. And so the thought process for identifying primary and secondary source of repayment capabilities is more focused. It has less moving parts. And so you take the income that the property is generating; you measure that against the debt service coverage requirements. And if you get to the 1.2 capacity, that's a reason to say yes, yeah.

 

Lisa Hochgraf  06:28

So what are you expecting for 24?

 

06:31

Well, a couple things are going to happen in 2024. For one, a lot of the commercial real estate loans that have been made are going to end up in a position where they need to be repriced because typically how they would be structured is you know, they will have 20- to 30-year amortization schedules, but five-year calls or balloon payments. And so at the end of five years, you have to revisit the deal, reprice it, restructure it and go forward. Well, when you look back five years ago, it's coming right out of the middle of the pandemic. And you look at where properties were, what's happened over the course of the last year and a half is we've seen, because of what happened with pandemic demand for let's say, commercial office spaces as an example, there are a lot of people you know, that are working from home. The demand for office space is low. It takes Seattle where I'm at commercial office space right now in downtown Seattle is about 20 to 23% vacancy rates. Wow, if you go five years ago, they were at about 10.

 

Lisa Hochgraf  07:25

Wow.

 

Lisa Hochgraf  07:26

And so you've got properties that aren't generating the gross income that they were because of the vacancy issue. And so the cash flow capacity that the building is generating to service the mortgage isn't as robust as it was five years ago.

 

Lisa Hochgraf  07:41

Here we go with the cash flow. If the cash don't flow.

 

Jim Devine  07:43

you got a challenge to meet the debt service coverage requirement. And it's a double whammy, because when you value the property, you take the income stream it's generating typically, and you apply a required rate of return against that income stream, a capitalization rate. And the net result is the capitalized income value of the property is X dollars. Well, if you drop the net income down because of the vacancy problem, and the pressure on branches is tough because you know, there isn't enough demand, pull that keeps the rents high, you could easily see a building today have a net income pool that that would be 60%, of what it was five years ago. So if I'm capitalizing that 60% number, and doing so with the current interest rate, so a cap rate based off current rates of interest, that property could be worth 30, 40, 50% less than it is now. If so, if you loan the money against the property, and the capitalized earnings valuation on the property drops, what was 80% loan to value and in compliance with your policy may now be 120%. And so now you're out of compliance. And so a regulator would say, "So what are you going to do to get back in compliance?" Well, I just need more collateral, or I need the property to be more valuable. Okay, easy to say when you say it fast, but very hard to execute. I read an article just the other day that Goldman Sachs said that there's $1.8 trillion worth of commercial real estate loans on the books of financial institutions in this country that have to reprice by the end of 2025. And so

 

Lisa Hochgraf  09:20

So let's see when I plan to do an article on how that works because I think that's something that would be really good to put down for our listeners. And then we'll circulate that out through CUES and get that information to people.

 

Jim Devine  09:32

Yeah because that concentration risk caused by the fact that 80% plus of the loan portfolios is linked into commercial real estate. And commercial real estate is very cyclical. I'm doing credit and credit means people have to be worthy and I have a primary source of repayment analysis and a secondary source of repayment analysis, and then maybe a tertiary source of repayment analysis that I have to do. And typically tertiary sources of repayment are linked to guarantees. Well, one of the things that the NCUA decided to do in their era of relief back in 2017 and 18 is they took the mandate to have all commercial loans personally guaranteed by the borrowers. And they lifted the guarantee requirement. So there's a lot of loans that have been made where there is no tertiary source of repayment, that guarantee doesn't exist. Yeah, oh, I am really back on the primary secondary source of repayment logic. And if interest rates go up 500 basis points in less than 18 months, and I'm dealing with a pricing issue for credit. That's going to have as as I said, before, a profound impact on the amount of cash flow you have to have to service the debt.

 

Lisa Hochgraf  10:39

Yeah. So Jim, you know, you're kind of laying out the big picture here, what happened last year, what people are going to be facing next year. And to me in my editor brain, it's translating into like, key things that credit union business lending programs might need to have. And one thing I'm hearing is readiness to pivot, right? When you get that five-year balloon, you got to know what to do. And another thing I'm hearing is layering of possible repayment. So you're talking about you'd like to have three and now we have two, but making sure you've got those solid, right?

 

Jim Devine  11:11

Right, right. What you can't do, you have to know that the analytics that you're applying are arm's length, and there's no bias. You're not trying to figure out a way to say, yes, you're trying to figure out whether yes is the right answer. And again, in order to do that, you have to have the analytical skills to do it, right. And, you know, with incentive compensation linked to a lot of commercial lending programs, and where people are getting paid to book credit, that's another issue that has an impact. And so the objectivity of the analytics really have to be championed now.

 

Lisa Hochgraf  11:46

Um, okay. So objectivity is another important characteristic of a solid program. Gotta have numbers. They have to be real. They can't be full of bias.

 

Jim Devine  11:49

Right. And if you think about loan portfolios, and again, because of the heavy concentration that's associated with commercial real estate, and most commercial real estate deals are transactional, so it's somebody who is going to build a commercial building. And so they form an LLC. They have a single property in the LLC. They form the LLC in order to create the liability coverage. But that's it; there's not multiple things involved. It's very linear; that deal has to work.

 

Jim Devine  11:58

And if you don't have a guarantee, the only thing you have left to fall back on if the cash flow doesn't service the debt property is the underlying value of the property. And unfortunately, the underlying value of the property is determined primarily by capitalizing the income stream that the property generates. And so if there's anything causing structure problems with that capacity, meaning that there's a higher vacancy rate, or whatever it might be, but again, if you take the cap rate, and you take a cap rate, I'm just gonna take pick a number, say I'm using a 5% required rate of return as a cap rate. And I decide, use 6%. If I go from 5% to 6%, 100 basis points up, what happens to the value of the property? Well, the value of the property will drop by 20%. You know, and so if I'm at 80%, LTV, and the rates go up, it doesn't take very long for that cushion that we have in the logic of our underwriting process to all of a sudden it's no longer 80%. It's 90 or 95%, either out of compliance, or worse yet, it's over 100%. I've got a chasm there that I have to somehow resolve.

 

Jim Devine  13:28

So there's just a lot of issues that I think are going to come up. And as I said, according to what, you know, that article said that Goldman Sachs wrote, there just happens to be a ton of these commercial real estate deals that are on the books of financial institutions that need to reprice by the end of 2025. And so in 2024, there's going to be a lot of need to identify those deals that need to reprice.

 

Jim Devine  13:51

And so what's the strategy? What are we going to do if interest rates are now up 500 basis points from where they were when that loan was originally underwritten and there was any pressure on occupancy that causes vacancy to go up--and as a result, possible operating income to drop because part of the property is not even being used. It's the double whammy, the attack on primary source of repayment capacity and the attack on backup plans for secondary source of repayment collateral value, that in combination are, you know, it's like a perfect storm.

 

Jim Devine  14:23

And so people are going to have to start looking at the feasibility of figuring out how to make more operating loans to operating businesses and not have such a huge concentration risk in a loan portfolio linked to commercial real estate. It's just gonna have to be a more diversified portfolio. And then having said that, what kind of business is it? Is it a service business or retail business, wholesale distribution, manufacturing construction? Every one's got a different chemistry. And so to understand how to do lending correctly, I have to understand business model structure because the structure of the business model will dictate the cash flow capacities that are generated.

 

Lisa Hochgraf  15:03

So what are some elements of the School of Business Lending that you'll lead coming up later this spring that are evergreen that never change from year to year? And I think you're gonna say the cash flow. But maybe there's other things, too. And why are those ideas so foundational?

 

Jim Devine  15:19

Well again, I mean, you know, we live in such an AI plug-and-play world that everybody's looking for a software tool that will be the answer. You know, "Why do I need to do all the diagnostic analytics? I can just push a button, and the software will take care of it." And again, software is a tool, right? And so what we need to understand is that if we don't understand structure, it's hard to apply analytical tools and do it accurately. And so the way we built the school is we want people to clearly understand the chemistry of the documents that are financially oriented that they're going to be analyzing to determine creditworthiness.

 

Jim Devine  15:55

So we start out by making sure they're aware of the various business entity structures that are out there, and what's unique about their organizational design. And we look at issues that are critical to continuity in those businesses and going concern capability. Then we segue into a discussion of the financial documents. So we get into basic accounting logic and how financial statements are actually designed and why they're designed in that fashion. So that kind of brings back, you know, some of the years of accounting experience we had when we worked in the CPA world. Then we say, "Okay, once we understand the structure of the documents we're going to analyze, now let's apply an analytical process to those documents. And what we're going to determine, if we're going to determine liquidity, solvency, capital structure, profitability, asset utilization in an analytical process, linking it all together to the structure of what these business financial statements look like, then once we get a financial analysis process down, we segue from that into a discussion of financial analysis in a credit context.

 

Jim Devine  16:57

So now, how do we make a credit decision where we have a primary, secondary, tertiary source or repayment logic that has to apply to the financial analytics that were utilized to determine, you know, how the business is operationally performing? And so does it meet the debt service coverage standards? Yes or no? And why?

 

Jim Devine  17:17

And what about backup plans whether it's, you know, collateral or guarantees, or whatever? What are we going to do so that we have a strategy for collateral a strategy for the use of guarantees the strategy for how primary source of repayment fits its business model structure expertise that we're trying to convey in the school. And we do it through a significant number of case study exercises that show how you apply the logic of the analytical process, and then segue in again, to a credit context.

 

Jim Devine  17:47

And so it's a boot camp workshop kind of experience. And so we're not assuming that anybody has specific background skills coming in. But what we are going to make sure is that everybody going out the back door has the foundational skills that give them confidence that they can take a set of financial statements from a prospective borrower, do a diagnostic assessment of the performance of that business, link it to their debt service coverage policies and guidelines, and determine whether I'm willing as a fiduciary to let my depositors' money fund their credit request.

 

Lisa Hochgraf  18:20

Yeah so, and then the School of Business Lending for 2024 will begin on April 1, right, Jim? Are there any new things or details that you're planning to add for the current environment as you teach it this year?

 

Jim Devine  18:32

Well, I think that, you know, again, what we want to try and create, we have always had a personal bias to face-to-face type type of training. And we like to look you in the eye and make sure that you're, as you look back at us, we can determine whether or not you're you're with me and you're getting it. And so as we've gone to online base training, we want to personalize it. And so what we have is we have a lot of sessions that are held that are live sessions, and we're trying to enable a more interactive capability than what traditional online kind of training does, so that they have, as a participant in the program, a capability of contacting me personally contacting Bob, personally, whenever they have an issue about application, and they're not exactly sure whether what they've decided to do fits, we have an open line to them. If you have a question, call us and we'll get you in a dialogue. And we'll make sure that you get it. And so the extension this year is to try and create more access and to you know, have these sessions where we kind of circle the wagons and we visit the key component parts of the architecture of the program and we make sure that everybody is okay. And so what people will have is an opportunity to ask more so than they have in the past since we moved to the web-based format for the program. And so I'm excited about that because it just gives us a chance for better personal dialogue with the participants. And to me, that's always been a big part of this educational experience

 

Lisa Hochgraf  20:02

And you and your partner in this, Bob Hogan, have so much experience and so many amazing stories to tell that I encourage anyone taking the class to reach out to these to further deeper expertise.

 

Jim Devine  20:13

Yeah and again, it's we say, don't suffer in silence. If you have an issue, you have an absolute capability to get it addressed. All you have to do is pick up the phone, drop us an email, and we will connect you and we will make sure that whatever it is that you are confused about or concerned about, we can address--because the intent is to give you a set of skillsets, that you can, you know, walk out the back door confidently with and utilize it to make good credit decision.

 

Lisa Hochgraf  20:40

Very applied. Jim, you've been really generous with your time today. But before we close the show, what's the question that I didn't ask that you would like to answer for our listeners?

 

Jim Devine  20:51

What's going to be really important over the next couple of years as the economy kind of settles in, I mean, we have an election year, we have lots of stuff going on this year, but the fact that rates are up and there's, there's never been a time in my opinion, where you just have to make sure that what you're doing from an asset liability planning perspective, from a credit decision making perspective, that you're doing it in a systematic way that says, "Look, I grant credit to people who are worthy. I don't sell credit. I'm not cavalier about my process, I'm consistent. And what I do is when I make the credit decision, then I set up a monitoring process. Because again, I'm anticipating capacity to pay. What I have to be watching is that capacity to pay actually happening. And I'm on track and you have to be capable of thinking about, you know, like, the real estate stuff. I mean, there's going to be a lot of reengineering that's going to be needed for these loans. And so if I'm going to re-engineer the loan, and still have it be creditworthy, given the environment, I mean, what can I do?" And so there needs to be a lot of thoughts about how the execution of both underwriting and then ultimately credit administration for those loans that you now have on the books. They now are an asset that you have to manage. How am I doing this thoroughly and consistently, going forward? Because it's going to be an interesting, you know, next couple of years as this economy starts to recover from the pandemic.

 

Lisa Hochgraf  22:17

We continue to live in interesting times. And it sounds like what you're providing is a nice framework, steady guidelines, solid metrics and clear ideas on which to make judgments.

 

Jim Devine  22:27

Yeah, don't be arbitrary, be structurally sound and consistent. That's the message.

 

Lisa Hochgraf  22:31

Thanks so much for being on the show today, Jim.

 

Jim Devine  22:34

Absolutely. I appreciate the time. And again, we look forward to anyone that's out there in the credit union space that has the time, come to the school, I think you'll find it it's a tremendous educational experience. It will be well worth your time and effort.

 

Lisa Hochgraf  22:47

I would like to thank you, our listeners for taking time out of your busy schedules to listen to today's episode of the CUES Podcast.

 

Lisa Hochgraf  22:54

And many thanks to Jim for sharing so many insights about doing member business lending during these economically interesting times.

 

Lisa Hochgraf  23:03

If you liked the show, you can sign up to learn more at cues.org/sobl. Find a full transcript of this episode at CU management.com/podcast 160. You can also find more great reading and specific content at CU management.com.

 

Lisa Hochgraf  23:23

Thanks again for listening today.

 

Lisa Hochgraf  23:25

CUES is an international credit union association that champions and delivers effective talent development solutions for executives, staff and boards to drive organizational success.