by L. Carlos Lara
Earlier this year we  (Robert Murphy and I) asked a high-level executive of a life insurance company if his organization had any problems with the increase of policy loans on their balance sheet resulting from the popularity of the Infinite Banking Concept. His answer still resonates inside my head. Although not an exact quote, this is in effect what he said — “Not if I can still fund them out of cash flow. So long as we stay in a high premium environment such as what we have today, I have no problem whatsoever with policy loans.”
I guess not! With that kind of cash flow, who would have a problem? A business that can do that sort thing—fund policy loans without having to sell off invested assets—obviously has a very strong inflow of cash that far exceeds its outflows. This is the type of business we would all want to own. Then it dawned on me within seconds that the policy owners taking out those same policy loans were the “owners” of that company. Suddenly, the entire cash flow concept espoused by Nelson Nash came full circle in my mind.
Cash flow really is king. It’s business 101. You can have a profitable enterprise, but if you have poor cash flow you can get yourself into financial trouble pretty quickly and even go broke. Liquidity is highly important, especially in a recessionary environment, and must be watched constantly by the money manager at the steering wheel of a business. When sales decline and receivables start to back up you can bet your bottom dollar that a liquidity trap (in the micro, not Keynesian, sense) is about to ensue. Immediate action must be taken to keep from having a complete lock up of the money flow. Many times that adjustment is not so easy to make and liquidating available assets in order to stay afloat can be costly. The only remedy to deal with that sort of problem is having a ready reserve of cash or credit to draw upon for those special deficit situations. No one knows this better than commercial banks.
Commercial banks are institutions that specialize in cash flow management. There are no financial gurus schooled more proficiently in cash flow management than bankers. This is their terrain and they keep a watchful eye open for prime lending opportunities and it is usually the unsophisticated small business owner. Statistics demonstrate to them that small businesses start out grossly undercapitalized and in constant need of working capital. Consequently banks have an enormous field of banking prospects to draw upon and the supply never ends. While a large percentage of new small businesses fail within the first five years, there are new businesses cropping up everyday. Most all of them are lacking cash and, therefore, in great need for bank lines of credit.
Should IBC Bankers extend loans to small business owners?
Upon reading this fact and considering this question, you may be musing over this huge market for banking opportunities that exists within the small business sector. Does it make sense for an IBC Practitioner sitting with cash in his policy to lend money to them and should you do it? What would be the reasons for not doing it? Actually this question came up recently in a conversation with a very good friend of mine who is a seasoned IBC Practitioner who is about to do just that. Up to this point in his IBC experience he has always been both the lender and borrower, one in the same. The only other time he has utilized a third party is in the use of his own corporation, but what he is about to embark upon now represents an entirely new type of third-party transaction. After I learned the exact details of the transaction, I expressed some concern and shared those with him. With his permission I am sharing our conversation here in this article. My purpose is not only to explore this option a bit further, but also to discuss more fully how commercial banks actually lend money and how they differ from what we may typically do in a lending situation.
Here are the details. My IBC friend has a friend who is a small business owner in the real estate business. He buys small houses and duplexes and rents them out. He was a bit short with the required down payment on a desirable piece of property that came on the market and my IBC friend was ready to provide his friend the needed funds under a well-constructed loan arrangement. Since my IBC friend is a knowledgeable businessman, he is taking great care in the preparation of all the required loan documents. My IBC friend is securing himself with a title and first lien position, not on the property that is being purchased, but on another piece of property the business owner already owns outright. The 15-year term mortgage is fully amortized with a set principal and interest payment. If all goes well over the next fifteen years both parties in the transaction should be very happy with their outcomes.
My IBC friend will borrow the funds for the loan from his insurance policy cash values at a relatively low rate of interest from his mutual insurance company, then lend the money first to his corporation and then his corporation will in turn lend the money to his friend, the business owner. In essence, the corporation will become the mortgage company. The corporation, in turn, will pay my IBC friend back for the funds coming from his insurance policy loan, but at a higher interest rate than what my friend pays to the insurance company. The net result is a seemingly perfect cash flow system of policy loan repayments with interest, deductions, taxing benefits and increases in wealth.
It really is a good banking transaction. The only one concern I had with this arrangement was that my IBC friend was transacting this loan arrangement with a friend. The reason this is problematic is that dealing with a loan transaction that’s gone bad can be difficult. The loan transaction must first be analyzed very carefully from its exit strategy, before considering any of the benefits. The fact that this is a lender-borrower transaction with a friend could potentially negate all of the protection rights the lender has over the borrower. When the timely payments in the contractual agreements suddenly fall behind, there follow some very uncomfortable emotional decisions, especially for the lender. As we all know, any type of collection measures are usually aggressive and simply do not work well with friendships. If more aggressive measures become necessary the friendship will most certainly not survive. Your friend’s cash flow problems may in fact be very legitimate and unfortunate. But will you be able to force the sale of the asset if it comes down to that or, because he’s your friend, suffer the loss yourself?
Still, this does not mean to imply that these types of loan transactions with small business owners, even if they are with friends, cannot be consummated and work well. What we are saying is that IBC Practitioners should look very carefully at all aspects of lending practices that go beyond themselves, or their own corporations, as the primary borrower. Loans can and do often go bad and we must know what to do when these loans collapse. Once we start lending to others beyond ourselves from our insurance policies, we should of necessity become more proficient in the nonfinancial analysis of credit granting and consider carefully the ramifications of the exit strategy.
The Four “Cs” of Credit1
Back in the 1980s when I taught credit management to high-level executives, I always started with the fundamentals. The most important nonfinancial factor in credit analysis is what we observe in the management of a business. Here we are specifically analyzing the business owner, his experience, background, knowledge, honesty, and ingenuity. These are all incorporated in the “Four Cs of Credit”: character, capacity, capital, and conditions of the times.
Briefly summarizing each, beginning with the first “C”—character, this factor searches out the willingness of the debtor to pay obligations. Without a long business history of the business owner it is difficult to make this business judgment.
Capacity is the aspect that deals with the ability of the business to operate successfully as an operation of three separate, specialized, and interlocking functions: marketing, production and finance. Without these three the business will remain retarded.
Capital in this sense has to do with the business’s ability to pay the obligation, as opposed to the first “C” which has to do with “willingness” to pay. This factor highlights the financial condition of the business and trend of operations.
Finally, Conditions of the Times. It goes without saying that general economic conditions of the country, the community and the particular industry will naturally exert influence on the financial analysis of a business. Beyond these basic four nonfinancial analyses, we move into more sophisticated measures, but the inexperienced credit grantor of loans should become proficient in these initial four functions if he is to make lending to third party business owners a regular practice.
Obviously, we can learn a great deal by studying what commercial banks do when they lend money to small business owners. One of the first things we see is that they practice very aggressive lending methods with no emotional attachments even though it may not seem that way at first.
Commercial Banks Use Different Lending Practices
To begin with, let’s always keep in mind that commercial banks are different types of financial institutions unlike any other in our American economy. Banks begin all their lending transactions with what appears to be friendly negotiations. Your loan officer is all smiles at the start of the initial loan request. You need some money and they are there to provide it for you. That is their business and they are very knowledgeable and skilled in their profession. Loan officers, for the most part, are sincere and innocent in their efforts of taking you through the different stages of your loan application, right down to where you sign on the dotted line. It is simply their job as officers of the bank to pursue your business. Unbeknownst to you, that loan application you are filling out covers all of the information necessary for the nonfinancial and financial analyses to be done in order to approve the loan. This function is not done by the loan officer, but by a cadre of credit professionals in the background. There will be credit checks and a thorough interrogation of your character and business experience. The entire inquisition is done in a spirit of making you feel wanted and important. One negotiating tactic is to get you to agree to make all your business deposits into their institution in return for the loan and a favorable rate of interest. This seems reasonable and fair and makes you feel like a real business partner and friend. However, you and I know the facts: for every dollar deposited into their bank, the banking system will be able to lend out nine dollars on that one dollar. This is fractional reserve banking—live and in person—a unique feature of commercial banks that serves to increase their wealth.
Also, in the same way that you had to borrow from a larger pool of money (the insurance company) to make loans, banks also need to go to their money source (the Federal Reserve) to be able to make their loans. Without the legal reserve requirement on deposit with the Federal Reserve and in their own vaults, banks have to borrow the money at the federal funds rate from other banks or at the discount window from the Federal Reserve. Without those required reserves they can’t make loans.
But the biggest difference between the banks and the insurance companies is that the insurance companies have a real pool of money, whereas the banks’ pool simply appears from the Federal Reserve electronically out of thin air. The loan funds appear in your bank account ready for your use. At that point you can access the money and go back to conducting your business affairs without a clue or consideration of what all that money will do to the community and the general economy. But if you should ever have a problem paying back your loan you go through an entirely different process that is already systematized in your loan transaction. You may get a few opportunities to talk to the same loan officer that originated the loan to explain your cash flow predicament, but after that you will be directed to another type of loan officer who will most likely be a complete stranger who has no emotional attachments to you except what is written in the loan documents. At that point things change dramatically for you as the borrower.
Commercial Banks Over-Collateralize All of Their Loans
Loans with commercial banks can become extremely problematic for small business owners once the business starts to experience problems making its loan payments. It is then that business owners realize how overly collateralized their loans really are. As a general rule of thumb, most business lines of credit in the fine print have given the bank a complete lien on all of the assets of the business. This will generally include inventories, accounts receivables, furniture, and equipment. Getting this lien released requires payment of the entire obligation. Given the circumstances, this would be extremely difficult to accomplish. Since most lines of credit are what small businesses rely on for the normal ebb and flow of seasonal cash flow needs, the business is doomed once the bank closes up these credit lines. Banks can easily move in to liquidate the assets, within the confines of bankruptcy or not, and often do, as a preferred secured lender. Usually the banks come out whole, while all other creditors, being unsecured, lose everything along with the owner of the business. If by chance the bank is still owed money at the end of this first liquidation, the bank will act on the personal guarantee granted in the fine print of the loan documents and start their move against personal assets. Notice— there are no emotions anywhere throughout any part of this entire process. I have witnessed this bank collections scenario played out hundreds of times in over 40 years of debtor-creditor relations. Their outcomes are very predictable. Banks are experts at their trade. Lending the money is only one facet of it, collections is the other.
In the October  issue of the LMR2 we showed our readers a graph that indicated that business owners were sitting on more cash (broadly defined to include MMMFs) than has been held since World War II. Even if we focus on cash in commercial banks proper, they are holding more as a share of the economy than at any time since the mid-1960s. A whopping $1.4 trillion worth of cash to be exact! It’s just sitting there losing income. [Corporate cash as a share of GDP was gently trending upward since 2014 and then skyrocketed during the pandemic where it was 17.8% of the US GDP, 3X the level of the early 1990s. ed]
It seems logical to me that IBC Practitioners would achieve more financial success with less emotional commitment, by simply introducing small business owners to the banking features of whole life insurance and the utilization of this available cash reserve. IBC Practitioners need not become lenders to them all. Business owners could be shown, through sound education offered by IBC Practitioners, the hazards of borrowing from commercial banks, the potential jeopardy to their businesses, and the inadvertent contribution to the national inflationary problem by borrowing from them. What better way to borrow than by using one’s own pool of money and bypassing the commercial banks altogether? By teaching them how to create their own privatized banking system, not only will their borrowing to meet cash flow needs be non-inflationary, but also those dreaded credit applications become totally unnecessary. Now this is real financial freedom and peace.
1. The Credit Executives Handbook, George N. Christie. PhD, and Albert E. Bracuti, M.B.A., Credit research Foundation Inc., Lake Success, New York, Copyright 1986 Chapter 18
2. October 2012, LMR, IBC and the Business Owner, by L. Carlos Lara