February 16, 2009
Isn't it Just Economics 101?
My kids have been asking what exactly is going on with the economy and what exactly happened that made the situation so bad, so fast. They are really referring to what the tipping point was that caused this entire iceberg to turn over in September 2008.
I try to explain it to them as simply and succinctly as I can and somehow, by boiling it down into terms that even my 7th grader can understand, it helps me to understand the situation a little bit better too. I don't need to speak in 7th grade language, but I think that for purposes of this example, simplicity goes a long way.
I have several friends who provide financing against invoices and accounts receivable. These two types of financing are called accounts receivable financing and factoring. Both of them use invoices as a form of collateral to advance funds to companies for sales that they've already made but where they won't collect the money until later. The smaller factoring and accounts receivable companies get their money from larger financial institutions. They use a facility called a rediscount line. They pay a modest rate of interest and then they loan the money out that they have on their line to their customers at a higher rate and make the spread. I know several companies that operate in the $100 million dollar category (meaning that they have lines of credit of approximately $100 million dollars that they can loan out to a wide variety of borrowing companies that make up their customer base).
So here is what happened. Let's take a lesson in Economics 101.
When the markets collapsed in September 2008, the banking and lending community felt an immediate liquidity crunch and it became extremely apparent almost overnight. Liquidity means that the banks have cash to lend and the reason that suddenly they did not have cash to provide to borrowers is that their balance sheets were exposed as "puffed up". This was largely attributed to the decrease in real estate values. Forcing the banks to reduce the value of the real estate securing their loans changed everything.
Since the amount that a bank can lend is based on the financial strength of that institution, a sudden decrease in the value of their real estate loan portfolio reduces the overall financial strength — leaving hardly any money to lend. This is why the Bush administration (and President Obama too) is pumping money into the banks. The logic is that propping up the balance sheets will create a climate where lending can resume. It's not working because the banks are using the money for alternate purposes. This is why Congress is so mad.
Here is how this affects our businesses.
The small and medium size companies that we work with frequently use factoring or accounts receivable financing. They get the money from commercial lenders. These commercial lenders get their money from much larger financial institutions using a vehicle called a rediscount line. But with the liquidity crisis, the companies that supply the rediscount lines such as Wells Fargo, Bank of America and CIT, immediately began reducing the amount of credit that they extended to their customers because they didn't have enough money to go around.
Therefore, the ability of the factors and accounts receivable lenders to loan money was reduced. The commercial lenders lost a percentage of their rediscount lines and therefore, they had to reduce the amount available to each of their borrowers.
The commercial lenders immediately looked at the files of their customers and they started butchering the credit that was extended. For example, if a commercial lender had a rediscount line of $100 million and it was reduced to $60 million, they had to shrink the lines of credit for their customers. That also means that instead of making a profit on $100 million, they now have to base their business on just $60 million. So, they have almost no way to grow and they have almost no way to make the amount of profit on interest that they had expected.
The impact of that is they have to go through their customer list and start reducing the lines of credit. So, imagine a company has a $1 million line. They probably got crammed down to the tune of $600,000 because that was the percentage that the commercial lender got crammed down from their supplier — the rediscounter. The ripple effect is dramatic and the pricing increase on the remaining balance will necessarily go up, otherwise, companies will not be able to survive. And the rediscounters will not be able to survive either. And the impact on the borrowers is that their price of funds goes higher even though the price of funds in the economy is relatively low.
There are lots of other reasons that the price of money goes up to the entrepreneurial companies too. One basic reason is that because they still need the money, they have to go to a "harder" source for it.
That explanation helped my kids, and I hope that it helps you to understand just a little bit more
about what is going on. It is a complicated situation and a sad commentary on our own economy and society.
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About Joel G. Block, President of Growth-Logic, Inc. Often dubbed a "Growth Architect" by his clients, Joel Block advises companies on explosive growth strategies by driving revenue and sales. Well known in the capital markets, Joel is a successful entrepreneur, speaker, advisor and faculty member of the iLearningGlobal community. To bring Joel into your company, please visit http://www.joelblock.com or http://www.growth-logic.com. Also, be sure to check out our newest project: a blog to organize the blogs that cover entrepreneurship — http://www.entrepreneur-hub.com And finally, for film makers: http://www.filmfundingblog.com – our newest project.
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Comments on Isn't it Just Economics 101? »
Hey Joel.
Thank you for creating this easy to understand explanation to us. You did an excellent job at breaking down a very complex subject.
You gloss over a very important point. We (the tax payers) are funding our banks with billions and they are not using the money for its intended purposes. This is indeed very upsetting.
What is Congress doing about it? What can we do about it? Does the White House have any influence (power) over the banks?
I guess the next question is really rhetorical, but was there nothing written in a contract or agreement as to how the funds were to be used?
Thanks again Joel. Please keep up the great work. It makes a difference.
The lack of liquidity is the result of counterparty risk in all areas of the economy - the lack of liquidity is not the cause.
Basically, the problem started with the credit rating agencies (Fitch, Moody's and S&P) supplying AAA ratings for MBS (Mortgage Backed Securities) which we know was incorrect. The failure of borrowers/loans in the MBS pools caused investors to question all aspect of the lender's portfolios and in March the credit markets began to seize.
We still have this lack of faith in counterparties which is most easily seen in a lack of credit (and sometimes very large yield spread differences between AAA rated companies and treasury notes).
I would explain it to a 7 year old as follows: People saved their money and lent it out (Shared it with borrowers) because our leaders and advisers told us it was safe to do so. When borrowers stopped paying their loans, the people lost faith in the leaders and refused to lend any more. Now no one is sharing and everyone is sad. Everyone is protecting their money and not trusting anyone.