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Part 1: Financial Crisis 101: The Way It Works
By Kelleen Griffin
Banking today in its most basic form is a really really simple idea. A bank takes in $1.00 in deposits, and is allowed to lend (this is approx) $0.30 of that dollar to the public. The rest has to sit in the bank vault as capital, just in case there are, ahem, problems. (See “It’s a Wonderful Life”, for George Bailey’s version of this explanation.)
As banking evolved, and I mean very recently, banks decided that they could make more money if they sold those loans (all the 30 cents’ they lent) to someone else, so they could then lend out that same amount to someone else and make the fees on it, again. So they’d sell the loan at a discount to other firms, say investment firms or government-sponsored firms, creating what everybody on Wall Street loves, liquidity. Liquidity is simply exactly the same as that moment when you pay down your credit card, you’re available credit goes up, you therefore have more liquidity, meaning you have more options. It’s a good thing.
So the banks have more liquidity, they lend again and again, always selling the loan quickly. Nothing wrong with this. Yet. Then along comes the day when someone realizes if they lend to folks who have a lower chance of fully paying back the loan, they can take a bigger fee upfront and justify it saying, hey you might stiff me. Now we’re making some cash! And we’re still selling those less secure loans off the books to other financial companies…think Fannie, Freddie, Lehman, etc.
But it didn’t stop there. The next step was someone saying let’s change the traditional type of loan, call it an adjustable rate, a lot more people will qualify for loans now, yay! People will own homes, interest rates will be low, well at least until they adjust, and home prices will soar because everyone will want to be a homeowner. It’ll create a seller’s market. And these loans will still being sold to other financial companies. The prices of home soared.
This is like the Ginzu knives commercial. But wait, there’s more. Then a few really edgy characters in the banking community decided to focus on subprime, the industries term for ‘weak-borrowers-that-probably-won’t-pay-us-back-but-we’re-not-scared-because-we’ll-just-take-the-house-back-and -re-sell-it-and-recoup-our-loses.’ And they lent them using the adjustable rate, so even if the economy stayed constant, once these mortgages adjusted to the higher rate, these borrowers were likely to default anyway. Oh, and these loans continued to be sold to other financial companies.
I’m not going to even try to pinpoint the exact moment when the music stopped; suffice to say somewhere in 2006, some of these loans started going bad. Losses were accumulating, and here’s where things really got sticky. The other financial companies decided to stop buying the loans from the banks making them.
Oh, boy. The first jolt of panic was felt. Many banks had already started reigning in their lending to the subprime, but, they didn’t shut it off! And that was critical. Countrywide and WaMu were most notable for this.
So remember that $1.00 of deposit, and .30 cents can get lent, then rest in the vault just in case. When the ability to sell off these loans dried up, banks were left with more than they could hold on their own books, so that .30 cents became .50 cents, and senior executives went, holy shit, we have to raise capital to cover the .20 cents. They all went out and borrowed from each other, a very standard practice, and some even raised capital to cover it. Remember WaMu raised $7 billion back in the beginning of the year.
Okay, phew. The banks raise the capital they need, and cross fingers that it isn’t as bad as all that. Meanwhile the economy is going bad, the ability to sell loans made on houses has dried up, so banks scaled back all jumbo lending as well as subprime; jumbo loans is a defined term for all house loans over approx. $430,000. Why? Fannie and Freddie were still buying conventional home loans from the banks, so the banks could still sell them and make money. That’s when homes in the $400,000 to $900,000 started losing value. Not only had we hit the stall point, we tipped over and we started crashing.
Home prices started falling fast in most places in the country. And the above cycle started to pick up tremendous speed. The velocity with which defaults were occurring, foreclosures were happening, was so fast and rapid, no one could even comment on how big the problem was…still can’t.
The final straw, in my opinion, the proverbial dagger through WaMu’s heart, came the beginning of September, when consumers seemingly en masse decided to withdraw huge sums from the bank, a kind of organized run on a bank. Almost $17 billion dollars gone in about 15 days, and remember that means they have to either raise capital to cover the loans they have outstanding, or they get seized.
They got seized. And then they got sold. Game over. Wachovia is now in the hot seat. Bank of America owns Merrill Lynch and Countrywide, and JP Morgan Chase owns WaMU. We are well on our way to having 4 or 5 national banking institutions as some speculate that Citibank will take Wachovia.
Bottom line, liquidity has dried up from our markets. Only the truly well capitalized now have the money, the liquidity, to keep lending. See part two for how this affects us as small business owners.
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Part Two: Financial Crisis 101 - What it means for you.
By Kelleen Griffin
When the lead singer from Rascal Flatts complained to Bruce Springsteen how hard the music life was on his marriage and asked for advice, The Boss famously quipped, “If Mama ain’t happy, ain’t nobody happy.”
Same thing with the banks. The landscape is changing, the banks liquidity is drying up, ain’t no one gonna be happy for a while.
Here’s what that means. There is a direct impact and an indirect impact.
The direct impact comes from the liquidity drying up. There’s no cash. With no cash, there’s a credit crunch. And the first people to go down on one knee are business owners who use lines of credit to make their businesses run. These are manufacturers who have seasonal lines, or heavy equipment owners who need to purchase the equipment first before they on-sell it. Just a few examples of which there are many.
Others already affected are those using a line of credit on their house to fund shortfalls in their business. Banks are finding ways to cut off the excess amount not already lent. So you could find your liquidity drying up as well. If banks, that are wobbling on that thin line of lending/capital ratio mentioned previously, can limit the amount they’ve lent by canceling unfunded commitments, they’ll do it, because then they won’t have to put up any more capital. It’s in their best interest to do so.
For anyone on Biznik who has unutilized lines of credit, don’t panic. Just review which institution you have it with. A strong institution, likely all is good. If it’s a second tier institution reporting major losses in the last two quarters, call your banker and ask about whether the bank is foreseeing making any changes to its lending policies, particularly unfunded commitments. Ask if they’ve ever called a MAC clause before. MAC is short for ‘material adverse change’ and was put in loan documents to protect the bank on any contingency they hadn’t thought of. Extremely rare to call a MAC clause, but it happens. Check to see if you have one in your document. Basically anyone who has a relationship with a bank that they count on needs to review their documents and understand their risks.
The indirect impact affects all of us, but in many different ways. If you sell to the people in the small business market (definitions vary widely but generally considered to be the $1 million to $5 million in revenue market), or middle market, ($5 million to $75 million), review your revenue concentration. If a significant portion of your sales comes from upstream or one or two customers, schedule a lunch, during which you discuss the market happenings and talk about the health of their company, and ask if you can do anything. No need to be surprised if this company comes back at some point and announces major cutbacks. Same goes for your credit extension policies. How long do some companies take to pay you? Should you wait that long? Should you ask for a retainer upfront?
If you don’t sell upstream, if your customers are mostly individuals versus companies, times are challenging right now too. There will be pullback, and that means prospecting should move up a level in terms of the amount of time you spend on it every week. Not networking, not marketing, but prospecting, the active task of reaching out to NEW people and putting yourself in front of them. These are calls; they’re in-person visits. The sales cycle is elongating and the tails are dragging out. I’ve seen some research estimate that it should be about 60% of a good salesperson’s time each week! 3 days a week, calling, researching, and speaking to people! Sure kicks the butt of my maybe three hours a week, so I will be doing more as well.
I offer these few tips as a way to be pro-active with your business, a way to feel a little more in control and to take steps to prepare. Hopefully, it will be an antidote to the crazy-making media frenzy we seem to face daily.
Last words: if others are hit directly by this situation, offer them a hand up. Find a way to help. The only way any of us will get through this, is if we all get through it together.