Beware the Ides of March

Posted by John Slater on March 1, 2009

We won’t be seeing bloody togas on the Senate steps, but there will be great pain and destruction in the American business community.  There’s an annual ritual which starts in March and generally goes through sometime in April, in which tens of thousands of private companies, the heart blood of the American economy, deliver their annual audits and reviewed financial statements to their banks.  For many the results will not be pretty.

In the fourth quarter of 2008, firms throughout the manufacturing, retail and distribution economy, and likely in a number of other sectors as well, were hit by a strong downdraft precipitated by the credit crunch of September and October.   Many of these companies sustained a precipitous drop-off in revenues and resulting operating losses for the quarter.  Others may have seen a dramatic decline in the value of their inventories, particularly if they were in industries dependent on volatile commodities or imported raw materials.  The bottom line is that many companies will report a loss for the fourth quarter and a substantial number for the full year 2008 as well.

Contrary to current opinion, banks don’t like to take losses and will do everything in their power to avoid doing so.  Until now banks have been relatively lenient with their commercial borrowers other than in industries related to residential construction, where the reality of losses is too obvious to be ignored.  Unfortunately for their borrowers, however, banks are subject to strict accounting rules and answer to regulatory supervisors that demand that action be taken to head off potential loan losses.  Delivery of the 2008 annual audits and reviewed financial statements will make the potential for problems all too obvious.

Partially in response to the CRA (Community Reinvestment Act), within the last ten years many banks began to apply credit scoring and other “objective” financial modeling to their credit analysis and management.  As the 2008 audits are plugged into these models, it will become quickly apparent that many, if not most, borrowers have not hit the financial projections on which their loans were based.  We are already seeing this with companies that depend on asset based loans and report on a monthly rather than quarterly or annual basis.  Many such companies are now in “negotiation” with their lenders, which are demanding higher interest, more collateral, loan reductions and more.  In such situations the borrower’s first response is layoffs, salary reductions and plant closings, further exacerbating the economic decline.  For many lenders this will not be enough.  Companies that do not act quickly and aggressively to shore up their balance sheets are in great peril.

Adding to the problem is the tremendous loss of wealth among the owners of small and medium businesses.  Frequently their lenders rely on guarantees backed by personal financial statements composed of stock portfolios, investment real estate and other assets, the value of which has declined precipitously in the market collapse.  We are aware of a small business lender that was forced to shut its doors when the owner’s stock portfolio dropped by 50% and the bank pulled its credit line.  The collateral damage impacted scores of small borrowers.

Perversely TARP has increased the likelihood that the scenario described above will result in more, not fewer, declarations of default and resulting business bankruptcies and shutdowns.  Troubled banks cannot afford losses, lest they fall below minimum capital requirements and become the subject of unwanted regulatory attention or even takeover by the FDIC.  However, once a troubled lender is recapitalized or acquired by a stronger bank, it has the breathing room to take strong actions to clean up its portfolio, particularly if those losses are covered by a guaranty from the Treasury.  Rather than working with borrowers, the recapitalized bank may elect to move quickly to cleanse its balance sheet through rapid write-offs, declarations of default and foreclosures.  In the process jobs, productive capacity and wealth are destroyed.

Much discussion is heard about the “other shoes” left to drop for the banks.  Those that have gotten some exposure include leveraged loans ($3 Trillion to be refinanced over three years), consumer credit and commercial real estate ($560 Billion in the U. S. over three years).  Little if any attention has been given to small and medium business loans.  Yet in an economy that depends on small business for 75% of job creation, this “shoe” will feel more like a pair of hobnail jackboots to the thousands of SMBs (and their employees) about to be crushed under foot.

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