Tuesday, November 4, 2008

Credit crunch

In this post I had claimed that the effects of the financial crisis on the real side of the analysis was too anecdoctal. I am not the only skeptic judging by the following post (Part 3 of Where is the Credit Crunch at MR):
Back in February I pointed out that despite all the talk of a credit crunch commercial and industrial loans were at an all-time high and increasing. In September I once again pointed to data showing that bank credit continued to be high (even if growth was slowing.) At that time I also discussed how bank loans were not the only source of funds for business investment and that many substitute bridges exist which transform and transmit savings into investment. I suggested that despite the panic the problems which exist in the financial industry may be relatively confined to that industry.

Three economists at the Federal Reserve Bank of Minneapolis, Chari, Christiano and Kehoe, now further support my analysis pointing to Four Myths about the Financial Crisis of 2008.

Mark Thoma (pointing to The Economist) and Felix Salmon disagrees.
In a subsequent post, I commented:

The phrase "credit crunch" needs to be defined. I don't believe that looking at prices and quantities alone can determine if we're in a "credit crunch". Suppose that there are 4 states in the economy: high, low, normal and crisis. And suppose further that we are currently in a crisis state. A "credit crunch" is the gap between the current (crisis) quantities (or prices) and one of the 3 other states. I would be conservative and say that a credit crunch should be defined as the gap between "crisis" and "low-state" quantities and prices. If we are going to be in a recession, is the current quantities/prices lower/higher that they "should" be? Going into a recession, is a business owner that would have qualified for loans in a low-state not currently able to get a loan? This is the measure that I think is more interesting.

I may have been mistaken by looking solely at the business sector, however.
Naked Capitalism looks at international trade volumes:
One of our pet themes in recent weeks is that the fall in trade traffic, indicated and possibly overstated by a dramatic fall in the Baltic Dry Index, is due at least in part to difficulties in arranging and getting other banks to accept buyers' letters of credit. For those new to this topic, international trade depends to a large degree on letters of credit. While they can help finance shipments, an even more fundamental role is that they assure the shipper that he will be paid for the cargo sent. Without banks using letters of credit as the means to send payment to exporters, parties that are new to each other or conduct business with each other infrequently could never trade with each other (one type, a documentary letter of credit, requires that forms, often a very long and elaborate set of them, verifying that the goods have been inspected and certified, that customs, have been cleared and all relevant charges and duties paid, be presented and vetted before payment is released).

More on the Baltic Dry Index is here and here. Some background is here and here.
In any case I thought I'd toss in a few more anecdotes from the latest issue of Inc Magazine.
1. About Nau, an apparel store that went bankrupt (Too much too fast or credit crunch?):
In 2005, half a dozen outdoor-clothing guys got together at Portland's Urban Grinds coffee shop to sketch out their new retailing concept. Times were good, and they were feeling supremely confident. Their big idea was to combine the eco-friendly and mountain-climbing chic of Patagonia with the fashion-forward urban cool of, say, Prada. Not only would their clothes be practical on the trail, but they would look sleek and hip in the city as well. Nau would design its own fabrics with new sorts of eco-friendly materials. Even Nau's retail outlets -- the plan called for 150 of them -- would be constructed from recycled wood and plastic.

The team also decided to funnel 5 percent of sales from each item to dozens of worthy nonprofit organizations that buyers could choose from. The clothes would be pricey, but shoppers could feel good that by buying a $40 T-shirt or a $350 jacket, they would also be doing some good. ...

The company, with its five stores and four more under construction, assumed additional financing would always be around the corner. Then the credit crunch hit. With no recourse to bank financing, the team implored its biggest investors for additional funding. But the investors who had been so generous just a few months earlier clammed up. "Everyone on the board understood we had gotten in too far to turn around and pare this thing down," says Gomez, then board chairman of Nau. The money was gone. The board voted to close down Nau's stores and suspend all business.

2. Norm Brodsky seems to make a lot of sense to me:
... Not so long ago, you could still get what bankers affectionately referred to -- in private -- as an "air-ball loan." That was a loan based not so much on your assets but almost entirely on your relationship and history with the bank. Yes, the bank would glance at your company's earnings and cash flow, just to be sure you could make your payments and weren't about to go bankrupt, but the relationship mattered most.

We needed to borrow $4 million to cover the building costs, ... a week later, the bank president called and said that because we weren't giving a personal guarantee, the bank would lend us the money only if we made a "substantial" deposit, by which he meant an amount equal to 50 percent of the loan. I pointed out that a deposit of that size was hardly necessary from a security standpoint. Our development company had unencumbered assets of $7 million. Once the construction was finished, the value of these assets would rise to more than $16 million. The risk to the bank was minimal. But it turned out that risk wasn't the issue. "In order for us to make loans, we need deposits," he said. "Things are very tough right now."
"In that case," I said, "I think I'd rather give you a personal guarantee." I didn't like the idea of tying up my money in a bank account.
"OK," he said. "I'll run it by the board." Another week went by, and he called me back. "The board would really like to lend you the money," he said, "but we only want to deal with people who are customers."
"Fine; we'll open an account," I said.
"You would still have to make a substantial deposit," he said.
It was June by then, and every day brought news of another troubled bank. The big issue, I realized, was the Telluride bank's solvency, not mine. "Why don't you send me the bank's balance sheet," I said.

"Sure," he said. "But why?"
"The FDIC only insures $100,000 per account," I said. "If I'm going to make the kind of deposit you're asking for, I want to know where my money's going."
When the bank's financials arrived, I showed them to my partner Sam, who has served as the point person in our company's banking relationships. "What would you do?" I asked.
"I wouldn't put more than $100,000 in any bank right now," he said.
I knew he was right. I told the Telluride bank that we weren't going to need its money after all. If necessary, we would do the financing ourselves.

... So what does all this mean? I have no doubt that companies like mine will still be able to secure the bank financing we need -- mainly because we don't need it that badly. I worry about smaller companies that really do need bank financing and may have a hard time getting it. That will have ramifications throughout the economy. Yes, interest rates are still relatively low, but cheap debt does you no good if no one will lend to you.
Part of the problem, I sense, is that the bankers themselves are still trying to figure out the new rules and standards. If you are going for a bank loan, I would suggest you ask right away, "What does it take to qualify for a loan these days?" And make sure your finances are in order. Developing a relationship with a bank is still important, but you are going to need earnings and liquidity.

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