Neil Berdiev
The currently frothy commercial debt financing market reminds us of the years immediately preceding December 2007 and the ensuing Great Recession – loan pricing is very low and very competitive for creditworthy businesses, deal terms are getting longer and longer, debt amortization during the term is thinning, and covenants are few and far between.
Not uncommonly, commercial lending institutions are chasing asset growth and market share by lowering pricing and underwriting standards. Throw in a slew of alternative lenders and we have a volatile mix on our hands that every business manager needs to understand.
And just like before the Great Recession, the majority of people deny that we have a bubble. You may think that business owners and managers of creditworthy companies should be happy with the abundance of extremely low-cost debt with few conditions attached. However, those who have been through these cycles before know that there is a price to pay for thinly priced and structured loans when a downturn strikes. There is no such thing as a free lunch!
Credit problems are not something you want to have on top of various strategic and operational challenges surrounding a recession. Below are suggestions that can help you better prepare your company for the next recession.
Commercial banks wrestle with economic downturns, just like their borrowers do. Just as businesses deal with economic and financial challenges, so do commercial banks. What this means is that commercial banks will be trying to figure out how to protect their loan portfolios, which is a balancing act between trying to do what’s right for their borrowing clients while safeguarding their depositors’ funds. Some will do it with thoughtfulness, while others will give you no room to breathe. It was a common conversation among many of my peers during the last downturn that their banks were lending one day and not lending the next day. These back-and-forth decision swings were a result of a protective mindset that gets invoked during a recession. The uncertainty was only fueling the flip-flopping. As much as a commercial bank may want to do right by your business, its first responsibility will be to protecting all of its depositors.
Credit is there when you don’t need it. If your business’ financial condition begins to decline during an economic downturn, which is commonly the case, so will its ability to secure credit. Lending to your company becomes riskier. It is tough to blame commercial lenders for that. Typical senior debt financing providers, a commercial bank or a credit union, can lose $1 to $2 on every $100 they lend at relatively low interest rates. They have very little room for error before their capital dwindles and regulators step in to take action.
Lower interests do not mean easier borrowing. Although interest rates tend to go down during a recession as a result of central banks’ lowering rates to stimulate the economy, low interest rates do not create the availability of credit until a recovery begins. Declined financial condition of businesses and a resultant higher risk of default also tend to limit credit availability. So, the credit tap will likely be closed unless your company is truly creditworthy and stronger financially than an average business.
Not all decisions are made locally.Banks that are local and have local decisions-makers are likely to think twice about exiting a particular geographic area or a line of lending. And they will definitely think hard about how they manage their customers and business partners during this process. For lending institutions whose decision-makers sit hundreds or thousands miles away, just like for larger businesses, credit freeze, credit exit or continued lending decisions are arguably easier to make based on looking at numbers as opposed to thinking about reputation and business continuity within local communities. It will likely have less concern for your business than for managing its own finances.
If it seems too good to be true, it is! Aggressive or very favorable borrowing terms typically mean aggressive approaches to managing credits in bad times to preserve a bank’s loans, cash flow, and therefore capital when economy deteriorates. When pricing, structure and profit margins are nominal, commercial banks and other lending outfits have little time to get a situation under control and to ensure that the loan principal is recovered. Some lenders will handle themselves with greater finesse than others, but the bottom line is that a commercial lender can sustain only minimal loan losses before it burns through its net worth and goes out of business.
There is very little room for error in the lending business, given risk and return compared to equity investments. You should start preparing for the next downturn now by assessing your credit situation to ensure that your business can successfully weather the next downturn.
(Dima) Neil Berdiev is a managing partner and co-founder of DNB Advisory LLC, a Boston-based advisory with focus on outsourced credit services for commercial lenders as well as privately-held companies. He may be reached at dnb@dnbAdvisory.com or at 617-233-1405.
