The New York Times is having a good week. Today, in “Lenders’ Belt-Tightening Stifles Growth in Economy,” Peter Goodman examines the recent sharp fall in credit extension to commercial enterprises, particularly small businesses. It’s a solid piece of reporting, and reading it, one wonders why the Federal Reserve’s Vice Chairman Donald Kohn didn’t allude to the contraction in lending in his widely-covered remarks at the Council on Foreign Relations yesterday. Bloomberg quoted him:
‘`Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses a well,” Kohn said.
The Times story tells us that “could induce” is the wrong characterization. Banks are tightening their purse strings now.
Nevertheless, there were a couple of places in this otherwise informative piece where Goodman missed some important nuances. Let’s start with the top of the article:
Credit flowing to American companies is drying up at a pace not seen in decades, threatening the creation of jobs and the expansion of businesses, while intensifying worries that the economy may be headed for recession.
The combined value of two leading sources of credit — outstanding commercial and industrial bank loans, and short-term loans known as commercial paper — peaked at about $3.3 trillion in August, according to data from the Federal Reserve. By mid-November, such credit was down to $3 trillion, a drop of nearly 9 percent.
Not once in the years since the Fed began tracking such numbers in 1973 has this artery of finance constricted so rapidly. Smaller declines preceded three recessions going back to 1975; at other times such declines tended to occur in conjunction with an economic downturn.
The contraction in the commercial paper market has occurred primarily in the asset backed commercial paper sector, which consists of CP supported by residential mortgages, auto loan receivables and credit card receivables. Since Detroit has become addicted to financing consumers as a way to move metal, the contraction in ABCP has a direct impact on the auto industry. Otherwise, the shrinkage of ABCP affects commercial borrowers indirectly, via its impact on banks (most importantly, the fact that some are having to extend credit when affiliated entities can’t roll maturing ABCP, which ties up their credit capacity, and that banks are now leery of lending to each other) and the housing market (the loss of ABCP shuts off another securitization outlet).
In fairness, traditional commercial paper, where companies sell their short-term IOUs to investors, has also witnessed a fall in outstandings over the last three weeks, and the latest drop was noteworthy, but modest compared to the decline in ABCP. Nevertheless, this is a new and troubling development.
Although the Times made it sound as if the Fed was aware of and worried about the fall in commercial credit (likely true), the story also indicated that Kohn commented on it. In fact, his speech focused on the mortgage markets and the turbulence in the financial markets, and treated the consequences for the real economy as an open question:
We are following this trajectory closely, but key questions for central banks, including the Federal Reserve, are, What is happening to credit for other [non-mortgage] uses, and how much restraint are financial market developments likely to exert on demands outside the housing sector?
The article also indicates that the Fed may cut rates to address this problem. While that is accurate, it is unlikely that a rate cut, or even quite a few cuts, will change the psychology of lending officers. When defaults start to rise, banks tighten their lending criteria, and they tend not to loosen them again until the economy show signs of strengthening. Thus a rate reduction is unlikely to do much for the small businesses interviewed in this story.
Back to the Times:
For now, though, the situation is looking bleaker for many businesses. Already, companies in everything from furniture manufacturing to Web site design are tightening their belts, delaying expansion and scrambling for other sources of cash.
“This is a very big deal,” said Andrew Tilton, a senior economist in the United States Economic Research Group at Goldman Sachs. “You’re basically crimping the growth of the more vulnerable companies. If they can’t borrow the money, their options are much more limited. They’d have to have less ambitious hiring plans, buy less machinery and cancel projects.”
Two years ago, in what now seems like another era, Carmen Murray easily borrowed $100,000 from a local bank to finance her company, Rodeo Carpet Mills, which makes high-end rugs in an industrial stretch near Los Angeles. Getting a check was as simple as returning a mass-mailed flier.
Today, Ms. Murray is seeking a fresh loan from the bank to finance an expansion to supply Las Vegas hotels with floor coverings. She needs new machinery and 15 more workers, bringing the total work force to 45. If she manages to get the money, it will not come easily.
“They want this; they want that,” Ms. Murray sighed. “I got the sense that I have to start all over again. They need to know who I am and all about my business.”
A survey of bank loan officers conducted by the Federal Reserve in October found that about one-fifth of lenders had tightened lending requirements for commercial and industrial loans for large and midsize businesses over the previous three months. A slightly smaller proportion reported tightening lending to small companies.
By themselves, commercial bank loans have actually surged: large companies have tapped prearranged lines of credit to weather the financial chaos that has accompanied the unraveling of the American real estate market.
But this source of finance has been nowhere near enough to compensate for the virtual shutdown of the short-term commercial paper market. Much of this debt had been pledged against the value of mortgages, making them effectively radioactive in markets around the globe.
In recent years, a lot of commercial lending was inspired by an upward spiral of enrichment: banks made new loans, then swiftly sold them off for profit, using the proceeds to extend still more. But with much of the financial world unnerved by the mortgage meltdown, buyers for commercial loans are scarce.
“Since the resale market went away, major banks have had much less availability to make loans,” said Mark A. Sunshine, president of First Capital, a private commercial lender. “Absolutely, credit is much less available.”
Some of the drop reflects the subsiding in the run of mergers, diminishing the demand for credit by companies buying other companies. Some can be explained by what many economists view as a healthy return to the skeptical scrutinizing of prospective borrowers by banks. But lenders and borrowers from northern Virginia to southern Arizona confirm that the credit tightening has already begun to cut money reaching healthy companies as well, affecting their spending and hiring.
What loans are being extended are going primarily to companies with longstanding relationships with banks. Lenders are reluctant to bet their increasingly scarce capital on riskier, less-established companies in a time of economic anxiety. That leaves many of those companies on a limb.
“Small businesses are just inherently more risky, and banks are going to be more conservative in protecting their assets,” said Jody Keenan, who chairs the board of the Association of Small Business Development Centers in Burke, Va. “We’re starting to see a tightening already, particularly for very small companies. We’re talking about real impacts in local communities.”
A slowdown among smaller companies could be especially costly to the economy in terms of jobs. More than half of American jobs are at companies with fewer than 100 workers, according to Moody’s Economy.com.
In recent months, smaller companies have been adding jobs even as larger firms have been shedding workers, according to the ADP National Employment Report, which tracks changes at companies with payrolls overseen by ADP. From May to October, 276,000 of the 378,000 jobs added were at companies with fewer than 50 employees, the report found.
To be sure, the strongest companies with property to put up as collateral and years of profits they can point to are still able to borrow, often at increasingly favorable terms.
The downturn in the housing market has made banks reluctant to sink money into anything related to real estate, from title companies to bathroom tile manufacturers.
But lenders have sought refuge in more vibrant areas — notably agriculture, which has benefited from the rise in global demand and the sudden boom in ethanol production.
Richard Brown, president and chief executive of the Krause Corporation, which makes soil-tilling equipment at its factory in Hutchinson, Kan., relies upon lines of credit from banks to smooth out the seasonal nature of the business. Though it sells its products mostly in the spring and fall, the company must make them year-round.
Mr. Brown said banks had been calling him relentlessly to offer new loans.
“They’re trying to maintain their business and get past the subprime debacle, and where can they go?” Mr. Brown said. “Agriculture in this country is very strong.”
But in other parts of the economy, notably the auto industry, access to credit has tightened considerably, as banks steer their limited capital away from companies with declining sales.
A year ago, when he needed new machinery, Doyle Hayes, president and chief executive of Pyper Products, an auto parts maker in Battle Creek, Mich., went back to the local branch of Comerica bank, where he has been doing business for years. He borrowed $300,000.
Last week, when Mr. Hayes needed $140,000 for a new robot, he did not even bother to inquire at the bank. “We knew what the answer was going to be,” he said, meaning the bank would have turned him down. “When the auto industry goes down, anything that has four wheels becomes suspect.”
Still, Mr. Hayes did not put off the purchase. “You can’t save yourself into prosperity,” he said. He managed to borrow the money instead from Battle Creek Unlimited, a nonprofit economic development arm of the city.
In Arizona, Dennis Long, president of Enterprise Resource Group, which manages computer networks for businesses in the Phoenix area, is keen to expand, particularly by picking up work from the federal government. But that requires hiring a sales representative, and he lacks the capital to go beyond his $100,000 line of credit from Wells Fargo Bank.
“The bank says we’re maxed out,” Mr. Long complained. “It just seems like before they were a little more ‘Let me see what I can do,’ where today I just get ‘no.’”
In Los Angeles, Ms. Murray, too, has grown accustomed to a less-than-exuberant reception from the bank. Having started at the rug factory as a receptionist some 25 years ago, she now owns the company. A Mexican-American entrepreneur, she hopes to capture contracts that are set aside for minority-controlled companies.
She may eventually try an alternative source of finance aimed at small lenders, with the state guaranteeing her loan. Curiously, at one such institution in Los Angeles, Pacific Coast Regional Small Business Development Corporation, the volume of lending has slowed considerably in recent months, said Mark Robertson, the firm’s president and chief executive.
It may be that the effects of the credit tightening are still unfolding, he suggested. Eventually, a parade of would-be borrowers may show up at his door. His business tends to move in the opposite direction of the economy: when times are bad, more people need help to qualify for a loan. Perhaps things just have not gotten bad enough.
But Mr. Robertson thinks another factor may be at play. Business prospects are so uncertain that smaller entrepreneurs have lost their nerve for risk.
“Any business owner that is experiencing less traffic to their establishment is not willing to take on more debt,” Mr. Robertson said. “Everybody has kind of a wait-and-see, hold-off sort of attitude.”