The Profitability of Patriotism: SME Lending

What a difference a year makes. A year ago the banks came crawling to Washington begging for a massive capital infusion to avoid an Armageddon of the global financial system. They sent out an urgent SOS for a $750 billion life preserver of tax payers money to keep the banking system liquid. Our country's chief bursar Hank Paulson, designed a craft that would help the banks remain afloat. Into the market maelstrom Mr. Paulson launched the USS TARP as the vehicle to save our distressed ship of state. The TARP would prove itself to be our arc of national economic salvation. The success of the TARP has allowed the banks to generate profits in one of the most prolific turnarounds since Rocky Balboa's heartbreaking split decision loss to Apollo Creed. Some of the banks have repaid the TARP loans to the Fed. Now as Christmas approaches and this incredible year closes bankers have visions of sugar plum fairies dancing in their heads as they dream about how they will spend this years bonus payments based on record breaking profitability. President Obama wants the banks to show some love and return the favor by sharing more of their balance sheets by lending money to small and mid-size enterprises (SME).

Yesterday President Obama held a banking summit in Washington DC. Mr. Obama wanted to use the occasion to shame the "fat cat bankers" to expand their lending activities to SMEs. A few of the bigger cats were no shows. They got fogged in at Kennedy Airport. They called in to attend the summit by phone. Clearly shame was not the correct motivational devise to encourage the bankers to begin lending to SMEs. Perhaps the President should have appealed to the bankers sense of patriotism; because now is the time that all good bankers must come to the aid of their country. Failing that, perhaps Mr. Obama should make a business case that SME lending is good for profits. A vibrant SME sector is a powerful driver for wealth creation and economic recovery. A beneficial and perhaps unintended consequence of this endeavor is the economic security and political stability of the nation. These are the worthy concerns of all true patriots and form a common ground where bankers and government can engage the issues that undermine our national security.

The President had a full agenda to cover with the bank executives. Executive compensation, residential mortgage defaults, TARP repayment plans, bank capitalization and small business lending were some of the key topics. Mr. Obama was intent on chastising the reprobate bankers about their penny pinching credit policies toward small businesses. Mr. Obama conveyed to bankers that the country was still confronted with major economic problems. Now that the banks capital base has been stabilized with Treasury supplied funding they must get some skin into the game and belly up to the bar by making more loans to SMEs.

According to the FDIC, lending by U.S. banks fell by 2.8 percent in the third quarter. This is the largest drop since 1984 and the fifth consecutive quarter in which banks have reduced lending. The decline in lending is a serious barrier to economic recovery. Banks reduced the amount of money extended to their customers by $210.4 billion between July and September, cutting back in almost every category, from mortgage lending to funding for corporations. The TARP was intended to spur new lending and the FDIC observed that the largest recipients of aid were responsible for a disproportionate share of the decline in lending. FDIC Chairman Sheila C. Bair stated, "We need to see banks making more loans to their business customers."

The withdrawal of $210 billion in credit from the market is a major impediment for economic growth. The trend to delever credit exposures is a consequence of the credit bubble and is a sign of prudent management of credit risk. But the reduction of lending activity impedes economic activity and poses barriers to SME capital formation. If the third quarter reduction in credit withdrawal were annualized the amount of capital removed from the credit markets is about 7% of GDP. This coupled with the declining business revenues due to recession creates a huge headwind for SMEs. It is believed that 14% of SMEs are in distress and without expanded access to credit, defaults and bankruptcies will continue to rise. Massive business failures by SMEs shrinks market opportunities for banks and threatens their financial health and long term sustainability.

The number one reason why financial institutions turn down a SME for business loans is due to risk assessment. A bank will look at a number of factors to determine how likely a business will or will not be able to return the money it has borrowed.

SME business managers must conduct a thorough risk assessment if it wishes to attract loan capital from banks. Uncovering the risks and opportunities associated with products and markets, business functions, macroeconomic risks and understanding the critical success factors and measurements that create competitive advantage are cornerstones of effective risk management. Bankers need assurances that managers understand the market dynamics and risk factors present in their business and how they will be managed to repay credit providers. Bankers need confidence that managers have identified the key initiatives that maintain profitability. Bankers will gladly extend credit to SMEs that can validate that credit capital is being deployed effectively by astute managers. Bankers will approve loans when they are confident that SME managers are making prudent capital allocation decisions that are based on a diligent risk/reward assessment.

Sum2 offers products that combine qualitative risk assessment applications with Z-Score quantitative metrics to assess the risk profile and financial health of SMEs. The Profit|Optimizer calibrates qualitative and quantitative risk scoring tools; placing a powerful business management tool into the hands of SME managers. SME managers can demonstrate to bankers that their requests for credit capital is based on a thorough risk assessment and opportunity discovery exercise and will be effective stewards of loan capital.

On a macro level SME managers must vastly improve their risk management and corporate governance cultures to attract the credit capital of banks. Through programs like the Profit|Optimizer, SME's can position themselves to participate in credit markets with the full faith of friendly bankers. SME lending is a critical pillar to a sustained economic recovery and stability of our banking system. Now is the time for all bankers to come to the aid of their country by opening up credit channels to SMEs to restore economic growth and the wealth of our nation.

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Risk: banking, credit, SME

Mom and Pop Go Chapter 11

The Wall Street Journal ran an interesting article about the devastating effect the recession is having on family owned businesses. The SBA estimates 90% of U.S. businesses are family-owned. During 2008 about 4.3 million businesses with 19 or fewer employees closed according to the Bureau of Labor Statistics. If 90% of those firms were family controlled businesses more then 3.8 million families have lost their livelihoods and most likely have also lost a considerable amount of personal wealth. This drastic dissipation of wealth and family control of assets is yet another blow to the middle class. Its impact of entrepreneurial activity and capital formation initiatives may create additional headwinds for the economy seeking to overcome the deep recession.

John Ward a professor at Northwestern University observed "that the economic downturn is really just the latest setback for family-run businesses. In the 1970s and '80s, exorbitant income taxes and estate taxes forced many to close. Before that, the anti-establishment movement during and after the Vietnam War made many children reluctant to take over the family business."

Beth Wood, a family business market development specialist at MassMutual observes that family businesses are "often steeped in tradition and not as flexible to change, tend not to have formal plans in place to respond to crisis. They've seen reductions in top line revenue that they just can't react fast enough to. Problems securing credit in this recession have also prevented some family businesses from getting the funding they need."

Ms. Wood makes an interesting observation about the importance of business agility. The need to assess the rapidly changing market dynamics is a critical exercise that SMEs must undertake. Business as usual will not get it done. SMEs must begin to transform itself to better align its business model to rapidly changing markets. Conducting a thorough risk assessment and opportunity discovery exercise is critical to creating a sustainable business enterprise. Sum2's Profit|Optimizer is a critical tool that helps SME managers assess risks, spot opportunities and initiate actions to achieve business growth and profitability.

Family owned enterprises must overcome the gravity of generational business cultures that inhibit and resist change. SMEs will survive and thrive if they can identify emerging opportunities the current business cycle is creating. SME's will survive and thrive if they have the will, resourcefulness and a supportive culture to change. These are the qualities required for long term sustainability and growth. Business as usual is giving way to a "New Normal," where adaptability to structural market changes are keys to asset preservation and wealth creation.

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Risk: family trusts, asset preservation, small business, bankruptcy

A Growing Contagion: One in Seven Companies Are a Credit Risk

The H1N1 Swine flu threat may be the big topic on CNN but a growing contagion of financial distress is widely infecting small and mid-sized enterprises (SME) with potentially fatal consequences.

CFO magazine reports that 14% of companies are struggling to pay their bills or are at risk for bankruptcy. These findings are the result of a study CFO conducted on 1500 Midcap companies. The 2009 Credit Risk Benchmarking Report indicated that 550 companies of the 1500 made the credit watch list and over 200 of the names were in or are entering a distressed financial condition.

The report measures each company on three factors: cash as a percent of revenue, days payable outstanding (DPO), and DPO relative to the DPO of that company's industry. The last of these measures is intended to expose which companies are under performing regardless of the economic condition of their industry as a whole. A company scoring low in all three areas is rated a potential credit risk.

The strain of a two-year recession and limited credit access is taking its toll on small and mid-sized businesses. This development is not surprising. The recession has hurt sales growth across all market segments. Banks, still reeling from the credit crisis are still concerned about troubled assets on their balance sheets. Bankers can't afford more write downs on non-performing loans. Banks remain highly risk adverse to credit default exposures and have drastically reduced credit risk to SMEs by shutting down new lending activity.

Reduced revenue, protracted softness in the business cycle and closed credit channels are creating perfect storm conditions for SME's. Bank's reluctance to lend and the high cost of capital from other alternative credit channels coupled with weak cash flows from declining sales are creating liquidity problems for many SMEs. As a defensive maneuver, SMEs are extending payment cycles to vendors to preserve cash. This same cash management practice is also being employed by their clients resulting in an agonizing daisy chain of liquidity pain. SME's that have concentrated exposures to large accounts are at the mercy of the financial soundness of few or in some instances a single source of revenue.

The growing contagion of financial distress is also a major threat to supply chains. Buyers might prize their ability to drive hard bargains with their suppliers but the concessions won may be the straw that breaks the camels back driving a supplier into insolvency.

It is critical that managers understand all risks associated with clients and suppliers. It is critical that managers assess risks associated with client relationships and key suppliers. In this market, enhanced due diligence is clearly called for. The financial soundness of suppliers and clients must be determined and scored so as to minimize default exposures to your business.

CreditAides is a company that delivers SaaS based financial health assessments on SMEs. CreditAides reports that their clients are becoming more vigilant and thorough in their due diligence of customers and suppliers. They have noted a particular emphasis on the growing practice of reviewing the financial health of suppliers. Supply chain risk is a heightened risk factor for SME's due to their over dependence on single source. Conducting a financial health assessment on key suppliers and other enhanced due diligence practices mitigates a risk factor that could have potentially devastating consequences. SME manager's need to button down their due diligence practices to prevent the sickness from infecting their business.

CreditAides SaaS can be accessed here: www.CreditAides.com

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Risk: contagion, credit risk, counter-party, supply chain, client, recession, banking

High Unemployment Spurs SME Bankruptcies

Two news items concerning the health of of the United States economy crossed my desk today. This morning ADP published its monthly National Employment Report for June. ADP announced that nonfarm private employment decreased 473,000 from May to June 2009 on a seasonally adjusted basis. Monthly employment losses in April, May, and June averaged 492,000. That equates to over 1.5 million jobs that were lost over the past 90 days.

The trend indicates that the rate of job losses is slowing; but the massive evaporation of jobs represents a serious erosion in buying power. The United States is a highly developed consumer oriented economy that is highly dependent on the discretionary buying power of consumers. Significant loss of jobs and the severe contraction of credit availability are severe headwinds that the US economy must overcome.

In recent years US job growth was fueled by small and mid-size enterprises (SME). Home based companies, specialty retailers and service oriented companies has fueled economic expansion and job growth. No more. The trend has been decidedly reversed due to the evaporation of consumer buying power, credit and capital constraints and other macroeconomic factors that conspire against the limited balance sheets of SMEs.

The USA Today reports, “The first five months of this year have shown a 52% increase in the total number of commercial bankruptcy filings (36,106) compared with the same period last year (23,829), according to the Automated Access to Court Electronic Records. On average thus far in 2009, some 350 commercial enterprises file for bankruptcy daily — an increase of 240% from 2006.”

The two attributes that distinguish the US economic colossus are the work ethic of its people and a deep abiding commitment and belief in a entrepreneurial culture that rewards hard work and risk. It would seem that these two virtues are under siege and are being stressed to a breaking point due to the depth and pervasiveness of the global recession. One thing is clear, the indomitable spirit of the American people are being put to the test. In time this great nation of great people will rise to meet and surmount the challenges posed by this great recession. It remains to be seen however how this will change the spirit and character of the American psyche and how future generations of countrymen will view the generations that left them with a debt laden legacy.

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Risk: work ethic, entrepreneurial spirit, economic recovery, depression