The Liquidity Squeeze – Small Business Financing and Sub-prime Loans

As news of the continuing problems in the sub-prime mortgage markets spreads, most people do not expect to be affected by it, since they do not have a sub-prime loan. Business borrowers especially may be wondering how problems in the residential markets could impact them, “How could someone else’s bad home loan impact my business?”

What has happened? Almost everyone knows this part of the story by now. Throughout the housing boom, some residential lenders attracted “sub-prime” borrowers to the table with low, adjustable rates. The residential lenders then assembled them into packages and sold them in the financial markets as securities.

As the fixed periods of these rates ended, the recent increases in rates (as an example, the Federal Reserve raised its key rate for 17 straight quarters from 2004 to June 2006 – from 1% to 5.25%) drove their home payments beyond their ability to pay. Although many of these borrowers were able to re-finance with fixed-rate mortgages, too many were not so lucky. Combined with a slowing housing market, these home-owners found themselves stuck in a mortgage that they could not afford. This has led to the “sub-prime meltdown” we are all hearing about.

So, what does that have to do with the lease on my forklift or the re-financing of my warehouse, asks the entrepreneur? Well, over time, the financial markets have become globalized – like every other market. Many of the same investors who bought those sub-prime mortgage securities buy securities in commercial loans or invest in private lenders or equity firms. Now, these funding sources have become skittish and are wondering if they should hold on to more of their money – just in case something else is going to happen. Also, as the sub-prime securities exceeded their expected levels of default and investors stopped buying new securities, lenders were left with billions of dollars of securitized mortgages on their books and were unable to flip them to replenish their funds for new loans – residential or commercial.

That means a decrease in supply and, as all of you business owners know, that leads to increased prices. Also, as with many markets, there is sometimes a “knee-jerk” reaction to raise prices because everyone knows you raise prices in this kind of situation. This is causing what many economists are referring to as a “liquidity squeeze”. A “liquidity squeeze” is where the riskiest borrowers are cut out of the market.

What is next? Well, there are two main paths that this could take – bad and good – with varying levels of pain for everyone. The bad path is that the sub-prime problem is more massive than anyone can foresee, that millions more are on the verge of foreclosure, and that we go from a “liquidity squeeze” to a “credit crunch”, which is where no one can get a loan.

The good path is that this is a temporary bump in the financial markets and that once the dust settles and everyone sees that there are not anymore shoes to drop, things can return to normal (normal being pre-boom with stricter underwriting standards) and rates will come back down some (there will still be less money out there and its owners will be more risk adverse).

Which will it be? That is a tough call for experienced economists, but the consensus of what I am reading and hearing from them in person is that we will follow the good path. Based on their arguments, I am going to come down on the side of the optimists in this case.

Why? The optimistic economists are pointing to a number of factors: 1) the global and US economies are still strong overall – in the US, inflation is low (though not low enough for the Fed to be excited about cutting rates, although that may be changing, growth varies from moderate to strong, and employment is high; 2) the Federal Reserve has room to reduce rates if necessary to improve liquidity; 3) estimates are that a significant number of the sub-prime borrowers were able re-finance their mortgages; 4) as a percentage of the overall, global financial markets, sub-prime residential securities are a relatively small segment (according to Ken Goldstein, an economist for the Conference Board, in a recent CNNMoney.com article, sub-prime makes up only 10% to 15% of a $10 trillion mortgage market and of that, only some 15% is at risk); 5) a portion of these sub-prime borrowers were investors with multiple loans who were stuck with too much inventory rather than primary homeowners; 6) although everyone is in agreement that housing sales will slow, many of the construction job losses associated with reduced housing starts have been absorbed by the economy; and 7) a total housing market collapse is generally triggered by people losing jobs in large numbers, which is not happening.

Against this, the pessimistic economists point to the impact that reduced customer spending from higher home payments and reduced home equity (thanks to substantial drops in home prices) will have on the economy. However, as one economist noted at a recent commercial real estate event, the economy was already moving out of the “consumer spending” phase and into the “business expansion” phase and is not as dependent on consumers to keep it going. He mentioned that the “massive” drops in the number of home sales are just returning us to what were considered great levels prior to the boom (i.e. we have been spoiled). Also, people need to be in fear of losing their jobs and not see their income growing to really cut back on spending. Neither of these is the case and the Conference Board recently reported that consumer confidence is at a six-year high.

What does all of this mean for your business? If we follow the path of the optimistic economists as I expect we will, this means that everyone is going to be forced to live with a spike in the cost of money for the short-term (probably three to six months) and real difficulty finding funding for less-than-perfect-credit businesses or higher-risk ventures until the markets calm themselves.

Deals that were tough to do two months ago may not even get out the loan officer’s in-box and even the easier deals will take longer to fund. Lenders will want to prove to their investors that they are doing all necessary due diligence and will be sure to tighten their standards. It will be more important than ever to prepare a good, clean package that contains no surprises.

As the market corrects in the long-term, there will be more news of sub-prime loan delinquencies in 2008 as another $500 billion+ of “teaser-rate” loans reset to market and it would not be surprising to hear that a few hedge funds and private equity firms have closed shop. However, these are now known problems and, unless there are more surprises, the market will adjust for them in advance.

You can expect interest rates to be higher than they were prior to the sub-prime problem on average (it is more likely that lenders and investors will price more appropriately for risk) and that the more stringent lending requirements will remain in place. It will mean a need to plan further ahead as deals will take longer to fund. The tougher deals will be possible, but they will pay more of a risk premium and face much more attention than many in that market have been accustomed to receiving.

However, we should move out of this “liquidity squeeze” and good deals with good packages will continue to move forward, albeit with a bit more scrutiny.