Behavioral Finance

Through Failure, We Grow Stronger

The credit cycle can be hazardous if not properly navigated. Those strong enough to endure the downside will be even stronger as the cycle turns—and it is starting to turn.

Small businesses' access to credit has been a concern for over a year, and rightly so. Underwriting standards in the US have tightened substantially as the banking industry reverted back to traditional methods—perhaps even overshooting a bit. The old adage is truer now than at any point in the last decade: You can always get a loan, if you don't need it. The problem is that many borrowers became accustomed to and reliant on easy access to credit—they needed it. Businesses with aggressive business models, those that needed an abundance of cheap credit to stay afloat, have either failed, are failing, or have changed capital structures—i.e. raised capital, sold assets, or in some cases renegotiated liabilities.

Although this may seem harsh, in many cases this process can be considered trimming the fat (Darwin fans may refer to it as natural selection). Think of it as a marathon: Those that did not prepare appropriately are not going to make it—hurting themselves in the process. But those finishing will be the strongest, leanest of the bunch. When this part of cycle is over, the business environment in America will be stronger (as a whole) than it has been in many years.

There may be fewer businesses, but that does not mean less economic activity. If you frequented a local store for your needs and wants, would the fact the store went out of business change your spending habits? Probably not. More than likely you would simply shop at the store next door—and that store becomes stronger because of your business. As it gains more new business, it will expand to account for increased activity—it has access to credit, because it doesn't need it. It may even gain pricing power, which could allow for better margins on greater revenue. Then, as the cycle continues, the store may witness increased competition as others see how profitable it is and want their share. Next, there will be some competitors who choose to become more aggressive and perhaps push it a bit too far. Finally, the cycle returns to an increase of failures and another round of trimming the fat as margins are pinched, profitability falls—and we start anew.

To be at the beginning of a fresh cycle is actually good news looking forward, though it might not seem like it now. But in case you're not convinced, here's some more good news: Small business credit conditions are not quite as bad as they seem.

According to the Small Business Administration (SBA), SBA loans have surged. This is mostly due to the implementation of Recovery Act provisions which allowed for improvements in SBA lending programs. Simply put, SBA lending jumped from $0.8 billion per month to over $1.9 billion per month. Moreover, in May 2010, approval volume was 28% ahead of the monthly average in 2008 and 77% ahead of the monthly average in 2009. The enhanced programs are subject to monthly extensions and future funding is uncertain, but even if the enhancements expire, SBA programs will still be available—the enhancements were meant to jump start lending, not support it indefinitely. SBA data illustrates how small businesses have had access to credit through SBA programs if certain criteria are met. While increased SBA lending is terrific, it is important to point out that it traditionally accounts for only a small part of lending. Outside of SBA lending, credit is still available, but if a small business needs the credit, it likely won't get it on favorable terms. If the business is sound and could continue as a going concern without the credit, the terms improve substantially.

Additionally, the Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices illustrates how things are not getting worse and in many cases are actually improving. The report shows we just witnessed an extreme level of underwriting standards tightening, following an extended period of loosening. Recent data show that banks are starting to loosen their standards again. While standards are still tight, this shows things are improving, not getting worse.

Another point to consider is financial regulation. Without knowing what rules to work with, banks have been on hold for over a year. The industry did not know what type of capital, how much capital, what type of liquidity, how much liquidity, what businesses it could operate or even what type of compensation structure would be allowable. It is no wonder credit is tight—banks can't take the risk without knowing what the rules are. With financial regulation nearing completion, it is possible banks will be more willing to extend credit.

Lastly, it is important to understand that in today's environment, the availability of credit is directly linked to the amount of skin in the game. Said another way, the lower the leverage ratio (i.e., the lower the risk), the higher the probability of getting a loan. Think of this like getting a home mortgage—will a bank be more comfortable lending $300,000 to a borrower with 50% down or 10% down? It works the same way with business lending. If they survived the recent period of deleveraging, most businesses today look a whole lot less risky than they may have two years ago. That bodes well for credit conditions.

Credit is readily available to all who want it, but only if it isn't needed. If it is needed, credit is still available, but the terms may be tough to swallow and difficult decisions will need to be made. This credit cycle is not a new paradigm. It is the way things have worked for years, the prolonged expansion simply made us forget.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.