Wednesday, January 21, 2009

Pulling the Pin on Good Business

Bankers are funny types. In an economy awash in bad debts, some have an instinctive impulse to add more to the pile.

The New York Times reports on banks calling loans on companies that have perfect loan repayment records. This is what often happens when credit shrinks and banks no longer need compete for borrowers.

The article focuses on Dave Brown of Tempe, Arizona, a home builder who had been in business, successfully, for 33-years. That came to an end when his bank, panicked at his company's declining revenues, demanded additional collateral for its loans - assets Brown simply didn't have. Even though not one payment had been missed, the bank simply called its "demand loans." That left Brown unable to complete his current projects which rendered them unmarketable and which led the bank to step in and foreclose.

Banks do this and they do it here in Canada as well. Every now and then something happens and the banks go "medieval" on their borrowers (h/t Pulp Fiction). When this develops into a trend it ripples through communities and, eventually, entire societies.

Here's what I mean. In the 80's there was a recession in Canada. In Vancouver, car dealers were particularly hard hit. The lenders - banks and automaker acceptance companies - panicked. They called their notes and hired bankruptcy lawyers and trustees (oh, the gravy!).

One particular trustee seemed to get most of the many car dealers, one by one, on a particular thoroughfare. He would move in and throw the dealer's inventory on the market at firesale prices. Basically he went into competition with every other car dealer in that market and they couldn't afford to match those prices and service their own debts. Like dominoes, one by one they fell as the market got saturated with below-cost inventory.

It wasn't just car dealers who fell victim to these debt realization Berserkers. Commercial auction houses were flooded with inventories of companies that fell into receivership. It was not atypical for assets to be blown out at ten cents or less on the dollar. Out of the paltry recovery the lawyers, trustees and disposal experts would all have a fine feast. They were often creating the conditions for the next company's failure. Buzzards are supposed to eat carrion, not manufacture it.

Then the recession passed and, once the hangover cleared, the banks noticed that they had little to show for their efforts, pennies on the dollar, in large part because of their counterproductive approach to debt realization. They had been pulling the trigger but the gun had barrels pointed at their own head as well as the debtor's.

That finally ushered in the era of "work outs," recognizing when a debtor was in trouble and concentrating on how to maximize recovery which in some cases meant keeping that company in business by writing off debt or deferring repayment. The bank got more than it would by shutting down the company, the business sometimes managed to keep operating and the employees kept their jobs and paycheques and kept contributing to society.

But this is a pendulum that can swing back again. We're going into a recession. Even Harper has finally grasped the need for a stimulus plan. But the devastation the feds need to offset should be addressed by the feds and the provinces. Preventing Kamikaze debt realization ought to be explored - now. It's much harder to force banks to extend credit than it is to restrict their freedom to shrink existing credit facilities.

I think we need to look at measures to protect borrowers during this extraordinary time. There's no point blaming them and saying they ought to have known better when our banks and our government utterly failed to see what was coming. Keeping as many companies as possible in business during this recession makes good sense. It continues economic activity and it reduces unemployment and all the consequent ills that flow from that.

Let's face it, we've got billions to bail out banks but, in terms of employment, they're small change.

Now, if the interim leader of the Liberal Party wants to look progressive, there's something he can chew on.


Ted Betts said...

DL: It is worse than that. And Harper is directly complicit in making it worse.

Canada did not have a subprime mortgage market like the US. Harper created it in 2006 when, after long lobbying efforts from the US mortgage insurance companies, he changed the rules to allow 40 year no money down mortgages. At that time, “Canada’s New Government” guaranteed the mortgage insurance, estimated at up to $300M. Interestingly and very tellingly, only the day before the legislation was passed, the mortgage insurers registered as lobbyists.

Now Harper has the gall to claim he saved Canada from the subprime nightmare in the US because he changed the rules back, partly late last year.

The Globe published an excellent, in depth investigation into the whole looming mess - wholly created by Harper’s “stable hand” on the economy. Here is the article: Special investigation: How high-risk mortgages crept north - The untold story of how elements of the first Conservative budget in 2006 encouraged big U.S. players such as AIG to make a push into Canada, creating our version of subprime mortgages.

The Mound of Sound said...

Yeah, I read that Ted. What I want to know is the extent of the Harper 40/zero mortgages among the securities "bought back" from the banks with the $75-billion "liquidity" bail out.

That said I fear the emerging American debt realization mentality could easily sweep north and bring with it the sort of bankruptcy/receivership ills mentioned in this post at the very worst moment for Canada.

Once this starts it may be enormously difficult, even impossible, to correct.

We're all familiar with the truism that recessions are created, in part, by a cratering of consumer confidence. We need to realize that a similar confidence problem on the part of lenders could be just as bad, even worse.