The Credit Crunch is here, what is it and what does it mean?

The so called “credit crunch” is here, we hear about it, we read about it and we are affected by it. But, do you know what it means?

Change in Terms, Conditions and Requirements

A credit crunch (also known as a credit squeeze or credit crisis) is a rapid reduction in the general availability of loans (or credit) or a stringent tightening of the conditions required to obtain a loan from banks and other traditional lenders. A credit crunch generally involves a reduction in the availability of credit, or the ability to borrow money, independent of change in official interest rates. In other words, the credit crunch makes it more difficult for you to borrow money for other reasons than the cost of the interest. In such situations, the relationship between credit availability and interest rates has changed such that either credit becomes less available at any given official interest rate, or there ceases to be a clear relationship between interest rates and credit availability (i.e. credit rationing occurs). Typically, a credit crunch also means a change in the types of loans a bank or an investor is prepared to give. In addition to looking at the “risk/reward” relationship, lenders look more closely at the “quality” of the borrower. Traditionally, that means that lenders favor, larger companies with a long and stable track record rather than looking at maximizing the return on their investment or providing more product (credit) to the market because it is in demand. Furthermore, loans for expansion are looked at with higher scrutiny. This means lending for current documented needs is more comforting than investment in machinery, tools or marketing efforts. In simple terms, one can say that the credit crunch is a reduction of fuel for the economy. You may have the need for it and the means to pay for it, but all of a sudden it isn’t available because the terms and conditions for borrowing have changed. The changes can be major, your industry may have fallen out of favor or, in a better case scenario, and all you have to do is provide a higher portion of equity relative to the amount you want to borrow. Previously we saw debt to equity rations of 4:1 today we see ratios of 3:2 and sometimes 1:1.

Credit is just another product

Credit is just another product provided by banks and investors and follows the traditional rules of supply and demand. The more the borrowers are prepared to pay in the form of interest (the price), the more credit (the product) is available. The less demand there is for the product the lower the price charged by banks and investors. The credit crunch redefines these rules. First of all the amounts available to the borrowers are decreased. Secondly, it increases the requirements of the borrowers and thereby limits the number of qualified customers in the market place and thereby reduces the aggregate demand. Therefore a lower pro rata share of borrowers is in the market place and the price (the interest rate) of the product (the credit) is reduced.

The table above illustrates how the interest rate and supply of credit changes in typical economic cycles. For simplicity sake, the typical economies are defined as Strong, Weak and Normal. In those three situations, there is a logical relationship between the amount of credit available and the interest rate. In the Credit Crunch scenario it is not. The volume of available credit is reduced because the market for the credit has shrunk as a result of higher requirements on the borrower. The interest rate is down because it is more difficult to attract the qualified customers. The interest rate may also be down because the qualified borrowers are reluctant to borrow when the economy is in such a depressed stage.

This is how it happened

A credit crunch is often caused by a sustained period of careless and inappropriate lending which results in losses for lenders and investors. The carelessness refers to overinflated asset values, overly positive expectations of growth as well as the over optimisms that comes with a rapid expansion. Once the optimism and expectation starts to change, the view of values and opportunities change from positive to negative. When losses starts to appear, the degree of loss accelerates as bad news feeds on itself and therefore lenders and investors become more and more prudent and restrictive. The prudence and restrictions are a reflection of the loss of confidence in the economy for the near future by lenders and investors. In times like this one often hears the term, “rule number one is not to lose money, rule number two is to make money”. If the sentiment is that “I am better off holding my money than lending it or investing it” economic growth slows down. If the credit crunch is so severe that banks and investors pull back credit that is already in place and performing, then the economy slows down. Healthy businesses can all of a sudden find themselves without the capital they need to operate. Credit is a necessary part of business. Most companies have some kind of credit facility such as a credit line with a bank or terms with its vendors. One can say that credit is like oil in a car; you don’t think much of it but when it isn’t there you have problems, big problems. For example, a portable storage company that is financing its fleet of rental containers with a credit line would have a major problem if all of a sudden the credit line was terminated. Credit lines are typically a one year term and are often renewed without any major issues (provided the customer is doing well and paying his interest). If the bank decides that it doesn’t want to keep the credit line, they are not obliged to if it is renewed annually, the rental company is then forced to find financing elsewhere. This is a monumental task in today’s restrictive credit environment. The other alternative to pay off the credit line is to sell part of the rental fleet and thereby generate cash. This will hurt more than help the company in the long run.

How will we return to a normal credit climate?

Currently, we are in what appears to be one of the most difficult economic situations since the Great Depression, the Second World War, the oil crisis of the 1970’s, the inflationary times of the early 1980’s etc. It is obvious that the challenges presented during those downturns where overcome one way or the other. What we don’t hear much about and which I think makes things worse are the opportunities that currently present themselves in various ways. Slowly but surely we’ll see opportunities and can convince our lenders that it is time for them to be less restrictive. It will help you to keep on top of your banker at this time. Show him your business and talk about the opportunities you see. He is, after all, a businessman and his job is to lend you money.

Current opportunities

Making investments in bad times is usually very good; the trick is to invest in the right kind of opportunity. If you are in the portable storage business look at what your business needs today. There are bargains to be made in buying trucks, trailers, lifts, tools and other machinery. Check the local newspaper listings and the Internet for distressed sales and talk to others in your local business community about your needs. I say needs because the time is great for buying what you need and not buying everything you think you can use. Taking advantage of opportunities doesn’t exclude being prudent. If you don’t need it, don’t buy it. But buy it if you need it because now the price is right.

If you feel comfortable with the long-term strategy of your company, now is also a great time to build out your infrastructure. Have you had another yard or expansion of your existing facilities in mind? Now is the time to look for real estate deals. Talk to your realtor and local banker about what’s available in your neighborhood. We see a lot of for sale signs but I think banks, accountants and bankruptcy lawyers currently sit on valuable information concerning things that are about to happen. With a few phone calls you’ll find out what is going on in your area that isn’t common knowledge yet. It may be some of the most profitable calls you’ll ever make.