Categorized | economy

Top ten myths about the economic downturn*

*That are making you madder or scareder than you should be.

In my consulting practice, the panic level of my clients is running on turbo-overdrive. Even Financial Times columnists are waking up in cold sweats without even falling asleep. Nancy Pelosi’s office just released a job loss chart that’s about as trauma-inducing as watching people jump from the World Trade Center on Sept. 11, 2001.

But allow me to tell a story about the last natural disaster I lived through, a story I tell in honor of one of the last survivors of the San Francisco earthquake, who sadly passed away today at the all-too-young age of 106.** He spent the San Francisco earthquake the way I spent the Loma Prieta quake 93 years later — speeding down a stairway and out the door.

I was at Stanford University that day, working, if that’s the word, on my doctorate dissertation. Bivouaced in the graduate student computer room, I was seated next to a fellow graduate student named “Joe” (to protect his identity because his real name was “Joe Lew”). He was talking to one of his freshman English students, a shy young girl, as they discussed her Freshman English essay. As I pretended to type, he regaled her with questions like, “Do you masturbate?” as I quietly but desperately debated how I was going to get her safely out lawsuit-free out of the room.

Suddenly, the quake hit. His student dived for the table and I was instantly in the doorframe and Joe was right beside me within a second. As the building rocked and thundered, two thoughts came to my mind. The first was, “Yeah, every building you see that’s knocked down in an earthquake has all the doorframes standing there intact. Right.” The second was, “If this building comes down and I survive, I’m going to be trapped in the rubble for days with Joe Lew.”

You see, Joe was the kind of guy who said things unprompted like, “Students never respected me until I got a new body” and “Do you masturbate?”

So I ran as fast as my little feet could take me down the stairs and out the door.

When I turned around, David Riggs, a master mensch and probably the best Renaissance literary biographers of our age (his indescribably masterful Marlowe biography is here), was right at my heels. As we stood there and watched the buildings dance and waltz in the late afternoon light, he made a comment worthy of David Mamet:

“I was standing in the doorway when I saw Richard run by. So I thought, ‘If Richard is panicking, it must be a good idea.'”

Well, everywhere you look today, everyone’s running for the door. So, is it a good idea to panic?

Before you rationally conclude that now is the time to panic, I offer up what I think are the top myths we’re laboring under in this crisis and what this means for entrepreneurs and small businesses. After all, one of the most memorable aspects of the Loma Prieta quake was that, for most of us, the ground shook a little bit while the outside world was regaled with disastrous images on the media — disastrous images of only one fire and two bridge collapses. All shot from different angles to make it look like the entire Bay Area had been atom-bombed.

Myth Number 1: The credit crunch
Credit, you are being told, has “locked up” or “frozen.” Without credit, consumers cannot purchase and businesses cannot invest. No, businesses can’t even stay in business because there’s no credit.

Credit, in fact, has not locked up or frozen. Plenty of lenders, particularly those healthy banks involved in the TARP CPP funds, are lending at levels comparable to or greater than before the so-called credit freeze. What has happened is that lenders are calculating risk far more rigidly and rigorously than they had previously. I have worked with several businesses that have obtained loans. I have found no obstacles to getting business or personal credit (although, because of my depression-raised parents, I’m fundamentally a “pay-in-real-time” sort of guy).

Credit qualifications, indeed, have tightened and will continue to do so. We are in an economy where credit of all stripes is inherently more risky, so folks and businesses who would have qualified for loans or financing in the past are greater credit risks because of the prospect of losing their job or their business. Now, as the economy continues to contract, the risk will become high enough that credit may effectively lock up, and that’s what the panic-button folks are trying to prevent.

Your job as a business owner or entrepreneur is to lower your credit risk. How do you do that? It’s a marketing problem. That’s right, make sales and you’ll get credit. Stop blaming the economy.

More importantly, other means of acquiring capital, such as venture capitalists, have dried up significantly so that more businesses are looking for financing through credit. I have put together sixteen investor presentations since the Lehman collapse, and only one has succeeded in getting venture funding. That is true for capital acquisition across the board. Naturally, as more small businesses head to the bank for capital, particularly operating capital, more are being turned away.

Myth Number 2: Wall Street Got Us Into This Mess
The sentiment plays well to our Babbitt tendencies, but it’s just not the case. Even if you focus like a laser beam on collateralized debt obligations, CDO’s, which was the primary means to attract investor capital to finance the mortgage, and particularly subprime mortgage, markets, the problem wasn’t Wall Street “greed” so much as it was consumer greed, realtors’ greed, bankers’ greed, mortgage brokers’ greed, financier greed, and Wall Street greed.

The Wall Street boogey-man myth is particularly insidious because it is the financiers, Wall Street included, that will be a significant part of the solution. We as a nation have elected governments that have allowed significant wealth to accumulate at the top. While some of us have vehemently disagreed with tax policies that have allowed for wealth disparities, it is the financiers that have found vehicles to redistribute that wealth back to the lower and middle classes in the form of debt. And it’s that greed that’s going to find ways to move so-called “toxic assets” freely on the market again and that Wall Street greed that’s going to find ways to attract capital to produce more credit.

Finally, complicated financial instruments, particularly those that offload or offset investor risk, permeate the entire financial system, not just the Wall Street investment banks. Municipalities, manufacturers, retailers — everyone is implicated. Karl Marx in Das Kapital once described the production of commodities as a set of social relationships between real groups of people, relationships that are hidden in the actual transaction of buying a commodity. Well, the complexity of the financial system is similar. Individual financial instruments spawn a bewildering series of interrelationships, a funhall mirror maze of dominoes. So the bulk of the finance system is actually healthy, but they’re all tied in with large institutions that are not. It’s the complexity of the interrelationships in mortgage financing, not Wall Street greed, that has made what should have been a painful rise in mortgage defaults into a major economic crisis.

And offloading risk by using financial instruments is here to stay.

A popular version of this myth has greedy Wall Street types dabbling in forces they didn’t understand, like mad and hormone-addled kids loose in the potions closet at Hogwarts. The financial instruments were too complicated, we are told; financiers had no real access to usable credit information (the mortgage companies had the lender information but the million-dollar guys in the Wall Street banks dividing these mortgages up into securities did not); they used complicated algorithms no-one really understood, they trusted the ratings agencies when common sense was a better guide, and so on.

But this is based on a clearly debunkable myth that Wall Street itself has promulgated: that they are so smart, they can figure all this stuff out and get it under control. But finance is about risk. Like entrepreneurship, the biggest payoffs go to the people who take the biggest risks. The folks on Wall Street did nothing really differently than the average small businessperson — take risks that they didn’t fully understand. I see it a thousand times a day in my consulting practice. But the average entrepreneur doesn’t pretend to have all that uncertainty under control, so we don’t all lose our heads when a venture goes south.

I think of Kierkegaard’s famous analogy, in trying to describe passion or faith, as “the leap off the cliff”; it’s that leap off the cliff that characterizes the best of entrepreneurs and the best of the finance.

It’s that “leap off the cliff” that led people to take out home equity loans on houses that were blindingly overpriced. It’s that “leap off the cliff” that led mortgage brokers to send thousands and millions of direct mail pieces to homeowners like me to get us to squeeze even more money out of our home equity.

It’s that “leap off the cliff” that will motivate banks and financial institutions to start moving these financial assets again and finding new ways to capitalize consumer and homebuyer credit and new ways to manage and trade the risk inherent in that credit.

Myth Number 3: The Bank Bailout (TARP) Was Supposed to Get Banks Lending Again
The first $350 billion that went into TARP was primarily designed to keep the banking system from collapsing entirely. Approximately $100 billion (along with individual, multi-billion dollar bailouts) went to large banks that were in imminent danger of collapse and, along with them, the rest of the financial system. Another $250 billion went to healthy banks in a program called the Capital Purchase Program. The healthy banks are using this money to make loans, pay down debt, and acquire other banks (usually troubled banks).

The one and only one purpose of the CPP was to provide banks access to capital in a market in which most if not all sources of capital available to banks had pretty much dried up. That’s it. Nothing more, nothing less.

Furthermore, the CPP wasn’t a “bailout.” The government received preferred stock as well as stock warrants. Those preferred stock shares work just like any other preferred shares, that is, they are essentially bonds — the CPP banks that distributed these shares to the government have to pay set dividends on those shares just as they have to pay interest on their debt. And, like bonds, those dividends are a senior obligation — they have to pay them before making distributions to unsecuritized credit or other dividends.

In other words, the “bailout” money has, just like any other source of capital, a “cost” of capital. Banks can only afford to assume the CPP capital because they plan to use the money to generate higher returns than the actual cost of capital, as any introductory finance textbook will teach you.

For almost all CPP participants, this is capital they would otherwise have raised on the capital markets. When you read economic studies such as that done by Luigi Zingales at the University of Chicago, which calculates the “cost” of TARP to taxpayers in terms of banks paying down debt, keep in mind that they’re calculating the “return” of TARP in terms of CPP money used to finance loans. But CPP money was only meant to replace money that the banks would normally have acquired on the capital markets to use however they would use that money relative to the cost of the capital.

Inevitably, to meet the cost of capital, these banks have to lend money at a higher interest than the cost of the “bailout” money. Just as they would if they had to acquire capital by selling preferred stock to any other investor.

Again, like the first myth I discussed, you see precious few numbers trotted out as to how many loans are being made or not being made. The relevant comparison is not the ratio of bank lending today versus bank lending some time ago, say three months or twelve months, but the ratio of lending today versus the ratio it would be if banks did not have access to capital through CPP.

Banks, as I said before, are not lending not because they don’t have the funds. They’re not lending because credit has become inherently more risky in an economic downturn. They have to figure in potential joblessness or undermployment when making personal loans and they have to figure in the much increased likelihood of financial distress when making business loans.

Part of your job as a borrower, then, is to reduce that risk.

Myth number 4: The credit crunch has reduced consumer demand
For business, bank lending is not the ten thousand problem sitting on the fence. The business-killing problem we face now is depressed consumer demand, excess inventory, and declining prices which threaten a “deflationary spiral” leading to double-digit unemployment and even more reduced demand.

Here’s the thing, the thing I’ve shouted at all my clients over the past few months: this is not just simply a lending problem, it’s a marketing problem. This recession means that all the traditional means of marketing, including product development, lifecycle planning, advertising, public relations, pricing, placement, discounts — the whole ball of yarn — has to be rethought. If you want to market your product, service, or store using the same promotions, pricing, product, and placement models you used last year (or other people used), you can’t blame the banks. The customers are out there. The money is out there. The potential demand is out there. You’re doing things wrong.

For instance, let’s look at car manufacturers. They’re losing sales, we are told, because of the “credit crunch” (that’s what they would have us believe). Not true. They are losing sales because of reduced demand based on rational customer expectations of the performance of the economy and the price of credit. The credit is out there. The customers are out there (unemployment is bad, but not bad enough to produce the drop we’ve seen in car sales). It’s the job of the car makers to produce the demand. And they have to market with consumers with justifiable concerns about their short-term income potential, their current debt loads, and the cost of credit.

Here’s an example. Hyundai, like other car manufacturers, suffered greatly in a rapidly declining new car market last year. Then it stopped feeling sorry for itself and went out there and did some innovative marketing, marketing perfectly targetted to the concerns of buyers in a recession. As a result, its sales have increased 14% this month — the same month every other carmaker has posted record declines in sales.

What have they done? They’ve offered, free of charge, job loss insurance for people financing a new car through them. Simply put, if a new car purchaser involuntarily loses their job (or becomes medically disabled) in the first year of the loan, Hyundai will take the car back and forgive the balance of the loan. With no black mark on the buyer’s credit.

And just in case you’re still all riled up about those Wall Street types and their incomprehensible financial instruments such as credit derivatives, that’s exactly what Hyundai is offering their customers. A credit derivative. In short, a credit swap contract. But the customer pays no premiums (the premiums the customer otherwise would have to pay on such job loss “insurance” is what Hyundai is actually offering the customer).

I’m serious about the credit swap analogy. When a trigger event happens (involuntary job loss), Hyundai purchases the debt (from itself) and acquires the asset (the car) and takes the potential loss (the car still has some recovery value). Just like a credit swap: a trigger event happens (loan default), the guarantor counter-party purchases the debt and acquires the asset (a bond, say) and takes the potential loss (the asset still has some recovery value).

Pretty bitching smart, if you ask me.

We are told that people aren’t buying big-ticket items like cars and refrigerators. They’re paying down debt (true) and they’re reluctant to take on new debt (equally true). That doesn’t mean they can’t afford debt, it just means that you need a different marketing approach to get them to take on debt. Hyundai figured it out.

It is true that Hyundai will lose some money (because they are not collecting premiums which would otherwise offset the total risk of the warranty portfolio), but they have calculated the risk and see the upside (increased revenue from sales) balances out the downside (losses from forgiving the debt and repossessing the vehicle for the estimated percentage of buyers that will lose their jobs).

Which illustrates a key principle — you should call it a law — of marketing in a recession: the only way to succeed is to transfer more value in the transaction to the consumer. In a recession, consumers will gravitate to the transactions that transfer more value to them than they would in a growing economy. Customer behavior in a downturn, then, is “value-seizing.”

Now, you can always transfer value to the customer by giving away the store, as the Florida Dodge dealer did when he offered a two-for-one sale, but giving away the store is never a good idea.

Hyundai, on the other hand, is transferring value to the customer by assuming a large part of the risk for a car loan for one year, just like a derivative. The accounting cost of the value transfer is the foregone premiums that a customer would normally have to pay for insurance like this. Hyundai is “giving” its customers job loss insurance premiums for one year after the purchase of a car. The actual cost will be the actual losses incurred by forgiving debt, repossessing vehicles, and reselling them, just like any other warranty cost. Hyundai can account for the cost as either foregone premiums (using the market value of job loss insurance) or as estimated losses (which is the typical way of accounting for warranty costs). In the aggregate, both the accounting and the actual loss amounts to a small discount on each and every car sold.

Every marketing effort that returns value to the customer can be characterized as a discount.

The simplest possible discount, of course, is a direct lowering of the ticketed price.

That’s the strategy other car manufacturers have embraced, returning value to the customer by giving big discounts (sometimes massive discounts), yet they are still seeing their sales fall to unsustainable levels.

Hyundai, on the other hand, through its job loss insurance program is effectively giving customers a small discount, but is increasing its sales.

Why? Customers would rather have value returned to them in terms of lowering their credit risk rather than have value returned in a lower price. The value of the lowered credit risk is higher than the dollar value of a simple discount, so they’re willing to take less dollar value out of the transaction. Now, considering that the premiums are probably worth less than $1,000, they are not making a rational decision by purchasing a Hyundai over another car with a discount greater than $1,000 and using part of that discount by purchasing something like job loss insurance from an insurance carrier. But the peace of mind they’re purchasing is worth it to them.

(Needless to say, Hyundai is calling it “insurance,” but it is technically not insurance. You don’t need to know why.)

As a businessperson, you must understand that you can sell in a recession (people still have money and jobs and homes). But the rules have changed. Follow the old rules and you go out of business. One of the new rules is that you have to transfer more value to the customer and, if your business depends on consumer credit, the best value you can give consumers is to reduce their risk as borrowers.

I promised ten, I made it to four. Live with it, because I’m mighty bushed after that bout of logorrhea. We’ll be back tomorrow. Same bat time. Same bat channel.

**Harold Hamrol — his secret to such a long life? “Wild women and good liquor.” God speed, Harold. Give ’em hell in heaven, my friend, give ’em hell.

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2 Responses to “Top ten myths about the economic downturn*”


  1. […] Money, February 11) And those bankers state the obvious, the same obvious that I pointed out in my first four myths about the economy, namely that without the TARP funds, credit would be even tighter than it is […]

  2. […] In a previous post, I started ticking down ten misconceptions many of us, especially those paid to have an opinion, seem to be laboring under as the economy continues to head south and our fearless leaders continue to head nowhere. Today is our special banking edition, turning the spotlight on all the fancy and fantasy conjured to keep us sleepless at night. So, with no more excuses, on to number five: […]

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