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Why CIT matters

McDonald's store front

Where the CIT failure will be felt first . . .

In the grand guignol of faltering banks, CIT, which ranks 26th in size, seems little more than a sideshow in the wholesale slaughter of giants like Lehman, Bear Stearns, and WAMU. It’s imminent demise, despite its desperate, last minute loan of $3 billion, however, will roil small business like no other bank failure before it. The hardest hit will be franchise owners, the hardworking, often cash-strapped entrepreneurs who run most of the chain stores we’re fond of, from McDonalds restaurants to convenience stores. For small businesses, the CIT failure is super bad news in a world of super bad news.

CIT is over a barrel. No, the barrel CIT is over is itself over a barrel. Many analysts quite rationally conclude that it’s all over at CIT except for the denial as executives gamely try to rescue the faltering giant. CIT needed $3 billion to satisfy debt it owed bondholders this month; they’ll need another $1.7 billion to pay off debts in January. By 2011, they have to pay another $7 billion in debt. Up until yesterday, they had $30 billion in assets that were not pledged as collateral to bondholders. In order to secure their deal yesterday, they had to put up all those assets as collateral on their $3 billion loan. That’s like you borrowing $30,000 and collateralizing $300,000 in your equity in your home to get the loan. You’ll get the money (quite a deal for the lender), but your options for future loans become severely constricted. And if all you have is $300,000 in equity to pledge, well, you’ve just effectively closed off any future loans.

So bad is the outlook, that CIT credit default swaps are now trading at 46% . . . in upfront premiums (in other words, each dollar of CIT debt is being insured at an immediate, upfront cost of $0.46 PLUS a yearly premium of $0.05 — this is a bit like collision insurance on a $20,000 car for $9,200 in one upfront premium along with yearly premiums of $1,000, which is decidedly not a vote of confidence in your driving).

While CIT is comparative small-fry compared to Lehman and WAMU, it is the nation’s largest lender to small- and medium-sized businesses — over 1 million of them, according to the bank. It is the biggest financial engine that keeps small businesses going — along with their employees (about half of all wage-earners are employed by small business) and their customers.

More particularly, CIT deals with small businesses that are considered too risky for conventional lenders, such as retail stores and restaurants. For many in the retail and food service world, CIT is their only lifeline to much-needed debt financing, whether it be capital financing, bridge financing, or just a credit line lifeline to meet cash flow requirements such as payroll.

But high-risk customers also include minority-owned businesses and startups. In fact, CIT is the largest lender to minority-owned small- and medium-sized businesses in the country (which makes sense since they’re the largest lender to small- and medium-sized businesses in general). CIT has long pursued minority businesses as part of its strategy, so its imminent failure is going to leave all the progress we’ve made in that area in peril.

Small- and medium-sized businesses already find themselves strapped for loans, and the borrowing binge and near-death convulsions of CIT will tighten credit markets even further. Should CIT go under, all these small business customers will see their lines of credit shrink or disappear when the loan assets are transferred to another financial institution.

And it’s not like other banks are stepping in to fill CIT’s shoes. Banco Popular (#6 in small business lending), Comerica (#9 in small business lending), and UPS Capital (#10) have all shuttered their small business lending. And in the realm of SBA franchise lending, the picture is bleaker, with GE Capital shutting down all lending to franchise small businesses and folks like Wells Fargo taking a chain saw to their franchise lending.

And that means that small- and medium-sized businesses will need to restructure to lessen their reliance on lines of credit, which typically go to payroll (number one use) and inventory (number two use).

Cutting payroll means cutting workers. Small businesses employ almost half the wage-earners in this country and have accounted for anywhere from 60% to 80% of the growth in jobs over the last ten years. Rationalizing payroll to decrease a business’s reliance on credit means putting a big fat wrench smack in the gears driving an economic recovery.

Of course, even if CIT manages to squeak by this crisis, small business loans and lines of credit will become scarce for its current and future customers. In fact, CIT has cut its lines of credit from $6.1 billion in March to $5.3 billion in July (a 13% decrease) — and will probably be taking a buzz saw to them over the next six months as their $1.7 billion debt service payment comes due at the end of the year.

You and I will see the difference primarily in franchises, like your local Burger King or Dunkin Donuts. These franchises rely disproportionately on CIT for bridge financing and lines of credit, making CIT the largest originator of franchise SBA loans. This is why IFA (International Franchise Association) President Tim Shay wrote to Obama begging them to throw more taxpayer money at CIT. That, for very good reasons, will never happen. So what will happen to franchise small businesses? Some will close. Nearl all will cut back seriously on employment.

None of these are arguments for saving CIT with taxpayer money. They are going out of business because they made incredibly bad decisions. Their loan portfolio has a staggeringly high default rate (over 5%), they rely solely on credit financing, and they went outside their core competency and exposed themselves too much in the subprime and student lending market. Of all the banks that have failed, CIT is probably the most deserving.

But it is an argument for finding ways to goose up small business lending by the banks still left standing, including federal guarantees for CIT loans and credit lines transferred to other banking institutions. The tow truck that will pull this economy out of the recession is small business, particularly franchising small business (franchises typically are the place where laid-off workers go when they decide to start up a business). Without those drivers (and, yes, we’re self-interested here as a small business), expect the economy to sputter and spin its wheels for quite a while.

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