Secured credit lines: insurance, or trap?

This article comes from First Tuesday Journal Online

This article examines the purpose and stability of credit lines during a recession, especially those lines of credit offered by financially unstable banks.

Cash on demand, as agreed

Consider the owner of a business that has been steadily expanding in the years leading up to an inevitable business slowdown, called a recession. Thanks to the introduction of new products and increased marketing efforts, and to the overall strength of the economy, the owner has encountered new demands for his goods and services, and has increased his operating expenses, inventory and accounts receivable in response.

However, the owner wants to make sure that he will always have a minimum amount of cash on hand, even when his funds are temporarily tied up in equipment, furnishings, inventory and the credit he extends for sales, called receiveables. To consistently have access to working capital, the owner enters into a loan agreement with his bank and pays a fee to open a guaranteed line of credit.

This line of credit obtained by the business owner is characterized in economic terms as liquidity insurance. It ensures his business will be able to meet its cash requirements even if cash is temporarily unavailable due to the business demands for maintaining inventory and receivables.

This business scenario is as uncontroversial as it is common (there are exceptions to this rule: Ford Motors was harshly criticized for obtaining a massive line of credit during boom times, but had the last laugh when General Motors and Chrysler, lacking such lines of credit, had to apply for government bailouts to remain solvent during the Great Recession of 2008). Both small and large businesses routinely take out lines of credit in case of a temporary drop in income such as occurs in an economic dip. In fact, a recent study by Amir Sufi at the Federal Reserve Bank (the Fed) of Philadelphia found that 85% of firms surveyed had obtained a line of credit between 1996 and 2003.

The wise squirrel gathers nuts for the winter ahead

Credit lines are appealing to businessmen. As pre-approved credit, a guaranteed line of credit sets terms for the business to draw upon when it needs to bolster its cash reserves and requirements, increase capital for additional plant or equipment expenditures or enlarge inventory and accounts receivable. Due to their ease of use and the peace of mind they offer, credit lines are often a business’s last line of defense against a failure to meet payroll and short-term credit obligations. In fact, many businesses use credit lines routinely during times of reduced cash flow, increased operating expenses or capital investment (inventory, receivables or plant and equipment).

The Philadelphia Fed indicates credit lines made up an average of 16% of total book assets among those firms in the Fed survey that admitted to holding credit lines. Businesses tend to prefer to use credit lines to provide a source of cash, since the only alternative to a line of credit is to issue stock in ownership or to hold more cash in reserve, limiting the business’s ability to expand by purchasing inventory and equipment or building up accounts receivable.

Unfortunately, as indicated by recent research from the Philadelphia Fed, businesses that seek to hedge against reduced cash on hand by acquiring a line of credit are not as protected as they have been led to believe. Although banks are always required to honor the terms of a written contract setting out a pre-approved credit line, multiple contractual “weasel clauses” allow banks to withdraw the line of credit when they become nervous.

While the cancellation of a line of credit was not often an issue in boom years, banks are understandably concerned about cutting their losses (or avoiding them altogether) during recessions, and take measures to avoid potential future losses from moderately risky loans. In recessionary periods, borrowers are not treated with the trust to which they may have become accustomed, as banks are more likely to use a borrower’s small breaches in minor loan covenants as excuses to modify the terms for use of the credit line, or even to withdraw the line entirely.

In fact, many small business owners during the recent Great Recession have already had their error revealed to them when their bank refused to fund loans on a credit line the owner/borrower believed to be completely guaranteed.

The dangers of “guaranteed” credit

Businesses – especially small businesses – considering a line of credit as a hedge against reduced cash flow or a needed capital investment need to be constantly aware of several risk factors.

First of all, pay close attention to the conditions written into provisions of the credit loan agreement, called the financial covenants. Financial covenants require the borrower to keep a certain amount of cash on hand at all times, as a sort of insurance or cushion for risk taken by the lender when advancing funds. The specific amount of this cash requirement will vary, depending upon the bank’s confidence in the buyer’s ability to repay any funds advanced under the credit line. Because of their generally less extensive resources, small businesses tend to have proportionally greater cash requirements in the financial covenants.

However, a cash-on-hand requirement is directly contrary to the goals that most businesses have when taking out a credit line in the first place. Not only do continuing cash reserve requirements reduce the utility of secured credit lines for borrowers (what is the point of a line of credit, intended for use as liquidity insurance, when it comes with a reserve requirement demanding cash deposits with the bank?), it also makes the credit line vulnerable to being lost if the business’s cash on hand ever falls below the set amount. The credit line originally intended to liberate the business instead creates more limits upon the way that it spends its money.

When the business’s amount of cash on hand does fall below the amount required by the financial covenants, it is considered a technical default, sufficient justification for the bank to cancel the entire credit line if it so chooses. Thus, if a line of credit requires cash on hand, the business must draw funds under the line of credit to keep sufficient funds on deposit with the bank – even though they are borrowed funds.

Approximately 15% of businesses with lines of credit were in violation of the covenants at any given time according to a 2007 report by Sudheer Chava and Michael Roberts for the Philadelphia Fed. More than a third of all the businesses in their survey violated the covenants at least once during their ten-year sample period.

Before the 2008-2009 recession, banks would often overlook this type of behavior, but with a recessionary economy placing borrowers at an increased risk of default, banks take no chances. While banks generally avoid cancelling the secured credit line entirely, it has become increasingly common for banks to use technical default as grounds to renegotiate the credit line on terms less favorable to the borrower.

A second contractual requirement in lines of credit can be even more troubling to businesses. While the financial covenants usually require businesses to maintain a certain amount of cash on hand, banks more often satisfy their need for security with an agreed-to borrowing base requirement. Such a requirement mandates that the business always maintain a minimum set amount of security — in the form of real estate, or business assets such as plant, equipment, inventory and receivables — as a source of repayment for any loans made under the line of credit in the event of a default. If the business lacks the minimum amount of value in business assets for security, they are simply rendered ineligible to draw upon their credit line.

Businesses have little trouble maintaining the security requirements under their secured credit agreements during boom times. However, those which hold a line of credit in the early days of a recession may be hit especially hard by the economic downturn.

For example, during 2008 and 2009, the economic recession accompanied by a concurrent financial crisis led to a tremendous drop in the value of both real estate and businesses, and cash revenue dropped as customers bought less. Thus, many businesses that had to maintain constant inventory during the recession fell below the minimum value agreed-to for their borrowing base. Lenders were merciful at times, but not always.

Those who continue to issue credit during a recession tend to be the lenders that are free from financial troubles of their own. On the other hand, troubled banks (those that held a higher proportion of toxic assets and have been harder hit by mortgage defaults) have been especially keen to avoid funding lines of credit. The Philadelphia Fed has discovered that troubled banks fund significantly less on pre-approved credit lines than banks in more secure financial positions, in spite of the “secured” status backing those lines.

The rare business that is certain of maintaining sufficient cash flow during cyclical recessions may still find some benefit in acquiring a line of credit. The vast majority of businesses, however, should NOT think of credit lines as a reliable source of backup purchasing power: they are far too subject to supply-side factors to satisfy the needs of most small businesses. [For a more detailed and scientific analysis of the issues discussed in this article, see the recent report from the Federal Reserve Bank of Philadelphia: How Committed are Bank Lines of Credit?]

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