Archive for May, 2009

Unlimited Risks or Empty Gestures?

Wednesday, May 6th, 2009

In an earlier posting, I wrote of the complications of the Small Business Administration’s new loan program. New details have emerged that the risks may be greater than the public appreciates. SBA loans were the main topic at a recent town hall meeting at which President Obama noted that the annual volume of loans backed by the Small Business Administration was trending below $10 billion, down from $18.2 billion last year and $20.6 billion the year prior.

To stimulate the flow of credit to small businesses, the administration endorsed provisions in the stimulus bill. The legislation attempts to unblock the flow of credit to small businesses by temporarily raising government guarantees from 80% to 90% on the SBA’s flagship loan programs. In addition, it’s temporarily waiving SBA loan fees to reduce the cost of capital.

The Treasury now requires the 21 largest banks receiving funds under the Troubled Asset Relief Program to report their small business loan volumes on a monthly basis. Other banks receiving TARP funds must report this information quarterly. Treasury advised banks not participating in TARP that they too should make every effort to increase their small business lending. This push suggests that after the banks repay their TARP obligations, Treasury will continue to take an interest in SBA loans.

Critics of SBA programs charge that SBA loan guarantees create a moral hazard in incentivizing lending that’s harmful to U.S. taxpayers who must bear any losses. The most recent default rate reported on the SBA loan portfolio is 12%.

Further compounding the moral hazard risk is that some of the 21 largest banks have limited experience with small business lending. With the SBA principal guarantee on loans increased to 90% from 80%, taxpayers could potentially be underwriting a steep learning curve for the banks. Bank executives presumably appreciate how the public would likely assign blame for loan losses requiring additional taxpayer support.

This raises the question: is this a sincere effort to unblock the flow of credit to small businesses or an empty political gesture?


Cash Flow Underwriting

Monday, May 4th, 2009
Harder Markets Ahead

Harder Markets Ahead

In Prepare for the Worst, Plan for the Best: Disaster Preparedness and Recovery for Small Businesses (John Wiley & Sons Inc., second edition, 2008), I explained the cash flow of an insurance company (page 178):

“An insurance company collects premiums from its policyholders. such as your small business. It invests these premiums in assets, such as high-quality bonds and blue chip stocks, to earn investment income. It pays out expenses, such as premiums for its own reinsurance coverage, salaries to employees and so forth. It also pays claims to its policyholders for insured losses, or damages. The cash flow of an insurance company (premiums plus investment income less expenses less losses) is often expressed in terms of a combined ratio. The combined ratio is the sum of the loss ratio plus the expense ratio. A loss ratio of 100%, for example, means that for every dollar the insurance company collected in premiums, it paid out one dollar in losses and expenses. An insurance company with such a loss experience stays in business by engaging in so-called cash flow underwriting; that is, its insurance losses are more than offset by the investment income the insurance company earns on its premiums. In 1999, for example, insurance companies were paying out $1.07 in claims and expenses for every dollar collected in premiums. You can appreciate how sensitive the insurance industry is to the financial markets.”

When the combined ratio becomes unsustainably high, the insurance industry can no longer rely on cash flow underwriting and has to raise premiums. Insurance industry professionals refer to this as a “hard market”, one in which rates are rising. This graph here shows the combined ratio for the U.S. property-casualty insurance industry from 1970 through the third quarter of 2008. The horizontal grey line shows the combined ratio at 100%, that is when the insurance industry breaks even. The bars that extend above the grey line are shaded in blue and show when the insurance industry is underwriting risks at a loss and relying on investment income to remain profitable. The green bars are those that do not reach the grey line; that is, the combined ratios are below 100% and the industry is making underwriting profits.

The insurance industry had a particularly difficult year in 2008: for the first three quarters of last year, the U.S. property-casualty industry paid $19.9 billion for catastrophic losses. These losses occurred at a time when the financial markets were in decline, and so investment income was insufficient to compensate for underwriting losses. Hence, the bar for the first three quarters of 2008 is blue in color, extending above the grey line for a 100% combined ratio. This suggests that the insurance market is about to become “hard”, cash flow underwriting is about to end, and premiums will rise. Better to renew your insurance coverage sooner rather than later, as later it will likely be more expensive.

Delays in the SBA Stimulus

Sunday, May 3rd, 2009
Pushing Pencils, It Seems

Pushing Pencils, It Seems

In a previous blog entry, I expressed skepticism about the Small Business Administration’s forthcoming emergency credit facility, tentatively named “America’s Recovery Capital (ARC) Loan Program”.  The legislation enabling this program, the stimulus bill, requires the SBA to create a new “business stabilization” program to back loans of up to $35,000 to small businesses “experiencing immediate financial hardship”. Now there is another reason to question the value of this program.

A recently released  Government Accountability Office report announces that the Small Business Administration will be a few months late installing some new regulations meant to revive SBA lending, which has dramatically declined over the past year. Two changes mandated by Congress, including eliminating loan fees and raising loan guarantees for borrowers, were enacted in the required 15-to-30-day period. But the SBA failed to increase guarantees on secondary market real estate and equipment loans and to issue regulations involving “systemically important” broker-dealers in the secondary market in a timely manner. SBA officials stated that it was too complicated to enact such rules in the short period required by Congress and that they hoped to have these matters resolved by June.

Neatness Counts

Saturday, May 2nd, 2009
Get It Together

Get It Together

When I had to submit insurance claims against both my homeowner’s and commercial policies, the insurance staff who processed my claim remarked that mine was the best organized submission that they had seen – and so processing my claim jumped to the front of the queue! That is not surprising: which would you rather deal with – the well-organized claim submission, neatly presented with supporting documentation or the hastily assembled report that will take some time to decipher? Make life easier for the person you are dealing with and you will make life easier for yourself.

Now I have another insight to support this recommendation. I recently met with an executive of one of the five largest property-casualty insurance companies in the U.S. and he told me that when he had started his career ten years ago, 40,000 monthly claims were processed by 8 claims adjusters. This business function was automated such that 1.5 million monthly claims are now processed by 12 claims adjusters. Often a human eye never sees the claim. Another reason to make your submission legible and your life easier.

Diversify Your Banking Risks

Friday, May 1st, 2009
Watch Where You Put Your Money

Watch Where You Put Your Money

In Prepare for the Worst, Plan for the Best: Disaster Preparedness and Recovery for Small Businesses (John Wiley & Sons Inc., second edition, 2008), I advised readers about the disaster category of third party failure. This is the risk of failure of the provider of a product or service upon which your small business depends such as, for example,  your Internet service provider or your telephone service. In the context of the banking crisis, a particularly relevant example was presented in the pages of the Wall Street Journal this week.

The Journal reported the story of a depositor who, eight years ago, put her life savings of nearly $600,000 into accounts at Superior Bank of Hinsdale, Illinois. Approximately one month after this deposit was made, the Federal Deposit Insurance Corporation (“FDIC”) seized Superior as a result of allegations over improper financial and accounting practices in its sub-prime business. The FDIC limits deposit insurance to $100,000, with the result that this depositor lost much of her money, as did hundreds of other customers of Superior Bank.

One way to mitigate the risk of third party failure is to diversify your suppliers. Your small business should have, for example, a primary Internet service provider and a secondary, unrelated, Internet service provider which you can use if the primary provider’s service is disrupted. The same is true of your banking services. This depositor would have benefited by making deposits  in separate accounts of no more than $100,000 each in at least six different banks. Then, when Superior was seized by the FDIC, she would have had immediate access to the other $500,000 deposits in the other institutions, while she waited for the FDIC insurance to make restitution for the $100,000 she had deposited with Superior.

Of course, since this event occurred, the FDIC raised its insurance limits to reassure depositors of the safety of our banking system during this difficult time. Even so, as a small business owner, if my liquid cash were, let’s say, $50,000, I would not deposit it all in a single bank, even though the entire deposit would be covered by the FDIC. Why? Because I have a business to run and that depends on immediate availability of funds. I cannot have my small business experience even a short period of illiquidity while waiting for a benefit from the FDIC. So I re-assert the advice I had previously given: think redundancy of suppliers. This depositor learned a lesson the hard way; make sure that your small business does not.