ARTICLES
- Mar 31st, 2011
Navigating the New Normal - Jan 11th, 2011
Leasing's Evolution - Jan 11th, 2011
Growth Strategies from the Recovery
Navigating the New Normal
The Aftermath of The Great Recession
March 31st, 2011
Introduction
Much has been written about the causes of the global economic meltdown which became evident to all of us in September, 2008, about how our country, and the world in general, went from seemingly never-ending economic prosperity to an abrupt and continuing economic calamity. Given the plethora of books, articles, and even documentaries that have thoroughly analyzed the meltdown, we will only address the causes at a very high level, just to set the stage for the real focus of this article, which is to suggest how small and medium-sized leasing companies – those that are still alive – can continue to navigate the still very choppy post-meltdown waters to survive and even prosper.
Prosperity Forever. Although there were the astute naysayers among us, most of us seemed to embrace – or at least accept – the mindset that economic growth and asset value appreciation would continue indefinitely. And as a society, most of us either actively contributed to it or at least passively allowed it to continue. In retrospect, it is easy to see that a collapse of some proportion was inevitable.
High Leverage the Norm. Of course, we can now so readily see that leverage at unsustainable levels became palatable, and even acceptable. Without debt, the short-lived escalation of asset values – particularly real estate – could not and would not have occurred.
Lenders as Enablers. The obscene level of leverage occurred because cheap, easy credit was made available to virtually all credit calibers: individuals and businesses. A herd mentality prevailed among the lending community as lenders in general flocked to participate in this seemingly unstoppable economic expansion. Tried and true underwriting standards of the past were discarded so that every American could become a homeowner, irrespective of whether he or she could afford the home. And the borrowers naively – some fraudulently – believed that their mortgage interest rates would never rise or, if they did, their incomes would increase even more.
Risk without Regulation. Most investment banks and commercial banks were contributors to the spiral, but the largest banks lead the charge, taking truly incredible risks which, in many cases, were not even recognized as applicable risks (i.e., the risk that the entire single family residential market could experience a substantial decline was not even evaluated in many conduit models). The fees generated were so large, and the appetite for the products was so great, that the balloon continued to increase in size at a truly astronomical pace. And during this creation of the balloon, there were virtually no checks and balances, as the policies of the Federal Reserve and the Bush Administration were very laissez-faire. Among the various ills that the laissez-faire approach created was a financial system containing many banks that were simply Too Big To Fail.
Financial Sector Rescue vs. Collapse. All of the foregoing, together with other missteps, caused the perfect financial storm – appropriately identified as The Great Recession, at the inception of which, our government, and many governments around the world, were forced to choose between rescuing the financial sector and letting it collapse. We believe that rescuing the financial sector was the right decision, as the economic calamity absent the rescue would most probably have been far worse that what we have experienced since September, 2008. But the rescue was most certainly the lesser of evils, and not a panacea, as the next section of this article will clearly indicate.
Consequences of the Meltdown
In the United States, a second Great Depression was narrowly averted, although the damage to the underlying economy from the Great Recession (the “Meltdown” or the “Recession”) has been enormous. The Recession was triggered by the bursting of the housing bubble that had inflated throughout much of the United States over the preceding several years. Panic within the financial sector of the U.S. economy ensued upon news of the bankruptcy of Lehman Brothers (September ‘08). Between January, 2008 and October, 2009, the national U-3 unemployment rate1 in the U.S. rose from 5.0% to 10.1%. During the same period, the nation’s U-6 measure of unemployment2 rose from 8.7% to 17.5% (or to approximately 27 million individuals, constituting more than 1/6th of the U.S. labor force). As a result of the Recession, federal, state, and local tax revenues fell precipitously, and state and local governments were forced to drastically cut services and operate in the red. The federal government and the Federal Reserve infused capital into the U.S. economy at unprecedented rates, while operating at unprecedented deficits.
Furthermore, in connection with the Recession, asset values plummeted in virtually all sectors (see Chart 1), exacerbating already unsustainable leverage ratios and causing high default rates, foreclosures, and bank REOs, and establishing the possibility for the “death spiral” of defaults, foreclosures and asset value deterioration. Bankruptcies (business and consumer) spiraled upward, and have continued to rise in 2010 (see Chart 2). Corporate profits became weaker overall, although sporadic. The banking sector found itself on the precipice of disaster and in need of receiving unprecedented bailout funding from the federal government. Within just a short period thereafter, many large banks are reporting record profits (see Chart 3). Small banks, however, continue to struggle through the still very sluggish economy. In the four months from October 2010 through January 2011, an average of approximately 10 banks failed each month, with average assets per bank of between $199 million (in December) and $650 million (in January) (see Chart 4).
Among other sectors, some are holding their own, but overall corporate profits are tentative. Manufacturing profits have been very volatile during the decade but have benefited from increases in each of the past several quarters; retail profits have been relatively consistent throughout the decade, although they experienced a significant rise from late 2004 through 2006, followed by a swift decline in 2007 and then a rise through Q2 2010 - nearly rebounding to Q2 ’07 levels – and a slight fall-off in Q2 2007; and transportation profits, after peaking in Q2 ’06, dropped to a bottom in Q2 ’09 and then recovered significantly in each subsequent quarter (and in Q2 and Q3 of 2010 exceeded the 2006 peak) (see Chart 3 above).
As the Recession took hold, companies very quickly reduced expenses and employee counts, improved efficiencies, and reduced and/or postponed capital expenditures (see Chart 5). Consumers also reduced spending and increased savings (see Chart 6). Governments were compelled to spend at unprecedented levels to stimulate the economy, and to take unprecedented measures to support the devastated financial sector and capital markets. Some instances of government action are the Bush Rescue Plan ($787 billion), the Obama Stimulus Plan ($800 billion), U.S. federal deficit spending (2009 deficit: $1.6 trillion; see Chart 15 below for additional details), and TARP.
The Federal Reserve (“Fed”) has also sought to stimulate the economy by pumping historic levels of money into the economy. Some actions taken by the Fed include: its purchase of $600 billion in mortgage-backed securities, announced Nov. ‘083; its purchase of $750 billion of agency mortgage-backed securities and $300 billion of longer-term Treasuries, announced Mar. 20094; and more recently, its purchase of $600 billion in long-term Treasuries by the end of the second quarter of 2011, announced Nov. 2010 (so-called “QE2”).5
The capital markets felt the impact of the Recession, as investors immediately embarked upon a “flight to quality.” Indeed, spreads over treasuries at a handful of dates tell the story of how interest rates at a variety of credit qualities have fluctuated since the Recession took hold (see Chart 7). Massive, market-wide illiquidity caused borrowing rates to spike, and although the spike was temporary and spreads have (surprisingly) compressed since Q1/Q2 2009, they remain volatile, indicating (i) institutional discontent with the stock market and real estate, (ii) trillions of available investable funds, and (iii) the need to earn yields greater than money-market returns. Equities witnessed a stock market devaluation unprecedented since the Great Depression, and the subsequent recovery is largely unsupportable and therefore tenuous.
The Current U.S. Economic Landscape
While the U.S. economy is showing some signs of improvement, it is still sluggish at best and uncertainty about its future looms. Only time will tell whether the bottom has been reached or whether a second economic dip will occur. Key indicators of the U.S. economy (e.g., GDP, unemployment, the pace of new jobs, loan delinquencies and charge-offs, home foreclosure activity, bankruptcy filings, and retail sales) give mixed messages about the current state of the economy and where it is headed. GDP, for example, indicates the Recession has ended. However, unemployment, and the prospects (or lack thereof) for new jobs sufficient to significantly improve unemployment, certainly indicate that the effects of a severe recession are still being felt. In addition, startling events in other parts of the world, e.g., the earthquake, tsunami, and nuclear facility meltdown in Japan, are taking their toll on economies around the globe, including the U.S. economy.
GDP has risen in each of the past six quarters, surpassing pre-Recession peaks (see Chart 8). Retail sales have been volatile since the Recession began, but like GDP, have experienced marked improvements. In recent months, retail sales have grown significantly over year-ago levels, with December 2010 retail sales (including autos) rising 8.07% above the year-ago level (see Chart 9). Unemployment, however, remains at nearly 9%. Although down from the peak of 10.1% in October 2009, the unemployment rate remains dramatically above the pre-Recession rates (in ‘07, the unemployment rate averaged 4.6%) (see Chart 10). The U-6 measure of labor underutilization, a figure many argue is a truer measure of unemployment, persists at a startling 15.9% as of February 2011 (down little from 17.2% in November 2009), meaning that close to 1/6th of the U.S. labor force is either unemployed, marginally attached to the labor force, or employed part time for economic reasons (see Chart 10).6 Since a recent low in February 2010, total payroll employment has increased by an average of 93,000 per month.7 While adding jobs is clearly a positive, the downside is that far more new jobs are needed just to provide for new entrants to the labor pool,8 let alone to chip away at the existing pool of unemployed individuals. Economic stress on consumers can also be seen in the number of consumer bankruptcy filings (Chapters 7 and 13), which increased 31.5% in 2009, after increasing 30.6% in 2008 (see Chart 2 above). In 2010, consumer bankruptcy filings increased an additional 8.8% over 2009.
Consumers also continue to face depressed asset values. Home values continue to face downward pressure caused by distressed home sales, and the pace of such sales has not let up. Indeed, in 2010, according to RealtyTrac, foreclosure filings were reported on a record 2,871,891 U.S. properties, an increase of nearly 2% from 2009 and an increase of 23% from 2008.9 According to the Federal Reserve, the delinquency rate on single-family residential mortgages fell to 9.94% in Q4 2010 from 10.90% in Q3 2010, but it is still up very significantly from 6.57% in Q4 2008 and from 3.06% in Q4 2007 (see Chart 11). The stock market has rebounded from the DJIA low of 6,440 on March 9, 2009 and recently reached a two-year high, but has been volatile (and, in our opinion, is not supported by the underlying economy). Thus far, inflation has been in check (see Chart 12a), but signs of inflation have begun to emerge – in particular with respect to food and fuel prices10 – and inflation is expected in 2011 or 2012. Some economists, however, are forecasting deflation and a “lost decade,” much like what occurred in Japan. The U.S. dollar has been volatile but is generally holding its own against other currencies (see Chart 12b).
For both businesses and consumers, the deleveraging process is underway (albeit somewhat inconsistently), as the federal government continues what by prior standards is truly extraordinary deficit spending. Since the onset of the Recession, consumers have increased savings rates dramatically from pre-Recession lows (e.g., in Q3 ‘05, the personal savings rate was 1.2%) to a subsequent high of 7.2% in Q2 2009, which has since receded to 5.4% in Q4 2010 (see Chart 6 above). To the extent consumers are able to continue saving, they will likely do so since consumer sentiment remains relatively low (see Chart 13). Although the consumer sentiment reading of 77.5 for Feb. 2011 was the highest since 78.4 was recorded in Jan. 2008, it continues to be significantly below pre-Recession levels. Furthermore, many consumers continue to face tighter underwriting criteria and therefore find it difficult to incur new debt,11 and many consumers are paring debt through workouts, foreclosures, and bankruptcies. Indeed, according to the Federal Reserve, total outstanding consumer credit as of January 2011 was $2.41 trillion, down nearly 6.6%, or nearly $170 billion, from the July 2008 high (see Chart 14).
Among deleveraging businesses, many large banks have benefitted tremendously from drastically improved interest rate margins (and profits) due to very low rates (from the Federal Reserve and from deposits), and are therefore better able to digest bad loans (including through the method of “pretend and extend” on commercial real estate loans) (see Chart 3 above). Assuming the economy improves and asset values benefit, banks’ increased loss reserves may be enough to absorb the lessening losses. Among other businesses, investment grade rated companies have access to debt at very low rates (the flight to quality is still strong) and sub-investment grade companies have volatile access to debt at higher spreads, but still low rates (because all of the interest rate indices have been at record lows). Small businesses, however, face very limited access to debt12, except at high rates,13 although a few large banks have recently reported a greater focus on making small business loans. In February 2011, business sentiment, as measured by the ISM’s Manufacturing Index,14 indicated expansion in the manufacturing sector for the 19th consecutive month15 and the NMI Nonmanufacturing Index indicated that economic activity in the non-manufacturing sector has grown in each of the past 15 months.16 However, small businesses do not yet view the economy with as much optimism. The National Federation of Independent Business’ Index of Small Business Optimism, as of February 2011, indicated that while small business confidence is gradually being restored, they are not very optimistic about future sales growth or future credit conditions.17 Total business inventories, as of December 2010, have risen to $1.435 trillion (up nearly 8.8% from the low reached in September 2009), but are still nearly 7.3% below the peak reached in August 2008. Simply put, tighter budgets and striving for enhanced productivity are part of our New Normal.18
In contrast, the U.S. government is following a path of rising budget deficits and is adding to its debt at an historic pace (see Chart 15). State and local governments, in the aggregate, are also operating at a deficit, although the pace of acceleration has not been anywhere near that of the federal government (see Chart 16). One example of a struggling state government is California, which estimates that budget deficits (if no new action is taken by its legislature) is $6 billion in fiscal year 2010-2011, $19 billion in fiscal year 2011-2012, and approximately $20 billion each year through 2015-2016.19 Federal government spending has certainly hastened the recent technical end to the Recession, although the medium-term and long-term effects are troubling at best. One potential consequence of heightened government debt levels is that the high debt loads will act as an ongoing drag on economic recovery and growth.20
While there has been an uptick in the U.S. economy, severe problems persist and unanswered questions loom.21 Only time will tell whether the bottom has been reached and a solid recovery is truly underway. In the face of uncertainties, however, we must address the problems that created the Recession. Furthermore, for those of us operating in the equipment leasing industry, we must assess what we can do to survive and even thrive in our new and developing environment.
Have We Learned any Lessons?
The Risk/Return Relationship. This is one of those questions that is much more easily asked than answered. If we were to have answered the question in early 2009, it would have probably been in the affirmative. The pendulum had definitely swung. Companies and individuals alike were reducing spending and increasing savings. Liquidity and safety were at a premium. The flight to quality was so strong that yields on U.S. Treasury Bills dropped overnight to almost zero. But since then, although the flight to quality is still a significant component of the investment philosophy, in many cases the risk/return relationship, i.e., debt spreads (as opposed to rates) for various credit calibers, have returned to near pre-crisis levels. In other words, the spreads between credit grades do not adequately compensate lenders for the increased risk associated with lower credit caliber borrowers. For example, in March, 2011, the Reuters Corporate Bond Table reflects a spread over U.S. Treasuries of 65 bps for A rated bonds, 145 for BBB rated bonds, 375 for BB rated bonds, and 600 for B rated bonds (in each case, assuming a 3-year term) (see Table 7 above for additional details).
We submit that, although the stock market has made an almost miraculous rebound since hitting its low in March, 2009, institutional and individual investors alike are wary of the stock market – many (although a minority) still believing that a double-dip is still possible. Inflation (spurred by energy and food prices, among others) coupled with the economic tremors and uncertainty caused by natural and manmade disasters (e.g., last year’s massive oil spill in the Gulf of Mexico and the very recent earthquake, tsunami, and nuclear meltdown in Japan) and political revolution spareading throughout North Africa and the Mid-East will undoubtedly have serious effects on the U.S. economy and stock market as consumers and investors process these major events. And, with interest rates for high grade borrowers so low, investors are pouring money into sub-investment grade bonds simply to generate some level of interest income. The consequence of so much money funneled into this segment is that spreads are compressing: borrowers are getting the better end of these transactions.
Preventing Another Meltdown. Stating the actions that will prevent another meltdown is a comparatively simple task. Most of the world’s most respected economists generally agree on those actions that are required. But taking those actions is exceedingly difficult for many reasons.
Back to Basics. Ask any Depression Era member of your family about what needs to be done, and you will likely get an answer along the following lines: we need a sea change in our societal attitude regarding managing our financial affairs – and this applies to individuals and families, businesses, and governments. We must move away from the immediate gratification, entitlement-oriented, just put it on your credit card mindset that has become so prominent in the last twenty or so years. Rather, that spendthrift mentality must be replaced with the post-Depression Era philosophy of work, earn, save, and then buy. The majority of economists today subscribe to some variant of the Keynesian approach to government intervention during economic downturns. But, leaving government intervention aside, will this more austere approach dampen economic growth? Yes, for a while (because our existing economy is so heavily reliant on consumer spending). But over time, the post-Depression philosophy will create a much more stable financial foundation that will help prevent another meltdown of the magnitude from which we are attempting to recover. Moreover, it will permit those of us adopting this tried and true approach to much more readily weather any future economic storms that will inevitably occur.
“Too Big to Fail” Has Failed. The sheer magnitude and complexity of the meltdown make prevention strategies and tactics exceptionally challenging and nuanced. But when the entire financial system can be jeopardized by the failure of a few extraordinarily large and interconnected financial institutions (without even addressing yet the specific causes of the failure of those institutions), it is time to suggest that we cannot permit any financial institution to get that large. The details of the legislation and attendant regulations to accomplish that are beyond the purview of this article (and the authors’ expertise), but it is clear that we must limit both the size and degree of interconnectedness22.
Rational Regulations. While the huge missteps of the “Too Big to Fail” institutions brought the U.S. economy, and really the global economy, to its knees, virtually the entire financial services industry was complicit in bringing the financial system to the brink of disaster. The big investment banks designed and packaged investment products that were replete with undisclosed – and in some cases unconsidered – risks. The rating agencies blessed them. And the investor community purchased them. Fannie Mae loosened its underwriting criteria to permit virtually anybody to become a proud homeowner. Mortgage lenders and commercial banks followed suit. Individuals purchased homes well beyond their means, enabled by loans that were not likely to be repaid (except under circumstances where homeowners were able to sell at further-appreciated prices). Developers and homebuilders purchased more land and built countless homes that were continuing to increase in value, and their banks provided them with the financing to buy more land and build more homes at a breakneck pace.
In a separate, but related, sector, corporations were borrowing money for expansion at rates and spreads that were not reflective of the risk, but the banks and institutional investment community were throwing the capital their way like there was no tomorrow. And, yes, even the leasing industry engaged in the party. Money was so abundant at ridiculous rates that lessors were “forced” to take unreasonable residual risks to get deals done. Credit standards were softened in all segments of the leasing industry (small ticket, middle ticket, and large ticket). Lease terms were lengthened to further lower payments, and the collateral value of the leased equipment continued to deteriorate as a percentage of the amount lessors (and their banks) were willing to finance.
In retrospect, virtually our entire economy participated in the creation of the massive balloon that exploded in September, 2008 and ensuing months.
The bottom line is that if capital is available, individuals and companies will avail of the capital to purchase assets – even if the purchase prices are in an unsustainable upward spiral. So the gatekeepers in our economy must be the providers of capital. And regulations need to exist to ensure that, when the capital providers have joined the party with reckless abandon, there is an automatic “braking system” that imposes rational constraints on the availability of capital.23
Medium Term Economic Trends that Directly Affect Leasing
Challenging Economy. The current challenging economy is expected to continue into the foreseeable future. Job growth will likely continue to be slow, especially in light of the ongoing growth of the labor pool in the U.S. magnifying the need for new jobs to pare down unemployment rates. The nation’s unemployment rate will likely remain elevated for the next few years. GDP growth, in large part due to high unemployment and the U.S. economy’s dependence on consumer spending, will also be slow, in the 1% - 2% range annually over the next few years.
Deleveraging. The deleveraging of consumers and businesses will continue over the foreseeable future to an overall lower leverage point. As described in greater detail above, consumers have increased savings and deleveraged significantly since the onset of the Recession, which trend will likely continue into the foreseeable future. More importantly to this analysis, however, as a general rule businesses are expected to continue to deleverage through the ongoing need/goal of tightening budgets and enhancing productivity. Notwithstanding the general deleveraging in the business sector, though, there are many examples of increasing leverage, as the institutional community is inconsistent in limiting additional capital to sub-investment grade companies.
Cap Ex Policies. While in the midst of severe economic contraction, and for a few years thereafter while the memory of the anguish and uncertainty is still vivid, most companies become much more conservative with their capital expenditure budgets and policies and procedures. The equipment replacement cycles are extended as companies make do with their existing equipment for a longer period (which bodes well for lessors’ existing lease portfolios). Cap ex budgets are generally reduced and re-prioritized, and CFOs and treasurers substantially tighten the authority levels for expenditures, all of which combines to make the equipment sales cycle much longer. In addition, financing decisions are generally made by a company’s Treasury Department, rather than by the individual departments or the Purchasing Department, which typically results in more competitive rates required to win deals.
Liquidity. Similarly, as the memories of anguish and uncertainty persist, businesses will preserve and build their liquidity to help ensure long-term survival and the ability to act opportunistically. Some ways in which companies will accomplish this include conservative cap ex policies (as described above), seeking alternative funding solutions for needed cap ex such as equipment leasing (as further described below), refinancing debts to lower interest rates, extend maturities, and/or take out additional cash for general corporate purposes; and generally cutting costs and improving efficiencies.
Vendor Financing. Business continues to evolve and competition increases. What is first introduced to the market as a novel idea quickly becomes the standard. That is the case with vendor financing. Customers want good prices, good quality, and convenience. It is as part of the latter (i.e., convenience) that the providing of financing has become a customer expectation -- although customers do not always articulate that to their vendors.
In virtually all industries, the largest and most successful companies provide customer financing as part of the sales process. Those vendors know that strategically integrating financing into the sales process produces incremental sales, increases the probability of closing budgeted sales, shortens the sales cycle, and creates a stronger overall relationship with their customers.
But in response to the Great Recession and the attendant and continuing challenges in the capital markets, many manufacturers with existing captives have limited their financing programs exclusively to the manufacturers’ products and services. Others have disbanded their captives and have decided to partner with finance companies in private label programs. And many vendors who have not implemented finance programs are recognizing the benefits and, therefore, seeking out relationships with qualified lease companies to seamlessly integrate financing into the sales process.
The bottom line is that financing is viewed by customers and vendors alike as a critical product to be provided by the vendor. This market dynamic presents substantial opportunities for lease companies that have the infrastructure necessary to support full service Customer Financing Programs.
Conservative Lending Environment. The reaction of the banking community to a severe economic downturn is always an immediate “flight to quality” and tightening of credit standards across the board. That occurred in response to The Great Recession and, although the economic outlook is much less bleak today than it was in the latter part of 2008 and in 2009, credit standards remain much more conservative and there is still a predominant focus on very high caliber credits (i.e., the flight to quality). That will likely continue for at least the next few years as we rebuild the economy and address the critical unemployment levels.
Alternative Funding Sources. To grow and prosper, all companies need capital – particularly those that are in the growth stage of their life cycle. So alternative sources of capital are filling the void left by the retrenchment of banks. And a conduit for these capital investments is leasing companies, many of which are establishing relationships with hedge funds, insurance companies, pension funds, family offices, Sharia-compliant funds, and the like. In general, the alternative sources of capital will have a higher cost, but will also have more credit and structuring flexibility. The conservative lending environment and development of alternative funding sources are substantial opportunities for entrepreneurial lease companies.
Success in the New Normal
There is no certain formula for success in a tumultuous economic environment or in its aftermath. But there are approaches that create a high likelihood that lease companies can first survive the trauma; second, prosper in its aftermath; and third, better prepare for subsequent economic downturns.
Play Defense. A more cautious approach is to deploy a defensive strategy. Focus on recession-resistant industries, e.g., energy, food production, healthcare, and telecommunications. Within your chosen recession-resistant industries, establish relationships with big companies that have large cap ex budgets. For sub-investment grade caliber lessees, the focus should be to lease mission critical equipment over short lease terms under “true lease” structures. A defensive strategy is a variant generally of the flight to quality that has occurred and which, to a significant extent, still exists. Therefore, you can expect the market to be more competitive, resulting in lower spreads and overall yields. Because there are inefficiencies in every market, though, you may find opportunities that defy the general rule. But by playing in recession-resistant industries, you will obtain the benefit of industry momentum, which may mean that you can take a little more risk with lower credit caliber companies to improve your overall returns.
Play Offense. Because of the very nature of the leasing industry – entrepreneurial, nimble, opportunistic – many lease companies have deployed an offensive (and riskier) strategy. This involves focusing on industries that have been substantially hurt by The Great Recession, are generally in some degree of disfavor by the mainstream providers of capital, and which have significant upside as the economy recovers – even if not to the pre-crisis level. For example, the construction, retail, and mining industries suffered considerably over the period following the meltdown and yet, with some recovery having occurred, various facets of those industries are doing reasonably well.
As in the defensive approach, within your chosen industry, you should focus on big companies with large cap ex budgets. To further mitigate the risk, because the industry does not have positive momentum, your lessees should have strong balance sheets and significant market share, despite current (and/or recent) losses. In disfavored industries, the positive industry momentum does not exist. Therefore, you should lease mission critical, or revenue-generating equipment with an established secondary market (in case you must repossess and remarket the equipment). And with more challenging credits – whether you are in a defensive mode or an offensive mode – the lease terms should be shorter, the leases should be structured as “true leases”, and you should incorporate as many “credit enhancements” into the transaction as available. You can expect this approach to involve more risk and hopefully disproportionately high returns, but more difficulty in finding financing partners.
Foundation in Place. Whether you desire to employ a defensive strategy, an offensive strategy, or some combination thereof, your level of success will depend on how well you execute your strategy. And to best execute your strategy, you must implement (or refine) seven foundational elements:
Origination. Develop predictable deal flow. Without that, nothing else matters. Vendor finance programs; programs with banks, brokers, and other lease companies; and direct relationships with lessees are the industry standards for deal origination. Whatever channels you utilize, you must ensure they generate consistent deal flow.
Funding and Liquidity. Develop reliable funding sources that match your deal flow. The criticality of appropriate funding is obvious. Given the volatility of the capital markets over the past couple of years, redundancy is essential. And maintaining internal liquidity to supplement a lease company’s permanent funding solutions is also important to ensure a lease company’s ability to close transactions.
Specialization. The leasing industry is a mature industry and, as such, lessors must continue to determine how to provide new value to their customers. Focusing in and becoming an expert with respect to specific industries allows lessors to bring value to all transaction participants, including lessees, lenders, and vendors. Understanding the players (both companies and individuals), the equipment, the market dynamics, and industry trends is an important benefit of specializing in a particular industry, and allows lessors to continue to find new ways to add value.
Customization. Thoroughly understanding the objectives and needs of your customers is another key component of adding value and distinguishing your company from your competitors. If you learn your customers’ objectives and needs, you are much better prepared to structure financing solutions consistent with those objectives and needs. Customization involves lease structure, pricing, term, invoicing requirements, sales/use/property tax administration, accounting, reporting, etc. Specializing in an industry provides a strong base of knowledge that facilitates effective customization.
Market Awareness. In normal economic times, the market (participants, access to capital, pricing, structure, terms, etc.) changes gradually and, therefore, it is much easier for transaction parties to stay apprised of the market as they are pursuing and completing transactions. But under severe economic conditions, the market can change overnight and can fluctuate wildly over short periods. That is exactly what transpired during the first several months after the inception of the global economic crisis. Customers’ need and demand for equipment fell precipitously. Availability of capital and the pricing of capital were subject to wide swings. To get a deal done, all of the components of the transaction must be in alignment, e.g., the vendor pricing and terms, the lease pricing and terms, the lessor’s funding pricing and terms. So in a volatile environment, lease companies must be hypersensitive to market changes.
Efficiencies. It is always important for lease companies to continue to improve their systems and policies and procedures so that lease processing (transaction review, pricing, credit analysis, documentation, funding, servicing, accounting and reporting, and remarketing) is consistently achieving enhanced efficiencies. But in challenging economic conditions, it is critical. Not only is it essential to stand out in this regard among your competitors (as viewed from your customers’ perspectives), but it also is a major cost containment measure which, in some cases, makes the critical difference between survival and closing your doors – forever.
Profitability. This is where it all nets out: transaction flow, customer pricing, funding availability and pricing, competitiveness, ability to meet your customers’ objectives and needs, ability to process efficiently. In challenging times, particularly over multiple years, it is critical to achieve profitability – even if not immediately. Without profitability, the likelihood of long term – and even medium term – viability is substantially diminished at best. And without profitability, even if only for a short time, a lease company’s lines of credit and funding relationships become tenuous (or non-existent). Without competitively-priced funding, a lease company quickly spirals into oblivion.
Conclusion
The latter part of 2008 and most of 2009 were truly a harrowing experience for our economy and our industry. 2010 was much better, but certainly no “picnic”, and still with a very unstable economic foundation. Most of us agree – including a broad array of our nation’s most respected economists -- that we have probably been through the worst of it, but the recovery will likely take several years, particularly to address our massive unemployment levels. 2011 is a far better environment than the preceding three years, but there is still a tentativeness and palpable uncertainty; and it is still possible (although becoming less likely every day) that we will encounter a double-dip recovery, which would considerably exacerbate both the pace and time frame of regaining economic vitality.
The exceptionally low interest rate environment will likely continue into at least 2012, and will perpetuate the highly competitive leasing marketplace, particularly in the investment grade space. Capital is available, but the cost is and will be higher (in terms of spreads), particularly in the sub-investment grade sector. As interest rates begin to rise, leasing will be viewed more favorably vis-à-vis secured loans and dollar buy-out leases. But the uncertainties stemming from the dramatic lease accounting changes proposed by the IASB and the FASB are creating consternation within our industry, as the changes will likely result in some lessees choosing non-lease forms of financing. So the landscape five years hence, and even two to three years from now, is opaque at best.
But as we have come to know over the past forty or so years, leasing companies, as a culture, are entrepreneurial and innovative. And we also know that opportunities are abundant in the midst of discord and uncertainty. Consequently, matching entrepreneurism and innovation with opportunity is the silver lining around the otherwise dark (but not as dark) economic and leasing industry cloud.
The bottom line, therefore, is more heartening: the leasing industry will not only survive the many and substantial challenges this adverse economic environment has presented and still presents, but it will emerge a stronger, more creative, more innovative industry that will be an even more important component of capital formation in the United States, in Europe, and across the world.
1. The U-3 is the official unemployment rate of the U.S., as reported by the Bureau of Labor Statistics of the U.S. Department of Labor, which is calculated as the total number of unemployed as a percent of the civilian labor force. (www.bls.gov).
2. The U-6 represents the total number of unemployed, plus discouraged workers, plus all other persons marginally attached to the labor force, all as a percent of the civilian labor force plus all persons marginally attached to the labor force. (www.bls.gov).
3. See Federal Reserve Press Release dated Nov. 25, 2008 (http://www.federalreserve.gov/newsevents/press/ monetary/20081125b.htm); and http://www.ft.com/cms/s/0/69e8c92c-e758-11df-880d-00144feab49a.html.
4.Federal Reserve Press Release dated March 18, 2009 (http://www.federalreserve.gov/newsevents/press/ monetary/20090318a.htm).
5. See Federal Reserve Press Release dated Nov. 3, 2010 (http://www.federalreserve.gov/newsevents/press/monetary /20101103a.htm); and Annalyn Censky, QE2: Fed Pulls the Trigger, CNNMoney.com, Nov. 3, 2010 (http://money. cnn.com/2010/11/03/news/economy/fed_decision/index.htm).
6. It is worth mentioning that a significant reason for recent improvements in the U-3 and U-6 unemployment rates is the decline in the labor force participation rate (from an average of 66.0% in ’08, 65.4% in ’09 and 64.7% in ’10, to 64.2% in 2011), significantly decreasing the number of unemployed/underemployed individuals in the unemployment percentage numerator. See www.bls.gov.
7. http://www.bls.gov/news.release/archives/empsit_02042011.htm
8. 150,000 new jobs are needed each month “to keep up with the growth of the U.S. population.” Robert Reich, The Jobs Picture Still Looks Bleak, www.WSJ.com, April 12, 2010. Mr. Reich also notes that while the economy “has shed 8.4 million jobs” since December 2007, it has also “failed to create another 2.7 million required by an ever-larger pool of potential workers” leaving us “more than 11 million jobs behind.” Even if we create 300k new jobs/month, it could be 5-8 years to catch up to where we were before the recession began.
9. RealtyTrac Staff, Record 2.9 Million U.S. Properties Receive Foreclosure Filings in 2010 Despite 30-Month Low in December, RealtyTrac, Jan. 12, 2011 (http://www.realtytrac.com/content/press-releases/record-29-million-us-properties-receive-).
10. See, e.g., Thomas Helbling & Shaun Roache, Rising Prices on the Menu, Finance and Development, March 2011 (Vol. 48, No. 1) (explaining that “[m]any countries – especially developing and emerging economies – are struggling with the implications of high food prices . . .”; that “[i]nternational food prices were broadly stable through the first half of 2010, but they surged in the second half of 2010, and have continued rising in 2011 . . .” taking the IMF’s food price index to a level approaching the previous spike in June 2008; and that “since the turn of the century, food prices have been rising steadily – except for declines during the global financial crisis in late 2008 and early 2009 – and this suggests that these increases are a trend and don’t just reflect temporary factors.”) (emphasis added); Bob Willis and Timothy R. Homan, U.S. Economy: Consumer Prices Rise More Than Forecast, www.Bloomberg.com, Feb. 17, 2011 (noting that “[r]ising global demand for food and fuel pushed up the U.S. cost of living more than forecast in January . . . .”) (emphasis added).
11. See OFFICE OF THE COMPTROLLER OF THE CURRENCY, SURVEY OF CREDIT UNDERWRITING PRACTICES 2010 (Aug. 2010), at 8-11.
12.See, e.g, OFFICE OF THE COMPTROLLER OF THE CURRENCY, SURVEY OF CREDIT UNDERWRITING PRACTICES 2010 (Aug. 2010), at 6-7 (reporting that during the year ended 3/31/10, 66% of the banks surveyed tightened underwriting standards for small business loans while none reported easing standards).
13. See, e.g., Christine Richard & John Detrixhe, Credit Markets: Small Companies, Big Borrowing Costs, Businessweek.com, October 21, 2010 (asserting that record-low borrowing costs for large companies are not trickling down to small companies); MARKET ANALYSIS, RESEARCH & EDUCATION, FIDELITY MANAGEMENT & RESEARCH COMPANY, UPDATE ON U.S. CREDIT MARKETS: DESPITE SOME VOLATILITY, BORROWING CONDITIONS HAVE REMAINED FAVORABLE (Dec. 6, 2010) (stating that “many non-corporate borrowers, particularly consumers and small businesses, have had difficulty accessing low average rates because lenders have maintained tight underwriting standards.”) (emphasis added).
14. The Institute for Supply Management (www.ism.ws) generates a Manufacturing Index and a Nonmanufacturing Index, measuring growth / contraction in the respective sectors.
15. Source: http://www.ism.ws/ISMReport/MfgROB.cfm?navItemNumber=12942.
116. Source: http://www.ism.ws/ISMReport/NonMfgROB.cfm?navItemNumber=12943.
117. WILLIAM C. DUNKELBERG & HOLLY WADE, NFIB SMALL BUSINESS ECONOMIC TRENDS (March 2011), at 7, 12-13.
18. The term “new normal” is not new; McKinsey & Company published an article titled “The New Normal”, by Ian Davis, in March, 2009. Sentry has drawn from this article and other similar articles to develop its own unique (but substantially similar) definition of the “new normal”.
19. Source: http://www.lao.ca.gov/laoapp/PubDetails.aspx?id=2365
20. See, e.g., Bill Gross, Investment Outlook: The Ring of Fire, PIMCO, February 2010 (citing CARMEN M. REINHART & KENNETH S. ROGOFF, THIS TIME IS DIFFERENT: EIGHT CENTURIES OF FINANCIAL FOLLY (Princeton University Press 2009)).
21. Among them is the question: who will step up and buy Treasuries following QE2 when the Federal Reserve is no longer buying them in massive amounts artificially driving down yields, and how much will the yields have to rise to draw those new buyers? See, e.g., William H. Gross, Investment Outlook: Two-Bits, Four-Bits, Six-Bits, a Dollar, www.pimco.com, March 2011 (asking “[w]ho will buy Treasuries when the Fed doesn’t?”, noting that since the beginning of QE2 the Federal Reserve has purchased approximately 70% of the annualized issuance of Treasuries, and pointing out that “Treasury yields are perhaps 150 basis points or 11/2% too low when viewed on a historical context . . . .”)
22. See, for example, Crisis Economics (2010), by Nouriel Roubini and Stephen Mihm.
23. Along these lines, the Dodd-Frank Wall Street Reform and Consumer Protection Act bears mentioning. It was signed into law on July 21, 2010, and is largely considered the most sweeping change to financial regulation in the United States since the Great Depression. See Damian Paletta & Aaron Lucchetti, Law Remakes U.S. Financial Landscape, www.WSJ.com, July 16, 2010. Following enactment, the regulatory implementation process began, which is expected to be an intense period of up to 18 months for U.S. financial regulators, as the various agencies create a new regulatory framework. See DAVIS POLK & WARDWELL, LLP, SUMMARY OF THE DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT, ENACTED INTO LAW ON JULY 21, 2010 (July 21, 2010) (noting that by its count, “the Act requires 243 rulemakings and 67 studies”). According to a summary of the Bill prepared by the Senate Committee on Banking, highlights include: it creates a new independent watchdog charged with protecting American consumers; it ends the possibility for bail-outs of large financial firms; it creates a council to identify and address systemic risks posed by large, complex companies, products, and activities before they threaten the stability of the economy; it eliminates loopholes that allow risky and abusive practices to go unnoticed and unregulated (including concerning over-the-counter derivatives, asset-backed securities, hedge funds, mortgage brokers and payday lenders); it streamlines bank supervision to create clarity and accountability; it provides shareholders with a say on compensation and corporate affairs with a non-binding vote on executive compensation; it provides new rules for transparency and accountability for credit rating agencies to protect investors and businesses; and it strengthens oversight and empowers regulators to aggressively pursue financial fraud, conflicts of interest and manipulation of the system. (http://banking.senate.gov/public/_files/FinancialReformSummaryAsFiled.pdf)
Jonathan M. Ruga
Jonathan M. Ruga is the CEO of Sentry Financial Corporation, a full service leasing company founded in 1986 that provides leases to “B and better” rated companies (or unrated equivalents), originated primarily through vendor programs and relationships with other lease companies and lease brokers. Mr. Ruga has worked with Sudhir Amembal for over 30 years and has co-authored various leasing books and taught various leasing seminars with Mr. Amembal. Mr. Ruga can be contacted at jruga@sentryfinancial.com.
Michael J. Newman
Michael J. Newman is Associate Legal Counsel and Vice President, Credit for Sentry Financial Corporation, in which capacities he is integrally involved in analyzing and documenting Sentry’s equipment leasing transactions. Mr. Newman can be contacted at mnewman@sentryfinancial.com.
