To better understand how the economic environment is affecting small businesses and small business lenders and lessors, PayNet conducted an industry-wide study using the PayNet database, which contains detailed data on more than 12 million individual loan and lease obligations from 1999 to the present, including the transactions of almost all the small-ticket and middle-market lenders in the Monitor 100.

The percent of contracts delinquent 30 days or more increased in December for the eighth consecutive month, marking the 18th increase in the last 20 months. Moreover, average delinquency increased by 31 bps in December, tied for the second largest monthly increase on record, behind 33 and 31 bps increases in November and December 2000. The good news, however, is that these increases are coming off a period of record low delinquency, so that the absolute levels of delinquency are, at the moment, below the long-term average.

When the industry’s outstandings are split in half based on the lenders’ delinquency rates, (with the high delinquency half in red, and low delinquency half in green in Figure 1), it is clear that the higher-risk lenders have been impacted the most, going from 2.53% delinquency in April 2006 to 4.66% today, more than 200 bps. During the same time period the lower-risk lenders increased just 50 bps, from 1.29% to 1.79%.

In contrast to the past recession, the higher-risk lenders are being impacted to a relatively greater degree than the lower-risk lenders. Our research has shown that usually the impact on low-risk lenders is proportionately about the same as it is on high-risk lenders (e.g., when high-risk lenders’ delinquency increases from 3% to 6%, low-risk lenders’ delinquency increases from 1% to 2%). Currently, however, high-risk lenders’ delinquency is at 56% of the high point they saw in the last recession (8.28%), while low-risk lender’s delinquency is only 35% of their previous delinquency high point (5.07%). And compared to recent delinquency lows, the high-risk lenders now have delinquency 84% above their low point (2.53%), whereas the low-risk lenders are up only 42% from their low (1.26%).

The pattern is similar on a 90-day delinquency basis. The increase is not as extreme relative to the highs of the last recession, though it is more extreme relative to the lows seen in 2006.

Based on this information, lenders need to prepare for increased credit losses over the next year or two, as these 90-day delinquencies roll into losses. So far at least, lenders have been willing and able to promptly recognize their losses, as “delinquency” over 180 days past due (where not-yet-recognized losses sometimes accumulate) has held steady at 0.24%, only three bps above the lowest level on record — and well below the record high of 1.96% reached in April 2002.

A likely culprit of the run-up in 30- and 90-day delinquency, particularly given the focused nature of the impact, is the current real estate debacle, and the fact that construction equipment is one of the most common types of equipment to finance. Unfortunately, the answer is not so simple; running the overall industry delinquency statistics excluding construction equipment produces charts visually almost identical to Figures 2 and 3, at just a slightly lower level (overall 30-day delinquency of 2.95%, instead of 3.22%).

Nevertheless, the broader impact of the drop in new residential construction should not be underestimated, and its magnitude is much greater than most realize. The seasonally adjusted 21% decrease in housing starts in the last two months is the largest two-month decline since 1990-1991, and the 56% decrease in the last two years is already greater than the 1990-1991 decline and about equal to that seen in 1980-1982. The absolute level of new housing starts (seasonally adjusted) is now the lowest it has been since 1991.

While the increase in industry delinquency is not limited to the construction industry, many other businesses are affected including building material transporters, real estate brokers, mortgage lenders, landscapers and furniture retailers — not to mention the overall impact on consumer spending of no longer being able to use one’s home as an ATM. Largely as a result, the Reuters/University of Michigan Survey of Consumers just reported that the consumer sentiment index is the lowest it has been since February 1992, and at a level that has always coincided with recessions.

We have seen that the lower delinquency lenders have been much less affected than the high delinquency lenders. One hypothesis to explain this might be that bank-owned lessors are usually low-risk lenders, and, everything equal, they tend to specialize in larger transactions with bigger borrowers — and bigger borrowers generally don’t have increased delinquency early in a recession. Unlike the smaller borrowers, the larger borrowers have a cushion of resources to rely upon, at least in the early phase of a recession. Figure 4 shows delinquency by high credit for five borrower-size categories.

Clearly this progressive impact by size phenomenon can be seen in the last recession. Borrowers in all three high-credit categories under $250,000 reached peak delinquency in January or February 2001, while those in the $250,000-$1 million category peaked in January 2002, and those over $1 million had twin peaks in January-February 2002 and January-February 2003. This time around, however, it’s different. All borrower size categories are now simultaneously experiencing materially increased delinquency and, relative to their low points, the increase is proportionately greater the larger the borrower (e.g., it’s 142% of the low for the categories under $100,000 but 192% of the low for the $1 million + category). So there is less safety in size today.

How is the economy affecting lease originations? Can we learn anything about the economy generally from originations activity? First, let’s examine the last recession. Figure 5 shows originations, again, by borrower high-credit category, versus overall industry average delinquency, from 2000 to 2003.

The red “X” marks show the origination peaks and the delinquency low; the green “+” marks show the origination low points, after which originations began increasing again, and the delinquency high point, from which it began to decline. The first observation is that originations patterns lag delinquency patterns by almost a year. So most lenders should expect reduced originations volume this year. The second is that originations peaked virtually simultaneously for every borrower size category in March 2003. But it just seems too much of a coincidence that small and large borrowers alike would behave in the exact same way — a more plausible explanation would be that lenders began tightening their credit standards for all borrowers about that time.

On the recovery side, while the small borrowers’ originations turned upwards about six months before the larger borrowers’ did, it seems likely that this is just a reflection of the general relative decline of large-ticket leasing, rather than a cyclic phenomenon.

What are originations now? December is almost always the strongest month for originations, so to compensate for seasonality, Figure 6 compares originations for each borrower-size category for the past three months against the same three months a year before. Again, we see a pattern that is different than the last recession. Rather than originations declining in all size categories, originations are still actually growing slightly in the two high-credit categories under $100,000 and declining just a couple percentage points for $100,000-$250,000. But the $1 million + category, which was almost even with a year before as late as July 2007, has since dropped substantially, and is now down 18%.

The good news, though, is that all the categories seem to be more or less stabilizing over the past few months, which implies two very important things. First is that business owners aren’t all that pessimistic, and aren’t going into a “hunker down” mode (yet anyway). Second, and perhaps just as important, it seems that this time around lenders aren’t just automatically tightening credit standards across the board. And in a way, this fits with the concept that, so far at least, this is a “focused” recession, affecting some segments substantially, but not affecting all segments. And, everything equal, this would tend to make the recession a short one.

Another unusual aspect is the extent to which large borrowers have been impacted relatively more in both delinquency and originations. While the longer-term decline in large borrower originations is the result of the loss of tax advantages to leasing, a consequence is that the highest-quality borrowers are more likely to switch to other forms of financing, thereby reducing the overall average credit quality of new equipment finance transactions with large borrowers— and explaining the higher than expected delinquency in that segment.

An additional possible explanation, which fits with what we have seen with some of PayNet’s consulting clients, is that small borrowers were hit so hard during the last recession, that lenders concluded that small borrowers are an accident waiting to happen, while large borrowers were always safe, in effect over-compensating. The significant decline in large borrower originations in the past five months could be a reversal of such a trend, (i.e., as lenders began seeing increased large borrower delinquency in mid-2007, they tightened the credit criteria for the segment).

So if this recession is really a “focused” one, where is it focused? Examining the PayNet database by collateral type reveals the answer. Three segments — Construction, Class 8 Truck, and Office Equipment — are experiencing substantially increased delinquency. In the past 20 months these three segments, which account for about two-thirds of the industry’s outstandings, have collectively seen delinquency increase 196 bps, from 2.18% to 4.14%. Meanwhile, the other third of the industry, including Manufacturing, Machine Tool, Agricultural, Medical, Retail, Forklift, Medium Duty Truck and general Commercial & Industrial, has increased just 21 bps, from 1.41% delinquent to just 1.62% delinquent. (See Figure 7)

While one might be tempted to say, “well of course those segments have lower delinquency,” the data shows that the two groups’ delinquency were very similar in the last recession. Why is it different this time? Construction is easy to explain. And Class 8 Truck is logical given a glut of trucks on the road from the emission rule change pre-buy, increased diesel prices and less work hauling construction materials.

The problem in Office Equipment is tougher to explain, because this cuts across so many different SIC Codes. Perhaps the way to look at it is in the reverse, that small business in general is in recession. But that there are a few bright spots — Manufacturing and Machine Tool, because the weak dollar helps exports; Medical, because demand isn’t cyclical, Agriculture, because crop prices are high; and Retail, Forklift and Medium-Duty Truck, because, at least until quite recently, consumer spending has been strong.

So what does the future hold? While delinquencies and losses do seem likely to increase over the next 6-12 months, history suggests that the modern Fed can avert disaster and generally limit the frequency and duration of recessions to the minimum required to wring out the excesses of irrational exuberance, this time in the housing markets.

Most importantly, however, it seems quite unlikely that commercial equipment lenders will experience problems anywhere near those of the consumer mortgage, home equity and credit card lenders — and the industry should really be proud of all the differences. While average terms may have lengthened a few months over the past ten years, structures where payments might significantly increase remained essentially unheard of. And while initial payments used to be required but are no more, the incremental risk is really just until the first payment comes in, and a very small change in practice compared to home mortgage lenders waiving their traditional 20% down payment requirement.

Occasionally lessors might get a bit too aggressive in their residual assumptions, but at least there weren’t structures where the whole deal was predicated on the concept of perpetual asset price appreciation. And as “liar loans” and no verification loans became a significant portion of the mortgage business, commercial equipment lenders availed themselves of more information, from more sources than ever, with new commercial credit data repositories like PayNet.

Equipment lenders have also generally done a better job with credit scoring and automated decisioning. Virtually all commercial lenders realize that scores “rank order risk” as opposed to predict absolute default rates. And all realize the critical importance of credit “capacity.” Mortgage lenders failed to do this, and then were surprised when consumer credit scores based on paying for a cell phone didn’t work very well in predicting mortgage repayment.

Finally, there is a critical difference in the whole purpose of the transactions. Consumer lenders were focused on financing consumer self-indulgence in oversized, overpriced homes and shopping sprees, from which there is little left to show, while the commercial equipment lenders have been providing the necessary, useful and remunerative service of enabling businesses to acquire income-producing and labor-saving equipment. Since the commercial equipment finance industry has avoided the critical mistakes that have plagued the consumer lenders, it seems quite unlikely that commercial equipment lenders will share their fate in this recession.

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Tom Ware is senior vice president of PayNet, and managing director of PayNet Analytical Services, which provides credit scoring, portfolio benchmarking, default forecasting and strategic consulting services to commercial lenders, including about half of the 50 largest commercial equipment finance companies. In 1987, he founded Sequa Credit Corporation, later known as Golden Eagle Leasing, and acquired by Hypercom. More recently, he has served as chief credit officer of American Express Equipment Finance, and as general manager of a billion-dollar financial services business of Case/CNH Capital. Ware is a member of the ELFA Credit & Collections Committee, and recently served on ELFA’s Small Ticket Business Council. He graduated with Distinction in Mathematical Economics from Dartmouth College, and has an M.B.A. from Harvard Business School.