Funding Sources Combat Credit Woes By Performing Stricter Due Diligence, Solidifying Relationships With Brokers

by Christopher Moraff March/April 2008
With the “irrational exuberance” of 2007 now long gone, yesterday’s excess liquidity has given way to a desert landscape of collapsed deals and skittish investors. But in this year’s Monitor Funding Source Roundtable participants say that at least where equipment finance is concerned — there’s still plenty of liquidity to go around; the trick is where to look for it.
Paul Menzel General Manager, LEAF Financial Third Party Funding Group
Ralph Mango Vice President/ Broker Sales, Marlin Business Services
Loni Lowder Founder & President, ACC Capital Corp.
Curt Kovash General Manager, U.S. Bank Manifest Funding Services
Jourdan Saegusa Syndication & Acquisitions Manager, Popular Equipment Finance

Over a seven-day period in January 2008, the United States Federal Reserve slashed its federal funds rate — the interest rate banks use for pricing overnight loans — by a significant 125 basis points. It was the largest cut in nearly a quarter-century.

But despite what some may have thought at the time, the Fed was not in panic mode. On the contrary the move was a calculated one, designed to lubricate the credit markets and hopefully get capital flowing again.

As of this writing it’s too soon to tell just how effective the move will be, but early indications suggest it may have been a case of “too little, too late.” As the Monitor goes to press, the Federal Open Market Committee is gearing up for its March 18 meeting, with every indication that another rate cut was in the works.

The Fed is eager to address what chairman Ben Bernanke recently called the “financial turmoil” wrought by a slowdown in the flow of capital, which is the lifeblood of a healthy economy.

The Congressional Research Service (CRS) dates this liquidity drought to Aug. 9, 2007; on that day, BNP Paribas SA, France’s largest bank, froze withdrawals from three investment funds following similar moves from Bear Stearns and several other European finance houses. The U.S. housing crisis, thought at first to be isolated, had gone global.

The same day, The Association for Financial Professionals (AFP) released its 2007 Liquidity Survey that found more and more businesses were hoarding cash, “a sign that businesses are unwilling to invest in acquisitions, capital improvements and expansion due to uncertainty about economic and business conditions.” Before the day was out, the Federal Reserve’s Open Market Trading Desk injected $24 billion into the U.S. banking system, while the European Central Bank (ECB) in Frankfurt, Germany pumped nearly E95 billion ($130 billion) into European financial institutions.

According to the CRS, on that day in August, what started as a mortgage crisis had made the leap into the wider economy, putting capital markets at risk. The resultant shock wave would amount to a double whammy: less willingness among lenders to fund and less appetite among businesses to buy.

Along with the Fed, the Treasury Department, the Securities and Exchange Commission, the Bush Administration, and both houses of Congress have been working overtime in an effort to keep the liquidity crisis in check. Their collective efforts culminated in President Bush’s Feb. 13 signing of the highly touted Economic Stimulus Package. The package is designed to spur activity in the economy and hopefully skirt a recession — if that is even possible at this point.

It was against this backdrop that the Monitor embarked on its 2008 Funding Source Roundtable. Not really knowing what to expect, we anticipated the worst.

Oh, What a Year Brings
This time last year, as the Monitor was preparing its 2007 Funding Source Issue, interest rates were hovering at 5.25% following 17 consecutive hikes by the Fed and it seemed the entire leasing industry was lamenting “excess liquidity.”

In a twist of irony, today the U.S. financial markets are working to bring liquidity back. A case of ‘be careful what you wish for,’ perhaps?

On the contrary; throughout 2007 we heard from lessors, brokers, funding sources, asset managers and analysts that while the U.S. economy was teetering on the brink of recession, the equipment leasing and finance sector had so far managed to dodge the bullet. Surprisingly, this year’s roundtable participants echoed that sentiment.

“We experienced a very positive trend line over 2007,” says Paul Menzel, general manager of LEAF Financial’s Third Party Funding Group. Menzel says a big part of this involved his transition to LEAF following parent company Resource America’s acquisition of Pacific Capital Bancorp.

But these unique circumstances aside, Menzel’s sentiments were anything but isolated. Ralph Mango, who recently joined Marlin Business Services as vice president of broker sales, says contrary to what might be expected, broker volume was higher in 2007. He attributes this to Marlin’s relationships with its brokers and its reputation for high service, which has kept the flow of funds open despite the changing paradigms.

“The world of equipment finance and leasing has changed, and success now is measured differently in an environment of tighter credit and growing uncertainty,” he says. “Relationships will be stressed as these changes occur.”

In his comments, Mango is addressing a crucial aspect of the broker/funder relationship — that is, the comfort that has built up through years of working together can serve as a lifeline during market downturns. But that doesn’t mean his company was completely immune from wider market forces.

“Clearly there have been, and we expect we will continue to see, shifts in the economy,” Mango admits. “Sectors such as housing, real estate and construction have been hit particularly hard by the subprime fallout. We are adaptive.”

Just about everyone we spoke with emphasized the importance of solidifying relationships with brokers that extend beyond simple deal making. “We believe the most significant opportunity in 2008 is to deepen our relationships with good brokers, and employ our structuring capabilities to provide brokers the help they need to get deals approved,” says Loni Lowder, founder and president of ACC Capital Corp.

Lowder notes that at ACC new business from the broker community was up a solid 18% in 2007 over 2006. “We added more experienced broker reps to better service the broker community. In addition, our relationships between brokers and broker reps are deepening,” he continues.

At U.S. Bank’s Manifest Funding Services, general manager Curt Kovash offers a similar take.

“The biggest driver of our growth comes from our clients,” he says. “Long-term funding relationships should be based on shared success. The funding source should care about the growth and success of their partners and the broker/lessor should care about the success of the funding source.”

Kovash says this strategy has paid off; Manifest experienced a record funding year in 2007, with 17% growth in new originations over 2006. “Being responsive and developing new financial solutions and services is critical,” he adds. To this end, “we introduced several new products to our partners to assist with their efforts to grow new originations in 2007.”

He also stressed his unit’s unique position as a subsidiary of the sixth largest bank in the U.S. “This put us in a position that is much different than other funding sources in the marketplace,” says Kovash. “We feel very fortunate that our parent company is well positioned for future growth. U.S. Bank’s balance sheet and funding capabilities remain strong, which is very important for our partners’ long-term success.”

Yet like Mango, Kovash tempers his enthusiasm with a clear understanding that things could change if care isn’t taken. “Despite our disciplined approach, there is increased stress in the portfolio with higher delinquency and charge-offs. Based on my contacts, it appears this trend is happening throughout the leasing industry at this time,” Kovash admits.

In fact, delinquencies and charge-offs increased across the board in 2007; and, on a wider level, while the equipment finance industry may have avoided the shock wave of the credit crisis, it has certainly felt the ripples.

“Though the equipment finance industry has been mostly insulated from the significant challenges and ensuing write-downs in the consumer markets, growing re-adjustments are evident, especially on the funding side,” says Roland Chalons-Browne, president and CEO of Siemens Financial Services, commenting on year-end data released by the Equipment Leasing & Finance Association (ELFA).

According to the association, new business volume remained flat in the fourth quarter and rose only slightly in 2007 — roughly 5% over 2006. The slowdown was attributed directly to the credit crunch.

“Year-over-year growth was off in December and the fourth quarter, which may indicate some pullback on investment due to uncertainty in the economy as a whole.” says ELFA president Ken Bentsen.

The roundtable participants agree that as funders, perhaps more than others, they have had to modify their approach to the market.

“Certainly things have shifted in the overall economy,” says Jourdan Saegusa, syndication & acquisitions manager at Popular Equipment Finance. “We try to do deals that make sense. Our credit philosophy has not changed, although certain industries and markets will be watched carefully moving forward.”

Menzel says LEAF’s risk-based pricing model has helped the company manage through a declining market and that the company is more vigilant today in verifying credit attributes. But he dismisses the suggestion the added focus on risk is necessarily a reaction to tightening credit markets alone.

“The highly liquid period of the last five years probably accounts for more portfolio risk than will be the case under current conditions,” says Menzel. “That’s why they call it ‘irrational exuberance.’”

Kovash says, in any case, it’s a mistake to presume the leasing industry is immune from the widespread financial troubles. “Every funding company in the marketplace has been affected by the credit crisis,” he says.

He adds his company’s approach to risk mitigation has also changed in response to the wider economy, but mostly in dealing with specific areas that have been hit the hardest.

“The biggest stress areas are related to the housing marketplace and any business directly or indirectly tied to it; mortgage companies, construction, furniture, stone and glass to name a few. We have increased our credit standards for businesses tied to these areas,” he says.

Lowder agrees, and says his group, too, has had to revaluate its approach to both new and existing accounts. “Our credit standards at ACC Capital have not tightened significantly, we do however spend a lot more time in due diligence on all parties to the lease transaction,” he says. “New vendors are thoroughly screened before we proceed with any transaction. Even vendors we’ve known for a long time, and have good relationships with, are additionally screened.”

Like Kovash, Lowder says, for the most part, the problem is confined to a few specialized industries. “With the exception of obviously troubled sectors in certain industries, we really don’t find it much tougher to justify a funding decision than we did say a year ago,” he adds.

Menzel says the leasing industry is fortunate to be in a position to learn from the mistakes made by the mortgage industry. “If there is a clear message to us from the mortgage meltdown, it is that all participants in any given transaction have a responsibility to manage the risk in that transaction. There are a lot of mortgage brokers, processors and appraisers out of work today. They threw caution and quality to the wind in favor of quantity and are now paying the ultimate price.”

Beyond the subprime lending market, it seems nowhere has the turmoil been felt so much as in the banking industry. As investors retreat from buying securitized debt, banks are forced to keep more loans on their balance sheets, adding to increased loan-loss provisions. At the same time, enormous write-downs have continued to batter most large banks’ bottom lines.

As Bernake recently pointed out: “The unexpected losses and the increased pressure on their balance sheets have prompted banks to become protective of their liquidity and balance sheet capacity and, thus, to become less willing to provide funding to other market participants.”

The result is that with the excess liquidity of 2006 no longer an issue, equipment finance companies have been able to step in and fill some of the demand. This has created new opportunities for some financiers.

“We are looking forward to 2008 with enthusiasm,” says Mango. “The current environment portends change, and we expect the competitive landscape will change as well. In that regard, we expect our competitors to modify significantly their risk profile.”

In the end, the lesson from the funding sources we spoke to seems to be stay the course, ride the storm and make the most of solid relationships. “Patience will be rewarded,” says Menzel. “There is still substantial liquidity in the world that needs to stay invested. I believe the experienced players with good track records will continue to attract equity and debt partners.”

Christopher Moraff is the associate editor of the Monitor.

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