Impact of the Liquidity Drought on the Equipment Leasing & Finance Industry

by David S. Wiener November/December 2009
The financial services sector of the economy has been in turmoil, yet many in leasing leadership roles have experienced a “frog-in-the-kettle” syndrome. Industry veteran David Wiener, a self-described layman economist offers his armchair perspective on the U.S. financial system — and the resulting systemic impact on the entire equipment leasing & finance industry.

If at some point we had jumped into scalding water — we would have immediately leaped out. But the economic water temperature affecting the equipment finance community was seemingly increased gradually — and has been ultimately fatal to some. The early 2008 Bear Sterns failure should have set off the financial alarms. But many hit the alarm snooze button after a discrete shotgun marriage was arranged with J.P. Morgan Chase to sweep away the problem.

At the New York, NY March 11, 2008 Seventh Annual Investors’ Conference on Equipment Finance, the keynote speaker Frederick E. Wolfert (then a senior advisor at Aquiline Capital Partners, LLC) built the conceptual case of reduced global lending capacity given the leveraged effect of write-offs. Expected global write-downs were estimated to total a maximum of $144 billion at that time, and Wolfert built the frightening case that estimated global lending capacity removed would total $1.7 trillion with an assumed leverage of 11.5:1.0. The financial theory that Wolfert presented was conceptually sound, but woefully understated in hindsight. But we didn’t know — we were just the frog in the kettle as the heat was being turned up. If only total financial system leverage was as low as 11.5, and if only total write-offs were no more than $144 billion. If only total liquidity destroyed was just $1.7 trillion. If only…

This was a good six months before the dramatic fall of Lehman Brothers and the financial devastation left in the wake of the failure of this once proud investment banking financial institution. This was quickly followed by more arranged marriages to mask our problem — Merrill Lynch, Wachovia and National City — to name a few. We have been put on high alert for over a year now that the entire worldwide financial services industry was in real trouble. But I am not convinced that even with a full year of this recession under our belt, all the ramifications of our troubles are yet fully appreciated. For the equipment finance professional to understand where we, our companies and our entire industry, are positioned today, let’s study what happened to the economy from a macroeconomic view, and then peek at the resulting impact on a typical equipment finance organization from a microeconomic perspective. Then we can determine where we are … and where we need to go from here.

Macroeconomic View
On a macroeconomic basis, write-offs combined with leverage have created a financial liquidity desert, forcing a monetary recession on our hands

On April 22, 2009, The International Monetary Fund (IMF)1 estimated that this current recession will result in write-downs totaling $2.7 trillion in the U.S. in the three years 2008 through 2010. Is this a big number? Yes, dramatically bigger. Our current situation is a trifecta disaster in contrast to 1991 — the year of the last major recession in the past 25 years:

  • Total bank assets quadrupled from 1991 to 2009.
  • The losses are expected to be more than double across the board per year than those experienced in 1991.
  • Residential mortgage charge-offs are up 23 times their 1991 level.
  • The 1991 recession lasted one year — with only one year of heavy charge-offs. Current market conditions suggest a soft economy for at least the next. So we are likely in for higher than normal charge-offs for a longer period of time.

According to the statistics maintained by the Federal Reserve in its H8 Report,2, 3 total bank assets have almost quadrupled in the past 18 years. Even if the percentage of charge-offs of total loans today are the same as the peak in 1991, the dollar amount in 2008 would be four times the dollar amount of the 1991 recession. However, the charge-offs today are higher — much higher than those in any cycle experienced in the past 20 years.

Within the June 2009 FDIC Quarterly Banking Profile, Second Quarter 20094 the net charge-offs by Asset Concentration Group is documented on page 59 of that report. Annual data points for the past 20 years as of the end of Q2 are plotted below for credit cards, commercial loans (and leases), mortgages and consumer loans. (See Figure 1.) Some sample charge-offs (as a percent of loan categories) are shown in Tables 1a and 1b.

Until 2008, the most significant recession in the past 20 years occurred in 1991. All charge-offs, by all asset categories, as of 6/30/09 have exceeded the 1991 peak. Just like floodwaters continue to rise until well after the rain ceases, these charge-offs are not likely crest until late 2010. According to the IMF Global Financial Stability Report5 and specifically Figure 1.20 in that report on U.S. Charge-off Rates,6 2010 charge-offs for consumer and mortgage loans are respectively projected to be 4.6% and 5.8% — up several fold from current charge-off levels.

Appreciably higher expected charge-offs for consumer loans and mortgages — already two and three times the ‘91 actual — are troubling, and are having a much wider impact on the financial services industry. Many have the fresh memory of abnormally low loss experiences in the first half of this decade — and began to draw the conclusion that this was the new normal. What a difference three years make. The 2009 write-off level in the top four lending categories are up between three and ten times what was experienced in the happily humming economy period of 2003 to 2007.

Already, equipment finance industry charge-offs in the 25 company survey sample reported in the Equipment Leasing & Finance Association compiled MLFI-257 spiked to 3.01% in September 2009 — almost three times the 1.16% average charge-off figure for all of 2008. The closest comp’s to equipment leasing in the IMF statistical database are Commercial and Industrial (C&I) loans. The current C&I charge-off data points show rounded increases that have not quickly abated — instead of sharp up and down spikes as was the case in 1991 and 2002 recessionary environments.

The Tier 1 capital adequacy ratios8 required for banks (by regulators of U.S. financial institutions) expect banks to maintain 10% equity — or a 10:1 Total Assets to Equity (9:1 Total Liabilities to Net Worth). Charge-offs are deducted from loss reserves, which put pressure on reserve replenishment, which will adversely affect earnings and dilution of equity/net worth. A sum total of $2.7 trillion in reduced net worth — applied to exclusively to banking institutions — would translate to $27 trillion in constrained lending applying the 10:1 Asset to Equity minimum Tier 1 capital adequacy. This writer contends this extrapolated dollar amount of lost liquidity is conservative. Bank leverage pales in comparison with average investment bank leverage (40:1) or the infinite leverage of various popular off-balance sheet instruments — CMOs, CDOs, CLOs, as well as popular securitization instruments. Arguably, total financial community leverage (liabilities to worth) of 12:1 (or 13:1 total assets to equity) could be reasonably applied, suggesting a real vanished liquidity number equal to $35 trillion from the expected $2.7 trillion of U.S. write-offs (times 13). (See Figure 2.)

The result of our write-down driven fiscal economic recession has actually brought about an ongoing lingering monetary economic recession from lack of liquidity. According to Bureau of Economic Analysis Report,9 published by the U.S. Department of Commerce, the rolling four-quarter annualized U.S. Gross Domestic Product (GDP) equaled $57 trillion from Q4/08 through Q3/09). The $35 trillion in evaporated U.S. liquidity is 61% of U.S. annual GDP. Put another way, a total of 32 weeks of U.S. GDP productivity is equal to the liquidity lost in this current recession. Available liquidity to lend, in turn, fuels economic growth. The absence of liquidity constrains that growth.

The earlier referenced IMF report as expanded in a New York Times10 article projected total non-U.S. write-downs from this recession equals $1.3 trillion ($1.2 trillion Europe and $0.1 trillion Japan), for collective worldwide charge-offs of $4 trillion total. Applying that same 12:1 leverage ratio (13:1 total assets to equity), the incremental damage to non-U.S. liquidity availability is $17 trillion ($1.3 trillion x 13) — for a total worldwide liquidity hit of $52 trillion ($4 trillion x 13).

Should the U.S. really care about a liquidity disappearance outside its borders? International financial institutions must contend with the fallout from their loan losses regardless of where they occurred. Overseas originated credit losses may result in a lending retreat from the U.S. as their balance sheets must be brought in alignment. Some top European banks, all with lending activities in the U.S. include: UBS, Deutsche, Société Générale, Fortis, BNP Paribas, Credit Suisse, Dexia, Barclays and RBS. None have been immune from write-offs. (See Figure 3.)

Microeconomic View
From a microeconomic basis — liquidity constraints have limited supply of money to finance equipment.

Picture a hypothetical middle-market bank. Let’s say that, in 2007, this bank has total assets of $10 billion and equity of $1 billion — a 9:1 leverage, within an acceptable range of operation. For the year 2007, the bank’s leasing executive has the mandate of $300 million in new business origination. In 2007, that bank leasing executive can — with reasonable assurance — project originations equal to $100 million from its direct sales force and $100 million from its established vendor programs. The source of the final $100 million has not been confidently identified. However, this “air ball” can be satisfied from incremental direct originations from, say, a marketing rep that exceeds sales quota by $10 million or a region experiencing above average economic growth and generates an additional $10 million of financing.

On the vendor side, a new program may be awarded that throws off $10 million in volume — or an existing program may hit its stride and create $10 million in unaccounted financing sales. If these drivers shore up $40 million of the $100 million gap, the remaining hypothetical $60 million volume target shortfall can be mitigated by indirect transactions purchased from third-party originators, which may include syndicators, brokers and investment bankers. In fact, years of shortfalls from direct and vendor channels have caused many banks to formally establish third-party buy desks to feed their volume hungry banks.

Fast forward two years and assume our U.S. recession that commenced in 2008 resulted in a total of $100 million in bank write-offs. Our bank just went from $1 billion in equity/net worth down to $900 million. To maintain an acceptable 9:1 leverage, the bank needs to go on a “diet” and shed $1 billion in assets. All origination platforms are shifted into reverse. Our leasing executive is shocked when informed that the 2009 equipment finance division volume objective maximum is capped at $150 million, down from a $300 million minimum in years past. These leverage-imposed liquidity constraints within each lending origination results in the requirement that financings provided to customers must be accompanied by other non-lending services offered by the bank.

The leasing executive with $100 million direct and $100 million vendor “in the bag” must allocate these now scarce resources among the $150 million lending cap. With overcapacity, our leasing executive is ultimately forced to cut sales reps, fire unprofitable vendor programs and shutter the third-party origination business platform. Financing commitments are contingent upon customer receptivity of other banking products. To further constrain product demand, transaction pricing is increased and minimum credit quality is heightened.

The Macro and the Micro Collide
No company or individual has escaped the fallout from the current liquidity crisis.

The Rip Van Winkle leasing professionals who took a short nap in 2007 have been startled awake in 2009. They are now facing a number of surprises that have come home to roost, among all sectors of the equipment finance industry.

  • Large Independents: Large independent leasing companies are embarking on their own financial diets in the wake of the current critical view on high leverage, a significantly less available commercial paper window, absence of a securitization market absent government support and fewer bank lines — the result of non-renewed or reduced commitment amounts from respective banking consortiums challenged with the liquidity constraints of their own. Many will attempt to grow up to be a bank or be adopted by a bank — to gain access to dependable capital under the auspices of FDIC-insured accounts. Examples have been announced even as this white paper is being researched.11
  • Small Independents: The Small Independent Leasing Companies (SILCs) are facing the double whammy of their bank lenders requiring higher spreads over a fixed rate index coupled with abandoning use of the lower T-rates as an index and now pegging transactions to like term SWAP rates. Bank advances on guaranteed rental cash flows have been reduced to enable higher available cash. Notably, there is a stark absence of subprime lenders in this space to the lessors that are just one tier below those attractive to bank lenders.
  • Captives: The captives are focusing on core customers as they face constrained capital access.
  • Vendor Equipment Finance Companies: Vendor lessors are soberly assessing their current stable of vendor programs. Unprofitable relationships — whether from low volume, thin spreads, poor conversion ratios, higher service costs or inadequate upside or renewed business — are all being eliminated or allowed to expire at their contractual conclusion.
  • Banks: Banks are building cross sell into the fabric of all lending platforms, including leasing. Many bank leasing arms are retrenching into their respective bank trade area to serve existing or prospective bank customers where non-lending products are expected to be sold — no longer just a nice to have.
  • Funding Sources: Without a multi-product relationship, the third-party aspect of many leasing organizations is the first to be cut and those that remain are offering their lending capacity at higher rates and for better credits with far more restrictions on industry and collateral types.
  • Brokers: Many brokers have exited the market for lack of funding sources or inadequate volume to sustain the cost of running their operations.
  • Mid & Large Ticket: Flight to quality. There is generally an ongoing market for BB+ and above transactions for transactions secured by value-retaining equipment as collateral. And those companies BBB and above (and their unrated equivalents) can still finance softer assets. But, across the board, transaction maturities are generally shorter and pricing is markedly higher.
  • Small Ticket: There is some soul searching by credit/risk leaders on the application of scoring models. Did this “100-year flood” of credit challenges mean that score thresholds were set too low? Was a past ability of refinancing in times of dramatic home appreciation enabling some private business owners to sustain payments on equipment financed? Did this mask underlying problems of modest economic downturns over the most recent decade? Were the correct regression factors incorporated and do they remain valid as an accurate future predictor of credit performance? To prevent a return to more time consuming financial spreads and continue to trust credit scores, the chief credit officer must be able to sign off on the continued reliability of these statistical prediction tools — a decision that they will not make lightly.

Sure the fiscal economic facets of this recession have resulted in a demand drop for new equipment and corresponding financing. The ELFA MLFI-257 documents that annualized volume financed has receded by 35%. Only deals in the market for better credits are being efficiently executed at competitive rates due to lender/lessor reactive flight to quality. Across the board there is sparse interest in transactions for companies that are below investment grade. So, in a backhanded benevolent way, this overall shortfall in deals being financed actually camouflages the true underlying soft available liquidity. As the economy comes off life support and financing demand returns it will become unmistakingly apparent that the supply of capital is grossly absent for all aspects of the credit spectrum.

Where We Need to Go From Here
There have been past notable equipment finance company studies such as those that showcased the Perfect Storm,12 which outlined factors contributing to the demise of those profiled equipment finance organizations. These storms were isolated and presented no real threat to the well-run equipment finance platform with the right business model. Today we are faced not with a storm but a drought. The constraints on liquidity will force an ongoing transformation of the business models of the equipment finance platforms that will survive beyond the decade. Others will likely die an agonizing death in the fallout of this nuclear liquidity winter.

Specific actions to take: Leadership of each equipment finance platform must conduct its own soul searching assessment. No business line can be considered a sacred cow. To paraphrase a principle offered in Jim Collins groundbreaking work Good to Great,13 each sector must be tested to ensure that it can be executed proficiently and profitably, and be in alignment with the passion of the parent company or ultimate business stakeholders. Customer centricity for the right customers becomes paramount. Superior one-time profitability on one deal should be subservient to forging mutually loyal enduring relationships that can be efficiently conducted. Vendor programs, too, should not be judged by mere spread metrics, but instead through the lens of a holistic assessment of the overarching relationship.

Action management: This systemic course correction must be carried out by staff in alignment with the business model. “What gets measured gets done, what gets measured most” is a good adage to apply. Executive leadership must implement the right self-governing practices and metrics — coupled with appropriate rewards and recognitions to achieve the right performance and behaviors in alignment with the best interests of the business and any course corrections being sought. Volume in isolation no longer is the solo objective of today’s equipment finance organization.

Nuclear liquidity winter will open up to a new spring of opportunity. Therefore, in this time of scarce liquidity resources, business leaders are being granted a great opportunity to prune for the future: eliminating dead wood programs, people and processes. To be ready to bloom again — when the season again changes to a new financial spring.

Footnotes
1 “Global Financial Crisis — Further Action Needed to Reinforce Signs of Market Recovery: IMF,” by Peter Dattels & Laura Kodres, IMF Monetary and Capital Markets Department. IMF Survey Magazine: IMF Research April 21, 2009. http://www.imf.org/external/pubs/ft/survey/so/2009/RES042109C.htm
2 FRB H.8 Release — Assets and Liabilities of Commercial Banks in the United States Current Release: October 23, 2009 (Board of Governors of the Federal Reserve System). http://www.federalreserve.gov/releases/h8/current/default.htm
3 FRB H.8 (510) Release — Assets and Liabilities of Commercial Banks in the United States (Historical) Statistical Release: February 25, 1991 (Board of Governors of the Federal Reserve System). http://fraser.stlouisfed.org/statreleases/h8/download/50845/H8_02251991.pdf
4 “Net Charge-offs as a Percentage of Average Loans and Leases by Asset Concentration Group, 1991-2009 Annualized,” Page 59. FDIC Quarterly Banking Profile Second Quarter 2009 (June 30, 2009 Report Date). http://www2.fdic.gov/qbp/2009jun/grbookbw/QBPGRBW.pdf
5 Global Financial Stability Report April 2009 International Monetary Fund. http://www.imf.org/external/pubs/ft/gfsr/2009/01/index.htm#c1figure
6 Global Financial Stability Report — Figure 1.20 April 2009 International Monetary Fund. http://www.imf.org/external/pubs/ft/gfsr/2009/01/c1/figure1_20.csv
7 Monthly Lease Finance Index (MLFI-25), September 2009 Equipment Leasing & Finance Association. http://www.elfaonline.org/ind/research/MLFI/0909.cfm
8 “Criteria for Classifying Banks as Adequately and Well Capitalized,” Table 3, page 24. Policy Brief 2006-PB-01 January 2006, Networks Financial Institute (at Indiana State University) by R. Alton Gilbert. http://www.federalreserve.gov/SECRS/2007/August/20070809/R-1238/R-1238_21_1.pdf
9 “Gross Domestic Product: Second Quarter 2009 (Third Estimate),” News Release, BEA 09-43. Bureau of Economic Analysis; U.S. Department of Commerce, released 8:30 a.m. EDT Wednesday September 30, 2009. http://www.bea.gov/newsreleases/national/gdp/2009/pdf/gdp2q09_3rd.pdf
10 “I.M.F. Puts Bank Losses From Global Financial Crisis at $4.1 Trillion,” by Mark Landler. New York Times April 22, 2009. http://www.nytimes.com/2009/04/22/business/global/22fund.html?_r=1
11 “Florida Thrift Acquires Tygris in Stock for Stock Transaction,” Press Release — monitordaily.com. https://www.monitordaily.com/app_enews/news.asp?news_ID=24457
12 “Perfect Storms: Why Major Lessors Have Exited the Marketplace,” by The Alta Group. Published 2001, Equipment Leasing and Finance Foundation.
13 “Hedgehog Concept” pages 96 & 118. Good To Great, by Jim Collins, c-2001 Jim Collins, (Harper-Collins).

David S. Wiener is considered a subject matter expert within the equipment leasing and finance industry. For 24 years (1983-2006), he was a member of the ELFA Research Committee responsible for development of the Annual Survey of Equipment Finance Activity and the MLFI-25 — chairing that committee for 17 years (1990-2006). Since 1998, Wiener has been an elected trustee of the Equipment Leasing & Finance Foundation. He has chaired the Foundation Research Committee for the past 11 years, over which time 35 academic research papers on equipment finance have been commissioned. Over the past 18 years, he has created, staffed and managed capital markets platforms for three Top-10 vendor finance organizations — personally responsible for over $2 billion in sales volume and nearly $100 million in income. He holds a B.A. in Economics from Wake Forest University and an M.B.A. from the Sellinger School of Business & Management (Loyola University Maryland). At present, Wiener is an available unsigned free agent and his profile can be viewed at: www.linkedin.com/in/wienerdavid. He can be contacted by e-mail at david.wiener@comcast.net.

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