The Second Wave

By Steve Klinkerman

As the recession's aftershocks continue, it's natural to hope for a ripple — but smart to plan for a Tsunami.

Start with dot-com mania and investors' irrational exuberance. Add Wall Street hucksterism and corporate malfeasance. Top off with the September 11 terrorist attacks, war in Afghanistan and the threat of war in Iraq. A witches' brew for sure, but does this fully explain the recession?

Though simple to present on the evening news, a tale of bad guys, outrageous acts and unfortunate episodes doesn't fully explain what this or any other recession is all about. Instead, collapsing bubbles and the exposure of excess and wrongdoing can be leading indicators of an even larger problem: a general over-deployment of capital in the economy. There's not enough sales and rental income to support all of the capacity that's been mobilized. Something's got to give.

There are good reasons why the full dimensions of a downturn do not immediately become clear. Backlogs of contracts can keep the wheels turning for quite some time before sales shortfalls are felt. The better companies, involved in sturdier projects and having more working capital, last longer before showing vulnerability. Certain sectors of the economy are removed from the epicenter of bubbles, and their shock waves are delayed.

Inevitably in the course of a major economic contraction, it becomes clear that all the players are basically fishing from the same pond. And all are affected, including the biggest companies, the most respected individuals, the most impressive projects. That is why the possibility of a "double-dip" recession can't be ruled out this time around. With problem assets continuing to rise in the banking industry, financial institutions certainly need to stay on the alert.

The lessons from past recessions offer bankers guidance on the key issues to be dealt with today. One is to never underestimate the toxicity of problem loans. Kept on the books, sour credits suck up precious cash flow with interest carry expenses, legal and accounting fees, management fees, etc. — try a 20% negative annual margin, for example. Taken off the books, they drain capital. The loan that was supported with maybe $8 of capital for every $100 of face value in good times may require a write-off of from $20 to $40 for every $100 of face value in bad times. The moral is to detect and treat bad loans as quickly as possible.

Another challenge is to avoid creating new credit bubbles in the act of recovering from old ones. The classic trap that distressed lenders fall into is trying to "grow out of problems" by quickly issuing a fresh crop of loans. The usual result is poor underwriting, additional strains on capital and a new rash of problems down the line. Torrents of credit are currently being pushed at consumers, which raises questions as to where today's most avid originators will wind up tomorrow.

A third priority is to control costs, and this perhaps is the thorniest issue for financial institutions. The Federal Reserve has done a marvelous job of lowering overall rates in the economy while holding inflation in check. A financial windfall has accrued to those institutions that have been able to lower their funding costs while preserving higher yields on loans already on the books. But this window of opportunity is closing. If the recession continues, stringent overhead reductions will become imperative. That leaves providers with the question of how to lower operating expenses while preserving customer relationships.

The point in mentioning all this is not to predict the worst, but to emphasize the preparation that is needed to avoid the worst. Every recession has its aftershocks, and while it is natural to hope for ripples, it's smart to have plans for dealing with a Tsunami.

Mr. Klinkerman is editor-in-chief of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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