Financing the Business Sector During the Credit Boom and the Credit Crisis (2004-2010) - Research Paper Example

Introduction: Also described as the worst financial crisis since the great depression of the 1930’s, the crisis originated in the US and was a resultof the United States Sub-prime mortgage crisis. However, many experts agree that it could be seen coming from a long way off. According to Rapp (2009), the crisis started when the prices of houses in America rose faster than people’s income. At the beginning , lending firms kept things going by offering people “easy loans” with extremely low interest rates that fooled people to think that could easily return the borrowed money. But as the Federal Government tightened rates and mortgage interest rates were reset at higher rates, people were forced to foreclose and homeowners were priced out of the market (Rapp, 2009). Due to this, foreign lenders and investors who had invested in the US housing boom were forced to reassess the risks of ,their investments and most of them pulled out their money, which lead to a drastic drop in the value of the real estate. According to Bartlett(2008), “Mark-to-market losses on mortgage-backed securities, collateralized debt obligations, and related assets through March 2008 were ever to be faced by the world. Yilmaz (2008) states that the loss was initially under-estimated and is actually somewhere around $1 trillion. This US sub prime mortgage crisis became a global financial crisis when people were forced to obtain foreclosures on the mortgages that they were unable to pay. According to Khatiwada and Mc Girr (2008), ““when sub-prime borrowers failed to repay their mortgages, the originating institution needed to finance the foreclosure with their own money, bringing the asset back on its balance sheet. This left many banks in a financially unviable situation, in a rather short, unmanageable timeframe”. The Global Financial Crisis and America: This banking crisis had a huge and widespread effect globally and in the United States. Although poorer countries felt the effect to the extent that some of them are now close to bankruptcy, we have chosen to prepare a study on the effect of this financial crisis on the activities of small, medium and large organizations of America. Among the main reasons for this is that since the crisis originated in the country, it shall be most relevant if the impact of the financial crisis on the industries of the country was analyzed. The United States of America is the largest economy in the world with the annual Gross Domestic Product in the excess of 14 trillion dollars. Being an economic leader of the world, the United states of America is a major driving force in the world economy and any shocks, turmoil, highs and lows in the financial markets of the country have globally resounding effects. For a larger part, the recession that is going on has been felt at the maximum by countries who are poorer than America and even though the country lost billion of Dollars in the crisis, it has by no means been taken to the point where its industry has suffered irreversible shocks and damages through which it could not climb out. The country has suffered various set backs and has also gone through an extended economic expansion which started form the year 1991 and lasted 10 years to end with the Clinton era in the year 2000. From the housing bubble to the dot-com bubble, the United State of America has gone through drastic financial times and through it all, still sits soundly atop the throne of the world “ super power”, while other smaller countries with lesser resources suffer due to the crises that were affected in the US. As the crisis expanded and banks and other financial institutions fell its crunch, credit became hard to find. With investors pulling out of the market, businesses world over fell the impact as lending organizations started declining loans and due to that there was a short fall of lending that was faced by organizations -large and small- all over the globe. However, to say that the country did not suffer set backs would be to make a wrong statement. Like everywhere, the general public has suffered the worse part of the crisis and the unemployment rate in America has inclined at an alarming rate and has increased to 7.2 percent and is at its highest in the last fifteen years as per the Bureau of Labor Statistics. Due to the financial crisis a large number of organizations had to lay off people or close their operation due to a number of reasons, ranging from a lack of funds to inability to obtain further funding. Due to this, in the year 2008, the government released information that the national employment level was at its highest in the last quarter of a century (mint.com) According to a survey conducted by Continuity Central entitled ‘The global financial crisis and its impact on the business continuity market’ have shown that the effect of this crisis on the continuity of various business set ups has varied from region to region. According to the survey, In the United States, 39 % people who took part in the survey responded that the business continuity spending at their organization will remain the same through this time. Only 29 % people responded that it will be less than expected and 4.5 % people actually said that it will be more than they expected (Continuity central website). For furthering our analysis, we shall divide our study in three parts; examining the impact of this crisis on the financial lending in the US, as experienced by small, medium and large organizations. Financing the Small sized enterprise during the financial crisis and boom: Small sized industries and organizations play a great role I the economy of the country. Office of the Advocacy of the U.S Small Business Administration says that it is the major force driving the United States economy. According to information released in 2006, Small businesses represented 99.7 percent of all the nation’s employer businesses in the year 2005. The data also showed that these small firms employed 57.4 Million American people, an amount which makes up a significant part of the united states workforce.(Office of Advocacy, 2006) According to Jones & Kohers (1993), “One of the major concerns for small businesses today is adequate cash flows”. These small organizations may suffer from negative cash flows, and according to the author this is most common during the early years of the firm’s operation and of course, “during prolonged periods of cyclical downturns in the economy” For an organization just starting out, the first few years are the most crucial, where the future of the business is decided. As time passes and organizations learn the ropes of the business and start making profits these cash problems can be solved. But that of course can only happen if the business survives the that initial crucial period. According to a study conducted about small businesses in the year 1989 showed that mainly two sources of financing are popular in the financial structures of the smaller firms(Jones & Kohers, 1993). These two major sources are equity and commercial bank loans. Although other types of debt financing are of course an option, this is what most firms opt for. During the time of this current crisis, there is decreased credit availability and the biggest impact of this is felt by the smaller firms who rely heavily on financial loans taken from commercial banks for funding various ventures and other business activities. Jones & Kohers (1993) note that when the borrowing of small firms from banks in America lessened in the year 1991, it happened for the first time since the world war 2. The current situation has also not been good for most small business in America. However, most experts report, that the reason that this borrowing decreased in the recent times was that the banks became extra careful about whom they loaned money to. With a 8% contraction in credit due to more than 600 billion Dollars worth of loans that have gone into default(Forest, 2010), banks and other lending institutions have tightened their lending procedures and now are lending to only those who seem to provide enough security that they will be able to return the loaned money. Due to this, even though, new firms have had a lot of difficulty in obtaining financing from banks, old and thriving smaller businesses that had a “blue-chip” status had little difficulty in obtaining loans from financers. Financing the medium sized firm during the financial crisis and boom: During the credit boom, as we all know, there was no shortage of credit availability for people who wanted it. Infract, there was too much to borrow, the biggest reason that so many businesses had to suffer insolvency when they could not pay back loans that they had borrowed. As is the case with small enterprises, medium sized enterprises also depend on banks or financing. How ever, apart from obtaining bank loans, more people are opting for “crowd funding”. A phenomena where a large number of investors pool money together small amounts of money. There are also trends of equity financing and if the organization has been in the business for long and is producing good cash flows, it might also consider funding by venture capitalists. However, the decreased level of employment is driving more people to look towards starting their own businesses. However, as mentioned before, a lack of financing is currently restricting new firms- specially small and medium sized- to enter the market. According to Pavoni (2009), some 559 banks took part in a survey and offered views about lending money to SME’s. According to the survey, 48.6% of the respondents approved fewer applications than last year, giving proof to the fact that banks have decreased lending. According to Anna & Robert (2005), when the financial markets are functioning poorly, the entrance of new firms into the market is limited, the firms that are already established, produce at a lower level and there is a great constraint on small and medium enterprises. The only bright side to the whole picture is that these financial hard times according to Bartlett (2008) is that these economic down-turns provide good opportunities for medium sized enterprises because they can employ counter cyclical moves that strengthen their competitive position. It also means that these medium sized firms can then hire talented employees that are released form bigger organization when they go through the process of down sizing in the harder times. But apart from that, thriving in today’s markets has become hard for medium sized businesses in America because of the financial crisis. Financing the large sized firm in the financial crisis and boom: It is increasingly difficult to predict how a financial crisis will effect the workings of large organizations that have their business set up on a larger scale. Most of the larger corporations and organizations in America are Multi-nationals and operate in countries/country other than America as well. Due to this, the effect that any crisis has on the financing of such organization is hard to tap as the business is spread out and its activities are effected according to the severity of the situation in the different areas where it is situated. In a paper presented on the trends shown in Bank lending during the time of the financial crisis through the October of the year 2008, Ivashina & Scharfstein (2008), noted that there was a steep decline in lending to large corporation by banks. According to the authors, this decline started as the crisis started and it accelerated in the months following that time period, reaching it’s peak in about October of the year 2008. They note that during the period from August to October 2008, the loans issued were 36% less than they were in the three months prior to that period. They also noted that “lending for investments such as physical and working capital has fallen as much as lending for leveraged buyouts (LBO’s) and mergers and acquisitions (M&A‘s). Some of the observations made during the study were these: Revolving credit facilities fell more than term loans Non-investment lending decreased as compared to investment grade lending. According to the study carried out by the authors about the patterns of bank lending in America during the time of the financial crisis , the average size of the money lended to large organizations in 2008 was $425 million and 90% of these loans were larger than 421 million. This shows that eve though the country faced a noticeable decrease in credit lending by its financial institutions, there was no drastic situation that arose and even though banks declined more loans than usual, there was still a huge level of borrowing going on by businesses. As compared to smaller and medium sized businesses, this lending was of course higher. As compared to these organizations, larger firms also did better. Conclusion: To a larger degree, the financial crunch which has had its repercussions felt very harshly in poorer countries around the world, has had not that enormously devastating effect on the American economy. Though the country’s GDP is lower than that of the previous year, the banks and the economy has still pulled itself on its feet again- although maybe barely. According to (Ebeling, 2009), ‘Business loans for viable commercial and industrial enterprises have remained available”, and that what the banks have merely done is that they have raised their standards of “credit-worthiness”. On the whole, larger firms have had easier access to financial lendings as compared to small and medium enterprises and a big reason for the higher unemployment rate has been the fact that many smaller businesses that had formerly been thriving were thrown out of the way by larger organizations as a result of this credit crunch. References Anna L.P., Robert M.T., 2005, “Financial constraints and entrepreneurship: Evidence from the Thai financial crisis” Bartlett, D., 2008, “Fallout of the Global Financial Crisis”. Continuity Central. (2008). The Impact of the Global Financial Crisis on the Business Continuity Market. Retrieved from: http://www.continuitycentral.com/feature0624.html on 3rd April 2010. Ebeling, Richard. M. (2009). The financial crisis and business loans: The crunch that isn’t. Retrieved from http://www.aier.org/ on 31st March 2010. Ivashina, Victoria & David Scharfstein. (2008). Bank Lending During the Financial Crisis. Harvard Business School. Jones, Ray G. Jr., & Theodore Kohers. (1993). A survey to Identify Reasons for Denial of Small Business Loan Requests. Managerial Finance. Vol. 19. No. 8. pp 50-61. Khatiwada S., McGir E., 2008, “Financial Crisis: a review of some of the consequences, policy actions and recent trends.” Mintlife. (2009). Unemployment Rate: A Visual Guide to the Financial Crisis. Retrieved from: http://www.mint.com/blog/finance-core/a-visual-guide-to-the-financial-crisis-unemployment-rates/ on 3rd April 2010. Office of Advocacy(2006). Small Business Drives The U.S Economy. U.S Small Business Adiminstration. News Release. Retrieved from: http://www.sba.gov/advo/press/06-17.html on 6th April 2010. Pavoni, Silvia. (2009). Advancing with Caution: SME lending. The Banker. Supplement. Retrieved from: http://web.ifac.org/download/Advancing_With_Caution_Silvia_Pavoni_Banker_Oct2009.pdf on 31st March 2010. Rapp, William. V., (2009). The Kindleberger-Aliber-Minsky paradigm and the Global subprime mortgage meltdown. Critical Perspectives on International Business. Vol. 5, No ½. PP 85-93. Yılmaz, K., 2008, “Global Financial Crisis and the Volatility Spillovers across Stock Markets” Read More