Some questions about the "credit crunch," which I THINK I am STARTING to understand. . .

[xiphias]

I'm throwing this to my friends list, which contains many smart people, several of whom are actual, gen-u-wine people working in finance -- actual economists, as well as people who run their own businesses and so forth.

Okay. I'm starting to get a sort of a handle on the "credit crunch."

Here's what I've got, so far:

Can people who actually study this stuff tell me if I've got this more or less correct?

If you are a business, you have to sell something. But before you sell that thing, you need to buy it/make it first.

Buying stuff and making stuff costs money.

So, you need to spend money in order to get the stuff that you're going to sell to make money.

Maybe what you're selling is a service: you still need to spend money to pay the people you've got who are doing the service.

The point is, if you're a business, you need to be spending money even before you can be making money.

As such, you need "credit". You need to borrow money from SOMEONE that you can spend, in order to get the stuff that you need to make the stuff you're going to sell in order to get money, with which you will then pay back the people you borrowed it from, plus a little for the favor of them lending it to you, and still have some left over for you.

I've got that much okay in my head. I know that my grandfather's construction company has "lines of credit" with some suppliers -- that they can go to a lumber store, and buy lumber, and not pay for it until 30 days out or something like that. So you can get credit from the people who are selling you stuff, sometimes, if they know you and have a working relationship with you.

If you know you have the money coming in later, and you need to spend money now, and you don't have the money now, then you need credit. If you're in that situation and you can't get credit, you have "cash flow problems."

Apparently, what I hadn't entirely realized is that basically no major company in the world has cash. At all. They do EVERYTHING through credit.

The reason why nobody ever had cash flow problems was because there was this entirely boring area of finance where a corporation would need cash every month, so they'd go to their bank and borrow their money for the month, and then at the end of the month, they'd pay back the money they'd borrowed that month and borrow money for the next month. Or something like that. More organic than that -- any time they needed money, they'd just borrow it then, and pay it back whenever.

And if a bank didn't have the cash on hand to loan, they'd just go out to another bank and borrow it from them, and make the loan, and this was all completely boring and dull and nobody paid any attention to it because it just worked.

And then the banks found out that they'd been investing in low-risk bonds that were secretly made up of high risk bonds, so that they were getting all the safety of high-risk with all the return of low-risk, and a bunch of other stuff happened, and the banks all suddenly realized that they have no fucking clue what's actually going on, and panicked, and stopped lending money to each other.

Because they realized that, if they don't know what THEY'RE doing, they CERTAINLY don't know what the OTHER guy is doing.

So they're just sitting totally frozen, panicked.

So, companies are coming up to their banks, just like they always do, and they go to ask for their loan, just like they always do, and the banks don't really have the cash on hand, just like they always don't, and they go to ask the other banks to cover it, just like they always do, and the other banks all go NONONOAAAAAGGGGHHH!, which is new.

So the companies don't have their money that they need to run.

Okay. So, that's my understanding of what's going on. First, is that vaguely close to reality?

Second, if that IS vaguely close to reality, WHY don't companies have cash? What is the benefit of not being able to pay your bills without borrowing money? I mean, I understand why you would borrow money to start with -- before you start a company, you have to get your seed money from somewhere, and that means borrowing it from someone. (Even if you're borrowing it from yourself. I mean, if you're putting your personal fortune into a company, it's like the company is borrowing from you.)

But once you're a company, and you're humming along, getting cash, buying stuff and paying people, and making stuff, and selling stuff and getting cash -- why not take some of that cash and use THAT for the next round of buying stuff and paying people, instead of using credit for it?

It costs money to use credit -- you need to pay people for the service of them lending you money. Why is it worth paying extra to use credit, instead of sticking to a cash basis?

Comments

[ailbhe]

Annual Bonuses are made of cash.

A.
Currently bitter because she's having nightmares about poverty and hunger.

[(Anonymous)]

It's an exaggeration to say no major company has cash on hand. In fact, most of them do. However, there are two major issues:

(1) A lot of companies don't. New companies, struggling companies, small businesses whose income fluctuates a lot, etc. Now this can spread: if, say, 10% of all companies are short of cash and stop paying their bills, then even the companies that thought they had plenty of cash will start to feel the effects. If they go broke, then the meltdown will spread even further. And this can happen even if the businesses in question are fundamentally sound. You may be doing a fine job, but if some of your previously trustworthy customers suddenly stop paying their bills, there's not much you can do.

(2) There's pressure from investors not to hoard excess cash. Investors want every publicly traded company to keep enough cash on hand to deal with any likely scenario, but they don't want excessive accumulations: they'd rather see it paid out as dividends or put into expanding the business than sitting in the bank earning a low interest rate. (Anything riskier than a money market account would defeat the purpose. Plus investors would rather invest it themselves, or more realistically have an expert do it for them, than have random corporate executives effectively investing their money for them.)

So part of the problem is that investors didn't anticipate such a huge crisis. Lots of companies have enough cash to make it through a short crisis, but not a long-term crisis, so the longer this continues the more companies will suffer. If everybody had been anticipating the problem, most companies would have a lot more cash now, but even as recently as last year it just didn't seem worthwhile.

[undauntra.livejournal.com]

(1) If you keep cash on hand to pay bills, then it's not being used to grow your business to make even more cash further down the line. It costs money to use credit, yes - but growing your business can make even more money than the credit costs. So it's better to put your cash to work now and risk maybe having to borrow to cover expenses. (2) Business cannot foresee the future. Sometimes, cash comes in earlier or later than you planned it to. The best you can do is to estimate what your average income stream is going to look like and plan your expenses accordingly. But since it's an estimate, sometime you're going to be wrong and you'll have bills coming due before the sales roll in. So you get a short-term loan to cover the gap. Big companies can have millions in short-term loans just to cover 24 or 48 hours until the cash comes in.

[xiphias.livejournal.com]

The impression I got is that the thing that the credit crunch is really hurting is that sort of short-term loan that you're talking about. Is that more or less correct?

[undauntra.livejournal.com]

Pretty much. Lots of companies rely on those short term loans.

[geekosaur]

Yes. If you've ever listened to a financial news report, you may have heard about an "overnight rate". That's the cost of a loan for less than 24 hours — which is the lifeblood of the corporate economy. If companies can't get those overnight loans, things start to fall apart quickly: even large and apparently well-capitalized companies will have problems.

I've heard an estimate that, were it decided to move to a cash basis for business operations, we would have had to start in the 1960s in order to be on a cash basis now. Far too much depends on those overnight loans being cheap and easy to get.

---

edit: These aren't actually business loans; they're inter-bank loans, and allow banks to provide cheap and easy credit for the aforementioned businesses. If banks stop loaning to each other, s*** happens fast.

[teddywolf.livejournal.com]

This is exactly right.

Since one of the ways banks make money is by lending money to other banks it generally was a boring part of finance. However, another way was by putting money into government bonds. Many banks have been parking their money in those bonds right now, which means the money isn't available to lend. For a brief period, according to Krugman at the New York Times, they were paying enough for those bonds to get no return at all or possibly even a small loss - on government bonds, which are considered to be the most stable investments in the country.

The banks are running scared.

There's also been some discussion recently for reasons why things have gotten so pricey in asset ownership, which is part of the reason for the bubbles, but that's another post :)

[gilmoure.livejournal.com]

Here's one article about how shipping is grinding to a halt. Shipping and cargo relies a lot on letters of credit and now, no one wants to honor them. Don't know about others but I've updated my hurricane supplies (2 months food (and I'm in New Mexico)), along with enough cash on hand for a month's worth of gas and meds.

[amberdine.livejournal.com]

Companies do have cash on hand for payroll, rents, utilities, normal bills... but like everyone said, it's a waste to just hoard profits when you could grow. Almost every business has irregular expenses, and irregular income.

Take for example, a retail store that does half their business around the winter holidays. They need to buy that inventory in November, but don't get the money until January. It would be silly to save up the whole year ahead, when you don't even know what exactly the store will be doing. And there's a huge ripple effect if businesses stop buying and selling to each other.

I don't know if this is an effect of the current credit situation, but Amazon is mysteriously not shipping me any of the stuff I've been trying buy from them. They keep having "unexpected delays from their suppliers."

[navrins]

Your analysis seems pretty close to the mark, to me.

Here's another factor you may not have considered, but is closely related. (I'm going to fudge some of the details of what follows because I don't know them exactly and repeating "or something like that" will get old fast.)

In "normal" times, like last year, companies often implicitly lend money to each other without really saying so. For example, my company's customers buy our product (computers) with a 50% downpayment and the remainder due 30 days after delivery. We're sort of loaning them half the price of the product for a couple of months. We can do that partly because when my company buys the computers from our vendor, we get billed and pay 30 days after we receive them. Which they can do because when they buy the chassis and motherboard and cards from their vendors, they get billed and pay later. And so on down the line, I assume, down to the people who mine the semiconductors and ores and whatever else that our products are ultimately made of.

Normally this isn't a problem... in fact, normally a lot of companies pay their bills late. It's not a big deal. One of the advantages of buying a lot of stuff from the same vendor all the time is if you're a little short on cash one month you can usually just not pay for a few extra weeks and they don't hassle you too much.

But now... now everybody's worried about the one link in the chain who says, "sorry, that thing we bought from you 90 days ago? We're out of cash. We can't pay you for it." So all the links in the chain are saying, "You know how normally you're supposed to pay after 30 days, and we don't bother you too much if you pay 60 or even 90 days later, because we know you're good for it in the long run? Yeah, well, now we really need you to pay in 30 days." Which means a lot of those links need to have more cash, just at the time they're losing access to it.

This is probably the most likely way for this crisis to bite me personally, because while my company's in pretty good shape right now, if enough of that sort of thing starts to happen, we could run into big trouble very fast.

[alaria-lyon.livejournal.com]

Our father explained it to me very well. I'm not sure I can repeat it. Xiphias' explanation seems pretty close to me, with some of the finer points missing, especially for small business.

The big thing being that companies, like people, have specific lines of credit. But they tend to have a number in different banks. Our grandfather, when he had a business before we were born, had lines of credit in 5 banks. At certain points, each bank will ask you to reconcile to $0, so the company borrows from one bank to bring that bank to $0. Now, say I have a $50,000 line of credit in two different banks, but I only borrow $25,000 from Bank A, and $25,000 from Bank B. Bank A asks me to reconcile this month, which is no problem because I can just take my other $25,000 from Bank B, this month to pay off Bank A, and then next month I can transfer it back the other way. But now Bank B is saying, sorry, even though you were initially allowed to borrow $50,000, we are freezing your line of credit at where you are right now. So I now have $75,000 less in liquidity than I did before. So I can reconcile with Bank A, but I can't pay my payroll. Or I can pay my payroll, but I can't reconcile with Bank A. And I have no money for added inventory either. No matter what, I'm screwed.

[dichroic.livejournal.com]

Honeywell is one that does tend to keep cash reserves on hand - its CEO, Dave Cote, likes to say "cash is king". (I used to work there.) But I wasn't able to find any article assessing how they might weather this storm in light of that.

[maggiebloome.livejournal.com]

I asked my dad the other day why on earth you'd have a credit card instead of just saving up for things, and he told me that having money sitting in the bank in a savings account has very little interest compared to investing it. So if you're lending your money at a higher interest rate than you are borrowing money you come out ahead. I assume the banks make a similar decision.

A bit of math

[(Anonymous)]

Suppose you have a construction company and 30,000 in cash. Your expenses are 1/3 payroll, 1/3 subcontractors and 1/3 stores. The subcontractors and and vendors give you thirty days to pay up. You do the work and your clients pay up in thirty days. Your payroll won't wait. Therefore you can support a payroll with the 30,000 cash, pay the stores and the subs when the money comes in from the customers, and more or less stay in business. If your credit dries up with subcontractors and the stores, and everything is cash, your cash has to do it all. Then your only options are to only work for people who have cash (fat chance) or cut your payroll to 10,000 a month.

This make sense? I've left out things like taxes and insurances to keep it a bit simpler.

Duzzy

[dancing-kiralee.livejournal.com]

Speaking here as someone who handles almost all of the day to day accounting for a small business (about 15 employess small)...

I think you are both right and wrong.

I think that what you are talking about has to do with "terms" on invoices. Basically, when I get an invoice is comes with "terms of payment" on it, which is the amount of time I have to pay the invoice. When the businesses I work for get an invoice the terms are usually "net 30 days" rather than "due on receipt." So I have 30 days to process and pay the invoice - and boy do I need it.

Because of GAAP (Generally Accepted Accounting Principles, put in place after the depression to keep things like the depression from happening) I need to make sure at least one other person besides me signs off approving the invoice for payment. This prevents fraud. I need to make sure the invoice is coded correctly (that office suplies are listed as office supplies, and not, say materials for making widgets), and enter it. When I have a bunch of invoices (once a week if I'm lucky, once a month if I'm way busy with other accounting) I make a list to check against the bank balance. Depending on the size and structure of the company, I may need to get a third person to approve cutting checks for my list of invoices. Then I cut checks, clip the checks to the invoices, and go to yet another person to get them signed. Then I send the checks out to the people being paid, usually in the mail, so it takes another day or two to get to them.

The point is that unless you are in a very small business, paying invoices is not as simple as handing over cash for a load of lumber. Very small businesses (Sole Propriatorships that are small enough that the owner has his hand in everything) work differently... if they are very very small, the owner does his or her own accounting. Since it's all his money anyway, he really can't embezzle himself. If they get a little bigger, the owner will hire a bookkeeper, and that relationship is usually based on trust - so, no fancy procedures.

But when you get a little bigger than that, big enough that the owner can't keep track of everything, you need to start putting procedures in so that no one can write a check to themselves with your money. The way you do that is to involve multiple people in the payment process - a manager type to approve the invoice for payment, a clerk type to process the invoices (that's me), and a finance type to release invoices for payment and sign the checks.

And, all that processing takes time, so the vendor extends credit to the payor to give them time to process the invoice. Because of the time and value of money, it costs the vendor a little bit to do that... but a) the vendor usually gets similar terms from his vendors to make up for it, and b) the whole system cuts down on fraud and embezzlement and results in more standardized financial statements which is in everyones best interest and so worth the small price of not getting paid right away.

So, it that sense, you are right; all Corporations do everything through credit. And they do it because GAAP requires them to spend more energy / effort / time processing invoices.

However, you are wrong on two counts. One, most corporations have cash on hand. The amount of cash on hand depends on the size of the corporation, and how well they are doing. If they are larger they will also have reserves (which are not infinite) and if they are even larger they will invest some of their reserves (which makes them more money but is less liquid).

Second, unless there are credit cards involved in this process, companies are not borrowing money from the banks. They are getting credit from their vendors, essentially other companies just like them.

Now, I could be wrong about where you are coming from when you say "They do EVERYTHING through credit." This sort of a guess from your story about buying lumbar. So, if I'm wrong about that, then most of what I say is irrelevant, and guess I'm sorry to have wasted your time with it.

However, this is where I think you were going, and even if it isn't I hope I didn't bore you too much (since most people find accounting to be boring drudge work).

Kiralee

[fuzcat.livejournal.com]

Last weeks This American Life does a pretty good job explaining it.