Was the Credit Freeze Real?

Now that the financial rescue package has passed, it’s time to answer the obvious question. Was the credit freeze real? In a word, yes.

Unfortunately, like the financial rescue package, it is not a simple thing to explain.

Probably the most accessible way to understand it is to compare it to a mortgage. Without the ability to borrow money for a home, most people could not afford to own one. With the median cost of a US home just over $210 thousand, most of us would be renters if mortgage loans weren’t available. To some extent, the same thing is true for business.

Publicly owned companies raise money through the stock market. They publish information about their business, and investors buy a portion of that business through purchase of stock in its initial public offering. After investment bankers take their fees, the company uses that money for a variety of purposes, including expansion, research and development, facilities and equipment. In addition, such companies often borrow money for a period of time through the credit markets. The total of its outstanding stock and borrowings is called the company’s capitalization.

Long term borrowing is facilitated through the sale of bonds, and shorter term cash needs, through more expensive commercial loans, or very short term commercial paper. These borrowing mechanisms allow companies to weather short term cash requirements caused by seasonality, economic slow-downs and a myriad of other reasons.

Most businesses have some degree of debt. The reason for that is, again, easiest to explain by comparing it to a mortgage. Let’s say you buy a $350 thousand home with 20% ($70 thousand) down. Seven years later, you sell the home for $430 thousand. After paying off your mortgage (now $255 thousand), you will receive about $175 thousand.

• Original price – $350,000 – $70,000 = $280,000
• 7 years reduction in loan balance = $ 25,000
• Loan balance after seven years = $255,000
• Sales price = $430,000
• Less loan balance = $255,000
• Gross profit = $175,000
• Original investment = $ 70,000
• Return on investment 14%

If you had not borrowed any money, and bought your house for $350 thousand in cash and sold it seven years later for $430 thousand, you would have made $80 thousand on an investment of $350 thousand, or 3% annual return.

This borrowing, or “leverage” as it is referred to in business, increased the return on the sale of this home by 11% per year over seven years. Businesses use borrowing, or leverage, for the same reason – to increase the return on investment for their shareholders.

Conservative business analysts usually recommend no more than a 30% debt ratio (total debt as a percentage of debt plus stock) for a business.