When Banks Won’t Touch Your Company

Alternative financing firms take on credit risks that financial institutions don’t want.

CFO.com
Vincent Ryan

When commercial bank lending rises on a sustained basis as it has the past year, it’s hard to fathom some companies being denied credit. … [There] are always companies (and industries) that are just not bankable. … Among them: firms that are cash-flow negative, start-ups with intellectual property but no customers, and young industrial companies that need to finance fixed assets before entering production phase.




Loans (Photo credit: zingbot)

The situation for the have-nots could get worse in the next few years: pieces of the new Basel III bank capital rules may force banks to be more selective with their capital commitments, especially to companies of marginal creditworthiness.

But there are some alternative financing sources that are hungry to deploy money and willing to finance higher-risk projects. … “There’s not a lot of yield to be gotten in the public bond markets. Private capital providers need yield in their portfolios,” says Allen Weaver, senior managing director at Prudential Capital Group, which invests long-term money from insurance companies and pension funds.

Take Deep Eddy Vodka. When demand was outstripping the capacity of its bottling line equipment last year, the two-year-old spirits start-up called on many banks but found its business model didn’t line up with their idea of creditworthiness. Deep Eddy spends a lot on sales and marketing to build its brand and grow its topline fast, paying less attention to profits for now, says John Scarborough, the company’s vice president of finance. Once bankers saw the business’s operating losses, they said they needed personal guarantees from Deep Eddy’s principals.




Image via CrunchBase

After searching, Deep Eddy found Fountain Partners, a provider of lease lines of credit for capital equipment. “Fountain was willing to look at the business model, peel back the onion a bit, and see that there was a fundamentally strong business underneath,” says Scarborough. Deep Eddy landed a $250,000, 36-month lease to buy its new high-capacity bottling line, as well as a sale-leaseback of existing equipment to generate additional working capital.

There is a knock on alternative financing, though. A nonbank financier’s cost of capital is higher than a traditional bank, ... Since its cost of capital is higher, the borrower pays a higher rate.
“With the funds we are running right now, we are looking for rates of return that are double-digit, and we are very clear about our willingness to take large-scale risks that make that [rate] deserving and fair,” says Tom Carter, founder of Fountain Partners and a former CFO.

Also taking those credit risks are business development corporations (BDCs), which are publicly held investment companies that must distribute 90% of their profits to shareholders. By leveraging their balance sheets, BDCs can get their cost of capital down, says Manuel Henriquez, CEO of BDC Hercules Technology Growth Capital. Hercules originates senior secured loans, often collateralized with intellectual property, and has a cost of capital of 5% to 7%, compared with 2% to 3% for a bank.

The real advantage of alternative financing is not in the hard costs, though. Henriquez says his clients … can place their deposits and operating accounts into any bank. … [The] financing agreements are a lot less covenant-driven. And in the event a company gets into trouble, “the loan doesn’t get passed to a workout group whose sole purpose is to get the bank’s money back at whatever cost, because regulators are breathing down its neck,” Henriquez says.
“Because we are not regulated like a bank and have permanent capital on our balance sheet, we can work with a company through difficult times,” he adds. “We expect our companies to stumble, like a little kid on a bike.”

Not that borrowers shouldn’t pay attention to the cost of alternative financing. In lease deals, notes Scarborough, sometimes the actual interest rate is buried in a bunch of numbers. …
While monthly payments with interest rates higher than a typical bank loan may scare finance executives, nonbank debt lets some companies save expensive equity capital for strategic uses. It doesn’t make sense for a start-up to buy furniture, servers, and routers or fund working capital with equity dollars, Henriquez says: …




Understanding Financial Leverage (Photo credit: Wikipedia)

“In consumer packaged goods, value is created by the brand,” says Scarborough. “We have a finite amount of capital and the highest-return, best use of capital is to invest in marketing programs and a world-class sales team, not equipment.”

But alternative financing firms don’t have an infinite appetite for risk, either. Fountain Partners looked at several deals in the solar industry between 2006 and 2011, Carter says, but never extended credit to one. His reasoning: basic science and execution risk around the companies’ manufacturing plans, and the fact that many of the solar companies didn’t have enough venture money to reach production phase.

Still, in general, firms like Fountain take a more expansive view of a borrower’s prospects. “We take risk that large-scale financial institutions shy away from,” says Carter.

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Five Ways to Build Business Credit

Entrepreneur.com
BY Kelly K. Spors | Yesterday|

… [Getting] credit is much easier when you don't need it. …Here are five options to get started.

1. Mind your personal credit rating. The biggest factor in many banks' decision to initially lend businesses money is the owners' personal credit ratings and they typically look for a personal credit score of at least the mid-600s, says Ami Kassar, co-founder and chief executive of MultiFunding LLC, a Broad Axe, Pa.-based company that helps businesses connect with lenders. … Moreover, lenders will also often check the personal credit of any investor or business partner with more than a 20% stake in the business, Kassar says.

Image via Wikipedia2. Apply for credit before you need it. To begin building a credit history for your business, apply for at least some sort of credit soon after starting up, Kassar says. A small business will often have to establish itself for two years before a bank feels comfortable offering a sizable credit line. … Some major retailers that supply to small businesses, such as OfficeMax or Home Depot, offer commercial credit accounts that can help build a credit history for your business.

3. Grow your credit and use it. Many businesses with enviable credit histories applied early for business credit cards and credit lines and used them as early as possible, says Wayne Sanford, owner of New Start Financial Corp., a credit consultancy in Allen, Texas. … Also, check to see if you have a profile with Dun & Bradstreet, a business data and credit reporting agency, suggests Gwendolyn Wright, a San Francisco business consultant and former first vice president of the Bank of San Francisco, a community bank. …

4. Forge relationships with more than one lender. Banks can change lending policies on a moment's notice and cut your credit limit overnight, so it can help to not have all your financial eggs in one basket, Sanford adds. …

5. Consider alternatives. Remember that traditional banks are not your only shot at credit, Wright says. … Other resources include asset-based lenders, which focus more on collateral rather than credit worthiness, factoring -- which lets you borrow against your accounts receivables -- and peer-to-peer lending and crowdfunding sites, such as Prosper.com and Kickstarter.com. …

Related articles

• Easy Ways to Establish Business Credit (thinkup.waldenu.edu)
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QE2 and the Great Wealth Transfer: A Spurt for the Economy?: Searching for Alpha

Advisor One
November 2, 2010 | By Ben Warwick

Quantitative easing (QE) is a government strategy of printing money in order to retire debt and purchase assets that increase the size of the public balance sheet. QE1, which occurred in March 2009, effectively took the markets off the mat. QE2 will likely also light a fire under stock prices, but the effect may be short-lived.
Since the assets purchased are all debt-related, there is little doubt that interest rates will stay low or even head slightly lower. Corporations will continue to sell bonds in this environment, which will increase their cash hordes even more. As more firms start distributing this cash in the form of dividends, investors will turn their eyes away from the negligible return of CDs and Treasury notes and toward the stock market.

Image via WikipediaThe economy should respond to such stimulus, but not with the vigor of the public markets. If GDP growth doesn’t get a sufficient boost, investors will begin to focus on the falling dollar and rising government debt levels. Although I’m still expecting a rally, it may be in the form of a powerful spurt rather than a long-term trend.

Not everyone will win in the next upswing. The battered middle class, who is already cash strapped and struggling with high unemployment, won’t have the wherewithal to participate in the rally. This will serve to separate them from the upper class even more—a vexing long-term problem that we will eventually have to deal with.

Ben Warwick is CIO of Memphis-based Sovereign Wealth Management. He can be reached atmailto:puzzler@investmentadvisor.com.

About the Author

Ben Warwick
Contributing Editor

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A better way to anticipate downturns

Credit markets, though harder to follow than equity markets, provide clearer signs of looming economic decline.

McKinsey Quarterly
OCTOBER 2010 • Tim Koller
Source: Corporate Finance Practice



What executive isn’t challenged by the daily barrage of conflicting economic reports attempting to clarify the question of the hour: will the global recovery build or lapse into another recession? Indeed, executives around the world are evenly split on the topic.¹ And while the savviest executives and investors know better than to get caught up in the short-term fluctuations of the economy, many others, looking for evidence of longer-term trends, still fixate on movements in the equity markets.
They shouldn’t. The fact is that those markets, … don’t predict downturns effectively. Credit markets are a better place to look for signs of impending trouble, in no small part because they have been at the core of most financial crises and recessions for hundreds of years. Parsing the credit markets isn’t easy—there’s no single number remotely like a share price to monitor, and there are many moving parts. But for executives willing to take the time to understand the relationship between the financial and real economies, the credit markets can provide clearer indicators that a recession is on the horizon.

Collective wisdom falls short

Subscribers to the theory that markets process all information efficiently would argue that equity investors should be in very good shape to recognize early indications of a looming downturn. If that were indeed the case, current market valuations might inspire confidence. … And since equity markets do a reasonably good job of tracking long-term economic fundamentals,² investors can expect longer-term returns—dividends and share price appreciation—that are in line with historical real returns, in the range of 6 to 7 percent.
Of course, the fact that the stock market is currently in line with the long-term trend doesn’t rule out the possibility of major fluctuations on the way to the longer term. The performance of equity markets shows that they have not been a good predictor of past recessions. Indeed, during every major recession since the early 1970s, most of the decline in the S&P 500 index occurred after the economy had already slowed (Exhibit 1). … Our analysis suggests that the equity markets give too much weight to current economic activity rather than to the situation likely to materialize in a couple of months or even a year.

Exhibit 1: Most of the decline in equity markets comes after a recession has already begun.

Moreover, when the index’s value does drop during nonrecessionary periods, this rarely signals a coming downturn. In the past 30 years, there have been few major declines in the market outside of recessions (Exhibit 2). Even an extreme case, such as the 20 percent drop during a couple of days in 1987, didn’t portend a systemic downturn, and the index was back to normal a mere two months later. In the past, such market fluctuations have been caused mostly by forces that didn’t have anything to do with the real economy—and any effect they had dissipated very quickly. Equity markets played the more typical role of bystander, buffeted by and reacting to economic events rather than anticipating them.

Exhibit 2: Stock market declines do not indicate economic downturns.

While the equity markets may not predict economic trends well, their depth does provide investors with liquidity, so they generally continue to function smoothly even in difficult times. … During that time, the S&P 500’s long-term trend value—the value you would expect to see if you were confident that the economy would recover to its long-term trend within several years—stood at about 1,100–1,300. Therefore, no one should have been surprised to see a drop to the 900–1,000 level, given uncertainty about the depth and duration of the recession. …

Incubators of crisis

Unlike equity markets, credit markets don’t always function smoothly during difficult times. That, in part, is why they are a better source of clues about where the economy is heading. The credit markets are where crises develop—and then filter through to the real economy and drive downturns in the equity markets. Indeed, some sort of credit crisis has driven most major downturns over the past 30 to 40 years (Exhibit 3). Such crises include not only the recent property debacle in the United States and the 1990 one in Japan but also the crises generated by excessive government borrowing in Latin America in 1980 and by excessive corporate borrowing in Southeast Asia in 1997. So executives who find reasons for optimism in today’s equity market levels might be less sanguine looking at today’s credit markets. It’s still not clear whether prices have stabilized in once overheated real-estate markets. Banks are still somewhat vulnerable. And the level of government debt in the United States and elsewhere is still an issue.

Exhibit 3: Most major downturns in the past 30 to 40 years have been driven by some sort of credit crisis.

Moreover, the pattern of crisis development shows clearly enough that the one thing we can know for certain is that economic crises will erupt in the future—in part because the credit markets work almost as if designed to cause them. That may be a provocative point, but consider this:

• The credit markets are extremely illiquid. The trading volume of most equities is many orders of magnitude greater than that of typical debt instruments. … This illiquidity sometimes makes it difficult for banks or other investors to sell credit assets at a reasonable price. In addition, providers of short-term credit—to banks, hedge funds, and other financial institutions—may be simply unwilling to extend new credit when old debt comes due, forcing debtors to sell assets to pay down debt just as they are least sellable.
• The banking system and many investors, particularly hedge funds, earn a significant portion of their profits on the mismatch between their assets and liabilities: they invest in longer-term loans and other investments and borrow with short-term deposits and debt. … Normally, this formula works well. But two things can happen to disrupt it. Sometimes the yield curve inverts, with short-term interest rates higher than long-term rates; then, normal banking profits disappear. More important, short-term credit markets sometimes freeze up, so banks, hedge funds, or financial institutions can’t get short-term debt at a reasonable price, or any price. As a result, they sell assets at distressed prices—if they can find buyers.
• The system suffers from chronic group-think. … Banks and investors observe which banks or other investors seem to be making the highest profits and then implement similar strategies. If contrarians in the market were to counterbalance credit excesses, the system should stay in equilibrium. But the system makes it very difficult for investors with contrarian views to apply them. …
• Expectations of government bailouts create tremendous moral hazard—… If the European Union hadn’t been expected to step in and rescue the country, the spreads on its debt would have been much higher, years before the crisis hit, relative to, say, German bonds or other euro bonds, given the enormous levels of government debt and its large social obligations. Instead, investors assumed that the EU or one of its members would bail out Greece and continued to lend to it at rates far below levels that would have reflected the true risk of the debt. And in the end they were right, as the EU stepped in.

Unfortunately, it takes several years for crises to develop, and once the conditions are in place, they are nearly inevitable. The only way to stop one is to anticipate it years in advance; for example, preventing the US subprime crisis would have required clamping down on borrowing in 2005. Avoiding the crisis in Greece would have required something similar in 2005, 2006, or even earlier.

Foreshadowing a downturn

The good news, relatively speaking, for managers of companies is that because the conditions for a crisis are in place several years in advance, it is possible to see the signs of one coming—and to avoid getting caught up in credit market hazards.³

Loose lending standards

One clear sign of trouble ahead is a deterioration of lending criteria. … [During] the 2005 real-estate bubble in the United States, buyers with little or no evidence of their ability to carry a mortgage could purchase houses.

Unusually high leverage

Another warning sign of crisis is unusually high debt levels and mismatches between assets and liabilities, whether by financial institutions, companies, governments, or individuals. For example, in the months leading up to the real-estate crisis that erupted in 2007, the leverage of both banks and consumers in the United States was at unusually high levels. In addition, many consumers were financing their homes—long-term, illiquid assets—with debt in the form of adjustable-rate mortgages that had the characteristics of short-term debt.
In the 1997 Asian crisis, companies financed production facilities—obviously long-term investments—with debt in US dollars. When the dollar strengthened, borrowers needed more local currency cash flows to service the debt. And as hedge funds have grown over the past decade, the importance to their returns of their financing model—short-term debt to finance less liquid assets at very high leverage levels of 90 percent or more—has largely been left unspoken. The general public couldn’t see how leveraged these funds were, but the banks lending to them could. And even with full access to their balance sheets, no single bank was willing to give up the business as long as the hedge funds were profitable customers.

Transactions without value

It isn’t always easy for casual observers to notice, but subtle signs often indicate that financial transactions are proliferating even when they aren’t creating value (for example, by substantially easing the allocation of capital). Indeed, many collateralized debt obligations, such as those blamed for the great credit crisis that resulted in the demise of Lehman Brothers two years ago, fall into this category. … Whenever a company tries to take debt off its balance sheet, investors would be well advised to wonder why. These transactions generate a lot of fees for bankers but rarely create any value.
Watching the equity markets for signs of future crises or downturns is unlikely to provide the kind of advance notice that can inform strategic decisions. Executives with the tenacity to follow the many moving parts of the credit markets are likely to be better prepared when the economy does turn sour.

About the Author

Tim Koller is a principal in McKinsey’s New York office.

Notes

¹ “Economic Conditions Snapshot, September 2010: McKinsey Global Survey results,” mckinseyquarterly.com, September 2010.
² See Richard Dobbs, Bill Huyett, and Tim Koller, Value: The Four Cornerstones of Corporate Finance, Hoboken, NJ: Wiley, November 2010.
³ Indeed, US industrial companies that entered the crisis with healthy balance sheets were able to withstand the crisis reasonably well, precisely because they were not overleveraged and had sufficient cash reserves to be flexible as the crisis wore on.

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Investors Tap Into 401(k) Money Tax-Free for Business Startups

BusinessWeek

May 27, 2010, 6:28 AM EDT

By Amy Feldman

May 27 (Bloomberg) -- Hal Mottet, a Lake Oswego, Oregon, businessman bought a family-owned packaging company for $3.5 million in late 2007, and he and a partner financed 40 percent of the sales price with their retirement money.

Mottet and his partner used a loophole in U.S. tax law to roll over $1.4 million from their existing 401(k) retirement plans to finance the purchase of Carson, California-based Empire Container Corp. The strategy saved them taxes and penalties they would have faced for cashing out the plans.

“If we hadn’t done it this way, we would have had at least $1 million more debt, and we wouldn’t have made it through the recession,” said Mottet, 51, who’s now chief executive of the firm. “It’s been a fantastic investment.”

Transactions like Mottet’s let entrepreneurs access their retirement funds without tax consequences. Withdrawals from 401(k)s are generally subject to income taxes on the proceeds, and cashouts done before age 59 1/2 incur a 10 percent penalty, according to the Internal Revenue Service.

Here’s how it typically works: An investor sets up a corporation, establishes a new 401(k) plan there, rolls over his or her existing 401(k) or Individual Retirement Account, and then uses part or all of the plan’s assets to buy shares of the new company. This funds the new business, while keeping the tax- advantages of the retirement plan.

The transactions have drawn the scrutiny of the IRS, which dubbed them ROBS, for Rollovers as Business Startups, and said in an October 2008 memo that some may run afoul of the law. The IRS is coordinating efforts with the Department of Labor because these rollovers may also raise issues under the rules that govern retirement plans, according to the memo.

Not ‘Home Free’

“Like many other recently marketed tax savings strategies that appear to have been designed to take advantage of the law, ROBS arrangements, designed to fit within existing law and guidance, do not present a ‘home free’ result,” the IRS said in a November 2008 newsletter. “In fact, they may violate the law.”

Among the issues the IRS found were prohibited transactions, questionable valuations of the company stock, and a failure for the rollover retirement plans to be available to employees other than the principal owner. …

Monika Templeman, acting director of employee plans for the IRS, said the agency would be reviewing these rollover transactions, and auditing them on a case-by-case basis over the next few years.

“It can be done just right, but we’re seeing problems,” Templeman said. “It’s open to abuse because of the structure, and the promoters are taking advantage of that.”

‘Saber Rattling’

In cracking down on tax shelters, the IRS generally goes after the promoters of a shelter, she said. She declined to say if the IRS was targeting any rollover promoter.

Stephen Dobrow, president of Primark Benefits, a Burlingame, California-based benefits consulting firm, called the IRS memo “saber rattling,” and said he expected increased IRS auditing of the transactions….

The rollovers are a relatively inexpensive way to finance a new business, said Jeremy Ames, chief executive of Bellevue, Washington-based Guidant Financial Group, which advised Mottet on the process. …

Cashing Out

…Joanna and Frederick Neubert, of Cleveland, South Carolina, used a 401(k) rollover to buy a residential cleaning franchise in 2004, after both were laid off from corporate jobs. The Neuberts used the entire $118,000 proceeds from their 401(k) plans, Joanna Neubert said. Last December they closed the business.

Risking Future

The result for the Neubert’s retirement savings: The business was valued at zero, and their 401(k) savings are gone, according to Joanna Neubert.

Of the rollovers that the IRS has reviewed, many of their sponsors had gone bankrupt, Templeman said.

“Our thinking tends to be that if you can’t raise enough money with friends and family and people who find your business compelling, it may not be a business that should be started,” said Dan Rosen, a principal in the Lexington, Massachusetts, office of venture capital firm Highland Capital Partners.

“There are a lot of ways to get a business funded without risking your future,” he said.

Investors using this strategy also may face risk of an audit. If a rollover transaction is deemed to be a tax shelter, its plan sponsor or manager may be subject to excise taxes, in addition to regular taxes and penalties, according to IRS regulations. …--Editors: Rick Levinson, Rob Urban.

To contact the reporter on this story: Amy Feldman in New York at afeldman16@bloomberg.net.

To contact the editor responsible for this story: Rick Levinson at rlevinson2@bloomberg.net.

Why value value?--defending against crises

Companies, investors, and governments must relearn the guiding principles of value creation if they are to defend against future economic crises.

McKinsey Quarterly - Corporate Finance – Valuation

APRIL 2010 • Timothy M. Koller

In response to the economic crisis that began in 2007, several serious thinkers have argued that our ideas about market economies must change fundamentally if we are to avoid similar crises in the future. Questioning previously accepted financial theory, they promote a new model, with more explicit regulation governing what companies and investors do, as well as new economic theories.

My view, however, is that neither regulation nor new theories will prevent future bubbles or crises. This is because past ones have occurred largely when companies, investors, and governments have forgotten how investments create value, how to measure value properly, or both. The result has been a misunderstanding about which investments are creating real value—a misunderstanding that persists until value-destroying investments have triggered a crisis.

Accordingly, I believe that relearning how to create and measure value in the tried-and-true fashion is an essential step toward creating more secure economies and defending ourselves against future crises. The guiding principle of value creation is that companies create value by using capital they raise from investors to generate future cash flows at rates of return exceeding the cost of capital (the rate investors require as payment). …The combination of growth and return on invested capital (ROIC) relative to its cost is what drives value. Companies can sustain strong growth and high returns on invested capital only if they have a well-defined competitive advantage. …

The corollary of this guiding principle, known as the conservation of value, says anything that doesn’t increase cash flows doesn’t create value.¹ For example, when a company substitutes debt for equity or issues debt to repurchase shares, it changes the ownership of claims to its cash flows. However, it doesn’t change the total available cash flows,² so in this case value is conserved, not created. …

These principles have stood the test of time. Economist Alfred Marshall spoke about the return on capital relative to the cost of capital in 1890.³ … Using them to create value requires an understanding of both the economics of value creation (for instance, how competitive advantage enables some companies to earn higher ROIC than others) and the process of measuring value (for example, how to calculate ROIC from a company’s accounting statements). With this knowledge, companies can make wiser strategic and operating decisions, such as what businesses to own and how to make trade-offs between growth and returns on invested capital—and investors can more confidently calculate the risks and returns of their investments.

Market bubbles

During the dot-com bubble, managers and investors lost sight of what drove ROIC …When Netscape Communications went public in 1995, the company saw its market capitalization soar to $6 billion on an annual revenue base of just $85 million, an astonishing valuation. This phenomenon convinced the financial world that the Internet could change the way business was done and how value was created in every sector, setting off a race to create Internet-related companies and take them public. …

Many of the companies born in this era, including Amazon.com, eBay, and Yahoo!, have created and are likely to continue creating substantial profits and value. But for every solid, innovative, new business idea, there were dozens of companies that turned out to have virtually no ability to generate revenue or value in either the short or the long term. …

Many executives and investors either forgot or threw out fundamental rules of economics … Consider the concept of increasing returns to scale—also known as “network effects” or “demand-side economies of scale”—an idea that enjoyed great popularity during the 1990s in the wake of Carl Shapiro and Hal Varian’s book Information Rules: A Strategic Guide to the Network Economy.⁴ The basic idea is this: in certain situations, as companies get bigger, they can earn higher margins and returns on capital because their product becomes more valuable with each new customer. In most industries, competition forces returns back to reasonable levels. But in industries with increasing returns, competition is kept at bay by the low and decreasing unit costs incurred by the market leader (hence the “winner takes all” tag given to this kind of industry).

Take Microsoft’s Office software, a product that provides word processing, spreadsheets, and graphics. As the installed base of Office users expanded, it became ever more attractive for new customers to use Office as well, because they could share their documents, calculations, and images with so many others. Potential customers became increasingly unwilling to purchase and use competing products. Because of this advantage, in 2009 Microsoft made profit margins of more than 60 percent and earned operating profits of approximately $12 billion on Office software—making it one of the most profitable products of all time.

As Microsoft’s experience illustrates, the concept of increasing returns to scale is sound economics. What was unsound during the Internet era was its misapplication to almost every product and service related to the Internet. …To illustrate, some analysts applied the idea to mobile-phone service providers, even though mobile customers can and do easily switch providers, forcing the providers to compete largely on price. With no sustainable competitive advantage, mobile-phone service providers were unlikely ever to earn the 45 percent ROIC that was projected for them. …

The history of innovation shows how difficult it is to earn monopoly-sized returns on capital for any length of time except in very special circumstances. …

When the laws of economics prevailed, as they always do, it was clear that many Internet businesses, … did not have the unassailable competitive advantages required to earn even modest ROIC. The Internet has revolutionized the economy, … but it did not and could not render obsolete the rules of economics, competition, and value creation.

Financial crises

Behind the more recent financial and economic crises beginning in 2007 lies the fact that banks and investors forgot the principle of the conservation of value. … First, individuals and speculators bought homes—illiquid assets, meaning they take a while to sell. They took out mortgages on which the interest was set at artificially low teaser rates for the first few years but then rose substantially when the teaser rates expired and the required principal payments kicked in. In these transactions, the lender and buyer knew the buyer couldn’t afford the mortgage payments after the teaser period ended. But both assumed either that the buyer’s income would grow by enough that he or she could make the new payments or that the house’s value would increase enough to induce a new lender to refinance the mortgage at similar, low teaser rates.

Banks packaged these high-risk debts into long-term securities and sold them to investors. The securities too were not very liquid, but the investors who bought them—typically hedge funds and other banks—used short-term debt to finance the purchase, thus creating a long-term risk for whoever lent them the money.

When the interest rate on the home buyers’ adjustable-rate debt increased, many could no longer afford the payments. Reflecting their distress, the real-estate market crashed, pushing the values of many homes below the values of the loans taken out to buy them. At that point, homeowners could neither make the required payments nor sell their houses. Seeing this, the banks that had issued short-term loans to investors in securities backed by mortgages became unwilling to roll over the loans, prompting the investors to sell all such securities at once. The value of the securities plummeted. Finally, many of the large banks themselves owned these securities, which they, of course, had also financed with short-term debt that they could no longer roll over.

This story reveals two fundamental flaws in the decisions made by participants in the securitized mortgage market. They assumed that securitizing risky home loans made the loans more valuable because it reduced the risk of the assets. This violates the conservation-of-value rule. Securitization did not increase the aggregated cash flows of the home loans, so no value was created and the initial risks remained. Securitizing the assets simply enabled their risks to be passed on to other owners: some investors, somewhere, had to be holding them. Yet the complexity of the chain of securities made it impossible to know who was holding precisely which risks. After the housing market turned, financial-services companies feared that any of their counterparties could be holding massive risks and almost ceased to do business with one another. This was the start of the credit crunch that triggered a recession in the real economy.

The second flaw was to believe that using leverage to make an investment in itself creates value. It does not, because … it does not increase the cash flows from an investment. Many banks used large amounts of short-term debt to fund their illiquid long-term assets. This debt … increased the risks of holding their equity.

Excessive leverage

As many economic historians have described, aggressive use of leverage is the theme that links most major financial crises. …

In the past 30 years, the world has seen at least six financial crises that arose largely because companies and banks were financing illiquid assets with short-term debt. …

Market bubbles and crashes are painfully disruptive, but we don’t need to rewrite the rules of competition and finance to understand and avoid them. Certainly the Internet … has not created a “New Economy,” as the 1990s catchphrase went. On the contrary, it has made information, especially about prices, transparent in a way that intensifies old-style market competition in many real markets. … [The] key to avoiding the next crisis is to reassert the fundamental economic rules, not to revise them. If investors and lenders value their investments and loans according to the guiding principle of value creation and its corollary, prices for both kinds of assets will reflect the real risks underlying the transactions.

Equity markets

Contrary to popular opinion, stock markets generally continue to reflect a company’s intrinsic value during financial crises. For instance, after the 2007 crisis had started in the credit markets, equity markets too came under criticism. In October 2008, a New York Times editorial thundered, “… In the last month or so, shares in Bank of America plunged to $26, bounced to $37, slid to $30, rebounded to $38, plummeted to $20, sprung above $26 and skidded back to almost $24. Evidently, people don’t have a clue what Bank of America is worth.”⁵ … [This] example points out the fundamental difference between the equity markets and the credit markets. The critical difference is that investors could easily trade shares of Bank of America on the equity markets, whereas credit markets (with the possible exception of the government bond market) are not nearly as liquid. This is why economic crises typically stem from excesses in credit rather than equity markets.

The two types of markets operate very differently. Equities are highly liquid because they trade on organized exchanges with many buyers and sellers for a relatively small number of securities. In contrast, there are many more debt securities than equities … and even more derivatives, many of which are not standardized. The result is a proliferation of small, illiquid credit markets. Furthermore, much debt doesn’t trade at all. … Illiquidity leads to frozen markets where no one will trade or where prices fall to levels far below that which reflect a reasonable economic value. Simply put, illiquid markets cease to function as markets at all.

During the credit crisis that began in 2007, prices on the equity markets became volatile, … The volatility reflected the uncertainty hanging over the real economy. The S&P 500 index traded between 1,200 and 1,400 from January 2008 to September 2008. In October, … the index began its slide to a trading range of 800 to 900. But that drop of about 30 percent was not surprising given the uncertainty about the financial system, the availability of credit, and its impact on the real economy. Moreover, the 30 percent drop in the index was equivalent to an increase in the cost of equity of only about 1 percent,⁶ reflecting investors’ sense of the scale of increase in the risk of investing in equities generally.

… Many investors were apparently sitting on the market sidelines, waiting until the market hit bottom. The moment the index dropped below 700 seemed to trigger their return. From there, the market began a steady increase—reaching about 1,100 in December 2009. Our research suggests that a long-term trend value for the S&P 500 index would have been in the 1,100 to 1,300 range at that time, a reasonable reflection of the real value of equities.

In hindsight, the behavior of the equity market has not been unreasonable. It actually functioned quite well in the sense that trading continued and price changes were not out of line with what was going on in the economy. … [Equity] markets rarely predict inflection points in the economy.⁷

About the Author

Tim Koller is a partner in McKinsey’s New York office. This article is excerpted from Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of Companies (fifth edition, Hoboken, NJ: John Wiley & Sons, August 2010). Tim Koller is also coauthor, with Richard Dobbs and Bill Huyett, of a forthcoming managers’ guide to value creation, titled Value: The Four Cornerstones of Corporate Finance (Hoboken, NJ: John Wiley & Sons, October 2010).

Notes

¹ Assuming there are no changes in the company’s risk profile.

² Indeed, the tax savings from debt may increase the company’s cash flows.

³ Alfred Marshall, Principles of Economics, Volume 1, New York: Macmillan, 1920, p. 142.

⁴ Carl Shapiro and Hal R. Varian, Information Rules: A Strategic Guide to the Network Economy, Boston: Harvard Business School Press, 1998.

⁵ Eduardo Porter, “The lion, the bull and the bears,” New York Times, October 17, 2008.

⁶ Richard Dobbs, Bin Jiang, and Timothy M. Koller, “Why the crisis hasn’t shaken the cost of capital,” mckinseyquarterly.com, December 2008.

⁷Richard Dobbs and Timothy M. Koller, “The crisis: Timing strategic moves,” mckinseyquarterly.com, April 2009.

The Upside of Irrationality

The discoveries by Duke’s Dan Ariely on how investors make decisions may transform your wealth management practice

Investment Advisor Magazine

• Olivia Mellan

4/1/2010

"We are all far less rational in our decision-making than standard economic theory assumes. Our irrational behaviors are neither random nor senseless: they are systematic and predictable. We all make the same types of mistakes over and over, because of the basic wiring of our brains."

That’s the financial world as Dan Ariely sees it. A professor of psychology and behavioral economics at Duke University, Dr. Ariely has wondered for years why people often don’t act in their own best interest. In 2008 he wrote about his research in Predictably Irrational: The Hidden Forces That Shape Our Decisions, which he updated last year with observations on the financial crisis. …

Other People’s Money Ariely disagrees with the assumption that people who deal with large amounts of money usually make more rational decisions about it. From investment bankers to mortgage brokers, he says, "a big part of the cause of the financial meltdown was conflict of interest."

While Ariely believes that most people are honest, he says that bad things can happen when you place good people into conflict-of-interest situations. "Imagine that I gave you $10 million a year if you were able to view mortgage-backed securities as a good product," he suggests. "Wouldn’t you be able to see them as better than they are? Of course you would."

What’s more, he adds, "when things like complex financial instruments are difficult to evaluate, it’s easier for us to rationalize unethical behavior and the effects of conflicts of interest become larger. Finally, when other people around us behave similarly, conflicts of interest rule even more." … Ariely concludes, "I think it’s inhumane to put people in strong conflict-of-interest situations and expect them to behave well."

… Interestingly, Ariely’s research finds that cheating is a lot more prevalent when it’s a step removed from cash. In Predictably Irrational, he recounts an experiment in which he first placed six cans of Coke in a refrigerator accessible to college students. All six cans were soon pilfered. He then placed six $1 bills on a plate in the same refrigerator. By the time he ended the experiment 72 hours later, none of the cash had been taken.

Ariely concludes, "When we deal with cash, we are primed to think about our actions as if we had just signed an honor code." … "When cash is taken away—and that’s what’s happening to our economic system," Ariely warns, "we will cheat by a factor bigger than we could ever imagine." Talk about a wake-up call.

Escaping Conflict-of-Interest Risks "This is a very hard time to have trust in financial advisors," Ariely says. He elaborates, "There are two kinds of trust: one is real trust, and the other is sticking a camera on someone to make sure they don’t behave badly." Today, we often opt for surveillance rather than trust. …

"Real trust is wonderful," Ariely says. But after this financial crisis, he feels that the time-consuming process of regaining it has to begin with a high degree of transparency. Unfortunately, Ariely told me, our government, legislators, and banks don’t seem to recognize what it will take to regain people’s confidence and trust. He keeps hoping some bank will break away from the herd to eliminate conflicts of interest and model full transparency—not just because it’s the moral thing to do, but because they understand that engendering trust is the best way to solve the liquidity problem. Without such bold actions, he fears we will not escape "this economic mess."

… Moving to fee-only compensation helps reduce conflict-of-interest perceptions, Ariely says, but it doesn’t solve everything. "Even with fee-only, they only get to keep the fee if they keep the client, so even if they really think at the moment that they’re doing the right thing, they’re biased to make the client happy." …

‘Hot States’ and Risk Tolerance In these turbulent times, investing in the stock market is not for the faint of heart. "The real issue for advisors is to protect people against themselves," Ariely says. He believes advisors can do more to help their clients truly understand how a loss would impact their life. "Imagine you come to me as your financial advisor," he suggests. "I ask how much are you willing to lose, and you say 20%. A little later I call you and say, ‘You lost 20%; do you want to change your risk tolerance?’"

Perceptions of any kind of risk can change dramatically when people go from a cold state, where they tend to make sound and rational decisions, to an emotional, hot state where they’re more likely to behave impulsively and irrationally. …

Ariely agrees with me that risk tolerance should be calibrated for a client’s cold state, while taking their hot (more emotional and risk-averse) state into account. In one experiment, he asked male college students whether they would engage in unsafe, kinky, or morally questionable sexual behavior. Most of the men responded negatively. Before questioning them again, he showed them erotic pictures. Thus aroused, the men were about twice as likely to say they would have unsafe sex or try to get an attractive woman drunk to seduce her. In short, they themselves failed to predict how they would feel when aroused. Other passions—rage, hunger, jealousy—may similarly make us strangers to ourselves….

Procrastination and Self-Control When emotions grab hold of us, we view the world from a different perspective. In a cold state, as Ariely calls it, we promise to save money, exercise, diet, and so on. But when we are in a hot state or aroused in some way, we feel that we have to have that new car, designer shoes, e-reader, etc. To help people start saving more money, Ariely came up with a creative idea: a "self-control" credit card that allows users to restrict their own spending behavior. Cardholders would set spending limits for clothes, entertainment, food, whatever. …

When Ariely presented this innovative concept to one of the major banks a few years ago, its executives could relate to everything he said about the terrible human costs of impulsive overspending. But when he went on to describe his idea, they seemed dumbfounded. Ariely argued that if one bank had the courage to offer consumers a card that helped them control debt and accumulate retirement savings, people would cut up their other cards and flock to this bank.

Despite the bankers’ promise to follow up on the idea, nothing ever happened. Ariely wonders if this was due to procrastination or to a conflict of interest: i.e., the potential loss of up to $17 billion in interest charges. …

Ariely comes back to the problem of not saving enough for retirement in Predictably Irrational. He blames "good old procrastination," as well as people’s inability to understand "the real cost of not saving as well as the benefits of saving." Along with the self-control credit card, he favors the Save More Tomorrow plan devised by Richard Thaler and Shlomo Benartzi. In the plan’s first implementation, a company’s new employees were asked to commit in advance to investing a portion of future raises in retirement savings. Since promising to change one’s behavior in the future is relatively painless, 78% of those eligible took part, increasing their average savings rate from 3.5% to 11.6% over the following 28 months. Ariely calls ideas like these "free lunches" that benefit all the parties involved.

Creating Loyalty: Money vs. Mutual Aid Another aspect of our predictable irrationality around money relates to loyalty toward others. In a purely social environment, people often make generous and altruistic choices. But the moment money is introduced, we lose our altruistic impulses and want to get the best possible deal for ourselves. This can become a problem for a business that insists it cares about its customers and/or employees. … A company can’t have it both ways, Ariely says. "If you want a social relationship, go for it, but remember that you have to maintain it under all circumstances."…

… Ariely points out in Predictably Irrational, money is an expensive way to motivate people. … "In a market where employees’ loyalty to their employers is often wilting, social norms are one of the best ways to make workers loyal, as well as motivated," he argues. Treating employees like "family" or members of a team tends to make them more "passionate, hard-working, flexible, and concerned." However, companies that model a social exchange must remember that they can’t expect employees to take on more work, put in longer hours, and travel at the drop of a hat without providing loyalty in return. This means helping them when they’re sick and keeping them employed when a market slump threatens their jobs. …

The Paradox of Big Paychecks After experimenting with different levels of salary and job performance, Ariely concludes that financial rewards can be a double-edged sword: "They motivate people to work well, but when these financial rewards get very large they can become counterproductive and actually hurt performance." When people start making tremendously high compensation, he explains, they are driven by the amount of the bonus, the stress involved in attaining it, and the fear of not getting it, instead of doing the best job they can. …

Asking the Right Question Sometimes we’re so intent on acting rationally that we don’t realize we’ve veered off into irrationality. For example, Ariely points out that during the mortgage market bubble, home buyers accepted that the key question was "How much house can I afford?" Many who believed the answer (and borrowed the maximum) have ended up defaulting. No one asked the right question: "Given our financial situation, how much should we spend on a house?" or its corollary: "How much should we borrow on a 30-year mortgage?"

Ariely says this is a lesson in human decision-making. When we can’t determine the right answer to the question facing us, we often figure out the answer to a slightly different question and apply this to the original problem. …

Why Can’t We Plan Better? "Rational economics is useful, but it offers just one type of input into our understanding of human behavior," Ariely writes in Predictably Irrational. "Relying on it alone is unlikely to help us maximize our long-term welfare." He cites several ways our emotions can hinder us from doing what’s in our best interest:

1. Relativity Error.

We often think we’re making enough money until we hear of someone in a similar job who earns more. …The only cure for this vicious cycle of "the more we have, the more we want," Ariely says, is to stop comparing oneself to others. …

2. The "Free" Fancy. Ariely’s research shows that once something is offered for free, people will stampede to get it, even if it winds up costing them money at a later date. …

3. Ownership Bias.

Simply put, we think what we own is worth more than it really is. Ariely finds that decisions to sell something (a car, a house) and buy a replacement are influenced by three human quirks: we fall in love with what we already have, focus on what we may lose instead of what we may gain, and assume other people will see things from our perspective. He counsels himself (and us) to "try to view all transactions (particularly large ones) as if I were a non-owner, putting some distance between myself and the item of interest." …

4. The "Price Equals Value" Perception. Ariely phrases this as "why a 50-cent aspirin can do what a penny aspirin can’t." …If you’ve been afraid to raise your rates even a little, you might try testing this irrational belief that more expensive goods and services are better.

5. The Planning Fallacy.

… Ariely adds that we often can’t plan well because we underestimate how long it will take to complete a task. This trips us up in deciding what we can and can’t afford, and what we should and shouldn’t buy. As a result, many of us don’t have a cushion when the unexpected happens.

Using Predictable Irrationality for Good As predictably irrational beings, Ariely says, "we are pawns in a game whose forces we largely fail to comprehend." We think of ourselves as sitting in the driver’s seat, but in reality our decisions are limited by the tools nature has given us. …

On a personal level, it’s good to be vigilant about a tendency to act emotionally. "Trust your intuition only after you have evidence that it’s useful," Ariely counsels. "Intuition is based on emotions, which are all about the short term; investment decisions are not."

… Ariely suggests that when you’re facing a hiring decision or deciding who to date, try testing your intuition by doing the opposite and seeing if it works out. Otherwise, you’ll never know whether or not your instinct is right. Don’t be discouraged by mistakes; they’re very educational. …

He also advises combining "immediate, powerful, and positive reinforcements with the not-so-pleasant steps we have to take toward our long-term objectives." An example might be watching a favorite TV show while exercising on a treadmill.

On a larger scale, businesses and policymakers could develop products and procedures that help us overcome our inability to act in our best interests, so we can make better decisions and improve our lives. In Predictably Irrational, Ariely quotes a Duke University colleague, Ralph Keeney, as saying that "our inability to make smart choices and overcome our own self-destructive behaviors" leads nearly half of us to early graves.

But we are not helpless. Ariely, who is already at work on a new book titled The Upside of Irrationality, urges us to "learn to embrace the Homer Simpson within us, with all our flaws and inabilities." By taking our predictable irrationality into account when we design schools, health plans, and other strategies, tools, and systems, we can create a better world. "This," he says, "is the real promise of behavioral economics."

SIDEBARS Stuck in the Status Quo? Why Women Should Take the Wheel Ariely on Retirement Planning The Risk of Parental Lassez-Faire Professor Ariely's Insights: In Brief

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Olivia Mellan

, a speaker, coach, and business consultant, is the author with Sherry Christie of The Client Connection: How Advisors Can Build Bridges That Last, available through the Investment Advisor Bookstore at www.invest-store.com/investmentadvisor. She also offers money psychology teleclasses for financial advisors and for the general public. E-mail Olivia at moneyharmony@cs.com.

Congress restores incentives to make SBA loans more attractive

Memphis Business Journal

Memphis Business Journal - by Kent Hoover

Congress … restored incentives that made Small Business Administration loans more attractive for borrowers and lenders.
The $636 billion defense bill that was signed into law Dec. 21 includes $125 million for the SBA, which the agency will use to increase the government guarantee on its flagship 7(a) loans to 90%. The funds also will enable the SBA to eliminate fees for borrowers on its 7(a) loans and 504 loans, which primarily finance real estate. This will return the guarantee and fees to where they were before Nov. 23, when the SBA ran out of the economic stimulus funds that enabled the agency to make these enhancements.
The new funding, however, is expected to last only through Feb. 28, 2010. The House, in a separate jobs bill, appropriated $354 million to keep the higher guarantee and lower fees in place through Sept. 30, 2010. That extension awaits Senate approval.
“We’re hopeful that it gets done,” said Tony Wilkinson, president and CEO of the National Association of Government Guaranteed Lenders.
…The SBA “needs to be stepping up and filling that void,” [Wilkinson] said. Given the constraints on bank lending, “this is pretty much the only game in town.”
The SBA’s normal guarantee on 7(a) loans ranges from 75% to 85%, depending on the size of the loan. The higher guarantee made SBA loans even less risky for lenders, and the fee reductions made the loans more affordable.
“These changes proved very effective at jump-starting small business lending, and the need to continue them is clear,” said Sen. Mary Landrieu, D-La., who chairs the Senate Small Business and Entrepreneurship Committee.
…The SBA set up a waiting list for borrowers and lenders who wanted loans with a higher guarantee or reduced fees if more money for these breaks became available. As of Dec. 21, there were 838 loans totaling $431 million sitting in the 7(a) loan queue, and 192 loans totaling $114 million in the 504 queue.
President Barack Obama, who urged Congress to renew the stimulus-funded breaks on SBA loans, also favors increasing the size limits on SBA loans. This, he said, would enable more businesses to expand and hire more workers as the economy recovers.
Landrieu’s committee approved legislation Dec. 17 that would increase the maximum size of 7(a) loans from $2 million to $5 million. The bill would increase the size limit on regular 504 loans, which are paired with conventional loans, from $1.5 million to $5 million. The loan limit for small manufacturers or projects that meet certain energy guidelines would increase from $4 million to $5.5 million.
This legislation also would allow businesses to refinance short-term commercial real estate into a long-term, fixed-rate 504 loan.
Kent Hoover is Washington bureau chief for American City Business Journals. He can be reached at (703) 816-0330 or khoover@bizjournals.com

Goldman Sachs, Buffett to help small businesses

Goldman Sachs teams with Warren Buffett on $500 million effort to help small businesses
Yahoo! Finance

• On 10:57 pm EST, Tuesday November 17, 2009

NEW YORK (AP) -- Goldman Sachs Group Inc. is teaming with billionaire investor Warren Buffett to invest $500 million to provide thousands of small business owners across America with college scholarships and boost their access to capital.
AP - FILE - In this March 27, 2009, file photo, Goldman Sachs Chief Executive Officer Lloyd Blankfein ...
The move comes as the company has been criticized for setting aside billions for employee paychecks despite the continuing weak economy.
Goldman's philanthropic effort, called "10,000 Small Businesses," includes a $200 million contribution to community colleges, universities and other institutions to give grants to small business owners to further their education.
The New York-based bank also will invest $300 million through a combination of lending and charitable support. Goldman said the money will be funneled through community development financial institutions to boost lending and technical assistance available to small businesses in underserved communities.
In addition, Goldman Sachs executives, in partnership with national and local business organizations, will aid small businesses with advice, technical assistance and professional networking opportunities.
An advisory council co-chaired by Goldman Sachs CEO Lloyd Blankfein will oversee the program. Legendary investor and Goldman's largest shareholder, Warren Buffett, and Harvard Business School Professor Michael Porter will serve as co-chairs as well. …
10,000 Small Businesses, which has been in development for nearly a year, is a five-year program modeled on the Goldman Sachs 10,000 Women initiative, which creates partnerships between academic institutions and non-profits to provide business and management education to women around the world.
Other Council members include George Boggs, president and CEO of the American Association of Community Colleges, Glenn Hubbard, dean of Columbia Business School and Marc H. Morial, president and CEO of the National Urban League, among others.
The first community college to participate will be LaGuardia Community College in New York City's Queens borough, which houses a Small Business Development Center. The first community development financial institution to receive financing from Goldman Sachs will be New York-based Seedco Financial Services Inc., with loans to underserved businesses in the New York area expected to begin early next year.

Know the Score

Financial Planning magazine

By Donald Jay Korn
June 1, 2009
… The days of the nothing-down, no-doc mortgage are gone. Returning to reality, homebuyers need a down payment and proof of income to get a mortgage.
Borrowers must also prove they're creditworthy; they need an acceptable credit score. The higher their score, the more likely applicants will get a loan and the lower the interest rate they'll pay. …
Boosting a credit score by 90 points might save a borrower about $250 a month, or $3,000 a year. … Landlords, employers and insurance companies also may evaluate credit scores…
DECIPHERING SCORES

Despite their importance, little is known about the inner workings of credit scores. …

Consumers have three consumer FICO scores, one from each credit bureau (Equifax, Experian and TransUnion). …

According to Fair Isaac, five components go into its credit scores: payment history (35%), amounts owed (30%), length of credit history (15%), new credit (10%) and types of credit (10%).

… Not surprisingly, clients who pay their debts on time tend to have high credit scores. …
"The fastest way to blow your credit is with a late payment," says Lauren Lindsay, director of financial planning at Personal Financial Advisors in Covington, La. "Even one day late makes a ding in your score." On the other hand, Lindsay says that six months of on-time payments will help to rebuild a credit score.
A consumer who makes one late payment should follow up with the lender or credit card company and explain why the payment was late. "Most of the time, the company will remove the late payment from the record if you call to dispute or explain, especially if you are a good customer," Lindsay says.
A client's payment history and the amount owed are the most important components in a credit score, accounting for 65% of the total. While paying on time is straightforward, it's not clear how high a percentage of available credit is permitted before scores start to drop.
"Consistently paying more than the minimum on all your cards will improve your score," says Bedda D'Angelo, president of Fiduciary Solutions, a financial planning firm in Durham, N.C. "Try to keep the ratio of outstanding debt to available credit under 40%."…
A large amount owed will lower a credit score, even if the payment is not late. …
The old and the new. Length of credit history and new credit account for only 25% of a consumer's credit score, but they are the source of much confusion. "Having accounts with long histories is generally a plus, so consumers are urged to leave older accounts open even if they are rarely used," Dan Moisand, principal of Spraker, Fitzgerald, Tamayo & Moisand, a financial planning firm in Melbourne, Fla., says. "Yet if you don't close accounts, you can get dinged for having too many accounts or too much credit available."

Jennifer Cray, a partner with Investor's Capital Management in Menlo Park, Calif, says that the credit history of a FICO score goes back 99 months. "Some people think the more cards you have, the worse your score, so you should have just one or even none. In fact, closing accounts can hurt your score." Cray advises some clients to use an old card once a year to keep it alive. "I also warn clients not to open new accounts."

GETTING INFORMATION
The more clients know about their credit score, the better. "Everyone is entitled to one free copy of their credit report annually, so I ask clients to provide a copy, …," Bedda D'Angelo, president of Fiduciary Solutions, a financial planning firm in Durham, N.C. says. "Many credit card companies also give people access to their FICO score. When a credit score isn't available for free, I shop online for cost-effective ways to purchase credit scores." At myfico.com, for example, consumers can buy a credit score for $15.95.
Getting a credit score is crucial for clients who need a mortgage or a car. "I have my clients check their FICO scores before applying for a loan," Cray says. "Requesting your own credit reports or scores will not hurt your credit score."…
REPAIR KIT
Some clients with credit scores well below the national median of 723 may need a boost. "Credit repair requires time and patience," D'Angelo says. "It takes 10 years for a bankruptcy to drop off your credit report and seven years for adverse credit reports to drop off. Good things like paying off a car loan or a mortgage drop off after four years."…
In today's times of tight credit, it makes sense for clients to know their credit scores and take steps to improve them-before they need to apply for a mortgage or a car loan. Helping clients buff their scores is another way to keep them at your side.