Tuesday, October 7, 2008

What were the "Experts" thinking?

As the credit crises progresses, some of the “hardship” stories tell a story far different from the perception. Some of these problems are simply a failure of supposedly responsible individuals not following long established and fundamental financing practices.

One of the basic rules in financing any purchase is that you match the length of the financing to the usable life of the assets. This is the principle that you pay for something as you use it. The simplest example is car financing. If you expect to use the car over a four year period, you get four year note so that as you use the car, you are paying for it.

It appears some borrowers (and likely their supposedly professional advisors) ignored this basic concept, and the results are not pretty.

Some counties are already in financial distress because they didn’t follow this basic concept.

For example, Jefferson County Alabama (Birmingham) expanded and modernized their water and sewer system with a large investment in their system. Instead of financing this the traditional way, with long term bonds (so the bonds would paid off over the life of the assets built) they financed 50% of the construction costs with short-term (30 day) commercial paper. When this market declined and interest rates spiked in this market, the county has been pushed to brink of bankruptcy since they are unable to refinance the thirty day debt.

Other counties, such as Suffolk in New York have run into the same situation.

We wonder what the “expert advisors” were thinking to structure this type of financing. Even on the lender side, someone should have seen this obvious mismatch of financing to the life of the assets.

Perhaps more than we know, the “financial experts” were the ones that were actually clueless.

Many firms screen project opportunities to be sure the owner has financing. Should you also be screening to see if the financing is not viable, rather than just available.

Bill Fanning
Director of Research

No comments:

Follow @PSMJ_Resources