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By News Staff | March 16th 2010 12:00 AM | 6 comments | Print | E-mail | Track Comments
Questionable lending helped sink the U.S. economy, but also provided a lifeline that kept countless firms afloat and averted an even deeper recession, according to research by University of Illinois finance professor Murillo Campello.

The research was cited by President Obama in a report on the state of the economy, so you know it must be correct.

The survey of corporate executives found that many small and mid-sized firms survived the economic storm by tapping easy, low-cost lines of credit locked in ahead of the downturn, during an era of loose lending that also included sub-prime home mortgages. "These lines of credit were so liquid and so accessible that it made this recession far less acute than it would have been otherwise," he said.

In hindsight, the economy-sparing credit was likely ill advised, similar to the risky mortgages doled out to under-qualified homebuyers that contributed to an economic collapse now dubbed the Great Recession.

Extended amid a robust economy, the credit became potentially toxic for banks when the downturn hit, he said. Interest rates were not adequately risk-adjusted, and banks gave themselves no outlet to deny firms that needed money just to survive, rather than for business-building projects the credit is designed to finance.

"Some bankers made mistakes by authorizing these lines of credit and we're lucky they made those mistakes," Campello said.

"It saved those firms' skin during this recession, but probably won't be as easy to access next time. There will be stricter terms and, of course, higher interest rates."

Campello says lines of credit not only spared small and mid-sized firms from bankruptcy, but also let them emerge from the recession on more solid financial ground. As a result, those firms may now be poised hire and spend, providing a needed jolt as the economy rebounds.

"These companies have more cash, more profits and it may be nearing the point where they will start to hire," said Campello.

The nation's unemployment rate remained flat at 9.7 percent in February after peaking at 10.1 percent in October, but analysts say the job market is beginning to show signs of recovery.

The February jobless report offers promise, including stable manufacturing employment and a 30,000 increase in temporary workers who sometimes move up to full-time in the aftermath of recessions.

How quickly hiring escalates depends on when consumer confidence rebounds and whether the government pumps money into job-creating programs.

"A wild guess would be that employment will stay roughly where it is for six months, then pick up in the third quarter," Campello said. "But everything is still uncertain now. Obama calls this the recession of our lifetime and it is. It's a unique situation, even the recovery we may be looking at."

Comments

Gerhard Adam
Interest rates were not adequately risk-adjusted, and banks gave
themselves no outlet to deny firms that needed money just to survive,
rather than for business-building projects the credit is designed to
finance.

Yes, I guess when you're used to be a thief, having to cut back on your thievery is difficult.  One of the major problems is that companies think they are entitled to money rather than that they have to earn it. 

Of course what the article fails to mention is that while credit may have been helpful, apparently getting free money is even better (i.e. bailout).  The next time such a thing happens, the financial organizations should not only be allowed to fail, but every bad investment should result in potential legal liabilities for those that made the reckless choices.

Talk about a sense of entitlement!

Many of these firms no doubt deserved to go under, and the economy ultimately would have been better off for it.

It's my understanding that lines of unsecured credit, where the lender doesn't have a claim on the borrower's assets, have to be collateralized somehow. A lot of securities that performed that function suddenly went up in smoke, and then it was Uncle Sam who kept the credit flowing by buying trillions of dollars of worthless collateral. Something else we're someday going to regret.

Gerhard Adam
... where the lender doesn't have a claim on the borrower's assets ...

This is another one of those economic fantasies that demonstrates the Pollyanna nature of the business.  Apparently it is not clear to economists that holding a borrower's assets as security against a loan, is only a reasonable guarantee when there are plenty of buyer's in the market.  However, when credit dries up, the lender is left with a fundamentally unsellable asset and no one that can get a loan to buy it.  In short, the entire process locks up and becomes worthless.

The "value" in this case was artificially generated by Uncle Sam putting in the money (as you mentioned), so that the banks had the cash to keep going.  So now after being subsidized by the federal government, the banks have the ability to hold on to such assets until enough of the economy recovers so that they can once again profit from their own greed.

Aitch
I don't think anyone's ever applied scientific principles to the BS about 'economy, capital, loans and ownership' have they?
It's just a game to the 'ferengies' who profit from our stupidity as far as I see

Aitch

PaulN
Yes, it is quite hard to understand all the negative and positive sides of cash payday advance and other types of instant credits. It is not about the credits, it is about people who have taken huge loans even if they haven't afford it. That's why the financial crisis have started. Now everything is getting back and it seems that world wide economical recession have slowed down. There is a chance to take a loan again however we have to be careful with them. Take only that sum that you can afford and everything will be fine. Thanks for the great article by the way. I will be waiting for more financial topics on your blog in the future too.

Gerhard Adam
While I understand your point, I have an objection on the grounds that it is misplaced and inappropriate.  The responsibility for lending money is with the lender and not the borrower.  I don't understand why every business mistake becomes a customer problem.  When businesses make bad investments then the taxpayer or consumer is expected to make up the difference?  When lenders make poor lending decisions then it's the borrower's fault for accepting the loan?

If we're going to have personal responsibility then it begins with those conducting the business.  We don't fault consumers for buying defective products from a manufacturer, so why should we fault them for accepting defective financial instruments from those that should know better.

If a credit card company gives cards to unqualified individuals then they should NOT have the protection of law, any more than any other business has such legal protections from bad decisions.  If I do business with someone that fails to pay me, then I'm forced to sue them to recover my money and I have to follow due process to get results.  Yet, these businesses have the government backing them up to do whatever they like without the benefit of the courts.  They can change the terms of a contract, add whatever fees they like without justification and destroy your personal credit, all without having provided a single shred of legal evidence that their action is justified. 

I've simply had enough of businesses behaving irresponsiby and then paying themselves bonuses while the rest of us pick up the difference.  As a friend of mine said, they like to privatize profits while socializing the liability.

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