Don’t rely on bank financing!

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I had a conversation this week with David Drees, president of Fort Mitchell, Ky.-based giant The Drees Co. [1] (No. 21 in the recently-released Giant 400 Rankings). He confided to me that the firm’s credit line with a coalition of banks is intact and Drees is, in fact, paying down its debt. He’s looking for alternatives other than bank financing to assure his company has the capital it needs to take advantage of housing market recovery, whenever that happens.

Drees is not confident banks will be able to fund the capital requirements of his firm’s growth in recovery. (You’ll be able to read more about what David Drees thinks about the future in the Aug. 11 issue of Housing Giants.)

From some of the things that have crossed my computer recently, there’s good reason for Drees to be concerned about the credit capacity of his lenders. For instance, Zack Howe of American Shareholders Association recently posted his analysis of the shaky ground investment banks and other financial institutions occupy due to their use of qualified special purpose entities — which are legally separate entities, with their own sets of books — where investment banks have been parking many of their more risky loans. The trouble is, after the transfer, the banks can no longer renegotiate the terms of the loans, which creates problems when defaults loom (like they do now).

Many of these loans came in the form of subprime mortgages, Howe writes, and their defaults were a large spur to the housing crisis. But the jig is now up. The Financial Accounting Standards Board [2] (FASB), the governing body of U.S. accounting rules, recently outlawed use of QSPEs for the purpose of removing mortgage-backed securities from the books of financial institutions. This should encourage the institutions to tighten underwriting standards, because all defaults will now be recognized on their own books.

Then there’s the report that appeared recently in London’s The Financial Times, warning that U.S. banks fear being forced to take back onto their balance sheets $5 trillion in assets. Accounting changes in the coming months will force the moves, the report says, which is likely to curb future lending. Analysts say the tightening of rules regarding off-balance sheet vehicles (I smell a whole bunch of QSPEs) will force such moves. Birgit Specht, head of securitization analysis at Citigroup, is quoted in the Financial Times report: “We think it is very likely that these vehicles will come back on the balance sheet. ...This will not affect liquidity because [they] are funded, but it will affect debt-to-equity ratios [at the banks] and so significantly impact banks’ ability to lend.” Better ask your banker what he knows about QSPEs!