The 2008 financial crisis that shook the global economy did not happen overnight.
It began in 2007 with multiple defaults of the subprime mortgages. On September 15, 2008, the Lehman Brothers collapsed. Its collapse has been attributed to excessive risk-taking and failing to follow regulations among others.
Other financial institutions could have followed the Lehman Brothers but massive bailouts by national governments had to be taken to prevent a collapse of the world financial system.
The crisis resulted from an increased approval rate of high-risk mortgages due to the 2000 housing boom and low-interest rates. When the borrowers went into default, there was a devaluation of mortgage-backed financial instruments. It resulted in a significant decline of buyers for these assets causing a liquidity crisis among banks that were invested in these securities.
The consequences were felt in the stock markets where there was a massive drop, families were evicted from their homes, and there was a decline in economic activity as it became more difficult to borrow money.
Regulation of Banks
The financial crisis opened the government’s eyes to the need for banks to be regulated. It led to the enactment of the Dodd-Frank Wall Street Reform Act which aims to protect consumers and prevent a reoccurrence of the crisis by preventing banks from taking risks that are too high.
Although the regulations protect depositors’ money, they have reduced the availability of 5000 bad credit loans to small businesses that are struggling financially. However, it has opened an opportunity for debt investors who offer high-risk loans at high returns.
Here are some of the investments that involve offering loans to individuals and businesses.
Collateralized Loan Obligations (CLO)
This is an investment focused on leveraged loans. Leveraged loans are high-risk corporate debt given to companies with a low credit rating that banks are unwilling to finance. The loans are sold to a CLO manager who groups 100 to 225 loans together and sells to external investors.
The investor, in this case, buys the bundle of debts with scheduled repayment dates. He or she assumes most of the risk in case the borrower defaults, and for this reason, the returns on CLOs are high.
When a company with a low credit rating is in need of capital for its operations, banks may be unwilling to finance it due to the high-risk involved. The company can then opt to sell debt instruments to investors such as bonds, with an expectation of getting the finances needed.
The investor then provides the capital with a promise from the company of repayment of the principal at a future date. The interest is paid annually. In case the company goes bankrupt, these investors have a higher claim on liquidated assets than the shareholders.
Business Development Companies (BDC)
Business Development Companies are closed-end investment companies that focus on investing in small to medium-sized businesses. They provide loans to these businesses or buy equity stakes. Business Development Companies are a viable choice for startups and financially strained businesses that do not qualify for bank loans.
Investing in BDCs comes with high risk and high yields and is an attractive income vehicle for investors. They are publicly traded and are required to distribute over 90% of their profits to the shareholders.
Peer to Peer Lending (P2P)
This is the use of online services to connect individual borrowers directly with individual investors. It cuts out the financial institutions that act as middlemen. The websites set interest rates based on the creditworthiness of the borrower. Examples of peer to peer lending include Prosper and Lending Club.
This is how it works.
The investor opens an account on the website and deposits the amount they wish to invest. The borrower creates a financial profile which determines the interest to be charged depending on the amount of risk involved. The borrower then picks an offer that suits them best, and the transaction begins. All activities are handled through the website.
A business that is need of immediate cash and does not qualify for bank loans could use their account receivables as collateral for obtaining financing. Unlike in invoice factoring, the task of following up on the debt, in invoice discounting, remains the responsibility of the borrower.
Invoice discounting platforms are attractive to investors due to the high returns, and the fact that invoices could take 30 to 90 days to be repaid. Although there is collateral, the risk of default still exists especially among businesses with a low credit score.
Benefits of Using Investors to Obtain Finances
1) Private investors are unregulated by the strict rules that govern banks. For this reason, they are willing to offer funds to high-risk businesses. Some of these high-risk businesses could evolve into successful corporations that impact the country’s economy.
2) Using private and institutional investors to obtain funds is fast and easy making it a convenient method, especially where the money is urgently needed for business operations. The complex processes that banks use such as committee approval and carrying out due diligence delay funds, and at the end of it, the loan application may be rejected.
3) Using Non-bank financial institutions and individual investors to finance a business comes with no hidden costs. There is complete transparency, and the borrower knows the exact interest or fees the transaction will cost. With traditional banks, there is likely to be unexpected charges such as a penalty for breached covenants or additional products that the borrower does not need.
4) Banks are strict in the need for collateral before disbursing a loan. They could require that the directors put up their home as collateral which they do not hesitate to repossess in case of default. Private investors and non-bank financial institutions are easy on the need for collateral. Instead, they focus on covenants and charge a higher interest rate if it is a risky borrower.
5) Unlike traditional banks, debt investors are flexible and open to providing financial products that are tailored to the needs of the borrower. Businesses are therefore exposed to better and a wider variety of credit facilities.
Risk of Non-Bank Financial Institutions to the Economy
Besides the many benefits of using debt investors to obtain funds when banks are unwilling, there are some risks involved.
The high returns of providing loans to startups, small and medium-sized companies are attractive to investors leading to an oversupply of funds. In fact, according to a paper by the Alternative Credit Council, the private credit industry is likely to hit $1 trillion by 2020.
The high-returns in private lending are due to the fact that the loans are provided to less credit-worthy businesses. When there is a large supply of these loans to the already indebted and financially challenged businesses, they could take on more loans eventually leading to a high rate of default.
Banks are expected to maintain cushion money to protect t against defaulters. However, this is not the case with private debt investors. A high rate of default could lead to panic among the investors causing them to withdraw their money.
The decrease in debt investors could lead to a situation where businesses are financially strained and do not qualify for bank loans, while investors are unwilling to take the risk. While this is a speculation, the risk is apparent and unless the government puts some kind of regulation to debt investors, we can only wait and watch.
The financial institutions are not immune to collapsing either, India’s Infrastructure Leasing & Financial Services Ltd, a non-bank financial institution whose services involve financing infrastructure defaulted its debt causing shock waves among its investors.
China has tried to regulate the non-bank financial industry in their country with a target on peer to peer lending, but other countries are yet to make a substantial move.
The fact is that the private debt industry is beneficial to the economy, providing it with a little grease to move ahead; business startups get the financing they need and investors earn better returns. Regulating the industry could be beneficial in the long term but slow down the economy.
If the government is to apply any regulation into the industry, it should be a well-calculated move, with consideration of both short-term and long-term effects on the economy, investors, and businesses.
The 2008 financial crisis was a big blow to the economy, but it paved a way for governments to better regulate banks and protect consumers.
There is always a downside to everything; the high regulation led to a decrease in access to funds by small-sized businesses, but investors have stepped in and provided a convenient source of finance for borrowers.
The private credit industry has contributed to the growth of the economy, helping businesses continue in operation even when banks say no to their financial requests.
The industry is evolving and growing, targeting not just small to medium-sized businesses but large companies as well.
Although there is an overflow of funds in the industry and an uncertain future for the industry, we can only enjoy its benefits now and hope for the best.