Financing companies are not ?normal? companies and their assets are not ?normal? assets.
A financing company?s main asset is the cash it loans to customers. Unlike a manufacturer?s assets?a metal-bending machine or a lathe, for instance?a financing company?s assets do not stay put at its headquarters, but instead get transferred to the control of its client.
The borrower generates a return on the borrowed money and repays the loan little by little. In a sense, the borrower?s payments are ?rebuilding? the original asset of the lender until a point at which the lender is ?made whole.?
A manufacturing company?s revenues consist of the cash flowing in due to demand for the company?s products. A finance company?s revenues consist of the gradual process of having its asset made whole. The borrower repays the loan, in part, because of its desire to take out future loans?credit is not given to companies that don?t pay back loans any more than to people who don?t pay theirs.
Thought about in this way, a finance company?s demand occurs on two levels. First, there is demand for the finance company?s asset in the first place?the loan. Second, there is the periodic and ongoing demand for future loans expressed through the repayment process. A company not paying back its original loan is, in a sense, showing a lowered demand for future loans. [1]
In an economic slowdown, a financing company suffers from demand destruction on two levels. Loan origination (representing present demand) slows and repayments (representing future demand) weaken as well.
Not only that, the financing company?s asset is not under its own control, but rather subject to the borrower?s ability to pay it back. In a severe downturn, not only does demand for present and future loans drop, its assets also get eaten away.
Of course financing companies try to protect themselves from downturns through the use of collateral–hard assets that they can sell on the open market to make their monetary assets whole again even if the borrow does not have the ability to pay.
But collateral is like any other good and follows the law of supply and demand: goods are?worth more if there is good demand and worth less if oversupplied. If a lot of financing companies are lending to the same kinds of clients and taking the same sorts of goods as collateral, the value of that collateral will be dependent on how much supply there is if the financing company has to sell it.
In the case of a widespread economic shock, demand falls on two levels, asset values fall, and what collateral is held as security become less valuable.
It’s no wonder that?profitability and equity in the firm can disappear so quickly if borrowers lose the ability to repay a finance company?s loans en masse. This fact became painfully obvious to investors in banks, mortgage issuers, and insurance companies during the 2008-2009 crisis. [2]
The financial statements of financial companies are, while they look as imposing and formalized as any other sector’s financial statements, they are in fact, largely figments of accountants’ imaginations. On the Income Statement, some costs actually represent what we would think of costs–money being paid to someone in return for goods or services–but a great many of them are simply estimates of how large future losses are likely to be given the information at hand today. On the Balance Sheet, equity is at least partially an imaginary store of previous years’ estimates and this store is again?contingent on future loan repayments.
So look again at that bank, at that insurer, at that leasing company. What do you see? Don’t blink your eyes–the image might not be the same when your lids reopen.
NOTES
[1] You might say that demand for future loans would be even higher if a company is having trouble making payments?surely a company in desperate straits desperately wants more money, after all.
However, demand, in the economic sense, is not only wanting something, but being willing and able to pay for something you want. The case of a company moving toward insolvency wants additional loans like a 17-year old boy wants a Ferrari; neither can pay for what they want, so the desire does not translate into economic demand.
[2] Ray Dalio, founder of hedge fund Bridgewater did a terrific 30-minute video describing his view of how credit cycles work that is really well done. You can see that video at this site: How the Economic Machine Works