Understand the Great Recession in 60 seconds or less

Photo by JoeInSouthernCalifornia via flickr

Generally speaking, the Financial Crisis of 2007-2010, sometimes called the Great Recession, was the result of a perfect storm: lack of oversight and regulation, combined with old-fashioned greed, and the bursting of a bubble that very few saw coming.

However, the financial crisis can be viewed in much more concrete terms.  The crisis was actually the culmination of a series of discreet events, occurring almost sequentially, with each event precipitated by one or more earlier events.  By understanding the nature and chronology of each event, one can quickly come to an understanding of the entire financial crisis.

1. The housing and mortgage crisis

The roots of the housing and mortgage crisis can be traced back to 2003, during the period of the Bush Administration, when the government was determined to ensure that everyone had the right to the great American dream: home ownership.

The move toward “home ownership for everyone” was fueled by low interest rates, followed by what I consider nothing short of anarchy in the mortgage lending market. Some of the lending practices that ensued literally defied common sense. Who, in their right mind, would lend money to someone with no income, no assets, and no foreseeable means to repay?

In hindsight, it almost seems comical. Anyone who could sign their name (and most likely some who couldn’t) qualified for a mortgage loan. That mortgage loan was doomed even before the ink on the signature line was dry. If he dressed appropriately that day, my dog could have purchased and financed a $500,000 home in the suburbs – with cable.

Such “no-documentation” loans were just one variety of the multitude of dysfunctional practices that arose simply because real estate prices had risen so quickly that lenders figured the trend would continue until the end of eternity. As a result, they encouraged other hazardous products, such as “interest-only” loans (Why require the homeowner to repay principal when the value of the collateral continues to increase so quickly)? Others made adjustable rate loans to people who didn’t understand them (that is, until their monthly mortgage payments suddenly increased from $800/month to $23,000/month, virtually overnight).

2. Mortgage-backed securities

Banks and similar institutions only encouraged, actually rewarded, these lending practices by buying mortgages from lenders and packaging them for sale to investors. So the original lenders didn’t have much to worry about anyway, because they knew they wouldn’t be holding the mortgages for long. They had no risk, only reward.

While all of this was going on, no one was “minding the store” – until the housing bubble burst and all hell broke loose. Fingers pointed in every direction. The decline in the value of housing was partly the result of unsustainable, artificially inflated prices, but I also believe that, as people began defaulting on their mortgages, the decline was further exacerbated.

Many banking institutions ended up with a variety of mortgage-backed securities on their balance sheets, mostly referred to as collateralized mortgage obligations (CMO‘s), which were, in essence, pools of mortgage loans purchased from lenders, then packaged and sold to investors.  The accounting regulations that govern banking institutions require that investments, including these mortgage-related investments, be reported at their market values.  Because of the sudden decline in the value of the underlying mortgages (remember, my dog could have been one of those underlying mortgage payers), the values of these investments had to be decreased, or “written down.”

3. Troubled banking institutions

The required write-downs of these securities created new problems.  No one knew how to value them accurately enough to record them at their true market values.  This uncertainty, in part, made potential investors wary, leading to further declines in value and even further write-downs. Ultimately these billions of dollars of write-downs wreaked havoc on the banks’ balance sheets, resulting in lack of compliance with regulatory requirements.

Part of the reason the banks and other companies, like AIG, were able to sleep at night was due to a concept they were all very much aware of: “too big to fail.” Arguably If they had not been at least partly aware that the government would ultimately bail them out, they may not have taken on so much risk.

4. The credit crisis

These issues in the banking sector had their own unintended consequences.  Because banks were out of compliance with banking regulations, and because mortgage-backed securities were difficult to sell, liquidity (i.e. available cash), the fuel that drives the banking system, was severely compromised.  Credit all but completely dried up and, with no liquidity in the system, businesses were the next to be affected. Companies and organizations that had always relied on credit for sustenance and growth suddenly had no access to capital.

Recently, banks have started to lend again, albeit cautiously, but this credit has yet to reach small businesses on Main Street, many of which have had to close their doors.

Many companies were able to weather the economic downfall, primarily through dramatic cost-cutting, including salaries.  The result, as we know, is unemployment.  The companies able to downsize their way through the recession are returning to pre-crisis profitability levels.  However, they aren’t using otherwise available cash to hire or invest in growth, because of the economic uncertainty about regulations, tax laws, and the government deficit, among other things. As a result, companies today are sitting on record amounts of cash that could otherwise be used to help put people back to work and fuel a recovery.

Finally, the crisis trickled down to the state and local governments, who tend to feel the effects last because they rely primarily on tax receipts, which decline only after the income of private taxpayers (both individuals and businesses) declines.  As a result, state and local governments, almost all of whom face record deficits, are struggling to balance their budgets. We are currently seeing reductions in the government workforce, and will undoubtedly see more before this is over.

5. Today

So here we are today.  The federal government is saddled with $14 trillion of debt, with no realistic plan in place to pay it off.  Financial institutions are facing new regulations comprising over 2,300 pages, which I would bet even its authors don’t understand in full. Simply put, there is too much uncertainty (risk) out there that must be digested until companies begin to hire employees again, the consumers who fuel 70% of the economy.

Until that happens, there will be no full recovery.

Non-Profit is a Tax Status, not an Operational Goal

The distinction between for-profit and non-profit organizations (“NPO‘s”) is often misunderstood.  Contrary to conventional wisdom (which is often more convention than wisdom), the difference between the two types of entities is not about the existence or non-existence of profit, but rather, how that profit is used.

In reality, the primary difference between NPO’s and for-profit entities is based on what each does with those profits.  When an NPO’s revenues exceed its expenses, we don’t refer to it as profit, but rather as an “increase in net assets.” However, to simplify this discussion, regardless of whether I’m referring to a non-profit or a for-profit, I will use the term “profit.”

Although widely accepted in use, the term “non-profit organization” is actually somewhat misleading.  For-profit entities are taxable – they pay income taxes on their earnings.  Non-profit entities are tax-exempt – they pay no income taxes on their earnings.  Over the years, the term “non-profit” has become a proxy for the term “tax-exempt.”

Internal Revenue Service regulations generally prescribe requirements for approval and maintenance of an organization’s tax-exempt status.  These regulations state that none of the earnings of a tax-exempt entity (i.e. a non-profit) “may inure to any private shareholder or individual.”  In short, you and I have no legal right to the organization’s profits.  Obviously, this provision does not prohibit an organization from paying reasonable salaries and benefits to employees.  Notice, however, that this provision (or any other provision in the Internal Revenue Code),  does not prohibit profits. Rather, it places restrictions of the use of those profits.

Unlike NPO’s, for-profit entities have the legal right to use their earnings for any purpose at their sole discretion, which includes the right to distribute those profits to owners and investors.  A good example is when a corporation uses excess profits to pay dividends to shareholders.

In exchange for the benefits granted to NPO’s as a result of their tax-exempt status, i.e. exemption from income and other taxes, NPO’s must use their earnings for their tax-exempt purpose, a purpose which has been previously approved to further the public good.  In essence, as part of its agreement with the NPO, the IRS says: “Because of the good you’re doing for society, we’ll give you the benefit of exemption from taxation.  In exchange for that privilege, you have to follow our rules, one of which is that, no one can be personally enriched as a result of your existence.”

Of course, over the years, less than honorable organizations have found ways to get around the laws which bar private enrichment.  Examples include purchasing property for personal use with organizational funds, and excessive payments to affiliated service providers, to name a few.  Of course, the vast majority of NPO’s do not engage in these practices, and, in fact, most maintain strict policies, procedures and controls to ensure that such practices do not occur.

So, is it wrong, then, for a non-profit to earn profits?  My answer is a resounding “NO.”  I would take it one step further by stating that, not only is it not wrong, it is often vital for an NPO to generate profits.  This is particularly true in the current economy, where government programs are chronically underfunded, or even face elimination altogether, while foundations and other donors have become more discriminate in their giving.  Guidestar, which maintains a database of non-profit organizations, estimates that there are approximately 1.8 million IRS-approved NPO’s operating in the United States, many of which, to one degree or another, are competing for the same scarce dollars.

The notion that non-profits shouldn’t earn profits, which is often based on the misconceptions I have described, is misguided.  I would venture to guess that proponents of this point of view have never witnessed an organization scrambling to find enough money to make payroll every few weeks.

I should point out that, quite often, NPO’s are funded by contracts and grants received from governmental and other agencies, which stipulate that 100% of the funding under that agreement must be used for a specific purpose – i.e. no profit is permitted.  Although quite common, this applies to that specific grant or contract only, and should not be confused with profits earned by the agency as a whole.

Unlike the Federal government, non-profits cannot simply print money or sell Treasury securities to China when money is tight.  Most NPO’s are independent and self-sufficient, no different from any other business entity in that respect.  To an NPO, as well as any organization, profits and cash flows are the fuel that keeps the organization running.  If you drive around with your tank near empty, eventually you’re going to run out of gas – and it will most likely be on a dark, deserted road in the middle of the night.

In the world of non-profit organizations, profits are used to sustain, maintain, and grow.  Yes, growth is as important to NPO’s as it is to for-profit entities.  Growth expands the organization’s ability to impact more of those who benefit from its programs and services.  Growth also enables the organization to diversify its programs and funding sources to minimize risk, such as, the risk that a particular program will be discontinued or the risk of losing an important source of funding.

In addition to mere survival, non-profit executives will be the first to tell you that there is no shortage of good uses for profits, including:

• Enhancing existing programs, most of which operate on shoestring budgets;

• Building the organization’s capacity to provide quality programs and manage effectively, by recruiting, hiring and training talented employees;

• Minimizing the financial impact of any number of unexpected expenditures, which are, by definition, beyond the organization’s control;

• Initiating and/or enhancing  fund-raising efforts, a necessity for any organization that relies on public funding to sustain its existence; and

• Functioning as a self-funded line of credit, or cash reserve, to protect against the down-side of cyclical cash flow periods.

These are just a few examples of the endless number of reasons why it is crucial for NPO’s to generate profits.  Because the term “non-profit” is a tax status, not an operating goal, it is by no means illegal, or even immoral, for them to do so.

Is the almighty dollar as almighty as we like to think it is?

Do you remember the eight-track player?  Because of their convenience and portability, eight-track cartridges rose to popularity during the early 1970′s, in many cases as a preferable alternative to vinyl records.  Of course, it wasn’t long before their popularity declined, when cassette tapes were introduced, followed by CD’s, then the digital MP3 format.  If you can find an eight-track player today, it’s probably not worth more than the parts it’s made of.

Imagine for a moment that we’re back in the ’70s and you’re a successful manufacturer and distributor of eight-track players.  You sell them to retailers, who sell them to consumers.  Demand is so high, you can barely make them fast enough.

Fast-forward a few years (pun intended): As time goes on, orders and sales begin to decline, but you’re so involved in running your business, you don’t see, or perhaps you may even ignore, the signals the markets are sending.  After all, you think to yourself, “This is by far a superior product.  That can’t possibly change.”

Despite your best intentions, it doesn’t take long for your company’s financial situation to deteriorate, and your business debt begins to grow.  Since the product isn’t completely dead, you cut a deal with your largest customer. To satisfy your debts, you will manufacture and sell more units at a discount. This cycle repeats itself a few times, but each time, you need to sell a few more units to satisfy the same amount of debt. Meanwhile, your debt continues to grow and the eight-track player becomes all but obsolete.

You wake up one day with the realization that you have a mountain of debt you are unable to pay.  You don’t have the cash and you can’t continue to pay with eight-track players, because your best customer is already overstocked with enough units that he is already unable to sell.  Moreover, he has already initiated a closeout sale in an effort to sell as many eight-track players as he can at ridiculously discounted prices.

Much to your dismay, the situation has become unmanageable.  By now, you have amassed mountains of debt, growing by the minute as interest accumulates.  You and the rest of the world are loaded with more eight-track players than anyone could possibly want, and they’ve declined so much in value, your customers can’t even give them away.

You don’t have to be a genius to determine how this story ends.

Fast-forward again, this time to 2011. Imagine that the federal government is the manufacturer, but instead of manufacturing eight-track players, it manufactures (prints) money to fund its ever-increasing mountain of debt.  Imagine further that, instead of your retailer, the government’s best customer for its product (money in this case) is – pick a country – let’s say China.  This astute customer, the People’s Republic of China, begins to sense that the supply of those dollars is beginning to outpace demand, so it begins to gradually get out of the dollar business by methodically dumping them.  At the same time, the government’s debt, and related interest charges continue to grow.

If this all sounds like a business model doomed for peril, I submit to you that it is.  Unfortunately, it’s all too real, and the government I refer to is the United States of America.  Despite the fact that the government, politicians and the press generally don’t talk about it in these terms, the scenario I just described is factual.  If you owned the “business” I just described, you’d most certainly file for bankruptcy.  Unfortunately, for a variety of reasons, that’s not a viable alternative for a country.  Besides, when we’re a few dollars short, we simply print more.

Given the facts as I’ve described them, how long is this scenario sustainable?  Are we naive enough to believe that the almighty dollar is invulnerable to decline or devaluation?  Do the principles of economics not apply here?  Are we naive enough to believe that what happened recently to Greece can’t happen here?

What Gets Measured Gets Done – Performance Measurement

I recently made a comment to a colleague that the simple act of measuring something improves performance by at least 10%.  Assume this concept is true and think about it for a moment.  What would it mean to you and your business if you were to capture an additional 10% of business from your current customers or clients?  A compelling proposition, no?

How are the Values of Companies Determined?

Did you ever wonder what your business is worth, or how, for that matter, businesses are valued?