Siberians have a saying: “There is no such thing as bad weather, only bad clothing.” This could well be the epitaph to the firms recently declaring bankruptcy (note, especially, the airlines and retailers) and to various busted private equity deals. Common to many of these was the heavy dependence on debt financing that left them exposed to the risks of minor variations in consumer spending, commodity prices, or real estate prices. These firms were poorly prepared for adversity—they were badly clothed, so to speak. ((The language of finance carries the metaphor much farther. The phrase, “naked investing” refers to strategies that leave you exposed to downside risks. Some investors sought to insure against the default of debtors by using credit derivatives. Now we know that these merely substituted the risk of default of the debtor for the risk of default by the counterparty. In the 2002 Berkshire Hathaway Annual Report, Warren Buffet called credit derivatives “financial weapons of mass destruction.” Maybe the current financial crisis will be best remembered for the proliferation of metaphors.))
What should firms do to “weatherproof” themselves? They should assess and manage their exposure to risks. A consulting industry has sprung up to assist firms in this effort, as have sophisticated tools, such as value at risk. But the various tools at one’s disposal basically embody the fundamental intuition about the determinants of creditworthiness. A long time ago, I worked as a banker and learned this intuition, a framework called the six “C’s” of credit. If one gains positive answers in response to the concerns raised by the six C’s, then perhaps the debt financing is appropriate:
Conditions: What is happening in the global markets and economies? Where is customer demand headed? What are the competitors up to? Do the prospective economic conditions favor timely debt payments?
Course: What is the purpose of the loan? Is the purpose ethical and legal? Will the loan sustain a business activity that generates an appropriate return? Is the general strategy of this firm “on course”? What are the debtor’s strengths, weaknesses, opportunities, and threats?
Cash Flow: Is the firm’s expected cash flow large enough to meet the principal and interest payments? What might cause variations in cash flow in this firm? How far might cash flow decline in a recession?
Collateral: What is the asset base of the firm: inventory, receivables, property, people, intellectual capital? If we have to foreclose on the loan, are there sufficient marketable assets that we could sell to repay the loan? What would it take to secure the loan?
Capital: Can the firm withstand financial shocks? Is there enough other capital ranking in priority below this loan to absorb a reasonable cyclical downturn in this firm’s business?
Character: Are the managers involved not only sufficiently intelligent and skilled, but are they also inclined to honor the repayment commitment? In his famous testimony before the U.S. Congress in 1912, J. P. Morgan said that “the first thing is character…before money or property or anything else” as the basis for obtaining credit.
For years, this venerable framework has been used by bankers to decide whether to make a loan, and if so, how. The stories surfacing about loan origination in the home mortgage industry suggest that these basics were forgotten or ignored.
Excellent fundamental credit analysis is not something to be learned by rote. It is really a way of thinking, of connecting disparate dots, and recognizing patterns in a noisy environment. This is where a great university-based MBA program can make a difference. Arguably, the six “C’s” distill a great deal of a good MBA program from ethics and organization behavior (“character”) to economics and strategy (“conditions and course”) and all of the functional courses in between. A university degree program can deepen your capacity to think critically, to master the strengths and limitations of frameworks and models, to anticipate human behavior, to gauge the soundness of people and their ideas, and to communicate well.
The deeper idea in this financial crisis is the need for management for all seasons. The time to prepare for chilly economic weather is when the day is warm and sunny.