Back to basics

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By Shyam Venkat and Peter Frank

With the stock market tanking and banks imploding, credit has tightened to an unprecedented degree. How should US companies respond? Not by looking back. The era of easy credit is over. Savvy companies, however, are looking at a new way of doing business that just might usher in an era of excellence nobody could have predicted.


The easy-money era of 2003–06 that preceded today’s capital markets crisis was actually a culmination of a quarter century of progressively more benign credit conditions.

At roughly the midpoint of the Reagan administration, the cost of capital was quite high, historically speaking. Long-term, high-grade bonds averaged 8.2 percent in the winter of 1983–84, for example. Short-term credit, too, was much pricier than traditional norms. Banks’ prime lending rate was about 7 percent higher than the rate of inflation—well above the more typical 3 or 4 percent.1 When then Federal Reserve chairman Paul Volcker eventually did champion lower interest rates to help spur the “Reagan Recovery,” it marked the beginning of a long-term period of generally falling interest rates and more-favorable credit terms for companies.

Figure 1: Tightening lending standards

Note: Only prime mortgages included from Q2-2007 and onward.
Source: Federal Reserve, Senior Loan Officer Survey

Figure 2: Capital expenditures and employees of majority-owned affiliates of US multinational companies

Note: Inflation-adjustment using NIPA price index for personal consumption expenditures.
Source: Bureau of Economic Analysis


Freewheeling credit markets helped fuel a booming global economy

Throughout the next 25 years—a period covering two recessions, four US presidents, and asset-class bubbles in both equities and real estate—lending conditions continued, in general, to ease. By the middle of this decade, credit spreads were almost unprecedented in their narrowness, meaning that both firms and individual Americans could “leverage up” as never before. For individuals, leverage provided the basis for one of the biggest housing booms in history.

Figure 1 shows the results of a recent senior loan officer survey conducted by the Federal Reserve. Values higher than zero indicate that more banks are tightening standards, and values lower than zero indicate the opposite. The chart clearly illustrates how lending standards greatly eased in late 2006, only to tighten dramatically after the credit crisis hit.

Today we all know how the credit-fueled housing boom story ended. Perhaps less well understood is how an upcoming period of increasing credit scarcity could very well fundamentally alter how companies grow their businesses. We anticipate that a corporate sector that came to rely disproportionately on debt to finance growth will transform into one that pursues more-classic, more-tested means of growth: operational excellence, quality engineering, sustainable cost management, and superior customer service.

The miracle of leverage

First, it’s important to understand how cheap credit helped companies achieve rapid growth. Financial planners like to talk about how the so-called miracle of compound interest can supercharge an investor’s portfolio (the present decade excluded, of course). Leverage worked its own kind of miracle by augmenting companies’ limited capital by 5 or 6 or 10 times or, in the case of some US financial institutions, 12 or 15 times.

The amount in dollars left if one had placed $100 into the stocks of leading US market indexes at the end of 2007.

 The turbo charging of profitability that accompanied achieving scale economies meant that firms could power top-line growth through acquisitions and business combinations that were financed with leverage. Easy credit provided them with the financial firepower to expand abroad, invest in new technologies, and hire tens of thousands of employees around the globe. (See Figure 2.)

And, not surprisingly, the easily available credit that helped spark an enormous increase in US market capitalization and the acceleration of global trade also prompted a shift in focus from more- conservative notions of business—in the form of reliable returns, steady growth, cost management, and operational efficiency—to more-aggressive growth models based on gobbling up other companies, financial engineering, and expanding well beyond core businesses. (See Figures 3 and 4.)

Figure 3: Mergers and acquisitions deal value: US acquisitions

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Source: Thomson Financial

Figure 4: Mergers and acquisitions deal value: Worldwide acquisitions

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Source: Thomson Financial

1 William Greider, Secrets of the Temple: How the Federal Reserve Runs the Country, Simon & Schuster, 1989.