The complexities of the problem are mind-boggling even to experienced, studied economists so, understanding the minutia of this economic tsunami is far beyond my skill set. Even the highest level officials in Washington admit that they don't know how to solve the problem.

When asked if this Congressional buy-out of garbage paper generated by the likes of Goldman, AIG, Fannie and Freddie would solve the problem, not even the U.S. Secretary of the Treasury knows. He was asked if this is “the last wrench in the tool box” by Senator Chris Dodd (D,CT), head of the Congressional Subcommittee on Banking. The Treasury Secretary replied that, “Yes, it is the last wrench.” Dodd, mildly shocked, asked, “Well, what if it doesn’t work?”

The Treasury Secretary of the U.S. stated simply, “It has to work.” Hardly an answer that fills me with the warm fuzzies. If the U.S. Secretary of the Treasury doesn’t have a Plan B, C, D right on down the line, I’m buying gold and burying it. the economic world is on the verge of collapse. Or is it?

Small Businesses Feeling the Credit Freeze

Just last week I ran across an article in the New York Times that exquisitely describes the problem, not in terms of numbers, predatory lending and failed mega-lenders like Bear-Sterns, AIG, Fannie Mae and Freddie Mac – all non-commercial lenders that have been pumping garbage paper into the sub-prime market. Why?

One word: greed. The Times piece explains the dual nature of the current “credit crunch” – the genesis of this domino effect we’re seeing in almost every market sector on a global scale. This isn’t a liquidity problem, even though the U.S. Congress is ready to pump up the world economy with an infusion of USD$750 billion that will now be loaded on to the backs of U.S. taxpayers.

The problem is one of perception – the perception of trust.

Credit Markets Are Based On Trust

If you want to buy a new car or home, but you have poor credit, that borrowed money is going to cost you more each month – if you can find a lender at all! You may not be able to because, frankly, trust in the global credit system has, in essence, vaporized.

And adding USD$750 billion to a sinking ship is only throwing more money down a rat hole. That support from the U.S. feds won’t begin to cover the 6,000 new foreclosures each day that muddy America’s economic waters. And experts (oh, them) don’t see an end to this crisis. It’s that deep and dirty. And politically charged.

“Alan Petrucci, whose small factory near Chicago makes metal molds that other manufacturers buy to form plastic parts, says his bank recently offered him an additional loan. Though orders for his molds are still plentiful, Mr. Petrucci says he will borrow only to upgrade existing machinery, not to expand.

“We are bracing for the downturn that is coming,” Mr. Petrucci said. “It is coming; there is no question about that.” -The New York Times

Mr. Petrucci’s business is simply one of millions that rely on borrowing to both expand and weather slow payments from clients and buyers – all part of the job.

“Mark Snyder, another businessman, is more optimistic, but his bank refused two weeks ago to grant another loan to his fledgling medical supply company near Denver. So he turned to a commercial lender, which has offered credit — at 30 percent a year. Mr. Snyder does not want to borrow much at that rate. “We desperately need more capital to grow our sales,” he said,” according to the same Times article.

The Surprising Basis of the U.S. Economy

Most of us (and most Americans) believe that the U.S. economy is built on heavy industry and durable goods – consumer items that last more than three years like cars, refrigerators and washing machines. In fact, these large manufacturing centers are responsible for a portion of the American economy – but surprisingly, it’s the small business owner that serves as the ballast for this gigantic money machine.

There are 27 million small businesses in the States employing 500 people or less, and in most cases, these micro-businesses employ fewer than five people each. This segment of the labor force delivers 40% of America’s output, a figure I find surprising.

To grow these small companies to become major employers and corporate taxpayers requires capital in the form of credit. If a lender won’t loan a small, well-established local business money to expand, that company may be in danger of failing. In the cut-throat world of some industries it’s grow or die. Just look at Ford and GM – two manufacturing stalwarts that pumped taxes and jobs into the American economy. I’m fairly certain that Ford will end up in the tank (3Q numbers released today show Ford sales down another 27%) and GM, only slightly better poised than its long-time competitor, faces layoffs and cutbacks across the board just to stay afloat.

“That sense of bracing for harder times is evident in little ways, at companies large and small.” George Wendt, owner of Chicago Metal Rolled Products, which forms steel into supports for stadium roofs, school gymnasiums, large canopies and the like, has reduced the steel he keeps in inventory over the last month, buying only what is immediately used.

That decision, multiplied across many companies, means suppliers will make less and stockpiles will shrink. There will be less production to drive the economy.

Chicago Metal is saving money, and so far its customers, mainly commercial construction companies, continue to buy the curved steel supports. “When you just watch the news, everything sounds pretty gloomy,” said Mr. Wendt, who employs 85 people at a plant in Southwest Chicago. “But so far our market is still relatively strong.” - New York Times

Perception IS Reality

I’ll say it again: we aren’t facing a typical recession or, worse, depression, although the numbers are anything but sunshine and roses. There’s plenty of money out there and the U.S. Congress is faced with the prospect of dumping another three-quarters of a trillion dollars on the pay cheques of workers and small business owners.

So, if it’s not a money problem what is it? It’s a trust problem. I’ve made this point in previous writings but the problem simply grows worse.

Workers don’t trust that those pay checques will keep coming. Lenders, fearful of the losses they’ve experienced in the past 36 months, are reluctant to lend money even to highly-qualified buyers.

The Fed doesn’t trust banks to loan out the money to commercial borrowers and banks and other lenders don’t trust each other because many of these sub-prime mortgages are buried in bundles of working mortgages and when these bundles are compiled by Fannie Mae and Freddie Mac and put out to auction, banks have a difficult time weeding out the performing and non-performing loans.

The result? A credit freeze that hurts economic growth world wide. Take Surgical Medical Supply, which was founded in 2004 by a small family. The company buys up medical equipment at bargain-basement prices and resells to healthcare facilities. And, for a couple of years, business couldn’t have been better. Then, the credit freeze stopped the flow of money, thus freezing Surgical Medical Supply and millions of other small businesses in place. Why?

Cash flow. Customers of Superior Medical Supply are on net 60 day terms. Superior, on the other hand, is on a net 30-day schedule. This creates a constant cash flow problem for the company’s owners. Oh, the money is there. It will be paid. But no lender will loan the company money even with millions in accounts receivable.

In another case, a small company sells drug testing supplies to local, state and federal agencies. These orders come in in the form of purchase orders from the government agency and the orders are promptly filled, often within days of the receipt of the order.

Unfortunately, government agencies are notoriously slow pays so the owner of the drug testing kits company never knows whether he was going to receive $1000 or $10,000 from a particular agency that month. After all, it is the government and the government has its own set of rules.

This company is forced to use a factor – a private investor/lender who loans the company money at a hefty 30% even though the loan is backed by the account receivables owed by government agencies. You know the money is going to be there. Just a question of when!

The Erosion of Trust

This is the crux of the economic crisis all small businesses face – a lack of trust. Oh, it’s nothing personal. It’s the economy. And whether you’re the owner of a very successful company or a homeowner facing a rollover on an adjustable rate mortgage, credit to see you through the next phase of growth – personal and professional – will continue to be hard to find.

I’m an optimist. But even I know that it took us almost a decade to find ourselves in the mess we’re in today. And it’s going to take some time to dig our way out of the hole we’ve all dug.

Confidence breeds trust. On a global scale, large institutional lenders will have to get their houses in order quickly, write off the non-performing loans (yes, it’ll hurt investors, but there’s no other choice) and put into place oversight and regulation that was taken off the books in ’98 and ’99 so non-commercial banks could compete with the bank down on the corner.

In principle, it should have led to greater borrowing options and, for a few years, that was exactly the case – until that house of cards came tumbling down in the States. Now, every lender is afraid to lend – even to solid, high-credit clients.

Let me repeat a critical point: Superior Medical Supply did finally find a lender – a VC that loaned Superior capital to upgrade equipment. The rate? 30% 30%!!! And this is a corporate borrower with over a million dollars in receivables.

But Superior’s owner is reluctant to borrow so much, at 30 percent annual interest, so he will draw down only $150,000. “We don’t want to expand at a rate that causes instability for our company, and borrowing $240,000 at 30 percent would do that,” he said.

So, with interest rates at 30%, fewer small businesses will borrow for expansion. The result will be stagnation in this usually robust economic sector. I expect that these credit conditions will last for some time despite what the U.S. Congress elects to do. A $750 billion cash infusion is a drop in the bucket when small businesses, home buyers and car buyers can’t obtain financing. Hang on, it’s going to be a bumpy ride.