Other People's Money

Throughout our lives, we make payments (expenses) for the goods and services we need and, in turn, get paid (income) for those we offer to others. Whether you are talking about people, organizations, companies, entire communities or states, the same forces are at work and I’ll be referring to them interchangeably in this article. Their collective activities generate constant flows of money, goods and services and constitute the fundamental dynamics of our economies at every level. It is part of what’s referred to in economics as the circular flow of income. The main enabler of these transactions is money and, in any particular period, we always hope to bring in more money than we pay out in order to stay solvent. Everyone works vigorously to ensure that the balance in the flow of money (cashflow) always favours them i.e. they want to have a surplus of income over expenses in any given period.

But, alas, it is usually not possible to sustain such a positive cash balance permanently and we, sooner or later, wind up having to spend more than we actually earn for a period. The resulting temporary shortfall can potentially lead to a catastrophe if it is not properly dealt with, e.g. the individual could find his landlord breathing down his neck or a company could simply find itself in a situation where it cannot pay its recurring costs such as salaries, utility bills, suppliers etc. In such cases, there is always that strong potential for collapse. This is the classic cashflow problem which is due to the fluctuations in income and expenses and occurs when expenses temporarily outpace income significantly enough to wipe out any existing cash reserves. Companies maintain cash reserves while individuals hang on to savings in order to forestall such unforeseen situations. Nevertheless, cashflow problems are still very common and almost unavoidable unless you’re sitting on all the money in the world and not transacting.

A cashflow problem can also develop because one has wealth in an illiquid form in the very short term. For example, one can own houses, cars, land and lots of other assets but still temporarily run out of cash and face the same serious consequences. The assets cannot be turned into cash overnight and are thus considered illiquid. Cashflow problems constitute one of the most significant dangers facing any individual, organization or company, especially as the pace of life accelerates and things continue to happen at Internet time. As we can see, it strikes at the heart of our daily economic existence at every level.

The great equalizer in these situations is credit or loans. Those entities who have more money than they need in a given period, may offer the excess to those in need in a loan transaction. Financial institutions pool together investors’ money and loan them out for huge profits. One may turn to a friend, a bank, an association or some other lending institution for the funds to cover the deficit for a time. Companies tend to go for lines of credit with their banks to implement automatic mechanisms to deal with the problem and avoid having to negotiate and renegotiate loan transactions every time the problem surfaces.

It is often said that money is the lifeblood of an economy at all levels - from the individual through the biggest corporation to the government – but credit is the heart that keeps the whole system flowing and functioning seamlessly. Without it, our lives would be punctuated by intermittent financial collapses with traumatic effects on everyone. Credit is so central to our lives today that failures in the systems that regulate it and the way it is implemented have triggered the biggest financial crisis since the Great Depression in 1929, eliciting drastic action from governments worldwide. Its importance can really not be overstated.

Credit comes to life when someone or an institution (Lender) with funds agrees to rent out money (principal) to another entity (Borrower). It could take the form of actually giving out cash or simply allowing the Borrower to defer payment that’s due to a later date. By so doing, the Lender is taking risks as well as providing a service to the Borrower. In return, the Lender demands compensation (Interest) from the Borrower for using the funds and as a reward to the Lender risking her funds. The risks range from the Borrower being unable to pay part of the principal plus interest to the Borrower defaulting on the full amount and there are several scenarios that could lead to this. The lender essentially engages in risk management when giving out a loan and this depends a lot on the confidence between the two parties.

Governments have laws and regulations governing credit and lots of economic tools are usually deployed to always shore up that much-needed confidence between the parties in loan transactions. Even between individuals, various mechanisms are put in place to minimize risk and increase confidence. The community approach to lending used in some microfinance institutions relies on peer pressure to minimize the chances of default. This same concept applies when individuals get together to form a self-help organization pooling together their savings for the purpose of providing loans to members as needed. It is all about minimizing risk and shoring up confidence. When either or both of these fail, the credit system comes crashing down.

Credit risk, in its simplest form, can be evaluated and managed within the framework of the three C’s:

• Character: this looks at the overall character profile of the Borrower, their standing in society and their credit history. References and endorsements can be obtained from those who really know the Borrower and are in a position to give references. It goes to expose who the Borrower really is. Have they been convicted? Have they been sued? Have they ever defaulted on a loan? What are their values?

• Capacity: the Lender needs to know how the Borrower will eventually pay the loan. Does the Borrower have a steady and sustainable source of income, e.g. a good job, strong sales, a solid monthly revenue stream from subscription services, etc? If so, is the income sufficient to enable repayment of the debt in time? The Lender also needs to verify what the Borrower’s true living or operating expenses and financial obligations are. Are they so highly indebted that they actually consume whatever revenue comes in with little to spare? Is the Borrower living beyond his/her means? What is the Borrower’s Current Ratio?

• Capital: does the Borrower own valuable assets, savings and/or investments that could be used as collateral to cover the loan in case of default? These can go a long way to reduce the risks associated with loan transactions.

The three C’s provide a conceptual framework for the Lender to approach the transaction methodically in order to minimize risks and create confidence. Both parties need to analyze these factors carefully before engaging in a loan transaction.

It used to be that loan transactions usually ended badly because the Borrower developed problems with Capacity and Capital, e.g. a sudden loss of employment; the damage and loss of an asset; sudden and unexpected changes in market conditions, etc. These two aspects were considered the greatest factors influencing a loan transaction and were usually closely analyzed and monitored. The transactions were usually simple and between Lenders who actually owned the money they were doling out and Borrowers who were somehow close to and knew the Lenders well. The Lender had a strong motivation to recover his money while the Borrower was motivated to keep the promise of repaying on time in order to maintain the relationship and even his standing in the community. Those were the halcyon days of credit management.

Today, Character has increasingly become the weakest link in the chain. Whether one is talking about young entrepreneurs who create slick presentations and package themselves carefully to get funds with no clear intention to pay back or the sophisticates who financially engineer investors’ money to literally try to create something from nothing, it is increasingly boiling down to Character. Greed, outsized ambition, the thirst for short-term gain, mind-boggling complexity in financial services far removed from Borrowers and inadequate regulation, etc. have all combined to push the financial world into making loans that seem to ignore the basic tenets of the three C’s. Lenders loan out investors’ money to Borrowers who can’t or won’t pay, resulting in high default rates in the long run. Credit risks skyrocket, confidence takes a hit and, yes, the credit system slowly grinds to a halt. Those intrepid Lenders who muster the courage to continue lending start demanding very high rewards (interest) for their high risk deals.

Some people seem to have a very loose idea of what their responsibilities are when it comes to borrowing and using other people’s money. Once they get the money, they promptly forget its origin and proceed to spend it exactly like it was theirs. The logical extension to that is they end up not reimbursing even the capital. Their activities tend to be shrouded in a thick veil of suave cosmopolitan make-believe that completely masks the true Characters behind the transactions. These sociopaths often know such behaviour is wrong, destroys other people’s wealth, ruins companies, breaks up families and never ends well and yet they persist in these activities that amount to some of the worst forms of white-collar crime. Some even go as far as setting aside funds for legal defense in the court cases that would inevitably ensue.

The Character problem is compounded when a country lacks the strong, independent and corruption-free judiciary to enforce credit agreements. This only reinforces the cocky attitude of these loan thieves and Lenders who simply see investors’ money as a means for them to get rich quick no matter what happens. The true losers are always those who really own the money. Banks, as diligent custodians of their customers’ deposits, tend to react to this by simply freezing credits. That partly explains why in some countries and regions of the world, there is over-liquidity in the banking system with the corresponding deleterious effects on the economies involved.

In a world where Lenders and Borrowers increasingly enter loan agreements involving third party funds, it is essential to pay particular attention to the Character of both parties. Their motivations, objectives and mode of operation must be carefully regulated to prevent the loss and pain they are increasingly creating in their use of other people’s money. Credit remains at the heart of the world financial system and the world economy. It has clearly become a matter of national security to ensure financial stability in every country and hence, the world financial system. But, more importantly I believe, it is also a matter of human rights that those who prey on other people’s hard-earned savings be stopped at all cost. The steady transfer of wealth from innocent hardworking people to crooked but highly intelligent con men must be halted and even reversed, and, why not, punished wherever possible.


Emmanuel Kijem © November 2008

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