I do not think it is an exaggeration to say that it is wholly impossible for a central bank subject to political control, or even exposed to serious political pressure, to regulate the quantity of money in a way conducive to a smoothly functioning market order. A good money, like good law, must operate without regard to the effect that decisions of the issuer will have on known groups or individuals. A benevolent dictator might conceivably disregard these effects; no democratic government dependent on a number of special interests can possibly do so.

F. A. Hayek
"Denationalization of Money"
Institute of Economic Affairs (1978)

First a reminder that IRA will be participating in the all-day event in Washington next Wednesday, November 4th, entitled "Regulatory Reform: Defining Issues and Tasks to Enhance Systemic Stability." The event is sponsored by PRMIA, the CFA Society of Washington and the FDIC Corporate University. Members of the financial regulatory community may attend the event free of charge. Click here for further details.

In this issue of The IRA, we feature a discussion with CreditRiskMonitor.com, Inc. (OTCBB:CRMZ), which operates as an Internet-based publisher of financial analysis and information services primarily for corporate credit professionals. CRMZ is one of the top 4 publishers of commercial credit reports and gathers trade data on corporate credit quality. They confirm what we've been seeing in the banking channel, namely that the supply of available credit to the real economy is down dramatically and continuing to shrink. Late last week we had a conversation with CEO Jerry Flum and President William Danner about the trends in the corporate credit channel.

The IRA: Jerry, Bill, thanks for taking time out to speak with us. We see that CRMZ's revenue has continued to grow in 2009, no doubt tracking with credit risk generally?

Flum: Our business has been very strong. Obviously if you can't sell credit analysis now, you never will. But the corporate budget environment is tough and most of our larger competitors are struggling: D&B Corp (NYSE:DNB), Experian (LSE:EXPN) and the rest. We are taking market share, so that is helping us.

The IRA: Taking share is always a good thing, but that may be all that you can do right now in a market that is shrinking.

Flum: Unfortunately that's true, but I think you'd agree as a publisher of bank ratings that there is a real need for risk analysis tools. Whether you believe that the economy is going to recover or not, credit risk is a top concern now for our clients. And I think that looking at the preponderance of evidence available right now, it is hard to say that we are headed for a robust recovery.

The IRA: Well, you know from our conversations how cheery we have both been on banks and structured exposures since, what, 2005? The first time we spoke was at least that far back and we have basically followed the story since that time. But people still do not want to accept how much trouble we are facing in the banking system. The FDIC closed seven banks on Friday and we expect the total to go into the hundreds during 2010.

Flum: Precisely. This is why having corporate credit budgets under pressure now is so dangerous, because if we see a second dip in the economy, corporate risk officers are going to need to be even more attentive.

The IRA: Agreed. The problem in many parts of the global economy is deflation. This is why we were so taken aback by the weak revenues in key business lines at both Goldman Sachs (NYSE:GS) and Citigroup (NYSE:C). Our worry continues to be that the breakdown in bank and non-bank lending to business is going to hit GDP and push corporate revenues down again in the US and globally, and even GS and C. The latter is a real shocker because we assumed that the "too big to fail" tendency in Washington understands that this zombie needs to be way north of $100 billion revenue for 2009 in order to survive. Raising the interest rate on C credit cards to 29% APR will not be enough. And we read in the media that C is unilaterally shutting down co-branded credit cards linked to major oil companies such as Shell (NYSE:RDS), Citgo and Exxon-Mobil (NYSE:XON).

Flum: At the end of the day, there is a limit to just plain momentum investing with no tether to the basic economics.

The IRA: So what are you seeing at CRMZ in terms of corporate credit, accounts receivable and the data you gather?

Danner: The dollar value of accounts receivable we collect are down sharply. In general vendor credit is down much more than the drop in bank lending.

Flum: Not only that, but you've got to remember that the rate of gain and the expansion of bank lending is down. If trade payables are also down, then there is no grease for the real economy.

Danner: Yes, to put a finer point on it, trade credit is down bigger than bank lending. Remember that commercial receivables are huge, something like 3x commercial bank loans. This is the real economy's lifeblood, but trade credit is down more than the decline in sales and down more than the decline in bank lending, including metrics you guys track on banks like exposure at default ("EAD").

The IRA: So what is your overall view of the economy given your perspective focused on corporate credit managers?

Flum: Well, as we said the first point is that there is no grease in the engine in terms of bank credit or trade credit. The other thing which is so disconcerting is that corporations are cutting back on credit managers just as problems are peaking. Budgets are flat and this means that the corporate world is going into a time of great uncertainty with incrementally less information and resources to act on it. If the new order comes in, how long does it take to approve and process that sale with fewer credit analysts and less data? You can book the sales, but if you can't collect the receivables, think what happens to the quality of your earnings.

The IRA: We watch for banks that are showing falling efficiency ratios, the cost of a dollar of revenue, in a time of rising credit costs, usually means management is cutting fat and bone to raise short-term liquidity. Banks that are spending more on credit management costs -- that is, people -- have rising efficiency ratios, which is the case with most of the industry today. But for many banks, expense reductions are cutting muscle and bone, leaving no capapcity to put on new business. All of the resources at many banks are focused on existing credits and loss mitigation.

Flum: I have been doing this for 40 years. Started in the financial business after working at a law firm. I got my head handed to me in 1973-74 in my hedge fund and had to learn how markets behave. When I boil what I've learned all down to one factor that drives the markets and an economy, it is debt. Debt vs. GDP, for example. Every dollar of debt moves a future purchase into the present.

The IRA: In a fiat money system, there is no money, only credit.

Flum: Correct, and as credit grows we spend more of it now. So, if you look at debt vs. GDP, we are already at record levels. We can also look at incremental debt vs. incremental GDP. In the 1950s, it took $1.50 in debt to produce an incremental $1 of GDP. Today it takes more than $6 in debt to produce a $1 of GDP, so we are approaching the end of the game. This economic inefficiency is a sign of being closer to the top than the bottom and a new beginning.

The IRA: Banks that have to spend more than a $1 to generate a $1 of revenue don't stay open very long. Bill, who are the primary providers of AR finance?

Danner: The primary providers of A/R finance are actually industry, the vendors themselves. This is all about vendor finance and the willingness of the producers of goods, and the distributors, to take risk on accounts receivable. When there is no vendor financing, then there are fewer sales and shipped units fall.

The IRA: So the efforts to restore the commercial paper markets and add liquidity to the markets has not trickled-down? The Fed would tell you that they have restored normalcy

Danner: The numbers we are seeing on A/R and trade credit volumes are continuing to get worse, not better. A big part of that is financing.

Flum: Commercial paper volumes are not going up. Who can issue prime commercial paper? Fifteen companies?

Danner: The good news is that we don't have a liquidity crisis any more. That is the good news, that the Fed stabilized liquidity. At what cost, I don't know. But liquidity in the financial markets is not the same as putting money on the street to finance commerce.

The IRA: So the impression we have of small and medium sized businesses being locked out of credit from banks is consistent with what you see on the trade ledger.

Flum: The small banks are out of the picture for the most part. They are trying to survive. These were the providers of working capital to small and medium sized businesses in the US, so the impact on GDP has to be negative. I don't know how economists can talk about a sustainable turnaround in the economy given what we see in the trade channel.

Danner: And we saw Treasury decide to throw CIT Financial under the bus.

Flum: Precisely, there is no non-bank credit or factoring, no vendor finance and no bank lending. Where is the working capital for the other 10,000 public companies after the blue chips?

The IRA: Well Bill mentioned EAD or unused credit lines. We saw available credit at the largest banks contract significantly in Q2 2009 and we expect to see more of the same in 2H 2009 and 2010. Just charge-offs alone will make the industry shrink 2-3 percent per quarter and asset sales could add to that number a couple of times over. We wrote about EAD in The IRA last month ("Exposure at Default: As Banks Shrink, So Does the Economy").

Flum: The thing that scares me is commercial real estate. These guys were professional borrowers, completely unlike the residential home borrower. That worked with rising valuations, but now we have a lot of excess commercial inventory that makes no sense. Residential borrowers are rookies compared with the CRE developer who was in the market every week. These deals were so over-done that there is no room for the banks to work in terms of restructuring. I don't know how you restructure deals that are so far out of line with current valuations.

The IRA: You restructure the company, wipe the equity and turn the creditors into owners. We should do the same with C and the other zombie banks. The shame is that there are a lot of CRE deals that do make sense that cannot be financed either, going back to your point about trade finance. CRE deals done over the last few years have short maturities because the valuations and rental rates made investors believe that they could get their money back faster. But deals done a decade ago with more reasonable valuations and thus longer investment horizons likewise are not being financed.

Flum: The thing is, dividends have represented about 65% of the overall returns on equity in the post WW II era, so clearly with the dividend yield on the S&P at 2.5%, it is going to be difficult to come home. I see a lot of bullish talk about the markets, but I also see a lot of credit data that suggests we could be headed back into the contraction again. If that happens, the next leg down is going to be twice as bad as the first.

The IRA: Because there is no credit. What is the last word Bill?

Danner: We run a proprietary credit-default model for our clients that calculates what we call the FRISK score. It represents a probability of default based on financial statement fundamentals, ratings, and stock volatility. So, if we look at the overall FRISK statistics for all the U.S. public companies, we see that the overall risk of defaults is way down from the peak seen at the end of 2008. This was before the liquidity crisis was resolved. But even today it is still showing an overall rate that is double where it was in 2007. Double the default risk is not a happy situation. There may be a lot more bankruptcies on the way before this is really over.

The IRA: More good news. Thanks gentlemen.

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