Floyd Norris had a very interesting article in the New York Times today.  He quotes Robert Barbera, the chief economist of ITG, to the effect that "...Alan Greenspan's conundrum is becoming Ben Bernanke's calamity..."  That is, when the Fed raised short-term interest rates under Alan Greenspan, long-term rates did not follow - hence the conundrum.  Now, under Ben Bernanke, the Fed has lowered short-term interest rates, yet long-term rates - including mortgage rates - increased.  A reverse conundrum, in effect, that, if sustained, will make it much more difficult to stimulate the economy.

He also sites two informative papers released by the Federal Reserve over the summer.  One addresses the reasons that a stronger U.S. economy resulted in more consumer debt than ever before and an associated decrease in savings out of income.  The culprit was the continuous increase in housing prices and values that lead to more consumer borrowing against the value of residential property - stimulated by financial innovation such as sub prime mortgages and the manner in which they could be packaged and sold to investors.  The fear is that a reversal in housing prices and values will lead to a reversal in consumption spending and patterns, which further exacerbates problems in the economy.

To add to a sense of anxiety, the index of leading economic indicators fell in August by the most they have done so in six months.  Building permits fell to their lowest level since 1995.

I was reminded today, in a fairly wide ranging discussion, about the importance of identifying clients with a concentrated customer base in attempting to understand which borrowers in a portfolio might encounter difficulties if the economy slows or heads towards a recession.

If we know our borrowers, identifying those with a concentrated customer base should be relatively easy to do. 

I think it will be most interesting to watch the reaction develop and emerge over the next few days to the 50 basis cut in the federal funds rate by the Federal Reserve today.  The Dow increased by 335 points, which is what we all expected in the wake of a rate cut.

But the larger issue is the more immediate and longer term impact on the economy, not the emotional Wall Street reaction.  The sub prime mortgage crisis has not disappeared, regardless of spotty news coverage in the past few days.  Any relief for those subject to adjustable rate mortgages will likely be too little, too late - especially in those instances when the original credit decision was senseless.  Further, the rate cut will likely have little impact on the steady decline in housing prices and, with that decline, a continued erosion in equity and borrowing capacity, which translates to continued softening in consumer demand. 

On the other hand, Best Buy and Adobe had rather robust quarters.  Since Best Buy is a retailer, their results give considerable hope that consumer buying has not hit the wall.  Let's wait and see.  Too many fundamentals point to a rather ambiguous future. 

Just thoughts for the moment.

 So what are the early warning signals that tip us off to borrower cash flow and debt service problems?  That seems to be one of the more pressing questions at the moment in light of the sub prime credit crisis and its emerging impact on the larger economy.

I’ve asked an array of seasoned and experienced credit administrators this very question, and they have responded with thoughtful and pragmatic answers.  But, in retrospect, I wonder if this is really the right question. 

The crisis is real, and the crisis is in progress.  How well a business survives the crisis obviously depends on a great many factors, including management’s financial knowledge, the quality of its financial reporting, and the lessons learned in working through the last credit crisis or economic downturn. 

If there is little financial knowledge housed within the management psyche, if the quality of financial information and reporting is poor, and if company management has not experienced – and survived – a prior credit crunch or economic downturn, then the prospects for success in an emerging crisis are diminished considerably. 

For such businesses and such management the early warning signals have always been there.  For example, it is very difficult to hide financial ignorance or indifference, even in the most cursory of conversations.  It is readily and painfully apparent if financial statements and financial reporting are marginal or inadequate.  And a single question can usually identify whether management ever experienced and lived through a credit crisis or economic downturn.

The problem, of course, is that we have so little continuing contact with management.  In the rush to generate and book business, there is little time to learn about the client and far less time to monitor business activity once the deal is done.  As a result, we may easily miss those early warning signals hidden so clearly in plain sight.