I received an interesting Email from “California Banker” a few days ago regarding margin calls on businesses.

Amazingly, businesses borrow money from banks with no idea how quickly banks can shut their entire business down.

“California Banker” Writes:

Hey Mish

There’s an interesting type of Margin Call that I think we’re about to see take place in great numbers within the banking industry, specifically within the business lending units. When a bank makes a business line of credit it files a UCC-1 filing against all business assets including accounts receivable.

When a business becomes over leveraged and sales fall they begin to look like that are not going to make it financially. If a business owner fails to demonstrate how and when they can rectify the situation, usually with capital injections, the bank’s primary tool to recoup their loan outstanding is to perfect their interest in those business assets.

They will notify the accounts (clients) of that business they are perfecting their interest in those accounts and they are to pay the bank directly. The bank will also notify them, that failure to do so or paying the borrower does not relieve them of their liability to pay that account to the bank and could end up paying it twice.

At the same time, the bank will notify the borrower in this case that if he receives payment from his account receivables he’s to forward that to the bank, and to not do so is an act of fraud.

This is the business owner’s “Margin Call”. I don’t think business owners understand the recourse a bank has, why and when they will use it, and how important it is for a business to keep their business lender happy and work with the bank as much as possible. They also don’t realize that when a bank notifies their clients it raises such a stink as to their solvency; their clients might just choose to do business elsewhere and the notification itself can put a business out of business.

PS If you want you can change the word perfect to secure, as in secure their interest and securing their interest, it might read easier.

Real Case Example

I asked “California Banker” for an example. Here is one from last week.

Hi Mish

To follow up on my previous email.

I have a client who has what’s called an asset based or account receivables line of credit. It’s a formula driven line of credit, and as accounts receivables go higher, their availability to borrow goes up. Likewise, as receivables go down, so does their availability under the line of credit.

If the availability falls below the outstanding of the line of credit then they are required to pay down the line usually from recently collected or paid accounts.

One client had $200,000 in accounts at the end of November 2009, and by the end of December 2009 that had fallen down to $100,000. The formula then reflected they could borrow roughly $50,000 and their line of credit outstanding was roughly $100,000.

In one month they had become significantly out of compliance and required to pay the line down by $50,000. The borrower could not pay down his line of credit.

When I asked “What happened to the $100,000 you collected from the pay down in accounts?” he said he used the money to pay off personal credit card debts.

In essence, he spent the banks collateral. This is a serious red flag in the world of bank. He reflects a negative financial picture and poor character as a business owner. In our discussion, he said he was “paying off consumer debts because the credit card companies had cut his credit limits well below what he owed and they were demanding to be paid off.”

What he failed to realize is that the consumer lenders had no ability to go after his business assets directly and therefore could not put him out of business. On the other hand, we as the business bank can perfect our interest in his business assets and put him out of business by doing so.

He failed to realize if he wants to stay in business it’s imperative to work with his business bank and stay within compliance of the loan terms, and if you’re having issues come to the bank early and discuss them.

He also failed in that he’s planning on filing personal bankruptcy anyway. That would have wiped out those credit card balances and he could have used the money instead to keep a healthy relationship with his bank and maybe kept his business alive.

Today, we are preparing letters to notify his clients they must pay us directly. It’s sad, but just like a real estate foreclosure, at some point you have to pull the plug and invoke the “Margin Call”.

Running up personal expenses when your business is financially in trouble is unconscionable. “California Banker” tells me this client went on an expensive vacation right before this. Was this planned fraud or simple stupidity?

That is hard to say and perhaps impossible to prove. However, the result is still the same: that client just lost his business and is facing a personal bankruptcy on top of it by failing to understand the business loan margin call.

It’s no secret that banks are lowering credit card limits and raising rates. Any businesses dependent on that credit and using personal lines of credit to help keep their business afloat better beware the above example. If not, they will end up personally bankrupt, and out of business as well.

Sadly, we can expect to see huge numbers of cases where people use their life savings foolishly attempting to keep a nonviable business alive. We can also expect to see huge numbers of cases where people bankrupt a viable business attempting to keep their nonviable living standards alive.

Mike “Mish” Shedlock
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