Q: What shady corner of finance will destroy the economy this time?
Never heard of a “factor”?
Before 2008, had you ever heard of subprime mortgage-backed securities? Collateralized debt obligations? Credit default swaps?
Simply put, a “factor” is a pay-day lender for small businesses. Factoring has burgeoned in the last decade and is poised to bring down the economy in 2020.
Say you’re a small business and you run into a cash-flow problem. Your clients owe you $200,000, but they are slow to pay. Your payroll is due.
Prior to 2008, a small business would tap its line of credit from a bank. But after the meltdown, banks pulled back on so-called risky lending.
I run a small business. One day in 2009 our banker showed up and told us our line of credit was going to be cut in half. No negotiation. Take it or leave it.
Consider yourselves lucky, he said. He’d left the last guy in tears when he pulled his line altogether.
The dirty secret is that, post-crisis, banks cracked down on small and midsized businesses and not the big guys. Deutsche Bank kept lending Donald Trump hundreds of millions of dollars well into 2011 even after he defaulted AND sued them.
Since necessity is the mother of invention, enter the factor industry:
If you’re a small business waiting on that $200K from slow-to-pay clients, you agree to sell your invoices to a factor. For a fee — say 2% of the invoice face value — the factor pays you, and the $200K owed from clients goes directly to them.
Then take an actual read of a factor contract.
“Nothing herein shall be construed to require the payment of interest.”
A line like this exists in all factor agreements, along with language that makes it clear the money you receive is not a loan.
Because factors don’t want to be regulated as banks. Banking regulations would require stricter lending standards, capitalization requirements and consumer protections.
Here are some other terrifying provisions in a factor contract:
· You grant the factor power of attorney.
· You sign as a personal guarantor of the loan, giving the factor access to all your assets if you default.
· If you default, the factor has the right to change your mailing address and open your mail.
· Unlike a line of credit, which can sit idle until you need it, you owe a factor a minimum fee regardless of whether you ever tap the money.
Okay. So, you can now picture factors wearing black hats with sinister twirly mustaches. But how exactly will they bring down the economy?
First, like subprime back in the day, factoring is absolutely rampant and yet no one seems to know anything about it. Scouring the financial press, you can barely find any coverage.
Yet, if you run a small business like I do, you are probably getting fourteen email solicitations per day from factors.
Next, borrowing against invoices is a teetering house of cards — primed to collapse in a downturn.
When money gets tight in your family, the first thing you ask is, “How long can I put off the tuition payment or the electrical bill?” Businesses are the same paying invoices.
Even worse, a belt-tightening client may dispute an invoice, saying you didn’t render the service, didn’t do it correctly, and don’t deserve to get paid. It’s not nice, but it happens All. The. Time.
Exactly how many small business owners would lose their homes to factors if there’s a downturn affecting invoice payments by clients?
It’s hard to say because of the lack of data on factors. However, we can estimate.
The Small Business Administration reports, “The amount of small business loan originations plummeted by more than half during the crisis and has seen only a very limited recovery post-crisis, leaving small business loan originations down 40 percent from pre-crisis levels.”
So that’s potentially 40% of small businesses relying on factors instead of banks — a monumental shift in finance mechanism.
Here’s another government statistic — Small businesses make up 99% of all enterprises and generate almost half of US economic activity.
A downturn is due in 2020. Overdue, in fact, as last summer’s “inverted yield curve” showed.
In 2008 we faced a huge, fatal, and largely unknown exposure to subprime.
In 2020, as much as half the economy has a huge, potentially fatal, and largely unknown exposure to a shadow loan industry.
Welcome to the financial crisis of 2020.