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Why the fed matters to entrepreneurs: interest rate changes x variable rate debt = problems for entrepreneurs.

ENTREPRENEURS TEND to be blase about what Alan Greenspan and his Federal Reserve Bank colleagues say about interest rates and inflation. It's just talk, after all, isn't it? Actually, it's not just talk, and no one should be indifferent to the Fed's statements. Here's why:

Entrepreneurs often finance their businesses with large proportions of debt, and much of the debt has either variable interest rates or matures in five years or less. Entrepreneurs use debt financing because it's relatively inexpensive due to interest tax-deductibility, and because it's fairly accessible compared to equity financing. Also, there are many lending institutions but few small private equity-capital sources. The problem is that using large proportions of debt exposes entrepreneurs' businesses to substantial levels of interest-rate risk, debt-service risk and liquidity risk. That is, if interest rates increase, then profits and cash flows of the businesses decrease, making it more likely they will not meet contractual principal and interest payments or be able to obtain future (re)financing. Of course, when interest rates increase, this also means businesses financed with variable-rate debt are at a competitive disadvantage to those with fixed-rate debt (and, indeed, to those financed with any capital source other than variable-rate debt).

The Fed's practice is to issue press releases about its views on the economy, inflation, and interest rates--giving ample warning and explanation of impending monetary-policy interventions--and then follow up with actions consistent with the releases. That is, the Fed does its best to provide reliable signals of actions it will take to influence interest rates if conditions turn out to be consistent with its views; it does its best to develop reliable signals about what will happen, so influencing peoples' (and, hopefully, our variable-rate-debt-heavy entrepreneurs') expectations and decisions.

So what reliable signals does the Fed produce that are important to entrepreneurs? The signals come through clearly in recent financial headlines: The Fed has become increasingly worried that inflation will heat up due to large government deficits and heavy private-sector borrowing; it has warned that it will act to increase interest rates, suppressing borrowing and (hopefully) incipient inflation; it has, indeed, increased short-term market interest rates sharply over the last year; and it has warned that further rate increases are likely. Taken together these form a nice clear signal: Short- and intermediate-term interest rates are going up, and are likely to continue to do so.

Why haven't entrepreneurs used long-term, fixed-rate debt instead of intermediate-term, variable-rate debt? First, local financial institutions familiar with the risks of entrepreneurs' businesses generally raise only short- and intermediate-term fixed-rate funds to lend. Second, due to federal banking regulations, such institutions are often averse to funding long-term, fixed-rate loans using variable-rate liabilities. Third, it's costly and time-consuming to locate funding sources willing to provide long-term, fixed-rate financing to entrepreneurs unless such debt is guaranteed by the U.S. Small Business Administration.

While the outlook for variable-rate-debt-heavy entrepreneurs might seem bleak, there is in fact good news to report. Over the last two or three years, the market for collateralized mortgage obligations and related securitizing activities have been developing rapidly. Such developments suggest the large pools of securitized mortgage obligations are well-diversified, resulting in the availability of reasonable interest rates on long-term, fixed-rate financing for our entrepreneurs; precisely the type of financing they need to continue doing what they do best: providing economic growth and stability to Indiana and the U.S.

Steven Young, Edward Young and Malcolm McLelland are respectively the CEO, CFO and chief credit officers of Midwest Capital Corp., a non-bank commercial lender specializing in long-term real estate and SBA-guaranteed financing.
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Comment:Why the fed matters to entrepreneurs: interest rate changes x variable rate debt = problems for entrepreneurs.(ADVICE / BUSINESS FINANCE)
Author:Young, Steven; Young, Edward; McLelland, Malcolm
Publication:Indiana Business Magazine
Geographic Code:1USA
Date:Jun 1, 2005
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