This Alert compares the current recession to prior cycles, and summarizes precautions and protections that advertisers, agencies and media can employ to reduce their exposure to today’s risks.
Background of the Credit Crunch
It is generally understood that the ongoing credit crunch has led to a shortage of financial liquidity. We now seem to be entering a new phase as businesses and consumers retrench.
- Loss of Confidence. One of the cornerstones of business is the confidence we have in the ability of those we contract with to pay us what they owe. For most, that means having the ability to pay debts as they come due and be financially solvent on a balance sheet basis. The model for our major financial institutions is quite different. As long as confidence prevails, their business continues as usual; but if there is a sudden loss of confidence in an institution’s ability to repay or return its customers’ deposits and assets, then a run on the firm ensues and, absent intervention, a financial failure quickly follows.
- Government Backstop. The Federal Reserve, the FDIC and the U.S. financial regulatory scheme were created to provide a backstop and capacity for intervention in order to forestall the possibility of a systemic financial breakdown. It appears, however, that financial engineering and the growing complexity of the financial system may have outstripped our backstop.
- The Bankruptcy Process. Bankruptcy does not work well for financial service companies because of the confidence factor—an insolvency proceeding will not stem a run on a bank but only exacerbate it. Bankruptcy historically has worked well outside of the financial sector, particularly in manufacturing, distribution, retail, and many entertainment and other service businesses; entire industries such as steel and the airlines have been restructured in bankruptcy in past recessions. There appears, however, to have been an erosion of confidence in the effectiveness of the bankruptcy process, as reflected in the widespread view that bankruptcy is not a good idea for the U.S. auto industry.
Signs to Watch For
- Credit and Housing. In this cycle, the credit and housing markets, and not the stock market, seem to be the leading economic indicators. The ongoing need for assistance and bailouts of major U.S. financial institutions remains a negative indicator.
- CPI. There has been a huge increase in the money supply from the injections of additional capital that the U.S. and other governments have made into their economies, and this should lead to inflation. Given the potential for a significant decrease in consumer demand in the first half of 2009, an increasing CPI may be a sign of recovery.
- Bankruptcy Backlog. There appears to be a backlog of companies that would benefit from a bankruptcy restructuring that have not filed because of the credit crunch and related factors. A rash of bankruptcies increasingly seems likely; Moody’s projects a 15 percent high yield default rate for 2009, which implies that 300 public companies will default in that sector alone.
- CDS Market. A good indicator of the financial viability of public companies is the market for their credit default swaps (CDS), which are a form of credit insurance protection for holders of a company’s debt. The more expensive a company’s CDS pricing, the more likely the market believes that it will default on its debt. CDS prices can be accessed daily, like stock market quotes, from sources that offer CDS pricing information to their subscribers, including Bloomberg and Reuters, among others.
Protections Against Risk
- Monitor and Speak to Your Clients. It seems apparent that some advertising agencies, advertisers, and media companies have or will become significant credit risks, especially if dependent on troubled industries such as retail, housing and finance. The first and most important precaution is to closely monitor your business partners and speak openly with them about credit risk and payment issues. Doing so should be easier than in the past. Conversing about the economy has become almost like talking about the weather. And like the weather, beware. Things can change quickly, so keep on top of it.
- Sequential Liability—Know Where You Are in the Payment Chain. The varied credit policies within the industry create a confusing picture—sequential liability, agent/principal liability, sole liability, and joint and several liability—that can lead to unexpected credit exposure. Sequential liability means that the agency agrees to be held solely liable to the media only after it is paid by the advertiser. Until payment is made to the agency, the advertiser is solely liable. Many media reject this position and rarely agree verbally or in writing to this policy. Agencies are aware of the conflict, but advertisers tend to ignore it and frequently have contracts with their agencies that are silent on sequential liability. In a recession, these conflicting obligations can be a serious risk. To avoid double payment liability, audit your documentation and either don’t agree to be liable or be sure everyone understands the risks being taken. Unfortunately, media often has leverage against an agency and advertiser, but that does not mean agencies and advertisers should not reevaluate current policies and shift liability to appropriate parties.
- Minimize Float. Frequently, agencies and the media are not paid within terms because astute financial managers recognize the benefits of holding cash to reduce risk and gain the benefit of float. Coupled with joint and several liability issues, this practice adds a great deal of risk to the equation. Agencies and advertisers must both be aware of their exposure to float and take steps to minimize it.
- Be Active in Bankruptcy. If you do find yourself a creditor in a bankruptcy, take an active role. The bankruptcy process is a court-supervised negotiation among the creditor constituencies that tends to reward those who are active in advocating their interests. Suppliers of goods have a priority in bankruptcy, but suppliers of services such as media do not. The cost of representation in a bankruptcy can be an inhibition, but a way to minimize that is for similarly situated creditors to organize themselves and share the cost of counsel and other advisors.