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I was reading the Comments on Credit blog (www.commentsoncredit.com) discussing the need for cashflow in lending and de-emphasizing collateral.  They are right, collateral is very chancy.  But they dont go far enough.  So ill pick up the baton.

Relying on collateral is risky for several reasons. First, established manufacturing companies, those more likely than not to provied assets for ABL structures, are very exposed to a synchronized downturn resulting from a cycle trough or exogenous shock.  This means that earnings will become strained as the industry is declining (cyclically or secularly). As a result, the demand for the hard assets (we will deal with current assets in a moment) will be at a low point, as the industry for which the M&E is designed or the real estate is best suited is generating lower cashflows.  Simulataneously, the synchronized downturn will flood the market with similar use equipment.  The combined increase in sully and decline in demand will yield lower liquidation values.

Moody’s recently published a report demonstrating that revolvers tend to rise as companies approach distress.  For revolving lenders, this means that excess availibility declines and the collateral cushion thins.  This also means that other secured lenders who might have a second lien on other assets (think about a lender with a lien on M&E who is starting to realize that the supply/demand imbalance in distress is depressing collateral value) will see collateral cushions disapear.

In the end, what matters is the ability of the assets to generate cashflow and that is driven by the microeconomics of the industry. 

At least, that’s just one credit analyst’s opinion.

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