Credit crisis: You ain’t seen nothin’ yet

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We’re already seeing some dominoes start to wobble in the legal community, as the short- and medium-term impact of the financial crisis becomes clearer. If you’re a law firm CFO or a law student nearing graduation, you probably won’t like what’s coming. But it looks to me like there are much bigger pieces likely to fall very soon.

Let’s start with the dominoes. Here’s an article from the Fulton County Daily Report about the impact of the credit crunch on law firms’ lines of credit, something I mused about last week. Lawyers who traditionally have not made accounts receivable a priority should read this:

Some banks are increasing their scrutiny of law firm loans, attaching more covenants and conditions and looking ahead to how well firms can collect their receivables in the coming year. According to some bankers and consultants who focus on law firm lending, a lag in collection time is pushing firms not just to borrow more money but also to increase holdbacks on partner compensation and, perhaps, decrease overall profit distributions.

Dan DiPietro, client head of the law firm group at Citi Private Bank, said his employer still views lawyers as a good credit risk — despite the crisis coursing through the markets and the collapse or merger of clients that supply billable hours to many of the nation’s law firms. … “What has changed is our focus and discipline on pricing and making sure that we’re pricing with the view that this is not a standalone credit facility but is generating other revenue. … In this market, there’s a huge focus on overall returns.”

Like many banks, Citi looks at firms’ cash flow, receivables and work in progress when assessing their creditworthiness and how much cash to advance on revolving or long-term lines of credit. … Citi is giving existing loans a higher level of scrutiny and is looking more closely at firms on an individual basis to assess how the economic turmoil might affect their receivables.

Then there’s law students, the vast majority of whom wouldn’t be able to meet tuition and living expenses without student loans — loans that are suddenly looking very dicey, according to an article in the National Law Journal:

[B]ecause banks are doling out less money to lenders, private loans are getting harder to come by, said New York Law School Dean Richard Matasar…. That means it will be more difficult for law school graduates to secure private loans, and graduates will, likely, pay higher interest rates if they do get a private loan to bridge the gap between graduation and the bar.

Recent law graduates also will be entering the work force during a slow economy, which means they may spend more time in the job search process. Consequently, they potentially could have a tougher time repaying money they borrowed to go to school, Matasar said. “It’s a time for caution. It’s a time for students to plan well for how much debt they are taking on and how they will pay for it,” he said.

Bleak tidings, potentially, and it’s not clear to me whether law firms or the bar admission system have the capacity to absorb the impact of a full-blown crisis in either area. But I’ve been pondering lately whether there’s another, far more dramatic potential result from the financial crisis: the underpinnings of many large corporate law firms.

Now, I’m far from a corporate finance expert — I’m a reasonably bright layman who reads The Economist whenever a spare moment presents itself. But it seems to me that a lot of the ballooning growth in the global financial sector over the past several years — the balloon that’s now rapidly decompressing — was driven by extraordinarily complex financial instruments that made derivatives look like child’s play. Consequently, over that same period, large law firms have transformed themselves from relatively balanced full-service legal shops to giant operations, powered by enormous corporate law engines and producing annual profits per partner to boggle the mind.

If, as I suspect, the modern mega-firm has grown so much and so quickly thanks largely to a ten-year injection of corporate law steroids, what will happen to all that bulk now? Most of the reports I’ve read indicate that once the crisis passes, the debris is cleaned up and things return to a new normal, corporate law will be facing a back-to-basics period of indeterminate length. The appetite for complex commercial instruments figures to be low — will demand for expensive corporate legal services decline accordingly?

Not only that, there’s a very good chance of an anti-corporate backlash at the legislative and regulatory level. Political parties with populist leanings are favoured to take power in the US within a few months and the UK within a couple of years, and there’ll be a lot of short-sighted “reforms” of the system designed to make sure this (again) never happens again. The Enron fiasco gave us the rushed and seriously flawed Sarbanes-Oxley Act — imagine what kind of laws will result from a crisis hundreds of times bigger than that one.

Sure, there’ll be work for lawyers — there always is. But it may require the transformation of an entire generation of aggressive corporate lawyers into painstaking compliance specialists. Compliance is less profitable now, and it’s going to be a lot less profitable down the road as software and systems take over more and more of the billable tasks and time. There’ll still be mergers and acquisitions, of course, and there’s always be a need for financing — but it’s more than possible that a golden age of securitization has just passed, and that it may take entire law firm departments with it.

If you’re in any way responsible for, or tied to the near future of, a law firm with a significant corporate practice, these are things you need to be thinking about. It is flatly not possible that the entire Western financial system will experience massive change, while the law firms that serve it sail through in peace and tranquility.

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