Sticking It To Shareholders

One of the by-products of the Bear Stearns “rescue” was the destruction of shareholders wealth. Forget the fact that the office building was worth US1 Billion; forget the fact that book value was apparently US80.00 per share; forget the fact that it’s share price fell 47% real quick. At the end of the day, when debt levels are officially “toxic” and cash flow is negative, the company was worth about US2.00 a share.

It’s worth remembering that Bear Stearns had a policy of actively encouraging employee share ownership. 30% of the company was owned by its employees, many of whom were subject to lock-up agreements as to when they could sell their shares. The point is now moot. Their shares are worthless. Ironically, this was the result of the company being deemed too important to fail.

Further, according to a report on Bloomberg TV today aired in Hong Kong, Bear Stearns had US50 - 60 Billion in liquid assets. Really? What took them so long to wake up and turn them into cash? After all, it was in August 2007 that they first reported that 2 of their hedge funds with exposure to mortgage derivatives, were in trouble.

For SMEs the sobering lesson is the fundamental importance of cash flow and liquidity. SMEs are notoriously lax in monitoring cash flow especially from their Receivables. In fact, look at the Accounts Receivables Ageing Report of an SME and it’s often shocking just how many Receivables are outstanding for more than 90 days or worse, more than 120 days.

Whilst they may be presently listed on the Balance Sheet as Current Assets and potentially liquid, the longer they remain outstanding, the greater the risk that they will turn toxic. In time, the Accountants will advise the company to shift those Receivables further down the Balance Sheet to Bad Debt. In other words, those Receivables are written off. The Invoice, which should have generated cash, is now a worthless debt instrument. Effectively, it’s no different to the massive writedowns witnessed on Wall Street from flakey mortgage backed securities. In either case, the cash flow is crippled.

SMEs don’t have the luxury of US Federal Reserve bail outs. The crippling of cash flow results in an erosion of shareholder equity. Yes, you can be profitable, and at the same time you can be insolvent. That’s the lesson Wall Street is now learning to its huge embarrassment.

And if the SME has lousy cash flow, is technically insolvent, is saddled with Bad Debts and has no other liquidity options, the Directors, who are usually the major shareholders, are holding potentially worthless shares.

© 2008 Sanjeev Aaron Williams All Rights Reserved

Manna From Heaven

“Leveraged risk is a cancer in the market”

So reported the online edition of the British newspaper Telegraph on 7 March 2008, apparently quoting UBS (and they should know, right?)

SAW decided to keep that quote, figuring that something would pan out in the coming days – and it did. First, the default and collapse of Carlyle Capital and then………. Bear Stearns, Wall Street’s fifth largest investment bank, nearly panned out, following a loss of confidence by hedge fund clients who withdrew their cash. All this against an accelerating backdrop of rumour and innuendo from 6 March 2008 that European banks, fixed income and stock traders had stopped trading with Bear because it was having trouble with daily liquidity and that it was not receiving short term financing from banks. You just knew something was very wrong.

By 15 March 2008, despite repeated statements from Bear executives that solvency was not an issue (the real clue that it really was), the US Federal Reserve and J. P Morgan Chase stepped in with an emergency cash lifeline for 28 days. The Wall Street Journal’s online report for 15 March 2008 spells out the sequence of events.

Since Bear is technically an investment bank and not a commercial bank, it could not receive the money directly from the Fed. Instead, the Fed lent the money to J.P.Morgan, a commercial bank, who then re-lent it to Bear. The Fed assumes the risk of default.

So what are the lessons in all this for SMEs?

• You don’t have, or at least you shouldn’t be having, the apparent luxury of massive debt to equity ratios. One of the more astounding facts to come out of Wall Street last week was the revelation that companies like Bear were leveraged in mortgage-related derivatives at 32 times equity. That’s a fancy way of saying that you have one dollar in your left pocket, but you owe 32 bucks from your right pocket – and you don’t have any cash flow. How long do you think you could survive?

• The more complex the derivatives, the deeper and more pervasive the risk of default. Let’s make one thing very clear. There is a difference between the sub-prime residential and other “asset” backed (read plasma screen TVs) mortgages – which are theoretically quantifiable, and the mountain of structured finance (read paper transactions) which sliced, diced, chopped and pureed these mortgages into ever more sophisticated and ultimately toxic cocktails whose value is unknown – except for the blatant fact that whatever it was, it ain’t now.

• By way of contrast to (1) and (2) above, the sale of Invoices through Factoring does not result in debt. First, it improves your debt to equity ratio. Second, it improves your Balance Sheet (because the Invoices, which are listed as Current Assets, are converted into cash). Third, it improves your cash flow. Funny how Wall Street titans forgot that the more dodgy the security, the worse your cash flow, the Balance Sheet and debt to equity ratio. Pretty basic stuff.

• For an SME, the unpaid commercial invoice is a quantifiable asset. The due diligence that the funding source does on the client and the ultimate payor ,is the assessment of risk to determine manageability. It's a tried and tested recipe without dubious notions of "mark to model" valuations.

• And the rumour and the innuendo? SMEs are sometimes concerned that Factoring will damage their reputation or give the impression that they are financially unstable. It’s well known that Fortune 500 companies factor to improve their cash flow. An SME that is cognizant enough to guarantee its cash flow through factoring, capitalize on the time value of money and ensure that Receivables outperform Payables, will be the subject of one kind of rumour. Smart.

© 2008 Sanjeev Aaron Williams

Tightening The Noose

It’s apparent since the last posting on this blog on 6 February 2008, that financial institutions are in credit-retraction mode across the board – and nowhere more so than in the US. Capital liquidity ratios are being watched – apparently diligently.

What a concept!! For the past 6 years in the US, assumed cash flow from dodgy based credit was considered “prudent” business. It didn’t occur to these stellar bankers that when cash flow stops, capital base erodes, and business confidence with it.

The following quote sums it up. It’s taken from an article by Doug Noland entitled “At The Heart Of Disorder”, Credit Bubble Bulletin, published in Asia Times Online on 12 February 2008:

“[A] survey of senior bank-loan officers provided confirmation both that bankers have become much more cautious in lending and that borrowers have lost enthusiasm for taking on more debt. Moreover, any indication of general tightening of bank credit takes on major significance today due to the seizing up and breakdown of Wall Street finance. Inarguably, what erupted last year in subprime has now evolved into a broad-based and severe credit tightening. Notably, 80% of banks tightened credit for commercial real estate lending and better than a third tightened commercial and industrial (C&I) credit.”

For SMEs the news is ominous. It suggests that credit tightening is so broadly based as to have become indiscriminate. In other words, the company’s track record and creditworthiness are now irrelevant. Financially responsible SMEs may be denied access to funds from banks on account of the inflated and reckless stupidity of Wall Street and their cohorts. These large “sophisticated investors” were leveraged over, above and beyond their equity base in so-called Asset Backed Securities, Mortgage Backed Securities (many of which were sub-prime) and the associated derivatives such as CDOs and SIVs.

All of these products are now the subject of rapidly depreciating asset values, forced sales and margin calls. As mentioned in earlier posts, the issues are one of liquidity and solvency in an inter-connected credit web, where the risks taken were both direct and indirect.

Yeah, interest rates may continue to fall, but what difference does that make if SME’s can’t get the funds at any price?

It’s been one year since this whole sub-prime fiasco broke. For an informative look at how this whole thing unfolded, have a look at the article by Julian Delasantellis entitled, “Subprime Crisis A Year Later – And The Band Played On”, Asia Times Online, 6 March 2008.

© 2008 Sanjeev Aaron Williams All Rights Reserved