What Lehman Did, You Can't

The Lehman Brothers saga in the US gets more interesting, although it’s unclear whether it’s a story in the making or simply rumour and innuendo attempting to create a story.

An online report by Randall W. Forsyth writing in Barron’s published on 4 June 2008, stated that less than 24 hours after the investment bank was reportedly mulling issuing US$3 – 4 Billion in common equity, it went into the market and bought back its shares.

The obvious question was asked: can a company be under-capitalized one moment, only to be over-capitalized the next? Not likely. Clearly something was going on. In certain situations where the stock price of a company is low and capital cannot be usefully employed for shareholder benefit, it might make sense to buy back the shares. The effect of a share buy-back is to stabilize or lift the share price. While that is what happened in LEH’s case, the stock still sits at its lowest level since August 2003.

SAW agrees with Forsyth’s view that it is arguable whether a share buy-back was the best thing to do, given that LEH’s Balance Sheet is purportedly riddled with (CDO-based?) assets of dubious value and limited liquidity. But, if, as it’s CEO is on record as saying, that LEH’s intention was to hurt those engaging in the short-selling of its shares, then a share buy-back using whatever liquidity a company has, would be a defensive move.

As a publicly listed company, LEH has the option of immediately going into the stock market and buying back its shares. They’re millions of them out there, they have an immediate market value and they’re liquid. Buying them back is a snap. If that’s what it takes to maintain a semblance of solvency and liquidity, so be it.

An SME faced with pressing liquidity and solvency issues as well as a Public Relations problem, does not have those quick options. As a private company, its shares are held by a handful of people, possibly a mix of family members venture capitalists or angel investors. There may be a Shareholder’s Agreement with rights and obligations, a mechanism covering notice of intention to buy back the shares, clauses covering how the shares are to be valued and an arbitration procedure if things get really ugly between a shareholder and the company.

Whilst it is possible for an SME to buy back its shares, it’ll take a while. Lehman still has billions of bucks worth of liquidity on its Balance Sheet and could afford to take an immediate bold move to spend some of that cash on a buy-back. The average SME with a looming cash flow problem, couldn’t do it. Either it has to deal with its Receivables properly, or tighten up on its debtors, or reduce the credit period currently extended to its customers, or get a bank loan (good luck with that, at the moment) or offer equity to outside investors.

Doing nothing will just erode shareholder value. And that opens another can of worms.

© 2008 Sanjeev Aaron Williams All Rights Reserved

Mortgage Defaults & Mortgage Insurance

2 interesting stories on the Calculated Risk blog caught SAW’s eye today. The first quoted a report from Housing Wire that mortgage delinquencies in the US are quickly spreading beyond sub-prime borrowers into prime borrowers. The second is that mortgage insurers are twitchy in anticipation of one or more of them failing.

Essentially increasing numbers of supposedly solvent or ‘affluent’ middle and upper middle class borrowers are now finding they can’t afford their properties. Ed McMahon, Johnny Carson’s sidekick, is the poster boy for this phenomenon. He’s reportedly fending off foreclosure on his multi-million dollar California home, having tapped himself out on a home equity line of credit.

Remember that “prime borrowers” have been hit on 2 fronts:

Firstly, chalk it up to financial inexperience, ignorance, greed, lousy budgeting, a proclivity to take on more debt that can be serviced and the habit of using the home as an ATM machine – while regarding it as the largest asset on the assumption that its value would continue to rise indefinitely.

Secondly, it’s well documented just how greedy mortgage lenders became when sub-prime Adjustable Rate Mortgages initially proved hugely profitable. They quickly pushed the product onto unsuspecting prime borrowers who found themselves downgraded into the sub-prime category, saddled with a mortgage they couldn’t understand or afford.

So, if mortgage defaults are now spreading up the affluence chain, it must mean that the cash flow from their jobs or from their own businesses are patently insufficient. Expect relocations and more SME failures in the US.

The increasing number of defaults would predictably make mortgage insurers twitchy. They are also exposed on 2 fronts: the insurance of individual mortgages; and more ominously, the insurance of the exotic alphabet soup of Collateralized Debt Obligations.

© 2008 Sanjeev Aaron Williams All Rights Reserved

Heard It Through The Grapevine

They’re baaa…cckkk…!! Lehman Brothers is back in the news. The Wall Street Journal of 4 June 2008 and one of SAW’s favourites, the Naked Capitalism blog, are reporting that LEH’s appears to be on track to report a quarterly loss larger than the US$300 million predicted by analysts.

And they’re not the only ones making predictions. Investors have bet huge amounts on puts that LEH is gonna sink,sooner rather than later. Their debt rating was downgraded and their stock downgraded to “underperform”.

And what’s LEH said to be doing? Looking for US$3 - 4 Billion worth of new capital to shore up its Balance Sheet.

Effectively, a tsunami of rumour and predictions are driving perception and behaviour. At least the big boys have PR departments, press statements and the luxury of resorting to slick financial euphemisms.

LEH’s denials that it had funding problems and that it did not borrow money from the US Treasury, failed to convince the market and its shares closed down 10%. Let’s not forget that it was in March 2008 that LEH raised US$3 Billion from investors in order to refute reports that it was in the same predicament as Bear Stearns.

For SMEs, any rumour and predictions by outsiders, or insiders, on solvency, are potentially fatal. If cash flow is erratic, intermittent or eroded and debt ratings downgraded in the face of contracting credit, expect to be doing what some SMEs in the US are already doing – taking their goods to the pawnshop in an urgent attempt to raise capital. (Or, to use a Wall Street euphemism, “to shore up their Balance Sheet”).

The problem with rumour is that it takes on a life of its own. For SMEs, even at the best of times, it’s a delicate balance between Accounts Receivables and Accounts Payable. Inevitably, the worst aspect of any rumour reaches the SME’s most intransigent creditors first and encourages the SME’s debtors to delay payments to the last. But the phone calls demanding an explanation keep coming thick and fast.

What a bind. Crippled cash flow in a hurricane of innuendo. What’s an SME to do?

Factor the Receivables immediately if possible – even just a portion of them.

Ironically, shoring up the Balance Sheet through Off-Balance Sheet financing (another term for Factoring) is the quickest way to get cash flow, without giving up equity or sinking further into debt.

One more thing. The reputable Factoring companies are acutely sensitive to outsiders’ perceptions of Factoring and adopt the role of Receivables Managers. It’s all part of the Factoring service. Their ability to make it clear to the SME’s creditors and ultimate debtors that the SME is raising working capital through ongoing cash flow management, often goes a long way in assuaging potentially suspicious parties.

© 2008 Sanjeev Aaron Williams All Rights Reserved

What Due Diligence?

In Factoring deals, the most important aspect is the due diligence conducted by the factoring company on its prospective client and on the client’s customer to whom the invoice was sent. This is because the client’s customer is the ultimate payor. The willingness of the Factor to purchase the invoice at a discount from its face value and to receive full reimbursement from the ultimate payor, is based on risk assessment.

In other words, is the client and the client’s customer worth the risk?

Frequently, SAW gets clients whining that the Factor is asking too many questions, or the questions are too intrusive about the company’s operations, or why is it necessary for Directors to disclose information about themselves and their finances? (the answer is to determine whether the Directors might be stripping the company to line their pockets).

Yet when a bank asks those questions – and more – just for a loan, the Directors meekly comply. After all it’s a “bank” right? The notion that an institution like a “bank” and all its credit checks, is somehow more “authoritative” and “trustworthy” than a private funding source, runs very deep.

And it is deeply misplaced.

The banks’ role in the residential sub-prime drama is history. What is now unfolding is Stage 2: the banks’ and their co-conspirators compounded greed in the exotic securitization and creation of mortgage-backed, debt-fuelled instruments with purportedly stellar credit ratings. These are now unraveling with billions of dollars of losses in the pipeline.

To say that consumers and SMEs have been hurt by the sudden indefinite contraction in credit, is an understatement. What’s really galling is the utterly feckless credit risk analysis supposedly undertaken by banks, investment banks and credit rating agencies as they fell over themselves to slice and dice these securitized instruments in order to push them onto hedge funds and other “sophisticated investors”.

It’s clear that the credit risk analysis of inherently dodgy instruments was a sham at worst, a formality at best. A nudge and a wink was the order of the day at Wall Street. And they have very thick skins. The effect of shoddy and virtually non-existent risk analysis is now blamed on a computer error. That error apparently led Moody’s to assign Triple-A ratings to billions of dollars worth of complex debt product. The error was discovered in 2007, but the debt instruments’ AAA credit ratings remained until early 2008. And it doesn’t end there. The suspicion is that Moody’s may have tweaked its computer model to arrive at the same result as Standard & Poors, in order to keep business as “a second opinion”.

Of course, Moody’s is now doing “a thorough review” of its derivatives ratings.

To which SAW would add, Really?? A computer error that lasted errr……………….7 years???!! Remember it was after US interest rates were slashed in September 2001 that sub-prime mortgages and their securitized derivatives took off.

So….back to Factoring companies and the questions they take the trouble to ask during due diligence. SAW’s humble advice is to stop complaining, be grateful they’re doing their job (properly) and answer their questions fully.

Your future cash flow depends on it

© 2008 Sanjeev Aaron Williams All Rights Reserved