A Whiter Shade Of Pale

So let’s see..........World Emperor Bush rode into the sunset and hopefully, will be consigned to the trash bin of history. 44 is in, sternly warned the planet that things wouldn’t be easy, partied all night, went to church and started work.

Meanwhile US, UK and Hong Kong markets – and markets pretty much everywhere else, tanked and still are. Bank of America, which swallowed Merrill Lynch is throwing up, divested its “strategic” shareholding in a Chinese bank and screamed for a cash bailout from the Feds. They got it – US138 Billion for them, US118 Billion in guarantees for Merrill’s crap err….assets.

Citibank, the world’s global bank, is a global embarrassment with a share price to match. It’s disembowelling itself and donating part of a vital organ, the brokerage arm, into a joint venture for a capital infusion.

Royal Bank of Scotland proudly announced it had scored another first: a 28 Billion Pound loss, the biggest in British history. One assumes that its overpriced leveraged acquisition of ABN AMRO for 49 Billion Pounds – at the time the largest banking acquisition in UK history –might have contributed to its backhanded stellar performance.

The British government is all set to open the floodgates of liquidity with 350 Billion Pounds of cash. They already have precedent on their side. First it was Northern Rock’s bailout of 55 Billion Pounds in September 2007, then Bradford & Bingley in September 2008, then credit guarantees, a liquidity scheme in October 2008, something about a toxic asset buy up plan etcetera, etcetera…….plus the hint that the Bank of England could be given license to print money, effectively at will to enable “quantitative easing”. That’s assuming that buying up the crap with UK Treasury Bills doesn’t work. And remember, British interest rates are the lowest they've been in 314 years.

Australia is not looking so thrilled. Access Economics reported that the country is heading towards the sharpest recession in its history. Plumetting commodity prices mean a decrease in government royalties, taxes and increasing budget deficits.

With the scale of the toxic debt instrument creation belatedly becoming coherent, both the US and the UK governments have announced plans to set up a special bank to absorb those assets, in exchange for equity in the surrendeing banks.r

Great….so we have creeping trans-Atlantic nationalization, the Fed prints money at will, the Bank of England can print money at will and soon the European Central Bank, given the mess that Eurozone is in, will also be printing money at will. Effectively, every white country is up the creek and the loss of confidence is damaging emerging economies. It’s worth remembering that this scale of money creation, whether individually or jointly, has never been done before. We’re all watching an experiment in which nobody knows what’s going to happen and nobody can predict how much confidence there will be in all this freshly minted cash.

© 2009 Sanjeev Aaron Williams All Rights Reserved

The Bigger The Trough

…..the larger their snouts…..

The US auto companies didn’t quite get the warm political reception they’d hoped for as part of their grubbing for US25 billion. Given that all 3 claim to be on the verge of bankruptcy, it didn’t help their case that the CEOs arrived in private jets. In mitigation, General Motors is returning 3 of its leased jets while promising greater use of video conferencing…..

Oh, and being asked by politicians to spell out exactly why they need capital, what they intend to do with it, over what time frame and what kind of returns to expect, was hardly a surprise. Any SME, whether looking for factoring funds, seed capital, mezzanine financing, venture capital or a bank loan would be asked exactly the same questions. What gave the auto companies’ CEOs the temerity to think they’d be exempt from the basic criteria of accountability?

Probably the fact that to date neither the US Federal Reserve nor the Treasury will disclose exactly what securities they have accepted as part of the now scrapped “cash for trash” deal that was the original TARP. The new plan to directly take equity in the banks (and potentially anyone else) has already been derided as incipient nationalization and crony capitalism. Oversight provisions as to how the government funds will be dealt with once injected, are non-existent, other than a bland assumption that the funds will be deployed for lending.

Meanwhile, according to Calculated Risk, as of 21 November 2008, 22 US banks have failed this year – so far. In fairness, some banks in the US, particularly those that stayed well away from the financially engineered toxic debt instruments, are doing just fine and are happy to continue and extend lines of credit to well managed commercial clients.

And the boys at Citigroup – whose share price is now that of an enhanced penny stock - are working overtime negotiating a government bailout or a sell off (of their lucrative credit card business, the Smith Barney brokerage, or their recently appointed CEO Vikram Pandit who announced jobs cuts totalling 82,000).

The joys of being an international conglomerate like Citigroup, allow for a degree of self-righteousness flatly denied to private companies: Citi is too big too fail and must be “saved” to end the hysteria; as a US company operating all over the world overseas governments should help bail it out; Citi is a victim of short sellers whose stock price has a reached a level that necessitates government intervention by way of cash injection, absorption of bad loans and an assisted merger.

Um… OK… government intervention for whose benefit? The shareholders or the financial system?

© 2008 Sanjeev Aaron Williams All Rights Reserved

Global Interest Rate Cuts

Earlier today, Hong Kong time, there was a coordinated response from the US Federal Reserve, Bank Of Canada, Bank of England, European Central Bank and the Riksbank of Sweden to cut interest rates by 50 basis points. All banks issued public statements in similar form, pointing out the need to take action in a slowing global economy.

Would it be impertinent to point out that interest rates are already low, have been for sometime and still the US economy, the European economies and the Asian economies are slowing or are expected to slow?

Is SAW missing something? How do lowered interest rates deal with the 2 fundamental issues of institutional decapitalization and deleveraging?

And if the problem is one of outrageous consumer debt and shoddy bank lending, are lowered interest rates going to make the banks thrilled to lend again to consumers who turned out to be lousy credit risks?

Not likely.

One of the widely read blogs, Mish’s Global Economic Trend Analysis, asserts in a posting, Global Coordinated Rate Cuts Won’t Solve Economic Crisis dated 8 October 200,8 that the root cause of this crisis is fractional reserve lending. Interesting……SAW is no economist just a simple lawyer, who in his previous post entitled What Crisis dated 1 October 2008 suspected the same thing.

As MIsh put it:

“The world is heading for a global recession and a sure bet is that it will be blamed on a subprime crisis in the US. The reality is the greatest liquidity experiment in history is now crashing to earth.

The root cause of this crisis is fractional reserve lending, and micromanagement of interest rates by the Fed in particular and Central Banks in general. The Fed started the party by slashing interest rates to 1%, but Central Banks everywhere drank the same punch to varying degrees.

The Greenspan Fed lowering interest rates to 1% fueled the initial boom, but like an addict on heroin, the same dose a second time will not have the same effect. The Fed, the ECB, etc. could have slashed rates to 0% today and it would not have mattered one bit.

The reason is simple: There is no reason for banks to go on a lending spree with consumers tossing in the towel, unemployment rising, and rampant overcapacity everywhere one looks with the exception of the energy sector.”

© 2008 Sanjeev Aaron Williams All Rights Reserved

What Crisis ?

It gets tedious after a while, reading all the political and media spewing espousing the need for an apolitical solution to an economic – and legal- problem. Superlatives are everywhere: “financial Armageddon”, “global meltdown” “catastrophic failure”….ad nauseam.

Yeah, it’s kinda fun watching history being made, and even more fun attempting to make sense of it. All this talk about the need to protect assets, to ensure credit markets don’t freeze and the risk of sharp inflation - even though SAW suspects that the term “inflation” is a misnomer. It’s probably sharp depreciation in purchasing power caused by too much US Dollars aka Funny Money swilling around.

And talking about Funny Money and credit, exactly what is seizing up? Here’s one theory from a simple lawyer. What is seizing up is the grossly over-inflated, exponentially grown, debt- based supply of money that was, literally, created, out of thin air without reference to anything else.

Whilst greed, fraud, conspiracy and tacit governmental approval are all in the mix, SAW suspects that the (presently legal) practice of Fractional Reserve Banking was exploited to the Nth degree with monstrous effect.

If Customer A deposits $1,000 in the bank, the bank has the legal right to lend the majority of that $1,000 to someone else. So the bank might lend say, $900 to Customer B. That is recorded as an electronic transfer of funds into Customer B’s bank account. Therefore, it is technically a deposit of $900.

That allows the bank to then use that “deposit” of $900 to make a loan of the majority of it to Customer C. So, Customer C might get a loan of say, $800. That would also be by way of an electronic transfer of funds into his account and would technically be regarded as a “deposit” of $800.

Again, the bank would lend the majority of that $800 dollars, say, $700 to Customer D….and the process would be repeated ad infinitum.

All this money (technically “currency” not “money” – there is a difference) is created out of thin air without reference to any underlying asset values. It operates solely as a debt-based creation i.e. the more debt that is created, the more money can be created out of thin air for lending. On that view, the creation of sub-prime mortgages made perfect sense. They were the perfect debt-creation vehicle upon which Fractional Reserve Banking could grow exponentially – and did.

And those sub-prime mortgages were subsequently, sliced, diced, repackaged and resold as “Asset Based” or “Mortgage Based Securities” to Investment Banks and Hedge Funds.

The simple point being made is that the money supply, created out of nowhere and based entirely on debt, was so outrageously large that it bore no relationship to the value of goods and services in the real economy. Putting it another way, the actual hard core assets did not exist to support that level of lending.

If that is correct, the widespread practice of shoving the exotic, and now toxic, debt instruments Off-Balance Sheet (and in many cases Offshore), also made perfect sense. Bringing them onto the Balance Sheet would result in an erosion of actual bank capital –which is exactly what is now happening. That explains the reluctance of banks to lend to each other and the recent spike in LIBOR.

Which is why a US Federal Government Bailout is such a lousy idea: the US Dollar is nothing but a debt-based fiat currency. In its crudest terms, the bailout is debt compounding debt.

Perhaps what we are now seeing is not a credit crisis, but a spectacular and necessary implosion of the debt bubble contracting to a level where the debt is backed by capital assets. Will there be severe restrictions on personal and commercial borrowing in the near term? Yes.

Will there be a change in Wall Street’s mentality? Dream on. People got filthy rich on this scam.

What’s a bet they created this situation up to this point plus the frantic requests for a bailout, in order for the next instalment of their grand scheme to kick in? SAW finds it impossible to swallow the notion that Wall Street is spiraling out of control or has been caught by surprise.

© 2008 Sanjeev Aaron Williams All Rights Reserved

Thanks For The Memories

“The reality is that the financial system has been operating as if it were an off-balance-sheet vehicle of the government. Private-sector companies and individual bankers have been making huge profits in the bubble. Their risk appetite has been enhanced by previous bail-outs and, in the case of Fannie and Freddie, by the government’s implicit guarantee. Yet their market pricing does not reflect the potential cost to the system of their own collapse.”

John Plender, “Capitalism in Convulsion: Toxic Assets Head Towards The Public Balance Sheet” published in the Financial Times, 19 September 2008.

OK agreed…something very exciting has been going on in the model of Western capitalism, at least in the US which will probably have to reconsider it’s claim to be the bastion of free market capitalism.

In case anyone forgot, back in 1933 commercial banks (i.e. the ones that take deposits from Joe Public) and investment banks (i.e. the ones that create financial instruments for primarily institutional investors) were required by law in the US, to keep their operations separate. The excesses of the investment banks via over-leveraging and speculation was one of the reasons for the stock market crash in 1929 and the start of the Great Depression.

Back to the present, at last count, 3 of the 5 biggest investment banks in the US have gone: 2 by self-sacrifice, Bear Stearns and Merrill Lynch; and one by insolvency, Lehmann Brothers, whose operational entrails are now being picked by Barclays Bank PLC and Nomura

The remaining 2, Morgan Stanley and Goldman Sachs have been offered the status of “bank holding companies”, allowing them to take deposits from Joe Public. Funny how history repeats itself. Once again, investment banks are morphing into commercial banks……

….and for 2 good reasons (at least for them): First, they will have access to Federal funding should they find themselves in a distressed situation again. Secondly, garden variety retail deposits, boring and predictable as they are, constitute a stable source of capital. It’s now clear that over the last few months, investment banks saw a massive erosion of their capital base when they were forced to bring in Off-Balance Sheet debt instruments over which they had no hope of getting paid.

Or to put it another way, Joe Public stands to fund Morgan Stanley and Goldman Sachs privately, via his retail deposits; and publicly as an over-indebted taxpayer through government largesse.

But the investment banks have to pay a price. First, a reduction on leveraged finance and debt ratios. Second, a submission to greater governmental regulation. Third an obligation to separate retail deposits from capital market activities.

What does all this mean in practice? With their newly re-capitalized status, expect Goldmans and Morgan to go on a predatory spree to acquire small distressed commercial banks – of which there must be lots.

Although the figures for bailouts have been gargantuan, the lesson for SMEs remains easy to digest. If your Balance Sheet is riddled with debt that you have no hope of collecting, your cash flow dries up, your capital base erodes and you go out of business.

And the government couldn’t care less.

© 2008 Sanjeev Aaron Williams All Rights Reserved

Sleight Of Hand - Just For You

Regulation is inherently prophylactic and cannot be properly created in the crises it seeks to prevent. Today calls for a single coherent and transparent approach to falling house prices (destined to continue), asset write downs (destined to continue) and liquidity crises (destined to continue). We simply cannot have Sunday closed-door meetings deciding the fates of tens of thousands of jobs, life and death for industries and billions in investor losses. Want to see what that creates? Pick up a newspaper.

Max Fraad Wolff
Editor of the Global MacroScope Website
From the article “US At A Turning Point” published in Asia Times Online 20 September 2008


Yes indeed……” a single coherent and transparent approach…..”

It’s not necessary to rehearse the hype or the horror that’s been seen on the streets and the media. More entertaining is how funny money i.e. the US Dollar (removed from the gold standard 37 years ago by Richard Nixon) continues to be printed at record rates to fill financial potholes created by Wall Street and their political cronies.

Having satiated themselves financially, they are now calling for regulation and the creation of a “Bad Bank”. The single coherent and purportedly transparent approach is a super-sized entity, by way of a fund of US800 Billion that will buy all the toxic debt and hold them indefinitely until they can be sold off at some point in the future. Effectively, it nationalizes the mis-managed, corrupt, criminally negligent results of the biggest fraud in modern history……..

…..with apparent legal immunity from prosecution.

There’s a trans-Atlantic threat to go after the short sellers and a temporary ban on short selling in the shares of some listed financial companies. But short sellers did what they do best – responding to rumour and fact by taking an opportunistic position against banks, hedge funds, insurance companies and investment banks who consciously leveraged risk to outrageous amounts then resorted to Sovereign Wealth Funds, private equity and carefully crafted press releases to buy funds and buy time. All this to allow them to dance around the perimeter of their rapidly growing pool of un-saleable, off-Balance Sheet, offshore-held, “asset”-backed and mortgage-backed securities.

If short sellers knew what they were doing, so too did the companies who were shorted.

There’s no denying that short selling abruptly stalls over-valued stocks and might crash their price, but that’s the inevitable flip side of overblown asset valuation, whose prices were allowed to bubble unchecked for……..7 years.

Quoted in the BBC’s online report of 19 September 2008, entitled, “Who’s In The Dock For The Financial Turmoil?” Professor Richard Portes of the Centre For Economic Policy Research said,

“A key issue is the opacity of the banking system. If no-one can truly assess the liabilities of a given financial institution, how can they confidently lend it money? But this has helped people make money.

"You make money when it is opaque, you make money when you have got information that other people don't have.”

The extraordinary dereliction of duty by regulators and central banks fuelled the opacity. The creation of the super-sized “Bad Bank” centralizes the opacity. True transparency requires the full disclosure of actual or suspected toxic debt instruments, the use of criminal sanctions and the refusal to cave in to financial industry demands for lenient accounting standards and waivers.

Granted, the devil is in the details, but just how do you value opaque debt instruments? If banks looking to offload to the “Bad Bank” are forced to declare their toxic mortgage and non-mortgage based assets at a discount, won’t that affect their capital base and drive them into insolvency?

Perhaps SAW is too philistine in his views, but a true meltdown is required to flush this garbage out. We now risk being drowned not in a sea of toxic debt, but in a foam of political blather, half-baked regulations and the cherry picking rescue of those institutions deemed too important to fail. It appears that free market capitalism that made a certain clique rich beyond belief, has now morphed into emergency socialism with the express intent of limiting their losses, while purporting to act for the public good.

© 2008 Sanjeev Aaron Williams All Rights Reserved

Fannie & Freddie

Yet again, it pays to shut up.

For weeks.

Anyone who read the assertive and incisive comments over the last few months by Nouriel Roubini in the RGE Monitor, would have reacted with déjà vu on hearing about the impending implosion of the US organizations Fannie May and Freddie Mac.

In case you didn’t know, Fannie & Freddie are privately owned organizations operating under the mandate of the US Government. They perform a dual function.

Firstly, they provide funding for home loans, not by lending directly to the consumer, but by buying up tranches of mortgages from approved lenders, re-packaging them as investments and selling them off to Wall Street and internationally (sound familiar?).

Secondly, they are the guarantors of last resort of about half of all US home loans. That’s about US6 Trillion out of US12 Trillion at the moment. The figures start getting a bit silly at this level of debt.

The theory is that in their role as middlemen between mortgage lenders and investors, more money would be available at cheaper rates to allow people to buy their homes.

It’s their role as guarantors of an increasing number of crappy and defaulting mortgages that sent their share price plummeting, amidst fears that Fannie & Freddie would run out of cash. Both issued statements that their capital base is strong – although Freddie is scheduled to sell US3 Billion in short term debt right about now.

Predictably, the US Government made patriotic noises about how they must not be allowed to fail. Their line of credit was extended (about time too: Fannie has US800 Billion in debt, Freddie has US740 Billion in debt) and the US Treasury may even buy equity in them. It doesn’t get much sweeter than that. And who would ultimately be paying for all this? The dear taxpayer of course. And what would they get out of it? Nothing, except for continued intransigence and reluctance to lend to individuals and SMEs citing the “global credit crunch” as the excuse.

Problem was, as the New York Times pointed out, for years nobody in the US government would even acknowledge the existence of the line of credit, even though it amounted to an implicit guarantee that a Fed bailout would always be there, while in the meantime the Government didn’t have to show mounting losses on its Balance Sheet for what was in effect, a subsidy.

Again, as the New York Times put it on 13 July 2008:

The dominant role Fannie and Freddie play today is no accident. The companies, Wall Street firms, mortgage bankers, real estate agents and Washington lawmakers have built up an unusual and mutually beneficial co-dependency, helped along by robust lobbying efforts and campaign contributions.

Back in the real world of SMEs, there isn’t the luxury of government insulation that gives the business owner discounted rates on the money markets, covers up lousy management, arguably encourages “moral hazard”, imposed lax capital standards – which went unsupervised for years - and aided and abetted the packaging of toxic debt instruments to private investors. Since you can’t pay for lobbying, the best you can do is network.

Who really benefits from this? It ain't the consumer or the SME. It's those investors in collateralized debt instruments, originated by Fannie and Freddie, seeking to have their returns guaranteed by the state. Or, put it another way, a prime example in the sub-prime saga where profits are privatized and losses are socialized.

© 2008 Sanjeev Aaron Williams All Rights Reserved

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

A Prompt Delay

It’s all getting farcical and paradoxical. Hence the title of this post. An online report in the International Herald Tribune dated 8 April 2008, said that the International Monetary Fund (“IMF”) warned that sub-prime losses could reach US$1 Trillion broken down as follows: US mortgage losses, securities tied to commercial real estate, loans to consumers and companies.

Since the total losses and asset write-downs reported by banks and other flakes are in the region of US$232 Billion, the forecast of US$1 Trillion suggests the worse is still to come.

“There was a collective failure to appreciate the extent of leverage taken on by a wide range of institutions - banks, monoline insurers, government-sponsored entities, hedge funds - and the associated risks of a disorderly unwinding.”

Interesting choice of words. A “collective failure to appreciate……”??? Garbage. It was a conscious act of cumulative greed, going back 7 years.

As one commentator put it, this wasn’t a problem on Main Street, it was manufactured by Wall Street.

Personally, SAW prefers the following quote taken from Byron King’s article, “The Flipping Industry” published online in The Daily Reckoning dated 8 April 2008:

“It is apparent that much of the old way of doing business - particularly in the realm of lending money - was rotten to the core. In my view, it begins with the dollar itself. The dollar has been steadily deteriorating in value for decades, so inflationary expectations are part of the worldwide consciousness. That is, just because of the long-term decline in the value of the dollar, most people expect most things to go up in price most of the time.

So is it any wonder that people developed a "speculation expectation"? This fed into an entitlement mentality, as well, that tainted every rung of the credit ladder. A lot of people wanted to buy and flip, whether it was houses or stocks or commodities. So other people lent to people to enable buying and flipping. Flipping became a dominant, if not defining, element of the financial "industry," of sorts.

But what an industry! For example, in the past five years, many people just plain lied through their teeth on everything from credit card applications to mortgage applications to the lending documents for multibillion-dollar takeovers. It was pure and brazen fraud in many instances, verging on burglary in plain sight. The next level up the food chain - the brokers and loan officers - often just looked the other way and rubber-stamped the papers. "Hey, not my problem."

This kind of bad buck-passing went all the way to the top of some firms, many with familiar names. There in the ethereal reaches of the nice office buildings in Irvine, Calif., and Fort Lauderdale, Fla. - let alone Wall Street - the chief executives knew, or should have known, how risky the portfolios were becoming……”

There’s no lack of wishful thinking in the IMF report either suggesting that banks improve disclosure and take write-downs "as soon as reasonable estimates of their size can be established."

Yeah right. In case nobody noticed, the banks are taking their own sweet time to disclose the size of their losses, apparently operating on the assumption that a periodic drip feeding of their loss disclosures would be easier for their shareholders to stomach – and in the meantime, sugaring the pill by begging from Sovereign Wealth Funds and, if they’re in the US, sucking from the Federal Reserve’s discount window in exchange for tendering worthless securities on a “no-questions-asked” basis.

Oh yeah, the new IMF boss who took office in November 2007 admitted that the organization,

“was not as vocal as it could have been about the risks that a subprime collapse posed for the global financial system.”

Maybe that’s all he should have said.

© 2008 Sanjeev Aaron Williams All Rights Reserved

And The Winner Is...Part 2

It just keeps getting better. Here, courtesy of the BBC’s online report dated 1 April 2008, is the updated list of the sub-prime losers. All figures are in US Dollars. See the up and coming post entitled Double Or Nothing for what SAW has to say about UBS.

• UBS: $37.4bn

• Merrill Lynch: $22bn

• Citigroup: $21.1bn

• HSBC: $17.2bn

• Morgan Stanley: $9.4bn

• Deutsche Bank: $7.1bn

• Bank of America: $5.3bn

• Bear Stearns: $3.2bn

• JP Morgan Chase: $3.2bn

• BayernLB $3.2bn

• Barclays: $2.6bn

• IKB: $2.6bn

• Royal Bank of Scotland: $2.6bn

• Credit Suisse:$2bn

© 2008 Sanjeev Aaron Williams All Rights Reserved

Directors & Home Equity Loans

Directors of SMEs, particularly those in start-up mode, are always looking for cash sources. It’s common for them to take a personal home equity loan and siphon the funds into their business. The assumption is that the business will make enough cash to service the home equity loan.

The reality is the home equity loan is usually a second mortgage and the business is saddled with paying that off – plus all the other overheads related to the business. In the US, particularly between 2002 and the end of 2006, rapidly rising home values and lowering interest rates, made home equity loans particularly attractive. Cash appeared to be right there, in the walls of the house.

People borrowed massively. The sillier ones for consumer items, the desperate ones to pay their other bills including their first mortgage, the greedy ones to speculate in property and the occasionally smarter ones, for business investment.

An online report of the New York Times dated 27 March 2008, put the figure of currently outstanding home equity loans in the US at US$1.1 Trillion. Falling interest rates and the Fed’s “nuclear option” of massive injections of “apparent liquidity” (yes, the words are deliberately in quotations because the liquidity is just recently printed money issued in exchange for less-than-stellar mortgage debt) have done nothing to ease the mistrust that exists amongst commercial lenders. Further, falling home prices, rising debt delinquencies and negative equity have only increased the mistrust between commercial lenders and consumer borrowers.

In a financial world awash with US Dollars from emergency measures (recently described as “Dollar Pollution”), there seems to be a huge shortage of US Dollars owed by the consumer borrowers to their lenders in the field of home equity loans.

So worried are lenders who made home equity loans, that they are actively obstructing the borrower from selling the house or refinancing it, unless there is some prospect of them being paid. As the New York Times article pointed out, when the going was good, they really didn’t mind what the borrower did. Using the home as an ATM was widespread.

Should the property have negative equity when sold (i.e. its value is less than the outstanding mortgage(s)), holders of the first mortgage have a priority lien to be paid in full first. That leaves nothing for the home equity lenders – particularly in areas of California, Arizona, Nevada and Florida where home prices are said to have fallen significantly.

If the same lender holds the first mortgage and home equity loan, they might be more willing to allow the borrower to sell or refinance. Where there are different lenders, home equity lenders are obstructing the sale and demanding at least partial recovery from the first mortgage holders.

For a director of an SME whose business cash flow is compromised by a souring US economy, refinancing the home equity loan may be difficult in the face of obstructive tactics by second mortgagees. Further, a delinquent home equity loan is noted on the borrower’s credit record. That will compromise the director’s ability to raise personal financing in future.

If the director files for personal bankruptcy, their ability to manage the company into which they poured equity in the form of cash and sweat is finished. Effectively, the director loses his home and his company. In other words, his cash flow.

It’s a zero-sum game: the worst kind of business equation.

© 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

Negative Equity & Negative Interest

Having earlier said in this blog that interest rates are being seen as both the cause and the cure, yet again (and entirely predictably) the US Federal Reserve cut interest rates on 30 January 2008 (Hong Kong time).

Interest rates in both Hong Kong and the US are now officially below the rate of inflation. That’s small comfort to the hordes in the US who defaulted on their mortgages, abandoned their homes and left entire neighbourhoods derelict. Increasing Adjustable Rate Mortgages hit falling home values and home owners fell into Negative Equity.

And with negative interest rates, borrowing theoretically becomes easier for individuals and SMEs.

Not so fast………….if banks and financiers are still coy about their solvency and quietly anxious about their liquidity ratios, particularly in the US, expect them to be stupidly obnoxious and outrageously greedy in the terms of the loan they attempt to extract from SMEs.

Banks have never been thrilled about lending to SMEs and never really trusted them. Given the lies that the banks themselves manufactured about sib-prime and the resulting derivatives, it’s now at a stage where they don’t trust each other.

© 2008 Sanjeev Aaron Williams All Rights Reserved

Interest Rate Cuts & Cash Flow

It was common knowledge that a US interest rate cut was in the works. Instead of waiting for their scheduled meeting next week, the Federal Reserve cut the overnight lending rate on 22 January 2008 (US time), 23 January 2008 (Hong Kong time) to 3.5% from 4.25% and cut the discount rate (i.e. the rate at which the Fed lends money to commercial banks) to 4% from 4.75%.

The Fed wants to be seen acting aggressively and proactively. But it’s beginning to sound like wishful thinking. Global stock markets, in Asia and Europe went in 2 different reactions: Asia, re-bounded on 23 January 2008. Hong Kong in particular, soared over 2000 points after slumping over 2000 points the day before. But, at the time of writing this, Europe and the US are sliding.

There’s no shortage of suggested reasons: more US sub-prime leakage, more US housing slumps, more US consumers defaulting on credit card debt, more US manufacturing slowdown, more weakening of the US Dollar, more US and global unease on commercial credit and the authenticity of bond insurers. They’re all related. Putting it another way, it’s just another stack of derivatives.

But 2 points need to be made.

First, interest rates are being seen as both the cause and the cure. The sub-prime mortgage fiasco was due to spiraling Adjustable Rate Mortgages that screwed US mortgagors into a colossal wall of mass defaults, triggering a complex global inter- bank credit panic which is still lingering and might get worse. Sub-prime lending went on in full view and knowledge of the US Federal Reserve which encouraged, and turned a blind eye to, what was unfolding.

Now, the US Federal Reserve is slashing interest rates as the simple solution to stimulate economic growth across the board.

Second, even if a full-blown US recession is avoided, the depth and global scope of the suspicious sub-prime derivatives has yet to be accurately measured – or estimated. Whilst central banks around the world stand ready to pump funds to ensure liquidity, a potentially more serious issue is the solvency of individual finance companies holding worthless bonds derived from sub-prime products. The first shots have already been fired with 2 US monoline insurers singled out – and whose credit rating was promptly dumped.

What does this mean for SMEs? Watch your debt exposure – both long term and short term. Tighten up your incoming cash flow because inflation is kicking in and your Accounts Payable will rise. If SAW is right and corporate solvency is the next major issue, SMEs need to be aware that even if the accounts indicate the business is profitable, it can still be insolvent. Cash flow, not the cost of money, is the name of the game. Don't expect banks to be overly-thrilled to lend to SMEs, even if interest rates have fallen. The control of your Receivables and the credit-worthiness of your debtors will save you or sink you.

© 2008 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Erosion Of Capital

Let’s face it. The cascading torrent of losses in the billions sustained by the *ahem* financial pillars of society, are no longer riveting. Lately, we’ve come to expect it in the same way as sewage leaks out of a ruptured pipe. For those doing the disclosing, their meltdown in the full glare of publicity might as well be the sequel to Al Gore's "An Inconvenient Truth".

Take Merrill Lynch for example. Not to bash, but reading the BBC’s online report for 17 January 2008 and Financial Times online report for 17 January 2008:

• In the last quarter of 2007, it lost US9.8 Billion – the biggest quarterly loss in its history;

• It made a net loss of US12.8 Billion in the 12 months ending on 31 December 2007;

• There were approx US15 Billion in asset writedowns:

• US3.1 Billion in contracts with bond insurers to hedge against losses;

• US9.9 Billion in *ahem* “asset-backed” CDOs;

• US1.6 Billion in its holdings of individual sub-prime mortgages;

So what’s the lesson for SMEs? The importance of enough working capital.

Merrill’s embarrassment, that eroded its market capitalization and its internal capital base, was attributable to debt and the assumptions made in respect of it. Specifically debt was very poorly assessed initially, then shunted “off balance sheet” via CDOs and SIVs, ceased to produce cash flow, could not be properly identified, could not be properly valued and ultimately had to be brought back on to the balance sheet and very publicly written down.

When one cuts through the artificial fancy corporate structures, the debt was intended to be a receivable that was supposed to generate regular cash flow. The entire sub-prime fiasco was a failure in receivables management that hit a company’s capital base and, in the case of Citigroup, its credit rating as well.

SMEs, focused either on survival or growth, often overlook the importance of receivables management. It’s handled in a haphazard or tardy fashion, only becoming urgent when the Accounts Receivables Ageing Report looks distinctly ugly, or the company faces a cash crunch like inability to meet payroll or rent. There’ll be some frantic activity for a few days to chase up on unpaid bills then it’ll die down again till the next AR Ageing Report or the next crisis.

In the meantime, the Receivables appear on the balance sheet as a Current Asset. That’s the formal way of saying “we’re keeping our fingers crossed and hope we get paid”. If the company doesn’t get paid for a while, their accountants will advise them to write it off as a Bad Debt. That’s a nice way of saying, “we’ve just lost capital we could have used”.

At that point, your SME is no different to Merrill Lynch or Citigroup. Bring on the firings, the tears and the downsizing.

Play your cards right, consistently tighten up on receivables management and the company could have predictable working capital for growth, overheads and a sweeter credit rating.

© 2008 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Lessons Learned

This blog has dealt extensively with sub-prime. But how does all that relate to private SMEs who are interested in improving their cash flow for the purposes of growth or survival? What lessons can be learned?

1. Surrender of Equity

Factoring does not involve going to foreign investors - Sovereign Wealth Funds in particular - and giving up, or issuing, equity in the company. Just ask Citigroup or Merrill Lynch.

2. Management Changes

The funding source will not demand management changes at Board level as a condition of funding (unless there’s suspected or actual fraud).

3. Debt-Free vs. Debt

Factoring is effectively debt-free growth for the company. It is based on the SALE of the commercial invoice to the factoring company. That invoice, which represents future cash, is a genuine asset. The factor buys it from the company at a discount from its face value and the company gets cash almost immediately. The factor then looks to the company’s ultimate debtor for payment of the full face value of the invoice.

Sub-prime was debt-ridden at all levels with catastrophic results. For the lenders, the “assets” of the individual debtors were either cars or plasma TV sets (which have no residual value) or the assumed ever-increasing value of a home which they knew fully well the debtor could not afford. The basis of sub-prime rested on loading credit challenged individuals with even more debt and then repackaging the “assets” as “safe” corporate investments for Wall Street and beyond.

4. Credit-Worthiness

Factoring is strongly dependent on the credit-worthiness of the company’s ultimate debtor. This is because the ultimate debtor remains liable to the funding source for the face value of the invoice. That is why factoring companies who are buying the invoices, demand to know details of a company’s debtors and run checks on them, including verifying that the invoice issued to the debtor is genuine. If the factor has doubts on the credit-worthiness of the ultimate debtor, funding for those invoices will be refused. Period.

One of the hallmarks of the sub-prime fiasco was that the credit-worthiness of the individual debtor, who often had a lousy credit rating to start with, was fudged or dishonestly recorded to make it appear better than it was. Everybody knew what was going on and simply turned a blind eye. Risk was compounded.

Factoring seeks to minimize uncertainty on 2 fronts: for the company seeking guaranteed predictable cash flow; and for the funding source that assumes the risk of repayment from the ultimate corporate debtor.

© 2008 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Passing The Hat Around

Whatever brave face that banks were putting on the sub-prime debacle when it first erupted i.e. it was only a small portion of their portfolios, has now all but melted. In the next few days it’s Earnings Reporting Time, specifically for the 4^th Quarter of 2007.

And it will not be a pretty picture. See the previous post, The Mushroom Cloud.

As Bloomberg pointed out in its online report dated 15 January 2008, the writedown on Citigroup’s losses are double what the company forecast in November 2007 and Citi has lost half its market value in the past year. Standard & Poor reduced Citigroup’s credit rating from AA to AA-.

But to put things in perspective, Citigroup’s capital base should not be an immediate issue (even though it did cut its dividend from 54 cents to 32 cents) It acted fast. In November 2007 it raised US7.5 Billion by selling a stake to the Abu Dhabi Investment Authority. It’s now slated to receive a further US12.5 Billion from the Government Of Singapore Investment Corporation, The Kuwait Investment Authority, its former Chairman Sanford Weill, Capital Research And Management (Citigroup’s biggest shareholder) and the New Jersey Division Of Investment – and not forgetting Prince Alaweed BinTalal of Saudi Arabia who’s been investing in Citicorp (as it then was) since the early 1990s and is investing more now.

And who else?

Oh yeah, Merrill Lynch is getting a further US6.6 Billion from the Kuwait Investment Authority, the Korean Investment Corporation and the Mizuho Corporate Bank. In December Merrill raised US5 Billion from Temasek Holdings of Singapore and US1.2 Billion from Davis Selected Advisors.

And these are only 2 banks on the list of The Mushroom Cloud looking for cash.

© 2008 Sanjeev Aaron Williams & Cashwerks All Rights Reserved