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

A Slightly Longer View

Sometimes, it pays to shut up – for over a month or so, and take in what the pundits are saying in order to make some sense of their pontifications, which could then form a pithy blog posting that would somehow relate to SMEs.

Well that was the theory anyway.

And what did the last few weeks of studied silence reveal?

That Wall Street is trumpeting that everything’s great in the credit and stock markets. That Henry Paulson and Warren Buffet think the worst is over, that Jim Rogers and Nouriel Rubini think the worst is yet to come. That the US is in even more of a financial mess than originally imagined. The credit crunch may (arguably) be over but the recession is yet to properly kick in, and the jury’s still out as to how long that will last and what “shape” the recession will take i.e. will it be “V” shaped with a steep recovery; a “U” shape with a lull and then a steep recovery or an “L” shape with a sharp drop and indefinite flat lining.

As Bill Bonner of the Daily Reckoning for 12 May 2008 put it:

“In America, meanwhile, people are working their way down. We're not kidding. Wages are stagnant. Prices are rising. At the end of the day, they have less spending power; they are poorer. Besides, it said so in the New York Times. People lose their houses…move back in with their parents…and put their stuff in a storage unit. Then, they either can't make the storage payments…or they realize that the move wasn't just temporary and they give up. Pretty soon, the auctioneers are selling the stuff.”

Yeah, that all seems to gel with what I was reading too: Americans hauling stuff to the pawn shops, giving up their SUVs, cutting down on the Starbucks latte (assisted by Starbucks closing some outlets). Foreclosures, especially in California and Nevada, are at record levels.

But here’s the question: if people in the US can’t afford their home payments it means that their incoming cash flow is simply insufficient or they’ve taken on more debt than they can handle. Usually, incoming cash takes the form of wages and salaries. Either they’re not being paid enough or the average American is up to their eyeballs in consumer debt, mortgage debt and worsening credit. The latter appears more likely.

But, what about those compromised homeowners who also own their own businesses? It seems reasonable to assume that amongst the pandemic of foreclosures, there must have been independent business owners too. Their business cash flow was insufficient to maintain their house. If they too are caught up in the scenario that Bill Bonner sets out above, and are forced to move, what happened to their business and their employees?

Could it be that the previously self-employed are now being forced to relocate and turn into employees?

© 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

Double Or Nothing

So it’s now official. Swiss bank UBS, Europe’s biggest investment bank, felt it needed to become truly famous and announced not only a 2^nd consecutive quarterly loss, but further sub-prime related write-downs of US$19 Billion – basically doubling its losses. It catapulted itself to the top of the loser’s league with total losses of US$37 Billion. See the earlier post, And The Winner is…2, dated 3 April 2008.

In addition, it is raising 15 Billion Swiss Francs by issuing new shares to Sovereign Wealth Funds from Singapore and the Middle East who had earlier thrown money at it.

Now here’s an interesting spin: the SCMP Business News, published in Hong Kong on 2 April 2008 quoted a fund manager at Mizuho Asset Management who said:

“The fact that the latest [news] from UBS is a combination of capital increase and write-down should be welcomed to some extent because it’s a reflection that they are speeding up their write-offs.”

Alternatively, it could be viewed as a sober realization that their mammoth write-offs had truly eroded their capital base and they had to act fast. So fast, that they are setting up a new business to handle their US property assets that are now worthless. That’s a pretty clear indication that a huge level of Receivables cash flow had just plummeted from the Current Assets column of their Balance Sheet to the Bad Debt column.

This blog has repeatedly warned SMEs that poor or inefficient management of Receivables cash flow would have a similar result. Unlike UBS, whose Chairman is not seeking re-appointment (and will leave suitably compensated of course), a CEO of an SME doesn’t always have that luxurious option. A Director’s failure to monitor the risks inherent in the company’s cash flow is a breach of fiduciary duty both to the company and to its shareholders. With shareholders of well known investment banks and Wall Street titans getting burned left, right and centre, it can be expected that shareholders of SMEs (often family members) and venture capitalists, will sit up and take notice of exactly how their business is performing – particularly in this time or rollercoaster uncertainty.

With banks reportedly reluctant to lend to SMEs, Directors of SMEs can expect to be asked hard questions by their shareholders about the company’s positive cash flow and the risk models in place to protect and guarantee that cash flow, the company's working capital and the Returns On Investment.

If the SME's Receivables are badly screwed up through reckless inefficiency and the Directors (to quote the UBS Chairman) promise that the next chapter will be one of "discipline and determination", don't expect them to last very long.

© 2008 Sanjeev Aaron Williams All Rights Reserved

Stating The Obvious

“If you’re a smaller player, you need more capital to do business in tough times. They now need to show that they can keep churning profits in this environment”

David Hendler, CreditSights analyst, quoted in the Business News, South China Morning Post, 2 April 2008.

He might as well have been talking about SMEs. He was actually talking about Lehman Brothers having raised US$4Billion from a special offering of 4 million shares. The proceeds are slated to increase its capital base and provide greater financial flexibility.

Sounds familiar doesn’t it? Some of the best known names on Wall Street are scrambling to raise working capital and giving up equity to outside shareholders, despite the bravado.

Whilst this blog is not exclusively about Factoring, the pain on Wall Street is a nice contrast to Factoring, the potential benefits of which can be found by going to the Labels column on the Right Hand Side of this blog.

© 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

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

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

False Positive

It’s one of the most ludicrous financial debacles to seep out of Europe – which only 2 days ago, was blaming the US sub-prime fiasco for the Earth’s financial ailments. The French Bank, Societe Generale, admitted that a junior trader responsible for betting on the European market’s future performance, racked up an unauthorized loss of US7.1 Billion on futures contracts.

In SocGen’s jargon, reported in the BBC’s online report for 25 January 2008, the trader had taken “massive fraudulent directional positions in 2007 and 2008 beyond his limited authority”. In other words, he was betting the bank’s capital that the European market would go up even though it was going south, hard.

What makes the whole thing so hilarious is not only SocGen’s abject lack of trader supervision, but just over a month ago, SocGen had to bail out one of its own Structured Investment Vehicles which was exposed to US sub-prime crap, to the tune of US4.3 Billion.

But it goes further than that. The US Fed claims that they had no knowledge of SocGen’s position when they cut interest rates this week (ahead of schedule) even though shortly after the fraud was discovered, SocGen sold massive amounts of futures contracts in a market that was sliding fast, which only amplified its own losses and that of the European markets generally.

The message for SMEs is clear: be careful who you laugh at. And just how good are your back room operations and internal supervision of cash flow? Often the directors of SMEs are so focused on marketing and bagging the next contract, they ignore the mundane administrative and supervisory aspects of Accounts Payable and Accounts Receivables only to take massive evasive emergency action when they least expect it. They blame everyone else, rather than accepting the blame for trusting the wrong people.

Next time a member of your staff says. “Everything’s under control”, be suspicious. Otherwise, like SocGen, your company may be the subject of an emergency cash call on shareholders and / or a rumoured takeover.

© 2008 Sanjeev Aaron Williams & Cashwerks 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

The Mushroom Cloud

SAW hates to laugh at another person’s pain, but herewith is the price of greed caused by the crock that was – and still is – sub-prime.

The table of losses is taken from the BBC’s online report dated 15 January 2008

Citigroup: $18bn

UBS: $13.5bn

Morgan Stanley $9.4bn

Merrill Lynch: $8bn

HSBC: $3.4bn

Bear Stearns: $3.2bn

Deutsche Bank: $3.2bn

Bank of America: $3bn

Barclays: $2.6bn

Royal Bank of Scotland: $2.6bn

Freddie Mac: $2bn

Credit Suisse: $1bn

Wachovia: $1.1bn

IKB: $2.6bn

Paribas: $439m

© 2008 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Writings On The Wall

According to the BBC’s Online Report dated 2 January 2008, the US manufacturing sector contracted in December 2007, seeing its weakest monthly output since April 2003. According to the Institute Of Supply Management, its index of factory activity fell to 47.7. Anything less than 50 indicates a fall in manufacturing output.

World stockmarkets generally, and in the US in particular, swooned.

Oil makes its first trade above US100.00 (not for any fundamental reason, just a lone trader purportedly engaging in a "vanity trade" for personal bragging rights)

The US Dollar continues to weaken.

Interest rates in the US and elsewhere are expected to fall futher.

What’s it all mean? Since it’s the beginning of 2008, here’s SAW crystal gazing:

A weaker US Dollar means cheaper US exports. Theoretically good news for US SMEs. But it also fuels inflation both in the US and elsewhere – and high oil prices don’t help.

Given that the full force of the sub-prime debacle in the US has yet to pan out, housing starts and housing prices are still declining. In other words, the US economy (the world’s biggest driver) is slowing as consumers think twice about spending.

But just how slow is slow? Some say a “near miss” US recession is on the cards, some say a recession is in its early stages and some say no chance of a recession.

Sticking his neck out, SAW’s view is “near miss” recession in the US, with inflation there and in other countries, particularly those whose currency closely follows the US Dollar. Expect the US to cause some (military?) mayhem elsewhere in any event.

Some pundits are already talking ‘stagflation” i.e. inflation continues to rise, even though economic growth slows or reverses.

SAW’s view? Possible if the sub-prime mess turns out to be even worse and international credit markets go into a tail spin again.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

We (Now) Love You

It wasn’t that long ago that voices in the US Treasury were telling the world that, as far as sub-prime mortgages were concerned, it was up to the borrowers and lenders to privately negotiate a settlement since government intervention would be counterproductive. The government would however, increase funding for debt counseling. Given that roughly 1.8 million happy debt-ridden families in the US with “teaser’ rate Adjustable Rate Mortgages stood to lose their homes pretty soon when rates were due to move up, the attitude was sanguine.

Now, deep into the Advent season when peace, love and compassion suffuse every crisis with a hazy glow, the US government has outlined a plan to freeze interest rates for 5 years for those holding Owner-Occupied sub-prime loans made between 1 January 2005 and 31 July 2007, the adjustable interest rates of which, were due to rise over the coming two and a half years. According to an online Reuters report dated December 6 2007, this covers US367 Billion worth of mortgages.

With foreclosures in the US at their highest levels since 1986, this avowedly “non-bailout” solution is intended to exclude those who have the financial means to pay as well as those real estate speculators who used a sub-prime mortgage as easy leverage into what was then a sizzling real estate market. In practice, it appears only 2 groups of borrowers will qualify:

• Borrowers who show themselves to be a decent credit risk but can’t afford the higher payment, will find it easier to qualify for a rate freeze;

• Borrowers who can afford the higher rate would be given help in re-financing;

Therefore those who were a lousy credit risk to begin with, who can’t afford their current payments and who definitely won’t be able to afford their future payments, will be excluded from this scheme. Presumably this means foreclosures will proceed and they will lose their homes. Not to sound crass, but aren’t the lousy credit risks the very people against whom sub-primes were aimed at in the first place? Factoring out the good credit risks, the speculators and the 2 groups listed above, SAW’s suspicion is that most sub-primers will be frozen out of this government scheme.

In an earlier post, entitled Town Planning By Default, November 8 2007, SAW suggested that sub-primes could be used as a method of social engineering, population clearance and land development. For the inner city areas of some major US cities, this scenario may be inevitable.

The government scheme has the potential to trigger some interesting displays of human behaviour. It’s widely acknowledged that people who ended up with sub-primes were lied to about the financial risks they were taking or who were downgraded in their credit rating to force them to take a sub-prime. SAW smells revenge here and suspects that many people through sheer anger will now lie about their financial condition to qualify for a rate freeze. And they’ll probably get away with it.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

A Stack Of Derivatives

Now that the media has been awash with the purported astronomical, catastrophic [add the doomsday superlative of your choice] consequences of the sub-prime mess, just finding out in simple terms how this lunacy was “structured” became an expedition in itself.

Perhaps the best explanation is contained in Jon Markman’s column for MSN Money. He correctly made the point that the commercial debt market is far larger than the stock market. It’s in the debt market that companies, governments and pension funds obtain financing, use credit instruments essentially backed by confidence i.e. an expectation that a debt will be repaid on time with requisite interest.

First, the debt forms a chain: banks borrow money from their depositors, pay them low interest rates, then turn around and lend that money at higher rates to companies. The difference between what the banks pay their depositors and what they charge to companies who want to borrow funds, is known as “the spread”. Banks make good profits when the spread is large.

Then, in comes the US Federal Reserve under Alan Greenspan which attempted to kickstart the US economy in late 2001 by cutting interest rates. The economy recovered but the Fed continued to cut interest rates and fell asleep at the wheel. The economy heated up, real estate prices went through the roof and the spread upon which banks relied to make their profits, narrowed.

The banks turned to their depositors, usually the low income ones, with a sales pitch to borrow more money from the banks to fund a consumer-driven lifestyle. It’s well known just how easy it is to hook the already over-indebted US consumer, so getting them to borrow more, wouldn’t have been difficult. At the same time, the banks employed an army of barely scrupulous mortgage brokers to dangle “teaser rate” home loans, a camouflage for the notorious Adjustable Rate Mortgages which trapped so many.

These shaky income streams were packaged and marketed to institutional investors as “asset backed securities”. These in turn were used as collateral to create the Collateralized Debt Obligations (“CDOs”) which were also re-sold to institutional investors. The banks pocketed huge fees.

The CDOs themselves were then used as collateral for “doubled” and “cubed” CDOs which were shoved into Structured Investment Vehicles, (“SIV”) purportedly managed at arm’s length and kept off the Balance Sheet.

Finally, in the ultimate act of over-confidence, the SIVs were used as collateral for the short-term commercial paper that forms the basis of the commercial debt market.

It all sounds so simple, yet jaw-droppingly reckless. The US Federal Reserve continued to cut interest rates in full knowledge of the burgeoning sub-prime market and of the imaginative shenanigans of Wall Street. The latter continued to stack their derivatives knowing fully well the Fed wouldn’t do anything. In fact the Fed is on record as saying it was not in the business of regulating asset-backed securities. Which begs the question…who was?

The irony is that following the massive loss of confidence in the commercial debt market, what does the Fed do? Cut interest rates of course. And apparently there’s more slashing to come.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved