Sing Y'All

With the sub-prime comedy heating up, financial analysts (read “professional guessers”) are falling over themselves to “estimate” the global and US losses caused by the value of sub-prime mortgage assets and mortgage-bond type CDOs heading south. For example, www.bloomberg.com has recently quoted a number of analysts offering their estimates. The figures are astronomical – in the billions - yet meaningless. Remember, the 2 issues are the direct exposure to sub-prime debt which soured, and, the widespread re-packaging of them as CDOs, which, when faced with a wall of defaults, contributed to the decline in the value of all mortgage debt, in a softening real estate market in the US.

There’s no shortage of analysts offering speculative figures, but there is a massive shortage of hard facts. Why? The banks, mortgage companies and institutional investors who bought the CDOs are still churning the best way of disclosing their exposure to increasingly annoyed shareholders and the public. After all, much of this exotic “Off Balance Sheet” financing was done via “Structured Investment Vehicles” a scientific-sounding term for a jerry-built deal.

Technically, these SIVs were managed on an “arms length” basis and the banks are reluctant to call SIV debts as their own.

Biting the bullet, HSBC Holdings PLC announced on 26 November 2007 that it would place 2 of its managed funds with mortgage exposure, on its Balance Sheet and spend US$35 Billion to bail them out. While lauded as timely and aiding in maintaining transparency and its reputation, the accolades would have made more sense had HSBC acted sooner. After all, wasn’t Bear Stearns’ inability to support its funds over the summer a prescient warning of what was to come?

Still, HSBC’s move is strategic in a number of ways: By acting first, it makes the other banks look conspiratorial, secretive and evasive. Second, it distances HSBC from the bailout plan or “super fund” that was proposed by Wall Street and only officially backed by Wachovia, after it was proposed by Citigroup, JP Morgan Chase and Bank of America nearly 2 months ago. Third, those banks that belatedly decide to place the SIVs on their Balance Sheet, may be obliged to announced larger write downs than those they have so far announced – a further blow to their reputation and credibility.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

And The Winner Is....

The nominees for best supporting non- performances in the category of Sub-Prime Comedy are:

Citigroup US11 Billion

Merrill Lynch US8 Billion

Morgan Stanley US3.7 Billion

Bear Stearns US3.2Billion

UBS US3.4 Billion

Deutsche Bank US3.2Billion

Credit Suisse US1 Billion

Wachovia US1.1Billion

IKB US 1 Billion

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Lie To Me *

It’s well known that those in the US who took out sub-prime Adjustable Rate Mortgages did so because their credit scores were lousy and were heavily influenced by the sales pitch. But that’s not the full story. It’s now apparent that the sales pitch came from unregulated mortgage brokers who, in their quest for commissions, were not averse to inflating borrowers’ incomes and their home values to the lenders, while misrepresenting the type of mortgage to which the borrowers were committing.

While sub-primes account for 1 out of 5 mortgages in the US, the figure would have been much lower. The sales pitch was so effective that a high proportion of sub-primes were dished to out to those with a perfectly normal credit rating who would otherwise have qualified for a usual or “prime” mortgage. In other words, this mortgage trap caught the inner city poor and the suburban middle class.

The Brokers were acting on behalf of banks and mortgage companies which originated the sub-prime mortgages. The banks and mortgage companies would have the borrowers’ financial credentials, whether false or accurate. The distinction was academic: many of these loans were "no-money-down" or "NINJA" loans (i.e. No Income, No Job or Assets). The same information, whether false or accurate, would also end up in the hands of the credit rating agencies.

Since the banks and mortgage companies were then re-packaging these sub-prime loans as CDOs for onward sale to investors, there was undoubtedly collusion between them and the credit rating agencies to talk up the authenticity of these “investments” as part of the “risk management” exercise.

In other words, US banks, mortgage companies and brokers were the originators and, co-conspirators with Wall Street and the credit rating agencies to perpetrate one of the biggest financial scams in America.

* The song title by Jonny Lang, one of SAW’s favourite blues singers

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Town Planning By Default

It’s politically incorrect to suggest that sub-prime mortgages could be used as a tool for social engineering, but that’s exactly what’s happening. News reports from various sources are replete with examples of entire neighbourhoods in the US boarded up and vacant as home owners simply walk away from the sting of their Adjustable Rate Mortgages. Those empty neighbourhoods are now subject to crime waves and vandalism. Remember that property taxes are a major source of revenue for cities and municipalities. Who’s paying now? But that’s only the first stage.

The second stage is also underway: banks and mortgage companies have commenced foreclosure proceedings against those still sitting in their houses. Some banks are acting in their capacity as agents for the investment syndicate that bought the CDOs; mortgage companies are acting in their capacity as lender (and originator of this sub-prime scam). From the anecdotal evidence in the news reports, US mortgage companies are showing a pointed reluctance to talk to their defaulting customer, give further information, explain the contract they signed, or consider re-financing.

Which all suggests one thing: the residual value of the real estate is more important than any cash flow that might be generated from it in the interim. And who would the residual value of the real estate appeal to most? Investors and developers.

Many sub-prime mortgages were issued in urban areas where the skin colour of the population implied that they might be children of a lesser god. It’s no secret that they were in economically depressed areas to begin with. But it didn’t end there. The middle class in all hues, with less than stellar credit and living in suburban belts were also enticed.

But here’s the question: if they’re abandoning their houses in droves or are evicted pursuant to foreclosure, where are they going?

And if the sub-prime scenario is as pervasive in the US as is being reported, isn’t there now a floating internal population of economic refugees?

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

It Looks Good, Anyway

The recent US interest rate cut looks and feels good: it seems to be the right gesture to help out the soon-to-be-evicted sub-prime mortgagors, or those desperate to re-finance. But substantively, it’s a crock, an utterly hollow gesture. The warm assurances from the US Federal Reserve that pursuant to its cash injections and twice-lowered interest rates in September and November 2007, credit is more easily available, doesn’t add up.

First, more mortgage companies and smaller banks in the US will fail.

Second, now that the conga line of superficially embarrassed, thick skinned investment bankers is forming (think Merrill Lynch, Citigroup, UBS, Northern Rock……….), the rest of their fraternity are now recalling that they were supposed to be “prudent bankers”.

After all, the final figure of failed sub-prime based credit derivatives is nowhere in sight. Christmas is coming too. There’s not much time left to act prudent. In corporate US, the yuletide tradition is that of firing employees. Banks are no different. If their figures just before Thanksgiving look so awful, the least they could do is to cut their workforce and look lean. It’s only a matter of time before the shareholder’s knives come out aimed at some turkey in a suit.

There will be a flurry of internal directives and sharp reminders to scrutinize credit applications at all levels – from retail, to corporate, to investment.

What does that mean for the business owner who’s been managing his cash flow quite well? More hassle. More paperwork. More refusals. Interest rates may be lower, but bank resistance will be higher.

The really smart business owner will start looking for finance from private funding sources.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Houston, We Have A Problem

As is now apparent, the fancy re-packaging of sub-prime loans into Collateralized Debt Obligations were credit derivatives and other forms of “Off Balance Sheet” Financing, responsible for the creeping and embarrassing disclosures of previously undisclosed losses of staggering amounts, now to be recorded on Bank Balance Sheets.

“Off Balance Sheet Financing” is precisely that – it is not recorded on the Balance Sheet as either a Current or Long Term Liability. But the cash flow from the CDO (so long as it was performing well), would be recorded as revenue in the Income & Expense Statement.

How it ended up as “Off Balance Sheet Financing” was as a result of “risk assessment”. That assessment was pursuant to a computer program, that could easily be adjusted to operate within optimistic parameters, thereby giving an impression of manageability and liquidity in order to ensure the sale of the CDOs (to “sophisticated investors”). It’s not as bizarre as it sounds: ask any major bank and financial institution and they’ll tell you just how heavily they rely on computer models to purportedly assess risk.

Since these CDOs were based on notoriously credit un-worthy individuals, it doesn’t take a rocket scientist or a computer program to figure out that the moment a colossal wall of defaults sets in, your fancy credit derivative is effectively, un-saleable (and your computer program not worth the software it’s written on).

At that point, you have a major cash flow problem.

Interestingly, Factoring is also described as “Off Balance Sheet Financing”. More on that in the next posting.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

The Teetering Of Icons

So Merrill Lynch took a beating on its “risk management” to sub-primes. According to the BBC website report of 30 October 2007, it was one of the first to re-package sub-prime housing debt as tradeable securities. Having recorded US7.9 Billion exposure to bad debt, its CEO left the building (suitably well compensated, of course).

And he’s not alone. Citigroup’s CEO also resigned, after having reported a 57% drop in quarterly profits and losses of between US8 Billion to US11 Billion in previously undisclosed losses (hello ??) attributable to a decrease in the value of its US55 Billion portfolio of sub-prime loans.

OK…first off, Citigroup is a huge group. Second, those are huge losses which would sink most other banks. Third, those are the currently disclosed losses on the sub-prime side. Fourth, given that there was a bubble in US real estate, what is Citigroup’s exposure to that sector?

It ain’t the end of the story. As Robert Peston, the BBC’s Business Editor said in his blog posting of 5 November 2007:

"Still, his exit [Citigroup’s CEO] will cause a frisson among senior bankers all over the world, because few of their organisations will escape unscathed from the problems in credit markets.

That said, Citi’s hit from sub-prime is spectacular. And it will cause widespread concern that other banks will be forced to disclose increased losses from their respective holdings of sub-prime, CDOs and the rest of the gilded rubbish…… "

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

The End Of Innocence

The funny thing about reality is that it hits first, then dawns later. Picture this: US home loan borrowers, many of them sub-prime, en masse, exhausted their ability to pay and defaulted on their loans. In many cases, they simply walked – and are still walking- away from their homes. An already depreciating US housing market accelerated its decline when millions of defaulting sub-prime homes flooded the market. For the lenders and buyers of the Collateralized Debt Obligations, (“CDOs”) their “assets” became non-performing loans and didn’t look that good on the Balance Sheet.

In practical terms the CDO values were being written down, or even written off. Hedge funds who had ought these high interest bearing CDOs and borrowed money against them, from banks at lower rates, faced margin calls from the banks, jittery at holding assets that were sliding in value. In order to pay the margin calls, the hedge funds had to sell their performing assets. Imagine their surprise when they discovered that their performing assets were insufficient to cover the margin calls. So much for “managing risk”.

Now that Wall Street was losing money, who better to turn to than the Politician-In-Chief and the US Federal Reserve? True to form, he made some utterances about “educating” borrowers (uh.. huh…..nobody had the temerity to suggest he might wish to “educate” the lenders and the institutional investors who fell over themselves to buy this CDO shit) and then got out of the way while the Fed cut interest rates – belatedly- first in September 2007 from 5.25% to 4.75%; and then on 1^st November 2007 from 4.75% to 4.25%.

And some of the reasons given for this cut? To make it cheaper to borrow money in the US and therefore to lend support to the US consumer in the critical Christmas shopping period. Oh please……………

Oh yeah, it’s also supposed to make it cheaper for businesses to borrow money. But that’s another story.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Not Mincing Words

From his perch here in Hong Kong, SAW has been observing the summer sub-prime meltdown in the US with the resulting spike in delinquent loans and foreclosures. The global stock market ride has been fun too. Sometimes, it’s best not to say anything for a few months, then take a deep breath and assess.

Scan the international cities on Craigslist.org and there’s no shortage of implicitly desperate American sellers flogging their properties to any overseas buyer at prices that seem pretty reasonable. No doubt, real estate investors specializing in distressed sales are cashing in and flipping the property for capital gain, looking for tenants, or turning the panic stricken cash-strapped seller into the tenant.

Although this whole sub-prime loan saga received saturation global media coverage, with accompanying gloomy predictions on the state of the world’s credit markets, let’s get a few things straight.

Firstly, sub-prime mortgages have been around for years in the US for those with a low credit score, and those with a perceived lower skin colour (both often operating together). Operating below the radar, the sub-prime market generally stood at around 1% of the mortgage market. Nobody paid much attention to it.

Secondly, by 2005, it made up about 5% of the mortgage market. By 2007, it was about 15%.

Why the spike? An inflated US real estate market and exploiting the “feel good factor”. The US consumer, internationally notorious for their rampant consumerism and inability to budget or save, was a sitting duck when confronted with greed: the greed of potentially owning real estate in a ramped up market; and the greed of buying goodies – both at the same time.

Thirdly, it was a cynical ploy that exploited those with lousy credit by enticing them with initially low interest rates that hiked every 6 months. Of course, the lenders never bothered to tell these folks that their wages wouldn’t increase every 6 months and that their mortgage payments would take up an ever increasing amount of their expenses. The customer never had a hope in hell of redeeming these mortgages and for the lenders, their cash flow was locked in.

Those sub-prime loans were then bundled together and called Collateralized Debt Instruments (“CDOs”), split into tranches and sold to so-called blue chip institutional investors who happily assumed they were “managing risk.” CDOs would be shown as an asset on their Balance Sheets, with the cash flow from the (ever increasing) interest rates appearing on their Income Statements.

Everything was fine and rosy – so long as the sub-prime consumer with the Adjustable Rate Mortgage made his monthly (usually interest-only) payment and real estate values soared.

In an example of lateral thinking by imitation, banks, seeing the profits that private lenders were making on their sub-prime loans, quietly revised their lending criteria in the US so that those with an otherwise good credit history, suddenly found themselves at sub-prime status. They too, sold the CDOs to Wall Street who was happy to oblige in a rising real estate market.

Everybody but the borrower knew the con: in a conventional mortgage where the borrower pays down principal and interest, their home equity increases. In a Sub-Prime

Adjustable Rate Mortgage, if the interest rate goes up every 6 months (the interest component being the larger amount of the monthly payment), the borrower’s home equity shrinks notwithstanding that the home value increases in a rising market.

Convenient huh? For the lenders it was a “No Lose” situation. The borrower was forced to increase his monthly payments while the lenders got the benefit of the increased home equity and the cash flow. It was predatory lending at its worst – and most profitable.

Why? Hedge funds were buying these high interest-bearing CDOs and using them as security to borrow funds from banks at lower rates, in order to leverage returns, confident that they were “managing risk” even if the lowly sub-primer defaulted.

And besides……European Banks wanted to buy these US CDO’s too. The contagion happily spread across the Atlantic. Everybody felt great, particularly the US Federal Reserve who, of all people, knew what was actually coming down the pike and did nothing. Even when they did act in September 2007, to bring down the interest rates from 5.25% to 4.75%, it was way too late.

If you’re one of the innocents who still assume that the US Fed has your interests at heart, and as lender of last resort will charge in like a knight in shining armor, your mediaeval fairy tale ended sometime ago.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Factoring & Bank Financing

The author has frequently said that factoring can be used in conjunction with traditional bank financing. What does this actually mean?

A business in the early stages of growth may not qualify for the best terms for bank loans since it doesn’t have a history. If a business line of credit or a loan is forthcoming, often it will be secured on the Receivables – in other words, every Invoice generated by the business acts as security for the loan. The problem with that, is those Invoices represent potential cash whose value is presently frozen – at least until they are finally paid by the debtor 30 plus days down the line.

For a start-up or early stage business, tying up the invoices to the bank and hoping the debtors will pay fast, is not the best strategy. It leaves the business without critical cash flow control and can hamper growth.

Since factoring requires creditworthy debtors more than it requires the operating history of the business, then (subject to good profit margins), factoring may be a better alternative.

Once cash flow has been stabilized and is predictable through factoring, the business will be in a better position to negotiate a bank loan – with the added advantage that its invoices have already been assigned to the factor and therefore out of reach of the bank.

Servicing the loan becomes that much easier since cash flow from factoring can already be calculated.

Remember also that banks tend to be conservative. Factoring companies are more flexible and forward looking in their assessment of the business prospects.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Stating The Obvious

It’s mind boggling to discover just how much difficulty business owners have in grasping the concept of a “final sale” in the context of factoring.

Start with this: For an invoice to be factored there MUST be a final sale B2B.

In other words, there has to be a completed product or service that has been delivered to and accepted by the customer – and on which, payment is now due.

• Forget about factoring partial deliveries where payment is not due until final delivery.

• Forget about factoring invoices on returned items.

• Forget about factoring invoices for sale by consignment i.e. the debtor does not have to pay until it has re-sold the product.

The Reader is also referred to previous posts under the label, “Commercial Invoice”.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

The Hard Truth

Frequently, companies moan that the cost of factoring is too high. Fine. In some situations, it is and would not be the best option. SAW has told companies to forget factoring and try something else.

A personal rule of thumb:

• A business with gross profit margins of less than 15%: forget it

• A business with gross profit margins of 15% - 20%: possible

• A business with gross profit margins of 20% or more: ideal

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

The Personal Guarantee

Many company directors choke when they look at the factoring documentation package and see the requirement for them to sign a Personal Guarantee. Some walk away from the deal altogether, claiming they’ve made enough disclosure. Others say the Personal Guarantee reeks of traditional bank financing.

Let’s make one thing very clear. Corporations, by themselves, don’t commit fraud. It’s the people behind them. The Personal Guarantee is the factor’s safeguard against fraud – and not, as is commonly assumed, an alternative means of recovering payment by going after an individual.

Factors carry credit insurance in respect of funds that they advance on a non-recourse basis. Many factors advance funds pursuant to a Line of Credit that they have with their banks. As a condition of the credit insurance and the bank Line Of Credit, factors are required to obtain a Personal Guarantee from the directors of their customers.

As and when the factor has funded an invoice for which it has not been paid by the ultimate debtor, it is far cheaper to simply off-set the amount against future advances, rather than resorting to litigation via the Personal Guarantee.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

What The Factor Wants To Know

Is There A Real Need For The Factoring?
Where in the business has the need for cash flow arisen? Fulfilling orders? Tax problems? Looming payroll? Inability to pay suppliers? What exactly?

When Does The Business Need The Cash Flow?
If it is needed to fulfil an expected contract, when will the contract be awarded?
When is the next payroll due?
By when do you have to pay your suppliers?

Just How Good Are Your Debtors?
Factoring is all about the creditworthiness of the debtors – the ultimate payors of the factored invoice. Factoring companies act as a Receivables Management function – they are not in the business of delinquent debt collection. There is a huge difference (and it is a different kind of financing).

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Which Funding Source ? 3

The author prefers to deal with funding sources that offer alternative products. If a client turns out not to be eligible for factoring, the funding source can still add value by offering say, venture capital or equipment leasing. Everybody wins and it saves the client the hassle of looking for alternative funders.

Besides, just because the client isn’t eligible for factoring at the moment, doesn’t mean it won’t be eligible in the future.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Which Funding Source ? 2

Since factoring is all about timely cash flow, the best factoring companies will be able to quote on the deal, or decline it, within 24 – 48 hours of a fully complete application being submitted. Note the operative words “fully complete application”. The author has seen enough companies whining to disclose the required information on the application form. It doesn’t help their case or the speed at which they might get the cash.

If a factoring company purports to charge an application fee when you’re submitting the initial paperwork, watch out. There are no grounds for it.

When the client accepts the quote, the factoring company will respond with a contract and supporting documents for the client’s signature. The contract is subject to due diligence. At that point, it is perfectly legitimate for the factor to request the due diligence fee from the client.

Some factors have preferred industries and will specifically exclude others. Others are more broadly based. Generally construction industry related factoring is a specialized niche and not all factors handle it – the risk element is highest in this sector.

Some factors have a monthly minimum value for a deal, below which, they will not fund. This is because the administrative costs of servicing the small account outweigh their returns on it. Hey, it’s business. Besides, there is a specialist market of “small factors” who will fund monthly amounts between $US2,000 – US$20,000. The author knows of some of them.

By contrast, other factors may not have monthly minimum values, but may have maximum monthly volumes, which can be increased on a case-by-case basis, or, syndicated between 2 or more factors.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Which Funding Source ?

Straight up, this author will only deal with funding sources affiliated to the American Cash Flow Association (ACFA). Several times, clients have “insisted” that the author should contact this or that funding source which a friend told them about and negotiate for them.

Forget it.

Secondly, the author is not in the business of playing one funding source off against the other, merely at the behest of the client. Within the ACFA group of funders, word gets around pretty quickly as to what’s going on. The client shouldn’t be surprised if the funding sources flatly refuse to play his game and dump the company’s applications.

The funding sources of ACFA are inherently flexible, more so than others and exponentially more so than banks. If a business is turned down, it’s not for a lack of interest, but a lack of “fit” or the due diligence didn't pan out.

So, what goes into choosing a factoring funding source? That’s the subject of this and the next posts.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Equipment Leasing Criteria 3

Once it’s clear that a business requires additional capital by way of Equipment Leasing, the funding source will require a list of the existing assets of the business to see if they are un-encumbered. If there are no un-encumbered assets, that pretty much kills the notion of Equipment Leasing.

Relevant assets (plus a Valuation Report) may include:

• Land
• Building
• Machinery
• Equipment
• Inventory
• Accounts receivables

Royalties, trademarks and goodwill are not included. This is because the funding source only considers those assets for which there is a ready market if the Borrower defaults.

Having evaluated the assets, a loan amount will be arrived at. Invariably, this is a percentage of the derived value of the assets

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Equipment Leasing Criteria 2

Equipment Leasing is an Asset Based Loan with the 3 fundamental characteristics of a loan:

• The use of the equipment as collateral for the loan;
• Defined payments to the funding source;
• The payments to be made over a specific period of time

Unlike Factoring, a debt is created and the funding source will look more closely at the Borrower’s financial position to determine cash flow strength for repayments. Specifically:

• List of assets and any encumbrances against each one
• Valuation report of the business assets – this must be higher than the loan amount, after taking into account any encumbrances.
• 2 years audited financial statements from the Borrower
• 2 years corporate tax returns
• Purpose of the loan
• Amount of the loan
• Likelihood of repayment
• Any recent contracts to verify increased business
• Bio on principals of the business
• Background and credit checks on them
• Additional data that will give the funding source a complete view of the borrower

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Factoring Denied 2

6. Invoice Cannot Be Verified or Verified In Time

• This is a problem in large organizations where there may be problems in tracking or approving invoices for payment in a timely manner

7. Contingencies, Offsets Or contracts Between The Client And The Customer

• These would cover indemnities, holdbacks, chargebacks, allowances or discounts. If they significantly reduce the amount of the future invoice or allow the customer put a stop to all payments, factoring will be denied.

8. Client’s Customers Are Not Creditworthy

• Remember that factoring companies always do credit checks on the Client’s customer. If there are no independent records of the customer’s payment history, factoring will be denied.

9. Potential Federal Tax Liens

• The Client has not paid payroll, excise or income taxes on time.
• There is an agreement with the IRS for late or deferred payment, but the IRS will not approve a subordination agreement with the Factor.

10. Lawyers And Accountants

• Those unfamiliar with Factoring may advise against it, since they still see it as a loan rather than the outright sale of the invoice at a discount.

These 10 deal killers will become apparent during the factoring company’s due diligence. Every factoring company will react differently to these 10 items, depending on their risk tolerance.

Source: Peter Pirri, Deal Killers: 10 Reasons That A Factoring Deal Dies In Compliance, American Cash Flow Journal, October 2002.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved