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

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