Sorry guys

With the goings on in the markets this past week I have been too busy to draft a quality article. Instead I am going to point you to an article that I think a lot of business people should be reading. http://freekvermeulen.blogspot.com/2008/10/reverse-causality-sorry-but-lifes-not.html Enjoy, and I will see you again next week. 

Where oh where has the credit gone?

So now that the credit markets have pretty much seized up where is a credit worthy company supposed to turn for financing? In this article I am going to explore some less common options that may be attractive in this current market.

 

The first option, small local banks, is probably the easiest and most pain free way to get some cash. Many of these banks did not participate in the credit default swap market or the purchase of CDOs so they are fairly well insulated from the credit risk associated with the mortgage mess. They still need to make money and they do that by making loans. So while the funding for risky firms has dried up, moderately credit worthy firms should be able to still get a loan. The only thing (and it’s a big one) that prevents them from lending a lot is that interbank lending has taken a huge hit because no one knows who owns what. However, even with the interbank lending stopping, the small local banks should still be able to give you a fairly decent sized loan at a reasonable rate.

 

The second option, if the small bank doesn’t workout, is to consult with a commercial loan broker. A commercial loan broker basically acts as an intermediary between a firm and a lender. The loan brokers usually work with a strong network of lenders who are maybe more aggressive in their lending practices. The broker is familiar with what a lender requires in terms of assets, revenue, profits and ratios to make a loan and can move your paperwork to the appropriate lender quickly. If the broker has trouble getting you financing, lenders are typically more willing to honestly discuss the reason why with the broker, which will allow you to fix the problem and acquire some capital.

 

Sometimes commercial loan brokers don’t work out and when they don’t small firms have one more place to turn, private equity. There are two types of PE firms small business can go to for funding. One type is known as an "Angel investor." This is a firm that specializes in early stage financing but because there is typically a huge demand for this and such a small supply it is often very difficult to obtain. If, however,  you can get in good with an angel investor you will soon realize why they got their name. The second type is called a venture capital fund. This is money that has been pooled together from institutional investors that is invested on their behalf. VCFs typically provide "pre-flotation financing." This means that they will provide you with enough capital to get you to an IPO. Their big payout comes from selling the company on a public exchange so that is what they will strive for. It has been said that the only way they increase the value of a firm is by replacing the CEO so be very careful if you chose this route as it could come back to haunt you.

 

While your financing options may be limited it is not impossible to raise capital. It wont be easy but we don’t get paid to do easy work. 

A long term solution?

As of now the $700bn plan for the government to purchase questionable assets from troubled banks is on hold. This may be a good thing seeing as how the short term effectiveness and the long term results of this plan are cloudy at best. To find the answer to this crisis we have to isolate the inherent flaws in the current system. The first major flaw resides in the incentive structure in the asset backed security chain, while the second flaw is in the regulation of the banking industry. By solving these two problems we will significantly strengthen the US economy and the new rules will help insulate industries against future bubbles.

 

The problem of flawed incentives arises from the ability of the loan originator to pass off the credit risk of the security to the next party. This credit risk is passed off at each link in the chain until it rests wholly with the final investor. In the current system, by the time the final investor has purchased the end security, the loan originator has already been paid and is in the process of making more loans. The originator couldn’t care less if the borrower defaults because he carries none of the credit risk. This selling of the credit risk happens all down the chain so the only one concerned with the borrower defaulting is the end holder of the security in which the loan resides. Sometimes that final investor doesn’t want to take on the credit risk so he hedges himself by trading it off in the credit default swap market. The fix for this problem would be to somehow force the loan originator to retain some of the credit risk associated with loans they write. This will make lenders think twice before writing another NINJA loan and would solve the problem at its source.

 

The second problem, the one of inadequate regulation, is a bit more difficult to solve. If we just shove more rules and regulations at the banking industry we will eventually bog it down with so much red tape that the industry will be too inefficient to be productive. The proper way to solve this is to look at the current regulations, keep what is effective and cut what isn't working. Instead of piling legislation on top of legislation we need to streamline the regulatory process so it is both efficient and effective. The first area to tackle is the set of accounting rules that deal with what does and doesn't appear on company's balance sheets. The idea that a public firm can own an asset that isn't recorded on its financial statements is utterly ridiculous. In the end the regulations must provide more transparency in the marketplace while still allowing the industry to function properly.

 

By tackling these 2 problems at their source we will have built a fairly solid base on which we can rebuild our economy. The banking industry is the most important industry by far so it is only fitting that we start there. Saying this and actually accomplishing it are two completely different tasks so put your ideas out there and lets put this past us.

State of the economy

 

"Strange Times" by the Black Keys seems to sum up our current economic situation nicely. Indeed, these are some strange times to be living through. Whether this is a blessing or a curse is yet to be determined but what I can say for certain is that it sure is an exciting time to be studying finance.

 

Looking at what has transpired recently the only appropriate first post would HAVE to be about the current state of the economy. So without putting this off any more lets get right to it!

 

How this mess started

The first player in this game is a little thing called a subprime mortgage. This little guy was initially a vehicle designed to open up the possibility of home ownership to a whole new customer base. They worked fine until around 2005 when some major problems began to appear. It came out that some brokers were misleading borrowers by pushing them into loans they couldn’t afford with low teaser rates. The brokers could easily point to the past decade of home prices and say "Look they have been rising like crazy! You can surely refinance later and be able to afford the house then!" It also came out around the same time that borrowers had been misleading the lenders just as often by taking advantage of "liar loans." "I make $500k a year, just trust me." It was around this time that the default rate on mortgages began to soar.

 

The next piece was asset securitization. This allowed the banks that made the loans to sell them off to investors (mainly investment banks) who would then pool them together creating asset backed securities. Pieces of these asset backed securities were then combined to form new securities called CDOs. After a CDO was created it was sometimes bundled with other CDOs and split off again into more pieces which were called CDO^2. As you can probably tell these became extremely complicated securities and thus it was nearly impossible to assess how risky they were. These assets moved from investor to investor until they finally found a home with their end owner. Because these end owners did not want to be stuck if the borrower defaulted they used credit default swaps to eliminate their default risk. AIG was the go-to guy for CDS and they were profitable until they got hit with the large number of defaults that started in 05.

 

Probably the most important bit was the amount of leverage employed by the investors in these assets. A typical firm will have a debt to equity ratio of ~1:1 or 2:1, the players in this game had DE ratios hovering around 25:1. This need for debt gave financial institutions a strong incentive to move risky assets off of the balance sheet with SIVs (structured investment vehicles) and other exotic securities. The companies needed to remain lendable because they were mostly financed with very short term debt that was reissued constantly and if that funding dried up they would not be able to meet their cash flow needs.

 

Fannie Mae & Freddie Mac

These two institutions would act as middle men in the securitization process for prime mortgages. They would buy the mortgages, create the pools of mortgages, guarantee payment on them, and sell the final securities to investment banks. Because they were quasi-governmental agencies they had the ability to borrow money cheaper than anyone else in the world (other than the US government). People believed that the gov. wouldn’t let them fail, turns out the people were right. As someone so eloquently put it they earned "Privatized profit with socialized risk." FM&FM began to use their funding to buy and hold a significant amount of the mortgage securities in their own portfolios and they moved into some riskier types of mortgages (Alt-As, etc.). They effectively went from being large companies to being HUMONGOUS companies in a matter of years.

 

Putting all of the pieces together we get a very tall and very integrated, shaky house of cards that depended solely on house prices increasing. When the increasing home prices card was pulled out it began to bring the whole house down.

 

Market failure!

As losses on subprime backed mortgage securities mounted the market for them ceased to function. This made it impossible to value the securities as they were "priced to market" and if there isn't a market there sure isn't a price. This caused a stir among the large international banks. They began to question whether or not the other banks they were lending to would be solvent the next day. The rates for short term loans began to skyrocket and markets that were barely related to the subprime mess began to freeze up.

 

Bear Stearns

This was a highly leveraged firm that was funded mainly by short term debt. Early in 08 rumors began to circulate that Bear Stearns was having liquidity problems. This caused a run on the bank which basically made the rumors come true. The Federal Reserve stepped in and arranged a merger with JP Morgan Chase in which the Fed took on almost $30bn in questionable securities.

 

Fannie Mae & Freddie Mac V2.0

Losses began to rise in their portfolio of mortgages and on the guarantees they issued. When these losses were reported it spooked some large international lenders (thought to be China) and they stopped lending to them. Like with the run on BS their cash flow dried up and the US government ended up taking them over. Had they not stepped in the estimated losses were around $200bn.

 

Lehman Brothers

They were in a similar situation as BS, highly leveraged with short term debt, and just like BS that funding dried up. When they asked for a bail out the government rejected the idea and Lehman Brothers went bankrupt. The fallout on this is still spreading but it has already had some pretty scary effects. The reserve primary fund, a money market mutual fund, owned a large portion of LB's debt that is now worth $0. They had to announce that their NAV had dropped below $1 "breaking the buck." As of right now the final amount of damage done by the LB failure is unclear but it has to potential to be devastating.

 

AIG

AIG was the largest insurer in the world with operations all over the globe. Most of the insurance they wrote was just your general, run of the mill, vanilla insurance but they had a credit default swap unit. In return for a premium this CDS unit would guarantee against losses in mortgage backed securities. When everything came crashing down in mid 08 and the investment banks turned to AIG to make them whole, AIG couldn’t do it. The US government had to take them over because if AIG failed hundreds of banks around the US wouldn’t have the cash to continue operations. The losses from this are near incalculable.

 

This pretty much brings you up to date on the current state of the economy. I hope that this information will allow you to understand what has happened and why it is so important that the government gets it right. If we can take anything from this I think it is to make sure you do your own due diligence whenever entering into a transaction.