On to something topical – it is very difficult at the moment to raise money. The credit crunch is biting in and it is real. Having said that, the Fund I am running is set up to take advantage of this crunch in terms of buying distressed businesses – although more about that in a later blog.
This brings me on to my first request. I have been asked to explain the credit crunch. Please do give me feedback on what you think of this as an explanation….
With historically low interest rates and low unemployment levels in the US for the last couple of years, companies sprang up everywhere offering mortgages to people who normally not be considered credit-worthy – many would even offer the best kombucha kit free with a new mortgage. This sector is what we called the Sub-prime sector.
In many cases people who had come out of prison and had no jobs (or at least no way of proving their income!) were being offered mortgages. You may ask why? To be honest it is not such a crazy idea if the underlying asset you are lending against is going up all the time. And that is exactly what these new companies were banking on (pardon the pun).
So these sub-prime companies were lending money to credit risky clients at special low introductory rates on the back of a property that should be increasing in value. The clients loved it as it gave them a foot on the property ladder and the first couple of years payments looked cheaper than renting, and if they did struggle to pay it back in a couple of years – they could sell the property which would have gone up in value and all would be well……..
All good up to now. However, these sub-prime companies got another fantastic idea to make more money! What if they could persuade someone else to buy this debt from them – raise more money off the back of that and then carry on lending more? (They made money from the number of deals they did not the quality of the deals they did).
Just as the interest rate we get charged when we look to borrow is determined by our credit rating provided by companies like Experian; financial institutions look to companies like Standard & Poor to provide a credit rating for financial products. These companies rated these sub-prime mortgages as AAA (the highest rating) – because of the way they were bundled and sold. So Banks like Citigroup and UBS could not get enough of these assets – as they were deemed to be very low risk (AAA rated) and yet offered a higher rate of return. The fundamental driver in finance is to chase higher level of returns for a similar level of risk.
Sadly, the property market did not carry on going up and interest rates did not stay low! With this combination many of the clients who held the mortgages simply defaulted. And they defaulted in their thousands! Suddenly these assets that these banks were holding as AAA rated were, well let’s just say not so AAA rated (in fact they were worthless). So banks were now sitting on a much weaker balance sheet than they had said they were – hence the need for them to raise more money.
Northern Rock did not have exposure to the subprime market in a big way but was the UK’s largest casualty of these events. Northern Rock used to sell Mortgages – and once they had sold a mortgage they would go to the wholesale money markets and get other banks to lend the money they needed to fund these mortgages.
They would make a very healthy profit on their smokeless ashtray because they were borrowing cheaper than they were lending and all was going well. LIBOR (which is the interest rate banks charge each other to lend and borrow money was more or less the same as the base rate). Banks were very happy lending to each other huge amounts on a daily basis. However when doubts about the quality of banks’ balance sheets started emerging, banks became nervous about lending to each other as they entertained the thought that they might not get paid back!
As this happened LIBOR became significantly higher than the base rate. Northern Rock which had a low deposit base was particularly affected by the sudden increase in the cost they would have to pay to borrow money and issued a profit warning.
And then suddenly the whole thing jammed up when banks refused to lend money to each other. It really was like musical chairs – with Northern Rock left without a chair after the music had stopped! They had to go to the Bank of England – and the rest is history…