CandidCapital

I was invited to deliver a talk last week on Financing for Companies in the Current Climate. The subject is timely as many of the things we might have taken for granted over the past decade or so are no longer as certain as they used to be. And so deep-seated is the gloom in financial markets that investors have become like Aunt Ada Doom in the classic 1930s satirical novel Cold Comfort Farm, who became reclusive and miserly after seeing ‘something nasty in the woodshed’ as a girl.

What WAS in the Woodshed?

In retrospect, it is clear that 15th August 2007 was a tipping point: stock markets finally realised that sub-prime lending was yet another perpetual motion machine running on snake oil. The only mystery is that it took so long for the obvious to worm its way into the collective consciousness of finance professionals, no matter how addled by greed.

To cut through the technicalities of credit rating procedures, my analogy for what happened is this. Imagine that either law or practice allows butchers to sell minced meat as ‘prime beef’ so long as at least 90% of the contents is indeed (a) from a cow and (b) of premium quality. But a few butchers started saying to themselves, ‘if we can pad our burgers out with 10% off-cuts, why not 15%?’ The health inspectors nodded and smiled, for reasons known best to themselves but maybe connected with the fact that their salaries are paid partly from donations made by the Butchers’ Association.

And as other suppliers in town saw what they could get away with, 15% became 20% and the off-cuts might not even have been beef… Then some customers started objecting to paying top dollar for economy food, and a few consumers even fell ill after eating ‘beef stroganoff’ that included 25% donkey meat that hadn’t been kept in the chill cabinet (why waste the money, after all?).

Soon a bout of salmonella went round the school canteen and a wave of hepatitis round the hospital catering department. But since all the mince had been comprehensively sliced and diced before distribution, it was pretty much impossible to trace the offending meat back to its original stable, the door of which was – of course – by now bolted. And customers can’t be sure that it is just the meat that is contaminated, so they are trying to avoid eating anything they haven’t grown themselves and a lot of food will perish on the shelves.

Cold Comfort Farm

Analogy over.

Back in the real world –if that is the right expression for such a dysfunctional wonderland - Northern Rock’s liabilities going on the public finance balance sheet may soon blow the government’s cherished ‘sustainable investment’ rule (debt/GDP ratio of 40%). Interbank lending rates (LIBOR) are out of kilter with central bank minimum rates (so solvency is no longer directly affected by the price of funds – banks are reluctant to lend even to each other at a significant premium). This diminishes the power of one of the most important macroeconomic policy levers: short-term interest rates.

What started out as a crisis specifically in the sub-prime mortgage market has spread to much of the rest of the housing market (many mainstream mortgage banks relied on the capital markets rather than savers to provide them with the bulk of their new funds for lending), then to corporations and municipalities. Last week, even a 15% quoted affiliate of Carlyle Group, one of the biggest private equity funds, defaulted on a margin call from its banks.

From Wall Street to Main Street

The ricochets are beginning to wound the real economy.

House prices are continuing to slow, which in principle is a good thing as by most measures of affordability prices in the US and the UK badly needed to be rebased. But it isn’t just suppliers of flat-screen TVs and other meretricious gewgaws bought with equity release loans that are affected by this: many start-up businesses rely on personal equity to get funded, and one of the most promising sources of such equity is running dry.

UK GDP growth may fall from 3% in 2007 to 2% or even 1.5% in 2008. The US may already be experiencing a recession, as last week’s data on the drop in non-farm employment show. Even China is planning to cut growth to curtail inflation, and inflation is creeping back into western economies as central banks drop huge amounts of liquidity (=cash) into the market to solve what is really a solvency crisis.

Whether or not you think of yourself as a monetarist, the ready availability of money is a sign to investors that central banks would prefer to ignore inflationary pressures tomorrow in the hope of dealing with moribund financial markets today. And as Milton Friedman showed, once inflation is in the system, it takes twice as long to squeeze out as it took to creep in originally.

Solvency vs. Liquidity

If you are wondering about the difference between liquidity and solvency, think of it this way. LIQUIDITY: you are a bit short of cash when I ask you if I can borrow £5,000 to kit out the office for my start-up. But you like my business plan and trust me to deliver, so you take the money off deposit from your rainy day account, and to compensate you for the interest penalty and the fact that lending to me represents a slightly higher risk than lending to your high street bank, you charge me 2% more than you would have earned if you’d kept the money on deposit National Barcloyds Bank.

SOLVENCY: as above except that instead of asking you for £5,000 for my start-up I’ve asked you for £5,000 to pay my overdue tax bill. And you do not trust me to deliver. So even if I offer to pay you 10% more than Barcloyds, you won’t lend to me because you simply don’t believe that I will repay. This is the state the financial markets have reached. Complex rules on overnight liquidity ratios and the fear of miscalculating them have led Royal Irish Bank and other clearing banks to be wary of lending to the Alliance & Nottingham Bank or the Bradford & Bolton Building Society.

And market uncertainty will increasingly impact on day-to-day decisions by businesses and consumers. We may have been lucky in that many fixed rate mortgages at low rates taken out two or three years ago have only now started to run-out just as base rates have been cut, but the next few months will be critical for fostering a return to confidence. After backtracking over capital gains tax, wobbles over non-domiciled residents and the shenanigans over Northern Rock, the government has not been helping.

Whichever way you look at it, finding funding for promising young companies has never been easy – and it’s about to get a whole lot worse. If one clearing bank won’t lend to another, what chances do innovative small firms have?

Mixed Feelings

Dennis Turner, the recently retired head economist of HSBC, had an uncanny knack of being able to explain complex financial problems in every day speech. One of his obiter dicta came to me when I saw the following headline in the Financial Times on 3rd March: “Fears for 10,000 City job losses”. Many economic events require careful interpretation because they generate mixed emotions (interest rates go up – is that good or bad?), ‘rather like,’ Dennis would say, ‘seeing your mother-in-law drive over a cliff in your brand new car.’

So although your first thought may have been similar to mine (a welcome comeuppance for loud people with more Bentleys than sense – or taste) the decimation of the financial sector is probably our new car going over the cliff: according to the Economic and Social Research Council, the strongest performing sector in the UK economy is business and financial services, which represented over 33 per cent of economic output in 2004.

Similarly, the curtailment of leveraged debt for private equity deals does not merely mean that fewer oysters will be eaten in Mayfair, it also means that industries that could have benefited from restructuring will no longer receive the attentions of private equity funds and so can relapse into somnolence and inefficiency. Think of how sports clubs and private medicine have been revolutionized through financial discipline and management innovation imported by PE fund managers.

Bubbles of Yesteryear

Now those of you over 30 may well remember something similar to today’s roller coaster taking place exactly 8 years ago today. On 10th March 2000, NASDAQ (the US-based online stock market prominently associated with tech stocks) peaked at 5,048 points and with it the dot.com bubble deflated like a soufflé.

Despite much talk of new economic paradigms, investors could not rely forever on finding a greater fool than themselves to buy their overpriced shares. They wanted old-fashioned things like turnover and profits. Since the business plans prevalent at the time (‘Web 1.0’) made little allowance for this and preferred to think in terms of expensive advertising to support a ‘land grab’ on the Internet,

But the Internet did not disappear. Instead, Web 1.0 was reinvented as Web 2.0 as the Internet became more and more important for commerce. Tim O’Reilly in a memorable article in September 2005 identified chracterisitcs of each Web incarnation. I’d summarise the two as follows:
Web 1.0: land-grab, expensive, dependent on advertising/branding, poor revenue models, little consideration of why the internet was the right tool, took much longer than expected
Web 2.0: used as a platform, harnessing collective intelligence, focus on content and services, end of software release cycles, co-operation not control, differentiated from high-street retail, consumer power, direct relationships (eg between bloggers and readers).

Later this week, we’ll have a look at how Web 2.0 rode to the rescue of the Internet, and how it might help today’s most promising companies get funded – even in the midst of the current credit crunch.

10 March 2008

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