Banks’ pyramid scheme
Back to school today. But those noisy boys from private equity, who were hyperactive last term and should have been on Ritalin, are curiously subdued.
In all my many years as a journalist, I have never seen an industry suspend activities with the speed and scale of what has happened to private equity – except when there has been a strike or industrial action.
Actually, private equity is in a way the victim of a strike, a strike of lenders.
Financing for big takeovers by private equity firms has evaporated.
Why did it happen? Nothing terribly sinister or complicated. It is simply that private equity firms became too cocky and ambitious for their own good.
In the first half of this year, they transacted so many big deals requiring so much debt-finance that eventually – as June turned to July – the financial markets simply could not and would not absorb all the debt being issued.
Who is to blame? Partly the firms themselves – but also the big international banks, like Barclays Capital, Royal Bank of Scotland, Citigroup, JP Morgan, and Deutsche Bank.
These underwrote the debt, on the assumption that they could then sell it to investors via artificial financial constructs, the so-called structured credit vehicles (the collective noun for those collateralised loan and debt obligations I’ve been banging on about).
But what they seem to have failed to notice was quite how much additional debt they were expecting these investors to buy. By the middle of the year, the big banks had agreed to provide somewhere between $300bn and $400bn of debt to new private-equity deals, which was six or seven times the amount of such debt placed in a typical year until very recently.
And then there was the banks’ second bizarre manifestation of short-sightedness.
Not only were they financing the private-equity takeovers, they were also financing (underwriting) the structured credit vehicles.
In other words, they were on both sides of equation: they were creating both the market for the private-equity debt via the structured credit vehicles and the debt itself.
Does that seem as bonkers to you as it does to me?
It looks a bit like a pyramid selling scheme – except for the surreal twist that one part of a big bank is selling to another bit of the same bank!
What went wrong (as if you had to be told) is that the banks suddenly took fright about their exposure to structured credit vehicles (because of contagion from sub-prime and all that). So they stopped financing these vehicles, which in turn had less money to buy the private-equity debt. The banks then couldn't sell the private-equity debt, because they had forced the buyers to shut up shop!
It is one of those occasions when it is quite impossible not to say "you couldn't make it up".
Who are the victims of this craziness? Well it looks like being the big banks and their shareholders (oh dear, that’s you and me if we’re saving for a pension).
The point is that they are stuck with between $300bn and $400bn of unplaced private equity debt, whose market value is considerably less than the price they paid for it.
And they still have considerable exposure to all those structured credit vehicles – whose true value is anyone’s guess.
Their theoretical losses on all of this – on a mark-to-market basis – would run to many tens of billions of dollars. Which would not be enough to break any big bank, but would be a bit of an embarrassment.
At the moment, Barclays, RBS and their ilk are insisting that their woes are simply the result of “abnormal” market conditions which – they hope and pray – can’t last more than a few weeks.
Theirs is the Micawberish “something-will-turn-up” approach to banking.
But what if investors’ appetite for all this debt isn’t restored promptly?
Well then the banks have an uncomfortable choice.
They can hold the debt for months and even years, in the belief that the borrowers are fundamentally good credits. But in the meantime, their own capacity to underwrite new deals would be constrained – which would delay the recovery on which they (and we) all depend. Think about what happened to the Japanese economy in the 1990s when its banks refused to recognise the imprudence of their lending.
Or the banks could sell all that debt at below par – which would mean they would have to suffer the short sharp shock of realised losses.
The world’s most successful investment bank, Goldman Sachs, has made its bet about what the banks will do. It has recently raised a substantial sum from investors to buy this debt as and when banks flog it for 90 cents in the dollar.
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Robert you are brilliant at exposing in such simple terms that we can understand the very insight that highly rewarded city finance executives fail to grasp. Perhaps they should read your blog before breakfast!
A key phrase here seems to be "Their theoretical losses". Chickens doesn't seem to like coming home to roost any more - maybe something to do with global warming?
Another good illustration of the markets unshackling from reality yesterday; the Dow Jones went up 90 point because of terrible economic data - investors thought that it would make the feeble, market distorting, Fed cut interests rates again so they piled in
Pretty bizarre when you consider that they would have already hedged their own risks using structures like CDSes - but you seem to be correct - all the risk is eventually flying between the same set of banks. My question: is a significant proportion of these risks being transferred onto end-investors? If so, then these banks shouldn't have a problem - because all their contracts with their clients/investors would come in play to save the day with nothing more than mild (??) damage to their reputation. If the risk is still flying around in the same big-bank circle, then we are in for worries - and the way some of these banks have been hesitant to lend money, it would seem that not all the risk of underwriting has been passed off to third parties.
If Goldman Sachs (and their investors) see a potential profit in buying the debt at only a 10% discount then, presumably, the debt is actually quite creditworthy (i.e. not too toxic) which begs the question why the banks need to sell it on and take a hit at all.
Robert - thanks for your perceptive and simple explanation of what is - for most of us - a 'black art'...
In the final analysis, it seems that bankers are no cleverer than the rest of us - and it could even be considered that they deserve their rhyming slang..!
"It looks a bit like a pyramid selling scheme"
Strange that. Eh.
From Wikipedia:
"A Ponzi scheme usually offers abnormally high short-term returns in order to entice new investors. The high returns that a Ponzi scheme advertises (and pays) require an ever-increasing flow of money from investors in order to keep the scheme going."
As I pointed out in a previous post. Debt based money (basically all of it, GBP, USD, Euro and all the rest) *requires* an exponentially increasing money supply and economy simply to continue functioning.
Of course, the bankers have managed to get this particular one legalised...
Being a simple soul, I liken all of the recent years "prosperity" to a spending blow out on a bunch of credit cards - you feel rich whilst it lasts but the time will come when the credit providers will stop and think whether you are good for your debts. This market for debt seems to operate upon a "greater fool" basis, that is, there will always be someone who you can offload the risk to - what surprises me is that there have been investors who have been taken in by all of this and have paid billions for "high yield bonds" on a no questions asked basis.
I agree with Paul (comment 4) if a 10% discount is sufficient to make the debt an attractive investment then all that could prompt such a sale is the banks wish to free up the facility to take on new business at the expense of returns on their existing debt.
This sounds to me like the situation with mortgage lenders who fight over new customers and don't seem bothered about trying to retain their existing borrowers. It seems activity is more important than profitability.
Pyramid schemes always fail because losses are left with those guys who are "LIFO's" i.e. Last In, First Out. Banks are no different to this basic tenet.
There is a wider picture unfolding here. Outside the US, the rest of the world is oiled by consumption, which is in turn fuelled by debt.
Cut off or reduce the debt supply by credit squeezes (an old fashioned 60's and 70's phrase) and you get a domino effect.
The UK has remodelled its economy since the early 1980's on services, both financial and other, and on niche manufacturing, which after decades of decline is starting to now show growth signs.
Our greedy City financial engineers have missed this point, focusing on the now and the bonus cultures. As a result, more traditional forms of lending, which created the financial instutitions these "engineers" work for, will suffer for many years. Ordinary people and sound businesses will pay more for their money. The result is an economic slowdown and start of a recession. This is a very real risk right now. In the UK, this also means the spectre of unemployment, falling profits and reduced tax revenues for the Government, who have significantly increased the National Debt in the past few years. Yikes!
I think 2008 is a watershed year, both in the UK and abroad. I think we are long overdue a major asset valuation correction in all classes, and a radical restructure and overhaul of global banking and investment models that now appear to be outdated.
Change is coming. What no one knows right now is just how much pain this will create. The banks and investment communities themselves have no idea on the true cost of all of the credit derivatives and their asset class valuation failures through poor credit underwriting. This will take years to unwind as all of these contracts come up for maturity. Banks will no doubt, stagger their losses over several years, to "paper over the cracks". This is normal lenders' practice, provided of course, that the "merry go round" of incresed new lending amounts continues i.e. grow your total asset lending base and revenue streams. Much banking profit of recent years as been fee driven from M & A deals funded by debt for private equity deals. This will drop from now on for the next 12-18 months at least.
Once the lending music stops, and the merry go round finishes, the true extent of loss will become evident. Banks in particular are vulnerable, as they repackage private equity deals and sell them to one another. I know of bankers who have "sold on" the same deal half a dozen times, tweaking valuation models, but without changing the business fundamentals of the company and its business. It is just madness and we will all eventually pay for it. Just look at LIBOR right now. Geez, this is scary. Every commercial borrower pays for this right now on their overdrafts and loans. Talk about killing the golden goose.
Couple this with the growing excess of demand over supply for all commodities, especially food, raw materials, oil and water especially from the "new world" and the BRIC's, it makes a heady new global economic cocktail.
Finally, for "defensive" assets, like gold and government bonds, spare this thought. These values are only good if the political as well as economic base of a country is viewed as sound. The US has a major issue here. The BRIC's hold much US Government stock as currency based assets in their reserves. Its values reflect the US economic strength. We should all worry if the US economy downturns. Then the BRIC's have a real dilemma. Dump US T-Bills or reinvest in "real cash flow businesses"?. Look at the Chinese and Singaporeans. They are shifting their portfolio investments into global businesses and away from equities and bonds. They are going for cash based dividends from trading.
Cash is king right now. Be liquid and be safe. Banks have to guard this fact. So do we all as individuals. I do not want to be a casualty of banks' pyramid selling thank you.
I hope nobody is surprised by the fact that private equity deals have slowed to a trickle. For months we have been subject to ever more questionable deals supported by absurd potential valuations, you only have to look at the Saga-AA transaction as an example. With respect with a few honourable exceptions the financial press have really failed to investigate and challenge some of the assumptions that have been made in support of deals of this type.
Debt providers have deluded everybody including themselves in the rush for volume rather than quality. Jon Moulton was right about MG and he warned of the credit crunch for private equity months ago.
Robert - I just want to thank you for your wonderful analyses of the recent credit crisis. You have brilliantly succeeded in explaining this hugely complex financial crisis in an easy to understand and structured way. You have become essential reading! From what you are writing, I feel there are still lots of negative repurcussions from what has occurred which will impact negatively on the stock market, the housing market and the economy as a whole in this country. Perhaps it's time to sell the house, sell my shares and take advantage of those lovely high interest rates!
The lack of enthusiasm on the part of the banks is entirely in character.
With the bank's sausage-machine in mothballs, they realise that the loan will sit on their own balance sheet and become more wary about the risks involved.
I might feel a trifle put-out if I were the hapless CDO customer, realising that the bank won't put their own money where their mouth is but were once happy to help me place my own chips on the table, for a fee...
What people forget is that in order to make a market onemust have a willing seller and a willing buyer. Much as they did in the days of the leveraged buyout jamboree (eighties') many the banks have created willing buyers of debt but without adequately assessing the substantive value of the assets on which the debt finally must stand. Even a breif review of the FT over the past two years shows that many leverged buyouts (MBOs, etc) are pretty heftily indebted. With the US slowly sinking into economic stagnation for the foreseeable future, a veritabel debt storm will sink number of europena banks in the next four years.
It has political considerations too.
Most world G8 governments are committed to very high spending as the cult of more and better is well established with respective electorates in order for these governments to gain power.
The Banks will be forced to write down sub prime associated losses which will impact their profits and share price. Its not likely to happen quickly but over a perod of time.
Goverments will lose substantial tax revenues that will challenge their abilities to meet their costs. The alternatives will be a rise in taxation or drastic cuts to services.
Do I remember Lloyds of London as a similar snake eating it's own tail a few years back?
Question is when it comes to the crunch, will GS put that money where their mouth is or wait a bit longer til it gets really bad and sellers get really desperate. If someone is willing to sell at a 10% discount, does that mean it's worth that price? It could be much more toxic than that and worth next to nothing. Not even the bank selling knows the contents of what their selling. Anyone for a lucky bag? 90 cents to you sir.
Question is when it comes to the crunch, will GS put that money where their mouth is or wait a bit longer til it gets really bad and sellers get really desperate. If someone is willing to sell at a 10% discount, does that mean it's worth that price? It could be much more toxic than that and worth next to nothing. Not even the bank selling knows the contents of what their selling. Anyone for a lucky bag? 90 cents to you sir.
Hmmm, banks borrow money to buy risk in borrowed money. Bank loses money by finding out the promise to pay back the borrowed money they have just bought was written in invisible ink. Tough luck they took the risk, they should get burnt.
Gordon Brown could actually by out some of those risky PFI contracts he and Tony created, by charging the investment banks an extremely high interest rate for borrow money to get them out of their own mess. Either that or let them all learn the thing "normal" investors have to learn. The value of your investments may go down as well as up.
Deja Vu, in the 80's Australian speculators such as Bondy, Holmes-a-Court & Elliot kept on buying more companies using 'Equity' in the companies the had already bought on credit. Fine, until the banks said no more, "credit crunch" the term was then. As Australia's richest man Kerry Packer said, A Bondy doesn't come round every day. He sold his TV Channel 9 to Alan Bond "an ex-pom" for $1 billion then bought it back for half that amount a few years later. Easy money creates easy debt from fools. How stupid are we to let fools play with easy money so as to trash the system that gives us all our wealth?
Rob,
I don't know which I find more disturbing - the lack of your understanding of the private equity world, or the lack any balancing insights at the bottom of your blog. Its all getting a little bit "Daily Mail-ish"
(1) Re "private equity industry suspend activities": have a look at the volume not value of announced or pending transactions. Sure things may be quieter at the mega-buyout funds (€5bn+), but not elsewhere in the industry.
(2) Re "too cocky and ambitious": average returns over ten years for private equity, 25%, compared to a modest return of only 14% for the public markets. There's still plenty of headroom to go before it becomes as inefficient a model as the public markets.
(3) Please explain how you consider "private-equity debt" to be different to corporate debt - because as a private equity investor I'm almost certain there's no difference. Would be happy to learn though.
I'm about half way through the article and still have more points. However, as a private equity investor I have new investment opportunities to seek out and work to do, there's still plenty going on where I'm sat...
You think this pyramid selling scheme is bad. The Liar Loan based UK housing "market" is the Greatest Pyramid Selling Scam of All time - and that is still to show itself. It will make everything else look like a storm in a teacup.
Surely the banks are not all "teeming and lading". That would be fraud wouldn't it?
The only reliable information in the posession of each individual bank concerns their own assets and liabilities.
If the decision not to lend to each other is based on the assumption,"If their situation is as bad as ours, there in way we can take the risk", then there really is a problem.
I am suspicious that in effect the same loan has been used many times as collateral for pyramids of debt, and that a vast amount of the loans are not secured by any worthwhile assets.
The house of cards will soon fall down completely.
All this strikes me as Fraser would say in Dad's Army, "We're all doomed...", complete with Scottish accent! Are we?
Yes the BOE is acting within published guidelines. Further scrutiny will reveal other insistences, to inspect banking practice on an annual basis for instance. And that's not just talking anti-money laundering, but totus: managing and reporting clients, products, risk control, operational risk, accounting, right through to legal and compliance. There is a lot more to uncover still, and if you are prepared to inject billions in liquidity into the system, you'd bally well ought to be convinced the others are up to it.
A very well structered and informative article.
Regarding the bank underwriting the private equity loan, I dont think it is merely based on the fact they can sell it to investors (by any other vehicle), but rather because the asset of the firms involved could easily cover up the cost of debt.
I dont think banks are foolish enough to base their assumption on potential investors buyers only.
Rob,
Let me understand this correctly.
A bank goes cap in hand desperate to borrow £2Billion but claims to have "high liquidity".
Banks, building societies, blue chips, investment fund managers etc scratch their aching heads as to where the crisis REALLY came from.
When are people going to understand, what spiralled up at frightening pace will fall twice as fast. If Ponzi was still alive he would admit that fact. The real problem is yet to come.
When you play cards with the banker it can keep its hand turned down until the end of the game. If you are playing...stick. The bank will eventually have to show its hand. Its Bust!!!
I am no financial whiss or any thing like that but I do buy and sell on a regular basis and there is a saying about fools and money .
I think somepeople need to re visit Adam Smiths wealth of nations for a bit of guidance.
FORGET THE MENTALITY OF MASS MARKETS STICK TO WHAT YOU KNOW AND DO IT WELL.THE FUNDEMENTALS OF ANY MARKET ARE THE SAME THE WORLD OVER ITS JUST PEOPLE THAT GET IT WRONG TIME AND TIME AGAIN BECAUSE THEY ARE DIVERTED BY ORTHER INFULENCES .
Write me a large cheque please.
Filling Voids.
I have taken a strange interest in the ongoings in the stock markets recently and indeed the reporting in the newspapers as to why the ongoing crisis might be happening.
In particular the notion that somehow there may be a possibilty that large scale fraud via pyramid schemes may be taking place within major institutions.
Is it possible Rob that somehow the inevitable void created in such schemes (in which the money really is not there to pay everyone if they all wanted their money out at the same time) could be filled by transferring funds from a less stressed associated company or obtaining an easy loan from a bigger financial institute who knows no better. This would give the impression that everything is AOK in the long run when things settle back down, when really.....
I am beginning to feel that something very serious is going on.
Macie
As I understand it, pyramid schemes produce enormous profits for the few at the top of the pyramid. I guess that must be the principals of the private equity firms that are taking enormous commissions for the deals they set up.
So, much like Black Wednesday when a few investors made millions on the run on the pound ahead of the exit from the ERM.
All of these money-making schemes are paid for over time by the day-to-day investors and everyday borrowers i.e. the pension funds and inevitably Joe Public.
Financial regulation seems to make a fair job of safe-guarding the public around the more straight-forward investment vehicles, but clever schemes like this will always emerge, that allow a few to make millions, and increasingly billions, out of the many.
Where will it all end???