Sublime Consulting

In the last few weeks we have been witness to one of the most interesting times in the global financial markets!

First it was the ’sub-prime exposure’ contagion from U.S. Housing Markets spreading like wild fire across continents.

Second was the ‘Leverarged Buy out’ market that went into a coma [and sealed the M & A story aided by cheap financing]

Third was the ‘Collateralized Debt Obligations’ market or the packaged financial weapons of mass destruction thats blowing up financial markets into pieces..

Fourth was ‘yen carry trade’ unwinding..

Ah..we are pretty much familiar with fourth one.. ‘Remember May 2006′!

what about the first three?
The answer is simple ..
‘When the lender becomes the borrower!’

Let me explain in simple terms .
Traditionally the lender used to be banker or a financial institution and the borrower used to be a corporate or an individiual like you and me.
Lets start with the first instance of ’sub prime woes’..
It was the traditional banker or financial institution which lend to individuals[American Citizens] to buy homes in the U.S.
Except that they lend to people who are so poor that they cannot afford to even pay interest leave alone the principal.
The bankers were under the notion that since property prices are bullish and it has only one way to go..yes..up..
Based on this notion..they securitised the assets and sold commercial papers to some hedge funds and other financial institutions promising higher yields.
The deliquencies went up to as high as 25% in some places in a very short time period that the banks were forced to seize the mortgaged property and sell it..Alas..if only they had buyers!..Yes..The property prices were heading south..
Few of the Bear Sterns and BNP Paribas hedge funds that were exposed to these ‘junk bonds’ lost all or most of its value creating a massive sell off in the global financial markets.

While this story was unfolding.. the M & A activity through leveraged buy outs [that was the toast through out this year for the equity markets being bullish] turned soar with banks not being able to raise funds for Chrysler and Alliance Boots deals. Well.. overnight.. the cheap financing tap [for leveraged buy outs] dries up!..

By the end of the week..The Fed says that the sub-prime contagion is contained!
Hell it was.. The CDOs made sure that it wasn’t..

You might wonder..All these still doesn’t answer the question of ‘how a lender becomes a borrower?’ Right..
Here we go ..
Now we all know a little bit of sub prime and leveraged buy outs ..

The CDOs are structured products created by banks as a result of debt financing for Mergers and Acquisitions of companies. As protection from a probable default from the borrower, the banks structure the loan product with the collateral being the assets of the borrower by providing higher yields and sell the product now to other banks and investors. This process is known as credit derivatives in the financial markets. By doing so, the first step to lender becoming a borrower has been put in place! In a similiar fashion the other banks re-package along with few more assets[like asset backed securities or sub prime loans] of different rating profile and maturity and tranches and sell further to some more banks and so on.. By doing so..the entire banking system has not only become highly leveraged to each other but also lost track of real assets and their value[thanks to the mark to model system!].. Financial engineering at its best or shall we say worst..
Statistics tell us that today the organisations that borrow money from the banks are less leveraged than the banks themselves..
So..when the lender becomes the borrower..thanks to the CDOs..the volatility is bound to go further up [with more and more banks and financial institutions going belly up] and this in effect brings down further the equity and other markets..
Like they say, this time around its different..
We sure are living in interesting times!!