Tuesday 12 September 2006

The Big Crunch

Today I will try to explain something complex in a way that I can understand and hopefully will be of use to people outside of the City.

The world of Private Equity has stormed our Financial Services Industry over the past 4 or 5 years. In effect, private companies have been sponsored by banks to lend money to existing plc's. As they are not banks they are not held to the same levels of scrutiny or credit worthiness; these companies are known as CLO's.

The business of CLO's is to lend money against the AAA credit given to them by the bank. They then make money from fee charges to investors who provide their initial equity and interest payments from companies they lend to. Companies are at the mercy of CLO's for their borrowing and can't control who owns their debt.

However, events have spiralled out of control. Now these companies lend money at silly prices. Often in deals there are 7 or 8 levels of complex debt; only a couple of years ago 3 was considered byzantine. However, all this lending has meant much liquidity in the market which in turn has allowed companies to borrow more - stoking the market for the CLO's.

Sooner or later this has to crash, the companies simply can't pay the interest they owe and they are 'leveraged' to a level of debt that they won't be able to pay. As long as there is a bull market the whole situation is a wealth creating circle. When it fails though there is a big crunch; think Dot Com. The CLO's are all in this together and when companies start to miss payments they will be left with worthless debt.

So the companies go bankrupt, the CLO's get taken down too. People lose jobs for reasons they don't understand and can't control. Interestingly the banks have protected them from this situation by selling on all the risk to other CLO's and hedge funds.

As of today deals are being done on the tipping point, companies borrowing money and being re-financed at 8.5% interest; that leaves nothing after paying debt ofr investment or weathering a storm. In the papers today companies such as Capital Radio are prime expamples of well known organisations facing this dilemma.

When the crunch comes there will be a massive upheaval and economic dislocation. The city boys have pocketed their money already and will be away to the Caribbean. What about you and your job? What about our good companies going to insolvency and shedding jobs or being bought on the cheap by foreign investors? What of the effects on our national tax income as compaines pay less overall due to faliure and debt?

These are huge issues for the government, who record of regulation in the area is negligible and only slowly improving; but too late. I hope both Brown and Osborne are considering this issue because it is the most likely scenario for the beginning of the next recession and it is happening right now


Pogo said...

Reads horribly like the rebirth of "dear old" Michael Milken's "Junk Bonds"... And we all know what happened to Drexel Burnham!

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