CDO and CDS – what are these? And how did they cause a global recession?

There are two acronyms that are at the heart of the recession talk, the CDO and CDS. But very few people know what they are and how they had such a pivotal role in the current recession.

CDS -

So what do the acronyms stand for? A CDS is a credit default swap. The loan seller can purchase a CDS , for this the loan seller pays a fee and in return if the loan is defaulted upon the CDS seller pays out compensation (usually the face value of the loan). As a financial instrument it’s highly effective at spreading risk without diversification of the loan seller’s portfolio. So, for example, banks can sell loans to homeowners or small businesses and not need to balance the risk in the portfolio with more secure loans sold to more established businesses. The advantage of this is that loans to small businesses and homeowners have higher interest rates attached and therefore are more profitable, so by loading the portfolio with these with CDS taken out makes for a highly profitable and low risk portfolio.

CDO -

The second acronym is the CDO, which is a collateralised debt obligation. Again, in its basic form this is a collection of loans that have been packaged together. By packaging loans together it reduces the risk of the package and also allows them to be sold on. There are three main advantages to banks for selling CDOs. Firstly its shifts the risk of loan defaults onto the investor. Secondly it turns small monthly payments that would normally be received from the loan repayments, into a large capital payment from the investor buying the CDO, which gives the bank more capital to give out as new loans. Finally by increasing loans and profits made from CDOs it boosts the financial performance, which results in increased share prices and boosts manager’s bonuses.

Why did they rise in popularity?

Both options sound great, they reduced risk and increase the debt capital available to the market, which should be a self supporting cycle of growth. However loans are highly dependent on interest rates. And the US interest rate had been consistently low since the early 90’s.

With interest rates being low over such a long time it encouraged everyone to borrow more and more. Banks were happy to lend as they were shifting the risk by selling all these loans as CDOs and reducing risk with CDSs as well as receiving cash from selling them, which again increases the amount of loans they can sell. Banks had so much cash they were struggling to lend it all out, so they increased the amounts they were giving out, in some cases offering 140% of the value of property loans and 6 or 7 times annual salaries of the receivers.  But look what happens when interest rates increase slightly.

Many loans start to be defaulted upon, but banks think they are covered with the CDS and CDOs that they took out. But they didn’t realise the extent to which CDOs and CDSs had flooded the market and the amount of companies whose balance sheets were loaded with these instruments that were so sensitive to changes in interest rates. The results of these errors are well documented and this blog doesn’t aim to discuss the results but to questions who was at fault for allowing it to get this far.

Who is to blame for the CDO and CDS issue?

Ok, so let’s line the main groups up who played some part in this over saturation of CDOs and CDSs. Firstly there is the US governments for consistently low interest rates. Secondly there are the homeowners taking loans they couldn’t afford. Thirdly, banks for offering loans that were up to 140% of property values and 6 or 7 times annual salaries. And finally the credit rating agencies that managed to rate CDOs incorrectly.

US Government to blame?

The US government kept interest low to encourage growth in the economy, however should they have realised growth is never expediential? And surely they saw the public debt levels increasing and should have stepped in by increasing interest rates to deter the public taking out more debt. It seems the American government became ‘blinkered’ and only saw the growth benefits of low interest rates. But because interest rates are low does it give other people and institutions the right to exploit that?

US homeowners to blame?

The US homeowners used the low interest rates to take out mortgages, which is great when the mortgage is manageable. The low interest rate would have enabled millions of young family’s gain the first step on the housing ladder and secure their futures. However greed kicked in and people took mortgages that were on the limits of their financial capabilities. It seems there was an over confidence of the public and as a result they didn’t try and ‘keep up with the Jones’, they bought the Jones’ house! It depends how harsh you want to be on the average American family, on one hand you could say it’s their entire fault for being so greedy, but personally I think the average American family is unlikely to understand the complex economics or the financial instruments that are involved when they take out a mortgage. Therefore they trusted the banks.

The banks to blame?

Should they have trusted the banks? Well, yes. The banks have the financial and economic knowledge and it was indeed the banks selling CDOs and taking out the CDSs, so they were in the best position to understand the extent to which the markets were exposed.  The banks also chose to lend huge sums of money to low earning families, it could be called predatory in some cases. However the banks thought they were spreading the risk, they believed they were being safe. You must understand that everyone believed that these CDOs and CDSs were truly safe and therefore you can’t land all the blame at the banks door step. Why did the banks think they were safe?

Credit rating agencies to blame?

The banks thought they were safe instruments because they are banded in terms of risk. Credit rating agencies rank CDOs from AAA to C or D.

The three main credit rating agencies (Moody, Standard & Poor and Fitch) were effectively fooled when it came to CDOs. Somehow they managed to band secondary CDOs into the same categories as primary CDOs. This in turn fooled the market into buying CDOs that were far more risky than they were labelled. The markets are so reliant on these ratings that if errors occur at this stage, the consequences can be catastrophic. It seems unbelievable that such a small error can have such large impacts, and errors that were made by the ‘experts’. The era of bank bashing began as soon as the financial crisis hit the headlines, but it seems that the error was made by the credit rating agencies and maybe instead of slashing the bonuses of the banking executives a little more digging should be done into the salaries of the rating agencies...

Glenstrata - A Damaging Super Merger?

Last week I discussed foreign direct investment and how that can benefit the company and inevitably the shareholders. But this week is centred around companies merging together or a company acquiring a company. Mergers and acquisitions (M&As).

So what’s the difference between a merger and an acquisition? Well the difference isn’t clear in the business world as sometimes it can be called a merger when really a company is taking over another or vice versa. But the simple way to think of a merger is two companies agreeing to combine into one. And an acquisition is a company buying another. For the purpose of this blog we can use merger and acquisition interchangeably.

There are several different types of M&As all of which have recent news stories to give real context to the theory. Firstly there is a horizontal merger, this can be seen in the recent news surrounding the two mining and commodity giants Glencore and Xstrata who are companies in similar lines of activities, which I will discuss in detail later. Another type of merger is the vertical merger, which means buying up parts of the supply and production chain, Greggs is a good example of this, they own the bakeries that supply their retail stores. The advantages being it can reduce costs for Greggs, it also allows greater degrees of product control and faster product alterations, which should give Greggs a competitive advantage over other rival retailers, boosting shareholder wealth. The final type of merger is when a conglomerate is formed, where the two companies are unrelated in their activity but see some commercial gains in merging.

The deal between Glencore and Xstrata hasn’t gone through yet but they would form a giant $90billion company that would have huge power in the commodity and mining markets.

So what are the main benefits for the companies and their shareholders? Well the companies sell a lot of their products such as copper, zinc and aluminium to China for manufacturing purposes. Merging creates less competition in the market which allows prices to rise, and if they charge more money, they make more money! The idea of synergy is also key when discussing a merger of this size, the shareholders and managers should be expecting the combination of the two sets of assets to produce “gains” which is extra value from the same asset base.  Other synergy benefits would possibly include tax bill reductions (which have been discussed in one of my previous blogs). The economies of scales the two companies could benefit from could be immense, by sharing suppliers they could negotiate even larger discounts, which would be eye watering for the supplier but would decrease costs for Glencore and Xstrata. Other than the obvious economical reasons for the merger, why else would the executives make this move? Business men like large businesses and want to be the biggest and the best! The idea of empire building is a reality, fuelled with a dangerous mix of status, hubris and power struggles of the top executives and if the opportunity arises to combine to make the world’s largest company, do you think the power hungry execs could turn it down?

Is this merger really going to be the perfect synergy, or will it all end in tears? No matter how rose tinted your glasses are, you must realise that this merger won’t be as simple as plugging the two companies together and value will instantly be created. The steps involved in merging are huge and ridiculously expensive, a company will have to broker the deal and they will be taking between 2-5% of the deal which is over $4billion. Which is $4billion instantly wiped off shareholder value. The ability for the two management teams to fuse together is critical to the mergers success, if they don’t resolve cultural, dominance and personal differences at the top of the firm it will quickly destroy the merger as they management will tear the companies apart from the inside. There is also the question as to whether anyone other than the management and shareholder benefit from this deal? If the merger happens successfully, I’m sure the executives will be very happy with their increased salaries and bonuses and the shareholders will be very happy with an increase in dividends and share prices, but what about the rest of the stakeholders? Will society actually benefit from this? As consumers would a company with the ability to control commodity prices be good? Probably not, because any increase in price will be passed on directly to us. As a driver for the company, would you be pleased when they manage to reduce transportation costs by 10% causing you to lose your job? Probably not. As a supplier would you be pleased when Glenstrata knock on the door demanding a 20% drop in price? Probably not. M&As can be great for shareholders and executives but do the largest really help anyone other than the select few?



British Brands Gone - FDI.

There have been several cases of high profile UK brands being snapped up by foreign companies recently. American based Kellogg’s recently bought Pringles for £1.7bn, Kraft bought Cadbury’s for £11.5bn and most recently Muller have bought Scottish based milk producer Robert Wiseman Dairies for a more modest £300m.



What is foreign direct investment?

Any company that takes managerial control over a company or assets outside of its domestic boarder can be identified as foreign direct investment (FDI). All three cases above are acquisitions, where the company has bought the shares of the foreign company to take managerial control. There are two other methods of FDI, greenfield and joint venture.

Greenfield investment is when companies literally buy a field and build from the ground up. Greenfield investments are popular within the car industry, for example Hyundai started construction in 2006 of a plant in the Czech Republic to supply is European operations. The advantage for Hyundai is a purpose built, state of the art production site that is specifically designed for their products. Greenfield investments have advantages for both the company and the local economy, and often governments offer financial support packages to attract large greenfield projects. The main advantage to the company is the complete control they have over the project, usually 100% owned they have no diluted of returns for shareholders. However they do require large capital investment and the planning and construction period mean it’s the slowest method to market, which are all risk factors to shareholders money.

Many companies also chose to enter into a joint venture, usually choosing to work with an established company to make use of their existing assets and infrastructure. For example Marks and Spencer bought a 51% stake in the Indian retailer Reliance for £29m to take advantage of its store locations. The advantage of entering into a joint venture is the knowledge transfer and experience the companies can share. Usually a large company enters into a JV with smaller company to take advantage and enter the market quickly, the smaller company is usually happy for the investment and the economies of scale the large investor brings. JVs are usually the cheapest method into a foreign location, however they do have disadvantages, there can be issues sharing technology and trade secrets that can potentially reduce competitive advantage. There can also be management and culture synergy issues, again which could potentially damage shareholder wealth if the project fails.

Is FDI the only way to generate sales abroad?

There are other options available to generate sales in a foreign market, such as exporting or licensing. Exporting offers one of the fastest routes to market but must be balanced with the costly transportation. Exporting is the only option for some companies that are restricted by resource location, such as diamond mines. Also exporting is seen as the only option for companies who rely on location branding benefits such as Barbour, Bentley and Aston Martin, who all use the UK production as part of their brand image.

Licensing is the process of granting the rights to sell a product under a specific brand. Again this is a fast entry to market with little capital required, however the loss of control of the brand can be potentially damaging in the long term. There can also be issues with loss of control over technology and trade secrets, effectively reducing competitive advantage.

Management must consider all of the above methods when considering FDI. The company must be aware of the potential risks of each method and select the option that will result in the greatest shareholder wealth production.

 Source: UNCTAD, UNCTADstat

FDI – The rich helping the rich?

There is no doubt FDI has major economical benefits for both parties involved, however the latest figures show the majority of FDI is still between developed countries. On one hand it makes sense you would aim to sell your products in the developed world, where disposable incomes are higher, but at the same time the developing countries would benefit from major FDI the most. Huge capital investment and job creation would create a self supporting spiral of wealth for the developing countries, but companies just aren’t willing to take the risk. Yet.