The Hindu Business Line : Making complex deals bankable

Much has been written about the sub-prime crisis and the hits banks are taking due to write-offs. The top brass of some of these banks have been given the marching orders but not before being given huge sums of money. Northern Rock, a bank in the UK known more for its sponsorship of football teams, faced the biggest of runs on banks in recent times.

The bank financed its huge expansion by arranging debt from thousands of British mortgages, sliced into neat packages with solid returns. These were attractive to international investors. In return for these debt parcels, Northern Rock was given fresh cash which it was able to lend to the next group of home buyers.

Now, as these billions of credits reached their expiry date, the banks which made the loans refused to renew them.

The Bank of England, the lender of the last resort, stepped and did a rescue act which led to the run. Investment banks and their cronies are busy working out a takeover proposal for Northern Rock.

Increasingly risky?

Nearer home, although there was no run, the erstwhile Global Trust Bank, which ran the business of banking till it was insolvent, was grabbed by another bank. Is the business of banking getting riskier? The very nature of banking involves risk. When there is an element of risk, there would be a mixture of the good, the bad and the ugly. However, what appears to have made the business riskier is the changing nature of business and their innovations.

The sub-prime mortgage market crisis started in the US during Fall, 2006 and became a global financial crisis by July 2007.

Many factors created the crisis, but the most immediate were the rising interest rate environment, which caused people with adjustable rate mortgages to see significant increases in their mortgage payments, and declining property values as the national real-estate market finally began making corrections. This left many home owners unable or unwilling to meet financial commitments, and lenders without a means to recoup their losses. Many observers believe this has resulted in a severe credit crunch, threatening the solvency of a number of marginal private banks and other financial institutions.

Such a complicated nature of lending would have been unthinkable a few decades ago.

Another factor that leads to such crisis is the tendency to go bearish on such new-age lending practices. A large fund is being created to provide liquidity to banks and financial institutions that get into such mess. This reflects the magnitude of the problem. Keeping caps on such risky lending and sticking to the core business of granting direct loans, earning interest on that and getting it repaid may sound too simplistic a solution but appears imminent.

Complex situations call for complex solutions. Now that the Bank of England has pumped in a huge sum into Northern Rock, it would be interested in getting its pound of flesh too when the takeover happens. Since the proposals have come in from those in all sorts of business backgrounds and not necessarily well-heeled bankers, the Bank of England may resort to a new trick in corporate finance known as “Schmuck insurance”.

Schmuck insurance

The other option would be the so-called “non-embarrassment” clause, known in corporate finance circles as “Schmuck insurance”. Vendors commonly introduce this when they are nervous that they are selling an asset to a buyer who might sell it on for a large profit. Typically, it pays the original vendor a share of the proceeds of the sale of the asset if a transaction takes place above a certain price and within 12 months. However, there is one drawback. Any bumper payout from a non-embarrassment clause would eat into the returns made by the new equity owner and that might deter them from a rescue deal. The chances of a good, clean takeover appear remote.

With rising complexities in business, such situations are bound to recur. A good risk management policy coupled with a curb on the tendency to overdo a particular type of lending should ensure stability.

(The author is a Hyderabad-based chartered accountant.)