Accounting for the Credit Crunch

Already financial services companies- investment banks and asset managers- are scaling back their recruitment intake for 2009.

The Credit Crunch has, so far, been a crisis born in the financial world that threatens to spill over into the real world.

Already financial services companies - investment banks and asset managers - are scaling back their graduate recruitment intake for 2009. Professional services companies - consultancies, accountants and lawyers - seem set to follow.

There is only one subject likely to dominate those graduate interviews that do go ahead - the credit crunch itself. So it's key you understand it and find original ways to explain it.

The Gateway asked former accountant and OxbridgeGroup founding director Andrew Williams to take a fresh look at the problem faced by our banks and financial institutions and explain their problem through the lens of accountancy.

If you work for one of the 'Big Four' accounting firms - Deloitte, PwC, Ernst and Young and KPMG - you will be preoccupied with the financial accounts produced by all companies. These accounts consist of three key financial statements. They are: (1) The Profit and Loss account (2) The Balance Sheet (3) The Cashflow Statement.

So if you were called in to audit one of the large commercial banks right now, what would you find and how would it shed light on what is the essence of the credit crunch?

Profit and Loss

The 'P&L' reflects two categories of financial information - income and expenditure with the net difference between them being the profit or the loss. For the banks, the former is falling and the latter is rising...

Income down - margins from lending are being compressed as the cost of the banks' own funding soars, as expressed in 'LIBOR' - the London Interbank Offered Rate which sits at an unprecedented spread above the Bank of England's base rate; as interest rates rise and fear takes hold, fewer people want to raise money for commercial activities

Expenditure up - well, not expenditure as such but losses taken to the P&L by having to write down the value of assets, like loans, bonds and other parcels of credit.


Balance Sheet

The Balance Sheet shows two categories of financial information - assets and liabilities - the net difference being net assets. For the banks, the former is falling and the latter is rising...meaning net assets are being wiped out.

Assets down - banks assets are loans, bonds and other credit receivables owing from counterparties. The value of these assets is bombing as creditors struggle to pay them back, or worse in the case of Lehman, go bust. The banks have to write down the value of their assets in line with the declining market value of all debts - "marking them to market".

Liabilities up - banks liabilities are their own funding commitments, often to each other, the government, and the wholesale money markets as well as counter-party commitments on certain derivative positions. One major liability is that on 'credit default swaps' (CDSs) which are insurance products taken out by a lender to protect against the risk that they do suffer some adverse credit event from a borrower. These might include the borrower going bust, being late to pay interest or principal or having their credit rating down-graded by the agencies. The value of CDS in issue is said to be $58 trillion. Their issuance is unregulated and never passes through a stock exchange. As such they are 'over the counter' products (OTC). CDSs attached to Lehman's bankruptcy are said to be worth $300 billion. Banks and investment firms are holding the other end of these commitments. In the view of The Gateway, it is the unprecedented existence of credit default swaps that represent the biggest systemic risk to the financial system and the global economy that the world has ever faced. It is rather like holding the world's insurance companies to pay out after a global nuclear war.



The cashflow statement records the simple inflow and outflow of cash, irrespective of when it is accounted for. The banks have been hoarding cash and refusing to lend it to anyone else because they fear being called on their obligations without being able to raise new funds in the money markets.

Cash in and Cash out - quite simply there isn't any; LIBOR is at an unprecedented spread above base rate and the short-term money markets are virtually frozen.

The banks have been caught relying on what now looks like a major gamble: they raised finance in the short-term and lent it for the long-term. This has historically made them a profit as short-term funds, being subject to less risk, are cheaper than long-term finance. However, the credit crunch has cut off the availability of short-term funding and means, while they cannot get back the money they have lent long, they cannot refinance the money they owe in the short term. This is the essence of their 'liquidity' problem.

The main source of money are governments and central banks who are willing to step in and provide liquidity to the market by lending it and accepting impaired securities (bonds, loans etc) as collateral.


What went wrong?

These factors created the climate for the credit crunch. They set up the conditions where the crunch could be triggered...they did not cause the crunch directly, they were enablers of it.

1. Low interest rates - since the end of the cold war in 1990 and until autumn 2007, the world has benefited from a relatively unbroken spell of warm financial sunshine. This has been characterised by an absence of political and military fighting leaving everyone to concentrate on economic growth. Also, inflation has been minimal due to two factors that have pushed costs downwards: (1) the emergence of economies like China and India providing cheap labour to reduce companies' manufacturing costs; (2) miniaturisation and information technology has reduced shipping and administration costs. These emergent economies also produced plentiful trade surpluses that they made available to the developed world for investment. With low inflation and a rosy outlook, plus little perceived risk and a plentiful supply of capital, interest rates were held low throughout the global economy.

2. Excessive leverage - faced with low interest rates, firms, governments and individuals could afford to support more debt - so they did. They increased their leverage using debt and credit to fund mergers and acquisitions, public expenditure, and consumer spending. However, this huge increase in debt gearing made borrowers vulnerable to any increase in interest rates if times changed.

3. Excessive complexity - investment banks created new financial products - mostly credit derivatives (asset-backed securities ("ABS"), credit default swaps ("CDS") and collateralised debt obligations ("CDOs") to assist lenders and borrowers to increase leverage and manage risk. These products were highly complex and contained multiple layers and conditions. Not enough people understood them. They were unregulated and not exchange traded. They obfuscated the real nature of credit relationships - that debt has to be managed and paid back and there is always a risk that debt cannot be repaid if the cashflow of borrower suffers.

4. Globalisation - in times past, investment managers have always looked to mitigate risk by diversifying. However, the globalisation of finance has meant that almost everyone is connected to everyone else and no market or asset can be insulated from others. So if one tanked, they all would. Derivatives link together the effect of financial products on each other. They inter-connect banks with hedge funds and national economies with global markets.

5. Mispricing of risk - when times were rosy, lenders lost all sight of risk - the risk of creditors not repaying debt, the risk of asset prices falling, the risks from leverage and the linkage in the financial system. They lent too much debt and interest rates that were too low. Investment banks encouraged short-term risking by paying annual bonuses. Governments exercised little oversight and created weak regulation regimes.

Short-term triggers

These factors actually triggered the crisis. They required the conducive environment of the enablers to be allowed to cause a melt-down.

1.Interest rate rises - as the exuberance of financial good times increased to unsustainable levels, culminating in 2007 with ludicrous LBOs of public companies with tiny amounts of cash and massive amounts of debt, profligate government borrowing to make wasteful investment in the public sector so inflation rose, and soaring asset prices especially in housing, central banks (finally) raised interest rates to dampen down the risk of inflation.

2.Defaults on sub-prime mortgages - when interest rates rose, those people that were over-borrowed faced defaults. Worst hit were 'trailer park' home owners in the US who had raised mortgages they could only afford if interest rates stayed low.

3.Busting of CDOs - investment banks had packaged together sub-prime mortgage debt into debt parcels called 'collateralised debt obligations'. Their creators expounded the misguided belief that in some way, simply by repackaging debt, risk could be reduced. The CDOs were bought by investment managers and hedge funds all over the world. When the sub-prime borrowers in the US defaulted, CDOs were exposed as a sham.

4.Busting of Hedge Funds and Investment Banks - on August 9th 2007, two of BNP Paribas' hedge funds blew up. They were soon followed by those of Bear Stearns and all the other investment banks. Suddenly risk re-entered the financial system and everyone was forced to confront the reality that the value of CDOs and other credit positions were a fraction of what was thought. Facing massive write-downs and calls for repayment from impaired capital, the investment banks became technically insolvent. Bear Stearns was saved at the 11th hour by JP Morgan, while Merrill Lynch had to be rescued by Bank of America. Lehman went bust while Goldman Sachs and Morgan Stanley had to relinquish their status as independent investment banks and re-register as commercial banks. In just a few weeks, two hundred years of investment banking history was eradicated.

5.Busting of Retail and Commercial Banks - in recent times, rather than relying on customer deposits to fund their lending banks have borrowed money in the short term and lent for the long-term as the latter is normally cheaper than the former. So historically, to make a loan of £10m to a company for 10 years at an interest rate of 7%, they would raise £10m in the short-term money markets at say 6% and renew this facility every three months over the 10 year period, making a lending margin or 'spread' of 1%. The credit crunch has cut off the supply of short term funds meaning that banks cannot renew their facilities. They have already lent out the money on a long term basis that is payable by them on a short term basis, so they are in huge difficulties and in danger of becoming insolvent.

Five impacts

1.Collapse of asset prices - there has been a huge deflation in the price of houses, shares, companies and credits. Given that people and companies use their assets as collateral to raise money, a collapse in asset prices puts a brake on all types of commercial activity. The collapse in wealth is disastrous for anyone approaching pensionable age. The value of the FTSE has halved in a less than a year.

2. Collapse of confidence - with no money to make investments, there is little for companies to think about apart from survival, while individuals are fearful because of its associated collapse in business confidence.

3.Collapse of funding - banks are refusing to lend to each other. Now they are refusing to lend to people in the form of mortgages, credit cards and bank loans, and refusing to lend to companies. If companies cannot raise money for long-term projects, investment and growth will suffer. If they cannot raise money in the short-term, they will not be able to buy stock or pay payrolls, and will go bust.

4.Collapse of public finances - Central Banks have been called on to fulfil their role as lender of last resort - using up their reserves and lending money securitised on assets of questionable value to make up for the lack of liquidity in the market. Meanwhile, Governments have been buying up toxic assets and providing tax-payer backed guarantees of insolvent banks. Where is all this money coming from? Initially, it is being piled on government debt. Later, its cost will have to be borne by the tax payer.

5.Slowdown of graduate recruitment - few firms will be bullish in recruiting large numbers of inexperienced graduates at times like this. They will scale back on their costs over the coming months and this inevitably means the graduate milkround.