Crash helmets required

If you work in the City, you don’t need us to tell you that it’s time to put your tin hats on – doubtless you have been wearing them for a day or two already. As the ‘credit crunch’ bites, markets all over the world are tumbling and banks and financial institutions are battening down the hatches in grim anticipation of worse to come. Only yesterday BNP Paribas put the freeze on over a billion pounds of funds linked to the US sub-prime mortgage market, because, in a nutshell, it doesn’t have a clue how much these investments are actually worth anymore.

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Last Updated: 31 Aug 2010

To those involved in the relatively straightforward business of, well, business, the recent revelations of what really goes on in the global debt markets have come as something of an eye-opener. Here at MT we make no claims to be financial sophisticates, but we do appreciate the crucial role that credit – and the debt which accompanies it – plays in business. However it seems to us that at some point, perhaps due to the pressure for instant returns at any price and a dollop of good old-fashioned greed, the cart has got a long way ahead of the horse.

A bank buying debt – ie parcels of loans that have been made – off another bank seems fair enough. Even the idea that banks can then use these newly-purchased debts as collateral to borrow more money from other banks is okay once you realise that the asset is not the debt itself but the money which will – all being well – be repaid. Although you can imagine how your bank would react if you tried that trick on them.

But it all gets a bit harder to swallow when banks start to ‘re-engineer’ debt that they can’t sell in the normal way, as CDOs – collateralised debit obligations – and then go on to make new CDOs out of these CDOs, so-called CDOs squared. These mystifying financial instruments were briefly a great way of repackaging dowdy old debt – especially for US banks which felt they were over-exposed to the sub-prime mortgage market there. Loans which they couldn’t shift suddenly became spiffy new high yield CDOs, and European banks snapped them up, unaware that vast numbers of the loans they were based on were either made to people who simply couldn’t afford to pay them back or just plain fraudulent in the first place.

For all their apparent sophistication, it seems that some of our financial institutions could do with a lesson in old-fashioned common sense. When buying anything second-hand – be it sub-prime debt or a used car - caveat emptor remains good advice.

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