I have just put the phone down to a friend of mine, who has a business back in the UK.  Like most in his sector, he is suffering due to the economy and also, like most he is heavily dependent on bank finance.

We were talking and he was telling me how revenues have nearly halved over the last 12 months or so and that trading is extremely difficult and he can't see himself lasting another 6 months!

I asked him if he had tried negotiating with the bank and he said that he had, some months ago, but not now as he feared he may push them too hard and they will foreclose.

I told him first, that a hell of a lot has happened over the last few months and second, that he is probably in better financial shape than the bank!  I also told him that he absolutely MUST start negotiating, asking for his payments to be suspended for a period, to get the business back to a positive cash flow and ultimately to profit.

In my business career, I have faced recessions and serious cash flow problems, even in 'boom' periods.  What I have learned most as a entrepreneur, is how to survive.  My idea of survival is to make sure that every creditor is aware of the problem up front and then to devise a plan to pay them back, but the plan must be realistic and achievable for all.

I have been 'bust' in my career before and at that time, my creditors would not negotiate with me and I told them that I was sorry, but I could not meet my payment obligations, their attitude was simple - pay or we bust you, which they did.  This was during the recession of the late 80's/early90's and I think one of the reasons why it occurred, was because I told them of my problems too late and they had effectively lost trust in me.  the next time I had a problem, I addressed it immediately and I worked out a deal with my creditors to pay them back.  At that time, I could have easily 'busted' the business myself and started a new one the next day, but I wanted to honor my obligations to the creditors and not lose the business.

There is always a deal to be worked out to solve any problem in business, but you have to be open and honest with everybody and the plan must work for all the parties involved.  Trust is the most important part of the relationship with financial institutions and trust can and is built and maintained in both good and bad times!

~Neil

In part two I talked about derivatives being at the heart of the problem and to explain the concept of derivatives fully, would occupy this blog for a year, so you can conduct your own research to understand further.

The real issue with derivatives is that you can literally create money out of thin air and it is lending without 'lending'! Banks are governed by strict rules that dictate to them how much reserves they must hold in relation to the amounts they can lend.  So if the capital ratio is 10, then the bank can lend monies equivalent to 10 times the amount of reserves - if the bank has $100M in reserves, then it can lend up to $1billion.

But, the banks are lending without really lending and this creates the term 'notional lending', which using the analogy of a poker game, the notional sum is the chips and you can keep playing with the chips until of course, it is time to cash in and you have to come up with the 'real money'.

Over the last years, nobody has had to come out with any 'real money' to pay off losses as counter parties have allowed them to roll over debt, but in doing so, charging an interest penalty for compensation. 

So why have things now come to a head?

In simple terms, because a package of loans, including the sub-prime loans of the housing industry defaulted into billions, which could not be rolled over, because the counter party was insolvent!

If you look at a traditional mortgage portfolio, you would see lending restricted to a maximum percentage of the asset (house) value, say 80%.  This afforded some protection to the lender, but we are now in an economy of hyper competition - some lenders will go to 90 or even 100% and also greed.

Greed is the whole game and over the last fifty years our society has promoted a lifestyle that is based on consumption - mankind has been indoctrinated to work harder and consume more and when do not physically have the cash to spend, there is always a bank willing to extend a loan and that of course created a credit based society.

Now putting this altogether, we have the creation of a credit based economy, which of course leads to huge amounts of consumer and corporate debt, we have a banking system that has changed into something akin to gambling and finally, the 'straw breaking the camels back' - the recent sub prime crisis!

So what about the future?

Well we could look at the fact that it is the central banks, working with the consumer banks that have created the boom and bust cycles of capitalism and the answer may well be in abolishing the central banking system.  Whatever it is, one thing is for certain, the financial architecture of the world will definitely change.

~Neil

I have talked about the fact that the modern banking system has collapsed and has triggered a financial tsunami, but now I will talk about the 'weapons of mass destruction', not those  - purported to be found in the Middle East, but the financial weapons of mass destruction - derivatives.

I will quote Warren Buffet, the world's greatest stock market investor, in his Chairman's Letter in the Berkshire Hathaway 2002 Annual Report:

"We view them (derivatives) as time bombs both for the parties that deal in them and the economic system.  In our view derivatives are financial weapons of mass destruction, carrying dangers that, while now latent are potentially lethal."

Further:

In 1990, Sir Julian Hodge in a memo dated November of that year to senior executives of the Julian Hodge Bank said:

"In no circumstances enter the derivatives trading market without first agreeing to it in writing with me…At some time in the future, it could bring the world's financial system to its knee."

So what exactly are derivatives?

First, let's establish that there is an organization that started all of this - the International Swap and Derivatives Association (I.S.D.A).  This is the organization that spawned the US$500 trillion global derivatives market - the organization that manufactured most of the derivative products, the financial WMD's. 

Derivative trading could, at the extreme, be described as 'loan sharking' and 'gambling'.  In reality, it is the ability to trade with money you don't have to 'put up' or even money that you don't own, the ability to trade on 'margin'.  Say you want to trade an amount of US$ 1000, you need only to actually part with 10% of that amount and despite the fact that you are 'truly' working with 1000, your actual physical cash exposure is only 100.  Now multiply this into the millions.  There is a downside however…losses can be unlimited!

The problem is that the officers of the ISDA are from the worlds leading banking institutions! 

I talked earlier about the fact that banks are now lending to almost anyone and this has spawned from the lack of money making opportunities from 'traditional' banking.  

The banks have been forced into forming their own 'elite' money making club in an effort to protect their industry, the industry that is worth literally billions.

Many mathematical geniuses are employed to create elaborate mathematical models to eventually come up with the 'sucker deals' - the endless list of investment products that are inveitably sold to the public.

If you are from the UK, you will probably be aware of how, in the early to mid 1980's, the building, banking and insurance industries collaborated to sell more homes and the creation of a set of 'products', that lined the pockets of the same industries, but only served to potentially bankrupt the individuals in the process.  I am talking about the 'endowment' mortgages that promised to pay off a 25 year mortgage in 15 years, through the 'prolific' investment capabilities of the fund managers…and we were sold!

I am not against the sales people who sold them for they were totally indoctrinated by the belief, nor the people that bought them, for they knew no better, but I am against the acceptance of blame when it all went wrong and disaster struck in 1989/90.

…continued

~Neil