To my fellow Joe Sixpack business owners, listen up. It is time to cut through the vague language in the news and sound bytes and discuss some factors that can give you an idea of what lies ahead for your business. I’m going to cover 5 points all of us “six-pack entrepreneurs” should be prepared to take, um, yesterday. First, let’s look at the “why are we here” issue so we can better appreciate the “so what do we do now” answer. I’ll cover 5 specific steps in that answer.
Ground Zero for the meltdown appears to be the Credit Default Swap (CDS). No need for your eyes to glaze over, this is not that hard to explain or to understand.
You already know that an insurance company is required to maintain a certain amount of money in reserves to cover what they have insured. It is just common sense that if a company has no money in the bank it cannot insure anything for someone else, right? If something happens that requires the policy to pay off, there would be no resource from which to make the insurance policy work. It is a hollow policy, a worthless piece of paper. No MBA required to figure this out, right?
A CDS is, in effect, an insurance policy on a contractual obligation, in this case, mortgage debt. It is a contract that basically says if the mortgage is not paid and a default occurs, a third-party will cover the debt. The problem with this concept is that the entity or person providing the coverage does not have to have any reserve or collateral to back up their promise. If the obligation is paid, the insuring party can make money. If not, a catastrophe is imminent because there is no way to cover the loss. Call it Russian Roulette, call it betting, call it a crap shoot. Whatever you call it, it is a bet, not an investment. Worse, it is a bet that, if lost, results in a defaulted insurance product. To get around the insurance requirements and regulators, creative financial services leaders called it a SWAP, a type of financial contract that is not subject to the scrutiny of insurance. At the end of the day, it is insurance disguised as a SWAP being treated as a bet.
If you purchase a CDS, you are betting on someone’s ability to pay an obligation. If you lose the bet, you owe an insurance payoff you cannot make, at least that is the case for 90% of the $60 TRILLION in CDS known transactions.
How do these events unfold and what should you be doing at your business?
(1) Though it is very much a form of insurance, this is called a “Swap” and as such there is no obligation to back the insurance promise with any reserve. Had it been called what it is, an insurance product, this would not be allowed, because there are laws to protect against this in the insurance industry.
(2) Mortgages were sold to people who could not pay them.
(3) CDSs were created to back the loans, so we have people buying homes they can’t afford and the loans being backed by insurance products that have no reserves or collateral, simply because they are called something other than insurance.
(4) CDSs were securitized, meaning they were turned into stock investment products and sold to investors. The compensation for the Wall Street execs peddling these investments was astronomical. Entire companies were built upon CDSs, and shareholders were never told about just how much it was a house of cards. This is really important to understand. The fact that CDS use is an attempt to use an unregulated insurance contract in an all-or-nothing bet is bad enough, but the horror compounds when you realize that these schemes were package and sold as investments to investors in bulk quantities. And to take that nightmare to its final outcome we are now experiencing, the shareholders of companies built upon CDS commissions and fees were never told of the vapor quality underlying that investment. The shareholders were led to believe these products were good investments and great opportunities. CEOs pocketed tens of millions and more on an individual basis - some maybe north of $100 million in compensation - and stockholders lost everything.
(5) In 2000, the total market for CDSs was approximately $900 billion. Today, the market is in excess of $60 TRILLION. This means that people were “investing” - and I use that term really loosely - in customers who could not pay the bills, insuring the transaction through companies that could not pay the insurance, and selling the package to investors who could not have the information.
(6) Only about 10% of the estimated $60 billion in CDSs is backed by an acceptable level of collateral or cash reserves. The remaining 90%, in excess of $55 billion, is vapor.
To put this in perspective, $60 TRILLION, the dollar value of known CDS investments, is larger than the ENTIRE WORLD ECONOMY!
And there is nothing there. Vapor. Nada. Zilch.
What does this mean for Joe Sixpack entrepreneur?
1. Forget the $700 billion bailout helping you. That is a water-gun against a raging forest fire.
2. Forget traditional sources of capital on any tolerable terms for the next few years. The Enron scandal that led to onerous regulation like Sarbanes Oxley was less than $10 billion. By comparison, Enron is the equivalent of a tee-ball baseball team compared to Major League Baseball’s World Series Champions. The magnitude of this scandal makes the Enron debacle look like the stuff of little league. If Enron spawned Sarbanes Oxley, a known inhibitor to the capital of the IPO market, how onerous do you think the next round of legislation will be spawned by the current economic crisis? Conclusion: the capital markets will dry up, be confused and become increasingly burdensome and expensive, before balance is restored.
3. Get comfortable with the idea of strategic alliances and joint-ventures. Companies will become each other’s lenders, partners and competitors all at once.
4. Prepare for a modified barter system. Potential alliance partners will perform more rigorous due diligence but for the qualified, alliance partners will provide in-kind contributions that reduce your need for working capital or growth capital. This will drive more intellectual-property-based transactions, as IP will become a more important asset class. CDS’s are intangible assets but had no underlying asset. IP comes with Federal protection backed by international treaties and attaches to tangible products that can be measured in real sales. IP will become more visible as a transactable asset.
5. Sharpen your relationship skills. Partnerships, alliances and joint-ventures will be driven as much by whom each leader wants to be stuck with in a foxhole as anything else. We are all in foxholes now.
The media and public temperature will keep the controversy of this insanity in the forefronts of our collective minds. This will be stressful and burdensome on many people. The criminal prosecution of certain corporate executives will likely become a daily staple of information for some time to come. If you think the Wall Street execs were creative in their interpretation of the SEC rules and regulations when they hatched this game plan, wait until you see how creative Federal Prosecutors and congressional leaders become in interpreting criminal charges.
Honest and hard working leaders are going to huddle up through informal networks, and admit into their clubs only those who can bring unencumbered resources and a dose of positive relationships in greater quantities than the depressed, over-leveraged and burdened leaders will muster.
Joe Sixpack entrepreneur, simplify your business model. Avoid debt like it is the Asian Bird Flu. Expand your relationships and focus on positive people who can advance to higher ground while others are consumed in fear.
There is no way to measure the depth to which the CDS-driven meltdown will ultimately plunge our lives. We simply know it is not measurable, at this time. Remember that when you are forecasting your future. The size of the underlying problem in the economy is currently unknown and unmeasurable by the brightest minds in our country. Why? Because CDSs are not required to be registered. The $60 trillion is simply what is known based upon voluntary disclosure.
Make friends. Huddle up. Get ready for many opportunities to pick up distressed assets.
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