Making Sense of the Financial Crisis

How does a 158 year old company, the 5th biggest investment bank in the world go bankrupt overnight? Why the TV channels have lost their obsession with Sarah Palin and are hanging on to every word uttered by Hank Paulson, US Treasury Secretary.

Though popular articles may have you believe that Lehman Brothers went bankrupt overnight, it actually was a culmination of a series of events which started as 2002, the beginning of the US subprime mortgage crisis. There is no single cause of the mortgage crisis they range from poor scrutiny by lenders, lack of regulation even insider trading in credit derivatives (there has been considerable evidence to account for this possibility). This mortgage crisis led to the housing bubble burst in 2006 and triggered off the global financial crisis. Lehman was greatly affected by this credit crisis due to its large investment in BNC Mortgage, its subprime lender and also its investment in other low rated mortgage securities. Failure to raise further capital and its tumultuous losses, led to its bankruptcy on September 15th.

The mortgage crisis set in motion a series of damaging events that would engulf the world in a recession unlike any other since the Great Depression. The $3500 bn US money market fund, used by banks and companies for their short term financing was locked. Many Hedge funds that used Lehman as their prime broker suddenly found their collaterals frozen due the complicated structure that Lehman used for its bankruptcy filing application.

A week before Lehman filed for bankruptcy, the Federal government announced takeover (or placing into conservatorship) of two of its biggest government sector enterprises, Freddie Mac (Federal Home Loan mortgage corporation) and Fannie Mae( Federal National Mortgage Association). Two companies considered to be “too big to fail” failed, ringing warning bells all across Wall Street.

A day after the Lehman filed for bankruptcy, Federal Bank announced $85 billion rescue package for AIG, the world’s biggest insurer. If AIG had failed, it was said that an average citizen’s savings and checking accounts could be in jeopardy. To gauge the magnitude of the issue, just try to imagine a situation where, you are not sure if your money is safe in a bank!

Since Merill Lynch was bought over by Bank of America to save it from going bankrupt , the next victim of the financial crisis became Washington mutual, the largest US savings and loans association. The bank’s home loan department took a big hit, a hit big enough to affect the $307 billion bank. Within 10 days customers pulled out $16.7 bn, increasing the urgency for a rescue act. This was the first case of direct government intervention, where the Federal Reserve put pressure on WaMu to find a buyer and even held a secret auction where JP Morgan was announced as the highest bidder.

The next step by the US government was the much publicised $700 bn bailout a.k.a the Paulson plan. Most of the $700 billion will be used by the Federal Reserve and Treasury to buy out liquid mortgage backed securities. This is done to increase the liquidity in the market.

Let us stop here for a moment. Within two weeks two of the five largest investment banks, two of the biggest GSE’s (govt. sector enterprises) seized to exist and the biggest insurer was saved by last minute government intervention. This is excluding all the activities going on with Wachovia, Britain and Iceland.

There is no doubt that the catalyst for the sudden crisis is the bankruptcy of Lehman Brothers. Unlike Bear Stearns which got a lifeline about six months ago from the Federal Reserve, Lehman got no such lifeline. “I never once considered it appropriate to put taxpayer money on the line in resolving Lehman Brothers”, Hank Paulson, Treasury secretary, said the day after Lehman’s demise.A statement he would probably reconsider. Of course arguably, things could have been a lot better were Lehman Brothers still present. I personally think that the financial crisis is too overwhelming to be stopped by the rescue of Lehman Brothers.

There has been quite some criticism that the government intervention came a little too late. There is also another sect of people who are against Hank Paulson assuming the role of god, (a role the US assumes very often when it comes to foreign affairs) with tax payer’s money. Only time will tell if Paulson’s plan is indeed sufficient to avert a bigger disaster, which indications in the financial market from the last few days seem to suggest.

Financial Bootstrapping: Smartly funding your start-up

Bootstrappers are entrepreneurs determined to make a business pay for itself. The freedom from relying on capital invested by VCs is a great motivator, if one knows how to acquire it from the right sources. Their secret weapon, is being nimble and cutting through the bureaucracy to grow faster.Most are entrepreneurs, who have a drive to learn and better themselves in all fields related to their start-up. They use unconventional means to raise funds for their business, without spreading out their arms. A small initial size helps them to focus by realizing that they have little to lose, and they are quick to catch on trends and exploit them.

But, how do they do all of this and survive the bloody battles on the tilted corporate battlefield? In this series of  articles we delve into some of the nuances of this seemingly esoteric method of raising money.

Part 1: What you’ve got and they’ve lost

It starts with identifying what a bootstraper doesn’t necessarily have as compared to his huge competition: Distribution, Access to Capital, Brand Equity, Customer Relationships and Great Employees. Each of these facets, one might say, hinges on the amount of capital available to the company to enable its sustenance and growth while maintaining its firm hold over the market. So, if you are a bootstrapper,
can you go toe to toe with the big names on their turf? No; the secret lies in waging the war in areas where you are more adept. For example, imagine yourself as a shoe manufacturer trying to sell your new line at retail outlets. You’d be clobbered by the current brands and be out of business while they won’t be losing a moment’s sleep. Successful bootstrappers know that just because they can make a product doesn’t mean they should. Instead,
they are well aware of the traits they need to have and the advantage they have over the major market players.
Some of these advantages are : A mindset of ‘We’ve got nothing to lose’, being happy with the small fish, direct presidential input , Rapid R&D, being the underdogs, low overhead costs and controlling the time of deliveries.

We will elucidate on these points in the next issues, but let us close on an example much closer to home. I am sure there are many who remember id software’s ‘Castle Wolfenstein’. Following the huge success of their game, the 4 developers decided to take on the major players with a unique strategy. They developed another path breaking game called ‘Doom’ and gave it away… for free! Millions of people downloaded the game off their servers and id had captured a huge pool of trusting customers. They launched a bigger version of the game with more levels and gameplay and made it available at a price. It was a huge success! Without having to go through the game retailers, or spend more than 50 cents on marketing they had used an unusual strategy which helped them cut out the middlemen and avoided losing capital as ‘commission’ yet firmly carve a niche in the gaming industry.

To be continued…Part 2: Why big ideas can kill you and what is the bootstrapper’s business model.