Credit Crunch..subprime mortgage Crisis..What are they?

Since the last few months we have a heard a lot the terms like “credit crunch, sub-prime mortgage crisis, re-pricing of risk etc”, which are sometimes difficult for non-finance background people to understand. In this article I will try to make sense of these things in simple language.

The whole system works like this. Banks take deposits from people on which they have to pay interest, to earn their income these banks then lend the money to people who need them at a interest rate higher than they pay, thereby earning their income. Since 2001 the interest rates in US were very low which led to US banks having lot of money. The money which lies with a bank (other than that required by regulations) is like a deadwood, it doesn’t earn anything for the bank. So banks are desperately in need for avenues to look for the investment.

Obviously when the banks have lot of money, the first place of investment are ventures (people or commercial enterprises or propositions) with good standing. But when there is lot of money the banks tend to look for avenues which happen to be more risky. What banks in this case did was offered loans to people who had bad credit history or less income, to purchase houses.

From the month of July 2007, the credit market started to collapse as financial panic spread the world over, the reason being “re-pricing of risk”: a phenomenon when assets that were fundamentally sound are hit by “supply demand imbalances” in the market. As a consequence liquidity evaporated and market turmoil in a risky sub-sector of the US mortgage market spread to impact market conditions globally. Such loans were called NINJA loans i.e. loans to people with No Income, No Jobs and No assets.

To entice these people to avail themselves of loans, the loans carried a interest rate which was below the prime-lending rate ( rate at which banks normally lend). Apart from that various innovative methods were devised like initial low rate and later on a teaser rate which is few points higher than initial rate. (other such products are 2/28 loans, balloon mortgage, piggyback loan etc)

Now it would be stupid of banks to have such “risky” loans on their own portfolio. So they turn these loans into securities which can be sold to investors (in 2006 $450 billion worth of such loans were converted into securities. A security purely consisting of a ninja loan is risky in itself so there investment bankers come to the rescue. They bundle such loans with other types of debt like credit card and auto loans and call the end result as an “asset backed security”. These securities are then bought and sold in the commercial paper market.

Things were going on perfectly fine till the time the houses which were bough on such loans were commanding loft valuations. Then by start of 2006, the housing market stagnated i.e. the prices of houses remained the same and in same cases they infact fell. Bankers stopped refinancing of loans and consequently many borrowers started defaulting. Asset-backed commercial paper, which accounted for half the market, tumbled $59.4 billion to $998 billion in the week ended yesterday, the lowest since December, according to the Federal Reserve

CASUALITIES
During this turn of events there have been many high profile casualities. At the last count close to 90 lenders in US had gone out of business. Many include high profile outfits run by many of big investment banks like Lehman’s BNC Mortgage Unit, Capital One;s Greenpoint mortgage company, two outfits run by Bear Stearns.

IMPLICATIONS
This has now made lenders more risk averse and made them wary of making further commitments to various deals and primary casualities have been Private Equity firms which depend on banks to carry out their leveraged buyouts to an extent. Plus the strain it has put on finances of so may banks, jobs and more prominently - SENTIMENTS! The financial world to an extent run on sentiments as well.

NOT GLOOMY EVERYWHERE
However in some quarters the credit crunch is being seen with positive connotations. Its being said that its has put some breaks in irrational lending frenzy and will bring some sense to the market. Also its felt that a slowdown in mergers & acquisitions will again create a space for venture funds to prosper. The great ideas might get backing to flourish again. Keep watching this space !!!

Analyzing Blackstone's IPO

Blackstone Group is a global asset manager and a provider of financial advisory services, however it’s known primarily for its Private Equity (PE) business.

The $31 a share IPO which opened on June 22, 2007, valued Blackstone at $33.48 billion which is about a third of Goldman Sachs Group Inc.’s market value and around three-quarters of that of Lehman Brothers. During the IPO 12.3 % stake was offloaded. The IPO mopped up around $3.48 billion for Blackstone and a separate deal to sell around 10% stake to China added $3 billion to IPO Proceeds.

The Blackstone IPO had great names of financial markets as its underwriters, like Morgan Stanley & Citigroup which have the option to buy 20 million more shares on top of 133.3 million already sold through IPO. That would mean an additional $620 million in Blackstone’s kitty.

Blackstone co-founders Stephen Schwarzman, 60, and Peter Peterson, 81, earned $2.4 billion between them from the IPO. Schwarzman's 23% stake in the company is worth $7.74 billion alone. However after the IPO Pete Peterson now holds just 4% of the equity.

Brief profile of Blackstone
Mr. Schwarzman and Mr. Peterson founded Blackstone with $400,000 in 1985 after leaving top posts at Lehman. Initially started as a merger advisory boutique, Blackstone grew into a private equity giant with more than $78.7 billion under management as of 1 March 2007. Based in New York, the firm has offices in Atlanta, Boston, Chicago, Dallas, Los Angeles, San Francisco, London, Paris, Mumbai and Hong Kong.

The Assets under management (as of March 1, 2007) and net income before tax (for year ended December 31, 2006) has been shown in Exhibit 1.

(Source: Form S-1 filed to SEC under The Securities Act of 1933)

The assets under management of Blackstone have shown a CAGR of 34% (Exhibit 2)

Exhibit 2 (Source: Form S-1 filed to SEC under The Securities Act of 1933)

Blackstone’s business is organized into four business segments:
1. Corporate Private Equity. Established in 1987, this business has managed five general private equity funds and is largest of its kind ever raised, with aggregate capital commitments of over $18.1 billion as of March 1, 2007.
2. Real Estate. Managed six general real estate opportunity funds and two internationally focused real estate opportunity funds. The real estate business has grown assets under management from approximately $3.0 billion as of December 31, 2001 to approximately $17.7 billion as of March 1, 2007, representing compound annual growth of 41.1%.
3. Marketable Alternative Asset Management. Marketable alternative asset management segment, established in 1990, management of funds of hedge funds, mezzanine funds, senior debt vehicles, proprietary hedge funds (Distressed securities hedge fund & Equity hedge fund) and publicly-traded closed-end mutual funds. It has grown assets under management, from approximately $3.5 billion as of December 31, 2001 to approximately $29.9 billion as of March 1, 2007, representing compound annual growth of 51.3%.
4. Financial Advisory. The financial advisory segment comprises the mergers and acquisitions advisory services, restructuring and reorganization advisory services and fund placement services for alternative investment funds. Over the last five years, the financial advisory business revenues have grown at a compound annual rate of 22.7%.

There isn’t a trend of Private Equity firms coming out with an IPO though this was not the first case. The first Private Equity group to take the IPO route was Fortress Investment Group, which had an offer price of $ 18.5 to a share and rose to $ 35 by the time shares opened for trading. The FIG has around $ 30 billion under management. Though the shares have fallen back since, closing at $ 24.4 on 15 July 2007.

Implications for investors

One major implication of Blackstone’s IPO on its investors is that they have/will have no say on how the company is run. Since Blackstone Holdings has been structured as a master limited partnership, investors are devoid of any voting rights. They are infact mere unit holders and not shareholders. The difference is critical in the sense that unit holders are not entitled to vote to elect directors and master limited partnerships don’t require to have a majority of independent directors on the board.

Current status of Blackstone Shares
Blackstone stock rose as high as $38 a share on New York Stock Exchange on listing and the volume traded was more than 113 million shares. However since then Blackstone’s shares have weakened after gaining 13% on opening. Currently they are trading in the range of $29-30.

The trend Blackstone shares have followed is depicted in Exhibit 3

Exhibit 3 (Source: http://www.forbes.com/)

The reasons for this drop in share price are manifold and have to do primarily with future performance indicators of Private Equity industry:
Tax proposal – The big money for PE players come primarily from “carried interest” which is 20% of gains they generate from buying companies and reselling them through IPOs or sales to corporates or other private equity firms. The firm pays capital gains rate of just 15% on them, as compared to 35-45% tax levied on corporate earnings. There is a proposal in US congress which would tax carried interest at regular income tax rate of 35% instead of present 15%. And this proposal if implemented would take a major part of their earnings.
Credit Crunch – Instead of using their own money PE firms raise money from other sources and invest them. However with interest rate marching upwards it will be harder for PE firms to raise money for further investment and that signals that the private equity boom may have peaked.

More PE IPOs in offing

However, the present state of Blackstone’s shares haven’t stopped other PE firms from joining the IPO bandwagon to raise money. One of biggest competitors of Blackstone, KKR (Kohlberg Kravis Roberts & Co) plans to raise upto $1.5 billion by listing itself on NYSE. The offering is expected to be complete by fourth quarter of 2007.

It would be interesting to watch how the IPO of KKR & Co. fares!!!