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Arrow Global
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Credit Today: Terminal velocity
Published on 01/01/2009

For most of the finance industry, 2008 cannot end fast enough. Credit crunches, bank failures, government bail outs, titanic drops in the stock markets, wild and simultaneous volatility in commodities, currencies and even LIBOR rates, have made 2008 a year for the record books.

Unfortunately, few prognosticators offer much good cheer in their forecasts for 2009. For debt purchasers, our Christmas stockings were saddled with coal lumps – rising unemployment, fewer large payments from customers, and challenging changes in law to name a few. Yet of all of the bad gifts, the one likely to cause the most tears is a wrenching change in the velocity of money.

For the past several years, banks and hedge funds have used the capital markets to create an unprecedented velocity of money. Loan assets were originated, syndicated, packaged, sold and securitised at dizzying speeds. Let us assume a bank could find an asset yielding LIBOR plus 200 basis points. Further, let us assume the bank’s internal financing cost is LIBOR. Accordingly, the bank was making a 200 basis point net spread before costs, taxes, and credit losses. In this rosy world, let us assume costs and taxes were zero. Further, assume that a bank that suffers a loss loses all of that money. This is probably too conservative but it illustrates the key issue.

In this example, the bank needs to make 50 successful one-year loans in a row just to break even. If every time the bank gets a performing loan it makes two per cent and every time it gets a non-performing loan it loses 100 per cent, then 50 successful loans are needed to balance each loser.

50 wins in a row is difficult in any activity. However, there are many examples of junior notes in securitisations, the riskiest tranches, carrying 200 basis point spreads. How did this happen? Basically, banks could cycle money with extraordinary velocity. If the bank could originate the loan and sell it off in sufficient speed and quantity, then the bank could earn that 200 basis points of spread many times in the same year on the same equity.

We are now seeing the nasty side of stagnation. This velocity that allowed the banks to lend at high volumes and low rates has painfully reversed overnight. This is very bad news for the debt purchase industry. Debt purchase has non-conforming assets that are not widely admired by ever more selective lenders (in most cases, these are assets the banks sold in the first place). Without some return of the historical velocity of money within banks, debt purchasers will be operating with only equity and that will change the industry greatly in the years to come. Hopefully, Santa will bring some better presents next year.

Zach Lewy, chief executive, Arrow Global

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Arrow Global Limited is registered in England and Wales with company number 05606545. Its registered office is at Belvedere, 12 Booth Street, Manchester M2 4AW. Arrow Global Limited ("AGL") is authorised and regulated by the Financial Conduct Authority for certain credit-related regulated activities, and is part of the Arrow Global Group. AGL is registered on the Financial Services Register under registration number 718754.