Chickenomics 2 – From the Henhouse to Government Debt

1 12 2009

Category: Finance

In my post ‘Chickenomics’ I gave a farmyard illustration of the forces at work with the credit boom. In my example I started out looking to finance a new chicken coop and ended up getting so much money I was looking for a private jet. This is how that process was mirrored in the real economy…

The Bank

When a bank makes a loan it has to consider the risk – obviously. That risk has to be judged on every aspect of the person or business the money’s being lent to.

So even though the money was for a henhouse, which was a good bet, all the other nastier stuff came into play, raising the risk. That meant the interest they would charge went up and they they would want better security, tying up assets.

Free Money

With securitisation, the thing that’s being securitised has a pretend fence put round it, theoretically isolating it from every other part of the company.

A new entity is set up (called a special purpose vehicle – SPV) and the asset (henhouse) is in that SPV. It makes it much easier to value the risk, and the asset. The securitised asset is the only thing they have to assess.

So in the example the profits from the henhouse can be isolated away from me and my dysfunctional private finances and other failing ventures. In the real world of course it’s not quite so easy to do that.

What’s the downside?

Well, I don’t have a downside. I get my money; hooray! If for some reason the henhouse business doesn’t turn out as expected then it’s the bondholders who suffer not me.

And the bondholders can insure themselves against a loss; that’s how Credit Default Swaps (CDS) came about. A passes on the risk to B who passes it on to C etc till it’s wholly removed from the risk being insured, and worse than that, a bit of each risk is mixed up with other bits of risk until it’s all jumbled up so no-one really knows who’s lost what.

A bit like when you take a bit of red Plasticene, yellow plasticene, green plasticene and blue plasticene. When you stick them together at first you can still make out all the bits of colour but after a while it just ends up a big grey blob.

How do they know what it’s worth?

The credit rating agencies work out what the risk is. They give a rating to the asset the money is being raised against; the higher up the alphabet the better. AAA is better than AAB. The higher the rating the safer the investment is and the lower the return the bondholders will get. Just to ram the point home; the lower your chance of losing money the lower the reward for risking that money and the reward is in the form of interest.

There are a couple of issues with rating agencies. One is the difficulty in truly assessing the risk. The other is who pays them: The rating agency is paid by the holders of the asset; the ones who want the best possible rating so they can pay out the minimum possible interest.

Out of a selection of rating agencies they are going to prefer the one that gives them the best rating. And the one that gives them the best rating knows it has the best chance for future work. No matter how much they guard against it, it is in the interests of the agency to give the best rating possible.

More Money

The money I get comes from a bond issue. I can maximise the amount of money I raise is by issuing different classes of debt on the same asset.

The Class A bonds will be first in line for paying out so they get the worst interest rate and will be taken up by the most risk averse, Class B gets paid next, they get a slightly better rate of interest for a slightly bigger risk and so on. If you take Class D and there’s a problem in the future you’re likely to be out of luck because all the people in the queue in front will take all the available money before you can get it, but the rate of interest you receive should reflect that risk.

Unfortunately in the credit boom investments of this sort were seen as virtually risk-free commanding only narrow margins on government bonds (which ought to be rock solid).

All these different classes of debt mean I can get a lot more money than I was expecting for the henhouse.

Everybody Happy?

I’m happy because I can raise a lot more money than the bank would give me and pay a lower interest rate.

Investors are happy because they get a much better rate than the bank would pay them for deposits, for what is seen as a risk free investment

The financial services industry is happy because of all the lovely fees they are getting for setting up these lovely schemes, and that includes the banks who are arranging the bond issues and getting all tied up in underwriting and holding assets.

Is that all?

They come up with a scheme that unleashes value from things that couldn’t be valued; they allow businesses to get money and pay lower interest rates, and investors to receive higher interest rates; meanwhile the financial services industry thrives. Everybody wins (apparently…). All of that incredible stuff, but I haven’t even got to the best bit…it’s “off-balance sheet”.


Off balance sheet means its special money – like the money you get from the tooth fairy. Doesn’t count in the normal scheme of things.

In the example, I used securitisation to beat planning regulations which limited the number of chickens I could keep. Let me give a more real-world example.

Banks have to keep a certain amount of money in cash for the times people want their money back. If the bank holds a securitised bond, or holds debt indirectly in the form of CDS, they don’t have to keep anything back in the form of capital. They can effectively lend and lend and lend without having anything to back it up. According to the BBC’s Robert Peston some international banks were down to a true ratio of less than 1% of capital to debt.

It’s not just banks that benefit from this; governments do too.

Why would governments want to do that?

Governments have a fundamental problem; people like stuff; hospitals, police, schools. But they don’t like paying tax. So governments have to borrow to cover the gap. The problem is that if they borrow too much the people who hold the government debt get nervous, their rating is lowered, they have to pay higher interest, and funny things can happen with the currency. Not good. But if the government securitises…

The Euro gave this a particular relevance. European governments were forced to converge on annual debt levels. If they go over a certain debt level they get into trouble with the European Central Bank. But they didn’t have a hope of actually keeping debt down to that level so…they securitised. They also used the massively inefficient PFI (Private Finance Initiative) but I’m not going to get sidetracked by that.

It’s similar to organizations taking on agency staff, which turns out to be far more costly than taking on full time or contract staff, because it comes out of a different budget.

Real Example

A nationalised utility company knows that tens of millions of people are going to be buying their product month after month and year after year. So they bundle up a few years of expected future revenue and get a nice big lump sum which doesn’t show up in the official figures.


With the mortgages, if you can bundle-up a billion pounds of mortgages and securitise the expected revenue you can go straight back out and sell the same billion pounds of mortgages again without having to worry about capital adequacy. And you can do it time after time after time so there’s more and more money available with fewer and fewer restrictions for lenders.

And they claimed house prices were going up every year because of a housing shortage: It was really because it was in the short-term interest of everyone involved to keep spewing debt.

Other real examples

A chicken producer securitises several years of future revenue for the chicken bits they expect to sell to a particular supermarket.

Here’s a good one…a supermarket sells a certain brand of soap. It obviously has to pay the manufacturer for the soap but there’s a separate deal the other way. The soap manufacturer wants to be on a nice high shelf so more people buy it. So they pay the supermarket a fee to be on the best shelf.

The supermarket then securitises expected revenue from that fee; the money the soap manufacturer pays to go on a great shelf. And that’s because…they get better terms than simply going for a loan; they’re creating something of value from something previously not valued. Alchemy.



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