How Faltering Financial Institutions can Raise Cash

You are running a bank, and the news is all bad. Your loans are going bad and your depositors are voting against you with their funds, while rumours swirl around the financial markets about your bank's problems. How can you meet this torrent of cash outflows? Wholesale investors stopped buying your unsecured paper in all maturities weeks ago, almost all your assets are very difficult to sell, and those that are easy to sell are fast running out: is there some other way to avoid running out of cash for a little longer?


I have often found such questions fascinating: is a bank likely to fail due to cashflow problems even while its assets are worth more than its liabilities?

Although it would appear that short term confidence problems could lead to a default, there are actually very good reasons to believe that in most cases a bank or similar financial institution can suffer stress, even past the point of failure, and still avoid running out of cash. The same reasons also explain why, when a bank does fail, depositors and other unsecured creditors face losses of typically 50c in the dollar.

There are several ways a distressed financial institution can raise cash, and their common theme is screwing unsecured creditors.

One way is to use your assets as security for further borrowings. This can be done with prior security funding, when most of your funding is secured, or by secured funding if most of your borrowing is unsecured. Even though your assets are of questionable value, and no one will give you unsecured funding, you can probably pledge them as security to raise, say, 50% of their value, from a vulture investor, who will charge you a high interest rate. If you can recover the confidence of the market, this could save you, and if you can't, it will leave your unsecured creditors will big losses in a few weeks or months time.

Another way is to securitise your assets, while retaining the more subordinated positions. For example, you convert a substantial part of your loan book into a, say, 70% super-senior tranch, that other financial institutions are willing to buy, while holding onto the more junior tranche that carries most of the risk. This has the same effect as pledging these assets to obtain funding.

For these strategies to work, the bank needs to have more than just demand deposits as unsecured funding, it needs to have a substantial amount of unsecured funding with a residual period before maturity. The demand funding can run off if creditors lose confidence in the bank, but the term funding cannot. The effect of this is to make providers of term unsecured funding subordinated: in the event of a crisis, the institution will grant security to other lenders. However, this also protects providers of call funding, since they can get their money back as soon as trouble strikes and before the institution runs out of cash.

See this article by Tim Hunter in the Sunday Star Times for an example of how a distressed institution, Strategic Finance, managed to raise cash during its distress before it failed, and how this is now impacting on the recovery of depositors funds:

Time for a Strategic investors to rethink strategy

By TIM HUNTER - Sunday Star Times

Last updated 05:00 17/01/2010

Hanover Finance and its high-living owners Eric Watson and Mark Hotchin may have hogged the headlines, but another failed finance company deserves just as much scrutiny.
Ten days ago property lender Strategic Finance broke its promise to pay debenture investors their first instalment of cash since freezing their funds in August 2008. Those investors, many of them elderly, are owed a collective $292 million, plus interest.
The failure means investors, via their trustee Perpetual, get a chance to review the moratorium deal they approved just before Christmas a year ago. It's a chance they should consider carefully.
The reason Strategic's mum and dad investors haven't had any money yet is simple – all the $28m or so paid out so far has gone to corporate lender Bank of Scotland International, which had lent $92m to Strategic by the time of its collapse. (By comparison, Hanover, which failed two weeks before Strategic, had paid mums and dads 6c in the dollar during the year and kept to the modest promises in its moratorium deal.)
Why did BOSI get paid first? Just before Strategic's default, BOSI was granted a prior claim on $25m, plus interest, of Strategic's assets. This was the maximum limit allowed under the trust deed and investors need to know why, and exactly when, this was done.
The documents available show this prior claim was granted between July 4 and July 14, 2008 – about four weeks before Strategic froze repayments on its debentures.
Why grant a prior claim to BOSI, damaging the interests of most investors, at such a crucial time?
Strategic was a longstanding borrower from BOSI and had a $75m facility in place for several years. However, between January and June 2008, its borrowing from BOSI blew out from $69m to $92m and a "temporary facility" of $15m was added to the existing $75m loan.
By June, Strategic had already been forced to get a waiver from BOSI for breaching clause 9.4(d) of its loan deal relating to excessive exposure to a single loan. Further breaches emerged as the accounts were prepared and BOSI granted waivers for them all.
For a corporate lender, BOSI appears unusually understanding of Strategic's position, but it had good reason – BOSI wasn't just a lender to Strategic, it was a partner.
Moratorium documents show BOSI lent $392m to borrowers who also borrowed money from Strategic.
Furthermore, in those last six months as Strategic's borrowing from BOSI blew out, its loans to borrowers funded by BOSI also soared from $30.6m to $123.5m. In all cases, BOSI held the first mortgage position and Strategic's loans ranked behind.
There are other signs BOSI was Strategic's master. One of Strategic's biggest loan exposures is the Hilton Denarau hotel development in Fiji. In June 2007 this was a $39m first ranking mortgage, but by the time Strategic collapsed just over a year later it had become a $76m second mortgage – Strategic's first ranking security had been transferred to BOSI.
Why? Strategic's CEO Kerry Finnigan told the Star-Times: "Past stage one we had to continue to fund stage two until we could get a senior debt provider to come in and complete the development finance. We had to keep the momentum going on that project.
"We conceded our security position to allow more money to come into the project to take it forward."
Asked how much BOSI had lent on the project, he said the amount was confidential. Media reports, however, put the sum at about $45m.
Finnigan said Strategic's first mortgage was relinquished to BOSI in May 2008 "at the time BOSI made their initial advance".
Investors have cause to look askance at Finnigan's explanation. For a first mortgage holder to allow a subsequent financier to usurp its security when so much was at stake appears poor management to say the least, yet it happened twice in the six months leading up to Strategic's default.
During the period, Strategic's security for its loans went backwards at a remarkable rate, from 55% first mortgages to 41%. In dollar figures, its second mortgage positions rose by almost $60m, while first mortgages fell by almost $100m.
While this was partly due to six first mortgages being repaid, two first mortgages slipped to second ranking, one of which was Denarau, and cash was lent out on several new second mortgages. The numbers indicate these new second mortgages were often for projects funded by BOSI.
This trend has damaged investors' interests because it means more of Strategic's assets are effectively controlled by whoever holds the first mortgage – often, BOSI – and money is much harder to recover.
As well as getting a prior claim, BOSI got extra collateral of $120m for loans to Strategic of about $100m. This collateral was debenture stock and meant that if push came to shove, BOSI would get 20% more than other stockholders in a wind-up. That extra security has been unwound since BOSI's prior claim was repaid last month.
Finnigan now characterises the early part of 2008 as a time of great promise. "If we wind the clock back, they were the best half-year results we had, to December 07. There'd only been a couple of failures of finance companies leading up to that period, we'd seen our reinvestment levels fall off marginally but remain quite solid, we had a parent company [Allco HIT] who was keen to invest and position us in a market where we saw continued opportunity and we had facilities which had been provided by them to the order of $50m which was a co-participation and another $50m fallback position.
"We had $140m in the bank and a great trading performance. We had shareholders' funds in excess of $150m.
"So we sit there and you run a slide rule over the numbers, it all looks pretty good. Working on what we've got there we start making commitments to fund loans and developments to various borrowers and we start looking at our forecast liquidity levels and say we'd still like to carry quite strong cash reserves, we'd look to see if we could create additional funds through the introduction of a prior charge. It was all done to take advantage of a market where we saw some strong opportunity."
According to Finnigan, BOSI's prior claim was initiated in January or February that year and designed to bring in more money so that Strategic could finance more loans. However, no disclosure of this prior claim was made in Strategic's prospectus of March 2008, and all other documents say it was done on July 4 at the earliest.
His bullish interpretation of Strategic's position is also at odds with some key facts. For example, loans 30-90 days past due had soared from zero to $58m in the six months to December 2007. Cash in the bank had actually fallen by $40m to $101m. The cost of its borrowing from BOSI had risen from 9.42% to 10.2% (mums and dads were getting an average 8.9% at the time).
Debenture investors were pulling out at a rapid rate – debenture stock fell by $31m in the period.
Finance companies were in meltdown. Rather than "only a couple" of failures, collapses at the time included Bridgecorp, Capital + Merchant, Nathans, Geneva, Five Star, LDC, Provincial and several others.
Finnigan's recollection on shareholders funds is also too rosy – net equity actually fell slightly to $116m.
Announcing the half-year result in early March 2008, Finnigan told NZPA the firm had stopped long-term lending and wanted to preserve cash to ensure it had enough liquidity "if things continue to be as hard as they have been in the past few months".
Still, based on the half-year result, Strategic's directors approved a dividend payment in March of just over $12m to its shareholder Allco HIT, an Australian listed fund also financed by BOSI. Allco was supposed to return the favour by co-lending with Strategic, but Allco Finance Group had its own problems. Its death spiral began that January and, by March, it was in desperate talks with its bankers aiming to renegotiate its crippling debts. The struggle ended in receivership later that year.
In contrast to the view now expressed by Finnigan, a more realistic interpretation of the situation in early 2008 would be that things were grim and the outlook was worse. Furthermore, Strategic's management made several decisions in the six months to June which seriously damaged debenture investors' interests – the dividend payment, the weakening of mortgage security positions, and the granting of the prior charge and extra debenture collateral to BOSI.
In addition, Strategic's huge exposures to a handful of property projects such as the Hilton Denarau suggest management's view of its own lending expertise was exaggerated.
It's worth noting that on July 17, 2008, three days after agreeing the final prior charge, Strategic announced a plan for its directors, in partnership with BOSI, to buy the firm back from Allco and pump in more finance. This effort came to nought. As Finnigan described it: "As the green light was pushed on that and it was all ready to go, the Bank of Scotland ended up with their issues which meant that the management buyout position was at risk.
"There was just no way, with the liquidity profile we had, that we could rely on borrowers repaying us in line with their obligations to meet the repayments to investors. So we came up early with a call to the trustee saying we need to call for a moratorium as well."Strategic's accounts show Finnigan had no option – the company expected to run out of cash within six months.
Clearly, Strategic's management made desperate efforts at the eleventh hour to stay afloat, but hindsight suggests investors would have been better off had Strategic called in receivers rather than hand over so much value to the bank.
Furthermore, it looks like Strategic was more concerned about its relationship with BOSI than its obligations to debenture holders. At the time the prior claim was signed off that July, management would have already known there was not enough cash to repay debentures. If the prior claim was the price of BOSI's participation in a management buyout, it should have been conditional on completing the deal. If it wasn't, debenture holders were simply sold down the river.
Strategic's announcement on Friday of $106m in further provisions and write-offs as first mortgage holders "undertake aggressive enforcement and recovery activity" underlines the poor quality of management's decision-making.
There are good reasons to call in the receivers.