“It’ll work Rodney, I’m telling yer. I’ve been looking at these ‘ere interest rates down the market and I reckon that if we borrow money over a short period, say 3 months we would only have to pay 5.5% back in interest. We invest that money for longer periods and get paid 7.5% interest. And if we do that in millions of pounds, this time next year we’ll be millionaires. Lovely Jubley!

Del Boy’s plan wasn’t an original one. This very simple idea has made a lot of clever people rich, but like so many of Del Boy’s ‘get rich quick’ schemes it failed due to a simple oversight.

I’ll try and keep it short and simple (like Del Boy), but bear with me as I’ll have to explain a few bits of jargon.

The Long And Short Of It
First off, interest rates can be higher or lower depending on how long you want to borrow the money for. If you lend Boycie a tenner so he can get a round in before he gets to the cash machine in Peckam High Street, you’re probably pretty confident that you’ll get it back. But if Del Boy needs a ‘monkey’ to pay for his motor and he says he’ll pay you back next June when he sells his consignment of fire-damaged smoke alarms you might feel a bit uneasy. In business you would expect to pay/receive a higher rate of interest the longer the period of the loan.

Short-term interest rates apply to borrowings of up to 1 year. They’re normally priced close to the official central bank rate, but are ultimately determined by whether the banks have a lot of spare cash to lend, or are a bit short of dosh themselves (economists refer to it as supply and demand).

Long-term interest rates are generally higher, to reflect the bigger risk being taken in lending for a longer period. Money is borrowed and lent using mortgages, corporate bonds or ‘structured products’. That last one is sort of all encompassing to include CDOs, credit default swaps, packaged loans and last night’s leftover pizza.

Now For The Cunning Plan
These ‘get rich quick’ schemes were called SIVs, though I reckon Del Boy would have called them STDs; once they went wrong the ill-effects certainly spread like herpes. An SIV is a Structured Investment Vehicle and all you need to understand is that it borrows money in the short-dated money market and invests it in longer-dated products to make a pretty penny or two (If you’re curious and want to know a bit more, an SIV raises money by issuing short-dated debt called commercial paper, which is priced off London Interbank Offer Rates (LIBOR) and may last up to 1 year).

As well as allowing banks to make money on the difference between interest rates, an SIV allowed the bank to dump a load of its dodgy loans off the balance sheet into this special vehicle, thus giving the bank greater freedom to lend more money.

One Good Knees-Up and The Party’s Over
Remember sub-primes? How could anyone forget (if you have there’s a whole category dedicated to it on the right-hand side of the page), but to re-cap, the banks lent billions of dollars to people who shouldn’t be allowed near a mortgage, so that they could buy their homes. These sub-prime mortgages were then slice ‘n diced to make them appear better quality and sold to investment funds around the world. Then one day a few of the sub-prime borrowers noticed that now they’d bought their house it was falling in value.
“Shoot man! That wasn’t part of the deal,” said one.
“Blow these repayments; lets spend the money on a street party,” said another. And as more and more borrowers decided it made more sense to blow their earnings on having fun than paying for something that was losing value we experienced the sub-prime crisis.

This article is about a distant relative, the liquidity crisis, but there is a link. When the music stopped the banks were left holding one helluva lot of sub-prime related loans; not only that but they knew the other banks were all holding similar forms of rubbish. These loans totalled billions of Dollars, but no one was showing their hand, so the banks’ response was to refuse to lend to each other.

The simple fact was that as more people needed to borrow money and fewer were prepared to lend it, the price of money (interest rates) went up-a lot!

Sorry Mate, The Market’s Closed
Back to Del Boy and his ‘get rich quick’ SIVs; remember that their long-term investments were paid for by borrowing short-term money. The flaw in the cunning plan was that the scheme relied on re-financing the short-term borrowings when they matured. It had always worked in the past, but now the prospect of lending to a bank for months on end was about as appealing as taking Amy Whinehouse home to meet your mum. The double-whammy was that if the SIVs could no longer pay for their investments then they’d have to sell them. But very rapidly, just as the commercial paper market had closed to short-term borrowing, the market in long-dated structured products shut up shop too.

Some SIVs were bailed out by funding from the banks that set them up, others died, leaving little for their investors, and some were taken back onto the originating bank’s balance sheet. Either way, the clever plan resulted in higher short-term interest rates at a time when even the Bank of England would prefer lower rates, and has hugely reduced the amount of money available for banks to lend to the rest of us.

The highest profile casualty wasn’t an SIV, but the Northern Rock Bank. Northern Rock wasn’t quite as cavalier with its money, but its business plan involved borrowing short-term money then lending it as long-term mortgages at variable interest rates. It came unstuck when billions of pounds of borrowings needed to be renewed and the market, he say “No”.

So, just to round up. Northern Rock, after teetering on the abyss, will be saved in some shape or form, but there are plenty of other banks out there that haven’t fully come clean on their SIV exposure yet. The loss of confidence and tighter lending conditions is going to spread to the wider economy and that won’t be good for equity markets.

Me? I’m not shedding any tears. Despite the rally, this market stinks and while shares are collapsing like a Del Boy cocktail cabinet I’m going to make my millions by shorting FTSE. Ha ha!