Dubai and Banking 051

I had posted a bit earlier about Banking 101.   After reading the press the past few days, I've decided that this approach was wrong.  Banking 101 would be a freshman course.  As in our great universities these days, we often discover that the entering class is not yet equipped to take the freshman courses.  So we offer remedial courses.

Sadly, in our financial world, it is fairly obvious that bankers and investors weren't ready for the freshman courses.  How they passed to get to the check writing stage is an educational mystery.  

Today while reading a rather prestigious foreign financial publication printed on salmon colored paper as well as what is considered the best newspaper in the United States, I was struck by the manifest claptrap that was being peddled.  It's clear that our financial journalists also need a bit of remedial tuition as well.

Some of the assertions that caught my eye and prompted this post:

1. The existence of a new financial instrument:  the implicit guarantee.  Like Bigfoot, the implicit guarantee is discussed around the bankers' and investors' campfire at night.   As well in credit or investment committee meetings.  Often glimpsed from afar or perhaps just imagined.  But nonetheless apparently real.  Or real enough to serve as a "sound" foundation for an extension of credit.   One that no doubt sounded "sound" to credulous ears at the time.  Sadly, the implicit guarantee more often than not pays off with implicit cash.  And implicit cash is not much use for settling transactions unless of course you made an imaginary loan or investment.
2. A case of mistaken identity.  We thought Dubai World was the government, despite the fact that it is separate legal entity.  A small fact noted in its constituent documents.  Yes, but we know that the parent will always bail out the subsidiary to protect its good name.  This is a real howler to anyone familiar with lending to subsidiaries of multinational firms or holding companies.  But perhaps the financial press believes the punters were suffering from sun stroke - Dubai is after all a bit warm in the summer and the sun is mercilessly blinding.  It is so easy to get confused in foreign lands as well. Strange food. Unfamiliar dress.  Why in many of these countries they speak another language! And again no one told us we were mistaken.  So it's clearly not our fault.  It's the fault of some local chap or Shaykh who didn't say anything.  This is not only not polite, it's downright irresponsible.
   
3. Guilt by association.  Well, there's this rich Shaykh in Abu Dhabi.  We all thought he was the lender of last resort.  He sure looked like one.  He certainly never said he wasn't.  So it's his fault that we thought he was.  We never bothered to ask him or to confirm his obligation in writing because well that wouldn't be polite.  And it pays to be polite. 
   
4. "Toto, we're not in Kansas anymore".  You mean the legal system here is different from that back in [insert name of lender's home country]?  Quelle surprise!   Another howler.  There have been enough debt crises since the first cross border loan where local laws have proven problematic  that anyone who makes this statement should expect to be hooted off the podium.  Yet despite abundant and painful history, this is a mistake the lenders and investors make over and over.  Sadly, while the right time for rigorous due diligence is much earlier, there is a lot of Monday morning quarterbacking after the loan goes bad.  Then legal defects are noticed.  The economics of projects are scrutinized in detail.  It's even said that offering circulars are read carefully.
   

So, let's start the class.

Here are ten basic and quite timeless rules for good lending and investing.  You will not require an MBA to understand them.  Nor the assistance of Philippe Jorion, sophisticated mathematical models or a Cray computer to implement them. Those skills - while highly useful - will be acquired in the senior year or graduate level courses.

1. Develop a reasonably firm grasp on reality so that you may distinguish fact from fiction.   "What is" from "what is not".  Or what you'd like to be.  My own experience suggests that this critical faculty is highly useful in other aspects of life.  In finance, it is the basic precondition for intelligent decisions.
   
2. Understand the environment in which you propose to do business:  the legal system and the enforcement mechanisms, the robustness of both regulation and regulators, business ethnics, availability and reliability of information, etc.  If you can't get a fair shake, (or a fair shaykh) you probably shouldn't be in the market.  You  might try to compensate by adjusting your lending strategy:  smaller loans, more collateral (ideally offshore) and higher pricing.  But be aware that prophylactic measures don't prevent disease.  They merely lessen the chances of an infection.  Ask yourself if you can afford to get sick.
   
3. Know your customer and his business: legal status, ownership, business model, corporate culture, management competence, style and ethics and so on.  Adversity is the true test of character.  When the chips are down and your bluechip customer has become a financial cowchip, it's nice to have someone with integrity on the other side of the table.
   
4. Appreciate the relative (legal and business leverage) positions between yourself and your customer.  Sovereign borrowers are indeed different than non Sovereign ones.  Members of a local elite may have certain advantages.  And so on.  If you can't fight City Hall at home, you may have even less chance overseas.
   
5. Analyze the transaction and its economics.  Distinguish between productive and speculative transactions.  Basic Level Hint:  Speculative transactions are generally more risky.  Intermediate Level Hint:  Risky transactions generally have a higher incidence of failure than less risky ones.   Advanced Level Hint:  When projects fail, lenders and shareholders can get hurt.  Post Graduate Level Hint:  Speculative transactions are easier for a borrower to walk away from.  Rather abstruse and profound concepts it appears.
   
6. Make sure the primary way out is cashflow from the project not the assumption that a greater fool is going to refinance your loan or buy your investment.   Or that the government will step up with a post-default guarantee.  Have a second way out if possible.  And, no, looking for a bail-out or a hand-out after the problem occurs is not a credible second way out.   Transaction structuring can mitigate risk.  Many "advanced" financial thinkers suggest it is a wise idea to match the repayment on a loan to the cashflow of the project or borrower.  If there is no discernible cashflow, adjust your loan amount commensurately, i.e., reduce it to zero.
   
7. If you need credit support, the time to get it is before you write the check. As I am told one Saudi borrower said in 1984 to his lenders who were requesting he personally make them whole for loans they had made to his flagship company, "Gentlemen, the time to ask for the guarantee is when you initially negotiate the loan not after it goes bad". 
   
8. Take a lesson from the auditor's rulebook.  "If it ain't written down, it doesn't exist."  If you have a guarantee, you will have a piece of paper carefully drafted by your legal counsel and with the guarantor's signature on it.  If you don't, what you don't have is not worth the paper it's not written on.  If you have an implicit guarantee, you may be in the position of  attempting to use imaginary proceeds  from the implicit guarantee to pay off your real loan.  
9. Read the prospectus or offering circular or loan proposal.  Read it carefully.  If you don't understand the transaction or it doesn't make sense to you, pass.  Borrowers and great investment opportunities are like the Dubai Metro.  If you miss one, the next will arrive in no more than 15 minutes.
   
10. If after all the above, you are satisfied, make sure that the reward you're getting is commensurate with the risk.
    

And be sure you perform these steps before you commit to the loan and for heaven's sake before you cut the check.

Because while hindsight is 20:20, usually at the point it is clear there is a problem,  it is really difficult to undo a bone-headed decision.  Not to mention very, very costly.