Sunday, 31 October 2010

International Investment Group - KPMG Report to be Released

IIG announced in several venues today that its new board had approved the release of the KPMG report to certificateholders of its Sukuk.

"Unfortunately", AA missed this "wonderful" investment opportunity.  What was I thinking?  And, so, I won't be getting a copy.

Anyone who has a spare copy that they don't mind sharing please contact me via this blog's Contact Page.

Friday, 29 October 2010

Awal Bank Chapter 11 Filing - Statement on Behalf of Charles Russell

In response to my request I received the following from Alisdair Haythornthwaite at Bell Pottinger Middle East (UAE).   BPME is a division of Chime Communications, a leading UK public relations firm (among other things).

Awal Bank BSC Chapter 11 Case Update

U.S. Court Delays Consideration of Awal Bank’s Proposed Chapter 11 Protocol

Bahrain, October 27, 2010:  Charles Russell LLP, acting as External Administrator and Foreign Representative (the “Foreign Representative”) of and for Awal Bank BSC (“Awal Bank”) attended a “first day” hearing on October 26, 2010.

At the hearing, the Bankruptcy Court considered the Foreign Representative’s Motion for Entry of an Order Establishing Protocol for Chapter 11 (the “Motion”).  After hearing from both the Office of the United States Trustee and counsel for the Foreign Representative, the Bankruptcy Court directed that the Motion be further considered at a later date after giving opportunity for creditors to make representations regarding the relief requested in the Motion.

The U.S. based legal activities form part of a multinational litigation process, with court proceedings also currently underway in Bahrain, the Cayman Islands, the Kingdom of Saudi Arabia, Switzerland and the United Kingdom. It is therefore necessary that any Protocol established in the U.S. works alongside the work being undertaken in Bahrain. In this regard the Foreign Representative is considering whether to further pursue the relief requested in the Motion.

In October 2009 the Foreign Representative obtained “foreign main proceeding” recognition from the Bankruptcy Court under Chapter 15 of the U.S. Bankruptcy Code for Awal Bank’s administration proceedings in Bahrain. The Bahraini administration governed by the Central Bank of Bahrain and Financial Institutions Law (“CBBFIL”), continues to be recognised as the foreign main proceeding under Chapter 15.
I'll keep monitoring the Bankruptcy Court of the Southern District of New York for electronic filings on the case to see if there is anything on the Court's reasoning for its decision. 

Thursday, 28 October 2010

Damas - New AED 614 Million Agreement with Abdullah Brothers

Damas announced on Nasdaq Dubai that it had revised its agreement with the Abdullah Brothers regarding the amounts they owe to Damas.

One key item is the fixing of the price of the 1,840,250 grams of gold the Brothers stole from the Company at AED 256 million.

Presumably, this has been set so that Damas is not disadvantaged.

Setting the amount owed is a key step.  Collecting it may prove a bit more difficult.

Awal Bank Chapter 11 Filing

There's a report in AlQabas Thursday edition that Judge Groper denied Awal Bank's Chapter 11 petition.  At this point, there is nothing posted on the NY Southern District Bankruptcy Court website.  The last document there is the notice of 26 October for the hearing to be held today (27 October).

Gulf Finance House 3Q10 Financials: A Train Wreck

Studio Lévy & fils  1895
When You Turn the Corner Make Sure the Track Goes There

Get out your magnifying glasses and join me in reading the full 3Q10 financials that GFH submitted to the Dubai Financial Market Wednesday morning. Since I've got my soapbox out for a later tirade, I might as well take this opportunity to suggest to the  DFM that they invest a few dirhams in upgrading their electronic imaging system for faxes they receive. There really is no good reason in this day and age that the output cannot by A4 size.

Looking at the financials we see from Note 12, that GFH's US$115 million loss was primarily caused by provisions. Some US$101 million of them. But not provisions for investments. Rather US$60.5 million for an investment banking service receivable. And US$36 million from the sale of investments. I guess if one sells assets of "volatile" quality, one might expect some "volatility" in the receivables from the sales.

That being said, GFH has continued to maintain in its Other Assets the US$134 million "magical asset provision" and US$161.8 million in "Financing to Projects".

Another unfortunate trend is operating income which is running US$60.7 million negative for the first nine months of 2010 as compared to US$36.7 million for the comparable period the previous year. This is due to a collapse in revenues. On the cost side GFH has actually done quite nicely in bringing costs down.  But, if one can't pay the light bills from operations, it's hard to see a bright future.

As a result of the net loss, GFH's CAR has slipped below the 12% minimum set by the CBB. In the financials, KPMG coyly states in Note 2: 

"Further, the capital adequacy ratio of the Group as at 30 September 2010 was below the minimum required by the regulatory ratio …"
No quantification is given. We don't know if GFH just missed the ratio and has a CAR of 11.99%. Or, if it's CAR is 1.9%. You might think that the auditors would consider it important to quantify this shortfall. It certainly is a bit of "material" information that stakeholders would like to know. And more importantly should know.

If like me that's what you think, you're disappointed by KPMG's apparent lack of action on this point. They were silent on this topic. And they did not force GFH to disclose this information in a note to the financials. It's unclear if this is due to desire not to embarrass its client. Or slavish adherence to some accountant's taqlid as to the wording used for "emphasis of matter".

Note to Central Bank of Bahrain: It might be a good idea to specify in Module PD that when the CAR regulatory threshold is breached, the Licensee state the resulting ratio with details of the calculation. And if anyone from the CBB is reading this, I'd reiterate my earlier suggestion that Module PD be amended to require that Licensees report on the BSE the more detailed of (a) what Module PD requires and (b) what they are required to report on other exchanges. There is no reason that Bahraini investors should get second rate incomplete information which is available to investors in Dubai or elsewhere.

We don't have all the information required to calculate GFH's CAR at 30 September 2010. But we can make some estimates which should give a pretty good directional sense of the CAR.

The Table below summarizes these:

30-Jun-10Case ACase B
Regulatory CapitalUS$   363,220US$   248,220US$   114,229
Total RWAUS$2,811,417US$2,683,417US$2,549,417
CAR      12.92%       9.25%      4.48%

Notes & Assumptions:

  1. 30 June 2010 CAR is as per GFH's Basel II Pillar 3 Disclosure. 
  2. The key assumption is that there is no real significant change in Regulatory Capital or Total Risk Weighted Assets (Credit, Market and Operational Risk) except for the adjustments specified in the two "cases". These adjustments are made from the 30 June figures reflected above. This is a simplifying assumption so the ratios derived will not be exact but should be "close enough" to get a good sense. 
  3. Case A: US$115,000 (the 3Q10 loss) is deducted from Regulatory Capital and US$128,000 is deducted from Total RWA at 100%. 
  4. Case B: US$134,000 (the "magical asset" provision) is deducted from both Regulatory Capital and Total RWA. And again at 100%.
And if you have any doubt about the realisable value of any of GFH's other assets, like those Project Financings which may very well be to the same firms whose financial condition caused their bankers to pull the GFH guarantee, it's not too much of a stretch before the CAR is negative.

The results are to say the least not encouraging. It's hard to see how even the "Prettiest" words could convince even the "wisest" of investors to put equity into this firm.

The Gulf Daily News is reporting that they've seen a GFH "Investor Presentation" in which GFH states it intends to sell assets to raise cash to pay back some US$90 million in debt maturing next year or restructure that debt. In further discussions with GFH, the GDN was told that other options being considered were an IPO of some of its mega projects (North Africa and India) or perhaps giving creditors land, shares or other of GFH's highly valuable assets. There is a danger with the latter for creditors. As the choice assets are stripped from GFH's balance sheet, remaining creditors are left with lesser ones to settle their debts. The only option not mentioned here was putting a brick from one of these projects under EJ's pillow in the hopes that the Real Estate Jinn would put US$500 million under his pillow.

It's hard to imagine a "wise" creditor putting funds into GFH. 

And it takes a bit of "optimism" to see a real future for GFH. 

You can find more posts on GFH by using the Label "Gulf Finance House".

Wednesday, 27 October 2010

Gulf Finance House 3Q10 Financials: GFH Continues to "Turn Corner". But Unfortunately Into Oncoming Car

Not sure how GFH will spin this, but they've announced a loss of US$115.1 million for the 3Q10 making the loss for the first nine months of the year US$162.8 million.   And, no, the optimistic US$134 million of reimbursement rights remains on the balance sheet.  So this loss is due to other problems,.  The reimbursement problem has yet to be acknowledged - which means of course that GFH is in a "world of trouble".

As a result, Shareholders' Equity is at US$303 million, well below the US$400 million TNW covenant.  As well as breaching the Central Bank of Bahrain minimum  CAR requirement.

More later when I have time.

Footnote for the Central Bank of Bahrain.
As usual, GFH has released the absolute minimum on the BSE, while releasing its entire 3Q financial on the DFM.   It's unclear why Bahraini investors should be disadvantaged.  Perhaps time to revise the regulation to require that if a firm is required to disclose more on another exchange, then it disclose the same on the BSE.

I will make no comment about the ethics of a firm that engages in such selective disclosure, particularly one that claims to follow the teachings of a noble religion.

Monday, 25 October 2010

Another Cut from Kawalis (Al Qabas)

Another gem from Kawalis.

- سئل مدير استقال من شركة استثمارية غير مدرجة عن ملايين دنانير طارت خلال عهده، فأجاب بأنها رشاوى دفعت لجهات حكومية!
That's funny I'm sure all my Gulf friends and those from the Levant and parts further West told me that Rashwa was a singer.  Sort of like Nancy but more modestly dressed and without all her provactive gyrations.  And so suitable for performances even for the self-proclaimed religious. "Discreet yet beautiful" was how one described her.  I'm guessing Rashawi is the name of her new band.  Perhaps like the Spice Girls. But definitely more modestly dressed as I said above.

Translation:  "A manager who resigned from an unlisted investment company was asked about the millions of dinars which "flew away" during his tenure.  He responded that they were bribes (rashawi plural of rashwa) paid to government departments."  

Pretty clear to me that this isn't an item about Kuwait.

Sunday, 24 October 2010


Getting generous in he gets older?

Friday, 22 October 2010

New Addition to List of Interesting Blogs - Dubai Nights

Another addition to our list of interesting blogs.   Dubai Nights.

More on Awal Bank Chapter 11 Filing

Updated for comments on Chapter 11.

Here are some additional details on Awal's filing.
  1. The case number assigned by the Bankruptcy Court of the Southern District of Manhattan is 10-15518-alg.  Awal's previous Chapter 15 filing has case number 09-15923alg.
  2. As indicated by the "alg" at the end of the case number, Justice Allan L. Gropper has been assigned this case.
  3. The Bank is being represented by Brown Rudnick LLP who filed the Voluntary Petition for Bankruptcy under Chapter 11.
  4. The filing was authorized by Awal's Administrator, Charles Russell, LLP.  Presumably before proceeding CR obtained the no objection of the Central Bank of Bahrain who appointed them.  I think this is a pretty strong indication that the CBB has decided to proceed with the liquidation of the Bank.  Note:  A Chapter 11 proceeding is of course a reorganization not a liquidation.  The latter is Chapter 7.  Chapter 11 allows the debtor to propose a plan for dealing with its existing obligations - either payment in full, in part, conversion to equity, etc.  Post implementation the debtor continues as a going entity (e.g., Continental Airlines).  So what I mean here is that the CBB has decided to proceed knowing it will cause the lenders some pain.  That in turn means the situation is beyond repair.  And that the Bahraini authorities have decided to "bite the bullet" and take the reputational damage that will come from such action. 
As part of its filing, Awal Bank made the following statements:
  1. After the payment of various expenses including that of administration, there will be no funds available for distribution to unsecured creditors.
  2. Estimated creditors are between 50 and 99. 
  3. US assets are above US$50 million up to and including US$100 million.
  4. Estimated debts (worldwide) are over US $1 billion.  (This is the largest amount provided on the Bankruptcy Filing Form).
As required on the Filing Form, the debtor lists its top twenty unsecured creditors.  No amounts are provided though.
Here they are in the order of appearance on the Form:
  1. Abu Dhabi Commercial Bank, Abu Dhabi
  2. Abu Dhabi Islamic Bank, Abu Dhabi
  3. AlGosaibi Money Exchange, Saudi Arabia
  4. Bank of Montreal, Canada
  5. Bayerische Hypo-und Vereinsbank, United Kingdom (London Branch)
  6. Bayerische Landesbank/Bayern LB Germany
  7. Boubyan Bank, Kuwait
  8. Calyon Corporate and Investment Bank, United Kingdom
  9. Commercial Bank of Kuwait, Kuwait
  10. Commercial Bank of Qatar, Qatar
  11. Commerzbank Global Equities AG (formerly Dresdner Bank) Germany
  12. Commonwealth Bank of Australia, United Kingdom (London Branch)
  13. Fortis Bank, Belgium
  14. Gulf International Bank, Bahrain
  15. HSBC, Australia
  16. HSBC, United States (NY Branch)
  17. HSH Nordbank AG, German
  18. JP Morgan, United Kingdom (London Branch)
  19. Kuwait Finance House (Liquidity Management House), Kuwait
  20. The International Banking Corporation, Bahrain
If you're wondering about TIBC (which also filed under Chapter 15 in 2009) taking a similar action, a  court hearing is scheduled under their case next week Tuesday (26 October).  Stay tuned.

    Awal Bank FIles for Chapter 11 Bankruptcy in US

    In terms of recovery all venues are likely to be highly inconvenient.

    UpdateSee subsequent post.

    According to news reports on Bloomberg, on 21 October Awal Bank filed for Chapter 11 bankruptcy in the Southern District Court of Manhattan listing assets of between US$50 million to US$100 million and liabilities of  more than US$1 billion. 

    That would not seem to augur well for creditors.  Though it should come as no surprise. 

    Earlier Awal had filed under Chapter 15 of the US Bankruptcy Code.  That Chapter is used when a company asserts its proceedings are taking place under a foreign jurisdictions laws and procedures broadly equivalent (in fairness) to US procedures.   It will be interesting to see what arguments were advanced for moving the proceedings to the USA.  Forum non conveniens?

    Wednesday, 20 October 2010

    Global Investment House Pays Another US$72.5 Million on its Restructured Debt

    Global announced that value 21 October 2010 it had paid down another US$72.5 million of principal on its restructured debt.

    With that payment it will have paid down 8.8% of its total debt.  It has nine quarters to pay the rest.  A journey of one thousand miles begins with a single step.

    Global Investment House - Better Times Coming. Capital Increase in 2011?

    Au or FeS2?
    Also from the Reuters Middle East Investment Summit, Ms. Maha Al Ghunaim noted that:
    1. Global's performance for 2H10 will be better than 1H10.   (Global lost KD34.4 million in 1H10 compared to KD98.6   in 1H09.
    2. The Company continues to monitor its costs and further reductions are in store.
    3. It expects to begin discussions with unnamed strategic investors in 1Q11 to discuss a capital raising.

    Gulf Bank Kuwait - On the Mend. No More Loans to Saudis.

    A banker's memory is a wonderful thing.  
    Even the most painful experiences can be forgotten. 

    Michel Accad gave an interview at the Reuters Middle East Investment Summit in which he made the following points:
    1. 3Q10 is the turning point in GB's two year strategy to rebuild.  
    2. Each subsequent quarter will be a relative improvement over the previous.  
    3. By 3Q11 the rebuilding will be done (apparently one quarter ahead of time) and the bank will move to strengthen its income generation or its geographic coverage.
    4. The goal is to increase local market share from today's 12% to some 16% in five years.
    5. After 3Q10, the Bank will not need to provision as much but will continue to do so for precautionary reasons (rather than need).
    6. The Bank has decided not to make any loans to Saudi clients for at least 3 years.  No doubt a reaction to its troubles with AlGosaibi and Saad Groups.  
    7. Instead it will, however, make loans to foreign investors for their projects in Kuwait. And no doubt concentrate on its high quality Kuwaiti clients.
    8. As of 3Q10, the Bank has successfully reduced its non performing loans below 20% of the total portfolio.  That's a lot of "Saudi" clients, it appears.

    Tuesday, 19 October 2010

    International Investment Group - Update from Delegate on IIG Funding Sukuk (Hint: No Good News)

    Deutsche Bank as the Delegate on the above transaction issued an announcement on Nasdaq Dubai advising that:
    1. IIG had advised that it was awaiting ministerial approval of its new board so that they could vote to release the KPMG study to certificateholders who had signed a confidentiality agreement.
    2. The Paying Agent advised it had not received the funds for the 12 October payment.
    3. Certificateholders reminder of Dissolution Events and that they need to vote to accelerate.
    4. That IIG has not honored the claim served under the Purchase Undertaking.
    5. That the Delegate is not obliged to take actions unless indemnified to its satisfaction.  Apparently, it has not been.

    National Bank of Umm Al Qaiwain 3Q10 Financials - Update on Global US$250 Million Deposit Dispute

    NBUQ released its 3Q10 financials earlier today.  (Yes, I'm still stubbornly using that abbreviation even though their stock symbol is NBQ  But I will alternate today between the two to partially satisfy those who have "complained".)

    The major focus is as usual on the dispute over the US$250 million "deposit" (if you're Global Investment House) or the "prepayment" (if you're NBUQ).  As you'll recall the dispute turns over whether an MOU between the two parties was a binding contract obliging GIH to buy securities convertible into NBQ equity.  Yet another example of poor transaction structuring and legal documentation involving this instrument - which has been a rather costly mistake for purchasers in the past.

    You can find more on this topic by using the labels "Convertible Bonds" and "National Bank of Umm Al Qaiwain".

    The relevant notes in their financials are Other Assets (Note 13) and Other Liabilities (Note 17).  

    As per Note 17, NBQ is holding the funds in a non interest bearing account in the amount of AED918.25 million (equal to US$250 million at the FX rate as of 30 September).  But as you'll see from Note 13, it has deposited AED1,034 million with the First Instance Court of Dubai pursuant to an order from that Court.  

    The difference (just under AED 116 million) is presumably interest and perhaps legal costs for Global.   The amount represents a little over one quarter's net income for NBUQ.

    The Appeals Court is scheduled to hear NBQ's appeal on 8 November 2010.   The 29 September session adjourned without taking a decision and was designed to let NBQ object to both the decision in Global's favor and the interest payment.

    You'll also note that in Other Assets, NBQ is showing some AED82.7 million in "split deals".  Shades of Mashreqbank and its deals with Awal Bank and with TIBC.

    The Sharp Tongue of Al Qabas

    Sometimes the Pen is a Sword

    Here's today's Kawalis from Al Qabas:
    - مدير في البورصة اصيب باحباط شديد بعد تعيين لم يكن يتوقعه اذ كان مطمئنا لوعود.. لم تتحقق!
    - مسؤول نفطي استعجل اصدار بيان عن «انجازات» وصفه البعض بأنه بمنزلة لفت نظر الى من يسعون الى اقصائه في تعيينات مرتقبة.
    - طلبت السفارة الاميركية السيرة الذاتية لمدير البورصة الجديد حامد السيف.. ولدى السؤال عن السبب قال طالب السيرة: نطلب سيَراً كثيراً من وقت لآخر
    I love the last bit attributed to an unknown person at US Embassy Kuwait who when asked why the Embassy wanted the biography/CV of Mr. Hamid AlSaif, the newly appointed Director of the KSE, said, "We ask for a lot of biographies from time to time".  

    The first two items deal with the difficult job market in Kuwait.  The first someone who was promised the position of Director of the KSE and didn't get it.  The second an oil executive who prepared a list of accomplishments designed to get him a new job (expected appointments).

    Kuwaiti Investment Companies Blame Central Bank for Delay in 2009 Financials

    AlQabas reports that unnamed listed Kuwaiti investment companies have launched a sharp attack against the Central Bank claiming that they provided their financials four months ago, responded to requests from the Central Bank for clarifications three months ago and have heard nothing.

    Since CBK approval is required to release financial reports and since financial reports are a condition for the holding of the required annual shareholders' meeting, these meetings have not taken place exposing the companies to fines from the MOIC.  

    The article also notes that where another company has a significant ownership stake in a "delayed" company its own financials are delayed because the first company's auditors don't have enough information to complete their audit work.

    While Al Qabas did not name the companies, according to the KSE, the following companies have been suspended for failure to provide 2009 financials:
    1. The Investment Dar, last financial released 31 December 2008.  It is therefore missing the quarterly reports from 2009 plus FYE 2009 plus the first two quarters of 2010.
    2. International Leasing and Investment, last financial released 30 September 2008.  So it is missing FYE 2008, the first three quarters and FYE for 2009 plus the first two quarters of 2010.
    3. Abraj Holding, last financial released 31 July 2009 so it is missing FYE 2009 (October fiscal year end) and the first two quarters of 2010. (Technically Abraj Holding is not an "investment firm", though it may look like one from its activities).
    Perhaps, it's a question of whether they (CBK) believe what they been given.

    Footnote:  As if "poor" Abraj didn't have enough problems already, a group of shareholders has reportedly written to the MOIC complaining that in contravention of the law two government employees are member of the board:  one gentleman who works in the general administration of the fire department and the second who works in handicapped citizens affairs.

    Monday, 18 October 2010

    Dubai Sovereign Bond: "Pay to Play"

    An article in the FT today reports that bankers were told that lead underwriters on Dubai's recent US$1.25 billion sovereign bond were told that in order to be considered they needed to make loans to the Emirate.  Supposedly a two-year loan for some US$300 million priced at Libor +300 bps.

    A couple of observations.

    First, this is a pretty standard request, particularly from a client having a bit of a problem.  Just as the good banker is taught to seek to increase his "share of a customer's wallet" in good times, borrowers especially those currently out of favor in the market look for their bankers to be understanding in more difficult times.  In both cases there's a lot of talk about the importance of relationships.  How strong they are.  Sentiments said with no doubt more sincerity than the average politician's promise.  But just as meaningful for that.

    Second, Dubai's Sovereign Bond was "priced to place".   Dubai could not afford to have this transaction fail. With a bond, a low price means the interest rate was set higher than it needed to be.   Pretty much the same rationale as IPO pricing.  Under price the security by a bit so that the offer is successful.  And then  as the share rises in initial trading, you've got a good story for the company and the investors.    

    I've seen estimates that Dubai's pricing may have been as much as 0.75% to 1.0% higher than required.  The underwriters who "sat" on a substantial portion of their allocations may not too far in the future have large capital gains - though probably not until after issuance of the DEWA bond.  If they've placed it with clients,  as some will have, then they will derive some relationship benefits there and can use those to secure additional business from those clients.    Just as the investment firm that can allocate IPOs to its customers gets something back.

    For HSBC and Standard Chartered with major domestic operations in the UAE, being seen as a good friend is a useful thing.  If indeed SC's threat to move its corporate headquarters to the more tax and regulation friendly shores of Dubai is more than mere posturing, another good reason.

    Finally, there's probably also a very hard headed calculation here - that it's going to be some time before Dubai regains full market access.  Amounts are likely to remain limited  and increasing only slowly.  Pricing will probably improve even slower.  As the thinking goes, there are opportunities for profit here.

    And of course, there is one other factor in play:  banker and investor ADD.

    Do bankers have short memories?

    Excuse me, could you repeat that, I've forgotten what you asked. 

    2-1 (Bit of a Scare There)

    Saudi Capital Markets Authority Levies Fines and Penalties in Excess of SAR102 Million

    On 12 October the Saudi Capital Markets Authority levied another set of record fines and penalties but not as high as its all time record of SAR278 million last January.  If you look closely, you'll see that many of those cited today were also involved in that fine.

    The CMA levied SAR800,000 in fines and SAR99,434,098.10 in penalties (disgorgement of illegal gains) against seven individuals (two of whom were apparently not involved in illegal activity but received gains from that activity).  The fines and penalties concern trading in the shares of Al Baha Investment and Development Company between 23 July 2006 and 27 September 2006 as follows:

    A.  Mr. Jarrallah Bin Muhammad Bin Nassir Al-Jarrallah
    1. Return of SAR28,923,826.57 in illegal trading earnings on the trading.
    2. A fine of SAR 300,000.
    3. Prohibition from purchasing traded shares for seven years.
    4. Prohibition from working in a securities firm for seven years.
    5. Prohibition from acting as a broker, portfolio manager or investment advisor for seven years.

    B.  Messrs. Sa'id Bin Muhammad Bin Nassir Al-Jarrallah, Fa'iz Bin Salih Bin Abdullah Bin Mahfouz, Nabil Bin Mu'id Bin Yahya AlQahtani
    1. Sai'd to return illegal trading gains of SAR2,119,935.00
    2. Nabil to return illegal trading gains of SAR24,896,213.23
    3. Each of the three of them fined SAR100,000.
    4. Prohibition from purchasing traded shares for five years.
    5. Prohibition from working in a securities firm for five years.
    6. Prohibition from acting as a broker, portfolio manager or investment advisor for five years.
    C.  Mr. Abdulrahman Bin Abdulmuhsin Bin Sulayman AlMoajil
    1. A fine of SAR200,000.
    2. Prohibition from purchasing traded shares for five years.
    3. Prohibition from working in a securities firm for five years.
    4. Prohibition from acting as a broker, portfolio manager or investment advisor for seven years.
    D.  Mr. Muhammad Bin Nasser Bin Jarallah Al-Jarallah
    1. Return of illegal trading gains in his account of SAR38,293,835 caused by actions of Jarallah, Said and Fa'iz.   No fine as he apparently was not involved in the activities just a beneficiary.
    E.  Mr. Nasser Bin Muhammad Bin Nasser Al-Jarallah
    1. Return of illegal trading gains in his account of SAR5,200,288.30.  Like Mr. Muhammad immediately above, a fine was not levied against him, presumably because he was not involved in the illegal activities.
    I'm guessing our friends above just didn't trade two stocks back in 2006 so we may be seeing more enforcement actions from the Saudi CMA.

      Sunday, 17 October 2010

      Gulf Finance House - Capital Reorganization and Raising - A Look "Behind the Curtain"

      "Pay No Attention to the Man Behind the Curtain"

      GFH published the agenda for its shareholders' general meeting on the capital reorganization/raising to be held 31 October.  So far only in Arabic on the DFM and on the KSE (copy below so you can follow along).  Strangely not yet on the BSE.

      As the picture above suggests, by looking behind curtain we can get a real understanding of what's going on.

      In brief the key points are:
      1. The capital reorganization and US$500 murabaha are being structured to make them as attractive as possible to new investors.  That means that existing shareholders are being substantially diluted through a variety of clever means - which might not be apparent to most readers of the agenda for the shareholders' meeting. 
      2. A share swap transaction between Mr. Janahi and GFH which seems designed to strengthen GFH's creditworthiness as well as provide some much needed "relief" on the CAR both in terms of risk weighted assets and potentially equity.
      First, let's look at what's immediately visible:  the agenda for the shareholders meeting.   Shareholders are being asked to:
      1. Approve a share swap between GFH and its Chairman/Executive CEO, Mr. Esam Janahi.  In return for his 104,923,734 shares in Khaleeji Commercial Bank ("KHCB"), GFH will give him 100% of its shares in AlAreen Company for Leisure and Tourism (whose main asset is the Lost Paradise of Dilmun Water Park in Bahrain) plus US$3 million.  The latter either in cash or Treasury Shares of GFH. 
      2. Reduce the number of GFH's issued shares from 1,896,332,565 to 474,083,141 in a reverse 4:1 share split.
      3. Reduce the paid in capital from US$625,789,746.45 to US$142,224,942.375.  A difference of US$483,564,804.075. 
      4. Reduce the par value of shares to US$0.3075 from US$1.32.
      5. Approve the issuance of up to US$500 million in a privately placed convertible murabaha through a special purpose company set up by the bank or established at its request.  (That is, the SPV will lend to GFH.  It will obtain its funding from various investors.)
      6. The profit rate ("interest rate") on the murabaha to be the "market rate" according to the rate and formula established by the Board of Directors shortly before issuance.  Such profit rate to be payable in cash or additional GFH shares.
      7. The conversion price to be between US$0.31 and US$0.40 per share - with the rate of discount not less than 20% to 40% of the market price of the shares - but not below the nominal share price.  The conversion price to be set by the Board shortly before issuance.
      8. A tenor of 3.5 years.
      9. Conversion at investors' option with right of Board to offer an early conversion "incentive" according to conditions the Board will set.  Note that means that the murabaha does not count as equity for either regulatory (CAR) or accounting purposes until it is converted.  For the latter, only the embedded equity option is counted as equity under IFRS.
      10. Waiver of pre-emptive right of shareholders to new equity.
      11. Authorization for Board or whoever it appoints to take necessary legal steps to implement and for Chairman or whoever he appoints to sign the necessary legal documents.
      12. Conversion of GFH's share register to electronic form according to the rules of the Central Bank of Bahrain and the BSE.
      Now a look behind the curtain via some hopefully informed analysis:

      A.  Share Swap - KHCB for GFH
      1. GFH gets several benefits from this transaction.
      2. Immediate strengthening of GFH's creditstanding.  KHCB is a better asset than the Water Park, which is why the West LB syndicate asked for the former.  Probably better earnings and better future.  The Water Park like the Riffa Golf Course, no doubt, looked like a very "wise" idea on paper.  In the real world, it's probably not.
      3. Regulatory relief on the CAR - a matter of great importance to GFH who sit right on the edge.  The first way this comes is by moving this "puppy" (the water park, which is risk weighted in the GFH's CAR calculation) to someone else's kennel (balance sheet).  In return GFH gets KHCB, increasing ts holding from 36.99% to 46.99%.  Currently, GFH partially consolidates  KHBC, and, thus,  it doesn't have to worry for CAR purposes about fluctuations in KHCB's share price - which has dropped by roughly 50% since last year this time.  Since KHCB's CAR is roughly 31% as at 30 June 2010, the impact on GFH's Risk Weighted Assets and thus its CAR should be positive.
      4. As you'll notice, the US$3 million owed to Mr. Janahi can be paid in cash or GFH shares.  So there's a potential boost to equity if the latter can be used to settle this amount.  Treasury Shares are deducted from Shareholders' Equity at their cost. What this means is that if GFH gets more than zero in proceeds from the sale or conversion of Treasury Shares, the amount of its Shareholders' Equity will go up by the amount of the proceeds received.  This happened in 2Q10 where GFH sold US$29.1 million (original cost) of Treasury Shares for US$7.6 million and recognized a US$7.6 million consequent increase in Shareholders' Equity.  While admittedly a small card in the scheme of things, this could be just the thing that helps GFH keeps its head about the 12% threshold in a close situation.   As I suspect the 2Q10 Treasury Share sale was.
      5. And, to round things out, a footnote on KHCB.  Without qualifying my opinion about the  credit benefit of acquiring KHCB, I call your attention to Note 3.4 in KHCB's Basel II Pillar 3 Disclosures as of 30 June 2010, which shows that some 24% of its Islamic Financing Assets are past due.  According to that information, some 42% of the past dues (BD47,385 - which is the total amount of the past due loans not just the past due installments which  are BD10,487) are up to 30 days late.  Proceeding cumulatively, 51% up to 60 days, and 72% up to 90 days.  According to KHCB's risk classification system, some 59% of the past dues are rated Credit Grades 1-6.  Personally, I would have thought a past due loan  would automatically go on the "watch list" (Credit Grades 7-8) but then I don't have the details of KHCB's loan portfolio including collateral.  In any  case those concerned with KHCB should keep an eye on this area to see if there is deterioration or improvement in the future.
      B.  Capital Reorganization
      1. Under the Bahraini Commercial Companies Law of 2001, GFH is obliged to take action now that accumulated losses are 75% or more of paid in capital. Approved methods for rectifying this situation are:  (a) reducing paid in capital by an amount sufficient to offset the losses and/or using other equity reserves (share premium, statutory or voluntary reserves), (b) raising additional capital and (c) a combination of (a) and (b).  Generally, financial institutions use Method (c).  In some cases a bank might get away with merely offsetting the losses against existing capital - assuming its pre-reorganization CAR were robust.  GFH's is not so it must do both.
      2. As you'll notice, GFH is not using its reserves.  Why? Very simply put:  the path it has chosen is designed to make the murabaha more attractive to investors.  Under GFH's plan, they will get more of the total shareholding of the Bank for each dollar they contribute.  
      3. 1H10 financials  provide the details of the components of GFH's capital.   If GFH were to use its US$206 million share premium and US$85 million statutory reserve  (total US$291 million), it would only have to "use" US$192 million of paid-in-capital.  Thus, leaving original shareholders holding US$433 million in common equity instead of US$142 million. 
      4. To take control, the new money would have to put in US$433 million plus $1.  Under GFH's reorganization plan it only needs to put in US$142 million plus $1. 
      5. Similarly, if the new investors put in the full US$500 million, under GFH's plan they get 78% of the total equity.  If the reserves were used as outlined above, they would only get 54%.
      6. Clearly, there is a conflict here.  Existing shareholders want to be diluted as little as possible.  New shareholders want the most value for their new dollar.  Sadly for the existing shareholders, including the even "wiser" ones who invested in late 2009, their money is already spent.  The new and presumably much wiser investors need to be persuaded to part with their money.  GFH has set  the reorganization and the terms of the murabaha to make it as easy as possible to get the money that it desperately needs.
      C.  US$500 Million Murabaha
      1. Use of an SPV as the lender can be quite a useful device in shielding the identity of the new lenders/shareholders, particularly if the SPV is not incorporated in Bahrain.  It will depend on how much transparency the CBB wants to demand here and how far it can push this Bank which has an important and powerful friend in Bahrain.
      2. One would expect the market rate for unsecured GFH debt to be rather hefty.  And the value ascribed to the option on GFH shares much less so.  The Board will price "at market" - which will mean in effect what investors demand. 
      3. The approval also provides for a discount from market price of between 20% to 40%.   This is where the reverse split comes to play.  There is nothing in the Bahrain CCL that requires this as part of the capital reorganization.  I suspect GFH is hoping that  the reverse split will work a bit of magic on their market price.  Over the past two weeks, GFH has traded at KD0.033 (roughly US$0.11) per share.  A 4:1 reverse split should bring the price to say US$0.44 per share - allowing the Board to discount the conversion price to say just a whisker over par to make the transaction even more attractive. 
      4. "But wait there's more" as they say on the late night TV ads for the ShamWOW!  The Board is allowed to offer an incentive (terms unspecified in the approval) for an early exercise.  That allows an even greater discount to attract new investors.  So, if the conversion price is set at a whisker over par, can the Board issue shares below par through this device? 
      5. You ask about the hapless existing shareholders?  Well, GFH already has their money and needs more.  So they are out of luck.
      KSE announcement below.

      [12:17:53]  ِ.اجتماع الجمعية العمومية العادية و غير العادية لبيت التمويل الخليجي
      يعلن سوق الكويت للأوراق الماليه بأن بيت التمويل الخليجي أفاده بأنه
      سوف يتم عقد جمعية عمومية عادية و غير عادية للبنك في الساعه 9 من
      صباح يوم الاحد الموافق 31-10-2010 في فندق منتجع و قصر العرين
      وقد طلب البنك ايقاف التداول على اسهمه في السوق اعتبارا من اليوم
      الاحد الموافق 17-10-2010 وحتى اشعار اخر حيث حصل على موافقة ‏
      مصرف البحرين المركزي على ذلك .‏
      هذا وسوف يتم خلال الجمعية العمومية مناقشة ما يلي
      أولا : جدول اعمال الجمعية العامة العادية
      ِ1- المصادقة على محضر الاجتماع السابق .‏
      ِ2- المصادقه على معاملة استبدال الاسهم بين بيت التمويل الخليجي و رئيس
      مجلس ادارته السيد /عصام جناحي و التى سيتم بموجبها تحويل حصته في المصرف
      الخليجي التجاري ش.م.ب بالكامل (104.923.734 سهم ) الى بيت التمويل الخليجي
      مقابل الحصول على حصه البنك في شركة العرين للترفيه و السياحه ش.غ.خ و ‏
      البالغه 100% (جنة دلمون المفقودة) بالاضافه الى مبلغ 3 ملايين دولار تدفع
      اما نقدا و / او بواسطة اسهم خزانه بيت التمويل الخليجي .‏
      ِ3- الموافقة على تغيير سجل مساهمي البنك من سجل عادي الى الكتروني ‏
      وفقا لاحكام مصرف البحرين المركزي و سوق البحرين للأوراق الماليه .‏
      ثانيا : جدول اعمال الجمعيه العامه الغير عاديه ‏
      ِ1- المصادقه على محضر الاجتماع السابق .‏
      ِ2- التباحث في والمصادقه على دمج الاسهم الصادرة لبيت التمويل الخليجي ‏
      بمعدل 4:1 لينتج عن ذلك تخفيض عدد الاسهم الصادرة من 1.896.332.565 سهم
      الى 474.083.141 سهم .‏
      ِ3- التباحث في والمصادقه على تخفيض راس المال المدفوع من 625,789,746.45 ‏
      دولار امريكي الى 142,224,942.375 دولار امريكي بسبب الخسائر المتراكمه ‏
      ِ(سيقدم المدقق الخارجي السادة كي بي ام جي بيانا مستقلا يتعلق بتاييدهم لهذا
      التخفيض ) .‏
      ِ4- التباحث في والمصادقه على خفض القيمة الاسمية الجديدة للاسهم والتي ‏
      ستبلغ 1.32 دولار امريكي بعد الدمج و تخفيض راس المال المدفوع المشار اليه
      في البندين 2 و 3 من بنود جدول الاعمال الى 0.3075 دولار امريكي .‏
      ِ5- التباحث والمصادقه على قيام بيت التمويل الخليجي من خلال اية شركة
      غرض خاص يؤسسها البنك او تؤسس بناء على طلبه لاقتراض ما يصل ‏
      الى 500,000,000 دولار امريكي من خلال مرابحة تمويليه قابلة للتحويل
      الى اسهم بناء على البنود و الشروط التاليه :‏
      ِ- معدل ارباح يحدد وفقا لسعرالسوق ووفقا للمعدل والصيغه المحددة من قبل مجلس
      الادارة قبل وقت قصير من تاريخ السحب . يمكن دفع  هذا الربح نقدا او في صورة
      اسهم عينية في بيت التمويل الخليجي .‏
      ِ- سعر تحويل يتراوح من (0.31 دولار امريكي الى 0.40 دولار امريكي) ‏
      ِ(بمعدل خصم لا يقل عن 20% الى 40% من القيمة السوقيه في اعقاب
      الدمج بحيث لا تقل عن القيمة الاسمية للسهم) فيما سيتم تحديد السعر النهائي ‏
      من قبل مجلس الادارة قبل فترة قصيره من تاريخ السحب .‏
      ِ- مدة تصل الى ثلاثة سنوات و نصف .‏
      ِ- غير مضمونه و لكن قابله للتحويل بمحض خيار المستثمر الى اسهم في بيت
      التمويل الخليجي قبل انتهاء المدة ووفقا للشروط التى يحددها مجلس الادارة.‏
      ِ- حافز التحويل المبكر لتشجيع المستثمرين على التحويل الى اسهم قبل
      نهاية المدة وفقا للشروط التى يحددها مجلس الادارة .‏
      ِ6- منح التنازل عن حق الاولوية الخاص بمساهمي بيت التمويل الخليجي ‏
      فيما يتعلق باصدار اسهم عادية جديده سيتم اصدارها عند تحويل تمويل المرابحه
      وفقا لبنود الفقرة 5 من جدول الاعمال .‏
      ِ7- تخويل مجلس الادارة و/او من ينوب عنه للقيام بجميع الاجرءات الرسمية ‏
      المطلوبه و الصحيحه لتفعيل تمويل المرابحه بما في ذلك دون حصر تحديد و/او
      تعديل شروط المرابحه والمستندات الاخرى ذات العلاقه .‏
      ِ8- تخويل رئيس مجلس الادارة او من ينوب عنه بالتوقيع على تعديل عقد
      التأسيس و النظام الاساسي نيابة عن المساهمين امام كاتب العدل فيما يتعلق ‏
      بالتغييرات في راس المال لتعكس ما تقدم .‏
      علما بأنه في حالة عدم اكتمال النصاب القانوني لهذه الجمعية سيكون الاجتماع ‏
      الثاني يوم الاحد الموافق7-11-2010 في نفس الزمان والمكان وفي هذه الحاله ‏
      ستسري احكام الماده 57 من النظام الاساسي للبنك. وفي حالة عدم اكتمال النصاب
      القانوني في الاجتماع الثاني ، سيتم عقد اجتماع ثالث يوم الاحد الموافق ‏
      ِ14-نوفمبر-2010 في نفس المكان و ذلك بسريان احكام المادة 57 من النظام
      الاساسي للبنك . ‏

      Abyaar Real Estate KD50 Million Asset for Debt Swap?

      Citing informed sources, Al Watan reports that Abyaar will sign an asset for debt swap of KD50 million with a group of lenders.  The amount represents 35% of FYE 2009 debt.

      The article also claims that additional debt settlement/restructuring agreements are near to signing and will follow in train.

      Earlier post on Abyaar here.

      Gulf Finance House to Seek US$500 Million in Additional Equity

      SWI (Search for "Wise" Investors) Project 
      The Large Array at Jabal Dukhan Bahrain

      Asa Fitch over at The National reports that GFH has issued a press release in which it advises that it intends to call a shareholders' general meeting to approve:
      1. A reduction in paid in capital (4 old shares for one new) in order to absorb accumulated losses in retained earnings.  Like other GCC states, Bahrain has a law that when a company's accumulated losses reach 75% of paid-in-capital, it must take action to eliminate those losses.  That can be done by raising new capital.  Or by reducing paid in capital and using reserves (if available) to offset the losses.  As a financial institution, GFH, has to maintain a minimum 12% CAR and so unless it could reduce assets (which it cannot without incurring more losses), the bank has to raise new capital.
      2. The issuance of US$500 million in new equity.  This is up from the US$300 million originally mooted by GFH.  It's unclear why the increase.  It may have found that there is substantial demand for its new shares.  I find that hard to believe.  It seems to me that with its track record and current market conditions, raising even US$300 million would have been a very hard sell.  Hence the picture above.  Alternatively, it may be that the additional amount is designed to cover the US$137 million in 2Q10 provisions that GFH magically turned into an asset. 
      At 30 June 2010, GFH's capital structure was composed of:
      1. Paid in Capital US$626 million
      2. Share Premium US$206 million
      3. Treasury Shares (US$23 million)
      4. Reserves US$88 million
      5. Accumulated Losses (US$480 million)  Equal to 77% of PIC.
      6. Total Equity of US$417 million.  
      7. If the "magic" provision assets of US$137 million are factored in, Accumulated Losses are (US$617 million), resulting in Total Equity of US$280 million.
      GFH are savvy enough to know that a failed rights offering would be an extremely unhelpful event.  So either this is an act of desperation (perhaps motivated by its auditors awakening to the US$137 million charade) or GFH has found some wise investors to carry the issue.   And that may become evident if the Board proposes that shareholders approve a structure under which any shares unsubscribed for in the Rights Offering be placed by the Board with "strategic" investors.

      One tactic the Bank can use is to mitigate its deal failure risk is to obtain shareholder approval to issue up to US$500 million over a period (usually the maximum is two or three years I think but am not certain).  In this way it could issue multiple tranches so that the amount it brings to the market at any one time is more digestible. 

      As to the motives behind the raising of new equity, I think these include more than just funding operating expenses:
      1. Regulatory compliance.  GFH's CAR is "on the wire".
      2. Market credibility.  New equity would be a demonstration of confidence in the future, though a failure will be a major setback.
      3. Funding for upcoming debt repayments.
      4. Funding for operating expenses.

      Thursday, 14 October 2010

      The "Developed" West - A New Kind of Forthrightness

      A quote from the Financial Times on JPMorgan Chase's 3Q10 earnings conference.
      Switching between annoyance at one analyst’s use of a “squawk box” to terse replies on JPMorgan’s soaring reserves against litigation and passionate perorations about the bank’s role in society, Mr Dimon displayed his customary forthrightness even if he was not always forthcoming about some of the details.
      This was just too good a quote to let pass without comment.  Positively brilliant. 

      And, I'd note it sets a high standard for this blog's favorite investment bankers in Kuwait and Bahrain to aspire to.  (And, yes, each word in that sentence has been deliberately chosen).

      New Addition to List of Interesting Blogs - Felix Arabia

      Felix Arabia by Sultan Sooud Al Qassemi.

      Hat Tip to David Roberts of The Gulf Blog.

      The "Developed" West - Burger King Kids Banking

      "First-Class Business in a First-Class Way"

      It's got to be gratifying to work for a first-class firm that labels you a "Burger King kid".

      Also on the subject of documentation, which is a frequent rant here, the rule should be very simple:  No note, no foreclosure.    

      If making a mistake in drafting a contract is  rookie behavior, losing one's contract is below the level of incompetence.  The Burger King Kids, as the bright executive had it, may be in the executive suite.

      The Capital Adequacy Ratio – How Accurate a Measure?

      Hard to Tell the Time With Just One Hand
      In a post on the Booz & Company study on Kuwaiti banks' stress tests, I said that The National Bank of Kuwait was the most creditworthy bank in Kuwait.

      Advocatus, one of the frequent readers/commenters on this blog, challenged that statement noting that as of 31 December 2009, NBK had the lowest CAR 15.03% versus 15.9% for Gulf Bank, 17.23% for Ahli Bank of Kuwait and 18.22% for Commercial Bank of Kuwait.

      I'd like to address his remarks in a bit more detail than is convenient in a comment reply. So I'm moving the discussion to the "main board".

      My intent is to reply with two posts. The first theoretical. The second specific to NBK and a few other Kuwaiti banks.

      In this post I will discuss some shortcomings in the CAR which make it an inaccurate as well as incomplete measure of financial strength.

      To start off a bit of introduction.

      What is the CAR?

      It is a ratio which measures equity capital against risk weighted assets ("RWA"). Neither the numerator nor the denominator in this ratio are the same numbers that appear in the financial statements. Rather both are constructed according to certain rules set forth in Pillar 1 of the Basel II Framework. A document of some 192 page. As that suggests, the rules are complex. Rather than delve into too much detail, I'll give a broad overview.

      Regulatory Capital

      The first step in determining regulatory capital is the allocation of a bank's accounting capital into one of three tiers. Tier 1 is considered the most solid. The others progressively less so. For example, common equity is Tier 1. Subordinated debt Tier 2. The amounts of Tier 2 and Tier 3 capital that a bank can use in calculating its regulatory capital for the CAR are limited. Tier 2 may be no more than 100% of Tier 1. Medium term subordinated debt may not exceed 50% of Tier 2 capital. However, to be counted even at the 50% level it must have an original maturity of five-years. If the maturity is shorter, it does not count. If the subordinated loan is a bullet loan, each year it must be reduced by 20% for CAR purposes. Tier 3 capital consisting of short term subordinated debt can be only used to support market risks and only to the tune of 72.5% of such risks. Any amount over these limits for Tier 2 and Tier 3 capital is not counted as part of regulatory capital for the CAR.

      Once these have been determined there are a series of further adjustments. Goodwill is deducted from regulatory capital as are significant minority investments (which are deducted 50% from Tier 1 and 50% from Tier 2) and excesses over the 15% single obligor (Group) credit exposure limit. The full amount of equity in insurance firms may be required to be deducted from regulatory capital at the discretion of the national regulator. There are also a variety of haircuts on revaluation reserves for both property and securities.

      Risk Weighted Assets

      Basel II classifies risks (for the CAR) as either credit, market or operational.

      The Basel Framework allows banks three options for determining Credit Risk. 
      1. A Standardized Approach (the bank is given formulas to apply to the face value of its exposure). 
      2. An Internal Ratings Based Foundation Approach ( the bank determines the Probability of Default for customers but uses the Loss Given Default, Exposure at Default, and Maturity as mandated in Basel II). 
      3. An IRB Advanced Approach (here the banks determines all these factors). 
      For Market Risk there are two basic approaches.
      1. The Standardized Approach (banks use the set of factors given in the Basel II Framework to determine risk weighted "assets" for market risk)
      2. A Model Approach (generally VaR). 
       For Operational Risk there are three approaches: 
      1. The Basic Indicator Approach
      2. The Standardized Approach and 
      3. The Advanced Measurement Approach
      Most banks in the MENA region use the Standardized Approach for credit, either the Standardized or a Model for Market Risk and the BIA or Standardized Approach for Operational Risks. As a general rule, Central Banks in the area prohibit use of the more advanced models: the two IRB approaches for Credit Risk and the Advanced Measurement Approach for Operational Risk.

      One way to get a quick sense of how this system works is to look at the Basel II Pillar 3 disclosures of Kuwaiti banks. For 2009, you'll find NBK here (starting on Page 33), CBK here, and Gulf Bank here (from page 17).

      What's the purpose of the CAR?

      Regulators are charged with preventing problems at a single bank or group of banks from having a systemic impact on their economies. Accordingly, Basel II is designed not only to measure risks (to give early signs to the regulator of impending problems) but by the  very act of measurement itself (expressed in the CAR) to dissuade banks from certain types of activities which are felt to be risky. This is achieved by raising the risk weights for these activities.

      It's important to understand this function. It is not merely a measure of creditworthiness. It is also a control device. And since the stakes are high, the controls are generally set with large safety margins.

      What are the major issues with the CAR?


      From the above discussion it should be clear that regulatory capital does not consider all the equity support a bank may have. One simple example: If subordinated debt at Bank A is twice its Tier 1 capital, half of that subordinated debt is not factored into the CAR. Yet, if Bank A encounters problems, that "excess" is still subordinated to other creditors providing an element of protection.

      More importantly, one critical aspect of capital the quality of retained earning is not considered. And often is not considered on a consistent basis.

      One example are changes in the fair value of financial instruments. If a bank takes these changes to income (Fair Value Through Profit and Loss – FVTPL), they are considered a part of Tier 1 capital dinar for dinar. If the same financial institution were to take the changes in fair value to equity (Fair Value to Equity), this income would be considered part of Tier 2 capital and would be haircut 55%. Calling these earnings FVTPL or FVTE does not change their fundamental economic characteristics. Yet for calculation of the ratio it does. 

      One might also argue that changes in fair value are not the same as cash earnings. If these changes are deliberately inflated or markets are in a period of irrational exuberance which reverses, equity can vanish with astounding rapidity. 

      Classifications of bond holdings as "banking book" versus "trading book" can result in different income and fair value treatments for exactly the same securities. Again the economic substance is the same, yet the CAR will differ. Same asset. Same economic reality. Different income and equity treatments.


      Credit Risk
      As indicated above, the mere act of classification of an asset can have an impact on its value. The same with its risk weighting. Securities held in the trading book generally have lower risk weights than those held in the banking book.

      But the key issue for banks is the Standardized Approach for RWA for loans, the major earning assets of most commercial banks.

      Under the Basel II Standardized Method for Credit Risk, risk weights are assigned to loans to private sector companies based on their credit grades (if any). 

      1. AAA to AA- receive a 20% risk weight
      2. A+ to A- a 50% weight
      3. BBB+ to BB- a 100% weight 
      4. Below BB- a 150% weight
      5. If the loan is unrated, a 100% weight. 

      You can well imagine that weaker credits avoid ratings like the plague because if one is objectively a B credit but not rated, one gets the same risk weighting as a BBB- to BB+. Again the presence or absence of a rating (but not the underlying economic reality) drives the CAR.

      More importantly, the following are not considered in determining the risk weight of a loan: the final maturity, the pattern of principal repayments, and the pattern of interest payments. Thus, a five year loan to Company XYZ has the same risk weight as a one year loan. A five-year bullet loan with quarterly interest payments is the same as a five-year zero coupon loan and is the same as a loan with quarterly principal and interest payments. The purpose of loans is not considered. A loan for real estate speculation is treated the same as a loan for a factory. Many forms of collateral are not recognized for CAR risk mitigation purposes, e.g., real estate, except the latter gives a partial mitigation for residential mortgages. Yet, the bank does have recourse to that collateral in the event of a borrower default and is more protected than one that has no collateral. Yet, the CAR does not reflect this.

      Operational Risk

      For Operational Risk, banks are generally limited to the Basic Indicator Approach or Standardized Approach. Under the BIA Operational Risk is 15% of the average of past three years' revenues (adjusted for certain banking book securities income and other items). If a bank has had zero adjusted revenue for those three years, it has no Operational Risk - at least for the CAR. Under the Standardized Approach a similar formulaic approach is used against revenues for eight defined lines of business with specific assigned LOB risk weight to each of the 8  ranging from 12% to 18%. 

      As you might expect, banks generally determine which method will give the lowest Operational Risk charge and select that method as being the most "accurate". Again the mere selection of the measurement method affects risk – at least for the CAR, though not I'd add in the real world.

      Market Risk

      Market risk calculations are more complicated so I'm just going to wave my hands here with an unsupported assertion.

      Sometimes VaR will give a lower market risk number than the Standardized Approach.   Sometimes not.  Depending on the choice of the measurement method, the same portfolio can have quite different risk weights.   No difference in economic reality.  But a difference in CAR.


      Let's take two imaginary banks: Bank A and Bank B. For simplicity sake we'll ignore market and operational risk.

      Bank A is a conservative bank that lends only for productive activities (no speculation) and structures its loans to require semi-annual payment of interest and principal. It also diversifies its risk among many customers, has a wide variety of tenors on its loans,  and makes a practice of taking real estate as collateral with borrowing base of 50% of collateral. Its KD100 loan portfolio is all to unrated clients so its RWA are KD100. After adjustments it has KD13 in capital giving it a CAR of 13%.

      Bank B is less conservative. It also has a KD100 loan portfolio. Its underwriting standards are much lower than Bank A's. If a borrower can find his way to a Bank B Branch, he can get a loan. As part of its customer friendly approach, Bank B does not take real estate or other collateral. All the loans it makes are for five-year tenors with interest and principal due at maturity. It also is less diversified than Bank A and has numerous customers with loans equal to 14% of its regulatory capital (just under the 15% threshold). After adjustments it has KD 15 in capital.

      Bank B's CAR is 15%. Bank A's CAR is 13%.

      Based solely on CAR, one might think that Bank B was a stronger more creditworthy bank than A. It is not.

      What credit factors are not considered in CAR?

      1. The quality of the Board and senior management. Are they seasoned and prudent bankers? Do they have a good business and strategic sense? Or do they chase the latest fad? As long as the music is playing, are they dancing? 
      2. Corporate culture and ethics.  Loose standards lead to problems.
      3. The quality of credit underwriting and structuring.  Most problems in the portfolio are caused by easy credit standards, weak or sloppy loan terms, etc. 
      4. The quality of loan monitoring and administration.  The earlier a bank finds a problem the earlier it can try to fix it.
      5. The quality and liquidity of assets. If the bank needs to raise cash, can it do so quickly? What sort of discount, if any, will be required on its assets? 
      6. The quality of earnings. Equivalent to cash or accruals of  imaginary promises? 
      7. The structure of liabilities. Diversified across lenders, instruments, and markets? Are maturities  appropriate for the bank's business? Or is the bank dependent on a very limited source of  funding? Most or all of which is short term?
      These are critical factors that can impact the ability of a bank to weather a storm. They are an essential element of its financial health.  The CAR does not consider them at all.

      For these reasons, one cannot rely on the CAR alone as the single measure of a bank's financial health and strength. A wider view is required.   One that evaluates a range of factors, such as the CAMEL approach used by US regulators.  To its credit the Basel Committee on Banking Supervision has recognized this - which is why it instituted the Pillar 3 disclosures - a first step to giving lenders and investors a look under the "hood" of a bank.

      The above also explains why some banks (Bank B in our case above) should be required by the regulator to hold more than 12% capital.  Economic capital is the buffer than absorbs unexpected risks.  The riskier the bank the more capital it should hold.

      Shocking Developments in Chile Mine Rescue: 34th Man Emerges. 35th Man Left Behind.

      Surprise 34th man emerges from San Jose rescue shaft.

      Today the World witnessed the remarkable rescue of 33 brave men trapped roughly 700 meters below the ground in the San Jose mine in Chile since August.  Bienvenidos, hombres!

      After the last miner had been lifted to safety, crowds were amazed at the emergence of the President of Iran from the rescue tunnel as shown in the above exclusive Al Ahram photograph.  

      As with events of this sort, amid the joy there was some profound sorrow.  An Egyptian citizen, one  Mr. Mohammed H. Mubarak, who was scheduled to be the first to come to the surface, has been left behind alone in the mine as the rescue shaft was too narrow to accommodate him.  Apparently, the physical description contained in his official Egyptian Government biography - which was used in designing the tunnel - understated his weight and girth.  Informed sources  have confirmed that he has been provided a chisel and hammer and is slowly working his way to the surface.  Suq Al Mal has been told by its sources in Egypt in yet another Suq Al Mal exclusive that Al Ahram expects to publish a picture tomorrow showing him emerging first from the tunnel.

      Wednesday, 13 October 2010

      What Does Fitch's Study on CDS Spreads as Predictors of Default Tell Us About Modern Finance Theory?

      Fitch released a report "CDS Spreads and Default Risk Interpreting the Signals" which has received a good deal of coverage in the press. One example from the Financial Times.

      Analyzing five property-sensitive sectors in USA market in the wake the recent housing crisis, Fitch found that all five of these sectors had wild swings in their derived default risk. For example, USA REITs went from a CDS-derived probability of default ("PD") of 0.7% at June 2007, to 10.1% in October 2008, to 18.0% in March 2009, and then to 4.4% in August 2010. Details on the other four sectors are in the Table on Page 3. Despite these highly elevated PD's, actual defaults did not increase as predicted. The derived PDs were inaccurate. Fitch cites the volatility of CDS markets and the tendency for directional momentum (that is, an imbalance of demand and supply) as the cause of these false positives.

      There are two key conclusions.  

      1. CDS-derived PDs can give potentially erroneous and costly portfolio management signals. 
      2. More importantly, as shown in the Table on Page 9, if the derived PDs are used in Basel II IRB models, financial institutions would be forced to dramatically and needlessly increase provisions at precisely the wrong time in a crisis. A pro-cyclical move which would depress the probability and strength of a recovery.

      Fitch's study confirms what various analysts (including yours truly) have been saying about CDS spreads. The market is too thin to give reliable information. These are at best directional indications of PD. Fitch's detailed empirical analysis on this topic is therefore highly welcome and useful.

      But there's more here.  Fitch's report raises fundamental questions about current finance theory:  both the construction of models and the use of market data – whether direct or derived –  as inputs to those models during periods of crisis. And so challenges some of the fundamental assumptions of corporate finance orthodoxy about market prices – both at the macroeconomic and microeconomic levels.

      The simple empirical fact is that during periods of stress or exuberance, markets are dysfunctional. Prices no longer reflect, if they ever did, intrinsic values. During a crisis, there is a dramatic increase in liquidity preference motivated usually by fear. We see this most clearly in the breakdown of "normal" correlations among markets and asset classes. During a boom, a dramatic decrease in liquidity preference motivated by greed and irrational exuberance. 

      This happens not only in illiquid markets like those for CDS but in the most liquid markets. In the period after 9/11, the NYSE plunged dramatically. While the attack was horrific, our way of life was not under serious threat. Our economy was not in danger of being destroyed, particularly by a relatively small band of cave dwellers in Afghanistan and Pakistan. For that task it would need and subsequently got some timely domestic help.

      In such circumstances as in booms, the usual assumption about what market equilibrium means has to be thrown out the window. When markets are not rational, in no sense do their prices reflect intrinsic or fair values. Using the values they give – potential inputs into our "sophisticated" models – makes little sense. Market equilibria are much more unstable than during more "normal" times.

      But, even if we assume that markets continue to function in such periods, we are misled by another myth: the imaginary no profit equilibrium derived from microeconomics. As this theory goes, intense competition leads sellers to lower their price until goods are sold at cost. Now, I recognize this is the one sacred doctrine on which all or nearly all the various economic cults agree. They may dispute vociferously with one another over which is the sole efficacious economic sacrament – the gold standard, the quantity theory of money, deficit spending, tongue of Newt, tax cuts etc  But on this issue there is by and large doctrinal unanimity. 

      However, back in the real world, I don't know many businesses that price at cost. Or that stay in business if they do. Yet, we derive our financial models based on this illusion.   Often we use it to derive inputs for those models.  As you'll notice from Fitch's report, the standard equation for deriving PD from a CDS is to take the CDS spread in bps and divide it by the presumed loss on default (LGD) in percentage terms. The result is the PD expressed in percentage terms.  So a 100 bps CDS spread with a 50% LGD turns into a 2% PD. 

      As you'll notice, this calculation assumes that the seller of risk protection is content to receive as his compensation exactly the amount of his expected loss. This is far removed from the standard microeconomic theory of equilibrium, which would have the seller's price result in an overall break even position. Here the seller does not recover his operating costs – salaries and other expenses which I believe it would be safe to say are not small in most investment banks. One might, I suppose, argue that in normal non crisis or non boom markets we can ignore these costs because they are spread over large volumes of business. Perhaps.

      But in a crisis or in a boom where there is excess demand for a product, I'd expect any rational business man or trader to take advantage of supply/demand dynamics and increase his profit margin. which as I've argued above was not at "zero" from "normal" times.  More importantly, in a crisis where an institution and a trader are assuming an ongoing risk (like a CDS), I'd expect there to be a strong incentive - both  for the trader and his firm - to price up to cover that risk taking. The personal and institutional consequences of a wrong bet can be rather serious – just ask AIG.  So we should rationally assume that during a crisis CDS spreads include  not just the protection seller's  objective best estimate of the PD and LGD but also a fear/caution based adjustment of those factors plus a rather hefty profit margin.  It's not hard to imagine a seller demanding profit margin well in excess of 50%.  
      As before, in line with best doctrinal thinking, we're ignoring costs. Clearly, the profit margin and the additional fear induced safety margin in pricing are going to be a major component of the pricing.  All of which of course explain why often CDS spread-derived PDs are greater than 100%. And why using them in models makes scant sense because the resulting PDs are inflated.  Probably by significant factors. Not percentages that would be considered "normal" tolerances.

      We like to think that we are more advanced than our predecessors. We have elegantly constructed apparently "sophisticated" and "scientific" models. Finance theories are expressed with imaginary mathematical precision. 

      Yet at the very heart of these models are assumptions that would make a medieval scholastic blush. 

      Assume a market with perfect information and no transaction costs and you will discover, perhaps - but hopefully not - to your surprise, that it turns out to be an efficient market. Something I believe has to do more with logic than economics: the principle of tautology.    

      Assume that the market price reflects intrinsic value and you are highly likely to input the silliest numbers as variables into your model. 

      What's needed at the core of this discipline like any other is a healthy does of skepticism, a constant challenging of revealed assumptions and a cold hard eye on results.