KHCB: Credit Metrics Part 3: Collateral Coverage

Post Foreclosure Sales Prices May Be Less than Appraisal Values

We ended the last post on KHCB’s credit metrics with some theological speculation.

Since AA’s province is finance and not theology, let’s look at collateral coverage.  Maybe KHCB is so collateral “rich” that classifying some loans past due 180 days as unimpaired makes perfect (credit) sense.

As outlined above, KHCB’s collateral position is not sufficiently “robust” to compensate for other weaknesses in its lending portfolio discussed in earlier posts.

1. Collateral is concentrated in real estate. That poses at least two problems. Illiquid assets like real estate are difficult to sell quickly and/or at full price, exposing lenders to loss.  Real estate is interest-sensitive. With real estate 85% of collateral, KHCB is particularly vulnerable to increases in interest rates. 
2. Compounding this problem, KHCB’s real estate collateral is primarily located in a single, very small market—Bahrain—, magnifying the inherent risks of taking illiquid assets as collateral. 
3. KHCB also seems to be relying on real estate to collateralize non-real estate loans thus increasing the bank’s overall exposure to real estate.  This appears to contradict GFH’s stated goal of reducing “land-based” exposure.   

Now to the detail.  

Key areas for investigation: 

1. Percent of portfolio collateralized and trends in collateralization.
2. Types of collateral.  

General introductory notes:

1. Note 34 page 72 (IFRS) and Note 4.10 page 93 (Basel Pillar III) are the sources for this post.
2. I have relied primarily on the Pillar III note as the IFRS note really doesn’t provide the same level of detail.
3. However, both have an apparently erroneous and misleading statement regarding collateral coverage of the portfolio.  This error appears only as a number in the Pillar III Note 4.10.  Note 34 spells out the error:  “The average collateral coverage ratio on secured facilities is 107.80% at 31 December 2015 (31 December 2014: 109.49%).”  
4. As Pillar III Note 4.10 shows this ratio was determined by taking the value of all collateral and dividing it by outstanding exposure. 
5. Two problems with that.
6. First and foremost, Pillar III Note 4.10 shows that BHD 106.5 million is unsecured.  The key point here is that if a loan is unsecured, then by definition it has no collateral.  Consequently, unsecured loans should be excluded from measures of collateral coverage.  That of course would apparently make the ratio higher at 148%.  Note that the data for “Other” and “Unsecured” is switched in both the Arabic and English versions of the 2015 AR as evidenced by data in prior years’ annual reports.   
7. Second, unless this collateral is pledged to all secured facilities the 148% coverage ratio is meaningless.
8. As a concrete example, suppose you take a $1mm loan from Bank Arqala (“BA”), assuming you can pass our stringent credit process, and pledge The Trump Tower in NYC.   Our fine bank has collateral worth let’s say a $1 billion, if not multiples more.  But TTTNYC only secures your loan.  If BA makes loans totaling $999 million to other borrowers, the average collateral on the portfolio is not 100%.  One loan for $1 million is over collateralized.  It’s also important to remember that BA like any other bank can only collect what you owe on your loan when it sells (realizes) the collateral you pledged.   If you owe $1.1 million in P&I, BA can take and sell the Trump Tower but only keep $1.1 million not the untold billions TTTNYC is really worth.  The bank must return the rest of the proceeds from the collateral realization to you.  

Collateralization Levels
	2015	2014	2013	2012	2011
Unsecured	106.5	105.2	55.9	47.9	40.3
Total Gross Exposure	408.7	361.8	306.0	286.3	217.3
% TGE	26.1%	29.1%	18.3%	16.7%	18.5%
Partially Secured	25.0	17.9	9.9	10.8	12.2
% TGE	6.1%	4.9%	3.2%	3.8%	5.6%
% TGE –All Unsecured	32.2%	34.0%	21.5%	20.5%	24.1%

Comments on collateralization levels: 

1. As is clear, KHCB has been expanding its unsecured portfolio.  It was at 18.5% in 2011 and 26.1% in 2015.  However, percentages don't convey the full extent of the change.  Unsecured loans have gone from BHD 40.3 million to BHD 106.5 million.  Why is that important?  Because over the period capital has not increased by 2.5x.
2. In general, but not always, uncollateralized lending is riskier than collateralized.  Tenor (maturity) of the loans would also affect risk.  That info is not available. 
3. Note the partially secured amounts are net after deducting the partial collateral shown in Pillar III Note 4.10 for “cash” and “other” collateral at face value (no haircut by AA).   

Types of Collateral: 

1. Pillar III Note 4.10 discloses that 85% of KHCB’s collateral is real estate. 
2. Three observations.
3. First, real estate is illiquid and may be hard to sell, unless one is holding a security interest in a piece of land in central Tokyo.  There’s probably not comparable land in Bahrain.  Additionally, it’s well known that with the right nautical partners one can create perfectly good land in Bahrain from the sea as GFH and Arcapita might testify.  Cash or marketable securities would be much more liquid and provide much more protection.  That’s why KHCB advances on average only 60 fils against each dinar of real estate collateral.
4. Second, real estate is interest sensitive.  As market rates rise so do cap rates (the interest rates used to determine the value of the property). As a consequence, property values decline.  That could be a problem as the US raises interest rates and currency pegged-Bahrain follows along.  The main consequence is likely to be eroding collateral values. Borrowers are shielded from rising rates by the fixed rates on their existing loans--absent covenants in the loan agreements that allow the bank to raise borrower’s interest rates.  Thus, borrowers’ ability to repay should not be affected directly, though general interest rate could indirectly stress their ability to repay by reducing overall economic activity in the Kingdom.   Potential buyers of “seized” collateral are likely to require financing.  If rates on new loans are higher than currently, the sale of real estate will be more difficult, perhaps requiring KHCB to make loan term concessions or reduce the price of seized property being sold.  That leads nicely into the next point. 
5. Third, when looking at an institution’s exposure to real estate risk, one needs to look at more than the purpose of the loan or the business of the borrower. If a bank makes a loan for a new airline, but secures it with real estate, it has an indirect exposure to real estate along with the direct exposure to the airline.  If the loan is being made because the real estate collateral “compensates” for shortcomings in the airline’s creditworthiness, then the exposure to real estate is more “direct”.
6. Some 55% of KHCB’s exposure (based on outstanding exposure not collateral values) is secured by real estate, which tempers KHCB’s management’s statement at the bottom of the chart in Pillar III Note 4.3.6 page 88: “The Board approved internal cap for real estate exposure at 40% of total assets. The Bank’s real estate exposure as of 31 December 2015 and 2014 are within the policy limit.”   Not exactly.  Assuming collateral is taken because it is needed to support extension of credit, then KHCB’s real estate exposure is larger than 40%. 
   

All in all a poor fit for GFH’s announced strategy.

Analyzing KHCB's Financials - Credit Metrics Part 2

Continuing our financial analysis of KHCB's lending portfolio, today we'll take a look at past due loans that have not yet been classified as impaired.

Past Due but Not Impaired Loans (PDNI)

1. When a bank declares a loan impaired, it takes provisions, ceases accruing income, etc.  It does not do so, with PDNIs.
2. Often today’s PDNIs turn into tomorrow’s impaired loans.
3. But note that a PDNI is not of itself conclusive proof that the loan will turn out to be “bad”.  Sometimes a borrower has a legitimate reason for being late and brings the loan current.
4. What analysts look for is trends in PDNI (increasing, decreasing) and the length a PDNI is past due to form an opinion on future impairments.

Let’s start with a macro view.  What has been the trend at KHCB between 2011 and 2015? 

KHCB Past Due But Not Impaired Loans 2011-2015
	2015	2014	2013	2012	2011
BHD Millions	60.8	35.8	39.0	39.5	18.7
% FA & LA	15.7%	10.6%	13.7%	14.8%	8.8%

1. At first glance, the trend doesn’t look good.  But let’s dig a bit deeper.  
2. How are the loans distributed by time past due? The theory being the longer a loan has been past due the weaker the probability of full collection.   

KHCB PDNIs Over 90 Days Past Due
	2015	2014	2013	2012	2011
90-180 Days	7.93	1.01	1.58	3.12	1.95
% All PDNIs	13.0%	2.8%	4.0%	7.9%	10.4%
180+ Days	17.2	1.0	1.8	4.7	8.3
% All PDNIs	28.3%	2.8%	4.5%	12.0%	44.4%
All Over 90 Days	25.2	2.0	3.3	7.9	10.3
% All PDNIs	41.4%	5.7%	8.6%	19.9%	54.8%

1. This is an even bleaker picture. 
2. In 2015 41.4% of all PDNIs are over 90 days past due. 
3. 28.3% of all PDNIs are over 180 days.  That is PDNIs are skewed to the longest shown past due “maturity bucket”.
4. The last time the numbers were comparable (2011) there was a massive loss two years later due to provisioning.
5. AA wonders and maybe you do too how loans can be past due for more than 180 days without being considered impaired.
6. But can think of two explanations.
7. The loans are collateralized by highly liquid assets with a robust margin of safety and based on impeccable legally enforceable agreements.  That is, if the borrower doesn't repay, the collateral is sufficient to repay principal and interest in full and the agreement is so watertight that no judicial delay will occur.
8. Another is something a GCC national banker once told me about “Islamic” banking.   “AA”, he said, “it’s often said that Islam has no miracles.  No wine into water.  No raising of the dead.  No healing of lepers.  And that is true, except with regard to ‘Islamic’ banking.  There halal profit rates miraculously track interest rates even with the latter are at a level so low that the average suk merchant couldn’t make a living.  But that’s not the only miracle. One can make a profit by buying and selling to oneself.” 
9. AA supposes that if this is true, then loans can be past due 180 days without being impaired.    أعلم الله

So far we haven't found a compelling reason why KHCB would be a good fit with GFHFG's new strategy.

One more post--a look at collateral--and AA's deep dive into KHCB's financials will come to an end.  Perhaps the "gold" is here that bolsters KHCB's credit portfolio.