Ring in the Old: Part 2: Suq Al Manakh The Crash

Symbol of the Suq Al Manakh

The Crash

When we left the Suq Al Manakh ("SAM") everything was going well, or so it seemed.  (Earlier post here). There was one worrying sign though, the premium on the deferred sales (post-dated checks) had climbed to 400% per annum.

In August 1982, a nervous or perhaps savvy investor (by some accounts a woman) presented a post dated check early. There was nothing under local law which required that the check be held until the future date. The check was due. The writer could not cover. Word got out. Panicked investors started presenting checks for payment ahead of their due dates. The entire house of cards came tumbling down. With a resounding crash.

Most of the stories you'll read about the wreckage of the SAM involve very large amounts. You'll hear that there were some 29,000 (I've seen, or think I have, the figure of 28,815) or so unpaid and apparently unpayable post dated checks issued by 6,030 or so investors totaling KD 26.7 billion (roughly US$94 billion dollars). And that was when a billion dollars was real money.  In 1984 Kuwait's GDP was US$21.7 billion. It didn't reach US$94 billion until 2006 when it surpassed that figure by US$7 billion.

The KD 26.7 billion is mind boggling, but it is the total of all the checks added together. If Investor Jawad owes Punter Jassim KD15 billion and Punter Jassim owes Investor Jawad KD14 billion, the real debt between the two is KD1 billion not KD29 billion.

There was significant concentration among the traders:

1. 18 traders were responsible for 95% of the amount. 
2. Some 8 of these traders (the so-called Knights or the Manakh, Fursan Al Manakh) were responsible for approximately 55%.
   

After the Government established a clearing house for the SAM post dated checks and netted bi-lateral deals against one another, the net amount outstanding was KD5.7 billion (US$20 billion). Still enormous in terms of Kuwait's GDP, but only about 21% of the original amount.  And cold comfort as five of Kuwait's six operating banks were bankrupt with uncollectable loans more than twice their equity. The one bank that escaped this fate, due to the prudence of its management, was the National Bank of Kuwait.

The Government's Rescue Plan

As you'd expect unwinding a problem this big was not easy. Nor was it accomplished quickly.

The first step was the passage of Law #57 in October 1982 which established:

1. A clearinghouse company to determine each trader's position after the process of conducting a bi-lateral netting of his obligations and receivables from each other trader. The first step in this process was reviewing, verifying and tabulating the payables and receivables of each trader. This process involved comparing Trader A's record of payables due to and receivables due from Trader B to Trader B's records of his dealings with Trader A and then determining the true position. 
2. A small investors' fund of KD261 million (US$1.7 billion). A small investor was someone with a loss less than KD261 thousand or US$1.7 million. Small investors were compensated for their losses. The first KD100,000 in cash. Amounts over that in Government bonds (I think six year tenors). 
3. An arbitration panel to assist traders in working out settlements, including the schedule of payments, and as well monitoring these payments. 
4. September 20, 1982 as the due date for all checks. This was done so that all obligations "matured" on the same date and all premium charges stopped as of that date. Initially the original premium (interest rate) agreed between the buyer and seller on each postdated check was retained with the only adjustment in the amount of the check being the truncation of the premium (interest) accrual on this date (20 September 1982).  Later the premium was reduced to no more than 25% per annum.
   

At this juncture the Government faced a difficult choice. Did it enforce the law on checks written against insufficient funds? To do so would mean the jailing of a large number of Kuwaitis with all the  societal and economic stresses and strains that would cause. The answer was no. The law was suspended.

The plan was that each trader would pay 100% of his net debt. A position some attributed to the influence of the then Minister of Finance and Planning, Mr. Abdulatif Yousuf AlHamad., who was reportedly adamant about the dangers of bailouts.   

Not many traders settled their debts over the next 12 months. The arbitration panel began to take legal action against some of the defaulters. Not unlike other jurisdictions in the region, the bankruptcy process is a long and difficult one. There were rather dire societal implications to taking this action  on a widespread basis as well as the crushing burden this would place on the courts.

So in April 1983, the Government looked for a new way. The first step was the creation of the Office for the Settlement of Deferred Share Sale Transactions. The office was to design and then implement a way for the settlement of the debts. Around this time, Mr. AlHamad left his position as Minister of Finance and National Planning. The Government then adopted a plan to resolve the aftermath of the Suq al Manakh through a debt settlement program that was not predicated on 100% repayment of debts.  

The idea was that each individual involved would pay according to his ability. Determining that ability would be through the calculation of a Debt Settlement Ratio ("DSR") for each investor. The DSR was the ratio of assets (cash, real estate, shares, and amounts due an investor from post dated checks) to his liabilities (the checks he had written, loans taken from banks, etc.)

An elegant, simple concept. But practical implementation was extremely difficult.

After the operation of the small trader compensation fund about 370 traders were left whose debts had to be settled.   But there was a very important complication:  Trader A's DSR was dependent on what his counterparties could pay him. That is, what amount of the face value of the post dated check in his favor he would receive.  His counterparties' ability to pay him depended on what their counterparties could pay them. If that wasn't complicated enough, many of those counterparties' ability to pay would depend on what Trader A paid.  And that as outlined above was dependent on what he was paid.  Even with the number of investors reduced to around 370, figuring all this out posed quite a challenge.

The Government turned to the Kuwait Institute for Scientific Research and some bright academics there came up with the idea of running a linear program. (Yes, that math you may have learned in business school does occasionally prove relevant in real life).

After a crude first pass, the 370 were divided into four groups: 

1. Bankrupt with No Payables from Other Investors
2. Bankrupt with Payables from Other Investors
3. Possibly Solvent (depending on the outcome of the LP exercise), and 
4. Definitely Solvent. 

The LP was run in batches for each of these groups.

The 18 names responsible for 95% of the trading were definitely bankrupt. And were the first whose DSR was calculated. DSR's were published in the newspaper. My mentor recalls seeing an article in AlQabas (where else?) listing the 18 and their individual DSRs. It took another two years to calculate the remaining DSRs.

At the time there was speculation that not everyone had disclosed all his assets. It is not uncommon in this part of the world as elsewhere that nominees (either trusted individuals or companies or trusts) hold assets to shield the identity of the true owners. Of particular concern were assets outside the State of Kuwait.

About one year after the last batch of DSR's were calculated, the Council of Ministers approved broad settlement outlines. Debtors were divided into two groups. Those with income producing collateral and those without. Those with got up to 15 years rescheduling with 0 to 7% interest. Those without 10 years and 0% interest.

There was not a great rush to settle debts. The unsettled burden of the SAM weighed on Kuwait's economy along with other factors. After the Iraqi invasion/occupation of Kuwait ended in 1991, a new tack was chosen. To aid in the recovery of the country which had suffered from the Iraqi invasion plus the lingering effects of the SAM crisis, in 1982 the Government bought up all "difficult" debts outstanding as of 1 August 1990 (the date of the Kuwaiti invasion) against the issue of Kuwaiti Government bonds. These included the unpaid Suq Al Manakh debts.

In 1993 the Government set the repayment terms for the debt it had assumed. This was followed by several further steps to give discounts for early payment of the debt, etc.   It appears from the news item about Mr. Bu Khamseen that some of these debts may still be in the process of being paid. 

Endnote:  This account of the Suq Al Manakh is not meant to be a definitive study. It is not based on original government sources nor on the accounts of insiders.  Much of it is drawn from recollections of those who worked in the area at the time supplemented with some additional written sources.

Ring in the Old: Part 1: Suq Al Manakh - The “Boom”

Symbol of the Suq Al Manakh Building

As promised earlier, a bit of background on the Suq Al Manakh market ("SAM").

The Previous Crisis: The Kuwait Stock Exchange 1977

In 1976 the (official) Kuwait Stock Exchange ("KSE") witnessed a dramatic increase in value. The market rose 135%. Some 176 million shares were traded versus 172 million the year before and 37 million in 1974.

Stocks were traded on both a cash and post dated check basis. Cash payments were at the current stock price. If the buyer wanted to pay in the future, he gave a post dated check. That is, the check would be dated for a date in the future. In effect the seller was granting a bi-lateral loan. The check would be for cash price of the shares (spot price) plus an agreed premium – effectively the interest rate on the loan. And just as in the typical "hire purchase" scheme, the seller delivered the goods (in this case the stock) ahead of the payment.

It's important to mention that in most GCC countries writing a check without cover isn't just a matter of bad accounting. It is an offense punishable by imprisonment. If one's account does not have sufficient funds and the bank refuses to pay the check and returns it to the presenter (in bankerspeak it "dishonors" the check),  jail beckons. On the other hand, if it allows the overdraft and creates a loan, jail vanishes. Generally dishonored check cases are relatively simple matters to adjudicate. The dishonored check is presented.  On its face it is both conclusive evidence and one's admission ticket to jail.

It's very important to understand the critical role of post dated checks in causing the crisis. The fundamental difference is that post dated checks operate outside the banking system. They are purely private transactions.

Within the banking system there are checks on the creation of credit. Authorities place limits on the total amount of lending a bank can undertake based on a leverage ratio.  At that time total assets to total equity.  Often they also set a loan to deposit ratio. Total loans may not be more than  some percent (usually less than 100% - at least in prudent jurisdictions) of total deposits. They also set maximum lending limits to individual obligors expressed as a percentage of capital - usually no more than 25% and more often 10% to 15%.  They specify the types of assets that may be taken as collateral.  In addition the banks have their own credit underwriting process. While as repeatedly demonstrated in Kuwait, this process has been deficient in many respects, it was still a hurdle to be crossed by a would-be investor.

As a purely private non banking form of credit, post dated checks were not subject to Central Bank of Kuwait restrictions on their creation. No ratios, no limits, nada. In theory the amount of loans that could be created was infinite. All that was required was a pen, a stock of checks and the acceptability of one's good name.

On the KSE this led to a dramatic increase in liquidity. With easy cash, investors could make a lot of wise investments. As noted earlier the market rose 135% in 1976.

In 1977 the KSE crashed. Shares declined roughly 40%. There was a severe knock on effect in the Kuwaiti economy.

The Kuwaiti Government took several steps to address the crisis. It bailed out investors by buying their positions at the lowest price during the 2.5 month period preceding the crash (which was the absolute peak of the market). The cost was KD150 million. As well, the Government temporarily suspended the creation of new Kuwait stock companies (KSC's) and halted the trading of other GCC shares on the exchange. However, no prohibition was put on the founding of closed Kuwaiti stock companies ("KSCC's"). At the time that seemed reasonable since by law the shares in KSCCs are not allowed to be traded until three years after the date on which the company was officially founded (the "lock-up" period). The authorities also placed fairly strong restrictions on the use of postdated checks, given their role in the crash.

The Suq Al Manakh

These moves restrained trading opportunities on the official exchange. Investors wanted to invest. Punters wanted to punt. So an alternative market sprang up in the Suq Al Manakh complex (whose front door is the masthead picture on this blog). The building itself is like many of the older small "shopping" malls in the GCC. Lots of small offices and shops. The ground floor was primarily real estate brokers – another local investment passion.

Because the trading of Kuwaiti stock companies (KSCs) was restricted to the KSE, the SAM specialized in the trading of Gulf Companies (companies established in other GCC states, primarily the UAE and Bahrain) as well as KSCCs. You will note that from its inception the SAM was engaging in what were illegal activities – the trading of KSCCs prior to the end of the three year "lock-up" period.

The SAM began operations sometime during the summer of 1979. As with the original KSE, real estate brokers were the first share brokers on this "exchange".

A major flaw was that there was no official regulation or oversight of the SAM, not to say that the KSE was then or is now known for its robust oversight and regulation. This not only affected the quality of securities traded on the market but also the practices associated their promotion as well as more mechanical operational issues. There were no uniform settlement and clearing procedures. There was no centralized record keeping system. Most trading was bi-lateral and dependent on the practice of the broker used. Deals were documented in the form of IOUs, post dated checks, and various other records of uneven quality and clarity. This lack of agreed trading procedures was later to greatly complicate matters when the SAM collapsed.

Like the KSE in 1976, trading was on a cash or a post dated check basis. At the beginning, the premium on such checks, the amount over the cash price reflecting the "interest" on the loan, ranged from 40% to 60% p.a. Clearly expected increases in the price of the stock had to be more than the certain premium for this method to be used. To "protect" themselves, purchasers of shares often immediately sold the shares they acquired in the spot market and used the cash received to buy other shares which they then sold on post dated check basis. Maturities were set so that their new sales would mature prior to the maturity of their own postdated check obligation. As such, they would have the funds to settle that obligation plus a neat profit. This works flawlessly as long as the market keeps moving up and as long as their counterparties fulfill their obligations.

While post dated checks had fueled a significant growth in liquidity in 1976, now they caused liquidity to explode. Liquidity drove prices to unbelievable heights with 100% returns not uncommon. Price increases of course "proved" just how great the investments were. Trading increased. Substantial (paper) profits were declared. Trading ramped up further. Even the KSE was affected.

Little focus was given to fundamentals. Investors demanded new investment opportunities. Kuwaitis began incorporating companies in other Gulf states (primarily UAE as well as Bahrain) to satisfy the demand. At the end of the market some 40 or so of these "Gulf Companies" were traded on the SAM. New Kuwaiti Closed Share Companies were created. Many of these began as real estate companies. At least that's what their founding documents said. But seeing the great opportunity in the financial market they quickly began investing in and trading shares. (Remember this point for later). Most of these firms had no business, no assets, no income, and no profit. Many published no financials. Yet, prices continued to climb. At one point the SAM and the KSE had trading volumes in excess of the London Stock Exchange.

My favorite story is that of Gulf Medical, a non Kuwait GCC company, which IPO'ed during the height of the frenzy. Originally founded as a real estate firm, things didn't work out so well in that endeavor. So the owners rebranded the company and offered its shares on the SAM. It was 2,600 times oversubscribed. After launch, it quickly went up approximately 790%.

Now in the Gulf when you subscribe for an IPO, you are required to make a deposit for the full amount of your subscription. How does one finance such large "tickets"? Well, one's banker is one's friend – at least until the due date of the loan. Banks happily advanced funds requiring only a small cash deposit. They knew that their loan was largely secure because the investor was likely to get only a small fraction of his requested amount. If the downpayment were equal or greater than that amount, the bank had nothing to worry about. And, as everyone knew at the time (except one really smart guy at the National Bank of Kuwait), this time it really was different. So even if the investor got all the shares, he could simply sell them and liquidate the loan. If not, the bank would take the shares, sell them and repay the loan. The bank then saw a risk free loan, though it did not offer the client the risk free rate on the loan for some inexplicable reason. As attractive as the interest was, the subscription fees - generally taken on the full amount of the subscription – were even more mouth watering. (Remember that bit of the deal economics: the fees dwarf the interest on what are essentially two week loans). At the end of the subscription period, the investor got his allotment. The bank had the excess funds returned to it and settled the loan after deducting its interest. Everyone was very happy.

As you probably have guessed, investors' practice of oversubscribing led to even greater levels of oversubscriptions. It was a bankers' (and fools') paradise.

With this sort of a compelling financial story and after careful and sober analysis, many of the local banks began lending against shares. Generally to "investment" companies so they could make a wise investment in these shares. And some highly creditworthy individuals. Many of whose most bankable collateral was their excellent family name. What excellent collateral these stocks proved to be. At least initially. With each passing day their prices increased. The collateral coverage on the loans increased. Why one might even increase a loan against this collateral so that one's client could make more wise investments.

Only one bank kept its head, the National Bank of Kuwait. From what I've been told it was Abu Shukry (Ibrahim Dabdoub) who recognized the irrational exuberance all around him for what it was and kept his bank out of the party. Even though the music was playing, Abu Shukry didn't dance. Other banks were not so restrained.

Accompanying the "boom" in the market was a boom in the premia. From 40% per annum to 70% then 80%. By 1982 the premium had risen to 200% and before the end of the saga 400%.

Everything was going really well. Or so it seemed.

A footnote on numbers: Since record keeping was not one of the Suq Al Manakh's strengths, many of the statements involving numbers are no more than estimates.  I've seen articles that state with certainty that 42 Gulf Companies were traded on the SAM. Absent a central clearing system, I'm not sure how one can know with the level of certainty required to use that degree of precision.  The same with premia on what were essentially bi-lateral deals.  The premia were whatever the two parties agreed. So I've used formulations like "about", "roughly", and "approximately" to indicate that these are not hard and fast numbers.

Jawad Bu Khamseen - Follow Up to Yesterday's Post

Mr. Jawad BuKhamseen - Picture Copyright AlQabas Newspaper

AlQabas ran an article today which consists of a letter from Mr. Bu Khamseen's attorneys (the Law Firm of Abdul Hamid AlSarraf, a very well known and respected law firm) in which Attorney Ahmed Tawfiq AlRashid makes the following points:

1. There has been no bankrutpcy or insolvency legal ruling made against Jawad Bu Khamseen.
2. The Court has ordered him to pay a certain sum to settle his deferred payment share trades.  AA:  Presumably those remaining from the Suq Al Manakh.
3. The judgment is not final but is subject to appeal which is what they are doing on his behalf.
4. By publishing the article AlQabas has violated certain laws and has impugned the good name of Mr. Bu Khamseen.  AHAS law firm will be taking the necessary legal action to seek redress for these violations.

At the end of the article there is a single sentence attributed to the Editor of AlQ:  "What we published yesterday was an official letter from the Ministry of Finance to banks regarding the necessity of implementing the judgment". 

Jawad Bu Khamseen - Assets Ordered Transfered in re Suq Al Manakh

Headline edited based on subsequent information.  See post here.
 
A story highly relevant here to Suq Al Mal - given our masthead and "mascot" picture.

Today's AlQabas reports that banks in Kuwait have received formal notification from the Office for the Clearance (Settlement) of Deferred Sales Shares Transactions informing them that judgment against Mr. Bu Khamseen in favor of the Office had been issued by the Court that he was to pay KD14,707,833.208 plus legal interest of 7% p.a. from 26 December 2002 to date of payment.

The Court order is final and there is no appeal.  In the subsequent post you will see that Mr. Bu Khamseen's lawyer challenges that assertion.

Accordingly, the banks were instructed to inform the Office of any of his assets in their possession, not to release any of these to him, but rather to pay any amounts immediately to the Office's account at Burgan Bank.

Jawad is one of the major punters in Kuwait.  He was one of the four or five "Fursan Al Manakh" ("Knights of the Manakh") responsible for the majority of the postdated check issuance during the Suq Al Manakh ("SAM") scandal.

The SAM was a "curb" or parallel market to the Kuwaiti Stock Exchange.  Most of the companies traded therein were not Kuwaiti.  And many if not all were paper companies with no assets or real businesses.  Transactions were settled with post dated checks.  Investor A would buy stock from Investor B against a check to be cashed in the future.  Investor A hoped to sell the shares to Investor C and cover his original check before "maturity".

As is common in many GCC countries, writing a check without cover is an offense punishable by imprisonment.   Hence the use of the post dating.   However, there was no legal bar to a holder submitting a check prior to its date.   The market took off.   In late 1982 investors started to get nervous and  one or more post dated checks were cashed.   Punters couldn't cover them which led to more checks being presented.  The market collapsed in a tremendous implosion in 1982 (1983?).   The wreckage was much more than the current declared debt of the Emirate of Dubai.  US$98 billion.   As noted above, 4 or 5 "investors" were responsible for most of the checks. 

Many of the banks in Kuwait - save for the flinty eyed bankers at National Bank of Kuwait - were involved in financing transactions in the SAM.  Loans based on the collateral value of the SAM shares.  That is, loans made against paper profits (where the underlying companies were paper shells).  No focus on cashflow.  A familiar story.  And one that has repeated itself since the SAM.

All the Kuwaiti banks save - NBK - were bankrupt and rescued by the Kuwaiti Government who bought their duff debts after the ejection of Saddam Hussein.  Take a look at Note #8 in the 2003 Gulf Bank annual report.  Or Note #7 in the 2003 Burgan Bank annual report.  You'll see that Burgan Bank was a major player.  Banks in other countries were hammered as well.  There was a region wide stock market mania - with IPOs being massively oversubscribed. 

Overnight I'll be approaching one of my early bosses to ask for a bit more color as the SAM crisis took place on his watch.  If I get anything interesting I'll post it.

It's the least we can do for those who inspired this website.  They were of course not the first temporally, but they were the first in terms of amounts of wealth destruction in the area.  And still hold that distinction though I believe that currently there is a strong challenger.