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.
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