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.

 

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?

Capital

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.

Assets

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.

Examples

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.

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. 

Norton Rose Survey on Middle East Lending

You may have seen some references to this survey in press articles.

The Middle East survey, which really seems to be focused primarily on the UAE and the GCC, is part of a larger NR global survey "Global Financial Recovery:  A Matter of Perspective".  The ME Section is pages 58 through 64.

As with all exercises of this sort, it's utility is a function of the selection of the group asked to participate and then those who actually did.

Dubai Courts: Potential Conflict of Jurisdiction Between Onshore and DIFC Court

Bradley Hope over at The National reports on the case between Taleem versus Deyaar and National Bonds.  In September the DIFC ruled that the case could be heard in its system.  Earlier National Bonds had sued Taleem in Dubai Civil Courts. 


Justice Chadwick of the DIFCC wisely did not issue an order to the DCC to stay their proceedings preferring sensibly to wait until he sees their ruling.  At that point if it is contrary to the DIFCC's then it will be time no doubt to seek the intervention of a higher power.  And hopefully this case will lead to a mechanism for co-ordination between the two courts on future such situations.

It seems this is all about a failure in precision to specify the governing law and judicial forum.  And so I'd mark this down to a lapse in one of the most routine matters of contract drafting.  As the episode of Shuaa's convertible securities, those of Citi Group, and those of  National Bank of Umm AlQaiwain show, it really does pay to pay attention.

And as with the examples cited above, the amount involved is no small beer -- AED236.6 million.  

Hard to understand this.  The parties to the examples mentioned above consider themselves sophisticated firms.  The amounts are substantial.  Yet they fall down on rookie mistakes?

Mayzoon the Magnificent

Kuwait sheep sold for KD25,000. Apparently gets KD200 per night for his "particularly good breeding ability."  Next stop Dubai?

This beats Sa'eed Al Huweiti's take on his falcon.  But not yet those tasty Kuwaiti pigeons!

International Investment Group - Explanatory Note on 2009 Financials

IIG Funding issued a brief explanatory note on IIG's 2009 financials on Nasdaq Dubai today.

Dubai Escrow Law: Exemptions Fueled Boom and Left Buyers High and Dry

 Credibility - Now You See It, Now You Don't

A very good piece of investigative reporting by Asa Fitch at The National.

In 2007 with great fanfare Dubai passed a law requiring that developers set up escrow accounts to ring fence buyers' funds so they would only be used for construction and related costs on the projects that the buyers invested in. 

Rather quietly and quickly the Dubai Land Department gutted the law by granting exemptions to certain master developers. Among this select group were Nakheel and Emaar as well as other Dubai World entities.  The latter two have recently (three years later!) disclosed this fact.  Apparently, neither they nor the DLD considered it material information an investor/buyer might be interested in knowing or have a right to know.

A couple of quotes:

The developers of multiple projects in Dubai that are stalled spent money in this way, and now homeowners find that their investments were spent but that the projects cannot continue without new funding.

But having to comply with escrow laws could be burdensome for developers such as Nakheel and Emaar because of their obligation to build expensive infrastructure in their master developments. Emaar said in its prospectus last week that if it had to comply with escrow laws, its "business model may be significantly impaired as it would only be able to finance the construction of projects with corresponding purchase price instalments once certain construction milestones are met".

Poof, there goes the last illusion of Dubai as a world class financial center.

And, no, it's not a matter of professionalism  as one "expert" has it.  It's much more basic.  It's a matter of running a fair, honest market.  When the games are rigged, one is well advised to go to another casino.  When one doesn't get a fair shake (or a fair Shaykh), it's time to look to another market.

To be very clear, the central issue here is not that an exemption was given.  It was that the granting of the exemption was not disclosed.  Neither by the Government or the companies.  There may have been what were considered at the time very good reasons to give an exemption.  The problem was that buyers had no way of knowing.  They should have.  

International Leasing and Investment Company - Attempt to Stack Board?

Al Qabas has a follow-up to their earlier report of the resignation of 3 directors at ILIC.  See earlier post on that topic here.

1. The Company has supposedly written to the MOCI requesting that it approve the replacement of Mr. Mohammed Al-Jasser with Mr. Basil Al Mutawa (a relative of Mr. Bassim Al Mutawa one of the major shareholders).  If this is approved then Abraj Holding/Boubyan Bank would not be represented on the Board despite AH's 32.3% share in the Company.  Boubyan has made a loan to Abraj and its representation on ILIC's Board was no doubt a way of looking after its interests in the collateral.
2. Also the Central Bank is said to have approved ILIC's 2008 financials which reportedly show a loss of US$120 million with the result that shareholders' equity was reduced to US$45 million.  Loans are said to remain at 2007's level:  US$600 million.  The CBK has, it is said, reservations on the financials.  And the auditors are refusing to give an opinion.
3. The two directors from the Islamic Development Bank are still tendering their resignations given their concern that the actions being taken are not in the interest of rescuing the Company.  Official bodies are reported to have rejected charges levied against the two directors as inventions and levied by parties who want to take control of the Company without involving other shareholders.
4. When the 2008 financials are released various infractions will be disclosed.  It's said that the auditors have concerns about the use to which loans were put.
5. The same parties behind the Board machinations are reported to be trying to block Mr. Faisal Al Zamil (Kuwait's representative on the IDB Board) from assuming a position in executive management  in the Company in order to enable them to put in someone who will look after their interests.
6. Finally creditors are said to be disgusted with the developments at the Company.

As I mentioned earlier, IDB and Abraj Holding, control over 60% of ILIC and should be able to take control of the Board.  If the Central Bank can finalize ILIC's financials, then the MOIC can call for a shareholders' meeting and presumably the majority of shareholders can vote in their own candidates for the Board - at least a majority.

Gulf Finance House - Back in the Game with Tunis Financial Harbour

Today on the fringes of the IMF/World Bank meetings in Washington, GFH announced the addition of a Financial Harbour to its existing project in Tunis.

This takes me back to the heady days of 2005 and 2006.

Can the US$10 billion Suq Al Mal Financial Harbour Cafe & Blog be far behind?  Get in on the ground floor, while you still can!  The Turkish coffee and baklawa concession could be easily worth twice that.  But be sure to scotch-guard those carpets.

SICO Bahrain: Dubai Debt Problems Just Deferred Until 2014?

SICO Bahrain has issued a new report, "Dubai Debt Concerns Deferred to 2014".  SICO Research is only available to registered users so you'll have to sign up to read the report in detail.

Here are some highlights.  Themes that might already be familiar and some not.

1. Forgetfulness of investors in limelight.  Some history on the trends in CDS spread differentials between Dubai and Abu Dhabi (180 bps in October 2009 to 480 bps in early December and then again to similar levels around the Greek crisis).
2. Recent US$1.25 billion issue not sufficient to plug the 2010 deficit (estimated at US$1.6 billion).  Plans to slash subsidies and other transfers by 64%, though wages to increase by nearly 20% as the Government needs to make room for more nationals entering the workforce.
3. Repayment schedule remains a challenge.  SICO estimates very modest debt repayments in 2011 and 2012.  For the period 2013 - 2015 excluding bilateral, the estimates are US$1.7 billion in 2013,   US$19.23 billion in 2014 and US$0.5 billion in 2015.   So a definite debt hump in 2014 - and the reason for the title to SICO's article.
4. Economic recovery may not improve Government revenues.  Trade and tourism not expected to generate significant large government revenues.
5. Not many options to improve finances.  Taxes a possibility but pose competitive disadvantage vis-a-vis other GCC states.
6. Sale of assets a possibility.  SICO believes the Government may take the strategy of selling partial stakes to raise cash rather than relinquish control of strategic assets.
7. Dubai increasingly "leveraging" the UAE brand.  Apparently in the prospectus for the recent bond, a great deal was made of the fact that the UAE has a AA sovereign rating.  SICO sees this as a way of diverting attention from Dubai's 395 bps CDS roughly 296 bps higher than Abu Dhabi.  In my opinion it may also be a way of reminding investors of Abu Dhabi's deep pockets.
8. Despite the negatives, SICO does not believe a sovereign default is likely.  It seems to me that the major issue here is one of pricing of credit as well as lenders and investors being careful about the quantum they commit to the Emirate.

Boubyan Bank to Liquidate Shares Owned by Awal Bank to Partially (Very Partially) Collect Debt

Mohamed Sha'ban at Al Qabas reports that having received judicial authority, Boubyan will sell some 300,000 shares in International Finance Company on the KSE to partially settle a debt of SAR 111 million owed by Awal to it.  Furthermore it will sell some 61,000 Global GDRs listed on the LSE through the manager of the fund holding the  shares.

Since AlDawliah is trading at around KD0.250 per share the recovery is half of that pictured above.  A penny on a dollar of debt.

US Elections: Nur Ein Wenig Harmloser Spass (Just A Little Harmless Fun)

Spot the Republican candidate for the Reichstag, sorry, Congress from the 9th District in Ohio.  Rich Iott.

He's not on the far right but second from the right which I guess might make him a moderate of sorts when you consider the wider context.

He explained that he participated as a history buff and as a way for a father to bond with his son.  If I remember correctly, there is an old saying "The family that goose steps together"  though I forget the rest of it.  I suppose that's the important bit, though, isn't it?

While I'm probably confusing a historical event, I believe the candidate was also heard to say:

1. Ich erkenne mich nicht schuldig.
2. Befehl ist befehl. 
3. Die Fahne hoch!

In any case, those familiar with this repulsive ideology  know the central importance of the Viking in the "Aryan" myth along with the Celtic Cross and Runic symbols.  That's why of course the SS Unit adopted the name  in the first place.  And why other later adherents of the ideology did.  The Wiking-Jugend.  Several "Aryan" rock bands  with variants of Wiking in their names. 

Just a little harmless fun, so they tell us.

Department of the Tragically Absurd: A New Structure for Arab Joint Action on the Table

It's Got to Hurt When Only a Few Recognize Your Completely Imaginary Genius

As Emirates 24/7 informs us:

Chairing the opening session, the Libyan President Colonel Muammar Al Gaddafi welcomed the Arab leaders and said that the summit would discuss a new structure for Arab joint action.

He added that a five-member committee under his chairmanship was formed during the last summit in Sirte to oversee implementation of the new structure.

Another decisive step forward.  A new structure.  Proven visionary leadership.  What could possibly go wrong?  (For one thing see picture above).  

Who could possibly object?

Amr Moussa voiced some skepticism and warned that steps should not be taken which would undermine the highly effective Arab League.

But as the report tells us several critical breakthroughs were made at the meeting:

HH Sheikh Mohammed Al Maktoum had several very important visits.

1. He visited Egyptian President Mohamed Husni Mubarak on Sunday for a session filled with Hope.
2. He met with Syrian President Bashar Al Asad also on Sunday.  While we're not told,, I believe this session was about Change. (Quite a busy day, it seems).
3. On Saturday the Bahraini Deputy Prime Minister and his entourage visited HH  and his entourage and conveyed the greetings of King Hamad of Bahrain!  That was, if I'm not mistaken. one of the major achievements of the conference.
4. Though there were no doubt many more,  perhaps more than could be recorded.  One of note,  that was, was a visit to a heritage market.

This event certainly lived up to its billing as the  extraordinary Arab summit.

Despite the many imaginary achievements of this remarkable event, I am left with one nagging doubt.  What sort of people make a habit of indulging a psychotic in his delusions?

Golden Belt Sukuk 1 Certificateholders Make Up Their Minds

Today via an announcement on the Bahrain Stock  Exchange Citibank, the Delegate on the Golden Belt Sukuk, advsied:

The Delegate refers to previous notices issued by the Delegate dated 24 August 2009, 7  October 2009, 17 November 2009, 23 November 2009, 2 February 2010, 16 March 2010, 28 April 2010 and 22 July 2010.

In these notices, the Delegate noted that, in accordance with the Terms and Conditions of the Certificates, prior to acting upon any instructions from Certificateholders it is entitled to be  indemnified to its satisfaction.

The Delegate confirms that on 27 September 2010, it entered into a deed of indemnity (the  Deed of Indemnity) with a number of Certificateholders (the Indemnifying  Certificateholders). The Indemnifying Certificateholders represent at least 25 per cent in  aggregate face amount of the Certificates outstanding.

Acting under instructions from the Indemnifying Certificateholders, the Delegate has served a  Notice of termination of the Sub-Lease and made a demand for all amounts due under the  under the Costs Undertaking.

The Investment Dar - Creditors Warn TID Central Bank Will Not Impose Restructuring Against Our Will

Nancy Reagan

White House Photo in the Public Domain

Al Qabas, as it often does, has a different take on the story about TID proposing a 50% haircut than Al Watan.

Here the story is that the creditors have said that if Dar's request for a 50% haircut proves true, then this will give the Central Bank of Kuwait full justification for turning down its application for the FSL.  (You may as I have been struck by this formulation.  Either a deficient translation on my part.  Or maybe the story of the 50% haircut was wrong).

They also remarked that the Central Bank will never force a restructuring on them without their consent as they are the owners of the money and should decide their fate.  So a consensual plan agreed by all parties will be required.

Finally they are quoted as saying that there is an indication that the entity charged with preparing the report on Dar's ability to remain a going concern and pay its debts shares Dar's opinion that it can comply with the financial ratio set in the new Central Bank of Kuwait regulations if it can deal with approximately KD500 million of burden which will strengthen shareholders' equity in addition to bringing it in compliance with the new principles.   I'm taking Al Qabas description of the "entity" to mean E&Y.  And am not sure why the circumlocution is necessary.

As I've indicated before, I really don't understand the fixation on the new CBK principles.  Dar is in a life or death situation with the rescheduling.  It seems eminently reasonable that if it can't meet the new regulations that should be a very minor consideration in the greater scheme of creditor repayment and the continued existence of the Company.  There are many ways this can be "handled" to preserve the regulation but give Dar some breathing room.  Would one really "put down" Dar because it couldn't meet a ratio if it could repay a substantial portion or all of its debt?

All this talk of the regulations makes about as much sense to me as arguing about the  poor  quality  of the band as it plays the final songs just before the Titanic sinks.

Maybe one of my regular readers can tell me precisely what I'm missing. 

It's also unclear if this story came before or after this one.

Ah, Kuwait land of mystery and intrigue.  And also family values.

The Investment Dar - No Intent to Ask for 50% Haircut

Barbershop in the Bus Station Tirth Raj, Rajasthan
Copyright funky footage

Creative Commons Attribution 2.0 Generic

Al Watan quotes sources close to The Investment Dar as saying that the Company has no intent to ask for a 50% haircut (KD 500 million) on its existing debts .  That it intends to repay its debts in full.  Moreover it would never sue the Central Bank of Kuwait  which it respects and values.  I guess the meaning here is won't sue again as they did earlier.

You'll recall earlier that there were reports that TID had made just such a request bypassing its creditors and writing directly to the Central Bank of Kuwait.

"Islamic" Property Financing in Syria "This Time It's Different. Really, It Is."

Rasha AlAss over at The National has an interesting article on how the pricing on "Islamic" banks' real estate financing in Syria and Lebanon is much higher than at conventional banks.  While she doesn't give a reason, I'm guessing that it's their much higher cost of funds and not any desire to earn an outsize profit.  The latter of course would run afoul of prescriptions to deal fairly.  Wouldn't it?

A couple of quotes from "wise" local bankers:

Some bankers are pleased with this, pricing their products on the speculative idea that property prices will continue to rise. Explaining why the traditional mortgage rates are so high, one banker says: "Well, real estate in Syria keeps going up. So even with a high interest rate, the appreciation will still be higher." Mr Darkazally echoes this sentiment. "Real estate prices in Syria will never go down," he says.

So does this constitute aggressive lending? And could the speculative behaviour by customers and bankers on a property boom that has not yet gone bust lead down the same road that brought the world to its knees in the recent credit crunch? "Not in our day," says Mr Darkazally .

Normal financial laws apparently don't apply in Syria.  This time it really is different.

Oh, and if you want a real surprise on your "Islamic" real estate loan, buried there in the fine print is a "prepayment penalty" or perhaps something called a profit rate protection clause. 

Department of Sycophancy: "Sheikh Mansour Emerges as the Arabian Warrent Buffet"

الشيج واران بوفيت منصور

So we're told by Arabian Business.

When I think of Warren Buffet I think of many things:

1. A determination to succeed and lots of hard work.  Warren began his career delivering newspapers from his bicycle (which he duly depreciated on his tax return!).
2. A ferocious pursuit of deals, many originating from "cold calls" on firms.
3. A generally single-minded focus on a particular investment philosophy (value investing as taught by Benjamin Graham).  
4. A cool rational head not swayed by whatever was the then current irrational exuberance.
5. A painstaking building of a fortune.  Earning money, saving, reinvesting, making a profit, and repeating the cycle
6. Many highly profitable and visible deals.
7. Despite all of this, little affect on his ego or lifestyle.  He lives in the same rather modest house in Omaha that he bought long ago.

Arabian Business is silent on all but the sixth point so we can only imagine how the other six apply to the Sheikh.

What we do learn from the article apropos of the sixth point is that:

1. He owns Manchester City Football Club.  How this came about and how it was funded are presumably too well known to require recounting, which is perhaps sad because we are left not knowing how he displayed his legendary skill in closing this transaction.  Did he begin with a paper route for The National or perhaps more likely Akhbar Al Arab?  Save his first earnings and by repeating the cycle amassed the GBP 300 million to buy the Club?
2. "He" made an investment in Barclays in the dark days of 2008 and has now made US$3 billion on an "exit".   One that we learn that leaves "the sheikh exposed to any upside in the share price and completely protects him from any downside."  

The latter deal sounds almost miraculous.  He exited Barclays yet retains upside in the shares.

So how can we understand Arabian Business's statement: he "completed his exit from this cool investment"?    Frank Kane has an account here.  As the words suggest, risk has been hedged but not eliminated.

First, PCP3, not the Sheikh,  will continue to own the shares.  PCP 3 has entered into a derivatives transaction with Nomura.  In effect risk on Nomura has been substituted for Barclays.

And as always with derivative transactions the devil is in the details.  What are the conditions for exercise?  Any restrictions or limits on the number of shares to be "put" at any one time?  What is the strike price (or its equivalent) on the transaction?  Current market price?  Something lower?  Is there a time limit at which point the (derivative) contract expires and Nomura is no longer obligated?   Will PCP3 need to roll the derivative forward to maintain its protection at that future date at a price to be determined?    And perhaps very importantly what did the derivative cost?  Are there future costs associated with it?   One presumes Nomura priced for the risk they're taking considering both price and time.  So this isn't a costless transaction.  But then PCP3 gets to keep the upside.

Still a remarkable return.  One worthy of much praise.  Especially when one considers such debacles  as one SWF's investment in Citibank convertible securities.

But before Arabian Business rushes to describe the Sheikh as the Arabian Warren Buffet, it may be appropriate to wait for the development of a consistent track record.  

Not so long ago, Maha AlGhunaim, Esam Janahi and others were lauded for their investment prowess.  And like many a legend, time has not been kind to these.

Special Dubai World Court Orders Nakheel to Pay CDG's Legal Costs

According to Tom Arnold over at The National, Sir Anthony Evans, The Chairman of the Special Tribunal, ordered Nakheel to pay CDG's legal costs.

At this point the Court has not rendered a judgment on CDG's claim.

Dubai's Real Estate Woes Continue

A Not So "Unique" 50 Story Dream from 1997 

 

One of our regular readers/commentators, Laocowboy2, called this New York Times  article on the continuing woes in Dubai's real estate market to my attention.

Some quotes with captions.

"We're not in Kansas anymore, Toto"  The biggest mistake - mistaking a foreign country for your own - and assuming that legal systems, services, construction quality are just like "back home".

“It’s not like in Western countries. It’s very difficult to exit here if there’s a problem. And we’ll never get our money back, but now we’re stuck dealing with this hole.”

AA's Second Law of Lending and Investing: "Due Diligence Before the Deal Not After"

"At the time, few asked if there was a legal framework for resolving potential disputes. Now, with the glitter gone, interviews with investors, legal specialists and real estate analysts here show that many who bought in are finding it hard to get out."

“The rules of the game are definitely opaque here,” said an investor who has bought several properties in Dubai and who insisted on anonymity because of delicate talks with developers and regulators. “In the United States, I would know my legal position much more clearly and could take actions if necessary.“ 

Besides "location, location, location" supply and demand also impacts prices.

Although about 70 percent of empty lots from three years ago have been filled, real estate construction since then has far exceeded the purchases, more than doubling the amount of vacant space available, said Timothy Trask, the director of corporate ratings at Standard & Poor’s in Dubai.

No mention of quality of materials and construction.  Perhaps, that will become  more widely apparent in a few years time, though there's always the odd Discovery Gardens or Sky Gardens or The Villa to help discover flaws.

The Investment Dar - Rumor of Restructuring Bombshell: Request for 50% Hiarcut

Major Al-Musallam Rides to Glory

Before we go further to be very clear this is an account which neither the Company, the Central Bank or the creditors have confirmed.
Update:  TID has denied this story.

Al Qabas reports that TID has submitted a completely new restructuring plan to the Central Bank of Kuwait which calls for lenders to forgive 50% of the existing debt, i.e. KD500 million.   According to the report, lenders were not consulted or advised prior to TID sending the proposal to the CBK.

What's going on here is anyone's guess.

Mine is that the Company and the lenders are jockeying from (what I think is) the fallout from the Ernst and Young report.  As you'll see below. TID and its lenders appear to have been discussing alternatives /modifications to the original plan. From the Al Qabas account these seem predicated on the fact that the Company cannot repay all the debt.  The unpayable quantum seems around a 50% or so.

I suspect that Ernst and Young came back with a very negative assessment of  TID's ability to repay in full and, thus, case serious doubt on the Company's ability to continue as a going concern.  As you're aware, the Financial Stability Law is designed to give protection to viable companies.  It is not intended as a mechanism to provide legal cover for disguised liquidations.  If I'm right (and as Umm Arqala will tell you that's a rare occurrence), a report like this would have thrown quite a large "wrench" into things, complicating the CBK's acceptance of the already agreed restructuring.  How could the Central Bank recommend to the Court that the Company be allowed under the FSL under such circumstances?

I'm also guessing this occurred prior to the end of the first four month period the CBK had for evaluation of the suitability of the original plan and of TID to enter finally under the FSL.

What leads credence to both assumptions are reports in the article that the lenders have floated some  proposals or modifications of their own and the timing of those negotiations.  One was the conversion of  roughly half the debt to equity with some preservation of the rights of the existing shareholders.  Presumably, the lenders could quite easily make the argument that if a debt conversion were required, the old equity has been lost .  And thus the old equity holders should be wiped out.  Their proposal is reported as more generous, though it's not clear what percentage they would allow the old shareholders in the post conversion equity.  Leaving 10% or 20% might for example be considered highly generous by the lenders and an "outrage" by the existing shareholders.  Negotiations on this proposal supposedly took place between July and September.  The story goes that TID's Board went back on a tentative agreement because some of the existing major shareholders did not want their equity interests diluted.  (Unclear to me how you dilute something worth nothing.  There's also a hint here that the major shareholders are very important people.   And, if you know Al Q's politics, you might suspect they are pointing the finger at regal personages).

As a second alternative, the lenders suggested taking some assets in exchange for the debt.  The article says  that E&Y determined that this proposal was acceptable under international principles.  Dar supposedly made a counter offer that brought things back to zero. 

At this point, the two sides are in a deadlock.  I think that TID's proposal (assuming the report is accurate) is more a negotiating tactic than a viable proposal.  Rather it is an attempt to break the logjam by setting forth a maximum position.  One they probably know both the lenders and the Central Bank would have a hard time accepting.  What this proposal does, though,  is shift the parameters of the debate.  While lenders may reject a 50% discount, it may be harder to avoid some meaningful haircut - particularly, if the choice is bankruptcy.  And in order to get itself out of having to make a decision that may prove wrong or hurt its and the country's reputation, the CBK may be inclined to lean on the parties to compromise.  TID has just set one bound on the compromise.

It could be that they are trying to play for time - hoping for a miracle.  Realistically playing for time  hurts all parties - TID, the lenders, Islamic Banking, and Kuwait.  But maybe that's the goal - to maintain the status quo.

The article describes the choices in front of the Central Bank as:

1. Issue a conditional acceptance of the proposal subject to conformity with accounting principles and the agreement of the lenders.  (Or in other words neatly pass the buck.  Or is that the dinar? As Al Q elegantly puts it, getting the lenders to agree may be very difficult given the Company's breach/violation of the existing agreement.  That raises AA's first law of underwriting and due diligence "know your customer".)
2. Reject the proposal.  In which case it's expected that TID will sue the CBK in an attempt to confuse the issue and buy more time.  As Al Qabas elegantly puts it الى ما لا نهاية . (Probably not a first choice. More likely is forcing the Company and its creditors back to the negotiating table.  Or putting them in a situation where they will decide the fate of TID, if that fate is to be bankruptcy).
3. Push the lenders to bankrupt the Company - which will lead to all sorts of negatives for all parties and harm the financial sector, Islamic Banking and the reputation of Kuwait. (I'm guessing not an alternative high on the CBK's list).
4. Convert TID to a holding company.  This would remove it from Central Bank supervision so that the lenders can apply the restructuring deal agreed.  Also the CBK's June ratios would not apply.  (This seems to me to be a bit of red herring.  The CBK can grant an exemption to TID as a finance company from the regulations.  Supposedly the lenders will reject this because they don't think the administration of the company is really interested in solving the problem.  The lenders have on more than one occasion made it quite clear what they think about management's ethics.  They began by asking the CBK to place a minder in the Company.  Then they pushed for the appointment of a Chief Restructuring Officer).
5. Force TID back to the negotiating table with the lenders to find a solution and return to the original plan.  (This seems contradictory.  The original plan is probably moot at this point.  I think the lenders are going to have to accept some changes - and these will be against their interests.  From the report of the alternatives they've offered already it seems pretty clear that they've accepted this - even if it was no doubt reluctantly.  The CBK may well force the parties back to the negotiating table but there will be a new deal.  Perhaps the CBK could impose a time limit for reaching an agreement using as the deadline some date prior to the date it's required to give a recommendation to the FSL Court).
6. Give TID an exemption from the new ratios saying the old plan was devised based on Central Bank advice to the lenders and thus it's not fair to change the rules on them.  As per the article, TID has apparently been saying that the original restructuring plan doesn't conform with the CBK's  "new rules".  The implication being the plan must be modified.   (I don't think that the CBK new rules are the real issue here.  The sticking point is TID's ability to pay and to continue as a going concern.  If the new rules were the only point, then I think the CBK would have given the exemption.  This could be quite easily fudged as an agreed plan to implement the new rules. And so it could be presented not so much as an exemption but a granting of additional time to achieve the goal.  When the debt is paid in full, TID will clearly be in compliance).
7. Exit TID from the FSL and leave it to its fate.  (The CBK probably doesn't want to be the one who puts down this dog.  Better to have the lenders do so.  The "trick" is to find a way to put the parties in a situation where they either come up with a solution or fail - a way which keeps the CBK's hands pristine.  The time limit for the CBK to give its recommendation to the FSL Court is a neat escape hatch.  If the parties haven't agreed by then, the CBK can tell the Court it cannot make a recommendation.  The Court should then refuse to allow TID final entry into the FSL.  Since this is the last extension allowed, the matter is out of the CBK's hands.  Nature and the courts then take their course.  That should be quite a frightening thought for the lenders .  As they stare into the abyss  of almost a complete loss, all sorts of discounts and compromises may become possible).

Finally to close out this post, a recap from the Creditors' Committee official letter to the Central Bank rejecting TID's new plan "in whole and in detail":

1. TID's proposal makes a gift of the money of others (the lenders) to the Company and strengthens (supports) the rights of equity at the expense of the lenders who have not received a single fils since the beginning of the crisis but only promises.  (But they were some really nice promises. Perhaps, even said with one's hand on the Qur'an).
2. TID's proposal is contrary to international and global practices (customary usage) and puts the lenders in the situation of a fait accompli with the proposal being put forward without their agreement or consultation.
3. TID's management is "hitting" (harming) the interests of the creditors and shareholders.  Therefore the lenders reject the idea of a discount which is unjust.
4. The Committee considers that TID's proposal ignores the repayment schedule already agreed.  10% in Year 1, 20% Year 2, 20% Year 3, 30% Year 4 and 20% Year 5.  (There seems to be an argument of a breach of faith here.  And, yes, while the lenders may be thinking of a breach of the agreed business contract for the rescheduling, AA also is thinking that in this context the term applies as well to  religion).
5. TID's proposal prefers (in the sense of giving priority) the shareholders over the lenders contrary to what was agreed previously.
6. The Company has wasted the shareholders' money hiring financial and legal advisors and wasted the banks time negotiating the past 18 months.  

This has been a bad situation from Day #1.  The passage of time has not made things better.  It's likely to get worse.

The lenders face a real dilemma.  Do they compromise to try and get back as much as they can?  Or at some point do they just bring down the house of cards?  With 18 months of time on their hands, lenders may have built rather hefty provisions against this name.  That may give them a bit more negotiating room.

The Central Bank is in the most uncomfortable of positions.  It's got to be hoping that third parties or events are dispositive and that it doesn't have to make a difficult decision.