Category Archives: Banks

chit funds, crowdfunding and p2p banking (II)

April 19, 2012 By in Accounting, Asian economic development, Banks, chit funds, chit funds, Current Market Thoughts, emerging markets, Industry Analysis, P2P lending Tags: , , , , , , , , , , 1 Comment

two lessons from history

Thailand

I was just getting acquainted with Thailand when the Ms. Chamoy Thipyaso chit fund scandal broke.  “Mae” (=Mother) Chamoy, the wife of a Thai Air Force officer, appeared to be running a very large chit fund investment operation that was stringing together a sequence of startlingly high investment returns.  She had agents throughout Thailand collecting new money for her.  Money was pouring in.

The fund turned out to be a gigantic Ponzi scheme, however.

The scheme sustained itself for an unusually long time.  It continued to operate even after it had become so large (US$100 million+) it was implausible to think Mae could find enough lucrative “secret” microfinancing opportunities in Thailand.  Several reasons for this:

–people wanted to believe.

–the fund appeared to have the backing of the military, the ultimate source of political and business leadership in Thailand.  This gave an implied assurance that the investment results were real.  Prominent high-ranking Air Force officers invested with Mae, and forcefully urged their subordinates to do so as well.

–investors who thought about withdrawing some of their “profits” were pressured not to do so, with the threat that if they took money out they would be blacklisted and not allowed to invest in the fund thereafter.

Interestingly, large investors in the Chamoy fund continued to urge their friends and work subordinates to plow money into the fund even after they realized it was a Ponzi scheme.  Their rationale?   …it bought them more time.  That extra time allowed them to continue to enjoy a lifestyle they knew was going to end when the fraud was discovered.  And it allowed them to arrange their financial affairs in a way that would minimize the negative impact on them personally.  To followers of the Bernie Madoff case in the US, this must certainly sound familiar.

my thoughts

In my reading about microfinance, it seems that Ponzi schemes have been a constant problem wherever third-party chit funds–not the ones where friends and neighbors lend to one another–operate.  That means virtually everyplace in South Asia and Africa.  There seems to be an especially large amount of study done of the industry in India, which I have no practical experience with (because the stock market isn’t easily open to foreigners–and I think the political environment is particularly unfriendly toward equity investors.)

Personally, I’d worry more about Ponzi schemes in the US springing up among the firms that the JOBS Act will allow to raise equity.  These are the entities that won’t have adequate financial controls or accounting statements for shareholders.

My chief p2p banking concern is a more prosaic one–that the present very low loan loss rates will prove to be more a function of the industry’s newness rather than of the creditworthiness of borrowers.  Time will tell.  And, unlike fraud, this is a risk we can take precautions for.

Taiwan

There was a unique twist to the Taiwanese chit fund industry that I encountered in the mid-1980s.   Chit fund loans were secured by post-dated checks issued to the borrowers by the lenders.  In Taiwan at that time, “bouncing” a check–having insufficient funds in the account to cover payment–was a felony, punishable by the check writer serving time in prison.

The threat of jail time was thought to be sufficient incentive to ensure repayment.  So no one worried too much about the creditworthiness of the borrowers, which–as it turned out–included large publicly-traded companies.  American accountants I met, who’d been sent to Taiwan to break into the auditing business there, told me that they could see the fact of unaccounted-for money sloshing around in potential client companies.  They just couldn’t see how much.  Because of this, they were reluctant to take any engagements.  And they were continually undercut by local accounting firms who charged virtually nothing for “audits.”   American bank lending officers told me the same thing.

The chit fund business received a major shock, during a mild economic downturn, some large companies had made hundreds of millions of dollars in chit fund loans–all unrecorded in the financial accounts–that they couldn’t repay.  Bankruptcies resulted.

my thoughts

This is another potential problem for equity holders in firms crowdfunded under the JOBS Act.  Without audited financials, it’s impossible for an outside investor to determine what the capital structure of a company is.

I also think, à la Taiwan, a legitimate auditor will simply walk away from a suspect company rather than make a public outcry.  Non-disclosure agreements may force it to do no more.  A less fastidious auditor, one nobody ever heard of, might take the business and issue a clean opinion.  After all, Bernie Madoff got one for years, didn’t he?

chit funds, crowdfunding and p2p banking (I)

April 18, 2012 By in Banks, Current Market Thoughts, emerging markets, Industry Analysis, P2P lending Tags: , , , , , , , , Leave a comment

chit funds in emerging markets

I began to look at smaller Asian markets as an investor in 1985.  It was there that I encountered the informal self-help savings and lending associations that are typical in developing economies.  My introduction came through chit funds in Thailand and Taiwan, but these structures exist throughout the developing world.

what they are

the simplest

In their simplest form, the associations are groups of friends of neighbors who contribute a specified amount of money to a pool on a regular basis.  The funds pooled each time the group meet are lent to a single participant, determined either by the implied interest rate bid or on a rotating basis.

more complex

At a higher level of organization, groups come to a designated place at a specific time–like by having a meal at a certain restaurant on Saturday–and offer to third parties the money they’re willing to lend.  They may signal their intent simply by piling their money in the center of their table.  Prospective borrowers move from table to table to negotiate loan terms.

the pinnacle

For the largest such chit funds, agents for the fund do the collection and forward the money to the fund’s central headquarters.  Lenders don’t have any direct contact with the borrowers.

why chit funds?

There are a number of motivations, normally all based on the idea that the formal banking system doesn’t function well. For instance:

1.  There may not be any local banks.

2.  Banks may offer very low interest rates to depositors.

3.  Banks may decide to lend only to large companies.

4.  Potential depositors may worry about bank solvency–the possibility that they’ll lose their money in a bankruptcy or nationalization.

5.  People may not want to reveal the extent of their wealth, or the extent of their taxable income.

the US equivalent

Interestingly enough, this emerging world form of microfinancing is beginning to make a strong showing in the US.  It’s taking two forms:

–Congress recently passed the JOBS (Jumpstart Our Business) Act.  JOBS greatly simplifies the procedures for a small company to make an offering of equity.  For companies with less that $1 billion in annual sales, JOBS does away with the requirement that they present audited financials to potential investors (not a stellar idea, in my opinion).  JOBS also defines the maximum amount that low-income investors can put into a given offering.  By so doing, it legitimizes the efforts at equity crowdfunding (see my post) now underway in the US.

–John Mack, former head of Morgan Stanley, recently joined the Lending Club, a P2P (peer to peer) lender.  P2P lending is chit funds come back to life, but on the internet instead of in your local restaurant.  You can go to the websites of P2P firms like Prosper and Lending Club and select the borrowers you wish to lend to by yourself.  Or you can hire a financial advisor to do this for you.

why now?

To start with the obvious, the technology needed to run P2P or equity crowdfunding is readily available.

Interest rates have been low for a long enough period of time–with little relief in sight–that more conventional means for savers to obtain high returns have been exhausted.  Not only that, but getting a return above 2% in Treasury bonds requires committing money for a very long time, exposing the lender to the risk of loss as/when rates eventually begin to rise.

I see the JOBS ACT as an attack (maybe as the first step in a prolonged attack) by Washington on the current IPO practices of Wall Street investment banks.  Conventional IPO costs in the US are very high by world standards, and a private individual stands about the same chance of getting an IPO allocation as a snowball in northern hemisphere July.

The naming of the JOBS Act suggests that Washington wants to be seen as doing something to create jobs.  What a commentary if this is the best they can do.

My first reaction to P2P is that it may be a true innovation, like money market funds and junk bonds were in their day.  P2P could end up being a very big business–unlike JOBS, which I see, in its present form, as gimmicky and filled with opportunities for fraud.

That’s it for today.  Tomorrow:  historic problems with P2P lending, including a word on Bernie Madoff.

collective action clauses: Greece’s deus ex machina

March 8, 2012 By in Banks, Derivative instruments, Industry Analysis, Trading Tags: , , , , , , , , , 1 Comment

Greek sovereign debt restructuring under way

Greece is in the final stages of restructuring €270 billion in government debt.  Its deadline for holders to “voluntarily” exchange their bonds for new debt that’s worth only a little more, on a present value basis, than a quarter of what creditors were originally promised, is today at 8pm London time.

For the past few months, EU governments have been engaged in high stakes behind the scenes duel with their major commercial banks, which hold a majority of the Greek securities, over whether the financial institutions would agree to the Greek offer.  During the past couple of days, the banks have all been falling in line and saying they’ll take the Greek deal.  I don’t think the banks ever seriously considered doing anything else.  The discussion has all been, I think, about what quid pro quo they would receive in return.

That leaves private holders  …who don’t stay up at nights worrying that the bank examiners will be unusually thorough this year or that their applications to open new branches might be denied.  So both the threat of future bureaucratic ill will and the call to make a patriotic sacrifice of their (own and their clients’) capital fall on deaf ears. That’s where collective action clauses come in.

collective action clauses

A collective action clause is a stipulation in a bond indenture saying that if holders of a certain majority percentage of the issue agree to a given proposal by the issuer, then the rest can be forced to go along with the decision of the majority.

About one outstanding Greek government bond in seven was issued under English law and have had collective action clauses in the indentures from the outset.

The rest were issued under Greek law.  Being subject only to local law isn’t the norm for emerging markets debt, but I guess buyers weren’t concerned because Greece is part of the Eurozone.  Until a few days ago, those bonds had no collective action clauses.  Then the Greek parliament passed a new law to retroactively include them in its government bond indentures.

Not only that, but the lawmakers conveniently set a low threshold of around 60% acceptance (usually, it’s 75%) as the point at which the clauses can be invoked.  EU banks who have been arm-twisted into agreeing to the restructuring will doubtless lift Greece past that mark.  So, like it or not, private holders will be forced to accept the huge haircut Greece is proposing.  The maneuver is all perfectly legal.  The move isn’t a surprise to the bond market, no matter what you hear in the news.  It has been anticipated by bond pundits for at least a couple of years.

the English-law bonds

The case of the English-law bonds is more interesting.  From what I’ve read, their collective action clauses are set at 75% acceptance.  Early betting is that Greece won’t come close to that amount.

But Greece has already announced that if holders don’t tender in lat least large enough amounts to allow it to exercise the collective action clauses, it simply won’t pay anything.  The holders can see Greece in court.  Tomorrow we’ll see how much of this is bluff–and how successful the tactic has been.

rating agencies have already declared a Greek default

Major credit rating agencies have already declared that Greece has defaulted on its bonds.  So far, the body that decides whether credit default swaps (effectively, insurance policies against default) must be paid off is saying that no default has yet occurred.  That’s because the language of the swap agreements that describes what a default is contains an accidental loophole.  The government-inspired “voluntary” restructuring doesn’t qualify, even though holders are losing almost three-quarters of their money.   If Greece invokes collective action clauses and forces bondholders to take the new securities, however, that may change.

not many Greek CDSs?

Reports I’ve read say that Greek CDSs amount to a relatively small €3+ billion.  If that figure is correct, it’s hard to see why the EU has put so much effort into arranging a “voluntary” restructuring that avoids triggering them.  Maybe bank issuance of CDSs on Spanish and Italian debt is immense and contagion is the worry  …or the official figures may substantially understate bank exposure.

This time tomorrow we’ ll have more answers.

there may be a real life for contingent convertibles, after all

February 14, 2012 By in Banks, hybrid bonds/contingent convertibles, Industry Analysis Tags: , , , , , , , Leave a comment

why I don’t like co-cos…or, (more) evidence investment bankers are on the dark side

Investing is conceptually very simple but emotionally very difficult.

Under most conditions, professionals can resist the Dr. Frankenstein-like impulses of investment banks to create bizarre security hybrids.  Not at the top of the market, though.  There’s something in the air that makes portfolio managers throw away their pocket protectors and revel in the purchase of the trashiest securities.

PMs will rue these buys for the rest of their careers–which may, incidentally, be quite short periods of time if they don’t recover their senses and sell the stuff on while a market for them still exists.

One of my favorites in this genre was a convertible bond issued in 1993 by Hong Kong-based New World Development, an indifferently managed family-owned property conglomerate.  It carried no coupon and was convertible on undisclosed terms into shares of a mainland Chinese company that did not yet exist.

And you ask me why I’m not a fan of investment bankers.

As it turned out, the issue met with high demand despite its dubious character–a sure sign that the markets were in the grip of speculative fever.  Right afterward, I was chatting about it with a highly skilled colleague, who confessed she had actually taken part in the deal.  Her reasoning?  In her peer universe there might be a half-dozen offerings during the year that would make or break performance versus competitors.  She felt she couldn’t take the chance that the deal would not only be successful but would trade up strongly in the aftermarket.  She didn’t want to be left in the unusual (for her) position of eating competitors’ dust.

co-cos, the brokers’ latest creation

Contingent convertibles are more recent spawn of the investment banking tendency to birth nightmarish creatures.

The idea is that the vehicles, known as “co-cos,” would be issued by financial companies, especially banks, that are required to maintain minimum levels of equity capital.  They start out as bonds.  But if the issuer’s financial condition deteriorates beyond a certain level, they automatically convert into equity.  Therefore, investment banking proponents argued, they should be considered as equity by the regulators even before conversion.  (True to form, when the original idea was floated, the intention was to not specify in the offering documents what circumstances would trigger conversion.)

not a winner…

Co-cos have never taken off.

The obvious flaw, other than that no one would know what would prompt conversion, is that the buyers would be bond portfolios.  They’d be reeled in with the promise of higher-than-average coupons.

If the issuer’s capital ratios deteriorated, its stock would sag significantly.  If conversion of the co-cos followed, that would leave large amounts of stock in the hands of PMs whose client agreements don’t allow them to hold equities.  So they’d have to dump the securities right away into a depressed market, sending the issuer’s stock lower and making its problems worse.  In fact, anticipation of conversion might launch the stock of the issuer into a severe downward spiral.

Also, the Bank of International Settlements said the idea wouldn’t fly.  Finally, the co-co idea also came too close to the disastrous demise of their close cousins, hybrid bonds.

…until now

It now looks like co-cos may actually have a use, according to the Wall Street Journal.  The buyers won’t be private investors, however.  They’ll be the governments of Spain and Portugal, which will use the vehicles to inject money into ailing banks.

Why use co-cos? Three reasons:

–the injections of money will look like investments, not the bailouts they really are,

–Spain and Portugal will get securities in return for the money they pour in, so their government deficits won’t increase, at least on paper, and

–Madrid and Lisboa won’t appear to be partially nationalizing the weak banks, which is what buying equity directly would mean.

I’ve never seen this before–an instance where a crackpot, top-of-the-market, caveat emptor ploy by investment bankers to boost their bonus pool is actually useful.  It’s nothing like what the i-bankers envisioned, of course, but still…

the Unicredit rights issue

January 12, 2012 By in Banks, Basic Concepts, Current Market Thoughts, Industry Analysis, Recent Market Action, rights issue Tags: , , , , , , , , , , 1 Comment

the Unicredit issue

Unicredit, a major Italian commercial bank, is in the midst of an equity raising aimed at shoring up its finances to meet new capital adequacy standards being set by the Bank for International Settlements.

It’s doing so in the customary European way, through a rights issue (see my post on rights issues for more detail).  The prospectus is available–but not to people in the US–on the company website.

No E-Z bank is eager to raise new equity today.  Their stocks are trading at well below half of the balance sheet carrying value of their net assets (which is the problem in a nutshell–no one believes the carrying values have much basis in reality).  Nevertheless, many are resigned to doing so.  Therefore, the Unicredit issue is attracting a lot of market attention as it proceeds.

Several aspects of the issue are striking:

its large size

Prior to announcement of the issue, Unicredit was trading at around €6.30 a share.  The issue gives existing shareholders the right to buy 2 new shares at €1.93 each for every one they held at the ex rights date.  The new money coming in from the issue amounts to about 60% of the pre-rights market value of Unicredit.

implied change of control possibility

The shares created by the issue will represent two-thirds of the new total.  The issue has the potential to completely rewrite the share register if traditional large shareholders choose not to participate.  That’s certainly an inducement for them to come up with the money.

the low exercise price

Think of rights as being like short-term warrants.  Suppose the existing shareholder doesn’t want to, or can’t afford to, exercise his right to buy new shares.  What happens then?

Usually, and in this case as well, the issue is underwritten.  That is, the investment bank group arranging the issue agrees to buy, at the rights price, any shares that shareholders don’t.  The underwriters, in turn, sub-underwrite part or all of their obligation to other investors–typically portfolio management companies (this is a whole other, semi-sordid, story–but a topic for another day).  No matter what, Unicredit will get the money it wants.

Underwriters don’t want shareholders en masse to refuse to take up their rights.  It’s embarrassing for all parties, for one thing.  The underwriters, or angry customers who act as sub-underwriters, are stuck with the shares on their books, at a loss and tying up capital.

Their solution?  Coercion.

Underwriters always price the new shares at a discount to the prevailing stock price.  The bigger the discount, the bigger the gun to the head of existing shareholders to avoid having their percentage ownership of the company assets diluted by not taking up their rights.  Conversely, the smaller the discount, the more eager underwriters figure existing shareholders are to give company management fresh capital.

In the Unicredit case, the discount is gigantic.  The new shares will be issued a less than a third of the pre-rights share quote.  More like a cannon than a gun.

the issue appears to be succeeding

…at least in the sense that the current share price is comfortably above the €1.93 level.  The stock hasn’t traded below the rights exercise price since it went ex rights and has strengthened each day, as well.

Unicredit is worth watching closely

This is a bellwether rights issue.  If it goes well–and signs are positive so far–other, stronger banks should be able to raise substantial new equity, too.

 

 

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