Tag Archives: Banks

Dubai World update: Abu Dhabi to the rescue

December 15, 2009 By in Banks, Current Market Thoughts, Recent Market Action Tags: , , , , Leave a comment

Abu Dhabi bailout

The government of Abu Dhabi announced on Monday that it is giving US$10 billion to the government of Dubai.  Dubai, in turn, will give the money to 100%-owned Dubai World.  DW will forward about US$4 billion of that to its property development subsidiary, Nakheel, to repay a large sukuk that came due on the 14th.  DW will use the rest of the money for debt payments and working capital while it tries to restructure itself.  (See my earlier posts for more background on the Dubai World debt problems.)

The Nakheel sukuk was suspended from official trading after the standstill request made late in November.  But gray market transactions were reportedly done at just above fifty cents on the dollar.  Courageous buyers will have doubled their money in less than a month.

I think it’s reasonable to conclude that three weeks elapsed between the time Dubai requested a debt standstill and yesterday’s bailout announcement because Dubai didn’t have the funds to bail DW out.  It had to get them from Abu Dhabi.  We don’t know if any strings were attached to the $10 billion gift, or if more money will be forthcoming, if needed–and it probably will be.  My guess is that the answer to both questions is “yes.”  (I’m not alone in thinking this.  See Bloomberg’s comments.)

Why a bailout?

Why not default?  I think there are four reasons:

1.  the possibility of cascading defaults. We know that a lot of DW debt was held within the United Arab Emirates.  If Nakheel defaulted and this triggered a disorderly process of unwinding of more of the DW group’s debt, the negative impact on UAE banks could have been severe.

2.  the sharia supervisory board. All sukuk activities, including presumably liquidation, are overseen by a group of scholars who ensure that they are sharia-compliant.  Because there have been virtually no prior sukuk defaults, it would be impossible to predict what actions the supervisory board would recommend.  Suppose it decided that because of negligent management by DW (or some other reason), sukuk holders could make claims against all the assets of DW, not just Nahkeel’s?  A ruling in this case might also set a precedent for other sharia boards in Dubai to follow.

3.  some holders apparently didn’t want to negotiate. Nahkeel sukuk was originally sold to few if any Americans.  But as Nahkeel’s problems emerged, it appears that some US and UK hedge funds accumulated positions at lower prices in the secondary market.  Armed with credit default swaps that would pay off in the event of a default, these owners had different interests from the rest.  For them, the worst outcome would be a protracted negotiation that resulted in a decline in sukuk value but no default.

4.  reputational damage. Despite the facts that the Nahkeel sukuk was issued by a Dubai entity and that the prospectus clearly said the government assumed no obligation to guarantee repayment, possible default was giving the entire UAE a black eye.  I’d bet that Abu Dhabi was less concerned that foreigners thought the sukuk had a sovereign guarantee that buyers in the UAE thought it did, too.

One odd consequence of the DW troubles is that the rating agencies have begun to focus more carefully on the financial problems of Greece. Greece is a short step away from having its government bonds downgraded to a level where the EU will no longer accept them as collateral for borrowings by the Greek central bank, thus shutting off credit from the rest of the EU.  This is an issue, but it has nothing to do with Dubai.  Go figure.

Will Wall Street stop providing research from “independent” sources?

December 8, 2009 By in Getting financial advice, Industry Analysis, Investment firms, Where are the customers' yachts? Tags: , , , , , Leave a comment

Background

Remember the aftermath of the collapse of the Internet?  Customers who bought once high-flying tech IPOs that had no fundamental merit and became worthless when the bubble burst filed lawsuits.  So did the then New York Attorney General, Eliot Spitzer. The SEC investigated, as well.

The basis for the uproar was not so much that buyers were caught up in the frenzy and made crazy purchases (although I doubt anyone would have complained if they had made money).  It was instead that the brokerage houses themselves had encouraged their customers by providing research reports from in-house analysts, who wrote that clients should buy the stocks–even though they firmly believed the securities had little value and that the proper course of action would be not to touch them with a ten-foot pole.

The poster child for duplicitous analysts was Henry Blodget, a relatively unseasoned researcher who became an overnight sensation  in 1998 with a prediction that Amazon would double in price, which it promptly did.  That report rocketed him into a job with Merrill Lynch and eventual recognition by Institutional Investor as the #1 expert on the Internet on Wall Street.

Mr. Blodget’s emails to colleagues, in which he derided companies he was touting in his official research, became a key feature of Mr. Spitzer’s case against the big brokerage houses.   Blodget was charged with securities fraud by the SEC, and settled with the agency by agreeing to be banned for life from the securities industry and to pay $4 million in fines and return of investment gains.

The overall brokerage industry settled with Mr. Spitzer.  Among other things, it agreed to provide customers, from late-2004 until mid-2009, not only with in-house research reports on stocks but also with research produced by independent third parties.  According to the Financial Times, brokers paid independents $430 million for their efforts.  (Incidentally, the FT article I cite strings together a number of aspects of the Wall Street research business that are individually correct but make up a picture that I don’t think is particularly accurate–maybe the topic of another post.  But the factual information is interesting.)

Where to from here?

There are lots of cross currents, but my guess is that brokers will return to providing only in-house research as soon as the independents’ contracts run out.  Why?

1.  For one thing, the samples of independent research I looked at in 2004 and 2005 (after that I stopped looking) were pretty awful.  The reports tended, for my tastes anyway, to be long on historical information, technical indicators and computer-driven, trend-following “recommendations”–and short on well-reasoned conclusions.

Why should this be?  I don’t know.  Maybe Mr. Spitzer only said the reports should be independent, not that they had to be good.  Maybe these were the best services out there, so the brokers had to make do.  On the other hand (what follows is just Wall Street humor on my part), you’d have to be crazy to point clients to outside research that’s better than your in-house product.

2.  Wall Street believes that providing research is a money-losing proposition.  The brokerage houses are run by traders, not researchers, so it’s natural that they would think this.  But they’re probably correct.

Over the years, many investment managers–firms, incidentally, that are typically run by marketers, not researchers–have shaped their businesses to rely heavily on brokerage research instead of in-house efforts.  The advantage to doing this?  Research is paid for by clients’ trading commissions rather than taken out of the manager’s fee income.  (Try to get that to change!!)  The brokers argue that they would doubtless get those commissions anyway, even if they provided no services in return.

(An aside:  Just before the financial meltdown, Fidelity, which has an extensive in-house research staff and which is also an industry benchmark for investment management firms trying to justify their research commission payments to brokers, was attempting to curtail such payments severely.  This would have created a real dilemma for rivals that depend mostly on brokerage research for their investment ideas.  Something to watch carefully.)

3.  Many research boutiques are/were staffed by analysts laid off by brokers in their efforts to control costs.  Rehiring them, even as consultants, might have been seen as awkward.

4.  My guess is that brokers’ website monitoring systems show clients never access the independent reports.  So the industry won’t upset anyone and will save $90 million a year by eliminating them.


An FDIC study of US retail banking: no room for growth?

December 4, 2009 By in Banks, economics, Industry Analysis Tags: , , , , 1 Comment

Federal legislation passed in 2005 requires that the FDIC regularly study the efforts of banks to bring into the mainstream banking system families that “have rarely, if ever, held a checking account, a savings account, or other type of transaction or check-cashing account at an insured depository institution.”

In the aftermath of the enormous losses of national income and wealth inflicted on the US by the banking sector through mismanagement of derivatives, you would think the banks might be looking for some way to make some social restitution for the economic damage they have caused to society.  And you might also figure that one way would be for the banks to provide greater (maybe “any” is a better word) services to two sets of households in the US that the agency calls the unbanked and the underbanked–especially since Congress is very interested in having this happen.

What do the terms unbanked and underbanked mean?  The FDIC defines them as follows:

—unbanked households are those which do not have either a bank checking or savings account;

—underbanked households are those which, although they have a checking or savings account, also make regular use of non-bank financial services, such as

—–non-bank money orders

—–non-bank check cashing services

—–payday loans

—–rent-to-own agreements

—–pawn shop loans.

Households are also classified as underbanked if they have taken out a tax refund anticipation loan within the past five years.

The FDIC queried the banks about their marketing to these potential customers, as the 2005 law requires it to do.  It turns out most banks have basic marketing materials, like pamphlets explaining services offered, that are targeted to families that now use few, if any, bank offerings.  But the FDIC report in February shows these potential customers, although they make up a quarter of all American families, are not a high priority.

The banks said they were apprehensive about the two sectors for three reasons, in order of importance:

these customers are likely not very profitable;

they might present regulatory compliance problems under, for example, the Patriot Act; and

they think these customers might bring increased risk of fraud.

So the FDIC decided to study this market more carefully.  It teamed up with the Census Bureau to try to collect more information about unbanked and under banked Americans.   The two agencies prepared a set of questions for a survey that the CB conducted in January.  The FDIC published the results on Wednesday.

This is what they found:

1. Unbanked and under banked make up over 25% of all households. The survey estimates that 9 million of households (7.7%) in the country are unbanked and 21 million (17.7%) are underbanked.

2.  Minority group members are more likely to fall in the two classes. 21.7% of unbanked households are black and 19.3% Hispanic vs. 3.3% white.  31.6% of underbanked households are black, 28.9% American Indian/Alaskan, and 24.0% Hispanic vs. 14.9% white.

3.  Incomes are low. Households with yearly incomes under $30,000 make up over 70% of the unbanked.  The underbanked tend to have incomes below $50,000.

4.  The highest concentrations of banked and underbanked, relative to overall population, are in the deep South and Southwest. The lowest concentrations are in the Northeast and Michigan/Minnesota.

The unbanked

The main reason the unbanked, which tend to have family incomes below $30,000, are unbanked is that they have no money. One-quarter of the unbanked appear to transact solely in cash.  The main benefit the unbanked see in having a bank account is not to write checks or obtain credit, but to have physical security for their money.

The unbanked divide roughly evenly into those who have previously had a bank account and those who have never had an account.  The former say the costs of their account were too high, as a reason for not having an account now; the latter say that they don’t have enough need for bank services.

The non-bank services the unbanked use are  primarily for check-cashing and writing money orders.  Only 9.9% say it is “very likely” they will have a bank account in the future.

The underbanked

Like the unbanked, the underbanked seem to primarily need transaction services.  Despite having bank accounts, however, they also tend to use non-bank money order-writing services and non-bank check-cashing services.

More than 80% of the underbanked purchase money orders from non-banks.  The primary reason is convenience, but 27.7% say they do so because bank money orders are more expensive.

About 30% of the underbanked use check-cashing services.  Again, the primary reason is convenience, but 17.6% say they get the money faster from a check-cashing service than from a bank.

The underbanked also make some use of pawn shops to obtain cash and of rent-to-own stores to obtain merchandise.  They appear to do so because they can’t qualify for bank loans or because the credit process is simpler at these non-banks.

My thoughts

At the risk of being much too simplistic, I’d summarize the FDIC survey findings by saying that the unbanked don’t use banks because they have no money.  The underbanked don’t use banks because there are no branches nearby.  Neither group needs more than basic services.  Although there may be much social good done by outreach to the underbanked, establishing new bank outlets in underbanked areas will involve capital outlay.  And the return on this investment is unclear.  So one can understand why the banks might not regard this market as a great untapped profit opportunity.

There is an obvious way, I think, of addressing the needs of the unbanked and underbanked–let Wal-Mart open a bank and provide financial services in its stores.  But Congress has already rejected this idea.

In a way, then, it’s not so surprising to see the present retail banking effort to substantially increase the fees charged for credit services to existing customers.  I think there is some risk of consumer backlash, however.  For example, I have a credit card from Citigroup that gets me a discount on gasoline.  I recently received a notice that the interest rate on unpaid balances will be rising from 19% to a minimum of 27.5%. This comes at a time when the Fed is providing short-term credit to the banks for just about free.  I also have the choice of “opting out” from this increase, i.e. closing my account and paying off the balance.

Luckily, I don’t keep unpaid balances so this is not a practical issue for me.  But at some point–and I think we’re close, the rate itself becomes close enough to loansharking to taint the reputation of the credit provider.  This is what happened in Japan with the sarakin and finally provoked a severe regulatory crackdown.

What we’ve learned about Dubai World since Nov 27th

December 1, 2009 By in Banks, Current Market Thoughts, Industry Analysis, Recent Market Action Tags: , , , , , , , , Leave a comment

The facts about the imminent restructuring of Dubai World are gradually becoming clearer.  Over the past several days , we’ve learned:

1.  The amount of debt that Dubai World proposes to restructure is about US$26 billion, less than half what was originally thought.  The borrowings are centered around DW’s property subsidiary, Nakheel, and Nakheel’s international property development arm, Limitless World.  According to DW, its other activities are on sound financial footing.

2.  It appears that about half of DW’s overall obligations are to entities within Dubai.  It’s a reasonable working assumption that the same ratio would hold with the debt requiring restructuring.  If so, foreigners’ exposure would be $13 billion or so, plus whatever credit default risk they might have taken on through derivatives.

3.   The UAE central bank pledged support on Sunday for the federation’s banks through a new liquidity facility, again suggesting that a lot of the direct financial exposure is held internally.

4.  The actual restructuring has been underway since at least November 20th, when Dubai fired the head of its International Financial Center, as well as three members of the Investment Corporation of Dubai–including Sultan Ahmed bin Sulayem, the chairman of Dubai World.

5.  Yesterday, according to Bloomberg, Dubai’s finance minister, Abdulrahman al-Saleh, clarified the relationship between the government and DW.  He said in a TV interview that when DW was set up the government decided that DW’s debt should be secured by its investment projects, not a government guarantee.  Further, the government stated in a sukuk prospectus in October that it assumed no obligation to support strategic state-owned enterprises (like DW) financially, although it reserved the right to do so if it chose.

6.  Despite the government’s statements, it appears most investors thought that this was similar to what the US government said about Fannie Mae and Freddie Mac–that in the end, despite its protestations, the government would bail DW out.  Unlike the US case, this expectation has proved false.  It would be doubly interesting if, again unlike the case in the US, a corruption investigation follows.

So the DW debt problems are looking more and more like a tempest in a teapot.  Yes, there may be domestic repercussions and emerging markets debt investors may look more askance at countries like Greece, but further fallout appears unlikely.

To me, by no means an expert on sharia-compliant finance, one big surprise is that investors should have so unreflectively assumed that they would be bailed out by the Dubai government.

In a country like the US, where the banking paradigm accepts that the interest of creditors and equity holders are somewhat opposed–that the equity holder is allowed to financially leverage his returns in return for the debt holder being partially insulated from the full consequences of business failure, debt holders would not expect to be fully sheltered from the failure of the debtor’s business.  Under a banking paradigm like Dubai’s, however, that, in contrast, brings debt and equity holders together as common participants in the fruits of business success or failure, it’s hard to imagine how a bailout of debt holders could be, even in principle, justified.  Go figure.

Also see my original comment from November 29th.

More on hybrid bonds and contingent convertibles

November 22, 2009 By in hybrid bonds/contingent convertibles, Vocabulary Tags: , , , , , , Leave a comment

Plato vs. Aristotle (the Greek version of Mr. T vs. Chuck Norris)

Ancient Greece, the cradle of Western civilization, lacked both bowling alleys and XBoxes.  This forced citizens to spend their leisure time debating the nature of reality.  On one side of the discussion were Platonists, who asserted that the physical world and all that is in it are imperfect copies of eternal, changeless and perfect Forms–the latter being the only truth. Aristotelians made up the other side.  They believed that truth was to be found through observation of the actual characteristics of things in the physical world–that there were no otherworldly Forms that worldly things aspired to be.

considering hybrid bonds

In looking at hybrid bonds (see my post earlier this week for a definition), Moody’s originally fell on the Platonist side.  In rating hybrids, the agency appears to have assumed that because the prospectuses called them bonds, that’s what they were.  It didn’t matter that they might have quirky characteristics–for example, not looking much like a bond at all (remember, too, that like all rating agencies, Moody’s was paid for its opinion by the issuers).

During the credit crunch, bank regulators have revealed themselves to be firmly in the Aristotelian camp, to a greater or lesser degree.  If it walks like an equity and quacks like an equity, they are saying, it is an equity and not a funny kind of bond.

Why does this make a difference?  In a reorganization or liquidation, equity holders generally lose everything but bondholders retain at least a part of their original investment.  Also, although I’m not aware that this issue has come up formally yet, investment management contracts with clients normally specify very clearly what kinds of assets a manager is permitted to buy.  Bond managers, who appear to be the majority holder of hybrids, are supposed to buy bonds, not equities.  If they buy a security outside their mandate and lose money on it, they expose themselves to possible lawsuits aimed at forcing the management company to compensate the client for those losses.

Moody’s has a new rating method for hybrids

Moody’s appears to have shifted to the Aristotelian side of the debate last week, although it is still referring to the securities as bonds.  It announced that it has developed a new methodology for rating hybrids.

The new scheme (unlike the original one) incorporates the  possibility that:

–the issuer might exercise its right to defer or eliminate payment of income on the hybrids and that

–in a reorganization an Aristotelian bank regulator would classify the securities, less favorably for the holder, as equities.

Individual hybrid results will be made known over the next three months.  It appears that the vast majority will be downgraded, some by more than one notch.  From the Moody’s announcement, it sounds like at least part of the downgrading will be a result of the differing behavior of bank regulators as to how they regard hybrids.

Contingent convertibles

The press is now calling them CoCo bonds.  Despite the cute acronym, the concept doesn’t appear to be going over well with bond buyers.  Over the past few days, regulators have been eager to say that they aren’t solely focused on CoCos, but have lots of other ideas as well.  Myself, I hope the other ones are better than this.  It’s a little disconcerting, though, that they talked about this one first.

Just for the record:  I think CoCos are non-starters in today’s world, where the chances of financial company restructuring are way higher than zero and where the scars of investor losses, in part due to carelessness, lack of analysis and excessive optimism, are still fresh.  Give it a few years though.  When the sun is shining every day and profits are rolling in, CoCos will likely come back–and be eagerly bought by bond investors with short memories (meaning almost everyone).