Holding the old maid

Edwin Ball, the former chief operating officer for Gulf Finance House, explains to GulfWeekly readers what caused the credit crunch and how its implications are touching our lives in Bahrain. Canadian Mr Ball, 41, who lives with his family in Saar, has held senior executive management investment banking roles in Europe, the Middle East and Asia.

What does the financial credit crisis actually mean to you? Whether you are a Bahraini national or an expatriate, the effects may be different but need to be understood. Firstly, what does it mean in macro terms? A simple answer: confidence and relative value.

In the financial markets, not only do investors and clients need to have confidence in their financial institution but these financial service companies need to have confidence in each other.

There were many factors combined and not exclusive which triggered this turmoil. Banks and mortgage companies were stretching lending guidelines originally put in place to mitigate the possibility of default: Lending funds up to almost the full property value without enough of a deposit; increasing the funds available based on ones affordability even when rates were at relatively historic lows and the ability for these institutions to 'structure and package' a portfolio of these mortgages and sell it off as a wholesale debt investment to other financial institutions.

There is an expression that you need skin in the game. Without a large deposit or equity investment or for that matter, if you can transfer your risk to some other player, it creates an environment for some to potentially take on too much risk.

Any shrewd investor realises that one must balance risk vs. reward. Any beginner's course on investing teaches us to identify the risk-free rate of return and then adjust the risk profile percentage of our portfolio based on conditions.

These new instruments sold off to other financial institutions were actually rated as fairly risk free investments by big ratings agencies like Standard and Poor. The rationale was that these agencies were confident that the funds were secured by the properties and therefore, in a rising housing market, even if there was a small increased percentage of default by creditors, the overall value of the portfolio was still intact.

Financial institutions spread this risk to each other with these new 'structured products' like CDOs - collateralised debt obligations. These mortgage companies were lending to realise a short term gain based on an initial commission rather than the old model of keeping the risk on their books for the life of the mortgage.

They essentially could pawn off the risk to other investors thereby eliminating their 'skin in the game'.

The size of the impact was compounded as many of these companies were lending funds to people who would not have met the prior guidelines for either payment affordability (relative earning or debt service requirements) or credit history quality. People need to be able to afford to repay their debts. A recent analysis shows that many banks have been lending funds requiring debt servicing of 30 per cent of their lending guideline limits put in place after the real estate market declines of the early 1990s. They just passed on this increased risk to other banks.

These new instruments that pooled these mortgages must be marked against the market value to determine the money made or lost on such an investment. When some of these factors changed, it compounded the effect and the value of these products plummeted. Even worse, institutions could not really measure the impact on the valuation. Companies report losses on their portfolio and then later have to continue to revalue it at an even lower amount. No one knew the actual value. These totalled losses in the hundreds of billions of dollars.

Have you ever played musical chairs or the card game 'Old Maid'? Recently, it looks like Bear Stearns, which was the sixth largest investment bank in America got stuck holding the 'Old Maid'.

The company was only bailed out by JPMorgan and the Fed to avoid further escalation passing on the 'Old maid' equivalent to other institutions. To put it in perspective, one year ago before this crisis, Bear Stearns was valued at over $18 billion; the market capitalisation of all of the companies on the Bahrain Stock Exchange is approximately $28 billion.

More disconcerting is the fact that just two days prior to selling their company to avoid bankruptcy, the CEO had stated publicly that all was well.

At that time, the bank was valued at over $6 billion. When the music stopped, and they determined value, JPMorgan attempted to buy it for $2 per share. That is only $240 million. After a big uproar from some shareholders, JPMorgan increased the offer fivefold to $10 per share although this is still subject to the Fed agreeing to back it.

When in history did a company propose an acquisition and within a week increase the offer by five times? It is difficult to determine relative value. Do you have confidence in the investment banking sector as an investor when you do not know who is holding the 'Old Maid', how to value the portfolio and even the experts cannot agree the relative value?

Even Chuck Prince, the ex-CEO of Citigroup had dismissed fears stating that 'when the music stops in terms of liquidity, things will be complicated but as long as the music is playing we're still dancing'.

The game of musical chairs cost him his job; shareholders over $100 billion in shareholder value and many Citibank employees their jobs. Maybe, he had too much confidence.

For these banks to continue to operate, they need funding and liquidity to meet cash flow obligations. See the issues with Northern Rock regarding liquidity and cash flow obligations and how they required the UK government to bail them out. I guess that we all question if, and when, the music will stop for each of us and will the consumer have enough liquidity.

The bigger issue in the financial markets is whether there are other surprises found in other banks. When will this be over and will we ever have financial reporting transparency?

Risk mitigation is one issue, business ethics and trust is another. As a bank is supposed to represent a safe place for investment, clients and investors need to trust them. When reports come out that traders manipulated valuations in order to make sure they got paid hefty bonuses for 2007 and then, it only gets noticed in the first quarter of 2008, integrity, trust and confidence becomes a greater issue than originally concerned.

If you are an expatriate or a Bahraini with foreign investments, you may have seen serious erosion of value. If you are holding a depreciating asset, do you sell it now or keep it?

The chief economist from Morgan Stanley has recently predicted that house prices in the UK will fall by up to 20 per cent over the next two years. The IMF speculated that it could be as high as 30 per cent.

The music may be already down a few decibels. Will you be able to have your mortgage refinanced if lending terms change? Yes, the actual rates are down however, due to increased risks, the spreads added on those rates have expanded. Companies wishing to secure debt financing face spreads over LIBOR practically doubled and that same spread effect has also been passed on to the mortgage consumer.

If you have investments or retirement savings/pensions invested in the global stock markets, you will have definitely seen a decrease in value in your portfolio. More than $7 trillion has been wiped off of the world stock markets this year alone. If you invested in local markets such as Bahrain, they have fared much better.

Bahrain Stock Exchange has actually increased from $20 billion to $28 billion over the last 12 months and while the world markets have tanked, the BSE experienced a slight increase over the last few months.

An economist has just estimated that expatriates send over $2.5 billion out of Bahrain each year. For example, the dinar to Indian rupee has devalued by nine per cent.

Bahrainis should be pleased to know that the Middle East along with Asian markets has attracted the attention of financial institutions looking for value and liquidity in these markets. This should stimulate opportunities in this sector and provide jobs. The growing profile of Islamic banking and the Sukuk markets should also provide an opportunity for Bahrain to solidify its position on the global stage.

The risk profile of these products is an alternative to the other debt market products which have complicated the current credit crisis. With the introduction of new products, there needs to be a balance of risk mitigation versus reward. This will require having the exceptional talent to provide such management oversight as well as risk and financial controls.

The emerging talent pool will benefit from directly leading in this development as well as from importing the talent to institutionalise as required.

Bahrainis outside the financial sector will wonder about the local and regional real estate market. Relax, as it is also based on relative value. Many projections still see positive growth in Bahrain to meet demand.

As an investor, please remember that stock market values are based on future projections which are still based on confidence and value.

Regional inflation is high due to a peg to the US dollar and its global devaluation. One has to remember that the global economies are tied together.

Americans are still the largest global consumers and as their currency devalues and imported products become more costly, other economies will suffer.

Conversely, the strength of the Euro to the USD has made real estate investments in America highly attractive. The effect should create a natural balance over time as the European economies should slow and therefore affect valuation of the currency.

Remember for value, it is still based on buy low and sell high. Remember relative value. If the Bahrain real estate market or certain Bahraini stocks appear a good value relative to other investments, then, opportunity exists for positive returns. I use the term positive as it is relative to other investments.

How confident are you on knowing what a low value is? Will the music stop in the Dubai real estate market? Hey, no one really knows.

Should we trust the top economists who make predictions? Well, let's look at relative value. The top economists of these major investment banks earn a fraction of their CEO counterparts.

The law of relative value would suggest that the CEOs would be more correct in their assumptions. If three of the top six American investment bank CEOs got it so wrong that they ended up losing their jobs, there can be no 'real expert'.

Collectively, these three CEOs earned more than $300 million in compensation over the last five years. If they got it so wrong, maybe confidence is not such an issue and it proves that value is also relative. To show you how distorted things got, according to Forbes.com, James Cayne, the CEO of Bear Stearns had owned 4.4 per cent of the stock or something that was valued at almost $1 billion in early 2007; JPMorgan attempted to buy the entire company for approximately a quarter of that value!

Their offer was increased to $10 and now some speculators expect to see that raised as at the time of writing this article, the share price had closed trading above $10 per share and Mr Cayne had already cashed out for only $60 million.

For a sound economy, we need to be confident in our financial services industry and in the management of the key institutions. Based on the current relative value, Bahraini institutions have faired well in performance against their global competition reflecting confidence by not only local but foreign global investors.

Bahrain banks have not been completely immune and we only need to look at the likes of ABC as being exposed to the sub-prime crisis having to revalue their exposure. Again, this confidence is relative and we only need to look at the wild ride example of Bear Stearns or the impact of some of the other major global players to demonstrate how things can change very quickly.