Sigrún Davíðsdóttir's Icelog

The curious pattern of illiquid collaterals and their costly consequences

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Kaupthing and The Tchenguiz Family trust have reached a settlement regarding exposure to the bank and claims. The collaterals related to the disputed loans give an interesting insight into correlations between lenders and borrowers

‘It’s interesting to keep in mind that the collapse of the three Icelandic banks is the largest corporate failure ever, the biggest bankruptcy in the world,’ said an Icelander to me the other day. It is indeed striking that a tiny economy, with a population like a London Borough, was able, so to speak, to produce the third largest corporate default in the whole wide world, after Lehman and Washington Mutual.

An obvious reason for the size of the default is that the banks were way bigger than the underlying Icelandic economy and in a way unrelated to it. The banks were funded by international banks who thought nothing of pouring vast sums of money into these three banks, newcomers to the international world of finance, run by people who mostly had no banking experience at all except from the Icelandic bank.

As the report of the Special Investigative Commission, set up by the Icelandic Parliament shows, one of the reasons for the banks’ demise was reckless lending to very few individuals. The largest borrower was the UK property billionaire Robert Tchenguiz. Tchenguiz owned a small stake in Exista, the largest shareholder of Kaupthing and sat on the board of Exista. At the beginning of 2008, Kaupthing had lent €1.2bn to Tchenguiz. When the bank collapsed in October 2008, his loans had gone up by 80%, to €2.18bn – during a period when banks were mostly not lending at all.

During the summer of 2008 the value of collaterals that Kaupthing had against loans to Tchenguiz fell. He had no assets to top-up the gap that was estimated to be £200m. His brother Vincent, who hadn’t been a client of Kaupthing, came to his brother’s rescue and placed the necessary assets to fullfil the requirements, not with £200m but with £222.5m because Kaupthing deemed the collaterals not to be very liquid and added 10% to the original request. At the same time, Vincent borrowed £100m from Kaupthing.

How this was all done tells an interesting story of the nature of the relationship between big borrowers and the banks. It’s a well-known fact that if you owe a bank 10.000 it’s your problem. If the loan is 10bn it’s the bank’s problem. Another extension of the correlation of power between a borrower and a lender is the nature of collaterals. The two brothers deny any wrongdoing and in fact are each suing Kaupthing, claiming that the bank’s former management fraudulently misrepresented the bank’s financial position to them, costing them dear.

Company structures seem to get more complicated with every year. The level of complications does not only make assets ephemeral and opaque when it comes to tax and beneficial ownership. It also makes the assets difficult to lay hands on for the banks that take these structures, or slices of them, as collaterals. It raises the question how well these structures serve the banks as liquid assets, at hand for the banks to claw back possible losses or if assets, structured in this way, are of any use at all as collaterals.

The collaterals provided by Vincent Tchenguiz, valued at £222.5m, related to a handful of his corporate structures, all highly leveraged, where he had a slice of equity. Through court cases involving Oscatello, the company where further collateral were needed, it’s possibly to gauge the outline of these structures.

The court cases show that if Kaupthing had enforced the collaterals, in effect Vincent’s equity, the banks that had lent into the leveraged companies, lower down the corporate structures would have called in their loans, causing a domino effect of defaults where everyone would have lost. It’s the so-called ‘change of control’ clauses in loan contracts that trigger these defaults.

Now, almost three years after Kaupthing failed, Vincent Tchenguiz and Kaupthing have come to a settlement. There were no doubt myriads of things to sift through but the ‘change of control’ has been a tough one, meaning that the borrower had huge power over the lender. When it comes to settlements, both parties normally agree to non-disclosure, meaning that terms and conditions won’t be in the public domain. It’s therefore unlikely that we will ever know the sums involved, what the bank has to write off and how much the borrower will indeed pay in the end.

The fundamental idea with a collateral is that if a borrower can’t repay a loan, the bankers can shrug their shoulders and say ‘no problem, we take the collateral, liquidate it and use the proceeds to settle the debt.’ Therefore, quality collaterals tend to be liquid and of low price volatility, making them easy to turn into money to settle the unpaid debt, if needed.

A ‘change of control’ clause within a collateralised structure is like a fuse that can blow up the whole thing and atomise the assets if touched and treated the wrong way. This opens up a question of how to value assets with these possibly lethal consequences. What’s the value of a collateral that can’t be fairly easily liquidated?

But did Kaupthing know how illiquid the Oscatello collaterals were? As far as can be gauged from a court case involving Oscatello and Kaupthing (Hight Court of Justice, Queen’s Bench Division, Commercial Court, Claim no. 2010 Folio 773), it transpires that Kaupthing at first offered not to touch the collaterals for a year and then offered not to touch them at all. The collaterals could be used for making the books look in order. But in reality, the collaterals were unenforceable, raising the question what story the bank’s accounts told.

The collaterals in Oscatello are no doubt not unique to this structure. It also explains why it took such a long time to find a settlement. The Oscatello collaterals are almost certainly not unique but explain why the large borrowers in the Icelandic banks, borrowers whose loans broke regulation on limited exposure, are by and large walking away with extremely favourable settlements: the loan deals were all too often in the favour of the borrowers, securing the borrowers all the upside and the bank the downside.

It’s fair to assess that this was nothing that Kaupthing invented. Shareholders should be asking bank managers some serious questions as to loans against collaterals with ‘change of control’ clauses. And so should regulators and financial services authorities. Since these collaterals are in reality illiquid, their value has to be estimated in connection to the illiquidity. It also raises the question who gets to place collaterals of this kind and why. And ultimately, if these loans simply turned out accidentally to have these unintended consequences so strongly in favour of the borrower, at the cost of the interests of the lender.

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Written by Sigrún Davídsdóttir

September 19th, 2011 at 9:03 am

Posted in Iceland

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