|Written by James Makau|
April 3, 2008: Over the last three weeks, Kenyan banks have been trying to lure investors to borrow money from them to buy Safaricom shares.
Some banks have even gone to the extent of analyzing the account activities of their customers and suggesting the amounts they would be entitled to with earnest letters promising growing riches backed by debt.
This is not the first time that banks have done this with financially disastrous results that did not deliver quick riches.
This is a poorly phrased sentence. If the results were 'financially disastrous' it is expected they would not deliver quick riches so why even bother mentioning it?
Graphic with a 'c' is the correct spelling. And aren't illustrations graphic so why say its 'graphic illustration'.
While the Central Bank remains silent to the issue of banks encouraging their customers to speculate on the stock market with loans underwritten with deposits, the law bars banks from doing the same using their own capital.
In the US and UK, which represent one of the best developed markets, lending customers money to speculate on the stock exchange, which is also known as margin trading, is one of the most closely regulated aspects of the financial markets.
Neither Nairobi Stock Exchange and Capital Markets Authority nor the Central Bank has guidelines on consumer margin trading.
But as millions flock to the Nairobi Stock Exchange (NSE) to invest in Kenya’s biggest privatization deal, they have to decide whether their best option is to invest in shares using borrowed cash or using their hard-earned money.
There is no doubt that using other peoples money to buy securities can produce fabulous profits and big investors do it all the time, however such share-trading strategies come with huge risks that the average investors can barely understand or control.
In order for a small investor to make money on shares bought using bank loans, the economic conditions must be such that the price of this security appreciates significantly to cover the original cost invested, interest rates and other fees on the loans, brokerage commissions and most importantly, reduced purchasing power of the shilling caused by inflation.
What has inflation do with anything here? You are comparing shares purchased using cash & loans so in both cases the effects of inflation remain constant.
In the case of Safaricom, investors have blind faith that the company will continue reporting super profits.
“There is no guarantee that the share price will rally so much as to cover a sizable portion of the loan one may take, largely due to the likely minimal allocation,” said Resa Imbuye, an investment analyst at Old Mutual Asset Managers.
This is what happened with investors when KenGen and ScanGroup were brought to the market. In the case of KenGen, banks were offering customers loans that went to Sh1 million, however, when it emerged that the Government could not satisfy the demand for the shares the maximum allocation was fixed at 6,500, which worked out to Sh78 million.
Wow, last time I checked the maximum allocation was NOT for Shs78 million. A simple mat error but very misleading!
As the Government refunded Sh18 billion, thousands of investors found themselves with excess unplanned debt that had not been factored in their investment plans. For those who speculated in the stock market, it would turn out to be nightmarish as the NSE tumbled in the first quarter of 2007, losing a lot of money for most people.
The debt was taken BEFORE the allocation & refunds thus it was 'planned'. All someone had to do was use the refund to pay down the loan. Of course, there was interest owed but this was nowhere near the original loan amount. I do not understand how the author links the refunds with unplanned debt to losing money in 1Q 2007.
The only beneficiary of these transactions were brokers who got their commissions and commercials banks which continue to receive interest rates on this loans. As opportunities to lend investors evaporate, banks had found an easier way of entrapping investors with expensive loans.
There is no trap. Do banks force them to take loans? Just as brokers don't force clients to buy shares, banks can't force you to take loans!
To grasp the gravity of this entrapment, notice that while KenGen and Scangroup share price has doubled, their returns have not matched the interest rates going up to 20 per cent charged on the loans that were issued and inflation continues to gallop.
OK... if the price of the shares have doubled (100%) in less than 2 years then why can't they keep up with 20% interest rates? I assume the refunds were used to pay down the loans. After all this was not a personal loan but a 'business' loan.
Though Suntra Investment, one of the brokerage firms selling has rated Safaricom as a strong buy, it however warns that investors should be careful. “A word of caution is necessary. In view of the large number of retail investors that will come on board, as they try to cash in on the small gains, the impact of this could keep the price subdued for a while,” says an investor’s note issued by Suntra Investment Bank.
For Safaricom to make money for investors, a lot will depend on how both the economy and the company performs. The economic outlook will affect the ability of businesses to make profits and taxes paid to the Government. All these factors affect the movement of interest rates.
So far, the situation does not look good for the economy and Finance Minister Amos Kimunya expects it to slow down to a growth rate of four cent. Inflation is running high because of food shortages caused by political violence and this will affect demand for goods and services, meaning lower corporate profits and high unemployment.
As businesses default on loans, this could increase interest rates. Since the shares loans are pegged on the prevailing interest rates, this means that investors will struggle servicing them.
Loan defaults do not necessarily mean increase in interest rates. Increase in rates generally lead to higher defaults.
As for Safaricom, the company is expected to continue making a lot of money, but it will face increasing pressures from Celtel, France Telecom and Econet Wireless. This means that in a weak economic environment, it will be tougher to make the kind of money it has been making. The situation however could be the opposite and things get rosy and everyone gets rich. But the watchword here is that the fortunes could swing like a pendulum both ways and investors with heavy debt loads could suffer most.
“A point of caution needs to be given to investors many of whom are not sophisticated. The returns they receive from the IPO may not cancel out the interest payments and inflation which very few have factored in,” reckons Mr Sam Omukoko, the managing director at credit ratings agency, Metropol East Africa Ltd.
This makes sense beacuse its not the author who is making the statement.
During the Kengen IPO for instance, banks were lending at a rate of between 17.5 and 20 per cent. As Kengen’s share price shot up to levels three times its opening price, many speculators raked in tidy returns even after factoring inflation.
But for the Eveready IPO in December of 2006, investors looking to play the markets through margin purchases got severely burnt as the share shot up but consequently slumped to levels below the opening price.
With inflation hovering in double-digit figures and bank lending rates currently between 15 to 18 per cent, it would be a massive gamble to borrow with the objective of investing in the stock market.
Again, inflation is good if you have borrowed since the payments are 'devalued' with time. With inflation at 15% and interest at 20%, this means a real rate of -5%.
Experts say that any form of borrowing should be to meet a need. Investing is a want and really does not warrant any borrowing. Borrowing to invest amounts to a speculative move in that the borrower is at the mercy of positive market movements for them to at least recoup some of the repayments they’ll be making to the banks.
Analysts say that one should really be wary of loans targeted on stocks, and should at the most take a personal loan, and then ‘invest’.
“With this strategy, an investor will be able to sell at his own discretion without reference to the bank. Should a client default, banks are more than willing to take up most these shares through nominee accounts,” says an analyst on condition of anonymity.
Erm, ok... so why would a bank want shares that a client doesn't want? If the bank is 'happy' taking up the shares, it means the consideration is higher than the loan in which case the client should sell the shares and repay the bank!
Some banks have made the deal even more tempting by letting the customers pay interest for the time the loan is outstanding, however brief. There have been cases where some organisations even arrange with the financiers for a concessionary deal.
How is it tempting to allow for the payment of interest while there is an outstanding loan? I thought the 'temptation' would be a deferred interest loan!
“While some of these practices are in line with those in free markets of willing lender and willing borrower, both borrower and lender must ideally compute the effects of both the upside and the downside,” says Mr Cassim Jivraj, financial advisor at PFP Financial services.
“It must be noted that on the borrower/investors side the possible downside and its effects are not often thought through very much,” says Mr Jivraj.
Currently, banks are unwilling to receive lump-sum repayments from these financing deals. At the end of the day, some investors may be exposed to credits they were otherwise unprepared for.
What does the author mean? I can't make head or tail of the statement. Kenyan banks want the refunds applied to the loan if there is no additional collateral pledged. It would be unwise of the banks not to 'ringfence' the refund.
But with the euphoria surrounding the Safaricom IPO and coupled with the massive demand for shares, a number of banks see this as yet another excellent opportunity to cash in with their loans
Nine years ago, banks financing of stocks or margin trading, was extremely prudent. An investor was required to come up with an estimated 30 per cent of the financing while the bank topped up the rest. In 2006 however, banks switched gears, lending finances up to a maximum of 80 per cent of the funds with investors putting in as little as 20 per cent.
And with the unsecured loan products targeting mainly salaried individuals, banks were assured of a steady interest repayments pegged on salary inflows and the share as collateral, should a borrower default.
Most banks are still sitting pretty and have not suffered a bit, although that cannot be said of investors. To most banks, they will have to get the clients paying using other income streams and not necessarily cash obtained through sale of the shares.
Based on the relationship with the bank however, loan rescheduling can be agreed upon over the repayment period and the amount. But the truth is the chance of success for the IPO is not assured. In most advanced markets, margin purchases and short selling are done but again with very high risks.
Hedge funds have high returns but with high risks because they implement these strategies. Currently, focus has turned on them (hedge funds) because of the high risks that are sometimes not well compensated for by the returns the investors get.
OK, what a twist. We are talking simple borrowing here not complex derivatives, associated leverage, betas & deltas. Why does the author jump from one to the other when there is little correlation between the two?
“I feel there is limited, if any, benefit for borrowing to invest,” reckons Mr Imbuye.
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