Don't Drink The Water: This Ain't No TARP

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The following post is by a hedge fund manager friend of DB who shall remain nameless. He runs the emerging markets desk at his firm.
Damn it felt good to be a Nigerian banker - until recently. Now, one of the largest banks is complaining of being the victim of "gang rape" (we'll get to that in a bit) and it along with several others have ended up wards of the government. At the end of last week, Nigerian authorities finished their stress test of the first batch of ten top banks. The results must not have been pretty: the Central Bank promptly intervened in the running of five of these banks, firing the existing top management and replacing them with Central Bank appointees and simultaneously injecting a total of $2.5B of new Tier II capital.
The Nigerian banking system may sound like the punch line to a joke involving the rate of interest on yams or the subject heading of an email addressed confidentially to the reader on the basis of his reputation as a trustworthy and discreet individual, but in point of fact it was for a time both an emerging markets reform "success story" and, for its size, a not insignificant beneficiary of the boom in capital flows to the emerging markets. In 2004, then-Central Bank Governor Chukwumo "Charles" Soludo pushed the government to institute a new banking law. It required the then-fragmented and undercapitalized sector to meet new increased minimum capital requirements by 2005, sparking a wave of consolidation and recapitalization. From an unruly mob of small, flimsy institutions, many with capital bases less than $10M, emerged a surviving group of around 25 larger, cleaned-up banks.

It didn't take long for Western bankers to discover these new potential borrowers. American and European banks bought bank-guaranteed corporate commercial paper from the top three or four banks to hold for their own account and on-sell to clients. Guaranty Trust Bank (GTB) and First Bank were able to place Eurobonds in early 2007. And, in point of fact, these top banks had undergone a major upgrade in management and systems, and had built banking businesses capable of absorbing wholesale funds from abroad and deploying them more or less sensibly. The problem, however, is that once a new "frontier" is opened in the emerging markets, investment banks make pharmaceutical companies look practically demure when it comes to pursuing "me-too" transactions. Once the initial transactions absorbed all the inevitable jokes about 519 scams and made it so that the phrase "Nigerian bank deal" passed the laugh test, practically every Nigerian bank had London bankers offering to do deals for them. Two of the intervened banks, Union Bank and Intercontinental Bank were the guarantors on most of the corporate commercial paper that Citigroup offered to its clients; Oceanic Bank came very close to getting a 5-year subordinated debt deal done in 2008 with the help of Merrill Lynch (note Ken Lewis: you can't say Merrill stepped in every pile of elephant dung).
It wasn't just the London bankers who found themselves caught up in a game of "anything-you-can-do-I-can-do-bigger." The Nigerians themselves appeared to subscribe to similar motivation. For at the same time that the banks were taking down expensive new debt from abroad, their loan-to-deposit ratios were among the lowest in the emerging markets, generally hovering around 50%. Loans-to-assets in 2007 for several of the banks, including some of the ones recently intervened, had barely broken above 30%. A refractory, irksome, difficult investor might have wondered, then, what these banks were doing borrowing from aboard at 9%, 10%, or even 12% rates (or even issuing senior convertibles) if they weren't able to originate loans. Borrowing at 12% to buy Nigeria T-bills yielding 9% or 10% is not a sustainable business. But the London bankers could find takers who wouldn't ask such impertinent questions.
In the end, several of the banks did find an answer to that question; it was just the wrong answer. While the best of the bunch, such as GTB, First Bank, UBA and Zenith Bank had a stable of reasonably high-quality corporate borrowers, good credit risks in Nigeria proved scarcer than risk-loving dollars flowing into Nigeria. The me-too banks found a product that would allow them to deploy large amounts of capital quickly: margin lending. The Nigeria stock exchange rallied sharply through the first quarter of 2008. One small detail: 70% of the NSE index consisted of bank shares. So by necessity, margin lending ended up collateralized largely with... bank shares. If you couldn't think of something Nigeria and Iceland have in common, well, now you can. When capital flows began to reverse in mid-2008, some of the banks started to find themselves a little squeezed, foreign money exited the Nigerian stock market, and Nigeria went from the Big Bang to the Great Crunch. Bank stocks were particularly hammered. Soludo was loath to see his reform triumph end in tears, and the authorities resorted to unorthodox measures such as briefly (luckily US Congress dared not think this big) promulgating a rule making it illegal to trade shares at a price lower than the previous day's close. Of course, these measures dried up trading volumes and rendered the collateral of margin loans totally illiquid.
What money they didn't push out via this channel went to loans to a concentrated group of high-profile Nigerian tycoons. Some of these have, in light of the drop in oil prices and downturn in the Nigerian economy, proven disinclined to pay back their lenders. Since the middle of 2008, the Nigerian banking system has played out like a George Romero movie. The healthy banks fear to deal with the others lest they turn out to be zombies. The interbank market ceased to function and the CBN by necessity became the guarantor of all interbank activity. In June, Mr. Soludo was shown the door. His replacement began the stress tests and on Friday we saw the reckoning. The five intervened banks represent about a third of the banking system. Their non-performing loans amounted to more than 40% of their aggregate loan portfolios. Margin lending accounted for over 20% of their total assets. The rest of their lending, according to the local press, is highly concentrated (and overlaps quite a bit with some of the banks that are still standing) - rumor has it that the top 5 local borrowers (all large local conglomerates) and their directors owe the banks nearly $10bio. This amounts to a significant fraction of the capital of the entire system.
Here's where we come to the gang rape. The managements of the intervened banks apparently feel ill-used. When they lent all that money so generously provided by London bankers and their clients, they expected to be paid back. The borrowers were, after all, big names. Surely, they say, we cannot be blamed for recklessness, for we lent mostly to the most prominent and powerful men in Nigeria, or at least entities associated with them! Intercontinental Bank decided to take its case to the people. It had its lawyers take out a two page advertisement in the Guardian, consisting of an open letter to the President, "His Excellency, President Umaru Musa Yar'Adua, GCFR" (these Nigerians are nothing if not punctiliously correct in their address; if only they had been so in their lending!) remonstrating against the utter injustice of their being forced by the CBN to take provisions against their bad loans and in turn being intervened. In that queer farrago of solecisms, fustian, and punctilio that makes up formal Nigerian English, Intercontinental Bank via its lawyers complains:

The situation with our client is not that there is a preponderance of bad loans in its books. Rather, our client has a plethora of personalities, otherwise called the cabal, who have deliberately refused to make returns in respect of facilities from which they have benefited.
To proceed to sue these institutions as ordinary legal dictates would suggest, is to get bogged down with the legal technicalities and slow pace of the adversarial practice of our judicial system, which these cabal would engage to wear us down. We are thus forced to run after loan defaulters and rabid debtors who are daily being serenaded in the media, as affluent Nigerians.
A clarion call in therefore being requested of you, Mr. President, Sir, to dismantle this cabal that is hiding under the auspices of the Federal Government's fiscal and economic policies whilst gang raping our client, as with such other well meaning banks, that oil the economy of this great country. This gang-rape is obviously because we lack a credit registry or bureau in Nigeria where information and data on the credit history of persons and companies can be accessed to determine their standing in relation with other banks.

Gang rape is a funny analogy to use, when you think about it. For in the north of the country, the legal system's answer to gang-rape is to execute the victim. Say, come to think of it, not so bad an analogy after all.
Previously from AHFM: Don't Drink The Water