Confidence and capital – Nationwide has neither

Nationwide Airlines is on the ground. A series of business and operational problems met the global economy of skyrocketing avgas prices and left them insolvent by R172m (assets of R46m less liabilities of R218m). They’ve also left friends of mine stranded in South Africa after a trip from Ireland for another friend’s wedding (congratulations Kay and Brennan!).

Simplistic overview of causes

  • High fuel costs – avgas has increased significantly recently.  However, this affects all airlines.
  • High fuel costs combined with fuel inefficient planes.  Nationwide’s older aircraft are less fuel efficient. Fuel costs per flight are thus higher than some competitors. An increase in fuel prices hits them harder.
  • Small capital base (now negative), high fixed costs and challenging break-even targets. Nationwide needed 75% capacity on its flights to break even. This reflects the high fixed costs per flight, and high fixed costs overall. A small capital base means that there was limited time to trade through difficult conditions and preserve the franchise / brand value of the operation.
  • Loss of confidence due to safety concerns, regulatory intervention. Since one of Nationwide’s planes “lost and engine” in flight confidence from the flying public has plummeted.  It has since emerged that the engine was in fact designed to free itself from the plane under certain circumstances. Combined with the pilot’s successful landing shows that the outcome was pretty good compared with other possibilities. However, a large portion of the market was not prepared to fly Nationwide anymore. Combined with the chaos preceding and succeding the operational and safety crisis, I stopped flying Nationwide simply because we had concerns about their ability to get us to our destinations on time. This may not have been based on a thorough analysis, but was based on several specific events. I’m sure I wasn’t the only one to reach this conclusion.
  • Price competition – pretty much the only customers prepared to fly Nationwide were those looking for the cheapest flight at any cost (safety, timeliness etc.). Thus, Nationwide’s pricing power diminished to virtually nothing. This exacerbated the need to fill planes to meet fixed costs.

Lessons for other organisations

Decreased capital bases have become a popular path to increased Return on Equity. Now, theory suggests that decreased equity will boost financial leverage if debt is involved (debt here including debt-like obligations such as fixed equipment leases). On a more practical level, decreased capital provides a smaller buffer against adverse trading conditions (default experience for banks, claims experience for general insurers, equity market declines for life insurers, interest rate shocks for most business). Assuming Nationwide had a viable business, a larger capital base would have allowed them to continue trading through the difficult times and emerge at the end of the tunnel a profitable business.

One of the standard counters to this is that if new capital were needed it could be raised from the efficient, deep, liquid, transparent, costless capital markets. Needless to say, those don’t exist. The practicalities of a bail-out package in sufficient time to keep an airline running make it especially challenging. Incidentally, it’s not unlikely that someone will take over Nationwide’s planes and staff – if our market does need those flights and employees that should find a home somewhere. If there was sufficient slack in the market for the other airlines to mop up the increased relative demand, then a company “exiting” the market is exactly what microeconomics would predict. Pity Mango has our tax money to shield them from a similar fate.

Financial services companies would do well not to dismiss Nationwide’s fate as “nothing to do with me”. Northern Rock’s catastrophic loss of confidence might have been a little closer to home, but shares the same message of significant gearing, illiquid assets and a loss of confidence. Capital strength provides more leeway to ride out tough times, but also adds confidence to customers (deposit holders, policyholders) which is most critical in tough times. The costs of financial distress rise as companies’ capital positions worsen. Low probability events can be catastrophic when they hit, and there is plenty of evidence to show how human beings chronically underestimate the probability of low probability events.

Hedging. Again.

Fuel price skyrocketed. Margins destroyed. Airline no longer profitable. Now, if an increase in fuel price really would be that deadly to an organisation, surely hedging of this otherwise uncontrollable risk should have been sensible? As it turned out, Nationwide was partially taking a bet on fuel prices declining or staying constant. Lose the bet lose your business. If they had hedged, even partially, and fuel prices had declined, they would have still been in a sticky mess, but presumably better than they are now. If the competitive position they would have been in with locked-in higher fuel prices would have meant that they would also have gone out of business, then I’m afraid this sounds more like a wild speculative fling than a sustainable business. Rolling dice on that scale doesn’t inspire confidence.

Three conclusions

  1. High gearing and a small capital base has definite costs they aren’t completely factored into a naive RoE analysis.
  2. Customer confidence is critical to a sustainable business and should be nurtured.
  3. Hedging of major, uncontrollable and potentially fatal risks must be included in an organisations risk and strategic management.

1Time down 11.4% today. Comair up nearly 9%.  Market taking bets on which company is better positioned for the new competitive landscape?

Repo rate raised 50bps to 11.5%

The South African Reserve Bank increased the Repurchase Rate today by 50 basis points. As usual, all the talking heads are out explaining why this was exactly the right thing, exactly the wrong thing, exactly the right thing for the wrong reason and several other combinations.

Historical levels of Repo

updated graphs – Short memory or what

Whatever your view, the following graph shows the repo rate inching towards the 12.5% of June 2002 and on to the 13.5% of September 2002. (Click image for a larger version)

South Africa repo rate since 1999

The steady, incremental increases that have typified Tito Mboweni’s increases since the bottom of 7.0% almost exactly three years ago stands in contrast to the steep mountain created between September 2001 and December 2003. In that period, rates increased by 4% within 12 months, stuck at the approximate level for 9 months before crashing down again by 4% in just 6 months.

Location, location, location. And interest rates

That incredible decrease in interest rates, and thus increase in the loans available to home owners had a critical role to play in the local property market boom that is now faltering in a serious way.

Even John Loss, FNB Home Loans’ property strategist, generally extremely bullish on property is worried:

“I believe that today’s development begins to raise the possibility of a small period of national house price deflation, which under a sideways scenario I believe would have been narrowly avoided”

Another viewpoint is that of RE/MAX’s Jeanne van Jaarsveld, who might have estate agent’s commissions in mind rather than property investors’ returns:

“…the latest rate hike would “further trim the already shrinking volume of residential property sales”.

However he said the “impact would again be cushioned, as have the earlier increases, if sellers lower their expectations on asking prices to effectively absorb the cost.”

A 5% decline in property prices only hurts by 5% if you earn the same percentage commission on the same number of sold houses. If you have geared exposure to the underlying asset, a 5% decline can easily magnify into a decline anywhere from 5% if you own the house outright, to 50% if you have recently purchased the house with a 10% deposit.

The total increase in the repo rate over this cycle so far is 450bps. For a home loan close to inception, this translates fairly closely to a 33% increase in repayment. For more mature loans, the impact will be less, perhaps in the region of 20% on average.

Impact on the economy

The impact on the property market is one of the reasons put forward against higher interest rates. Unlike Alan Greenspan’s apparent views, our Reserve Bank’s mandate has nothing to do with asset prices. Inflation control, currency stability yes. Property prices (or bond prices, or equity prices for that matter) should be of no concern. However, there are concerns around the broader economy. Manufacturing output, consumer confidence and business confidence are down.  Vehicle sales are down. Defaults and bad debts are way up. The full impact of the power shortages have not yet been felt. Higher interest rates will make it more difficult for most.

We want more, Tito… More!?!

However, there are several who believe the rate hikes should have come sooner and harder. Tito Mboweni states in his most recent speech that he (or the Monetary Policy Committee) should have raised rates sooner. Perhaps the slowly slowly approach has not been aggressive enough after all, allowing inflation to increase well outside the inflation targets. We will now have to deal with a prolonged period of high inflation and high interest rates.

And now?

Fiscal spending is still high, some companies have considered that perhaps the power crisis will have a smaller impact on their businesses than previously feared, Zimbabwe may have a chance of new government and South Africa have soundly beaten India in a Cricket Test Match in India. There is good news to be had, but finding it is becoming more difficult.

Given the large swings in the repo rate that we have experienced over the last few years, and given the totally unexpected shifts in both short-term and  long-term interest rates in countries such as the UK, the US and Japan over the last 25 years, who would still try to make long horizon forecasts around the level of interest rates, inflation and economic growth? Weather forecasts are relatively accurate, and weather forecasters have a realistic understanding of their own abilities.  Analysis of the accuracy of economist and analyst forecasts shows them to be poor, hugely overconfident estimators.

Sounds like an argument to manage your organisation’s risk exposure to uncertain, un-knowable, uncontrollable, exogenous effects.

Optimism and flawed decision making

Behavioural finance is no longer a “new idea”. It has entered mainstream finance education through CFA, Business Schools, even actuarial exams (ST5 for UK and South African actuaries). Some of the biggest lessons revolve around how bad we as a species are at making decisions in the face of uncertainty. Emotional biases, overconfidence, loss aversion, anchoring, problems related to framing, cognitive dissonance…  In this case it is no exageration to say that the list continues.

These problems are not only related to the financial markets. Hofstadter’s Law is that everything always takes longer than you expected.

Yes, even when taking into account Hofstadter’s Law.

When it comes to public works, Michael Coulson calls it “delusional optimism” in a fascinating short article focussed on our Gautrain debacle and analogous examples elsewhere in the world. The cause of these problems in public works programmes adds another element missing from most individual trading decisions. “Group Think” where a group performs poorly as a result of natural human characteristics in an unfortunate configuration. Given that the financial consequeces of failed, over-budget and under-expectation projects doesn’t fall too heavily on the planners and political sponsors, the third element must be lack of accountability. An awful mix.

Research by Flyvberg, a professor at Aalborg University, concluded:

The average cost overrun on transport schemes, estimates Flyvbjerg, stretches from 20% for road projects to 40% for rail schemes.

Given all the available reasons, perhaps we should consider ourselves  fortunate that the numbers aren’t a great deal worse than that.