The first of many BEE deals drowning

Moneyweb’s article on Barlow’s re-striking of BEE options echos my earlier post on the trouble of underwater incentive options.

The sense of the article is that this sets a bad precedent. Of course, the precedent has been set years ago – I’ve personally calculated the additional costs under IFRS2 for BEE deals in danger of expiring worthless because the share price didn’t perform as expected. I’ve also seen deals where performance conditions for BEE partners have been massively relaxed because the performance was massively below the original targets.

But more than that, what choice do companies have? I’ll quote my comments on the Moneyweb article below:

Company’s issue the share options in order to improve their black shareholding for BEE purposes. The cost of this was born by shareholders, presumably because the alternative was more costly. (One can argue “right” and “wrong” but here we are talking economics not politics.)

Now, if the options expire out of the money, then the company loses the BEE points. In that case, providing the cost of issuing new options is still less than the cost of not being appropriately BEE rated, then the rational choice is to issue new options. Re-striking existing options is just a pragmatic approach of achieving the same end.

IFRS2, the accounting standard that governs the measurement of the expenses of issuing share options to employees or BEE partners, will require the increase in the value of the options to be expensed. Thus, the economic cost of issuing the options will be recorded in the income statement as well as being a true economic cost.

If the BEE partners had been given shares rather than options, then there would be no chance of them expiring out of the money. They would then experience upside and downside just like ordinary shareholders. However, to achieve the same % black ownership, the expense incurred would have been greater.

The company took a gamble that the share price would rise, hoping to save a buck. Market turned against them, and now they have to dip back into their pockets to pay a little more. Does it make sense for a company to gamble on its own share price? Wouldn’t it be better to take the hit upfront, with no fuzzy option-like liabilities floating around, half-hidden on the balance sheet?

The really frustrating thing is that often the utility cost of the issue options (to the current shareholders) is greater than the utility benefit gained by the BEE partners due to the restrictions on sale and concerns around concentration of risk.

Share options issued by companies for various purposes have many hidden dangers. If you’re planning to use them, it might be worthwhile getting a second or third opinion on:

  1. How to structure it
  2. How much it will cost under a range of scenarios
  3. What impact it will have on the financial statements
  4. How much it will cost to be valued for each financial period as well as audited
  5. Whether it will incentivise the desired behaviour
  6. Whether the beneficiaries understand and appreciate the structure, so that utility discounts are limited
  7. How the costs and benefits of the chosen approach compare against alternatives

Each of these 7 points requires careful thought, experience and training. A little consideration and planning can give dramatically better results.

ETFs and gearing, and the property market

Brief introduction to Exchange Traded Funds

An “ETF” is an “Exchange Traded Fund”. In it’s simplest form, it is:

  • a company…
  • with very specific assets (e.g. gold bullion or a portfolio of shares with the exact weights of a particular index)…
  • listed on (and traded on) and exchange
  • in which one can invest to get exposure to the underlying assets…
  • more easily, more cheaply, in smaller amounts and with higher liquidity than purchasing the underlying assets directly

The trick is that specific rules which allow market participants to “swap” appropriate portfolios of the underlying assets for new shares in the ETF, or redeem shares of the ETF for a proportionate share of the portfolio of underlying assets. This forces the price of the ETF very close to the fair value of the underlying assets. Arbitrage handles it.

This is a pretty simplistic descrition of ETFs, but it covers the major characteristics well enough to explain gearing in the context of ETFs and how this relates to the property market.

How ETFs can increase volatility in their chosen assets

ETFs have become very popular. The increasing gold price has meant that many investors want exposure to gold (since the price is going up at the moment, it will always go up, right?… right?). An easy way to get this exposure is to buy shares in the gold ETFs. This requires the ETF to issue new shares, and invest the cash in physical gold.

So the ETFs suddenly become significant purchasers of gold. Only a certain amount of gold enters the market every day. Some from raw production, some from recycling or sold jewellry, some from tightly held supplies with central banks or other investors. If we create a demand shock by introducing a new player (the gold bullion buying ETFs) on the demand side, the price will increase. The full price increase is mitigated through an increase in supply (think central banks in the short term, jewellry in the short to medium term, and gold production from new exporation and reopening of moth-balled mines in the medium to long term).

As the gold price rises, investors in ETFs tell their friends of their success.  More investors want exposure to gold (going up, always going up, can’t lose) and pile further into ETFs. The act of buying in such large amounts forces the prices up.

Hopefully this is sounding much like a bubble to you. And much like a bubble, two things are true:

  1. For a while, prices will continue to rise and there is money to be made selling on to greater fools
  2. Eventually the last fool will purchase and the bubble will deflate. Quickly.

Investors are a fickle bunch. Particularly individual investors who only piled into gold (to continue the example) ETFs because their Uncle Mike was doing so. As the price is on the way down, they sell their ETFs. The ETFs in turn sell gold and the geared effect unwinds in a hurry.

Prices move up more than they should due to feedback into the system and the inability of supply to increase instantaneously to meet demand. Prices move down for exactly the same reasons.

The price of eggs and property

FNB announced that they are withdrawing approvals for home loans on a large scale. This is on top of the banks existing moves to tighten lending criteria, and on top of higher interest rates, higher inflation, economic slowdown and both an increase in emmigration and a decrease in immigration.

So yes, demand for property is down. FNB’s move is both a result of declining property market and will become a driver of it.

The extensive expansion of credit financed a large part of the property boom. Credit expansion was profitable and low risk because “property prices are going up and will always go up”. Banks don’t really mind if you stop paying your home loan if you or they can sell your house easily for more than the outstanding loan balance. Once the sure-thing of rising property prices is found out to be the wolf wearing grandmother’s clothes, the party is over and the risks to lending institutions increase dramatically.

The greater fools have all gone.

Sounds like the sub-prime crisis in the US, doesn’t it? And we wonder why our banking shares are so “cheap”?

Didn’t expect this? Then you were foolish.

FNB has confirmed that they will be pulling approvals for home loans on a large scale. Many seem to have been caught by surprise. Fools.

To an outsider, it appears that FNB made a mistake in underestimating the trouble in the property market when they first gave these approvals. Their estimates of property price growth, interest rates and overall affordability were sufficiently incorrect that they have been required to publicly back-track. This decision would not have been taken lightly and must reflect serious concerns on the part of FNB management around future recoveries on these approved loans. So we aren’t talk about slight optimism either.

But again, many are surprised that one of our four large banks would get to this stage. Fools.

The property market only goes up. It’s a sure thing. Maybe the market will be flat for a while, but overall you will always make money. Property market cycles are long, due to the slow nature of supply reacting to demand and banks reluctance to sacrifice market share for profits. Markets do strange things, stranger than this.

Few remember that life insurers cut bonuses, previously thought to be guaranteed set-in-stone never to be removed during the troubled markets of the late 1990s.

So, if a bank recognising that property prices are not heading up and borrowers on 100% loans will be in negative equity positions for several years, why would we not expect them to take appropriate action?