Yesterday – yesterday was the day of much public opinion. And much of the opinion fell in the direction of “abuse of taxpayer money”* and “African Bank should have been allowed to fail”.
*I already dealt with this yesterday. There is no taxpayer money at play here. The SARB has bought a R17 billion loan book (that’s book value net of impairments) for R7 billion. That R7 billion will be borrowed from investors (because the government is already in deficit – so it’ll come from government bond proceeds). In all likelihood, that R7 billion will be repaid long before any taxpayer would cover it. People need to calm down about their taxpayer money.

Also, some of my Austrian Economist friends spent time explaining why African Bank is a malinvestment, and therefore why its failure would actually have been better for the economy.

I clearly disagree*.
*Full disclosure: I have a vested interest as an African Bank shareholder. Although I think that fact is entirely irrelevant here – I invested last week on the expectation of a bailout, not on the basis of some moral/economic position as to whether bailouts are a good thing.

I’m going to get to that in a moment. But I’ll begin with some preamble:

1. This post follows on from two earlier posts:
   1. And I give you….African Bank 
   2. African Bank: How I LOVE me a bailout
2. The first post explained why I thought African Bank was worth a punt.
3. The second post (from yesterday) explained the bailout plan (at least, as far as we can understand it from Gill Marcus’ speech), and why I thought the bailout was good for shareholders.

But neither of those really dealt with whether or not the bailout was good for the economy.

And to be honest, I think it hinges on this question:

“Who would have benefited from African Bank’s failure?”

To which my answer is: “Only the liquidators“.

Who would have lost if African Bank was left to deal with this on its own? 

Here is a picture of African Bank (and contrary to popular belief – it did have depositors):

 

The primary problem: African Bank has been struggling to collect from some of their borrowers (in all likelihood, many of those that weren’t being paid in all the industry strikes).

In addition, because of their bank status, they had to keep up with some regulatory stuff (like capital adequacy requirements), which meant a whole lot of rights offers in order to maintain the right equity balance.

However you want to describe their failings, African Bank had impact on a lot of people:

1. Borrowers – even though it was struggling to collect from some of its borrowers, 65% of its loans were just fine. The liquidation of the bank would have cut all those borrowers off and left them relying on loan sharks and other microfinance houses. 65% of their borrowers! Consider that the net loan book was worth around R43 billion. Then consider that most of these loans were small (under R20,000). I mean – we’re talking millions of people here that would lose access to formalised credit.
2. Depositors – yes, there were some. Not a lot – about R100 million worth. Who were they? They were people with fixed deposit accounts and notice deposit accounts. Fixed deposits with very low minimums (like, R500). Compare this with FNB, who has minimums that look a lot like R10,000. And the interest rates being offered by African Bank were high – high enough to attract the lower income classes to save.
3. Employees – because these banks were run by people. With families.
4. Third Party Contractors – because each branch would have employed cleaners and IT support and so on.
5. Investors – pension funds and money market funds and people that manage the money of fairly ordinary people. And some individual investors.
6. All of us – no one really knows what the impact of a particular bank’s failure will be. Because credit is so interwoven into the fabric of our economy, the collapse of a part of it can have sudden and dramatic consequences. It’s a bit like doing a frontal lobotomy – sometimes it’s sort of fine in the end. Other times: vegetable.

So all of the above stood to lose: jobs, investment, livelihood, pensions, savings, economic stability.

But for the sake of argument, let’s assume that the economic stability actually wasn’t an issue. That African Bank could fail without contagion. And that the bank itself was a malinvestment that ought to be allowed to come to its final end. That is: all the borrowers, employees and investors had made some bad decisions, and that the whole thing was unsustainable, and that therefore, it was best to let the thing die.

Let’s Talk About Liquidation

So the standard story is: liquidation is just realising the losses that have already been made through mismanagement (and/or malinvestment).

That theory, while convenient, is totally and empirically false. And dangerous.

Under South African law, creditors can apply for orders of liquidation when debts are not being paid. The standard test for liquidation is insolvency. Consider what insolvency is:

Factual insolvency is that moment when a company’s assets are less than their liabilities.

To give you an example: if a company has R60,000,000,000 (R60 billion) worth of assets, and R60,000,000,001 (R60 billion and one rand) worth of liabilities, then it’s factually insolvent and may be liquidated.

Is the company being mismanaged? Perhaps.

But is there still value in it? Absolutely. You are talking about tens of billions of rands worth of assets that are under dispute. And for R1, we’ll liquidate it.

So let’s assume that we do that: we have now initiated a wildfire of value destruction.

What happens next:

1. Lawyers are appointed.
2. A liquidator is appointed.
3. Trustees of the liquidating estate are appointed.
4. How are these people paid?
5. They are paid based on their ability to turn the assets of the company into cash.
6. In the current legislation:
   1. Liquidators take about 10% of whatever they recover.
   2. The Master of the High Court takes about 5%.
   3. The lawyers and trustees and the other overseers charge their own fees which are payable long before anyone else.
7. So even assuming that the liquidator manages to recover the full R60 billion, at least R10 billion will be gone in fees before anyone that originally funded the business has a look in.
8. But the liquidator will never recover the full R60 billion. He won’t even try. The faster he does the work, the quicker he gets paid. Those assets will fly onto the market at deep discounts in order to liquidate them as quickly as possible. It’s why you hear people only recovering 30 cents on the rand – fees and fire-sales.
9. And even more so, those markets where the assets are being sold will be destabilised by sudden floods of supply (especially if the liquidation is signficant).
10. The liquidation will destroy more value than management ever did.

Liquidation is a last resort precisely because it so destructive.

 

So here’s the real question

Even if you believe that African Bank is a malinvestment, why is liquidation the best way to deal with it?

It is the worst way to deal with it.

Surely surely it’s better to try and turn the malinvestment into an investment? You can change the management and reform the business model and manage the process.

All that the SARB did was use borrowed money to create some breathing space for the market to have a moment to conduct its own reforms on African Bank. You have a whole lot of new investors (almost half of African Bank’s issued share capital traded hands on Thursday and Friday last week). You have new management. You have a more solid chance of a capital raising.

And that is a far more constructive way of dealing with a malinvestment.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.