All That Glitters / Ten Reasons to Expect the Extreme

Bank Leumi CEO Galia Maor issued a rare - and jarring - warning that now is the time to prepare for unlikely disaster scenarios. Here's why they aren't all that unlikely after all.

Galia Maor, Bank Leumi's departing CEO, rarely speaks her opinion in public. When she does so, it's always with reserve and caution. At the recent economic conference at Nazareth, however, Maor gave an extraordinary warning: "We all need to be better than ever before in preparing to deal with extreme scenarios." This advice is always appropriate for households and small businesses. But when it comes from the CEO of a bank that funds many of the economy's largest borrowers, the big tycoons should also take notice. Here are 10 reasons why.

Galia Maor - Ofer Vaknin - 08022012
Ofer Vaknin

1 Yields on bonds are high. Israel's 10 biggest borrowers owe a combined NIS 180 billion to the banks and to bondholders. This sum only includes companies: It doesn't apply to personal debts of the tycoons at the top of the business pyramids. No less that NIS 40 billion of this amount is in bonds now trading in junk territory, with double-digit yields.

Such yields convey the market's lack of confidence in the tycoons' abilities to repay the money. These yields don't merely reflect the stock market's mood: A company with debt trading at returns of more than 10% cannot issue more bonds at a lower yield, and cannot go get credit from a bank at 5%. Even if the loans officer thinks otherwise, he simply can't ignore the price set by the market on that company's debt.

2 Israel's banks don't have money. A local credit crunch has been developing over the past few months. This is mainly due to directives by the Bank of Israel's bank supervisor requiring banks to expand their capital cushions to conform with the worldwide trend. As a result, the banks' capital resources are extremely thin and limited, and the banks would rather extend credit to medium-sized institutions and to borrowers they are confident will pay them back. If credit is limited, the last thing the bank wants to do is pour it all out in one large transaction.

3 The big borrowers' reputations are in tatters. The big borrowers were considered a sure bet up until three years ago. Thanks to their diverse businesses, the banks and institutionals relied on the tycoons' word and readiness to save a floundering business with guarantees and cash injections from other businesses and personal wealth.

The crack in this theory appeared two years ago when two tycoons, Lev Leviev with his Africa Israel group and the Ofer family with Zim Integrated Shipping Services, failed to meet their liabilities and arranged for debt settlements. The theory was completely shattered by the recent affair involving Delek Group owner Yitzhak Tshuva, who had built a reputation as a businessman who can be counted on when he poured his own money into the bankrupt Green Computers more than a decade ago, even though he wasn't obliged to.

When the extent of Delek Real Estate's losses was revealed, it became clear to all that even a well-intentioned tycoon cannot meet his liabilities if they are too large. Last week, Tshuva finalized a debt arrangement with Delek Real Estate creditors that included a haircut that could exceed 50% - and his reputation went up in smoke.

4 The crisis in Europe is worsening. While the U.S. has recently seen harbingers of economic recovery and dropping unemployment figures, Europe is still teetering on the edge of the precipice. Last month the continent was caught in a grave credit crisis and its leaders were forced to order the European Central Bank to give commercial banks a special, unlimited three-year credit line, a creature called LTRO - Long Term Refinancing Operations.

In the past few days it came out that banks already have taken out no less than half a trillion euros, proving that LTRO prevented the European version of the U.S Lehman Brothers incident. But this money is only emergency funding, and European banks are still going through a painful and deep process of reducing their balance sheets and cutting back credit to customers. They don't have the means to recycle the debts of Israel's big borrowers, either.

What about the U.S.? American banks are also far from done ridding themselves of the "radioactive garbage" accumulated before the 2008 crisis. And this is before taking into account the consequences of a full-blown crisis in Europe - a scenario many economists deem inevitable.

5 The social protest, Trajtenberg report and competition. For every business, and certainly for the large business groups, the ability to recruit credit depends on the quality of their assets and their ability to generate cash flows to cover financing costs. But for many of the large companies, profitability has been whittled down by the social protest and the government's battle with monopolies and uncompetitive markets.

The cellphone companies were hurt by the reduction in interconnect fees and the welcome opening of the market to new competition. Food companies have been besieged by irate consumers and were forced to lower prices. Real estate companies are facing an end to the price increases of the last few years, coupled with directives from the central bank to cut back on housing credit and mortgages. When profitability drops, it becomes harder to obtain credit, both from banks and from the bond market.

Meanwhile, the Trajtenberg report made it clear that companies enjoying excessive monopoly profits won't be able to count on this for long. An example from the news: Nesher, Israel's sole cement maker and part of the IDB group, was singled out for special attention in the report, resulting in calls for the government to open the cement industry to competition.

6 The real estate bubble in Israel is losing air. Almost all the big borrowers have real estate operations in Israel and around the world. When prices are steadily rising, it's easy for business barons to revaluate their assets, raise the value of their collateral and receive additional loans to help refinance the debt of other group companies.

The credit bubble in the U.S. and Europe has long burst, leaving behind quite a few victims like Yitzhak Tshuva's and Nochi Dankner's Las Vegas casino scheme, Tshuva's British properties, and Lev Leviev's and Moti Zisser's Eastern European malls. The hot air is now starting to let out from Israel's real estate sector, rocking one of the big borrowers' last islands of stability.

7 The tycoons' "mutual support network" has disintegrated. Once upon a time, when there was more money, the tycoons would help each other out when one got into trouble. The business barons collaborate in business and ownership, and largely divide up the sectors of the economy between themselves. Tshuva's Delek and Zadik Bino's Paz Oil dominate in energy and don't interfere with Dankner's Cellcom, Ilan Ben-Dov's Partner Communications, or Shaul Elovitch's Pelephone and Bezeq, all telecoms. Ben-Dov and Eliezer Fishman cooperated in several mutual business deals. But when half of these businessmen are having trouble rolling over their own debt, the mutual support of the top 0.1% club collapses.

8 Personal leverage. The calculations of the big borrowers' debt don't include a rather important element: the loans many of the tycoons took to buy their business groups in the first place. The precise value of that element is not known, because these are family firms that borrowed from banks, but it does weigh on their companies' borrowing capacity.

Why? Because lenders, banks and institutional investors fear the tycoons will squeeze their companies dry by transferring profits up the pyramid, up to the controlling shareholder, so he can return his personal loans to the banks.

That fear came out into the open over the last month, when Altshuler-Shaham wrote a letter to the board members of IDB group company Discount Investment Corporation, warning them against approving dividends that are not in the best interest of the company or its public bond- and shareholders.

9 The concentration committee. It will be announcing its final conclusions only sometime in the next two weeks. But it is known to have identified some weaknesses in the capital market, and tried to find cures. The first is that some of the big borrowers own both financial and non-financial companies, and their non-financial companies borrow from the financial institutions (which manage the public's pension savings ). The committee will be recommending that some of the tycoons be forced to choose: they can own financial companies or non-financial companies, but not both.

A second problem the committee noticed is pyramid holding structures, which allow the controlling shareholder at the top to do as he pleases with the companies lower down in the structure, even though a majority of those companies' shares are owned by the public, not by the controlling shareholder. In short, the committee exposed conflicts of interest in borrowing and lending within business groups. The groups had been used to this conduct and are already being forced to wean themselves of it.

10 Liquidity trap? One can almost taste the tycoons' frustration. On the one hand, the base interest rate - that the government pays on its bonds, which is the benchmark for interest on corporate debt - is very low. On the other hand, they can't take advantage of it.

This is known as a liquidity trap. Described by the economist John Maynard Keynes, this happens when the central bank injects a large amount of money at low interest into the private banking system to stimulate economic growth - but interest rates fail to drop. People are hoarding their cash due to fears of brewing economic woes, such as a recession. Israel isn't there yet, but with a credit crunch worsening by the day just when interest rates are declining, Israelis will probably have to add "liquidity trap" to their lexicon soon enough, alongside the terms "tycoon," "debt arrangement" and "haircut."