Irrespective of whether New York-based M. Fabrikant & Sons will go Chapter 11, Chapter 7, or whether the company will end up flourishing again and rise to greater prominence with new outside investors at the helm (and we still like to bet on the last option), there is one conclusion that seems to me to be inescapable: if the bankers of the company – all of them – would have worked together in harmony, the present calamity could have been avoided. This isn’t just journalistic speculation, this is a view shared by some of the principal banking players involved.

We shouldn’t get carried away. The Fabrikant diamond company, established in 1895, operating 20 companies in 10 countries, and employing close to 1000 employees, was facing a difficult period. It was losing money – but, that being said, it wasn’t, and didn’t need to become, a doomed company. The company’s business model had become problematic with the diminishing role of the polished wholesale distributor in the diamond value chain. The $1 billion turnover was not sustainable, and the company’s turnover declined by hundreds of millions within a short time span. But it was more than that. A spate of retailer bankruptcies hit the company and hit it hard.

The owners of Fabrikant could possibly have made a greater effort in rescuing the company – or they may have underestimated the severity of the situation. This is hard for us to say. They certainly underestimated the results of discord among its bankers. If there is one diamond company that earned and deserved the unqualified support of its bankers, it is M. Fabrikant & Sons. Charles (Chuck) and his son Matthew Fortgang had established a tradition that, in February each year, the company would reduce its banking debt to near zero.

Right from the beginning of this crisis, the larger banks favored a different strategy than the smaller ones. The main lending institutions proposed injecting more credits; the smaller institutions wanted the opposite. Some were “in the middle”. One of the triggers of the Fabrikant problems came when, early this year, the company didn’t reduce its debts at HSBC to the aspired-to level – and then was confronted with an unwillingness of the bank to allow the company to maintain the credit facilities it enjoyed before the debt reduction.

The company claims that it proportionally reduced its exposure with all its banks and that paying more to HSBC would not have been fair to the other banks. Apparently, by that time various agreements with and among banks were in place – and cracks became apparent when the friction among some of the lenders became evident. Then HSBC called for the return of the remaining debt. Technically, it is correct to say that the company defaulted at HSBC – and the latter pulled the plug. When, in a difficult market, cash flow is negatively impacted – one stops buying, which leads to reduced sales; it’s a vicious circle.

Apparently, many months earlier, in the year before, HSBC had notified both its client and other banks of its intention and had shared concerns about the plight of the company. The lead banks didn’t share HSBC’s concerns – and refrained from taking early action. So when one bank pulled the plug, the consortium’s lead banks together with some minor players, provided bridging facilities.

These banks were by then fully aware of the difficulties – and of the possibility that the company may “not make it” – but they also saw the challenge of assisting in the restructuring of the company. Lower volumes required massive reduction in overhead, redundancies of employees, etc.

In February 2006, the company was asked by its lenders to put more money in the company and the shareholders complied. It was asked again a few months later and was unable at that point. It was apparent by that time that substantial amounts were needed. Owners were willing instead to raise equity by bringing in an outside investor and they remain committed to that position.

There appears to be considerable discord within the consortium of lenders, which may face a potential loss of 50 to 75 cents out of the US$1.00, unless, of course, a successful bailout will occur soon. From a banking perspective, when a few hundred millions of doubtful debt is potentially at stake, it is inevitable that lenders devise loss-mitigation strategies. At the end of the day, for any corporate giant at the mercy of its bankers, the final end-game scenario is written by the lawyers of the financial institutions rather than by the representatives of the company’s owners.

The window of time to bring in an outside investor seems to be rapidly closing. Unsecured creditors have been meeting this week (which includes an Israeli bank) and it is expected that demands for full debt payments may be forthcoming now at any time. Ideally (if that word can be used), Fabrikant should present its recovery plan, including the commitments of an outside investor, as part of a Chapter 11 filing without much further delay. Some of our sources had expected some action today – it didn’t happen. Let’s hope for the company, the trade, and the business at large that the final touches are being made to the restructuring plan, jointly with the new investors.

We wish Matthew and his team well.

Banks Employ Different Risk Mitigation Instruments

The rest of this article has basically nothing to do with Fabrikant – and is essentially a separate piece focusing on risk-mitigation strategies of banks. [In a way, Fabrikant serves as a “case study” – and as a warning of what can happen to a borrower if one’s bankers don’t see eye to eye. We can easily cite a dozen similar examples.]

 It is the core business of banks to lend money – and, through risk management, banks try to optimize profits and minimize risks. When a default may be pending, a borrower needs to understand what instruments a banker employs to mitigate his or her risks. The borrower’s future may depend on this.

Let me be more precise. One might remember that Citibank, which was a major lender to Enron, had apparently protected itself from a significant portion of Enron’s credit risk by passing it on to investors in credit-linked bonds. The name of the game was transferring the credit risks. In the Enron situation, Citibank had accomplished a transfer of risks through a combination of different, innovative (at the time) transactions that combined credit derivatives, insurance and traditional securitization.

There are other examples in recent history of calamities that left innovative banks relatively unscathed. J.P. Morgan Chase had covered virtually all of its exposure in the infamous WorldCom case (the now defunct telecommunications company). If articles in financial studies are correct, some US$17 billion of credit had been securitized, and the bank itself lost merely some US$20 million.

What many diamond-industry players may not sufficiently appreciate is that the future of a company facing hardship, to some extent, depends on the risk-mitigation instruments in place among the banks.

            When Enron and WorldCom are mentioned, there is an immediate association with possible fraud and with “cooking the books.” Let me make it crystal clear: we don’t have one single shred of evidence that there may be anything improper in the Fabrikant business, which has been managed and owned by successive generations of some of the most respected diamond and jewelry merchants in the diamond business.

            In a general way, we are aware that there are time-honored customs and practices in the diamond industry that may not meet the most stringent accounting standards (though the industry’s record on this is improving every year, month, and day, especially in the United States). Having weaknesses in one’s books of accounts makes a company vulnerable. Banks, desperate to limit their losses, might find a loophole here to use to their advantage.

            This takes me back down memory lane to the Israeli diamond industry in the early 1980s. Diamantaires would deposit diamonds with the banks, draw credit, and then the banks would hand the diamonds back to the borrower “in trust” to enable him to trade in these goods. The banks had secured an insurance cover from Lloyds Underwriters in London in the case that diamonds were not returned to the banks because of infidelity or fraud. So when many borrowers defaulted, the banks – mostly unsuccessfully – tried to prove fraud. The courts disagreed and the banks had to write off their losses. Some banks exited the industry at the time.

            Back to the present: What intrigues me – and worries me deeply – is that we may again see a period in which some banks may wish to rely on their insurance cover not just as a risk mitigation vehicle, but rather as a loss recovery tool. When lending banks may not have much collateral, they may not have a great deal of hope to recover much from the outstanding debts – unless a case for fraud can be made.

Ask Your Bank about its Risk Mitigation Tools

            Banks know quite a lot about their clients. Though apparently still not enough, or mega-defaults wouldn’t happen. However, for most borrowers, their banks may know more than any other party on the intricacies of their business. But what do we know about the banks? What are their risk-transfer mechanisms? In India, for example, risks are reduced through consortium financing. In Israel, at least in the past, the Union Bank had risk-sharing agreements in different forms with Bank Leumi and, later, Israel Discount Bank. In Antwerp, some large players have various securitization programs in place (on accounts receivables and inventories), and it is known that the Antwerp Diamond Bank has developed some innovative debt syndication products.

            Have you ever asked your bank how much “self-deductible” they have in case of an insurance cover? If the bank’s own participation is at least US$8 million, then the bank has no reason to start a “fishing expedition” if the exposure is, let’s say, US$5 million. Don’t jump to the conclusion that banks “don’t trust their clients.” Most banks hold large insurance policies to protect themselves from their own employees. In the wake of the (stock market) trade-related losses that brought down Barings Bank, and severely hit other institutions (Sumitomo Bank), Lloyd’s has began issuing “rogue trader insurance,” which will reimburse a bank for damages sustained from unauthorized trading.

            There is another ugly side to this: In the United States, deposits in banks are insured through the Federal Government’s FDIC. Thus, if through losses, a bank is not able to honor the deposits its hold – the government will jump in. However, a little-known clause in the law says that if any bank in the United States has been defrauded (and thus indirectly putting Federal Government money at risk), the FBI has a right to look into the situation as well. In the GIA bribery scandal, we have reluctantly concluded that the prosecutors didn’t find the frauds committed serious enough to expedite meaningful actions. But this hardly could be compared to a banking fraud; this is far sexier for prosecutors than a grade-change-for-money.

The Interim Lessons from Fabrikant

            Though the market knew that the consortium had joined a restructuring program, which would have given the company a lease of life well into early 2007, word had it that the parties were clashing: some banks wanted Chapter 7 now, while the company owners were pushing for a Chapter 11. [For non-U.S. readers, When a troubled business decides that it is unable to service its debt or pay its creditors, it can file (or be forced by its creditors to file) with a federal bankruptcy court for bankruptcy protection under either Chapter 7 or Chapter 11. A Chapter 7 filing means that the business intends to sell all its assets, distribute the proceeds to its creditors, and then cease operations. A Chapter 11 filing, on the other hand, is an attempt to stay in business while a bankruptcy court supervises the "reorganization" of the company's contractual and debt obligations. The court can grant complete or partial relief from most of the company's debts and its contracts, so that the company can make a fresh start.]

            Why would banks – or any bank – favor a Chapter 7 just weeks before the best jewelry sales month in our industry’s calendar? Doesn’t it make sense that the value of a diamond jewelry business as a going concern is undoubtedly higher than the value of the sum of its parts if the business's assets were to be sold off individually? Conventional wisdom would have it that – in almost any scenario – Chapter 11 would be preferable

            Banks have many different ways in which they mitigate their own losses. Most will give preference to restructuring. However, some of them have internal and external fraud insurance. In a Chapter 7 or Chapter 11 situation, any creditor may ask the court (or the appointed receiver or administrator) for forensic accountants to come in for – what one might call – a fishing expedition.

            Take, for example, a bank that has an uncovered exposure of US$20 million. When all assets are sold and divided in a hypothetical bankruptcy, it may, let’s assume, recover 20-25% of a debt. It thus faces a loss of US$15 million. However, in the fraud insurance, it carries a US$1 million self-deductible. In the case of fraud, the insurance would pay out US$19 million. That makes a big difference.

            And it makes for quite a scary scenario.

Ripple or Domino Effects

            When making queries about the impact of the Fabrikant situation, reactions range widely. It is clear that the reputation of the company has received a blow. When staff is made redundant, this always creates ill will, frustrations, and bad feelings. Needless to say, for none of the suppliers or clients it is business as usual. 

            But surprisingly, most people in the trade are worried about how a massive banking loss will impact the banking industry. Currently, there are only a few dozen major banks servicing the diamond industry, and every main center has only a handful – Antwerp may not even have that. The impact of one or more banks withdrawing from the industry could have a tsunami-type of impact. This business cannot operate without money. Period.

If there is any lesson for the bankers to draw on, it is that in times of difficulty, they must get together at the earliest possibility. In the case of Fabrikant, some believe that it wasn’t done early enough. It is imperative for the banks to work together. If one or two members of clients’ lending consortium break ranks or hold contrary views, it not only may spell catastrophe for the client, but banks usually end up losing more than they would have lost otherwise.

            The lending banks in the Fabrikant situation are quite an odd bunch in terms of size and positioning. My back-of-the-envelope calculations apportion some 40 percent to ABN-AMRO, 38 percent to Chase, 12 percent to HSBC, and 10 percent to Leumi. The Antwerp Diamond Bank and others hold some smaller – but still sizeable – amounts. This would all add up to slightly over 100 percent, which underscores the approximation of this journalistic conjecture. The exact figures aren’t relevant in this instance. Each of these banks has different ways in which they mitigate their own losses. As a group, they could, and should have coordinated better and made greater efforts to have one joint position and approach.

Like any book, it’s the final chapter that counts. If Fabrikant survives and flourishes, it will certainly be because of the banks. If it goes under, banks will have to live with the uncomfortable thought that possibly – though there are no guarantees – they might have been able to avoid such an outcome. This should, however, strengthen their resolve to do better next time. As bankers know, there will always be a next time.

Have a nice weekend.