“Why the hell should we finance DTC Sight boxes, which we know to be overpriced and are causing losses to our clients?” fumed a diamond banker from his holiday resort somewhere on the Mediterranean coast. “That’s irrational behavior on our part. The time has come to put a stop to it. It is irresponsible from a banking risk perspective to make facilities available for the financing of an over-priced commodity.” An Antwerp banker echoed this view, “We have already put a policy in place - we refuse to finance a Sight box that makes losses.” Almost as an afterthought he added, “We have been thinking of sending our own valuator to London who will look at the goods together with our clients. If the valuator believes the goods are overpriced, the client can go and shop somewhere else for the money…”

            That is quite an intriguing scenario!

            “Sometimes I think we live in self-denial. We seem to be unwilling to face the fact that the DTC Sightholders, always viewed as the most financially powerful players in the market, have become high or higher risk clients. In recent years, they have made downstream investments against their own best judgment, just to please the DTC and solely to maintain or increase their allocation eligibility. They have purchased stocks they don’t need. And now, on top of it all, they feel compelled to purchase goods which are overpriced and will lead to financial strains or even losses. If you think about it objectively, it is insane.”

            What the banker didn’t say was something that was clearly on his mind. Regulatory authorities or the bank’s own board of directors may find the diamond bankers at fault. There are several fundamental lending criteria that the diamond bankers may be violating. Loans should be granted on a sound and collectible basis. Loans should satisfy legitimate credit needs of the borrower. The point may come when the banker’s judgment may be challenged by top management or auditors. At the end of the day, the integrity and credibility of the lending process depends on objective credit decisions that ensure an acceptable risk level in relation to the expected return.

            Does the financing of a $10 million Sight box that has a market value of $9 million meet the criteria of an “objective credit decision” and “acceptable risk levels?” There are some banks that specialize in diamond industry financing and have a limited ability to diversify their lending portfolio risk. Credit risk is still the most common cause of bank failures; are the diamond bankers taking too great a risk in financing unprofitable business?

            “Bank failure? You must be out of your mind,” one might argue. Not so – the early 1980s isn’t so long ago that we have forgotten what happened then. But a look at the past 12 months is sufficient to recognize that there is a fundamental problem. Defaults, near-defaults, major solvency problems, debt rescheduling – you name it – all have occurred in the lending portfolios to Sightholders.

            Allow me to say it with sadness: the Supplier of Choice's (SOC) policies in conjunction with the pricing policies of the DTC have made Sightholders high or higher risks clients for banks.

The DTC Client Scorecard vs. the Banker’s Own Scorecard

Over the past five years, banks have bent over backwards to assist their Sightholder clients in meeting the DTC Sightholder criteria in terms of, for example, the lending versus liquidity ratio. SOC’s criteria encourage using the bank’s money as this will provide a greater return on one’s own capital. SOC’s criteria have, de facto, encouraged the withdrawal of equity from the business in favor of higher leveraged operations.

            A regulator or risk-compliance officer looking at some of the banking lending policies prevalent in the diamond industry will see all the signs of a distorted credit culture:

            Compromise of Credit Principles. This situation applies to loans that have undue risks or are extended under unsatisfactory terms and are granted with full knowledge of the violation of sound credit principles. [Reason for doing so: eagerness to help the client; unwillingness to face up to the fact this is not the kind of help that the client needs – or has the right to expect from his bank.]

            Anxiety over Income. Historically, within the banking systems, the diamond industry financing branches are among the most profitable branches of a bank. That is certainly the case in Israel, as it is in some other centers. Unwittingly, a banker’s preoccupation over earnings may outweigh the soundness of lending decisions, underscored by the hope that risks will not materialize – at least not on “his or her watch.”

            Poor Judgment of Risks. De Beers’ executives have attributed the recent liquidity crunch to rising interest rates. They should have added the volatility of rough diamond prices as a factor which, more than anything else, is leading to an increase in the financing risks. In any event, banks should have known better. The extension of loans that initially seem a sound financial risk may quickly deteriorate to a level beyond the reasonable payment capacity of the borrower. (Hand on your heart: how many lending portfolios depend on an increase in future diamond prices in order to return to some comfort zones?)

            Banks are showing many of the signs of implementing strategies to “work with clients” to reduce the credit risks. In New York and elsewhere, attempts are made to reduce the facility levels while at the same time the borrower provides additional capital (from where?), collateral, or guarantees. Consortium agreements are signed among banks and arrangements are made for a problematic borrower to be bought or taken over by a more creditworthy party, or some form of joint venture is arranged.

            But these are all part of “rescue operations.” These situations can often be avoided if good money isn’t thrown away for the wrong reasons – to finance situations where banks should have the courage to say “no.”

The DTC Monitors the “Top 18” Diamond Banks

            Occasionally we hear stories about banks telling the DTC not to have a large Sight or not to provide goods beyond the normal ITO (Intention to Offer) allocation levels. I think that diamond industry bankers who truly believe that the DTC is listening to them live in delusion. Don’t mix a kind of acknowledgment of concerns with an affirmation of action.

            The DTC has become extremely sophisticated in monitoring the diamond banks and the levels of unutilized facilities available to clients. It is an uneven level playing field. The DTC knows “how far they can go.”

            Because of the Sightholder profile questionnaires, the DTC has the tools to plan its moves carefully – it knows exactly how far the banks have committed themselves to the Sightholders and, by providing goods beyond the ITO, can test how far a bank may go beyond the agreed facility.

            One banker was angered by a specific question in the Profile Lite, the latest questionnaire to DTC Sightholders. The profile lists 18 diamond banks by name and Sightholders are required to list precisely the size of the available credit facility at each of these banks. (Somewhere else in the questionnaire questions about the utilization of credit appear.)

            There is nothing new in the DTC asking for information on credit availability - but by requiring credit facility information extended by each of the leading 18 diamond banks, the DTC signals that it clearly has the tools to see precisely to what limits it can go – and to see if it can go beyond them.

            With one click of a computer button, the DTC can print a list of the 18 banks, see at a glance how much they have committed to the DTC Sightholders together and how much of these commitments are utilized. This is a wonderful management tool to optimize sales in a market that suffers from a credit crunch. If De Beers was only interested in knowing the total available credit facility to a client, one question and one simple answer would suffice. As one Sightholder wondered aloud, “from a DTC perspective, it should have been sufficient for me to state ‘I have a total facility of XXX’.”

Concerns about Bankers Intentions and Behavior

            There is another side to the coin. In the past, De Beers conducted a regular liaison with the banks. Nowadays, they hardly talk. De Beers, however, cannot afford surprises – the company must do scenario planning and must take into account that a bank may suddenly decide to withdraw altogether from financing the industry. This has happened in recent years, and it will undoubtedly happen again. For De Beers’ own wellbeing, it may indeed need to monitor exactly the levels of total utilized and non-utilized credit facilities at all of the top 18 diamond financing banks. On the one hand, De Beers provides the DTC with a considerable advantage in optimizing its rough diamond placing power in the business. On the other, it can also better anticipate a bank’s withdrawal from the business – or monitor irrational banking activities.

            Something else needs to be said: bankers are vocal on “overpricing” by De Beers – and that is quite understandable, as De Beers is still the dominant producer. The bankers are less vocal on the “overpricing” by other producers, such as the outward insane prices paid by diamantaires participating in Alrosa tenders. Though there were some banking protests when Argyle customers were asked to enter into extraordinary price commitments, banks by and large acquiesced. Today, many diamantaires who entered into such arrangements are, de facto, defaulting on their own promises. They are taking 10-15 percent of what they had undertaken to purchase.

            Or take the BHP Billiton premium obligations. Commitments were signed, but clients weren’t able to meet their own obligations. The same can be said about clients’ commitments surrounding the CanadaMark. One observer recently remarked that, “the industry is very quick in making costly undertakings. When, at a subsequent stage, they are actually defaulting on their pledges, what is left is a larger banking debt.”

            Today there is no single market custodian; there is not even an effective market leader (more about this later). There is a spiraling banking debt – which we believe is actually above $14 billion and probably more – and a massive collective commitment to pay the higher interest rates. If we assume that industry players at an average may pay Libor plus 2 (let’s say 7.5 percent), the annual industry-wide interest bill hovers just above $1 billion!

            That is a lot of money for banks to collect. There is a real concern about the collectability of the interest, there is a real concern about further rate increases; there is obviously a real concern about the industry’s ability to reduce (i.e. pay) the debts – and there is a real concern about the bankers’ ability to manage defaults.

            This may well explain why De Beers is closely monitoring the 18 banks that provide most of the facilities to the DTC Sightholders. These banks are: ABN-AMRO; ADB; Bank Leumi; Bank of Baroda; Bank of India; Canara Bank; Central Bank of India; Corporation Bank; Dena Bank; Dexia – Paribas; FIBI; Fortis; Israel Discount Bank; Mizrahi; State Bank of Hyderabad; State Bank of India; State Bank of Saurashtra, and Union Bank of Israel.

            Then there is also an “other” category, but tellingly, there is no need to provide the names of these other banks – just the total facility level at other banks. Among these other banks there are at least 60 Indian lenders who may hardly understand either the business or the risks. They are only interested in giving money – always more.

            I used to smile at diamond business conferences where the industry’s main bankers would always succeed in explaining that the banking debt is high – but it is “responsibly high” and “commensurate to the volume of the business.” As conference moderator, I often sympathized with these bankers. Their management bosses were often in the audience; the speakers hardly could have gone on record stating that the debts are too high – as then the question, “who has given the credit to begin with?” would arise.

Friendly Bankers may become Less Chummy

            We expect that diamond banks will soon be forced to review their credit policies, not just because of the enhanced industry risk levels, but as part of their own internal reviews in preparation for Basel II. No heads will roll, because nobody has given “too much money.” What has changed is the evaluation of the segment risk, the benchmarking matrix, and the new risk models. Banks will not reduce credit because they have given too much in the past – but rather because the lending models have changed.

            For the industry, it comes down to the same thing – the availability of less money. We feel that now, and we use fancy terms such as liquidity shortages or credit crunches.

            So far, banks have shown great sensitivity to the DTC and other producers’ sales conditions and have gone overboard to accommodate clients. The DTC sales conditions state clearly that a client only gets the box after the DTC has received payment in full. There is another clause warning that if a Sightholder fails to pay the price for any boxes in full within five business days after the DTC’s acceptance of the Sightholders offer [to buy the box], DTC shall be entitled to cancel or suspend delivery of the boxes to the Sightholder.” And then the following magic words are added, “No credit facilities shall be made available.” [If you must pay well in advance, it is clear that there is no credit. But it is useful to have it clearly spelled out. No credit. Ever.]

            In recent months, there have been several Sightholders who have not been able to find the money within five days – and not within weeks – and that should certainly raise an alarm bell. But that is a technicality.

Rough Suppliers Providing Credits is deemed Inevitable

            The real issue that is gradual emerging is when the banks will say, “Stop, this is enough. If De Beers wants its clients to lose money, it is time for De Beers to finance its own clients. Why should we take the risk?”

            Actually, as one banker explains it, if De Beers extended credit to clients, it could create a new profit center for its own shareholders. (Nicky, Anglo – please take notice.) De Beers itself has an excellent credit rating in the financial markets. De Beers can borrow money at far better terms than any of its clients. So if De Beers provided credit to clients at similar terms now commercially available to clients from the 18 diamond banks, it would actually make money! Extending credit might provide it with more revenue than it collects through Value Added Services (VAS), as it doesn’t require manpower, training courses, etc.

            Moreover, if De Beers extended credit, it would have a vested interest in the financial welfare of the client and recognize the need to earn sufficient money to pay the interest and principal – so the rough supplier would have a reason to avoid making scorecard demands which would waste rather than create value. De Beers may actually have a reason to insist that the client reduces its leveraging and its gearing, and starts working more with its own money. At the end of the day, having your own money is the only reliable cushion when the DTC decreases selling prices! Incidentally, though I write about De Beers, clearly the concept of rough suppliers providing credit applies equally to all producers.

            In an earlier article I wrote that under the new capital adequacy rules of the international banking system, known as Basel II, credit facilities to the diamond industry may well be reduced in any event – or charges will be made for holding unutilized facilities – so the need for producers to provide credit may well become inevitable at some point.

            Today’s commercial realities may thrust banks into action well before the starting date of Basel II. The immediate trigger may well be the rough price instabilities and downward sliding price trend, which seriously impacts the quality of the collateral held by the banks.

DTC Clients Expect Further Price Declines

            Depending on with whom you talk, it is believed that at the last DTC Sight anywhere between 25 and $70 million worth of goods were refused by the clients and that up to $100 million of goods have been deferred for delivery in the last two Sights of this year. The reason for the refusals doesn’t need to be stressed: the goods were over-priced and the clients didn’t want to take a loss. There may also be a banking factor – we suspect so, but it hasn’t been confirmed to us. What is worrying, however, are the reasons that are publicly given for the postponement of purchases: Sightholders appear to be convinced that the DTC will be forced to lower prices towards the end of the year in order to avoid a sharp decline in annual diamond sales.

            All of a sudden, the ITO is becoming a “hedging instrument” – by not taking the goods now, you may minimize or reduce your losses by waiting a few more weeks. But things aren’t that simple. The DTC sets limits on how long one may defer taking goods. Moreover, “allowable rejections” are generally limited to 5 percent to 10 percent of the boxes (of goods above 2 carats). By reducing one’s purchases, one literally “jeopardizes” maintaining one’s levels of sights in 2007, as the application thresholds for allocations in 2007 are based on the actual purchases of 2006.

            What is fascinating – or actually worrisome – is that the conviction by some Sightholders that DTC selling prices will fall further is so strong that they are willing to take the risks of getting lower future allocations. Moreover, the DTC selling apparatus is basically managed by legal terms and conditions, rather than by compassionate and sensible human beings. (Please read this line carefully: we don’t say that the relevant sales people lack compassion or sense – they have plenty of it – but Sightholders have grown used to the fact that unfavorable allocation decisions, which don’t represent the requirements of the client, are generally viewed as “computer outcomes” rather than decisions by sensible people.)

            The legalistic framework may also come into play when not taking goods, or deferring goods. The rules say that “at the beginning of each [half yearly] selling period, DTC will provide the Sightholders with an Intention to Offer (an “ITO”) indicating the aggregate level and nature of goods it intends to make available for inspection by (but shall not be obliged to supply to) the Sightholders during the subsequent selling period.”

            We picked up some discussions on whether those who deferred taking goods may actually get them when the prices are down. De Beers’ management is providing very conflicting signals to the market by saying that it is not likely to increase prices this year and it is also not intending to reduce the allocations.

            Once upon a time, the DTC was extremely proud of following a policy of only raising prices when such price increases were sustainable. The DTC would probably argue that it still adheres to that policy and blame the need to reduce prices on external events. That may or may not be the case – some external events are clearly predictable. In a few phone calls with Indian Sightholders, they made it clear that their present refusal to take goods are not flood or interest-rate related, but purely a matter of price. They (and their banks) are simply fed-up with losing money, month after month.

            De Beers, loyal Sightholders, and also this writer could possibly argue that Sightholders are quickly forgetting the years in which the DTC was the lower cost supplier to the market; years in which Sightholders made lots of money. That this is part of the game: you have some good years and then you have some bad years. In the long term – you win and therefore, there is never a shortage of applicants who want to become Sightholders.

            I know the arguments. They may have all been true once – but they aren’t true today. DTC brokers find it difficult to persuade non-Sightholders to join the application process, to start making presentations, etc. Sadly for De Beers, the supplier has long ceased to be the supplier of choice. And selling boxes at exaggerated prices defeats the very reason for SOC: if the Sightholders doesn’t have the margins to invest downstream and to support retailer and jeweler promotions and programs, the very objective of turning the industry in a demand-driven one will fail.

            What is now needed above all is some credible confidence building measures. De Beers has abandoned its custodian roles, but has consciously sought to provide industry leadership. It is now failing to deliver. In the old days of communism, Kremlin watchers would carefully view the May 1 parade pictures to see who stood next to whom around the great leader. Analysts went crazy watching who was going places and who was moving away from the center. After witnessing spates of redundancies at the DTC in London, and when it is clear that all sorting and sight aggregation will move to Botswana, the focus is now on South Africa – on the De Beers headquarter staff of some 1,000 people.

            “In the past few weeks well over a hundred senior executives have submitted resignations,” confided one official earlier this week. “De Beers Managing Director Gareth Penny is expected to announce a major corporate restructuring within the next few weeks. The mood around here is no good.” These kinds of reports come in addition to newspaper stories about lay-offs in the South African diamond cutting industry.

            If, indeed, Penny is planning to announce structural and personnel changes, let him present a great A-Team, inspiring workable ideas, and a clear vision of where we are heading. This will be conducive to restoring confidence in De Beers and in the market. Every word uttered by Penny will, just as in the old Kremlin balcony days, be analyzed and interpreted by the market, by the clients, and, most importantly, by the 18 diamond bankers, their head offices, and by those responsible for assessing the banks’ commercial and operational risks.

            Let me take that back and rephrase: I don’t really care what the market will say – just make sure, Gareth, that banks will find reasons to cease viewing DTC Sightholders as high risk or higher risk clients. Nobody can afford that. Nobody wants that. Nobody gains from such an unwanted and potentially lethal state of affairs.

            Have a nice weekend.