The Diamond Trading Company (DTC), in preparation for its Diamond Bankers Seminar that took place this week in London, sent out a questionnaire to participants containing a number of what we call in Israel “kit bag questions.” This expression can be traced back to basic training in the army.

As part of the routine applied to rookies, a bullying sergeant may demoralize you by making you do things like run back and forth a lot (and things of that nature). So, imagine the response when a sergeant tells his soldiers, “Run from here to that tree and back!” and some idiot asks “with our 40 pound kit bags, or without?”

Thus the term “kit bag question” was born. It usually describes the type of question that brings on some sort of misfortune just by virtue of the question being asked. Asking a teacher, “didn’t you forget to give us homework for tomorrow?” is another kind of “kit bag question.” One is better off keeping quiet and simply not asking.

I am not sure how many bankers replied to the questionnaire, but some were so kind to respond to us to give us a feeling of banking sentiment regarding the industry. The question, “What proportion of your diamond customers’ receivables do you estimate are currently overdue?” could be answered through multiple choices ranging from "none – or almost none" to "more than 50%.” The answers I received indicated more than 50 percent. But the question should have been different. Most diamond banks have relaxed their level of tolerance. Accounts receivables, which in normal days might be considered overdue after four months, will often now be reviewed as being problematic only after six months. Among bankers around the world, the definition of ‘overdue’ is anything but uniform, so I am not sure what the answer will give us. Nevertheless the question is relevant in a sense.

This question was followed by "what percentage of these overdue accounts would you estimate to be at risk of default?" Here too there was a range of answers, and the ones I received indicated less than 50 percent but more than 25 percent.

It seems to be rather offensive to the industry that a supplier of rough diamonds would even go around the world asking their clients’ bankers directly to make an estimate of anticipated industry defaults. Banks were also asked by how much they estimate that their diamond clients’ inventories will change in 2009 over 2008. The options given were more limited, and the answers we received provided a consensus of "will decrease by up to 25%."

We don’t want to dwell too much about the questionnaire, but I am just taken aback by the very fact it was sent out. The intention of the DTC was that the responses gathered by the survey "will be consolidated and reviewed at the DTC’s bank forum, where they will form the basis of further discussion."

This whole thing scares me. Surveys, summaries, conclusions etc. tend to gain their own life. Nobody is served by floating a document somewhere in which diamond bankers have concluded that almost half of their overdue accounts will end up in default. It would give a very disheartening message to those diamantaires who know they have a problem, but at least they now know what their banks may think about that.

Bankers were asked, "how clear a picture do you believe your bank has of your diamond customers through financial strength and resources?" That’s almost an insulting question. If you answer "very unclear," you are actually confirming your own incompetence by admitting that you are extending credit without really knowing what you need to know to justify such a decision. I wonder what management would say, when a banker admits "there are some significant uncertainties" as one of the other optional answers reads.

One question I find shocking is, "how attractive is the diamond industry in comparison to other industries to which your bank lends?" One questionnaire that we saw, which originated from New York, replied, "the least attractive industry in our portfolio." In a presentation that I had the privilege of giving this week in New York to the Diamond Manufacturers and Importers Association, I identified that increasing the comfort level of our bankers should be one of our main priorities.

Understanding Defaults

We’ll get through the crisis one way or the other. The long-term fundamentals of the industry look good. In any scenario, demand will exceed supply and prices will go up. It’s just a question of timing. The current economic tsunami is global, and we were caught up in a very disadvantageous way holding high stocks and we overpaid for rough. None of this is the end of the world, but we have to deal with the temporary - and I stress temporary – fall in collateral values and/or collateral availability. We have to work it out with our bankers, and the picture that I received in New York was anything but encouraging.

Some banks are believed to be in the process of exiting the business, and only one bank seems to be aggressively expanding its portfolio. The new bank coming in seems to proceed very cautiously. Some of the lending models are being adjusted, but very often for reasons unrelated to the industry itself. In some places credit facilities have been reduced by lowering them to the actual outstanding level rather than the higher ceiling that was previously agreed. This has to do with Basel II requirements where even on committed and non-utilized facilities, these amounts have to be taken into account in terms of setting the level of banking capital adequacy.

I am taken aback by the "ease" with which the questionnaire uses the word "default." The occurrence of a "default" event may be defined differently by each bank and within the diamond industry. Several bank managers told me that they don’t have a clear definition. In general, default occurs when a borrower has not met its legal obligations according to the debt contract, e.g. it has not made a scheduled payment, or has violated a loan covenant (condition) of the debt contract. Default may occur if the borrower is either unwilling or unable to pay his debt or a scheduled interest payment on the debt.

The default status in the current banking environment shouldn’t scare us. Terms like "bad debts" or "doubtful debts" are merely possible outcomes of an initial default. The term default needs to be distinguished from words such as insolvency and bankruptcy. In many – and I would almost say most – instances, a default doesn’t need to lead to losses. It is more often than not a reflection of a temporary cash flow imbalance.

The financial situation of the industry is exceedingly complex, but at the same time the industry seems to be managing its debt in a quiet, exemplary manner. In Israel, from the peak of $2.5 billion indebtedness in August last year, it has now reduced the debt to $1.7 or $1.8 billion. In Belgium, one of the large diamond financing institutions has reduced its exposure by almost 30 percent. In New York debts are also declining to a level of anywhere between $1.5 and $2 billion. Worldwide, the debts will have come down by now from well over $15 billion, to somewhere around $12.5 billion.

While the industry’s activities decline so does the banking debt. We don’t want to address the issue as to whether the reductions are sufficient – or whether the reductions go in andem. Atcually, they don’t. It’s a kind of kit bag question where the answer cannot really add comfort. The DTC asked its the diamond bankers ‘broadly speaking, how would you characterize the current liquidity position of your diamond customers? The bankers were given four choices including “fine -no real problems," " fairly tight – but not too alarming," and “under severe and abnormal strain.” The fourth option was," it’s a genuine crisis. “We will analyze the questionnaires and the responses that we have received in the forthcoming Diamond Intelligence Briefs.

If one does a back-of-the-envelope exercise, much of the current financial news seems positive. The rough suppliers have done the right thing by reducing supplies and thus lifting some of the financing burden on the pipeline. In certain areas of goods some rough shortages are being felt and prices are firming. The business today is definitely better than it was yesterday or the day before. One banker informed me that in Antwerp the terms of trade are changing. There are transactions and they are in cash – without credit. We are in a transition and restructuring process which should be viewed as favorable. The DTC asked the bankers "do you believe the current financial structure of the industry is adequate and sustainable?" One of the answers that could be given reads, "definitely not, it will collapse without a complete overhaul." That is just another classic kit bag question. I cannot see the purpose of the question – especially when the answers are obvious to all.

I haven’t heard yet reports on the seminar itself, and I’m sure it will be heralded as a great success, as having enhanced the understanding of bankers, of the market and I expect that we will see some kind of public relations statement confirming that both the DTC and the bankers are confident about the future of the industry. The results of the kit bag questions will probably never be disclosed. They should have never been asked in the first place.

Have a nice weekend.