“We are now some ten months into the most serious industry crisis since the early 1980s. In the United States alone, some 1,800 jewelers have closed their doors, and hardly a week passes without some jeweler going Chapter 11, leaving a trail of diamond suppliers among its unsecured creditors. How come, miraculously, we haven’t seen any significant bankruptcies in the cutting centers?”

This question came up at the recent Antwerp Diamond Town Hall, and the short, public relations-type of answer, mumbled under the breath, was something about the banks being responsible, “Working together with clients,” and understanding their clients’ needs, etc. To me, this answer sounds almost too good be true and ignores a basic truth: it is not the banks that determine whether or not a company is solvent, whether or not liabilities exceed assets, or whether obligations towards the trade and suppliers are being met, etc.

The banks don’t determine the underlying conditions of their clients; they do, however, have some discretion in the decision of when to pull the plug. They will do so if and when it is good for the banks. Yet if it is in the best interest of the banks “to work with the customer,” they’ll do so – up to a point.

So far, if there are any “winners” in the current crisis, these are mostly the diamond banks – but they don’t get any prizes. Their clients are selling out of inventory, they need little “new money,” and, mostly, their credit exposure is going down. Meanwhile, the value and quality of the collateral held by the banks seems to be going up and up – though this issue is too complex to make generalizations.

Let’s say that before the crisis, one’s “open credit” was about 30 percent of the debt, and 30 percent consisted of accounts receivables. The remaining 40 percent was covered by security consisting of real estate, diamonds, bank guarantees and deposits.

The worldwide cutting center banking indebtedness has gone down by some 25-30 percent in the present crisis so far. This reduction has been mostly achieved by the payments of accounts receivables – in essence, the “good accounts receivables.” To quote one banker, “It is the good part of the debt that has been paid – we are now left with the difficult part.” Also, in the first eight months of this crisis, business activity fell by some 70 percent. The reduction of the debt was far too little to comfort most of the banks.

After the “good accounts receivables” were paid, the bank was left with the paper for which the customer asked for extended payment periods of one or two extra months. When the money still doesn’t come, the bank rates the accounts receivables as “damaged collateral” – and the client is asked to provide alternative collateral. A significant part of the pressures for more collateral is “replacement” of bad collateral.

This process is rather similar in all cutting centers. What is the end result? After the accounts receivables collateral has evaporated, banks are left with a lower quality debt (the “difficult part of the debt”), which is covered 50 percent by hard assets and 50 percent by “open” collateral. Thus, the “open part” of the security has gone up as a percentage of total collateral. This is the source of much of the present collateral pressures exerted on the industry.

No banker will ever say: “you have reduced your debt by 25 percent, so now we’ll release some of the pledged real estate” or “we don’t require so many bank guarantees anymore.” No way. (One of my economist friends pointed out that if the “open credit” part is not covered by tangible assets and needs to be repaid out of future earnings, assuming a highly optimistic return of 15 percent on equity, and depending on the equity-debt ratio, it would take between 6 and 10 years to pay off one’s debts. Will the banks have the patience to wait? They need to see that the industry makes money!)

Demanding Additional Collaterals

The debt security issue is far more complex. The steep fall in rough diamond prices, and the emergence of “damaged collateral,” has become the pretext to demand ever more security. In Israel, at least two banks now have the equivalent of 25 percent of their total diamond credit portfolio covered by diamonds in their vaults. In the pre-crisis days, this was rarely more than 2-4 percent.

In general, diamonds in bank vaults are diamonds that are not being sold or worked on by their owners – they are a net withdrawal of “liquidity” in a diamantaire’s business. Moreover, the pledged diamonds are valued on their present value, not the price at purchase, and then these values are discounted (for credit purposes) down to some 60-70 percent at most, depending on the bank’s policies.

But it isn’t just diamonds. In the banks’ scramble for ever more collaterals, some diamantaires have already pledged most of their personal assets – in some instances including valuable paintings on the walls of their private homes, art collections and private jewelry. One needs considerable imagination to describe the pressure to deposit diamonds as collateral, or as “working with the client” – but, of course, this is preferable to triggering a formal default.

To avoid misunderstandings, whenever a client doesn’t honor a commitment to his or her bank, a material clause in the loan covenant, this amounts to “default.” However, we have learned throughout the crisis that banks employ considerable discretionary leeway in their decision to declare an account as being in default. At the same time, almost every account is viewed as “problematic,” and most bankers review accounts every week or fortnight instead of conducting the half-yearly reviews of better times.

Do I blame the banks? No, they are managed by corporate or semi-government employees doing what they are paid to do – defending the banks’ assets. If anything, they are doing such a splendid job that really no need has arisen to force a client into formal bankruptcy – so far.

There are also powerful commercial considerations why it is not in the interest of the banks to pull the plug now. Foremost, there is a pragmatic matter: there is no way in the world that banks acting as receivers or liquidators of client assets would be able to recover more than a fraction of the moneys the clients can collect when selling stock. There are no buyers in the market – and if there were buyers, the clients would know and would sell on their own. (As we have seen in Israel, the only instance banks went to court during this crisis is when they feared a flight of collateral – that the client may use all available collateral to settle trade debts.)

Then there is an accounting issue. The bulk of diamond loans are subject to hold-to-maturity accounting, which – in contrast to so-called fair-market accounting – typically does not recognize losses until the loans default. As the short-term loans in diamond banking are typically viewed as revolving loans (overdraft), where the maturity is technically extended automatically twice a year or more, “working with the clients” enables banks not to enter bad loans as being in default. Let’s call it creative accounting or, simply, “being realistic.” Again, I emphasize that pulling the plug now doesn’t make any commercial sense, which is the true reason we have seen no major bankruptcy in the cutting centers.

There is a downside to all of this: banks collectively maintain the illusion of robust industry solvency in the diamond cutting centers. The renewed speculation in rough diamonds (especially by Indian players), the creation of a new mini-bubble in rough prices and the return to some of the traditional abuses of subsidized bank credits are only some spillover effects of the false illusion of robust industry solvency. Some players are literally playing with fire – and in post-elections India, the government-owned banks are giving clear signals that “what was” is not what “is going to be.” The market, however, hasn’t yet internalized that message.

If one wouldn’t know better – one would call this period the “golden age” in the banks’ relationships with clients.

New Credit? Pipe Dreams?

If things are so good, why do we need governmental guarantees? As we discussed at length (and in depth) a few weeks ago, in Antwerp it is believed that warehousing another $1.5 billion of “dead” or “slow-moving” stocks will enable banks to expand the credit facilities. When I reported on the scheme, I asked whether it could actually work. Today, my doubts are greater than they were then – but that’s not the issue.

What is the issue is that this “new collateral” would partly be used to shore up even more the existing collateral (50 percent) of the current debt and partly (50 percent) to allow the diamantaire to obtain new credit. The Belgian scheme in a way tries to get around the prohibition to finance stocks and to accept stocks as collateral. It wants a “legal circumvention,” i.e. it wants a system approved by the banking regulators – something that hasn’t happened yet.

Whoever worked out this scheme (and much credit is due to ABN-AMRO’s Victor van der Kwast) realized something that is only gradually being grasped by the industry at large: the problem will start when the crisis comes to an end – when new credits are needed. That’s the moment of truth for the cutting centers. That’s the moment of truth for each and every company. That’s why both in Antwerp and in Israel government assistance is sought that focuses so squarely on the post-crisis period. Will there be new credit when it is needed? Will there be new credit in a dramatically changing regulatory environment that goes far beyond Basel II?

We want to be precise: every account and every client represents a different story – and even today, some clients are expanding their debts. These are also days of miracles to some companies, such as the Indian conglomerate that negotiated a long-term debt maturity date for its existing debt and secured new credit to facilitate a mammoth purchase of rough in London.

But, basically, with each and every jewelry retail Chapter 11 bankruptcy in the U.S., the unsecured supplier in the cutting center needs to replace “damaged collateral” – and part of his banking indebtedness becomes basically unrecoverable.

So another part of the answer to the question “why-no-business-failures” is simply that banks will not force anyone into a bankruptcy situation when these clients’ debts are going down and collaterals are being strengthened. Why would they? And even when the client runs out of new collateral, there is still little to gain from pushing the client into liquidation.

Borrowing Base Marching Downwards

As De Beers Managing Director Gareth Penny showed graphically in Antwerp, after each recession, the industry recovers rapidly, and rough prices jump upwards. When the reverse ripple effect comes into action, new boom periods will come speedily and decisively. But not for everyone. A fundamentally insolvent company doesn’t automatically get solvent just because the economic climate changes. As, inevitably, rough prices will go up exponentially faster than polished prices at the retail level, a resumption of demand doesn’t equate to a restoration of profitability. Time is needed for the diamantaire to create new financial cushions – time that many companies may either not have or be able to afford.

In the post-crisis period, all kinds of automatic triggers come into play. Banks will then put on the brakes when reviewing (what is called in the U.S.) the monthly “borrowing base certificate,” showing insufficient receivables and inventory collateral to cover the outstanding debt, not leaving any room for giving more credit. Most companies will discover that their borrowing base, their facilities, have been brought down. They will be denied the financial oxygen needed to become part of the post-crisis recovery.

The diamond industry requires short-term, activity-based financing. In its most basic form, it goes something like this: show me your accounts receivables and your inventory and we’ll open the money tap ever so slowly…. There is a vicious chicken-and-egg type of cycle: if you don’t get money for rough, how do you produce and sell it, especially if you need inventory and accounts receivables to get the new credit to begin with? (Maybe ways must be found to turn part of the debt into long-term loans, allowing greater flexibility of new credit for the short-term facilities.)

Credit Will Remain Tight

It seems to me that each and every credit-dependent player should start to prepare for “the day after.” The contours of some of the new “day-after” realities are already clearly visible.

Banks will have less money to lend – and they will prioritize sectors. Money for diamonds will compete with money for almost everything else. As we reported before, in the United States most diamond-financing institutions are in a “downsizing” mood – and I refrain from using the “w” word – for withdrawing from industry financing altogether. In southern Africa, banks have entered into a “freeze” mood – even in Botswana.

Antwerp has gradually grown used to uncertainties around the world’s largest diamond-financing institution – ABN-AMRO Bank, which presently seems quite secure through its firm Dutch government support. However, now Antwerp is facing a new bout of market rumor suggesting that the KBC banking conglomerate is planning the disposal (sale) of the Antwerp Diamond Bank (ADB).

Guido Segers, the head of KBC’s Merchant Banking Division, informed us through a KBC spokesperson that in context of a strategic review of activities, KBC is “reviewing how we can make optimal use of our capital (reduce risk-weighted assets) and which activities are and which are not deemed essential/core for our company in the current challenging economic circumstances. This exercise is ongoing. … We are already reducing (e.g., certain activities of KBC Financial Products or will reduce a number of niche activities,” said the spokesperson.

Then came the key line, “For the time being, no change in policy is planned for our subsidiary Antwerp Diamond Bank.” Maybe we should try to get used to the fact that no bank anywhere can be taken for granted today. Everything is for sale, all of the time. Whether the ADB is owned by KBC or another player will, at the end of the day, make little difference as long as the oldest diamond bank remains in business. In the meantime, KBC’s denial is noted.

When we come to “the day after,” the total size of the diamond jewelry market will not go back so quickly to its pre-crisis size. Closed jewelry stores will not immediately open up again. Rough supplies will embark on a declining trend. Prices may go up, but (unit) volumes will decline. The industry shake-up that had been expected, but didn’t arrive, may still be ahead of us. Call it, euphemistically, a capacity alignment to new realities. In this exercise of survival of the fittest, the bank will play a major role.

What Plugs to Pull…

Over a luncheon in Antwerp yesterday, I asked a seasoned player what would happen if a few of the largest industry players, who may hold some $1.5 billion in banking debt, would go bust. Would this create an industry earthquake? The gentleman reflected a few moments and said, “This would bring the industry back to where we were decades ago. A fragmented industry of hundreds, or thousands, of small players. The rough producers may benefit from this: they’ll always have companies to sell to – their rough placing power would be enhanced. In times of crisis, they would have to sell at discounts.”

This scenario is not likely to happen – the banks will not allow it. Whether in Antwerp, Mumbai or Tel Aviv, a gigantic default would not be acceptable by the owners of the diamond banks. Life isn’t fair – and no bank has promised rose gardens as part of its covenant with clients.

It is easier to pull the plug on marginally smaller and medium-size players. As odd as it may sound, to some players “pulling the plug” may provide a preferred exit route out of the industry.

It may not be an appropriate metaphor, but think in medical terms about a successful operation, after which the patient dies. Bankers have become our doctors. Together we come with them relatively unscathed through the crisis – just to find the real trouble starting at the end, when the doctors remove the lifeline’s oxygen plugs.  

This is, of course, conjecture. The point this column wants to make is that we cannot afford complacency in our relations with our banking partners. It is a joint industry and it is in the banks interest to have maximum stability and make minimum waves for now.

It is “the day after” we should worry about – and prepare for today. For many companies, “the day after” may well become the beginning of the end. But it doesn’t need to be that way.       

Have a nice weekend.