How banks shifted bonds to hide losses

The fairly undeveloped and opaque Kenyan bond market is playing out in favour of investment and commercial banks.

But, investigations by The EastAfrican show that the bid by commercial banks to protect their profitability in 2011 saw them play smart games in the bond market to avoid huge losses.

The commercial banks — the largest players on the bond market — benefit mainly during the good times, when interest rates are falling.

This was the case in 2010 when the interest rates went as low as 1.6 per cent — and the banks booked handsome profits from bond trading.

However, during bad times, when interest rates rise — like they did in the second half of 2011 — banks work hard to dodge the losses by playing smart on accounting rules.

An analysis of the market data for 2011 and interviews with financial market players show that then, scores of Kenyan commercial banks played behind a tool known as “sell-buyback” to hide their bond losses.
Last year, banks faced huge losses as interest went up, hurting bond prices.

International banks operating in Kenya, however played by the rules, thanks to strict standards applied globally.

In a series of articles, The EastAfrican tries to pry open the bond market to the investing public by explaining dealings which have exposed loopholes in the bond market which traded Ksh891 billion ($10.6 million) last year, and bred millionaire traders. (see related stories)

The inner dealings in the bonds market are expected to come to light in the Central Bank of Kenya (CBK) annual banking sector report, whose audit for 2011 the regulator finalised early September, according to bankers who spoke to The EastAfrican.

However, some bankers said CBK may be more concerned about how banks’ main business — collecting deposits and lending to customers — is performing than trying to nit-pick on why the bond bubble did not burst in 2011.

“Banking is based on confidence. That is why the regulators will be keen on looking at the deposit and the lending side of the business. The regulators would be very concerned if the deposits are threatened. Many banks cooked their books in 2011 because of the losses in bonds but the regulator is unlikely to pick it up,” said a senior official at a commercial bank.

Ordinarily, a bond is a borrowing instrument used by companies and governments to raise funds from the public and traded at the stock market.

The borrower promises to pay back in full with regular payments of interest, usually semi-annually.

Buyers (investors) who include individuals, commercial banks and investment companies, have the option of either holding their bonds until the company or government pays them back in full, or trading them at the bourse.

n choosing to trade their bonds, investors are guided by interest rates — the cost of money. If the interest rates are rising, other interested investors prefer not to buy the bond in the market because they think they can always get the bond when interest rates have peaked, so the seller of a bond will lower the price, and the rest of the market takes the cue, lowering the price of the bonds.

But when interest rates are falling, investors want to buy bonds with an attractive interest rate, before the interest rates reach the bottom, so the rush to buy leads to a rise in bond prices.

So, if you bought a bond when the market interest rate was 10 per cent and then sell it when the market rates have gone down, say to five per cent, prudence dictates you sell at a high price as the buyer will be enjoying high rates of returns when other investors are currently buying at the lower return of five per cent.

Banks can also use bonds as a form of security to borrow money from another bank, the same way an individual can use their car log book to borrow money.

There are two options here: The bank that is borrowing money, for say two weeks, will put up its bond as security.

The lending bank will put a charge on the bond, which means the borrowing bank still has ownership of the bond but because of the charge on the bond, it cannot use it.

The second option is that the bank borrowing money will sell its bond, at an agreed price to the lender. In this case, the bond as a security changes ownership from one bank to another.

But there is an agreement that the borrower will buy back the bond and repay the loan from the lending bank. If the borrower defaults, the lender can sell the bond to recover the money.

Banks are allowed to hold bonds in three baskets. First, they can hold the bonds until they mature, accounting for interest earned in any given period as income and never recognising any capital gains or losses that might result from movements in interest rates in the financial markets.

This basket is called Held to Maturity (HTM). Second, there are bonds that banks buy to speculate in the financial markets in order to take advantage of movements in currencies, inflation and interest rates.

Any unrealised gain or loss is accounted for in the balance sheet and thus has the effect of reducing the shareholders’ funds in the case of a loss or increase if a gain is made.

This basket is called Available for Sale (AFS). The third basket is where banks hold the bonds for purposes of trading them for a gain. Any loss or gain is accounted for through the profit and loss account. This basket is called Held for Trading (HFT).

There are stringent rules on how the banks move a bond from one basket to another. A bank cannot sell a bond held in the HTM basket before it matures.

If it does, then the basked is “tainted” and the bank would have to sell all the bonds in that basket. And if the bank decides to move bonds from either the AFS or the HFT market at a time when interest rates are rising and bond valuations are falling, the bank is compelled to sell the bonds at market prices and buy them back according to the market prices

In 2011, when interest rates rose sharply, the commercial banks, which were holding billions of shillings in bonds in the HFT basket, should have declared their reduced value in their profit and loss accounts.

But instead, they circumvented this by using the “sell-buyback” tool (where a bank sells its bond and later buys it back).

They turned to other banks and highly-liquid institutions, such as parastatals, to sell the bonds at the rates at which they had bought them in 2010, with the promise to later buy them at slightly lower rates as an incentive for the other parties to take up the bonds.

So, for example, if bank “A” was holding a bond that it had bought at an interest rate of nine per cent, and the market rates had gone up to 15 per cent, it sold to bank “B” at the same nine per cent.

After a short while, bank “A” would buy back the bond at 8.5 per cent. Since the rate had been artificially brought down, bank “B” booked a profit of 0.5 percentage point. Bank “A” then moved the bond, previously in the Hold For Trade basket to the Available for Sale or Held to Maturity basket.

During this transaction the investment bank selected to handle the deal would collect trading commissions twice.

A circular by the Institute of Certified Public Accountants (ICPAK), the custodian of accounting standards seeks to explain how banks can move bonds across the baskets, under the International Financial Reporting Standards.

Data on the trading of bonds, especially in periods close to June and December, when banks report their half-year and full year results, reveal trends of an abnormal market.

On December 22, for example, a Ksh150 million ($1.79 million) 12-year bond issued in 2009 (IFB1/2009/012) traded at 6.54 per cent, only for another similar bond to trade 30 minutes later at a more market-reflective rate of 15.90 per cent.

“Someone would have to be willing to take the big loss permanently for the trade to be deemed a normal trade,” said a fund manager who did not wish to be named.

If the trade was to happen at 15.9 per cent the seller of the bond would have to report a Ksh14 million ($166,667) loss from the trade attributable to the 9.36 percentage margin. If the trade was to be genuine, the buyer is incurring an opportunity loss of a similar margin.

However the buyer is sure that the buyer will come back for his bond at a lower rate allowing him to earn a return.

A week later, on December 29, a Ksh150 million ($1.78 million) trade of a similar bond (IFB1/2009/012) was traded at 5.05 per cent.

Assuming it’s the same parties (the data which had the names of participating parties deleted) then the initial buyer who is now selling is making an estimated Ksh2.2 million ($26,190) in a week — attributable to the 1.49 percentage margin between his buying and selling price.

On December 16, Ksh660 million ($7.86 million) of a 15-year bond were traded at 6.95 per cent, below the yield curve rate of 13.37 per cent. Such trades resulted in the distortion of the yield curve which should have raised a red flag to market regulators.

“Banks were doing this claiming that they were having a liquidity crunch. Which crunch, when they were not lending due to the high interest rates?” asked an investment banker.

A recent Citigroup report estimated that by failing to observe international accounting standards, specifically standard 39, which guides on how financial assets should be reported, a number of banks overstated their profits between 2007 and 2011 by between 15 and 23 per cent.

Bond traders who spoke to The EastAfrican however, defended the sell-buybacks at below market prices, saying that local rules allowed for such trade.

“There are no foreign investors — the market is entirely local and local rules apply. Whatever happened then was with the full knowledge of the auditors and ICPAK and so there is nothing illegal,” said an official of the Bond Traders Association.

In its financial sector stability report released last week, CBK admitted to the extent of the problem which faced the banking sector as interest rates shot up and the bonds were seen as a hot potato. Banks wanted to dump the bonds.

 “The second half of 2011 experienced excessive volatility, with bonds’ yields hitting the roof in response to risks manifested in short-term interest rates, high inflationary pressures and general lack of demand from investors. 

Holders of existing bonds panicked and resorted to dumping their stocks to cut losses,” said CBK in the report released last Wednesday, referring to a period last year when interest rates shot through the roof as the regulator scrambled to protect the shilling.

This was the first official report that acknowledged how the bond market had turned against the banks.

With the market confidence at its lowest ebb, CBK and the market players said they introduced sell-buy backs in October 2011 “to provide liquidity for bondholders who needed cash urgently but faced difficulties in selling their bonds.”

CBK, however, added: “Introduction of sell-buy backs in October 2011 to restore confidence helped somehow, but it was characterised by pricing risks.”

The pricing risks resulted in the distortion of the market price list, referred to as yield curve, as the sell-buy backs were done at below market prices which led to a collapse of the corporate bonds market and a near-crush of the entire bond market, pointed out the Central Bank.

“Corporate bonds market, whose pricing is benchmarked on government bonds, totally collapsed during the period, as pricing was not only unpredictable, but punitive,” the report adds.

Bankers who spoke with The EastAfrican said the banks lending money to other banks faced a pricing dilemma: “At what price do you buy the bond?”

Since interest rates had gone up then the borrower, if he were to sell the bond would have to sell it at a lower price and enter a loss in the profit and loss account.

So, banks which needed to borrow money through the sell-buyback transactions urged their lending counterparts to take the bond at the same price which the borrower had bought the bond and not at the market price.

But some lending banks refused to buy the bonds at a price set by the borrower, insisting they will only buy the bonds at the market price.

One banker explained: “If I have a house which I bought at Ksh1 billion ($11.9 million) and the value of the house drops to Ksh700 million ($8.3 million), who would want to buy the house at Ksh1 billion ($11.9 million)?”

Standard Investment Bank, in a report released in July, noted that had the banks strictly adopted the International Accounting Standard 39, they “would have treated sale of AFS securities as yielding realised losses/gains, which are recognised in the income statement.”

In 2015, a new accounting standard, IFRS 9 requiring that banks hold bonds in only the Hold for Trade and Hold For Maturity baskets, will come into effect. Analysts note that once this is adopted, banks will have little room to play accounting gimmicks.

“Post-adoption, banks will have less room to smooth earnings as was witnessed in 2011, where available for sale securities were reclassified as held to maturity by entering into sell-buy back agreements,” said the investment bank house.
Source: The EastAfrican,, reported by George Ngigi and Emmanuel Were in Nairobi, Kenya

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