RISK management today is the pillar of any business to ensure corporates are well-prepared for any unprecedented events; and if it is related to financial matters, it is able to withstand catastrophic losses via mitigating action plans.
In the 2011 Wall Street-themed movie, “Margin Call”, although the storyline was rather fictional, the drama that unfolded over a period of 24 hours was very real.
In the movie, an investment bank known for issuing mortgage-backed securities (MBS) started to lay off a large number of employees, including the head of risk management.
The long-serving employee had been working on a risk management model, but his work was unfinished.
As he managed to pass on his saved work to one of his colleagues, the colleague, upon finishing the work, discovered that the model showed that the firm was over-exposed based on recent historical volatility levels of this asset class as the market had turned weak.
The firm was at risk of huge losses or even bankruptcy. The only option left for the firm was to exit all its positions the very next day.
Although by knowingly doing so, the sale of this remaining MBS on their books would damage the firm’s relationships and reputation within the industry and cause major instability in the markets, it was the only choice the firm had to save it from going under.
So, the very next day, the traders of the firm were ordered to sell everything on its books related to MBS, even at taking a big cut from its book cost.
This was an example of how an over-exposed position sitting on the balance sheet of an investment bank could turn ugly if the unprecedented movements in the markets were to be taken into account.
Similarly, we saw this happen last year too when little-known Silicon Valley Bank (SVB) was over-exposed to long-term US treasuries and the rise in yield (which translates to lower bond prices) suggests that the bank was sitting on huge unrealised losses.
Not helping the situation was when some of its clients began to withdraw their deposit holdings due to their own funding needs, leaving the bank no choice but to liquidate its position at a loss.
Pledged securities
Pledging of shares for financing is rather common. Early last week, we also witnessed the unwinding of carry trades done by those who had used the Japanese currency as a source of funding to invest in higher-yielding assets.
It worked for a long time, but when the tide turns, those swimming naked will be exposed.
Similarly, many individuals or even corporations use hard assets as collateral to obtain bank funding and typically this can be in the form of property or shares of a listed company.
As collateral, most banks are rather comfortable with real assets like property where the valuation is less volatile.
However, if the collateral used is marketable securities such as listed company shares, the volatility of the market can have a significant impact on the exposed positions.
For individuals or corporations that use margin facilities, especially for major shareholders, their ability to withstand margin calls is crucial.
Failure to do so can be devastating to the company’s stakeholders as the company’s reputation may be impacted by the company’s free-falling share price.
In the recent episode involving the major shareholder of Cape EMS Bhd, while the share price has been struggling to stay above its initial public offering (IPO) price of 90 sen per share, the sudden sell-down towards a new low triggered the first round of what is seen to be a forced selling done by a broking firm.
The first tranche was less than two million shares at about 67 sen per share.
What surprised many observers is that with the total value of just under RM1.3mil, the concerned shareholder surely would have the means to cover the margin, but alas, this was certainly not the case.
Cape EMS’ two main shareholders held some 502 million shares or 54.4% stake in the company post-IPO, having sold some 86.7 million shares for RM78mil in the IPO as selling shareholders.
This was later diluted as one shareholder undertook a placement of some 20 millon shares at RM1.16 in September last year, generating RM23.2mil in proceeds.
The combined shareholding was further diluted in December last year as the company undertook a private placement exercise of 69 million shares at RM1.07 per share.
Before the recent massive sell-down, the two main shareholders held 443 million shares, representing a 44.7% stake. After the intense selling pressure since the start of August, their combined stake is now down to just 120.5 million shares or 12.1%.
In essence, some 323 million shares were sold, representing the disposal of about 32.5% stake.
Margin perils
Margin financing, as provided by financial institutions or even via a private arrangement by a lender, is a straightforward financing facility with clear thresholds established in terms of the level of margin provided and the cost of funding.
When the collateral provided by the borrower is marketable securities with an observable market price, the lender will make a margin call when the market price drops below the threshold level.
The borrower has two choices in this instance.
The borrower can either raise the amount of collateral that has been provided earlier and restore the total collateral amount or allow the borrower to force sell the collateral that has been provided for in the market, thus restoring the agreed margin level between the two parties.
A lender will not hesitate to sell down aggressively in the market as it cannot afford to hold on to a collateral that is collapsing in value.
An over-exposed position could prove to be fatal and wipe out a lender’s balance sheet if the margin financing facility is deeply underwater.
For a borrower, margin facilities allow them to monetise their assets into immediate cash and allow them to use the proceeds for other intended purposes.
This could be for investment purposes or in some instances for a borrower to provide security for a financing facility given by a financial institution.
For all intent and purposes, margin financing works well when the borrower is responsible and restores the margin position when there is a margin call.
It only becomes an issue when the borrower either does not have the means to respond to the margin call or knows that the collateral has deteriorated in value and hence it was best to let the lender force sell in the market.
For the borrower, this is akin to using good money to make good a bad position, which is only going to get worse. Minority shareholders
The case of Cape EMS is not the first case in Malaysia where the share price of a company has collapsed due to a margin call.
Early this year, we saw how the share prices of a few companies linked to an individual collapsed likely due to a margin call as well as the shares of the company being dumped in the market by the lenders too.
In this instance, one could rationalise the reason for it as the share prices of these companies were held up rather artificially at an inflated level and not backed by fundamentals.
In the case of Cape EMS, the company that went public last year had strong fundamentals and was well followed by the institutional investors.
Yes, it may have had a few bad quarters but the fundamentals of the company were not in doubt even as recently as a month ago.
The collapse in Cape EMS’ share price is painful to investors and made worse by the likelihood of the major shareholders losing control altogether.
Worse, we have not seen the emergence of any new substantial shareholder(s) just yet despite the massive volume of shares traded over the past two weeks.
What’s next for Cape EMS is anybody’s guess.
For investors, the lesson learned from this episode is that, while we may be vigilant looking at the fundamentals of a company’s financials, analysing if the block of shares held by substantial shareholders are pledged or otherwise too may now be an important checklist.
Pankaj C. Kumar is a long-time investment analyst. The views expressed here are the writer’s own.
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