Kuwait's al Manakh Stock Market 1 KUWAIT'S AL-MANAKH STOCK MARKET Sam Riese pepe his eave under he supervision of Profesor Petr Bel, Richard Ivey Sehoo of Busines, the University of Wester Ona, oe t prove ratil for css discussion. The ators done end fo lusbte eter efletveo nelle aang es manages simaton The authors may have disguised cert pares adhe ening information tet Coden, INFORMS prottits ay fom of reproduction storage or rans of hs maria without ts waten permison. This mae isnot over under authiaton fom any reproduction Fh opanietion, To order copies ot eques permion epee onic INFORMS, 501 EMkridge Landing Foad. Suite 400, intcum, MD 21092900 ©-nalinforstnfomns re Copyright© 1998 yy INFORMS, The Kuwait al-Manakh Stock Market crash in 1982 resulted in outstanding debts of some $94 billion and left the country in a state of economic panic. The Kuwaiti judicial system faced the near impossible task of assigning criminal and financial liability among the 6,000 investors caught in a web of 29,000 “bounced” post-dated checks and [OUs with the associated bankruptcies and business failures Post-dated checks and IOUs, written on behalf of speculative Kuwaiti investors and traders, funded the market's boom and led to its dramatic crash. Developing a method to disentangle the web of outstanding debt could save many years, and nearly $10 billion in court and attomey fees. In addition, the disentanglement would "net out" offsetting debts, and reduce the magnitude of the total outstanding debt resulting from the crash, thereby reducing the negative impact of the market crash on the economy. The government of Kuwait recognized that this complex web had to be disentangled quickly, fairly, and in a way most beneficial to the economy. His Excellency Shaikh Ali Al Khalifa Al-Sabah, Minister of Finance and Oil of Kuwait tumed to the Kuwait Institute for Scientific Research for help Events Leading up to the Creation of the al-Manakh Stock Exchange The al-Manakh Stock Market was established in 1979 by Kuwaiti trading companies and speculative investors to take the place of the very tightly controlled official stock market of Kuwait (KSE). After the KSE had undergone a major crash in 197, permanent government controls were put in place to control Kuwait's highly speculative investors, who were motivated by high liquidity coupled with poor returns on Kuwaiti investments abroad as a result of volatile exchange rates. Oil-rich Kuwaitis had few places to invest their money other than in the country's stock market, but as the KSE began to boom,Kuwait's al Manakh Stock Market 2 speculative traders entered the market, and the rapid speculative growth eventually caused the KSE to crash. Speculators writing post-dated checks for investments that they could not afford meant that the market's boom was supported by funds that did not exist. Once out of control, when one investor defaulted, a chain reaction of bankruptcies was inevitable since investors could not honor their checks and IOUs because their accounts receivable and expected market returns were needed to fund these debts. ‘After the crash, the complicated puzzle of unpayable debts led to the bottom falling out of the KSE and produced a widespread panic in the Kuwaiti economy. As a result, the government bailed out creditors at a cost of $525 million. Tight government controls, including new laws severely restricting the use of post-dated checks on the KSB, were established following this crash to curb further speculative trading Events Leading up to the al-Manakh Crash ‘The Kuwaiti government owned nearly half of the country's share-holding companies, and with very few investment opportunities other than oil, wealthy Kuwaitis had few investment alternatives at home. After a third major oil hike in 1979, wealthy Kuwaitis enjoyed a time of prosperity. Public spending and the demand for places to invest money rose. This increase in liquidity combined with few investment alternatives led to another speculative bubble. Since returns on foreign investments were poor, investors looked at the al-Manakh Stock Exchange as a place where they could carry out the speculative trading that had occurred on the KSE prior to the 1977 crash ‘The al-Manakh exchange was unregulated, and in the absence of government regulation or supervision, the use of post-dated checks soared along with stock prices. Traders created numerous Gulf companies in neighboring Arab states solely for speculative purposes to avoid domestic regulations governing new companies. Investors poured money anywhere they could, At the peak of the stock market's explosion, 3.5 billion shares were traded, or more than four times the 837 million of the KSE. A 100% increase in stock value within a few weeks was not surprising to the 6,000 individuals and corporations feverishly trading in the al-Manakh market, By 1982, the al-Manakh exchange was out of control. Untrained and uncertified brokers were trading worthless securities at astronomical P/E ratios. With a complicated mesh of post-dated checks being traded to fund the explosion, traders used crude and often illegal methods of settlement. The inevitable crash left traders in a complicated puzzle of post- dated checks and IOUs, making it difficult to determine who was responsible for each trade. Traders faced the disastrous implications of having written post-dated checks against funds that they expected to receive in the future, from the sale of stocks at a profit before the post-dated checks came due.Kuwait's al-Manakh Stock Market 3 ‘The Crash In August 1982, the bubble burst when one of the largest of the 18 major trading companies defaulted on its debts. During the month, traded shares fell from 602 to 72 million as securities traded in the market lost 60% to 98% of their value. The crash was a huge shock to the Kuwaiti economy. Initially, neither the central bank nor the government knew the magnitude of the crash and the resulting outstanding debt ‘Traders were left with worthless stocks in defunct Gulf companies as well as a web of two-way IOU notes and post-dated checks. First calculations of the resulting outstanding debt after the crash produced a figure of ‘$94 billion, or 4.3 times the Kuwaiti gross domestic product. The majority of this figure ‘was the sum of the face value of nearly 29,000 post-dated checks. In addition, 95% of the total outstanding debt involved only 18 traders who were caught in a mesh of entangled debt responsibilities. Attempts to Rectify the Situation In late 1982, the government took some steps to attempt to contain the damage. It established a clearinghouse with the purpose of collecting, matching, verifying, and systematizing the financial accounts of individuals and brokers, and set aside a $1.7 billion trust fiund to compensate small investors (losses less than $1.7 million). Finally, an arbitration panel was established to effect settlements, and to sanction and finalize settlements reached voluntarily between traders. Unfoitunately, the government's initial strategy of forcing traders to pay their debts as ‘part of the solution did not work. Many traders had become insolvent and few were willing to meet their accounts payable before collecting their receivables, especially when their accounts receivable were needed to pay off their debts. This problem, and the fact that a resolution did not seem to be arising in the near future, led the Kuwait government to form the Corporation for the Settlement of Company Forward Share Transactions. This company established a special task force made up of A. A. Eliman (San Francisco State University), M. Girgis (LTC Techno-Economics Research Group, Inc.), and S Kotob (Kuwait Institute for Scientific Research). Under the supervision of the Kuwaiti minister of Oil and Finance, the task force began the high priority task of untangling traders and settling debts.Kuwait's al-Manakh Stock Market 4 Appreciating the Traders’ Entanglement Figure 1 illustrates the example of four entangled traders. Each trader had some assets, had (potentially) an uncollected receivable from each other trader, and each had (potentially) an unpaid payable to each other trader. Figure 1: Example of Trader Entanglements Each trader's assets were further broken down into four asset classes. These were, in order of decreasing risk, cash and KSE shares, real estate, receivables from other entangled traders, and shares of Gulf companies. For the example, consider the four traders’ assets to be as follows ‘Trader A BC D Cash and KSE shares 1 06 15) 5 Real Estate 4°12 4 7 Receivables from solvents 3 0.2. 2703. Shares of gulf companies 2 1 19 15 TOTAL ASSETS 10 8530 In this situation, three of the traders (A, B and D) could not determine how much of their debt they could pay before knowing what portion of their receivables they would collect from the other entangled traders. Therefore, one can appreciate how the situation could not be resolved without outside intervention to decide who could and should pay what and to whom. In addition, there was the issue of how the different asset types were to be treated and in what proportion they were to be paid.Kuwait’s alManakh Stock Market ‘The task force first defined the debt settlement ratio (DSR): DSR= Minimum [Assets + Actual Receivables , 1] Actual Payables In order to determine the portion of debt that could be honoured by each trader, the task force set out a series of equations to determine each trader's DSR which was dependent on actual receivables: computing each trader's DSR would essentially require first determining the payments that each trader would make. A further problem with this method was the necessity to restrict the payments from solvent traders to the amount they actually owed.. The task force, however, was able to use DSRs as a method of trader classification without knowing what portion of actual receivables would be collected (Figure 2) paar] aeco |, SAT DSR=> DSRa Detinitety Seemingly ——_Definntely Detinntety Solvent Solvent Insolvent Insolvent with 0 receivables Figure 2: Classification of Traders A Method for Disentangling the Traders After considering the dilemma faced in determining the traders’ DSRs, the task force realized that determining DSRs would actually disentangle the traders, since each inter- trader payment would have to be calculated in order to determine traders’ actual receivables. However, the rationale behind these payments needed to be decided. What should these payments accomplish? What possible settlement options were the fairest and/or the most beneficial to the economy?Kuwait's al-Manakh Stock Market 6 Possible payment disentanglement rationales considered included attempting to: limit the number of bankruptcies, pay off as many solvent creditors as possible, achieve the largest possible total payments to all creditors, ‘maximize the sum of insolvents’ DSRs, minimize insolvents' deficits (assets + receivables - payables), determine DSRs that were least susceptible to further deterioration in asset value, and * determine DSRs while keeping the DSRs of the largest 18 insolvent traders equal. ‘The task force also needed to consider the following factors: ‘¢ all traders had to be treated equally and in accordance with the strengths and ‘weaknesses of their financial portfolios, al-Manakh stock trading, and their choice of trade cohorts. © maximizing the ability for traders to pay their debts in full would minimize the negative effect of the crash on thie economy. © a trader's DSR could not be higher than 1, since that would imply that the trader would be paying out more than the amount owed. «by Kuwaiti law, debts to multiple creditors had to be paid in equal proportion of the amount owed to each creditor. + all solvent traders should honor their payables in cash (even if this required them to liquidate other assets). # the disentanglement solution must prevent traders who actually owed money from making net gains. ‘The task force had many decisions to make in order to arrive at an equitable solution that would disentangle the web of debts and "net out" the actual loss to the economy. Ifa credible solution could not be found, each of the 29,000 post-dated checks and IOUs would require three court cases to settle: a criminal case, a commercial case, and a bankruptcy case, The outcome of this legal process would send many Kuwaiti entrepreneurs to jail, including many with strong political and social ties, would cost the government some $380 million, and would require the judicial system to increase capacity 18-fold for five years. Most importantly, the Kuwaiti economy's state of panic and recession would not improve until the situation was resolved. Time was of the essence.