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  • Mar 19th, 2005
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The history of stock markets is littered with booms and busts, spectacular rises and equally spectacular falls. The Souk al Manakh (crash of Kuwait's unofficial stock market 1982 - Manakh is an Arabic word which means, resting place for herd of Camels) was the greatest speculative mania of all time. Kuwait had temporarily lost its reputation for discipline and financial stability. Trading on the Souk began in the summer of 1981. At that time, capital drifted back into Kuwait following the drop in interest rates in the United States and elsewhere.

Moreover, at the same time, the government had hoped to create an investment opportunity for the entering surplus capital by allowing the formation of "non-public" corporations which could go "public" after fulfilling certain requirements. Original Souk trades had been conducted by a small group of Kuwaiti billionaires, the "Magnificent Nine" who knew and trusted each other, despite the doubtful legality of their operation. These big dealers soon developed a network of subsidiary investors.

Some were non-Kuwaitis and thus not eligible to invest directly. Eventually, thousands most with little business experience, even from the neighbouring gulf states joined the bandwagon and bought shares of companies listed on the Souk.

The post-dating of cheque represents a legal fiction in Kuwait. The country's bank must honour cheques as and when they are presented. The date on the check suggests nothing more than a seal on the personal understanding of the parties to the cheque.

After the government had restored confidence in 1977 (bail out of investors on a mini stock market crash by way of support prices at a cost of over D 3 billion), it contributed to the renewed growth of speculation by committing two important blunders: first, it did not resell the stock it had bought in the support operation; consequently, there was a shortage in the number of shares available for trading; second, the government prohibited the foundation of new companies for two years.

This practice also exacerbated the existing shortage of shares, increased prices, and fostered further Souk activity. One government official indicated he thought the Souk began "on the understanding that the government would bail it out again, if necessary."

Thus, the market was spurred to speculative excess by the investors' belief that the government would not allow prominent citizens to default on their post-dated checks. When the Souk crashed, these investors demanded that the government rescue them. They argued that the crash was the government's fault, since it had failed to regulate the market. It was not surprising that investors request government help in a nation where they even pays the citizens marriage expenses & telephone bills.

On the other hand, tradition-minded individuals thought that the Souk should regulate itself, that it did not have government recognition, and that the government had no responsibility for protecting it.

MARGIN FINANCING - THE MAIN SOURCE OF CRASH: Margin financing reached unimaginable extremes; one Kuwaiti speculator, who had been a clerk in a Ministry two years earlier, had at the peak $14 billion in stocks financed with $1.4 billion of debt margin. After the crash of the market, he was declared as the single largest debtor in the world and was portrayed at Madam Tussads London wax museum for many years.

Some 4,500 people involved believed that the oil rich Kuwait with reserves of over D 100 billion was truly entering a "New Era" of business boom. It did not take a trigger to burst this bubble; it simply crested sometime in the dreadful heat (50o C) of Kuwait's summer. The market decline was so disastrous that it cannot be called a crash.

THERE WERE SIMPLY NO BIDS FOR MANY YEARS THEREAFTER: The actual collapse was triggered by share declines, accompanied by defaults on the first batches of maturing discounted checks held against forward transactions. Speculation on the Souk al Manakh was financed with a curious type of informal margin financing by way of post dated checks. So rapid was the rise in stock prices that post dated checks paid an interest rate of 100% per annum.

The eventual declines unfortunately occurred in July 1982 when some sellers tried to collect on checks, prior to maturity, breaking the chain of maturities cash flows & found there was no deposit to draw against them.

Approximately 29,000 cheques of gross amount of $93 billion were estimated to have been written against the shares of companies that were, for practical purposes, worthless since they also had large exposures in Kuwaiti stocks and real estate.

By the end of the Souk crash, $93 billion in worthless cheques had piled up. The net difference estimated a shortfall of D 13 billion, out of which government had to spent over D 6 billion in a span of 2-3 years to rescue small investors by providing relief funds (each investor getting a maximum of D 6 million against surrendering all claims and shares to the government), while some 400 larger ones (representing exposure of 65%) were declared bankrupt.

Indeed, the Kuwaiti government had to build a new stock market and re-start all over again, they could afford to do that as the crash bailout cost of approximately $ 10 billion (paid to small investors, bail out banks and many large financial institutions) was much lower than the reserves they had from oil boom.

HOW IT WORKED? The spot purchase of stocks via forward post-dated cheque represented an informal futures market. A purchase would buy stock spot with a forward post-dated check, for example, 3, 6 12 months in the future, paying a premium of 35 percent to 400 percent above the stock's current value.

The investor received the stock which could be sold immediately or mortgaged to buy additional stock. In the meantime, the seller could discount the post-dated check for cash; that cash then could be used to buy more stock.

The obvious risk in the practice was the strong bullish expectation on the stock market (running unabated for 9 months) that stock prices would increase to the levels where the amount necessary to cover the premiums paid would be covered.

The large exposure in forward share transaction backed by post-dated cheques represents an unfortunate hybrid and soon the brokers and their customers had begun to find themselves short of cash. Kuwaiti banks simply could not, or dared not, lend enough to meet the total demand.

These banks (six out of eight commercial banks, however, voluntarily or involuntarily, had become participants in the vortex) were involved in the stock market proceedings, either through lending against shares or by discounting post-dated cheques.

Consequently, when rise in spot shares prices could not meet the demand of forward rate premiums, the extensive amount of exposure began to tumble and could not provide the continuation of an illicit credit system, which was beyond the control of the banks and the regulators.

It is believed that banks, investment, exchange, trading and real estate companies who were involved in the stock trading had extensively damaged their financial health.

COMPARISON WITH CURRENT BOOM AT KARACHI STOCK EXCHANGE: Following the KSE Bull Run since December 2004 and recent crossing of the psychological barrier of 10,000 marks, investors in Pakistan should draw some lesson from the crash of Souk Al Manakh:

Forward transactions (adding hefty premiums to shares prices ascertaining future levels) exceeds PKR 80 billion levels, which look alarming as the same is widely used as a source of raising credit for carry over position. Although there is no post-dated cheques issued against forward stock purchase but brokers holdings margins other than cash (in the shape of shares), if any, can lead to a debacle when any large forward buyer fails to honour commitment on maturity date due to sudden profit-taking by spot investors. Thus large decline in spot prices of shares can lead to a market crash.

The government should consider improving the supply of recently launched blue chips public sector companies' shares in order to anchor prices close to undisclosed privatisation levels and reduce forward exposures.

Companies due on a privatisation calendar should be taken out of the forward market and strictly restricted to spot transaction. Restrict Cash/Bonus payouts from financial institutions (other than mutual funds) that have accumulated more than 50% of total revenues from the stock market related business.

Risk managers at financial institutions handling stock broker's bank accounts should consider monitoring and/or putting Intra daylight limit for stock broker's settlement accounts.

After decades of economic mismanagement in Pakistan, recent improvement at macro fundamental levels has led to growth rates touching 7% followed by a boom at the stock markets. It is imperative that investors preserve and retain strong positive economic fundamentals intact clearly taking steps on strict risk management on future liquidity and price sensitivity issues. At this point, investors must heighten concern on speculative moves; otherwise the cycle of crises and bailouts that have been such a sorry feature of the past may re-emerge.

Copyright Business Recorder, 2005

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