Innocent bystander takes hit

Bahrain looked to have dodged the bullet from the downturn, but troubles at two Islamic investment houses have provided more reminders that Islamic banking is not immune to boom and bust.

Gulf Finance House, one of the top two Islamic investment houses in Bahrain, occupies nine floors in the Bahrain financial harbour.

MANAMA // Bahrain's financial companies have so far avoided the shadow that the global downturn has cast over Dubai and Kuwait, but recent troubles at two of its largest investment firms have fed concerns about the health of the sector there.

Gulf Finance House (GFH) and Arcapita, two of Bahrain's biggest Islamic investment houses, recently announced significant losses. GFH, which is heavily exposed to property in the Middle East, turned in a US$607 million (Dh2.22 billion) loss in the final quarter of last year, while Arcapita last week revealed it lost $159m in the same period. "With GFH, they don't have a business model at this point and their revenue streams have dried up," said Karthik Sankaran, an analyst at Bank of America Merrill Lynch who covers the company's stock. "The balance sheet is a mess and they don't have sufficient liquidity to meet near-term refinancing."

Bankers in Bahrain had hoped that losses of $786.5m in the 12 months to last June at Investcorp, another big financial firm, and Arab Banking Corporation, a wholesale bank that lost $880m in 2008 due to exposures to exotic derivatives and hedge funds, would close the book on the crisis in the country. But with the further losses at Arcapita and GFH, questions are emerging about the resilience of the financial services sector, which accounts for more than 27 per cent of economic activity in Bahrain, central bank figures show.

In another sign of mounting problems, the central bank last year took control of The International Banking Corporation and Awal Bank after they defaulted on financial obligations. Those banks are owned by two feuding Saudi family conglomerates, Ahmad Hamad Al Gosaibi and Brothers and the Saad Group. So far, challenges such as these have been cast more as anomalies than being indicative of a wider trend. Unlike many other governments in the Gulf, Bahrain's did not deem it necessary to guarantee deposits at banks or prop up financial institutions during the crisis.

"Although we needed to place two wholesale banks into administration in the course of 2009, these events did not have a spillover effect to the wider financial system," said Rasheed al Maraj, the governor of the central bank of Bahrain (CBB). "In fact, the financial markets seem to have taken comfort from the prompt and effective action taken by the CBB in dealing with these two problem banks." There was also a prevalent perception that Bahrain would be insulated from the crisis because of the predominance of Islamic investment firms and banks there.

Bahrain has 27 Islamic banks and more than 100 Islamic investment funds, making it a centre for the fast-growing Sharia-compliant sector in the Gulf. Given Islam's prohibition on charging and collecting interest, as well as its disavowal of the western world's more risky and complex financial derivatives, the thinking was that Bahraini companies were less likely to have been caught up in the speculative excess that sank the western model.

But as Sharia scholars and bankers, including Mr al Maraj, have since acknowledged, the fact that companies follow Islamic principles does not immunise them from cycles of boom and bust. Islamic banks and investment funds have put money aggressively into property projects in the Gulf, investments that have performed poorly of late. As one banker in Bahrain put it, Islamic investment was "almost synonymous with real estate". Although Bahrain's property market is small and has not had the destructive speculative element that prevailed elsewhere, including the UAE, many Bahraini firms participated in much more volatile markets.

"Now, some people might believe that because Islamic financial institutions cannot invest in CDOs (collateralised debt obligations) and CLOs (collateralised loan obligations), they must be immune to this problem," Mr al Maraj said recently. "But think about the exposure of many Islamic banks to the real estate market. It might be a reasonable assumption for an individual institution that it could exit profitably a property development that it is funding.

"But when many other institutions are making similar assumptions about the projects they are funding, the industry as a whole may find it difficult to exit its investments without substantial losses or within a reasonable time frame." Those concerns about liquidity - being able to sell investments and raise cash in times of need - appear to be at least partly the reason for Bahraini investment firms struggling recently. GFH, for example, ran out of money to repay debts that were coming up and was not able to sell enough assets quickly enough to do so.

Put another way, the company had borrowed in the short term to finance long-term projects that were hard to exit, a seemingly reasonable thing to do when refinancing of debt appeared assured. Now, however, the company's touchy liquidity situation has prompted a wholesale rethink of its business model. GFH aims to cut expenses by between 40 and 45 per cent, and has already laid off nearly 100 people, consolidated its nine floors of office space in the Bahrain Financial Harbour and cancelled last year's bonuses.

As it reduces expenses, Ted Pretty the acting chief executive of GFH, has tackled its debt load head-on. The blunt-talking executive reached a deal last month to pay off two thirds of a $300m Islamic loan that was maturing, extending the remaining $100m for six months. And GFH is close to signing off on a deal that would give it more time to pay off a separate $100m loan. Such adjustments at GFH and other Bahraini investment firms facing the same sorts of stresses have been made necessary by a lack of new financing from banks and a pull-back from investors.

Many Bahraini firms have raised new capital from their shareholders to help weather the financial storm. Arcapita has also cut back its workforce by about 15 per cent, the company said last week. "When the liquidity crunch hit and the global downturn started, it became clear it was becoming increasingly difficult to raise debt or raise new equity to continue funding ever larger projects, and some projects have suffered from that," Mr Pretty says. "Equally, property values declined as well."

That reliance on property has only exacerbated the woes of Islamic financial firms, Mr Pretty says. GFH helped set up multibillion-dollar developments in Bahrain, Qatar, Jordan, India, Tunisia and Morocco that it then sold on to investors, in some cases keeping a stake for itself. It also has stakes in financial firms and owns more than a third of Khaleeji Commercial Bank in Bahrain. All of those assets are now for sale as GFH works to raise as much as $420m in cash to reduce debts.

"One of the good things about the Islamic banking sector has been that it was not exposed to the toxic derivative-style assets that were faced in the US, which is good news, but there was a heavy reliance on real estate and infrastructure," Mr Pretty says. "So as a consequence of the meltdown in the US or the UK and Europe, the repercussion here was the fact that liquidity dried up both for debt and equity, and therefore these large projects could not continue to be funded.

"The vulnerability that the investment and commercial banks here had to the property sector became more pronounced. It's sort of the kick-on effect." Whether changes such as the ones Mr Pretty is making at GFH, stripping the company of its assets and settling debts, will be a successful recipe for recovery has yet to be seen. But it is a model that some struggling Bahraini companies may be forced to follow in the coming months as it grows ever more apparent that the global downturn has not spared the island kingdom.