Economic Confidential, February, 2009

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Nigerian Stock Market Crash and Challenges to a Prosperous Exchange

By - Ike Okwuobi, Canada

It's no longer news that the Nigerian Stock Market crashed to a record N4.7 trillion ($30billion) down from the N12.6 trillion ($85billion) recorded in the first quarter of last year; or that the Nigerian Stock Exchange was recently rated by Bloomberg as the worlds worst performing stock market for the month of Jan 2009.

This is dire news considering other macro economic factors: Oil; which accounts for more than 90% of the country's income, trades around $40 per barrel, down from its 2008 high of $145; Inflation is up by 10% (according to the Nigerian Central Bank); Nigerian Foreign Reserves fell by $8billion to $49billion in the last 8 weeks. This cantankerous scenario has been compounded by the fact that most Nigerian banks naively took collaterals of Share Certificates on loans, wiping away over $2.5 billion of their value when they crashed. As if that was not enough, the banks are further owed about $2 billion in otherwise bad loans made to players in the oil sector - both losses amount to over 15% of the value of the entire 225 companies trading on the Nigerian exchange.

In analyzing the way out of Nigeria's stock crash; let's broach three major concepts which coupled with an understanding of the latent advantages inherent to the Nigerian banking sector, will form the basis for the necessary policies (below), that will reshape and revitalize the Nigerian Stock market; its participants; and the Nigerian banking sector - which if going by the past five U.S recessions - must recover before the rest of the market can.

GAAP

The first is GAAP (Generally Accepted Accounting Principles) -accounting principles that allow publicly traded companies' recordaccounting events in specific ways for all the benefits of standardization; full disclosure; and accurate financial reporting.

Though Nigeria has Accounting Standards for Banks and Non-Bank Financial institutions issued by the Nigerian Accounting Standards Board as well as Guidelines issued by the Central Bank, it needs to incorporate a Nigerian GAAP (closely aligned with U.S GAAP as Canada has done). This will form the basis for increased International Investor confidence which directly affects the Capitalization of the Stock Market, the overall Stock Exchange, Nigeria's Foreign Direct Investment (FDI), Foreign Exchange Rate (FOREX), and Foreign Reserves.

Without which, one could be overly creative in financial reporting, and the long-term foreign investor knows this. In North America, financial analysts and investors appreciate how easy it is without GAAP to turn, say - a $5million loss, into a $20million profit and vice-versa. They understand that External Auditors are not Accounting Forensics; a misconception not lost upon them. And so as long as the target market for the stock market recovery is the long-term foreign investor (who buys `preferred shares'), rather than the short-term "pump and dump" international investor who plays the market, then Nigeria literally has to speak that fiscal reporting language.

In Nigeria, for instance, at what amount would a bank which issued loans backed by Share Certificates before the Stock Market crash of March 2008, record these assets on its books: at the amount of the issued loan or the market price? By what method do they record these specific doubtful accounts on their balance sheets? In the same vein, while in Nigeria sometime last year, I observed banks driving inflation, buying landed property at over 300% of its market value.

Granted, most banks are quick to state in their books that they record these fixed assets at "Historical Cost" (which means at a certain costnot upwardly revised as the property appreciates), but they are silent at the price such a fixed asset would be recorded in its books; the amount paid or the true market value?

The point is that the higher the price the bank records the assets, the higher the banks value. It goes against the GAAP principle of Conservatism leading investors to conclude that the banks' assets are highly overvalued. According to Canadian GAAP (which closely resembles U.S GAAP), such property would be recorded at the lower of its market value or purchase price. There could be similar issues with the goodwill value of assets on mergers and acquisitions. GAAP includes hundreds of standardized accounting methods and principles which speak to: Cost; Conservatism; Matching; Consistency; Going Concern; Full Disclosure and Materiality amongst others. Without a Nigerian GAAP, the true international investor can at most limit their participation to short-term loans at predetermined interest rates as evidenced by their current agreements with most banks.

500 YEAR OLD ACCOUNTING RULES

The second principle is borne from the 500 yr old accounting concept introduced by Luca Pacioli in 1494; simply put that for every asset there is an equal liability. But more importantly: The Assets of any company are equal to the sum of its Liabilities and Shareholder Equity. This means that if we assign imaginary numbers to the assets and liabilities of companies, and one decides to sell its assets to pay for its liabilities, any money left is its shareholding or what the company is actually worth (book value). Thus when the value of the companies stocks diminishes, the book value of the company similarly diminishes. So it would not be entirely accurate to say, as it has been, that - despite the decreased value of the value of stocks of Nigerian banks - these banks "still have assets and as such are healthy!" to which they proffer solutions asking banks to buy back their stocks. Not in Nigeria's current scenario where local investors (citizens) are heavily leveraged and foreign investors are short-term.

Such capitalization may not necessarily lead to a long-term appreciation of its market value as it could be suppressed by local investors desperately in need of cash, who are ready to cut loses and move on.

Thus; a buy back policy could be pointless, depleting the banks operating capital without any meaningful change. But don't get me wrong, one solution is to buy back shares, but in a specific manner which I'll get to shortly.

THE SPECULATOR IS OUT FOR HIS OWN INTEREST

One reality Nigerians will have to contend with is that the speculator or short-term investor is out for his own interest, which rarely coincides with the interest of the trading company. In response to the stock market crash, the Nigerian government said "Investors took their money and left when the recession hit their home countries" Yeah, right! I'll rephrase that to mean "The speculators, pumped, and dumped

the shares at the right time to militate against potential loses. They are gone forever, with all our monies, never to come back but to pump and dump again!" The speculator has been successful in Nigerian particularly because of the size of the Nigerian Stock Market. At $30billion, it can easily be manipulated by foreign investors.

Unfortunately, one more occurrence like this could totally devastate the Nigerian economy. This is what the next few policies will seek to overcome; but first: the Nigerian advantage.

THE NIGERIAN ADVANTAGE

Immediately after the 2008 crash of the banking system in the U.S, all eyes turned to Nigeria for two major reasons: Firstly, because Nigerian banks were not over-leveraged. Banks typically lend money they don't have in a process called "fractional reserve banking" This is the basis for modern banking where $1 in the banks vault can be loaned ten times, expanding $1 into $10. This system only works if the banks debtors don't default on their loans and depositors don't take their deposits all at once. Unlike Nigerian banks, foreign banks, through some `funny business' had partaken in the business of "Leveraged Buy Outs" and "Exotic & Vanilla Derivatives" that stretched the dollar 30 or 35 times. Nigerian banks did not. As such were relatively insulated. But a more powerful advantage of the Nigerian banking system is that it presides over a relatively credit free economy, which means there is room for expansion of the banks and the economy.

According to The US Federal Reserve, in 2007 US households had a combined consumer debt of $13.8 trillion. The US household consumer debt is 140% of its Disposable Income, (Nigeria's is virtually non-existent). Students have an average of $20k debt. What all this means is that Nigeria could be a gold mine for expansion if properly driven in partnership with the banking sector.

POLICY SOLUTIONS

- The first policy suggestion therefore will be: to immediately embrace a form of Nigerian GAAP, which like its Canadian equivalent will closely align with its U.S counterpart. This could take up to 6 months to streamline and for companies to revise their earnings accordingly. And then in 2014, along with the U.S, Nigerian GAAP could evolve into the new global accounting standard – International Financial Reporting Standards (IFRS).

- Once Nigerian GAAP has been introduced, the next solution will be a Strategic Stock Recapitalization. Because of the relatively small size of the Nigerian stock market at $30billion, it cannot be allowed to float like other markets. Besides, the market should not be about gambling, but leveraging the synergy of capital and ingenuity for the mutual benefit of both parties (investor/trading company). Consequently, the recapitalization solution should be unique to its size, culture and true to its ideals.

- We can take a cue from the world's richest man, Warren Buffet, the `Oracle of Omaha' who owns 30% of Berkshire Hathaway, a company he founded (it trades above $100,000 per share), or from Wal-Mart; one of the worlds largest companies, with a market capitalization of over $200billion. The Walton Family still owns 40% of Wal-Mart. Something is to be said for the growth of such companies' viz-a-viz investor confidence when owners retain a commensurate percent of their stocks. CBN should include a regulation mandating a minimum ownership of shareholding of publicly traded companies in Nigeria.

- But in reality, neither the directors nor the banking operations may have these funds; so the question is how they achieve this. It can be done through a Stimulus package. For instance, if CBN determines that the directors of the banks should have a minimum of 50% shareholding and they currently hold say 20%, after the GAAP restructuring period, CBN could buy back 30% shareholding across all banks. (A different level could be set for other industries).

- With the government having part-ownership, it can leverage the Stimulus capital to expand the economy with broad macro-economic policies which capitalize on its inherent advantages. Without delving deeply into macro-economic policies to achieve this, an example could be: for the Nigerian government to offer University students' long-term student loans of say ~ $500 to $1,000 each year. This will totally revamp the economy. With such a macro-economic policy, everyone will be winners: The Banks will have a most important long-term loan instrument (long-term student loans). Government will be able to expand the economy; it will reduce crime, kidnappings, prostitution and create a new destiny for our future leaders. Equally importantly, it will lay the foundation for a proper consumer-credit system, etc. Indeed, the stock market crash may be Nigeria's greatest opportunity yet, to catalyze an expansion of the economy with smart structural and macro-economic policies.

- Notwithstanding, the CBN, as a matter of urgency may consider working with the new Owerri Exchange and peg the amount of shareholding that listing companies can offer to that public at a certain maximum of say 60% with owners holding the balance of 40% lest it becomes tool for gambling and Nigerians find themselves in a more chaotic position a few months down the road.

Ike Okwuobi, an I.T Systems Analyst and a Financial Analyst contributed this piece to the Economic Confidential from Montreal Canada.  He is the President & CEO of GoGagga Corp www.gogagga.com, a Financial Software Company and can be reached for comments or discussion at okwuobi@yahoo.com.