Will you trust Credit Rating Agencies?

Oct. 22 (Bloomberg) -- Employees at Moody's Investors Service told executives that issuing dubious creditworthy ratings to mortgage-backed securities made it appear they were incompetent or ``sold our soul to the devil for revenue,'' according to e-mails obtained by U.S. House investigators.

The e-mail was one of several documents made public today at a hearing of the House Oversight and Government Reform Committee in Washington, which is reviewing the role played by Moody's, Standard & Poor's and Fitch Ratings in the global credit freeze.

``The story of the credit rating agencies is a story of colossal failure,'' Committee Chairman Henry Waxman, a California Democrat, said at the hearing. ``The result is that our entire financial system is now at risk.''

Moody's and S&P in recent months had to downgrade thousands of mortgage-backed securities, many of which were originally given top AAA ratings, as delinquencies on the underlying loans soared well beyond the companies' estimates and home values fell faster than they expected. The downgrades contributed to the collapse of Bear Stearns Cos. and Lehman Brothers Holdings Inc., and compelled the U.S. government to set up a system to buy $700 billion of distressed assets from financial companies.

The Securities and Exchange Commission in a July report found the credit-rating companies improperly managed conflicts of interest and violated internal procedures in granting top rankings to mortgage bonds.

An e-mail that a S&P employee wrote to a co-worker in 2006, obtained by committee investigators, said, ``Let's hope we are all wealthy and retired by the time this house of cards falters.''

`Race to the Bottom'

Former executives from S&P and Moody's told lawmakers today that credit raters relied on outdated models in a ``race to the bottom'' to maximize profits.

Jerome Fons, a former managing director of credit policy at New York-based Moody's, told lawmakers that originators of structured securities ``typically chose the agency with the lowest standards, engendering a race to the bottom in terms of rating quality.''

The top executives of the credit-rating companies said in testimony that they were unprepared for the sharp drop in home prices and that their systems failed.

http://www.bloomberg.com/apps/news?pid=20601087&sid=ac8Bkp_7F4Rc&refer=home

Indian crisis - Liquidity crunch and workaround

The recent step by RBI to reduce CRR by 250 basis points is perhaps the most drastic step in the history of Indian economy. Reducing the CRR is an attempt to inject liquidity into the system. The GoI should review other features such as reduce the SLR, repo rate (rate at which the RBI lends to the banks).

It is important to understand the problem in Indian context. The economic crisis is further complicated in view of the upcoming election in 2009. At the heart of the problem in the global financial system is excessive leverage. Many of the financial institutions even now are leveraged at close to 25-30 times their equity, which means capital adequacy in the western financial system is between 3-6% of the assets. Indian banks on the other hand have a capital adequacy ratio of 10-20%. Moreover, with CRR and SLR Indian banks they have almost 30% of the money with GoI and RBI. Hence banks can be trusted in India; however PSU banks will command more faith than their private counterparts.
(N.B. – The present trend shows huge rise in the deposits with PSU banks; PSU banks are likely to see a increase in deposits by 30% this year. This would enable PSU banks to have huge funds at their disposal. Thus it is expected that performance of PSU banks would improve dramatically in near future consequently a spiraling stock price once the markets swings to +ve. Caveat: Waivers like the one provided by UPA govt may prove otherwise!)

With the global finance companies going bankrupt, the ECB (external currency borrowing) options are drying up. The Indian banks are facing a-never-before-situation of higher borrowing demands from the corporate today. Issuing equity (through rights issue) is not a feasible option, and with the debt markets (even debt-mutual funds have been enormous liquidation pressures from small investors) collapsing there is increased pressure on banks to provide loans to these corporate.
However, there is a trick – a typical vicious circle has formed – with banks unwilling to lend to the corporate because they are apprehensive that the corporate may not be able to pay back as a recession may set in. On the other hand corporate with shortage of funds may not perform thus pushing the economy into recession. This may prove catastrophic in growth figures of both companies as well as that of the GDP. In fact, inter-bank lending has reduced drastically – as banks no longer trusts other banks regards paybacks. The GoI must positively interfere to instill confidence into the whole system.
There is a serious need of a BIG BANG in Indian banking system is required (as suggested by Mr. Amit Mitra):
1. Reduce CRR
2. Reduce SLR by 2% without having major impact on the economy
3. Reduce bank rates – otherwise SMEs (which employ about 40%) may flop.
4. Rethink Foreign investments strategy (revival of old P-notes/ban short selling etc)
5. Reduce repo rates ( as I am writing this article RBI has already reduced the repo rate by 100 BP)
6. Increase interest rates for NRIs to increase foreign inflow of funds.
Higher interest rates make many projects unviable for execution.
On the other hand there have been remarkable changes taking place on the commodities front. Wheat, Rice Steel, Oil etc are all down from their all time highs (about 50-70 % correction in some cases). Thus inflation may see single digits in the coming months. Interesting to note that the steel / cement companies clamoring for removal of price control may end up asking for price protection! Thus the UPA govt may get a sigh of relief temporarily. The fall in food commodities is primarily due to huge productions across the globe (with the exception of Australia) – in fact this time it’s a record production. But with decreasing area under cultivation, especially in Western Europe, food prices may not be as low in next FY.

Another bout of regulations is sure to come both for Indian as well as global financial institutions – but tricky brains still exists, who would device new financial instruments to get around the regulations.

Inflation and the government

It has been long since my last post - however things have remained volatile on the bourses. This post discusses in brief the major changes in India polit

Bull runs have been intermittent, ebbed away by the larger bear market and profit bookings. Oil prices have taken a dip but has not impacted the stock markets significantly (except for oil intensive industries such as airlines etc).

On the other hand the UPA govt seemed strong and healthy after sweeping the vote of confidence; people seemed to believe that without the nagging left support reforms were round the corner. Much to our disappointment things turned out not-so-bright for the bulls. With Lok Sabha elections close by it is tough for the UPA govt to bring major reforms in the economy. To add fuel to fire, the inflation number have peaked their fourteen year high. Interestingly, the government has hardly taken any steps to contain the inflation, but rather adopted populist economic (or political!) policies. The forgoing of 60,000 crores of loan to the farmers have hardly impacted the needy farmers (they are unable to avail loans - as rural loan policies are dictated by local politics in each state) but have added to inflationary pressure. The avg hike of 21% of central govt employees (through the 1oth pay commission) was a kind of trade off. This would further add 30000 crores into economy thereby driving inflation higher. Only occasional interest rate hikes by RBI has failed miserably. In fact the worst is yet to come so far as inflation numbers are concerned.

I would attribute the bear market largely to the global credit crisis - the FII investments have been diminishing since the January crisis. Its only when these subside, that the Indian markets would take off. The losses incurred by various financial institutions will be accounted across a number of quarters (as I had already mentioned). Thus, we may see more institutions going bankrupt in near future. However, I do believe that the Indian growth story is intact and the very fact that the Indian equity is now trading at a lower P/E than the Chinese counterpart - the reversal / recovery would be faster on Indian bourses. Value picks and long term investments are tick of the day.

Real estate dilemma

There has been a drastic change in the real estate space - many of the bigwigs have touched their 52 week's low and some have gone doen below their listing prices.

Firstly, in the recent months post Jan 2008, if the major falls are observed they are preceeded by a crash in the real estate index. This may be due to some conceptions that the real estate stocks are trading far above their fair PEs. But I would attribute this more to the FIIs - almost all the FII have real estate stocks like DLF, Unitech, Parasvanath etc in their portfolio. These form a major component in thier portfolios and with these FIIs selling off the first indication comes on the real estate index.

Second being the fear that real estate prices would come down drastically in the coming months in Mumbai and Delhi (20-30% in topslap and 10-15 % in middle tier real estate assets). Yeah, this may be a possibility but the major real estate companies are mainly focusing on Tier B and Tier C cities as the development of a township gives far higher returns than some highly priced apartments in A+ cities).

In any case there is no justification that the stock prices falling almost 50%. However, these are more robust companies than any other because land remains the limiting factor in the Indian scenario. Infact the next craze would be REMF (Real estate Mutual funds).

The future of Indian equity market is not as gloom as it appears. Yes we had a fall of more than 500 points on the Sensex and many of the so called big corporated are reeling under selling pressure trying to gauge new all time low (or 2 week low) as the case may be.
But the story dosen't end here - lets analyze little things. The Indian economy is the same as it was a month or six months ago. No fundamentals have changed that much to have a drop of 50% or so. It just as good a concoted story as the 20k euphoria was.

The reasons - cited are a) rising oil prices , b) inflation, c) global equity crisis (this was supposed to have started with the sub-prome) d) lower GDP growth rate than forecasted.

Let's analyze them one by one:

a) oil prices - read my previous post. Also note that commodities is now at its peak undergoing a boom - similar to the equity market we had six months back. Like all things that which has gone too high will ultimately bust and even out. The question remains when ? Not too far from now - 3 months would suffice.

b) inflation - stupid indexes invented by morons have been used to gauge inflation. Its more of a number game - and some technical junkies use these to defend their statement. All such indices try to measure the inflation are grossly off the mark and many of these does not take into account seasonal changes niether do they discount abrupt price jumps of particular products.
Will post a detailed analysis in my next post.

c) Yes the US had a poor growth may be on the border line of what is defined as quote unquote "Recession". The unemployment rate has risen to 5.5%. But what the heck! Emerging economies provide far better return than the developed counterparts. What if the investment banks & insurance companies sell of in US ? Where the hell will they place that money ? Will they invest ? Yes. Where ? in growing economies and commodities. Aye no more in Gold ... Gold story is gone for the the time being. There you see the cycle - equitues, gold, commodities ...

d). GDP growth does have an impact - but its applicable only to the long term story. The nature of investment of FII is most cases do not adhere to such pronciples.

More to come later ...

Oil: is price hike justified?

International Energy Agency: Oil supplies sufficientWalid Khadduri Al-Hayat - 18/05/08.

In its monthly report that came out last week, the International Energy Agency (IEA) announced that oil supplies were sufficient and that the primary cause for the current big hikes in prices are the result of the attempts by industrial countries to secure sufficient oil reserves along with meeting domestic consumer demand. The International Energy Agency represents oil-consuming industrial countries in international economic circles.The IEA also indicated the growing calls to increase oil supply as the price of oil reached $125 per barrel. But do we really need more oil? The answer to this question according to the IEA lies in the fact that a closer look at the balance of supply, demand and future risks, it becomes clear that the reason behind the price hike is the increasing demand and not supply shortages.The report also indicated up to date data and forecasts confirming a surplus in oil markets during the past two months. It expected this surplus to persist throughout the year in case OPEC decided to maintain the same level of production. The IEA also added that demand rates in the US are dropping gradually and expected this decline to continue, and the same with the patterns of high demand in China and the Middle East.However, it also pointed out that consuming countries are calling up on OPEC to increase production to reduce prices. This is true, according to the IEA, since increasing production will raise the level of available reserves in consuming countries which in turn will lead to improving the performance of refineries and hence the prices of oil products. OPEC, however, asserts that supplies in the market are sufficient and that the current situation suits the increase in reserves.The IEA concluded its discussion of the subject by confirming that the past 18 months have been dedicated to the discussion of the subject: are the oil reserves of consuming countries sufficient, and is the timing of the decision to raise the reserves appropriate? It is generally believed that the market can only express its need for sufficient reserves through price. Hence, if supplies allocated for reserves run short, prices increase, and if a few consuming nations insist on a certain level of reserves, they would have to compete against consumer demand which in turn would raise prices.In addition to reserve levels, the IEA also added another factor influencing prices, namely the perceptions of traders in futures, that is, speculation.In this context, it is worth referring to what the IEA casually mentioned, namely the impact of speculations on the rapid price hikes. The New York-based Integrated Oil Update bulletin indicated that crude oil futures dealings (speculation) at New York's NYMEX and London's ICE were up from about $9.5 billion per day five years ago to almost $86 billion barrels a day last year, then to $140 billion per day earlier this year.Once again, these figure are a reminder of what OPEC ministers continue to say and confirms the credibility of their claims and arguments, namely that the record hikes in oil prices are not caused by supply shortages, and that a major factor behind these hikes is the element of speculation which does not take into consideration the demand and supply market fundamentals but rather responds more to rumors and future political and economic fears more than any other element.Speculators and investors benefit from positive or negative price speculations, depending on the nature of their investments and bets, and market dealers increasingly respond to reports published by research departments at financial institutions such as the report recently published by Goldman Sachs which warned about the possibility of prices rising to the $150-$200 range within six months to two years.

Writedown of losses

The Article below explains how and why brokerage houses writedown partial losses over a period of time. The same applies to big banks and it is supposed that they would writedown the loses over a period of time (say for next 8 quarters). As a result there maynot be any significant bull run in near future.

Business Standard -
NBFCs of brokerages refrain from announcing one-time hit due to margin funding. A good number of non-banking financial companies (NBFCs) belonging to big brokerages are keeping themselves from announcing a one-time hit by losses arising out of margin funding following the market meltdown in the early part of this calendar. Instead, the broking houses are carrying forward these huge losses as loans under recovery, and announcing only minuscule bad debts. Through this move, say experts, these broking firms can avoid making huge provisions for losses and, to a great extent, neutralise a possible negative impact on their share prices. Stock prices normally take a hit if a company's provisioning or writedowns is huge, they say. It's surprising to know that provisioning and losses announced by brokerage houses do not form even 1 per cent of the entire margin funding business. Chartered accountants say brokerages can carry forward their losses for six to eight quarters, after which they will have to show it on their books.

However, they can avoid mention of any loan as loss, even after two years, if the matter is sub judice.'Typically, what most of them would do is make small provisions for NPAs every quarter, so the loss amount does not seem to be too big. Eventually, they would also try and offset these losses with their profits in the coming quarters,' says an accountant.In the last three years when the share prices were shooting up, the NBFCs of top broking houses made a killing by lending money to investors at an interest rate as high as 18-25 per cent.While the NBFCs earned high interest rates, their broking arms benefited from commissions earned from the share transactions. Conservative estimates put the size of the margin-funding market at Rs 10,000 crore during the market peak of 20,000-plus levels.The funding reached unparalleled proportions as brokers aggressively pushed for loans to small retail clients too. Investors typically bring in some portion of the money to purchase shares, while the broking outfits (through their NBFCs) finance the remaining amount. The shares are then kept in the name of the NBFC.In a rising market, when an investor chooses to book profits, he gets his portion of the contribution and the gains. The broking firm takes home its funds and the interest amount.This led to a bubble-like situation as investors were seduced into paying more for a stock than its fundamental value. Margin-funding trades were also responsible for the huge volumes generated in recent times. 'However, when the market crashed, the entire system collapsed like a pack of cards, leaving the broking houses with piles of bad debts,' explains a dealer, while stressing that the margin-funding business is now down by over 60 per cent.Currently, the brokerages have huge NPAs and bad debts. They're now moving the courts. 'Such cases drag on for years, and it will not be surprising if the brokerages do not announce any writedowns in some cases on the pretext that they are still in the court of law,' says the accountant.

Trading strategies - Technicals

There has been enormous research on trading methodologies to be pursued by any rational and intelligent investor. Volumes have been written but none provide a definite path. I believe that if a path did exist to make assured profits, then imagine a market where every investor follows the same pronciple! Will all make profit ? Who would sell when the theroy says one to buy? !!!

Non exists dear friend. W. D. Gann (one of the most controversial and successful traders) had charted out numerous predefined technical analysis. But they are so complex and incomprehensive (especially when you are not sure whether to implement all or a few of the rules laid down) that it is impractical to follow them.

Technical charts may provide you some guidance - resistance, supports and moving averages but they cannot be solely relied upon on deciding which stocks to pick and which stocks to sell.
Purchases should be made on a company's fundamentals or news (speculation). The later can give hansome profits or leave you nowhere!

But I would rather view Gann's principles from the philosophical angle - which advices one to show restraint on greed and be unnerved by losses. Stock market is essentially different from any other form of business - in other cases of life 'you' are the actor and your efforts get reflected; but in the market its too huge for any single participant to control ( leave out the stories of influencial people who can change credit policies or set the company rules ). Other forms of insider news is stictly unfair though they have significant impact on determining stock prices.

"... it turns out for all practical purposes there is no such thing as stock picking skill. It's human nature to find patterns where there are none and to find skill where luck is a more likely explanation ..." - William Bernstein, The Intelligent Asset Allocator

Rally in a Bear Market

It's quite a common occurance to have a rally in a bear market. These are the mechanisms that are used time and again for the bigger players to exit the market.

Subprime crisis is far from over. It is reported that every month 250,000 foreclosures are taking place, that means that Primary Lenders seized the assets and sell them out, with entire profit and losses belonging to them, leaving ZERO for the secondary holders. Thus the total loss per month is 250,000 x US$ 0.25 Million (US$ 250000 mean average price per home) = US$ 62.5 Billions. Against this amount, the secondary derivatives issued (which were bought by ICICI Bank and SBI and also BOI) were 6 times or US$ 375 Billions per month. Deducting $ 62.5 Billions for primary lenders, the holders of secondary derivatives are US$ 300 Billions PER MONTH. Since the Primary lender has seized the primary mortgage assets, and leaves nothing to secondary holders, the secondary derivative holders are losing at the rate of US$ 300 Billions per Month. Their valuation is ZERO and may be they are not recognizing in their books, but they will have to. When $300 Billions, the size of India's entire FOREX reserve, is disappearing every month, where is the question of 'End of Subprime'.

Profits, EPS, P/E are the good old fundamentals. When markets crash - money normally flows into the bond markets. But nope - the situation in bond market is too poor, the returns in teasury is far too low.

Giant banks have started issuing shares, bonds to face their loss/crisis. This is no growth story.
When big banks start loosing out credit tightens, sensex falls, margin calls come into play and we/you loose!

Soros and theory of reflexivity

Legendary investor George Soros was of the view that equities market was a total chaos - and the sooner one accepts it the better. He was of the view that its not always that the company's fundamentals determine the stock price (or equilibrate) but rather the stock prices can change a company's fundmentals in ways such as M & A. Stock prices being primarily a function of the perception people have, it is important to identify the inclination of the people towards a particular stock.

I would differ to some extent - in major index stocks its price is controlled/governed by the sal/purchases by QIB and HNIs etc. These being educated and rational woulf try to identify what rest of the markets think and conclude. Thus when each of the major entities think otherwise the common thinking may prevail. Its similar to a paradox. Let's illustrate - let the rational/intelligent participant be X and the rest of the market (excluding X ) be Y. Thus with X and Y together makes the universal set. X tries to identify how Y would interpret the market and accordingly steps counter measures - so if Y thinks stock A would perform X thinks its time to sell A. Similarly the other way round. But there are many participants who would think with the same logic - as a result we get the complementary set of expectations. Thus it would be really difficult to think as separate identity - i.e. there is no such thing like 'I' and the 'rest of market'. Its a sum total!

Monetary supply and Inflation

Government of India can print any number of notes.
There are two ways of generating Currency Notes, some may take physical form and other in the form of book entry.
One is through 'Deficit Financing' where the government of India's total expenditure exceeds total income from all sources - Income Tax, Excise duty, Central Sales Tax, Value Added Tax, Import duty etc. Supposing Net Expenditure for 2008 is say -80,000 crores. Since the GOI does not have money, it gives credit or print notes to the extent of Rs 80000 crores.

Secondly through FOREX intervention. When the lot of dollars or other Forex currencies come to India, they need to be converted into rupees before they could buy stocks, bonds or make direct investment. The foreign investor has to buy Rupee from the market which will cause Rupee demand to exceed the demand, so the rupee appreciates. In this case, no currencies are printed. However, when RBI at the instance of GOI decides to intervene in the FOREX market to 'sterilize' Rupee currency's rise, it ask the Foreign Investor not to go to the market and buy the Rupee. Instead, RBI give special rate to the foreign investor to buy dollars in 'off market' and give him the credit to his current account with any bank (book entry). For instance, if Citibank approaches RBI to sell US$ 500 Millions on behalf of its Mutual fund customer, it will get better rate, say Rs 41 instead of market rate of Rs 40, so it saves about 2.5% on exchange. RBI then gives credit of Rs 2050 crores by buying US$ directly from the Citibank. This avoids selling of dollar and buying of rupee in the market, so rupee exchange rate remains same. Had Citibank sold $500 Millions in the market, rupee might have appreciated to say Rs 39 or it would have got 5% less than what it would have got by selling to RBI. In short, Money Supply (called M1) increases in the market. The book entry slowly gets converted into real money because when Citibank buys the stock, it has to pay in rupees, and that rupee will circulate in the marketplace. This is a suicidal policy; it does not increase the good, but merely increases money supply. The equilibrium between Goods and Currency in circulation is adversely affected as result of which 'Inflation' in the system increases.
This second type of practice is adopted by most Asian countries including Japan, which have highly inflationary effect.

One cannot pay Rupee to IMF to discharge the debt. The debt was contracted in US$, so you have to buy US$ by selling rupee in the marketplace to pay off the debt. If what you say was possible, practically every country will discharge its debt by printing more notes. USA is exception. Because it was used as Intervention Currency, or common currency, US government was encouraged to issue more notes and contract debts. Since the debt was issued in US$ or its own currency, it will pay off the creditors by printing more notes. This is what it is doing. It borrows from the world, and the President Bush go on giving Tax Rebates to its citizens at will, because he can afford to, because the world is foolish in giving more value to dollar.

Above should help you understand some basics of Monetary Management. Note there is no free market for currency in India.