Monday, March 31, 2008

Towards a forex derivative safety net

Soon credit rating agencies will have to factor in solvency of customers before they evaluate and grade banks for their financial stability.

Here are a few more skeletons falling off the cupboard of ICICI bank – customers taking it to court for alleged mis-selling of derivative contracts. Obviously the bank will plead the customer was fully aware of his downside risks while entering the contract. Unless the parties settle for out of court settlement, it could lead to a protracted legal battle.

But I suggest a few measures the banks could take before they enter into complex derivative contracts with customers –

Enter into contracts only with customers that have relationships with the bank for over 5 years;
Begin relationships with smaller sized contracts – say $ 100,000 ; every year the deal size can go up by 2x;
Go by net worth linked limits for contract sizes – say aggregate exposure should not exceed 25% of customers’ net worth;
Banks should make provisions for net exposure on a risk weighted average basis, of about 50% of negative outcome on the day of entering the contract;

All contracts should carry personal guarantees of MD /CEO and all executive directors of the customer to make good the losses to the bank if the customer defaults on its obligations under the contract;

RBI should set up a neutral authority –someone like a Notary Public- to endorse the fact that the bank has explained all possible outcomes of a derivative contract and the customer has completely understood all its risks and grant a certificate to this effect. This NOC should be a pre-condition for entering into a derivative contract. The fact of obtaining of NOC and the extent of its risky exposures should be informed to stock exchanges by the customer where it is listed within 3 days of grant of NOC by RBI.

Update : More spillover – Sundaram Brake Linings v. Kotak Mahindra Bank


Spunky PE - J.M.Trivedi of Actis

Besides Renuka Ramnath [CEO, ICICI Venture] whom I admire a lot in Indian PE scene, J.M.Trivedi of Actis has demonstrated spunk. Here he is getting a professional CEO for Ahmedabad based Paras Pharma (makers of MOOV, DERMICOOL, KRACK) knocking back family management to a corner.

ICICI and Actis can be counted among the few buyout funds active in India. Most others settle for negotiated PIPE investments in listed firms or do some odd venture capital investments in unlisted firms. Their fortunes glide along the directions of equity markets and fund managers have no active participation besides attending board meetings and scanning dull reports. Nothing of the sort where they take majority control and guide their fortunes themselves. It calls for strategic clarity besides pure spunk. That’s where the process discipline matters.

I wrote about Wockhardt back in March, 2007. Now after the IPO of its subsidiary (Wockhardt Hospitals) got pulled back, the deal looks even better. Mr.Trivedi, why don't you take a look?

Friday, March 28, 2008

Itching to hit the familiar turf

Too much money can drive people nuts. Perhaps India’s huge reserves – around $300 billion – has exposed the clueless top dogs at M/o Finance and RBI finally concede their inability to deal with a never before situation of surplus. Looks like they are itching to get it out of the way quickly so that they get back to familiar terrains of penury and economic destitution.

Their strategy? To ride on all their inexperience of fund management and set up India’s sovereign wealth fund (swf) to invest in risky energy and financial assets overseas – on the lines of Singapore, Abu Dhabi and even China.

Vinay B Nair of Wharton Center explains why it is a bad idea.

Politicians are famous for economic apathy. But know what it takes for their lot of under-privileged to buy a strip of paracetamol!

Wednesday, March 26, 2008

Ambani-Deora Master stroke

Government is in a fix over closure of petrol pumps by Reliance Industries over denial of subsidy on par with public sector companies, with Oil Minister Murli Deora today admitting that dealing with the situation was not easy – BS report.

Fertilizers and Petro products have always been subsidized in India as these are more a political issue than economic. Are they telling us Reliance Industries and Essar Oil entered the business without doing their math?

Anyways, Government is in a dole-out mood. It recently announced a Rs.60,000 crore farm loan waiver. Followed it up with the 6th pay commission costing about Rs.12,000 crore. Now let’s wait for the climax to play out in this grand conspiracy to favor big business. Screenplay seems ready. Film directed by Ambani-Ruia-Deora trio. First phase already won as per grand plan – Murli Deora re-nominated to Rajya Sabha unopposed.

Time to go long on RIL and Essar…?

Sunday, March 23, 2008

Dance of the bands

SEBI lifts price bands for non-IPO listings here.

Currently, the stock exchanges impose a price band on first day of trading / resumption of trading post corporate actions like merger, de-merger, capital reduction, CDR / capital restructuring, revocation of suspension, direct listing on another exchange etc. Now SEBI feels that in such cases there is no need for price bands because they restrict normal price discovery.

This has been my pet peeve too. Why not open up price bands for IPO as well? SEBI has been mulling over this for quite some time. In a free market, nobody can wish away volatility and price discovery can only be a function of demand and supply. There could be scope for manipulation by some operators but their span of control is limited. Driving the stock prices up or down by artificial intervention of operators come at a high cost and associated risk. The best way is to let a few players suffer the carnage. Mostly these operators are funded by promoters of companies to see their net worth zoom on the listing day. When a few get scalded, caution will rule and normalcy shall prevail. Allow some casualties.

It also seeks to extinguish the perilous grey market for securities – regarded as one of the primary concerns of Mr.C.B.Bhave, the new SEBI chief as soon as he assumed office recently. He seems to be a fast cat, having already enabled short selling by acting out lending and borrowing mechanism. Now it’s time he pays attention to my no-band philosophy on IPO price discovery as well.
Who is SEBI trying to protect? The small investor? Nobody is a saint. Everyone big or small, comes here because she is greedy. Regulation is welcome to the extent anarchy doesn't get a reception. Taking regulation too far by imposing price bands is meddling. Let the markets rule.

Wednesday, March 19, 2008

Farm loan waivers and Investment bank bailouts

John Ruskin said “the highest reward for man's toil is not what he gets for it, but what he becomes by it.” I wonder what will he make of the global financial system that never seem to learn from its mistakes.

Have governments and central banks finally aligned? Or have they all run out of ideas? I certainly see character here. Very charitable one at that. I see across the board farm loan waiver in India (a massive $15 billion bill on the tax payer) and a massive bailout of failing investment banks in the US. The fed backed it up by cutting interest rates – sixth cut in a row since September,2007.

I see parallels that feed systemic excesses –

In the US, the financial services industry has defied gravity by using debt, securitization and proprietary trading to boost fee income and profits. Why care for capital adequacy if the tax payer is obligated to bail them out? In India, farmers have been pampered for long – tax exemptions, loan write-offs and yet keep them clustered under priority sector. Why repay a debt if it’s likely to be written off?

The value of outstanding credit-default swaps in the US financial system, for instance, has climbed to a staggering $45 trillion. In 1980 financial-sector debt was only a tenth of the size of non-financial debt. Now it is half as big. In India, outstanding agricultural credit is currently less than 10% its net NPA. A couple of waivers like this, and it will get there.

Leverage process practised by Wall Street has turned investment banks into debt machines that trade heavily on their own accounts. Goldman Sachs is using about $40 billion of equity as the foundation for $1.1 trillion of assets. At Merrill Lynch, the most leveraged, $1 trillion of assets is teetering on around $30 billion of equity. In rising markets, gearing like that creates stellar returns on equity. When markets are in peril, a small fall in asset values can wipe shareholders out, as it did with Bear Stearns and many others.

Globally, salaried tax payers can't escape tax cuts because they get checks after deduction of tax. That comfort is making governments smugger and they're emboldened to write more loans off, bailout wrongdoers in one swoop. It is not within our power to not let them cut taxes before they cut our checks. But with a bit of initiative and aided by a stroke of luck, we can certainly turn farmers or investment bankers and benefit from the largess that won’t stop any sooner :-)

Sunday, March 16, 2008

FCCB has a short fuse

The Rupee appreciation and market declines have struck a double whammy to Indian corporates – especially those who have raised funds thro FCCB route during the boom times. I am not surprised. Most of them raised FCCB debt because it was available or worse, I-bankers goaded them into it. Now they grieve. Here is the Business Standard story.

It says “Non-conversion into equity may erode profits by 12% in FY09: Study”. I fear the erosion could be lot more if the study has provided only for annual interest outgo on FCCB borrowings. Let’s figure it out by a case study.

Take Amtek Auto (featured first in the list of companies in that report). It has $250 M (Rs.1000 cr.) in outstanding FCCB liability. I checked its operating profits [BSE CODE:520077] for CY 2007 (being the trailing four previous quarters) and its operating income is Rs.460 crores. (I hope the company follows prudent norms and accordingly assume the pro-rata interest on FCCB is included in the interest figure for respective quarters.) Now, after providing for depreciation and taxes, the company has a net income of Rs.257 crores.

As per the table, the market price of the stock is currently quoting at a 35.2% discount to the agreed conversion price of Rs.414. FCCB is due for maturity on June 2011. If the stock price goes further down or if it maintains below the conversion price, the liability shall remain as debt in its balance sheet and the company will have to provide for its repayment. Given the gloomy outlook, I don’t see the market getting back to its Jan 2008 peak levels any sooner and so would recommend providing for repayment of its principal (Rs.1000 cr) out of current profits. That would call for creation of a FCCB redemption reserve and transfer a sum of Rs.250 crore each year for 4 years between 2008-11. That would leave a net income of Rs.7 crores.

Now imagine the dent in the EPS. It’s earnings are currently at about Rs.16 per share. After creating the FCCB redemption reserve, it’s net income would stand reduced to Rs.7 crores and the resultant EPS would be Rs.0.63. Give it a liberal PE ratio of 16 as at present, even then the stock price would be a dismal Rs.9.90. That’s the emerging picture if FCCB leverage is taken out. The company may either choose to recap it with other means of finance of equal amount to sustain its liquidity and operating leverage. Even then, with the cost of debt going up, it may not be able to borrow at those low FCCB levels of 5.5%. This means higher interest outgo and lower EPS in the event the company is not able to accelerate its revenues or improve its margins. Both the options are unlikely since the company caters to auto sector that is rate sensitive and runs on low cost financing for sale of vehicles. That spells disaster for shareholders.

Now I have nothing against Amtek Auto as such. I just picked it up as it was figuring on top of the list in that table. But then this is a sufficient case study that highlights what over-indulgence during boom times can entail. Don’t bite off more than what you can chew.

Thursday, March 13, 2008

A new kind of oil hedge

Ask Diana Farrell and Susan Lund in this McKinsey quarterly report dissecting the motives of sovereign wealth funds -

“How will state investors behave as public shareholders or owners of companies in foreign markets? Will they seek to maximize value creation and long-term growth, or will their investments reflect the political objectives of their governments and the interests of businesses in their home countries? Financial markets require the free flow of information to function efficiently. The presence of huge, opaque players with non-economic motives could distort the pricing signals that other investors need...

…..Can higher oil prices really be good for the world economy? As we have seen, petrodollars are creating inflationary pressures in markets for illiquid investments, such as real estate, art and companies. If the pressures move beyond those markets, the potential asset price bubbles could burst. So far the world economy has accommodated higher oil prices without a notable rise in inflation or an economic slowdown, but this may change in the future.”

I see an indirect oil price hedging opportunity here for net importers. Create a vibrant, deep local financial market across asset classes, rich with intermediaries that optimally deploy the huge surpluses of SWF. Whatever they lose by incremental oil bill can be hedged by tax revenues from incremental fee income generated by local SWF managers. Oil importing nations after all, can’t keep paying fat import bills forever by printing currencies :)
Now I'm getting ideas. My daughter's been an avid painter ever since her junior school. I've archived some of those amateur works of art that look a lot better than a few of those auctioned for over a million $$ and probably bought by (who else?) SWF managers. Thinking of auctioning a few of them to help meet my fuel bills for the rest of my lifetime ;-)

Sunday, March 09, 2008

I want all my tax back, NOW!!!

Swaminathan A Iyer suspects political ploys initially hailed as master-strokes often end up as flops. He refers to the Rs 600 billion ($15 b) farm loan waivers announced in the budget. It writes off 100% of overdues of small and marginal farmers holding up to two hectares, and 25% of overdues of larger farmers.
People holding two hectares of farm lands – small farmers?
And how do you think it will be funded? By selling off PSUs at a time when the market tank rate is 3% per day and stock prices are down by about 35% on an average, across the board.

Economist Surjit Bhalla says less than 5% of farmer loans to banks are overdue. If so, then the 95% who have repaid loans will not benefit. They will be angry at being penalized for honesty. The beneficiaries will include some of the truly distressed who merit relief, but will also include cynics who can afford to repay but have not done so, anticipating a waiver.

Gets me thinking. I’ve been paying income tax for over 15 years. I patiently put up with potholed roads, blackouts and erratic water supply all these years hoping that the underfed millions need to be attended first. Despite the rampant corruption in PDS, I am one of its greatest fans. After all, I was a beneficiary for the first 20 years of my small town life. I wanted to earn more so that I could pay more tax that goes to feed more underfed and malnourished kids. Not the gorilla cronies of a pot bellied Sharad Pawar, Laloo Yadav or O.P.Chautala.

Seriously Mr.Chidambaram, you just lost me. It’s game over. Now gimme’ all my tax back!!!

Tuesday, March 04, 2008

It's the election eve stupid !

Ask me why I don't buy PSU bank stocks. Or why I stock up on sugar stocks...!

If you own any business, you’re supposed to have a say in its affairs. You expect to be consulted, at least by postal ballot, before taking critical decisions. But in PSU banks, it's as if you've surrendered all your equity so that it solely rests with the government. You just commit the capital and shut up. The government plays the big brother and writes off huge loans. It has happened before and it has happened in 2008 budget as well. Farmers owe banks $15 billion that stand as assets in the bank’s books. Last week FM wrote off all of them in one swoop, before you said bottomline.

The finance minister P.Chidambaram walked out from a live post-budget television interview, upset at repeated questions on how the government would fund the Rs 600 billion ($ 15 b) loan waiver by public sector banks he had announced. Of course, he returned to complete the interview.

That’s why I don’t own PSU bank stocks. Exactly why I stock up on sugar… You get it cheap and the business benefits from populist largesse like this. Remember, you live in a democracy and it's the election eve stupid !


Monday, March 03, 2008

Making compliance less PITA

One the most mundane acts that enterprises do everyday is compiling reams of data for compliance purposes. The data painfully extracted and filed, not much attention is paid to it until its time for the next filing. Many CFOs have often rued this fact and some have even confided the futility of this effort. I remember asking them “why don’t you just go use that information for your business purposes as well?”

To which, I am yet to get a convincing reply.

I recently found Brian Scheld and Sean Culbert of IBM debating the same question. I am glad there are like thinkers. Excerpts -

"Slowly, financial institutions have come to the realization that successfully competing in an accelerated, data-clogged business environment requires an enterprise capability that permits them to quickly access, integrate and deliver data that can be used to make lightning-fast decisions related to regulatory compliance, risk management, customer retention and profitability. The trend is called convergence, and it refers to an enterprise-wide alignment of governance, policies and processes to enable the quick and efficient sharing of business information among multiple stakeholders."

"...In essence, data convergence can help financial services institutions link their overall business strategies to their enterprise risk-management strategies by offering a graduated path from basic information-based regulatory compliance to a tighter management of business processes and risk, and then to fully optimized performance and value creation."