Never blame securitization

Securitization offers many advantages to all participants in the marketplace. Derivatives decrease barriers of entry to a host of markets, increase potential diversification and customization, and enhance liquidity and hedging activities.

Securitization has represented a series of innovations that have brought about greater efficiency but the problem with innovation, almost by definition, is that they outpace the ability of the infrastructure, on both the private and public side, to sustain the innovation.

Now, the system is trying to catch up but we risk an overreaction that may limit the potential of securitization. Hopefully, an understanding that a return to securitization is crucial to economic recovery (by allowing banks to lend more through risk transference) will lead policymakers to resist any misguided populist sentiment.

The new products present challenges for risk managers and regulators alike. It also burdens operations, technology, and settlement systems in the process. In reality, every level of the financial system will need to continually adapt to changing risk and complexity.

Unfortunately, policymakers, almost by default, will always be behind the curve. Because an attractive fee is extracted at every stage of securitization, the agents, or intermediaries, will will always be prone to excesses. Innovation will always outpace the ability of the infrastructure to sustain it and securitization crises will be a recurring phenomenon in the new age global finance, you bet. But try doing away with it, you're only deepening the liquidity crisis.

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The Goldman heyday

What are we to make of Goldman’s Q1 results…? Making $3 b in as many months is indeed recession defying but how much of it is its own making in contrast to the near absence of competition – Citigroup, UBS, Lehmann and its ilk? The Economist says - To the survivor the spoils - and I can’t agree more.

Monday, after market close, Goldman Sachs Group, Inc. reported 1Q09 earnings of $1.66 billion or $3.39 a share, up from $1.51 billion, or $3.23 a share a year earlier. The results were way ahead of consensus estimates of a profit of $1.64 per share.

Higher-than-expected profit was mainly due to strong trading revenue. Of the first quarter net revenues of $9.4 billion, $6.6 billion (34% higher than its previous record) was the contribution from the company’s fixed-income, currency and commodities (FICC) group. High volatility (benefiting the Treasury markets and the Dollar), wide spreads in fixed income and reduced competition in the markets were the main reasons for strong earnings.

However, the areas outside fixed income and currency businesses showed weakness during the quarter. Investment banking revenues were down 30% year-over-year, due to the low activity in the capital markets. Asset management revenues also declined 28% to $949 million.

Again as the Economist says this windfall will likely dwindle soon. The firm may be scooping up market share at quite a clip. But the bigger picture is still far from pretty. Goldman and other survivors will benefit from the coming wave of debt issuance by federal, state and local governments. But dealer spreads are sure to shrink as markets normalise and those that have retreated return to the fray. This is likely to be offset only partially by a pick-up in businesses tied more closely to economic growth, such as advising on mergers and acquisitions.

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Mortgage crisis, Madoff madness - so what comes next?

Agreed. Mortgage crisis was because of a complex web of sliced and diced mortgages that escaped instant scrutiny. But how about a ponzi scheme run by an ex-Nasdaq broker dealer?

As a broker-dealer, Mr. Madoff's firm was already heavily regulated, and news reports say the Securities and Exchange Commission investigated him in 1992 without finding anything wrong. The SEC said in a statement Friday that its New York staff also conducted inquiries into Mr. Madoff's firm in 2005 and 2007. Mr. Madoff's separate investment company registered with the SEC in 2006, which is all that hedge funds would have had to do under the SEC's proposed (but failed) hedge-fund rule of a few years back.

The recent spate of scams from the US has made this once famous financial innovation powerhouse a den of con artists and shoddy regulators. Alright how about foreigners that invested so much money?

Without this flow of easy money into the U.S., globalization in its current form would not have been possible. The U.S. was the consumer of last resort, absorbing cars from Germany and Japan, electronics from Taiwan and Korea, and clothes and furniture from China. The earth was flat, and why not? Pluck a laptop from Taiwan and pay for it with a home equity loan, which—if you trace back the connections—was at least partly funded with foreign money, too.

The big unanswered question, for years, was why this money flow persisted. Why the heck were foreign investors willing to lend the U.S. such large amounts of money on such good terms? Economists and journalists spun out hypothesis after hypothesis (we'll see more below), but there was no agreement on why.

What comes next? The fallacy is punctured. Globalization will be seen as what it is—a game with risks that can't be wished away. And U.S. prosperity will depend on the success or failure of its ability to innovate—not its ability to tell an implausible story to foreign investors.

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"Vaccum before you dream again"

“The stock and commodity markets seem to go just one way and that’s down. Hundreds of millions of market cap eroded, value destroyed. The recession is here to stay and no policy measures, interest rate cuts, liquidity infusion seem to work. OMG, it’s pushing us back to where we started out – point zero.

Not that I am scared. But it’s a daunting task to claw your way back from such depths. I’d managed it with little resource and a lot of will. But I was a lot younger then. Now after a couple decades, if I’ve to repeat that trek, I might have to reinvent. Then I was alone; now I’ve got a family too!”

This was the kinda’ talk that did rounds when a bunch of us old pals met recently. There were software pros, engineers, finance pros and even one professor of economics in the gang. This concern about the future and the hard times that we’re forced to go thro was the common thread.

They say if we are facing in the right direction, all we have to do is keep on walking. But who knows? Suddenly we feel like a bundle of beginnings. In front of us lay a stone with a hole in it. Who could’ve bothered to drill it? Nature. The drops of rain make a hole in the stone not by violence but by oft falling. That meant something. It really did. You can't go through life quitting everything. If you're going to achieve anything, you've got to stick with something. Consider the postage stamp: its usefulness consists in the ability to stick to one thing till it gets there. The race of life is not always to the swift, but to the one that keeps running. Fall seven times, up eighth.

Coming to think of it, this recession is like a mountain. Nobody trips over mountains. It is the small pebble that causes you to stumble. Pass all the pebbles in your path and you will find you have crossed the mountain. So why despair? It's often the last key in the bunch that opens the lock. You may not be there yet, but you're closer than you were yesterday.

And what if your dreams turn to dust? Simple. Just vacuum before you dream again ;-)

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No more band-aid; Need bold fixes

Just got back after a vacation to Mussoorie hills for over a week. Had a great time driving around the hills and eating choicest Punjabi, Tibetan, Chinese and South Indian food. It had been more of a `getaway’ - unless someone truly wanted to witness the market mayhem.

Now back to work. The first thing that strikes me in the morning is the now almost daily paean from Mint Street. They have done it several times in the recent past. Tell me – does it really matter?

If RBI is serious about liquidity reinfusion, it should by now have realized that the cuts of 50 basis points or 100 bps are loose change in these times of massive financial drought. Cash flows of businesses are fast drying up; the ones that have cash to spend are fearful of counter party risk. No one is trusting the other. There is no real economic exchange.

So I have a one line agenda for this crucial Monday meet, if it is meant to be that – facilitate Economic Exchange. Let's call it EE.

If the meet were ever to yield a positive outcome, it has to be by way of drastic measures. I for one think post cut repo rate at 7.5% is still a bomb. It has to be around 5% levels so that banks that borrow can make some meaningful credit forward. Why do I say this? I am glad my bank deposits earn me 11% if I park it in my mother’s (a senior citizen) name, but I am equally wary that the bank has fewer avenues to deploy that high cost money. How many takers will lift credit at rates higher than 14% (assuming that bank will have an administrative cost of 2% leaving it a margin of just 1%)? If ever they do, what business will earn still higher return so that they are able to pay it back to the bank? So I worry about the sustainability of that higher return that I get before moving on to worry about the probability of retrieving my capital.

So this is what I suggest to D.Subbarao, RBI guv. He shouldn’t just stop at cutting rates, he should inspire the banks to lower their lending rates and deliver EE. Money flow has to resume. Liquidity is the current that can drive the economy forward. We’ve all experienced it during the bull years April 2003 – Sept 2007 and we know the difference now. I would even go FM and SEBI should be infected by RBI’s bold moves. It should leave the doors open for every serious investor to walk in with his money and do business on our markets. That's EE for you. Short term measures and band-aid type fits and starts don’t mean much in these hellish times.

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How about tax exemptions for equity investments for the next two years? Cut Dividend distribution tax? Lower income tax rates leaving more money in the hands of the investors? Think on these lines and surprise us on Tuesday morning bozzos... and see the markets giving a thumps up to that ;-)

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Get your act together, IT vendors...!

Readers of this blogstream should be wary of my screams for innovation in India’s IT vending space.

Now here is an analysis that explains why overwhelming focus on one sector – Financial Services – is extremely vulnerable. With the Wall Street turmoil, some of India’s big IT outsourcing vendors face a frosty weather.

I shall repeat. Go beyond BPO, ADM and easily replicable services. Differentiate. Make meaningful dents in diverse high-end fields like system integration, data center management, remote architecture support, process automation coupled with product innovations that stun the markets with their utilities and features.

And…And…And… Focus on domestic market. You’ll be in far better control. See Bharti has awarded its $1 billion IT infrastructure maintenance contract to IBM, not to any of our famed vendors ;-)

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How fair is Fair Market Value?

The whole world seems to despise Fair Value or Mark-to-Market (M2M) accounting standard that is, what an asset would be expected to fetch right now in a sale. It’s when regulators enforced it, the banks had to expose their ugly underbelly that led to massive write downs. It now stokes a fear that whether the liquidity crisis will eventually lead to a solvency crisis. As holders of mortgage-backed securities (MBS) and the like revalue their assets at fire-sale prices, they are running short of capital—which can lead to further sales and more write-downs. Are the bean counters ensuring a crash? Asks the Economist.

So is historic cost accounting an alternative? Hardly. It could be worse. In a crisis prices fall until bottom-fishers start to buy. Yet when assets were booked at their original price, rather than at market price, banks could delude themselves—and investors—that dross was gold. Look at Japan, where the economy was sunk for most of the 1990s by stagnant loans to “zombie” companies. Historic-cost left investors in the dark about valuations; it was also prone to fraud and fraught with moral hazard, since sloppy lending went unpunished.

It would be perverse to ignore market signals when finance is increasingly based on broad capital markets. Fair-value accounting is indeed flawed. To paraphrase Winston Churchill, it is the worst kind of accounting, except for all the others. But one can be careful on selection of the benchmark.

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They just don't `get it'

It’s results season again. I glanced at the results of ICICI Bank and HCC.

For ICICI, the net profit for the quarter fell by 6.07% (Rs.728 crore) in relation to Q1-07-08 (Rs.775.08 crore). Nothing unusual, given the sluggish business sentiment tempered by high interest rates. But something else rankles. The bank’s non-tax provisions and contingencies (for bad debts / bond trading losses) rose nearly 43.5 per cent to Rs 792.49 crore during April-June this year, compared with Rs 552.27 crore during the corresponding period last year. The increase in interest rates and adverse market conditions hit the bank’s trading portfolio and treasury income by Rs 594 crore. This is for a bank that is quick to grab an opportunity, having an agile management that is high on financial savvy and in using sophisticated risk management systems. CFO Chanda Kochar can play down the worries on the lines that the provision levels are `nearly’ the same as in earlier quarters, but they are mistakes in a row just yet. An indication that they are clearly losing sight of the market risks.

For HCC, revenues grew 22% to Rs.895 crores (Rs.731 crores for Q1-07-08 quarter) but PAT slipped to Rs.31 crores as against Rs.34 crores. What stands out is a provision of Rs 50.6 crores on account of foreign exchange losses on foreign currency loans including FCCB. This is bad choice of debt since prudence demands raising Foreign currency loans only if you have foreign currency income to hedge its exchange risk. But construction companies merrily used FCCB route to bet on rising values of land banks and a seemingly ever appreciating rupee (so that they will end up repaying less as Rupee gets stronger). But the trends reversed, the tide ebbed and they realized they were swimming naked.

Where did they let up? Were they not forewarned of the risks by smart managers that signed up for such financial arrangements? The numerous credit crises from the past (remember the great depression, the asian meltdown) has destroyed the idea that unregulated financial markets always efficiently channel savings to the most promising investment projects. Several Indian companies took on unsustainable debts, pushed around by I-bankers and other “debt merchants” who made a quick buck by disregarding risks. While this happened, our central bankers though a little unnerved by the swelling forex reserves, were still marveling at the creativity of capitalism. When the bust came, most borrowers / bond traders aiming to make quick bucks on currency / bond appreciation were left catching the hot end of the rod.

So I begin to distrust the individuals in charge as also our macro economists. Neither `get’ the true picture of the flip side of risks they assumed. The I-bankers that peddled these instruments never really understood it themselves to explain it to the borrowing clients. Now I see the same pattern in the manner in which both RBI and Finance Ministry handle the oil price shock and resulting inflation in commodity prices. Finance minister can hide behind his oft-quoted statement `it is imported inflation’ only for so long. He may have to soon come up with a plausible defense. Clearly, arresting inflation and maintaining price stability is an important task of the central bank as is ensuring financial stability. But this dimension is completely absent from the macroeconomic models now in use. In addition, since financial stability these days also depends on avoiding deep recessions, stabilizing the business cycle should also be of the concern of the central bank.

But that is at a macro level and CFOs can’t rely on that to shield their individual risks. ICICI treasury has clearly goofed up by ignoring cyclical nature of bond yields. Their bet on junk bonds went haywire. HCC and other construction majors played fast and loose with FCCB for long gestation projects where eventual profits (as and when they come) might have already been eroded by the exchange risks they suffer here and now. Stock prices have also fallen so badly that the lenders would not want to exercise the loan conversion (into equity) option attached to these bonds. They are reeling the under grave liquidity crisis in their home markets and could do well with a cash pay back.

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So here are the lessons. Never miss the wood for the trees. Look at the indicators. Stock markets don’t beat down stocks without reason; and you can’t blame it all on bad sentiment alone. So Ms.Kochar and Mr.Ajit Gulabchand, it's time to roll up your sleeves and begin to see risks from a mile. That’s when you can claim you're really `getting it’.

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