The Madoff Ponzi- Loosing faith in America

Over the last 12 months the US and its regulatory agencies have made a mockery of themselves. If the financial crisis wasn’t enough to prove their inefficiency and ineffectiveness now we have Madoff popping its ugly head out robbing investors of over $ 50 Bn. To put things in to perspective this is the largest financial scam ever.

Securities and Exchange Commission Chairman Cristopher Cox said the agency failed to act for almost a decade on “credible and specific allegations” of wrongdoing by Bernard Madoff, who authorities say bilked investors of as much as $50 billion.

We have asked time and again what the regulators were doing when exotic derivative instruments were being invested in indiscriminately, we have asked the same question about off-balance-sheeting various assets. And now we beg again to know why a blind eye was turned to the Madoff Scandal.

This brings about a lot of questions pertinent to the way America’s businesses, policies and politics is governed. It is no secret that Madoff was a contributor or a lobbyist and donated over $.2 million in the past few years to various political parties. Lobbying is something I’ve always called an official form of bribery. To compliment that statement I’d like to throw one around. Who’s the biggest backer of any assistance to the Big-3? Yes spot on, none other than President Elect Barrack Obama. May I ask how much has been given for his campaign by these entities? I think it’s a big question it always has been. It’s a form to legalize cash for favorable policies and this time the world is seeing and not just like other times when they were just witnesses this time around the world is casualty.

The world has considered America a safe place to do business, the US Dollar a safe currency to hold and US assets the safest to bet on. All these beliefs have been shunned in the last 12 months, yes I put my hand up and say the dollar myth will be shunned soon.

Lets not fool ourselves here:
Regulators are literally blind.
The Fed doesn’t have a clue of what it’s doing.
American Debt is now beyond correction.
It’s not Wall Street but Main Street that’s in the doldrums.
America is trying to pull of the biggest scam ever.
And the dollar is no safe haven (really).

Wats Up India: The hara-kiri down here

The Sensex closed below 10K and has now broken the 9K barrier. 9771.7 yesterday’s close was the lowest close in 2 years. The NIFTY closed below 3k for the first time in 2 years. FIIs have been pulling out funds from the markets and Indian investors are too scared to invest. Mind you most of them had seen a 7 year long bull-run.



The FII’s pulling out money, have increased the demand for the dollar and the dollar is at an all-time high, a tad above Re 50 to a $ at the moment.

Meanwhile, Unitec defaulted on a payment to the government of INR 1500 MM for land dues for its ambitious Noida project. The company is amongst the largest realty players in India. Post this news when KPS Gill (of DLF) was contacted he said that it was difficult to draw on existing lines of credits in a liquidity crunch like this one.

Tata motors, Mahindra and Mahindra Maruti Suzuki and Ashok Leyland are taking huge hits on their ECB’s or forex loans. Tata Motors and Mahindra & Mahindra's forex exposure is seen at $4 billion and $700 Whereas Maruti Suzuki may have forex loans worth $500 million. Ashok Leyland has posted a forex loss of Rs 14 crore in the second quarter.

Tata Motors the commercial vehicle market leader, which commands more than 60% of the market has gone in for a production cut by as much as 40-50% over the last two months or so. Ashok Leyland has also announced similar cuts to the tune of 40 to 50% to reduce its inventory pile-up of 13000 vehicles.

Tata has also announced a cut of 400 non-permanent employees with immediate effect yesterday. The above indicates that the are far more job-cuts waiting in the wings. Furthermore, realty sector players have claimed that we should see job cuts to the tune of 20% in the sector as a whole. Additionally a large number of smaller players and fly-by-night operators who were in for the quick bucks may even be forced to shut shop considering significant correction in property prices. Of course, it was only recent news of the airlines cutting jobs with Jet leading the pack. We are also expecting significant job cuts across the banking and financial services sector and the IT sector.

Coming to property prices we have already seen a correction to the tune of 20% across all segments. Even at the renewed rates there is no activity. The prices are still expected to correct sharply. In my opinion we should see at least a further 25% to 35% correction.

Reliance Industries Ltd (RIL), the country’s largest company by market capitalization, has closed half its polypropylene plant at Jamnagar, Gujarat, because demand for the raw material used for packaging has slowed.

The Airline players have been awarded a bailout package due to the sudden downturn. Whilst Airport BOT players GVK, GMR have decided to approach the government for change in contracts (read: additional benefits) due to the lower traffic volumes at the airport. For the main-street what this means is that there could be significant job cuts waiting in the wings (pun-intended).

Vodofone has approached the government, asking them to post-pone the 3G-spectrum bid to the beginning of 2009. Stating that it would not be possible for players to raise money in times of such tight liquidity.

In spite of RBI’s recent moves to infuse liquidity into the system through CRR and rate cuts. ICICI has just yesterday increased home loan rates by 1%. I have said this before and I say it again, we need higher margins in this country. Tight margins just won’t help you sail through tough times.

It’s festive season here in India (Diwali), supposedly the best time for business in the year. But the regular hustle and bustle at malls and stores, jewelers, car dealerships and banks for loans is simply missing. The glitter seems to have been taking out of the season due to the negative sentiment and the worsening global environment.

The recession has dawned upon us. India is still better coped to deal with it and the long term growth story seems to be in tact owing to economic comparative advantages. There may be a little detour enroute to getting there and we will see tough times till 2010, and hopefully its just till then.

Linkedin Answer: Is New coffee start-up still a good business opportunity

The above question was an open question asked on Linkedin and what I post hereunder is my answer to it. I thought the answer was pretty interesting and it can be a yardstick to measure the strategic performance of almost any business. More so in economically tough times where businesses models are going to be stress tested.

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My personal opinion is that it’s going to be a real tough one. The competition in the sector is enormous, as a business you’ll compete with stores like Mocha, CCD, Barista (now Lavazza), Coffee Beans, Costa Coffee and the scores of other local operators. That is however just one aspect. Any place you go these days, be it a mall, an airport, or anywhere you’ll definitely find a coffee shop in some form or the other be it an actual store or a kiosk. The price of entry in most modern markets is to be fast, good and cheap…. Obviously cheap is a relative concept to the kind of perceived value your business provides. Not just that when entering a market where significant competition exists you need to be fast, good, cheap plus have an x-factor. Two questions you would need to ask yourself. Can I be fast, good and cheap, to make a dent in the market you would need to be industry standard at two and a market leader at one. Then you need to ask yourself what is the x-factor I can provide to my customers to induce a switch from their preferred brand. Further questions you may ask yourself: What will be the difference in experience I provide over competition? Do I have a price advantage I can leverage? Is there an un-satiated need of my target audience that I can satiate? Can I have number 1 market share/ Mind share? If you find answers to the above questions and you believe that you could be FGC + provide the x-factor then you have an up and running business model and all that then remains is the execution. I tried to think on the above lines and honestly could not come up with how this could be done in the coffee market in India. I thus believe that it’s going to be a tough ask, never the less it still is possible to make inroads into the market.

TED Spread- Don’t Say I didn’t tell you….

Update: Well here we go again we are well past the 3% mark, the TEDs currently at 3.13%, well I see it zooming past further too.
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Well just yesterday I mentioned that we could see the TED spread shoot past its peak of 1987.


http://ecobizindia.blogspot.com/2008/09/ted-spreaad-again.html


So here we are today the Ted spreads at a hefty 2.99%, the highest figure since we have data.

The Great Depression II is truly here; trust is at all time lows, the market will punish even fair performers for all the trust is lost. Additionally there’s no easy way out of this, de-leveraging is going to be a long and painful process. We are sure to see the pain well into 2010 may be even more.

For all those looking for an investment opportunity, hit the Gold. It’s your best bet against a falling US currency and depletion of purchasing power. In fact it’s the only hedge. By the way gold’s rallied a 11% in the last trading session, I see more of it, much more.

The way I see it, Gold will shoot past the $1000 barrier soon enough and the next target thereon is $1200, which I see it shoot past in the next 3-4 weeks.

-Puneet Gulwani

Ecobiz on Reuters

Another one
http://www.reuters.com/article/blogBurst/investing?bbPostId=B922Cq4UnKrkCz9siTVg4bYgjCz8HBAkPcQx0pCzCV1XIMbTWjx

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http://www.reuters.com/article/blogBurst/investing?bbPostId=B922Cq4UnKrkCz9siTVg4bYgjBzAwV47RGKNoBCbPW2wnTtuf

Total Views: 429

The TED Spread Again

Update 17th Sept, 2008: TED Spread shoots further, zooms to 2.17%... this is the highest in the current crisis.... just a tad lower than Oct, 1987.... we could see it shoot past there in the next couple of days
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Update 16th Sept, 2008: TED Spread now shoots upto 1.82%
T-Bill 3 M: 1%
LIBOR US 3M: 2.82%

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Well here we go again. It's fairly evident now that the FED and the US government doesn’t have any further appetite for bailouts!!!.... With Lehman filing for bankruptcy and Merrill being sold clubbed with 'No More Bailouts' the TED spread today shot up to 136 basis points.... higher than the previous months figure.... need I say this is what was expected....

Well it looks like it's going to shoot up further additionally it’s is expected to stay above the 110 basis points mark till at least March'08...

(PS the previous post was drafted much before it was posted….. the post timing however was coincidental with the hara-kiri on Wall Street.)

Liquidity, inter-bank trust and the Ted Spread

The Ted spread is the difference between the 3 month T-Bill and the LIBOR rate. While the T-Billis a completely government backed bill, the LIBOR rate factors for the inter-bank risk. The Ted spread can be used as an indicator of credit risk. This is because U.S. T-bills are considered risk free while the rate associated with the LIBOR futures is thought to reflect the credit risk of banks. As the Ted spread increases, default risk is considered to be increasing, and banks will have a preference for safe investments. As the spread decreases, the default risk is considered to be decreasing.

Now lets just take a peak into what’s happened with respect to the Ted spread since January, 1987.

The highest spread was witnessed in Oct,1987. Surprisingly this was in the midst of another mortgage crisis. Mortgages on the wall street have been since the 1990’s the single highest traded securities. From 1990 the average Ted spread till march of 2007 was 0.50. It was only after analysts were hinting at the sub-prime and the crisis broke out did the Ted spread rise to over the 100 bps figure, it touched 1.98% in December, 2007. From 1997-1990 the spread was at an average figure of 129 bps, this when the crisis was a far cry from the sub-prime crisis of 2007. The gravity of this crisis has already been witnessed with Meryll writing down up to 88% of their CMOs and ADB writing of 90%. So, the question that arises here is are we assuming its over so soon? Or are we overly relying on the Fed? Or do we actually believe that banks have spun out of this crisis in a jiffy (6 months)?

Well honestly, I think not. The Ted spread still indicates that we are well in the midst of the crisis. In July,08 the spread shot 26 bps to touch 1.16%. Believe me it’s bankers who know best about the real situation that they are facing and thus will price the risk most accurately, and I believe that that is what they are doing. The Ted spread for the past one year since August,07 to July,08 has been at an average of 133 basis points. And, the spread is too high for us to believe that it’s all over.

The clear indicator that the crisis, in terms of write-offs, trust, and liquidity will be truly over only when the spread is less than 60 bps at least for an entire quarter. And obviously what we are seeing now is a clear indicator that a good proportions of the write-offs are still to come.

- Puneet Gulwani

Liar Liar - and this one ain't even funny

While every 3rd day some so called expert says the worst of the sub-prime crisis is done with, the market shows that well its all a plain and simple lie.

From a government perspective there’s a limit that the US and the Fed can take isn’t there.
Freedie Mac and Fannie Mae popped their ugly heads out after it was seemingly all over. And they said ‘it’s all over now’ after this one AGAIN!!!

HOWEVER:
Merrill has sold a chunk of toxic CDOs at 22 cents to a dollar and there’s no reason why we won’t see similar write-down’s from other Investment Banks. This again after the worst was done with.

Further the National Australian Bank on the 25th of July wrote of 90% of their US conduit loans.
Now don't investment banks need to rationalize their assets.

The only question here is, is it going to be slow and painful write-downs month after month or is it going to be one big write-off.

The great depression was a slow painful period lasting many years, and quarter after quarter experts then said it’s all over… did that make it any better…. The answer a resounding No. The post sub-prime is set to be no different. It's going to take a while before things normalize and the impact will be in years and years to come.

While this set the total write-offs are set to surpass $ 1 trillion, this from the $ 450 million written-off till date.

Besides this: The US economy grew at 1.9% in the 2nd quarter against an expectation of 2.4%. Further Labor Department data indicates that the number of people seeking jobless benefits jumped to the highest level in five years.

Well then folks times that we see ahead for the US are expected to be marred with further write-downs and further lies at every write-down trying to console the markets that it's all over. One day, in the distant future, they may be all over, but it still wont be all rainbows and butterflies.

-Puneet Gulwani

The Subprime Saga- What Happened, How, and What to Avoid

The subprime crisis has inarguably been the most talked about issue in this past year, and rightly so. It has changed the face and outlook of the financial world, it has thudded the US economy into depression, whilst other economies flirt with it, or live in fear of it, and it has revised growth estimates for even the fastest-growing economies. While the financial world is still trying to value the subprime loans and ascertain the hit it will have to take, there are lessons to be learnt, more so for us in India. We need to learn, and we need to learn fast, or the growth story may just be a “Once upon a time” fairy tale.

In this post I will begin by explaining the causes of the subprime crisis, as plainly as possible, and then move on to the situation in India. I’ll end with a few suggestions that could prevent a similar situation from occurring in India.

The Subprime Crisis………. What caused it?

A subprime loan is a loan given to those borrowers that are considered ‘high-risk’. The borrowers are typically persons who have had some poor credit history, perhaps in the form of delays or defaults in credit card payments, or any other form of credit defaults or delays. With respect to US standards, these are guys who have a FICO rating of <620.

After the tech bubble burst in 2000, there was a fear that the US would slip into financial depression. In a bid to avoid this, the FED slashed interest rates to facilitate borrowing, in turn leading to economic growth. In time to come, the FED would aggressively cut interest rates as well. The lowest interest rate was a mere 1% p.a.—compared to the current rate of 5.55% p.a. In addition to these measures, the FY 2000 market crash had significantly increased liquidity on account of a flee of funds from the equity markets. Now, an increase in the supply of money also facilitates a reduction in interest rates.

So, interest rates were at an all-time low, and liquidity was very high. Banks and Financial Institutions thus began lending aggressively, which is exactly what the FED wanted. However, a good proportion of the demand was from the subprime class of borrowers, so naturally when banks did lend to them, it was with the pleasing knowledge that the interest rates would be higher for this class of loans. If everything went well, these higher rates would mean an increase in profitability and an increase in the share price. This seemed great, and a little difficult to resist in the prevalent situation.

This increase in money also led to an increased demand for housing, which led to a continuous growth in the market value of these assets (i.e. Real Estate), which was the collateral for the debt. Another angle is that the average American is highly debt-oriented, and resultantly, refinance is fairly commonplace in the US. In order to capture the market, banks began to value these assets higher and higher, as a higher valuation meant a higher loan amount which could enable them to win a deal over competition. This higher valuation also had an impact on the real money-value of the asset.

Let’s take an example: an asset is valued at $100 by the market and the bank, and they decide to fund $80 on this asset. Going forward, banks are willing to fund say $100 on this asset, and as a result the money-value of this asset will eventually increase to re-align itself to the 20% margin.

For the first few years things went well. Interest rates stayed low, the economy continued to grow and the value of real estate assets continued to increase dramatically. This situation made it easy for borrowers to make payments, in case they did run into troubled waters they could top-up their loans, or re-finance their loans at more favorable terms. Now both these mean borrowing to repay previous debts. Such increase in debt is nothing but a debt-trap waiting in the wings. This was, however, a dream run for the banking fraternity. High profits, low defaults. On seeing such profits, banks literally went crazy, offering sub-prime mortgages was the ‘in’ thing and by then a rampant practice.

With high property valuations many borrowers had amassed debts that they could not afford to repay in the long-run. Also, many of these loans came with lower initial payments (step-ups), or initial interest only debt, which made it easier to repay initially. The borrowers thought that since the value of the asset would continue to increase when the low-paying payment ended, they would simply re-finance at better values and favorable interest rates.

Now, the reason for the impact of the crisis being so widespread is because so many banks, firms and investors the world over have exposure to these assets. The toxic credit is simply all over the place, and the reason is securitization. The reason loans were securitized was to diversify the risk and also to free up funds to lend further, banks can only lend a certain multiple of their capital and in order to continue lending they needed to sell down these loans, or put them off-the-books.

So the banks basically clubbed the assets to form pools, the pools were sold to investors and investment banks and called CDOs, MBOs or ABSs. Now, the investors buying these naturally shy away from such poor credit. So the investment banks played it smart and categorized this otherwise toxic credit into 3 different risk levels (also referred to as traunches), and each level is defined by who would take the hit first. These investment banks also got ratings from rating agencies, who rated the lower risk levels at par with quality debt (well above subprime ratings), this was because this was backed by many loans even the other categories. Simply put there guys took the hit last amongst all categories of securities, Now the poorest of the poor loans were obviously not saleable, so a large amount of such instruments were put away into SIVs (Special Investment Vehicles). These are semi-separate off-balance sheet entities, which are basically set up in tax havens, which allow more flexibility from an accounting and regulatory perspective.

These SIVs fund their operations by borrowing short-term at lower rates of interest and invest in long-term instruments. It must be kept in mind that these short-term loans have to be re-borrowed or rolled-over frequently.

It was now 2004, and the problems were beginning. The US economy was growing fast enough. Also, with the new growing economy funds had started flowing back into equities and the money supply had reduced. This led to both the FED increasing interest rates and the supply reduction leading to an increase in rates. As a result, re-financing became uneconomical. Since most of these rates were on an annual reset, the interest rates increased, leading to a difficulty in meeting finance commitments. As loans became more expensive, the demand for housing reduced, leading to a reduction in the value of the asset. Now this led to a chaotic situation, where borrowers began to default on their loans at an alarming rate. The investing institutions who held the securities backed by this debt stood to loose.

All this led to two things: a liquidity crisis, and mass mistrust in other financial institutions, which reduced lending amongst various financial entities. This further impacted the liquidity in the market.

The market situation is such that no one trusts anyone enough to lend money at reasonable rates. No one knows who is stuck deep in how much toxic credit. The largest banks and financial firms have been trying to ascertain and value their assets for a few months now and are still unable to do so accurately. The SIVs now are unable to avail of funds to cover their obligations and are therefore having to sell off huge chunks of toxic credit which has no market.

Importantly, since there is now virtually no market for the toxic credit pools, it is difficult to ascertain how much it is worth. Thus it’s impossible to ascertain how much of a loss one needs to make provision for in order to come off clean.

All in all, banks and firms will need to take significant hits, which may be painful now, but from a long-term perspective it’s the only solution. No pain, no gain.

Now, coming to the lessons
There is no substitute for quality underwriting and the faster lenders realize this the better it will be. Business cycles are just business, there will be the not-so-good and even the ugly times, and while lending it is critical to understand this.

Growth rates sound lucrative, but these are only projections. It’s important to remember that when the base expands growing on this higher base is more difficult. So a lender needs to critically examine if the borrower has the strength to expand his business in that way, weather he has the execution capability and the team to manage such an enlarged business and whether he has the flexibility to sail across rough waters when they are encountered.

It’s critical to understand that a default situation besides being bad for the company and the bank is extremely hazardous to the economy at large. Bailment like the FED’s bailing out of Bear Sterns may sound good but the impact is, in reality, quite hazardous.

Now coming to the Indian perspective:
Banks and FIs in India in order to grow at staggering rates are lending extremely casually, this on the backing of an aggressive growth story. Deviations from such estimated growth rates may lead borrowers into troubled waters. It’s important that we lend only after quality due-diligence.

Another important fact is that we need to keep customers informed, and transparency is critical. Only recently there was a big hue and cry when customers figured out that their home loans in India were reset when rates increased. The problem was that customers were not informed or explained to about the fact that their loans were on floating rates.

Besides as an investor one needs to understand the investment very well and be able to make an informed investment decision. This is something that was completely missing in the subprime saga. Besides, many investors took huge hits in India, only recently, while investing in exotic options that they were not well informed about. This has also led to litigation between the sellers of the investment product and the investors. Such practices will do nothing but reduce confidence in the system.

Remember, we had parked the FICO rating in the first part of this article. In that light it is important that in India we move to an individual and company rating system. This will lead to better information symmetry between lenders and will do only good to the industry and the economy.

Finally, the last point is the need for proper governance, requiring more elaborate reporting by banks and adequate categorization of assets and investments. Cross-holdings need to be depicted properly and assets valued correctly. Conduits, if any, must be disclosed accurately along with any indirect credit lines that may exist.

It’s the greed to grow faster than a natural rate that hampered the US and will hamper any economy. The big avoids remain ignorance, greed and purely stupid bets.

To conclude:
“No drug, not even alcohol, causes the fundamental ills of society. If we're looking for the source of our troubles, we shouldn't test people for drugs, we should test them for stupidity, ignorance, greed and love of power.” - P. J. O'Rourke

-Puneet Gulwani

India: Taking Financials with a pinch of Salt – The impact of de-laundering

The last time I tried to purchase residential property in India’s financial hub, Mumbai, I was a little surprised by the fact that the property owner specifically mentioned that the deal would be an all cheque deal, “No cash sir, I will take 100% cheque”, is what he said. This prompted me to dig a little deeper, so I looked up some properties on the Internet and called the owners and builders, the maximum cash (read: black money) they would accept was 20%. Nobody, and I mean nobody, accepted more than that. Further probing revealed that a similar situation exists with rentals.

Now, since property prices in Mumbai are high, and have been increasing at a rapid pace, I might add, the money value invested in property is significant. Also, since cash is not accepted here, this would mean that the use of black money in India is reducing. Besides, a few years ago, after the advent of dematerialization of shares, the use of cash in the stock market too has been significantly negated.
Now, what this effectively does, is that it reduces the earning power of black money.

So, if the earning power of black money is reducing, where's it all going? Is it put away in sacks and locked up in safes? Or is it all being spent?
Well, I think not, the Indian businessman is too shrewd to let inflation erode his money, and too conservative to blow it all up.
What this brings me to is of far greater significance.

It could well be that companies are converting these funds and bringing it onto their books. On speaking with a few known small to medium entrepreneurs, my suspicions were confirmed, and in fact, we are now witnessing a de-laundering effect. What this brings me to, is the fact that the growth rate of companies, and thus the economy, from a macro perspective, is not what the balance sheets depict.

Essentially, financial statements are showing over-inflated revenues and deflated costs. What this does is it reduces the net cash flow of the promoter and company combined, as it increases the tax outflow for nothing but investment in the business itself. This explains an increase in the tax collections, which Mr. Chidambaram, by his own admission, allocates at least partially to increase in compliance.
This may be witnessed in sectors moving towards organization, like transport, infrastructure etc. Further, this will be more significant in promoter-driven and family-owned companies and newly-formed corporates (i.e. partnership firms, proprietorships recently converted to corporates etc.)

I am in no way alleging that there is no real growth at all, or that all companies are doing this, but what I am propounding is that we should all try to take balance sheet figures with a pinch of salt, more so, in the case of companies which have just converted from partnerships and proprietary firms to corporates.

Moving on now, to what sort of impact we could expect to see. While overall this is a plus for the economy going forward, after the clean up exercise or write-back of siphoned-off funds into the books, the financial statements will depict a true view of the company and, by and large of the economy. However, while this change is taking place investors and financiers need to discount the growth rates, projected growth rates, cash flows and thus intrinsic values of these companies.

All in all it's a caveat for investors "Just take it with a pinch of salt".

Note: My medium to long-term outlook for the Indian economy remains bullish

-Puneet Gulwani