Accretus Solutions

Just a few minutes ago, the Central Bank of U.S.A or Fed cut the Fed Funds rate by 50 basis points. Yes. 5.25 to 4.75. Lo behold! It cut the discount rate too by 50 basis points. From 5.75% to 5.25%.

What does it mean to you and me in India?
Well for starters..the Dow Jones has already rallied by 260 points to 13663.
Tomorrow the Asian markets and India will follow the rally..

While the Fed’s aggressive move of cutting 50 basis points in both fed funds rate and discount rate may stem the recession in the short term, what we need to watch is whether the American consumer is going to be wise enough this time or not..

It is interesting to note that equity markets across the world surge for a very short period and then decline considerably with interest rates climbing up again.

Meanwhile oil climbed above $ 82 per barrel!

All this leads us to Hyman Minsky’s ‘The Financial Instability Hypothesis’

At its core, the Minsky view was straightforward: When times are good, investors take on risk; the longer times stay good, the more risk they take on, until they’ve taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. “This is likely to lead to a collapse of asset values,” Mr. Minsky wrote.

When investors are forced to sell even their less-speculative positions to make good on their loans, markets spiral lower and create a severe demand for cash. At that point, the Minsky moment has arrived.

Another famous Bond Fund Manager Paul McCulley’s ‘Plankton theory meets Minsky‘ is one of the widely read and appreciated report on the current financial crisis thats roiling the markets.

From an India perspective, we are fairly insulated thanks to our domestic demand and the pro-active RBI being ahead of the curve. The RBI’S focus of reducing inflation and inflationary expectations, bringing price stability and managing the rupee has been very well appreciated by most of the economists in the world. It went ahead with tightening credit through various measures when other central banks were groping in the dark, followed by stricter regulations in specific sectors like the banking sector[in terms of change in accounting system with respect to securitization activities], realty sector[curtailing ECB inflows to $20 million and higher risk weight for banks lending to realty sector] and allowing the rupee to appreciate have till date ensured that we are insular from many of the major global crisis in financial markets.

Thus be it the recent Sub Prime Crisis or Credit market bubble[the contagion though has not reached our shores, thanks to our corporates being lesser leveraged and the debt market in the country is literally non-existent] or Asian Crisis in 1997, we have been fairly insulated from the turmoil that affected other markets.

Further, unlike our wester counter parts our regulations do not allow mutual fund managers to invest junk bonds in money market funds. Neither does the Government’s Sovereign funds invests in risky investments or Private Equity Funds like some of those whose values have gone down significantly post the credit bubble.

India’s resilience has been well documented very recently by Jim Walker of CLSA in his report on Apocalypse Now! But India is a Safe Bet.

On this momentous day will leave you with two quotes that sum the current global crisis in financial markets:

Jeremy Grantham, Chairman of GMO LLC which manages $ 150 billion in assets, once ended one of his notes to clients in early 2006 with, “Guinea pigs of the world unite. We have nothing to lose but our shirts.”

“We are in the midst of a Minsky moment, bordering on a Minsky meltdown,” says Paul McCulley, an economist and fund manager at Pacific Investment Management Co., the world’s biggest Bond Fund Managers.

To sum up..what should you and I as an Investor do now in the next 6 months?
Book Significant Profits, buy Gold, stay in Cash , wait for correction and buy during the lows.

Jennifer from Canada asked a very interesting question in one of the websites I frequently visit. She wanted to know if one were to get Inheritance Money, where and what should one invest in.

Jennifer needs to ask 3 questions to herself before investing .. why would she want to invest? What for? How Long?
By asking these questions :
1. She would get clarity on her goal or goals for investing
2. She would get to know the time horizon for investing in each of her goals.

The next step forward for Jennifer would be to look at her risk profile and accordingly plan her asset allocation. That is, how much of her investments should be in equity, debt, realty and cash. Once the asset allocation is through, she could get down to security selection. That is what product mix or portfolio to be constructed for each of her goal. Say for example, if she is planning to buy a house in the next 1 year or so..its better to put all of her allocated money for the goal into debt product which invests in treasury bills or government securities. Because she needs the money back to buy that house..

If you have questions like Jennifer has, please feel free to write in to me.. I would be happy to answer your questions..

Note : I had recommended Treasury Bills or Government Securities for the example we had taken, based on the context of the Country, Jennifer lives in – Canada and also factoring in the current global financial crisis that has roiled the markets, specifically the corporate debt market and money market funds[thanks to sub prime market crisis and CDO blow ups]. Case in point is couple of BNP Paribas Funds which went bust [funds that invested in the short term corporate debt] recently in U.S. and also the run on Northern Rock of U.K. [ last week depositors withdrew more than $ 3 Billion of deposits from the Mortgage Lender]

India-focused hedge funds delivered a yearly return of 53% as on July 2007 while the sensex returns was 44%.According to Hedge Funds Net which tracks the hedge fund flows across the world, the current assets of hedge funds investing in India are to the tune of approximately $14 billion. In just 2 years the assets have multiplied 5 fold from $2.8 billion to $ 14 billion.

Anectodal evidence points to the fact that during 2005 and 2006 these funds trailed behind the sensex returns while the trend has reversed this year thanks largely to rupee appreciation to the tune of 8%..

While the debate on hedge funds investing through P -Notes rages, there is a new breed of funds that is all set to reach our shores – Yes ..the Soverign Wealth Funds or Government owned Reserve Funds.. Some of the well known investments of Soverign Wealth Funds are China’s investments in BlackStone Group LP – one of the largest private equity firms in the world , Qatar Royal Family’s Investment in J Sainsbury of U.K.

The total assets managed by all hedge funds put together is estimated to be in the region of $1.3trillion while the Soverign Wealth Funds currently manage in excess of $ 3 trillion!

Customers of Northern Rock Plc withdrew $2 Billion yesterday after the stock went down by 26% ..
Northern Rock is one the biggest mortgage lender in U.K.

The sub prime contagion is now spreading across the world and I don’t think its ‘contained’ as it was believed to be..

One is reminded of the famous words of J P Morgan on Lending – ‘character, credibility and collateral’

Nowadays the banks would want to first see your collateral [the housing documents] and as far as credibility is concerned..forget it..there are enough players in the market who don’t need your income proof to lend you the loans..

Finally..character..who has time to see you, talk to your references and process the loan documents!

In these days of ‘NINJA’ [no income, no job and no assets] loans for customers..God Save America and the rest of the world hell bent on following American financial systems!

In the last few weeks we have been witness to one of the most interesting times in the global financial markets!

First it was the ’sub-prime exposure’ contagion from U.S. Housing Markets spreading like wild fire across continents.

Second was the ‘Leverarged Buy out’ market that went into a coma [and sealed the M & A story aided by cheap financing]

Third was the ‘Collateralized Debt Obligations’ market or the packaged financial weapons of mass destruction thats blowing up financial markets into pieces..

Fourth was ‘yen carry trade’ unwinding..

Ah..we are pretty much familiar with fourth one.. ‘Remember May 2006′!

what about the first three?
The answer is simple ..
‘When the lender becomes the borrower!’

Let me explain in simple terms .
Traditionally the lender used to be banker or a financial institution and the borrower used to be a corporate or an individiual like you and me.
Lets start with the first instance of ’sub prime woes’..
It was the traditional banker or financial institution which lend to individuals[American Citizens] to buy homes in the U.S.
Except that they lend to people who are so poor that they cannot afford to even pay interest leave alone the principal.
The bankers were under the notion that since property prices are bullish and it has only one way to go..yes..up..
Based on this notion..they securitised the assets and sold commercial papers to some hedge funds and other financial institutions promising higher yields.
The deliquencies went up to as high as 25% in some places in a very short time period that the banks were forced to seize the mortgaged property and sell it..Alas..if only they had buyers!..Yes..The property prices were heading south..
Few of the Bear Sterns and BNP Paribas hedge funds that were exposed to these ‘junk bonds’ lost all or most of its value creating a massive sell off in the global financial markets.

While this story was unfolding.. the M & A activity through leveraged buy outs [that was the toast through out this year for the equity markets being bullish] turned soar with banks not being able to raise funds for Chrysler and Alliance Boots deals. Well.. overnight.. the cheap financing tap [for leveraged buy outs] dries up!..

By the end of the week..The Fed says that the sub-prime contagion is contained!
Hell it was.. The CDOs made sure that it wasn’t..

You might wonder..All these still doesn’t answer the question of ‘how a lender becomes a borrower?’ Right..
Here we go ..
Now we all know a little bit of sub prime and leveraged buy outs ..

The CDOs are structured products created by banks as a result of debt financing for Mergers and Acquisitions of companies. As protection from a probable default from the borrower, the banks structure the loan product with the collateral being the assets of the borrower by providing higher yields and sell the product now to other banks and investors. This process is known as credit derivatives in the financial markets. By doing so, the first step to lender becoming a borrower has been put in place! In a similiar fashion the other banks re-package along with few more assets[like asset backed securities or sub prime loans] of different rating profile and maturity and tranches and sell further to some more banks and so on.. By doing so..the entire banking system has not only become highly leveraged to each other but also lost track of real assets and their value[thanks to the mark to model system!].. Financial engineering at its best or shall we say worst..
Statistics tell us that today the organisations that borrow money from the banks are less leveraged than the banks themselves..
So..when the lender becomes the borrower..thanks to the CDOs..the volatility is bound to go further up [with more and more banks and financial institutions going belly up] and this in effect brings down further the equity and other markets..
Like they say, this time around its different..
We sure are living in interesting times!!

Circa Sep 2008

Lehman Brothers collapses..Credit markets freeze.. Equity markets crash.. Commodities Markets go on a tail spin..

Central Banks start getting their act together in a coordinated effort to revive the credit market..

Circa May 2009

Quantitative Easing led by the Fed and followed by other Central Banks have brought down the interest rates to near zero..

All major asset classes and commodities have risen dramatically since March 09..

While the U.S. Government, by using the extreme measure of monetary policy of ‘quantitative easing’ is hoping that the credit flows would lead to economic recovery, in the medium term it is setting itself up to ‘hyperinflation’ due to the dollar that would start losing its value.

In this context it is interesting to note that the famous author of ‘Black Swan’ , Mr Nassim Nicholas Taleb and his collaborator who manages and runs a hedge fund have launched a new fund betting on ‘hyperinflation’.

There is a great probability that we would see higher inflation in India too..

The financial linkages have become stronger across the world in the last 4 years..

How should we re-align our portfolios to prepare us for this new scenario that would hit us in the next 2-3 years..

Watch out for the next post which would focus exclusively on this theme..

Asset Allocation owes its origins to the Nobel Award Winning Professor Harry Markowitz’s Modern Portfolio Theory or ‘ Mean Variance Analysis’.

Data Collected by his team over long periods of time on markets and specifically on equities, bonds and cash indicated that the proportion of these 3 major categories played a vital role in the portfolio performance. In fact, the asset allocation contributed 91.5% towards the portfolio’s performance vis a vis ‘market timing’ that contributed just 1.8%.

Also ’security selection’ contributed 4.6% to the portfolio performance. Few other factors like ‘re-balancing’etc contributed 2.1% towards the portfolio performance.

As you can see..clearly the winner is ‘asset allocation’.

Well… so much for market timing and security selection!!

Asset Allocation is the way to go!

Amen to market timing!

Indian markets continued the bull run for the fourth straight year with 46% returns in 2006.

FII flows in the Indian equity markets for the year 2006 stood at $ 8 billion compared to $ 10 billion in 2005.

Domestic mutual funds contributed $ 3.5 billion. It is 17% higher than last year.

This is a healthy sign which indicates that more retail investors are entering the equity market through mutual funds.

Tough to time correction in the markets, especially for the first few months.

Data and Analysis points to India in the over valuation zone.

According to Morgan Stanley estimates markets could have a downside of 18% and an upside of 21%.

Various external and internal factors could contribute to the downside.

The key ones are possible U.S. slowdown in 2007, interest rate sensitivity, geopolitical risks, liquidity squeeze, oil factor etc..

But the broad consensus[estimates by brokerage houses] is that the corporate earnings growth will be in the region of 30% for FY2007.

Data and analysis points to aligning one’s portfolio predominantly to large caps and select mid caps stocks/funds.

Overall.. the long term equity story for India is intact and one could get reasonable returns [with a time horizon of 2-3 years] by holding investments predominantly in large caps and in select mid /small cap stocks/funds.

On the flip side.. will we[Indian Stock Markets] show the money in 2007!?

Time will tell..

The derivative statistics and trends for Dec 2006 indicate a clear bullishness for the month of Jan 2007.

The trend in high open position contracts point to the expectations of strong quarterly results and a run up on pre-budget sentiments.

Quarterly results is expected to be strong due to consumption boom during Diwali and Christmas. This will reflect in the 3Q 07 results.

Lower crude oil prices and softening in other commodity prices have reduced the input costs for manufacturing companies.

Higher Advance tax payments made by corporates are a clear indicator of the bullishness in the quarterly numbers.

Post results season, budgetary news flows will be the key factor driving the markets.

Overall, the month looks quite bullish for the markets.