Saturday, September 17, 2011

Global Market Updates / Special Coverage For Indian Bourses - 16th September 2011

So things apparently seem to be on a song in the Western world yet again. The European bourses had a fantastic counter-trend rally as if everything that happened a few days ago was a nightmare. That incidentally is a fundamental fallacy and the tendency of excessive leverage being used to drive as many short term whipsaws as possible. Dow pulled back above the 11450 zone as expected and rather closed above 11500. On Monday, if the sad Monday streak continues, then it is a routine story. However, if Dow extends its gains and posts a 2nd consecutive close above 11450, then the pullback rally can move all the way to 11875.

First things first, time and again, we see the news saying stress tests have been conducted and banks seem to be ok upto a certain degree. Whilst I am no expert in conducting stress tests nor do I know the exact variables that go into the complex derivative[calculus derivatives for a change and not speculative securities] functions, there seems to be something missing in these tests. I prefer to keep things simple and I do not want to get into any specific bank, but just say a Banco Banca with 1 trillion euros book-value.

Assumptions for Modelling and Analysis
Book-Value = 1 Trillion Euros
  Securities / Assets that make up these 1 Trillion Euros
  0.6 Trillion Accounts Receivables via loans collateralized by real assets like houses, cars etc
  0.4 Trillion via Property and Other Assets that the banks have in their own names
  0.2 Trillion via Cash Holdings itself for day to day operations

As the stress models are used, typically a test is done on the basis of a hypothetical measure of defaults on loans and/or decreasing asset values and/or increasing demand by savings customers to withdraw cash back.

The first and foremost fundamental fallacy is to assume 1 Trillion book value in all scenarios which is wrong. If customers default and the market conditions are not good, the collateral security tends to have value much lower than what is recorded on books and in case of a foreclosure, the western banks typically have a double whammy. One, part of the book value is already eroded as it had discounted for interest income from that particular loan given out. A default implies that the principal and interest to the extent outstanding is knocked down already. Second, the decrease in value of collateral security can hardly mitigate these risks. Now one can argue here that there is an additional hedge taken by the bank in terms of Credit Default Swaps etc; I would like to keep it simple saying that there is a premium attached to the CDS as well and whilst it may mitigate some risks, the bottom line is that the stress test model is partially wrong over here itself.

Second, at any given point of time, the bank is assuming that the savers who have deposited their hard earned cash will only come to the bank for withdrawals for an x%. In case of a strong crisis, there will be a huge demand from savers to withdraw the money from their accounts [after all, in good times, the bank only kept a certain degree of cash and used the rest to lend money to debtors]. As the proportion of people withdrawing money increases, there will be increased pressure on the bank to either borrow from another bank or take some drastic measures. It is in principle unfair for the bank to tell any saver, no you can't withdraw your money now. The greater the pressure of withdrawals, the greater will be the pressure to start taking a hard look at the components that made up the book value.

So these 2 factors alone can lead to a vicious circle of sell-offs in asset classes [all included i.e. interest income, investment income, collateral security vide houses etc] Once stress test models start taking into account all of these factors in unison, it may turn out that a lot of banks that seem adequately capitalized suddenly risk a lot of exposure which right now the world doesn't want to look into and this is what the banks are hoping would happen.

The other factors are that the stress tests are just models that use 'all other factors constant' premise. It does not take into account the currency risks, the risks of huge cashflows that are needed in case of job cuts etc and suddenly, everything that looks ok turns out it is not. This is the primary reason why banks in the past have needed bailouts because the 'assets that back' the risks don't perform as needed and the banks risk total loss of operations.

The other thing to note is that credit that is extended to customers are predominantly done with the hope that business credit will be used to produce goods and services that eventually feed the economic cycle and the wheels keep rolling. The fact is that for the last 10 years and especially after Lehman Brothers, credit growth for business has been paltry. Banks are already sitting on a house of cards that have eroded significant book values and this has hampered business credit. Moreover, the business credit that has been extended has not really grown the economy to vibrancy overall. The Baltic Dry Freight Index suggests that core freight rates have been consistently dropping and now with so much excess capacity in the containerized shipping industry, there is very little scope to increase freight rates. Rather in gloomy scenarios, freight rates will keep decreasing. The fuel surcharges put on the cargo just covers the raise in crude oil prices.

If we start slicing the main sectors, banking and real estate collapses are going hand in hand. Shipping is in a downtrend. With jobs becoming a problem, the auto industry is going through some tough times and only now a drop in steel prices is somewhat aiding the input costs. The pharmaceutical industry, a darling 'alpha' return sector is heading towards a great crisis - next year, all the pharmaceutical majors will see a lot of patents expiring on their billion dollar labels that will force them to convert the patented drugs to over the counter medicines. Once a product is off-patent, any pharmaceutical company can produce a similar one and this is going to be a very turbulent time as all companies want to rationalize costs and get volume shares that will benefit customers no doubt but erode a lot of share-holder value [thereby again leading to banks losing money]

So Banking, Automotive, Pharmaceutical, Transport all are off the list for even normal performance. They are heading towards blood bath. Coming to FMCG, the capacity of factories overall have increased to a large degree and as past research has it, with turbulent times, brand loyalties start dropping. People prefer to save every dollar possible for expenses and hence to rationalize the production costs, big ticket factories will end up producing more and more Private Label products that erode revenues by over 20% to 35%. The customer at the supermarket will of course benefit from these lower prices but yet again, there is a lot of shareholder value erosion in such instances. Electronics and gadgets are going through such revolutionary times that marginal costs and revenues are decreasing significantly with volumes as the prime driver.

So this death spiral is slowly extending itself to all sectors of economy and hence, forcing banks to go easy on business credit. To summarize, this entire news and hoopla about stress tests on banks revealing safety levels is a big fat blatant lie. There is trouble and double dip trouble brewing. If the employment statistics are any clue, already job cuts are being planned, salary freezes being discussed and budgets for next year being rationalized to cope with 'realistic targets' [and one should remember that in good times, a perpetual growth was discounted for in the valuations of companies that in turn were discounted in book values of banks!]

All this blogosfear mumbo jumbo above only covered the retail banking [and to an extent investment banking segment] of the western world. Coming to Sovereign Debt, that is a grossly different story all together. Let us not forget that these countries are already sitting on debt accumulated over the last 15-25 years of which the principal amount is totally unpaid to a large degree in most cases. It is servicing the interest on the principal that has been causing trouble and all the 'successful bond auctions' that we are seeing in news is plain simple robbery of taxes of the normal, gullible hardworking taxpaying citizens.

All that these bonds are doing is borrowing to repay the interest of a borrowed amount of the past! That there will be more interest and principal payable on this is a separate issue. It is just that a drastic daring to say 'Yes there is trouble and we need to slow down' is simply missing. Our great leaders want to show that 'Everything is ok' now. This is akin to a depressed person consuming drugs and 'forgetting' the core issues. Once the drug stops having its influence, the sense that the real trouble is aggravating further will resurface and the great leaders just want to have more drugs. As is known about drugs, with passage of time, one needs more and more drugs to have the 'illusory' effect and eventually a breakdown does take place. We are heading in an accelerated form to a double dip recession and the earlier we come to terms with this, the better it is for us.

Now the other aspect is talking about 'austerity' measures - what austerity measures can a sovereign actually take now with inflation spooking beyond normal terms. As it is unemployment is a major issue and even in the western world, there is acute shortage of teachers and doctors and schools itself to begin with. If people have challenges with jobs, there will have to be more assistance provided for healthcare, public transport, social security and this means that they need more money to need the system. Austerity goes out of the window bang bang bang. So a prudent person should ignore the news, see what are his/her job prospects and prepare himself/herself. The day is not far when there will be a whammy from the government for 'austerity' measures and pat comes the announcement 'With effect from now, there will be no social security!' God help the world in such circumstances.

[There will be a separate article on what we the mango people need to do to take care of ourselves later over the weekend. Inspiration for the same lies in the written works of noted economist Nadeem Walayat and Conquer The Crash by Pretcher Jr]

Continued in Part 2....Coverage For Indian Bourses.

1 comment:

nalin said...

hi nagraj bro,

Drug eg. In the above post...is apt and awesome!!! Gr8 2 read ur blog.tks.