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Commentary that affects the market


Lots of ups, downs, and sideways things happening in the broad market. Some news:

FIIs are selling.
FIIs have sold more than 8500 crores this month, till August 22. They invested around 24,000 cr. in July, so this isn’t a panic situation. Yet. In fact,their net investment in 2007, even after these sales, is 34,000 cr.

Why are they selling? I don’t know. People say it’s the subprime problem, and that some funds have been forced to liquidate their assets. Perhaps they want to go to the US where the market has fallen to what may be attractive levels. The reasons always become apparent much after the fact – and the fact is: FIIs are selling.

The subprime problem is worse than we think.
What is the subprime problem? Here is a step-by-step recipe to create a subprime problem, for a new bank:

  • Interest rates are low, and people want to buy houses. But many of them can’t get loans because they either don’t have known sources of income, or have declared bankruptcy earlier, or have generally had bad credit history. How can we help?
  • Okay, let’s give them loans at higher interest rates! “Er…but won’t they default? They already have bad credit history!”.
  • No, no, we have the house, right? We’ll sell the house and recover our money! Anyhow housing prices are going up and up and up.
  • Okay, but they don’t have income to pay the principal+interest.
  • no problem. Let’s give them “interest-only” loans. They will pay only interest for, say 2 years, after which they’ll pay back principal also.
  • Fantastic. Now we have hajaar loans. Homes are increasing in value, so some customers are selling their houses for 40% more, paying back the loan and taking another loan on a bigger house! Great stuff! But how can we give MORE such loans? We have not got enough capital!
  • I have a great idea: We have all these loans no? Let’s package them as “mortgage backed securities” and sell them to other companies. They will give us money, which we can use to give more loans. Where they won’t buy it, we’ll borrow from them. Anyhow interest rates are low.
  • Great, now hedge funds have given us hajaar money for our securities and we have also borrowed more money, and are raking in huge amounts of money from the loan payments.
  • But interest rates are starting to move up!
  • Er…see, we will “reset” their interest rates only after two years, by that time they will be able to sell and give us back all the money.
  • Uh oh, the housing market is slowing down.
  • It’s time for the loans to reset, but the customers can’t pay higher rates, and they can’t sell their houses.
  • Uhm. The default rate has reached 35%! One out of three customers is defaulting because instead of paying our “interest only” loan, they can get a new home for cheaper! How do we account for this now?
  • Let’s go and get more money from the market.
  • Interest rates are too high and nobody wants to buy our mortgage based securities. In fact the people we borrowed from want their money back.
  • Uh, oh, the hedge funds who bought our loans can’t recover them because of the default rate, and need to pay back their investors, so they are selling what they own – which is things like Indian stocks, Chinese stocks etc.
  • Uh, oh, but if we don’t give more loans we will make no money! And how do we pay them back? Can we get some money from ANYWHERE?

This is the story of many funds and banks in the US. First Magnus declared bankruptcy. HSBC, Lehman Brothers and Accredited have nearly shut down their mortgage operations. Countrywide just got a $2 billion funding from Bank of America, without which it would be finished.

The rest is starting to unfold. The Fed and the European banks have already thrown in more than $200 billion of money. The fed has cut rates by 0.5%. They want to save the economy by propping these big banks and funds up – the way they did in 1998 by saving Long Term Capital Management.

You can never really subvert a crisis like this. Eventually the lid will blow. But they can soften it for a few years; so don’t go about selling everything, just the basic bits.

How does Subprime affect India?
Short Answer: You will only know after it hits us.
Long Answer:

  • IT outsourcers and BPOs can be hit badly if the banks stop giving them business. WNS recently announced a $26 million hit to its profits because they lost First Magnus as a customer.
  • Banks in India, which participate in consolidated funding or sourcing, may be hit. ICICI bank for instance takes loans from all over the world to fund its Indian operations.
  • If the US market is hit badly, FIIs will swing over, and the move will cause a slump in local markets (temporarily, but still, a hit).
  • If that happens the dollar will move up. Companies with ECBs will be forced to report losses on foreign currency gains, which as a line item made their growth seem fantastic this last quarter.
  • Subprime loans are in India as well. What we call “personal loans” or “pre-approved loans” are examples. Default rates on homes are moving up, it seems. Both ICICI and SBI have dramatically increased their NPA provisioning, and have both independently announced either slowing of credit growth or increase in defaults. Not good. ICICI, ever the smart financial cookie, has already taken on additional equity of 20,000 cr. and more loans to fight the obviously impending crisis. HDFC and SBI will follow shortly. The rest of the banking pack aren’t yet responding.

All of the above is a short term problem. If you’re investing for a ten year period, you should look at different things. If you ask me though, I would not invest in banks or IT till this drama settles down.

But interesting things are happening locally. Cement acquisitions: Holcim just bought a 15% stake in Gujarat Ambuja Cement. This may fuel more acquisitions in the Cement segment.

The political stage is also crazy; We may have fresh elections. My feeling is that elections will be good for us, because then we can vote out the Left parties. But if the Congress loses its enthu and pulls back on the Nuclear deal, all future deals will be seriously impacted. Then I will pull out whatever little I have from the markets.

On a personal front, I am still working hard with Kaushik to build Moneyoga. We are getting data on the markets and identifying patterns on them that will give us an idea of how good the odds are to invest in today’s markets. We’ll soon present that picture to you as well, in a form that is easily understandable.

And of course, it’s raining in Bangalore. But before you go buy umbrella company stocks, note that it only rains for half an hour at a time.


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