Archive for March, 2008

SEBI's new proposed rules for brokerages include very strict guidelines on how they should work with their clients. Some salient points.

The Exposure/Turnover limit given by the trading members should be commensurate with the financial details of the clients reported in the KYC. The said limit to be specified in the KYC and strictly adhered to or the details in KYC to be suitably modified.

Only person with financial standing at least comparable to that of the client he is introducing should be accepted as introducer. The documents such as PAN Card, Income Tax Return / Proof of residence etc to be maintained alongwith the KYC of the client to whom he is introducing.

This is weird. If I don't know someone who is as rich as me, I can't trade? (on a funny note, What does Mukesh Ambani do?)

The KYC point is well taken, that trading limits should be set on the basis of financial information provided by the client. But it is also stupid because: Client finances change EVERY SINGLE MONTH. There is no "credit rating" system for individuals in India, which can give anyone an idea of how creditworthy a person is. The broker may give a small limit based on today's data, but the person may get a 50% increase in wealth or may inherit a fortune later, but he can't use that fortune to trade! And if brokers are to do KYC every few months, people will get pissed off.

KYC makes sense only if there is a centralised system managing all people's records, and all agencies (banks, credit cards etc.) reporting to that system. Otherwise it's a waste of effort.

While recommending purchase or sale of any security / derivatives contract to a client, trading member shall have reasonable grounds for believing that the recommendation is suitable for such client on the basis of the facts disclosed by such client as to his / her financial position, other security holdings, past investment experience & pattern and investment needs.

So brokers can't recommend anything anymore. They are not going to get your holding information, your financial position etc. Let's face it, no body gets this info. And reco's are a good part of brokerage revenue.

Prior to the execution of transactions on behalf of a non-institutional client, trading member shall make reasonable efforts to obtain the following information regarding the client

• Financial status
• Investment objectives
• Past investment experience & pattern
• Risk appetite of the client.
• Such other information considered to be reasonable by the trading member

I suppose we will all have to keep this handy, because we may not be allowed to make transactions without this info. I don't even know if I want to part with this information.

The clients may be required to have certain minimum amount of networth (e.g.5 lacs) for trading in Derivative Segment. A net-worth certificate from a practicing Chartered Accountant or acknowledgement for I.T. return filed should be accepted in this regard.

Fantastic. Now I must pay a CA to give me a net worth statement before I buy derivatives? Isn't this a sure fire way to kill the market, which already sees little transactions? Why can't this be done within the KYC norms?

People will defend this saying we should limit people's losses. I say bull. People who want to do this will do it anyway, and give some random CA statement if required. It's only going to trouble the majority, i.e. those that can really afford it.

Most of the remaining recommendations are good, like maintaining a Chinese wall between the trading and analyst operations, ensuring full and fair disclosure of holdings of every analyst, making brokers liable for fraud on their employees part etc.

What is missing is the extent of penalties. SEBI is a toothless tiger, or has been to date. They should present how they can fine misdemeanors heavily and have it stand, like the US SEC. Many of SEBI's harsh verdicts get thrown out at the SAT level, and the rest at the court level - what use is this? No disgorgement, no system of real penalties - no wonder entities like Karvy still survive. Can we please show some real strength, SEBI?

Note: This is not yet a regulation. SEBI has requested for comments and we should mail them as given in the article (you and I can also mail) before April 15.

The Institute of Chartered Accountants of India (ICAI) has announced that companies holding derivative contracts must provide for losses on them on a mark-to-market basis. Prior to this announcement, the standard for derivatives (AS 30) was to be applicable only from April 2011. ("Recommended" from 2009).

AS 30 is still not mandatory, but ICAI maintains that if AS 30 is not followed, the losses must be mentioned separately by the company and failing that, by the auditors, from March 31, 2008 onwards. It will be interesting to see the auditors statements on public financial results this year.

I fully expect companies to dress up their results for this quarter. So it will be very interesting to see which companies have audit notes for non-compliance to AS 30. And where AS 30 has been used, to find out the extent of MTM losses.

This is a non-India post. But it has some significance to the Indian markets. Ambac and MBIA are bond insurers in the US - called "monolines" (though they do work with multiple lines of business now).

These guys insure municipal bonds. That's an organised crime by itself, something that unravelled after the S&L failures in the early 90s. The funda is: municipalities issue bonds to raise funds. School systems, road development authorities, states and city councils etc. Some of htem have "failed" earlier - i.e. they had to default on the bonds because they couldn't collect taxes or had a tough situation.

The bonds therefore seem to have a "risk", and monolines provide insurance on default (on both principal and interest).

But is it really risky? Of course not, a Moody's study found only 41 defaults in 37 years. Not quite enough to be called "lots of risk".

So why the insurance? This is the big insurance scam. The risk is defined by a rating - where AAA is practically no risk (don't laugh), AA is little teeny weeny bit risk, and BBB- is junk. The three big rating agencies - who literally own the rating industry - are Moody's, S&P and Fitch.

These guys (the rating agencies) get their biggest business from the monolines. If they rate the municipal bonds AAA, the bond issuers (the municipalities or school systems or whatever) will not buy bond insurance from the monolines. (Why buy insurance when there is no or low risk of default?). The monolines will then cut the rating agencies' business as a revenge or as it's known in business, quid pro quo.

So the rating agencies keep the municipal bond ratings low, so that the issuer of bonds will buy bond insurance and keep the system running. But that not only drives costs up, it also raises interest rates - a bond rated AA has to pay more than a bond rated AAA and so on.

But the underlying bonds are very safe in reality. Some of them get federal guarantees, some others are guaranteed via letters of credit from pension funds and state funds. That should give them a AAA rating, but the rating agencies don't want to rock the boat.

So 15 states have revolted against the big rating and bond insurance game. They want their ratings to be top-notch and rated exactly like corporations are rated, which is likely to give most of the bonds a AAA rating, and therefore no insurance requirement. (Note that the muni rating process seems to be different from the way corporate bonds are rated, and even Moody's has admitted that should they rate muni's the same way corps are rated, most muni's are likely to be AAA)

Giving muni bonds AAA ratings is a problem. So serious it will kill the bond insurers. Ambac and MBIA have had phenomenal losses in the subprime crisis, because they also insured subprime mortgages and CDOs. They still have a AAA rating from two of the three rating agencies even though they are far closer to insolvency than any of the municipal bond issuers! (Due to the you-scratch-my-back-i-scratch-yours between rating agencies and monolines)

If you take away their bond insurance income, (billions of dollars a year) the monolines would be insolvent very very soon.

The states can squeeze them now, because bonds and short term debt is being priced high, as if there was no insurance. (partly because no one believes Ambac and MBIA are solvent enough to pay on default) Some ports had to pay as much as 20% annualised, to roll over extremely short term debt. (Read this)

Apart from that, the subprime problem is huge. Read this presentation to see how horrible the situation is - there are a HUGE number of defaults waiting to happen in the next few months, and that alone may wipe out all the capital of MBIA and Ambac. Even after fresh capital raising efforts and all that.

What's in it for us in India? Complex fundas but here goes: Ambac and MBIA are counterparties to hajaar MBS and CDOs held by hedge funds, pension funds and investment banks like Citibank, Goldman Sachs, Lehman Brothers etc. These entities have assumed that their CDO insurance would pay against default, but that is not going to happen if the monolines go bankrupt. Goldman actually recorded about $11 billion of profit last quarter, some of it on the mark-to-market price of the CDS they own. (The CDS may be priced high now, but is toilet paper if backed by a bankrupt company on the other side)

So if the monolines go under, a huge number of other entities will end up with massive losses. (They already have big losses, but they countered those with the profits made on this "insurance") Many of these entities invest in India, directly or indirectly.

The Indian market will see massive cash-outs if this situation pans out. Hedge funds, investment banks and pensions are going to take out whatever little profit they have, to balance their other losses, and we will be in the next storm.

This situation is now looking increasingly likely within the next year. It will take the market deeply down, and at any sign of this happening, I would take all my long positions out. But watch first, it could take months before the first signs emerge.

The latest weekly release of the WPI Index, according to the Economic Times, is at 6.68%. This is the highest we've seen for a while.

High inflation is a big election problem and the only way to counter it is high interest rates. We already have high interest rates. Will the RBI increase them further?

Also it could reduce the money supply in the country, if the inflation is a function of greater money supply. But it seems like there may actually be less of that as foreign investors take money out of the country. Though to be honest I have no idea what the money supply statistics are, and if the RBI has the ability to control it. (If it has to absorb the money by issuing bonds, it will increase govt. debt and such factors that I cannot even begin to imagine.)

The other thing the government can do is to curb speculation. Commodity prices contribute to the WPI, which determines the WPI inflation - and if they banned trading of certain commodities the govt. will "appear" to have controlled inflation. In reality all that does is to create a grey market for the same goods, because who will sell to the government for cheaper when someone is willing to pay more? A ban is stupid, but a choice between smart and "appear good to the common man" always yields the latter, from our political history.

Still a commodity trading ban will affect not just farmers but also anyone else that is using or selling the commodity, including listed companies. Watch this space.

Is this a one time thing? Last year, at this time, WPI inflation was over 6%. Meaning we don't have a "low base effect". Two weeks more and we should see a trend. If the prices dip back we have no problem.

I'm seeing a lot of TV and media interest in the price rise - alu, pyaaz and all that. That's a bad sign - in this day of yellow journalism, the media doesn't usually go behind important topics like inflation when they have other fascinating stories like how Aishwarya Rai refused Will Smith, how Dhoni has been seen with Bipasha Basu and so on. So when they focus on inflation you know that it has become serious.

Inflation by itself isn't so bad for the stock market investor. It's the impact of measures to CURB inflation that can affect your investment.