Archive for April, 2008

Banks and Corporates fight it out over derivatives. Banks will lose either way.

4 comments Written on April 28th, 2008 by
Categories: Commentary, ICICI Bank
From Bloomberg:
Jasmin Mehta says that when he told salesmen from ICICI Bank Ltd. he didn't understand currency derivatives, they chauffeured him to a hotel and bombarded him with charts showing how his company could make a profit with zero investment.

Jasmin Mehta says that when he told salesmen from ICICI Bank Ltd. he didn't understand currency derivatives, they chauffeured him to a hotel and bombarded him with charts showing how his company could make a profit with zero investment.

Three months later, Mehta, then chief finance officer of Sundaram Multi Pap Ltd., told his chairman that two of the contracts had turned sour, incurring losses of 60 million rupees ($1.5 million). ICICI has served a bankruptcy notice to collect the money, Sundaram says.

"I was made to believe these bets don't go wrong," says Mehta, 33, a commerce graduate from Mumbai's Dalmia College. "It was all about making profit, no mention of losses." ICICI, India's second-biggest bank, denies misleading its customers.

Indian companies may lose $4 billion on derivatives, according to Hong Kong-based brokerage CLSA Ltd. Sundaram is among a dozen firms that have filed lawsuits against banks including ICICI, Kotak Mahindra Bank Ltd. and Axis Bank Ltd., accusing them of hiding risks to lure small businesses into contracts they didn't understand. No rulings have been issued.

"There's a lack of transparency at banks," says Gautam Rao, director of Business Risk & Hedge Management, a Chennai- based consulting firm. "They don't explain the various legs of the transaction. The companies have no clue what they're doing."

Looks like the companies are claiming they weren't advised right.
The banks say clients were fully aware of the risks.

"We maintain records to show that companies knew what they were getting into," says Madhabi Puri Buch, an executive director at ICICI who declined to comment on specific cases. "There were no complaints when they were making profits."

In Sundaram's case, ICICI has a signed contract and the recording of an Oct. 24 phone call in which Mehta says, "Yes, yes, yes, I agree," according to papers filed at Bombay High Court.

Indian banks may lose 16 billion rupees if they can't enforce the contracts with smaller companies, according to CLSA, the Asian brokerage arm of French investment bank Calyon. The estimate is based on the assumption that 10 percent of companies may renege on the agreements.

ICICI declined to comment on potential losses for its clients on April 26, when the bank reported earnings. Axis Bank, India's fourth-largest by market value, set aside 719.7 million rupees for possible losses April 21.

Two things work in favour of the corporates. One, that they may be able to prove that the banks sold them products they did not understand. The usual statement is "caveat emptor" - buyer beware - which means if a buyer agrees to buy a product he is responsible for the risk. But in banking circles, a new term - caveat venditor, or seller beware - is doing the rounds. Given that financial derivatives are horrendously complex, understanding them can sometimes be beyond the ability of small companies. And then, some products are disguised lose-lose situations for the corporates, because the banks have access to far more information that the corporates. When this comes out, it is likely that an authority - either the RBI or the courts - may rule in favour of the corporate. (They have done so many a time, telling brokers to return clients money even after having a power-of-attorney to trade)

Second, ICICI bank can't sell them a derivative if it's a speculatory hedge - because the RBI bans those if not traded on an exchange. Most of these contracts are OTC - over the counter - products, which are ok for a hedge, but not really for the kind of contracts that have been taken which are simply speculation. If the corporates prove that the contract was illegal, they cannot be enforced and the banks are left holding the loss.

So two things work against banks - that the contract may be deemed invalid because it's illegal, or that they missold the product. If the court ruling is for Sundaram, expect a huge number of cases against the banks.

What are the other options? Out of court settlement. This will necessarily be in favour of the corporate - as obviously the payment will be much lesser than the demand (why settle otherwise?) Even there, there will be more such cases by other corporates who know they can get away with paying less.

Lastly, what if ICICI wins? They may not get the full money - in this case, the company may be bankrupt and only part of the money may be recovered. But after this, no one will deal with ICICI for derivatives; that means a huge reduction in fee and treasury income. With credit growth slowing and now fee/treasury income also impacted, the net impact on banks is negative.

This is very bad for the big P/E banks. If anything it is good for the traditional, conservative banks, who are likely to get the business. They're all at P/Es of 6 and 7 and such, and growing reasonably - like Corporation Bank. (But these PSUs suffer on account of the government's policies so risk isn't small)

(Note: Canara Bank just announced bad results. Will cover that separately.)

Posted in Commentary, ICICI Bank

ICICI FY08 EPS growth is 4%, Q4 EPS Contracts

No Comments » Written on April 26th, 2008 by
Categories: ICICI Bank, Results, Stocks
ICICI Bank reveals it's Q4 results and annual results for FY 08.

What I'm concerned with is the EPS contraction in the fourth quarter. In Q3, I'd noted that EPS growth was only 2%. In Q4, EPS was Rs. 5.68 versus Rs. 6.2 in Q4 FY07. This is an EPS contraction of 52 paise, or nearly 9%.

Note that again, carefully: EPS growth in Q3 was 2%, and in Q4, EPS growth was a NEGATIVE 9%. Slowdown, anyone?

Now for the financial year, diluted EPS was Rs. 32 versus Rs. 30.75 last year. That's a 4% growth. At current price of Rs. 916, you are paying a P/E of 28 for this company. Now 28 P/E for slowing growth is a tad high, huh?

(Note that the official result statements show some 39% growth in profits. But that is an absolute number - they raised 20,000 cr. last year, which diluted the capital severely. If growth can only come from capital expansions, then we shouldn't be paying this kind of P/E.)

Having said that - let's conider the "weighted average EPS", which has grown to 39.4 from 34.8, which is a 13.2% increase. Again, way lower than P/E. What's more scary is that EPS growth is really slowing down in a quarterly manner.

Other points:

  • Growth from UK and Canada is huge. Is this subject to a slowdown in those countries? Time will tell.
  • Impressive growth on the Mutual fund and Brokerage subsediaries.
  • Insurance is unimpressive. The numbers don't seem to provide too much confidence in the businesses. Insurance actually lost a heck of a lot of money (1500 cr.) which may be good to demerge.
  • Coming to demergers, there wasn't much that was heard of the demerging of the mutual fund, insurance and brokerage subsediaries. Any news?
  • Retail credit growth may be suspect because of the home loan squeeze and generally high asset prices.
  • ICICI Bank has provisioned a further Rs. 400 cr. for this quarter's mark-to-market losses. In my earlier post we had seen this figure being switched back and forth. But now they are clear - 280 cr. earlier to this quarter, and another 400 cr. now.
  • ICICI refuses to mention what derivative losses it's clients have. That's ok, they don't have to. It's their clients that lost money.
  • What's weird is that they mention that they have some customers who have filed legal cases against them. And they have provisioned some money against such cases. They have specifically not mentioned how much the provision was, and the potential impact of these cases. Beware the unsaid words - they will come back and bite.
Disclosure: No positions. Was short, but am out of that position now. I wouldn't short this stock on Monday - the technicals look very strong. But the fundamentals are weak, and I think now it's a matter of time before this stock goes down.

Note: This is not a bad company - it's not going to be bankrupt. It has a lot of assets, and capital to support itself. But it cannot command such valuations with obvious growth pressure. The company is consolidating and the stock needs to do so as well. At the current price, there's not much more left to go - but take 1/3rd off and maybe there's a story.

Update 27/4/08: ICICI Bank's 1 hour conf call provided more details.

  • IPOs not planned until they get a "fair value" for the subsediaries.
  • There was some difference between the way Prudential valued the exposure in insurance to the way ICICI did it. The reason mentioned was that the actuarial fundas were different (we are a growing economy etc.) for the two players. I am not very convinced. This is going to be an Achilles heel unless ICICI gets rid of it through an IPO.

Posted in ICICI Bank, Results, Stocks

Can’t Believe Financial Statements Anymore

No Comments » Written on April 26th, 2008 by
Categories: Commentary
From FT (tip: Marc's blog):
Rules regarding how banks account for off-balance sheet interests are “irretrievably broken”, a senior group of international rulemakers has warned.

The rules, which have allowed trillions

in assets to escape close scrutiny, have come under attack in the wake of the credit crisis as banks have been forced to disclose huge losses on these holdings.

But a report by a high-level group of accountants has warned that completion of the current overhaul of the rules would not be possible in the near future.

“Completing a final standard by mid-2011 will be extremely difficult, perhaps impossible,” says the report seen by the Financial Times and prepared by board members of the US-based Financial Accounting Standards Board and the International Accounting Standards Board.

While the report does not yet represent the official view of the accounting bodies, it is a sign of the turmoil within the industry in grappling with the off-balance sheet issue. [By "grappling", they mean, "Holy s---, are we in trouble now."]

Accounting standard setters are already under pressure for their support of marking assets to current market prices – a practice that has resulted in billions in writedowns and affected banks’ profitability seriously. [That's not the issue with mark-to-market -- the issue with mark-to-market is that it leads to a death spiral by which new downward marks lead to loan calls and fund redemptions which lead to panic selling which leads to new downward marks which leads to... you guessed it, banks' off-balance-sheet entities going kablooey and suddenly showing up at the door like your unwanted uncle.]

The Financial Stability [ha!] Forum, a global body of regulators and central bankers, has asked the IASB and its US counterpart to consider the issue as a matter of urgency. Accounting standard setters are in the throes of discussing how to respond.

However, the report by the high-level group of accountants says the project to overhaul current rules on off-balance sheet interests has lost momentum because of staff turnover and “relative inexperience”.

We would do well to heed this in India as well, where accounting standards are much more lax. Banks don't have to reveal a lot of details on underlying data, companies don't need to release balance sheets (only P&L accounts) every quarter, and there are enough ways to hide or toss around revenue.

We have all the more reasons to mistrust management and indeed, even auditors. I would not make a huge decision based on reported growth numbers - discount the upside, and amplify the downside.

Posted in Commentary

Reliance Power Bonus: Ex-Date is 30 May 2008

4 comments Written on April 25th, 2008 by
Categories: ReliancePower, Stocks
A number of you are searching for the record date of the Reliance Power Bonus issue and then hitting my blog. Note now that the management has announced it - Bonus shares will be issued to all those that own shares as of June 2, 2008. That means you must purchase the share on or before 29 May 2008. On the opening of the 30th, the share will go "ex-bonus" meaning any purchases from then on will not give the owner any bonus shares.

Posted in ReliancePower, Stocks

Airtel’s Auditor Notes: What To Make Of It?

1 Comment » Written on April 25th, 2008 by
Categories: Bharti
From Airtel's auditor's report:
Note 7 to these financial results, regarding the revaluation of investments in Bharti Infratel Limited (' BIL') at fair value, recognition of the difference between its book value and fair value as Reserve for Business Restructuring in the books of the Company and utilization of this Reserve for write off of losses on transfer of Telecom Infrastructure Undertaking, where the Company has followed such treatment prescribed in the Scheme of Arrangement as sanctioned by Hon'ble High Court of Delhi vide order dated November 26,2007, effective from January 1, 2008, in preference to relevant Indian Generally Accepted Accounting Principles, which, in the absence of such Scheme would not permit this fair valuation or utilization of Reserves for Business Restructuring.
I honestly do not know what this means. Airtel, when it put its tower assets into BIL - a different company - should have taken the assets off the books. It decided to "revalue" the assets at the time of transfer, and presumably this value was higher than book value (which is cost minus depreciation). The difference was a positive number, which was used to offset losses on the transfer.

I don't know what losses can happen when they demerge a unit into a subsediary company. Unless they decided that they can transition some loss into the subsediary and declare a higher profit in the main company. Is that what's happening? Need more clarity.

If a demerger to an unlisted subsediary is a way to increase profits in the core company, a lot of demergers are going to happen. Wait. They are already happening, in a number of companies.

And there is more in the auditor's report.

Note 11 to these financial results, where based on a legal opinion, the Company has continued with its accounting policy to adjust foreign exchange fluctuations related to purchase of fixed assets to the cost of fixed assets as per the requirement of Schedule VI of the Companies Act, 1956, which is at variance to the requirements of Companies (Accounting Standard) Rules 2006 dated December 7,2006.
Again, I think the implication of this is negative. (If it had been positive, the auditors would have said that should the real accounting standard been followed, the net profit would be higher by XX cr.) This means that some legal loophole exists that allows Bharti to have a lower forex loss from dollar appreciation by doing some accounting magic.

Note that there seems to be no evidence of any wrongdoign here. They are likely to be using the right legal and accounting methods to maintain fantastic topline and bottomline growth.

But I am wary of such reports in seemingly bad times - and if we start seeing more auditor warnings, chances are that growth has to be "created" by moving numbers around. I expect a lot of excellent bank results going forward - we've already seen excellent numbers from Axis Bank, Yes bank and HDFC Bank, and are likely to see phenomenal numbers from ICICI too. Because we will never understand the accounting, and we have to trust the management.

My feeling is that this quarter and the next will see all sorts of funny-money accounting, and then we will not be able to deny growth slowdown any longer. Already we have seen EPS growth of 13% on the Nifty, and in a few days we'll know if the last quarter was any better. (All results of Nifty stocks are not out). Fun times.

Posted in Bharti

The Trust Is Gone

2 comments Written on April 23rd, 2008 by
Categories: Commentary
From Calculated Risk:
Homebuyer's were speculating with no money down. Mortgage brokers didn't care because they would sell the loans immediately and collect their fees. Wall Street didn't care because they could package the loans and sell them to investors. Investors would have cared, except they trusted the rating agencies. And as this article describes, the rating agencies weren't evaluating the underlying loans - they were performing statistical analysis using models based on lenders that cared if the borrower would repay the loan.
Who takes the blame? Rating agencies (the article referred to is here) seem to be the focus now.

What this entire business is is a loss of trust. Investors trusted the hedge and pension funds. Hedge funds trusted the rating agencies. Rating agencies trusted the banks. Banks trusted the borrowers. But if the trust was all ok, why was there a need to charge fees and high interest rates?

That means there is somewhere a small tiny possibility that someone will betray you. Currently it's all being pinned on the borrowers. They lied, so we all suffer. But who asked the rating agencies to trust the banks? What kind of idiotic person decides that homeowners can lie, but a bank will not? In the history of mankind, more banks have lied as a percentage of their population, than home-loan-borrowers. [Note: I'm making this up, but I think the data will prove me right] But we will still trust them over the latter?

So rating agencies were stupid. And why then were investors trusting rating agencies? Especially since they hadn't even paid for their (obviously laughably wrong) opinion?

Trust was breached at every level, and history will show us it has always been that way. You can fix the banks by forcing them to take on a lot more of the risk they offloaded. That fixes the borrowers - who will lie if they can, but banks will catch them if they have so much to lose. Then suddenly no one wants to lend anymore, which is more a political problem than an economic one. No loans, no lucrative jobs, and no risk taking - not signs of good capitalism.

You can fix the rating agencies by open-sourcing their business and providing no government protection. (i.e. public funds should not be required to have AAA or even rated securities). That will kill the rating business, a much lesser political problem.

But then it increases the burden on hedge and pension funds. Or does it? Such money comes with little accountability and in some cases a mongoose can do better investing; but investors persist because they do not want to become mongooses, or don't really know what being a mongoose involves. (What will I eat? Snakes? Yuck.)

Investors, we know, are the stupidest of the lot anyway and will trust anything even if it is only etched on telephone poles. Some of them are rich sods that understood the risk. Most of them are funds that didn't deserve to even think of the risk. Towns in Norway. School funds. Pension funds.

The trust is gone, and now all of the investing will unwind. Do whatever regulation you want, the trust is not coming back that easy. It will take a long time for us to realise that while there may be a lot of money in the "sidelines", it will not come easy to those that need it, because they can't trust anyone anymore.

Posted in Commentary

Reader Comment: Sea of Red For Real Estate Lenders

25 comments Written on April 20th, 2008 by
Categories: RealEstate
Two comments that piqued my interest, on the CRR Hike post:
Indian IT will be in X roads..and India will have a sub prime crisis of its own since many of these IT wizards have taken home loans of the order of 20-30-50L for a salary of 20-50-100K and believe me, not a soul will pay that outside the a/c halls of IT. So, what will happen - simple default and banks will employ goondas to sell the flats in B'lore/Noida/Hyd/Chennai. There will be a glut and when all this is over, there will be a sea of red.
And a concerned reader writes in:
When do you think this problem will happen in India. All the IT companies are talking of good growth for next 5 to 10 years so this [roblem might not happen at all. Your comments please.
The theory is: The real estate sector has been propped up folks who've picked up houses at fairly high loan-to-value rates. Outside of IT, where growth looks good, people will not be able to pay such high loans back, and then defaults and recoveries will hit bank bottomlines.

So the question is: Are these assumptions true? It may be that realty prices are out of whack with reality. [That's putting it nicely] But price was never a problem. Flats were overpriced even at 1500 per sq. ft., but people continued to buy. The reason: Someone would be willing to pay Rs. 2,000 and then 3,000 and even 15,000 for the same square foot. So if I am a fool today, I can easily find a bigger fool tomorrow.

Now we've reached a point where it doesn't look like prices can get MORE out of whack. So the investors have vanished. Prices haven't come down because builders have gotten complacent; in the last four years they never had to do this much fighting to sell property. Usually properties would get sold out in the instant they released the rumour that they will construct sometime in the future. Now people spit on their posters. I guess builders are hoping that they can get some suckers to buy at this price, before they are forced to lower rates.

With salary hike quantums going down, and general job insecurity, people aren't going to commit to higher EMIs - when the future gets more uncertain, people take lesser risks. So prices need to come down to attract investment.

Now if rates are lowered on under-construction apartments, what happens to the guys that bought them a while back? They get pissed off when they go upside down (loan value greater than current price of house). This may happen inspite of the black money cushion because of the structure of such agreements, where the black money changes hands only when the house is ready.

Now defaulting isn't legally bright because all loans are recourse loans. Meaning the banks can sell your house, and if that falls short of your loan they can make you sell other stuff you own, to recover the difference. But since litigation takes time and the RBI doesn't like goonda tactics, a default may take an enormous amount of time to turn around. [Note also that people may gather their own set of goondas to counter any bank pressure, something the banks haven't really accounted for]

So if people are very likely default on going upside down, and banks have a recovery problem on the upside-downs, then yes - banks are going to be hit quite badly. Because they can't pass off the risk easily like they did in the US through Mortgage backed securities. (but ICICI did sell bad personal loans to Arcil recently)

But firstly I don't see huge defaults in primary residences - as people generally don't default on the houses they live in. I don't have any data on how much "investor" (second or n'th home) interest there is in new housing, but it seems to me that big cities - NCR,Mumbai, Bangalore, Hyderabad - have much more of these. In Kerala there is a lot of NRI interest. Defaults are more likely if people don't have to stay in the house and if they haven't paid too much in "black" for it. In Bangalore it does seem to be the case - the other places don't (yet) apply. (Loan to rent ratios are so ridiculous there is no point discussing them)

Secondly the implicit assumption that a good IT sector means highly paid Indian employees is fallacious. Companies like TCS, Infosys and Genpact have big investments in China, Philippines and Eastern Europe. They may grow their profits by increasing their focus in such locations rather than India. Which is actually negative for the guy trying to sell Real Estate to Mr. Infosys-Employee-That-Just-Got-Outsourced.

So I think banks have to worry about the wage levels and employment growth of IT companies whose employees they lend to, and not the growth of the companies themselves.

Now here is the last factor: Construction costs. Typical costs of construction, in 2002, was about Rs. 500 per sq. ft. Today it's 1500 per sq. ft. That's cement, steel, tiles ceramic, etc. Now these are cyclicals so they will come down, and second, they are commodities whose price the government is keen to lower to counter inflation. Let's assume that the prices come down to a neat Rs. 800 per sq. ft. in a couple years. Land cost is already going down, so in two years, the cost per built up sq. ft. (considering FSI and TDR prices etc.) will likely be Rs. 600; even lower for those that held property for a long time. So to make a profit, a new developer will be able to sell houses for 1,400 to 1,800 per sq. foot. This destroys the model for current houses which sell for two or three times that. What happens then?

It's a complex cycle, but there's only one answer. Going down.

Posted in RealEstate

CRR Hike And Rupee Woes

10 comments Written on April 17th, 2008 by
Categories: Commentary
With today's inflation figures coming out and a 7.14% inflation, RBI's response has been to hike the Cash Reserve Ratio by 0.5% to 8% now. The CRR hike is a signal that the RBI wants to rein in inflation through interest rate hikes.

CRR is the percentage of their money that banks are supposed to deposit with RBI otherwise RBI will get really angry. How does the CRR affect inflation? I mean why would the hafta that banks need to give RBI to stay in business affect the price you pay for vegetables? The answer, my friend, is "magic".

I wish it were, so that I don't have to type all of this, most of which is theoretical and amazingly paradoxical considering the state of today's world, but I'll go ahead anyhow.

CRR means banks give money to RBI so they have less to lend. And in general they have less money to invest or trade or whatever shady things they do. If they have less to lend, they will raise interest rates to maintain their return on capital. They will trade lesser, because there is less to go around. Or so we all like to think, because this is NOT what is happening right now, but please listen to this theory.

Having less money hanging around means the value of money goes up. Inflation usually means the value of money has gone down. So net-net, the value of money gets stabilised and inflation gets controlled. Clap-Clap.

That must means your vegetable vendor who has a huge loan from your bank, which has just increased interest rates, will now REDUCE his prices because the value of money has gone up. Er. Wait. There is something wrong with that sentence. Uhm. Ok, we don't really know how veggie prices come down. Maybe RBI sends someone with a gun to all vegetable vendors and they reduce rates. Or maybe it's magic.

Whatever happens, interest rate hikes are supposed to be the preferred way to contain inflation. If it works, it is with a serious lag - 6 months to a year. Inflation however is a political problem once it gets out of hand, and right now these 7% figures are just bunk - the real inflation in food and goods prices is much much higher. I've seen the price of rice and wheat go up more than 10% in the last two weeks itself, and it's even higher in the cheapest varieties.

Interest rates weren't exactly low earlier, so why did prices go up? I think this inflation is imported. Prices abroad have gone up - because for one the US has absurdly low interest rates due to their internal problems - so we have people who prefer to export, or that imports are expensive now. Low interest rates do cause inflation, so inflation in western countries is hopping over here.

Maybe we would do better off by strengthening the rupee. That way imports aren't much more expensive in rupee terms and exports are less attractive. And it deters anyone thinking they can borrow cheap from the US and get risk free high rates in India - if the dollar depreciates that advantage is wiped out.

But rupee appreciation kills exporters. Still, inflation today is a bigger problem than export jobs, so I'm sure that the numbers will play on the mind of the politicians soon.

If the rupee goes up - it went up by what, 20 paise to the dollar today - we will see all IT stocks impacted seriously. And it's not just the dollar, it's the Euro as well, so no hiding there this time. Plus, textile stocks which just went up, will be impacted seriously as well.

Watch the rupee closely. If it hits 39 and goes below, it's going way below. Inflation has to be controlled. No choice on that matter.

Posted in Commentary

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