Commentary

From The Daily Beast, Quants, Derivatives and the Myth of the Rogue Trader: (HT: @ashenoya)

Just what did these sorcerer’s apprentices do all day? The City veteran tries to explain to a non-math-speaker. Let’s say you want to develop a financial product that will protect investors with huge amounts of money against various contingencies in the market. “The people who build the models are the technical guys, and those are called the quants,” says the veteran—“quant” being short for quantitative analyst, as you’ll recall, although the math can be reminiscent of quantum physics in its incomprehensibility. “Everything is very mathematical in derivatives, and it is pure math, even though we say it is applied mathematics,” the veteran says.

Then you have “the structure guys,” as the City veteran calls them. They’re the ones who actually put together the financial products that are based on the models developed by the quants; the City veteran was one of them. After the structure guys come the traders, who buy and sell the various elements in the packages the others have devised and assembled. “The traders manage the risk,” the veteran says, “and they tend to have similar backgrounds to the quants.” Very broadly speaking, the quants work in the financial equivalent of an ivory tower to develop models for instruments they think will work; the traders report the results from the trenches, and the structure guys figure out solutions and improvements. And finally there are the salespeople, who may not know much about the math, but know how to talk a persuasive bottom line.

The danger in this juxtaposition of mathematical theory and multiple billions of dollars should be evident to anyone who has ever heard of Murphy’s Law. And yet it may not be so obvious to traders in the middle of the action as they implement the quants’ models. In fact, their world can be simultaneously very high pressure and almost mystical. “The richness of math is in the abstraction,” El Karoui told a science publication for women in 2008, after the crash. “It allows you to take a step back from reality, and that gives us the freedom to think the way we want. Mathematicians display a great deal of imagination.”

The issue of using an imaginary world versus a real one prompts statements (largely from big banks) that a market is "not reflecting real value", when positions go against them. Buyers often complain that speculators have, by short selling, taken stocks way below where they should go. Yet they don't complain when valuations get way ahead of themselves (like in the dot com boom, or the real estate boom, or in India, the stock market madness of 2007-08).

And selling complex products to customers who should know better amounts to mis-selling in the end. Because the salesmen hardly understand the complexities enough to warn their customers about the inadequacies of the models, of the underlying assumptions and so on. From selling what's best for the customer, they move to selling what's best for themselves at the cost of the customer.

Remember actuarial-funded-insurance policies that IRDA banned in 2007? These products offered nearly 100% allocation (no charges!) but hid the charges under a complex formula which penalized early withdrawals with charges mentioned through flowcharts. The model might actually work, but it doesn't make sense to sell it to someone who trusts the insurer to provide him a good product instead of nickel-and-dime methods to steal his money.

The essential problem in such products is the fact that risk is hidden behind complexity, and transferred to someone who doesn't understand. In the stock market, I might create a quantitative trading method and thus buy a set of stocks that I think are ridiculously low priced. That's okay, because I have no obligation to disclose my methods to the seller; I have no fiduciary relationship in which he trusts me to get him the right price. And if things go wrong, I assume the risk. The problem would only come if I created a hedge fund, and invested a customer's money in this kind of model when they are unaware of the risk, and if I say anything short of "you could lose nearly all your money", I would be lying. But in reality, that's what happens, people lie.

The secondary issue is that quants fall in love with their models even when it's divorced from reality. When real estate prices fell in the west, the traders who had carefully modelled their derivative bets saw the basic assumption in their models collapse: that one fall wouldn't trigger another in a different part of the world. When prices fell in a synchronized manner, their thought process was: this doesn't make sense, and it's even more out of whack than before, so let's double our bets. Now that does result in huge wins at some point, but it all comes down to nought when the market really misbehaves.  

Like radioactive material, quant models are only useful if handled carefully.

Things aren't going well for freedom nowadays. First, a high court banned Vimeo and ThePirateBay, because ostensibly they carried pirated versions of a film no one wanted to see. This case will need to be challenged in the Supreme Court and the rules made more strict and defined, but some freedom was lost, which has to be won back.

Then there was the new set of IT rules announced by Kapil Sibal that, if they go through, will result in your being sent to jail for not asking your facebook friends to vote for the Congress. I'm kidding. Or maybe not. But the bill is out there to take our freedom away, and thankfully, the opposition is being an opposition and opposing this bunch of utter horseshit that Mr. Sibal has no problem smelling.

And then, the US joined the fray with Senator Chuck Schumer proposing a tax on people like Eduardo Saverin, who relinquished US citizenship (supposedly) because of tax purposes. Saverin, who now lives in Singapore, has taken on a Sing passport and let go his US one and the main reason, they say, is so he won't have to pay a ton of taxes when the Facebook IPO happens (tomorrow). But wait.

He does pay taxes. The day his citizenship is relinquished, the US tax law assumes that all his assets (even non-US) are sold at their market value, and full tax needs to be paid on such capital gains. (Only for those worth over $2 million) No other country that I know of has this kind of batshit insane rule. Imagine if India told people - okay, give up your Indian passport but you have to pay Indian taxes on all that you own, at market value, the day you return your passport. People would go blue in the face and tell us how retrograde we are and how we are unreasonable, and how people left India and [Country X] is their new home and what not. But you can't argue that with the US. You have to pay that tax. Saverin WILL pay that tax.

What he will pay, though, is the privately discovered price of the Facebook shares he owned on the day he gave up citizenship. That will be substantially lesser than what his tax would be, if he had said bye-bye AFTER the IPO. So the outrage is that boss, you didn't pay tax that you could have paid had you given back your passport in the future. I mean if that earlier rule was batshit insane, this outrage is beyond ludicrous.

To their credit, the US *can* tax Saverin on any of his gains made out of the facebook IPO. They don't charge foreigners capital gains tax (India does, except those from Mauritius and Singapore etc.). They can. If they did, many people investing in the US will walk away; but to be honest, where will they go? They should charge it when they can.

But Schumer's approach is not that. Schumer's approach is to say: We will find out if you left citizenship because of tax reasons, and if we think so, we'll ban you for life and label you a traitor and cover you with tar and feathers. This, while some of the biggest US corporations hide their money in tax havens abroad so they don't have to pay US taxes. This, while it's evident that Saverin no longer LIVES in the US, and probably gets hassled by US tax authorities to pay taxes on anything he does (because the US, in its brilliant uniqueness, charges even non-resident citizens tax on their non-US income).

The rationale is that the US saved him, so he owes it. I think that is a dumb excuse. India should try that on its IITian citizens and see what outrage that causes. But we don't because, honestly, Kapil Sibal is too busy smelling his brand new IT rules.

Anyhow, we all lose a little bit of freedom every day. It's no wonder the Greeks are telling the rest of the world to go suck eggs.

Legendary fund manager John Arnold told investors that he was closing the Centaurus Energy fund, to pursue other interests. Arnold was one of the "good" guys in Enron, making around $750 million in profits for Enron the year that it died from upper management fraud, and got a (tiny) $8 million as a bonus.

Arnold went on to start Centaurus, and made more than 100% for a significant part of its existence, and more than 50% in each of the first seven years. In 2006, when it made 300%, it took on the giant Amaranth on a bet on natural gas markets (Arnold was short) and made $1 billion.

The last three years have been tough, though. The fund saw its first loss in 2010. (According to one source, just 4%) 2011 saw a sub-10% return, and supposedly in 2012, the fund is up just 3-4% (hearsay) till May.

Zerohedge says it's probably the new commodity player limits (which restrict the size of each player in a market) and the fact that people are getting into energy futures as a way to protect wealth that promotes the natural player's exit. It's that time when demand and supply matter less than the fact that some central bank is doing a quantitative easing and so people rush to buy energy and gold to save their money from the debasement of currency. So you could wager that it's going to be a warm winter and people need less gas, but one Fed statement will take prices up. Much of the game in energy or commodity futures is based on small moves that give outsized return through the use of insane leverage (some positions can be levered 30-40x). So a sudden rush of money in or out of a commodity can make sudden, large jumps unconnected with fundamentals, and thus destroy the old-trader-with-lots-of-leverage. But there's no pitying anyone - Arnold played his game and left it when he could no longer be king.

Also to those saying trading is a bad thing and trying to use Arnold's exit as an example: his net return to investors over 10 years is probably over 40% CAGR. The last three years have been bad but nothing spectacularly low - they would have gained. And of course, a good thing about the trading business is that you can't be wedded to a trade, so you can quit whenever you like and keep the money.

But it goes to say: today, the micro-strategies don't matter. Fundamentals don't matter. The Macro picture trumps the micro. You have to keep one eye on Greece, another on the Fed, and find other eyes for all those big things that might just happen, and react accordingly. The risk is leveraged trading has gone through the roof.

Business Standard notes that Vodafone was forewarned that their transaction with Hutchison would be taxed. This communication seems to have happened in March 2007, a few months before the Hutch transaction was completed in May 2007.

Finance Secretary R S Gujral had said in an interview with this newspaper on Monday that even before the transaction between Vodafone and Hutchison was completed, the companies were advised that the deal was liable to tax. A day later, Vodafone issued a statement that Gujral’s comments were completely untrue, as only Hutchison was contacted by the tax authorities prior to the closing of the transaction, but the communication did not give an indication that the authorities were re-interpreting the law.

Official letters exchanged between the tax department and HEL reviewed by Business Standard showed that in March 2007 the department wrote to the company, suggesting the Hong Kong-based Hutchison pay tax on capital gains from the sale of its stake in HEL to Vodafone. It was also said Vodafone was liable to deduct tax at source.

This is damning to Vodafone's case that it is being taxed retrospectively - a retrospective tax is only bad if you had NO idea at the time of a transaction that it would be liable for tax later.

I believe strongly that Vodafone did the deal knowing that the structure was setup only to avoid tax. That is, the deal between a Dutch entity and one in the Cayman Islands was only to transfer the holding of Vodafone India - the entity being transferred had no other meaningful assets or operations. Since this transaction was purely to avoid tax, the Indian tax authorities have every right to say they will tax it; but the means they adopted were terrible.

They lost the case to Vodafone in the Supreme Court, on a technicality, and then instead of saying they learnt a lesson and will tax any FUTURE transactions of this type, the finance ministry amended the law retrospectively. This shakes business confidence because now, along with Vodafone, everyone else needs to be worried about any transaction they undertake. Who knows who will piss off the Tax Department in the future and therefore alter the tax treatment of whatever is done today.

And it's not that Vodafone is the only party doing such deals. FIIs come in from Mauritius purely because there are no capital gains taxes there. This is again a transaction designed only to avoid tax, since the FIIs have no meaningful operations in Mauritius. It's a misuse of a foreign treaty, and the tax department would be very wise to close that loophole. But if they did it retrospectively, regardless of the honourable nature of their argument, all hell would break loose.

Think of IT and SEZs. It was designed to only favour "new" transactions created from that SEZ. Many companies (even Infotech) set up units, closed existing contracts and created new ones with the same parties from the SEZ units, purely to avoid tax. If the finance ministry decides that all such contracts will be analysed, retrospectively, and taxed, what happens? (Clue: Everyone's guilty)

However, with the revelation that Vodafone knew earlier that they should have withheld capital gains taxes from the Hutch payment and paid it to the government, the analysis changes again. It's not a small amount of money - over 10,000 cr. was just the tax part. If the tax department has pre-analyzed the transaction and then asked Vodafone it needs to withhold tax, BEFORE the transaction even took place, then Vodafone's outrage at the retrospective tax now is highly diluted.

I might sound like I'm making the debate for both sides, but my point is:

• Vodafone-Hutch only structured that deal to not pay Indian tax
• The fact that the govt. chased the case, lost in the Supreme Court and THEN did a retrospective tax to override that SC judgement is almost like slapping the SC on its face.
• Plus, the retrospective nature is strange, because already too many laws are unclear - they can "clarify" something and then tax everything going back 10 years.
• Vodafone though has no real leg to stand on, since it had been told even before the transaction that India intends to tax it.

So I don't feel for Bodafone, but I feel for all those who now fear the uncertainty.

I've moved to Bangalore, and have achieved one note of significance: Varun's school admission to a school that we thought would suit him best. To compensate, we now struggle to find a house to rent in the Sarjapur Road area (where the school is closest - my priorities are that the kids need to travel the least amount!) That goes on, so if you know anyone who has a house vacant in the vicinity, please do connect.

Coming to things more sanguine: I have been listed under people to follow in Outlook's cover story on Twitter, in the Corporate section. I'm not sure how I ended up there, ahead of much better corporate people, such as @agrawalsanjeev (ex-CEO at Big Bazaar) or @anandmahindra (of M&M fame). I will of course take all the credit I can get, so let me not be modest and say I didn't deserve it, even if I didn't.

One thing that worries me is the impact of the budget on foreign fund flows. Let's see what we know:

• We import a lot more than we export (The trade deficit as of Feb 2012 was $166 billion, much higher than the $115 bn same time last year)
• Just oil imports are $132 billion till Feb 2012 (figures are from April 2011). This is 41% higher than the $94 bn last year.
• We can reduce oil usage by increasing the price of fuels (especially diesel) so that people consume less, but there is zero political will for this.
• In the past, when the trade deficit was high, FDI and FII flows financed it. The dollar remained more or less fixed.
• Now, there has been FII outflows (though some inflows have come since Jan)
• FDI will likely slow down even further (it has been really small last year), with the budget increasing taxes, creating uncertainty with GAAR and other rules, and in general adding regulatory burden.
• This means: we can try to cut the trade deficit by reducing our consumption (imports) or we increase our exports. Both these look very unlikely, as there is no external incentive.
• That incentive can be provided by a depreciating rupee. Assume the rupee goes to 60 or 65 - that will force the government to increase oil prices somewhat, and will make consumption imports more expensive in rupees, and the higher prices will help cut demand.
• But the rupee depreciation creates other issues - apart from inflation, there are a number of corporates who have borrowed in dollars and now need to return it, but they now need more rupees to pay their loans back. If they default, that will hurt all Indian corporate borrowing.
• The RBI has sold dollars from its currency reserve recently to stem the depreciation. To keep reserve money (in rupees) from being affected, the RBI uses the rupees it gets to buy GOI bonds instead.

Here's one crazy but plausible course of action. The rupee continues to slide. RBI sells dollars to counter, but that doesn't hold up for too long. Oil prices in rupees keep going up and increasing the government's own deficit, and the government is forced to up retail prices. This creates a political problem, and more uncertaintly. A few corporates default (they'll do so anyhow, according to me). Interest rates remain high due to inflation, growth comes down to the point at which RBI can ignore it no more and then it cuts rates.

The next few months are interesting, and if it's anything to go by, I would stay away from PSU stocks or those that depend on government policy (like infra stocks). I don't see a trigger for a sudden, deep fall just yet, but there are global issues that dominate such issues, and there are enough problems abroad that can hurt us.

Just penning my thought process, in creating an investing plan for the next financial year.

Piramal Healthcare has sent me an email asking for a vote on a resolution for appointing Ajay and Swati Piramal’s son-in-law as an executive of the company. I’ve got a gazillion different resolutions earlier – for different companies – but usually they send you a postal ballot paper with explanatory notes.

This time, Piramal Healthcare let me vote electronically. They sent me a mail with a user id and password, and an electronic voting number, which I could use at www.evotingindia.com . I also got the resolution copy as a PDF attachment.

Using that and voting was a breeze – log in, change password, write in the number of shares you own in the “YES” or “NO” column, and click submit.

This is so much easier than the drudgery of using post – first they send you a letter (to an address you have forgotten to update with your broker), and if you get the letter, you have to fill it up, and post or courier it back. Which is why most shareholders don’t even bother voting. At least this e-process will make voting easier.

What remains to be seen is – if this gets popular will it get abused (as in people putting proxy votes if they know userids/passwords) and secondly, will people even try to understand resolutions before voting? But then you can’t diagnose a disease until you remove the barricades leading to the hospital.

Vodafone has won the case against the Income Tax department, with the Supreme Court ruling that the IT department has no jurisdiction to tax Vodafone.

Vodafone had acquired Hutch a few years back for USD 11.2 billion, and the acquisition wasn’t in India; the owner of the Indian company was a Hong Kong company (Hutchison Group), and the transaction was in the Netherlands/Cayman Islands. Effectively since there was no money exchanged in India, no one should have been taxed by India. But the IT department maintained that this was effectively a sale of the Indian assets so capital gains would apply, and Vodafone would have to pay.

This is strange, for multiple reasons. Firstly, it is never true that a buying company is responsible for capital gains tax – it’s always the seller. The reason the IT department targeted the buyer – Vodafone – was that they couldn’t do a darn thing about the seller, which was a Hong Kong company. This is stupid because you don’t go after someone just because you can’t go after the real culprit.

As an aside: This reminds me of a story of three teams of cops – British, American and Indian – sent into a forest to capture a lion. The American team brings a lion within an hour. The British team comes back in 2 hours successfully, but there’s no sign of the Indian team even after 10 hours. Fearing the worst, the camera crews and rescue staff go into the forest to find the Indian cops roughing up a bear tied to a tree, saying, “Now admit you’re a lion”. ( “Bol Tu Sher Hai” )

That sounds like the IT department in this case – when it can’t find the real culprit, catch anyone in sight.

Secondly, the issue was about the Indian assets being transferred, by virtue of buying out the owning company. But similar tax rules should have applied when Merrill Lynch was acquired (effectively) by Bank of America – effectively, BoA should have paid the capital gain on whatever ML owned in India, even if the merger was between two companies abroad? And so on for every single merger? Doesn’t entirely make sense.

(Btw, these structures are also used when transferring property – use a company to buy a piece of property, and when you need to sell it, sell the company instead. The idea is to avoid the 5% to 7% stamp duty on property transactions.)

Also, since tax havens have been used, it could be that this deal is unique in that it is executed abroad purely for the sake of avoiding Indian tax. This will be a problem in the new Direct Tax Code, even if this particular judgement went for Vodafone. But the IT department will have to go and hit the "seller” for the tax, in this case, the Hutchison Group. I wonder why a case against them hasn’t been initiated already.

The win also positions Vodafone well for an Indian IPO that they are planning. Also, the clarity is useful in that buyers can’t be chased for cap gains – sellers may still be on the dock for it.