Podcast EP37: The hidden risks to the financial systemPodcast EP37: The hidden risks to the financial system

[podcast]

 

Are the recent problems - GME, Greensill and Archegos - signs of a damaged financial system that is so terribly fragile that a slightly bigger disaster can easily crush it? Like what Covid has done to the world's health system, are there more hidden risks in our financial system that can trigger a repeat of 2008? In this episode, Deepak and Shray explore what's happened in the US over the past few months, and examples of hidden leverage within India - from Harshad Mehta to Karvy, Zee, DHFL and more.

Preview

"There are 169,000 crores worth of futures open as of this moment in the stock market. Which sounds great, but here is the thing. The guys who actually manage this entire settlement process on the exchange is the Clearing Corporation for NSE - the NSCCL.

They reveal the results every quarter. In that quarter they tell you there is something called a settlement guarantee fund. As of December 2020, this fund is about 3400 crores."

"So they have only ~2% of it, which is 3400 crores as capital. Now banks in India are required to have 10% capital against the loans they lend. It actually means if out of this... if 3400 crores go bad, just 2%, the settlement guarantee fund of the Clearing Corporation is finished. Now how does it settle?"

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Full Transcript

Shray: Hi everyone and welcome to episode 37 of the Capitalmind Podcast. It is a bit worrying out there, when we look at the number of Covid cases. That graph looks awfully steep, and I guess, we are in the nth wave right now and just waiting to see how this pans out and whether vaccinations will get into our hands fast enough or not. But as we look back at this year, which is still surprisingly 5.1% up on the NIFTY, as Deepak just showed me. We are starting to see some signs that do not look all that happy in the financial markets.

And so, while all of us are sitting and worrying about what may be the next crisis in the health system could be like, we thought we would just take a critical eye at the last couple of months and try and look at what could be some potential risks or cracks in the financial system.

So, Deepak, Welcome! once again! And as you said, we are going to start off with three stories, which is actually one of my favorite House MD episode titles. So, let us hope that this episode does as well as that one. So, Deepak, let's start. Three stories you said, right? That is how we will start. Three stories of things that have happened since the start of this year in fact, and which might talk about, what is a somewhat more fragile system than we thought it was. Please take it away.

Deepak: Thanks! Firstly, Shray and I really hope that the cases apart- the health system does not have the same kind of issues as the financial system seems to. And the first story I want to talk about is a one that has been made famous by the Reddit crowd the Subreddit crowd, or GameStop or Wallstreetbets.

And you know, the weirdest part of that system is that you would not imagine that a small thing like GameStop would impact the world’s financial system in any meaningful way. And it is really so small. Then you see these little things and I will take you through the story.

So, it started off with this system where you have got a company called GameStop, not particularly doing so well, but not particularly doing so badly either. You suddenly find out that, there are certain hedge funds which are short 140% of the stock.

This sounds like OK - Big numbers, but what does it really mean?

Now, if you have a company which has about say 5 million ~ 50 lac shares. It has 50 lac shares, there are 50 lac voting shares in the market and so on. But I own those 50 lac shares and you decide that this company called GameStop is going to go down and you say, ‘listen Deepak, can I borrow 10 lacs shares i.e  1 million shares from you?

I say fine, you will pay me some fee and I am very happy to lend it to you and I will lend it to you. You go and short sell this stock in the market because I have lent it to you and then somebody else buys it. Now I think I own 5 million shares.

You have sold it to somebody else. Let us call him Vashistha and Vashistha owns over 1 million shares. I think I own 5 million, Vashistha owns 1 million. So, there are 6 million shares in total, right? So now I have 5 million. He has 1, So 6 million, but there are only 5 million shares ever issued.

This is a 20% short. Now imagine this at 140% short. Does it effectively mean that there are 7 million shares short of a company who has only 5 million shares in existence. So, there are 12 million people who think they own shares of this company called GameStop.

Why has this happened? It is inherent leverage in the system. This is the leverage system, right? So, when you have 5 and there are 12 that actually exist. It is inherent leverage. It is allowed in the US. It is not allowed in India. India's regulatory system in this is far better. So, for a 5 million share company, you could not go more than 5.5 in total interest, which means only 500,000 only 10% of it can be shorted.

Shray: A little less than 140%.

Deepak: Yeah, a little bit less. So, I would say restricting leverage even to 20% was fine. In India you can do 10% in futures, 10% in short, so you could do 20%, but that is it. So, America has no such problems. This inherently created leverage. Now, you find out that these people are short, and how are they short?

They borrow shares, they pay a small fee, and they short those shares in the market. They use that money to do other things. Now in general, there is a lot of leverage involved here as well. So, the guy who shorts 5 million shares does not pay 5 million shares worth.

He has not put as much as 5 million shares worth. He puts only perhaps as a million shares worth, so he's further leveraged 5X. Now, people at Reddit figured this out at Wallstreetbets.

They said listen, you cannot have a company with 140% short exposure. This makes no sense at all. So maybe that made some other people think. They said, “if these people are so badly short, if the stock rises a little bit, the short people are going to be in losses.”

And in typical short-squeezes and we have talked about this in the Reliance episode before this and all that. In the short squeeze, the guy who short has to buy back shares. So, if you raise the stock price up, the short guy gets squeezed out and has to buy at a much higher level, makes losses and so on.

The interesting thing about this is that the subredditor, now, typically hedge funds play these games, but the subredditor who is a retail individual start to play the game and said let's take this stock up. So, GameStop from $20 a share started to move up to 25 and 30 and so on, but this was another interesting point. They did not just go by the point of saying I'll buy shares of GameStop.

They started to buy options. So, options are a leveraged creature. So now, I could say at $20 give me $50 options. That means strike price of $50, options of GameStop, which means I don't get paid until GameStop crosses $50. Now who's on the other side? The guy who sells me this option is probably a market maker or from a hedge fund or from a prime broker or from one of the big banks.

He's looking at this and saying, ‘listen, Deepak says he wants to buy $50 strike options of GameStop and is willing to pay me $5 for this. I'm happy to do that. Guess what, I will sell him these things. But what if GameStop actually goes from $20 to say $100, for whatever reason, I might lose a truckload of money.

So let me do this. I will do this hedging by buying shares of Gamestop, equivalent to the position that I would lose.’ And by a complicated mathematical formula, they will say that listen if I've sold Deepak 100 shares worth of GameStop options, at a $50 strike price. Because the strike price is $20, it's 40% of the overall thing, in a rough calculation I will buy 40 shares of GameStop.

Now, think of this, I pay say $100 for this Option and this induces the market maker to buy about $1000 worth of shares of GameStop. So effectively, my $100 forces the market maker to buy $1000 worth of GameStop shares. GameStop goes up to $25. Market maker says, ‘Oh my God, I need to buy more shares because now I'm closer to the strike price.’

He buys another $500 and then it goes to $30. He buys another $500.

So, my $100 of buying has pushed the market maker, to himself put $2000 or $3000 worth of money behind, just to keep his position hedged. And why would he do it? Well, he's only $100. Even if he puts $3000, interest rates are very low across the world. If he puts $3000 on his position and he earns a $100 of premium, as long as GameStop is below $50, he is fine. He has made 3%. And you know what? Even if it goes above, he is fully hedged, so it is fine again, so he still makes that 3%. He is fine with that. But what this has done, is my $100 has forced him to buy $3000 worth of GameStop- a 30X position. Hundreds of subredditors figured this out.

Shray: So that is a lot of leverage created.

Deepak: Yes, so they have just gone in and bought options, that options have taken the price up and $20 became $350. At $350, a number of these hedge funds that were short GameStop, obviously lost their shirts because at this point, the stock price is so high that their positions are losing money every single day and on the other side they are leveraged themselves, remember 1:5 and their brokers are telling them listen ‘if you don't cut your position, you got to pay as a truckload of margin money’. So, how do you cut a position or get money? If you are long, if you own stocks, you sell it.

Shray: You sell it, yeah?

Deepak: Sell it, Yeah. If you short stocks, you buy them. So, by the time it hits $250, they have been told, listen, ‘you got to put up margins.’ They go and say ‘no, no, we'll cut our positions’. They buy stock [that they are short]. Then they buy stock, the stock goes to $350, it causes a mini crash in other stocks also because while they do not want to buy GameStop because buying even a little bit of GameStop is taking it up a $100, they sell what else they own.

So, there is a mini crash in some of the big stocks as well. All because, some people in a subreddit, figured out that somebody is levered like crazy. They levered themselves up, by using options, added so much leverage more to the system that it brought a lot of people nearly to bankruptcy.

Shray: One question that comes to mind is, I do understand players you have mentioned so far, but when I look at it, one of the people who came out looking very poor in this episode was Robinhood, the brokerage. So where did they fit into this and how were they spaced?

Deepak: Yeah, it is amazing because you know what has happened after Madoff in 2008, was that people started to say, listen, ‘we cannot allow brokers, to use their client money as collateral for their positions. In the US also like India, there is a T + 2 settlement, which means if you buy shares today, you get shares two days later.

Unlike in India, in India, by the way, if you take a position and now of course the two days, there is a risk who handles that? The answer to that is if I buy shares and the other side does not deliver shares, then there is an auction mechanism. The stock goes into auction, the auction is played through and whatever is picked up in the auction, the shares are given to me, so I do not lose money.

If there is nobody available to take shares on the auction, then the money plus 20% as a penalty is given back to me. So, I paid my money. But there is still this factor that there is a two-day lag. How is that solved? In India, they created this rule that said, ‘well, you know what? You shouldn't use client money’ and why shouldn't you use client money is because Karvy mishandled client money and used client shares and perhaps client money as well, to use as collateral to borrow for itself.

So even in India you cannot use client money, but there is a little bit of an exception which says if you are paying for a share, you can pay in with the client money on the same day, otherwise, the brokers funds are blocked. In the US, there is no concept of this early payin concept.

So, the broker Robinhood, has a lot of customers who are subredditors, they go and buy these shares. Now, because the US does not have this early payin concept, the broker Robinhood has to cover for those two days of risk on its own. So, what happens is, there is a clearing company in the US which is used by a lot of brokers. Now clearing Company says, ‘Well, Robinhood, if you are clearing with us and a lot of your customers have bought this share, how are you going to assure us that should the other side not pay up, you're able to buy those shares in the market’. Well, Robinhood says, ‘fine, I'll pay you some margin’ and this margin is based on the volatility of the underlying stock.

But GameStop stock is going up from $20 to $40, $40 to $80, so it is going up 100% a day. So, the market maker or the clearing agent is probably saying, ‘listen, you can't just give me like a dollar or $2. You gotta give me $20 as margin, just to be able to keep these positions on.’

Robinhood does not have the money because it never estimated that it would have to deal with so much collateral to be paid.

Shray: Yeah, I thought it was a marketplace inside.

Deepak: I mean in that sense, the Indian system is far superior, but of course we have just had a Karvy, so we should not say that it is phenomenal. But I do think that over here, at least the leverage was restrained. So, what happened was Robinhood, unlike the bank brokers, did not have access to insane amounts of capital, so the big broker bank, broker dealers like Goldman or any of the others would not have had this problem because they have access to funds. But unfortunately, Robinhood did, and so it had to go suddenly and borrow money.

Shray: And stop customers from buying more and so on.

Deepak: Yes, it had to stop customers from buying more because for every new share that was being bought, they had to put in their own capital. The problem with this whole system was, it started off with one form of leverage and another form of leverage that countered the first form and now suddenly the broker gets impacted.

The broker himself which is levered maybe 4x-5x because he has to put margin against trades that are happening, suddenly gets a margin call, because stocks are going up too fast. So, Robinhood then has to raise capital, has to dilute himself. He has to raise a billion dollars overnight just to survive. This was a very interesting point, because it was the fact that nobody even knew, that this entire system was leveraged to this extent, right? And we will hold that thought because at some point this will come back to us in multiple ways.

Shray: Yeah, I think the words ‘who knew’ are going to be repeated a few times in this podcast.

Deepak: Yeah, it is amazing, because GME itself is not a stock worth talking about, in any meaningful way and there is no reason why a GameStop should bring a financial system, a Robinhood, even Interactive Brokers to a halt, and the answer seems to be it did.

This was because of these crazy levels of leverage by the hedge funds, by the financial system, by their redditors through options, where the market makers of those options - everybody indulged in this form of leverage that magnified a problem that was maybe a billion or $2 billion in size to $40, $50 billion and we will keep that as a note because this happened in February this year.

Shray: Yes. So, I think the second story you wanted to talk about was Greensill, right? How did that pan out?

Deepak: So, interesting concept again! So, ...[earlier in the Subprime crisis], the idea was that people were subprime, they did not have enough money to pay loan. But if you somehow combine all these people together, they would somehow not default on the loans, at least not at the same time and then you put them together, you package them as a security. You sell them to somebody, that somebody says, ‘well, you know what? I am not buying just one such security, I am buying 10 of these different pools of security’ and the credit rating agencies were complicit, etc.

What happened in Greensill was that it finances for something called receivables. That means if you as a company were, let us say saying ‘Nike has to pay me $100 million, why don't you give me a loan, of say $90 million and take my 100 million receivable from Nike in six months and then you can keep that entire $100 million.

Shray: That sounds like a great business.

Deepak: It's fantastic because sometimes you can get upwards of 18-20% because put to another way, if my profit margins are 20%, I could reduce my profit margins to 18% and give you those remaining 2%. If that 2% comes to you in a month, it's effectively a 24% interest return on the money. [annualized]

So, you are fine doing that except Greensill was financing a bunch of companies and one of them was this company called GFG by Sanjeev Gupta, the steel magnate and aluminum, alternative energy and all sorts of things, and bid for a bunch of companies in India as well. The interesting thing about this was that GFG would get financed from Greensill.

And how would Greensill finance it? It went to banks like Credit Suisse which created a structured product to buy out these receivables which were packaged into a securitized product. Similar to the way Subprime loans were packaged. So, Credit Suisse sold to its customers a fund and then on top of that gave Greensill a loan of $140 million as well. That money was used to pay GFG for its loans and a bunch of other people. Well, it started in a weird way, where one company in Australia said it will not insure the loans that GFG had taken or Greensill had taken- one of those securitized products.

This caused a lot of investors to lose interest in that product because without the insurance it was notalled  as attractive. At the same time, a German regulator cBaFin said, ‘listen, who are you financing these receivables of? Can you really tell me for sure if this is real?’ They go in a little bit deeper and find out GFG has actually put receivables into these securitized products where they started billing customers before they were allowed to.

Shray: Let us call it slightly aggressive accounting.

Deepak: Well, yeah. I mean, until we find out otherwise and we can name that this was actually illegal, we believe that their problem was that they were aggressively accounting. BaFin came down heavily on Greensill and said ‘listen, either you put in more margin on loans or don't do it.’

The problem now was suddenly Greensill blew up because if it was not able to raise money from the likes of Credit Suisse, it was not able to finance GFG and it was not able to earn anything and therefore it said, ‘listen we are done.’ GFG, which is the recipient of this effectively leverage trade is suddenly in trouble because it does not have money. It announces publicly that listen if Greensill kind of financing is not available to it, it will go belly up.

So, you have got a system that did not seem like there was leverage, but there was leverage all over the place. There was a fact that somebody was giving money. So, GFG could continue to pretend they were deliverables? Greensill would continue to roll them over forever. Whether those receivables came or not was not even the problem because you could finance a receivable by giving that receivable more money.

So, effectively you could keep rolling it over forever and it would look great until somebody found out and the shit hit the fan and this leverage was inherent in this entire equation. It has hit the fan. Again isolated case, you should not have a problem, but suddenly you are seeing this problem and this happened in February and March of this year and you are like, why is this happening now? Why is such a small problem creating such a big issue?

Shray: Yeah, this keeps coming up in the Financial Times with some political affiliation. I have never been able to quite understand it, but I get your point. It feels that it should be small.

Deepak: It should be small, but it is the third story then makes it even more interesting, which is the market also.

Shray: Well, this one actually said big numbers.

Deepak: Yes. So, Bill Hwang, a Tiger cub, a guy who had made a lot of money for Julian Robertson striker in Asia, they had to shut down Tiger Asia Capital after there was some insider trading cases against them and so on. So, he went in and said, let us become a family office. Now, family offices are weird extra that is allowed. They do not necessarily have to disclose their own positions with anybody, simply because there are a family office and privately owned and therefore no public money is involved.

So, let us say I am a family office and I come to you Shray and suppose you are an investment bank and I say, ‘listen, I want to buy a certain stock and maybe it is called Viacom, CBS, Discovery Channel or whatever it is. I say I want to buy this stock, but you know what? I do not want to buy this stock. I want you to pay me a dollar if Viacom goes up $1.00 and I will pay you a $1 if Viacom goes down $1.00.

Shray: There is a name for this, right?

Deepak: Well, in India it's called a Dabba trading. In the US it is called bucket shop. So, you do not actually have an underlying position. The other side says, ‘listen, I will pay you if it goes up or goes down and typically people lose money, but you know they are dabba shops and if people don't lose money, then these dabba shops vanish.

Shray: Here we are talking about a fairly sophisticated one.

Deepak: Yes, and dabba trading is illegal in India, so are bucket shops in the US. But bucket shops with people wearing suits and ties like Goldman Sachs is allowed, because people wearing suits and ties can never get you wrong, right? I mean you come on, you are always in the right side of the financial system if you are wearing a suit and a tie.

But the point here is what would happen was a Goldman would look at this and say, ‘well, fine, I will pay you a $1 if Viacom CBS stock goes up, you pay me $1 if it goes down South, how much you going to give me?’ He says, ‘well, I'll give you a $1 million’.

‘Well, if you give me $1 million, I will buy $1 million worth of Discovery shares.’ ‘No no, you got to buy me $5 million. Do not worry, if Viacom goes up you are paying me a $1. If it goes down just for 20%, I lose my capital, so why don't you give me your 5X leverage?’ Goldman and Nomura and Credit Suisse and Morgan Stanley all said, ‘yes we will do it because there's lots of fees here, we can tack on and make lots of money.’ Viacom’s stock goes up 75% between January and March.

Shray: And this is perhaps from this person’s buying.

Deepak: Yes, and here's where it gets peculiar. 29% of CBS stock i.e Viacom CBS Stock was owned by the banks. Now, why would a bank own this kind of stock? The answer was when I tell you that you are a bank and if the stock goes up $1 you have to pay me a $1 and if it goes down, I will pay you a $1. The bank has to hedge its risk. It then goes on its own book and buys the shares as the hedge.

If I were to set up a position which was 29% of a stock by buying it directly, I would have to disclose the hell out of myself. So, I would have to tell them at every 5% and then every 1% increment that I am buying more stock. But if the bank, does it as a hedge against positions that its clients have, nobody asked questions because banks do this all the time.

Except, there was a stock, I forget the name, where the banks collectively own 60 or 64% of that stock. No, you cannot have a set of banks with 65% in the stock. You are the market. So, the banks kind of realized this, got together and said listen, ‘can everybody tell each other our positions? And who is the end client here?’ They figured out it was Archegos Capital which was family office of this guy called Bill Hwang and everybody knew who he was. Goldman and Morgan took the route of saying ‘I don't care what happens. This is too much of an exposure and either Bill Hwang gives us more money...’

Now what was Bill Wong doing? He was saying, boss! I took this stock 75% up. So, if I give you $100, you give me $500 worth of stock equivalent derivatives called a CFD (contract for difference). You then went and bought stock. I do not care because I am like, ‘OK boss, I have got my exposure.’ You give me $500 of exposure stock is up 75%. So, by now you paid me another $375 and I have taken the $375 and bought another 5X version of the same stock.

So now I have like (375 + 100) is 475 X 5 times nearly $2,500 worth of stock that you have in your name, but I am getting exposure to.

Except Viacom CBS said ‘listen people are going mad about our stock. Why don't we just issue some more shares because we really need the money.’ They announced a stock offering. At the same time a bunch of other things happen. When people hear about the stock offering, the stock price starts to fall.

Shray: This happened to Tesla also and they seem to defy gravity incessantly so.

Deepak: Interestingly, Tesla has had multiple situations of a similar kind. But to come back to this, these stocks are to fall and when they fell about 10 to 15%, these banks got together and said, ‘what's our real exposure?’ Then, somebody must have tripped a fuse and said, ‘come on guys, we cannot be owning 64% of a company, against one guy's position. That guy owned 64%, but he doesn't because we own it in his name on behalf of him, but not actually for him, because we have a CFD against this.’

They said ‘listen, we got to liquidate.’ What Credit Suisse and Nomura said was ‘let us talk to Bill Hwang, negotiate, maybe he'll bring in the money, maybe he'll do something else.’ What Goldman and Morgan said was ‘we're getting out’. They have learned from subprime crisis that the first person to get out is the best person to get out. So, they just dump this stock as fast as they could. The stocks fell 30-40% on a single day and Nomura and Credit Suisse were left holding the bag. I think they each have a $2 billion hole.

Shray: I guess we will find out at the end of the quarter, right. Oh, the quarter is over., so we will find out...

Deepak: Yeah, we will find out very soon enough. So, the interesting thing is this leverage is completely unknown. A bank owning 68% is not forgivable, especially if it owns it against the same person’s exposure and they did not have any real disclosure requirements. So, you have this massively leveraged position. You have had a person with $8 or $10 billion worth of money, which has been levered up 5X, so it’s $50 to $60 billion. Now 50 to 60 is a serious amount of money and whatever you say, it can bring down a lot of the financial system just by being what it is. This may not have resulted in a massive crash so far, but think of this, you got a GME, you got a Green Sill and you got Archegos, in three months.

Shray: Each time you are looking at it and saying one off, one off.

Deepak: Yeah, we say it is one off, one off, but is it really one off? Is it a sign? and is it a sign of something that is deeply embedded in our system which we do not realize and it is coming out like before a volcano there are these little earthquakes, and then eventually the final thing comes out. But anybody who knows volcanoes erupting, knows that the earthquakes are the signal, not that suddenly you have a volcano erupting.

Shray: OK, I had no idea about this, but I will Google it after this podcast, but I get you.

I would like to make a quick digression here.

You have mentioned that India's regulatory framework is far superior, right? I know, Obviously, things can go wrong here as well, but at least on the identifiable risks we seem to have done pretty well. You had made it clear on GME, where you said we have limits on how much leverage can be there and short interest can be there in a stock and it is not left to the broker necessarily that the broker has an early paying facility and then there is someone else behind them, some centralized agency who can handle this. On Greensill and Archegos, could you tell us, how does India makes sure that it does not happen here so far?

Deepak: So, to that extent, for instance, Archegos, the issues are different, in a sense that you have had a system where you have these contracts for difference and in India, a bank cannot even own more than 10% of a company.

Banks together collectively, if they own so much, you will find out in regulatory things, and you know people will talk about it. Contracts for difference in general like this will be caught very early by the banking system itself.

Greensill also like for instance, if you do not have cash flows at all, the banking system has connived to reduce that kind of leverage quite substantially, but by different mechanisms. So, you have large corporate exposures, they are shared between the banking system, and banks know that a company has loans by somebody else, and some of these securitization products are not allowed in the format that they are allowed in the US or in the West.

So, a lot of our regulatory mechanisms reduce the impact by just bringing in our leverage. So, saying, ‘oh, you can do this, but you can do this only 20%’. So, people are like oh come on quit 20%. What is the point! So, they do not do much of it, but the point is, it protects your system, from having people with 140% shorts with Greensill level of refinancing receivables forever and so on. So, that part is one, but the important part is this- despite India having the regulatory framework to address these and having just gone through a Karvy, having addressed it in a different way, no rules in America have changed.

So, you still have the possibility of a 140% short and you still have the possibility that swaps like Archegos are not required to be disclosed. They haven't changed the rules, although the shit has just hit the fan. How long does it take and if it takes long then there are more things waiting in the racks.

Shray: Yeah, so that was actually I think, the next point you wanted to say. Well, without being overly dramatic, you are saying this is how things felt in 2007 in that regard. There was one bad incident. Couple months later, another one and each one is reasonably dealt with by the regulator at the time or by the market participants at the time. But eventually it just cascades and becomes bigger and bigger and then eventually everything falls apart. I just want you to talk a bit more about that. I mean what happened then?

Deepak: So yeah, I mean Shray where we started off in 2007 was system where in 2005 housing prices peaked. Interest rates start to go up roughly in 2006 and in 2007 something strange was happening. The stock markets were going up, the housing prices were kind of flattening out and a certain set of products called subprime loans, which were being packaged into this securitized MBS and CDOs were being bought by everybody including some money market funds typically equivalent in India would be a liquid fund or really short-term money market fund. These are funds which are not supposed to go down any day. So, what would happen is all these funds would have a NAV of $1.00. And when they went up, they would pay a dividend equivalent to how much they went up every day.

Shray: As opposed to letting the capital appreciate...

Deepak: Letting it appreciate and then every day the value of it would be $1.00. Two funds from Bear Stearns which were invested in apparently some of these subprime securities went below $1.00 because the value of the securities they held fell. Because the underlying loans of them were starting to go bad.

The mutual funds which were not supposed to lose money started losing money, which means they broke the buck. This was July 2007. Everything was hunky-dory, two funds go down, everybody is like, “excuse me, you're not allowed to see this happen. How can this happen?” “Oh oh, we'll rescue this. We will do this; we will stop redemptions. Everything was quiet or about 6 more months.

In six months, Bear Stearns goes bust because of its exposure to subprime. Everybody looks at it and says, “well we got to rescue it. We got to do something. Oh no, no... we will not rescue it per say. We will let the shares go down. Let us JP Morgan take over the company.”

Meanwhile, India stock market crashes 40%, then comes back up 35%. So, we are nearly back up to the same point in March when JP Morgan makes this offer of $2.00 a share and the Fed chair says, “no, you have to pay 10”. And he pays 10 and again, everything is fine for a couple of months. Now you are seeing chinks in the armor. Something is wrong. Sub-prime is going seriously down, and it is hurting. To the point where me as an external tiny little observer in India was saying that this crazy stuff is going to hit the fan next year and that was November 2007. By about July 2008, you had started to see this go across the system. A lot more banks were impacted. People are talking about the failures of various financial institutions.

Now remember the first signs of these things that come in July 2007. It took till September 2008, before Lehman went down. Lehman went down, MF Global went down, Bank of America and Merrill Lynch merged and a bunch of things.

So great financial institutions were on the verge of dying. And it was not sudden. Everybody knew it for roughly a year before that. We were seeing signs and seeing cracks in the system. Our current problems, which are small otherwise – GME, Green Sill- are these signs of a damaged financial system that is so terribly fragile, that tomorrow a slightly bigger disaster can easily come and crush us back to the same kind of levels. Maybe not as deeply as Lehman going down because nobody is going to let a big financial institution go down anymore but brief enough to hit us financially. Unlike covid hit us with health-related issues, but will this system as a financial system itself, hurt tremendously?

And, I keep giving these US examples, but I can tell you this. If the US system has an impact, then even if it sneezes, India will catch cold.

Shray: Yeah, I think you had mentioned that even though we have made very significant efforts to have stronger regulatory frameworks, less leverage and so on, we are not immune. Both, we are not as strong in economy in the 1st place, but in addition to that, there is undisclosed leverage here as well.

Isn't that right? I mean, what comes to mind when people think about undisclosed leverage in India.

Deepak: Yes, you know this is an interesting point. Let me give you one example. So, we have talked about undisclosed NPAs, for instance, which has been recently overridden by the Supreme Court. It is possible that the Supreme Court's decision will cause India to reveal the true nature of NPAs that they are. Even the RBI is saying, “listen we are at 8 lac crores of NPA and it is going to be a 13. A 5 lac crores is a lot of money and we know this. This is not undisclosed. This is available to us and we know it is coming.

The point is, what is undisclosed? I'll give you an example. So, if I have 100,000 shares of TCS, I might say I have 30 crores because it is ₹3000 a share. I have 30 crores worth of money. I do not want to sell my shares of TCS and lose the exposure. I want to still own TCS.

But I want some money for maybe a year to borrow against it. They say, “well, who's going to give me money to borrow against?” The answer was, “well, you could go to bank.” You go to a bank and the bank says listen my max is 10, may be 50 lacs so nothing more. I'm like, “dude, that's not even going to make my life... can't even invest in a Swiggy anymore”

So, there is no point. So, I move away from that and I go to an NBFC and NBFC says, “fine, you know what? Give me 30 crores worth of shares. I'll give you 15 crores.” Little better but you are thinking, “OK why only 15? I have 30 crores of shares. Why are you giving me just 15 crores worth of money? I want more.

How do you get anymore? So, before a few years earlier you would have the ability to issue a bond. Against which you say, “I have 110% of stocks!” So, there was a guy called Subhash C

handra who owned a company called Essel. Well, he still owns it, and he is still there. His company Essel went and said, “listen, we own Zee TV shares, and we own Dish TV shares and we will take 100 crores of a loan and we will give you a 110 crores of Zee and Essel. A lot of mutual funds - Franklin, HDFC, ICICI Prudential - all of these guys said, “well, such a great man Subhash Chandra , good company...so you know what? No loans and all that. But yeah, the Essel company wants some money. So why don’t we give it to them.”

And shit hit the fan. The stock fell.

Shray: So, this was done out of respect for promoter and the fact that company is supposed to be a good company.

Deepak: Plus, I have collateral of 110%! But the point is nowhere else we are getting this good deal - I have 110 crores. I can get a 100 crores of cash for it.

The problem was when the stock started to fall, a few mutual funds like Reliance sold it. Now the rest of them tried to make a deal. They did all sorts of things. They eventually did get most of the money back.

But, in the process, the stock had fallen quite tremendously. If you give me 110 crores worth of stock for something that, I have given you 100 crores against. Then the stock falls 10%. I now tell you, “listen, you got to give me another 11 crores because I still want to make 1.1X.” You do not have that 11 crores of cash or you are going to give me more shares. If you do not have either, then I am the one who is hurting, not you. So, when people did this tremendously and you know overtime, you had a system which was allowing people to borrow too much money against stock.

So, what Sebi did was, said “listen, we recognized this has happened in the past, but the max you can do from now on is that minimum you should have is 2X.” Which means if you give me 110 crores worth of stocks, I will give you 55 crores. Suddenly it was not attractive anymore.

So, you found this - as a way to break leverage you went up.

But it is still an item. I'll give an example.

I have 100,000 shares of TCS. I go to the market and I tell you, “Shray, so you're a broker. I will give you this 100,000  shares of TCS. You sell them.” And what I will do then as a client of your, is I will buy 100,000 futures of TCS.

Now to finance 100,000 futures of TCS, I have to give you cash of only maybe 6 crores, 20%. Out of that, half of that can be in stock. But assuming that I gave you even the 6 crores, you would give me 24. So, where a bank is giving me max 1 cr, the NBFC is giving me max 15 crores, where even a bond market is max giving me 15 crores. I am able to go to the stock market and get 24 crores of money for the same thing. I am long the futures, you are short on the futures. If the stock goes up you have to pay me, if a stock goes down, I have to pay you. It does not matter because we are both known to each other and you are now financing me.

How am I paying the interest? Every month I roll over the future at a slightly higher cost, you get an interest rate for it.

Shray: So, you still manage to, in this hypothetical example, you retain the exposure to the TCS shares that you had, and you have got this amount of leverage. And the broker is happy because the brokers getting like business and whatever.

Deepak: Yeah, 20% and you know fairly great guy called Sharad Shah is the person who revealed this to me. And I was like, my God this is right because... OK who is behind this? Who finances these trades? There are 169,000 crores worth of futures open as of this moment in the stock market.

Which sounds great, but here is the thing. The guys who actually manage this entire settlement process on the exchange is the National Stock Exchange.. Clearing Corporation (NSCCL)...and they reveal the results every quarter. In that quarter they tell you there is something called a settlement guarantee fund. As of December 2020, this fund is about well around 3400 crores.

Shray: So that is like 2%, right?

Deepak: So, if you take a...forget the stock market, forget anything else, just take the futures open interest - 170,000 crores. They have only 2% of it, which is 3400 crores as capital. Now banks in India are required to have 10% capital against the loans they lend. It actually means if out of this 170,000 crores, if 3400 crores go bad, the Settlement Guarantee fund of the Clearing Corporation is finished. Now how does it settle?

OK, let me give you an example. There are three stocks. Bharti Airtel, Reliance and ICICI Bank. The futures against these three stocks are 5000 crores each. There are 5000 crores worth of exposure each. Let us say all three of them fall 20% in one day. That is just the three of them. That means that each of them sees a 1000 crore fall. So, the guys who were short the futures must get the money. The guys who were long the futures must pay the money.

For some reason, these brokers of the clients who were long these shares find that their clients are bankrupt. They have taken some money as an advance, but it is not enough, and they end up losing, maybe out of the 3000 crores they lose 2000 crores. The brokers themselves do not have the ability to pay, so they go bankrupt.

Now, who pays the 2000? The answer is the Settlement Guarantee fund of the Clearing Corporation. Which is only 3400 crores. So, you have lost half their money on just a 15,000-crore exposure going down 20%, which is such a tiny thing. So, imagine if the whole 170,000 crores see a shakeup of say 10 or 15%. The Settlement Guarantee Fund is in no way enough, to be able to cover the damage that steep fall has caused.

We have not seen this in the recent past affecting us, but tomorrow if it did, would it be because we were blind to the fact that this kind of leverage exists? The answer is people can go to the market and borrow at 80%, which means putting only 20% down. The fact is that there are 170,000 crores of futures in the market - open interest- waiting in the system.

The fact is that the only thing backing this whole thing of course, apart from a broking infrastructure and so on, is a Settlement Guaranteed Fund which is only 3400 crores. Why are we not mandating a much higher settlement guarantee fund of say 10,000 crores? Even a 17X leverage is much lower than a 50X leverage. Currently we have 3400 crores.

So, sometimes these things are not visible to us. But when things really go bad, they will go back and say, “Oh my God, why was it only so low?”

Our regulations may be very good, but I do not think they are enough. Yet. And we are going to need more, and the SEBI is constantly working. So, they have tried to reduce intraday leverage.

They have reduced intraday leverage already twice and in another six months, we are going to see intraday leverage reduced by half again. So today you can have a maximum of 10X leverage. In six months, you can have a maximum of 5x intraday leverage.

This is great because the systemic leverage coming down is a good thing. The same thing with a lot of other things that the RBI is doing which is helping bring down unnecessarily excess leverage. Some of it is in the form of...I mean they have not yet cut, for instance housing leverage.

We have a stock like Dewan housing. I will give you an example of what happened over there. So, what happened over there was that the NBFCs were told, ‘If you lend 10,000 cores, you got to have at least 1000 crores in capital’. Now Dewan Housing said ‘listen, I have 1500 crores in capital.’ How did you generate that cap?

A very interesting instance. They took this company they had, which was DHFL General Insurance or Life Insurance, (one of them I forget what it was) and they said “listen, we are going to sell our stake to this buyer for 4000 crores. Everybody clapped and said, “fantastic because after tax you're going to get 3000 crores and that's going to sit on our balance sheet and is going to give you the ability to show great capital ratios. "Except the buyer was a company called Wadhawan Capital which is owned by the same founders as DHFL.

So, what was this deal? Wadhawan capital had to now pay 4000 crores to DHFL? I do not know the exact number, but I am giving you the (illustration). So, they got 4000 crores and paid it to DHFL. Where did they get these 4000 crores from?

They went to a mutual fund and said, “listen, we will issue bonds because we now own this fantastic insurance company.” The Mutual Fund started laughing their heads off. When they stopped laughing, they said, “listen give us more than an insurance company. We have no idea what that means.” So, they said, “listen, here's the deal. We have bought it from DHFL, which is our own company. And we made a deal with DHFL saying that ‘listen in two years if we're not able to find an external buyer, DHFL will buy it back from us.’

So DHFL gets the 4000 crores through this angle of these mutual funds financing Wadhawan, Wadhawan then paying DHFL. The mutual funds only contention is, ‘listen, if these guys can't sell this insurance company and we know that DHFL will buy it back’.

For DHFL, the point is this. I now have 3000 crores more capital. I pay tax on that 4000. I get 3000 more capital. I can now lend 10X that so I can do a lending of 30,000 cores on this capital. But this capital is not really capital because there is an obligation to buy it back.

Shray: So, when this works out, that 30,000 crores will generate enough profits to be able to manage all of this...

Deepak: Yes, except it did not. And DHL went bust and eventually all these shenanigans have come out. And this is one of the lower ends of the shenanigans. It turns out there is more shenanigans on the inside.

So, the point is not that. Point is that you created leverage because you now lend 30,000 crores plus the original 10,000 - so 40,000 crores against what, a capital of only 10,000 crores. The remaining 3000 crores was quasi capital. It was not really there. So, you actually generated a leverage of 1000 into 40 times where everybody else got the impression it is 4000 into 10 times.

And this is where the problem is in the system like. Every of India’s past problems as well. Whether it is Harshad Mehta. Remember the scam? The scam story is now coming out, but he had money that was unofficially leveraged. So, when I say unofficially leveraged, he had 500 crores that SBI had paid him. That money was supposed to go and buy government securities. Government securities would take 20 days to arrive. So Harshad Mehta said, ‘listen, why don't I use this money for 20 days’ and he would go speculate it in the market.

He went and bought a bunch of shares whose prices were to fall. Now he could have sold them and generated the 500 crores required to pay back SBI, except there was a strike maybe engineered in the Stock Exchange. He could not sell those shares. SBI, meanwhile, got to know and placed a complaint. Harshad goes to jail from where he cannot now sell those shares because they have been attached.

Now, the stock market may be open. He cannot sell them. Stocks are very low. He tries to make a deal with somebody at Citi and Citi says, ‘well, we give lowball a price for it, just about enough for you to just survive. He does not take the deal. The whole system falls.

Undisclosed leverage. Nobody knew where the leverage was, but everybody knew the system was tremendously leveraged. That was not all. More stuff like this that happened with Ketan Parekh. More of that happened with DHFL, with Karvy … so all of these cases are small pieces of undisclosed leverage that just resulted in the system weakening. And in India at least, that fragility has caused the regulators to build on more fortresses of defense.

It may hurt a few people who say, ‘how can we do it without intraday leverage of 50 types?’ The answer is, ‘well, you're going to have to, because what the regulator is doing is protecting against that massive fall, which each of these chinks open.’

What is the American regulator doing? Nothing. And like we have talked, it is not like America, if it goes down - if the American markets were to go down that India would be unimpacted...

Shray: Unimpacted, far from it. So that is a very worrying note to end on. We are working very hard to make sure things are under control here, but we are still too exposed. And as you said, this still hidden leverage here as well. So, I for one, really really hope you are wrong and then all of these turn out to be one offs - the Biden administration or the US or whatever over here. We manage to keep these as the stray anecdotes that never materialized. Unless it became a giant snowball downhill.

Deepak: Yeah, I hope so. Too bad because the problem really is you can always predict a doomsday. But the only reason why I am worried is because three things happen one after the other in this one quarter.

And I am wondering if that's 2021 for us the first three months. What else? I mean, you have had riots in the US White House. You had situations which you never imagined in the last one-year materializing. And suddenly you are staring at the rest of this, you know, rest of the financial system and saying, “Oh well, it's all fine. Let us just go buy stocks forever.”

There is a little more in it than I think we are going to be expecting.

Shray: Right, well, Deepak, on that ominous but watchful note, let us hope that you are keeping good care of all our customer’s portfolio so that we are all able to sidestep whatever garbage comes up again.

Deepak: Yeah, I hope so too. We are scared but we got to react more than predict.

Shray: On that note, thanks very much Deepak and thank you everyone for listening.

Deepak: Thanks, Shray, thanks again. Thanks all for listening to the Capitalmind Podcast! Cheers.