A 50-billion dollar lie

Dec 16, 2008

In this issue:
» Declining demand for investment banking services
» Ecuador's dubious distinction
» The dollar is losing steam
» HCL Tech purchases Axon. Did Infosys lose out?
» ...and more!

Bernard Madoff's US$ 50 bn scam which he himself calls a 'Ponzi* scheme' and 'one big lie' is a truly international affair. Sample the following list of victims with their nationality and amounts involved as per Bloomberg: HSBC (UK, US $ 1 bn), Nomura (Japan, US$ 302 m), BNP Paribas (France, Euro 350 m), Banco Bilbao Vizcaya Argentaria (Spain, Euro 300 m), Banco Santander (Spain, Euro 2.33 bn), Royal Bank of Scotland (UK, US$ 601 m), Natixis (Paris, Euro 450 m), Man Group (UK, US$ 360 m), UniCredit (Italy, Euro 75 m).

What's even more startling is that apparently, Mr. Madoff had advised the US Securities and Exchange Commission on how to regulate markets! Rampant corruption in India has given rise to scams every now and then, which has not really been the case in the US. But when it comes to the size of the fraud, US certainly takes the cake!

* A Ponzi scheme is a fraudulent investment operation that involves paying abnormally high returns to investors out of the money paid in by subsequent investors, rather than from the profit from any real business. It is named after Charles Ponzi, who became notorious for using this technique in 1903.

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Indians propose. The government disposes.

The Indian stock market has lost around 60% of its value this year. The rupee has lost 20% of its value against the US dollar since January. Not that the government is to be solely blamed for any of these. But it certainly shoulders a large share of the responsibility. The reason why India still remains relatively less affected by the global financial turmoil is the country's handsome savings rate.

Until recently India's investment splurge has mostly been covered by domestic savings. As a percentage of GDP, savings have risen from 28% in FY04 to 35.5% in FY08. This is a China-like level, and explicable by the same demographic change that China has undergone. India's bulging working-age population gives it a high ratio of earners to elderly dependents. Nevertheless, the government which is nearing the end of its term has left no stone unturned to splurge the nation's savings.

The policy makers have over the past few months been on a spending spree citing social welfare measures. Public expenditure has risen by over 20% YoY in each of the past two years. This has returned India's public finances to their traditional mess, after a temporary improvement thanks to buoyant tax revenues over the past three years. In fact economists expect a budget deficit of around 8.4% this year (nearly double the budgeted figure). The government's profligacy makes it all the more essential that it retains the confidence of foreign investors. The best way would be to surprise them with some long-awaited reforms.

The adverse impact of the financial turmoil almost brought the US down on its knees with everything right from house prices to the economy as a whole heading southwards. But there was a notable exception to this which flummoxed everyone.

We are talking about the rise of the dollar. While the world including the US was falling apart, the greenback incredibly gained considerable ground. This was more to do with the fact that investors perceived the risk of other countries to be higher than that of the US and hence the 'flight to safety' to the US dollar. The US economy has entered into a recession, but so has Japan and some countries of Europe. Even growth in the Asian countries has slowed down.

To put things into perspective, the dollar's rally lasted for four months gaining 24% along the way, as reported on Bloomberg. But the tables have now turned. The dollar has now begun to lose steam. The currency has weakened 5.9% measured by the trade-weighted Dollar Index after strengthening between July and November.

The US is flooding the market with money to bail out the battered financial system. What it will do to the already ballooning deficit is playing an instrumental role in the dollar's decline. In fact, Bloomberg reports that the consensus estimates for the dollar against the euro through 2009 have fallen.

Ecuador has earned the dubious distinction of being the first country to default since the credit crisis began. The country was due to make a US$ 30.6 m coupon payment on its 2012 global bonds by December 15, which was the end of a 30-day grace period that the Government exercised to examine the option of default.

Ecuador voluntary opting to skip interest payments means that the country will plunge headlong into a financial turmoil. The fallout of the same will be severe. Besides its credit ratings being slashed to default, its overseas borrowing costs will soar and foreign investment will most likely decline. What makes matters worse is the fact that Ecuador's default reflects more of its unwillingness to pay rather than an inability to pay. This means that negotiating a more favourable agreement with its creditors will be that much more difficult.

While 2008 is a year that investment banks will dearly like to forget, the scenario will only get tougher in 2009. Firms such as Goldman Sachs and Morgan Stanley have been cutting jobs, foregoing bonuses and getting a slice of the bailout package but come 2009 and things are not likely to get any better as the declining demand for investment banking services will continue.

As it is, these banks are expected to report losses during the fourth quarter and even if there is some semblance of a recovery in the stockmarkets in 2009, these will still have trouble growing due to their reputations having been tarnished. Thus, at the moment, investment banks regaining their former glory will seem like a long shot indeed!

Source: Yahoo Finance

One of the legendary investors who have lost huge money in the current stock market carnage is Bill Miller. His track record has been very impressive. He is the only fund manager in recent history who has beaten the S&P 500 for fifteen years in a row. But the recent meltdown in the US stock markets has done a big harm to his reputation. His fund is down nearly 60% as compared to 40% fall for S&P 500. Miller took a big contrarian bet on financial stocks at the wrong time. And this has hurt his performance. He has always taken concentrated bets. This time it was no different.

Concentrated bets were the reasons he outperformed every fund manager in the past. Concentrated bets are fine. But businesses with inherently sound models should accompany them. Not financial companies that have huge leverage ratios. Furthermore, they come loaded with exotic derivatives products these days. There is a big lesson to draw from Miller's experience. Do not take concentrated bets. If you take them, make sure the fundamentals of underlying businesses are inherently sound. The key word is 'inherent'.

HCL Tech has completed the purchase of Axon. So, did Infosys lose out on an opportunity? We believe not. By not paying a higher valuation than what it had earlier finalised, Infosys has been prudent enough to stay away from a bidding war against HCL Tech. Had Infosys decided to pay a higher price for Axon, the purchase valuation would have been higher than what the company (more valuable and much bigger than Axon) was itself trading at.

Given the concerns surrounding the global IT industry and the fact that a whole host of IT companies were then (and still are) available for attractive valuations worldwide, Infosys backing out from the deal was a wise decision indeed.

The Indian markets closed higher today by 2%. As far as the Asian markets are concerned, barring Japan and Indonesia, the other key indices closed in the green. The European indices are also trading in the positive currently. As reported on Bloomberg, crude oil rose by 1.8% to US$ 45.3 a barrel after Venezuela's oil minister said OPEC will reduce production by at least 1 m barrels a day. Gold fell by 1% to US$ 833 an ounce as a 9% gain in seven sessions propelled some investors to sell.

 Today's investing mantra
"We've long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie (Munger) and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children." - Warren Buffett

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