The Alphabet Soup - Part I - The Honest Truth By Ajit Dayal
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Investing in India - Honest Truth by Ajit Dayal
The Alphabet Soup - Part I A  A  A
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11 SEPTEMBER 2007

This morning I was teaching my son his "times tables".
His progress is, alas, terrible but that is not a sign of worry, really.
In the world of creative finance, 2x2 never equals 4.
The creative geniuses and financial engineers have ensured that 2x2 equals 9, with 5 being the fees that they can earn on a transaction with an inherent value of 4.
My son seems to understand that.
Given his mathematical skills, my son is destined to be a financial engineer.
Maybe he will make a lot more money than his father.
Hopefully, he will make it honestly.

The relevance of Alphabets.
But now that this exercise of "times table" is over, it is time for me to learn my alphabets.
The financial engineers, not happy with usurping the numbers charts, have now laid claim to the alphabets.
To better understand why the Indian stock market behaves the way it does, we need to know our alphabets. We stay awake every night worrying about the US stock markets and its effect on the value of our shares. The answer, I assure you, lies in the alphabets.

A, B, C, we are told are the first three alphabets in the English language.
But not when the financial engineers take over.
For them its all about M.
The M that equals Money.
The M that gives their companies more P (for Profits), so that they get higher S (for Salary) and they get more B (for bonuses - because of the extra profits they made for their company due to the genius of their financial engineering). That’s not the end of it, though. For when the share price of the company they work for rises in value, their ESOP (for Employee Stock Option Plans) go up in value, too, and these financial geniuses get a triple-benefit: a great salary, bonuses, and profits from the sale of shares via their ESOP.

So, the most important alphabets for most people in finance is M, P, S, B, ESOP.

Sadly, this M is seeping its way into everything we do in life - and in all economic activity.
The more M you have in life the more of "anything in life" you can buy.

People will happily maximise M and use any alphabet to get there: it could be selling you a useless mutual fund (F for Fund distributors - now challenged by SEBI's desire to put an end to this malpractice) or bring you a useless real estate stock to buy at the highest price (I for IPO).

AB + CP = ABCP
For now, the most relevant alphabets for the movement of the Indian stock market are: ABCP.
No, this is not an Amitabh Bachhan company. And if it was, you should buy shares in it.

ABCP is actually a combination of two very simple concepts.

The first concept recognises that companies need to borrow money for short periods of time, say 90 days, to run their businesses.
Companies borrow this money to run their normal, day-to-day operations.
Take the example of Dayal Motors.
The company needs to buy parts (engines, doors, gears) from its suppliers to build the final product (cars). The company has to pay its employees a salary to work in the factories and build the car. Then Dayal Motors needs to pay someone to move the car from the factory to the show room. Finally, when you walk in to the showroom and buy the ZoomZoom car, your money winds its way from the car dealer's bank account back to Dayal Motors.

From this money Dayal Motors pays back the money it borrows for what is known as "working capital". Because it needs money on a continuous basis - to build the next car and truck and wait for the next buyer to pay for it in the dealer's showroom - the company has a Commercial Paper (CP) program. It is a pogram because there is a continuous need for money. The people who lend money to Dayal Motors may change but the company needs that Rs 100 crores on tap at all times. It issues a certificate (paper) saying, “Dayal Motors agree to pay you back Rs 100 crores”. Nothing wrong with that. Companies need CP to keep their factories running - money here is the liquid oil that keeps the economy humming.

The next simple concept is collateral. This is a security. If Dayal Motors wishes to borrow money via a CP, the person lending that money says, "Hey, Mr Dayal, I know you are a nice guy with a nice business and people will buy your ZoomZoom cars but what if something happens and a new, zoomier car comes out, and people stop buying your car? Or if I need my money back and no one else is willing to lend you that money? That piece of paper is pretty worthless so how about giving me some security, some collateral, against this Rs 100 crore CP?

Dayal Motors in all its wisdom tells the lender of the money. "What if I give you this land at my Thane factory? It is worth Rs 100 cores but some real estate developer is bound to get funded by some adventurous FII and they will pay Rs 300 crores for it - so you are safe."

And the alphabet soup of ABCP is born.
Take concept one: Commercial Paper
Sprinkle it with concept two: Asset-Backed
And, viola! You get ABCP - Asset Backed Commercial Paper.

Now every time a ABCP is created, there is a fee generated. To the bank who arranges the loan and to the rating agency that confirms that the loan is “safe” and assigns a risk level to the loan.
Then these loans can be packaged and sold to other investors who wish to assume certain risk for some potential return. Every re-packaging and every sale meant more “More fees, more Money”. M for Magical Money. The 2x2 equals 9 equation was born.

...Stay tuned to see how ABCP could affect the Indian stock markets...


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