The deadly mix of short termism, unbridled greed and lax oversight - Straight from the Hip by J Mulraj
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Investing in India - Straight from the Hip by J Mulraj
The deadly mix of short termism, unbridled greed and lax oversight A  A  A

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14 FEBRUARY 2009

The global financial crisis is really the consequence of an excessively short term outlook, propelled by greed and unstopped by regulation. The short termism is due to several factors, not least of which is the enormous growth, in the past 3 decades, of the mutual fund industry. When mutual funds were first launched, they were sold as open ended funds, primarily to enable this product to compete with bank deposits which could be withdrawn. The majority of assets of mutual funds, (the industry has surpassed the banking industry in asset size) are open ended. This places enormous pressure on fund managers for short term performance, relative to competition and relative to the index. This pressure, in turn, gets translated to corporate management, which is asked to deliver short term (read quarterly) improved numbers, never mind the long term future.

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One of the earliest casualties of such short termism killing an excellent company was Lucent Technologies, earlier known as Bell Labs, the font of technological innovation as part of AT &T. Its management sacrificed, for improved quarterly reporting, important long term technologies.

US tax laws also abetted in short term outlook. A few years ago, tax amendments made claims of salaries above $1m. a year ineligible for deduction. However, bonus payments, if linked to performance, were allowed as deduction. Corporate managers responded by capping salaries under $1m and paying out large bonuses, linked to ...obviously...short term performance! Such bonuses are now coming in the limelight after President Obama criticised Wall Street firms paying them out, but the root cause was the Government's own tax laws.

Institutional holding of corporate equity is now around 70%, so corporate management heeds their warnings to deliver better quarterly performance, or else! In a bid to grow the business in order to do this, scrutiny becomes horribly lax. Banks, for example, in order to increase business, lowered risk assessment standards dramatically. They consoled themselves by securitising home loans, thus taking the risk of default off their balance sheets but onto those of investors in securitised mortgages. Investors relied (foolishly, as it turns out) on the credibility of rating agencies who rated such securitised products.

An article 'Move over, subprime' in the Feb 7 issue of the Economist says that Moody's downgraded, in just 5 days, 91% of Alt-A mortgages (Alt-A being a category between prime and subprime) from AAA to junk status! This is unbelievable! Imagine the fate of investors of these securitised bonds, who had foregone the higher interest of junk bonds, so as to invest in AAA bonds rated by Moodys, to be told, overnight, that they were, in fact, junk! It seems amazing that rating agencies have escaped their share of the blame for the current crisis, for they seem to have failed miserably in assessing risks properly, and of being too slow in re-assessing them.

The financial industry, in its bid for short term growth, went into innovative overdrive. All sorts of exotic derivative products were introduced, and allowed to be introduced by lax regulatory overdrive. This created a mountain of 'funny money'. It is estimated that funny money is 90% of total money, implying that central banks and other regulators have control over only a tenth of global liquidity! Such funny money has gone into the financing of various products including stocks, commodities and real estate, all of which formed asset bubbles that are now breaking. The cleansing of such toxic assets is expected to take years and would need much more than the huge bailout packages being cleared by various countries (the US cleared a second, $787 b. TARP package).

What these bailout packages are seeking to do is to restore a bit of confidence, which has vanished. Banks are not lending to the other, or to corporate, for fear of counterparty risk of doing so to an institution with toxic assets. Some bit of confidence seems to have returned, according to Lawrence Fink, in a CNBC interview. He points out that CISCO was able to raise debt at 200 basis points over comparable treasury rates, whereas just 3 months ago Verizon was able to do so at around 400 basis above. There is an estimated $ 8 trillion of funds available in the US for investment; once confidence seems to be returning, this could find its way partly into emerging markets. For calendar 2009 China and India will have lower, but decent, growth whereas it is expected that GDP growth in the developed world will be zero! Dr. Mukul Ashar, delivering the CC Shroff Memorial lecture, opined that the UK may approach the IMF for a bail out, in a few months!

India would thus be a beneficiary of any temporary revival of confidence, which could result in a short term rally (pardon me for taking a short term view in a column that rails against it). Besides, the Indian Government has suddenly become driven by circumstance, to think rationally not emotionally.

Thus, for example, FDI rules have been tweaked to allow for more foreign investment. If an Indian company were to have, say, a 49% foreign stake, it would still be considered an Indian company. Were it then to acquire a stake in a telecom company, that acquisition would be counted as domestic investment and not, as till now, proportionally (49% of it) as a foreign investment. Expect to see a lot of M&A activity in sectors hampered by limits, though the Government has retained right of review in industries with caps. However, this also means discretionary powers to ministers, which, more often than not, can be influenced.

Similarly, VC funds had, in the 2007 Budget, been made liable for tax even though, world over, they are treated as pass through entities with the investors paying tax on encashment of their investments. The necessity-is-the-mother-of-invention pragmatism has now made VC funds pass through entities. Why do Indian politicians and bureaucrats need a crisis to think logically?

Similarly, when the Government threw open blocks for oil and gas explorations, they threw in tax concessions to attract the huge investment needed for it (a deep water rig, for example, costs over $500,000 a day to hire). By way of an 'explanatory note' in a previous budget, it was 'clarified' (sic) that mineral oil did not include gas! This defies logic, because no one exploring under water can know whether he is going to find oil, gas, a mix of the two, or neither. Maybe babus in the finance ministry have a second qualification as a hydrocarbon expert. Or maybe they, too, needed to be influenced into thinking logically. RIL is investing another $ 6b. to develop satellite discoveries in the KG basin. Its gas production is expected to start from March.

These three things, viz. FDI re-definition, declaration of VC as a pass through and belated recognition of gas as a co product of oil, for tax concessions, can facilitate inflow of funds, should investor confidence return.

Last BSE-Sensex the sensex rose 333 points to end at 9634 and the NSE-Nifty rose 125 to end at 2948.

Some confidence appears to be returning and, if investors become more confident after Tarp II has been cleared (reminds one of Rambo II, doesn't it?) one could expect a bit of a further rally. If this happens it could take the sensex to its previous turning points of around 10,500. The rally should be taken as an exit opportunity because the removal of toxic assets is not going to happen soon. It could take a year, likely more.

J Mulraj is a stock market columnist and observer of long standing. His weekly column on stock markets has run for over 27 years. An MBA from IIM Calcutta, he has been a member of the BSE. He is Conference Head - India, for Euromoney. A keen observer of events and trends, he writes in a lucid yet readable style and takes up issues on behalf of the individual investor. Nothing pleases him more than a reader who confesses having no interest in stock markets yet being a reader of his columns. His other interests include reading, both fiction and non-fiction, bridge, snooker and chess.

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