Wanted: a financial innovation NPT - Straight from the Hip by J Mulraj
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Investing in India - Straight from the Hip by J Mulraj
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27 SEPTEMBER 2008

The US Congress is currently very concerned, and very busy, trying to do two things. One is clearing a proposal by the US Treasury Secretary, Hank Paulson, to clear a whopping $ 700 b. package to bailout a crumbling financial system. The other is to clear the 123 Agreement that would provide India access to nuclear technology for peaceful purposes, denied it under a nuclear non proliferation treaty (NPT).

Whilst clearing the first, the Congress may well debate about the impact of poorly supervised proliferation of financial products that has caused so much damage that it has brought down iconic names like Lehman Brothers, AIG, Fannie Mae and Freddie Mac and now, Washington Mutual. And the root causes of the problem.

One believes that the US Congress will clear the bailout package early next week, which would cause world markets to cheer. Later in the week, one believes it would also clear the 123 Agreement, which would cause further cheer in the Indian markets. So the coming week should end sharply in the black. Investors would, however, to well to understand the roots of the current problem, and why the bailout package, large though it is, would be more of a palliative than a cure.

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In the 80s when the US found themselves trailing behind Japan and Germany, which adopted stakeholder capitalism as the drivers for their successful and innovative companies, it retaliated by adopting shareholder capitalism. Under the former, interests of various stakeholders are looked after; in the latter, interests of capital providers assume primacy. It worked, and US regained its lead in innovation and corporate performance. Their stockmarkets boomed; Japan went into a long slump.

The pendulum swung too far, pushed by unsupervised greed, and the current crisis is the result of that. Investment bankers hired fresh MBAs at starting salaries of over $100,000, to justify which, they would need to produce profits a multiple of that, to generate which, they would need to bring new business a multiple of that! To bring in this business, they needed to ‘innovate' new financial products and to sell them at a fast clip, allowing little time for a proper scrutiny of the risks involved.

In order to allow investors the comfort of investing with little scrutiny, the evaluation of risks was outsourced to rating agencies. James Ward, in an article "Silence of the Agencies" in Financial Times of Sep 25, maintains that these agencies have been significant contributors to the crisis but have remained silent. For example, in order to drive up business once the better borrowers for home mortgages had been tapped, banks started selling these to Ninjas (a clever acronym for those with no incomes, no jobs or assets). In order to find buyers to whom these loans could be securitised and offloaded, the originators got credit rating agencies to rate slices of them. Some of these slices were rated AAA. That was crazy, and supervisors did not raise any questions!

The rating agencies have a cosy oligopoly (S&P, Moody's, Fitch just about completes the competition) and vie for the business of rating. Their fees are paid by the sellers of assets, the ratings are used by the buyers. This raises questions of conflicts of interest, to drum up business.

The article is critical of legendary investor, Warren Buffett, who did not question the role of rating agencies in giving higher ratings and downgrading them, at the cost of investors, only after the damage was apparent. He owns nearly a fifth of Moody's. Michael Milken, aka junk bond king, had been criticised for both originating junk bonds, and owning a rating agency (Duff & Phelps) that rated them.

In an article on Bloomberg, Frank Raiter, a former head of S&Ps mortgage rating business, which then did 85% of such ratings, says it put up a ‘For Sale' sign in March 2001, when it competed for fees on a large deal for rating, by a company called Pinstripe I CDO Ltd.

There would be a scrutiny into the role played by rating agencies which would impact them, domestically too. There would also be, hopefully, greater competition and more oversight.

Will $700 b be enough to avert the crisis? Kinichi Ohmae thinks not, by a long shot. He believes the figure needed would be closer to $5 trillion!

The global financial scene is therefore still fraught with lots of dangers even if the bailout package is cleared, as it should be, early this week. The patient would still be critical, fed by the $700b. glucose IV. It may bring colour to his cheeks, but not restore his health. For that a lot more would need to be done, and will involve pain.

What would the domestic scene be like?

One of the biggest cause for bullishness is the commencement of the newly discovered oil and gas flow from KG basin. Reliance Industries announced start of oil flow, at 5000 bpd, which would go up significantly to 5.5lac boe (barrels of oil equivalent). This would save the country some $20b, or a quarter of our import bill. It could remove the approximately Rs 1 lac crores bill on subsidising fertilisers, thus giving a fillip to contain fiscal deficit. By shaving imports by $20b. it would create a current account surplus, thus driving up the declining rupee which, in turn, would give foreign investors a better return.

This, however, is subject to an ongoing dispute on gas supply and pricing between the two brothers, which would be in the country's interest to resolve soon.

Another bullish factor in the short term is the expected release of past increases as per the Pay Commission. The money should be released in the first of two stages, prior to the festive Divali season, and can lead to a spurt in sales and investment.

Last week the sensex fell 940 points to end at 13102 and the Nifty fell 260 to end at 3985. Clearance by the US Congress of, first, the bailout package, and later, the 123 Agreement, would cause the market to rally. Investors should look to exits at points where they feel comfortable, knowing that $700 b. is quite a lot of money, but also realising that it is still a part of the problem.

Investors should go back to their nursery rhymes and recall what happened to Humpty Dumpty when he sat on the wall. Those who sat on Wall Street haven't done a whole lot better, either, unfortunately.

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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