Continued Rise of Evils identified as Culprits of the 2008 Crash

1. In 2008, in the wake of the financial crisis, assets under management in so-called "retail alternative funds" in the US [a.k.a. alternative investments, and defined to include absolute return, commodities, currency trading, dedicated short bias, equity energy, leveraged strategies (both long and inverse), managed futures, market neutral, multi-strategy alternatives, natural resources, options arbitrage, precious metals, real estate and volatility strategies; but to exclude distressed debt] crashed in the US from $368Bn to $275Bn. However, as a percentage of "all long term retail fund AUM" [defined to include mutual funds, closed-end funds, ETFs and UCITs (Undertakings for Collective Investments in Securities) structures, and excludes limited partnerships and separately managed accounts], it never fell - indeed, the figure of $275Bn in 2008 was 5% of LT Retail Fund AUM in 2008 whereas the bigger figure of $368Bn was 4% of the same figure in 2007. 
2. From 2009, the share of alternative investments as a percentage of the all long term retail fund AUM started rising once again, boht, in the US, and globally excluding the USand they have been growing @21% CAGR in absolute terms in the US, and at 11% globally excluding the US;  till 2011.
3. At the same time, several other disturbing parameters have been heading in the "wrong" direction. See the table below, which shows these statistics as they stood  at three different times I have tracked them in my blog. 
4. Reading this table closely shows that the average American is on the right path (reduced personal debt per citizen; higher GDP per citizen) but the US Government has continued its profligacy with a vengeance (rise in National Debt as % of GDP; Total Debt per Citizen; and US Debt held by Foreign Countries). Just look at the US Total Liabilities and US Interest Burden per citizen from April, 2010 to September, 2011 to see what havoc the US fiscal and monetary policies are wreaking.   
5. What is worse, the investment bankers are back with a vengeance: as paras 1. and 2. above indicate, and as the figure of Currency and Credit Derivatives in the Table below confirm, what Warren Buffett famously termed as Weapons of Financial Mass Destruction are growing in value at an uncomfortable pace.  Derivative exposures have risen by as much as $91 Trillion (or 6.37 times the US GDP in just 30 months), when they should have been falling! 
6. It is time that the US Investment bankers are stopped from selling "innovative" risk-masking derivative products - for the sake of the financial health of the entire world.

Table 1

Parameter	8 Apr 10	26 Jul 11	11 Sep 12
US National Debt as % of US GDP	89%	98%	104%
US National Debt per citizen ($):	41,381	46,619	50,959
US GDP per citizen ($):	46,381	47,488	48,805
US Total Debt per citizen ($):	1,80,484	1,76,113	1,81,307
US Personal Debt per citizen ($):	53,787	51,441	50,132
US Interest Burden per citizen ($):	1,493	11,664	12,343
US Total Assets per citizen ($):	2,34,181	2,43,086	2,96,124
US Total Liabilities per citizen ($):	3,50,054	10,26,974	10,54,522
US Gross Domestic Product ($):	14.333 Tr	14.809 Tr	15.342 Tr
US Debt held by Foreign Countries ($):	3.875 Tr	4.584 Tr	5.376 Tr
Currency and Credit Derivatives ($):	648.975 Tr	611.499 Tr	740.277 Tr

Sources of data: 

Para 1 and 2 above: from "The Mainstreaming of Alternative Investments - Fueling the Next Wave of Growth in Asset Management", a Report by the Financial Services Practice of McKinsey & Co, Sep 2012.

Para 3 : extracted on 11 Sep, 2012 from www.usdebtclock.org,

Table 1 above: extracted on dates mentioned in cols 2-4 of table 1 from www.usdebtclock.org,  

Dexia Bank Collapse: What it means for Europe, Belgium and the World

Dexia Bank is among the Top 50 financial institutions in the world. It is not just some small, unknown bank. It is different from other banks because it, and with it, Belgium, are caught in an uncomfortable spot. How? Let me attempt an explanation.

1. Belgium has external debt to GDP ratio of close to 100% already. The Government thus does not have room for manouevre to fund losses of Dexia. That's already been done once - in 2008, the Belgian Government took control of Dexia. Various arms of Belgian and French Government now hold over 50% in Dexia. This closes off one source of succour. Worse, there is a political standoff in Belgium because of which there is no functioning Government at all at present in Belgium! Worst time for such problems to hit.
2. Dexia's leverage at present is estimated to be almost 60:1 – double that of Lehman Brothers when its collapse was triggered. So Dexia is not in pretty shape at all. Worse, of its over €500Bn of assets, €20Bn are debts of Portugal, Italy and Greece, all of whom are in need of bailouts.
3. After the 2008 takeover by the Government, instead of getting better, things got worse, because Dexia was a source of funds for the various parts of Belgium's Government. When they took it over, instead of stopping loans to Government which were the major part of its NPAs, they stepped up lending to Government, which enabled the Government to reduce its fiscal deficit somewhat. Now, if the Government were to bear even a small part of the losses of Dexia, its external debt to GDP ratio will shoot up to almost the level that Italy is at currently (which is 134%). So PIIGS will no longer be a sufficiently comprehensive acronym of European states in deep fiscal trouble. We have to find some way of adding a “B” to it. Just for comparison, US, Australia and India are at 99%, 94% and 22% respectively. France, one of the co-owners of Dexia, is at 208%.
4. The only time-tested solution for banks or financial institutions in such a mess as Dexia finds itself in is to break up the institution into a “good bank” and a “bad bank” - like India did for Unit Trust of India a decade or so ago. Usually, the bad bank sells the 'bad” assets for anything they can get for it – which could be single digit percentages of the book value. In Dexia's case, this is apparently not feasible because (a) Belgium's Government does not have the money and the political will (there is no functioning government now!) to bail out Dexia because it would mean choking its own source of funding; and (b) “Good bank” assets have not takers almost anywhere in the world today. So the good bank-bad bank solution will not work very well for Dexia. But that is the only solution – so you can expect sell-offs of any saleable assets.
   
   
   Already, Reuters reports Qatar as being interesting in buying out Dexia's Luxembourg business. So the dismembering of the Bank has officially begun. The vultures are circling, but then, there aren't too many vultures, this time. Trading has been suspended in Dexia's shares, and S&P has downgraded Dexia's group companies steeply. In its downgrade press release, it notes that there is negative revaluation reserve in respect of available-for-sale securities of almost €6.9 Bn. Moody's has followed S&P in steeply downgrading (by 3 levels) the sovereign rating of Italy, and also some Italian banks in the last 2 days. Besides, 12 UK banks and 9 Portuguese banks have also been downgraded. Sovereign ratings of Spain, Ireland, Greece, Portugal and Cyprus have been cut as well. From the US, Ben Bernanke has said that the US economy is close to faltering. Deutsche Bank has warned that it will miss its profit target.
   
   
   One must remember that failing banks are not just like manufacturing or services companies that fail. Banks, as they fail, tear asunder the transaction enablement capability of its citizens. Thus, slitting the banking system's throat is akin to slitting the underbelly of a crocodile – however strong the economy may otherwise be, the banking system is its weakest link. This, all the above news in just a few days is bad news indeed, for the entire world. When banks collapse, other businesses will follow, and depositors will panic, causing a financial logjam in not just those countries, but in all countries where businesses have business ties with enterprises in countries whose banking systems are collapsing.
   In India, our very own SBI has suffered a downgrade because of its low Tier-I capital level that would require it to raise money and/or ask for Government help/ support. So where is the good news? If at all, it is in India where the Government has both, the wherewithal (with some difficulty) and the will and inclination, to support its banks.
   PostScript: This is the text of an email I received. Makes for interesting reading.
   Uncertainty has now hit Japan. In the last seven days, Origami bank has folded, Sumo Bank has gone belly up and Bonsai Bank has announced plans to cut some of its branches. Yesterday, it was also announced that Karaoke Bank will go up for sale and will likely go for a song, while shares in Kamikaze Bank were suspended today after they nose-dived. While Samurai Bank is soldiering on after sharp cutbacks, 500 staff at Karate Bank got the chop and analysts report that there is something fishy going on at Sushi Bank, where it is feared that staff may get a raw deal.

Re-visiting Modern Accounting Standards

Should acquisition cost of an asset depend on how it is financed?

To my mind, and to most non-accountants, the simple answer seems to be No. But that is not how modern accountants see it. Costs incurred (including interest) till the time an asset is ready for use is treated as part of the cost of the asset. Whatever compulsions may have been behind adoption of such a treatment as standard, it tends to militate against simplicity, and creates needless (in my view) complexity.

Can a company have Net Profit After Tax equal to double its turnover for a quarter?

Common sense tells us that this is impossible. How can profits exceed turnover, that too profits after tax? However, modern accounting is not all common sense. Or maybe, it is such highly developed common sense that it takes truly uncommon levels of sense to understand why this can happen. As it happens, there are several reasons why this can happen. Deferred Taxation Accounting (DTA) is one of the reasons. DTA is one more area where accounting has been made dreadfully complex. So much so that it creates situations occasionally as the one described in the question above, where quarterly Net Profits After Tax of some companies exceed even quarterly revenues! How can accountants explain to laymen this paradox – where, say, the quarterly turnover of a manufacturing company is Rs.50 crores and its NPAT is Rs.90+ crores? Most accountants trying to explain this situation will end up tying themselves and their listeners in knots. This happens in the relatively rare instance when a company has just turned the corner after several years of losses. One argument in favour of the currently favoured treatment of deferred taxes is that it makes clear the differences in expected tax provision on reported profits, and the actual tax provision. However, we lose sight of the fact that the net result of the income statement becomes almost impossible to understand, even to reasonably financially literate individuals. Surely, this could not have been the intent of introducing such accounting treatment!

Is it a bad thing to allow retired employees medical treatment for life in hospitals run by the company?

Certainly, one cannot fault managers in Tata Steel if they begin to think like this. Accounting for Employee Benefits is another area where accounting complexity has reached ridiculous levels (in my view). Tata Steel used to routinely allow their retired employees and their families to be treated in the wonderful hospital they have built in Jamshedpur; and absorb and meet the net losses or cash shortfalls of that hospital quite routinely, as part of its employee-friendly initiatives. Let us say their costs were Rs.30 crores per annum, give or take a few crores. When AS 15 was made mandatory, suddenly they realized that because they allowed their retired employees and their families to enjoy these facilities for life, they suddenly had to recognize the present value of all the costs they expected to incur over the next several years, as a cost in a single year. This resulted in a hit to their Income Statement to the tune of hundreds of crores in the year in which the new Standard was made mandatory (if I remember it right, it was over Rs.250 crores). Why? Could not well enough be left alone? Now, it has accountants and managers thinking closely about the impact of such facilities to its past employees on its current profits, way beyond the actual cash expenses of offering such facilities. Simplicity flies out of the door, to be replaced by dreadful complexity. What I wonder is, what purpose is served by such complexity?

Why did Warren Buffett call derivatives "weapons of financial mass destruction'?

Buffett should have included "securitised, structured products" which are a class of "innovative" derivatives, by the same appellation. We know now that derivatives and securitisation have made financial life, and accounting for the new-fangled "innovations" they spawned infinitely more complex. Banks in the developed world are still facing the consequences of the complex accounting legacy of the millions of securitised structured note transactions it entered into almost without thinking in better times. They are now realising the impact of all that complex accounting – it only passed the parcel of risk onto others. It did not eliminate risk. Ultimately, every bank in the developed world was left holding such risk parcels to varying degrees. But they did not simply pass on risk to others. Some structured products passed on risks to a distant tomorrow.

We have yet to see the complete impact of such contracts that, in addition to passing the risk around to different people, also passed the risk to a future date. There are several apparently innocuous deals and assets sitting on the books of several companies (not just banks) which represent accounting legerdemain of pushing losses off to a point of time in the distant future, so that the current management came out smelling like roses though their results should have had the faecal matter hitting the overhead rotating cooling device. They are the financial equivalent of mines in modern warfare. They will go off and claim the lives of innocents at any time in future, without warning. This is because several best-selling "structured products" designed by mathematical geniueses sitting at investment banks the world over, were designed to hide losses from shareholders, future management and regulators alike. We have yet to see the full impact of such deals. Liabilities under such contracts will crawl out of nowhere, as it were, and trouble future managers and bankers alike. This is the long-term legacy of allowing untramelled financial innovation. AS 30, 31 and 32 (collectively dealing with accounting and reporting of derivatives) is something that almost 90% of practising Chartered Accountants – those charged with implementing them and checking their implementation incompanies, will privately admit to not being comfortable with. I think these Accounting Standards is a gigantic case of GroupThink – the management phenomenon where even a unanimous decision taken by a Group is completely at variance with what almost all of those participating in taking the decision privately think and opine. We need the small boy who points out shrilly that the Empe3ror is not really wearing clothes!

Why should we bother about all these complexities?

Almost all the modern accounting standards that have contributed their bit to making accounting more complex and less understandable have behind them the objective of making a company's Balance Sheet more "realistic". What they have actually succeeded in doing is to make the Income Statement almost impossible to understand or predict. Why should one prefer Balance Sheet accuracy to Income Statement accuracy? I think that the Balance Sheet showing assets at unrealistic low values based on historical cost is a form of desirable conservatism in accounting. We have succeeded in making the Income Statement, which is a good indicator of how well a company is being run, almost too volatile to be of any use – whether to compare results with past years, or to compare results with those of peers. Therefore, what I make above is a case for a complete re-thinking of the basis of modern, fair-value based accounting, and slowly going back to the traditional historical cost based accounting.

Algorithmic Trading - Why Indian Stock Markets are Endangered

A few months ago, I had blogged about tight coupling in financial markets. In that entry,I had explained at a micro-level the impact of algorithmic trading. Given below is a "macro" story about how high-frequency trading in securities using computer programs played a big role in (though I would stop short of saying that they caused) a violent fluctuation in shares' and securities' prices on Wall Street last year. In less than 15 minutes, the Dow Jones Industrial Average Index plummetted and lost almost 6% of the opening value - and then recovered almost all of it in the next 15 minutes.

What happened on May 6, 2010 on Wall Street?

Major equity indices in futures as well as securities markets, already down 4% from the earlier day's close, suddenly plummetted a further 5-6% before recovering equally quickly, all in minutes. This affected almost all the 8,000 securities and ETFs in similar manner. Over 20,000 trades were reported to have been transacted at prices 60% from their prices just a few moments earlier.

Why did this happen?

At 2:32 pm, on an already volatile day, Waddell and Reed Financial Inc (not named by the joint CTFC-SEC report dated Sept 30, 2010, but named by many news reports) started a computer program to sell 75,000 E-Mini futures contracts worth close to $4.1 Bn. This was programmed to sell at any price and time, so instead of an orderly sale over a few hours, it sold this huge quantity of contracts within the space of 20 minutes, accelerating the sales as prices fell.

What actually happened during the crash?

The contagion spread to the equities market when arbitrageurs noticed the growing gap between the equities and futures prices. A significant finding is that 6 HFT (High Frequency Trading) firms (i.e., firms that extensively used algorithmic trading) remained active in the market even during the crash period of a few minutes. A blow-by-blow account follows:

• Five minutes into the crash, at 2:37 pm, data feeds from computers groaning under the huge numbers of contracts, started slowing down, leaving both, exchanges and investors uncertain about where share prices stood.
• The NASDAQ went into “self-help mode” at 2:37 pm where the transactions were not routed through NYSE's Arca electronic trading platform. CBoT and BATS exchanges (BATS at 2:49 pm) followed and also went into “self-help mode” which means that trades on NASDAQ, CBoT and BATS did not need to honour an Arca quote from NYSE.
• By 2:40, some trading and market-making firms started pulling out, due to algorithms that pause when they sense large price movements that could be due to questionable data feed. This left the market short of ready buyers and sellers. Apple, for example fell by $23 in 2 minutes, with the buy-sell spread going up to $5 instead of a few cents.
• Volumes of E-Mini contracts that normally mimic the S&P 500 surged but liquidity dried up. As a result, at 2:45:17 pm, E-Mini prices plunged 12.75 cents in half a second. This set off a circuit breaker that halted trading for 5 seconds.
• As individual stocks declined as much as 10%, ETF traders started withdrawing from the market.
• Then, at 2:46, even more strange things started happening because of the sheer speed difference between trades being put through and displayed – P&G shares were offered for purchase at prices higher than offered for sale! This is never supposed to happen in an electronic exchange.
• At 2:47, Dow reaches its nadir for the day, down 998 points or 9.2% from the opening level. Accenture, trading minutes earlier at $40, was offered at 1 cent.
• Then, at 2:49, the Dow rebounded by 300 points in 1 minute.

• There were no takers for ETF shares – iShares S&P500 Value Index Fund traded for 11 cents. But the broad recovery continued. By 2:58, indices reached the level they were at 2:30 pm.
• At 3:01, almost a half-hour to the minute since the crisis began, NASDAQ snapped out of its self-help mode and resumed routing orders to the Arca trading platform.
• At 4 pm, the DJIA closed 340 points below its previous close.

The Joint CFTC-SEC investigating committee reported that several HFT firms they interviewed had algorithms that took trading decisions based on direct proprietary data feed from the exchange directly rather than on consolidated market data, to reduce “latency” or delays measured in milliseconds. These algorithms went awry when the data feed from the exchange slowed down. Those HFT firms that did not depend on direct feeds for trading decisions got contradictory feeds that led to unease in taking decisions. Yet others that were not concerned with data latency in milliseconds simply withdrew from the markets.

The HFT firms that depended on their algorithms for trading decisions were not affected by the “self-help” declarations of NASDAQ, CBoT and BATS, and continued to rout orders to these exchanges. Therefore, the “self-help” declarations were ruled out as a cause of the volatility.

While no clear single cause was pointed out, HFTs using algorithms to trade rapidly (in one documented case, 200 trades exchanged hands 27,000 times in 14 seconds) were commonly thought of as the villains. It must be said, though, that there have been spirited defences by algorithmic trading experts, who point (among other factors) to volatility when markets are closed (ie difference between closing prices and opening prices on next day) as the real villain of the piece – on the logic that overnight differences can only be caused by humans, who are prone to panic unlike computers.

Even so, the SEC has since instituted a system of circuit breakers to arrest rollercoaster falls like the one experienced on Wall Street on May 6, 2010. This is another lesson that they have learnt by experience – instead of simply looking eastwards and learning from Indian bourses.

What can we learn from this?

But now, the stage has come to re-learn from our own wisdom. Algorithmic trading is now allowed on Indian bourses. Reports have suggested that over 40% of all trades are done by computers on NSE and BSE. Add to it the other dangerous fact - that FIIs that invest "hot money" that can fly out of the country in seconds account for over 70% of all floating stock (ie, stock that gets traded on the bourses).  See this in juxtaposition with the often displayed behaviour of FII fund managers who, like a herd of sheep, make a beeline for the two exits (NSE and BSE) for their investments at the merest sniff of danger anywhere in the world (even if it does not endanger their holdings in India), and it becomes clear that we have set up our bourses for spectacular volatility where securities' prices falling off a cliff in minutes will become sickeningly regular occurrences.

Putting the Bank of America situation in perspective

What would you think of the state of the Indian economy, if what I said of BofA and Citibank was said of State Bank of India and ICICI Bank in India by some economist of repute? 

The situation is that serious for the US and for many countries in Europe, where the nation's top banks have dug themselves into deep holes that not even the EU or their respective Governments can afford. All these economies have their underbellies exposed.

On both continents, banks are hiding behind accounting gobbledygook called Impairment and Fair Value Accounting. But the understanding is filtering through. Tonight (in India) brought news of a blood bath on bourses in the US and Europe. So tomorrow (19th August) will almost certainly see a bloodbath on Indian stock exchanges - as FII Fund Managers make a beeline to the nearest exit. Expect a fall of at least 400 points in the Sensex on 19th August, 2011 before short covering enables a partial recovery.

I believe that this is the beginning of the unravelling of several economies in Europe and of the US economy as well, with them slipping into R-2, needing QE-3 and possibly QE-4.

I shall write again tomorrow to report whether what I said about the bloodbath on Indian stock markets was accurate. I feel comfortable making these gloomy predictions because I currently am sitting on cash, having (fortunately) believed in my own predictions and taken my own advice!

The Gold Standard: In Memoriam

On August 15, 1971, 40 years and 3 days ago, President Nixon, remembered today for another of his “achievements” - the Watergate scandal, announced that the United States will go off the gold standard. Till then, the gold standard meant that the money supply in any country would be limited to a specified proportion of the gold reserves owned by the Government. The gold standard was abandoned when the consumption-hungry Americans found the fiscal discipline it imposed on all Governments too inconvenient, and substituted it with a promise of the United States Government, then the most powerful and richest country on Earth.

After this epochal action, demand for Gold fell worldwide. To such an extent that India (its citizens, not the Government) was the only net importing country in the world, importing what the rest of the world exported, for well over two decades. Till India reached its economic nadir in 1991, when the Government was forced to sell or pledge tonnes of gold to save the country from financial bankruptcy. After that, India has slowly picked up its gold buying again, and Indians are still the world's leading buyers of gold. The RBI has bought back all the gold it pledged, and more. I am also sure that the RBI has recently bought more gold – it announces the value of its foreign currency reserves in US Dollars, but the actual composition is India's best-kept secret. I suspect that the RBI has fallen back on the age-old wisdom of buying gold when all currencies' future looks uncertain.

For aeons, gold has been considered in India as a refuge against uncertainty, as well as a status symbol – something no family would sell unless they were in dire straits, and then too, with the internal understanding that they would buy it back at the earliest. So while India's Government is the 10^th richest in terms of gold holdings officially declared, Indian citizens' private hoard of gold, if added to the RBI's holding, would probably make India the richest nation with the most liquid reserves in the whole world.

In the meanwhile, the freedom from the peg to gold allowed the United States to spend like there was no tomorrow. Whenever it looked like tomorrow would dawn, the United States would instigate a competitive devaluation game among other countries, which enhanced the external value of the dollar, which ensured that tomorrow was deferred yet again. Dollar prices of gold went up briefly following the 1974 oil price shock; and then again after the 1979 oil shock. Then, it continually fell till 2001. So, if one compared gold prices against inflation or any other currency value, gold always suffered, till end of 2001 when it was $272.22 in the NY market. After 9/11, some Middle Eastern countries and their residents, sharing the Eastern love for gold with India, began hoarding up on gold. So dollar prices of gold started looking up. But then, in 2007-8, tomorrow arrived.

By 2009, gold had crossed the hitherto unthinkable barrier of $1,000 an ounce. To put this in context, in August, 1971, when the gold exchange window closed, the price of gold per ounce (1 troy ounce=about 31.1 grams) was $37.60 (according to Niall Ferguson in his excellent book, The Ascent of Money). Going to $1,000 in 38 years means a CAGR of around 9% per annum. A handsome rate, but absolutely mind-boggling, if one allows for the fact that for almost 32 of these 38 years, gold prices hardly rose at a CAGR of 3% in dollar terms, when it rose at all. Do you know what the price of gold now is? It is $1,794 an ounce as I write this, in August 2011. Which means a growth of 79% over the 2000 value of gold.

Let us look at this from another perspective. If an American had turned in $1,000 before the US went off the gold standard, he would have got almost 26.6 ounces of gold. The same quantity of gold today would be worth $47,720. This is an index of how much the value of the dollar has slipped and that of gold has gone up. This means that gold worth $1,000 is now worth almost 48 times as much in 40 years – a CAGR of about 10.1%. Not bad, for something considered as a bad investment by the whole world, for almost 30 years! When the world realizes that gold has proved to be a safer haven than any other currency, there could be a renewed weakening in the belief in the US Dollar as a store of value and as a reserve currency.

Way back in June, 2008 I had written that it was time to buy Gold.  Elsewhere, I have written that gold prices could touch $4,000 an ounce in 3-5 years. At the rate the price of gold has been shooting up in the last few months, this price point should be reached much sooner than 3 years, if only because of the expected continuing weakness of the dollar. So will we see a return to the Gold Standard, or some variant of that? That has to be counted as a distinct possibility after the S&P downgrade of the AAA+ rating of the US.

Till that happens, we Indians should thank our womenfolk for consistently ignoring advice that investing in Gold was a poor bet. Thanks to that, India is possibly the most liquid and financially secure economy in the world today. What's more, it is a hidden strength - it is the reason why Indian families will survive in a world without Medicare/ MedicAid/ Social Security.

(Historical gold dollar price data sourced from www.measuringworth.com and current price from http://goldprice.org)

 

BofA: The vultures are gathering ...

Barely 3 days after I blogged on the death spiral Bank of America seems to be sliding into, the signs of death throes have become clearer. Already, its share price represents only 32% of its book value, showing that the market agrees with my assessment that its assets are massively overstated. I had pointed out only one asset, Goodwill, that called for significant impairment.  
Wall Street Journal now reports that Bank of America has entered into deals to sell the following:

• its Canadian Credit Card portfolio to TD Bank
• its Spanish Credit Card unit 
• its small-business cards in the UK to Barclays

WSJ also reports that BofA intends to sell other card units in Europe. It further speculates that BofA may also sell its stake in China Construction Bank Corp. Another report states that Bank of America has also sold off portions of its credit card business within the United States to Sovereign Bank and to Regions Financial Corporation. In April this year, BofA sold its stake in Black Rock Inc.. 
All these sales are obviously intended to shrink its way into a viable situation by raising money without a share issue, and also thus raising "tangible net worth per share" of Bank of America.
If you think BofA was the only bank in trouble, look at this list of 64 FDIC-insured banks that have failed and closed down in the first 7 months of 2011. This is in addition to 157 banks that failed in 2010, and 138 in 2009. It is obvious that things aren't getting better. But that they have company is cold comfort for BofA, around whom vultures are gathering. 

• In early 2011, it settled charges of mortgage-backed securities fraud charges with BlackRock, PIMCO, Freddie Mac, Fannie Mae, insurer Assured Guaranty and a few others, agreeing to pay $8.5 Bn. These settlements have run into some trouble, and are now facing opposition.
• Already, AIG has claimed $10 Bn damages for securities fraud in sale of mortgage-backed securities by BofA, Merrill and Countrywide. 
• In addition, over 90 similar suits have been filed demanding damages of $197Bn, says the above article, quoting LawyerLinks, a legal consulting firm.
• Now, it  is being reported that the National Credit Union Administration has declared that it is suing several banks for damages of up to $50Bn for misrepresenting safety of securities it sold to several credit unions that collapsed as a result of the investments. Among those likely to be sued is Merrill, now part of BofA. 
• Credit Default Swaps on BofA have risen to their highest level since May 2009, showing nervousness of investors.
• BofA has begun writing down principal on Californian "underwater" home loan mortgages of troubled borrowers. BofA is reported to be seeking immunity from prosecution in return for paying fines and writing down principal outstandings of underwater mortgages.
• Elsewhere, BofA is facing energetic protests from locals fed up of the number of foreclosed properties that are ill-maintained, sending property values in entire localities tumbling. 
• The richest Hedge Fund Manager in the world according to Forbes' 2011 List of Billionaires, John Paulson, and who is known for sticking to his bets for longer than most fund managers, has sold half his stake in BofA and Citigroup.

There is speculation that it could spin off Merrill Lynch Wealth Management and Investment Banking operations. There is also some speculation that BofA could put Countrywide, acquisition of which is by consensus considered as a big corporate blunder, into bankruptcy. However, moves taken to consolidate Countrywide and BofA have clouded BofA's ability to ringfence Countrywide-related liabilities. 
Watch this space! 

The Death Spiral beckons ...

Bloomberg reported that as of August 10, 2011, 186 US-based financial services companies traded for less than 60 percent of their book value, or common shareholder equity, including Bank of America, Citigroup Inc., Morgan Stanley, AIG and SunTrust Banks Inc. Together, they had a market capitalization of $300.5 billion, compared with $686.4 billion of book value. This means that a fall in their share prices to this extent (40%) is well nigh inevitable. 

How likely? These banks are very, very vulnerable. For example, earlier this week, AIG filed a suit accusing Bank of America of securities fraud; demanding damages of $10Bn. This sent the BofA stock down 20%, in addition to the bloodbath that the Dow Jones has experienced in the week after August 2, and the S&P downgrade. Its market cap stood reduced to $68.6Bn. Compare this with just one year-end intangible item on its 2010 Balance Sheet: Goodwill is shown at $73.8Bn (see p.130, Table XIII. See also Footnote 1 below)  – forget the rest of its balance sheet, BofA would have the world believe that this intangible item alone, built up from excess over book value paid for its past acquisitions, is worth more than the entire BofA is worth on Wall Street. How many will believe this, and for how long? There will always be the small boy who shouts, “The Emperor is not wearing any clothes!”. After reading Page 114-115 of its 2010 Annual Report, any accountant will understand that BofA will have to write down goodwill significantly (it wrote down $12.4Bn in 2010) - and to keep the shareholders' equity intact after this write-down, it would need to raise more equity. The dilution this would almost certainly drag the share price lower. Which will require them to raise more equity at even lower prices ... leading to a death spiral.

What about the demand for financial sector shares? All but non-existent. Retail interest was never very visible in the US in equities; now it has disappeared. Institutional investors are worried about what write-down of such intangibles would do to the Balance Sheet – and will stay away from any further issues in sufficient number as to make a public issue a very big gamble that could very easily fail. So the only solution – a government bailout wherein the financial institutions that still bear the TBTF tag (Too Big To Fail) are partly nationalized. Expect this to happen in the not too distant future, when the pressure of reporting numbers that have no relation to stock market prices forces them to look for ways of raising their net worth to blunt the edge of the writedowns that are inevitable already. 
What if the US Government finds it politically unpalatable or impossible to rescue these firms with a QE3? Refer to the title of this post! 




Footnote 1 referred to above: 
Table XIII on p.130, and Table XII and Table XIV before and after it, were the result of BofA's attempt to dress up their Income Statement and Balance Sheet, and the justifications for using these were on page 40. If they had followed GAAP alone, the Tables and the explanation on p.40 would be unnecessary. They used "non-GAAP measures" - euphemism for accounting legerdemain to make accounts smell sweeter, euphemism for which is "additional clarity". The footnote to Table XIII reads: Presents reconciliations of non-GAAP measures to GAAP financial measures. We believe the use of these non-GAAP measures provides additional clarity in assessing the results of the Corporation. Other companies may define or calculate non-GAAP measures differently.

Tight Coupling of Financial Markets

Nassim Nicholas Taleb made famous the concept of "tight coupling" to explain why there were sudden, interlocking failures in different markets or sudden crashes in prices of securities.
A recent example highlights and illustrates this problem beautifully. An obscure book on genetics of a fly, The Making of a Fly, created a record on Amazon.com when the price quoted for a used copy of this out-of-print book went up to beyond $23 Mn (shipping $3 extra) as recently as in April this year! (At the time of writing, the price was down to $65) 
What happened? 
Apparently, two booksellers who listed this book as among their offerings, had an algorithm (i.e., a computer program) that quoted the price of the books, esp. used books, they offered for sale, so that the price that was quoted was never very far from the market price. Quite independently, the algorithm both used took, among other things, the price quoted by the other as a benchmark, and raised it by about 10%. So, effectively these algorithms competed with each other to set a higher price! It is easy, knowing this, to understand how this caused the price to spiral beyond reason. With no human being checking the price quoted, the price soon went beyond the dictates of reason, with no stopper!
Exactly the same thing happens in stock markets as well. This is especially true in the so-called High Frequency Trading (HFT) firms. Today, well over 70% of the trades by volume as well as value in the US are carried out by HFT firms' computers that initiate orders based on information received electronically, before human traders can even read and process the information they observe, leave alone decide and implement the decision. 
Algorithmic trading, or algo trading, or simply black box trading, is also used to divide large trades into several smaller trades in order to manage market impact, and risk. Sell side traders, such as market makers and some hedge funds, provide liquidity to the market, generating and executing orders automatically. Algo trading is also used almost every investment strategy for market making, arbitrage, or pure speculation (including trend following). That is the "good side" of algo-trading.
It is very common for traders to also put in "stop-loss" limits in algorithms - the point to which, if the price falls, a sell order at market is implemented. This is intended to cap the downside of any bet taken. However, there is a major side-effect of this: When prices are falling, when stop-losses are triggered, the number of shares being sold sharply rises - which results in the prices falling further, which then sets off a fresh wave of stop-loss orders ... and so on, till you have a price crash that nobody can stop, because it all happens faster than the human mind can comprehend and act on! This is analogous to how we get pile-ups on high-speed superhighways, but much lesser scale of accidents on very crowded roads.
That is the reason why, today, sudden single-day (or even single-hour) falls in several markets all over the world are unsettling, but alas, not infrequent occurrences.
In the next few days, I will be writing more on algorithmic trading. Look out for more!

Some scary statistics about the US - revisited

In April, 2010, I had blogged about some scary statistics about the US economy. I revisited these statistics, and here are the results. While everyone is absorbed about whether the Republicans will agree to increase the US debt ceiling, let us revisit some statistics that looked scary to me in April, 2010. Let us see what has happened since then.

• US National Debt has gone up from 89% of US GDP to 98% of GDP.
• Total US Public Debt stands at $14.293 Trillion; by August, it will touch $14.3 Trillion, which is the current ceiling.
• US GDP per citizen has actually gone up by a little over $1,100, in spite of increasing unemployment numbers.
• However, US National Debt per citizen has gone up by $5,200 in the same period.
• US Debt held by foreign countries has gone up from $3.875 Trillion to $4.584 Trillion.
• US external debt to GDP ratio has crossed 100%. The equivalent figure currently for India is 21%. For the UK and France, this ratio is at a staggering 388% and 208% respectively.
• Assets per citizen has gone up by $8,900 while Liabilities per citizen has gone up by a staggering $674,000. Similarly, Interest burden per citizen is up from $1,493 to $11,664.
• There has been winding down of about 5% of currency and credit derivative exposures, but a much longer road remains to be traversed.
• All-in-all, a dismal report card. For a Nobel Peace Prize-winning President who has got the US involved in a third senseless aggression in Libya, and so far failed to unwind its involvement in two other messy wars it has been engaged in for more than a decade. 

	8 Apr, 2010	26 Jul, 2011
US National Debt to GDP (%):	89.12	98.18
US National Debt per citizen ($):	41381	46619
US GDP per citizen ($):	46381	47488
US Total Debt per citizen ($):	180484	176113
US Personal Debt per citizen ($):	53787	51441
US Interest Burden per citizen ($):	1493	11664
US Total Assets per citizen ($):	234181	243086
US Total Liabilities per citizen ($):	350054	1026974
US Gross Domestic Product ($):	14.333 Trillion	14.809 Trillion
US Debt held by Foreign Countries ($):	3.875 Trillion	4.584 Trillion
US Government Bailout ($):	6.387 Trillion
Currency and Credit Derivatives ($):	648.975 Trillion	611.499 Trillion

• One point about India: Gold is a bulwark against uncertainty. Indian Government's holding of gold currently is higher than all countries save 9; if the private hoard of gold in Indian families is taken into account, India's gold holdings would be at least twice that of any other country on Earth. Gold prices are at their record high of $1,600 and John Paulson (the hedge fund manager who made a killing in 2008 by betting that the sub-prime crisis would result in CDO/CMO defaults) says it will touch $4,000 an ounce in the next 3-5 years.

Sathya Sai Baba departs

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Expect some sleazy stuff of palace intrigue and financial misdoings to come out, now that Sathya Sai Baba has departed, leaving no clear successor or succession plan, but huge wealth and assets meant for public charity. The rumbles began even as the Baba was on his deathbed.


One prosaic, non-spiritual lesson we can learn from this is, WRITE YOUR WILL. Howsoever rich or poor you are. So that your heirs do not fight or do not have too much trouble with paperwork where nominations are not recorded, or where property title deeds are mortgaged, or where your property may need to be sold in order to share proceeds.
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Whither "Canned Education"?

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Recently, Agrawal Classes closed shop. Begun in the late 1950s, it spawned several "toppers" in the Science stream, and its students who got admitted into the IITs over the decades would be large enough in number to fill several batches. The owners' family was no longer interested in running these successful classes, and, instead of cashing out by selling the not-inconsiderable brand value of that trade mark, which needed to be defended quite often from sound-alike me-too's, they chose to close down quietly. 


This made me ponder on the phenomenon of "classes" -- teaching shops that supplement the primary educational institutions, viz. schools and colleges and also help students prepare for hyper-competitive examinations like the IIT-JEE (which Jim Clark, co-founder of Netscape, called the most difficult examination in the world to pass) ; or examinations that are notoriously difficult to pass (like the CA Examination which has pass percentages in the low single-digits). 


Rather than dwell on the question of whether they are a good thing or not, a point that can be argued ad nauseam, I thought of looking at the phenomenon and the number of business models it has spawned. I had first-hand experience of Agrawal Classes myself as a student of Mathematics, and I knew then as I do now that it was geared towards super-achievers. Ordinarily good students like me often fell at the first hurdle, and it was all we could do to even score 35% marks in their internal tests - when there were some students (destined to be toppers) who rarely dipped below the 90% mark. Only students who had scored above a particular percentage in the qualifying examination merited admission, even if one was willing to pay the stiff fees. 


Over the years, coaching classes have flourished -- with many being obviously more successful than others. But like Agrawal Classes, they were largely brand extensions of a single "Sir". They have often been named accordingly. For example, one of the most successful of such classes, JK Shah Classes, run tightly by the eponymous  "JK Sir", now runs out of 10 locations in 2 cities. Mr. J K Shah still engages classes, and he now has several other teachers who teach the mind-bogglingly large number of students in multiple batches, more than the total enrolments of any single commerce college in Mumbai, even though he uses a fraction of the space available to any large commerce college in Mumbai. Each of the teachers (many of them being CAs)  works really hard. 10 hours a day stand-up teaching is not uncommon. Each earns as much in two or three days than what a salaried CA with equivalent years of experience earns in a whole month working with a large company as a Finance Manager. J K Shah has run his business for over a quarter century with a sharp, single-minded focus: catering to coaching needs of CA-hopefuls. While he gets several opportunities or proposals to diversify, or to expand, he has kept things firmly in control -- all classes are owned by him; he has eschewed franchising or expansion into other domains (like teaching science). He personally selects and recruits teachers for his classes, and has very low attrition.  I had the good fortune of meeting him, and in a longish conversation I had with him and one of his proteges, I learnt or observed all what I have written above. Thus, this model is nothing but a scaled up (by a single order of magnitude) model of Agrawal Classes, in a particular domain.  However, there is one difference: the energy level demanded of teachers in JK Shah Classes (they have to teach a single topic/ subject repeatedly at all 10 locations, which means significant commuting every day) is much higher than the average teacher in Agrawal Classes - some of whom had time and energy left for conducting their own private tuitions as well.  If a teacher falls ill or is on leave, this always poses significant pressure on scheduling; because the others have to work harder and somehow fill the gap. The one thing common in JK Shah Classes and Agrawal Classes was their total commitment and absolute seriousness with which they viewed time schedules -- rarely are there time overruns because the syllabus is not covered.  The one big difference is that Agrawal remained a class for toppers or topper-hopefuls; JK Shah Classes prides itself on teaching almost any eligible student it can manage within its classroom capacity. However, many classes offer significant discount for students scoring very high percentages, thus encouraging high-scoring students to join.  


Of late, a newer model has emerged -- that of a model of growth in breadth of offering and also geographical coverage, often through partnering and franchising; sometimes through distance education, and sometimes through acquisition. Some, like Brilliant Tutorials, have pioneered a distance education model for competitive exams, in  engineering, medicine, banking, management and the civil services. Contact programmes are held in 14 cities (according to its website) and Model Tests are conducted in 44 cities across India. 


Educomp Solutions has pioneered use of high technology to achieve scale and reach (14,500 schools; benefitting 7.9 million students) for the K-12 (School+High School+Junior College) that were hitherto thought unthinkable. According to its website, teachers in some 4,500 schools now enhance their teaching by dipping into the large proprietary digital "instructor-led" content library built up by the company, using teaching aids like 3D animation, films, etc provided by Educomp through "SmartClasses" set up by them in different schools. Towards the end of a typical  class, every teacher displays questions on a screen, and every child in class gets ready to answer the questions with their personal answering device. Students click the answers, and instantly, teachers can get a score sheet for every child in class. She ends the class going over the parts of the lesson that the scores show as not clearly understood by the class. The technology also involves interested parents more closely by making available to them information the school chooses to share with them digitally. Also, the system largely reduces the drudgery involved in manual paper corrections by teachers.


Mahesh Tutorials (a brand owned by MT Educare Ltd) is another such model. It is a coaching class in the Agrawal or JK Shah Classes mould, with a major difference: It is growing its depth and geographical reach far, far more that the earlier named and their ilk. It is growing not so much through technology (though it spends a lot of money and effort on developing tutorial content) but through partnering (and lately through franchising, but these are tiny steps). They basically "swallow" individual classes, and allow these teachers a great deal of freedom to run them under the name and style of Mahesh Tutorials, thus getting advantage of both, the brand name recognition and marketing clout of Mahesh Tutorials, but also the excellent back-end support facilities that are shared by all "MT" educational offerings, like tutorial content, classroom scheduling and management, student interaction management, etc.. Over the years, after beginning with coaching classes for Std IX and X only, now they have day-care for pre-schoolers, kindergarten, junior college classes for Science and Commerce, and CA (CPT, IPCC, Final) students. They have grown from a single location to over 180 locations, including Dubai and London. And they still boast of the regular crop of "rankers" in most of the courses they offer, belying fears that quality and results may suffer with horizontal and vertical growth. 


Many feel that coaching classes themselves (Educomp is not strictly in this category) tended to make students dependent on "spoon-feeding" and that if they are not discriminating about the students they admit (like Agrawal Classes was), their results are bound to cluster near the average result for the examination as a whole. However, since so many students (an overwhelming 95% of CA IPCC and Final Students, for example) think that coaching classes is a good idea, maybe they need a second look. Especially because so many different business models all seem to be flourishing, the difference being scale and geographical reach. Indeed, some are simply cash-rich; some others are profitable but their expansion plans make them cash gobblers (like MT Educare which, while being profitable, is growing so rapidly that it has needed private equity infusion, and is likely to go public soon). 


MT Educare hopes to cross the chasm between "coaching classes" and educational institutions by setting up a private University, like Sikkim-Manipal, Amity or Lovely.  This is a "crossover" model - where one removes the distinction between coaching class and teaching institution. 


Are there other variants/ business models in this space? Would like comments from persons in the know.
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