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!

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! 

More on ULIPs - esp NAV Guarantee

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In this entry, I had done a round-up on the ULIP SBI vs IRDA controversy, quoting a few experts. One of those experts, Jayant Thakur, commented on one aspect of my entry on which entity takes up the downside of the NAV guarantee, and what is its capital adequacy. He pointed out this article to me.  Inter alia, this article points out that the way the guarantee is managed is that if the NAV spikes on any day, enough of the portfolio is transferred to debt to cover the guaranteed NAV on maturity. This struck me as very unfair to the investor.

 Most ULIP brochures (here is an example) include words to this effect:

There will be an additional charge for the cost of investment guarantee of 0.10% per annum. These will be made by adjustment to the NAV.

This actually is the opposite of what advertisements make out implicitly -- that the risk and cost of the guarantee is being borne by the insurance company, whereas they are charging the investor every year. This sentence was what made me think in the first place that perhaps there would be a third party backing up or taking the downside for the guarantee, in return for a fixed charge, similar to bond insurance premia charged by monoline insurers in the US. Till I saw this sentence in the above-referred example ULIP brochure:

If the NAV of Pinnacle Fund falls below allowable limits, assets will be completely reallocated to debt.

If the guarantee is to be implemented by shifting from equity to debt as the article suggests, (and also what the above example brochure suggests) then it is insult added to injury added to dishonesty. Why so?
(a) It means they are charging the investor for what the fund managers already have the right to do, viz. invest any part of the portfolio in debt. That is Insult.
(b) It means that when the going gets tough, switching to debt to contain the fallout of the guarantee is a "poison pill" that the fund manager forcibly makes the investor swallow, because it lowers the expected rate of return dramatically and reduces NAV fluctuation dramatically too. It also means that the fund managers have virtually abdicated their fund management function. That is Injury.
(c) Switching to debt predominantly to de-risk and cap NAV guarantee liability means hardly any equity exposure left. Why should the investor pay a higher fund management charge on the now specious argument that investing in equity being riskier justifies a higher risk management charge? Worse, the fund reserves the right to increase the fund management charge to 2.5% per annum [being almost double of what they are charging today (1.35% in the example)]. All this when the investment risk is borne by the investor! That is Dishonesty. It is also Unfairness.
If, on the other hand, the guarantee is being implemented by passing on most or all of the guarantee cost to a third party, then the questions raised in my earlier blog entry remain relevant.
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Credit Default Swaps

Jayanth Varma of IIM, Ahmedabad, draws atention to the fact that the Depository Trust and Clearing Corporation of the US has published what is perhaps the first comprehensive official numbers on the global credit default swap market, including the top 1000 reference names, that account for over 95% of the market by gross notional value and a little less than 90% by net notional value.

Global gross notional exposure is $15.38 Trillion and Net notional exposure is $1.76 Trillion.

There are 4 Indian-owned entities in this list (ICICI, Reliance Industries, State Bank of India and Corus).

The gross and net notional exposures of these 4 Indian entities is $30.8 Billion and $3.8 Billion respectively.

Suggestions for a healthier debt market

In this informative article, the India CEO of Citigroup suggests some steps India can consider to improve the state of its debt markets.

Banks -- Their importance to financial markets

With the Sensex at an all-time high of 12900, I do not know what to think about investing in the stock market. Idly, my hands went to a book which I had written in September, 1991 (it was published in November '91 by Bharat Law House, Delhi). One small extract from it struck me as relevant even today as a sobering thought and influence.

"Our stock markets are still not so large that they cannot be affected except marginally by the actions of a few large operators acting in concert. This has happened today ... Already the BSE Sensex (Sensitive Index) has risen over 65% over only one year -- from around 1200 to nearly 2000 today. This is the tell-tale evidence of too much money chasing too few shares."

And another one:
"... there is a logical limit beyond which share prices cannot be leveraged. This limit is linked to the amount of real assets which all shares represent in totality. As long as there is some relation of the amount of shares available in the markets and the amount of real assets represented by this share capital, share prices can be maintained.
But what happens when, for every rupee of real asset, there are Rs.10,000 or more worth of shares? There will be many companies and funds which have no real assets barring a table and a chair, and yet, they will be capitalised in the millions on the stock market.
When too many such companies come to exist, sober reality will begin to assert itself and the stage will be reached when the people will realise that the Emperor is not really wearing clothes at all. Then will come the massive denouement: prices will begin to plummet in the stock market and people will lose confidence in all shares. This is exactly what happened in the United States" (in the late 1920s)
... What we are seeing is the beginning of an investors' bubble: the task before the Establishment is to puncture the bubble before it gets too big, and puncture it without it bursting, but so that it subsides gradually. By all standards, this is a delicate task."

This proved very prophetic --- and very soon too. In May 1992, a scarce 5 months after this was published, came the first denouement. Then we had the Ketan Parekh lesson of the mid-1990s. Each of these saw two banks go belly-up. In the first, it was the Bank of Karad and Metropolitan Co-operative Bank. In the next, it was Global Trust Bank and the Madhavpura Co-operative Bank. The lesson I saw in these experiences was that banks are the soft underbelly of the financial marketplace. If you have strong banks with robust processes and people, that is the best insurance against major shocks in the marketplace.