April 27, 2009

Stress Testing - Too Late?

So finally US banks are being stress tested ! Everybody now seems to look forward to May when the report of US banks stress testing result is released. This is supposedly to separate the healthier banks from the weaker ones. A report in Washington Post states that a total of 19 US banks would be stress tested.

The results would give an indicator as to which bank is doing fine and can steer clear on its own without further government funding. The weaker ones shall continue to receive government money for some more time. This seems to be a good move by the Obama Administration since it is hoped that the results of the tests would be made public.

However, i feel that although it is very important to stress test the business, it would have been better if the banks were stress tested before the crisis hit. Doesnt it make more sense that way? Stress testing, as most of us know, gives an insight into the micro/macroeconomic effects on the business. for e.g. it deals with questions like what will happen to our portfolio if interest rates rise by 5% ? How adversely our portfolio shall get affected if the sovereign bonds of country X default? Wouldnt one expect that banks conduct such tests on an on-going basis to identify potential impact on its business and the measures it can take to shield against it?

Ofcourse, almost nobody could have imagined the size and the global scale of the current crisis. But I feel if the banks had conducted such testing more rigorously and diligently (even a child could have easily pointed out to the problems with the mindless lending and bad loans), the red flags could have been detected much earlier and the impact of the crisis could have been reduced to a smaller scale (possibly). We had all the necessary tools at our disposal then but the problem was no-one was willing to use them (out of sheer greed !)

April 18, 2009

Nuke for Commodity Trading !

Seems like US authorities were searching in the wrong part of the world for Nukes. An interesting article on the New York posts mentions "It turns out we were looking in the wrong place for weapons of mass destruction. They were not in Iraq. They were in Lehman Brothers'

See here for the related news.

April 17, 2009

Auto Profit Booking - Mutual Fund

Timing ! and more Correct Timing ! we know in all activities including Investment decisions is so important. Sometime or the other, we have felt "I should have invested in this a year ago and i would have made a killing" or "It was a stupid decision to buy that stock 2 months ago. Rather it would have made more sense to sell it and lock the 10% gain"....Timing our investments is very difficult and even though you have planned when to get in, you have to also carefully plan when to get out.

Recently, i read a news about a new Mutual Fund that gives an option to an investor regarding the exit point. i.e. Auto Redemption of fund units. Investors can choose between 10,20,50,100% return options. With this feature, once the fund returns since invested date reach the desired percentage, the units are auto-redeemed and the proceeds are invested in a safer instrument (such as a debt fund for example).

With this feature, an investor gets his desired returns which are then safeguarded (from value erosion in case of adverse market movement). Plus he doesnt need to track the market to find an exit point. Infact, i feel this feature can also aid to control investor greed. Studies have found that only few people redeem their investment at their desired return level. This is because investors become more greedy after a certain return % is reached and they still want more out of their investment !

I find the auto-redemption feature pretty cool and i wish all AMCs should have this option for all of their Funds especially in these uncertain times. This feature would certainly benefit the common investors. However, ofcourse if the market continues to move southwards, this feature is useless !

April 13, 2009


As we know, many companies all over the globe are facing liquidity problems. i.e. are short on cash reserves. They are thus finding it very difficult to pay (interest) to their creditors. So who they will go to for funding? In usual case, the answer would be a bank loan or public debt (issuing bonds for example). But these days, the banks themselves are finding it extremely difficult to lend money (as trust among the market players is lost) and the public too would be hesitant to lend money to a company whose future is uncertain (a troubled company might default on its bond payment in the future).

The situation is so severe that many companies have become bankrupt or would file for a bankrupty in the near future if their need for cash is not satisfied immediately. There are already about 1,700 bankruptcies in Japan in 2009. The US government has helped such companies with multi-billion loans through the TARP (Trouble Asset Relief Program). For companies, who are finding this aid insufficient are now going to the public for help; by not offering debt but by means of equity shares ! some also want to repay their government debt by borrowing from the public. The idea is simple; in case of public debt the company is obligated to pay back the money with interest to the investors. If the company doesnt meet its obligations, it defaults, tis credit rating takes a hit and in worst case can even go bankrupt. On the other hand, by issuing equity, the company is on a safer side. It is not obligated to make dividend paymens to its shareholders.

I do not wish to name such companies or the size of their offering, but recently there has been a rise in number of equity offers in Japan as well as in the US. These amount to multi-buillion dollar deals. Companies are trying to woo the investors with such offers. This means from now on, it is the turn of the common investor (tax payer) to throw their hard-earned money at (troubled) businesses next to the US government. Do i sense some danger here? By the way, from where does the US government fund the money it loans to these "troubled" companies? From the tax payers pocket ofcourse. So it is the common man who is on the receiving end and is at high risk.
My view : Doubly evaluate the risks before jumping onto investing in any company (especially if its on the TARP list) else you might be in a TRAP !

April 12, 2009

Economic Poetry - on the lighter side !

With the world deep in recession
People are awaiting government action
With jobs vanishing into thin air
There seems no end to the common mans dispair

Some say the crisis was caused by unlimited greed and sub-prime
Leaving thousands without a nickle or a dime
With banks finding difficult to lend
Consumers cut down on their spend
With cash and assets gone in mortgages
Many now survive on just sandwitches

Something surely did go wrong
Erasing the value from dollar to the won
Gone are the days when businesses were making hay
With Defaults and Bankruptcies the order of the day
We all hope for a soon recovery come what may

April 07, 2009

Mark-to-Market Accounting rule relaxed !

With the global Financial Crisis getting deeper, we know that banks are finding it very difficult to lend and raise capital. To tackle this problem, seems like banks are coming up with new ways to make their portfolios "look" better than before. But how are they trying to achieve this?
By de-regulation ! Let me explain below what i mean

Recently FASB (Financial Accounting Standards Board) relaxed the rules for mark-to-market accounting. Now you may ask what is mark-to-market? Simply put, it means reflecting the market (fair) price of assets in your account. For e.g. if 1 year ago, you bought an asset at 50$ and today its market value (worth measured by investors) is 30$. This means the asset is now worth 20$ less than the price at which you bought it. So it makes sense to report the asset in your account at 30$ (which is the fair market price).

This erosion in Portfolio value is giving banks many sleepless nights. Their assets (like mortgages, and complex derivatives) which they thought were Apples a year ago have turned into Lemons ! thereby causing huge losses. So these banks now want to convert their lemons into Oranges ! How? by relaxing accounting rules.

I think this is outrageous. These are the same banks who asked the regulators to enforce Mark-to-Market accounting regualtion in the 1990 boom period and later. Why? Because at that time, prices were on the rise so reflecting a higer value in assets would surely prove to be beneficial. Banks wanted to show fair prices on their balance sheets which were higher than the prices at which they first bought the assets. But now the economy on the down-turn and assets fetching only Lemon value (literally!), they want to de-regulate the system.

The question now arises "Is regulation something that is flexible and can be tweaked as per the need or should it be permanent and fair enough irrespective of the global economic health"? I prefer the latter.

April 02, 2009

Covered Call Strategy

Last time i discussed the Straddle strategy which can be used in a volatile market condition. Today we discuss about Covered Call; a strategy to adopt when you anticipate some upside potential for the stock but at the same time wish to protect from the downside loss.

A Covered Call is nothing but a combination of short (sell) call option and long (buy) stock.For e.g. you bought a stock at 100$ and sold an option on the same stock for 10$ (this is the commission called as option premium). This option expires 1 month later with exercise price of 105$ (this means you promise to sell the stock at 105$ to the option buyer 1 month later). Lets assume this is a European option (exercise possible only at maturity).

Consider 2 scenarios for the Stock price 1 month later:

Scenario 1 : Stock price is 90$
You loose (100-90) = 10$
Commission earned by selling the option = 10$
Your Net Profit = 10-10=0$

The option will remain unexercised (it wont make sense for the option holder to buy the stock at 105$ when its market price is 90$)

Scenario 2 : Stock Price is 107$
Commission earned by selling the option = 10$
The option would be excercised. i.e. You have to sell the stock at 105$. but since you bought it at 100$, your gain is 5$
Your Net profit = 10+5 = 15$

In both the above scenarios, your loss is minimized and gain maximized.

The above example is quite simple without considering trading costs, etc which would reduce the pay-off. Also, one can argue that if the stock price shoots to say 130$ or is pulled down to say 80$ then your entire commission is lost and you make a net loss. So this strategy is better when market anticipates a lower volatility in the short term.It can also be argued that the option premium can be re-invested at a risk-free rate thereby increasing your gains.