The Great Depression of Debt: scary : Book Review

Book review

The great depression of debt: Warren Brussee

by Atim Kabra

I hope the author, Mr. Brussee, is wrong. In fact, I hope is dead wrong. For if he is right then the immediate future looks look bleak and the time beyond that looks bleaker still. Lending weight to the bleak scenario is the author's track record. He called it right in 2004 when in his previous book ( The second great depression ) he correctly predicted not only the foreclosure crisis haunting us now but also the crisis engulfing Detroit that has left the American car makers gasping for survival.

 

In a way the book is refreshingly different as it is shorn of jargon. Mr. Brussee has spent his career implementing six stigma at GE plants in Hungary, China and USA. I guess he mixes his skills for numbers with a common sense approach of someone watching the markets from the sidelines, away from the day to day pressures of traders and market men and away from the daily tumult which can hide and blind the judgement of the best. The first few chapters establish the inevitability of the current crisis and establishes the propensity to live beyond one's income as the root cause.

 

Mr.Brussee's crystal ball for the markets predicts continuing turmoil, with depression bottoming out by 2012 or 2013 and he expects USA to fully recover only by 2020 though there will be several apparent recoveries as the depression marches down its path. You would have read by now the reasons elsewhere too for the pessimistic version of how the world events could pan out going forward. Mr. Brussee predicts massive government downsizing, fall in birth rates, increase in retirement age, pressure to cap obscene managerial remuneration, drop in dollar value, inflation and much more.  Though it might be a bit hard today to agree with many of the scenarios which he attempts to paint for the next few years, Mr. Brussee insists that these are realistic predictions and he goes on to paint even more dire scenarios of how things can go even more wrong. He also tries to define a remedial action plan in a chapter which he says was most satisfying to write. He lays great store on increasing spending on renewable and clean energy sources.  However, I would have been more satisfied if he had dwelt a bit deeper into the rationale behind the futuristic scenario building exercise.. Similarly, the chapter on remedial prescription left me wanting more insight into the details which would need to be put in place to operationalise his action plan.

 

This book should be regarded as two books rolled into one. The first book covers what I have described above: The reasons for the mess which exists today, future scenario building exercise and a prescription of medicines that need to be delivered to recover from the era of past excesses. The author thereafter moves into a completely different arena. He attempts to define an investment strategy focused on inflation protection and a depression survival guide complete with retirement savings charts. I would leave it to the reader to figure out their sweet spot of investing but would seriously recommend this book as a practical guide towards understanding the gravity of the depression threatening to engulf us and preparing to face it head on. Proper planning and preparation is half the battle won.

 

The author is based in Singapore and runs two private equity funds. Views expressed herein are his own. 

Mobs, Messiahs, and Markets : Book review

Book Review: by Atim Kabra

Mobs, Messiahs, and Markets : surviving the Public spectacle in Finance and Politics

Authors: William Bonner and Lila Rajiva

 

I have a confession to make. Twice while reading this book, I felt a compelling need to refer to the first few pages and refresh my memory on when the book was published. For your information, it was published in the year 2007 (I believe August) and well before the mega crisis and financial blowup of second half 2008 unfolded. If not for anything else then you got to read this book for its clairvoyance alone.

The authors have been bang on target painting what was then a potentially scary scenario which ended up becoming of the biggest blowups in the financial history of the world as it unfolded. They deserve credit for having faith in their contrarian doomsday vision when everyone else was going all out buying mortgage originator companies and expanding prop desks funded by Bank’s leveraged books without any due regard for the inherent risks.

 I ended the book wanting some more insights into the future but I guess that even the authors would not have imagined the scale and speed of the ensuing blowup. Besides a bit of Japan and a bit of gold on the long side and the need to stay away from the US Dollar on the short side, I am sure a lot more insight into what might work as an investment or hedge in case their views come true would have been helpful.

That said, this is one witty book which delights in taking the pants off almost everyone. Alan Greenspan is one such obvious target but I enjoyed the authors ripping off the sweeping generalizations made by the likes of Thomas Friedman.  The canvas of quotes is indeed wide and travels all the way from ancient philosophers to modern day pundits. It is clear that the author’s value the insights provided by history and he who ignores a historical perspective does so at his own peril and loses his rear view mirror. .

In the last 10 years, we have lived through the real estate mania and the internet bubble. Easy money and massive systemic liquidity played a crucial part in creating the irrational exuberance. Even now, to my amazement, I am reading pundits wishing away the fundamental shift that should happen worldwide as profligate US based spenders turn into savers leading to a slowdown in overall consumption impacting a consumer driven USA to a production driven China to a commodity supply  driven Australia, Canada and Indonesia. Successful money making in the new environment requires, in equal measures, an understanding of the interlinked gears driving a global market place as well as the psychology of the investors financing the mechanics through their participation in various markets. The authors do a yeoman service in baring these correlated and complex processes and highlighting the role played by the politics of decision making.

It is natural to expect the authors take a negative stance towards an inept government which turned a benevolent blind eye to the unbridled speculation and actually ended up promoting and exacerbating the crisis in part by creating excessive liquidity flows. As always it is the public (tax payers in today’s environment) who are suckered and left holding the bag in the end. A question that is still unanswered is the culpability of the regulators and their accountability for failing to stem the rot in time. Who polices the police is not clear. I do wish that the book was a bit more structured though. At times I did find myself questioning the extension of certain thought processes which kept going in a loop. The canvas of the chosen subjects is so wide that even 424 pages turn out to be inadequate to addresses the issues. I would strongly recommend this book to everyone with an interest in Markets and investing and also make it a compulsory read for the regulators in charge of minding these markets. 

A blueprint for improving Corporate Governance & preventing scams

Improving Corporate Governance: A blueprint for preventing future scams like Satyam Computers

By Atim Kabra

Why are we so surprised at Satyam Computer blowing up?

Probably not because there were accounting shenanigans, not because Raju placed himself before shareholders, not the fact that auditors were probably hand in gloves with the management and conveniently turning a blind eye to the fraud being perpetrated at the company, certainly not the fact that the so called independents were dwarfed by Raju, his charm, his wealth, his connections or were just plain incompetent and beholden to Raju for inducting them as independent directors in the first place. We are surprised by the sheer scale of the fraudulent activities which went on unchecked by reputed auditors and the numerous corporate governance awards which multiple organizations vied to bestow on Satyam. Well, it speaks volumes for these organizations but that is a matter for another debate. I wonder whether we are more shocked at the events that unfolded at Satyam or shocked by the fact that Raju had to own up to the going ons at Satyam. That such a well connected man with assets of gigantic size had to own up to mischiefs and scams , gives rise to innumerable conspiracy theories ranging from blackmail to jail in India being preferred over jails in the USA by Raju.

I have had the opportunity to discuss this issue in details with many fund managers based in India as well as overseas and I am attempting to detail a few steps which might help in preventing such scams in the future. I acknowledge that greed and hubris is an integral part of human nature. History of mankind and the scams perpetrated by humans on unsuspecting fellow humans make for an interesting reading. I believe that no amount of regulation can eliminate completely the possibility of recurrence of such scams. However, we certainly can make efforts towards minimizing the probability of scams and their size, by utilizing the twin tools of enhanced scrutiny and deterrent punishment.  It is critical to work towards increasing the probability of discovering nascent scams early enough if we were to minimize damage to trust and transparency which combined together form the underpinnings of any financial system.  The interesting part if that most of these suggestions are already being applied in parts in India with quite positive results. So we are not reinventing the wheel but just suggesting extending the existing format for wider coverage. While I do believe in self regulation, I also believe in strong industry regulators who can ‘police the police’. Without further ado, here is a prescription sheet which if implemented can probably control the spread of the disease.

Make the watchdogs accountable for the theft: punishment should be substantial

We hope that the truth about the role played by Satyam’s auditors will come out after an extensive investigation. When questioned about the investment decision, the common refrain is that the investors relied on certifications by Price Waterhouse, the reputed auditors of Satyam. If these so called savvy and professional watchdogs could not detect the fraud at Satyam, then how can we expect the due diligence done by investors to throw up the mischief?  I am not in a position to conclude conclusively whether the auditors were misled and were negligent in the conduct of their duties or they willfully colluded with the management at Satyam in perpetrating the fraudulent events. In any event, the impact of their role cannot be underestimated.

In both the scenarios, they failed their duties miserably. I would not be alone in calling for an exemplary punishment to be meted out to these auditors, a punishment which would raise the stake for others who may have been knowingly or unknowingly aiding or turning a blind eye to similar events at other firms.

SEBI had passed strictures against some prominent foreign banks some time back due to their role in activities considered undesirable. I am told that this action by SEBI had indeed led to a greater due diligence by their risk management and compliance departments and certainly has led to a salutatory effect on these and other foreign banks in respecting the laws of the land. Do not get me wrong. Deterrent punishment is not the panacea for all ills. However, it does serve its purpose in raising the stakes for players abusing the system. I must mention here that while SEC in the USA prosecuted more than 600 companies for wrongdoing in 2008, it still was unable to prevent Madoff from ripping off more than $50bn from investors.

Rotate the Watchdogs : fixed, finite and rotating tenure

Auditors and Independent directors are the first line of defense against abuse for ordinary investors. The best strategy would be to have one watchdog watch the other. I suggest a fixed tenure for auditors for a finite period of three years. At the end of his tenure the auditor will have to hand over his assignment to a new auditor. The new auditor will take a signoff from the previous auditor and it would be reasonably difficult for any auditor to assist in perpetuating wrongdoings if there is a more than reasonable chance of being discovered by the new incoming auditors. This could be a simple and effective deterrent against wrongdoing.

A similar system is already in place for the Indian banking sector where auditors are appointed in rotation for a fixed tenure of three years.

Make Independent directors truly independent with a finite tenure

A lot of hopes have been pinned on the role of Independent Directors on the Board of Directors in recent times. However, their impact has been hollowed by giving the managements the prerogative of choosing the Independent directors. This in itself is a contradiction with directors being called independent. More often than not, the Independent directors chosen by the management are chosen because of their proximity to the controlling management and are beholden to the management for choosing them to the Board of their companies. This raises serious conflicts of interest in impartial discharge of their duties. Many of the independent directors are not technically and professionally qualified to head the committees they chair in the companies.

I recommend that the Independent Directors be chosen from a pool of qualified professionals who are known for their expertise and integrity. Further, like the auditors they should be chosen for a fixed tenure of three years after which they should be replaced by other set of independent directors from the identified pool of independent directors.

A small note on identifying this pool of watchdogs (auditors and independent directors) would be appropriate at this juncture. SEBI is quite suitable for implementing this scheme.

·         There should be clear guidelines for eligibility for admission to the proposed pool of auditors and independent directors.

·         A thorough and open vetting process at the selection stage itself is critical for this initiative to succeed. Internet as a medium can be used effectively for this. The list of eligible candidates and their resumes and qualifications should be posted on the internet and public feedback invited. The feedback so received should be considered on due merit. My guess is that the rotten apples amongst the eligible candidates would be exposed by empowering the masses in this manner.

·         The watchdogs should be divided into various categories depending on their size and experience in the case of auditors and experience and qualifications in the case of independent directors. An appropriate match between experience, size and qualifications of these watchdogs and the size of the companies where they are to be appointed should be made.

·         The companies should be given a slate of eligible Independent Directors from the pool from which they can choose the directors.

·         A 360 degree feedback system could be used to monitor the performance of the watchdogs and keep the pool fresh with movement between the various categories depending on skill sets and feedback

·         A market driven compensation guideline for the watchdogs should be disclosed. The compensation should be reviewed every three years to keep it in line with market requirements.

 Subsidiaries over a certain size to have different auditors than the parent company

The business conducted in subsidiary companies is normally not scrutinized in the same details as the parent company and is open to abuse. Subsidiary companies which cross a certain size relative to the size of the parent company should not be audited by the same set of auditors auditing the parent company. This combined with a rotating tenure for auditors would ensure transparency and further minimize the possibility of conflicts of interest.

Institutional nominees on the Board

Pension Funds, Mutual Funds and FIIs today own a bigger chunk of equity than the promoters in many of our large companies. They owe it to their own shareholders and stake holders to work towards protecting their business interests and underlying investments. The same pool of independent directors which I spoke about earlier could be utilized to have them nominate their directors on the Boards of various companies.

To finish off, there is another significant player in the curious cast of characters who has been the first one to cry foul but this play of events could not have been as intriguing and melodramatic as it has been now without them. We would be erring if to the cast of Raju brothers, their ‘independent directors’, the infamous auditors, the bestowers of corporate governance awards, we forget to add the collective conscience of the ‘fund managers and brokers’ who, in my opinion, had a fair inking of not all being well at Satyam. Any broker or fund manager worth his salt would have heard not only of the huge real estate parcels said to be owned by the Rajus but also of their extremely close political connections. They would have known of the phoenix like rise of Maytas and the lucrative contracts housed in these ‘Satyam Group Companies’. They would have had an understanding of the nature of real estate transactions in India and the significant cash component which accompanies these transactions. Yet, they chose to turn a blind eye to the shenanigan, invested and traded in Satyam Computers, contributed to the enhancement of its market capitalization and ironically now profess shock at the lack of corporate governance at Satyam. While the financial community needs to introspect at its own doing and the propensity to turn a blind eye to the going ons in Corporate India, I believe that collectively, the financial community can be one of the most significant agents of change.  However, I worry that by the time change is implemented and percolates down the system, the same Satyam story might have been repeated in many companies in India and Satyam most certainly would not the last one to hit the can due to accounting fraud. 

Indian Equities: Still not time to buy

Indian Equities: Still Not Time To Buy
by: Atim Kabra November 17, 2008

The wealth destruction happening all over the world is on an unprecedented scale. The scale of the collapse of the markets is gigantic and almost all asset classes have moved south in tandem. There is no place to hide. As money searches for a safe haven, the US Dollar has been the biggest gainer. These gains are driven by the relative transparency of the US financial system and the flexibility in the American system to take drastic cost cutting measures through job layoffs and shutting down of unprofitable and unsustainable businesses. There is a flight to safety though the CDS pricing (Credit Default Swap) on US treasuries has been creeping up with investors seeking protection from a potential default by the US government itself.

Year to date, the best performing major equity markets in US dollar terms have been USA (Dow Jones down 38%), Switzerland (down 36%) and Chile (down 36%) while China (down 73%) and Russia (down 72%) have been amongst the worst performers. India, Austria, Greece, Hungary, Norway, Turkey, Indonesia and Venezuela are all down in excess of 60% year to date in US dollar terms. On a year on Year basis, metals are down over 44% since November last while Oil has closed at its 20 month low on its journey south. Gold which was thought of a safe haven in times of imploding markets and a cloudy future is down 9% over its closing previous November. Commodity index is down over 40% over November 07.

The Indian equity market has been amongst the worst performers in the world. Partly it is because it was amongst the world’s best performing markets last year and had attracted a lot of portfolio inflows and the trend has since reversed. The surging liquidity in the markets had attracted a lot of new players in the markets (primarily new hedge funds) who value short term price considerations and value the ability to trade in and out quickly. The long term fundamentals of the companies take a relative back seat to short term stock price movements. One can make a case that this factor distorted the fair pricing mechanisms of many companies which got priced at unsustainable valuations in the giddy days of daily new stock market highs. The market demanded new stories and the soaring ambitions of Indian entrepreneurs backed by stratospheric valuations supplied new investment opportunities with scant regard for valuations.

While the going was good, it did generate a favorable climate for attracting new equity for large capital intensive projects. New projects were announced and easy availability of money and limited analysis assured that not only they got funded but the companies embarking on these projects also got a boost in their valuations as future earnings streams from these projects were captured in the stock prices while scant attention was paid to the gestation periods and operational aspects of these projects. In retrospect the disastrous performance of Reliance Power post listing should have set the warning bells ringing for the market. However, greed overshadowed reason and the party continued.

Now the chickens have come home to roost. The pendulum has swung in the opposite direction and a lot of value stocks have emerged. The very stocks which were the darlings for many investors have suffered a horrendous bashing and now quote for a fraction of their peak valuations. This has led to several calls in recent past arguing that India is a fundamentally attractive market right now and can be bought with a 12 month horizon for decent gains.
My argument is that indeed while many attractive investment opportunities have emerged in individual stocks, it is premature to buy the market as a whole at this point. This is at best a trading market and there well may be a scenario where there will be market rallies which will not sustain and indiscriminate buying at this point in time may well lead to significant losses. Fundamentals based investors could do well avoiding the markets at this point in time. In a massively interlinked world as it exists today, recessionary conditions globally are being transmitted across to India at warp speed.

The main arguments for serious long term investors to wait before investing are based on the following thought processes which I shall expand in detail over the next few posts:

The sectors which led the boom suffer from serious issues at this point in time.

Slowing global and domestic demand, excess capacities coming on stream globally, shortages of capital, credit squeeze at suppliers end, job losses abroad and domestically leading to tapering demand etc. One can argue that there will still be further value erosion there. (Real estate & commodities sector)

Poor availability of credit (infrastructure & industries dependent on financing: autos)

Unavailability of funds for equity portions of large projects (infrastructure)

Wealth destruction on a global scale (banking)

Expected defaults amongst corporate and retail borrowers (banking)

Repricing of risk

Dramatic reductions in overseas orders (IT & export focused industries : textiles, gems and jewelry)

Reducing GDP growth rate assumptions and decreasing earnings estimates


However, I need to state that most of the damage is already priced in the valuations today. We now have to wait for the impact of the above to become clearly visible in the earnings stream of the corporate sector. I would be closely watching for the capitulation which has to happen. Somehow there still seems to be a vague hope for recovery which has still lingered on due to the rapidity at which the correction has happened. Only when that hope is crushed beyond redemption that the market will be a screaming buy again. Till then trade with abundant caution.

short term strength in US Dollar article on Seeking Alpha

The article on short term strength in US Dollar can be accessed by going to

http://seekingalpha.com/article/100590-seeing-short-term-strength-in-the-usd

access CDS article on www.seekingalpha.com

CDS article got published and can be accessed at

http://seekingalpha.com/article/101457-understanding-credit-default-swaps-a-case-for-regulation

Credit Default Swaps- the case for regulation

Understanding Credit default Swaps: the case for regulation

Imagine a market where you can trade your perception of someone else’s credit worthiness. Imagine a market where you can encash an insurance policy on an asset gone bad without owning the underlying asset itself. Imagine a market which is larger than the capitalization of New York Stock Exchange and is yet not regulated. Welcome to the world of Credit Default Swaps (CDS).

The Instrument: The Credit Default Swap market is massive, estimated to be in excess of $50 trillion. CDS are derivatives, ie financial contracts without the underpinnings of any actual assets. They are used to bet on the credit worthiness of a loan or debt instrument. The price of the swap moves in line with perception of the borrower’s credit worthiness. A swap seller believes that the borrower’s ability to repay the underlying loan will improve while a swap buyer seeks protection against the possibility of a loan or bond failing. Almost all players in the financial markets are involved in trading CDS be they banks, hedge funds, Insurance companies, mutual funds or pension funds. It is estimated that over 30% of the volumes of CDS markets would be on account of hedge funds. CDS were initially devised as a means of hedging loan default risk by banks in USA. Since then they have grown to cover bonds, corporate loans, CDOs (collateralized debt obligations), auto loans, junk bonds, credit card delinquencies and all sorts of debt securities. CDS can be structured on individual company debt or can be based on baskets of mix of securities or baskets of similar securities with varying risk profiles.

It is this very flexibility that makes CDS fascinating. The fact that it can be structured as per the requirements of the buyer and the seller and can be customized to cover the risk and offer protection being sought by the buyer makes CDS a prudent risk management tool.

Driven by global liquidity: However, with the massive amounts of liquidity injected into the system by the then Fed Chairman, Alan Greenspan, the advent of 2003 saw a significant decline in defaults on instruments of all sorts. The premium earned by hedge funds, who were a significant seller of CDS instruments, became a near riskless and lucrative source of profits in view of negligible defaults.

Sub-Prime assets: Very soon the path of CDS intersected with a reckless mortgage industry in the USA which was busy fuelling the upward spiraling home prices in the USA by bringing in home buyers with dubious credit history through innovative home loan instruments which created the optical illusion of highly priced homes being affordable to many. Borrowers with dubious credit histories and poor balance sheets got home loans creating the much maligned sub-prime category of loans. Then the ingenuity of human hubris took over and led to the creation of an out of control and spiraling circle of greed which now threatens the very banking system which created it.

Transfer of Risk: In the good old banking days, the home loans a bank made remained on its books and the bank earned a profit on the spread between its cost of funds and the return it got from the borrower. The bank had a vested interest in lending to a credit worthy borrower and vigorously following up with a borrower if he or she showed signs of falling behind in his monthly payments. The CDS market enabled the bank or the lender to transfer the risk of loan default on to a third party which often traded it out further. The CDS seller got a premium while the lender having effectively insured the loan against default risk traded the asset out. They buyer of the loan asset was smug in the belief that while he generated a higher than market return, he was covered for the downside of the borrower defaulting on the loan. If the risk of a borrower defaulting was being transferred out to somebody else, the lender had limited interest in evaluating credit worthiness and following up for timely payment. No one bothered to check whether the counterpart insuring the loan (the CDS seller) had adequate capital to back up his potential liabilities or the amount of gross CDS issued by them. This set the stage for massive defaults when the US housing market started collapsing. CDS were getting called in to be honored and the stage was set for collapse of the insurers who could not meet their liabilities.

Role of rating agencies: While all this was happening it was the rating agencies which in my opinion played one of the most critical roles in exacerbating the crisis. The rating agencies did not somehow see the risk in the real estate markets or did not downgrade the pool of toxic securities in time (or were the risks ignored in the chase of profits: that is a separate topic in itself) or did not see the huge quantum of contingent liabilities being underwritten by their investment grade clients. The net result was that banks all over the globe rushed in to capture the high yields being offered by CDO’s riding on the investment grade ratings. From an investor’s perspective, they were buying into graded securities offering high yields and capturing the spread between their cost of funds and the yield.

Enhancing Risk: The returns could be enhanced by using easily available leverage and the adventurous could further boost their return through effective use of carry trade (borrow in a lost cost currency to buy assets in another high yield currency). To put it in perspective, the underlying risk in assets was being multiplied by exchange risk and leverage risk though theoretically, the risks could be contained through forward contracts and swaps. However, friends in the industry aver that this was a fairly inefficient market where CDS trades were done in a non standardized format and settlements took a long time to close, exposing the participants to significant risks. This was a time bomb in the making.

Absence of Regulation: One of the biggest lacunas of the CDS was the absence of regulation. This enabled literally anyone to participate in the CDS market. There were no capital adequacy requirements which would have acted as brakes on profligate writers of CDS protection. There was an absence of a mechanism which shed light on the total exposure or contingent liability of the firms offering protection against default risks. The pricing in the CDS market was not regulated and quotes were not that easily available to players other than the market participants. Settlements in CDS trades were not following any established pattern approved by the regulators and unsettled trades abounded. When the markets started unraveling, there was a wild rush to the exits and price plummeted. Mark to market regulations ensured that banks had to provision for the fall in the value of the securities. With the Capital cover for the banks getting blown up, the stage was set for the de facto nationalization of banks all over the globe. AIG bailout, Lehman collapse, Bear Stearns blowout, Iceland collapse and governments stepping in guarantee deposits to prevent a global crisis of confidence in banking are symptoms of a severe crisis.

Need for strong regulatory bodies: Bailout packages have ensured that governments all over the globe will end up owning significant chunks in their banks. Hopefully, this will lead to better regulation and a clear set of rules governing the markets. It has been amply proven that in today’s electronic age where massive capital flows happen at the press of the button, all markets are interrelated. The need for strong regulatory bodies with participation from the government, the industry and independent experts has never been more acute. Such regulatory bodies will ensure a systematic growth, better risk management and will hopefully prevent sudden collapses with disastrous consequences.

Atim Kabra (October 22, 2008)

The author runs two private equity funds and can be reached at hiatta5@yahoo.com