The Ghost of Subprime Crisis

Being jobless sometimes gives you luxury to do things that you enjoy doing, but still can't do because of lack of time and commitment or just due to laziness. I was a regular author on this blog till the time I joined my first job. But now with the market crashing and all of my efforts failed to secure me a new job, I decided to continue with my one time love and that’s blogging.

Choosing a topic was not a tough choice for me as market which has given me this tough time, deserves all possible attention as a tribute. Lot has been written in financial media about current market meltdown. Sometimes back I got an article from one of my former colleagues about Credit default Swap and I decided to share a simplified version of same story.

The Ghost of subprime crisis is still there and fueling what has been described as worst recession after 1929 great depression. This post is about one of the biggest name in Insurance industry that is AIG. Last month with fall of Investment Banking giants like Lehman Brothers and Merill Lynch, AIG was also on the verge of collapse before Fed taking control of situation by putting $85 billion. AIG with presence in almost 130 countries and ranked 18^th biggest company by Forbes Global 2000 list is another example of consequences of bad bets on subprime related assets.

What Went Wrong With AIG?

Fundamentally core business of AIG is doing fine. Root cause of problem was exposure in Credit default swap.

A credit default swap is an OTC insurance instrument whereby two parties enter into an agreement, one insurance seller and one insurance buyer (who want to cover default risk on Loans disbursed by him). Insurance buyer pays an upfront fee and yearly premium (same as we pay for life or any other insurance) to insurance seller. Now if the loan on which insurance buyer has taken this insurance defaults insurance seller has to pay the full loan amount.

Suppose you are an institution engaged in housing finance. You (let’s say A) has given loan to some person (say B). Now there are chances that B can default on loan repayment. So to protect yourself from default risk you go to an insurance seller (say C). You pay an upfront fee and yearly premium. If B repays loan, C keeps all upfront fee and premium, thus making profit. But in case of default by B, C will be required to pay the full loan amount to A.

Basic purpose of this instrument is to serve as a hedging tool for institution who provides loan,buy bonds or in broad sense holds loan portfolio, thus subjected to default risk by borrowers.

As discussed CDS is basically an OTC instrument hence they are subject to counter-party risk. One more serious problem with CDS is that Investment Banks, Insurance Companies often use them in excess of their actual capital base. Lack of regulation on CDS exposure results in institutions taking as much as exposure they want.

Final Blow

With the collapse of housing market and subprime crisis most of institution in this market was in red. Firms like AIG before this crisis written insurance in the form of credit default swap for corporate and kept all upfront fee and premium as default rate on loans was low, thus making handsome profit. But once the housing bubble busted and default rate on loan increased AIG has to pay for insured loans. CDS that AIG has written as an insurer had much of toxic debts, asset backed security that has started to default as housing bubble busted. The mortgage pool that AIG insured started to fall rapidly. Losses started mounting and it was only after Fed’s intervention company could be saved by the way of injecting $85 Bn.

The biggest lesson from this crisis, that has emerged is need of proper regulation on OTC market. OTC market indeed helps hedgers and other market participants to take customizable position in the market, but lack of regulation results in reckless exposure by companies. Accounting principles has largely misused in this case.

OTC markets now needs proper attention by regulators. Even capital base requirement for firms needs to be updated in the light of emergence of more complex financial instrument.

Real Estate Investment Trust (REIT)

For most people investing in a property is like a dream, let it be residential, shopping mall, office building etc. what we generally mean by investing in real estate is either by owning them or purchasing shares of some real estate companies. But here we are talking about investor who wishes to invest directly in real estate. REIT offers investor who couldn’t afford to do so because of their financial capability to invest directly in real estate.

What is a REIT?

It is a corporation which primarily invests in real estate. But to get this designation they have to pay 90% of their income as dividends to share holders. By doing this they get exemption from corporate tax in most of developed countries.

Simply put, Indian real estate market is booming like any thing right now. Property prices are on exponential rise in tier I and tier II cities. Now you want to cash on this opportunity by buying some property. But is it possible for every investor like you and me?? This is a big question. So what you can do instead of this is to invest in some REIT (Just for explaining the concept, because as of now we don’t have any REIT in India). Now your money goes directly in real estate.

We can define REIT as a security that trades on major stock exchange and Invest directly in real estate.

Forms of REIT

Depending upon where they invest i.e. property, mortgage or a mix of them they can be classified as equity, mortgage or hybrid REIT respectively.

Equity REIT: They invest in their own property. This means they buy property, manage that and whatever profit earned pass back to shareholders. In this type of REIT rent from the property is main source of revenue. . Equity REITs tend to specialize in owning certain building types such as apartments, regional malls, office buildings or lodging facilities. Some are diversified and some are specialized.

Mortgage REIT: This kind of REIT primarily invests and owns property mortgages. They loan money for mortgages to owners of real estate, or purchase existing mortgages or mortgage-backed securities. Their revenues are generated primarily by the interest that they earn on the mortgage loans.

Hybrid REIT: they combined feature of Equity and Mortgage REITs.

Apart from this classification REITs can also be classified on the basis of where they invest, like shopping malls, office buildings, apartments, warehouses and hotels.

Structure of REIT

(source: http://www.zerinproperties.com/)

Unit holders invest in REIT. REIT on behalf of investor appoints managers for Asset management service. Money pooled from investor then invested in property. There is a property manager who for a fee provides property management services. Trustee is appointed to look after interest of unit holders.

Property generates income, after all fee and expenses the remaining net income is in hand of REIT. REIT has to distribute atleast 90% of this to unit holders.

From shareholder’s perspective

Question arises why one should after all invest in REIT, what is the advantage and disadvantage that REIT investment has. Advantages are Stable and recurrent income, Diversification, Professional management, Liquidity, Affordability and Convenience. Risks: Distribution is subject to cash availability, Returns are not guaranteed, Loss of control over investment, Market factors.

Qualification for a corporation for REIT designation

In order to qualify for the advantages of being a pass-through entity for U.S. corporate income tax, a REIT must:

· Be structured as corporation, trust, or association

· Be managed by a board of directors or trustees

· Have transferable shares or transferable certificates of interest

· Otherwise be taxable as a domestic corporation

· Not be a financial institution or an insurance company

· Be jointly owned by 100 persons or more

· Have 95 percent of its income derived from dividends, interest, and property income

· Pay dividends of at least 90% of the REIT's taxable income

· No more than 50% of the shares can be held by five or fewer individuals during the last half of each taxable year

· At least 75% of total investment assets must be in real estate

· Derive at least 75% of gross income from rents or mortgage interest

· No more than 20% of its assets may consist of stocks in taxable REIT subsidiaries.

(Source Wikipedia)

REIT in India

India's combined commercial and residential real estate market is valued at $12 billion, which is around 2 percent of the country's GDP and 2 percent of total stock market capitalization. And it is only getting larger. The real estate market is growing at a rate of 30 percent per year and expected to reach $90 billion within the next 10 years.

India is right now in process of setting up legislation for this. Once introduced these Indian REITs (country specific/generic version I-REITs) will help individual investors enjoy the benefits of owning an interest in the securitized real estate market.

According to Reuters (28h Dec 2007) SEBI has proposed setting up of real estate investment trusts (REITs), paving the way for wider participation by retail investors in the country's booming real estate sector. Under the draft guidelines issued by Securities and Exchange Board of India (SEBI) scheduled banks, public financial institutions, insurance companies and corporate will be eligible to set up a REIT, with initial networth of 50 million rupees.

Margin Trading

Suppose you want to buy shares of XYZ Company. You hope that in future the stock price will go up and you will make good profit. You have 50 Rs. with you. Stock is trading at 10 Rs. So with the money you have you can buy 5 share. Here your expectations are high on this stock. Hence you want to buy more than 5. But you don’t have the money. In this case you can take a loan from your broker. Suppose you buy 10 shares (50 Rs. borrowed from broker).

This mechanism of buying stock by borrowing money from broker is known as Margin Trading. It’s about borrowing money to buy more stock than you could own with your money. Investors generally indulge in margin trading because it provides opportunity to ramp up their profit by leveraging.

But margin trading is a risky proposition. As its increases returns so downside risk is also dramatically increases. To understand this mechanism lets take an example which we took on the first paragraph. Now suppose that as an investor you have bought shares worth 100 Rs. by borrowing 50 Rs. from your broker.

(1)Price at later stage	(2)Amount Paid back to broker	(3)Value of your Investment (1-2)	(4) Profit/ Loss ((3)-50)	(5) Profit/ Loss in % terms
140	50	90	40	80%
130	50	80	30	60%
120	50	70	20	40%
110	50	60	10	20%
90	50	40	-10	-20%
80	50	30	-20	-40%
70	50	20	-30	-60%
60	50	10	-40	-80%

So from above table we can say that for a 40% increase in price of stock has resulted in 80% profit !!!!! Isn’t it looks great but read a bit further for 40% decrease in price your loss is 80%..... Shocking ????

Mathematically we can put this formula for calculating profit/loss as follows:

Profit/Loss= Change in price(% terms)/(your own money in total investment in decimal terms)

Example: you bought 50,000 worth share by borrowing 20,000. Your own money is 30,000.

So your own money in total investment in decimal terms= 30000/50000= 0.6

Now lets take two cases, in first price goes up by 20% second price falls by 30%.

Profit in first case= 20/.6= 33.334 %

Loss in second case= 30/.6= 50%

Why this happens? Simple, broker doesn’t participate in your profit or loss. A broker only gets some fee for providing you this facility; you need a margin account to avail this facility apart from usual cash account. For the money you have borrowed from him, he takes your shares as collateral.

Margin accounts can be very risky. They are not suitable for everyone. Things one should keep in mind before going for margin trading:

* Money one can loose can be more than what he has invested;

* Your broker may ask you to deposit more cash or security in your account on short notice to cover market losses (Known as margin call);

* You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities.

One should check his risk appetite before venturing into margin trading.

Regulation in India (taken from SEBI/MRD/SE/SU/Cir-15/04)

In US Federal Reserve Board and individual self-regulating organizations, such as the NASD or NYSE regulates and issues guidelines for margin trading. In India SEBI is regulatory body for this.

On March 19, 2004 SEBI through its circular clarified regulations for margin trading:

Corporate brokers with net worth of at least Rs 3 crore are eligible for providing Margin trading facility to their clients subject to their entering into an agreement to that effect. Before providing margin trading facility to a client, the member and the client have been mandated to sign an agreement for this purpose in the format specified by SEBI. It has also been specified that the client shall not avail the facility from more than one broker at any time.

The facility of margin trading is available for Group 1 securities and those securities which are offered in the initial public offers and meet the conditions for inclusion in the derivatives segment of the stock exchanges.

For providing the margin trading facility, a broker may use his own funds or borrow from scheduled commercial banks or NBFCs regulated by the RBI. A broker is not allowed to borrow funds from any other source.

The "total exposure" of the broker towards the margin trading facility should not exceed the borrowed funds and 50 per cent of his "net worth". While providing the margin trading facility, the broker has to ensure that the exposure to a single client does not exceed 10 per cent of the "total exposure" of the broker.

Initial margin has been prescribed as 50% and the maintenance margin has been prescribed as 40%.

The arbitration mechanism of the exchange would not be available for settlement of disputes, if any, between the client and broker, arising out of the margin trading facility. However, all transactions done on the exchange, whether normal or through margin trading facility, shall be covered under the arbitration mechanism of the exchange.

External reference: http://web.sebi.gov.in/cis/circulars/2004/cirsmd152004.html

Exchange Traded Funds

I guess most of you must have heard about Index funds, which are generally floated by Mutual funds. Index funds has sole objective of providing same return to its investor as a benchmark index (like S&P CNX Nifty or Sensex). To do so they bundle up security in same proportion as in the benchmark index which they are tracking. Thus value of portfolio fluctuates with the market resulting in almost same return with market. Exchange traded funds are just like Index fund when it comes to formation of portfolio. But they differ on some important aspects. They first came into existence in the USA in 1993.

Definition: A fund that tracks an index, but can be traded like a stock. ETFs always bundle together the securities that are in an index. So we can say ETF are Index fund that trades on stock exchanges.

How it’s different from Index funds:
Trading: Investors has advantage to do anything with ETF that they do with normal stock. Short selling, margin trading etc. is allowed which is rare in case of Mutual funds.
Intra-day trading: ETFs are traded on stock exchanges so they can be bought and sold at any time during the day (unlike most mutual funds). Their price will fluctuate from moment to moment, just like any other stock's price. In case of Mutual fund they are generally traded on their last day’s Net Asset Value (NAV).
Operating and transaction costs: ETF is purchased through brokers so they attract brokerage fee unlike Mutual funds.

Next Post: ETF in India

Recent CRR hike by RBI and its implication

What is CRR?

This is the amount of money that the banks have to necessarily park with the RBI. The base of this is the total of the deposits that a bank has.

CRR is one of the best ways to remove excess liquidity from the market, thus cooling of the money supply.
As the money is not available with the banks, banks are forced to lend at higher prices and also push for deposits with higher interest rate. Higher interest on loans will drive people away from loans and higher interest on deposits will incline people towards depositing the money in the bank, rather than consuming it. The reserve ratio is sometimes used as a tool in monetary policy, influencing the country's economy, borrowing, and interest rates.

Recent Hike:

Dr. Y. Venugopal Reddy, Governor, RBI, presented the Mid-term Review of Annual Policy for the Year 2007-08 on 30^th Oct 2007, in a meeting with Chief Executives of major commercial banks. RBI hiked CRR by 50 basis point from 7% to 7.5%. Bank Rate, Repo Rate and Reverse Repo Rate kept unchanged. This is aimed to suck out Rs. 16,000 cr. from the system effective from 10^th November. The measure has been taken to manage capital inflow and suck out huge liquidity in system. RBI has aired it concern over huge inflow in real estate and equity market.

Was it expected?

No, it was not. Last time US Fed cut interest rate thus easing monetary policy. So even RBI was expected to follow this and take liberal policy decision.

Reason behind CRR hike

According to RBI governor Y. Venugopal Reddy the step has been taken to stabilize the economy from unwarranted excessive liquidity in system. He said in the bank’s mid-term review of annual monetary policy statement: “Financial markets continue to experience conditions of surplus liquidity, warranting an appropriate response in order to ensure orderly market conditions.”

Reddy also recognized the risks from “the rapid escalation in asset prices—equity and real estate—driven by capital inflows”, saying: “...the biggest challenge for monetary policy is the management of capital inflows and the attendant implications for liquidity and overall stability.” we have seen USD 8.9 billion flow into the Indian market in past one month and apparently Dr. Reddy is concerned about that and he thinks that the asset prices have risen to elevated levels

Sensex in recent past has climbed to new levels. During this month Sensex has gained more than 14%.

Implications

CRR hike generally triggers increase in interest rate. But at this point of time when Repo, Reverse Repo and other key policy rate has remained same, there is no chance of immediate increase in interest rate. In short run equity market will suffer a bit. Investors who find India a long-term attractive story will continue to put in money through various routes through portfolio, private equity, FDI. So in long run this decision has no impact on equity market.

Some public sector banks, like Bank of Baroda chairman A.K. Khandelwal and Punjab National Bank chairman K.C. Chakraborty said they would not hike their lending rates following the CRR hike but deposit rates would certainly go down.

Overall we can see this decision more as liquidity management tool rather than an attempt to increase interest rate.

To get a copy of Mid-term Review of Annual Policy for 2007-08 visit http://www.rbi.org.in/scripts/NotificationUser.aspx?Id=3908&Mode=0#p1

Mutual Fund Series - II

History of Mutual Fund:

The mutual fund industry in India started in 1963 with the formation of Unit Trust India, at the initiative of the Government of India and Reserve Bank. The history of mutual funds in India can be broadly divided into four distinct phases:

FIRST PHASE – 1964-87

Unit Trust of India (UTI) was established on 1963 by an Act of Parliament. It was set up by the Reserve Bank of India and functioned under the Regulatory and administrative control of the Reserve Bank of India.

In 1978 UTI was de-linked from the RBI and the Industrial Development Bank of India (IDBI) took over the regulatory and administrative control in place of RBI. The first scheme launched by UTI was Unit Scheme 1964. At the end of 1988 UTI had Rs.6, 700 Crores of assets under management.

SECOND PHASE – 1987-1993 (ENTRY OF PUBLIC SECTOR FUNDS)

1987 marked the entry of non- UTI, public sector mutual funds set up by public sector banks and Life Insurance Corporation of India (LIC) and General Insurance Corporation of India (GIC). SBI Mutual Fund was the first non- UTI Mutual Fund established in June 1987 followed by the following. At the end of 1993, the mutual fund industry had assets under management of Rs.47, 004 crores.

THIRD PHASE – 1993-2003 (ENTRY OF PRIVATE SECTOR FUNDS)

With the entry of private sector funds in 1993, a new era started in the Indian mutual fund industry, giving the Indian investors a wider choice of fund families. Also, 1993 was the year in which the first Mutual Fund Regulations came into being, under which all mutual funds, except UTI were to be registered and governed. The erstwhile Kothari Pioneer (now merged with Franklin Templeton) was the first private sector mutual fund registered in July 1993. As at the end of January 2003, there were 33 mutual funds with total assets of Rs. 1, 21,805 cores. The Unit Trust of India with Rs.44, 541 Crores of assets under management was way ahead of other mutual funds.

FOURTH PHASE – SINCE FEBRUARY 2003

In February 2003, following the repeal of the Unit Trust of India Act 1963 UTI was bifurcated into two separate entities. One is the Specified Undertaking of the Unit Trust of India with assets under management of Rs.29, 835 Crores as at the end of January 2003, representing broadly, the assets of US 64 scheme, assured return and certain other schemes. The Specified Undertaking of Unit Trust of India, functioning under an administrator and under the rules framed by Government of India and does not come under the purview of the Mutual Fund Regulations. The second is the UTI Mutual Fund Ltd, sponsored by SBI, PNB, BOB and LIC. It is registered with SEBI and functions under the Mutual Fund Regulations.

Structure of Mutual Funds:

All mutual funds comprise four constituents – Sponsors, Trustees, Asset Management Company (AMC) and Custodians.

1. SPONSORS

The sponsors initiate the idea to set up a mutual fund. It could be a registered company, scheduled bank or financial institution. A sponsor has to satisfy certain conditions, such as capital, record (at least five years ‘operation in financial services), and default free dealings and general reputation of fairness. The sponsors appoint the Trustee, AMC and Custodian. Once the AMC is formed, the sponsor is just a stakeholder.

2. TRUST/ BOARD OF TRUSTEES

Trustees hold a fiduciary responsibility towards unit holders by protecting their interests. Trustees float and market schemes, and secure necessary approvals. They check if the AMC’s investments are within well-defined limits, whether the fund’s assets are protected, and also ensure that unit holders get their due returns. They also review any due diligence by the AMC. For major decisions concerning the fund, they have to take the unit holders’ consent. They submit reports every six months to SEBI; investors get an annual report. Trustees are paid annually out of the fund’s assets – 0.5 percent of the weekly net asset value

3. FUND MANAGERS/ AMC

They are the ones who manage money of the investors. An AMC takes decisions, compensates investors through dividends, maintains proper accounting and information for pricing of units, calculates the NAV, and provides information on listed schemes. It also exercises due diligence on investments, and submits quarterly reports to the trustees. A fund’s AMC can neither act for any other fund nor undertake any business other than asset management. Its net worth should not fall below Rs. 10 crore. And, its fee should not exceed 1.25 percent if collections are below Rs. 100 crore and 1 percent if collections are above Rs. 100 crore. SEBI can pull up an AMC if it deviates from its prescribed role.

4. CUSTODIAN:

Often an independent organization, it takes custody of securities and other assets of mutual fund. Its responsibilities include receipt and delivery of securities, collecting income-distributing dividends, safekeeping of the units and segregating assets and settlements between schemes. Their charges range between 0.15-0.2 percent of the net value of the holding. Custodians can service more than one fund.

ORGANIZATION OF MUTUAL FUNDS

Next Post: Types of Scheme, Terminology, Performance Measurement of Schemes