Financial engineering?

Engineers are believed to be doing very well in financial services, especially in the areas of complex derivatives using Mathematical models.

Logically, the purpose of engineering should be either to increase returns for the investors or reduce the risk on investments. In many cases, exactly opposite happens. Either the investment returns go down or the risk goes up or both. Here is another such case that promised to offer both the promise of capital safety and higher returns. Read the article to know the final outcome. Those interested in further analysis, may also like this blog post by Joshua Brown, the reformed broker.

When there is excess money in hand and when the yields are low, very often investors chase yields – something that seems to be offering (promising) higher yields than available in the market is lapped up even by ignoring the risks involved.

Investors beware. Caveat emptor. Don’t invest in something you don’t understand.

When ignorance and excess liquidity meet, the results often are interesting case studies for future generations.

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Why bubbles matter to even a cautious investor?

The creation and bursting of bubbles can have direct or indirect impact on the finances of even a very cautious investor.

If the investor is aggressive and has invested borrowed money during a bubble, the results could be disastrous. However, even for a conservative investor, there could be major impact if a large number of big investors have invested borrowed money. Such a situation can lead to severe economic consequences in the aftermath of the bursting of the bubble.

Less than a decade ago, we witnessed such an event, popularly known as the sub-prime crisis. Large banks, institutions, hedge funds and even some Sovereign funds borrowed heavily and invested the money in risky assets. The after effects were felt across the world and by all investors – aggressive or conservative.

I have written the following in the beginning of the Chapter 2.9 – The Sub-prime Crisis:

In early 2014, while referring to the global meltdown of 2008-09, an IFA asked, “How does one explain to a school teacher in rural India that her portfolio value dropped by around 50% because someone on the other side of the world defaulted on his housing loan?”

Think about it. The investor thought that she was conservative and taking least risk. What she did not know was that it was someone else’s action that impacted her.

Read and learn from history. It is a good protection against the stupidity of others and of your own.

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Why are markets taking a nasty ‘U’ turn? – an article wrote years ago, but still relevant

Why are markets taking a nasty ‘U’ turn?

The financial markets have borrowed certain terms from Physics, e.g., leverage or gearing, equilibrium, momentum, etc. Those who understand the concept of leverage or gearing as in Physics or as in real life as an application of Physics can easily understand what can happen in case of financial leverage or financial gearing.

What is Leverage & when is it used?

Levers are used to enhance the effect of limited power available with a person. In other terms, levers are used when one needs more work done but has limited power. In the same manner, leverage is used when one has limited capital, but needs to get higher returns on the same capital. We have the facility to borrow money from those who have surplus; in most cases it is the bank. This borrowed capital added to one’s owned funds allows one to take a bigger position (invest more money) than one could take with only the owned fund. Now we know in levers, if the direction of the force is reversed, the result would be exactly opposite, but of the same magnitude. In financial leverage also, similar thing happens. Let us elaborate this.

Financial leverage is a double-edged sword

An investor has capital of Rs. 5 lacs. He goes to the bank and borrows Rs. 20 lacs. Now he has Rs. 25 lacs at his disposal. Let us say, he invests this amount where he earns 10% on the investment (10% of Rs. 25 lacs is Rs. 2.50 lacs). The profit of Rs. 2.50 lacs is 50% of the investor’s own capital. Although the investment gave a return on 10% on the amount invested, due to leverage, the investor could earn 50% on his capital from the same investment option. And that is the power of leveraging. However, what happens if the money is invested in stock market, which is volatile by nature? Some times, the stock prices move up, but there are certain occasions when the direction changes. Let us assume in the same example that the investment depreciated by 10% instead of appreciating as before. Now the current value of the investment stands at Rs. 22.50 lacs, which is less by Rs. 2.50 lacs than the amount invested. However, out of this, Rs. 20 lacs belongs to the bank (or the lender) and hence, the investor, if he gets out of the market, would get only Rs. 2.50 lacs, which is 50% of his original investment. As seen here, leverage can work both ways.

How do banks (or lenders) assure safety?

Normally, as a matter of safety of their own money, the banks (or lenders) insist for some security against the loans. In the above example, the money that the investor invested is called margin money and the bank has the first right over all the stocks bought for the Rs. 25 lacs. That is the security of the bank. If this is the norm, in banking parlance, the bank has kept a margin (Rs. 5 lacs) of 20% of the value of purchase (Rs. 25 lacs) – margin of 20% is mentioned only as an example; in reality, the margin may differ from lender to lender. In other terms, the bank has restricted its exposure to the investment to the extent of 80% (Rs. 20 lacs of loan in the total investment value of Rs. 25 lacs). When the prices appreciated, the bank was fine since the value of the investment was Rs. 27.50 lacs whereas the bank’s exposure in the investment was Rs. 20 lacs (72.73% – Rs. 20 lacs divided by Rs. 27.50 lacs), which is lower than 80% of the value.

However, when the prices declined, the portfolio value stands at Rs. 22.50 lacs, out of which the bank’s exposure is 88.89% (Rs. 20 lacs divided by Rs. 22.50 lacs), much in excess of 80%. The bank now calls some money from the investor (known as margin calls) to restore its exposure back to 80%. If the investor is unable to meet the margin call, the bank is left with the only option of selling some of the shares in the market. How many shares does the bank have to sell to restore the exposure level to 80%? The answer is surprising (in fact, this also is a result of leverage). The bank has to sell shares worth around Rs. 10 lacs so that the value of the investments is now Rs. 12.50 lacs and the bank’s exposure is Rs. 10 lacs (80% of the investment value – Rs. 10 lacs divided by Rs. 12.50 lacs).

As discussed earlier, the bank calls for margin when the prices decline, and if the investor is unable to pay the margins, the bank is required to sell some shares in the market. This causes the prices to fall further and the bank requires more margin money. Add to this the fact that most of the loans also happen to be for buying the shares where the investor interest is the largest. That means when the banks need to sell shares to safeguard their own positions, most would be selling the same stocks. Eventually, the rally stops and the markets takes a nasty “U” turn leaving many investors shocked with the steepness of the decline.

If one understands the behavior of the markets as per the above discussion, the decline or its steepness is never a surprise. This was set up when the prices were moving up. And every uptick was only increasing the risk level in the market.

Are we suggesting that loan is a bad thing?

Not really. A loan is a good thing as it allows those with limited resources to acquire assets beyond reach. However, as is said about many other things, anything could be good if it is within limits. Loan for buying a house property is generally a good thing as long as one has enough earnings from other sources to pay the installments and that the ability to continue the income in future is good. Taking loan for business is also a good thing as long as the profit margins from the business are higher than the interest cost.

It is important to understand the nature of the loans and the asset / property one acquires. If the asset price is very highly volatile and not generating any income, taking loan for acquisition of such property is a good idea only if, (i) one has other sources of income and other assets to a bankruptcy and (ii) in the short term one has the ability to pay margins to the lenders.

Meeting the above conditions means that the amount of leverage gets capped to a certain extent.

There have been many examples in the history of large institutions and experts completely getting wiped out due to excessive usage of leverage. Those interested in knowing more about the devastation leverage can cause may read a classic called “When Genius Failed” written by Roger Lowenstein.

Amit Trivedi

This article was written when I used to work with Franklin Templeton

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Bond markets and maturity

There is a popular joke about the bond markets:

“What is the difference between bonds and bond traders? Well, bonds have maturity”

Look at the history of financial markets and you will realise that at the root of most of the crises, leverage was involved. People borrowed too much and invested the proceeds in a risky investment that did not appear to be too risky then. Risk was not absent, it was just not visible for various reasons. One of the most significant reasons behind this invisibility of risk had nothing to do with the risk, it had everything to do with the eyes of the person involved – the sight was clouded by greed.

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Leverage and illiquidity

Leverage used to invest in illiquid assets poses a serious risk. Similarly, if you do not have an alternate cash flow and the asset is illiquid, repayment of borrowed money becomes difficult

You may also want to read this article.

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Ignorance, illiquidity and leverage

When you combine ignorance, illiquidity and leverage (or borrowed money), it can create havoc.

Very often, the ignorance is about liquidity and sometimes about leverage. Ignorance may lead to making rash decisions.

Remember the story of Abhimanyu in chakravyuh? (You can read the story here Abhimanyu in Chakravyuh)

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Beware of leverage

Recently, I read an interview of Mr Rajeev Thakkar, CIO of PPFAS Mutual fund in the Value Research magazine. Somewhere in the interview he mentioned, “… leverage in the wrong hands can be devastating.”

During the great depression, a young investment professional  – Benjamin Graham – used too much leverage. This was a combination of leverage and a crash in the market. His portfolio hugely underperformed the overall market.

Graham corrected his mistake subsequently and emerged a winner. Graham eventually came to be known as the “Father of investing”. One of his disciples, Warren Buffett, earned more fame than the teacher.

After his disastrous experience as an investor during the great depression, Graham said that the mistake was that he owed money. “I didn’t repeat that after that.“, He said.

Leverage is not bad by itself, too much of it is disastrous.

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