Chart Fun | Friend, when will you choose to panic?
“The state of things now became alarming. To prevent, if possible, the utter extinction of public confidence in their proceedings, the directors summoned a general court of the whole corporation. By nine o’clock in the morning, the room was filled to suffocation. Several resolutions were passed at this meeting, but they had no effect upon the public. Upon the very same evening the stock fell to 640, and on the morrow to 540. Day after day it continued to fall, until it was as low as 400. Mr. Walpole was sent for, that he might employ his known influence with the directors of the Bank of England to induce them to accept the proposal made by the South Sea Company for circulating a number of their bonds. The Bank was very unwilling to mix itself up with the affairs of the Company; it dreaded being involved in calamities which it could not relieve, and received all overtures with visible reluctance. But the universal voice of the nation called upon it to come to the rescue.”
— South Sea Bubble, 1720. Excerpts from Extraordinary Popular Delusions and the Madness of Crowds
Human behaviour, specifically in the area of speculation, has remained unchanged over the centuries. The actors and dates change but the underlying boom-bust cycle of euphoria and despair repeats itself.
Yet, we tend to forget the lessons.
This time is different?
The Indian financials space has been a source of heartburn for many investors of late. A leading housing finance company delayed interest payments, causing mutual funds that hold the debt to markdown their holdings. Some debt funds that had large exposures to the issuer saw their net asset values fall by over 10% in less than a month.
This time is following a similar playbook to past financial crises.
- Growth slows down.
- Large financial institution goes belly up.
- Squeezes financing across the board.
- Some companies default.
- Rating agencies (belatedly) downgrade debt.
- Exacerbating a panic sell-off. Early birds in this sell-off manage to exit.
- Most others watch as they all populate the Ask. The Bid side of the market evaporates.
- Regulators pull up mutual funds that relied on Rating agencies as a ‘credit check’ before committing public capital.
- Mutual funds point at Rating agencies.
- Rating agencies point at issuers.
- Issuers point at the frozen financial markets.
- Financial markets point at the heavens.
- Regulators restrict participation in corporate bond markets, ostensibly to prevent further losses.
- The disappearance of a counteracting force exacerbates the contagion. But everyone thinks they are behaving rationally.
- Borrowers find themselves being shut out of funding.
- With complete breakdown in confidence, the magic Ferris wheel of finance comes to a halt.
- Bail out?
Friend, when will you choose to panic?
In some market regimes, market participants ignore known problems, because the stock prices of the said companies may be pushing higher.
In other market regimes, market participants choose to react belatedly to these previously known problems.
The trigger for this is usually a rapid sell-off in stock prices of the said companies.
1. How would you react if a widely-held, leading bank highlighted a serious divergence in bad loan disclosure in its Annual Report?
The bank’s own classification saw Gross NPA at 5% of its net-worth. The regulator’s classification pegged the same at 36% of net-worth. Yet, the stock price soared higher soon after, and investors re-rated the stock from 2.5x price-to-book to 4.5x!
The story repeated a year later.
What would you do? Buy/Sell the stock? When?
2. A covenant breach
The debentures of a leading financial services company had a financial covenant clause (stuff that the issuer needs to maintain; conveying good financial ‘health’). The covenant seemed to be in breach.
Portfolio at Risk (PAR) is the value of the outstanding balance of all loans in arrears. The debenture covenant mentioned that this ratio had to be maintained below 4%.
Yours truly reached out to the CFO.
Email excerpt:
In your presentation you have shown PAR %. PAR > 0 = 5.4% and PAR > 90 = 4.6%. The Financial Covenant in this debenture refers to PAR > 30, which is not mentioned in your presentation. But since PAR > 90 itself is 4.6%, it is likely that the PAR > 30 would be higher than 4%. PAR on each calendar quarter end seems to be higher than 4%, putting the above covenant in constant breach. Could you help me reconcile this with respect to the above Financial Covenant in the debenture Prospectus?
The email went into the abyss.
A covenant breach may be cast aside. As long as the loans get serviced and repaid on time. But if that was the case, why have Covenants? Equity investors in this company remained oblivious to this.
In many instances, such obliviousness does not hurt investors. No one enjoys poring over dozens of prospectuses that run over 300 pages, filled with sentences that begin at the top of the page, frequently running down several agonising lines, until the exhausted reader eagerly awaits a rendezvous with the full-stop.
When regimes change, and markets enter an environment of tight liquidity and increased risk perception, such events tend to trigger sell-offs and risk aversion.
The queer behaviour of market participants to such events poses a more fundamental question.
How can three entities (bank, regulator, market participants) looking at the same information derive vastly different conclusions?
One, or more, (or all) interested parties seem to overestimate their ability to truly ‘know’ the innards of a financial institution.
The answer to this conundrum lies in the beauties of accounting for financials. And in the vagaries of human behaviour.
One sees what one chooses to see.
When an institution is leveraged 5–10x, the ability of management to behave rationally and deploy capital prudently assumes paramount importance. The hidden incentive structures that underlay financial transactions become a key lever that investors need to focus attention on.
Finally, the moot question:
Why would businesses; that needs to employ 5–10x leverage, assume systemic and contagion risks, only to generate 10–15% return on equity; be valued at a premium to book value?
The Bank was very unwilling to mix itself up with the affairs of the Company; it dreaded being involved in calamities which it could not relieve, and received all overtures with visible reluctance. But the universal voice of the nation called upon it to come to the rescue.
It is time to invite The Big Bank.
