Why are markets taking a nasty 'U' turn?

The financial market 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 their 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.

Is yen the new market villain?

The yen's appreciation to the dollar has taken most analysts and market participants by surprise. Experts were expecting the yen to touch 116 levels, but it has already appreciated above 113. This is an 8-9% appreciation in just two-three weeks. There is a global sell-off in markets with investors rushing to exit their carry trade positions and the Nikkei has seen one of its worst intra-day falls ever since 9/11. Indian markets have been falling like ninepins and are breaching one resistance level after another.

This unwinding was prompted by investors who are worried about the happenings in the US sub-prime mortgage market, extend of the damage and the impact that it could have on global liquidity. A lot of the carry trade unwinding has happened already but analysts feel that more unwinding could still be remaining.

Anil Manghnani of Modern Shares & Stock Brokers feels that after sub-prime, yen carry trade could be the next villain. "First it was sub-prime and now it seems to be yen carry trade. The way Asia has traded in the last three days, suggests there is still some unwinding left in the yen carry trade. The way a lot of delivery base selling took place in some of the larger A group blue-chip stocks would suggest that there is still some pain left in the system," he added.

So, what is this yen carry trade all about?

In the mid- and late-1990s, Japanese interest rates were almost near zero. Their economy was fighting a deflation and the central bank there progressively reduced interest rates in a bid to spur households and businesses to spend, invest, and revive the economy, which was in deep recession. Meanwhile, when Japan was in a slump the rest of the world tried to have a good time at its expense and thus was born the yen carry trade.

Investors used to borrow in the yen and convert the same into dollars to invest and take advantage of low interest rates on the Japanese currency.

The trick in making money out of the yen carry trade has always been to catch the yen in phases of depreciation, which has been few and far between.

This was a sound strategy, which was profitable in a depreciating yen scenario. Now, with the yen appreciating, tables are beginning to turn.

To aggravate matters the Bank of Japan, or BoJ, may also raise interest rates in its August 23 meeting. This could have huge fallout in India as well as a number of domestic companies had tied up loans when the yen was depreciating, which was to be settled in dollars. However, most companies have not hedged against the sharp upmove in the Japanese unit. A number of corporates that had swapped their rupee and dollar loans into yen through synthetic currency futures may now be in a soup.

Mkts essentially bullish despite seesaw: Experts

It was one of the most volatile day for the markets in recent past wherein Sensex opened weak with over 150 points cut following second steepest ever drop yesterday and proceed to trade extremely weak on account of subprime issue coupled with Yen carried trade. Sensex fell nearly 600 points by the mid session but in post lunch trade the bulls put up brave fight leading to spectacular recovery over 500 points. But finally, bulls could not maintain their momentum and again markets slipped in late trade on the back of sharp sell off witnessed in metal and IT stocks.

Sensex ended down 216.69 points or 1.51% at 14141.52, and the Nifty was down 70.55 points or 1.69% at 4108.05. About 1010 shares have advanced, 1940 shares declined, and 52 shares are unchanged.

BSE Midcap was down 92.97 points or 1.46% at 6,259.47 and BSe Smallcap was down 102.46 points or 1.31% at 7,694.80.

Ketan Karani, VP Research of Kotak Securities says, "I think the recovery was overdue. We were getting hammered by triple digit falls everyday and nervousness was there all round. So at some level, the buying was supposed to come in. The market has bounced back from 200 day moving average and a reasonable amount of short covering along with long investment buying was seen. We believe for the day, this should at least continue."

He is advising his investors to purchase, but be cautious. "We have been advocating buying as of today and we have been buyers in lot of the frontline stocks. We have been buyers at lower levels and as of date, I do not know what is the strategy being followed. But we have been buyers since morning, since the fall around 14,000 and below 14,000 was activated. We have been advising clients to purchase in a staggered and selective manner and be very choosy with the stocks, which you would want to invest."

Looking forward, Karani feels that we are in a structural economic bull run. "We believe the economy is doing the right things and yes, global things have impacted us significantly, not as significant as they have impacted the global markets, we have been lesser impacted. But there was too much of complacency among traders and among investors. So the complacency has gone away, lot of loses would have been taken, profits would have been booked. From here we believe as and how the economy moves and how the news flow comes from the economic side, markets will tend to move up but liquidity will be the deciding factor. What kind of liquidity flows back to India and what kind of domestic liquidity is pumped back into the equity markets. So these two things will decide the course of direction going forward. But yes, bottom formation would be a process. Today's bottom would be a good healthy bottom for reasonable long period of time. Let us see how it test going forward," he adds.

Nilesh Shah, CIO of ICICI Prudential shares a similar sentiment. "The end game will be certainly bullish for Indian investors I have no doubt in my mind about it. The moral of the story is that if you are domestic investor base is not strong enough to take the global volatility then your markets will slide down like this. Even if fundamentally it doesn't warrant the same treatment," he says.

U.S. financial-services shares rose after Fed Rate cut

U.S. financial-services shares rose for a second day, led by mortgage lender Countrywide Financial Corp., after the Federal Reserve cut banks' borrowing costs to alleviate a credit crunch.

The Standard & Poor's Financials Index advanced 3.2 percent to 459.07 at 1 p.m. in New York, after gaining 3.5 percent yesterday. Ambac Financial Group Inc., the world's second-largest bond insurer, climbed 9 percent and its larger rival, MBIA Inc., added 6 percent.

Regions Financial Corp., the biggest bank in Alabama, led a 3.6 percent gain in the Philadelphia KBW Bank Index, while E*Trade Financial Corp. paced a 4 percent increase in the Amex Securities Broker/Dealer Index.

The 0.5 percentage point reduction in the Fed's discount rate may encourage banks such as JPMorgan Chase & Co. and Citigroup Inc. to provide more cash to mortgage lenders, including Countrywide, and ease concerns that stock markets worldwide will fall further. Declines in all three indexes reached 10 percent or more for the year yesterday.

"It's a positive for the whole financial system,'' said Mark Batty, an analyst at Philadelphia-based PNC Wealth Management, which oversees $75 billion. "For lenders who are having difficulty accessing cheap sources of funding the discount rate coming down gives them more options to borrow at attractive rates.''

Countrywide, the largest U.S. mortgage lender, gained $2.17, or 11.5 percent, to $21.12 at 1:26 p.m. on the New York Stock Exchange.

Tapping the Lines

The Calabasas, California-based company remains the year's biggest decliner in the S&P Financials after tapping the entire $11.5 billion available in bank credit lines yesterday, a move that drove its shares down 11 percent.

"Yesterday's announcement that CFC is drawing on its $11.5 billion credit facility should provide it with the time to address liquidity/capital concerns,'' Bank of America Corp. analyst Robert Lacoursiere wrote in a note to investors today. He upgraded the stock to "neutral'' from"sale.''

The Fed's move buoyed banks and brokerages in the U.S. and Europe. Bank of America, the second-largest U.S. lender, climbed 5.6 percent, while Citigroup, the biggest U.S. bank, gained 1.7 percent. JPMorgan, the largest lender in the leveraged buyout market, advanced 3.3 percent.

Europe's Gains

Morgan Stanley, the world's second-largest securities firm by market value, climbed 4.5 percent. Lehman Brothers Holdings Inc., the No. 1 U.S. underwriter of mortgage bonds, rose 4.3 percent. Goldman Sachs Group Inc., the world's most profitable securities firm, increased 1.3 percent.

Deutsche Bank AG, Germany's biggest lender, added 2.8 percent. UBS AG and Credit Suisse Group, the No. 1 and No. 2 Swiss banks, gained 2 percent and 3.4 percent, respectively.

Bear Stearns Cos., which yesterday gained the most since October 1998 on speculation that it's close to getting a big investment, gained 1 percent today.

Buyers of asset-backed commercial paper lost confidence in the quality of mortgage loans made by lenders such as Countrywide and shut them out of the market for short-term financing this month.

Thornburg Mortgage Inc., a provider of so-called jumbo mortgages that don't qualify for purchase by federally sponsored agencies such as Fannie Mae, rose 23.3 percent today. IndyMac Bancorp, which lends to home buyers who fall just short of the qualifications for a prime mortgage, gained 8 percent. Thornburgh is down 39 percent for the year. Indymac is down 52 percent.

'Poster Child'

"The financials were the group that have basically been the poster child for this whole negative environment,'' said Theodore Weisberg, president of Seaport Securities Corp.

Bank of New York Mellon Corp., the world's largest custodian of investor assets, rose 5.3 percent. Rivals State Street Corp. and Northern Trust Corp. also advanced. Regional banks including Huntington Bancshares Inc. and National City Corp., two of Ohio's biggest banks, and Cherry Hill, New Jersey-based Commerce Bancorp rose at a faster pace than larger lenders such as Citigroup and Bank of America.

Crude Oil, Copper, Gold Advance After Unexpected Fed Rate Cut

Crude oil, copper and gold advanced after an unexpected cut in the Federal Reserve's discount rate eased concerns that a credit crunch will slow economic growth and hurt demand for raw materials.

The Fed, in an unscheduled announcement today, reduced its discount interest rate by 0.5 percentage point to 5.75 percent and said it's prepared to take further actions to "mitigate'' damage to the economy from the rout in global credit markets.

"The Fed cut rates, and the stock market started to scream, and commodities followed,'' said Leonard Kaplan, president of Prospector Asset Management in Evanston, Illinois. He has traded precious metals for 34 years.

Crude oil for September delivery rose $1.11, or 1.6 percent, to $72.11 a barrel on the New York Mercantile Exchange as of 11:17 a.m. local time. Copper for delivery in three months advanced $205, or 3 percent, to $6,945 a metric ton on the London Metal Exchange. Gold advanced $6.24, or 1 percent, to $658.25 an ounce.

"There is a fear the credit crunch could lead to weaker demand for oil products, and this is trying to take some of the fear away,'' said Hannes Loacker, an analyst at Raiffeisen Zentralbank Oesterreich AG in Vienna.

Brent crude for October settlement climbed $1.20, or 1.7 percent, to $70.62 a barrel on London's ICE Futures Exchange.

Copper futures for December delivery rose 4.8 cents, or 1.6 percent, to $3.139 a pound on the Comex division of the New York Mercantile Exchange.

Today's rate cut is providing "confidence,'' said Mo Ahmadzadeh, president of metals trading at Mitsui Bussan Commodities Ltd. in New York, said by phone.

Index Gains

The Reuters/Jefferies CRB Commodity Price Index fell 3.4 percent to 301.27 yesterday, the biggest percentage drop since at least September 1956. The index was 1.2 percent higher today.

The slump will be ``short-lived'' because global economic growth will soften any slowdown in U.S. demand, Goldman Sachs Group Inc. said in a report yesterday.

Equity markets in the U.S. and Europe rallied after the Fed's cut. BHP Billiton Ltd., the world's largest mining company, rose as much as 9.9 percent in London, while Anglo American Plc jumped as much as 8.8 percent.

The gains in commodities may be short-lived, analysts including Prospector Asset Management's Kaplan said.

"This is a short-term fix and the only question is: how long will it last,'' he said. "In my opinion, it may last for two or three days,'' he added.

"It's only one step the Fed has taken here,'' said Wolfgang Wrzesniok-Rossbach, head of marketing and sales at Hanau, Germany-based Heraeus Metallhandels GmbH, which owns five precious-metal refineries. "We shouldn't count on a complete change in sentiment.''

Metals Advance

Among other metals traded on the LME, nickel gained $750 to $25,850 tons. Aluminum gained $25 to $2,495 a ton, lead rose $90 to $2,895 and zinc increased $74 to $3,064.

"Nothing changes with this,'' Rudolphe Roche, a commodities fund manager at Schroders Plc, said by phone from London today. "The picture is still bullish for commodities.''