Easy come easy go

When markets were booming, Dipen Sheth warned against overleveraging. Now that his fears have come true, he elaborates. Sudhir Gore spoke to investors who suffered.

Dipen Sheth and Sudhir Gore         Print Edition: February 21, 2008

Click here to read on what went wrong in January

When markets were booming, Dipen Sheth warned against overleveraging. Now that his fears have come true, he elaborates. Sudhir Gore spoke to investors who suffered.

My rant against leveraged trading (see Boom & Bust in MONEY TODAY, 24 January) sounded like a severe case of sour grapes till some of the stock market “grenades” that the leveraged “monkeys” were holding blew up in their faces, to put it mildly. The BSE Sensex tanked over most of the trading week (21-25 January).As a fund manager for my clients (and readers of MONEY TODAY), I had dung all over my face in less than two trading sessions.

This was in line with global markets, from the Hang Seng, Straits Times and Kospi all the way to the German DAX, FTSE and the Dow. Meanwhile, a number of events after this global “meltdown” suggest that my old-fashioned dislike of derivatives and leverage (financial weapons of mass destruction, in Warren Buffett’s opinion) is worth a second look.

Consider the evidence from across the globe. Over-extended positions in European index futures taken by rogue trader Jerome Kerviel are being ascribed to a loss of over $7 billion (Rs 28,000 crore) at French banking giant Societe Generale, perhaps the largest ever such loss suffered by any bank Exposure to “sophisticated” bundles of subprime US housing loans have forced leading financial powerhouses like Citibank, Merrill Lynch and UBS to book billions of dollars of write-downs. Indian investors’ stock market holdings have depreciated over 16% (over Rs 6,00,000 crore in absolute terms) from recent peaks, primarily due to the domino effect of margin triggers on overextended positions in futures and options.

Saurabh Chaudhary, 28, Chandigarh
Saurabh ChaudharyStarted investing in stocks in May 2006. Moved to F&O in June-July 2006 because he “was seeking profits early”. Invested Rs 3-4 lakh in F&O and made money in DLF and Nifty futures. During the January meltdown, he lost almost 70% of his principal investment in GMR, IFCI, Tech Mahindra, Dr Reddy’s, IOC and IDBI futures. Faced with a liquidity crunch, he borrowed from friends and relatives to pay for the margin. Lessons learnt: Invest, don’t trade.

Purushottam Das Rathi, 55, Indore
Purushottam Das RathiA businessman, he started investing in stocks in 2003. Initial investment of Rs 2 lakh became Rs 20 lakh in five years. Moved to F&O in early 2006 because “one can invest in stocks by paying only 20-25% as margin”. Invested Rs 2-3 lakh in F&O and earned Rs 1.5 lakh in 18 months. Made money by investing in Nifty futures and index options. He prudently exited the F&O market in October 2007 when markets turned volatile. Lessons learnt is to keep liquid cash, control emotions and study fundamentals before investing.

Bhavin Shah, 42, Ahmedabad
Bhavin Shah
Investing in stocks since 1995. Moved to F&O in early 2006 because “one can make fast money”. Made Rs 5 lakh in F&O in two years. Had 17-18 positions worth Rs 10-15 lakh when markets crashed last month. Lost Rs 8 lakh within two days. Redeemed mutual funds to pay margin. Lessons learnt is never to overleverage or be overconfident. May not invest in F&O in future.

As of now, hedge funds, foreign institutional investors and private equity funds are unwinding leveraged positions in markets across China, Russia, Hong Kong, Brazil and India. The game continues, with little or no response from regulators, except for the odd tightening of margins or curtailing of trading facilities for the more reckless players who have driven themselves (and their clients) to bankruptcy.

The US Fed, of course, is easing money supply even more. The 1.25 percentage points easing of the Fed rate suggests that providing succour to the markets is an important concern for the financial mandarins. More important than controlling the reckless actions that went into creating the financial crisis in the first place.

This rate cut encourages the monkeys to play around with more grenades, does it not? Cut to the Indian stock market. For at least two days during the carnage, there was no way in which any small investor could have traded on the Indian stock market. Reason: many brokers had their trading terminals shut down by the exchanges due to margin shortages on their “exposed positions”.

The same lion-hearted brokers who persuading us to “buy more” were now not taking our phone calls, and were scampering out of Dalal Street like rabbits with their tails on fire.

If bankers in the US can get irresponsible while overzealously extending housing loans to folks, then can you imagine how reckless retail brokerages can get with their buying tips after lending money to investors? Especially when those tips will earn them risk-free brokerage on top of the usurious interest rates they charge?

The fact is that equities are a risky asset class, and therefore any “recourse”-based lending to finance the purchase of such assets increases system risk. (The “recourse” here is a “sell option” or exit in case the market value of the financed asset falls below a “safe” level.)

The point here is not whether my broker friends did the right thing by egging us on (they certainly didn’t), or even whether we investors were irresponsible enough to get egged on (yes, our greed played right into their hands).

Instead, the point is that a system that actively creates room for this kind of egging on (followed by the inevitable meltdown) deserves to be taken to the cleaners. We need a change in the system, no less. Here, then, is my thesis: let’s put an end to futures, options and other derivatives that the financial whiz-kids conjure out of thin air. Let’s disregard all those fancy presentations that bright young MBAs are shoving in your face to justify leverage in financial markets.

We don’t need the liquidity, jobbing and market depth, thank you. If the jobbers (or any other kind of traders) want to create depth in the markets, they should be willing to put some chips on the table, not just 20% of the proceeds or less. All we need is a low-cost platform to actually buy (and sell) what we really want to.

Not some fancy “derived” stuff that represents a leveraged “position” in the underlying asset. Let’s also put an end to brokers (or any other variety of modern day Shylocks) lending money to us to invest in their “hot tips” or “well-researched” stories. Meanwhile, here’s my thought for the fortnight: who was the first guy to go belly up in a leveraged trade whose implication he didn't quite understand? Not Nick Leeson, who brought down Barings in 1994.

Not Harshad Mehta, who diverted short tenure money market funds into the stock market in 1991. I think the first big leveraged loss was booked by one of the shining stars of the Mahabharata, and it was none other than the ever truthful and virtuous Yudhisthira, who gambled away Draupadi in a game of dice. Leveraged loss? Yes, since Yudhisthira was one of Draupadi’s five husbands, and had only 20% “right” to put the lady’s honour at stake. The rest of what he blew away was not even his (if at all such a thing could be allowed)!

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