Sunday, March 16, 2008

Credit Default Swaps

Last week, Indian economy has seen many banks creating provisions for CDS and CLNs as an after-effect of sub-prime crisis...let's get a detailed view of what Credit Default Swaps are and how does it affect the parties associated.....

CDS are an unfunded credit derivative instrument in which credit protection is bought and sold between the parties directly. When the credit derivative is entered through a financial institution and payment under it is funded through a structured financial process, it is called funded credit derivative. An example of funded credit derivative is Credit Linked Notes (CLNs).
A Credit Default Swap is a contract between two parties in which one party gets the credit protection for a fixed income product by buying the CDS and the other party guarantees for the product by selling the CDS. In this way, the risk of the default or failure to pay (called credit event) is diverted from the buying (or holding) party to the selling party. It is similar to an insurance policy in which the seller insures the credit risk in exchange for regular periodic payments (premium). In case of credit event, the protection seller purchases the product to compensate the protection buyer for the remaining interest and principal (Physical settlement) or pays the protection buyer the difference between the par and the market value of the product as a compensation (cash settlement).
Some of the questions that can arise while talking about CDS are:

1. How to define the Product? Is it a pool of assets - is the pool static or dynamic, meaning can assets be removed or substituted?

2.Does the swap allow for cash settlement so that in case of a credit event, the protection seller provides cash payments? Or does the cash payment be made at the maturity of the deal?

3.What could be the procedure and timing for determining the severity of loss on a defaulted product?

4.How is the "credit event" defined?

The explanations of the above issues can be illustrated as under:

1. In the first situation described above if the reference credit is an open ended pool, the underlying asset quality of that pool will fluctuate as credits are removed or substituted in the pool. For the Seller to avoid any unpleasant situation, there should be careful investment guidelines which cover when, how and what credits are allowed into the pool. If the terms of swap introduce elements other than that of default, the Seller is potentially exposed to risk which is not reflected in reference credit's rating.

2. In the second issue mentioned above, if the swap requires cash settlements as credit event occurs, this will present a different liquidity issue than normal for a financial guarantor. If a bond mantled by a financial guarantor defaults, the guarantor is required to make payment only in accordance with the regularly scheduled debt service payment schedule. This feature allows the guarantor to have sufficient cash reserves and liquid investments available to cover any potential payments required by a defaulted bond. But in case of credit swap, there is less predictability for the protection seller. Not all swaps require a cash payment. A physical settlement would require the financial guarantor as the Seller to pay par to the Purchaser for the credit. The credit then becomes the property of the financial guarantor as Seller. This asset can be held if the Seller anticipates that it may increase in value over time. The Seller will also be able to pursue traditional creditor remedies against the issuer which may increase the asset's value to the Seller. However, the Seller now owns an asset with limited liquidity and must continue to own is until it either increases in value or becomes liquid, thus losing the opportunity to invest in other more attractive assets.

3. The amount, the protection seller has to pay depends on how and when the loss is valued. Since the value of the credit fluctuates over time, especially after default, the timing of the determination of loss is important. There may be instances when it is in the Seller's best interest to have the value established at the time of default, if the Seller anticipates that the credit will decrease in value over time. However often the credit will increase in value over time. Then an immediate valuation at the time of the default will not be in the Seller's best interests. The market value 30 days after default is considered to be the best standard. This allows for the market to abide the available information about the credit which would be reflected in the price and that the price will be relatively stable. Any swap which calls for valuations earlier than 30 days after default will expose the swap provider to higher pricing volatility and potentially greater losses. Additionally the quantification of how much loss has occurred is a crucial point for the protection seller. The amount of loss should be calculated using objective methods. The preferred methods are either by obtaining bids from independent third parties or going through a formal workout process to arrive at a workout value. A swap provider is thus subject to the market risk of the particular reference credit as well as the default risk.

4. The last common credit default swap term is the definition of "credit event". It is the credit event which will trigger the financial obligor as Seller's obligation under the swap and is, therefore, a crucial component in determining the risk to the financial guarantor in any swap transaction. The definition of credit event in most credit default swaps will incorporate one or more of the following events as defined by the 1999 International Swaps and Derivatives Association ("ISDA") Credit Derivatives Definitions:
• Bankruptcy
• Failure to pay
• Restructuring
• Repudiation/moratorium
• Obligation default; and
• Obligation acceleration.

How is it different with normal Financial Guarantor:

The first difference lies in the high predictability and certainty for the financial guarantor for the amount to be paid in case of default, whereas in case of credit swap, the amount to be paid as default happens depends on the time and way of valuing the loss.
The uncertainty over timing of the loss and the quantification of the amount of loss are issues which a financial guarantor does not face in the operation of its business as a financial guarantor. A financial guarantor which has mantled a bond has a very definite time when payment is due. It is when the issuer has missed a debt service payment, or there has been a payment after a bankruptcy of the issuer. Both of these events are definite and can be predicted by the issuer's credit rating. Likewise the amount of loss is definite. It is the amount of the missed or disgorged payment. There is no market risk, interpretation or valuation necessary to establish how much the financial guarantor is obligated to pay.

Additional Risks Present in Credit Default Swaps

• An additional risk to the financial guarantor is introduced if the Purchaser of the protection can determine whether a credit event has occurred. Thus an aggressive Purchaser could determine that a credit event has triggered the terms of the swap, forcing the Seller to perform under the swap. Since the actions of the Purchaser will be hard to predict, the financial guarantor as Seller should make sure that the swap is structured so that the occurrence and severity of losses on the reference credit can be objectively and independently identified, calculated and verified. For example the credit event should be published in a well known news source, corporate filing or court document to prevent the staging of credit events solely to trigger the swap. The amount of loss should be calculated using bids from third parties or a formal workout process. Again these risks are not present in a financial guaranty. There either a payment has been missed by the issuer or a payment previously made by an issuer who has subsequently filed for bankruptcy has been disgorged by the bankruptcy trustee. Thus the instances in which a financial guarantor must make a payment are clearly defined and the amount of the payment required is also not subject to interpretation.

• A correct documentation is an important factor in the protection bought by the Purchaser and the final loss attributable to the Seller. A mistake in even a simplest term can have important consequences. For example, the reference credit must be referred to in the documents using the correct legal name of the entity (product) for which the Purchaser is seeking default protection. A default by an improperly identified reference credit from the Seller's perspective may not legally trigger its obligation to pay under the swap. However, lack of proper documentation is the same risk factor for a financial guarantor either in its financial guaranty business or in the credit default swap business line.

Friday, February 8, 2008

Delisting of Securities

The term "delisting" of securities means permanent removal of securities of a listed company from a stock exchange. As a consequence of delisting, the securities of that company would no longer be traded at that stock exchange.
Compulsory delisting refers to permanent removal of securities of a listed company from a stock exchange as a penalizing measure at the behest of the stock exchange for not making submissions/comply with various requirements set out in the Listing agreement within the time frames prescribed. In voluntary delisting, a listed company decides on its own to permanently remove its securities from a stock exchange.
SEBI (Delisting of Securities) Guidelines, 2003 provide an exit mechanism, whereby the exit price for voluntary delisting of securities is determined by the promoter of the concerned company which desires to get delisted, in accordance to book building process. The offer price has a floor price, which is average of 26 weeks average of traded price quoted on the stock exchange where the shares of the company are most frequently traded preceding 26 weeks from the date public announcement is made. There is no ceiling on the maximum price.
In case of infrequently traded securities, the offer price is as per Regulation 20 (5) of SEBI (Substantial Acquisition and Takeover) Regulations. For this purpose, infrequently traded securities is determined in the manner as provided in Regulation 20 (5) of SEBI (Substantial Acquisition and Takeover) Regulations.
A company listed at BSE/NSE does not have to provide exit offer to shareholders in case it delists from stock exchanges other than BSE and NSE because it continues to be listed on the BSE / NSE which have nationwide reach and shareholders can exit any time they decide to so by way of selling shares in NSE/ BSE.

Thursday, January 3, 2008

A small note on Call loans

A loan provided to a brokerage firm and used to finance margin accounts is called as call loan. The resulting interest rate is referred to as the call loan rate. Call loans use securities as collateral for the loan.
Call loan rate can change on a daily basis, and the loan can also be canceled with 24hours notice.

Broker's Call Loan
Short-term demand loan to a broker secured by pledged securities. Brokers use the loans to finance underwriting or to secure advances to customers who maintain margin accounts. The broker loan rate usually is a percentage point or so above such short-term rates as the federal funds rate or the Treasury bill note.

Telecom Infrastructure Challenges

The existing telecom infrastructure would not suffice because the subscriber base would be 500 million by 2010. In order to serve this market we would require approximately 330000 towers by 2010 as per Cellular Operators Association of India (COAI). As of today we have just 110000 towers in place. Thus, there is a huge gap that needs to be filled as the currently tele-density in India is in the range of 20-25%.
The upcoming challenges:
• Procedural Delays – there are approximately 40 clearances that are required prior to setting up a site. In India there is no scheme of exemption or single window clearance that would assist in tower execution. Thus the gestation period is very long thereby increasing the uncertainty and the financial burden on any party that builds the tower.
• Fund Raising – given the capex requirement fund raising in itself is a big exercise. Thus a constant hunt for creative finanacing is a time consuming and significant task.
• Absence of Tax benefits – there are no tax benefits available to the telecom infrastructure sector though it is in alignment with govt. and TRAI objective of enhanced tele-density and increades penetration in rural as well as urban areas. These challenges are common to carriers (Bharti, Reliance etc.) as well as independent tower companies. However the one challenge below in only for carriers.
• Sustainability – setting up infrastructure in circles B and C is significant and these two circles are recording the maximum growth in subscriber base. As compared to that the ARPU ( avg. revenue per user ) is comparatively lower in these circles. Thus a major challenge is to incur huge capex on building infrastructure in these locations and surviving on lower returns.

Sunday, December 16, 2007

Types of Life Insurance Policies

Some basics about the various types of insurance policies:

Life insurance policies can be broadly classified into two types, term life insurance and permanent life insurance. Term life insurance policies are basically meant for younger people who live with their families. These policies offer cover to a person's requirement on a short -term basis. If any unfortunate accident was to happen during the term of the policy then the policy holder can make an insurance claim with a term life insurance policy. You name any leading life insurance company and they will offer such term life insurance policies. The range of a term life policy will vary. With a permanent life insurance policy the entire life of a policy holder is covered. Whole life insurance policies are of this type and require you to pay for a small period of time. This is till the total amount is fully paid-up.
Here is a snapshot of the types of policies and what they offer.

Term Insurance
Term insurance covers for a term of one or more years. It pays a death benefit only if the policy holder dies during the period the insurance is in force. It is the cheapest form of life insurance. Most of the term insurance policies can be renewed for one or more terms even if the health condition of the insured person has changed. Though each time the policy is renewed for a new term, premiums may rise higher. This policy is particularly useful to cover any outstanding debt in the form of a mortgage, home loan, etc. For example if someone has taken a loan of Rs10 lakhs, he/she will have an option of taking an insurance to protect the loan in case of passing away before the debt is repaid.

Whole Life Insurance
Whole life insurance covers for as long as the insured person live if the premiums are paid. The premium payments remain stable and level throughout the life of the policy, and upon the death of the insured person, the beneficiaries receive the death benefit in whatever amount the policy was originally set up. It is different from term life in that it also builds "cash-value" as the years pass. However, that it takes many years for this to happen, so it can’t be looked at as a means to make money quickly. There are options in the market to have a return of premium option in a whole life policy. That means after a certain age of paying premiums, the life insurance company will pay back the premium to the life assured but the coverage will continue. Some whole life policies offer the premiums to be paid for a shorter period such as 15, 20 or 25 years. Premiums for these policies are higher.

Money Back Insurance
Apart from covering life, Money Back Insurance also assures the return of a certain per cent of the sum assured as cash payment at regular intervals. It is a savings plan with the added advantage of life cover and regular cash inflow. This plan is ideal for planning special moments like a wedding, child's education or purchase of an asset, etc. Money back plan have "participating" and "non participating" versions in the market.

Endowment Assurance
Endowment insurance is a level premium plan with a savings feature. At maturity, a lump sum is paid out equal to the sum assured (plus dividends in a par policy). If death occurs during the term of the policy then the total amount of insurance and any dividends (par policy) are paid out.
There are a number of products in the market that offer flexibility in choosing the term of the policy. The terms can be chosen from 5 to 30 years. There are products in the market that offer non participating (no profits) version, the premiums for which are cheaper.

Universal Life
This is a flexible life insurance policy and is also market sensitive. The investor decides here the several investment options on how the net premium is to be invested. While the money invested has the potential for significant growth, such funds are subject to market risks including the loss of the principal.

Unit Linked Product
Market-linked plans or unit-linked insurance plans (ULIP) are similar to traditional insurance policies with the exception that the premium amount is invested by the insurance company in the stock market.
Market-linked insurance plans (MLP) mimic mutual funds and invest in a basket of securities. It allows choosing between investment options predominantly in equity, debt or a mix of both (called balanced option).
The major advantage market-linked plans offer is that they leave the asset allocation decision in the hands of investors themselves. Investor is in control of how he/she wants to distribute the money among the broad class of instruments and when to do it or pull out. Any of the products mentioned above except term products could be unit-linked.

Riders are additional add-on benefits that one can opt to include in one’s policy over and above what the policy may provide. However, these additions come at an extra premium charge depending of the rider one opt for. These riders cannot be bought separately and independently. The extra premium, nature and characteristics of the riders are based on the base policy that is offered.

Some riders available in the market are :
1. Accident Death Benefit: Provides an additional amount in case death occurs as a result of an accident.
2. Term Rider: It allows the payment of an additional amount if death of the insured happens.
3. Waiver of Premium: In case of total and permanent disability of life insured due to accident or any other means this rider allows premiums on base policy or riders to be waived.
4. Critical Illness: It provides payment of an additional amount on the diagnosis of some critical illness.

Wednesday, December 12, 2007

US credit squeeze and India

It is obvious that Indian policymakers can do little about containing the magnitude of the liquidity squeeze that has been the by-product of the sub-prime saga in the US. The RBI will have to factor in this reduced availability of external credit in its plans, if any, to tighten the credit delivery system.....a nice article from Business Line:

News from the US, the main engine of the global economy aided by funds from emerging countries such as China and Taiwan, has been engaging the attention of economists and commentators for the last few weeks. The rising current account deficit of the US, its falling currency and the latest sub-prime credit woes have all drawn excited and focussed attention. Can India remain decoupled from what happens in the US economy?

Notwithstanding assertions of Indian policymakers to the contrary, when America sneezes, India catches a cold, although India is mainly sustained by domestic consumption and investment. Exports in general, and software exports in particular, are linked to US market demand.

If demand in US markets contracts, Chinese goods displaced from the US will descend on the rest of the world, including India. Directly or indirectly, the US economy’s contraction, which can result from a credit squeeze, can impact India. The implications are even more deep-seated than appears to a superficial observer.

Contraction of credit
Recently, TV channels flashed the views of the Chief Economist of Goldman Sachs who predicted that the abstraction from US credit markets will run into a global credit reduction of $2 trillion — a large sum of money by any reckoning.

Such a sharp contraction of credit will mean, at a minimum, the reduction of external borrowing by Indian corporates through the credit markets abroad, or, at any rate, a tightening of interest rates for such borrowing. It will also mean reduction of capital flows into emerging markets, including the Indian markets, which have already been alleged to have too high a valuation.

While this last aspect may not be good news for the Indian market punters, it may be music to the ears of the central banker struggling with $250-plus billion reserves and dreading further inflows.

The rupee may perhaps depreciate a tad from the high levels it has seen in recent months. This may be good news for our exporters and capital goods producers fearing the onslaught of cheaper goods from abroad. Overall, the impact would turn on whether the liquidity drop falls on external commercial borrowing or on investment in Indian stocks.

The reduction of global liquidity may spell a sharp reduction of access to resources for the Indian corporate sector.

The RBI will have to factor in this reduced availability of external credit in its plans, if any, to tighten the Indian credit delivery system. Already, the industrial production index has shown a sharp decline, as the latest reports show. It is important that the RBI does not pursue its inflation fighting credo to the exclusion of growth objective. It is, however, possible that the RBI’s inflation targeting hawks may gain an upper hand in view of the factor of crude oil prices touching the $100-mark.

Avoiding a repeat
The RBI has to take a holistic view of the combination of tightness of global credit availability and Indian investment needs in its next monetary policy stance. One hopes that there will not be a repeat of the mid-nineties experience when a burgeoning pace of economic growth had to be curtailed mainly because of the RBI’s tightening of monetary policy. In the light of this experience, at this time, one has to be doubly careful. This is possible since inflation is already down and global resources as a whole are under pressure.

It is quite possible that the US central bankers may themselves respond positively to the liquidity squeeze by pumping in more resources to avert a US recession. It this happens, the situation may not be as grim as Goldman Sachs predicts. But with Bernanke’s stance being primarily focused on inflation targeting, one may doubt whether he would counter the liquidity drain forecast.

At the same time, one has to bear in mind that world liquidity will be under strain, given the heavy drafts on resources by the $100-plus crude oil and its consequences on both developed and developing economies. How OPEC handles its surpluses will be critical to the issue. If it invests again in US securities, the damage will be mitigated. There is no alternative avenue for OPEC investment.

Difficult task ahead
The implications for Indian policymakers as a result of the global credit squeeze resulting from the US sub-prime mess are varied. First, the reduction in industrial growth might impact adversely, although not immediately, corporates’ profits and hence lower a bit of the good news on the corporate tax front. On the other hand, the recessionary impact of the reduction in credit to Indian corporates must not be worsened by financial tightening by the RBI.

While fiscal deficit reduction is a declared goal of the Government of India, its impact on growth of demand has also to be kept in mind. The Finance Minister may feel that he has a difficult task. On the one hand, he has to stimulate the economy fiscally. On the other, he has to keep fiscal deficit within the Fiscal Responsibility and Budgetary Management targets in order to keep inflation under control. Who said the FM’s crown has no thorns?

While the recent emphasis of Indian policymakers has been on containing the impact of capital flows, it has to be modulated now that the global scenario is changing. It is important that we remind ourselves continuously that we are in and part of a globalised economy. There is no point in insulating ourselves, whatever the other risks may be.

But, the RBI and Ministry of Finance have to work together to ensure that the liquidity in the system, continued effect of external capital flows and internal deposit resources remain optimal. While inflation has, of course, to be contained, food grain prices are showing a slight softening trend, aided by prospects of imports.

Balancing act
The prospects of a recessionary trend in the US have to be kept in mind in framing India’s tax proposals, especially its impact on the export sector. The impact of a rising rupee, plus a falling US market, can be a double-whammy for India’s service sector as well as manufacturing, particularly textiles, auto and electronics. It is the task of the budget-makers to keep these conflicting demands in mind to formulate a growth-friendly budget. Growth is vital if jobs are to grow. Jobs have to grow, if poverty is to be contained.

The debate about the US sub-prime mess and its consequences seems to be necessarily an extensive one because of the growing interconnections of the world economy. What happens in the remotest parts of the world seems to have an impact on us. Globalisation and its discontents are, indeed, many. There is little we can do about it.

For instance, it is obvious that our policymakers can do little about containing the magnitude of the liquidity squeeze that has been the by-product of the sub-prime saga in the US. But we have to do what is our remit — to contain its damage on India’s growth — both in the corporate sector and others.

Inflation management is, of course, critical, but the lack of adequate growth can be a disaster. Let it not be said that India’s growth became hostage to the sub-prime mismanagement of the US housing financial markets.

The answer lies in the hands of our undoubtedly competent central bankers, the mandarins of the Finance Ministry and the magnates of the corporate sector.