Archive | September, 2008

Chapter 11 Bankruptcy….

26 Sep

Great! Lehman has filed for chapter 11 bankruptcy. If the losses that the jewels of American financial stalwarts was not enough, we now have bankruptcies also. In this short note, lets have a close look at the term ‘bankruptcy’ and its different implications. A chapter 11bankruptcy is not an immediate liquidation. That is covered under chapter 7 of the American bankruptcy laws in which the assets of the firms are sold off and the money distributed to the creditors of the company. In a chapter 11 bankruptcy, the company is not liquidated but allowed to operate with restructuring and reorganizaion. A chapter 11 bankruptcy is a case when the bankruptcy court decides that it will be pareto optimal (i.e. will be a better solution for the creditors, owners and employees of the firm) to not let the firm die and give it a chance to reorganize itself and get itself out of the mess. This reorganization is carried out under the aegis of the bankruptcy court. The existing management may be asked to vacate and a new management may be installed by the bankruptcy court in consultation with the creditors. The new management may be from the side of the creditors or bankruptcy court or both.

Giving it a hard thought, a chapter 11 bankruptcy makes a lot of sense. If a firm is allowed to reorganize, say by, terminating badly negotiated contracts which are a drain on the firm’s resources (did we say terminate a contract? But how can the firm terminate a contract unilaterally that it entered into with some other party before? Well, under chapter 11, the bankruptcy court can invalidate any contract the firm has entered into which is very taxing to the firm’s profit’s and is inimical to its future survival), or by entering altering its structure , it may again start churning profits which will benefit the creditors (they wont have to accept discounted payments in settlement of their claims), the employees (they wont become jobless) and the owners (the profits will accrue to them).

As to whether Lehman should have filed for chapter 11 or for chapter 7, only time will tell.

Published by Ravi Saraogi

Freeze your gains….

12 Sep

A volatile market invariably unnerves an investor. Or rather a speculator. Any which way, wouldn’t it be great if there was a way where you could lock your gains in a particular scrip. We came across such a strategy in an article titled “Here’s a way to lock-in minumum gains on your investments”, Business Line (7th Sep, 2008). The following article explains the above strategy using real life data for Maruti Suzuki. So, here goes…

Assume you purchased 200 shares of Maruti Suzuki @ Rs. 500 per share. The scrip presently trades at Rs. 679 per share (closing price for 12th Sep 2008). That leaves you with an unrealized gain of about Rs. 35,800. Now, given the present volatility in the markets, you are concerned about preserving the above unrealized gain. You can use the option market to bail you out of this risk.

Suppose the minimum gain that you would like to lock out of your investment in Maruti Suzuki is about Rs. 12000, i.e., you would not want to be in a situation where you have to sell your shares at a price less than Rs. 560. Also assume that the maximum gain that would satisfy your greed to the point of you converting your unrealized gain into realized gain (i.e. selling your shares) is Rs. 40,000. In short, on an investment of Rs. 1,00,000 (Rs. 500 per share X 200 shares), you would like to pocket a minimum gain of Rs. 12,000 (gain of Rs. 60 per share X 200 shares) and a maximum gain of Rs. 40,000 (gain of Rs. 200 per share X 200 shares).

Now, all you have to do is sell a Rs. 700 27-Nov Maruti Suzuki Call option on nifty which presently trades at Rs. 66.05 (on 12th Sep 2008). Given a lot size of 200, that would fetch you Rs. 13,210 (Rs. 66.05 per call X 200 calls). Correspondingly, you have to buy a Rs. 560 27-Nov Maruti Suzuki Put option on nifty which presently trades at Rs. 37.95 per put (on 12th Sep 2008). That would cost you Rs. 7,590 (Rs. 37.95 per put X 200 puts). Lo and behold, you have done it. Lets see how the above strategy would unfold.

If the share price, which currently trades at Rs. 679 per share, falls below Rs. 560, you will have the option of selling at Rs. 560 and lock in a minimum gain of Rs. 12,000 (gain of Rs. 60 per share X 200 shares). And if the share price moves above Rs. 700, you should be willing to sell your shares at Rs. 700 per share and pocket a neat sum of Rs. 40,000 (gain of Rs. 200 per share X 200 shares). Thus from now (mid September) to November end when the options expire, you can just sit back and relax and smile over the fact that on an investment of Rs. 1,00,000, you have ensured yourself a minimum gain of Rs. 12000 and a maximum gain of Rs. 40,000.

Now for the icing on the cake. The puts cost you Rs. 7,590. But how much did you make on the calls? A cool Rs. 13,210. That leaves you with Rs. 5,620. In other words, the market is paying you a premium to guard yourself against its volatility. Woa !!

Published by Ravi Saraogi

Fannie Mae and Freddie What?

9 Sep

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With the subprime crisis in full effect, you must have come across words like ‘Fannie Mae’ and ‘Freddie Mac’ a lot. They may appear to be names of cartoon characters, but trust me, they are not. Fannie and Freddie are the two most important players in the US secondary mortgage market.

A secondary mortgage market is a market for the sale of securities or bonds collateralized by the value of mortgage loans. In simple terms, when a bank issues a home loan, the loan is broken down into bits and pieces of securities called mortgage backed securities (this process is called securitization) and sold by the bank in the market. The payment of interest and the principal on such securities depend on the monthly installments by the borrower of the home loan from the bank. Thus if the borrower of the home loan from the bank defaults, the liability no longer lies with the bank but with the investor who holds the mortgage backed securities issued in lieu of that home loan.

The above process of securitization and issuing of mortgage backed securities has had the effect of widening the market for home loans and also providing liquidity to entities providing home loans. The presence of the secondary mortgage market has thus helped the American borrowers. However, in recent times, it is becoming evident that such a market has a dark side to it also, and that which is capable of drowning the entire global financial system.

Fannie Mae is short for Federal National Mortgage Association, Freddie Mac short for Federal Home Loan Mortgage Corporation. Fannie Mae was founded in the depression era of 1938, at a time when millions of families could not become homeowners, or faced losing their homes, because of a lack of mortgage funds. It was a government agency until 1968. Freddie Mac was created in 1970 to provide competition to Fannie Mae. Fannie Mae was established in order to provide local banks with federal money to finance home mortgages in an attempt to raise levels of home ownership and the availability of affordable housing.

The Federal National Mortgage Association, nicknamed Fannie Mae, and the Federal Home Mortgage Corporation, nicknamed Freddie Mac, have operated since 1968 as government sponsored enterprises (GSEs). This means that, although the two companies are privately owned and operated by shareholders, they are protected financially by the support of the Federal Government.

The two firms do not lend directly to homebuyers, instead buying mortgages from approved lenders and then selling them on to investors, i,e, participating in the secondary mortgage market. They buy house loans from banks and other approved lenders, break them down into pieces, and issue securities backed by such loans to investors, or invest directly in mortgage backed securities issued by others.

One part of Fannie and Freddie’s income is generated through the positive interest rate spread between the rate paid to buy home loans from the banks and the return it earns on securities that were issued backed by these loans. They also earns a significant portion of its income from guaranty fees it receives as compensation for assuming the credit risk on the mortgage backed securities issued by it. (Remember, that when Fannie or Freddie issue mortgage backed securities or invest directly into them, they assume any credit risk that might originate on account of default by a borrower on a home loan.) Investors, or purchasers of mortgage backed securities, are willing to let Fannie and Freddie keep this fee in exchange for assuming the credit risk; that is, Fannie and Freddie’s guarantee that the scheduled principal and interest on the underlying loan will be paid even if the borrower defaults.

The recent prominence of Fannie and Freddie is on account of the fear that both might collapse as a fallout of the subprime crisis. Following the crisis, billions of dollars worth of investment grade mortgage backed securities have been reduced to junk on account of large scale default by American borrowers on their home loans. Since a substantial part of such mortgage backed securities have the Fannie and Freddie guaranty, it now appears that their capital base is too insignificant to absorb such guarantees. Thus the entire hoopla about the State taking control of the two bodies.

A perfect case of “privatised profits (remember, both Freddi and Fannie are listed companies with private shareholders) with socialized losses.”

Published by Ravi Saraogi

The Little Post that Beats the Market

4 Sep

I recently read the book ‘The Little Book that Beats the Market‘ by Joel Greenblatt. The book basically advocates a formula based approach to investing. The approach advocated by the author is rather simple. He talks about forming an index for each stock based on two variables, Price to Earning Ratio (PE) and Return on Capital (RoC), and then ranking them, with the highest rank given to the stock with the highest RoC and the lowest PE. The author calls this index a “magic formula” to deliver superior returns. In layman terms, what the author is asking us to do is to buy into companies which give high returns on invested capital and are available cheap. Makes perfect sense.

So, we did a study as to identify which Indian companies (only large caps) would make the top 20 list according to this criterion and came with the following results-

* Data collected from icicidirect.com

Do remember that the required investment horizon should be at least 3 years and the investor should stick to his decision to stay committed with such a portfolio irrespective of what the markets does. So invest in a mix of the above mentioned companies and stick to them for at least 3 years. And you should comfortably beat the benchmark sensex.

So says Mr. Greenblatt.

Published by Ravi Saraogi