Haircuts and Stock Markets

I had referred to some reasons attributed for the fall of the Stock markets in the piece titled "Stock Markets or Monkey Business".  Some of them were like earthquake in Japan, higher inflation going up still higher,  great difficulties of  Greece or even that there was not enough steam for markets to move up.  One reason I forgot to mention was Haircut!  

A friend has sent me a joke about haircut.  A high profile Hair Dresser in Delhi has regular VIP visitors.  In fact, he is reported to have exclusive rights on big heads, political and bureaucratic ones.   Nowadays, he has stopped attending to general public.  Like we used to have "Raajapurohitas" who would attend to rituals of the Royalty only and not accessible to the common man.  Not affordable as well.  This Hair Dresser had a visit by a high profile CBI official last week.  The Dresser greeted the official warmly and started to clean the already clean chair in an invitational gesture for a haircut or hair dressing.  The officer brushed him aside and curtly told him that he had not come for a haircut this time and he was so busy he had no time for a haircut.  He asked the Hair Dresser whether he was an agent of Baba Ramdev.  The surprised Hair Dresser said he was not.  The Officer asked him whether he was an agent of Anna Hazare.  The Dresser again replied he was not.  The officer now asked him why he was talking too much lately about Swiss Bank Accounts and asking too many questions  to VIPs about this.  The Hair Dresser politely replied, "Sir, the moment I ask these people about Swiss Banks, all their hair stand up and that makes my work very easy.  That is why I ask them question about Swiss Banks.  Otherwise I neither have an account in Swiss Banks nor I have any interest in Swiss Banks".  The Officer warned the Dresser against asking too many questions about Swiss Bank accounts in future.  The Dresser was surprised and enquired why it was so.  The Officer replied that the agencies were closely monitoring "Swiss Bank Issue" and since they could not make much headway with Swiss Banks, they were now concentrating on people who were asking questions about them.

Stock Markets all over the World had a heavy fall on 27th and 28th November 2011 on a report that European Banks had agreed to take a voluntary haircut of 50% on Greece bonds.  The Banks took a 50% voluntary haircut, but the small investor once again had the pleasure of an involuntary 100% haircut. 

In financial parlance, a haircut simply means the margin deducted from the market value of an asset accepted as a collateral.   It is the value deducted from the market value of the security for considering lending against it.  Higher the haircut, lower the amount of loan given.  Just like higher the length of the hair cut during dressing, lower the length of hair left on the head or wherever the hair is cut or kept.  The percentage of haircut is decided on the risk perception associated with the security.  Even when haircut is applied for deciding the amount of the loan, the lender has a full value of the security.   Lower haircuts allow for more leverage or higher entitlement for borrowing.  Haircut has an important role on many kinds of trades, for example for Repo or Reverse Repo transactions and borrowing from the Central Bank of a Country.

Then what actually happened when European Banks voluntarily accepted a haircut of 50%?.  Why should it affect us as investors?  When Euro zone was formed and a single currency was accepted by all the member countries, the fundamental strength or weakness of the economies of individual countries were set aside and the financial dealings became to be treated on an equal footing.  Borrowing of a Country and its entities depends on the "Rating of a Country" and a Country with higher rating can borrow higher amounts more easily on better terms.  Better terms like better interest rates as the risk of default is perceived to be low.  Financially weaker countries like Greece were bracketed with economically stronger countries like Germany and France and hence were able to borrow higher amounts at cheaper rates which they would not have been able to borrow on their own strengths.  This could not go on for ever and ultimately the borrower has to pay back the money and unless the economy is stronger and generates surpluses, the risk of default is always lurking in the corner.   By accepting higher haircuts, the lending against Greece securities would come down and thus partly remedy the situation.  But in market perception, holding such securities with even higher haircuts is risky and hence the consequent turbulence in the market.

The issue of haircut is technical and has assumed higher importance in view of Basel III norms, which is even more technical.  But for the small investor, whether it is technical or non-technical,  higher or lower, more important or less important,  haircut has resulted in a real cut of his investments.