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. 

Stock Markets or Monkey Business?

The are many and oft repeated stories about stock markets.  This is one of them:

Once upon a time a man appeared in a village and announced that he would buy monkeys by paying Rs.10 for each monkey.  Make it ten cents for a monkey if you want to make it an International story.  The villagers seeing that there were so many monkeys around the village and in nearby forests went around and started catching them.  The man bought thousands at Rs.10 or ten cents as per the choice of the sellers.  As supply started to diminish and villagers started to stop their efforts, he announced  that now he would buy monkeys at 20 rupees or twenty cents each. This renewed the efforts of the villagers and they started catching monkeys again.  Even the farmers left their farming activities and took up monkey catching.  Soon the supply diminished even further and people started going back to their farms. The offer rate increased to 25 and the supply of monkeys became so thin that it was an effort to even see a monkey let alone catch it.

The man now announced that he would buy monkeys at 50!  However, since he had to go to the city on some business, his assistant would now buy on behalf of the man.  In the absence of the man, the assistant gave an option to the villagers. "Look at all these monkeys in the big cages that the man has collected.  I will sell them to you at 35 and when the man comes back you can sell it to him for 50. You will make a profit of 15 on each monkey with no efforts.  The villagers queued up with all their saving to buy the monkeys.  The assistant sold all the monkeys and converted the rupees into dollars and made a remittance abroad from the local bank. He went back with a promise that he would certainly return with his master after finding out the present demand for monkeys or other animals.

Then they never saw the man or his assistant again.  It was only monkeys everywhere!

There is another golden saying. It is very easy to become a millionaire in a stock market.  Just start as a billionaire.

An average small investor looks at the stock markets and is encouraged when he sees the indices and individual company shares are going up.  Foreign Institutional Investors are investing as the prices are attractive. He also starts buying.  He can only buy small quantities.  A small fish in the ocean of  big fish, very big fish and whales. When samll investors enter the market, the index raises even further. Individually he is small but collectively it is considerable investments. But he will discover shortly that the stocks he purchased have started falling even if others are rising. Rising was in units but fall is in tens.  Then suddenly FIIs start selling.  Before he realises and reacts, the shares have fallen steeply and the index has collapsed.  At a time when he exits the market he has already lost a large part of his money. When the small investor is exiting FIIs are again buying  cheap. The cycle repeats. Monkey business continues.

There are many reasons  for stock market crashes. As well as for runaway upward movement. For crash there is earthquake in Japan.  Deficit in Greece. Downgrading by rating agencies. Higher inflation.  Even fear of inflation going higher.  there are no more drivers of growth.  Or simply that the rise was too fast to sustain!  None of them are in our control.  Only thing in our control is losing money. Or sometimes one wonders, Whether it is in our control?

We have wonderful stock market experts who go on appearing on TV channels one after the other.  One expert after the other on the same channel.  Again, the same expert on different channels.  And have their analysis for what went wrong. and advise for where to invest. They are like GPS.  Or in one way better than GPS.  GPS gives you advise on what route to take.  If you take a wrong turn because road signs are not clear or get into a wrong exit, it immediately stats recalculating and gives a fresh direction. Does not hesitate one bit or waste a minute.  The experts are also like that. They predict a market upsurge. You invest. Market drops. They have an immediate fresh advise.  Before the markets open on the next day.  Just like GPS.  They had good arguments and reasons for the previous advise.  They have better arguments and reasons why the  advice went wrong.  They have even better reasons why their advice is sound now. Sounder than before. They are even better than GPS. GPS gives an advice, you make a mistake, it gives a fresh advice.  These experts gave an advice, you followed it; their advice was wrong and things went wrong.  Now they have a fresh advice against their earlier one which went wrong. Is it not better than GPS?  Don't ask any more questions. Have they not given the first advice?  That they are only giving an advice and you should invest only after satisfying the correctness of their advice by independent research?  Don't tell them that if you were capable of making independent research, you would yourself  be an adviser.  In fact they are preparing you for becoming a better adviser in future.  Probably because all of them lost a lot of money in the markets, gained a lot of experience while doing so and now they are making up the losses and even making a profit by becoming advisers.  Don't worry if you lose money. Nothing to worry if you lose money. Money is not everything in life. You are gaining something even more valuable for leading a good life - which is experience.  You can always become an adviser due to the richness of experience though money-wise you have become poor.

It is not that stock markets always produce losses.  There are many who have made fortunes in there. But for every one such lucky person, there are ten who have lost.  An investor has to ask himself some questions before investing:  Is he investing the surplus he has or is it money on which he depends for the daily bread?  Is he willing to wait for long or looking for a quick profit?  Does he regret if he loses a substantial part of it or is it fine with him?   Does he have other sources of income to depend on in case of severe losses?  Does he have the will to sell at a loss to avoid further losses?  Above all what does his doctor say about the condition of the heart?

Sensex is again climbing to 17000.  Dow is nearing 12000.  Come let us not lose time in silly discussions. Take my advise.  It is time to invest and lose!  There is nothing to lose, except money!!  That too your money!!!