Issue of Haircuts in US Crisis

What happened in the case of US Financial crisis was also related to haircuts. Normally, At the initiation of loan contract, a Bank takes up a collateral and grants a loan considering the type and the value of the collateral. The value of the loan granted depends on the type of collateral and the Haircut (as explained in my previous post).

Now, with the passage of time, the value of collateral changes depending on market conditions. If the value of collateral decreases to less than the value of the loan, then the bank is in a serious risk if the borrower defaults.

In the case of US financial crises of 2007, there were many mortgage borrowers. People took up mortgage loans. Mortgage loans refer to the loans taken against a real property(mortgage) as collateral. Property prices were rising and so the banks were more than happy to give loans against these collaterals. Haircuts were low as they were supposed to bear low risks. But when the property prices plummeted (because of many reasons, will explain some other day), the value of the collateral decreased to less than the value of the loan and the banks, even if sold the collaterals that they had were not able to recover the loan amounts. (it is a different fact that because of huge supply of these collaterals from banks, prices of collaterals decreased further more and resulted in huge losses to banks)

The concept of Haircuts

Most of the times, Whenever one decides to take a loan, he/she needs to deposit collateral with the bank for the loan to be sanctioned. Not every collateral bears the same amount of risk and so they cannot be valued equally.

Take for example, a 100 rs. treasury bond and a 100 rs. stock of company X. Treasury bond is less risky and so with a 100 rs treasury bond as a collateral, a loan of say 90 (say) can be obtained but whereas with a 100 rs stock as collateral, less than 90 rs loan , say 70 rs loan, can be obtained.

And so the Haircut is 10% for Treasury bond and 30% for a stock (in this example). In more generalized terms, Haircut refers to the percentage by which an assets market value is reduced for the purpose of calculating capital requirements, margins and collaterals.

The whole point of Haircut is to have a collateral which is atleast worth the value of loan at any point of time. And at any point of time, if the value of the collateral decreases to less than the value of the loan, then the lender of the money(say bank) will have the risk of loosing on the money i.e. if the borrower defaults then the bank can only recover money to the value of the collateral and since this value has been decreased to less than the value of loan, the bank looses on some part of the loan.

Korean Peninsula and the Six Party Talks!!!

More than a century of history and still going on.....

If i have to put the whole episode in a paragraph or two, let me put it this way...

"A couple (US and Russia) enters into a country (Korea) after the end of era of the villain (Japan) in Korea. They give birth to two babies - North Korea(B1) and South Korea( B2). They then divorce each other and B1 grows up with the Father(Russia) and B2 grows up with the mother (US).

The intense hatred between the parents and the way they bring up their child instills the same hatred between the babies. Mother(US) being a little soft, B2(South Korea) grows up similar to a hero(Kind, Democratic etc.) in a movie whereas B2( North Korea) turns himself into a monster. And the Fight Continues...........In one of their fighting shots, the Mother and B2 enter into the territory of C1(China) . 

As the dictum goes, Enemy's enemy is a friend and So C1 and B1 become good friends. And the fight Continues still...And hence the Six Party talks"

Read on to know the complete story....

Present State of the Koreas :-

The Complete Story……

The current relationship between the Koreas and Japan is to a large extent shaped by the latter’s unsavoury actions during and after the Russo-Japanese War of 1904-05.

Forced or Voluntary Default for Greece

(Wrote this article for an event... posting it here...)

Rising debts and a loss of competitiveness are the main challenges facing Greece Economy. Presently, it does not have any options which can be proved to be good for all.

Problems of Greece increased with the adoption of Euro. In February 1992, European leaders signed the Maastricht Treaty, laying the foundation for monetary union and adoption of the euro. Greece qualified in 2000 and was admitted on 1 January 2001. Prior to the adoption of euro, Annual inflation in Greece was one of the highest in the region and GDP growth was the slowest in Europe.

Adoption of the Euro led to a drop in inflation from an average of 18 percent from 1980–1995 to just above 3 percent from 2000–2007. After averaging annual GDP growth of 1.1 percent from 1980 through 1997, Greece’s economy expanded at an average rate of 4.1 percent over the next ten years, the fourth fastest rate in the Euro area. Per capita GDP rose from 39 percent of that of Germany in 1995 to 71 percent in 2008. It quickly became an attractive destination for foreign capital.

But, this fuelled the domestic demand. Domestic demand growth drove up prices in Greece increasing domestic labor costs and eroding Greek competitiveness. If we have a look at numbers, since 1997, consumer prices have risen by 47 percent and since 2000, per capita employee compensation has grown by over 80 percent. Competitiveness was hurt further by a shift away from manufacturing sectors in favor of the expansion of service and non-tradable sectors. Increase in Revenues increased government spending especially in social transfers and public sector wages.

Reflecting the economy’s rapid growth, public sector deficits averaged 5 percent of GDP from 2000 to 2007. The scenario changed markedly with the financial crisis and when markets realized Greece’s chronic failure to report accurate statistics. GDP expanded by only 2 percent in 2008 and contracted by 2 percent in 2009, pushing down tax revenues and driving up the restated deficit to 7.7 percent in 2008 and 13.6 in 2009. 

With debt levels rising and the IMF projecting it to reach nearly 150 percent by 2012, borrowing costs of Greece skyrocketed. Attempts are being made by EU and IMF to restore the economy of Greece and other EU nations(PIIGS)

Bailing out Greece

There are different views and solutions to restore the economy of Greece and other EU nations in danger. There are three different viable options possible in the existing situation

1.      Greece voluntarily leaving Eurozone

2.      Other EU nations forcing the Greece out of the EMU

3.      Greece undergoing a massive debt restructuring plan and with the aid of IMF and other EU nations, it stabilizes itself

Let us analyze each of these cases in detail in order to understand the best possible option available for Greece. 

The Complete Trading Cycle

During a trading process an investor buys the shares and sells the shares and after the trade execution the buyer and the seller receives the shares and funds respectively. This is what the process in stock exchange looks like. But in reality there is much more complex process that goes on at the back end. The transactions in secondary market pass through three distinct phases, viz., trading, clearing and settlement. While the stock exchanges provide the platform for trading, the clearing corporation determines the funds and securities obligations of the trading members and ensures that the trade is settled through exchanges of obligations. The clearing banks and the depositories provide the necessary interface between the custodians/clearing members for settlement of funds and securities obligations of trading members. The clearing process involves determination of what counter-parties owe, and which counter-parties are due to receive on the settlement date, thereafter the obligations are discharged by settlement.

The System applicable in India today is Rolling Settlement. One of the greatest achievements of the current system is settlement of trades within three working days, i.e. T+2 rolling settlement which has replaced account period settlement, which used to take at least a week. days later. This is called ‘T+X’ rolling settlement, where ‘T’ is the trade date and ‘X’ is the number of business days after trade date on which settlement takes place. The rolling settlement prevailing in India is T+2, implying that the outstanding positions at the end of the day ‘T’ are compulsorily settled 2 days after the trade date.

Understanding Rolling Settlement :-

Rolling Settlement involves for major activities. Trading, Clearing, Settlement and Post Settlement(Post settlement has not been explained in this post).

Derivatives - What they are and their types...

IMF puts the definition of financial derivatives as ''Financial derivatives are financial instruments that are linked to a specific financial instrument or indicator or commodity, and through which specific financial risks can be traded in financial markets in their own right". A little complicated!!

click here to get a basic hold on to the derivatives and their types explained in a very good fashion...

Shares and Bonds

Shares

Equity Shares: An equity share, commonly referred to as ordinary share, represents the form of fractional ownership in a business venture.

Rights Issue/ Rights Shares: The issue of new securities to existing shareholders at a ratio to those already held, at a price. For  e.g. a 2:3 rights issue at Rs. 125, would entitle a shareholder to receive 2 shares for every 3 shares held at a price of Rs. 125 per share.

Bonus Shares: Shares issued by the companies to their shareholders free of cost based on the number of shares the shareholder owns.

Preference shares: Owners of these kind of shares are entitled to a fixed dividend or dividend calculated at a fixed rate to be paid regularly before dividend can be paid in respect of equity share. They also enjoy priority over the equity shareholders in payment of surplus. But in the event of liquidation, their claims rank below the claims of the company’s creditors, bondholders/debenture holders.

Cumulative Preference Shares: A type of preference shares on which dividend accumulates if remained unpaid. All arrears of preference dividend have to be paid out before paying dividend on equity shares.

Cumulative Convertible Preference Shares:  A   t ype of preference shares where the dividend payable on the same accumulates, if not paid. After a specified date, these shares will be converted int equity capital of the company.

Bonds

Bond: is a negotiable certificate evidencing indebtedness. It is normally unsecured. A debt security is generally issued by a company, municipality or government agency. A bond investor lends money to the issuer and in exchange, the issuer promises to repay the loan amount on a specified maturity date. The issuer usually pays the bond holder periodic interest

payments over the life of the loan. The various types of Bonds are as follows:

Zero Coupon Bond: Bond issued at a discount and repaid at a face value. No periodic interest is paid. The difference between the issue price and redemption price represents the return to the holder. The buyer of these bonds receives only one payment, at the maturity of

the bond.

Convertible Bond: A bond giving the investor the option to convert the bond into equity at a fixed conversion price.

Treasury Bills: Short-term (up to one year) bearer discount security issued by government as a means of financing their cash requirements.

Posts in the making!!!

I will be posting articles on these issues shortly....

1. Korean Peninsula and the Six party talks

2. Israel - Palestine conflict

3. Germany Hyperinflation 

4. Ratio Analysis Decoded