Sunday, December 30, 2012

The debt overhang in the stock market

By R.M.B Senanayake

In 2009 the government security forces finally vanquished the LTTE and regained control over the whole island. There was a sense of euphoria among the brokers and the retail investors and they thought there would be an enormous peace dividend with the economy as well as company earnings growing significantly. A bull run was widely anticipated.

On May 13, 2009, the All Share Price Index was at 1,884 with a volume of four million shares traded with a turnover of a mere Rs 138 million. From then on the ASPI began to rise driven by the sentiment generated by the war victory. By the end of 2009 it had risen to 3,335 (increase of 77%) with a volume of 16 million shares (increase of 400%) traded with a turnover of Rs 765 million (increase 454%). The market continued to rise in 2010 and at the end of 2010 the All Share Price Index was 6,635 ( 99% growth) volume was 154 million shares ( increase 862%)and turnover Rs 2.09 billion ( increase 173%). How did such phenomenal growth take place?

While investor sentiments were running high, this doesn’t explain the growth in the volume of shares traded. The liquidity of shares available for trading was rather low since 75% of company shares are tightly held by the controlling shareholders and only 25% of the share capital of the listed companies is traded. How then did this growth in volume take place?

Driven by credit

 Trading was fuelled by the broker firms providing credit with few restrictions. CSE rules fixed the collateral requirement for margin finance providing at a limit of 50% of a portfolio’s market value. The Exchange did not fix any interest rates. Both collateral and the interest rate affect the borrower’s decision to borrow.  As market prices of shares soared, the broker firms became lax in the grant of credit to clients. The 50% limit was exceeded and no margin calls were made from the borrowers as is the usual custom.  As prices continued to rise the collateral requirement was overlooked and unlimited credit was given to clients to buy shares expecting them to sell and book profits since the market was rising.

Broker firms even did not bother to collect interest although they debited the interest payable to the clients’ accounts. Share prices along with the volumes and turnover rose up to 220 million shares traded for Rs 4 billion and reached a peak of 600 million shares with turnover of Rs 4.9 billion. The market continued to rise in 2011 up to the end of June. On April 12, the All Share Price Index was 7,575 (growth for the year 13.8%). It fell below 7,000 from June 21, 2011.

The increase in volumes and turnover were largely fuelled by liberal broker credit provided to share traders.  Broker firms extended credit several times the value of the clients’ portfolios and also several times the brokers’ own equity. In short the leverage was excessive. Unlike the concepts of accounting leverage based on Total Assets / Equity  Economic Leverage refers to the volatility of the un-levered investments in the assets ( in this case the portfolios of clients’ shares pledged as collateral) to the equity. The collateral was going up and up in values. But as the share prices weakened after June 2011 the volumes declined along with the turnovers. Volumes fell below 100 million, almost half the earlier level. But in August the volumes again rose as did the prices of the shares. The market correction seemed to be over.

Some analysts then started calling it a bubble and allegations were made of market manipulations. These allegations led the Securities and Exchange Commission to investigate and it realized that the broker firms were excessively leveraged. The SEC imposed limits on credit - relating it to equity of the broker firms. By this time the broker firms had extended an enormous amount of credit.

The bubble bursts

From the October 3  the All Share Price Index fell continually until December 21, 2011. The volumes traded also fell and reached 15 million from the previous high levels over 200 million. The Index revived in the last week of December 2011 and regained the 6,000 mark. Volumes and turnover also increased. But it was a fools rally. The downward trend continued with occasional rallies which petered out after a few days. The rally in volumes also disappeared. On December 21, 2012 the volume traded was below 10 million. Compare this with the heady days when it was over 200 million. The decline in prices this year (2012) is about 5% or 326 points.

The present volumes are too small to sustain the incomes of the broker firms. What should be done to increase the volumes and turnover? The economy is still growing at over 6.5% and the company earnings are still high although they may come down in the 4th quarter owing to the credit restrictions that prevailed.

What then is the problem? Economists refer to economic leverage which is a concept a little different from the accounting concept of leverage.  It refers to the volatility of the underlying asset bought for cash or credit. When the collateral held by the broker firms on the credit extended to their clients started falling in value, few broker firms took corrective action. Normally clients live in hope that the market would revive and refuse to accept a permanent decline in the prices of their share portfolios. But the rules require the broker firms to mark their portfolios to market.

If they did not sell out they would have to take a haircut (reduction in the value) on their net capital which consists of their equity and trade debtors among other items. Some brokers sold out their clients’ portfolios despite the protests of clients. But the majority did not do so and instead agitated against the haircuts imposed by the SEC in the computation of their net capital. They wanted extension of the time period before the imposition of the haircuts. The SEC obliged them and the period was extended to 120 days before the 100% hair cut was imposed on their debtors (counted as assets although the clients were not paying up and should have really been classified as bad debts). These should be written off where there was no collateral value or were only partly provided for rather than carried as an asset in their balance sheets. The period of time held before the debt is treated as a bad debt subject to the haircut was extended by the SEC to 120 days. But the broker firms agitated and got the rule relaxed and the time period allowed before the broker firms were required to force sell or face 100% haircut was not enforced.

De-leverage process must take place before the market can recover

Thus the de-leverage process was halted. The broker firms found that their clients were unwilling to reduce their credit positions while their collateral was falling in value. These firms are still hoping that the market would recover and hence are continuing to hold the clients’ shares pledged as collateral. Other broker firms that forced reductions of their clients’ positions are carrying bad debts which they are refusing to write off and the SEC has given 120 days for the hair cuts to come into effect. .

According to data published in the Central Bank the total Assets of the broker community has come down to Rs 10.885 billion in June 2012 from Rs 17.084 billion in June 2011.This shows that the brokers have de-leveraged to some extent. But they still hold assets of Rs. 10 billion on a capital of Rs 6 billion. But this capital should be written down to Rs 3.9 billion vide the Central Bank Review of Recent Economic Development Highlights 2012 (page 87 Table 8.6). Since the broker firms do not own buildings or properties, the assets may include bad debts which are not recognized as bad debts. What is required is to write off bad debts not covered by collateral and where there is collateral to provide for the difference in value between the debt and the collateral.

Economic de-leverage is not an automatic process. Unless this is done the volumes and turnover will not recover to allow 27 broker firms to run profitably. The foreigners are attracted to our market because of the fall in value of the rupee by 15% making the shares cheaper in dollar terms for them to buy. But having brought in their money they will face the exchange risk unless they are allowed to hedge this risk in the forward exchange market which is not permitted. But the authorities cannot hold the rupee unless foreign capital or migrant remittances continue to flow in excess of our foreign payments. Let the broker firms clean up their balance sheets by taking the haircuts and then making them good by pumping fresh capital to bring up their net capital up o the required minimum.

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