I am not really amazed by the recent developments in Indian financial markets- losses in derivative markets. It started with ICICI Bank, then we had news of L&T and I wouldn’t be surprised if we hear more such cases.
The ICICI Bank press release says the bank had no direct and indirect exposure to the subprime markets in US but the losses have been due to widening of credit spreads. This has resulted in mark to market losses. It points to two losses:
1) Credit derivatives: ICICI Bank and its overseas banking subsidiaries have an aggregate exposure of USD 2.2 billion in credit derivatives. As of January 31, 2008, the mark-to-market negative on this portfolio due to movement of credit spreads was about US$ 155 million of which USD 88 million had been provided for in the financial statements of the bank and its subsidiaries for the nine months ended December 31, 2007.
2. Fixed income portfolio: In addition, ICICI Bank and its overseas banking subsidiaries have fixed income investment portfolios which have a mark-to-market negative due to widening of credit spreads. As of January 31, 2008 this negative was about US$ 108 million of which US$ 101 million had been accounted for in the financial statements as of December 31, 2007. This includes mark-to-market on the available for sale portfolio which has been accounted for in the shareholders’ equity.
So total mark to market losses are $ 155 mn+ $ 108 mn= $ 263 million.
How about Larsen and Toubro? I couldn’t find anything on its website. However, disclosure is there in NSE (see the release on 10 March 2008) :
Larsen & Toubro Limited has vide its letter inter-alia stated, “We wish to clarify that during the year 2007-08, thre has been extreme volatility in the markets, especially in commodity prices. The Company has exposure in commodities and part of it is being hedged by it. As per the un-audited numbers, there could be a loss in commodity hedging of around Rs. 200 crore. The actual number will get crystalized on finalization of Accounts. We have reduced the exposures to a considerable extent. However, the Company maintains its guidance on order booking, sales and operating margins for the year with an emphasis on improvement in the operating margins.”
200 crores = $49 – $50 million.
Now, the possibility of this spreading to other companies has caught up with the media. BS says worse is to come.
This Mint story says there is 128 trillion of derivatives on Bank’s books. (I know it is wrong to compare financial stock with GDP but just to get some relative picture it is about 2.7 times the GDP!!) The story also says there is a possibility that companies have not understood these risks and have simply taken exposures.
I had pointed this long back when it was reported that one of ICICI Bank’s customers had complained that ICICI Bank had sold exotic stuff it was not aware of.
This will automatically lead the derivative sceptics to step in action and ask to ban these items. It is amazing how often the financial markets give these sceptics a chance. Mint edit says it will be wrong lesson to take forward this lesson and instead asks for better regulation and governance.
I wonder whether regulation and governance alone can help. The financial market players need to become more responsible. We keep on creating more and more derivatives (read this excellent John Bogle view) and fancy our chances of making monety by trading them. Most of these creators have a basic education in finance which says you can’t predict markets. But still we keep on taking chances. In good times, they manage and in bad times they need to be managed. By the very nature, derivatives should help you in bad times but what you see is the opposite.
Another point is this rise in trend of other incomes of the companies (read this Bimal Jalan interview). Most companies have nowdays have fancy looking treasury departments/special entities that engage in trading and creating financial assets. There is no problem with this but why the euphoria over the treasury? The main task of a company is to generate profits from its mainstream business not trading financial assets.
We may get tied up with the media coverage over rising and falling growth but the real story is we have a long way to go. There is wide exclusion and deficit across sectors- financial, infrastructure, qualitative employment etc. The organisations should concentrate on them and not get carried away by these asset market movements.
This article from Business Standard explains how the above mentioned 128 trillion derivative book of banks could go for a toss.
Meanwhile market rumours have picked up. This news from ET says (look for Crash course at the end):
Kotak Mahindra Bank fell 9.5% on Monday following media reports of RBI audit looking into an overexposure to equity. But the truth, possibly is, that RBI is looking into small manageable hits in currency derivative books of some private banks. Clients of these banks who have bought derivatives are refusing to pay after an unexpected surge in euro and yen. According to the market grapevine, Kotak’s provisioning may be in the region of Rs 100 crore, some of which has already been accounted for in December.
1. As I feared, we are seeing more and more banks are accused of selling exotic derivative products to the manufacturers. Mint has an update where it says clients of 5 banks- Kotak Mahindra Bank, HDFC Bank, ICICI Bank, Yes Bank and Axis Bank have turned adversaries.
2. Satyajit Das interview in ET where he says all these developments are Naked Greed.