Elections & Banking - Red Light Ahead

My last month's column for Wealth Insight:

While private banks are part of any investor’s portfolio, PSU banks have to remain a trading play 
While private banks are part of any investor’s portfolio, PSU banks have to remain a trading play

By Anand Tandon | Nov 24, 2012

The year 2012 has been and continues to be an election-heavy year – with 7 state assemblies completing their terms. Elections are a time when politicians are at their “promising best” – often promising voters rewards in the form of lower power tariffs, waiver of farm loans, and nowadays computers, TVs and other goodies. It is common knowledge that elections spoil rural credit culture: farmers wait for elections for waiver of overdue credit, and are too often rewarded with it. I recently came across a working paper published by Harvard Business School which offers some interesting insights. Authored by Shawn Cole (http://www.hbs.edu/research/pdf/09-001.pdf), the paper establishes some important points which have implications for investing in bank stocks.

Higher credit, but no increase in production
Using data for 32 elections conducted across 19 states over 8 years, Cole establishes that in an election year, agri-credit portfolio of state owned banks (PSU banks) increases 5-10 per cent. Private sector banks, on the other hand, do not reveal any such increase. This increase cannot be attributed to rainfall, population or any productivity-linked variable. Importantly, the paper establishes that increased credit does not result in increased output.

Higher defaults, and write-offs
Another related observation is that while the average increase in credit is 8 per cent, the increase (peak to trough) in defaults increases 16 per cent. While it should be expected that an increase in credit will lead to higher bad loans, the increase of 16 per cent is too high to be explained by just the rise in credit.
Data also reveals that post the election, the bad-loan percentage falls quickly. This is not because recoveries increase – the author suggests that the drop is a result of write-offs that the banks undertake to live up to the pre-election promises made by the politicians.

Higher benefits to areas where election results are uncertain
The areas that seem to get the largest bump up in credit are those that are viewed as being at the margin with regard to the ability of the ruling party to win elections. The study revealed that areas where the ruling party/coalition won by a margin of 15 per cent or more, received almost 5-6 per cent lower credit than those areas where the voting was closer. In other words, bank loans were being used as a means to “buy” votes in “swing” districts.

The “committed” voter received a different reward: he had his loans written off! Where the margin of victory exceeds 15 per cent, “forgiven” loans increase, leading to an almost 27 per cent drop in figures of delayed loans. Other areas, where the ruling party lost, do not witness such largess. The formula seems to be inducement before and reward after.

Implications for investing in banks
The paper re-establishes the notion that politicians will use whatever resources they can to win elections. It also explains why government of the day does not wish to reduce its investment in state owned banks to lower than 51 per cent, despite facing the daunting prospect of having to invest between Rs 1 trillion and Rs 2.5 trillion over the next ten years. This, despite the investment yielding poor returns – dividends to shareholders are lower than borrowing cost; capital gains are notional since policy does not allow equity to be sold since government holding is already near the 51 per cent threshold in many cases. After all, who would voluntarily wish to give up the means of “purchasing” voter goodwill.

Without going into the moral or ethical dilemma that this poses, what does this imply for the average investor?
It has long been known that whenever a new chairman takes charge, there is a sudden jump in the non-performing assets of banks. This is particularly true for state owned banks. SBI offered a great example at the last change of guard. Consequently, investing just after a new chairman takes over is hazardous for investors. Better to wait a couple of quarters for the “clean-up” to be visible.

To this, we now add another tool – whenever an election is due, state owned banks operating in that state will likely witness a sharp increase in agricultural credit in the year prior to the election, followed by increased write-offs. Consequently, investment in such banks is best avoided till atleast 6 months after the elections to enable the write-offs to work through the system.

The current year has seen a revival in the stock market. However, state owned banks have significantly underperformed. A combination of inadequate capital, larger exposure to poorly performing sectors, and consequently, higher re-structured loans have driven valuations to below stated book in most cases. In addition, it is possible that the market is already factoring in the decline that is likely in agri-credit portfolio for reasons stated earlier.

Inefficient capital allocation increase societal costs in many ways. Taxes have to increase to pay for government spend; including the capital required to be infused in banks. This is an indirect transfer from urban to rural India since farmers are not directly taxed. Another impact is lack of accountability of state owned banks for their performance resulting in below par customer experience and higher cost ratios. In a perverse way, the private banks benefit, since they gain a greater share of the market due to better product and service, despite having to work harder to raise capital which is “freely” available to their state owned competitors.

While private banks will form part of any investor’s portfolio, state owned banks have to remain a trading play. Consistent performance for state owned banks will have to wait till the level of government ownership and control falls to lower levels. However, given that politicians across the world attempt to use public institutions for private ends, it will be a long time coming.

CAG Reports and the Markets

My column for Wealth Insight on the CAG reports is here. The article is reproduced below

CAG deserves the kudos of all right- thinking Indians for raising the level of public debate

The Comptroller and Auditor General of India (CAG) is not a position most people in India have been familiar with. This changed recently when CAG reports repeatedly made headlines claiming massive loot of the public exchequer. In August, a multitude of reports hit the Parliament — all pointing out lacunae in government policy and putative losses. The government’s spin masters went to work quickly. While some attempted to show that the CAG reports overstepped their mandate, others challenged the content of reports — in particular, the attempt to quantify losses arising to the public from flawed implementation of policy. Yet others have attempted to question the motives of the CAG.

Irrespective of the outcome, Vinod Rai — the incumbent CAG – deserves the kudos of all right- thinking Indians for raising the level of public debate. Every once in a while, a leader comes along who uses the full power of a constitutional authority. The Election Commission underwent such a change under TN Seshan. I hope this continues even after Rai demits office.

Analysis is succinct yet comprehensive
CAG has released a number of reports. For want of space, I discuss only the report on Ultra Mega Power Projects (UMPP) here. The report — something I recommend all to read for its lucid and incisive analysis is available at http://saiindia.gov.in/english/home/Recent/Recent.html. If only analysts wrote as clearly and authoritatively!

The report makes several points with regard to the allocation of UMPP licences and related coal reserves:
# The government did not follow its own rules — starting with appointment of the bid consultant
# Terms of the bid were altered to suit certain bidders (in particular Reliance power or RPL, the eventual winner), by diluting requirements of ownership, investment, and experience
# Extra land was allotted despite a study to show that it was in excess. No effort was made to recover the land despite it being established that it was in excess
# Allotment of coal blocks were made — in excess of the requirement — despite having no justification or study to show the need
# The excess coal was allowed to be diverted to another project — tariff for which was already determined based on the need to buy coal. This clearly amounted to violation of bid conditions in favour of Reliance Power
# The report quotes from RPL’s own estimates which put the extra gain to the company from the allotted coal to the tune of Rs 29,000 crore It is worth recalling that Tata Power has a case pending in the Supreme Court challenging the use of coal allotted for Sasan for Chitrangi Project (as approved by the Empowered Group of Ministers, or EGOM).

The defence
RPL’s defence is simple. They are not responsible for the excess coal, that the allocation of the extra mine has been ratified by the EGOM twice — once in 2008, and again in 2012. There are also somewhat gratuitous comments suggesting that CAG’s recommendation of reviewing the allocation of coal would result in India continuing to remain short of coal.

The argument is self-serving. Of course the allotment of mines has to be a government decision! The mines belong to the public and are being allotted. To suggest that this happens without intervention of the beneficiary is to stretch credulity to the point of breaking. To assert that without the mines being allotted to RPL, India would remain short of coal is laughable. First, the mines have not yet started delivering anything. Also, there are other perfectly capable companies that can mine the coal, and would pay for it.

The government’s defence is even more pathetic. To the primary allegation of extra allotment, the ministry of power has responded that the Attorney General of India has opined that the decision of the EGOM in 2008 was “well considered” — and hence the recommendation of the CAG that the extra allotment be withdrawn, may be ignored. It begs the question on why the EGOM allotted the extra mine in the first place, and why it felt imperative to overrule the conditions of allotment. Sample this: ‘The coal produced from these mines would be exclusively used in the Sasan UMPP.’

The other points are even more wishy-washy — and have been torn down in the report of the CAG itself with arguments that seem perfectly reasonable.

Greater transparency: churn in the index
The reports will now be referred to the Public Accounts Committee, where the matter is unlikely to result in corrective action. Given that this cannot be blamed on allies (unlike the 3G imbroglio), it would result in serious embarrassment for an already embattled government.

However, it may and hopefully will, result in a new and clearer policy of allotment of natural resources, in particular coal. Short-term, this may result in even slower decision making. Our shortage of coal is likely to continue. Longer term, the challenge of allotment of scare resources — airwaves, coal and iron ore, and even concessions to operate airports and roads — is likely to become more streamlined. Clear policies will remove the politicians’ ability to “seek rent” — a polite term for extracting money from public goods. With that, infrastructure companies will be less attractive to secondary investors — as unpredictable upsides are unlikely to occur. This may result in another shake up in the index. Currently 40 per cent of the index capitalisation is from companies dependent on energy, coal, and steel — all industries benefiting from ability to influence government policy. A reduction of this number over the next decade will represent the coming of age of the Indian economy.

Why is Ratan Tata protesting about privacy?

Ratan Tata, the Chairman of the Tata Group is, reportedly, planning to move the Supreme Court against publishing intercepts of his conversation with Niira Radia. The stated reason - private conversation not connected with the 2G scam should remain private.

In principle, there cannot be a disagreement with the argument. On the other hand, unless there is something in the conversation that would be of interest to the world at large, it can be assumed that it will not attract attention, even if made public - after all, there is voluminous data that is threatening to come out in Wikileaks, that is likely to attract a lot more public attention over the next few days. So what can be a reason?

Perhaps it lies in a report published many months ago in a little know hindi website. This report, which purports to be a confidential letter written by a taxman investigating the 2G case has some interesting comments. The relevant excerpts are in points 2 and 3 above.
 Some interesting links to the original site are :

http://www.bhadas4media.com/tv/5036-barkha-vir.html
http://www.bhadas4media.com/tv/5071-barkha-vir.html
http://www.bhadas4media.com/vividh/5065-barkha-vir.html
http://www.bhadas4media.com/tv/5036-barkha-vir.html

The role of key media personalities is also revealing.

Draw your own conclusions.

Moral Relativism

Last evening I had occasion to meet a very senior finance sector executive from the US –now involved in equity investments. He invests serious amounts of money in India, his own as well as that of others –in private equity and public markets.

While commenting on investment opportunities in India, he mentioned that valuations in India do not mean much since corporate reporting is suspect. To use his words – “why should I pay for the expenses of the promoter”? The implication was that all companies “cook” books and therefore investors were seriously disadvantaged.

I mentioned that while it may be true that many company founders tended to take some money out of the business, it appeared to me that this was not significantly different from the behavior of professional managers, especially in the US, who paid themselves disproportionately. I mentioned that I would tend to rate the behavior of Mr. Vikram Pandit of Citicorp in the same category. In my book, taking $165m (out of an estimated $800m) for selling a lemon of a fund to Citi (subsequently shut down one year after it was taken over) and then offering to manage the company for a salary of $1 smacks of extreme cynicism. The response was that this was legal and above board – and more a mistake made by Mr. Prince the earlier CEO of Citi (who, incidentally, received $138m for his efforts at Citi over 4 years).

This is correct. However, the question I ask is – if something is legal is it necessarily morally acceptable? Should society not expect a higher level of ethical behavior from its leaders – political and corporate? In other words – is there a case for expecting moral absolutism rather than accepting behavior because “others do it too”. If the latter, why should society not make such behavior legal – thereby making it “acceptable”.

The shenanigans of corporate America are too well known to bear repeating. Enron through Madoff, the story continues. What is however, only now attracting comment, is the excesses that corporate America has resorted to – well within the law, but way over the top of what one should classify as acceptable behaviour. John Thain’s $35,000 commode is symptomatic. When the senior executives of the top 3 American car companies went to Congress for a bail-out package, they went by private luxury jets.

If Satyam’s Raju is accused (correctly) if siphoning of large sums of money, the story of Merrill is interesting in that it is legal! In a letter dated Feb 10, 2009, the Office of the Attorney General, State of New York, points out that Merrill, with the apparent complicity of Bank of America, paid out $3.6bn of performance bonus on Dec8, 2008 – well before the due date, and after having lost $15.31bn in the last quarter of the year alone. This necessitated a take-over by Bank of America, and a subsequent bail out by the US tax payer. Does the fact that this is legal make the shareholder’s risk lower? I think not!

It would be well to remember that it is not the case of “poor corporate governance in India” vs “rule of law” in the US. It is simply a case of human greed tilting the scales. At the current moment, it can be safely argued that the level of greed exhibited in the West far outstrips that in other other part of the world – perhaps in human history.

Does this mean that Indian corporate governance standards should not be raised? Or, investors should blindly trust the numbers that companies put out – either in India or anywhere else in the world? The answer, clearly, has to be in the negative. As investors, the cardinal rule has to be “buyer beware”. But this is true as much in India as any other part of the world.

The repeated failures of credit rating companies to predict credit defaults, and audit firms to collude with managements point to the acceptance of moral relativism that has, unfortunately, become a norm in corporate behavior.

John Bogle’s recent book “Enough” (an apt book for current times) quotes Henry Kaufman as saying –

“Trust is the cornerstone of most relationships in life. Financial institutions and markets must rest on a foundation of trust… Unfettered financial entrepreneurship can become excessive and damaging as well – leading to serious abuses and the trampling of basic laws and morals of the financial system. … Only by improving the balance between entrepreneurial innovation and more traditional values can we improve the ratio of benefits to costs in our economic system”

An “us vs them” debate at this stage is futile. We all need to look within to see that we act in a manner that can truly be called “professional”.

Now its Larsen's turn - another case of corporate misgovernance?

The public relation exercise is in overdrive trying to justify the 12% stake that L&T has acquired in Satyam. However, it does not take much to cut through the smoke screen. Let's face it, there is absolutely no reason for anyone to buy a stake in Satyam, much less L&T. 

The revenues of Satyam are as yet unknown. As are the state of the finances - except to say that the company is scrambling to raise a loan to pay salaries for the month. Clients will bolt as soon as they can, as will employees. The class action suits, and the as yet, undecided case of Upaid, remains. Why buy more shares at this time? This is the question that the independent directors of Larsen must ask when they get together on the 3oth of this month to discuss the results for the quarter. Failure to do this would amount to dereliction of duty and should form a fit case for shareholder activism.  

L&T had, presumably, identified Satyam as a possible investment candidate at an earlier date. However, to suggest that this identification remains valid even as the skeletons have not finished rolling out of the cupboard, requires a huge leap of faith and a degree of nonchalance in the use of shareholder funds bordering on negligence. To risk a significant portion of the capital of the company in an unrelated "di-worsification" (to use a term from Peter Lynch's famous book) takes the cake.

The way the deal was executed too, leaves room for suspicion. The exchanges seem to record only one buyer of the size reported. Who is the seller? If there was a single seller, it should have been reported on the other side of the trade - after all it is a "bulk deal". This seems to lend credence to the rumour doing the rounds that L&T actually purchased all the Satyam shares on the day that Raju made his declaration, when the share were in a free fall. However, the rumour goes, once the company realised the magnitude of the fall, they requested the transacting broker to hold the position, with a promise to take it on their books at a later date. 

This rumour, even if untrue (and I sincerely hope it is - after all who could have funded such a large trade) needs to be suo moto investigated by SEBI. If true, it will mean that a large amount of money may still remain to be paid to some intermediary since the price difference is unlikely to have gotten fully adjusted - bad news indeed for Larsen shareholders. It will also open a whole new can of worms with regard to practices of corporate governance in India despite protestations to the contrary. 

Even if we were to take the deal at face value, shareholders need to ask the L&T management some tough questions:

- who authorised the purchase of such a large quantum of shares

- was there a shareholders or board approval taken for a "strategic" investment of this magnitude - after all, if no white knight appears, Larsen is now the main shareholder in Satyam

- Is there a plan on how to revive Satyam and put it back on track. Who has made it and how could it have been made without getting a full picture of the assets and liabilites of Satyam

- Will Larsen step in as a "promoter" to invest in Satyam? What will it do in the event the latter becomes insolvent

Assuming that the right questions are asked, we could see new leadership in Larsen. In any case, the shareholders of Larsen have every reason to feel fearful of the status of their investment. Yet another case of non-alignment of interest of management and shareholders - something I had commented on earlier. For the un-involved, the movie promises to be interesting.

Insider Trading or margin calls?

The Satyam episode offers an interesting case which could help define insider trading more sharply. To recap, the Maytas merger announcement led to a sharp drop in Satyam share price. Ostensibly, this triggered part sales of shares which were pledged by the Raju's and against which money had been raised. The events are chronicled here. Interestingly, Merrill Lynch, which was appointed as an investment banker too had extended loans to the Raju's and had shares pledged against this loan. These shares too, were sold at a time when the company was an investment banker, and consequently privy to the inside story. 

The moot point, as raised by my partner is an earlier venture, is - do these "margin calls" qualify as insider trades. After all, the effect of these trades, was to extinguish, atleast in part, liabilities of the Raju's, when their own subsequent actions ensured that the value would completely erode in a few days. Is this, therefore, a fit case for "disgorgement" of unfair profits made by the promoters. Particularly in the light of the precarious fiscal situation that Satyam finds itself in, should the shareholders - in particular those seeking to prosecute the class action suits - not make IL&FS and Merrill a party, and seek to extract the excess value they received as a result of sales made of promoter shares just a few days before the confession?

More legally oriented minds need to comment.

Two minutes of silence

More than fifty thousand families directly, and perhaps almost as many indirectly (Maytas group, other persons involved in Hyderabad real-estate, head hunters and placement agencies) need that silence – as a requiem for their dreams – atleast temporarily. These are the real losers in the scam at Satyam.

For the non-institutional shareholders, my sympathies, for having being on-board at the time when the story blew-up. They are collateral damage. For the rest, institutional investors in particular, it’s an occupational hazard. Investing in companies that adopt dubious practices (exploiting governmental contacts being one among them) is a regular provider of the elusive “alpha”. Much “wealth” has been created at the hands of such dubious managements to provide any long-lasting aversion to such practices.

The Madoff case in the US is an example. A complainant to the SEC two years before the ponzi scheme finally crashed, pointed out several “red flags”. Some related to the behaviour of fund of funds – that are meant to conduct a proper due diligence on funds they invest in. Here are some excerpts

Red Flag #14: Madoff subsidizes down months! Hard to believe (and I don’t believe this) but I’ve heard two FOF’s tell me that they don’t believe Madoff can make money in big down months either. They tell me that Madoff “subsidizes” their investors in down months, so that they will be able to show a low volatility of returns. These types of stories are commonly found around Ponzi Schemes. These investors tell me that Madoff only books winning tickets in their accounts and “eats the losses” during months when the market sells off hard. The problem with this is that it’s securities fraud to misstate either returns or the volatility of those returns. These FOF professionals who heard BM tell them that he subsidizes losses were professionally negligent in not turning BM into the SEC, FSA and other regulators for securities fraud.

Red Flag #15: Why would a fund of funds investor believe any broker-dealer that commits fraud in a few important areas – such as misstating returns and misstating volatility of returns – yet believe him in other areas? I’d really like to believe in the tooth fairy, but I don’t after catching my mother putting a quarter underneath my pillow one night.

Can you spot the similarities?

Many business leaders have appeared on TV expressing surprise, dismay and shock. I wonder why. Indian companies have been consistently ranked amongst the most prone to bribery. “Public works” ranks on top as the area most corrupt. Satyam promoters had a background in construction. Can it be that companies that are willing to bribe others, are going to be the epitome of probity when it comes to their own operations? Surely, we cannot rank amongst the world's worst without large companies in the country being a party to this practice. This combined venting to consternation seems to me to smack of the same hubris – the search of which brought Satyam to its demise.

Instead of repeatedly denouncing Satyam, we need to do some soul searching here. Can society ever create the incentive structure that balances what is needed for survival against the greed for wealth. Till then, people in glass houses….

Independent directors - new incidents old problems

After the recent botched attempt by Satyam to merge with a company belonging to the "promoters", the role of independent directors on the boards of companies had been brought into focus. Now comes the news that the Andhra police are looking at ways to implicate Mr. Nimesh Kampani in a case which relates to defaults by Nagarjuna Finance.

In the case of Nagarjuna, it appears that Mr. Kampani was not on the board at the time when the company defaulted to depositors. Prima facie, it appears to be a case of harrasing a person for something over which he would have had little control, and perhaps no knowledge. This, once again, highlights the need to have a specialised law enforcement division within the police force that deals with white collar financial crime.

However, it also calls into question the role of and expectations from independent directors. If they are not to be held responsible for day-to-day executive decisions, and have not proven themselves capable of acting on behalf of minority shareholders when it comes to strategic decisions, why have them? And, when does one penalise inaction (at best) and malafide action (at worst) on the part of independent directors? Is loss of reputation a good enough penalty, or should there be a more serious penalty including possible financial liability and/or possibility of imprisonment. In all this, we should not forget that a company with a properly functional board would benefit from the experience and oversight of external members who monitor corporate performance and keep the management on their toes.  

Agency theory just got more complicated. 

Satyam's Shenanigans and related issues

Its been said that truth is stranger than fiction. Satyam Computer demonstrated it aptly this week - first, announcing the purchase of a company owned by a relative of its promoters, and then, withdrawing the proposal in the face of a falling share price. Several issues emerge - not the least, one of corporate governance.

The presence of external directors is supposed to mean that minority shareholder interest will be looked after. When you have as an independent Board Member, Prof Palepu of Harward Business School, who claims to research "corporate governance" and has, to his credit, a presentation made to Nasscom on "How to make corporate board more effective", you expect that some basic application of mind would take place. As events proved, you would be wrong.

Another worthy, Mr. T R. Prasad, a former Cabinet Secretary to the Government of India, the highest post a bureaucrat can reach in India, and another independent director had this to say “Even your uncle will not sell you the land at the price Maytas was selling it to Satyam". This, post the protest that shareholders registered at the conference call announcing the deal. Clearly, providence has awarded the man a particularly nasty set of uncles. It may be worth checking if he too had bought land along with Maytas and was therefore miffed if the transfer value eroded the value of this investment.

This well written article raises many pertinent questions. Not least, one of conflict of interest of the nature that required audit firms and consulting companies to be different entities in the US. When Prof Palepu generates close to $200,000 as revenues from Satyam, one cannot truely expect that he will be fair to minority shareholders. So is there just cause for a class action suit? After all, Satyam is a US listed entity !

Another, albiet somewhat peripheral point I would make is, that once again, it proves that education is no guarantee for integrity - a point most forget when we plead for "educated" politician. The most academically qualified PM currently runs the country, and has had the ignominy of presiding over an alleged case of cash-for-votes while facing a no-confidence motion. Human values and education qualifications do not have a high correlation!

But is it all the fault of the company, or are investors to blame for mixed signals? If corporate governance was such a big requirement for stock price performance, how do you explain that the highest "wealth generator" (where the criteria is market cap increase) for the past few years has been Reliance - not perhaps the epitome of corporate governance.

If the objection was to unrelated diversification, not too long ago, we had analysts suggesting that Unitech would "unlock value" by setting up a JV for its telecom business. Why on earth was the Unitech stock not hammered for attempting to get into telecom in the first place? It fell sharply only when it got into a liquidity crunch. If it is okay for a real estate company to attempt a telecom business foray, what is wrong with an IT services company getting into real estate - that too, when the promoters of the IT company are, incidentally, in the IT business, and their roots are in the construction business?

So is not corporate governance, and not unrelated diversification. It is really that Satyam's proposal would take out the cash from the company and give it to the promoters (largely). The mistake the company made was that they should have proposed a merger / share swap rather than a sale of shares. Maytas Infra share price had actually risen 15% between July to Nov 2008 when peer group shares fell 60% or more. Would this have been enough to satisfy promoter greed? As it turned out, clearly not. But I wonder if a merger would have generated significantly lower heat and dust.

Lastly, how have the institutional investors (and the investor in their funds) benefited. The deal has fallen through, but the stock price is down 25%. And the company is now suggesting a buy-back, while all analysts have changed their ratings to a "Sell". In the end, the promoters would have increased their stake (by reducing the outstanding shares through a buy-back) at a significantly lower cost than that prevailing a week ago. A few weeks later, once the dust has settled, this issue too will be forgotten. Who is the loser in this - it does not appear to be the promoter group. They should pay some royalty to Pakistan for stealing this terror of an idea!