Fenil's Library

Greenback could stop being the international reserve currencybefore long

Does life move in circles or do we? I ran into her in a coffee shop in Bangalore yesterday.

“What are you doing here?” I asked.

“Waiting for you,” she said with a mischievous smile.

“The last time we met, you said the US dollar might be the next big bubble waiting to burst. Why did you say that?” she asked as I started sipping my coffee.

“I said that because that’s the way I see it. In order to get out of the current financial crisis, the US government is literally printing dollars. And this I feel will lead to the US dollar getting into big trouble in the days to come.”

“As simple as that, is it?” she asked.

“Let me give you an example of a Japanese investor who invested in a 30-year US Treasury Bond in 1985. Treasury Bonds are essentially long-term debt securities issued by the government to raise money to make up for the difference between what it earns and what it has to spend. At that point of time, one US dollar was worth 250 Japanese Yen. Today, one US dollar is worth 92 Yen. So the Japanese investor has lost nearly 64% of the principal he had invested.”

“Now, how did you arrive at the 64% figure?”

“Simple. Let us say a Japanese investor wanted to invest $1 in 1985. He would have needed 250 Yen back then to buy $1. Now if he wants to convert that $1 back to Japanese Yen, he would get only 91 Yen. That means a loss of 159 Yen (250 Yen - 91 Yen). This when expressed in percentage terms is 64% (159 Yen as a percentage of 250 Yen). The logical takeaway here is that when the currency of the country whose financial securities you have invested in depreciates in value against your currency, as the US dollar has against the Japanese Yen, you lose money.”

“Hmmm, interesting. But what are you trying to suggest?”

“When does a currency depreciate or lose value against other currencies?” I asked.

“That I guess happens when people do not want to hold investments in that currency anymore and sell that currency to convert into some other currency. Since the supply of that currency increases, its value falls against other currencies.”

“Are you telling me that in the days to come people won’t want to hold investments in the US dollar? That they would want to get out of the US dollar and that would mean they wouldn’t want to invest in financial securities issued by the US government either?”

“Yes on all the counts,” I said.

“But that does not seem to be the situation right now. The US dollar has appreciated against most currencies except the Japanese Yen and this clearly means that more and more people are buying the dollar to invest in US government financial securities. How do you explain that contradiction?”

“Well. In the recent past, most of the bigger investors have pulled money out of various markets across the world, converted that money into the US dollar and used that money to buy securities issued by the US government. Right now, there is great demand for securities issued by the US government. And that to a large extent explains why the returns on US government securities have reached an all-time low. The return on three month US Treasury Securities currently is at around 0.02%. The return on one-year security is around 0.61%. This is surprising in light of the fact that the US government debt currently stands at $10.6 trillion, the highest it has ever been. At the same time, the government is borrowing big time. Lately, it has also been printing dollars to carry out the various rescue measures for the financial system. Given all this, it is surprising that the return demanded on the financial securities issued by the US government hasn’t been going up.”

“So why is the return being demanded not going up?”

“Oh that’s not been going up because right now investors are ready to buy financial securities issued by the US government. They feel the US government security is the safest thing going around. But that is likely to change. Let me explain why. Oil exporters are a major buyer of US government securities As of September 2008, they owned $182.2 billion of US government securities or around 6.37% of the total. Now you know that the price of oil has fallen from around $150/barrel to currently around $45/barrel. So the oil exporting countries, which had been buying up the US government financial securities at low rates of return will not have enough money going around to continue buying. Also, China, which has reserves of $585 billion, or 20.5% of the total, and has invested in US government financial securities, is entering into a slowdown. This means, all the dollars they were earning through exports will come down. And when that happens, they cannot continue to buy US government securities,” I said.

“So the demand for US government securities will come down?”

“Yes. And when the demand comes down, the return on investing in US government securities will have to go up. That would also mean that the US government will have to pay more interest on the financial securities it issues, than it currently does. So that will worsen the financial position of the US government even more.”

“But what’s all this got to do with the dollar?” she asked.

“See, one reason other countries buy dollars is that it is the international reserve currency. Now, as the US Fed prints more dollars and the US government raises more and more debt, investors in US government financial securities will start to question the creditworthiness of the US government. And when that happens, they will want to sell the US government securities. When they sell the US government securities, they will get US dollars in return. They will sell the US dollar, get the currency they want to and repatriate that money to their own countries. When all that dollar-selling hits the market, the US dollar will depreciate, i.e., it will lose value against other currencies. Now, as I have explained already, when the currency of the country whose financial securities you have invested in depreciates in value against your currency, you lose money. Also, as the US Fed prints more dollars, the supply of dollars in the market increases, this again adds to the value of the dollar against other currencies going down,” I said.

“I think I understand it now. As the dollar depreciates, the value of the US government securities held by various countries will go down. This may make them want to sell these securities. And this, in turn, will put further pressure on the US dollar. In fact, in the recent past, foreign central banks have already sold $120 billion of US government debt,” she said.

“So what’s your doomsday prediction?”

“You see, the US till now has had a big advantage, which most countries don’t have. The US can raise an international loan in its own currency. This is because the US dollar is the international reserve currency. So countries, which have US dollar reserves are ready to invest in US government securities at very low rates of interest.”

“But if things pan out as I feel they should, central banks and governments around the world wouldn’t want to invest in US government securities. And when that happens, the chances of the US dollar continuing to be the international reserve currency are bleak.”

If and when that happens, the US will have to probably start borrowing in other currencies. In order to repay those loans, they wouldn’t really have the option of just printing dollars. That money will have to be earned.”

 

(The example is hypothetical)

k_vivek@dnaindia.net

 

References: ‘Don’t be surprised if theUS government defaults on debt’,Satyajit Das, September 16,2008, DNA

‘US dollar: The Next Bubble to Pop’, Jack Towne, www.seekingalpa.com

The next bubble to burst could well be the greenback itself

I used to think candle-lit dinners were romantic, until I became a part of one. There we were, sitting across the table with two candles between us, looking at each other. But soon enough, mosquitoes started their sting-song, sending me scurrying across the room to switch the lights back on.

“I have been reading,” she said. “And the more I read, the more confused I get.”

“There goes our romantic evening,” I told myself.

“The Federal Funds Rate, the rate at which the US Federal Reserve lends to banks in the country, is currently at 1%. Despite this, the interest rate charged on a 30-year home loan in the US is still at 5.5%. Why is there such a huge gap?” she asked.

“The primary reason is that banks do not want to lend. They find lending to small borrowers very risky at this point of time, which is kind of ironical, given that until around a year back, they were falling over one another to lend money. Hence, even though the Federal Funds Rate is at 1%, banks continue to lend at a much higher rate.”

“But is that the only reason? What happened to the $350 billion of the $700 billion troubled asset relief programme (TARP) the US government has used to recapitalise banks? Wasn’t that supposed to jumpstart lending?”

“Technically, yes, the bailout money was supposed to help the banks and financial institutions in the US so they could start lending again. But this is not what the money has been used for. Experts suggest that nearly a third of the $350 billion already spent has been used by banks to pay dividends to their shareholders. Of the remaining, some amount of money has been used to pay salaries and bonuses to employees of these banks and financial institutions. Some banks have deposited the money back with the US Fed or used it to buy financial securities issued by the US government,” I explained.

“So, the money given under TARP came with very few terms and conditions, giving banks the leeway to use it the way they want?”

“You are right, but it doesn’t stop there. News just coming in seems to suggest that banks have been using this money to even make acquisitions. Bank of America, which is getting $15 billion under TARP, is using the money to double its stake in the China Construction Bank, which happens to be China’s second-largest bank. After the deal is finalised, the Bank of America will hold 20% stake worth $24 billion in the bank. Similarly, US Bancorp, which got $6.6 billion under TARP, is using the money to buy out two lenders — Downey Savings & Loan Association and PFF Bank & Trust. Both these lenders are based out of California (“TARP Funds Fueling Global Buyouts, Not Lending” by William Patalon III, December 5, 2008, www.seekingalpha.com),” I explained.

“How convenient? If they had to raise the same amount of money through the market, they would have had to pay a very high rate of interest, i.e. of course only if some investors were ready to lend them the money.”

“But there are other reasons for banks not lending. The collapse of the structured investment vehicles (SIVs) is also a reason banks have slowed down their lending. You know by now that most banks and financial institutions giving out home loans and other loans did not keep home loans on their books. They used to securitise these loans by converting them into financial securities — called mortgage-based securities (MBS) — and selling them to investors. This ensured that they immediately got back a large portion of the money they had given out as a loan, thus cutting out the risk and freeing up capital for lending again. The investors, on the other hand were passed on the major portion of the equated monthly instalments (EMIs) that the borrowers repaid. SIVs were big investors in these MBS and other asset backed securities (ABS). At one point of time, they had around $400 billion invested in these securities.”

“And then?” she interrupted.

“The way these SIVs operated was ‘borrow short, lend long’. In other words, they essentially issued commercial paper, which was bought by other investors, but which matured in less than one year, and used the money thus raised to buy MBS and ABS. But at least MBS were clearly long term, with maturity periods of as long as 30 years. So the entire business worked till SIVs could keep issuing commercial paper. Then the news started to come in that a lot of MBS held by the SIVs was going bad, in that those who had taken home loans backing the MBS were not paying up their EMIs. So the SIVs were not getting paid against the MBS they had bought. This, in turn, led to investors not wanting to put money in commercial paper issued by SIVs. And this led to the entire securitisation market coming to a stand still. Also, since SIVs could not issue any commercial paper, they had to sell the MBS they had previously bought in order to repay the commercial paper that matured and had to be repaid. But since the MBS held by these SIVs had supposedly gone bad, there were no takers for these. And this led to a whole lot of SIVs going bust. A lot of big banks such as Citigroup and Dresdner Bank of Germany had set up SIVs to play this business,” I explained.

“And since there are no SIVs now. There is no securitisation market. Since there is no securitisation market, banks cannot securitise the loans they have given. And since they cannot securitise these loans, they obviously cannot keep lending at the same frantic pace as they had done before and more than that they continue to carry the risk of the loan going bad on their books. And given the increased perception of risk, they are charging a higher rate of interest on their loans even though the Federal Funds rate is at 1%. The situation I guess is more or less the same in the United Kingdom and other parts of Western Europe as well,” she said with a lot of enthusiasm. “But how are governments and central banks planning to tackle this?” she asked.

“Well, governments and central banks all over the developed world are now trying to flood the markets with money. The US Fed has announced another plan to spend a whopping $800 billion to buy MBS and ABS. It also plans to buy US government financial securities held by banks and other financial institutions, to flood the financial system with more and more money. This they are hoping will lead to banks getting into the lending mode again. Other than this, there are plans of a fiscal stimulus of anywhere between $500 billion and $700 billion being legislated as and when Barack Obama takes over as President of the US. This money will be used primarily on infrastructure projects, social reforms, etc. The idea is to flood the economy with money so that banks lend, people earn more and then they go out and spend that money, which in turn revives consumption and that in turn revives the overall economy. At least that’s the theoretical construct.”

“But where is all the money going to come from?”

“Oh, that’s simple. They are simply going to print it. Quantitative easing is what economists have been calling it.”

“But isn’t that abusing the strength of the US dollar?”

“Yes it is. But right now dollar is a very strong currency. And everybody wants to hold it even more after the financial crisis. And that explains the fact that even though the US government is borrowing more US dollars, the interest rate they are paying on their borrowing continues to be very low. But if they continue to abuse the strength of the dollar by printing more and more of it, as they are doing right now, who knows what might happen.”

“Are you suggesting the US dollar could be the next big bubble to burst?”

(The example is hypothetical)

References: ‘Central Bankers Open the Floodgates to Flight Deflation’ by Gary Dorsch, December 3, 2008, www.safehaven.com; ‘Plan C’, Economist, November 29-December 5, 2008.

 k_vivek@dnaindia.net

 

Two negatives needn’t a positive make

 Negative amortisation loans getting into negative equity territory may prove a big worry for the US

 Vivek Kaul. Mumbai

 “The more I know, the more I know that the more I don’t know,” she said getting a little philosophical early in the morning. “What was that?” I asked. “Guess the vodka you had last night is still speaking.”

“Shut up. I was reading something last night and came across negative amortisation home loans. Experts have been saying that these loans will cause more trouble in the US in the days to come. I have been up for two hours trying to figure out how these loans work, but have been unable to.”

“So that’s the problem. Let me explain this to you. Say someone has taken a negative amortisation home loan of $190,000 with a tenure of 30 years or 360 months. This is a 5/1 home loan where the interest rate resets after the first five years and then every year after that. The house he plans to buy is priced at $200,000, which means he has to put in $10,000 of his own money. In other words, the bank or the financial institution that gives him the loan has financed 95% ($190,000/$200,000) of the value of the house.”

“But what is different about this loan? From what you have described till now, it sounds just like any other floating rate home loan,” she interrupted.

“Have some patience, my dear. A negative amortisation loan comes with a teaser rate for the first three to four months. Let us say the teaser rate is 2.5% for the first three months of the loan. The equated monthly instalment (EMI) for the first three months thus works out to $750.7. But after three months, the interest rate changes to 6.5% for the remaining 57 months of the initial five year period. Does that mean the EMI should go up?”

“Of course, if the interest rate goes up, the EMI should also go up. That’s no rocket science,” she said.

“That’s where things get a little different in this case — the EMI does not go up. The EMI stays at $750.7 for the next 57 months of the five-year period. And all the extra interest keeps getting added to the loan outstanding. Let me explain in a little more detail. At the end of three months, or the beginning of the fourth month, the loan outstanding is $188,933.1. The interest on this, at 6.5% per year, works out to $1023.4. But the EMI being paid is only $750.7. What this means is that $272.7 ($1023.4-$750.7) of interest is not being repaid. This gets added to the loan outstanding. So the loan outstanding at the end of the fourth month or beginning of the fifth month stands at around $189,205.8 ($188,933.1 + $272.7). On this, the interest to be paid is $1024.9. The EMI being paid is $750.7 and so interest not paid works out to $274.2 ($1024.9 - $750.7). This is added to the loan outstanding, which at the end of the fifth month or the beginning of the sixth month works out around $189,480 ($189,205.8 + $274.2). And this continues. At the end of the 60th month, or five years, the loan outstanding stands at $206,715. This is much more than the $190,000 of the loan that was initially taken. As is obvious, since the interest to be paid is greater than the EMI, no principal is repaid and hence the loan outstanding just keeps growing,” I said.

“That’s interesting. I had never heard of a loan in which the loan outstanding keeps growing in spite of the EMI being paid on time. So what happens after five years?”

“After five years, the rate of interest can go up. Assuming that the rate of interest goes up to 8%, the EMI needed to pay off the loan outstanding of $206,715 over the remaining period of 300 months or 25 years works out to $1595.5. But at this point, there is another clause built into most negative amortisation loans, which gives the lender the option to limit the EMI at 107.5% of the last EMI. This, despite the fact that the actual EMI required to pay off the loan in the remaining period is much higher. So, in the example we have taken, the new EMI will work out to around $807 (107.5% of $750.7). And I need not tell you that this EMI cannot repay even the interest portion of the loan outstanding. All the extra interest that needs to be paid keeps getting added to the loan outstanding and thus the borrower ends up paying interest on interest,” I explained.

“Reminds me of usury. But how does the bank protect itself? They cannot keep the loan outstanding growing beyond a point,” she asked.

“You know, the bank keeps track of the ratio between loan outstanding and the loan that they gave originally. When this ratio hits 1.1, the process of negative amortisation stops and the borrower has to go back to normal amortisation. At the end of five years, this ratio stands at 1.09, in our example. So the negative amortisation is all set to go and normal EMI is about to kick in. As and when this happens, the EMI is likely to go up from around the current $800 level to around $1,600 level. In other words, the EMI is likely to double. And when this happens, the chances of the borrowers continuing to pay are highly unlikely. It needs to be kept in mind that these loans were largely made to borrowers at the lowest end of the market, whose ability to repay was anyway questionable.”

“Interesting. But wouldn’t falling house prices have an impact on this as well?” she asked.

“Yes. A lot of houses right now are now in a negative equity situation wherein the market value of the house is much lesser than the loan to be repaid. So, in our example, if the market value has fallen by 20% to $160,000 from the initial price of $200,000, the borrower has even lesser incentive to keep repaying. This is primarily because he is repaying more than what the actual worth of the house is. Also, as I have explained before, a lot of individuals borrowed money to speculate since the real estate prices were going up. The entire idea was to sell the house as and when the price goes up, repay the loan outstanding and cash in a neat profit. Now, with home prices falling, that logic clearly does not work. More than this, in the US, home loans are non-recourse loans, i.e. the lender can seize only the collateral; the lender cannot go beyond the collateral and seize other assets or money in the bank account. The borrower is not personally liable for it. Hence, there is all the more incentive to default, since the borrower can only seize the house. Also, every time a borrower defaults, the bank seizes the house and puts it up for sale. This adds to the housing prices going down even further.”

“I get it now,” she said. And since banks had securitised away most of their home loans, investors who bought that securitised paper will be in trouble as the defaults increase.”

(The example is hypothetical)

Reference: Tanta: Negative Amortization for UberNerds, www.caculatedrisk.blogspot.com

 

k_vivek@dnaindia.net

The central bank is keen to see people spending, for without consumption, the US economy is nothing

 “The Fed and other central banks that used to be the “lenders of last resort” have become the “lenders of first and only resort” as banks don’t lend to each other, banks don’t lend to non-bank financial institutions and financial institutions don’t lend to the corporate and household sector.” — Nouriel Roubini, reacting to the latest move of the US Federal Reserve

“You know, these days something or the other keeps happening before I have figured out what went before,” she said rather excitedly over the phone.

“Now what?” I asked.

“It seems you haven’t read the newspapers today. The United States government has announced another bailout, this time for $800 billion.”

“This isn’t exactly a bailout,” I protested. “Besides, it is the US Federal Reserve, the central bank of the US, which has made the announcement and not the US government.”

“It’s one and the same thing, isn’t it?”

“Not really. If the US government had to spend the money, it would need approval from both Senate and the Congress,” I explained.

“And how is it not a bailout?”

“Since this is going to be a rather long discussion, we will get back to that.”

“Okay. But what is this $800 billion going to be used for?”

“Good question. Around $600 billion will be used to support the big housing finance companies in the US and the remaining $200 billion will be used to support recently originated consumer and small business loans,” I said.

“That’s rather vague,” she said.

“Okay. Let me get into some detail. Of the total amount, up to $500 billion will be used to buy up mortgage backed securities, which are backed by housing-related government-sponsored enterprises (GSEs) — Fannie Mae, Freddie Mac, and Ginnie Mae. Through this, the government hopes to revive home loan lending by banks in the US. As you would know, home loans are referred to as the mortgages in the US.”

“I didn’t get that,” she interrupted.

“Let’s go back to the basics of securitisation. Banks first give out home loans to borrowers. Then they agglomerate similar loans together and convert them into financial securities. These financial securities are sold to investors willing to buy them. Once the securities are sold, the major part of the equated monthly installment that the borrower pays to repay the home loan is passed on to the investors who have bought these financial securities. This entire process is referred to as securitisation. Once a bank sells these securities, the risk does not remain on its books. Also, the money comes back immediately and the bank can give out more loans.”

“I know, you have told me that before.”

“I have, but have patience. The GSEs — Fannie Mae, Freddie Mac, and Ginnie Mae — were major buyers of these financial securities or mortgage backed securities. They provided liquidity to the entire market. Since they kept buying these securities, banks got their money back upfront and could go out and give more home loans. That’s how it worked until borrowers who had been given loans way beyond their repayment capacity started to default on their loans. That killed the securitisation market. Investors who once clamoured for these securities did not want to touch them at all. And once this happened, banks could not simply securitise their risk away and this made them more than cautious while giving out home loans. Also, since they couldn’t securitise, the number of loans made reduced significantly.”

“Are you suggesting that the Fed is trying to revive the securitisation market and thereby the housing market?”

“Yes. The Fed plans to appoint asset managers to buy mortgage backed securities. This will put more money in the hands of GSEs, so they can buy mortgage backed securities from the banks issuing them. Thus, the banks will get their money back upfront and can make more home loans, which in turn is expected to provide some support to the housing market that has gone into free fall.”

“How does that help?”

“As the house prices have fallen, a lot of loans are in negative equity. Negative equity is a situation in which the home loan outstanding at any point of time is greater than the market value of the house. Let us say the loan outstanding at this point of time is $250,000 and the market value of the house has fallen to $200,000, then there is a negative equity of $50,000. The bank that has given the loan is not into charity. At any point of time, they would like to ensure that value of the house, which is the collateral they have, is greater than the loan outstanding. If that is not the case, they would want the borrower to make up the difference. So, in this case, the borrower would have to pay the bank $50,000. But if the borrower is not in a position to pay, he might just choose to default on the home loan. In the US, home loans are non-recourse loans, i.e. the lender can seize only the collateral; the lender cannot go beyond the collateral and seize other assets or money in the bank account. The borrower is not personally liable for it. Hence, there is all the more incentive to default. Also, every time a borrower defaults, the bank seizes the house and puts it up for sale. This adds to the housing prices going down even further.”

“Hmmm. So the idea is to somehow stabilise housing prices and ensure that the number of defaults does not rise…”

“Yes,” I said.

“But what happens to the remaining $300 billion?” she asked.

“Of this, the Fed plans to buy up to $100 billion of debt issued by the three GSEs. That leaves us with $200 billion. This money will come from the Federal Reserve of New York, and will be used to buy recently originated top rated asset backed securities based on student loans, auto loans, credit card loans and small business loans. As with home loans, the other loans can also be securitised. And as has been the case with mortgage backed securities, there are few buyers for asset backed securities as well, giving very little incentive to banks to make these loans. Once the Federal Reserve of New York starts buying these securities, it is expected that banks will make more student, auto and credit card loans, in the same way as they are expected to make more home loans. Also, with the securitisation market picking up, interest rates being charged on loans are expected to come down, because the risk for the banks giving these loans will also come down.”

“In effect then, the Fed is trying to get Americans to start borrowing again?”

“You got that right.”

“But didn’t their borrowing binge cause these huge problems in the first place?”

“Yes it did. But remember that nearly 70% of the US GDP comes from private consumption. So, if people stop borrowing altogether, the economy can get into a recession, even a depression for that matter.”

“But where will all the money come from?” she asked.

“The Fed hasn’t said that yet. There has been no talk about increased borrowing. Neither has the US government talked about raising income tax. So, in all probability, the Fed will print all this money.”

“Will that help?”

“I wish I knew. Right now, the major problem is that banks don’t trust anybody. They don’t trust other banks, they don’t trust borrowers and they don’t trust prospective borrowers.”

“And why did you say it’s not a bailout?”

“Well, the Fed is buying mortgage-backed securities and asset backed securities in the hope that the borrowers will keep repaying their loans and over a period of time, it will get back its money. “Hope” is the keyword here, and there is a chance it could end up being yet another bailout.”

(The example is hypothetical)

k_vivek@dnaindia.net

President-elect Barrack Obama might stop just short of taking Keynes’ advice literally, to create jobs

“We are all Keynesians now”

—Richard Nixon, former US president

“You know, I was wondering what has happened to the $700 billion being spent under the troubled assets relief program (TARP)?” she asked, as we finished our morning walk.

“The bailout package?” I asked, as we stopped and sat on a bench.

“Yes that’s what the press is calling it. But officially it’s TARP.”

“It’s a bailout either way. Of the $700 billion allocated, $300 billion has already been spent. Of this around $250 billion has been infused into various banks including the Citigroup and $40 billion has been infused into insurance major American International Group (AIG),” I explained.

“All that I know. What I wanted to know was what are the banks doing with that money?”

“Interesting question. The idea behind bailing out these banks was to get these troubled banks and financial institutions to get lending again. But from what one has been reading in the international media, banks haven’t stepped up efforts to give out more car loans, student loans or even loans to businesses. Estimates suggest that banks are using a good portion of the bailout money to shore up their share prices. I was reading this blog by Robert Reich (A Bottom-Up Bailout Rather Than Trickle-Down, www.robertreich.blogspot.com), former US labor secretary and currently a professor of Public Policy. He says that about one-third of the money has “gone into dividends the banks are paying their shareholders; some of the rest into executive salaries and bonuses; another portion toward acquisitions designed to raise share values; another chunk for bailing out giant insurer AIG.”

“So what is the problem with that?” she interuppted.

“The idea behind the bailout was to get banks to start lending again, which they had stopped doing for some time. But that clearly is not happening because the bailout money did not come with enough conditions to get them to start lending again.”

“Hmmm... But why is it important for banks to start lending again?”

“Let us try and understand some economic theory here. The aggregate demand of any particular country is made of four distinct elements and can be represented in equation form as Y = C + I + G + NX; where C stands for private consumption or money you and I spend on buying things and availing services; I stands for investment made by private sector in setting up factories or any other thing that helps in producing stuff that can be consumed in the future; G stands for government spending; NX is essentially the difference between exports and imports. The rationale is that the money the country earns through exports comes back into the country and the money the country spends on imports leaves the country.”

“And how does it connect to the US?”

“The American economy is heavily dependent on consumers. Nearly 70% of the aggregate demand comes through private consumption. Today, spending by American citizens is falling. One reason, of course, is that a lot of the spending was done with borrowed money and with banks not willing to lend that is not happening now. Also, job cuts and fear of job cuts have led to people to save up for a bad day. As a result, retail sales in October fell by 2.8% in comparison with September and by 4.1% in comparison with October last year. Automobile sales also fell by 32% in comparison with October 2007. With private consumption taking a beating and banks not willing to lend, it is highly unlikely that investment spending made by the private sector will go up. If people don’t buy stuff, why produce more?” I explained.

“How about net exports?” she asked.

“The US imports more than it exports. For net exports to add to aggregate demand, American exports need to go up considerably. With most of the developed world entering into a recession, the chances of American exports going up are highly unlikely. The US dollar has been appreciating against most currencies and this makes it expensive for other countries to import stuff from the US. (The Mini Depression and the Maximum-Strength Remedy, www.robertreich.blogspot.com). I don’t see net exports going up”

“Are saying that only a rise in government spending can raise aggregate demand? And how would it help?”

“Oh, simple. Whenever we spend money, it ends up as income in the hands of someone else. Then that individual goes out and spends a certain proportion of the income and so the chain works. Economists call this the multiplier effect. And this works because individuals, firms and the government spend money. Right now, as we have seen, the consumers and companies are not spending, and exports are unlikely to rise. Only the government is in a position to spend money.”

“And this brings us back to John Maynard Keynes, the famous British economist, who suggested that in a recession the government should pay people to dig holes in the ground and then fill them up, or build roads or schools. He said it doesn’t matter what they do as long as the government is creating jobs,” she said, repeating what I had told her in our last meeting.

“Well, US president-elect Barack Obama is taking the idea seriously. He has gone on radio saying the US economy has a big problem and “We must do more to put people back to work and get our economy moving again. We have now lost 1.2 million jobs, and if we don’t act swiftly and boldly, most experts now believe that we could lose millions of jobs next year.””

“So what does he plan to do? Get people to dig holes?”

“Well, sort of. He has directed his economic team to come up with a recovery plan that would create around 25 lakh new jobs by January 2011.”

“And how?”

“Well as he said in his speech “We’ll put people back to work rebuilding our crumbling roads and bridges, modernising schools that are failing our children, and building wind farms and solar panels; fuel-efficient cars and the alternative energy technologies that can free us from our dependence on foreign oil and keep our economy competitive in the years ahead.” Experts feel this would involve spending of around $700 billion dollars, an amount similar to the bailout package,” I explained.

 

(The example is hypothetical)

k_vivek@dnaindia.net

Income on Rs 78 lakh can be tax-free

Here’s how someone in the highest tax bracket could do this

sandeep shanbhag

With the stock market expected to continue being choppy and fixed income plans of mutual funds battered under credit concerns as well as interest rate swings, investors have been increasingly turning to bank fixed deposits (FDs) as a safe shelter for their money. As bank interest is fully taxable (thereby reducing the effective rate), the rationale for preferring FDs over other investments seems primarily to ensure security of capital rather than earn a high return.

However, there are ways the investors can jack up the return from their FDs. Last week, we examined how tax-saving FDs can potentially earn a rate of 16.67% p.a. This week, we shall reexamine a strategy that can optimise the effective rate of your FD. Though this subject has been dealt with in a past column, the current environment definitely warrants a relook.

Let us familiarise ourselves with two concepts of income tax before we set off.

First is the basic threshold. Readers would know that the first Rs 1.50 lakh of income is exempt from tax. For non-senior ladies, the limit is Rs 1.80 lakh and for senior citizens (65 plus) the limit is Rs 2.25 lakh.

The second concept, which works hand in hand with the first, pertains to Sec 56 of the Income Tax Act, which basically exempts cash gifts between relatives. Though there is a long list specified in the section, for our purposes, suffice it to know that as per the Income Tax Act, you, your parents, your brothers and sisters as well as your children are all relatives of each other.

Now, in order to understand how these two tools can be used for some smart tax planning, let’s take the example of one Mr Mehta who is 49 years of age. He happens to be in a senior management job, which puts him in the highest tax bracket. His wife is a homemaker and they are the proud parents of an 18-year-old daughter and a 20-year-old son who are both studying in college. Mehta’s retired parents live with them.

Read Mehta’s profile once more if you must because it is important in our scheme of things. Also remember that some of the numbers that are going to be thrown up are astonishingly large. Don’t get thrown off because of that. This is just the power of the tools at work. You can use them at any income level to suit your particular situation, as long as you understand the concept, individual numbers can always be plugged in.

Mehta, though keen on investing in FDs, is not too happy about the tax aspect. Being in the highest tax bracket, he finds that a 10% pre-tax rate ultimately ends up earning him just 6.6% after tax.

It was at this juncture that Mehta was introduced to our strategy by an old chartered accountant friend of his. This is what he did after a brief but illuminating chat with his friend.

He gifted Rs 22.50 lakh to his father and a similar amount to his mother. This gifted money was invested by his parents respectively in a bank FD, yielding 10% p.a. This basically meant that both his parents earned Rs 2.25 lakh as interest from the FD (10% of Rs 22.50 lakh). However, not a penny of this was taxable as this was not beyond the initial tax slab available to senior citizens.

Thus in one stroke, Mehta effectively made income from Rs 45 lakh of capital tax-free in the family’s hands. Realise that had Mehta invested the funds himself, he would have paid full tax on it. However, since the gift was tax-free and the tax slab was available, this strategy could be put to work.

Now, Mehta finds that his children have some time to go before they start earning. His daughter can earn up to Rs 1.80 lakh without having to pay tax and his son can similarly earn Rs 1.50 lakh. But they aren’t earning as of now, are they? They are studying and will continue to do so for the next five to seven years. So what does he do? He gifts them around Rs 18 lakh and Rs 15 lakh, respectively. This money is in turn invested in a similar bank FD by the kids, thereby earning Rs 1.80 lakh and Rs 1.50 lakh, respectively. Of course, as explained earlier, no tax would be payable.

In effect, by using two simple tools that the Income Tax Act offers, Mehta had managed to make Rs 7.80 lakh of income completely tax-free for the family. Putting it differently, as much as Rs 78 lakh of capital was deployed, however, the income there from was totally tax-free.

Note carefully that it is not Rs 78 lakh of income that is rendered tax-free; it is the income on a capital of Rs 78 lakh (Rs 7.80 lakh) that is sought to be made tax-free.

Admittedly, Mehta is an extremely rich man. He had Rs 78 lakh to spare in the first place before trying to make it tax-free. Not everyone will have this kind of money. However, the example given is an optimal one. You can use a similar strategy with the funds at your disposal and the benefit you derive will be proportional. In other words, it’s not an all or none strategy… use it to the best of your ability.

Also note that Mehta’s profile was an ideal one - that of a man working in the highest tax bracket with retired parents having no income of their own and two major children who are still studying. Again, not every taxpayer will have a similar profile. Your father may be having taxable income but your mother may not be working. Or your children may be earning already. The idea is to use the particular element in the equation which applies to your situation directly.

There is a way to further refine the strategy outlined above, as suggested by Mr Meswani, a reader, when this topic was discussed earlier. Each recipient (both parents and the two kids) can potentially be given a further Rs 10 lakh each. At the rate 10%, this will result in an extra income of Rs 1 lakh, which in turn can be invested in any Sec 80C instrument such as PPF, NSC, etc. This way, a further Rs 4 lakh income or Rs 40 lakh of capital can be sought to be made tax-free. Added to the earlier Rs 78 lakh, this means Mehta and his family can earn tax-free income on a capital of over a crore!

sandeep.shanbhag@gmail.com

Tax-saving FDs merit more than a look

Though the rates appear lower than on other FDs, the real effective returns are much higher

Sandeep Shanbhag

The recent liquidity infusing measures taken by the Reserve Bank of India saw some banks lowering their rates for advances, including those for home loans. If interest rates for advances fall, it is but obvious that deposit rates, too, will follow.

Consequently, investors are rushing to lock in their funds before these special deposit schemes that offer higher rates permanently go off the shelf.

Past columns have discussed alternate investment avenues such as gold and Nabard bonds, amongst others. However, if it is indeed the Bank FD that is the preferred instrument, then I suggest investors stop worrying about the discontinuance of the high yielding deposits and instead focus on tax-saving fixed deposits that offer the Sec 80C deduction. This is in spite of the fact that these tax-saving FDs offer a rate that is prima facie lower (around 9%) than their plain vanilla counterparts, where the rate can even go up to 11% p.a.

Though the nominal return from a tax-saving FD, per se, seems low, the real effective rate is much higher. In case of individuals who fall in the 30% tax bracket, the effective return is as high as 16.67% p.a.

This is primarily because of the tax deduction. Remember that the initial investment saves you tax. And since a penny saved is a penny earned, the saving in tax payable works akin to having invested that much lesser in the first place. For example, let us assume that an individual deposits Rs 1 lakh in a fixed deposit u/s 80C and he is in the 30% tax bracket. This means, because of his investment, his tax outgo will be lower by Rs 30,000 (Rs 1 lakh x 30%). In other words, he will be receiving an interest of Rs 9,000 (9% of Rs 1 lakh) on an outlay of just Rs 70,000 (Rs 1 lakh — Rs 30,000). This, as we shall see, jacks up the effective return.

Consider the following table:

Date     Interest         Cumulative

amount     (Rs)         (Rs)

Jul 1, 08              —        1,00,000

Dec 31, 08        4,500   1,04,500

Jun 30, 09       4,702   1,09,202

Dec 31, 09       4,914   1,14,116

Jun 30, 10       5,135   1,19,251

Dec 31, 10        5,366   1,24,618

Jun 30, 11        5,607   1,30,226

Dec 31, 11       5,860   1,36,086

Jun 30, 12        6,123   1,42,210

Dec 31, 12       5,759   1,47,969

Jun 30, 13        5,992   1,53,962

It is assumed that a deposit of Rs 1 lakh is made on July 1, 2008. The deposit matures after 5 years, i.e. on June 30, 2013. Interest is payable @9% on a half-yearly basis. The depositor has opted for the reinvestment of interest option and hence the interest is not paid out and accumulates. The second column specifies the interest earned every six months and the last column contains the cumulative deposit figure for each half year.

This is very similar to National Savings Certificate (NSC VIII) as far as the structure is concerned. In case of NSC VIII, the interest accumulates and is not paid to the investor every year. The interest that accumulates is treated as invested in NSC VIII. Hence, it qualifies for an exemption under Section 80C for the first five years. In the last year, the interest is handed over to the investor and does not qualify for a deduction and therefore is taxable. Tax experts are of the view that if the investor opts for a reinvestment of interest option in case of fixed deposits, the accumulated interest would also be eligible for a tax deduction under Section 80C, as it is in case of NSC VIII.

Given this, the interest for the first four years is tax-free as it is deemed to be reinvested. Only the interest for the last year is taxable and the tax rate is 30%. (As can be seen in the table, the interest earned in the last year is less than the previous years because it is taxable at the rate of 30%). Given this, the maturity amount works out to Rs 1,53,962 at the end of five years.

An initial investment of Rs 70,000 (as explained earlier), more than doubles in five years and grows to Rs 1,53,962. The effective return on this works out to be 16.67% per annum and that too net of tax. Now, how many fixed income investment options give you that kind of return?

 

The following are the net effective rates for the various tax slabs:

10%                 20%                 30%                 33%

11.34%            13.79%            16.67%            17.63%

The above numbers should make even those investors who reject fixed income investments for potentially higher returning equity-oriented products sit up and take note. Because, this is like saving tax and getting paid for it.

However, as in all good things, there is a caveat. Readers should note that the above effective rates work out to be so high because there is a tax deduction available on the amount invested, but the maturity amount is tax-free. That is as of now. Once the exempt-exempt-taxed (EET) system of taxation is put into place, the maturity amount would become taxable, thereby bringing the effective return down. However, this would apply to all other instruments, too. Also, EET isn’t coming anytime soon, especially not in a Budget being presented before elections. Lastly, there is a very good chance that when EET is indeed put into place, it would be on a prospective and not on a retrospective basis, which means that it would not be applicable to investments made already. A clarification on this front will benefit the investor community immensely.

sandeep.shanbhag@gmail.com

Rebates, kickbacks kill your money

Or, why getting the insurance agent to pay your first premium is not such a good idea

Kishore Kale

Agent: Sir, this is the best plan for you — it will give you good returns as well as proper risk cover. The premium is low, just Rs 35,000 per year. The insurance cover is Rs 5 lakh. After every five years, you will get 20% of this insurance cover back. At the end of the 20th year, you get the remaining 40% of the insurance cover with accumulated bonus. You are just 28 years old, so this is just what you need.

Client: OK, I know this plan very well. Another agent had explained this plan to me. When I asked him how much premium he was willing to pay on my behalf, he said he could pay 2 months’ premium. If you can pay more than that, I will purchase this plan from you.

Agent: No problem, sir. I want to complete my sales target for this year. I can pay 3 months’ premium for you. You should know that I am paying more than the commission I am receiving.

The sale is made.

This is the Indian financial services market. Nobody seems to be bothered about critical considerations such as financial needs analysis, risk measurement and management, rate of return from investment, or capital appreciation.

The result: mismatched asset allocation, huge uncovered risk, poor rate of return, capital eradication due to inflation and non-achievement of financial goals.

Here are some reasons kickbacks in financial products are so common in our country:• Competition among agents and financial organisations • Lack of a professional approach to financial planning • Perception of financial consultancy as a part-time profession • Lack of innovative financial products from financial organisations • Lack of trust and confidence in the customer’s mind about the financial planner • Lack of back-up for the so-called financial planners - no proper knowledge, no proper office with staff and no technological assistance • Low standard of entry into financial consultancy — HSC-pass plus a few elementary examinations is all that is required to start off as a financial consultant • Huge market requiring huge number of financial planners, resulting in financial organisations recruiting any half-decent Johnny as a financial planner Until 2000, insurance companies did not bother about their agents’ knowledge and skills or how they procure business, due largely because there was no competition. The only competition was among the agents — to grab maximum business — and this would often result in them offering part of their own commission to the buyer as rebates. These practices continue to this day, long after the market has been thrown open to competition.

Although such offers are unethical and illegal, they have nevertheless grown deep roots in the insurance fraternity. As a result, the customer has begun to consider a premium rebate a matter of right and has no qualms about receiving it.

After 2000, various private companies entered the fray, increasing customer awareness about maintaining financial health. With these players offering new products and services to gain market share, public sector players were forced to increase their portfolio of products and services as well.

But where were the staff required to sell their products and services to the public? Enter fresh graduates, call centre executives and banking employees, who started selling financial products with the same elementary knowledge and wrong information as their predecessors in the public sector entities.

Result? The rebating habit caught hold here too.

Sellers often offer customers freebies and discounts for buying particular products during particular time periods. Sellers use stock clearance sales as a tool for moving dated products from their stores. But, rarely is a product sold below its cost. In fact, often prices are first increased and then reduced by giving discounts, so as to give the customer a feeling that he is on the winning side. Even so, such discounts aren’t unhealthy, for the customer doesn’t lose out on quality.

But the same cannot said of intangible financial products or services. The benefits in this case come in the future and are dependant on external factors such as the world economy and market conditions. The impact of a wrong financial decision can thus be verified only in the future, by which time it would be irreversible.

Besides, it is not a one-time affair. As in farming, one’s financial health requires nurturing and caring, regular review, changing plans as per changing needs, and regular follow-up to ensure a rich harvest.

When a customer demands a rebate, he/she is risking not getting future follow-ups, regular reviews, and proper attention to maintaining his/her financial health. Discounted service cannot but lead to discounted quality.

Thus, if a financial consultant agrees to provide service on rebate, the customer must suspect his intentions and abilities. Come to think of it. You don’t ask your doctor for a rebate. Why then should you demand a rebate from the financial doctor?

A good financial planner needs to assess a customer’s present position, prioritise his needs and goals as per his risk appetite, and then suggest the proper financial product (s) required to fulfill those goals. This requires proper knowledge of various faculties of finance such as insurance planning, risk management, retirement planning, investment planning, portfolio management, estate planning, plus various laws such as the Income Tax Act, Gratuity Act, Companies Act, etc.

But, a more important quality needed in him is integrity. When a financial planner offers rebates, he compromises his integrity. This should mean that he would have no qualms about suppressing or misrepresenting valuable information to earn extra commission.

Now would you leave your money in his hands? Or would you rather go to a good financial doctor and pay his fees for proper diagnosis and treatment?

 

This piece first appeared in The Apnapaisa Blog, a personal finance forum.

When Ponzi lost his scheme to Madoff

In scale as well as reach, the latest Wall St fraud is the biggest ever

 Vivek Kaul. Bangalore

“The answer, I believe, is that there’s an innate tendency on the part of even the elite to idolise men who are making a lot of money, and assume that they know what they’re doing” —Paul Krugman, Nobel Prize-winning economist

As the flight took off from the Bangalore airport, I was looking to an hour and half of a peaceful snooze. But I hadn’t taken into account the fact that she was sitting next to me.

“What is a Ponzi scheme?” she asked.

“Why this sudden interest?”

“Well, Bernard Madoff, a highly respected figure on Wall Street until recently, has admitted that the investment fund he was running was essentially one huge Ponzi scheme. In fact regulators are now saying this may be the biggest Ponzi scheme the world has ever seen, at around $50 billion,” she said.

“Hmmm... Ponzi scheme gets its name from Charles Ponzi, an Italian immigrant to the United States of America, who promised investors in 1919 that he would double their money in 90 days, which he later reduced to 45 days. Money started pouring in as no other investment in the market at that point of time offered such high returns. At its peak, the scheme had 40,000 investors who had invested around $15 million in it. Ponzi thought he had in place a business model that could help him deliver the astonishing returns he had promised. But all he ended up doing was use he money brought in by new investors to pay off the old investors.”

“So, basically no new wealth is created in a Ponzi scheme. But, wouldn’t such a scheme last only as long as the money entering the scheme is more than the money leaving the scheme?”

“You are right. This was the case with Madoff’s investment fund. In the beginning, he tapped money locally. He targeted country clubs, Jewish charities (he was a Jew himself) and even charity dinners. He was good at networking, of course. As his fame grew, on the back of consistent returns of 10% per year that his investment fund generated, other feeder funds started to invest money into his investment fund. Madoff’s fund continued to do well even when the broader market was falling. Even as recently as November, when the US market fell by 7.5%, this fund generated positive returns. All this good news led to the fund bloating even more, and when this happened, he needed even more new investors who would invest money to be able to pay investors who wanted to redeem their investment.”

“So what did he do?”

“Well, he started to look at markets outside the United States. His salesmen touched base with investors in Europe, the Persian Gulf, South East Asia and finally China. This is the first true blue global Ponzi scheme.,” I explained.

“I don’t get one thing. Madoff ran this fund for years. How come no one questioned his investment strategy?”

“Good question. In a Ponzi scheme, the investment strategy followed appears to be a genuine one, but at the same time it is obscure enough to prevent any scrutiny. Madoff, when asked, told his investors and other investing professionals that he was employing a strategy known as “split-strike conversion.” This is a common investment strategy employed by derivative traders and investors. Other fund managers who had tried it were of the view that it was impossible to generate the kind of returns Madoff was generating using this strategy. However, no one really questioned it because Madoff’s fund kept generating the so-called consistent returns. This consistency also ensured that the investors rolled over profits into the next investment cycle. This is another characteristic responsible for the success of Ponzi schemes — as more and more people roll over their “profits” by not redeeming their initial investment, the chances of the scheme surviving increase. In Madoff’s case, the “so-called consistent returns” assured investors that their investment is safe.”

“But if everything was going so well, why did the fund collapse?” she asked.

“Well, October and November have been particularly bad months for stock markets worldwide. Due to this, a lot of investors wanted to redeem the money they had invested. At the same time, new money wasn’t really coming in. In early December, Madoff was struggling to raise nearly $7 billion to redeem the money his investors wanted back. A little later, on December 10, he called his sons and his employees and admitted that there really wasn’t any investment model in place and that his fund was one big Ponzi scheme. What broke Madoff’s back was essentially the same thing that has broken the back of every Ponzi operator before him — the point where the money leaving the scheme exceeds the money entering it.”

“How come nobody figured this out?”

“Typically, people running a Ponzi scheme have a ‘halo’ around them. Indeed, many cases of financial fraud involve individuals with charming and convincing personalities who have an ‘infectious optimism’ that makes others trust them. Madoff, for example, was a family man who did a lot of philanthropy as well. He was also the non-executive chairman of the Nasdaq stock exchange for a few years in the early nineties. All this worked for him.”

“Will the number of Ponzi schemes come down in the days to come?”

“I don’t think so. Over the years, investors have been fooled into investing money into various Ponzi schemes. They ignore the most fundamental principle of investment theory: You cannot make large profits without taking risk. Investors should logically seek large amounts of information before investing. But most do not do so. Few ask the right questions at the right time and are naive enough to believe in what is communicated to them by those carrying out the fraud. Most are driven to investing in such schemes by greed.

“Maybe we should start calling Ponzi schemes as Madoff schemes now.”

“Oh the renaming has already happened, at least in the US press.”

(The example is hypothetical)

k_vivek@dnaindia.net

References: ‘The Madoff affair: Con of the century’, The Economist, December 20, 2008;Madoff scheme kept rippling across borders,The New York Times, December 19, 2008

Making equity investments in this market

A look at some strategies that could work in this market

Suresh Sadagopan

“Cheap and bess, leke jao. Hazaar piece beccha hai, koi complaint nahin,” said Patel Bhai, unleashing his clincher. We had heard this pitch from him several times before. Somehow, it was comforting to hear it before he made the sale, every time.

What Patel Bhai probably meant was that the product was value for money and we would be happy to have bought it. Anyway, it connected with us.

Value is something we all keep looking for. The price itself does not matter so much as the right balance of price and performance. There are good bargains now, not just in malls and car dealers, but in the equity markets as well. The deep correction due to the global crisis has made valuations attractive. The weak economic scenario, pullout of money by FIIs, the liquidity crunch and uncertainty in the country — all contributed to the stock market slide in India. Hence, even good stocks are available fairly cheap.

So how does one go about selecting good stocks now? There are a few strategies:

Bluechip stocks: These are typically large-caps and market movers. They have come down not so much due to their poor fundamentals or lack of performance as much as due to poor sentiments. Due to the adverse economic scenario, there has been a lag in performance, too. Still, that does not explain a 60-80% drop in prices. Reliance Industries, L&T, ICICI Bank, etc belong here. Prices are down — time to pick them up.

Industry leaders: Small or big, industry leaders have tremendous staying power. They have built up their brand equity, built up their core and loyal patrons and hence have tremendous pricing power. These are companies that can weather storms much better than the also-rans. They are the all-weather supertankers, which can sail the seas, no matter what. Gillette, Colgate, Parachute (Marico), Bournvita (Cadbury’s), etc have brands which are legends and will continue to sell — boom or bust. Buy them.

Recession-proof businesses: Some companies are comparatively immune to slowdown or recession. The sectors they operate in are like that. Sectors such as FMCG, pharma and telecom will not face much of a problem in a slowdown. Some other sectors, such as insurance, security systems (in the current scenario), education & training could actually do well; as might comfort foods & entertainment. So, it’s not all bad news. You need to just look carefully and select companies from such sectors.

Contrarian investing: Then there are sectors/ companies that are down in the dumps and seem to have major problems. Commodity plays (steel, cement and aluminium, etc), energy, real estate and textiles, etc are sectors that are in the trenches. They are the pariahs of the stock market today. But, they will not stay that way forever. If you have the foresight and the risk appetite and long-term horizon to match, you could end up with a pretty packet in future by stocking them up now.

Dividend yield candidates: Again, there are a whole lot of stocks whose dividend yields have become attractive. These stocks give you the security of some basic level of returns, coupled with the chance of appreciation of stock prices. Also, some of them make the investment cut in other ways - in the sense, they are good blue-chip stocks in the first place, or they are good contrarian picks, etc. Great investments, anyway you look at them.

Looking to the future: Then there are those expected to be boom sectors in future — hospitality, healthcare, water, agriculture & agro processing and pollution control, etc. Some of these companies are again available for a song - Indian hotels for instance. Invest with several years’ horizon.

Like Patel Bhai, I would say, “Cheap and bess, abhi time hai khareedne ka.”

 

The author is a certified financial planner who runs Ladder 7 Financial Advisories and can be reached at ladder7@gmail.com.

Selling property can be taxing

Or, why buying property does not always make for good investing

 Vivek Kaul. Bangalore

Buying property has always been considered a great investing exercise. A number of people even take home loans to buy property as a mode of investment.

But is it really as great an investment as it is made out to be? Maybe not, if we take into account the various taxes that need to be paid.

Let us take the example of an individual who bought a house for Rs 35 lakh around two years back and has been able to sell it for Rs 50 lakh, even in these difficult times.

In an ideal world, where no income tax needs to be paid, his gain would have been Rs 15 lakh (Rs 50 lakh - Rs 35 lakh).

But we don’t live in an ideal world. In the one we live in, the individual would have to pay tax on the capital gain of Rs 15 lakh, unless he feels it is fine if the tax man comes knocking on his door.

As per the tax laws, if one sells a property within 36 months of buying it, the resultant capital gain (the difference between the sale price and the purchase price, which is Rs 15 lakh in this case) is added to his income for that year, and taxed as per the tax bracket he is in.

We assume that the individual we are talking about comes under the highest tax bracket of 33.99%. The tax to be paid on the capital gain of Rs 15 lakh then works out to Rs 5.1 lakh, which leaves Rs 9.9 lakh (Rs 15 lakh - Rs 5.1 lakh) in his hands.

But even this Rs 9.9 lakh may not be his.

Let us say the house was bought with a 15-year home loan. Two years back, some banks were desperate to give out loans and borrowers could even negotiate a 100% home loan. So let’s say our man got the entire Rs 35 lakh as a loan from some bank. Assuming he has paid interest over the last two years at an average 11%, his equated monthly instalment (EMI) works out to Rs 39,780.

Under Sec 80C of the Income Tax Act, the principal portion of the home loan can be claimed as a tax deduction. But, the Act also says that if a property is sold before five years from the end of the financial year the flat was bought in, the tax deductions claimed would have to be reversed. Since the flat was bought only two years back, the repayment of principal he has claimed as a tax benefit for two years has to be reversed.

As per the Act, the aggregate amount of deductions so allowed in respect of the previous year or the years preceding such previous year shall be deemed to be the income of the assessee of such previous year and shall be liable to tax in the assessment year relevant to such previous year.

Sounds complicated? Well, at an interest rate of 11%, the individual would have repaid principal of around Rs 2,05,600 over the last two years on the Rs 35 lakh loan taken by him and claimed that as deduction. This would be reversed and added to the income for the current year. So, on Rs 2.06 lakh, an income tax of around Rs 70,000 (33.99% of Rs 2.06 lakh), would have to be paid. This brings down the gain to Rs 9.2 lakh (Rs 9.9 lakh - Rs 70,000).

The killjoys don’t end there.

As we all know, home loans come with a price. In the 24 months since the loan was taken, an interest of around Rs 7.49 lakh would have been paid, which whittles down the gain to Rs 1.71 lakh (Rs 9.2 lakh - Rs 7.49 lakh).

At the same time the interest paid can be claimed as a deduction from income. A maximum of Rs 1.5 lakh can be claimed as a deduction in a given year. So over two years, a deduction of Rs 3 lakh would have been claimed, even though the interest paid on the loan is around Rs 7.49 lakh. Since the individual we are considering is in the top tax bracket of 33.99%. This would mean a saving of Rs 1.02 lakh ( 33.99% of Rs 3 lakh).

This needs to be added to the gain of Rs 1.71 lakh. So the gain now increases to Rs 2.73 lakh.

And there is at least one more deduction left.

At the point of selling the house, the home loan outstanding will have to be repaid. For this, the bank will levy a prepayment charge on the principal outstanding. At a prepayment charge of 2% on a principal outstanding of Rs 32.94 lakh (Rs 35 lakh - Rs 2.06 lakh), the prepayment charge works out to Rs 66,000.

That leaves him with Rs 2.07 lakh (Rs 2.73 lakh - Rs 66,000) — nearly a seventh of the gain he would have thought he had made.

k_vivek@dnaindia.net

How to pick stocks based on m-cap

The math is easy to run on your own

Mahendra Naik

The market capitalisation (m-cap) of a company is defined as “the number of outstanding shares multiplied by the market price of each share.”

For instance, a company having an issued capital consisting of 1,00,000 shares valued at Rs 100 each on the stock exchange on a given day will have a m-cap of Rs 1 crore on that day. Predictably, the m-cap of a company keeps changing, with the change in its market price.

Companies in India are classified into three broad categories on the basis of their m-cap:

l Large-cap companies, or those with m-cap of more than Rs 5,000 crore;

l Mid-cap companies, or those with m-cap between Rs 500 crore and Rs 5,000 crore; and

l Small cap companies, or those with m-cap of less than Rs 500 crore.

M-cap indicates the relative size and stability of a company as compared with other companies in the same industry. An investor can give due weightage to the m-cap of a company before judging its potential as an investment candidate.

FIIs and other large investors usually favour large-cap companies because of the liquidity they provide and the fact that they can invest large amounts in these companies without causing wide fluctuations in the price. Also large-cap companies have an inbuilt stability due to their size and are better equipped to weather adverse business cycles.

M-cap is generally used as a valuation tool in calculating the future earnings of a business discounted to present values.

An analyst estimates the likely earnings from a business, usually over a period of 10 years. The earnings for each year are discounted to present value using an appropriate discounting rate, normally the rate of government securities of similar tenure. The liquidation value of the business is estimated at the end of 10 years. The sum of the 10-year discounted earnings and the liquidation value gives the intrinsic value of the business. If the intrinsic value is greater than the m-cap of the business by a wide margin, the business can be considered investment worthy.

Take a company having sales of Rs 500 crore, an m-cap of Rs 1,000 crore and earning profits of Rs 75 crore per annum. The first-year profits discounted to the present at the current yield on G-secs of 8% would be worth Rs 69.5 crore. In arriving at the above figure, we use the following formula:

PV = FV/(1 + i)n

In this case,

PV is the present value = 0

FV is the future value =• (in this case Rs 75 crore)• is the number of time periods (in this case 1)

i is the discounting rate (in this case 0.08, i.e. 8%)

We estimate that the company can grow its profits at 10% per annum over the next 10 years. The second year profits would be Rs 82.5 crore. Therefore, the earnings of the second year discounted to today’s prices would be Rs 70.75 crore. Carrying this calculation over 10 years we get the sum of the 10-year discounted earnings figure at Rs 755 crore. We estimate that the liquidation value of the business at the end of 10 years to be Rs 500 crore.

Therefore, intrinsic value = 10-year discounted earnings + liquidation value = Rs 755 crore + Rs 500 crore = Rs 1,255 crore.

Since the market cap is Rs 1,000 crore as compared to the intrinsic value at Rs 1,255 crore, the business is a good buy at current levels and the Rs 255 crore represents our margin of safety. It is for an individual investor to decide what margin of safety he desires on a particular investment.

Another useful indicator in evaluating a company is its m-cap to sales ratio (see table for m-cap to sales ratios of some engineering and infrastructure companies). This ratio indicates what value the market gives a company as a multiple of its sales. Generally, 2 to 2.5 times of sales is considered to be fair valuation for a business, depending on what industry it is in and its growth rate.

If a company is being valued by the market at extremely low multiples to sales, an investor can use this as a starting point to investigate why. This can be an important clue to discover undervalued companies. If further investigations into the fundamentals do not reveal any significant problems, it can be inferred that the market has not recognised the value of that particular business and it can be considered as an investment candidate. Like all other ratios, m-cap to sales cannot be used in isolation but should be viewed in conjunction with other fundamental parameters and business attributes.

Another useful hint the m-cap gives us is that it points us towards the untapped potential of a business model which is in the nascent stage in a country and therefore is not making any profits yet, but the same business model has performed well in other countries where it has had time to flourish and realise its potential.

Serious fundamental investors should therefore look at the m-cap not only from the viewpoint as an indicator of business soundness, but also as a starting point to spot businesses which are being ignored by the market in spite of being strong investment bets based on other parameters.

 

The writer is proprietor of Capital Management Services. He blogs at www.investologic.blogspot.com and can be reached at mknaik99@rediffmail.com

We’re in December. Done your tax-planning yet?

Starting early helps obviate the hassles at the fiscal end

Sandeep Shanbhag

I find that investors at large fail to plan and structure their investments and taxes optimally, not so much because of negligence or a lack of inclination as much as because they are so busy with their work and so preoccupied that financial planning keeps getting forever postponed to the next week. Then, before they know, March arrives… and they must rush to make an appointment with the chartered accountant. Some last minute, convenient tax-saving investments are done and a solemn resolution is made that next year is going to be different.

With December already upon us, it is as good a time as any to act upon this resolution. The trick is to start early and take the necessary actions step by step. Tax-planning is at all times a process and not a one-time, sporadic exercise.

Here are a few things to keep in mind as you go along. • Well begun is half done

That you are reading this with interest (and intention hopefully) is in itself a big thing. Since you are starting early, you have time on your side. And believe me, time is a great ally. Slowly and surely, act upon these pointers (whichever is applicable to you) and perhaps you won’t even need your CA’s appointment come March.

The following, in my experience, is a list, of aspects largely neglected by most investors. • Use the fringe benefits of marriage

In sickness and in health… and in paying taxes too!

The wedding vows are done, the honeymoon is over and reality has begun. I should know, for I have been married over ten years now. However, I did discover a silver lining — marriage helps in reducing taxes substantially.

But first, some ground work has to be done. Have separate joint accounts, one for husband and wife and the other for wife and husband, even if one of them is not assessed for income tax. This may sound trivial but actually is of great importance for proper tax planning. This is especially important if you have or are planning to buy a house on mortgage and would like to benefit from the tax breaks • Loan to spouse

You are in the highest tax bracket and she doesn’t have taxable income. (For all you working and earning ladies there, I am not chauvinistic; it’s just for writing convenience. The situation could well be the reverse, and the same principle would apply)

Anyway, it is vital to start a tax file in her name. The idea is that she starts earning income up to Rs 1.80 lakh (Rs 1.50 lakh for males). This income being below the tax threshold will not be taxable. You might ask how such a miracle is possible that your wife starts earning so much overnight. She doesn’t. You transfer money to her, which you would have otherwise invested in your name. If you earn it, you pay tax @34%. If she earns it, it’s going to be tax-free.

But there is a glitch. You cannot transfer money by means of giving her a gift. The problem is that income on such gifted amount will be anyway clubbed in your hands for tax purposes. How do you work around this situation? Well, give her a loan. Though an interest-free loan is technically possible, it is better to have an arm’s length contract by charging a nominal rate of interest (say savings bank rate of 3.5%). If she were to invest the gifted funds into an FD at a rate of say 10% p.a., the difference of 6.5% p.a. will be tax-free between the two of you.

Housing finance

Marriage has benefits even when buying a house. Are you planning to buy a house anytime? Then, even if you are Mr Deep Pocket, it is better to opt for housing finance. Tax breaks are available only on borrowed funds, and not on the use of your own equity.

Since real estate can be co-owned, buy the property with both having an equal share. The loan should also be taken equally and the interest and principal payments for the same should be made separately by each from their respective bank account.

If the above is carried out, each is entitled to an interest deduction of up to Rs 1.5 lakh under Sec 24 and a principal deduction of Rs 1 lakh under Sec 80C. So, between the two of you, up to Rs 5 lakh of income will escape tax.

Mediclaim

Mediclaim is a must for all, taxpayers or otherwise, rich or poor, young or old, in view of the high cost of hospitalisation. If you haven’t bought a Mediclaim policy so far, do so now. There is a tax break of Rs 15,000 available, but that is not the point. Mediclaim is for the financial protection of you and your family members — the tax cut is just an added benefit.

Public Provident Fund (PPF)

In the absence of government social security, a regular PPF investment works like a safety net for the later years. This is especially true in the case of the self-employed who do not have a company provident fund to fall back upon. A sum of Rs 70,000 invested per annum can net you over Rs 32 lakh over 20 years.

Tedious TDS

Last but not the least, the most important thing to do is to aggregate your TDS receipts. TDS operates like tax already paid from your final tax liability, and you have to pay only such amount that is over and above the tax already deducted. Do this as the year goes along. Most leave this exercise towards the end of the year, leading to huge inconvenience and short counting.

To conclude

You will appreciate that the above-mentioned points are really commonsensical and do not need much of one’s time and effort to put into practice. However, these baby steps have a way of adding up and sometimes make all the difference between financial health or the lack of it.

sandeep.shanbhag@ gmail.com

Subprime’s bad? Deflation will be worse

A deflationary spiral could ultimately propel economies into recession

Vivek Kaul. Mumbai

 “This guy’s saying inflation isn’t such a bad thing. Of all things, inflation! How can inflation be good?” she was saying.

I could barely open my eyes after a Sunday afternoon siesta.

“How did you get in?”

“That’s not important. Answer my question first.”

“Okay, okay, don’t start pushing me around. See, there is a lot of uncertainty across the world today. Companies are slashing jobs, leaving workers in the lurch all of a sudden. People in the US and parts of Western Europe have some form of social security in the form of unemployment allowances, though it cannot quite compensate for a full salary. But workers elsewhere don’t even have this support. Naturally, in times of uncertainty such as this, people in much of the world tend to be cautious with their money.”

“But what has that got to do with inflation?”

“A good lot, you’ll see. Those who lose their jobs will obviously be hurt directly, but others would also be more careful while spending money for fear their job may be on the line, too. And when many people cut spending like that, it slows down consumption. Lower consumption means lesser business for companies and professionals, which in turn means lower profits. And when that happens, businesses are forced to cut prices to maintain revenue growth. This may lead to a spurt in demand initially. But as more people lose their jobs and more uncertainty comes in, spending falls further and companies are forced to cut prices of their products and services even more. This phenomenon of prices coming down is referred to as deflation.”

“Deflation?” she repeated.

“Yes, deflation. When consumers know that prices are falling and are likely to continue to fall, they have an incentive to delay their purchases. You know, why buy something now when you know it will cost much less sometime later? This is known as a deflationary spiral, where prices continue to fall, leading to progressively lesser revenues and profits for companies,” I said.

“And how does that explain the situation in the US where everybody has borrowed big time?”

“Good question. The unemployment rate in the US in October was around 6.5%, up from 4.8% a year ago. This increased unemployment is adding to the deflationary spiral there. More than unemployment, it is the fear of unemployment at work. But there’s another factor at work here. See, most of the consumption in the US was financed through loans. People first bought a house on loan. And since everybody was buying houses, the price of property went up. Now, if you bought a house for $200,000 and over a period the price went up to $250,000, you could even borrow against the increased value of $50,000, also known as home equity. This home equity loan was used to buy stuff. As the price of the houses kept rising, more home equity loans were taken and more stuff was bought. So, people kept financing their consumption through more and more home equity loans. Now that home prices have crashed, there is no more home equity loans are available. Also the financial system is in a mess and banks are not willing to give out such loans.”

“So, Americans have run out of money they could splurge.”

“By and large. Today, the debt-to-disposable income ratio is at 140%, up from 100% in 2000. Also, they now realise that all those loans have to be repaid. So where is the money to buy things? Companies have had to cut prices to make their products more attractive. But that hasn’t helped because many are just not in a position to borrow, while those who have money are waiting for prices to fall further. The resultant deflationary spiral means companies make lesser revenues and profits as people buy lesser goods and services. Adding to the problems is the erosion in the stock market wealth of Americans, which has fallen by a little over 40% since the start of this year. When the stock market is doing well, the positive wealth effect is at work — investors feel richer and that leads to them spend more. When the stock market falls, the effect is the exact opposite. This has led to a recession in the US, Western Europe and Japan.”

“Now, how do you define recession?”

“An economy is said to be in a recession if its gross domestic product (GDP) contracts for two or more consecutive quarters. GDP is the value of goods and services produced in the economy during a particular period.”

“Is there any other reason for companies cutting prices?”

“Yes. The dollar has appreciated against most other currencies. US financial institutions had invested in stock markets all across the world. As the stock markets fell, these institutions exited these markets. And when they exited these markets they got paid in the local currencies, which had to be converted into US dollars before being repatriated back to the US. Due to this, demand for dollars went up and it appreciated against almost every major currency. This made imported goods cheaper for Americans, but forced American companies to offer lower prices, adding to the deflationary spiral.”

“So, a little bit of inflation is good, isn’t it? At least people won’t defer consumption if they know the prices will rise in the days to come,” she said.

“Yes. But the American situation is a little different. Going by economist Nouriel Roubini, who correctly predicted the current financial crisis, the US consumer is “shopped-out, having spent for the last few years well above its means.”

“Can’t the government do anything to revive consumption?”

“Oh, it needs to remember the famous British economist John Maynard Keynes.”

“Keynes? How does he fit in here?”

“Years back, Keynes had suggested that in a recession, “The government should pay people to dig holes in the ground and then fill them up.” Some said, “That’s stupid, why not pay people to build roads and schools?” Keynes said “Fine, pay them to build schools. The point is it doesn’t matter what they do as long as the government is creating jobs.” His idea was that the government should intervene when a recession looms and give the economy a fiscal stimulus. You know, print or borrow money, which can be spent on things like creating infrastructure, social reforms etc. Money spent is likely to create jobs which end up as increased income in the hands of some and these people are likely to go out there and spend it. In fact, most American economists are now talking about Barack Obama legislating a fiscal stimulus package as and when he takes over as the US President.”

“Will this fiscal stimulus work?”

“We can only wait and watch. But first tell me, how did you get in?”

“Oh, simple, the door was open.”

 

(The example is hypothetical)

k_vivek@dnaindia.net