Europe's Plan for Solving Debt Crisis

Dear readers, in the last post we talked about Eurozone crisis. The world was looking at the eurozone leaders to find solution to this crisis as it seemed to be a never ending problem which was driving the world economy to its limits. The long wait is finally over as eurozone has delivered its plan to curb this soverign debt crisis. Only time would prove its effectiveness but here we can discuss the plan itself. Three main things have been decided:

1. Current Greek debt holders would take a 50% voluntary ‘haircut’ i.e. an investor who has invested €100 in Greek debt would only receive €50 back. This step is to reduce the debt of Greece and make its debt level more sustainable. A voluntary write down by the debt holders was important to prevent the event from triggering the Credit default Swaps.
2. As banks are one the major debt holders of Greek bonds, taking such a write down would threaten their own stability. To prevent this from happening, banks would have to maintain a Tier 1 ratio of 9%. To achieve this, banks will have to raise €106 billion. Banks would first try to raise the capital from private investors, if they fail to do so they can go to their government for capital. The final point of help would be the ESFS (European Financial Stability Facility). The banks have until June 2012 to achieve this aim.
3. To restore the confidence of the market and to increase the firepower of the bailout funds, the funds in EFSF would be raised to €1 trillion. This would be done by leveraging the EFSF, but how exactly and on what terms money would be borrowed is not clear. China, the world’s largest foreign reserve holder has been approached for help. EFSF would support the sovereign debt by providing guarantee on the first 20% loss for investors. It would also help banks that would be under stress.

In my opinion calling the announcements made as solution is wrong as these are just promises which if implemented as said would lead to a solution, but even that won’t solve all the problems faced by eurozone. The reduction of the debt of Greece by forcing the debt holders to take a voluntary haircut would surely ease the problem of Greece but that leaves the already stressed banks in more problems. They have also been asked to raise more capital which is going to be very difficult in these conditions. What would they do if they can’t raise the capital form market? They would go to their government. If the government is strong enough to support their banks, why do we have debt crisis in the first place. If the government fails to support the banks, they have EFSF as their final resort. We did discuss in the last post that EFSF is a company backed by the eurozone. The plan of increasing its firepower from €440 billion to €1 trillion sounds good. But then we have to understand how the eurozone is going to back such a huge amount, provided Germany has already passed a legislation of not contributing more to the EFSF. Following all these arguments, I once again say that the announcements are just promises, until they are met, as it won’t be easy to implement all these promises. Here we also need to understand that market works on expectation and hope. These announcements were positive for the market, as we now expect that the crisis would be solved. This was seen as nearly 3% rise in all the major indices after the announcements. But is the crisis really over? I would say that this an attempt, a good one, but a lot of work has to be done to make it successful. The road won’t be smooth and we should be ready to have some bumps in our journey.

 Feel free to leave your insightful comments and join the blog if you like it. Keep tuned as there is more to come....

EUROZONE CRISIS EXPLAINED

Dear readers, I know that in my last post I promised to talk more about valuation. Believe me I haven’t forgot that. But I am bound to discuss the pressing issue of eurozone crisis as it is affecting the life of all of us. Every day we hear and read about euro debt crisis and saving euro. But all the issues are reported in isolation so we don’t get an overall picture. In this post I would try to provide a complete picture by answering some basic questions asked by all. So to begin with the first question should be:

What is Eurozone crisis?

We all know that the currency euro is used by eurozone in 17 countries. Each member country has its own central bank and the overall eurozone has a central bank called European Central Bank (ECB). The main aim of ECB is to maintain a price stability throughout eurozone by maintain an inflation rate of close to but not more than 2%. To achieve this aim the ECB sets the interest rate it would charge for giving out loan to the banks which ultimately determines the interest rates charged by commercial banks on loan. Here an interesting point to note is that usually a country like UK determines its own monetary and fiscal policy. With eurozone the member countries have their own fiscal policy (i.e. tax rates) but the monetary policy is determined by the ECB which is an independent body and any country has no direct control over it. So if one member country like Greece wants to change its monetary policy, it can’t.

Now we would come to the main part, the debt crisis. To begin with, the first thing to understand is the main source of income for a country is the tax revenue that it collects which is spent  for the welfare of the citizen like social welfare, infrastructure, military etc. Now as a normal household, we generally spend depending on our income. What if in a month we need to spend more than we earn? We would borrow some money from the bank and in the next month spend less, save some money and payback the bank. When a country spends more than it earns it is called budget deficit which it finances form banks by issuing its bonds. Because the countries like Greece, Portugal, Ireland, Spain and Italy are members of eurozone and had top credit ratings, the banks had no problem giving those loans so these countries can borrow at low interest rate. But this borrowing went beyond their means to payback which came into light in 2010. As these countries and mainly Greece had no money to payback the maturing debt, it had to raise more debt and this is what they had been doing. But at this point, the creditors (banks) lost confidence in these countries and they knew that it is not safe to give these countries any loan as they would not be able to pay it back. To take the extra risk, the banks started demanding higher interest rates on their loan which reached over 60% for Greece 2 Year bonds.  For the countries struggling to pay their original loans, paying such high interest is impossible.  At this point, if these countries are left alone they would default which would have serious repercussions for the global economy. This could be understood by the fact that the bankruptcy of an American Investment bank Lehman Brothers had spread such a contagion which ultimately resulted in the financial crisis, what would happen if some countries in the eurozone default on their debt? To prevent this from happening ECB and IMF decided to help these countries by giving them bailout funds. Greece alone had been promised a package of €110 billion and a further €109 billion. The main aim of these bailouts is that the economy of the country would improve and it would again be possible for it to borrow money commercially. But this is not happening as the rating agencies have downgraded the Greek bond to the junk category.  So the bad economic condition of many eurozone countries with some on the brink of default is what is termed as eurozone debt crisis.

Why don’t the ECB let Greece default?

         Greece can be thought of as a patient on his death bed who is kept alive on life supporting machines. You remove these machines and the patient would die. But his death would be a huge blow for his family and friends. Greece is living on the bailouts which are not enough for it to get better owing to its vast amount of debt. And these bailouts are not free, they come with conditions attached. Greece has to reduce its budget deficit which can only be done by spending less and taxing more, the so called austerity measures. This on top of already high unemployment rate in Greece is highly protested against. Also Greece can only affect its fiscal policy as the monetary policy is controlled by the ECB. Usually under this condition a country can dilute its debt outstanding by increasing the inflation following a loose monetary policy. But Greece has not got this option. So what if Greece defaults? The biggest lenders for Greece is the European banks, so if Greece defaults on its debts these banks would have to write-off its loans which would lead to great loss for these banks and they would themselves need huge bailout packages from government. A lot of American banks have written Credit Default Swaps (CDS) against the European Sovereign debt. These countries defaulting means the American banks would be in trouble. The ECB itself has brought a lot of these debts, so a default means ECB taking a huge hit. If the banks collapse there would be no credit in the market, the money market would freeze, signs of which can already be seen. The contagion won’t stop there as the borrowing cost for other troubled countries like Spain,  Ireland, Portugal and Italy would go through the roof and the size of these economies is a lot larger than Greece , ECB hasn’t got enough firepower to bail them out. The bottom line is the already suffering global economy would be in deep trouble and the whole economy would collapse.

So what is being done?

The eurozone leaders are holding summits and are pushing towards some agreements.  There are many options to be explored:

● Letting Greece pay less than it owes. This simply means that the creditors won’t get back all that they owe. Initially it was said that the banks would take a ‘haircut’ of 20% but now the discussion is over 50%. The French banks have the highest exposure against these loans, so France is opposing such a move. The debt level can be seen from the following figure:

● Increasing the size of European Financial Stability Facility (EFSF) from €440 billion to about €2 trillion.  EFSF is a company which was agreed by the countries that share the euro on May 9^th 2010 and incorporated in Luxembourg under Luxembourgish law on June 7^th 2010. The EFSF’s objective is to preserve financial stability of Europe’s monetary union by providing temporary financial assistance to euro area Member States in difficulty. But confusion is over how this assistance would be provided. Some are suggesting the guarantee of a portion of default on debt by any member states; others are in favour of using the money to bailout countries in trouble. No one is certain if the €2 trillion would be enough to bailout big economies like Spain and Italy. Also debate is over how the size of this facility can be increased. There are two options, either leveraging EFSF or increasing the amount it could raise through bond issue guaranteed by the member states.

● The third option is to safeguard the banks by providing them rescue packages and letting Greece default. This would restore confidence in European banking sector which has been worst hit by this crisis.

Whatever is to be done should be done now. The market needs some solid and firm steps to calm down. The anxiety and volatility of the market results in the market rally one day on some good news and sell off for the next four days on some bad news. The investors no longer can be certain as to which is a safe investment as no one is certain of who and to what extend is exposed to these debts and what would happen in case of a default. The eurozone leaders must take decisive actions to save the euro and the world economy. Feel free to leave your insightful comments and join the blog if you like it. I would end this post with a cool song on the eurocrisis, it can be found at http://www.guardian.co.uk/business/video/2011/jul/14/euro-crisis-song-video

Keep tuned as there is more to come....

Valuation

As promised I am back with my new post on valuation. Before discussing anything about the topic, we need to understand the importance of 'Valuation'. Valuation is in the center of finance and has to be done for many different reasons like stock selection, initial public offering, venture capital investing etc. It is important to understand what we mean by value before starting our exciting journey of Valuation. I believe that value lies in the eyes of beholder. As a glass of water would worth a lot for a thirsty person and a lot less for a person who is not thirsty, the value of a security would depend on the expectations and assumptions of the appraiser. To confuse us more, the world of finance throws at us different kinds of value like market value, book value and intrinsic value. Market value is the price at which a security is traded at in the market. An important factor determining the market value of a security is the supply and demand in the market which in turn is affected by information available in the market. A recent example of how the price of a stock is affected by new information in the market is the 5% decrease in the share price of Apple just after the announcement of Steve Jobs's death (http://www.guardian.co.uk/technology/2011/oct/06/apple-stock-steve-jobs). The type of information affecting the price is determined by the efficiency of the market which could be the topic of a separate post. Moving forward, book value is the value at which a security is recorded in the balance sheet. There is no one way to define'intrinsic value' but it can be best defined as the value derived by an analyst by using the perfect valuation model and having all the information. In simple words it is treated as the true value of the security. The discussion of different types of value is by no means intended to confuse the readers but to provide a better and overall picture of the world of VALUATION.
We now know different concepts of value, but how can we actually value a stock? There are many methods available but the two most widely used are Discounted Cash Flow (DCF) method  and the Relative Valuation method. DCF states that the value of an asset is the future cash flow generated by an asset discounted at its discount rate. In simple words, DCF suggests that if you own a stock, its value would depend on the future cash flow that it would generate in the form of dividends and the risk of your investment which would be reflected by the discount rate. It can be shown as:

There are many types of cash flow that is used like dividend, free cash flow to equity and free cash flow to firm. Similarly cost of equity or weighted average cost of capital (WACC) can be used as the discount rate. A point to note is that the cash flow and discount rate should be matched. Free cash flow to equity goes with cost of equity and free cash flow to firm is matched with WACC. To keep the introduction simple we would discuss cash flow and discount rate in details in some other post.
Relative valuation is comparatively simpler as it doesn't require many inputs and numerous assumptions. It values a stock based on how other similar stocks are valued in the market. It basically look for a comparable firm or a peer group, tries to find a price ratio like price to earnings, price to cash flow etc. and then applies that ratio to the target firm. To explain it further lets say that we need to value company A. We know the earnings of Company A is $2. Under Relative valuation method we would first find a peer group of company A having same risk-return characteristics. We would then find the price-earning (P/E) ratio of the peer group. Lets say that we find it to be 5. Now all we need to do is to apply this ratio to company A to find its value. As we know the earning of company A is $2, its price would be $2*5=$10 (earning*P/E). We do this because we believe that similar companies should be priced equally in the market.
This was an attempt to give an introduction to Valuation. The technicalities would be intensively explored in the coming posts. Please leave your insightful comments after reading the posts as it would provide me a feedback to improve my work. Also feel free to join this site and leave your email address if you want to receive the posts through email. Keep tuned, more to follow.........

Basics of Invesment

The purpose of this blog is to discuss in length the concepts and issues related to investment. The readers at times may find the views expressed being naive, where the insightful comments would be very useful. If the blog is about investment, it is better to first clarify the very term. Simply put, investment can be defined as the process of parting from your money today in an expectation of a greater return tomorrow. Now comes the question of how you invest? The answer is following the sequential steps of investment process which is - understanding your specific situation, formulating an investment strategy, implementing your investment strategy and monitoring your portfolio. To explain it in simple terms, one has to identify one's risk appetite depending on one's situation and return needs, then select securities to invest in and monitor the performance of those securities.So why can't we do it ourselves, why do we need an investment manager? The answer is simple, investment process requires the expert knowledge of an investment professional to evaluate the fundamentals of  many different asset classes and decide where to invest (asset selection) and how much to invest (asset allocation) to generate the maximum return. Asset allocation would depend on the risk appetite of the investor. Considering only two types of assets, stocks and bonds, a more risk averse investor would invest more in bonds than stocks because bonds are safer. After deciding the allocation of the assets, we would have to select the assets where the important concept of valuation comes into play. We would like to buy the assets that are undervalued, hoping that it would rise in value and we would get a return. Similarly if we have an overvalued security in our portfolio, we would sell it to avoid the future loss. Starting from my next post, we would discuss the topic valuation in more details as it is in the center of the investment process.