Game theory in the stock market: On the Island of the Green-Eyed Tribe, blue eyes are taboo

In response to
yesterday’s piece a friend pointed out that John Maynard Keynes’ “stock market as a beauty contest” parable is an example of common knowledge game in modern game theory. Game theory is essentially a study of strategic decision making.
Hearing his comment I almost fell from my chair. “
Ab game theory bhi padhna padega?” I wondered. But as good friends usually do, my friend mailed across some excellent reference material. (You can read the two pieces by Ben Hunt who writes the Epsilon Theory newsletter here and here).
In this piece I have summarized the two pieces written by Ben Hunt and tried to explain how the stock market is currently working from a game theory point of view and what are the learnings that we can draw from it.
First we need to understand what a common knowledge game is. In order to understand that we will go through the example of the island of the green eyed tribe. On this island people have eyes that are green in colour. Anyone having blue eyes, is supposed to leave the island in a canoe at dawn, the morning after he has found out.
However there are two problems. There are no mirrors on the island. So no one knows what is the colour of their eyes. Further, residents are not allowed to tell each other what is the colour of their eyes. So, if Ajay knows that the colour of Vijay’s eye is blue, he is not allowed to tell Vijay about it.
To summarise, the island of the green eyed tribe is a small island. Given this, every resident knows the eye colour of everyone else who lives on the island, but himself.
In a normal scenario, if the island has residents with blue eyes, they could continue to live on the island. This happens because they themselves do not know they have blue eyes and no one else can tell them about it.
Now let’s say a missionary lands up on the island and declares that at least one resident of the island has blue eyes. Further, let’s say only one resident on the island has blue eyes. So what will happen in this case? This individual, let’s call him Ajay, knows that everyone else has green eyes, so he comes to the conclusion that he must be the one with blue eyes. Hence, next morning he gets into a canoe and leaves the island.
Simple!
Now let’s complicate the situation a little more. Let’s say two residents, Ajay and Vijay, have blue eyes. What do you think will happen here? Ajay and Vijay have seen each other and each thinks that the other has blue eyes. They themselves do not know that they have blue eyes. Hence, Ajay thinks that Vijay will leave the island on a canoe the next morning and vice versa.
Next morning, neither Ajay nor Vijay has left the island. This leaves both Ajay and Vijay confused. But they soon figure out the situation. Ajay thinks that Vijay hasn’t left the island because he has seen someone else with blue eyes. At the same time Ajay knows that everyone else other than Vijay has green eyes. Hence, that leaves only him with blue eyes.
Vijay also realises the same thing. The next morning both Ajay and Vijay leave the island. As Ben Hunt writes in an excellent newsletter titled
A Game of Sentiment and dated November 3, 2013, “The generalized answer to the question of “what happens?” is that for any n tribe members with blue eyes, they all leave simultaneously on the nth morning after the Missionary’s statement.”
But that is something for economists who carry out game theory experiments to ponder on. What is the learning here for stock market investors? Before the missionary lands up on the island every resident of the island knows the colour of the eyes of every other resident on the island. But this is private information which is locked up in the minds of the residents.
The missionary comes and changes this situation. He does not turn the information locked up in the minds of residents into public information, meaning he doesn’t tell them loud and clear that Ajay and Vijay are the ones with blue eyes.
Nevertheless, he turns what is private information until then into common knowledge. And common knowledge is different from public information.
As Hunt writes in a newsletter titled
When Does the Story Break and dated May 25, 2014, “Common knowledge is simply information, public or private, that everyone believes is shared by everyone else. It’s the crowd of tribesmen looking around and seeing that the entire crowd heard the Missionary that unlocks the private information in their heads and turns it into common knowledge. This is the power of the crowd watching the crowd, and for my money it’s the most potent behavioral force in human society.”
Further, it takes time for the residents of the island to realize what they know. It doesn’t happen immediately. As Hunt writes “The truth is that an enormous amount of
mental calculations and changes are taking place within each and every tribesman’s head as soon as the common knowledge is created. The more tribesmen with blue eyes, the longer the game simmers. And the longer the game simmers the more everyone – blue-eyed or not – questions whether or not he has blue eyes.”
In the example of Ajay and Vijay, it took them a day to realize that both of them have blue eyes. And once they did, they left the island the next morning, i.e two days after the missionary made the statement.
If there had been three people with blue eyes, it would have taken them three days and so on. That is how the dynamic works. So Ajay is watching Vijay and thinking that Vijay has blue eyes and hence, needs to leave the island. A similar dynamic is playing up in Vijay’s mind as well about Ajay.
The next day Vijay hasn’t left the island and Ajay realizes that Vijay is thinking the same thing about him, as he is thinking about Vijay. And once they have figured out they leave the island. So, nothing happens for two days and then they leave the island. In case of three people with blue eyes, nothing happens for three days and then they leave the island.
The point being it takes time for common knowledge to seep through and then there is immediate action.
If all that has left you wondering what all this has got to do with the stock market, allow me to explain. “If you haven’t observed exactly this sort of dynamic taking place in markets over the past five years, with nothing, nothing, nothing despite what seems like lots of relevant news, and then – boom! – a big move up or down as if out of nowhere – I just don’t know what to say. And I don’t know a single market participant, no matter how successful, who’s not bone-tired from all the mental anguish involved with trying to navigate these unfamiliar waters,” writes Hunt.
In the Indian context, the Sensex was yo-yoying over the last few years but has made a definitive move in 2014, with gains of nearly 33%. “And then boom,” is the best way to describe this move. That’s the power of the “crowd watching the crowd” for a while and then suddenly deciding to invest because the “common knowledge” of they thinking that everyone else is investing, seeps through.
That’s one part. The other part here is that of the “missionary” and the message he is sending out. The message will be believed depending on how credible the missionary is viewed to be and how loud is his voice. In the media this loudness and credibility is established by being seen at the right place. And that’s how the message is amplified.
As Hunt writes in
A Game of SentimentHow do we “see” a crowd in financial markets? Through the financial media outlets that are ubiquitous throughout every professional investment operation in the world – the Wall Street Journal, the Financial Times, CNBC, and Bloomberg. That’s it. These are the only four signal transmission and mediation channels that matter from a financial market CK (common knowledge) game perspective because “everyone knows” that we all subscribe to these four channels. If a signal appears prominently in any one of these media outlets (and if it appears prominently in one, it becomes “news” and will appear in all), then every professional investor in the world automatically assumes that every other professional investor in the world heard the signal.”
And this has an impact on the financial markets. In an Indian context one could add
The Economic Times to the list as well. Fund managers want to be featured in these publications because it increases their ability to influence the financial markets. The stories they want to tell people about explaining the various reasons behind what is an “easy money” driven bull market are more likely to be believed.
The big missionaries in the current scenario are the central banks. What they say is closely watched.
As Gary Dorsch, Editor, Global Money Trends newsletter, wrote in a recent column “Bad economic news is treated as bullish news for the stock market, because it lead to expectation of more “quantitative easing.” And the easy money flows that are injected by central banks go right past goods and services (ie; the real economy) and are whisked into the financial markets, where it pushes up the prices of stocks and bonds. In simple terms, what matters most to the stock markets are the easy money injections from the central banks, and to a lesser extent, the profits of the companies whose stocks they are buying and selling.”
But that is something that fund managers are not very comfortable talking about.

This piece originally appeared on www.equitymaster.com on Nov 26, 2014

What Uday Kotak should learn from Citi: Bigger banks can end up as liabilities

Over the weekend Pramit Jhaveri, the CEO of Citi India, had a thing or two to say about the size of Indian banks. He said that other than needing more banks, India needs bigger banks to compete on the world stage. “At this point, sensible consolidation would be one way to achieve scale,”
he said.
The comment comes right at a time when the Kotak Mahindra Bank has decided to acquire the ING Vysya Bank. The irony here is that Citigroup, of which Jhaveri is a part of, was rescued by the Federal Reserve of the United States from going bust, only a few years back.
The Fed came into rescue Citigroup because it was too big to fail. And if it had been allowed to fail, the repercussions would have been felt by the entire financial system.
The United States Congress passed the the Glass–Steagall Act in1933. This Act was passed after the stock market crash of 1929 and essentially drew a line between commercial banking and investment banking on the grounds that the riskiness of the latter would lead to the required safety and soundness of the former being compromised upon.

This made banking a very boring business with commercial banks having to stick to borrowing money from depositors, and lending it out, and making the difference in interest rates as their income. This meant banks which raised deposits could not trade in stocks and other financial securities. They could not get into the brokerage business either.
The Glass–Steagall Act was replaced with a new Act in 1999 (the Gramm-Leach-Bliley Act) to clear the merger of Citicorp, a commercial-bank-holding company, with the insurance company Travelers Group. This led to the formation of Citigroup, which was a company that had several different financial service brands under it. There was Citibank, which was a bank, Smith Barney, a stock brokerage firm, Primerica, a firm that sold insurance products and Travelers, an insurance company.
Long story short, what emerged was basically a very unwieldy company. A firm which was too big to fail.
On October 31, 2007, Meredith Whitney, an analyst of financial firms at Oppenheimer and Co., went all out against Citigroup. She said that the bank had so mismanaged its financial affairs that it would have to slash its dividend or go bust. The market heard out Whitney. The share price of Citigroup was down by 8.8 percent, to \$38.51, by the end of that day.
Chuck Prince, the lawyer CEO of Citigroup, quit seven days later, on November 7, 2007. The stock price by then had fallen by 20 percent, to \$33.41, from where it stood before Whitney’s pro­nouncement on the bank. What was interesting was the way Prince looked at things. Only a few months earlier, on July 7, 2007, he had said that things could get complicated in the days to come “But as long as the music is playing, you’ve got to get up and dance.” “We’re still dancing,” he had remarked.
The troubles for Citigroup just erupted after this. It had made huge investments in subprime securities and other financial securities using the structured investment vehicles (SIVs) route which started to go wrong (this story is too long to go into detail here). Once the financial crisis broke out in September 2008, the market did not expect Citigroup to survive.
But Citigroup was too big to be allowed to fail. On October 14, 2008, the treasury department of the United States (or what we call the ministry of finance in India) invested \$250 billion in 10 financial institutions as a part of the capital purchase programme.
The Citigroup was a part of this and got \$25 billion from the US government. After receiving the investment from the government, the then CEO of the firm, Vikram Pandit, said that the investment would give his firm more flexibility to borrow as well as lend.

But the market wasn’t too confident about the chances of Citigroup surviving, given its huge investments in subprime and other shady securities through the structured investment vehicle route.
The trouble was that like AIG, Citi was also deemed to be too big to fail. So, on November 25, 2008, the government decided to inject \$20 billion cash into the firm. This was over and above the \$25 billion that Citigroup had already received as a part of the capital purchase programme a little over a month earlier. The government also decided to guarantee \$306 billion worth of troubled mortgages and other assets of the firm. And this is how Citigroup, like many other financial institutions was rescued by the government, simply because it was too big to fail.
A firm like Citigroup, which is present in a large number of financial service businesses as well as investment banking businesses, was and continues to be extremely unwieldy to manage. But, at the same time, the firm was so big and into so many different businesses that letting it go, would have led to a lot of job losses and other firms going bust as well.
To his credit, Alan Greenspan, who was the Chairman of the Federal Reserve of the United States from 1988 to 2006, had pointed out the risk of big banks as far back as October 1999. He had said in a speech that “megabanks being formed by growth and consolidation are increasingly complex entities that create the potential for unusually large systemic risks in the national and international economy should they fail.”
Hence, it is important to make sure that there are no institutions which are too big to fail. As Bob Swarup puts it in
Money Mania,If the vanishing of an institution will destroy the network of our economy, it is too large to survive. Citigroup will one day go bust. Probability and evolution tell us that. Therefore, we can either keep trying to postpone the inevitable or remove that anomaly. This can be done over time by shrinking the institution through incentive or breaking up the institution.”
Interestingly, research carried out by the Federal Reserve has been unable to find any economies of scale of operation beyond a certain size. As Greenspan asks in
The Map and the Territory: “I often wondered as the banks increased in size throughout the globe prior to the crash and since: Had bankers discovered economies of scale that Fed research had missed?”
In fact, there is little to suggest that banks benefit from any economies of scale, when they grow beyond \$100 billion in assets, suggest Anat Admati and Martin Hellwig in
The Bankers’ New Clothes. (On a different note Kotak Mahindra Bank had Rs 1,22,237 crore as on March 31, 2014. Hence, as far as economies of scale are concerned it is still well below Admati and Hellwig’s cut off point).
Moral of the story: bigger banks aren’t necessarily better, especially in an environment where governments cannot let a bank go bust in case it runs into trouble. As Swarup points out “No government will ever take the electoral risk of bank failure. Governments throw money at the problem, even if it is in vain, because the incentives are based on perpetuating their political hegemony.”
And this is something worth remembering every time a banker talks about bigger being better.

The article originally appeared on www.FirstBiz.com on Nov 25, 2014

Sensex @28,500 : Stock Market as a beauty contest

Vivek Kaul

We never know what we are talking about – Karl Popper

The Sensex closed at 28,499.54 points yesterday (i.e. November 24, 2014). The fund managers are confident that this bull run will last for a while. Or so they said in a round table organised by The Economic Times.
Prashant Jain of HDFC Mutual Fund explained that during the last three bull markets that India had seen, the market had never peaked before reaching a price to earnings ratio of 25 times. The price to earnings ratio currently is 16 times, and hence, we are still at a “reasonable distance” from the peak.
This seems like a fair point. But how many people invest in the stock market on the basis of where the price to earnings ratio is at any point of time? If that were the case most people would have invested in 2008-2009, when the price to earnings ratio of the Sensex
By buying stocks at a lower price to earnings ratio, they would have made more money once the stock market started to recover. But stock markets and rationality don’t always go together. Every investor is does not look at fundamentals before investing. “In investing, fundamentals are the underlying realities of business, in terms of sales, costs and profits,” explains John Lanchester in How to Speak Money.
A big bunch of stock market investors like to move with the herd. Let’s call such investors non fundamentals investors.
So when do these investors actually invest in the stock market? In order to understand this we will have to go back to John Maynard Keynes. Keynes equated the stock market to a “beauty contest” which was fairly common during his day.
As Lanchester writes “Keynes gave a famous description of what this kind of non-fundamentals investor does: he is looking at a photo of six girls and trying to pick, not which girl he thinks is the prettiest, and not which he thinks most people will think is the prettiest, but which most people will think most people will think is the prettiest…In other words the non-fundamentals investor isn’t trying to work out what companies he should invest in, or what company most investors will think they should invest in, but which company most investors will think most investors will want to invest in.”
Or as Keynes put it in his magnum opus
The General Theory of Employment, Interest and Money“It is not a case of choosing those [faces] that, to the best of one’s judgement, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
Hence, a large bunch of investors invest on the basis of whether others round them have been investing. That is the beauty contest of today.
Nilesh Shah, MD and CEO of Axis Capital pointed out in
The Economic Times round table that nearly Rs 25,000-Rs 30,000 crore of money will come into the stock market through systematic investment plans (SIPs).
Anyone who understands the basics of how SIPs work knows that they are designed to exploit the volatility of the stock market—buy more mutual fund units when the stock market is falling and buy fewer units while it is going up. This helps in averaging the cost of purchase over a period of time, and ensures reasonable returns.
Investors who are getting into SIPs now are not best placed to exploit the SIP design. Nevertheless, they are still investing simply because others around them have been investing. This also explains why the net inflow into equity mutual funds for the first seven months of the this financial year (between April and October 2014) has been at Rs 39,217 crore. This is when the stock market is regularly touching new highs.
And if things go on as they currently are, the year might see the
highest inflow into equity mutual funds ever. The year 2007-2008 had seen Rs 40,782 crore being invested into equity mutual funds. This was the year when the stock market was on fire. In early January 2008, the Sensex almost touched 21,000 points. It had started the financial year at around 12,500 points.
So, now its all about the flow or what Keynes said “what average opinion expects the average opinion to be.” And till people see others around them investing in the stock market they will continue to do so. This will happen till the stock market continues to rise. And stock market will continue to rise till foreign investors
keep bringing money into India.
No self respecting fund manager can admit to the fact that these are the reasons behind the stock market rallying continuously all through this year. This is simply because all fund managers charge a certain percentage of the money they manage as a management fee.
And how will they justify that management fee, if the stock market is going up simply because it is going up. Nobel prize winning economist Robert Shiller calls such a situation a naturally occurring Ponzi scheme.
As he writes in the first edition of
Irrational Exuberance: “Ponzi schemes do arise from time to time without the contrivance of a fraudulent manager. Even if there is no manipulator fabricating false stories and deliberately deceiving investors in the aggregate stock market, tales about the market are everywhere. When prices go up a number of times, investors are rewarded sequentially by price movements in these markets just as they are in Ponzi schemes. There are still many people (indeed, the stock brokerage and mutual fund industries as a whole) who benefit from telling stories that suggest that the markets will go up further. There is no reason for these stories to be fraudulent; they need to only emphasize the positive news and give less emphasis to the negative.”
And that is precisely what fund managers will do in the time to come. In fact, they have already started to do that.
They will tell us stories. One favourite story that they like to offer is that India’s economy is much better placed than a lot of other emerging markets. This is true, but then what does that really tell us? (For a
real picture of the Indian economy check out this piece by Swaminathan Aiyar).
Another favourite line you will hear over and over again is that “markets are never wrong”. This phrase can justify anything.
The trick here is to say things with confidence. And that is something some of these fund managers excel at. Nevertheless it is worth remembering what Nassim Nicholas Taleb writes in
The Black Swan: “Humans will believe anything you say provided you do not exhibit the smallest shadow of diffidence; like animals, they can detect the smallest crack in your confidence before you express it. The trick is to be smooth as possible in personal manners…It is not what you are telling people, it how you are saying it.”
And this is something worth thinking about.

The article originally appeared on www.equitymaster.com on Nov 25, 2014

Kotak-ING Vysya merger: Why M&As are like Elizabeth Taylor’s marriages

Kotak Mahindra Bank is set to acquire ING Vysya bank. “All ING Vysya branches and employees will become Kotak branches and employees” after the deal is completed,” the banks said in a statement yesterday. “Congratulations @udaykotak on a brilliant merger move. The enormous synergies are obvious,” industrialist Anand Mahindra tweeted after the deal was announced.
Big companies like to acquire other companies and the reason that is often cited is synergy. But things are never very obvious, even though they may seem to be initially. The history of mergers and acquisitions is littered with examples of things going terribly wrong for companies. Nevertheless, the zeal to merge and acquire, and thus grow bigger in the process, doesn’t seem to die down with executives who always remain confident of making it work.
As Paul B Carrol and Chunka Mui write in
Billion Dollar Lessons — What You Can Learn from the Most Inexcusable Business Failure of the Last 25 Years “Executives can be like Elizabeth Taylor, who has said that with each of eight marriages, she was convinced that somehow, someway, this marriage would work.”
Usually a merger is justified by harping on a particular synergy. And what exactly is this synergy? It could be something like the scenario that was used to justify Coca Cola buying Columbia Pictures—consumers while watching movies made by Columbia Pictures will drink Coke. Not surprisingly, this did not work out well and Coca Cola had to soon sell Columbia Pictures.
But on a more serious note what exactly is synergy? John Lanchester defines the term in his book
How To Speak Money: “Synergy: Mainly BULLSHIT, but when it does mean anything it means merging two companies together and taking the opportunity to sack people.” He then goes on to explain the concept through an example.
As he writes “If two companies that make similar products merge, they will have a similar warehouse and delivery operations, so one of the two sets of employees will lose their jobs. The idea is that this will cut COSTS and increase profits, though that tends not to happen, and it is a proven fact that most mergers end by costing money…When two companies merge, the first thing that ANALYSTS look at when evaluating the deal is how many jobs have been lost: the higher the number, the better. That’s synergy.”
An interesting story here is that of Bank of America stepping into acquire Merrill Lynch around the time the current financial crisis broke out. Michael Lewis writes in
Flashboys that Merrill Lynch ended up taking over the equity division of Bank of America and went about firing employees of the bank. Merrill Lynch employees also gave themselves huge bonuses. Lewis quotes John Schwall, who had for Bank of America for nine years, as saying: “It was incredibly unjust. My stock in this company I helped build for nine years goes into the shitter, and these assholes pay themselves record bonuses. It was a fucking crime.”
Also, even in cases of firms which are in the same line of business, things can turn out all wrong, even with all the projected synergy. As an article in a September 1994 edition of
The Economist points out “Even complementary firms can have different cultures, which makes melding them tricky. And organising an acquisition can make top managers spread their time too thinly, neglecting their core business and so bringing doom. Too often, however, potential difficulties such as these seem trivial to managers caught up in the thrill of the chase…and eager to grow more powerful.” This is something that Kotak and ING Vysya will have to deal with. Essentially, what might seem like an extremely valuable operating synergy may simply evaporate because of the cultural differences that exist between the two firms.
A good example here is the merger of America Online and Time  Warner. “At the time of the merger in 2000, when the company’s market capitalisation was \$280 billion, AOL’s Steve Case and Time  Warner’s Gerald Levin proclaimed that they had done nothing less  than reinvent media by combining an old-line media company with a new age one. They said AOL  would feed customers to Time Warner’s magazines and its cable, movie, music, and book businesses. Time Warner would provide new kinds of content that would help AOL sign up even more customers for its online subscription service,” write Carrol and Mui.
But the synergy that had been thought of before the merger was simply not there. And there was a reason for it. The idea was to combine the “old and new media”. The top management did a lot to get the synergy going. Nevertheless it did not work out. As Carol and Mul put it “But the folks on the Time Warner side, in particular, didn’t make the jump with them. Time, Fortune, Sports Illustrated and scores of other magazines had prospered for decades. They had well-established practices for how they produced their stories and sold their ads.”
And once these so called obvious synergies evaporate, there is trouble ahead. Hence, most mergers and acquisitions do not work out well. As Carrol and Mui point out “A McKinsey study of 124 mergers found that only 30% generated synergies on the revenue side that were even close to what the acquirer had predicted. Results were better on the cost side. Some 60% of the cases met the forecasts on cost synergies. Still, that means two out of five didn’t deliver the cost synergies, and forecasts were sometimes way off — in a quarter of the cases, cost synergies were overestimated by at least 25%.”
There is other similar evidence available. As Jay Niblick writes in an article titled
The Problem with Mergers and Acquisitions “According to KPMG and Wharton studies, 83% of mergers and acquisitions failed to produce any benefits – and over half actually ended up reducing the value instead of increasing it. Multiple other studies would agree, finding that the failure rate of most mergers and acquisitions ranges somewhere between 60-80%. It would seem obvious that something is wrong with this industry.”
Niblick goes on to ask “even the average village idiot should be able to notice that something isn’t working here – right?” But that as it turns out is not the case.
Even with a huge amount of evidence that mergers and acquisitions don’t seem to work, the idea of acquiring companies is seductive. This is primarily because “they fill the need for CEOs to make some bold move that will redefine an industry and establish their legacy,” explain Carol and Mui This leads to the acquiring company typically overpaying for the acquired firm and shareholders of the acquired firm lose out in the process. As
The Economist points out “Shareholders of acquiring firms seldom do well: on average their share price is roughly unchanged on the news of the deal, and then falls relative to the market. Part of the reason for this is that lovelorn company bosses, intent on conquest, neglect the needs of their existing shareholders.”
To conclude, the top management of Kotak and ING will have to keep these things in mind once they start merging their operations on the ground. And if history is any guide for things, tough times lie ahead for the two financial firms.

The article originally appeared on www.FirstBiz.com on Nov 21, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The great Indian debt time bomb

Vivek Kaul

On November 17, 2014, Adani Enterprises put out a statement saying: “Adani Mining, the Australian subsidiary of Adani Enterprises, and the State Bank of India (SBI), the country’s largest lender, have today signed an MOU in the aftermath of the successful Brisbane G20 Summit…The MOU provides for a credit facility of up to \$1 billion USD subject to the detailed assessment of the company’s mine project at Carmichael, near Clermont in Western Queensland.”
This MOU was questioned in the media. The basic question asked was: Should Adani Enterprises, a company already having a lot of debt, be allowed to raise more debt? Further, the environmental concerns around the mine were highlighted as well.
As on September 30, 2014, the total debt of the company stood at Rs 72,632.37 crore.  It had shot up by Rs 7653.33 crore from where it was on March 31, 2014.
The total operating profit of the company over the last four quarters was at Rs 8,999.92 crore. The interest that it paid on its debt was Rs 5,733.77 crore. This means an interest coverage ratio of around 1.57.
Interest coverage ratio is essentially the earnings before interest, taxes and exceptional items (or operating profit) of a company divided by its interest expense. It tells us whether the company is making enough money to pay the interest on its outstanding debt.
If we look quarterly data, the situation becomes more interesting. The interest coverage ratio of the company was 2.67, for the period of three months ending March 31, 2014. It fell to 1.58 as on June 30, 2014. And for the period of three months ending September 30, 2014,it stood at 1.12.
An interest coverage ratio of close to one basically tells us that the company is making just about enough money to keep paying interest on the debt that it has. Clearly, a worrying situation.
Ideally, the interest coverage ratio of a company should be over 1.5.
What this tells us is that Adani Enterprises isn’t in the best financial shape. After some criticism in the media, Arundhati Bhattacharya, the chairman of SBI, said that the loan
will go through “proper due diligence both on the credit side as well as on the viability side.” She also said that the board of SBI had yet to take a call on the loan. “The board will take a call and then only the loan will be sanctioned,” Bhattacharya said.
Bhattacharya further clarified that a new loan to Adani Enterprises will be given only after the company had repaid portions of the earlier loan given to them by SBI. After that had happened, the fresh lending to the company would work out to only \$200-400 million.
As far as environmental concerns went, Bhattacharya said that she had been assured by the Queensland government (where the Carmichael mine is located) that there were no environmental issues around the project.
News-reports appearing in the media clearly suggest otherwise. There seem to be environmental concerns around the mine, as the project is adjacent to the Great Barrier Reef. A recent news-report in
the British newspaper The Guardian said that the Rainforest Action Network, a US environment group, had written commitments from US banking giants Citigroup,Goldman Sachs, and JPMorgan Chase, to not back the project.
Before this several British banks had also ruled out funding the project. The news-report pointed out that “several avenues of finance have already been shut off to the \$16.5bn project. Deutsche Bank, Royal Bank of Scotland, HSBC and Barclays all ruled out funding the development, before the US banks’ refusal.”
Another recent report in The Guardian points out “construction of Australia’s largest ever mine[i.e. the Carmichael mine] will be well underway before its impact upon the environment is known, with a requirement to replace critically endangered habitat razed by the project pushed back by two full years.”
So, clearly there are environment concerns around the mine, irrespective of what Bhattacharya has been told by the Queensland government. Nevertheless, it was nice to see Bhattacharya come out in the open and clarify that SBI would go through proper due diligence before deciding to give Adani another loan.
If other public sector banks had done that in the past, they would not be in a mess that they currently are in. In August 2014, the finance minister
Arun Jaitley had told the Parliament that bad loans in the banking system had risen to 4.03% of the advances in 2013-14. The number had stood at 3.42% in 2012-13 and 2.94% in 2011-12.
In fact, the situation is much worse for public sector banks. As on March 31, 2013, the gross non performing assets (NPAs) of public sector banks had stood at 3.63% of the gross advances. By September 30, 2014, this had jumped up to 4.80% of the gross advances. During the same period the gross NPAs of private sector banks has been more or less stable at 1.8% of gross advances.
This is something that the Reserve Bank of India points out in
the Financial Stability Report released towards the end of June 2014, as well. The stressed advances of the Indian banking system stood at 9.8% of the total advances. For public sector banks the number stood at 11.7%. What this means in simple English is that for every Rs 100 given by Indian banks as a loan nearly Rs 9.8 is in shaky territory (for public sector banks the number is at Rs 11.7) The borrower has either stopped to repay this loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan (which also entails some loss for the bank).
The report further points out that “There are five sub-sectors: infrastructure (which includes power generation, telecommunications, roads, ports, airports, railways [other than Indian Railways] and other infrastructure), iron and steel, textiles, mining (including coal) and aviation services which contribute significantly to the level of stressed advances.”
These sectors (especially the infrastructure sector) are dominated by crony capitalists, who were able to get loans from public sector banks, and are now unable to repay them.
An excellent example here is that of Lanco Infratech. As on March 31, 2014, the company had total loans amounting to Rs 34,877 crore. Against this the company had a shareholders’ equity of Rs 1,457 crore. This means the company had a debt to equity ratio of around 24. Not surprisingly for the period of three months ending September 30, 2014, the company had an operating profit of Rs 317.23 crore and finance costs of Rs 773.02 crore.
What this clearly tells us is that the banks giving loans to this company did not do any due diligence or were simply under pressure to hand out loans. This is not surprising given that its founding Chairman L Rajagopal was a member of parliament from Vijaywada on a Congress Party ticket, in the last Lok Sabha.
There are many other companies run by crony capitalists which are in a similar situation and are unable to repay the loans they had taken on. This has led to trouble for banks, particularly the public sector banks.
Uday Kotak, Executive Vice Chairman and Managing Director of Kotak Mahindra Bank,
in a television interview earlier this year had estimated that the Indian banking system may have to write off loans worth Rs 3.5-4 lakh crore over the next few years. When one takes into account the fact that the total networth of the Indian banking system is around Rs 8 lakh crore, one realizes that the situation is really precarious.
To conclude, it is worth recounting here what the economist John Maynard Keynes once said “If you owe your bank a hundred pounds, you have a problem. But if you owe your bank a million pounds, it has.”
The modern day version of this quote was put forward by the
Economist magazine when it said “If you owe your bank a billion pounds everybody has a problem.”
The point being that any bank has to be very careful when giving out a large loan. Indian public sector banks seem to have forgotten that over the last few years. And now we have a problem.

The article originally appeared on www.equitymaster.com on Nov 24, 2014