Impact of regulatory/accounting arbitrage on the Returns from Distressed securities

Here my focus will be on distressed debt securities and my idea of distressed securities is broad enough in including the investments in non-performing assets of financial institutions. Investors are generally attracted towards distressed securities/assets to earn higher risk adjusted returns.  The prominent reason for such risk adjusted returns is the arbitrage opportunity created by the regulatory/ accounting process.

  The financial institutions in general and commercial banks in particular are highly regulated. Such regulatory pressures do create the opportunity for the investors to purchase the distressed loans (NPAs) at the attractive prices. Given the regulatory costs involved in having large amount of distressed loans, many banks prefer to sell the loans at the throw away prices (even at less than the recovery value).  Such behavior of the banks may be attributed to two reasons. First, tax laws allow the banks to deduct such losses from the EBIT. Second, market pursues the larger amount of NPAs thereby higher regulatory reserves as the negative information (may be market short sightedness). The buyers of these assets (may also include commercial banks) do place them in their trading account. As the assets in the trading account are marketed to market and no ‘regulatory’ reserves need to be held against the assets in the trading account, they provide the economic value to the buyers. Hence, the sellers of the distressed assets do sell them on the regulatory/accounting reasons where as buyers of such assets do buy them on the economic reasons.

 (Your comments and suggestions do inspire me the most. Thanks….)

Does the Counter Cyclical Regulation ensure the cycle free regime?

During the run up of 2004 to 2007 world economies in general and emerging economies in particular have experienced the highest levels of consumer confidence and corporate optimism. The increased purchasing power driven by increased investments and confidence among the economic agents (I mean corporate entities and individuals) has escalated the inflationary pressures around the world.  To counter such an imbalance in the system, the apex bodies around the world have resorted to counter cyclical monetary measures such as increasing the reserve capital (which may be used in the event of negative outcome). Such a counter cyclical regulated environment has forced the firms to incur more cost of capital than market requires.  In fact during the boom times, given the confidence level in the economy, the probability of default though is very remote; the cost of capital in the economy remained irrationally high. Hence such a regulatory environment prompted the firms to shift to unregulated or less regulated activities such as structured investment vehicles which in a way caused the present trough. 

 

Aftermath of the bursting of the bubble in the housing sector, almost all the apex financial institutions around the world resorted to the (traditional) counter cyclical monetary measures which are again proved to be irrational and may contribute to the potentially void results. The trouble in the housing sector has been translated into disastrous crisis in the financial sector by the so called counter cyclical regulations of the boom period. The resulted crisis has evaporated the confidence among the economic agents and drafted vague picture about the future prospects thereby steep fall in consumer demand, accumulated inventories and unimaginable job cuts. Given the present pessimistic environment, market demands a relatively higher cost of capital from the firms and financial institutions requires higher cushion in terms of higher reserve to tide over the potential uncertainty. Counter intuitive to such an end, the regulatory bodies brought down the reserve requirements of the financial institutions and virtually advocating the low cost of capital to the firms. The credibility of these measures in the event of possible corporate mass defaults is not only questionable but they may also pose the terrifying questions about the future systemic cushion…  (to be continued)

(Comments and suggestions are hightly respected)

Inital steps - 1: Board for Industrial and Financial Reconstruction (BIFR)

What is it about?

In 1981, the Governement of India set up a committee headed by Mr. Tiwari to suggest a comprehensive legislation to deal with the Industrial Sickness prevailed in the economy. Based on its report (submitted in 1983), the GoI enacted the Sick Industrial Companies Act in 1985 (SICA) and set up the  Board for Industrial and Financial Reconstruction (BIFR) in 1987 with the objective of determining (early) the sickness and expedite the rivival of potentially viable firms and closure of unviable firms.  It was expected that by rivival the idle investments in the viable firms will become productive and by closure the locked up investments in unviable firms will find their productive uses elsewhere.

What does it provide?

It works on the provision of timely detection of sick and potentially sick industrial companies, speedy determination and enforcement of preventive, remedial and other measures with respect to such companies. They do provide the legal protection for the speedy revival of viable and closure of the unviable firms. It facilitates the required financial assistance and also provides the managerial expertise.

What is the eligibility criteria?

• Firm to be reported to BIFR under SICA should be 5 years old after the incorporation.
• Accumulated loss of the firm has to be equal or more than its net worth (paid-up-capital + Reserves).
• Firm's workforce should exceed the minimum of # 50.
• It should have the legal status for its existance (license).

Curtesy of BIFR