Financial Turmoil – Part 2: Subprime is good!

Subprime was innovated on the back of de-regulation in US banking.  In banking parlance, subprime customers are borrowers with less-than-preferred credit history. I’m convinced with the benefits of Subprime as it has resulted in productive gains and enabled economic activity.

 

Access to credit helps people to keep them afloat during bad times. On contrary, curtailing access to credit creates disparity and leads to economic divide. Developed nations have highest economic disparity despite having de-regulated banking sector. When India is trying to catch up with developed countries, we will also be exposed to rising economic divide. Will banking de-regulation and bringing in less-stricter lending criteria enable financial inclusion and address financial needs of larger section of the economy?

 

Financial regulation leads to better governance, protection of capital, reduces volatility and ultimately reduces risk of run on banks. However, we have to agree that this comes with risk of shrinking the economic development and creates greater diversity among people. Invariably, most of the banking regulations commissioned earlier have prevented lesser-privileged people from having access to capital.

 

Whenever there is a change in regulation the opinion on the new policies have been always divided. Currently, we are experiencing one of the greatest financial crisis, which is exerting huge pressure on the economy. Different parties are putting together various solutions such as $700bn bail-out package. Globally, market pundits are advocating against subprime lending but doing so is nothing but judicially approved financial discrimination.

Subprime is not bad and should not be looked with contempt. Subprime hasn’t created all the havoc, some blame is due to the financial astrologers and fragile financial markets backing these loans. So, the solution lies in developing efficient financial market to support subprime loans. Further, it calls for optimal methods to regulate the subprime market rather than constraining them.

Financial Turmoil – Part 1: Is it a bottomless well?

It all hasn’t happened so quickly as hyped and discussed but over 2-3 years. We are left with the benefit of hindsight, but the price we have to pay is the astronomical financial loss.  

We were residing in low point of the economic cycle and the interest rates were cut steeply to bring economy out of the recession. This encouraged people to borrow beyond means. Economy also reacted positively with bubbling liquidity, expanding businesses, lowering unemployment levels and rising income levels. However, the cycle had to take a turn and it started to reverse with fed increasing interest rates. During 2004-07, upward spiral in interest rates put pressure on asset prices and on speculative bets taken by banks resulting in colossal losses. 

Who should be held responsible for the financial catastrophe that we are experiencing today? Is it irrational i-bankers or profit hungry commercial banks or credit rating agencies or homeowners borrowing beyond means or regulators? 

The recent meltdown showcases that the entire financial services ecosystem is at risk. A closer examination reveals that the banks were lending subprime loans as they could securitize and trade it with investment banks. Investment banks were trying to mitigate risk by using CDS (Credit Default Swaps) with their peers and insurance companies. These equations seemed to be in balance but they went beyond control as the economic variables were not aligning to the financial bets taken earlier.  

I believe, we have just now started seeing the impact of the entire financial mess around the Wall Street. People have to look beyond subprime mortgages into subprime auto and personal loans and even subprime cards. More banks are expected to go bust, especially regional banks. If the US government starts assuming the bad debts and losses of these institutions it will run into trillions of dollars. However, US government is trying to calm the situation by proposing a $700b bail-out package, which will be significantly deficient to handle the toxic! 

In the coming months,

• We will see banks orchestrating more stake sales, and trimming down balance sheet.
• Equity markets haven’t bottomed-out yet. Fundamentally markets should find its bottom aligning with business cycle i.e. corporate earnings should reach lows
• Central banks across the world will continue pumping money into the market to ease the pressure and build investor confidence
• Oil prices will stabilize around $100 mark.

 Some unanswered questions

• Will top echelons compensation be rationalized and NOT incentivize them to take undue risks?
• Will the soft treatment to Wall Street firms by bailing them out set precedence to take riskier bets in future also?
• Were credit rating agencies unable to sense the impending danger earlier? OR Were they not independent on their opinions and ratings?
• How well the corporate governance of the institutions measure up? Lehman in their last reported quarterly results were cautious but reassuring to handle the situation!

 Hope we sail through the tougher time ahead.

Infosys – Axon: Deal in the right direction

Infosys has offered $753m to acquire UK-based SAP consultancy service provider Axon Group. This breaks Infosys’ conservatism and provides option to move up the IT services value chain. Further, this deal marks the first significant step of offshore providers to become a “transformation agent” and compete better for larger deals.

Deal positives

• Infosys has tabled a rational bid for Axon, pricing it at 600p per share. However, Indian analysts believe that Infosys might have over paid on the lesser margin potential consideration. In my view, even if Infosys has over paid, it is justified by better revenue per employee of Axon. Infosys garners 24% of its revenue from consulting and SI, within this 33% was from SAP services. Infosys employs 2100 people to generates c.$330m from SAP related services meaning $156k per employee. With 2000 employees, Axon generates $410m meaning $205k per employee.
• This acquisition will provide access to new verticals (public sector) and extend Infosys’ capabilities to high-end consulting and integration services.
• Infosys is trying to break the linearity of revenue growth. Axon’s revenue grew 53% last year.

Deal risks

• Axon is UK focused company which might not cater to Infosys’ pan European expansion ambition. Certainly, Infosys doesn’t need an inorganic formulae to grow in UK as it has been growing at 80-100% in UK over last 5 years.
  
• SAP demand has been relatively unscathed by the current macro economic environment. However I believe this is restricted to the SAP integration services, the consulting demand still remains a threat
• Obviously there are sensitivities associated with retaining consultants (employees) under an Indian offshore brand.
• Offshore vendors are used to 20+% margin, which Axon cannot deliver proving the acquisition to be dilutive.

Some credibility in expecting counter-bid

• Axon shares have closed above the Infosys’ offer price of 600p on the expectation of counter bid at higher price.
• As Infosys hasn’t provided any targets on revenue and cost synergies, I think the level of discussion between Infosys and Axon hasn’t been very intense. This makes me believe that Axon might be talking to other bidders also.
• Global market analysts believe that Infosys has under-paid for Axon suggesting that 600p doesn’t fully reflect the potential value of Axon and also considering the Axon’s share price levels reached in September 2007 (900p).

Some moot points

1. Why hasn’t other offshore-based player bid for Axon?
2. How are other offshore providers going to react to this deal?