Jamal Mecklai: Gambling in disguise

MARKET MANIAC

Press reports about the second major corporate derivative loss in India (the first was Food Corporation of India some months ago) took me back to my somewhat misspent youth, when I was a regular at the race track, and "" beginner's luck or whatever "" I was making a lot of money. I had a partner in this activity, and as we made money, we got cockier, took bigger bets, made more money and got cockier still. We talked proudly about being gamblers, till one day someone said, "You haven't really gambled till you risk more than you can afford to lose."

Now, as 18-year-old kids we took this as a challenge, and, one day we did risk more than we could afford to lose. And we lost.

Fortunately, God was looking after us and the next race day "" a Tuesday, I still remember, I had had an oral exam at IIT on the Monday and I rushed back to Bombay to figure out what to do "" we borrowed some money and bet on another horse. It was the first race of the day, and I can still see Filmonzy, owned by Mr S Mody, Wally Swinburn up, purple colours fluttering in the wind just squeaking home, and saving us from a fate worse than we could have imagined.

The story is apocryphal for the detail with which I remember the incident. It was the only time I risked more than (I believed) I could afford to lose "" indeed, by that stringent definition, the only time I gambled.

Which brings me to another story, this one many years later. I must have been gassing about my horse racing days when my son "" about 11 or 12 at the time "" asked me the difference between gambling and business. I reflected briefly and said, "Business is about taking measured risk; gambling is about taking unmeasured risk."

All of which goes to show that the companies that have fallen for (or, to be fair, have asked for) the lure of easy money, attractively packaged in apparently sound quantitative terms, have been gambling rather than doing business.

Now, being of a laissez faire temperament myself, I think there is nothing wrong with any one (or any company) gambling, provided that the owners of the company (or the board, as their representatives) are cool with it. It is decidedly not the Reserve Bank's (or anyone else's) business to tell me (or anyone else) what to do with my money. However, the company's board needs to set up processes to ensure that the company is not gambling and implement controls to ensure that these processes are being followed "" indeed, Clause 49 or Sebi's listing agreement requires this as well. Again, and importantly, the company's auditors, who are responsible to the board for ensuring that the processes are being followed, need to ask the right questions to be able to uncover such "gambling" exposures long before they turn into what could be serious losses.

Of course, all of this is well-known "" corporate governance boilerplate, so to speak. But it is perhaps the nature of the beast "" and there certainly are reams of empirical evidence for it "" that corporate officers will, from time to time, overstep the boundaries of sensible risk-taking and plunge companies into the cycle of hand-wringing, recriminations and, finally (sometimes after a few iterations), a change from business as usual.

In an optimistic light, these losses could be seen as the price of an open economic system "" school fees, in a sense "" and we could be proud that the Indian economy has reached a stage where losses are created by risk-taking rather than, as in the old days, by crony capitalism.

But to return to the issue at hand "" how big is the problem? Well, judging from the fact that one mid-sized company has acknowledged possible losses of $20-25 million, it would seem that total losses in the market could be quite significant. Even if we assume that this company was one of only, say, 25 or 30 who were highly aggressive, possible losses could exceed $500 million (about Rs 2,000 crore).

If we add in "" and we must "" the huge number of SMEs who, quite happily seduced by some of the more aggressive banks, have each lost Rs 80 lakh, Rs 3 crore, Rs 1.8 crore and so on, the total possible loss number could quite easily be much more than double that amount. Incidentally, in many of these cases, the losses are as much as (or more than) the company's profits.

Now, let me rush to say that these are just back of the envelope numbers "" they could be very far off from reality, in either direction. Again, as was pointed out to me by a senior banker, some of the exposures are long-term, as long as 5 years, so even if they were out of the money on a mark-to-market basis, they may not end up in losses "" markets can do anything in 5 years. Well, tell that to the auditors "" they would agree that markets could do anything in 5 years and require you to make a provision.

Another interesting number to toss into the pot is 3,000 cr "" that's the total reported treasury profit in fiscal 05-06 earned by the dozen or so banks who were very active in the derivatives trade; reportedly, the first half of 06-07 was much more profitable. No doubt some part of that came from the mouth-watering margins banks made on these deals.

It would seem that we are going to see an erosion of banks' treasury profits this year, as savvy companies negotiate hard with banks, particularly those who had been lax on compliance with regulatory guidelines, and, of course, there will be a hit to corporate bottom lines, possibly serious enough to impact the equity market.