THE RISKS INVESTORS FACE.

Credit risk is a big deal these days. What we fail to grasp is the inherent complexity in the credit business. it might help to remain realistic amidst all the sensational din surrounding defaults. Formal lending practices make reasonable assumptions about the future prospects of the borrower. Working capital loans assumes reasonable values of current assets; personal and credit card loans make assumptions about future personal income; and home loans and asset-based loans assume that the future value of the asset will cover the loan. Lenders use past data and analysis of businesses to make assumptions. There are no guarantees here. It is important that care and diligence are exercised before a loan is made. Regulations prescribe the processes, disclosures and penalties to ring-fence this risky business. The risk of unexpected events, including changes in the ability and willingness of the lender to choose well and the borrower to keep commitments is always present. Can this risk be mitigated? Let me offer three situations to illustrate approaches to default risk. Consider the stock exchange. A transaction takes place between the buyer and the seller at a given price. The seller expects the price to fall. The buyer expects the price to rise. The settlement of this trade happens later (t+3), by which the time one of the parties has a high propensity to default. Someone who bought a share for Rs. 100/- has to keep his commitment to pay up, even if the market price when his settlement is due turns out to be Rs. 90/-. He faces an immediate loss of Rs. 10/-. Stock exchange trades thus are transactions with a high default risk.
The stock exchange's clearing house takes two steps to mitigate this risk. First, it asks members to deposit some money in advance. The value of trades they can enter into is linked to this deposit, which can be used to make good any defaults. Second, as prices of the stocks move, mark-to-market margins are imposed and collected. This takes care of any defaults beyond initial deposit. The net effect is that any changes in the value of the asset at the end of every trading day, is secured. Therefore, traders do not worry about default and settlement is guaranteed by exchanges. Consider a bank. Its primary risk is that the loans it holds may turn out to be bad. The capital that a bank has to hold is similar to the initial deposit the broker has to hold. The amount of loan a bank makes is linked to this capital and it is expected that any loss in the value of the assets will be lower than the available capital. What the bank does not have is the facility to mark its assets to market. It holds the loans at book value. As its borrowers' business turns bad, the bank waits for interest payments. It then classifies the asset as non-performing and begins to write off the bad loan. The capital is all a bank has to protect itself. The depositor is protected only as long as bad assets do not erode its capital. Consider a debt mutual fund that buys bonds issued by borrowers. It runs the risk that the lender would turn out to be bad, or suffer deterioration in credit quality. The mutual fund does not have any capital to buffer losses. But it marks the value of its assets to market on an every day basis. It does not wait for a default to happen. It diversifies its holdings in a way that a single asset's risk does not impact the entire portfolio. 
To create a system of guarantees like the stock exchanges have done, it is important that assets are held for a very short time and can be liquidated quickly. A long-term borrower setting up an infrastructure project will not be able to return his borrowings at short notice. Therefore, investors who want to lend for a longer period of time, should choose between the capital risk of banks and the market risk of mutual funds. If they lend directly by buying bonds, they take on market risks without the benefit of diversification offered by funds.
Should investors shun banks, given the high NPAs? No, they can choose banks that are capitalised well and keep their deposits with banks that have lower NPAs. Should investors shun debt funds, given the fluctuation in Net Asset Value (NAV)? No, they can choose funds whose NAV is not too volatile and the portfolio is well diversified to hold a good credit profile. Shoul investors discount credit rating? No, they should be aware that a rating can suffer a downgrade and avoid investing in businesses that have become risky.
How economies and markets function does not dramatically alter in short spurts. The fundamentals that underlie investment decisions also do not change overnight. Thankfully for investors, there is always choice. We have the freedom to shun what is bad. Defaults are sensational, but not the norm, thankfully. Sensible investors can still find their way if they know the hows and whys of the choices that they make.
-Challapalli Srinivas Chakravarthy-                  ----------------------------------------------------------------        



































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