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NSEL crisis – Mini Version of US subprime crisis in Indian capital markets

The US subprime crisis in 2007 had shaken the foundation of US economy and eventually the global economy. Subprime loans (loans for people with not so good credit history, jobs, assets etc.) had high probability of default. These loans were structured by investment banks into Bonds and sold to various Financial Institutions around the world. The mortgage (subprime loan) issuers had the incentive to issue as many mortgages as possible. The practice became so unprofessional, that the loan applicants were asked to fill the form in pencil so that issuers could misrepresent certain details so as to meet the issuer’s lending criteria and get the loans issued. The package of such loans was not managed well from risk perspective, not regulated well by US regulator (who believed the markets will determine correct prices of such bonds) and were falsely rated highly by the Credit agencies.

This was the fundamental flaw in the building blocks of such bonds. The fall in US house prices lead to the subprime mortgage defaults and the Subprime Crisis. The global financial institutions’ losses (investment banks, commercial banks, investment funds, etc.) due to sub-prime and related activities had topped $1 trillion by the end of 2008. These losses led the banks to reduce their leverage significantly. This eventually led to the credit crunch across the economy.

National Spot Exchange Limited Crisis (August 2013) in India was caused by lack of trade settlements in a commodity spot exchange based on the assumption that there is underlying commodity held by the seller in his warehouse. These products sold on the exchange were not approved, the exchange was not regulated, the underlying stocks in the warehouses are still being audited, the exchange settlement guarantee fund is not sufficient to ensure payments to both sides of the parties; hence, net exposure left is around Rs.5500 crore (less than $1bn).

One can draw few similarities between the US subprime crisis and the NSEL crisis,

The fundamental flaw was forged documents.

Forged loan documents by load issues to subprime people, and (arguably) forged warehouse receipts in the case of NSEL crisis.

Greed lead to the rise in scale of the crisis.

US subprime crisis was scaled up by subprime borrowers, loan issuers, financial institutions who could all make lots of money from the attractive transactions over a period of 5-10 years. NSEL crisis was scaled up by investors who were happy with forward booking of profit i.e. payment in 25 days which they felt was “risk-free” (this is also similar to the Kuwaits crisis of paying for OTC trades by post dated cheques and the brokers and the exchange also benefitted from such transactions.

Large brokers were involved…

…and took losses in Subprime crisis (Lehman Brothers filed for bankruptcy, Merrill Lynch and Bear Sterns were sold off, Goldman Sachs & Morgan Stanley became holding banks) and in NSEL crisis (Motilal Owal, Anand Rathi, Indian Infoline, Geojit, several other brokers have already stated their large exposures … the retail participants, commodity producers and various others are also due to lose out if the money is not paid out)

Both losses were caused by the lack of regulation.

Arguably US subprime crisis was lead by designed lack of regulation by US authorities (where they believed the markets would determine the right prices of such securitised subprime mortgages’ bonds), whereas NSEL crisis was caused by inaction of Indian authorities (SEBI, FMC, Consumer Affairs and NSEL the exchange) who were aware of flaws in the exchange operations since 2012 (these products were launched since 2010) and did not take required action for over a year.

There were winners and losers in both crisis.

Several financial firms and investment firms lost out from the sub-prime crisis (the losses by some estimate run in trillions of dollars), whereas some hedge funds like Paulson & Co made a killing by betting in favour of such crisis and all the individuals who made hay between 2000 and 2007 while the sun was shining. In a similar way, some large brokers will most likely lose out in the lack of full payments or delayed payments by the other counterparties. And surely lots of brokers and investors made money by such transactions between 2010 and August 2013. Presumably few were aware of the regulatory movements of banning these securities in early 2013 and exited all positions and trading in these products.

Lawsuits follow both crisis and various defaults lead by the crisis.

It’s likely that various investors will sue their brokers, brokers will sue the exchange NSEL, and the exchange’s parent and related companies’ assets may be brought in to fill the default payments.

Regulators need to move fast and make bold and rational decisions in short span of time.

US regulators raised 100s of $bn within a matter of weeks and saved the markets from crashing severely.

Everyone is waiting for Indian regulators to put their act together and move fast. Fortunately this NSEL crisis is small crisis (in grand scheme of things) and is hopefully fairly contained (to a few participants of NSEL only) and hence likely to be manageable.

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