Friday, May 8, 2009

MFs Want New Rules for Bad Times

By Dhirendra Kumar | May 8, 2009

The financial crisis around the world has made a lot of people realise that they could pretend that things aren’t so bad if only some accounting rules could be bent into a more convenient shape. The biggest such issue around the world has been the global campaign against the so called Mark-to-Market (MTM) accounting rules. Now, some Indian mutual funds are attempting a variation on the same theme by trying to get Securities and Exchange Board of India’s (SEBI) rules on Non-Performing Assets (NPA) diluted.

In the MTM issue, the argument that was generally given was that there are notional losses that are temporarily there because markets are not in a ‘normal’ state right now. The argument was based on the supposed unfairness of mark-to-market pricing and fair-value accounting. Indian companies had made losses mostly in currency derivatives. Under fair-value accounting rules, they are supposed to show these on their books. Their argument was that these notional losses would turn into profits when the markets turned ‘normal’. The current financial turmoil was claimed to be an abnormal situation and corporate managements should be permitted to adjust their accounting and hide losses that result from what they deem to be unusual circumstances. In essence, this boiled down to having one set of accounting rules for good times and one for bad times.

The variation on this theme that is being attempted by some fund companies goes like this. SEBI has very precise rules for recognition of non-performing debt assets that funds have invested in. Currently, if the issuer of a debt security delays payment of interest or repayment of capital by more than a month, then that investment must be marked as non-performing and its value be deducted from the NAV. In essence, the value of that asset falls to zero. It’s a strict rule and it has served mutual fund investors well for many years now.

Now, some funds have investments that have gone sour and they’d like this rule to be adjusted because, you know, these are abnormal times. From what I hear, it seems that they’d like the one month period to be adjusted upwards to three or even six months. Basically, their fund managers have invested in debt assets that have gone bad and they’d like to be able to hide this disaster from the investors to whom the money belongs. Currently, SEBI permits them to hide such uncomfortable facts for just one month but these fund companies would like to hide them for a much longer period.

The public relations (PR) spin is that this rollback of transparency is somehow in investors’ favour. It’s not. There were a handful of mutual funds that had built up massively undiversified portfolios with overwhelming exposure to specific sectors and even individual companies. Creating such portfolios was commercially expedient, but against every principle of prudent fund management. Now, these funds have blown up like the time-bombs they were.

Part of this problem arises from a basic confusion of what a mutual fund is. India’s huge debt fund industry has become a sort of a quasi-banking activity that is informally understood by investors to guarantee capital and returns. This attitude is actively encouraged by some fund-marketing outfits. In fact fund salesmen with heavyweight parentage openly imply that investors’ money is safer with them because their asset management company (AMC) is owned by a bank or a large conglomerate. This is a dangerous game. In terms of capital safety, funds should strictly be a pass-through entity where the only guarantee is the quality of their fund management and the competence of their risk-control measures. The fund business can never operate with enough capital to recompense investors’ losses from the AMC’s capital.

The current crisis arises from this confusion about the exact role of debt funds. The answer to this and related problems is not to bring the AMC’s size or capital into the picture, but to raise a wall between the AMC’s finances and that of the funds it runs. And let the marketplace take a call on who can manage money safely and who can’t.

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