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INVESTMENT AND PORTFOLIO MANAGEMENT

Read the following discussion by Ernst & Young (April 2009) and answer the required questions.

Africa has not escaped the impact of the sub-prime crisis entirely. Although the crisis origins lie in the USA, it has spread rapidly across the globe, hurting European and then Asian companies along the way. Whilst few African financial service companies have had direct exposure to the crisis, the secondary impacts are all too clear. First, and most crucially, GDP growth is declining (South Africa’s GDP in fact contracted in the last quarter of 2008).

Secondly, the major currencies of southern, eastern and western major African countries (South Africa, Kenya and Nigeria) experienced rapid depreciation, as foreigners sought to repatriate funds to their home countries, and collapsing demand for the continent’s mining and manufacturing goods followed. The South African rand depreciated 40% against the US $ in 2008.

In addition, the effect of the global liquidity crunch was also felt across the continent through reduced credit availability. Many infrastructure projects were placed on hold, given the unavailability of finance, and the cost of raising that finance. Again, foreign banks became far more risk averse than they were in the recent past, and were not keenly providing funds for (perceived) riskier emerging market countries. Infrastructure projects which were viable with high and rising commodity prices were no longer attractive, and hence many have been shelved, either for lack of funding, or due to the reduced economic rationale.

For all the above reasons, the impact of the crisis was by no means over in 2009. South African financial services companies reported record low confidence levels in the first quarter of 2009, with expectations that profits and revenue will continue slowing through 2009.Whilst interest rate cuts may provide some relief, there is no strong evidence that corporates or individuals are taking up credit again. In South Africa, for example, credit growth between January 2008 and 2009 slowed from 28% to 13.2%. Bad debts continued to grow in the 1st quarter, and growing unemployment may yet prove to keep the trend of impaired debts to total advances growing for the foreseeable future.

Having said that, South African banks were by no means as bad as their peer global banks. Most major global banks have reported hefty losses since the middle of July 2008. South African banks, by contrast, were reporting lower profits than they were prior to the beginning of the sub-prime crisis, but profits remained positive.

1. With reference to the above discussion, discuss the effects of the US sub-prime mortgage crisis on the financial risk management practice of banks in the first world economies, and the impact of the crisis on the operations of South African financial institutions specifically. Your discussion should explain causes of the sub-prime crisis, describe various financial risks observed during the crisis and explain how these risks were affected to affect South African banks (1200 words maximum for this section). (25)

2. Gather the financial statements of one bank of your choice (from the big four banks in South Africa namely, ABSA group, FirstRand bank, Nedbank and Standard bank) and use ratios to analyse the liquidity, profitability, financial leverage and market value of your selected bank for the period of 2007 to 2011. (16)

3. Gather daily or monthly closing prices of your selected bank and the JSE All Share Index for the period of January 2007 to December 2011. Using technical analysis describe the movement of share prices for your selected bank against the JSE All Share Index, providing well-reasoned explanations for your findings. You may use a spreadsheet to assist in constructing tables, graphs and generating descriptive statistics. (14)

4. Based on your analysis of the historical performance (ratios and technical analyses) explain how the sub-prime crisis affected the South African banking system. (10)

5. Examine the fundamental factors of your selected bank. On the basis of this fundamental analysis and other methods of share valuation, determine if your selected bank is overvalued or undervalued. You should conduct a top-down analysis of global economic indicators, domestic economic indicators, industry factors and company’s specific factors. You should use this analysis to calculate the intrinsic value of your selected bank. Refer to the relevant chapters of Macroeconomic and Industry Analysis and Equity Valuationof the prescribed text book by Bodie, Kane and Marcus (2010). (25)

Solution

Investment Portfolio Management

Introduction

In this competitive world and changing economic and financial conditions, investment is considered to be one of the most important aspect with which the individual is able to plan its future and its financial resources properly and adequately. It is important for the individual to design proper investment which gives adequate returns to them, for this it is important for the individual to analyze different resources and aspects on the basis. (Frank K. Reilly, Keith C. Brown, 2008),

In this paper a strong focus has been given to analyze the impact of subprime crisis in South Africa, with a strong focus on the banking sector.

Part 1: Financial US subprime - crisis

The recent US financial crisis (2008) has spread fast to other countries in integrated global financial markets, which had significant impacts on the operations of many multinational corporations and the lives of numerous individuals around the world. The financial events of this nature could have changed the financial market fundamentals and the relationships between financial markets with different degrees of openness. (Beitel, 2010)

The recent subprime crisis, consumer overindebtness and household bankruptcy rates have increased the need and requirements of the financial literacy across the globe. Financial literacy is very important as it helps the organization. It is important for the individuals to have adequate base and knowledge about the personal financial planning so that they are able to manage their expenses and income adequately so as to have the better focus on the future investment planning as well as their retirement planning. (Kling, A, 2008)

Subprime Crisis is the financial crisis which has occurred all around the world in 2007. It is the crisis which has arouse in the mortgage market and the real estate market. This financial crisis which occurred spilled the global credit market, it lead to the reduction of the capital liquidity and increased the risk concerned with capital. This Subprime Meltdown is also knows as “Subprime Collapse” or “Subprime Crisis”. In the year 2007, as there was a decrease in the rates of the houses, so the banks started giving loans to the borrowers. This was the stage when it was considered that real estate is at its boom and thus, people took extra loans to purchase houses.

With the bankruptcy of the Lehman brothers, AIG insurance firm also collapsed badly

The stock market was also at a boom and was liquid in nature. Many different portfolio were made in this respect. This created attractive opportunities for investment. So, the market of loan was growing at a fast pace.

The stock market slashed down, this crisis not only affected the US economy, but it also affected the world, there was a high time fall in the share prices of the shares of the companies. NADAQ, SENSEX, DOW JONES all the stock markets saw a fall. (Pagano, U. and Rossi, 2009)

With this the stock market was highly affected and the shares of the stocks fell down tremendously.

The recent global financial crisis has brought into picture the effects as well as the limitations of the financial innovation and reducing its effect on the core benefits of the economy. The main reason behind the same is extensive use of different financial vehicles such as collateralized debt obligations (CDOs), credit default swaps (CDSs), securitization, which led to the crisis. We can say that the mortgage securitization was one of the financial innovations which were adopted by the countries to reduce the financial information, but this instrument did not help in reducing the informational problems pertaining to credit transactions, nor it worked as an appropriate risk assessment tool. (Beenstock, M, 2010)

The massive use of mortgage securitization was one of the strongest reasons which led to the financial crisis of 2008. There were many loopholes and loose standards in the financial securitization which led to the crisis. Securitization and CDSs were considered as the main means to decide the expected risk and return evaluation of securities in the market which formed the basis on which the rating agencies made the problems of asymmetric information which worsened the effect of the financial crisis. (Friedland, 2008)

The global crisis ended in the loss of $4 trillion which was lost output and resulted in the loss of 28 million jobs along with the increased debt and deficits across the market. With the Euro zone crisis, the leaders focused on adopting G-20 action strategy as well as changes in the structural policies of IMF and monetary and trade policies which were also one of the biggest failures. The negotiations for the new trade policies also failed along with the failure in the delivery of the millennium development goals.

The major loopholes in the policies did exist in the form of there being no processes that were stringent when it came to assessment of credibility while giving loan. The global financial crisis is an event that led to a recession in the United States of America. This greatly impacted all of the countries that were associated with America in the form of trade relations and foreign investments.

The global financial crisis that occurred in America was mainly due to clashes between the credit risk and market risk. In case of the real estate market in America not having appreciated, it resulted in lack of liquidity for all of the loans and debts that were created on the basis of real estate assets. This comprised a major portion of the loans lent in the United States of America.

Moreover these loans were further securitized and sold in the stock and securities market with the underlying assets which happened to be real estate assets having lost the value and these securities having become overvalued. (Stiglitz,, 2009)

Considering the case of South Africa banks it can be said that subprime crisis had a strong affect on the banking system of South Africa. The outlook for South Africa, which accounted for more than 80 per cent of group revenues last year, has clouded recently as a national power shortage, high interest rates, and rising food and fuel costs slow growth rates that hovered at about 5 per cent for the past four years. (William 2008)

Non-performing loans in the South African mortgage market were the largest contributor to the bank's R4.6bn impairment charge for the year, up 68 per cent from the previous year. (William 2008)

Standard Bank cut 2008 financial targets to reflect the worsening global outlook and the dilutive effect of 152m new shares issued to ICBC. Its earnings-per-share target of South African consumer-price inflation (CPIX) plus 10 per cent was lowered to CPIX plus 5 per cent. The group's longer-term growth potential, however, was "enhanced" by ICBC's newly approved 20 per cent stake, it added. (William 2008)

Headline earnings per share rose 23 per cent to R10.33 for the year to December 31, while pre-tax profits rose 24 per cent to R22.8bn. (William 2008) Return on equity was 26.7 per cent, matching rates in recent years.

The reserve bank of Africa, changed its monetary policy so as to improve on its economic and financial condition.

It is extremely important that appropriate financial policies are formulated and utilized in a nation in order to keep the economy strong. The initial changes in Latin American countries came in the form of freedom from the British rule and the beginning of the industrial revolution. Slow and steady development of the industries with the advent of several machines helped these countries grow and prosper.

Yet till the present times the focus on the social sector has remained less and there has been higher focus on manufacturing, international trade as well as finance sectors. Focus on social sectors and service sectors are also crucial which have been ignored for long.

The major outcome or lesson out of the great recession was that there needs to be focus on the social and the services sector. It is not possible for America to grow without focusing on services and being production centered or without having appropriate economic policies which are focused on present global scenarios. (Ocampo, 2009).

It was extremely essential that there be avoidance of mistakes like these in order to ensure that America is strong and versatile in various dimensions and not just one single dimension which in this case was production. In this way the learning out of this traumatizing recession for America was to concentrate better on the social sector. (Brown, 2012).

The world has become an extremely small place and the impact of an event in one place is greatly affecting the complete planet. The subprime crisis was one such economic event. The U.S mortgage market faced a fall down due to the failure and end of the process of securitization. This impacted eh complete financial market and led to an economic failure of a number of firms as well as businesses. People were no longer blessed with the economic boom and this should be understood by financial mangers (Kregel, J. 2009). 

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