Anita Kapur had barely woken up when a friend called to convey the gloom over Dalal Street. On holiday in the US, Kapur rushed to log on. Even as she stared at the bloody red graph of the Sensex, she frantically called Anil Chopra, CEO, Bajaj Capital. Her question: is it time to unwind mutual fund investments? It was a question that haunted many on May 22, whether they were invested in mutual funds (MFs) or stocks directly. This was not the only such call that Chopra got. And he was not the only broker who got such calls. As many as 15-20 per cent of brokerage house ILFS Investsmart's 80,000 retail clients pressed the panic button of share sales. In Ahmedabad, the equity capital of the country, police was deployed around the Kankaria Lake to prevent bankrupt investors from committing suicide. Big brokers in the investment hub of Mumbai were busy trying to raise bank guarantees by pledging their homes and offices. Others kicked in distress sales of gold bars and bluechip Sensex stocks that they had painstakingly accumulated over the past two years.

ANATOMY OF A CRASH

1 Global developments, like a hike in interest rates in the US, affect both cost and flow of funds. FIIs react to this and domestic investors echo their actions. 2 Sales trigger fall in prices initiating margin calls on leveraged investors who sell share holdings to pay up. 3 Such selling further depresses share prices activating greater margin demands from the exchanges. 4 To meet these, more and more stock is sold and margins are paid and the cycle keeps repeating itself. 5 This increases price volatility, automatically raising the amount of margin required to be paid at every round. 6 Prices fall precipitously as buyers are shut out because the exchanges close trading terminals for brokers who don't pay up the margins. 7 The market becomes a breeding ground for rumours, and hardly any buyer comes forward in a steeply falling scenario. 8 This becomes an ideal situation for anybody wanting to play mischief in the market. 9 f&o positions are wound up to cut losses due to falling share prices. 10 Circuits are hit and trading is suspended to cool the market.

In Delhi, chaos had a political colour. Finance Minister P. Chidambaram was irritated at the rumour-mongering over a Central Board of Direct Taxes (CBDT) memo and angry that his mandarins had let this happen. Savouring all this in Parliament with a smug "I-was-there" look on his face was Yashwant Sinha who was baying for Chidambaram's blood. Even as he battled in Parliament, the FM put his firefighters on the job. The CBDT chief clarified that there was no move to allow greater discretion to officers assessing tax payable by stockmarket investors. SEBI chief M. Damodaran, who happened to be in Delhi, told reporters that there was no scam. In Mumbai, RBI Governor Y.V. Reddy assured credit support as rumours of brokers and investors going belly-up surfaced. Economic Affairs secretary Ashok Jha held forth on the fundamentals of the economy.

TREMOR TRIGGERS

INTEREST SPIKE The US hikes rates on May 12. FIIs sell shares across markets over the rising uncertainty. Indian investors follow suit. HEAVY METAL Prices of metals crash both due to higher cost of funds and lower demand for metals. Scrips tumble here as investors sell. GLOBALISATION EFFECT India is everywhere as the same set of funds invest in all markets. Markets in Asia lose over 20 per cent. The downturn in global markets is echoed on Dalal Street. FUTURE IMPACT F&O positions turn loss-making on falling share prices. Prices fall further as investors wind up contracts to cut losses, leading to a fresh squaring up of positions. RUMOUR-MONGERING A draft for discussion is reported as policy to tax FIIs. Was it an attempt to embarrass the UPA? By the time the government reacts, the damage is done.

There was no mistaking it. The mood was decidedly bearish for over a week. The US interest rates hike, fall in commodity prices and a correction in Asian equity markets combined to keep the market at its most volatile. In just seven trading sessions between May 12 and May 22, the Sensex had slid from 12,400 points to 9,827 points, losing 2,573 points or 20.75 per cent, shaving Rs 600,000 crore off the Bombay Stock Exchange's market capitalisation. On manic Monday alone, the Sensex collapsed by over 1,100 points. On the National Stock Exchange 345 shares hit lower circuits, while bellwether stocks like Reliance Industries, ITC and ONGC shed between 18 per cent to 20 per cent. For every stock that gained, 23 lost. The biggest fall ever-the Sensex plummeted by over 11 per cent between 10.30 a.m. and 11.56 a.m. on May 22-triggered an automatic cool-off shutdown of the bourses. That evening, at a dinner to mark the UPA Government's two years in office at the PM's residence, 7 Race Course Road, the FM had to virtually sing for his supper as journalists and ministerial colleagues interrupted his frugal meal for soundbites between bites.
The markets were not tumbling in India alone, but the severity here was the worst. Thanks to the rise in the US interest rates announced on May 12, the cost of taking risks also rose for global investors. Emerging equity markets slid on fears of a slowdown in overseas inflows as global investors borrow in the US to invest here. Asian markets tumbled between 10 and 20 per cent. In India, the slide that began on May 12 amid fears that FIIs, who own one-third of the market cap and control one-tenth of the daily trading volumes and have been the prime drivers of the rally in share prices since 2003, would leave. It became worse due to two systemic flaws: margin calls on brokers and the unwinding of the positions in the futures and options (F&O) segment of the stockmarkets. Both these features are not specific to India and work perfectly well in markets around the world. But they manage to create havoc here because a significant proportion of the daily trading comes from local day traders and arbitrageurs who over-leverage themselves by buying much more stock than they can afford.
The Indian markets have a sizeable chunk of such investors-who offer just a part of the cost of shares upfront in either cash or stocks (called margin)- and pay the rest when they take delivery of the stock bought. Every time the market slides, these investors have to either top up the cash portion or make good the loss of value of stocks offered as security. On May 22, the stock holdings that brokers sold off to pay up further depressed prices which triggered fresh rounds of demands for margins. But as prices crashed, the required margins rose at every stage as they are calibrated to the volatility levels.

FMSPEAK

Sensex at 7,000: July 2005 "If the Sensex crosses 8,000, then I think I would be concerned." Sensex at 8,000: Sept 2005 "The Sensex rise is not a cause for worry or concern. Stockmarket movement is orderly." Sensex at 9,000: Dec 2005 "SEBI and I are watching the movements carefully to see if there is any manipulation." FM to India Today, April 2006 "As long as there are systems to prevent scandal or manipulation, one should just let the market move by its own logic." In Rajya Sabha, May 23, 2006 "The fall worsened on Monday on the inability of highly -leveraged traders to meet margin calls within time."

Trading terminals of brokers are automatically shut until they pay the margins. With terminals shut down, many investors couldn't buy and in the absence of any buyer, the market collapsed like a pack of cards. "I wanted to buy shares on Monday but my broker refused to take the buy order," says Vipul Dave, a Mumbai-based investor. While the safety measure of the margin system prevented a payment crisis like the one in the Ketan Parekh scam in 2001, it also aggravated the slide. During the KP scam, many investors did not receive payments for the stocks they had sold and others didn't get the shares they had paid for as over-leveraged brokers defaulted on their commitments following the crash. The payment crisis-versus-higher volatility dilemma needs attention. "I will take this up at the next meeting of the SEBI board," said the finance ministry's nominee on the board, joint secretary K. P. Krishnan.

The second systemic issue that worsened the crash and has MOF officials worried is the impact of the huge outstanding positions in the F&O segment which have increased by 55 per cent over the past six months. On May 22, contracts were frantically unwound as falling share prices rendered them non-profitable. The unwinding of contracts further depressed stock prices.

"The government and the SEBI have lost control, the market is in the hands of manipulators." YASHWANT SINHA FORMER FINANCE MINISTER

"There is no cause for panic. There is no systemic issue in the May 22 fall." M. DAMODARAN CHAIRMAN, SEBI

"There are no signs of a systematic risk. May 22 saw a healthy correction. " Dominic price COUNTRY HEAD AND MD, J P MORGAN CHASE

Adding to the panic was rumour-mongering. In India anyone well connected with the media can trigger a rise or fall in the market with a piece of paper. A CBDT draft circular that allegedly discussed taxing of FIIs became the final straw on the Bull's back. "The intent of speculative reporting about the impact of the CBDT circular on the stockmarkets is being studied," Jha said at a hastily-convened press conference-the second within 50 hours.

The priority for mandarins at the MOF and SEBI is to determine the part played by day traders who haunt the F&O markets and to ascertain how a correction became so savage. Was someone trying to take advantage of the initial fall? What the MOF and SEBI need to worry about is the absence of any deterrence. No scamster since Harshad Mehta has been punished. Even companies who indulged in price manipulations have got stay orders on the SEBI diktat. For instance, the six overseas investors who allegedly exacerbated the 1,000-plus point fall on May 17, 2004 are yet to be punished. While SEBI had passed an order against those it thought were responsible, its verdict was over-ruled by the Securities Appelate Tribunal (SAT).
The markets will probably remain volatile till the odds on expectations are evened out. Chidambaram told the Rajya Sabha later that markets will go up and come down. True. But the cause cannot be rumours, rigging and rapacious leveraging by traders. Nor can the solution be a running commentary on the state of equity markets by babus. SEBI and MOF must weed out the systemic flaws, come hard on rumour mongering and establish the fear of law by setting examples. After all, the credibility of any market depends on the primary principle of equity.

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