At the moment, the temptation to be like an ostrich and bury your head in the sand till the storm gets over is extremely strong, says a wealth manager with a leading multinational bank. And this is not without reason.

At the beginning of the year, his clients were upbeat and would call him up to seek advice on which areas to place their monies. Now, they keep hounding him, some panic-stricken, threatening to pull out their funds. The spate of bad news does not just seem to abate.

Last week, the Institute of Chartered Accountants of India (ICAI) announced that companies will have to report and provide for losses incurred on their derivatives portfolio with immediate effect. The rules that were to be applied two years later were preponed. And, many companies could well have to take losses on their books and see their share prices taking a beating.

While things remain uncertain yet, it is estimated that the extent of losses can actuallybe significant. Experts reckon that the losses could be in the range of $1 billion to $5billion. If it is on the higher side, Rs 20,000 crore or 7% of the estimated annual net profit, around 3,000 large companies will be wiped off.

Party pooped

The party which lasted for 15 quarters, where sustained growth in earnings was reported, can actually be pooped. And the writing was on the wall. Reporting such phenomenal numbers on a sustained basis was always a difficult task. ?The old tenet of economics that super-normal profits don?t last, equilibrium has to be met is being realised,? says an investment banker, not wanting to be named.

He is not without reason. Numbers for the third quarter of FY08 show that other income for companies (sample 3,000) had grown by 62% over the previous quarter and this had contributed significantly to the 30% growth in net profit reported by India Inc. In fact, other income, which constitutes earnings from non-core activities like trading gains, was around 38% of the profit before tax ? the highest ever in the last 15 quarters.

So when corporates were pulling wool over investor?s eyes, they themselves were getting gypped, reckons a senior executive with a leading audit firm. Normally, companies with a foreign exchange exposure would take a simple forward cover, pay the charge for the cover and then insure against adverse foreign exchange movements.

For the importer, an appreciation would be adverse and an appreciation for the exporter.

Enter exotic derivatives offered by banks. So, a company wanting to cover its $100 million exposure, could take $500 million bets through cross currency movements.

These financially-engineered products, developed by rocket scientists, worked well initially. A lot of money was made and then when the yen and franc market turned the other side, bets turned wrong.

A research report by Morgan Stanley suggests that exposure to exotic derivatives by Indian banks and branches of foreign banks in India tripled in December 2007, when compared with the figures in the same month of the previous year.

The impact

Normally, these contracts could have been extended or reworked so that when the markets normalised at a later date, some of the losses could be recouped. But then the ICAI ruling to have these losses accounted for with immediate effect will hurt. Already, companies like Hexaware Technologies, Amtek Auto and even the biggie Larsen & Toubro have come out inthe open and spoken about the extent of possible losses. ?Many more skeletons will tumble out,? says Devendra Nevgi, CEO of Quantum Asset Management.

An SSKI research report suggests that around 70% of exotic derivatives exposure has been taken by large corporates, and the extent of exposure of small and medium enterprises is around 20-25%. This clearly means that mid-cap segment on the stock market is going to be extremely vulnerable.

?The larger companies will be able to take on the impact and the numbers will not be significantly lower. But the mid-cap companies will be shaken,? says TS Harihar, head of derivatives research with Karvy Securities. The divide between the large and the mid-cap segment will definitely widen, he adds.

Here the segment that is likely to suffer the most is the mid-range IT sector which has strong exposure.

Already, this segment has been taking a hit due to the US slowdown and the possibility of its effects rubbing off on other markets.

Commodity-based companies like those in the metals and chemicals business usually take smart bets on currency and commodity movements. While earlier most of these were genuine hedges, many have turned to these as a source of profits. These would be the ones that could get hit the most. Textile and jewellery players are also amongst those who are like to report derivative losses this quarter.

For the banks, this could be a triple whammy, if there was one. Their own exposure to the derivatives or sub-prime assets will have to be marked to market and ICICI Bank has already mentioned of a Rs 260 crore loss on this account. There are others like SBI, BoI and Axis Bank which too will have an impact, albeit a lower one.

Normally, banks would have no reason to worry about corporate derivative exposure going bad. They have risk management systems and regulations in place that require them to have a square position in the market, to take care of any movement in the market.

However, now the corporates have started taking an aggressive stance against banks alleging that the banks have duped them into buying exotic derivatives, something that they did not understand. Banks could then get into a big legal mess. ?The market risk could also turn into a credit risk if there are defaults. And this is more dangerous,? says Nevgi.

And then there is the overall impact of falling capital markets. Banks have been gaining on account of their exposure to the capital markets. For some private sector banks, this accounts for 10-20% of their profit before tax. With the capital markets tanking, this could be curbed in the fourth quarter. And with the inflation raising its ugly head, the bond portfolio will also see substantial erosion. The effect of which, however, will not be felt in FY08. The banking sector is one which will remain tensed in the current year, reckon analysts.

What now

There are chances that the ICAI ruling will be reworked. ?After all, the government would not want a major embarrassment in the election year. There will be some intervention,? says a chartered accountant.

Then there are chances that not many would work out some arrangement with banks and restructure their obligations.

?Banks also don?t want bad books at this stage?, he adds.

?I think that there will be a lot of companies reporting derivative losses this quarter.

They will bank on the fact that there is a gloomy sentiment all around and the impact of reporting these losses might not be as bad,? says Harihar. Many would just want to get over this and move on, he adds.

Investors now have to be extremely careful now. There could be some good companies that have been trapped in this derivative tangle and while there could be losses, the long-term prospects remain bright. It would be unwise to shun such companies off the portfolio, reckon advisors.

At the same time, the silver lining is that the companies will have a better balance sheet. The ICAI move will only enhance the transparency that investors require and should be seen as a positive one, reckon experts.

It also reinforces the age-old investment practice of conducting self due-diligence and questioning the decision to invest in companies that have a high amount of other income. Some companies, like Hindalco, Tata Steel or even a Bajaj Auto might have a substantial component of other income. And this is because they also have huge investment portfolios. Also, certain business income streams, for example, earnings from income selling scrap a byproduct for a steel maker, are qualified as other income. They are not from equity or derivatives trading.

However, companies that keep shoring up earnings based on non-core activity related trading gains should be shunned. It is at times such as these that old lessons are revisited. India Inc remains on the growth track and after taking a breather and a clean-up, it would resume its journey.