Brokerages exit low-rung stocks

Top equity brokerage houses are either selling 'high-risk' small- and mid-cap stocks or asking clients to square off their derivatives positions built on them before the end of the financial year.

The brokers' move comes in the wake of avoiding a possible loss arising from these stocks, which they have taken as collateral from clients to extend margin funding.

Sources said non-banking financial companies (NBFCs) of brokerage outfits had extended loans to clients by availing of bank credit. They could face serious trouble if auditors 'qualify' their books for extending loans on small- and mid-cap stocks as 'highly risky'.

With just over a week to go before the end of the current financial year, most of the NBFCs are cleaning up their books before the audit to avoid being caught on the wrong foot and are only accepting frontline stocks for margin funding, for now.

As a consequence, both small- and mid-cap indices on the Bombay Stock Exchange (BSE) witnessed a free fall on Monday.

While the BSE Mid-Cap Index was down 2.66 per cent, the BSE Small-Cap Index fell 3.77 per cent, even as the Sensex rose over 1 per cent. Since January, both the indices crashed by 52 and 45 per cent respectively, while the benchmark Sensex fell by 26 per cent.

Margin funding is a loan that allows investors to take positions in the futures and options (F&O) segment by initially putting down only 30-50 per cent value of the contract, while the rest is financed by the broker.

The loans were extended to clients at an interest rate as high as 18-25 per cent through brokerages' NBFCs. These NBFCs, however, availed of loans from top banks and financial institutions at a much lower rate.

Most of the brokers also accepted stocks as collateral and every broking unit had its own list of exclusive stocks that would be accepted as collateral for margin funding.

This practice by brokerage firms pushed margin funding business to unparalleled levels and created a bubble-like situation in the market before the late-January crash by inducing investors to pay more for a stock than its fundamental value. It also opened up an avenue for stock price manipulation.

Since investors preferred to pledge cheap small- and mid-cap stocks as collateral to dabble in the risky F&O segment, promoters of some companies could get in touch with the broker to include their company's stock in the NBFCs' 'exclusive list of securities' accepted as collateral.

Consequently, huge buying would come on the particular counter, which was included into the NBFCs' collateral list, resulting in a sharp rise in the stock price.

Over the past one year, prices of some small- and mid-cap stocks, common in most brokerage houses-promoted NBFCs' list, shot up between 100 and 500 per cent in line with the margin funding business, estimated to be over Rs 10,000 crore before the crash.

Big names in margin funding include Motilal Oswal Securities, Kotak Securities, Indiabulls, Religare and Edelweiss Securities, among others. But it could not be verified whether all these firms were offloading small- and mid-cap stocks in a big way.

The market fall of over 6,000 points in this calendar year took a toll on the funding business and it declined by over 60 per cent, leaving a huge pile of bad debts for brokers.

Meanwhile, small- and mid-cap stocks continued to bear the burnt in the recent mayhem. Recently, BSE, as a damage-control exercise, lowered the circuit filters to 5 per cent from the existing 10-20 per cent for nearly 15 per cent or 235 stocks of the 1,900 actively traded 'B' group small- and mid-cap stocks to avoid a further steep fall.