More thoughts on the NBFC crisis

Resolving this crisis of confidence requires either more granular information or getting independent confirmation of asset quality

It has been two months since Infrastructure Leasing and Financial Services (IL&FS) first defaulted on its debt-market obligations. That default has thrown debt and money markets into turmoil and created a mini panic on some NBFCs (non banking financial companies), including housing finance companies. It has been a very tough period for NBFC stocks in particular and the equity markets in general.

What have we learned in the past two months? What is the way forward?

Firstly, the government superseding the board of IL&FS was probably the right response and it did manage to calm the situation. It gave IL&FS breathing room and hopefully allowed the preservation of asset value at the subsidiary level. However, the issue has also now acquired a political dimension because of the takeover. Government-owned institutions such as State Bank of India (SBI) and the Life Insurance Corporation of India (LIC) may now find it difficult to recapitalise IL&FS, and do not want to be seen as bailing out a private company. In the absence of a takeover they may have found it much easier to support a recap. In the absence of a recap the ultimate resolution may take much longer. Any politicisation of an economic issue of this magnitude is very dysfunctional.

It still remains unclear how much of a haircut IL&FS’ lenders need to absorb on their outstanding debt. Will lenders to the holding company get any recovery at all? Depends on whether the excess collateral at a specific subsidiary level will be allowed to be transferred upstream to the holding company or not. Will the lenders to the individual subsidiaries be allowed to firewall their exposures, and restrict their exposure to the specific project they have collateral against? In this case some lenders may have no haircut on their exposures and others could have very large hits of up to 50 per cent, depending on the specific project they have lent to and the quality of the collateral. There may be a move to club all the subsidiaries and give the lenders a uniform haircut, with excess collateral at one subsidiary being used to fund the deficit at another entity — basically, pooling of all the exposures. It will be fascinating to see which way this goes. It will be in a way setting a precedent, as to how a bankruptcy of this type is handled in all future cases. 

Illustration by Ajay Mohanty

The IL&FS case has made lending to holding companies a non-starter. The risks are simply too great. No one will want to be seen holding such exposures. The initial fears that the losses and markdowns on IL&FS paper would mark the end of debt and liquid mutual funds seem to have been too hasty. While there was a withdrawal of Rs2,000 billion from these funds in September, 25 per cent of these funds returned in October, as investors calmed down. I would expect more funds to slowly come back in the coming months, as there are few alternatives available to high-net worth investors and corporate treasurers. The more aggressive funds, who were trying to maximise yields by fully utilising all the permitted regulatory limits on NBFC paper have lost assets, while more conservative funds have gained. There also seems to have been some consolidation, with the larger, more-established fund houses gaining share from smaller rivals.

The short-term commercial paper markets have reopened for non-NBFC issuers, and even some of the best NBFC issuers are now hesitatingly coming back to issue fresh paper. After the initial shock, markets are now differentiating between NBFC issuers based on leverage and asset quality. However, undoubtedly the percentage of assets invested in NBFC paper will decline for all debt-market players, their investors will demand it. There are also likely to be regulatory changes on these lines. While things are normalising in the short end, longer-tenure debt is still very difficult for NBFC’s to access. Healing at the long end will take time. The infusion of liquidity by the Reserve Bank of India (RBI) has definitely helped the normalisation, and this will need to continue.

There was a very large bunching of short-term debt repayments in the months of October and November. The October debt cliff has been navigated successfully, with no defaults. It is likely that even November will be seen through, after which the next big test is March 2019. The liquidity concerns seem to have been addressed. The NBFC majors have been able to roll over or repay their obligations. They have passed this stress test. The worst case fears of the market of there being a liquidity crisis have thankfully not come to pass. However, all NBFCs will henceforth need to keep larger liquidity buffers. The market and rating agencies will demand it. They will also need to be more conservative vis-à-vis asset liability mismatches. One should also expect regulatory intervention on defining what constitutes an acceptable asset-liability mismatch (ALM). All of this will impact profitability. ALM and gearing, two levers to optimise return on equity are both going to be constrained going forward. 

Taking a step back, this was never going to be a Lehman type solvency crisis for India. The housing finance companies have leverage ratios of 7-8, and the other major NBFCs have leverage ratios of between 4 and 6. This is not Lehman, wherein the banks had leverage ratios of 20-30, and were dealing in complex derivatives. On asset quality, fears remain over real estate developer exposure. Given the lack of granular detail available, markets fear the quantum of exposure, the extent of mark downs and who has this exposure. Given the inter-linkages in the financial system, these fears are infecting the perception of all wholesale-oriented NBFCs. There is a general lack of confidence on real estate exposures, and a strong perception that there was ever-greening of loans and a movement of troubled exposures from one balance sheet to another to prevent non-performing assets (NPAs) surfacing. With deleveraging of balance sheets, this ever-greening and shifting of exposures will end. We are fighting perceptions and whispers here. The only way for the wholesale NBFCs to regain market confidence is to provide more granular details on their developer exposures. An alternative would be for the Regulators to conduct a stress test of the asset quality of the major players in this space. This would stop the rumours. Markets need assurance that there is no time bomb sitting in the books of one or two of the larger NBFCs with significant real estate exposure. The rating agencies have lost all credibility. We need someone else to give us an independent stamp of approval on asset quality. NBFCs have grown their developer exposures by more than 50 per cent over the past two years, and while the total real estate exposure of Rs5 trillion cannot blow up the system, it can severely damage the balance sheets of one or two players. Given a general lack of understanding of the real estate lending business model, and anecdotal evidence that high-end property is not selling, investors fear the worst.

This is a crisis of confidence. You can only boost confidence by giving more granular information or getting external independent confirmation of your asset quality. Otherwise time will heal, and the fears and rumours will slowly dissipate but in the interim certain more wholesale NBFC business models could really suffer. Can they profitably thrive in an environment where they cannot raise even three-year paper at competitive rates?

The writer is with Amansa Capital. Views are personal