Between the devil and the deep blue sea

When the reticent Ravi Parthasarathy suddenly resigned on July 21 as the non-executive chairman of Infrastructure Leasing & Financial Services (IL&FS), the holding company of the IL&FS group, which he served for over 30 years, no one quite expected the IIM-A alumnus to set off a financial tsunami over the coming months.

After first defaulting on inter-corporate deposits and commercial paper (CP) worth about Rs.4.5 billion in June, the term lending infra lender saw its long-term ratings being downgraded. The final straw that broke the lender’s back was placed on September 4, when the institution and its subsidiary defaulted on a short-term loan of Rs.1.5 billion from the Sidbi, prompting the institution to sack its chief general manager in charge of risk management.

As it turns out, the infra financing behemoth, with 169 arms, including 24 direct and 135 indirect subsidiaries, is now grappling with a debt of Rs.910 billion, of which Rs.680 billion is secured and Rs.230 billion is unsecured. The term institution, which claims to have assets of Rs.1.65 trillion, had used its short-term borrowings, worth Rs.250 billion, to fund long-term projects which weren’t fetching any revenue and, eventually, with rising cost of capital and projects taking longer to get off the ground, the institution collapsed like a house of cards. With around Rs.160 billion stuck in claims and termination payments, the writing on the wall was only getting clearer.

The entire board has been sacked and the Serious Fraud Investigation Office is investigating irregularities. The government is trying its best to soothe nerves of the financial system, but the damage has already been done. NBFCs, the seemingly peaceful island of growth in the financial sector, are suddenly in the throes of a liquidity crisis. Jayanth Varma, professor of finance at IIM-A, believes that the problem was waiting to happen. “Infrastructure projects in the country haven’t done well partly because of the problem in the real economy and partly because the financial sector lent out loans which shouldn’t have been given out in the first place.”

In fact, according to media reports, the Singapore-based distressed debt analytics firm, Redd Intelligence, has estimated that the bankrupt financier would require an equity infusion of up to Rs.300 billion if it has to write-off Rs.150 billion as impairment losses on loans given to subsidiaries, including IL&FS Transportation, which has 28 road projects under the build-operate-transfer (BOT) model, of which 21 are operational and the remaining under construction. In fact, since 2015, the subsidiary hasn’t participated in a single BOT project. Varma feels most of these projects may not be viable: “A lot of roads have been built but they have become economically unviable as the anticipated revenue is not materialising.”

Under a new board helmed by Uday Kotak, major stakeholders, including LIC, Orix Corporation, and Abu Dhabi Investment Authority, are trying to salvage the situation by selling assets and by raising fresh capital. However, a contagion has gripped NBFCs across debt and equity markets. With mutual funds holding close to Rs.30 billion of IL&FS debt, the crash was accentuated when DSP Mutual Fund sold Rs.3 billion worth of AAA-rated commercial paper (CP) of Dewan Housing Finance (DHFL) at a steep yield of 11%, triggering a panic in the system. Since September 24, the freefall has wiped out Rs.1,019 billion in market cap of leading NBFCs in 28 sessions. That’s a complete turnaround in the fortunes of a sector that was just till recently seen as the next best alternative to beleaguered banks.

As good as it gets

A confluence of factors over the past five years helped NBFCs come into their own. Prashant Jain, executive director and chief investment officer at HDFC Mutual Fund, explains: “Over the past 4-5 years, liquidity was good because fiscal deficit was reducing and private sector capex was weak. Low rates resulted in NBFCs borrowing significantly from wholesale market, mutual funds, banks, etc and lending it primarily for retail loans. Today, retail debt to GDP has gone up from about 12% in FY12 to almost 18%. NBFCs grew fast, led by retail loans.”

In the three years to FY17, nearly Rs.4 trillion had flown into Indian bond and liquid funds, which meant that wholesale borrowing rates fell to as low as around 6-7% till mid-2017. This cheap money bolstered the confidence of NBFCs. Even as bank lending slowed down, NBFCs emerged as the new czars in the credit market as they rapidly increased their market share between FY13 and FY18 (See: Bingeing on cheap money). “It was a virtuous cycle as the numbers kept growing for NBFCs, so did cheap credit,” points out Saurabh Mukherjea, founder, Marcellus Investment Managers.

The mesmerising growth tripled the market cap of top NBFCs from Rs.3,058.99 billion in FY14 to Rs.9,214.32 billion in FY18. The number of HFCs, too, went up from around 50 in FY13 to about 100. The market frenzy also resulted in NBFCs of different hue and size going public. Over the past five years, 12 NBFCs, including the likes of PNB Housing Finance, HUDCO, Credit Access Grameen and Aavas Financiers, went public. Krishnan Sitaraman, senior director, Crisil, points out: “Of the Rs.400 billion capital raised by NBFCs over the past five years, Rs.200 billion came in the previous fiscal (FY18).”

As the NBFCs’ loan book swelled, valuations rocketed, especially over the past two years. Stocks of Can Fin, Shriram Transport Finance, Gruh Finance, and Mahindra & Mahindra Financial Services doubled after the rally, which started in January 2016 and lasted till January 2018. In fact, DHFL’s stock, which has corrected nearly 70% from its peak, tripled during this period. Even GIC Housing Finance, moved from Rs.236 in January 2016 to Rs.466 in January 2018. The valuations (trailing 12-month) of most NBFCs, especially housing finance companies, reached a peak at the start of the year. While investors paid a premium for NBFCs, public sector banks such as SBI, OBC and UBI were trading at 1.15x, 0.56x and 0.48x book at end-FY18, largely because of their NPA-riddled books.

Crunch hour

Interestingly, the flow of cheap money changed the funding mix of NBFCs over the decade and readjustment became more pronounced during the past five years. From 37% in FY08, bank funding was down to 23% by end of FY18, while market borrowing went up from 48% to 56% (See: Mix and match). According to Nomura Research, 40% of MFs’ incremental funding went to NBFCs. Around 21% of NBFCs’ market borrowings comprised CP and short-maturity non-convertible debentures (NCDs), with MFs picking up 97% of the CP and 78% of NCD issuances since March 2017. Pankaj Agarwal of Ambit Capital points out the reason, “NBFCs were borrowing very short because the 100 basis points differential between six-month and three-year money could be used to maximise margins.” Agrees SBI chairman, Rajnish Kumar, “Some NBFCs grew without paying attention to how they will fund their growth. They went for short-term funding which was cheaper and mutual funds, too, bought in as lot of money was flowing into AMCs.”

However, funding long-term assets with short-term borrowing leads to an asset-liability mismatch. That’s precisely what happened when the RBI, after leaving interest rates untouched for an extended period, started increasing the benchmark repo rate since June 2018, citing risks due to higher oil prices. While the cumulative repo rate increase has been 50 basis points, the 10-year yield had hardened by 100 basis points since the start of the current financial year on worries of a higher fiscal deficit. Accentuating the spike was the fact that FIIs worried about the worsening macro, have pulled out Rs.603 billion from the debt market year-till-date. 

For housing finance companies such as Indiabulls Housing Finance and PNB Housing Finance, short-term borrowing accounted for 26% and 28% of the overall borrowing in FY18. DHFL, which faced the sharpest correction, had short-term borrowing of 11% out of the overall borrowing. But its asset-liability mismatch is wider as its liabilities up to six months are 17% of total liabilities against 11% of its assets maturing in six months. 

The market borrowing of these players is around 40% to 50% of their overall borrowing. DHFL’s dependence on debt market was around 40% in FY18. Even LIC Housing Finance raised 79% of its funds from non-convertible debentures. 

The market borrowing for NBFCs has risen from Rs.6.4 trillion in FY13 to Rs.12.3 trillion in FY18. Owing to a rise in the 10-year bond yield, the cost of funding increased across NBFCs. “Chola, Shriram Transport Finance, IIFL, Shriram City Union Finance, Mahindra & Mahindra Finance and Aditya Birla Capital have seen bond coupons increase by 130-160 basis points over the past 12 months, whereas HFCs like LIC HF and HDFC have seen an increase to the tune of 30-60 basis points. Indiabulls HF, aided by rating upgrade in FY18, witnessed its coupon rate increasing by 90 basis points over a similar time frame,” states a Credit Suisse report.

Mukherjea mentions that the over 200 basis points jump in wholesale market rates has now put a spanner in the works for NBFCs. The IL&FS default has also resulted in the once benevolent MFs turning a bit wary of short-term lending. But, more importantly, it is going overboard in lending to the real estate sector that might end up haunting NBFCs the most. 

Concrete problem

With the banking sector grappling with its biggest bad-loan mess, bank lending to the real-estate sector has plummeted from 68% in FY13 to 17% in FY18. Already reeling under the 2008 crisis, the real estate market was further hit by demonetisation in November 2016, followed by the introduction of the Real Estate Regulatory Act (RERA) and the Goods and Services Tax. Importantly, since RERA meant that builders had to complete projects on time to avoid penalties, NBFCs saw an opportunity to make the most of the funding squeeze. Unlike banks loans, which cost 11%-13%, NBFCs charge significantly higher interest rates of 18%-21%.

According to a report by Ambit Capital, based on data from analytics firm Propstack, the total exposure of lenders to developer financing is Rs.4 trillion, with banks having an exposure of Rs.1.8 trillion and NBFCs and housing finance companies holding the rest. “Yields on loans show NBFCs/HFCs have significantly riskier real-estate loan books than banks,” Agarwal of Ambit states in the report. NBFCs/HFCs have placed riskier bets because 63% of the loans have originated over the last 21 months with the highest exposure (52%) to lower-rated developers and concentrated loan portfolio with top ten borrowers accounting for 43% of loans.

“Lenders such as Piramal Capital, L&T Finance, PNB Housing, Indiabulls Housing, Yes Bank and JM Financial seem to have the riskiest loan portfolios,” says Agarwal (See: Towering problem). Piramal Capital and JM Financial are running huge asset-liability mismatches of two years, and rising bond yields can impact their margins further and their asset quality, the report added.

Rajesh Saluja, CEO, ASK Wealth Advisors, which runs a PE real-estate fund, points out NBFCs weaned away developers over the past two-three years by offering aggressive lending rates. “A lot of NBFCs courted developers by asking them to stay away from PE funds and offered cheaper rates of 16-17%, since everyone wanted to grow their books in a competitive market. But in doing so they ended up lending to a lot of poor quality developers.”

According to Agarwal, while L&T Finance and Yes Bank have 100% exposure to developers rated BB and below, PNB Housing has more than 90% of exposure to these lower-rated developers. Lenders such as City Union Bank, Edelweiss and IIFL have little or no exposure to lower-rated developers. Edelweiss and Aditya Birla Finance did not comment on queries sent by Outlook Business. Nirmal Jain, chairman of IIFL, believes there is a bit of over-reaction. “Right now it’s all speculation and rumour mongering and that’s getting exaggerated by the fall of NBFC stocks.”

Raja Seetharaman, director and co-founder of Propstack, concurs with the Ambit’s findings. “NBFCs were lending to developers and expecting sales to take off but, over the past six months, there have been hardly any sales.” That would be bad news considering that unsold inventory in the National Capital Region (NCR) is around 167,000 units, which will take 52 months to be sold, while Mumbai’s inventory is pegged at 116,000 units and is expected to be sold in nearly two years.

Developers were looking at the onset of the festive season to change their fortunes but that hasn’t happened. As per media reports, only 25 units were sold in Mumbai on Dussehra. Commenting on the sale, Seetharaman says, “Even if the number had been 400, it’s just too low and indicates huge stress in the system. If the question is whether some NBFCs could go belly up, I fear the answer is yes.” Trouble is already brewing with the first default reported on October 10 from Supertech, which missed its payments to two state-run banks owing to cashflow mismatch. According to Macquarie Research, Indiabulls Housing’s loans to SuperTech could be more than Rs.5 billion.

Similarly, Piramal Enterprises (PEL), whose subsidiary Piramal Capital & Housing Finance provides early stage PE, structured debt, construction finance, rental discounting and housing finance, has seen its stock price fall from 3,300 (August 31) to 1,890 (October 19). On October 21, PEL issued a statement denying any defaults on its real-estate exposure. Ironically, in September 2015, the buzz was that Piramal wanted to buy a stake in IL&FS at Rs.750 a share but was thwarted as LIC was keen on a valuation of Rs.1,150 a share. Chairman Ajay Piramal in an earlier interview had dismissed concerns about stress in his lending portfolio. “We have been the most conservative…real estate is still about 35-40% of our book. Our strategy right from the beginning has been to go only for the A class developers. They are not likely to default easily and this has been borne out by the fact that after RERA, these are the only companies which have survived.” Importantly, PEL had recently raised Rs.70 billion through a qualified institutional placement (QIP) and a rights issue, besides the group has around Rs.200 billion in equity in its financial services business.

According to Ambit, a significant (15-65%) part of HFC loans are for under-construction properties. In other words, a developer’s inability to complete the project could lead to bad loans rising in the segment. Anuj Puri, chairman and country head, Anarock, believes NBFCs’ exposure to under-construction lending could be closer to 50%. Though the asset cover for developer loans is, usually, 2.5-3x of the loan amount, the question is what happens if the project is stuck midway. “Despite the high cover, what will an NBFC do with a half-built structure in the event of a default, as buyers won’t invest in it even if prices were to be slashed by 50%,” points out Puri. Unlike Piramal group, which is also a real-estate developer, most HFCs don’t have the advantage. “In that sense, groups such as Piramal are better off than the NBFCs,” adds Puri.

However, Saluja believes while Piramal may not feel the pangs of leverage, equity does come at a cost. “There is a cost of capital, and also taking over a project, not to mention the possibility of litigation, and ensuring you are able to sell at the desired price is far from easy. You will have to contend with lower IRR and that’s not exactly a happy outcome for any investor.”

ASK, which has lent over Rs.15 billion to developers across Mumbai, Pune, Bengaluru and NCR, has still a drawdown option of an equal amount. “We did not just lend against some collateral. We have tracked end-use of money by jointly signing cheques from an escrow account and ensuring that the money is used only for the project that it has been lent for,” adds Saluja, who believes some NBFCs in their enthusiasm catered to developers who were an “ICU case.”

Even as pure-play HFCs are grappling with a crisis, the SME portfolios of NBFCs don’t appear to be safe either. As of September 2017, the assets under management of the top 10 asset financiers, which represent 70% of the NBFC universe, stood at Rs.3.3 trillion. In this, SME loans and loan against property constituted 8% each. One of the bigger worries is that, again in the case of these loans, the collateral is largely land and properties. Uday Kotak, managing director of Kotak Mahindra Bank, had in the bank’s first quarter earnings call in July raised concerns over such lending. “When you are going out to actually realise value on these collaterals, the collateral realisation is a fraction of what these valuers have given,” mentioned Kotak.

The insight from Kotak came when the bank following its merger with ING Vysya started looking closely at the fundamental valuation of its secured assets. As per RBI valuers, fixed-asset valuations are valid for three years. In some stressed accounts, between what was the valuation report and what the bank could sell, Kotak revealed that the number was not 20%-30% lower, but 50%-70% lower. He put the issue rather succinctly: “The trouble is, on the one hand, you price secured assets loan at a more attractive rate and then if it is effectively unsecured and a lot of your core lending and comfort comes out of security, then we are burning our boats on both ends. Neither are we getting the spread of a unsecured loan nor are we getting the real value of the security we are supposed to have.” It is a cause for concern as Kotak believes the issue of collateral and fair valuation permeates across several categories of secured loans.

Throwing a lifeline

Even as the situation appears to be grim, the RBI in its financial stability report early this year had ruled out a crisis, given the sector’s improving financial profile. While 11,402 NBFCs are operating in the country, it’s the top 400 NBFCs, primarily backed by banks and finance companies, which control 90% of the sector’s AUM. NBFCs are required to maintain a minimum capital level comprising Tier-I and Tier-II capital of not less than 15% of their aggregate risk-weighted assets. Incidentally, NBFCs’ CAR (or capital adequacy ratio) increased from 22% in FY17 to 22.9% in FY18 (See: All in the past). However, there was deceleration in share capital growth of NBFCs, whereas borrowings grew at 19%, implying rising leverage as the aggregate balance sheet size of the sector grew to Rs.22 trillion in FY18. Not surprising that NBFCs were the largest net borrowers in the financial system with gross payables of around Rs.7,170 billion and gross receivables of around Rs.419 billion in FY18.

According to a Credit Suisse report, 41% of NBFCs’ borrowings are maturing in the next six months and any liquidity pressure would increase the refinancing risk of these instruments. Analyst Ashish Gupta estimates MFs own 60% of NBFCs’ commercial paper issuance, which could worsen pain as redemption pressure at funds could cause yields of NBFC debt to spike further. Bond dealers expect the liquidity deficit to touch Rs.3 trillion by March 2019 from Rs.1.5 trillion, thus pushing rates higher.

Of the total Rs.12.3 trillion AUM of debt MFs, around 12% is invested in papers of HFCs and 5.32% is invested with NBFCs. As of FY18, overall MFs debt exposure stood as high as 26% towards NBFCs and 19% to HFCs (See: Debt attraction). At a post-policy interaction with the media in October, Viral Acharya, deputy governor, RBI, urged NBFCs to raise equity and long-term debt instead of relying on short-term funds. “Chasing lower marginal cost of funding in order to retain or acquire market share in lending is a myopic strategy,” said Acharya, even as the central bank has said it is looking at strengthening ALM guidelines to avoid any rollover risk. Jain of IIFL agrees, “What NBFCs have to do is to raise long-term resources and not short-term CPs.” To ease liquidity concerns, the National Housing Bank and SBI have been roped in to provide Rs.510 billion of refinancing. SBI’s Kumar says that Rs.450 billion has been earmarked for this fiscal. “While we are largely looking to refinance priority loans we are also open to buying non-priority sector loans comprising HFCs and SMEs.”

Besides, the RBI has allowed banks to consider higher lending to NBFCs, equivalent to excess government bonds that they own, for meeting the liquidity coverage ratio and also lend up to 15% of their capital, from the earlier 10%, to a single non-infrastructure funding NBFC. The move is expected to release up to Rs.500 billion of additional funding for the sector.

However, Varma is not in favour of the move. He believes providing liquidity to solvent banks in a crisis makes sense, but providing liquidity to debt mutual funds is a bad idea because it simply allows rich, better informed investors to steal from less informed co-investors. Consider this: of the over Rs.12.3 trillion debt AUM, institutional investors account for Rs.11.5 trillion. When mutual fund investors redeem their units at an inflated NAV, Varma feels they simply steal money from their co-investors. “This adjacency risk or co-investor risk comes to the fore every now and then, when heightened default risk makes bond prices volatile and unreliable. We must force mutual funds to mark down their bonds so that their NAVs are fair and correct.” 

Living with the times

For now, the regulator has not sounded the alarm bell as its stress tests of NBFCs’ portfolio for the year ended March 2018 have not thrown up any nasty surprises. The test was done under three scenarios with the first showing gross NPA increasing by 0.5, 1 and 3 standard deviation. In the first scenario, the sector’s CAR showed a decline from 22.9% to 21.6%, in the second scenario, it fell to 21.3%, and in the third, to 20.4%. However, the central bank has revealed that some individual NBFCs could end up facing a capital squeeze. Under first two scenarios, around 8% NBFCs will not be able to comply with the minimum regulatory capital requirements of 15%, while under the third scenario, 10% would fail to meet the minimum CAR norm. As on date, as per the RBI, bad loans of the NBFC sector stand at 3.5%.

Though in September, liquid fund outflows totalled Rs.2.11 trillion, a lot of NBFCs have raised money this fiscal with retail bond issuance touching Rs.290 billion against Rs.50 billion for the whole of last year. But the money is not coming cheap. Tata Capital Financial Services raised Rs.33.73 billion via a non-convertible debenture at coupon rates between 8.7% and 9.1%, Shriram Transport Finance is looking to raise Rs.13.5 billion through NCDs at annual coupons of 9.40% for three years. Some stressed NBFCs such as Indiabulls have been forced to raise mortgage loan rates by 200 bps to 14.90%, a clear indication that good old days of non-banks are over.

Ambit’s Agarwal believes non-banks won’t be able to maintain high margins that they reported over the past five years. “The market perception about NBFCs has changed. Investors have realised that if there is an asset-liability mismatch (ALM) and there is liquidity issue, the business model will come under pressure,” says Agarwal.

With the end of the golden run and sharp correction in stocks, NBFC valuations are expected to contract to pre-FY14 levels by the end of FY19. Despite the recent carnage, some top NBFCs are still trading at a one-year forward price-to-book of 2.1x-8.1x compared with public sector banks which are available at 1.20x-1.26x. However, this is far from a buying opportunity as NBFCs going ahead will see lower growth, lower gearing and eventually lower RoE. “NBFCs’ growth rates should moderate as banks’ exposure to NBFCs is already high and they will have to correct the asset-liabilities mismatch,” says Jain of HDFC MF. Analysts believe eventually sustainable RoE will come down from 18-20% to 15-17%, if there are tougher restrictions on ALM management, curbs on short-term funding and higher equity requirement. 

Kumar of SBI believes that though the timing for the central bank to put in place ALM guidelines is ripe, the NBFC industry has to be given time for transition. In a rising rate environment, investors expect bargaining power to shift in favour of large banks, which have relatively higher retail funding base. “Given that CASA deposits don’t re-price, loan growth acceleration at these banks will be accompanied by rising spreads,” states a Morgan Stanley report (See: Changing equation). Kumar, too, believes that banks will have the upper hand. “NBFCs inability to leverage will dampen growth and this, in turn, will mean less competition in the market.”

Though the RBI is doing its best to prevent a contagion from spreading in the non-banking finance sector, given it accounts for 12% of outstanding bank credit, Varma believes since NBFCs per se are designed to take on riskier businesses, they should be allowed to fail. “The regulatory oversight on banks is higher because they are not supposed to fail and if they do, they are bailed out. But that’s not the case with NBFCs.” But given that elections are round the corner, the incumbent government will do all it can to prevent a blow-up in the sector. However, unlike the previous crises of NBFCs in 1990s and 2000s, when the banking sector was in much better shape, this time around that doesn’t seem to be the case.