Financial market turmoil
The IL&FS crisis has been badly managed. There seems to have been a systemic breakdown of accountability and governance
The Indian financial markets are in a state of turmoil at the moment, with issuers and investors in both debt and equity under pressure. The immediate cause of this stress is the IL&FS debt default. IL&FS is one of India’s largest financial conglomerates and infrastructure developers with a large NBFC, and infrastructure assets across power, roads and renewables. It has a marquee shareholder base, with LIC, SBI, HDFC, ADIA and Orix of Japan it’s largest shareholders. The company and its subsidiaries have more than ~900 billion of debt outstanding, but were till recently
AA+ rated and large issuers of bonds, commercial papers (CPs) and intercorporate deposits.
In the month of September, the conglomerate has defaulted across multiple instruments, issued to various counter parties.
The problems and contagion these defaults are causing is the source of the current financial market stress.
First, how can an issuer rated AA+ go into a default rating in 10 days? What were the rating agencies doing? I have heard of name-based lending, but name-based ratings? Given the credibility of this rating, the obvious concern among debt investors is who is the next such whale? Are there other large, complex financial entities and NBFCs where the rating, based more on the name than numbers, is suspect? Having been burnt once, debt investors are now in the risk-aversion mode. This creates a ripe environment for fear and rumour mongering. Any whispers of XYZ in trouble and immediately, investors, facing career risk, jump to exit all assets of this issuer at literally any price. Investors, many of whom have based their decisions on the ratings rather than common sense judgement and simple financial analysis, are being held hostage by their emotions and fear of their investment committees.
Second, mutual funds own almost ~50 billion of IL&FS bonds. These bonds will have to be severely marked down. The funds will have to take the hit on their net asset value (NAV). Not knowing who has how much IL&FS paper, marked at what price, investors are redeeming their funds, hoping to avoid the NAV hit. These debt funds, fearing redemptions are being forced to raise cash. Like midcap equities, Indian corporate bonds, in times of stress, are very illiquid. Who will buy and at what price? Everyone is on one side of this trade. This is creating price and yield dislocations. NBFC paper is in the eye of the storm, since NBFCs have been the most extensive issuers of bonds in the last few years, everybody has their paper, and where naturally balance sheet leverage is the maximum. Most of the money in debt funds is from corporates and high net worth investors. They are not used to seeing losses. If they redeem in mass, we have a real problem. If mutual funds will not buy NBFC papers, then who will? There is a risk that some financial entities will have issues rolling over their maturing obligations. If you cannot roll over your bonds/CP, then any institution will have severe liquidity challenges.
The equity markets are killing NBFC stocks, as their growth and profit assumptions, underlying the high valuations, are now in question. Most NBFCs will need at a minimum to slow down their growth. If they cannot fully fund in the debt markets, bank lines can only make up part of the gap. At a minimum, their cost of funds has risen by 125-150 basis points, leading to margin pressure. High multiple stocks are very sensitive to growth and margin assumptions. Any negative revision in either is corrosive for multiples. Markets no longer believe that most NBFCs can grow for years at 30 per cent-plus and sustain current ROA’s (return on assets), hence the multiple resets.
This has systemic issues as well. We all know the state of the PSU banks and their inability to lend. It was believed that private banks and NBFCs would fill the gap. Just when the underlying economy is picking up and credit demand is accelerating, these shocks have hit the system. If NBFCs have to slow their lending, can the remaining handful of private banks make up the difference? This looks difficult. This assessment is why many sectors where consumer credit is critical to growth like automobiles and housing have also come under equity market pressure.
Indian macro conditions have been under pressure this year as it is. Surging oil prices, rising current account deficit (CAD), weakening rupee, deteriorating fiscal and rising rates have all pressured the macro. Now, this bout of risk aversion in debt markets puts further pressure. If not stabilised soon, we may see consequences on the country’s growth rates. What needs to be done?
The RBI has to inject liquidity in size and quickly. They have already begun the process. The debt market seizing up has very adverse consequences for liquidity, which has to be countered, in force and quickly.
Liquidity lines and repo facilities have to be set up for the debt mutual funds. We cannot allow forced selling at panic prices. Panic selling will force other funds to also mark down their bonds, showing paper losses, creating more redemptions, more selling and we will spiral into a negative feedback loop.
Those entities where yields have blown out due to lack of confidence, we need to see confidence building measures — either compulsory: Immediate RBI audits to check the books and give a clean chit or very granular disclosures on both asset quality and liability profiles. These entities need to make special efforts to attract the most respected debt market investors into their paper at whatever cost. I call them lead steer investors. Others look towards these investors in times of stress, to provide leadership and direction. If they come in, the taint around your paper is removed. Much like a Buffet investing in Goldman Sachs (GS) in the depths of the Global Financial Crisis. It was a very expensive deal for GS but it stemmed the rot and brought confidence. Fresh equity issuance and lowering of leverage may also help to rebuild market confidence in these entities. For any financial institution, it is ultimately all about confidence. Without it, you have no future.
This crisis has been badly managed. With the shareholders that IL&FS has, how was it allowed to default? If they are willing to inject equity now, why wait till default? How was it allowed to build the leverage and ALM mismatch? What were the shareholders doing at the board? Even a cursory reading of the consolidated accounts indicates stress. How were the rating committees justifying an AA+ rating? There seems to have been a systemic breakdown of accountability and governance. More on this in a future article.