Some food for thought
"It's not that I'm so smart, it's just that I stay with problems
longer."
—Albert Einstein (German Physicist, 1879-1955)
Word for the day
Vulgarian (n)
A vulgar person, especially one whose vulgarity is more
conspicuous because of wealth or prominence.
First random thought this morning
#MeToo campaign has reached Indian shores and is dominating the
media headlines these days. Some women have decided to speak against the men who
have misused their position and exploited them.
I am confident that this movement will certainly provide courage
to many women who are being exploited. This will also instill some sense of
fear amongst the lechers prowling on these unsuspecting women.
From my small corporate life, I have seen the ugliest side of
this phenomenon. This cancer must be eliminated from our society.
Media on its part is playing the easy game here. They are
highlighting only those cases where either the exploiter or the victim is a
celebrity. The desirable thing would be approach the common people and
encourage them to speak up. Motivate them to narrate their story to the world
so that the women who are not resourceful, rich or famous also feel part of the
campaign.
It is shocking to see that the government has been mostly silent
or dismissive on this issue so far. A central minister has even suggested that
it may be a ploy to blackmail popular people. It is deplorable.
I feel the government should come out openly in support of the
women and encourage them to speak up whenever faced with a situation of
exploitation. Would be a brilliant idea, if the prime minister himself sets an
example!
Chart of the day
NBFC conundrum
Non bank financing companies (popularly known as NBFCs) are at
the center of the nervousness in Indian markets. The market participants are
much more concerned about the turmoil in debt market, than the equity markets.
Apparently, the concerns have been triggered by default of
IL&FS, a hitherto top rated infrastructure lender in the country. This led
to substantial MTM losses in numerous debt, income and money market funds.
Unsubstantiated rumors about liquidity problems at the third largest housing
finance company in the country (DHFL) have further exacerbated the situation.
As it happened that stocks of financial companies and banks had
the maximum weight in most of the equity portfolios, the jitters soon traversed
to the equity market. Real estate and infra builders also witnessed a massive
sell off.
In case any of the readers is feeling that the present
correction is consequence of one off IL&FS default and rumor mongering, I
would like to share my oversimplified view with them.
(a) Non bank
financing companies raise money primarily from the following five sources:
(i) Equity from
promoters and other shareholders and retained earnings (reserves).
(ii) Long term
borrowing through issuance of bonds and preference shares.
(iii) Transfer of
borrowers' accounts to banks and other institutions, through securitization or
outright sale of its credit assets.
(iv) Short term
borrowing from banks and other institutions through credit lines and commercial
papers (maturity ranging from 1month to 12months).
(v) Fixed deposits
from retail investors (maturity 1yr to 5yr).
(b) NBFCs are
required to maintain Capital to Risk-Weighted Asset Ratio CRAR) as specified by
RBI from time to time. So, if the specified CRAR is 15%, an NBFC cannot lend more
than 6.67x its capital (Equity, preference and reserves). This implies that an
NBFC can borrow maximum 5.67x of its capital (15% owned funds and maximum 85%
borrowing).
(c) The efficiency
of an NBFC is measured in terms of how much return it can generate from its
loan book (Return on Assets or ROA). ROA is function of three factors:
(1) The differential
or spread between the cost of borrowing and rate of lending for that NBFC (net
interest margin or NIM);
(2) Operating cost of
the business or simply revenue expenses like salary, rent etc.; and
(3) Credit cost or
amount of bad debts (NPA).
(d) Ideally for an
NBFC, the mix of borrowing from various sources of funds should be directly
proportionate to the maturity profile of its debtors. For example, if an NBFC
gives housing loans of 5-25years or funds long gestation industrial or
infrastructure projects, it should raise funds mostly from equity and long term
bonds. Whereas, if an NBFC finances purchase of consumer durable for
6-18months, it should raise more money from short term instruments like CP,
fixed deposits etc.
(e) However in
practice, NBFCs do not exactly follow this principle of Asset Liability
Matching (ALM). In their endeavor to maximize their NIM, they take risk and
borrow short term (if it is cheaper) and lend long term (to make few basis
point extra spread). In a stable interest rate environment this works well.
However, as the near term rate rise, they face roll over
risk on their short term instruments. Remember, since they have
lent only long term, there would be no repayment from their borrowers. They
need to repay their existing short term borrowing only from their new
borrowing, which could be at a higher rate. So their NIMs come under pressure.
The situation further worsens if there is a liquidity squeeze in
the market and for some reason they are not able to roll over their short term
debt. This leads to default in honoring their commitment towards the retiring
debt. A default can lead to downgrade in their credit rating and hence even
higher overall cost of borrowing and even lower NIMs.
So, we can see that even though the NBFC has adequate amount of
good assets to honor all its liabilities, a mismatch between maturity profile
of its assets and liabilities can make it a defaulter.
(f) There are also
cases where to make few extra basis points in interest or stay in competition,
NBFCs lend to borrowers with poor credentials (subprime lending). The chances
of defaults by these subprime borrowers are much higher as compared to the
standard borrowers. So if economy turns down, or rates begin to rise, the
credit cost of NBFCs also rises sharply.
So, basically it is the greed to make few basis points in
additional interest that mostly leads to troubles with NBFCs.
This is the debt market part. Now let's come to the equity
market.
In an environment of abundant liquidity and stable to low
interest rates, NBFCs are able to generate extraordinary RoA (primarily driven
by higher NIMs) by creating an asset liability mismatch (ALM) in their books as
the roll over risk is perceived to be pretty low.
Analysts extrapolate these cyclically higher earnings to
perpetuity and assign lofty valuations to these NBFCs. For instance, a couple
of months back, most large NBFCs were trading at 3.5 to 8x their book value and
were still being termed "attractively valued" by a majority of
analysts.
Now as the global liquidity is getting squeezed, inflationary
expectations have risen and rates are expected to climb steeply, many NBFCs
running poor ALM, are facing roll over and default risks. Besides, almost all
NBFCs face prospects of sharp earning downgrades as spreads shrink and credit
costs rise.
This is not necessarily a localized temporary problem. This
could well be end of this leg of the dream run for NBFCs. The prospects of
implementation of significantly tighter regulations by RBI shall further impact
the business.
We shall see a large number of smaller and weaker players
getting eliminated, midsized players decimated and large efficient players
downsized. The survivors shall of course make merry as the cycle will
inevitably turn in due course. If you want to study more, please see what
happened during 1993-1996.
As I wrote yesterday, "In case you want to enjoy the feast,
you need to survive till good times arrive; lest Brahmins and crow shall enjoy
the feast. (see
here)
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