Month: September 2015

How insurance companies robbed the hard earned savings of Indian investors

LIC
The Report of the Committee to recommend measures for curbing mis-selling and rationalising distribution incentives in financial products was released on September 3, 2015.

The financial product which is perhaps most mis-sold in India is insurance. There is enough anecdotal evidence to suggest that hordes of investors bought equity unit linked insurance plans (Ulips), over the years, on the mis-sell that their investment would double in three years. Ulips are primarily investment plans with a dash of insurance.

Ulips, as they used to be structured, paid a very high commission to insurance agents during the first two years of the policy. Also, in case the investors failed to pay the premium during the first three years of the policy, the insurance company was allowed to keep the entire premium that had been invested up until then.

As the report cited at the beginning of this column points out: “The regulation on a three-year lock in period which allowed companies to keep the entire value of the policy if surrendered within three years, left very little incentive to the insurance companies to promote follow-on premium payments from their customers. The rule on front-loaded commissions, which were as high as 40 percent in the first year, incentivised agents to sell products that earned them the highest pay-off.”

In fact, an estimate made by Monika Halan, Renuka Sane, and Susan Thomas in a research paper suggests that investor losses due to policies lapsing mounted to Rs 1.5 trillion between 2004-06 and 2011-12.

This is a huge amount of money. Many investors stopped paying their premiums after the money they had invested did not double in three years. Over and above this, the insurance agents sold Ulips as a three year policy, instead of telling the investors that there was a lock-in of three years.

At the end of three years they got people to invest their redeemed amount back into a fresh Ulip. This was done so as to ensure that they (i.e. the agents) could continue to earn a high commission.

In fact, in a research paper titled Understanding the Advice of Commissions-Motivated Agents: Evidence from the Indian Life Insurance Market, Santosh Anagol, Shawn Cole and Shayak Sarkar point out: “We find strong evidence that commissions-motivated agents provide unsuitable advice. Depending on our treatment, agents recommend strictly dominated, expensive products, 60-90% of the time.”

Also, not surprisingly, the research paper points out that “the selling of unsuitable products is likely to have the largest welfare impacts on those who are least knowledgeable about financial products in the first place.”

This is also visible in the low persistency that insurance policies have in India. As the report of the committee to recommend measures for curbing mis-selling points out: “A manifestation of this is the low persistency of policies in India. Persistency tracks the behaviour across time of policies sold in a year. The 13 month persistency rate for insurance companies ranged between 41 – 76 percent in 2013-14. In the case of LIC [Life Insurance Corporation of India] for example, the 61st month persistency in 2013-14 was just 44 percent. This means that less than half of the policies sold in FY 2009 were retained.”

The low persistency is primarily because of “mis-selling and poor service by agents.”

The question is what can be done to curb this mis-selling. The Insurance Regulatory and Development Authority (IRDA) of India has cut down on Ulip commissions over the years. Nevertheless, high commissions on the traditional endowment plans still remain. If mis-selling has to come down, the commission on endowment plans needs to be slashed.

In fact, as the report on curbing mis-selling points out: “The Insurance Laws Amendment Act, 2015 has led to the removal of the ceiling of 40 percent on the maximum commission, fee or remuneration. IRDA for now has the power to lay down the structure of commission/brokerage for intermediaries as well as the power to determine the expenses of management.”

The question is will IRDA implement this and start limiting the commissions paid on traditional plans. The Life Insurance Corporation (LIC) of India benefits the most from the high commissions on traditional plans. The high commissions on offer on these non-transparent plans, help in collecting a lot of money from people all across the country.

Also, it is worth remembering that LIC comes to the rescue of the Indian government regularly. On August 24, 2015, the government was investing around 10% of its holding in Indian Oil Corporation (IOC). On that day, the stock market fell big time. LIC came to the rescue of the government and picked up around 86% of the shares that the government was selling in IOC.

In this scenario, the government and the IRDA limiting the commission that LIC is allowed to pay to its agents, is highly unlikely.

The column originally appeared on Firstpost on Sep 9, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

 

The real story behind the bad loans of Indian banks

rupee
In several previous columns in The Daily Reckoning newsletter, I have talked about the bad loans that are accumulating with banks in general and government owned public sector banks in particular. A major portion of these bad loans is from corporates who had borrowed and are now not repaying the loans.

A standard explanation from the corporates is that these are tough times for the economy and given that they are not in a position to repay. The trouble is that this is not always true. As a recent research brought out by EY and titled Unmasking India’s NPA issues – can the banking sector overcome this phase? points out: “While corporate borrowers have repeatedly blamed the economic slowdown as the primary factor behind it[i.e. defaulting on bank loans], periodic independent audits on borrowers have revealed diversion of funds or wilful default leading to stress situations.”

Nevertheless, despite many wilful defaults, banks don’t declare such defaulters as wilful defaulters. The RBI defines “wilful default” as a situation where a borrower has defaulted on the payment/repayment obligations despite having the capacity to pay up. Or the borrower hasn’t utilised the loan amount for the specific purpose for which the loan was disbursed and diverted the money for other purposes. Or the borrower has siphoned off the funds. Or the borrower has defaulted on the loan and at the same time sold off the immoveable property which acted as the collateral against which the loan had been granted.

The EY report explains quoting bankers, why banks and bankers don’t declare borrowers as wilful defaulters: “It is more or less certain that if we declare a borrower a “wilful defaulter,” he will approach the court. Then it becomes our responsibility to justify our action with supporting evidence. It is not always possible to establish that the borrower has siphoned off the money or used it for a purpose other than the one which loan has been taken. Hence, we need to be extremely cautious before we declare someone a “wilful defaulter.” Otherwise, we will not only lose the case, but we will also let the defaulter off the hook.”

What the survey does not point out is that unlike the corporate defaulters, public sector banks do not have the best lawyers on their speed dial.

As on December 31, 2014, the top 30 defaulters accounted for nearly one third of the bad loans of close to $47.3 billion, which is clearly worrying. Also, many high value loans have gone bad. And they keep piling up. In fact, in a survey carried out by the EY Fraud Investigation & Dispute Services found that 87% of the respondents that included bankers stated that diversion of funds to unrelated business through fraudulent means is one of the root causes for the NPA crisis.

Also, 64% of respondents believed that these bad loans resulted primarily because of lapses in the due-diligence carried out by banks before the loans were sanctioned. In fact, the report also talks about third party agencies that banks need to depend on while figuring out whether a borrower is good enough to be lent money to, as well as what he is doing with that money, once the loan has been given out.

As the report points out: “Third party agencies such as surveyors, engineers, financial analysts, and other verification agencies, etc., play a critical role in assuring financial information, proposals, work completion status, application of funds, etc. Lenders rely significantly on the inputs issued by such third parties.”

The trouble is that the system can and is being manipulated. “Reports are made as a routine, with little scrutiny. In some situations, the reports may be drafted under the influence of unscrupulous borrowers,” the EY report points out.

For the entire process of loan disbursal as well as monitoring mechanism to work well, the third party system needs to work in a transparent manner, which it currently doesn’t. As per the EY survey, two out of the three respondents agreed that third party reports could be manipulated in the favour of the borrower.

Further, 54% of the respondents attributed the bad loans to the inefficiencies in the monitoring process, after the loan had been given out.

And if all that wasn’t enough 72% of the respondents claimed that the crisis in banking because of bad loans is set to worsen before it becomes better. The reason for this is very simple—many loans which have gone bad have not been recognised as bad, and instead have been restructured i.e. the borrower has been allowed easier terms to repay the loan by increasing the tenure of the loan or lowering the interest rate.

As the EY report said quoting the bankers who had participated in the survey: “The stressed accounts that have been hidden till now would keep the NPA [non-performing asset] level rising at least for the next 2-3 years.” In simple English what this means is that many restructured loans will turn bad in the years to come, as borrowers will default.

The EY report further pointed out: “The reported numbers are quite high, and there are fresh additions every quarter, leading to further deterioration in asset quality. The portfolio of restructured accounts is adding to the problem at hand, thereby resulting in crisis.”

In fact, the corporate debt restructuring numbers have jumped up big time over the last few years. The number of cases has jumped from 225 to 647 between 2008-09 and December 31, 2014. This is a jump of 187%. In fact, in terms of the amount of loans, the jump is 370% to over Rs 450,000 crore.

The bankers that EY survey spoke to made several interesting points. Several borrowers go through the corporate debt restructuring mechanism just to ensure that they can drive down the interest rates on their loans or increase the repayment period. Also, even in cases where the borrower is in trouble nothing really comes out of the restructuring scheme. As the report points out: “These schemes are often used to soften the pricing terms, elongation of repayments, without improving the basic viability of the business.”

What all this clearly tells us is that the Indian banking system will continue to remain in a mess over the next few years, as restructured loans keep turning into bad loans.

Stay tuned and watch this space.

This column originally appeared on The Daily Reckoning on Sep 9, 2015

Big fish in a small pond

fish
One of my bigger regrets in life is having spent two years getting an MBA degree, though I made some good friends along the way. Ironically over the last decade I have lost touch with these friends.

I have often asked myself why things turned out the way they did, given that they were a good bunch of people. And the answer I have come up with is that these friends over the years started cribbing a lot. They were unhappy people in their daily lives.

They were unhappy with their bosses. They were unhappy with their sales targets. They were unhappy with their bonuses. They were unhappy with their colleagues. Different things on different days. The only thing that gave them happiness was planning their weekends and their holidays. As one of them told me with great pride a few years back: “This year we did New Zealand. Next year we will do Turkey.” This was hardly surprising given our fascination for anything phoren.

What I found surprising was these friends spent more time figuring out what to do over a couple of weeks of holidays than trying to figure out what to do over the 50 weeks that they were slogging at their ‘unhappy’ jobs. Why would you want to be unhappy 50 weeks in a year, so that you can be happy for two weeks? Beats me.

The Nobel Prize winning psychologist Daniel Kahneman talks about the focussing illusion in Thinking, Fast and Slow. As he writes: “Any aspect of life to which attention is directed will look large in global evaluation. This is the essence of the focusing illusion, which can be described in a single sentence: Nothing in life is as important as you think it is when you are thinking about it.”

And this possibly explains why my MBA friends had turned themselves into non-stop cribs. Whatever bothered them at a given point of time took precedence in their thoughts and they chose to crib about it.

But cribbing was essentially a symptom to the problem. These friends were constantly comparing themselves with others while working for large companies. In other words they were small fish in a big pond. As Barry Schwartz writes in The Paradox of Choice: “If there were only one pond—if everyone compared his position to positions of everybody else—virtually all of us would be losers. After all, in the pond containing whales, even sharks are small.”

What this tells us clearly is that a major part of satisfaction from what we do comes from how well we look at ourselves in comparison to those around us. Hence, things are relative. As Schwartz writes: “As others start to catch up, the desires of those who are ahead in the “race” escalate so that they can maintain their privileged position.” And if they can’t stay ahead all the time, they crib.

In fact, a few years back an interesting piece of research was carried out. In this research participants where were asked to choose whether they would be like to be in a situation where they were earning $50,000 per year, while others were earning $25,000 or they would like to be in a situation where they were earning $100,000 per year, while others were earning $200,000. And the results were rather surprising.

As Schwartz writes: “In most cases, more than half of the respondents chose the options that gave them better relative position. Better to be a big fish, earning $50,000, in a small pond than a small fish, earning $100,000, in a big one.”

Hence, the trick to be happy is not keep comparing ourselves with those around us. As Schwartz writes: “Instead of comparing ourselves to everyone, we try to mark off the world in such a way that in our pond, in comparison with our reference group, we are successful. Better to be the third-highest-paid lawyer in a small firm…than to be in the middle of the pack in a large firm.”

The column originally appeared in the Bangalore Mirror on Sep 9, 2015

One idea that real estate companies want to borrow from Gulzar

Gulzar
In the film Ek Thi Dayan, lyricist Gulzar wrote a song, which had the following line: “koi khabar aayi na pasand to end badal denge [if we don’t like some bit of news, we will change the end.]”  In the recent past, the real estate companies do not seem to have liked the bad news that has been read out to them. And to tackle that they plan to create their own news. Or at least that is what a recent development suggests.

The Confederation of Real Estate Developers Association of India (CREDAI), a lobby of real estate companies, which has about 10,000 members, now plans to collect its own data on the industry.

As President of CREDAI Geetamber Anand told Business Standard: “The need to come up with its own set of data cropped up after varying figures from real estate consultants including Knight Frank, JLL India, Liases Foras and others, which at times create panic amongst the buyers fraternity.”

A spate of research reports brought out by real estate consultants in the recent past has suggested that real estate developers in large cities are not able to sell homes that they have built. A recent research report by Knight Frank suggested that over 7 lakh homes were unsold in the top eight cities of the country. The report also estimated that it would take more than three years to sell homes that have piled up.

Other real estate consultants have come up with similar reports with similar numbers. This is something which has not gone down well with the real estate lobby, which now wants to put out its own data. How can someone else tell them that all is not well with them?

What has also not gone down well with them is a recent comment by the Reserve Bank of India governor Raghuram Rajan, asking them to bring down prices.

As Rajan said: “It would be a “great help” if realty developers sitting on unsold stock bring down prices…Once the prices stabilise, more people will be keen to buy houses…I think we need the market to clear.”

The CREDAI responded to Rajan with the following statement: “While we respect the RBI governors concern for kick starting the real estate sector, it would be prudent to say that from the developers side a substantial reduction in prices has already happened across the country [italics are mine] and any further decrease in sale prices would be a deterrent for the growth of a sector that contributes so much to the economy and employment at large.”

CREDAI President Anand told PTI that “housing prices have gone down by 15-20 per cent on an average in last two years across India, while input costs have risen by 15-20 per cent.” The good bit here is that here is a top real estate lobbyist admitting that prices have fallen. It is tough to get them to admit even this much. Nevertheless, if the reduction in prices has already happened, why there is an inventory of 7 lakh unsold homes across top 8 cities? Also, the total number of unsold homes all across the country would be much higher than 7 lakh, but no such data is complied.

The real estate companies need to go back and learn some basic economics. One of the most basic laws in economics is the law of demand. The law essentially states that there is an inverse relationship between the price of a product and the quantity demand by consumers. If the price of the product goes up, demand falls and if the price of a product falls, the demand goes up.

In case of the real estate sector in India what the law of demand tells us is that if prices had fallen enough, people would have bought homes to live in and the unsold inventory would have cleared out. Nobody likes to let go of a good deal. But that hasn’t happened.

Why? Some simple Maths should explain this. In the National Capital Territory (Delhi and other smaller cities around it) an average flat costs around Rs 75 lakh (most research reports agree on this number). Assuming 20% of the price has to be paid in black (and I am being extremely conservative here), the official price of the flat is Rs 60 lakh (80% of Rs 75 lakh). A bank or a housing finance company gives a loan against this price.

The housing finance company HDFC has a loan to value ratio of 65%. This means it gives 65% of the value of a home as a loan on an average. This would mean that HDFC would give a loan of Rs 39 lakh. The buyer would have make Rs 21 lakh as a down-payment. He also needs to raise another Rs 15 lakh to be paid in black.

Hence, the buyer would need to raise Rs 36 lakh (Rs 21 lakh down-payment and Rs 15 lakh black) on his own. How many people have that capacity even in a city like Delhi? And I am not even taking into account the cost of furnishing the house, the cost of moving into it, other expenses like stamp duty etc.

The same maths works for all other big cities as well. What this clearly tells us is that home prices are way beyond what most people can afford. They are in a bubble zone. The sooner the real estate companies understand this, the better it will be for all of us.

They may want a different end, but that isn’t going to happen. The longer they hold on to prices, the longer they will have to hold on to all the inventory that has piled up.

The column was originally published on Sep 8, 2015 in The Daily Reckoning

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Dear PM Modi, ache din won’t come just by meeting corporates

narendra_modi
As I write this on the morning of September 8, 2015, Prime Minister Narendra Modi and his team are meeting the top businessmen of this country along with the governor of the Reserve Bank of India (RBI), Raghuram Rajan.

The press release put out by the Prime Minister’s office pointed out that “a wide-ranging discussion is expected on the impact of recent economic events, and how best India can take advantage of them.” For a meeting which is expected to last over two hours, this is as general an agenda as it can get. Since it chooses to address everything, it will end up addressing nothing.

As far as representatives of Indian business are concerned they have constantly blamed high interest rates for investment as well as economic growth not picking up. But the point is who is responsible for high interest rates? The conventional wisdom on this matter is that the Reserve Bank of India has not been reducing the repo rate, or the rate at which it lends to banks.

Only if it was as simple as that. The repo rate is at best an indicator of which way the interest rates are headed. At the end of the day banks need to decide the interest rates they charge on their loans. A major reason that has been stopping them from lowering interest rates is the massive amount of bad loans that have been accumulated over the years.

Take the case of the State Bank of India, it has a bad loan ratio of greater than 10%, when lending to corporates. This means for every Rs 100 that the bank lends to corporates, more than Rs 10 has turned into a bad loan.

A standard explanation for these defaults is that businesses have got hit during what are bad economic times and hence, are unable to repay the loans they had taken on. While that may be true in a large number of cases, it is not totally true.

As a recent report brought out by Ernst and Young and titled Unmasking India’s NPA issues – can the banking sector overcome this phase? points out: “While corporate borrower have repeatedly blamed the economic slowdown as the primary factor behind it[i.e. defaulting on bank loans], periodic independent audits on borrowers have revealed diversion of funds or wilful default leading to stress situations.”

The question is will Modi and his team crack the whip on these defaulters and ask them to pay up? From past evidence the answer is no. If they had to, they would have already done so by now. Hence, calling the corporates for a meeting and listening to the same old things all over again, is basically a sheer of waste of time.

Further, as far Modi is concerned he has a lot of explaining to do on the economic reform front, something he had promised during the course of the election campaign last year. During the course of the last year he has come up with slogans like Make in India, Digital India etc., with very little changing on the ground.

For businesses to make in India, different things like the ease of land acquisition and electric supply, need to improve. Many state electricity boards all over the country, continue to remain in a mess.  Further, the inspector raj that small businesses face, needs to be unshackled. Labour laws which stop favouring the incumbents (i.e. the labour in the  organised sector) need to be brought in. Very little seems to have happened on this front.

Further, the government hasn’t been able to push through a goods and services tax either, despite making a lot of noise on that front.

The basic point is that what was Modi’s strength has now become his weakness. During the course of the election campaign last year, Modi came across as a man of action—a man who got things done. The bar was set very high with slogans like “acche din aane waale hain”.

For acche din to come Modi needs to create jobs for the 13 million Indians who are entering the workforce every year. And for that to happen he needs to unshackle many things that are holding back the economy.

The ease of doing business has to improve, if India wants to take advantage of the current economic scenario where the Chinese economy is in doldrums. Just coming up with new slogans and meeting corporates regularly won’t help on that front.

The column appeared on Firstpost on Sep 8, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)