Banking

Ratings shopping: Lessons from the Amtek Auto default

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Amtek Auto was supposed to repay Rs 800 crore of its debt by Sunday (Sep 20, 2015). It has not been able to do so. Media reports suggest that the company has a total debt of Rs 18,000 crore, whereas the Amtek group has a debt of Rs 26,000 crore.

The interesting bit is that this debt that Amtek Auto has defaulted on will not be declared to be a bad loan immediately. As I have often written in the past in The Daily Reckoning, banks do not like to recognise bad loans immediately.

More often than not they kick the can down the road by restructuring the loan. When a loan is restructured a borrower is either allowed to repay the loan at a lower rate of interest or over a longer period of time or possibly both.

Deepak Shenoy makes this point on Capitalmind.in: “For a bank holding the bonds[on which Amtek Auto has defaulted on] this account is technically not an NPA [non-performing asset or a bad loan] until 90 days is over. So they can extend and pretend and hope that Amtek manages to salvage itself. Since the banking system has exposure to more than Rs 7,000 crore of loans to Amtek, you can bet your next salary that they will restructure the loan in some way and manage to not call it an NPA at all.”

And that is not the only disturbing bit. Amtek Auto is also a very clear case of rating agencies having been caught napping on their job. The agencies should have seen this default coming. But that did not turn out to be the case.

Care Ratings suspended the rating of the company on August 7, 2015. Before suspending the company Care had rated Amtek Auto at AA−. Care defines an AA rating as: “Instruments with this rating are considered to have high degree of safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk.”  Over and above the rating, Care also uses plus or minus for a certain level of ratings. These signs “reflect the comparative standing within the category.”

From a rating of AA−, Care stopped rating Amtek Auto. Another rating agency Brickwork Ratings downgraded the debt of the company from a level of A+ to C−. This was a downgrade of 12 levels in a single shot.

Brickwork defines an A rating as: “Instruments with this rating are considered to have adequate degree of safety regarding timely servicing of financial obligations. Such instruments carry low credit risk.” It defines a C rating as: “Instruments with this rating are considered to have very high risk of default regarding timely servicing of financial obligations.”

It is worth asking here that how did a company go from being categorised as having an “adequate degree of safety” to a “very high risk of default,” all at once. The only possible explanation here is that the rating agency was caught napping or just chose to look the other way.

In fact, Amtek Auto is not an isolated case. There have been other such instances as well. As a recent news-report in the Mint newspaper points out: “In the past one year, there have been other instances where ratings have been cut sharply by three notches or more in one revision. In July, CARE Ratings downgraded Jaiprakash Associates Ltd by six notches from a rating of BB to D-, a rating that reflects a default in the debt security. Non-convertible debentures of Bhushan Steel Ltd also saw their rating drop by six notches following a revision by CARE Ratings in December 2014. Punj Lloyd Ltd faced a similar drop in ratings in July.”

Monet Ispat and Energy Ltd, Bhushan Power and Steel Ltd, Shree Renuka Sugars and 20 Microns Ltd, are examples of other companies that the Mint news-report points out.

There is a basic problem with the way rating agencies operate. The company which they are rating is the one which pays them as well. In this scenario one rating agency can be played against another, and a company can indulge in ratings shopping.

In fact, ratings shopping was a major reason behind the financial crisis. Banks and other financial institutions looking to rate their sub­prime bonds and other mortgage backed securities played off one rating agency against the other. If they did not get the AAA rating (which is the best rating on a financial security), they threatened to take their business elsewhere.

There was a huge ratings inflation that happened as well. As George Akerlof and Robert Shiller write in their new book Phishing for Phools—The Economics of Manipulation and Deception: “One ratings agency alone, Moody’s, gave 45,000 mortgage-related securities a triple-A rating(for the period 2000 to 2007); that generosity for the mortgage-backed securities contrasts with only six US companies that were similarly rated AAA(in 2010).”

This possibly explains that the rating agencies were giving high ratings to subprime and mortgaged backed securities in order to continue to get business from investment bank issuing subprime bonds and other mortgage backed securities.

As Akerlof and Shiller point out: “The originator of the packages [i.e. subprime bonds and the mortgage backed securities], typically an investment bank, was rewarded by high ratings on its offerings. And the ratings agency, in turn, would be shunned if it did not give the investment bank what it wanted. It was in the interest of neither the investment banks nor the ratings agencies to go back and do that extremely difficult—and perhaps impossible—task of opening up the packages and carefully examining their innards [the emphasis is mine].”

This is precisely what has happened in the Indian context as well. In their zeal to get business, the rating agencies awarded these companies higher ratings than what they deserved in the first place. If they hadn’t done that the companies would have taken their business elsewhere. Pretty soon shit hit the ceiling and they had to cut ratings by several notches all at once.

To conclude, it is worth repeating here, something that a managing director of Moody’s told his employees: “Why didn’t we envision that credit would tighten after being loose, and housing prices would fall after rising, after all most economic events are cyclical and bubbles inevitably burst. Combined, these errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue, or a little bit of both [the emphasis is mine].”

The Indian rating agencies did something similar as well.

The  column originally appeared on The Daily Reckoning on Sep 24, 2015

Corruption in bank lending starts at very beginning

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“Anyone with any sense had already left town…” – Bob Dylan in Lily, Rosemary and the Jack of Hearts

In the Daily Reckoning newsletter dated September 9, 2015, I had extensively quoted a survey carried out by EY. In this survey 64% of respondents believed that the bad loans of banks resulted primarily because of lapses in the due-diligence carried out by the banks, before the loans were sanctioned.
As the report which came along with the survey pointed 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.”

And this system 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 pointed out.

In response to the column someone with a detailed knowledge of the loan processing and disbursal process of banks got in touch with me. He gave me two examples of the loan disbursal system being manipulated. This ultimately led to several banks ending up with bad loans.

The first case was of an unlisted entity in the business of manufacturing luggage, borrowing from two big public sector banks. The promoter of the company offered his equity in the company, as well as land and the factory, as a collateral. This transaction took place in 2007. The valuation report by a third party agency put the combined value of all the assets at Rs 35 crore. Against these assets the banks gave a loan of around Rs 27 crore. The promoter took this loan. He also borrowed Rs 3 crore more from the banks.

Later another valuer was brought in to examine the value of the assets, and the value of the assets was put at a much lower Rs 19 crore. The old valuer was dismissed but by then the damage had already been done. The company had given out a loan of Rs 30 crore against assets which were worth only Rs 19 crore.

Ideally the situation should have exactly been the other way around.

The second case involves a listed company in the building materials space. The company came out with an initial public offering in 2008-2009. The company was listed at a three digit price. Currently, the price of the stock is in lower single digits.

The company took loans amounting to Rs 325 crore from two big public sector banks and one of the bigger new generation private sector banks. The promoter did not stop at this. He borrowed more using his other listed entities as well. In 2013, he defaulted on the loans citing slowdown in construction activity.

Now he owes banks around Rs 1000 crore to the banks. The book value of the assets that banks have as a collateral is around Rs 225 crore. The market value is expected to be in the region of Rs 325-350 crore. The rest of the money was lent by banks against shares, which are now quoting in single digits.

In both the cases, the banks ended up with losses. Both the companies that we talked about are not very big companies and they were able to do so much damage to banks so easily. Now imagine what must be happening when the banks deal with the bigger corporates.

The Reserve Bank of India (RBI) governor, Raghuram Rajan, summarised the situation accurately in a speech last year when he said: “The promoter enjoys riskless capitalism – even in these times of very slow growth, how many large promoters have lost their homes or have had to curb their lifestyles despite offering personal guarantees to lenders?” Almost none.

In fact, these defaults have pushed Indian banks into a difficult situation. As R Gandhi, one of the deputy governors of the RBI, said in a speech he made on September 15: “The amount of non-performing assets [have] witnessed [a] spurt and as on March 2015, it was at 4.62. per cent of the gross advances of the banks in comparison with 2.36 per cent of the gross advances as at March 2011.”

Further, non-performing assets or bad loans have grown at a much faster pace than the overall lending in the last few years. Along with the growth in bad loans, as I have often pointed out in the past, the restructured assets (where the tenure of the loan or the interest on the loan has been changed in favour of the borrower) have also grown.

As Gandhi pointed out: “The ratio of restructured standard assets to gross advances grew to 6.44 per cent as at the end of March 2015 from 5.87 per cent of gross advances as on March 2014. The total stressed assets (i.e., NPAs plus Restructured Assets) as on March 2015 were 11.06 per cent of gross advances.”

All this has had a severe impact on profitability of banks. “The sharp increase in stressed assets has adversely impacted the profitability of the banks. The annual return on assets has come down from 1.09 per cent during 2010-11 to 0.78 per cent during 2014- 15,” Gandhi said.

This has become a drag on the economy. The increase in bad loans and restructured assets also hurts those borrowers who have been repaying their loans without fail, as they end up paying higher interest rates. As Rajan said last year: “One consequence of skewed and unfair sharing is to make credit costlier and less available. The promoter who misuses the system ensures that banks then charge a premium for business loans.” Hence, the next time the businessmen want the RBI to cut interest rates, they should understand they are a major part of the problem.

Other than the fact, that the banks lent more money than they should have [i.e. due-diligence wasn’t proper], they also did not monitor the loans properly. In cases where money had been lent against shares, the falling share price should have led to some action from banks. But that doesn’t seem to have happened.

The RBI has since asked banks to follow a proper credit-risk management system. As Gandhi said during the course of his speech: “The guidelines entail involvement of top Management, including the Board of Directors of the bank in actively managing the credit risk of the banks. Banks are required to put in place proactive credit risk management practices like annual / half-yearly industry studies and individual obligor reviews, credit audit which entails periodic credit calls that are documented, periodic visits of plant and business site, and at least quarterly management reviews of troubled exposures / weak credits.”

While this will help banks in not making the same mistakes as they have in the past, it will do nothing about the mess that they already are in. For loans that have gone bad already or are in the process of going bad, all these steps are essentially too little and too late.

The column originally appeared on the Daily Reckoning on Sep 18, 2015

How corporates have turned Indian banks lazy

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One of the data points that analysts like to refer to while talking about slow economic growth, is the slow growth in loans given out by banks. If we consider the one year period between July 25, 2014 and July 24, 2015, the overall lending by banks grew by 9.4%. In the period of one year between July 26, 2013 and July 25, 2014, the loan growth was much stronger at 12.8%.

In absolute terms, in the last one year, the banks gave out Rs 5,71,820 crore of loans. This is lower than the total amount of Rs 6,88,640 crore, that banks gave out between July 2013 and July 2014.

So banks are not lending as much as they were in the past. And that clearly is a problem. But this does not apply to the money that banks have lent to the government.

Between July 2014 and July 2015, the banks invested Rs 3,40,750 crore in government securities. The government issues financial securities to finance its fiscal deficit or the difference between what it earns and what it spends. Banks buy these financial securities and thus lend to the government.

Interestingly, the investment by banks in government securities during the period July 2013 and July 2014 had stood at Rs 1,298,50 crore. Hence, between July 2014 and July 2015, the investment by banks in government securities has jumped a whopping 162.4%.

In fact, the comparison gets even more interesting when we get deposits raised by banks between July 2014 and July 2015 into the picture. In the last one year banks raised Rs 9,34,090 crore as deposits. Of this 36.6% (or Rs 3,40,750 crore) found its way into government securities. Between July 2013 and July 2014, only 14.7% of deposits raised had been invested in government securities.

What do all these numbers tell us? They tell us loud and clear that the Indian banking system currently wants to play it safe. In other words this is “lazy” banking. Lending to the government is deemed to be the safest form of lending. This is primarily because government can borrow more money to repay the past borrowers. It can also print money and repay its loans. Private borrowers cannot do that.

What is also interesting is that banks are also giving out more home loans than they were in the past. Between July 2014 and July 2015, home loans formed around 17.6% of the total lending. This number between July 2013 and July 2014 had stood at 12.2%. This is primarily because a house is a very good collateral. Also, the rate of default on home loans is very low. In case of HDFC (which is not a bank but a housing finance company) the default rate is at 0.54%, which means that almost no one defaults on a home loan.

In case of State Bank of India, for retail loans, the default rate stands at 1.17%. The bank does not give out a separate default number for home loans. Auto loans, education loans and personal loans, are the other forms of retail loans. The default rates in case of these loans is likely to be higher. Hence, the default rate, in case of home loans given out by the State Bank of India, should be lower than 1.17%.

Compare this to what happens when the State Bank of India lends to mid-level corporates. The default rate is at a very high 10.3%. Hence, for every Rs 100 that India’s largest bank gives out as a loan to a mid-level corporate, more than Rs 10 goes bad.

If one factors all this into account it is not surprising that banks are comfortable lending only to the government and giving out home loans. In fact, over the last one year, banks have lent 47.3% of the total deposits they have raised during the period either to the government or as home loans. The number during the period July 2013 and July 2014 had stood at 24.3%.

Hence, banks are clearly trying to play it safe. This is lazy banking at its best.

Prime Minister Narendra Modi in his meeting with businessmen on September 8, 2015, asked them to increase their risk appetite and increase their investments. This is clearly not going to happen without banks being ready to lend to corporates.

The problem is that the last time banks went on an overdrive while lending to corporates they burnt their fingers badly, with corporates defaulting big time on their loans. And there is no easy way to solve this problem.

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

The column originally appeared on Firstpost on Sep 11, 2015

The real story behind the bad loans of Indian banks

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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