restructured assets

The Bank Ponzi Scheme

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Every six months the Reserve Bank of India (RBI) publishes a document titled the Financial Stability Report . In the December 2011 report, it pointed out that at 55 per cent, loans to the power sector constituted a major part of the lending to the infrastructure sector. It further said that restructured loans in the power sector were on their way up.

Restructured loans are essentially loans where the borrower has been given a moratorium during which he does not have to repay the principal amount. In some cases, even the interest need not be paid. In some other cases, the tenure of the loan has been increased.

This was nearly five and a half years back, and the first time the RBI admitted that there was a problem in the bank lending to the power sector. In the December 2012 report, the RBI said: “There are also early signs of corporate leverage rising among the several industrial groups with large exposure to infrastructure sectors like power.”

When translated into simple English this basically means that many big industrial groups which had taken on loans to finance power projects had borrowed more money than they would be in a position to repay.

In the years to come by, other sectors along with the power sector also became a part of the RBI commentary on loans which were likely not to be repaid in the future. In the June 2013 report, the central bank said: “Within the industrial sector, a few sub-sectors, namely; Iron & Steel, Textile, Infrastructure, Power generation and Telecommunications; have become a cause of concern.”

In the December 2013 report, the RBI said: “There are five sectors, namely, Infrastructure [of which power is a part], Iron & Steel, Textiles, Aviation and Mining which have high level of stressed advances. At system level, these five sectors together contribute around 24 percent of total advances of scheduled commercial banks, and account for around 51 per cent of their total stressed advances.”

Dear Reader, the point I am trying to make here is that the RBI knew about a crisis brewing in the industrial sector as a whole, and power and steel sector in particular, for a while. In fact, in the June 2015 report, the RBI pointed out: “the debt servicing ability of power generation companies [which are a part of the infrastructure sector] in the near term may continue to remain weak given the high leverage and weak cash flows.”

The funny thing is that while the RBI was putting out these warnings, the banks were simply ignoring them and lending more to these sectors. Between July 2014 and July 2015, banks gave out Rs 86,500 crore, or 71.5 per cent, of the Rs. 1,20,900 crore that they had lent to industry to the two most troubled sectors, namely, power and iron and steel.

What was happening here? The banks were giving new loans to the troubled companies who were not in a position to repay their debt. These new loans were being used by companies to pay off their old loans. A perfect Ponzi scheme if ever there was one. If the banks hadn’t given fresh loans, many of the companies in the power and the iron and steel sectors would have defaulted on their loans.

Hence, the banks gave these companies fresh loans in order to ensure that their loans didn’t turn into bad loans, and so, in the process, they managed to kick the can down the road. In the process, the loans outstanding to these companies grew and if they were not in a position to repay their loans 2-3 years back, there is no way they would be in a position to repay their loan now.

Many of these projects, as Raghuram Rajan put it in a November 2014 speech, “were structured up front with too little equity, sometimes borrowed by the promoter from elsewhere. And some promoters find ways to take out the equity as soon as the project gets going, so there really is no cushion when bad times hit.”

The corporates brought in too little of their own money into the project, and banks ended up over lending. Over lending also happened because many promoters in these sectors were basically crony capitalists close to politicians to whom banks couldn’t say no to.

Over and above this, the steel producers had to face falling steel prices as China dumped steel internationally. In case of power producers, plant load factors (actual electricity being produced as a proportion of total capacity) fell. Along with this, the spot prices of electricity also fell. This did not allow these companies to set high tariffs for power, required for them to generate enough money to repay loans.

All these reasons basically led to the Indian banks ending up in a mess, on the loans it gave to power and iron and steel prices.

The RBI has now put 12 stressed loan cases under the Insolvency Bankruptcy Code, in the hope of recovering bad loans from these companies. Not surprisingly, steel companies dominate the list.

The column originally appeared in the Daily News and Analysis on June 23, 2017.

 

When it comes to bad loans of banking, the big boys are the bad boys

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The Reserve Bank of India(RBI) released the Financial Stability Report on December 23, 2015. One of the key themes in this report was the fact that large borrowers are the ones who have landed the banking sector in trouble. As the RBI governor Raghuram Rajan wrote in the foreword to the report: “corporate sector vulnerabilities and the impact of their weak balance sheets on the financial system need closer monitoring.”

That is a euphemistic way of saying that corporates are essentially responsible for the rising bad loans of banks. As on September 30, 2015, the bad loans (gross non-performing advances) of banks were at 5.1% of total advances [i.e. loans] of scheduled commercial banks operating in India. The number was at 4.6% as on March 31, 2015. This is a huge jump of 50 basis points in a period of just six months. One basis point is one hundredth of a percentage.

What is the problem here? The inability of large borrowers to continue repaying the loans they have taken on in the years gone by. As on September 30, 2015, loans to large borrowers made up 64.5% of total loans. On the other hand, bad loans held by large borrowers amounted to 87.4% of total bad loans.

What this means is that for every Rs 100 of loans given by banks, Rs 64.5 has been given to large borrowers. At the same time of every Rs 100 of bad loans, large borrowers are responsible for Rs 87.4 of bad loans. Hence, large borrowers are clearly responsible for more bad loans.

As on March 31, 2015, bank loans to large borrowers made up 65.4% of total bank loans. At the same time, the bad loans of large borrowers constituted 78.2% of the total bad loans. What this means is that for every Rs 100 of loans given by banks, Rs 65.4 was given to large borrowers. At the same time of every Rs 100 of bad loans, large borrowers were responsible for Rs 78.2 of bad loans. This has since jumped to Rs 87.4 for every Rs 100 of bad loans.

What these numbers clearly tell us is that in a period of six months the situation has deteriorated big time and large borrowers have been responsible for it. As the RBI Financial Stability Report points out: “While adverse economic conditions and other factors related to certain specific sectors played a key role in asset quality deterioration, one of the possible inferences from the observations in this context could be that banks extended disproportionately high levels of credit to corporate entities / promoters who had much less ‘skin in the game’ during the boom period.”

What does this mean? Banks gave loans to corporates/promoters who had put very little of their own money in the project they had borrowed money for. Banks essentially gave more loans than they actually should have, given the amount of capital the promoters put in. And this is now proving to be costly for them.

In fact, lending to industry forms a major part of the stressed loans of banks. Stressed loans are essentially obtained by adding the bad loans and the restructured loans of banks.  A restructured loan is a loan on which the interest rate charged by the bank to the borrower has been lowered. Or the borrower has been given more time to repay the loan i.e. the tenure of the loan has been increased. In both cases the bank has to bear a loss.

As the RBI report points out: “Sectoral data as of June 2015 indicates that among the broad sectors, industry continued to record the highest stressed advances ratio of about 19.5 percent, followed by services at 7 per cent. The retail sector recorded the lowest stressed advances ratio at 2 per cent. In terms of size, medium and large industries each had stressed advances ratio at 21 per cent, whereas, in the case of micro industries, the ratio stood at over 8 per cent.”

Lending to the retail sector (i.e. you and me) continues to be the best form of lending for banks. The stressed loans ratio in this case is only 2%. This means that for every Rs 100 lent by banks to the retail sector (home loans, car loans, personal loans and so on), only Rs 2 is stressed.

Why is this the case? For the simple reason that it is very easy for banks to go after retail borrowers who are no longer in a position to repay the loans they have taken on. Further, there is no political meddling when it comes to loans to retail borrowers, hence, the lending is anyway of good quality.

In comparison, lending to industry has a stressed loans ratio of 19.5%. This means for every Rs 100 that the banks have lent to industry, Rs 19.5 is stressed i.e. it has either been defaulted on or has been restructured. Interestingly, even within industry, the situation with the micro industries is not as bad as the medium and the large industries.

The large industries have a stressed loans ratio of 21% i.e. for every Rs 100 lent to large industries by banks, Rs 21 has either been defaulted on or has been restructured. In case of micro industries, the number is at 8%. This is because banks can unleash their lawyers on the small industries in case the loan is in trouble. They can’t do the same on large borrowers. And even if they do it does not have the same impact.

Five sectors have been responsible for a major part of the trouble. These are mining, iron & steel, textiles, infrastructure and aviation. These “together constituted 24.2 per cent of the total advances [i.e. loans] scheduled commercial banks as of June 2015, contributed to 53.0 per cent of the total stressed advances.” “Stressed advances in the aviation sector6 increased to 61.0 per cent in June 2015 from 58.9 per cent in March, while stressed advances of the infrastructure sector increased to 24.0 per cent from 22.9 per cent during the same period.”

To conclude, when it comes to the bad loans of banking, the big boys are the bad boys who are responsible for a majority of the mess.

The column originally appeared on The Daily Reckoning on January 5, 2016

Banks having a bad time, as King of Good Times celebrates his sixtieth birthday

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A few days back sections of the media reported that Vijay Mallya, a part-time businessman and a full-time defaulter of bank loans, had celebrated his sixtieth birthday by throwing a huge party at the Kingfisher Villa in Candolim, Goa.

As the Mumbai Mirror reported: “International pop icon Enrique Iglesias belted out his 2014 chartbuster ‘Bailando’ (Dancing) hours after Sonu Nigam completed a nonstop two-hour session with ‘Tum jiyo hazaron saal, saal ke din ho pachaas hazaar’.”

This is while banks wait to recover thousands of crore of loans that Mallya has defaulted on, in his quest to own and run an airline.

While Mallya and other industrialists continue to have a good time, the bad loans of banks continue piling up. The Mid-Year Economic Analysis released by the ministry of finance last week points out towards the same. As it points out: “Gross Non Performing Assets (NPAs) of scheduled commercial banks, especially Public Sector Banks (PSBs) have shown an increase during recent years.”

The total bad loans (gross non-performing assets) of scheduled commercial banks increased to 5.14 % of total advances as on September 30, 2015. The number had stood at 4.6% of total advances, as on March 31, 2015. This means a jump of 54 basis points in a period of just six months. One basis point is one hundredth of a percentage.

The situation is much worse in public sector banks.  The total bad loans of public sector banks stood at 6.21% of total advances as of September 30, 2015. This number had stood at 5.43% as on March 31, 2015. This is a huge jump of 78 basis points, within a short period of six months. The number had been at 4.72% as on March 31, 2014. This tells us very clearly that the bad loans situation of public sector banks has clearly worsened.

In fact, we get the real picture if we look at the stressed assets of public sector banks. The stressed asset number is obtained by adding the bad loans and the restructured assets of a bank. A restructured asset is an asset on which the interest rate charged by the bank to the borrower has been lowered. Or the borrower has been given more time to repay the loan i.e. the tenure of the loan has been increased. In both cases the bank has to bear a loss.

The stressed assets of the public sector banks as on September 30, 2015, stood at 14.2% of the total advances. Hence, for every Rs 100 of loans given by public sector banks, Rs 14.2 are currently in dodgy territory. In March 2015, the stressed assets ratio was at 13.15%. This is a significant jump of 105 basis points. In fact, if we look at older data there are other inferences that we can draw.

In March 2011, the number was at 6.6%. In March 2012, the number grew to 8.8%. And now it stands at 14.2%. What does this tell us? It tells us very clearly that banks are increasingly restructuring more and more of their loans and pushing up the stressed asset ratio in the process. And that is not a good thing. The banks are essentially kicking the can down the road in the hope of avoiding to have to recognise bad loans as of now.

In a research note published earlier this year, Crisil Research estimates that 40% of the loans restructured during 2011-2014 have become bad loans. Morgan Stanley estimates that 65% of restructured loans will turn bad in the time to come. What this tells us very clearly tells us that a major portion of stressed assets are essentially restructured loans which haven’t been recognised as bad loans.

This clearly tells us that the balance sheets of public sector banks continue to remain stressed. Data from the Indian Banks’ Association shows that the public sector banks own a total of 77.4% of assets of the total banking system. This means they dominate the system. And if their balance sheets are in a bad shape it is but natural that they will go slow on giving ‘new’ loans. As the latest RBI Annual Report points out: “Private sector banks with lower NPA ratios, posted higher credit growth …At the aggregate level, the NPA ratio and credit growth exhibited a statistically significant negative correlation of 0.8, based on quarterly data since 2010-11.”
As the accompanying chart clearly points out the loan growth of private sector banks which have a lower amount of stressed assets has been much faster than that of public sector banks.
Source: RBI Annual Report

Also, it is worth asking here why are public sector banks continuing to pile up bad loans. The answer might perhaps lie in the fact that the interest paying capacity and the principal repaying capacity of corporates who have taken on these loans continues to remain weak. As the Mid-Year Economic Review points out: “Corporate balance sheets remain highly stressed. According to analysis done by Credit Suisse, for non – financial corporate sector (based on ~ 11000 companies in the CMIE database as of FY2014 and projections done for FY2015 based on a sample of 3700 companies), the number of companies whose interest cover is less than 1 has not declined significantly (this number was 1003 in September 2014 and is 994 in September 2015 quarter).”

Interest coverage ratio is arrived at by dividing the operating profit (earnings before interest and taxes) of a company by the total amount of interest that a company needs to pay on what it has borrowed during a given period. An interest coverage ratio of less than one, as is the case with many companies in the Credit Suisse sample, essentially means that the companies are not making enough money to even be able to pay interest on their borrowings.

Further, “the weighted average interest cover ratio has declined from 2.5 in September 2014 to 2.3 in September 2015 (research indicates that an interest cover of below 2.5 for larger companies and below 4 for smaller companies is considered below investment grade).”

Given this, it is not surprising that bad loans of banks continue to pile up, while guys like Mallya continue to have a “good time”.

Postscript: I will be taking a break from writing The Daily Reckoning for the next few days. Will see you again in the new year. Here is wishing you a Merry Christmas and a very Happy New Year.

The column originally appeared on The Daily Reckoning on December 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

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