- Financial Services Risk Perception Shifts
In the hay days before the Lehman crash, investors saw the huge potential of the I in the BRICS economy and were willing to fund brokerages to expand their business. Brokerages often got valuations for simply the number of branches, sub brokers or market share they possessed and the money received was to be utilized for margin financing to grow the brokerage business. Every brokerage house in India drew up plans to become a full-service investment bank adding new layers of products to the core broking or investment banking business. Today for most of these players broking is a side business and the core has become lending.
Around the same time NBFCs, known as specialty finance companies in certain markets also found a lot of interest. Traditional Indian NBFC models were designed around a core competency viz. used CV finance, equipment finance, new CV finance, gold finance and housing finance. Now investors wanted each to diversify and jump into the core competency of others. At some point in time this strategy morphed into infrastructure financing, real estate financing and sub prime for various players.
The NBFC business was an attractive business with 10% to 12% equity contribution, and a leverage of 4 to 7 times, ensured Return on Equity was high. Banks lent to NBFCs owing to their reach, regulatory arbitrage and specialized skills in lending to certain segments. A specialization as we discussed was slowly giving way to new product segments.
The underlying assumptions to these investments/ loans
1. The credit to GDP ratio and retail participation in stock markets was much lower than most developing and developed markets and there is unlimited growth potential. Also there was a large pool human capital to tap it
2. Infrastructure needs are massive; government is pro private sector and this is hence a massive opportunity to grow
3. Housing needs are massive, land is limited, Real estate prices will keep rising, real estate prices never drop
4. Indian retail borrowers have better credit discipline and with social stigma attached to it, do not tend to default
A shift in risk perceptions can be traced as follows:
1. A Sensex fall from the high of 20,873 on the 8th of January, 2008 to a low of 8,343 on 12th of March, 2009 in the aftermath of Lehman provided the 1st shock to the thesis. Chart below (source Moneycontrol)
It led to a spike in default rates in unsecured lending and margin financing of several banks, NBFCs and brokerages. Risk perception on these suddenly changed and most players withdrew from this segment or scaled it down. Most moved to secured lending especially scaling up the loan against property business or infrastructure financing if you were a wholesale lender. NBFCs and Brokerages were busy explaining how they have diversified books in investor calls and some banks were busy explaining the soundness of their international books, unsecured lending and derivative exposures. Sub prime credit cards, personal loans, margin financing were now the bad words in the lending business.
Then pursuant to the diversification mantra came the boom in wholesale lending to companies who had benefited from the equity boom pre-Lehman and raised massive amounts of equity capital. The low risk perception merely shifted now to a different asset class. The underlying assumptions which built the foundation of the low risk, high growth and high returns investment and lending thesis turned out to miss certain crucial details.
2. The unlimited growth potential in infrastructure was however subject to the limitations discussed in detail in part one and more importantly any market opportunity is subject to competition intensity and an organisations capability to assess risk and monitor it.
With a large number of banks and NBFCs chasing infrastructure lending for growth (typically with a dual mismatch on asset-liability at the treasury end and loan and project cash flows at the asset level), the credit standards fell. One could say the same for Private Equity funds in terms of their valuations and risk assessments.
Secondly core expertise in assessing infrastructure project risk was severely lacking and monitoring standards for project capex and cash-flows were lax. While there has been ample qualified manpower available for financial services in India. The investment required in establishing process, standard operating procedures, project management and monitoring systems and checks and balances was and to an extent still is a challenge in several financial institutions and corporates
3. A similar story played out in real estate financing, a high return segment (developer financing and to a lesser extent in retail/ SME loan against property). Lenders/ Investors diversifying into this segment perceived the risk on real estate prices to be negligible and returns to be massive.
Security valuations on which decision making was done were on paper valuations based on flimsy assumptions and cash flows rarely featured into this arithmetic. Land Banks were the value drivers for investors and demand for luxury properties was assumed to be insatiable. With the underlying presumption of no decline in real estate prices and insatiable demand, risk perception in real estate was low. It was also a dirty business where securing approvals was the domain of a few select companies in each city.
With real estate rental yields between 2% to 3% and affordability at a low leading to decline in demand, recycling of advance money from one project to another stuck under construction became the norm. Often all it took was a refinancing of loan from one lender to another in an ever-bloating quantum to keep things intact. A few tweaks on the excel spread sheets and a valuer to certify ensured a 2.0x cover was always present.
Yet NBFCs lending to these segments were presumed to have specialized skills. Typically, 30% of the books were developer or land financing against a 12% equity capital and rest included retail and SME loan against property or at times home loans. Loss ratios on paper rarely crossed 2%, even though often individual group exposures were themselves higher than this. Returns were high on the back of 16% to 20% lending and risk perception was that this music would never stop. Ratings of these NBFCs were in the AA and AAA category and banks lent to these companies at 8% to 9%, even as they on-lent at 16% for a significant part of their portfolios
The music did slowdown with RERA regulations, the tightening of refinancing norms, IBC and the snail-paced demand. The final nail in the coffin was the IL&FS blow up, with 10.0x consolidated debt to EBITDA and 10.0x consolidated debt to equity this behemoth was rated AAA in the wisdom of all rating agencies. The risk perception on the IL&FS paper was low and the paper was high in demand for most mutual fund houses, institutional investors and banks. Risk perceptions as we see seldom rely on facts, often they are made on reputations.
4. Over the past several years pursuant to the high non performing assets in the wholesale lending business there has been a marked shift by almost all major banks and NBFCs to the retail financing side of the business. Lately several new Chief Executive Officers in leading private sector banks owe their credentials in retail banking or insurance segments. While there have been instances of localized NPA flareups in Micro Finance companies, overall retail lending is perceived to be low risk. An asset liability mismatch led liquidity strangle on Housing Finance Companies (HFCs) and NBFCs has curtailed liquidity to these segments, but the asset side challenges are still perceived to be more in the wholesale book. The low penetration of credit in personal balances sheets does build a strong case. The chart below gives a view of the change in pecking order among the leading NBFCs in 2008 and 2019. One must however note that as market caps are relative to each other an HFC like HDFC has given multi-fold returns to its investors even though bubble sizes look similar in the two charts.
And it shifts again now..
However even as the risk perception on conventional NBFCs has gone up with investors, another slice of the market fin-techs is finding a whole new class of investors. Most lending related fin-techs have models designed around unsecured lending – Personal and Business Loans direct or under P2P lending mode, supply chain financing to retailers, etc. Most are running losses; many have limited collection experience and rely on data analytics to reduce risk. The experiences post the Lehman crash on unsecured lending are a distant memory, fledgling start-ups are in a position to attract more money than established NBFCs or Banks who have access to decades of customer data and portfolio behavior. Risk Perception once again shifts back in favor of unsecured loans and rising competition once again puts many into sub prime loans for growth. While a margin financing related NBFC fraud has given a small reminder to the post Lehman events, it is still considered a one off.
In the third concluding part of the article we will look at certain players which have avoided the above risk perception traps and common factors that sets them apart and certain decision making inferences from the risk perception shifts. I will also attempt to examine the external factors that impact risk perceptions in brief.
Reproducing an article posted on writer's Linkedin Profile on December 28, 2019
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