Good discussion. Let’s use the same example. The total debt in the system is 900 + 1000 = 1900 and Equity is 100 + 142 which means D/E is 1900/242 = 7.85 (that’s assuming the equity of the NBFC itself wasn’t financed by leveraged debt, which I presume can happen in a QIP) so the 9x leverage of banks and 7x leverage of NBFC’s means that the total leverage in the system is 7.85, best case. Now look at this way - If the bank wasn’t ready to lend the 1000 to a risky sector, now the NBFC is willing to lend 1142 to the same risky sector and somehow the bank is absolutely OK with this because the responsibility for end use/collection is not with it. This is what I meant by rising risk with the reduction in responsibility.
It is not that Bank does not lend because it is a risky sector. No bank has capabilities to lend to all kind of businesses/people. Skills and reach required to do loan against gold are different from housing loan or consumer durable loan or micro finance etc. That is where these NBFC come into picture where they have specific domain expertise. This is not different from any other Industry… We have Maruti, Bajaj Auto, Hero and all big names but they do not make all auto components. They focus on the core design, marketing and assembly and that is why so many auto ancillary came up and thrived. Both exist together and are complement to each other. I believe there is no breakage in basic model of Bands and NBFCs… only thing that will happen is some non-efficient player may die and efficient ones will recover and thrive back in few quarters though they may not get the same valuations if sector goes thru PE de-rating.
Theoretically I disagree with the above computation. Assume that the NBFC advances this entire Rs 1142 to a single customer. The total Debt in the system is the debt of the Final Customer only ie - Rs 1142 My logic is as follows
1- Suppose one makes a Consolidated Balance Sheet of the Bank and the NBFC, the loan given by the Bank to the NBFC will be offset against the Loan taken by the NBFC from the Bank. Therefore in the Consol BS, advances will be only what the NBFC has lent to their customer. Also, if the NBFC has sources it’s equity from its own funds (whether out of share issue proceeds or retained profits), the same will be addiditinal equity. So the total equity in the Consol BS will be Rs 100 of the bank and Rs 142 of NBFC= Rs 242.
2- Another way of looking at it is let’s assume a scenario where the final customer fully defaults on his debt. What will be the total loss in the system?
Scenario 1) if NBFC fully bears the loss and fully repays its Loan to the Bank. Loss to NBFC - 1142. Loss to Bank - 0.
Scenario 2) if NBFC only bears loss to the extent of its equity and in turn fully defaults on the loan taken from Bank. Loss to NBFC - Rs 142 (to the extent of equity), Loss to Bank - Rs 1000.
You can make this calculation for Any scenario in between where part of the loss is borne by Bank and NBFC - the total loss will not exceed Rs 1142.
Therefore in theory, the total debt to equity would be Rs 1142/242 = 4.72
However in practice, one would never be able to make such a detailed computation because of the cobweb of inter-se lending between banks and NBFCs. At the headline level, one would only hear that leverage of Banks is 10x and leverage of NBFCs is 7x.
That is why I believe Mr shah is stating that there is some safety built into the system. (Which people may not be fully appreciating)
Also, there are regulations like minimum capital adequacy norms that would prevent the situations you are fearing - large increase in leverage. I believe presently no Bank can go above 12x leverage in India, in 2007 you can check the data for American banks the leverage was incredibly high sometimes around 30x also.
I don’t agree with this D/E calculation because it will keep reducing as the chain of (ir-)responsibility is extended which runs counter to basic logic I feel.
Debt creates credit creates debt and the cycle goes, in feedback loops. We cannot, not consider the total debt as debt on every individual balance sheet because that is the sum total of pain in the system because each entity is responsible for repayment of debt on its balance sheet.
I agree with what you are saying that the problem is solvable at a system level by making small calculated moves. It boils down to the problem being a liquidity problem or a solvency problem. If it’s the former, the reserve bank can step in (and it did proactively last week) and solve the issue and if it’s the latter, the govt. will have to step in, along with the central bank. Already every govt entity from LIC to SBI to NHB is stepping in, which means that this could also be a solvency problem. Time will tell.
Exactly. Banks do not have capability to lend plus they face policy restriction from RBI in lending to certain sectors. For example banks are not allowed to lend for “Land purchase” or “Capital Market” activities. Whereas NBFCs / HFCs are allowed to do the same.
Basically RBI does not want banks to lend in this sector as they believe banks do not have adequate risk assessment to give such loans (PSU banks tend to follow a checklist approach and may incorrectly lend). By lending to NBFCs / HFCs who in turn further lend, banks are in a way transferring the risk of such lending to NBFCs/HFCs.
Also their is a question of reach - reaching out clients in tier 2/3 cites and MSME clients is easily acheived by NBFCs & HFCs
Edel for its part has collateral cover on most of its credit origination and in general lends at 40-55% LTV. They are a risk averse lender. One can’t control temporary MTM’s but if they are able to hold these loans for the tenor, the defaults will be a tiny number. MTM and NPA are less important than loss given default. In the latter, Edelweiss’s credit origination has been excellent and with time that will show.
People can keep freaking out about wholesale funding issues but these are natural and par for the course for wholesale funded lenders. If anything such moments are rare opportunities if someone has a perspective of a full cycle. 7-10x leverage is nothing. Lehman and Bear sterns went belly up because leverage was 25-30x and temporary liquidity issues became permanent erosion of confidence and capital. With proper risk control, Banks can do 15-20x leverage without issues (look at some Australian banks for eg)
Connect the dots
1 - “Essar Steel is among the first 12 non-performing assets that RBI had directed banks to take to insolvency resolution in June 2017. The Ruia family-promoted company owes Rs 49,394 crore to its financial creditors and approximately Rs 5,000 crore to operational creditors.”
2 - “ArcelorMittal Picked As Winning Bidder For Essar Steel.”
3 - “As reported earlier by BloombergQuint, the global steel major had bid Rs 42,000 crore, the most among the three players in the second round of bidding. Numetal had bid Rs 37,000 crore and Vedanta had offered Rs 35,000 crore, reported Bloomberg.”
4 - “As on 10 September, Edelweiss ARC had ₹ 14,666 crore admitted claims of ₹ 49,394 crore of all Essar Steel’s financial creditors put together”
5 - Average discount on Edelweiss’s purchase price seems to be 30-50%
6 - If winning bid is at 80% it Face value of creditors, it means the overall haircut is only 20% (Ofcourse it would be wrong to take this overall average as the same haircut for all creditors, as some would preferred). My guess is that Edelweiss would have got atleast 10-15% extra realisation over purchase price (most of which would be abt 1 year old).
Again another example of disproportionate payoff in a successful resolution.
If the transaction is concluded in the next few weeks, the monetisation of security proceeds would be bonus cash inflow in these liquidity starved times.
Disclaimer - Invested and views biased, not a recommendation. Do your own due diligence
Source for 5
“In fact, for Edelweiss ARC, a large part of SR redemption will be due in the next two-three years as bulk of the assets were acquired after 2014. The SRs are generally redeemed over a period of five to eight years. Last year, Edelweiss actually redeemed SRs worth Rs1,000 crore. According to sources, Edelweiss is expected to redeem more than Rs2,700 crore SRs in Binani Cement alone. If Essar Steel also sees a resolution, Edelweiss will redeem another Rs3,000 crore to Rs4,000 crore. There are some estimates that Edelweiss would redeem around Rs10,000 crore SRs in the current year. “This will be the highest by any ARC in India since its inception,” say sources.”
The above article says , “The SRs are generally redeemed over a period of five to eight years”. I am not clear about this part. In case of successful resolution - Won’t the SRs be redeemed in year 1 itself?
Thanks for sharing and the brilliant analysis.
What I can understand is that perhaps ARCs guarantee payment to Banks within 5-8 years of debt transfer, while SRs are redeemed by default in case the stressed asset is monetized early.
Good conversation and clarity of thought. Looks like they want to be fixed income champion of India.
There are no guarantee payment. Based on trust document between SR investor and ARC, cashflow waterfall is determined. After meeting expense of resolution, managment fees of ARC, the left over cash is available to SR investor. There also possibility of superior and subordinate SR class. The superior class SR would get principal along with interest yield for period held. Whatever left after that is distributed to subordinated SR investor first towards principal and then towards stipulated yield of period of investment. In case there is further cash is available same may be shared between SR holder and ARC as success fees which is mentioned in trust document. So not very simple to assume cashflow for ARc and SR investor from publicly available information in my view.
Discl: No investment in Edelweiss.
great set of numbers again
This is from results release "We will in the next six months continue to strengthen focus on asset quality and liquidity, long term business and
building customer value while we remain relentless on heightening our risk management and corporate
governance practices, technology investments, building foolproof systems and processes across businesses and
strengthening our leadership pipeline. Once profitability adjusts, we will again come back to the growth path. "
Looks like they want to go slow for next couple of quarters.
I think great management always look first risk management and try to adjust bad time by strengthening processes instead of taking hasty decision to maintain growth for praising market !! I love PEL and Edelweiss and started accumulating PEL and Edelweiss at this level as I see future for such management is brigther than other. Be greedy when other are fearful !!
We should wait for concall but this is essentially function of diversified biz they have. They can keep the growth contained for any temporary issues without disappointing investors. What I understand is that they will most probably slow down their corporate/retail loan segments. Distress credit is anyway in a sweat spot. I think they also need to raise longer term liabilities asap to keep the growth going.
Very detailed and more importantly FAIR presentations by Edelweiss on Q2 overview and path ahead for H2 FY19.
Key takeaways on the lending business (comments in brackets)
- “We are in an environment where liability management models are being tested. Liquidity is returning to the system steadily and slowly. We have raised ~ INR 2,600 Cr since September 21st, including INR 1,450 Cr in CPs. We have bought back around INR 1,000 Cr in CPs”
(Re: liquidity returning - as per various info, rate of CP issues is going up https://twitter.com/deepakshenoy/status/1055798219291090944. However, As funds are expected to get costlier, hence chucking out costlier source of fund seems to be a margin protecting move, which is welcome)
"We have been here before in 2008 and also in 2013. This is a passing phase; we expect normalcy to return in next few months.We expect to see a return to the growth path in FY20.
We expect the corporate credit book on our balance sheet to reduce while simultaneously investing in such opportunities through our funds in Asset Management"
(In a recent interview on a TV channel, Mr Rashesh Shah mentioned that NBFC’s growth would moderate to ~15%. Looks like management is prepared for even zero or marginally negative growth in Loan book in next few quarters. Again, not too concerning as markets seem to have already priced this. But nice to hear the management being up front and fair about this)
- “We will continue to grow our SME and small ticket housing loans in a focused manner. Our customer understanding and product suite in these segments enable us to have pricing power and hence protect NIMs”.
(To be fair, the management has walked the talk in the past on the aspect of increasing Retail as a % of Total book.Against the self set target of 50% of Retail by 2020, it has already reached 42%.
Further Management has significantly reduced proportion of risky Structured Lending with increase in proportion of relatively less risky Retail Mortgages and LAS in the last 2.25 years, refer tabulation below
However, the concern here is that to achieve the target blended yield of 16%, if the high yielding Corporate Book is to be replaced with SME loans - there would either be a reduction in spread or an equally risky SME loan book as a consequence. This I feel is an inherent problem of an NBFC which borrows at 9.5-10.5%. A lot of these SME loans would have to be unsecured. As per management their unsecured SME loans have an average yield of 21% and average ticket size of Rs 10 lacs. Another factor is what would be the demand for these loans, especially in times of rising interest rates and the competition. I think it would be reasonable to expect a contraction in spreads of Edelweiss, relative to banks. Refer tabulation for spread analysis of Edelweiss QoQ
IIFL, which has a more retail oriented Loan book had an Yield of 14.5% as on 30.06.18.
Long term borrowing as a % of Total borrowings has gone up from 34% in FY 15 to 59%. (Aggressive long term borrowing when interest rates were lower, will certainly help spreads in short - medium term)
Management has disclosed ~ No of groups in Wholesale Loan Book.
“Wholesale Mortgage market is ~INR 5 Lac Crore”
“Edelweiss Wholesale Mortgage book size is ~INR 12,000 Cr (~2.4% market share)”
“All lending post land acquisition and key approvals”
“Sole lender status gives exclusive control - 95% of Total”
“Well collateralized at ~1.9x cover; Exclusive charge on the collateral and cashflow control”
“Strong legal documentation with step-in rights - eight Asset Resolutions done through a mix of stepping in, bringing in new developer and end customer sales through captive distribution team”
(I feel the management is telling us that they have most of the controllable risks under control. For eg: a builder having approvals will largely eliminate the risk of unfavourable political, environmental events which will jeopardize the project; sole lender and escrow mechanism will largely ensure crony promoters dont divert inflows of projects; management capability to ‘resolve’ potential deadlocks by bringing new developers, end customer sales etc.
The inherently non-controllable risks like slowdown in demand cannot be addressed by any lender.
I feel Edelweiss’s RE lending book is more seasoned and less risky vs someone like a Piramal which gets into pre-approval lending and loans for land acquisition.
However, having ~50 groups in a Structured Loan book of Rs. 9000+ crores and ~ 100 groups in a Wholesale book of Rs. 11,000+ crore is something that Im not very comfortable with. Even One or two groups turning Non-Performing would cause a significant spike in NPA %.)
Overall, it is very comforting to see the management attitude in being upfront and sharing such information. If one is able to read between the lines, there is plenty to digest This is a welcome change from the lop-sided investor presentations released by some peers.
The risks of contraction in margins, slowdown in growth and asset quality continue to loom over the horizon, but management performance (and perception) has been equal to the challenges faced in the recent past.
I continue to hold and add on dips. Views invited
Nice summary! in fact quite a few worries have been answered with adequate detail.
Funding: available for them but they remain cautious and not boasting like others in the town.
Growth: Some slowdown in credit growth was given but ARC should pick up the slack
Real Estate: very few know that Edel has RE book since 2008 and has been well managed despite many mini crisis. Still they do not want to grow I guess it is also to do with the fact it consumes capital faster and locks funds for longer period. They will have raise longer duration liabilities to grow this book.
Structured book: the problem is that there are not enough buyers of these structured books in the market so growing it will require good enough funds on their own side. Best done through fund based route.
My rough cut valuation
1) Non Credit Business
PAT of Rs.308 Cr. in FY18
Estimated PAT of 339 Cr. for FY19 (10% growth)
at very conservative (High ROEs & high teen growth business) 15x of PAT - Value of Rs.5,082 Cr
2) Credit Business
Book Value of Rs.6142 Cr. @ 1 B/V is Rs.6,142 Cr.
(Book Value assumes the book is not majorly cooked up and can take losses of 10 to 15% due to its Real Estate & Structured Finance book the ARC business would compensate with its huge profits - Essar should itself give Edelweiss Rs.500+ Cr of profit and secondly retail portion of the book has now reached ~42% share thus providing necessary diversification and lenders with retail books are trading at minimum ~2x)
3) Insurance Business @ Rs.1200 Cr. (Edelweiss stake at last deal plus some time value)
All the three add up to market value of Rs.12,500 Cr. or a stock price of Rs.135/-
chance to buy a strong business which has diversified income streams and has potential to grow very fast when dust settles.
Please provide your comments.
Any one has the details on when the Con call is going to happen ?