Margin of safety
Margin of Safety in gold financing comes through various measures
As per RBI regulations, gold loans are restricted upto 75% LTV. This means that if a customer provides 1 lakhs Rs worth of gold jewellery as collateral, then he can avail himself to a maximum of 75000 loan. In fact, as per RBI guidelines, only the value of raw gold can be used in calculating LTV – so, other value add in the jewellery like making charges, gems, diamonds, etc do not contribute to the calculation of LTV. So, in reality the value of the jewellery may be 1.2 lakhs, but the customer can avail only a maximum loan of 75000.
The gold jewellery is handed over to the custody of the gold financing company. Thus, in case the customer fails to repay the loan – then the gold financier doesn’t have the headache of having to send recovery agents to recover (e.g. anyone seen the goondas who are sent to recover 2/4-wheelers when customers default on auto loans?)
Gold is traditionally an appreciating asset. Thus, if a customer fails to repay his loan – then the company is allowed by RBI to auction the gold jewellery after waiting for a fixed number of days (If I remember correctly, it is 6 months). Typically, by the time of this auction the gold jewellery has appreciated in value, because of rising prices of gold.
Testing of purity of gold is very easy – the gold jewellery is dipped in acid solution for a few minutes. If it is real 18+ carat gold, it won’t corrode. So, chances of being defrauded with fake jewellery is very low (If fake jewellery is accepted as collateral – it is almost certain that the company’s official is a party in the fraud).
Muthoot Finance has a large internal vigilance department, which is almost entirely filled with retired senior police officials. This helps in two ways (1) the guys are extremely good at investigating any employee fraud (2) these guys are well connected to the police department, so they are able to ensure that anybody defrauding the company gets punished.
The gold jewellery accepted as collateral is stored in the respective branch of Muthoot Finance in strong-rooms – this is required by RBI regulations. I have been told by knowledgeable people that the strong-rooms of Muthoot Finance is more robust than that of most banks. Since, the gold jewellery is not transported from any of the branches (e.g. to a regional office), the risk of burglary in between transit is almost not there. Also, even if a burglary is done in a branch – the risk is low – as each branch is holding only about 5 – 6 crore worth of gold jewellery (20,000 crore worth of gold jewellery across 4000+ branches). There are no systemic risks in terms of gold storage/transit.
Indians (especially the womenfolk) have high emotional attachment to their gold jewellery. So, it is unlikely that customers would default on their gold loans, as they would lose their treasured gold jewellery.
Gold financing is mainly availed by small/medium entrepreneurs and lower income people who need emergency cash (e.g. to meet hospital expenses, etc). The average loan ticket size is small – in the case of Muthoot Finance it is less than 50 thousand Rs. So, it is mostly availed by marginal folks (unlike the Vijay Mallyas who take gigantic loans and manage to not repay these loans with the help of his army of highly talented lawyers)
Any risk in lending to marginal folks is compensated by the ability to charge higher interest rates. Muthoot Finance charges interest rates of between 12% and 24%, depending on the riskiness of the loan. (E.g. a customer availing a loan at 50% LTV, is charged a lower interest rate than a customer availing a loan at 75% LTV). Thus, there is inbuilt safety as a few defaulting customers are compensated by many highly profitable customers.
Gold financing in general is less risky that every other form of financing
(1) Infrastructure financing – highly risky, as infra projects have long gestation periods and questionable viability
(2) Micro-financing – highly risky as it involves lending to marginal folks without any collateral
(3) 2-wheeler financing – highly risky mostly availed by young college passouts, with questionable incomes.
(4) 4-wheeler financing – risky as in case of default, it is difficult to recover the vehicle, and often the resale of the (depreciated) vehicle doesn’t fetch enough money to recover the dues from the defaulting customers
(5) Commercial Vehicle financing – very much linked to economic cycles, as truck fleet operators have low utilization (and profits) during economic down-cycles
(6) Housing loans – risky as real estate is highly illiquid in bear cycles. Defaults in housing loans typically happen in bear cycles (why would anybody default on a housing loan if the price of the house is rising fast as in a bull cycle). Banks/NBFCs are unsuccessful in auctioning/disposing off real estate during bear cycles, when real estate transactions die down to a whimper
(7) Working capital / short term bridge loans – medium risky (risk mainly due to lending without collateral)
(8) Long term loans to corporates – Risky, as many corporates flex their political connections to avoid repaying