Debacle of DHFL : Story so far & some staggering questions

How is it possible that the company which hit a high of Rs. 691.50 on 3^rd/ Sep/18, is trading at paltry Rs.17 in just one year and three months?

How is it possible that the company which was once a darling of foreign portfolio investors, mutual funds, Rakesh Jhunjhunwala (RJ) etc. has seen many of these investors vanishing?

How is it possible the company which was supposedly in pink of health and had clean chit from various credit rating agencies (CRAs) having AAA or equivalent of ratings for debt instruments has now ‘default’ rating and heading for insolvency proceeding?

What has happened?

The ominous day of 21^st/ Sep/18 when DHFL (Dewan Housing Finance Corporation) crashed by 42%, has changed permanently the fate of DHFL (and its’ investors & lenders) for the worst. The crash which never recovered was in a response to the rumors generating from the bigger crisis of IL&FS.In the last 15 months, DHFL the NBFC- has degenerated from ‘safe bet’ and ‘sound NBFC’ to a candidate for insolvency proceedings. Fast-forwarding to the recent development, DHFL has stopped making any payments to secured/unsecured creditors as well as fixed deposit holders as per the order of Bombay High Court in a case filed by Reliance Nippon Life Insurance. However, the court has amended the order and allowed DHFL to make payments to the banks and NBFCs with which it has existing securitization and loan assignment agreements. Looking at the grim situation, with this circular the Board of Directors of DHFL has been superseded by the RBI. Also, RBI has appointed the resolution professional to take charge of insolvency proceedings.

How it has happened?

1. Snowball effect from IL&FS trouble: First and unrecoverable dent came from IL&FS crisis and related rumors. I could not find any warning bells on DHFL before the ominous day. In fact in the same month last year, DHFL clocked all time high of Rs. 691, with the promise of further upside from so called analysts & talking heads. Default by IL&FS on various obligations certainly choked the credit market and liquidity crunch was felt across the financial system for a sometime. This undermined DHFL’s capability to arrange much needed capital for meeting the upcoming debt obligations.

2. Cobra bite - Fraud and fund diversion: Lethal salvo was fired by a post (Thank God at least few are doing their job seriously!) from cobrapost.com alleging the promoters of DHFL for siphoning off Rs. 31,000 crore worth of public money to shell companies. Well, recently submitted forensic report by KPMG confirmed that the funds were siphoning from DHFL to other promoter backed entities. Consequently, Ministry of Corporate Affairs has ordered investigation by SFIO (Serious fraud investigation office). Only time will tell what SFIO is going to unearth but this has led to a huge trust deficit from investors and lenders in the DHFL. The share holding pattern -shown as below - at the end of Sep-19 quarter vis-à-vis Sep-18 quarter is reflective of vanishing investors’ trust and interest in DHFL.

            Share holding pattern of select public shareholders of DHFL

Public shareholders	Sep-19	Sep-18
Foreign Portfolio Investors	9.48%	19.43%
LIC	3.44%	3.44%
Mutual funds	0.01%	2.94%
Body corporate	6.20%	12.76%
Mr. Rakesh Jhunjhunwala	2.46%	3.19%

          

            Source: As per filings by DHFL 2018&2019

3. Faulted business model & Asset- liability mismanagement: It is an open secret that how NBFCs run their shop. Majority of NBFCs reside to the strategy of borrowing for short term tenure and lending for long term tenure. Lure of borrowing short term and lending long term to safeguard better interest margin/profitability is overpowering among many financial institutions. But time and now, it has been evident that the exploitation of borrowing short term & lending long term- strategy has transmitted into asset –liability mismanagement. Improper asset-liability management is harbinger of liquidity risk which if remains unattended can lead to solvency risk. Seemingly, DHFL also travelled the same path. Due to market conditions, downgrade in credit ratings and unearthing of the fraud, ‘money’ pipe-line for DHFL was choked and it was put into such a dire state that it could not arrange capital to meet various redemptions of debt obligations leading to a default and cascading effect.

Bigger questions:

No matter whatever bitter remedies are going to get suggested, be it- securitization (selling loans to banks), liquidation, equity conversion to lenders etc. following staggering questions remain unanswered!

1.     Why do we remarkably fail to see the ‘Black Swan’ events and system at large remains stubbornly reactive?

2.    Is the process and basis upon which deposit-taking NBFCs are granted the permit to take a deposit from public robust? Does RBI on regular intervals appraise such permits? Should it cancel the permit after regular audit if it finds the NBFC is not fit to take deposits from the public?

3.    What will happen to the ‘hanging fate’ of fixed depositors(unsecured creditors) consisting of retirees, salaried, senior citizens and of course there are Mutual funds & banks?

4.   Are the employees of UP Power Corporation Limited whose money through state power employees' provident fund was fraudulently invested Rs. 2600 crore in DHFL going to get their money back?

Round-Trip Fallacy: The reasoning error to avoid

The human brain is wired to interpret similar sounding sentences/scenarios/situations in the same way however the reasoning behind it may not be similar at all leading to the generation of reasoning errors and faulty decisions.

The classic similar sounding situations;

"No evidence of cancer" 

                   &

“Evidence of no cancer”

The above situation looks similar hence our brain interprets it as the same. But the below explanation reveals that these are completely different. 

1). "No evidence of cancer" = The test/expert/instrument was unable to detect evidence of cancer.  

    "No evidence of cancer" ≠ There is no existence of cancer. 

It simply means we are so far unable to detect the cancerous cell in the body however this does not lend itself to the premise that there is no cancerous cell in the body.

2). “Evidence of no cancer” = simply there is no cancer.

 But this is not possible as no amount of tests/experts/instruments can confirm with a hundred percent surety that there is no cancerous cell in the body. 

Technically speaking:

The technical term for the above confusion (absence of evidence of such events-cancer for evidence of absence of such events-cancer) is ‘Round-Trip fallacy’ which was coined and elaborated by NassimTaleb in his book The Black Swan. 

 An analogy from the world of finance:

“There is no evidence of fraud/ wrong-doing/ cooking the books in this company” = The so-called auditors/experts/regulators could not find (didn’t want to find!) so far any evidence of fraud. OR They did not know where to look to find evidence. 

“There is no evidence of fraud/ wrong-doing/ cooking the books in this company” ≠ The company is clean.

“There is no evidence of financial trouble/ crisis in the economy” = So far no evidence found to say that there is trouble or crisis.

“There is no evidence of financial trouble/ crisis in the economy” ≠ The economy is booming & everything is rosy! 

In a nutshell:  

When we try to interpret these kinds of similar sounding situations/events, our brain tricks us into believing that no evidence of any such events means no existence of such events. But understanding the ‘Round-Trip fallacy’ and learning to go a little slow while processing such information may help us avoiding faulty decisions. It is high time that regulators/ fraud detection experts/ auditors etc. start understanding this reasoning error in order to perform their duties in a better way. Being more skeptical than usual while analyzing companies/situations/events/economies for financial or any other decision making may be more advisable especially in the world with tariff wars, grappling with negative interest rates, frauds, defaults….!    

Linking bank loans to external benchmark rate : the good, the bad and the ugly

In an effort to uplift the falling economic growth rate and consumer sentiment, RBI made an announcement regarding external benchmark based lending on 4^th/Sep/19. Though the final guidelines are awaited yet, the details can be read in this circular. However RBI may deny that this announcement has nothing to do with the current state of the economy, but the timing of this announcement and its’ direct influence on reviving the consumer and business sentiment by lowering the cost of borrowing tells the opposite of it.

I attempt to do a quick analysis of this announcement in the Good, the Bad and the Ugly style…!

The Good:

1. Better and faster policy transmission:

Undoubtedly, linking loans to an external benchmark rate seems more effective and faster policy transmission tool. We have come across as a borrower, the propensity of bank to quickly raise the lending rates when there is a rate hike cycle but being laggard when there is rate cut cycle. RBI has been suffering a severe headache due to this reluctance of banks to reflect a rate changes disproportionately and with longer lag. This year so far 110 bps (Basis point) rate cut is made in repo rate by RBI of which very little has been passed on by banks to the customers. For varied reasons, banks were less willing to pass on these cuts.

The Bad: 

1. Time period mismatch:

The external benchmark rates provided by RBI are 1. Repo rate of RBI 2. Three-month T-bill yield 3. Six-month T-bill yield or any other market interest rate as published by Financial Benchmarks India Private Limited (FBIL). As it can be observed, these benchmark rates are there for very short time period instruments. The lending rate for long term business loans to MSEs and home loans to retail borrowers if linked to one of these external benchmark rates, it may lead to interest rate risk as well as asset-liability mismatch due to time period mismatch. (When long term loans are linked to short term rates and not long term rates)

2. Challenges of linking deposits rates to external benchmark:

To take the pressure off from volatile profit margin, banks may eventually introduce linking of deposits (savings account, term deposits etc.) to the external benchmark rate. As per this article, SBI being one of the first movers, has announced the linking of savings deposits to the external benchmark rate. For CASA (current account-savings account) deposits, floating saving rates may not be much of a deterrent but knowing Indian depositors for term deposits, they may show strong reluctance in adoption of floating rate term deposits as they generally crave for stable/fixed rate of interest on such deposits. Banks with higher CASA portion in their total deposits may have a less bumpy ride to migrate to external benchmark linked deposit system but for others (having a higher contribution from term deposits) they can be placed between the devil(keeping the fixed rate on deposits & hurting the profit margin) and the deep blue sea. (Moving to floating deposits rate - facing depositors’ wrath & losing the business) One remedy to this challenge can be if all banks migrate to floating deposit rate system it may mitigate the competition of fixed-rate v/s floating rate deposits but still there will be competition.

3.  Not market –driven rate but RBI governed rate:

It may not be well advised to link commercial rate directly to the monetary policy rate (repo rate) as both rates are set and revised based on different factors.RBI manages the repo rate keeping in mind several factors and repo rate management has multiple objectives to achieve. A floating interest rate of loan benchmarked against repo rate may not be a correct reflection of the market forces.

The Ugly:

1. Volatile profit margin of banks:

The announcement of linking loans to an external benchmark from 1^st/Oct/19 may set the cat among pigeons (banks). For banks maintaining net interest margin may turn out to be a walk on a thin line, especially when lending rates (rates on various loans) are pegged to external benchmark rate which will be reset at least every 3 months while borrowing rates (rates on various deposits) which are mostly fixed/constant for the tenure. If a bank chooses to keep borrowing rates fixed/constant while on other hand lending rates are going to be flexible/volatile then this may exacerbate the interest rate risk problem and reduce the predictability of bank’s profit margin. So, an act of boosting the customer sentiment (by lowering the borrowing cost) may lead to the creation of hindrance for NPA-stricken and already struggling banking sector. 

2. Faster revisions of EMIs or interest payable:

Mandatory linking of floating loans to an external benchmark rate and resetting the rate at least once in three months is going to result into faster revisions of EMI amount or effective interest payable amount. Changing EMI amount which I hope banks will not resort to, can lead to gruesome experience for individual and MSEs borrowers. But borrower’s effective interest payable amount is certainly going to be more fluctuating in nature. A very fine analysis of pros and cons of this announcement is done in this article.

3. For long term borrowers - short term bliss and long term pain:

After a cut of total 110 bps and expecting a few more rate cuts, we may reach at the end of the rate cycle. Cost of borrowing will be fairly lower than the prevailing borrowing cost for various loans from 1^st/Oct/19 for new borrowers and this may lure more and more people to borrow. Fruits of lower borrowing cost will be sustained for short term may be around for next 18 months (as per my expectations) after that interest rate cycle may bottom out and if the economy is reviving the gradual rate hike cycle may commence. Once the hike cycle starts, the long term borrowers be it individuals or MSEs are going to face higher interest cost leading to increased interest payout or larger EMIs. In a nutshell, looking at the interest rate cycle for short term there will be lower cost but in longer term as reversal in cycle kicks in increased cost will be inescapable.

I believe (I can be wrong here) there is a possibility of identifying better external benchmark rate as the currently announced benchmark rates are either not market-driven (repo rate) or having a mismatched time period(T-bill yield) with underlying loan products.

Why RBI should immediately join NGFS?

Recently, an article by Wharton titled as ‘Why central banks are talking on climate change’ , caught my attention. It nicely summed up the reasons for central banks to sit up and notice the imminent impact of climate change for the finance industry.

Network for greening the financial system (NGFS), which is relatively new but supposedly very powerful and crucial organization is going to play increasing pivotal role for the finance industry and climate change. NGFS is a forum created for central banks and financial supervisors to understand and assess the financial risk and also the opportunities emerging from climate change.  NGFS consists of 36 members as of now including central banks and financial supervisors. Unsurprisingly, Reserve bank of India is not part of NGFS (however IDBI bank & Yes bank are mentioned as a part of supporting institutions), while People's Bank of China is part of the steering committee. One of the primary goals of NGFS is carbon risk management. My concept paper(published in 2017)  titled as 'Carbon Risk and Impact Assessment from the Perspective of an Institutional Investor'  which deliberates on the identification of key non-physical carbon risk factors and impact assessment on financial performance drivers of the firm, fits right away into the goal of NGFS.

Why RBI should join NGFS?

Sooner the RBI joins the NGFS, better it is for the Indian financial ecosystem.

Joining NGFS reaps following benefits to us;

1. Not being part of such initiative especially when India is a signatory to Paris agreement only shows lack of focus from financial initiative perspective. 

2. Whatever contribution from Indian finance sector will be by joining NGFS will go long way in building the 'Finance India' image especially when China is being so proactive. (as being part of the steering committee of NGFS) 

3. Joining NGFS may also give us a chance to look into where the world finance think tank is leading in terms of financial regulations & disclosures, upcoming trends in interaction of financial sector and climate change and so on. This shall certainly give chance to smooth transition for Indian financial sector to future changes otherwise, it will be very chaotic to all the stakeholders to make a sudden shift to new regulatory or other changes. Carbon tax, carbon emission disclosure in annual report, carbon footprint exposure by various institutional investors like; mutual funds, insurance companies, banks, AMCs, etc. may become part of regulatory changes as many countries have started implementing these norms.

Indian financial regulatory bodies can afford to be laggards at their own peril and the cost will be paid by all the stakeholders of Indian financial ecosystem!

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Is RBI playing with fire by contemplating to open up exotic currency derivatives to Indian firms?

A few days back a news article on RBI's proposal (in the discussion stage) of uplifting the ban on exotic currency derivatives caught my attention. Since then various opinions on this have cropped up.

I believe the proposal of allowing firms to trade exotic derivatives may create more problems than solutions for the broader financial ecosystem in India due to followings factors;

1. Poor understanding of the majority of Indian corporates regarding usages of exotic derivatives (exotic currency derivatives gets more complicated)

Note: I believe plain-vanilla derivatives are good enough in normal-case scenarios for the purpose of hedging the financial risk, the creation of exotic derivatives is done to cater the complex and customized transaction requirement which may be needed by a small fraction of Indian corporates. And of course, the creation of exotic derivatives is to earn big fat commission!   

2. Mis-selling & burning figures: 2008 financial crisis and post-crisis time period has witnessed many entities burning figures (also by foreign currency convertible bond issuance) with the initial intention of making some cool profit out of currency swings. When the product is exotic mis-selling is rampant. Opening up of exotic currency derivatives to firms will lead to heighten mis-selling from many broking/consultancy/advisory companies. Amidst this hyped mis-selling, hardly corproates realize that they may not need such ‘exotic’ derivatives at all!

3. The greed rules: moving from hedging to speculation: By my own trading experience and losses, I reckon that there is a very thin line between hedging (primarily done to protect the downside risk or loss) and speculation (done with the intention of making a profit by undertaking risk )! It is extremely difficult for the company (decision makers/treasury department) to control the urge to move from hedging to speculation. Companies don’t know when they silently get tilted from hedging to speculation and get addicted to speculation after the initial taste of profit! Many cases such as Barings bank , Metallgesellschaft AG derivative debacle, Sumitomo Corporation more are examples of mismanaged hedging or firm’s entry into speculation without much realization.  

Standard derivatives are forward, futures, options, swaps and so on. Exotic derivatives can be any combination or hybrid of any standard derivatives, differently designed/structured derivatives to meet customized requirements and so on.

My advisory:

1. Strictly NO–NO for MSME & mid-sized cooperates:  Runway ASAP if you hear exotic currency derivatives words uttered by some super formally dressed smart looking executive, trying to convince you how cool it is! Profit-creator! & it has no big risk! Plain-vanilla currency derivatives are suitable enough for the varied requirement, provided cost-benefit analysis is in your favor.

2. Big corporates but not truly MNCs: As you have war chest you may try these exotic currency derivatives (many times pushed by overconfident treasury department and of course ego- boosted by consultants/banks/advisory firms etc.) only to realize later on that this misadventure has burnt the hole in the pocket. Plain-vanilla currency derivatives are suitable enough for the varied requirement.

3. MNC giants: Exotic currency derivatives are more suitable if they have complicated and customized transactions requirements and may have better resources to play in the currency market.  

If only one book you have to read - it is the 'Mindset'

If there is only one book you choose to read in your entire life then it has to be the book: 'mindset' by Dr. Carol Dweck. I’ll add one more book to this list which is  'Thinking Fast and Slow' by Dr. Daniel Kahneman (Nobel prize winner). I’ll talk about that in another blog.

Book name: Mindset the psychology of success

Author:  Dr. Carol Dweck

Publisher: Random House

Reach out to me via tirthanks@gmail.com , if you are interested in reading materials/videos etc. on this book, I’ll be more than delighted to share.

A year or so back I came across some ted videos such as ‘The power of believing that you can improve’ and ‘Growth Mindset vs Fixed Mindset: An Introduction’ and other video Growth mindset V/S Fixed mindset.  These videos caught my fancy after viewing & understanding it. Though I kept reading/viewing some articles and videos on this, I have to admit I was super late in reading the book on this theme. ( A piece of advice read this book ASAP you get your hands on it!)

Why this book is a must read for anyone?
 It makes revelation based on more than 2 decades of research in human motivation and power of belief under the broader domain of psychology. The book is an outcome of this research done by the author.

And the revelation is

• Humans are found to have either a GROWTH mindset OR a FIXED mindset OR both, and switching from one mindset to another is possible.
• GROWTH MINDSET = believes that intelligence/ talent can be developed, by constant learning & efforts one can become smarter, take criticism constructively, accepts mistakes as a part of learning.
• FIXED MINDSET =  believes that intelligence/ talent is fixed or given or unchangeable, efforts are needless/fruitless, hide mistakes, believes success/failure define them, learning/efforts are not required.
• It proves the most essential point that success means constant endeavor for learning & improving & it does not mean proving your smartness or adding trophies/medals for the sake of it.
• It highlights profoundly the impact of GROWTH V/S FIXED mindset for as varied different fields as sports, parenting, relationship, business, teaching, coaching, leadership and so on.

·    For every reader, there is something to gain from this book. In fact, I would go to the extent and say… as long as you are a human being there is no reason for you to not read this book & to not implement it!

I would try to cover here a brief overview of this book with few domains.

Sports: The book elaborates on how mindset shaped the life of many sports celebrities. Sports prodigies labeled with  talented, skilled, genius, ‘you are different/unique’ tags at the early stage of their sporting career have inculcated on their own or conditioned by other (coach & parents primarily) for the FIXED mindset. As the FIXED mindset takes larger control, these likely prodigies have shown sign of least improvement/learning, unacceptability for the slightest failure and confirmation for the belief that their talent is no good. While sports prodigies inculcated with the GROWTH mindset either by on their own or positively reinforced by their parents/coaches go on to develop their games, continuously learn/improve with rigorous training, embraces failure - take feedback & improve. With the GROWTH mindset they go long way with a focus on improving the game & becoming better sports character with a larger sense of fulfillment. With the FIXED mindset success can come with prodigy being super egoist, trophy collector along with the fear of failure/bad image. Here, success may not be long-lasting.

The above context is crucial for all sports enthusiast kinds/adults and pro & also for their parents & coaches. Think of Sachin Tendulkar when you think of a GROWTH mindset.

Business: The book nicely highlights the case of Iacocca as CEO of Ford Motors as how FIXED mindset of him eventually destroyed not only him but also the culture of the company and the company itself. The CEO/Head/ Chairman with FIXED mindset are generally fixated with notion of them being a super genius, talented, intelligent, deserving royal treatment – and being a hero of the company. This mindset leads to significant but absolutely unwanted expenditure for buying fancy cars, charter planes, executive suits etc. on company’s money to feed their FIXED mindset. Many times the business decisions they take are influenced by their FIXED mindset only, with lack of a larger goal of taking important stake-holders of the company into consideration while making such decisions. While the career of Jeck Welch as CEO of GE is highlighted as a case of GROWTH mindset in business. The leader with a GROWTH mindset lives and acts with a belief of him being as good as any other employee of the firm, continuously co-learning & improving, readiness to accept the challenge & failure.

One can easily find an Indian version of CEOs with a GROWTH or a FIXED mindset- may be you don’t have to look far – may be you know them!

Relationship:  The book uncovers how mindset influences the relationship at various stages with the example of some real cases. People with the FIXED mindset take break-up or rejection as a failure with a tag of unlovable. They suffer from constant hunger for revenge. For people with a  GROWTH mindset, the break-up or rejection in a relationship is equally painful but they focus on forgiving and moving on. Among married couples having a GROWTH mindset leads to more mature, evolving, accepting relationship even if there is a presence of conflicts.

Few lines from the books aptly summarize the above theme;

FIXED mindset thinking: “You can believe that your qualities are fixed, your partner’s qualities are fixed, and the relationship’s qualities are fixed—that it’s inherently good or bad, meant-to-be or not meant-to-be. Now all of these things are up for judgment.” – chapter 6, page no: 86, e-book.

GROWTH mindset thinking: “The growth mindset says all of these things can be developed. All—you, your partner, and the relationship—are capable of growth and change.” – chapter 6, page no: 86, e-book.

I feel any reader can sense it from the above few lines from the book that how mindset has a profounding impact on relationships which has gone sour or sweet.

In a nutshell, below image captures the gist of the book;

Source: Mindset by Dr. Carol Dweck

Do read it ! The book may just change you!

Making of curative society – in action

A few months back I wrote a blog titled as ‘making of curative society’ which was talking about how we collectively as a society (and also as a broader culture) always inclined to cure rather than prevent any crisis/phenomenon/attack etc. The blog also deliberated on why we are more curative than preventive.

When I was looking around, I could find some of the glaring examples with an imprint of curative instead of preventive psychology.

Financial/Economic scams & crisis:

In spite of financial/economic history of the world is replete with scams & crisis we cannot boast of designing a better system which can help prevent the next copycat crisis/scam.

IL&FS financial crisis in Indian market is yet another story of reaction/cure after the crisis erupted. However, there were enough warning signs indicating crisis was brewing under the surface which were ignored. IL&FS financial crisis could have been prevented like many other crisis/scams.

The debacle of Jet Airways/ Rcom and other companies prove the same point. If we dig deeper, many of such companies had long journey full of many warning signs hinting towards crisis looming over a horizon. Again instead of preventing or reducing such troubles, our curative mindset allowed it to stretch resulting into full-blown crisis.  

The outbreak of Swine flu or other such incidences: We have been witnessing an intermittent outbreak of swine flu for quite some time now. But every time when honorable court asks municipal corporation/ health ministry to share what measures are taken to control swine flu, under-preparedness and lack of preventive measures got overwhelmingly reflected in response from these bodies. We know better preventive healthcare system is the solution but we tilt towards curative/reactive healthcare system.

It seems our mindset is deeply engraved with the ideology of reaction/cure to any problem rather than prevention of the problem. Why it is so, is the topic for another blog!