Mutually assured
destruction is a term normally associated with nuclear war.
Its origins go back
to the post-World War II era when the then three superpowers of the world – the
USA, the Soviet Union and China – engaged in a race to spend billions of
dollars to build nuclear weapons. Other countries including India followed
suit. But these countries quickly realised that if and when there is a nuclear
engagement between two nuclear-armed countries, it will lead to disruption and
destruction on such a large scale that perhaps it would destroy life for
generations to come. And the destruction may not be limited only to the
countries engaged in the war, but perhaps to the entire humanity. This
potential destruction caused by a nuclear war is what came to be known in the
US as ‘mutually assured destruction’. The acronym for this, ‘MAD’, is very,
very apt!
‘MAD’ is a term
which today can be widely applied in several areas, including the Indian
Corporate Lending scenario. Just as in nuclear war everyone destroys everyone
else, the stakeholders in this industry have acted in such a way that they have
ended up in a ‘MAD’ state.
WHY THE PLETHORA OF NPAs
Today in the
lending industry in India there is a plethora of NPAs. We have seen the biggest
names in the industry crumble, we have seen insolvencies like never before and
we have seen unprecedented destruction of wealth. The question to be asked is
how did we land up in this scenario? What was it that led to this? To answer
this question, we need to start by looking at corporate lending prior to the
NPAs and prior to the build-up of all those bad loans. To understand this
better, there is a need to comprehend a very simple methodology that any lender
uses while lending money to a corporate. This model is called EIC – basically,
economy, industry and company. A lender will look at not only the company, its
promoters, its business, cash flows, etc., but also look at it in reference to
the industry in which it operates. Thereafter, the industry is analysed based
on the prevalent economic scenario.
There is now one
more ‘E’ to this model and that is environment or the global environment /
economic state. The key point is that none of these elements, i.e., company /
industry / economy can or should be analysed in a silo. The analysis always has
to be comprehensive (or in toto, if you wish).
Statements such as
‘India should grow at 5% or 8% or 10%’ are very naïve, to say the least. All we
need to do is to look around and ask which countries have grown at this pace,
or have even grown at all over the last decade? And, what has growth brought?
Has it ensured equal distribution of wealth amongst all people? Has it pulled
people out of poverty? If not, what good is this growth? India, after all, is
not a bubble which floats around by itself. Its economic state is a result of
what happens around the world. This is typically what is called ‘big picture
dynamics’. Unfortunately, when we forget the big picture and try to look at the
short term and view things in a silo, it inevitably leads to trouble and
destruction.
So, along with the
EIC model, traditionally any lender would also looked at the all-important
three Cs – Company (promoters, business, products, etc.), Cash flow
(serviceability) and Collateral (back-up). This EIC+3 Cs pretty much worked
fine for many years.
Then there was a
huge change in the demand-supply dynamic that came in with licenses being
distributed to a huge number of NBFCs, small finance banks, MFIs, etc. All
these players wanted a piece of the very under-penetrated but very attractive
Indian market. The Indian market though very large, had a certain segment that
the whole industry was after. This segment was already being catered to by
banks. But now these new players also wanted to break in. The question for
these new lenders was what USP could they offer to lure these customers away? Then
began a rat race to grab the all-coveted market share of borrowers.
And this is what
led to the creation of a series of new, innovative, flashy, unthought-of
financial solutions under the domain of structured finance. Structured finance
typically features off-balance sheet funding, name-lending, zero coupon bonds,
etc. Some of these structures were very attractive to the borrowers because
they allowed them to raise debt without disclosing additional leverage on their
financials. While there was nothing inherently wrong with these structures,
what went wrong was that the lenders who were lending under these models
completely forgot and ignored the EIC+3 Cs model. The big picture dynamics also
seemed to have been forgotten. That is what has led us to this mess.
‘NAME-LENDING’ BECOMES
A PROBLEM
While there is no
dearth of examples to prove this, if we can just pick a couple of very well
written and publicised cases which went bad, we will realise how aptly the term
‘MAD’ fits in the corporate lending business. Both of these cases can
technically fall under the domain of ‘name-lending’ which is basically lending
to a reputed customer without thorough analysis and without collaterals (in
most cases).
The corporate
lending business has five critical elements – the borrowing entity, the
promoter, the lender, the auditors and the rating agencies. The best example of
how these five elements collaborated to ensure ‘MAD’ is the downfall of the
IL&FS group. In this particular case, the reason that it stands as one of
the largest NPAs in history is that almost all the stakeholders acted with no
vision, no big-picture dynamics and with a complete ignorance of basics. The
lack of integrity from the management and a total lack of accountability from
the auditors and rating agencies allowed IL&FS to become the mess that it
is today. The lenders, on the other hand, were guilty of showing blind faith in
the name, in the rating agencies and lending without thorough analysis and
collaterals in some cases. This all but ensured their own destruction in the
process, along with the destruction of several corporate entities within the
IL&FS group. This is a classical example of ‘MAD’.
The second apt
example would be Kingfisher Airlines. If we look at this case carefully through
the lens of the EIC+3 Cs model, some glaring, unfortunate decision-making on
the part of the promoter, the company and other stakeholders comes to the fore.
The Indian aviation
industry was booming at the time when KFA was launched. However, for years
together it has been a known fact that globally only five to ten airlines have
ever shown sustainable profitability; and there is a reason for this – this
industry, along with telecom, is completely marred by cut-throat competition.
The fact is the players in this industry cannot really control or decide a
floor price for themselves. Besides, to enter aviation you have to invest large
sums of money and you have to operate almost completely at the mercy of your
competitors who decide the price that customers are willing to pay, on the one
hand, and the ATF and other costs, on the other. There is very little an
aviation company can control on its own. Now, the important thing to note is
that any company to be sustainable has to make profits; possibly after a few years
of operations in industries where there are longer gestation periods. But in
the long run making profits is a must. The revenue model has to be robust
enough to make sustainable profits. In aviation, the only thing you can perhaps
control is a few peripheral costs. But really, without any predictability of a
top line, it is extremely difficult to run a profitable company and to make
sure that it sustains. That’s where the KFA story is very interesting.
At the time of its
launch, we had a reputed promoter who had run a very successful liquor
business. When he launched the airline, he seems to have had this vision that
his airline would resonate the King of Good Times slogan. With that in
mind, KFA was launched with a brand-new fleet, best in-flight entertainment,
best available crew and amazing meals; in short, a fully satisfying customer
experience. All seemed hunky dory for a while. While the airline was not making
too much money, it still seemed to be able to sustain its debt and operate
comfortably. What happened next was just naked ambition – the decision to take
over Air Deccan which was a low-cost carrier.
HIGH COST FOR A
LOW-COST BUY
As it turns out,
this was the starting point of all troubles for KFA. With this takeover, the
airline had a low-cost carrier under its brand and was still trying to match
its ‘best in industry’ service and the other standards that it was known for.
With the pricing of the low-cost carrier being about 30 to 40% lower than the
full-cost carrier, it was a simple case of costs outweighing revenues. It was
unabashedly a failed business model. Typically, any low-cost airline is
supposed to only fly its passengers from point A to point B. No value-added
services are provided because the cost of the tickets is not enough to cover
any other expenses. But KFA Red, which was the low-cost carrier, ignored this
and started operating in its own silo. Again, a case of losing sight of the
basics and losing sight of the big picture. While this happened, to cover the
deficit between income and costs, KFA kept leveraging its balance sheet more
and more and more. The lenders, knowingly or unknowingly, played a crucial role
in allowing this leverage to build up, eventually leading to destruction of
both the company and of themselves.
This was done
through the use of another common concept of corporate lending, i.e.,
‘refinancing’, which is a common end-use stated on the sanction letters of
borrowers in several industries, including real estate. What it means is that
when a Rs. 100-crore loan is up for repayment in the next two to three months,
the borrower approaches another banker and asks for a Rs. 100-crore loan to
repay the first one. And if this cycle continues to go on, it basically means
the borrower never actually repays the principal amount to any lender from his
own pocket. It is like one lender financing another through the borrower’s
balance sheet. This eventually ensures ‘mutually assured destruction’ because
the banker intentionally or unintentionally helps the borrower get
into a habit of never having to repay the principal amount.
MONEY LENT FOR ALL THE WRONG REASONS
Then there is
over-leveraging, another demon that has led to the downfall of most companies.
It is high time the lending industry restrains itself when it realises the
company has passed its ‘sustainable debt’. This is another concept which seems
to be lost on the industry. Lenders keep lending to the same company over and
over again even though its cash flows simply can’t keep up with the piling
debt. What makes it worse is that the money is lent for all the wrong reasons,
such as meeting quarterly targets, eating into another lender’s market share,
name-lending because the promoter is reputed and so on. None of these loans are
lent on the basis of any analysis. Once again, a case of moving away from the
basics, not thinking of the big picture and eventually mutually destructing.
A very important
point to note here is that bankers or lenders are not meant to be in the
business of invoking securities. It is the least productive thing a lender can
do. It basically means that your entire assessment has failed and you are now
relying totally on your back-up. A collateral is just that, a back-up. Yet
today, most lenders spend substantial amounts of time and money in trying to
invoke securities and recover their money.
Now, we can ask
whether all this is too idealistic. Shouldn’t we look at being practical? Who
cares which company survives and which doesn’t? But the problem with this
approach is that it has created a systemic issue of ‘bad credit’. And the
inconvenient thing about ideals is that they are difficult to chase, they
require resilience, they require courage, they require character. But we also
need to remember that if we have all these and we reach our ideals, or even
close to our ideals, very few things can topple us.
Therefore, a lender
needs to have the will and the vision to say ‘no’ when a borrower inches
towards over-leveraging or is struggling with a flawed revenue model.
No promoter who has
built his or her business from the ground up wants to see it destroyed. And
therefore, lenders and rating agencies and other stakeholders need to also
think about sustainability of the businesses they are dealing with and, in
turn, their own sustainability. The sooner this realisation of interdependence
and responsibility comes, the sooner will we start digging ourselves out of our
graves. Perhaps, then, we will automatically also see that there is enough
credit available for the people who need it.
