ILFS Died One Year Ago, But its Pain is Alive & Throbbing

The financial sector dreads September, the month that has just gone by. In 2001, the twin World Trade Center towers in Manhattan were struck by two commercial aircraft, shutting the NYSE/Nasdaq for a whole week. In 2008, Lehman collapsed, paralysing global markets. Last year, ILFS filed for bankruptcy, seizing India’s shadow banks. For one year now, Dalal Street has been gripped by a death wish, which culminated in the bizarre case of Altico Capital – last month, in September!

Altico’s story is surreal. It’s an unlisted non-banking finance company (NBFC) founded by three global giants who manage world-wide assets of nearly $ 300 bn. Altico itself has over Rs 500 cr in equity and Rs 3000 cr of net worth. Its profits in Q1 this year were over Rs 75 cr. The company had more than Rs 550 cr in cash – yes, in cash. And yet, it defaulted on a paltry interest payment of under Rs 20 cr to Mashreq Bank. Yes, under Rs 20 cr. Bizarre, right?

A similar defeatism has gripped India’s financial markets ever since the government treated a systemically important financier as if it were a shoe or a biscuit company! “ILFS is a private entity; the government should not back-stop its defaults; let the bankruptcy system work itself out” was the refrain on Raisina Hill.

Alas, India’s finance ministry ignored the stark fact that when a biscuit or a shoe company closes, a few workers lose their jobs and some customers their favourite dip or slip-on. But when a large finance company goes belly up, it sends a cardiac tremor through the economy. Many – savers, lenders, borrowers, investors, consumers – die.

Killing ILFS Created an Awful Trade-off: Saved Rs 25k Cr, Destroyed Rs 25 Lakh Cr

Right or wrong, ILFS (like UTI in 2001, which was remarkably bailed out by the Vajpayee government), was seen to be a quasi-sovereign entity, owned and controlled by a clutch of public sector behemoths, including SBI and LIC. It had already defaulted several times in the weeks leading up to that fateful closure in September 2018. While its debt was nearly Rs 1 lakh cr, it needed to repay a mere Rs 35,000 cr until 31 March 2019. It could have hastily sold equity and assets of around Rs 10,000 cr, leaving it short by Rs 25,000 cr. Since its operating cash flow was negative, it needed a bail-out.

Otherwise, the contagion would have been – and unfortunately, it was – devastating. Within weeks the markets wiped out Rs 10 lakh cr of investors’ wealth. The credit economy gummed up. Beleaguered public sector banks had a direct exposure of Rs 40,000 cr in term debt given to ILFS. Provident and pension/insurance funds had an additional Rs 30,000 cr at risk. NBFCs, mutual funds and others were staring at a write off equal to the balance Rs 20,000 cr.

That was not the time to argue nuances around moral hazard. That was the time to hoist the fire hose, and spray calm into the markets. The government had a plethora of options:

• It could have created a superior debt/equity instrument for NIIF (National Infrastructure and Investment Fund), which could have installed a brand-new management and overseen an orderly rescue, including asset sales over the next few months/years.
• Alternately, it could have quickly calculated the vastly denuded Net Asset Value (NAV) of the company and floated a rights issue of shares at half that value. For example, if the NAV had halved after the bad assets were written off, the rights issue would have happened at a quarter of the NAV on the balance sheet before it blew apart. I am sure ILFS’s pedigreed shareholders (or others) would have jumped at the mouth-watering valuation, especially if they were assured of a public listing within a year.

Whichever option was chosen, the defaults had to stop. And once order was restored, the regulators would have begun the arduous process of systemically reforming, and holding accountable, everybody who messed up in this saga, from the founders, directors, ratings agencies, the fragile apparatus of using short-term finance to fund long-gestation infrastructure projects, whatever!

Unfortunately, the government stayed as still as the proverbial deer trapped in the headlights. No option was chosen. The defaults did not stop. Over 400 companies – double the number compared to the previous 12 months - have filed for bankruptcy since then. By refusing to cover a temporary hole of Rs 25,000 cr, the economy eroded value by nearly Rs 25 lakh cr; worse, it continues to lose copiously even today, one year later.

So, what were the lessons the government should (and perhaps still can) learn from the ILFS meltdown?

One: systemically important finance companies inflict an exponential damage if not rescued; refer to the commentary on TARP, below

Two: overall economic welfare increases if finance companies are saved, since a general, cross-sector pain/slowdown is pre-empted

Three: there is a moral hazard only if wayward owners are given a lifeline instead of being punished; but there is a moral benefit if the underlying asset is saved, even as unscrupulous founders/managers are taken to the cleaners

TARP: Why did Acronym-Loving Modi Government Ignore These Four Letters

Picking up lessons from our ILFS fiasco, I have advocated a TARP-like rescue plan for systemically-important-but-stranded assets in our economy. Let’s begin with a bit of history. Lehman filed for bankruptcy on 15 September 2008. Markets plunged, threatening the global economy with a disorderly collapse.

But to the US government’s credit, it swiftly got into emergency mode. In less than three weeks, on 3 October 2008, President George Bush signed the Emergency Economic Stabilization Act, also known as TARP, or the Troubled Asset Reconstruction Program. The US Treasury resolved to buy $ 700 billion of distressed assets, or pump cash directly into bankrupt balance sheets.

$ 245 billion was given to banks; $ 70 billion to the insurance giant AIG; $ 80 billion was used to rescue auto companies like GM and Chrysler; the rest was given to a clutch of endangered entities. Surprisingly, only $ 410 billion was used; $ 290 billion was never drawn down.

Cash given under TARP was neither a grant nor a subsidy, but an investment which the companies had to pay back with an appropriate return. Yet, the Congressional Budget Office initially estimated that $ 356 billion (out of the $ 700 billion) would be irretrievable, to be written off; but the lawmakers were happy to burn this cash to save their economy. They understood that the promise of cash-on-tap would obviate a systemic meltdown (how I wish the Modi team had the same understanding of market psychology!).

How Successful Was TARP?

Since it’s impossible to argue for the negative, ie to assess how much damage would have occurred if TARP had not been promulgated, we can only rely on guesstimates. A study by Alan Binder and Mark Zandi showed that US unemployment could have touched 16 percent (it had peaked at 25 percent in the Great Depression of the 1930s).

But there’s another, more tangible way to assess TARP as opposed to the feared loss of $ 356 billion – TARP ended with a zero loss, perhaps even a marginal gain for the US Treasury!

Prime Minister Modi, in his new avatar as dramatic tax cutter/reformer, should make the TARP Handbook a mandatory text for his economic advisers.