IL&FS Crisis: It's the Rating Agencies That Really Need Some Fixing

For mutual funds, provident funds, pension funds, and insurance companies, the near collapse of Infrastructure Leasing and Finance Company (IL&FS) was a complete disaster. Few had anticipated this kind of a situation, in spite of the series of warnings from IL&FS itself. Why? Because almost all of them had unflinching trust in the rating agencies, CRISIL (S&P associate), ICRA (Moody's associate), India Ratings (Fitch subsidiary) and CARE.

That faith in the rating agencies now stands shattered. And it is not without reason. It is because funds are now left with securities -- commercial papers, debentures that have steeply depreciated in value. IL&FS debt to the funds are close to Rs 31,000 crore. That is, almost one-third of IL&FS debts are held by mutual funds, provident funds and pension funds. All of these had invested in the papers on the strength of the ratings.

Unsecured Exposure

Banks' unsecured exposure to IL&FS, however, is far lower. That is because banks have tight single-party exposure limits and sector exposure limits. Besides, some banks have also taken IL&FS' own real estate as collateral.

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In the case of mutual funds, that however was not the case. Funds, particularly debt and balanced funds, are not bound by exposure norms of the Reserve Bank of India. That is determined by the rating and the yields on the securities. Ideally, issuers with the the best rating and offering the highest yields are the ones that attract mutual funds. The reason for this is that funds are able to offer their investors good returns in turn. In the secondary market, it is these kinds of securities that find takers in the event of a fund facing redemption pressures.

As for provident fund, and pension funds, what is true is that they have also invested in corporate bonds quite substantially. What is also true is that the funds may be faced with the losses on their IL&FS investments. Employee provident funds are required to invest at least 20% of its corpus in corporate debt, 45% in government securities and another 5% in equity or equity-oriented funds. The operative word in the guideline is 'minimum'. That would in turn imply that of the Rs 10 lakh crore corpus, at least Rs 2 lakh crore is permitted in funds.

Till 2008, provident funds were restricted to investing only in government securities, state government securities and to some extent in bond issues made by public sector entities. But since then the guidelines have periodically raised provident fund exposure to the private corporate bond market. But the investment guidelines were restricted to instruments with ratings equivalent of “Double A” .

However, the Pension Fund Regulatory and Development Authority permits investment in “Single A”-rated instruments, with the rider that the investments are not allowed to exceed 5% of their overall investment in corporate pounds. That would mean that only about 1% of the corpus would be invested in single A-rated securities. In fact, that would be the regulatory cap.

Breaching the Regulatory Cap

The reality is that most funds would have actually breached the cap, after the IL&FS mayhem. The reason being the series of downgrades. Double A-rated instruments are now in default or near default “Single B” ratings. These papers are technically not allowed to be on the books of provident funds or pension funds or even insurance company investments. Yet the funds are now stuck with securities where defaults have occurred. Repayments are likely to take a long time or may actually never be repaid or only partially repaid. That would imply that any restructuring entailing deferring or writing off unsecured bonds are unlikely to be acceptable.

Also Read: Is Serial Defaulter IL&FS Heading For A Rapid-Fire Sale of Assets?

For mutual funds, such deferrals or write-offs would mean that the final cost would have to be passed on to the investors. Ditto in the case of both provident and pension funds where the costs would have to be borne by those who saved for a retirement income.

Funds are unable to get rid of their holdings of their IL&FS investments even at high yields. Given the current liquidity demand for meeting redemption requirements, the funds are literally cash-strapped. Mutual funds in theory could attempt to offload the securities in the secondary markets, incurring losses with hopes to offset losses through trading gains.

As for provident and pension funds, their trading frequencies are lower, and most hold debt instruments till maturity. Their investments to maturity come from the underlying assumption that the credit rating grades issued by the rating agencies were iron clad.

Oversight by Rating Agencies

But can the rating agencies deny that they were unaware of the IL&FS developments? Can they even absolve themselves from the present failures of oversight? After all, a rating once given means that the clients need to be kept under constant surveillance. However, even after the IL&FS dropped clear hints of liquidity problems,  downgrades by rating agencies started only after the September 14 commercial paper default announcement. A partial reason could be because rating agencies take shelter behind client confidentiality clauses. It is after all the borrowers that pay for the rating. There is little obligation for raters to reveal the credit rating or downgrades without client approval. Rating agencies' incomes after all come from the rating service to clients. Isn't a credit rating a contract for assessing credit worthiness for a fee?

Secondary markets, particularly the National Stocke Exchange debt and the collateralised borrowing and lending obligations (CBLO) market (inter- institution borrowing and lending of overnight funds) were far quicker. Prices of IL&FS bonds fell fast or, in other words, yields rose steeply. Indications are that even at 20% yields, there no buyers for IL&FS bonds. Yields of 20% (or liquidity costs) in the current environment are mostly for borrowers that are in a category with a high potential to default. In the CBLO markets, IL&FS bonds are no longer being accepted as collateral. In fact, most private corporate bonds are no longer being accepted. The only bonds that have credibility irrespective of the ratings are public sector bonds.

Yet, the rating agencies have refused to take the hint and move IL&FS to default. ICRA’s downgrade on IL&FS came only on September 20 when the infra major had already defaulted continuously since September 12. The rating agencies though are unlikely to be held accountable, since their contract is with clients, those who commission the rating. Rating agencies functions do not include fiduciary liabilities from potential investors. They function outside the ambit of any regulatory oversight of all financial sector regulators.

Also Read: ILFS: Ponzi Scheme of Loans Unravels, Public Money to the Rescue

Fortunately, few banks in the public sector or in the private sector have made investments on the basis of credit ratings unlike in the international market. Although RBI guidelines provide for a rating-based approach, banks tend to rely on their on internal assessments based on multiple risk scenarios and collateralisation. The higher the lending risk, the greater the collateral or physical asset cover. Collateral value should be at least 150% more than the value of the loan. It was government neo-liberalism that since 2008 progressively worked to disintermediate public savings from banks into the financial markets.

As a result, indications are that any fire sales of IL&FS assets would be focused on redeeming confidence of the funds and international lenders. So far, IL&FS's international obligations amount to Rs 550 crore. The amount may be small, but a default could trigger a loss of confidence in the entire corporate sector, triggering loan recalls. International lenders, so far, have not called back any of their loans, though the covenants provide for them. But the risk of global lenders recalling loans remains, since all it is against is corporate risk. In fact, it is IL&FS's fallout on the mutual, retirement funds and global lenders that unnerved the government and prompted it to approve the supersession of the company's board.

Fixing IL&FS, however, is only a short-term resolution. It is the rating agencies that really need some fixing since what is involved is public interest!

(The writer has over 30 years of experience in financial journalism, including Business Standard and Hindu Business Line. He has also been  a foreign exchange trader in a well-known broking company. He now pursues his passion in wildlife photography and farming based out of Kotagiri in Nilgiris district, Tamil Nadu.)

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