In our Q2FY18 letter dated 4 July 2017, we had made the following observations –   “A sector where valuations worry us particularly is NBFCs, especially Urban focused Housing Finance. The prevailing narrative here is one of the strong tailwinds due to the low home ownership and mortgage penetration relative to other economies. A flurry of entrants (~80 at last count) and renewed focus from Banks has resulted in declining spreads in the core Retail business. In the quest for higher profitability, most housing finance companies have diversified into higher margin “Loans against property” and “Developer financing”. Now we know that finance companies are very opaque/creative with NPA reporting as one recently discovered with Yes Bank where its assessment of NPAs varied to the tune of 5X from that of the RBI, or more recently with Religare. We would venture that reported Asset quality in many companies could be suspect given the state of Real Estate developers and prices in India and tightening regulations and pressure on SMEs/entrepreneurs post GST. If margins in the core retail business stay muted and NPAs in LAP/developer loans come to the fore, there would be hell to pay. Yet, market momentum is the highest in Housing Finance companies which have on average risen 75% in the last 12 months and where valuation multiples are at an all-time high. “It is only when the tide goes out will we realize who is swimming naked”

In this note, we provide more context and what is likely to follow.

NBFCs had a spectacular run over the last couple of years benefitting from multiple tailwinds.

• The bad loans mess in PSU Banks left them distracted and with a shortage of capital to lend.   This void was taken up by NBFCs
• Declining interest rates and ample liquidity resulted in rapid growth with healthy margins.   Compared to other borrowers banks were willing to lend to NBFC as the NBFCs 20% capital buffer provided security.  Bank lending to NBFCs grew exponentially
• Growth with healthy margins boosted valuation multiples resulting in massive share price movements.  NBFCs raised a large amount of Equity capital on the back of these higher valuations 

However, much of these Equity Gains are poised to reverse

• The market void left by PSU Banks attracted a large number of new NBFCs.  For example, the no. of Housing Finance Companies went up from ~ 50 in 2013 to over ~100 at present.    Competition has become fierce.  Spreads in housing finance are close to all-time lows.
• The impossible trinity in Lending is high growth, high margins and low NPAs.  Rising competition will mean pressure on growth, or margins … or pursuit of riskier segments to lend, which should result in higher NPAs
• Wholesale funded NBFCs will face challenges in sourcing funds.  As the US Fed raises interest rates, this impacts interest rates all over the world.   Liquidity in India is also tightening. Hence, access to credit will be at higher prices and with lower volumes.
• Most NBFCs (barring the long-established AAA ones) depend on bank or MF financing.  As liquidity tightens, and cases like ILFS hit the headlines, they will unlikely get the same quantum of credit from the banking system as before.  Inability to access credit will result in lower growth and surrendering of market share to Private Banks

A slow-down in growth and/or margins should impact profits and also impact valuation multiples.

The other soft belly of some NBFCs is the “round tripping service” some provide to Banks.  As many NBFCs are dependent on the kindness of Banks for their funding needs, at times favours are called up.   Money lent by banks to NBFCs is in turn routed by NBFCs to Companies who may be close to default, who in turn use this money to repay Banks to ensure the account does not slip.   Or a potential bad loan is bought by the NBFC via a “parking service” so the bank reports lower NPAs.     

NBFC’s have softer regulations than banks – lower standards of NPA recognition, no limits on sector concentration, etc. The “regulatory arbitrage” vs Banks should reduce over time as the regulator tighten the screws

In a bull market, risk management is often forgotten.  However, whenever a mini crisis occurs, analysts remind themselves that the above practices exist and there is a stampede for the exit.    A sell off than feeds on itself.  This reversal of fortunes is reflecting in stock prices at present