Why the IL&FS is default huge? It is not just a lending institution but it is a kind of a shadow bank, not exactly a charitable definition. To be fair, IL&FS is not exactly outside the finance system in India because RBI regulates it as Critical Investment Company (CIS). IL&FS does not accept deposits from the public, but has borrowed $12.5 billion with most of the large banks, mutual funds, insurance companies and even the EPF as its clients. That is where the problem comes because these short term funds raised through CP and CD and deployed in long term infrastructure assets. A classic asset liability mismatch!
The genesis of the problems at IL&FS
IL&FS was structured as an intermediary that will fund infrastructure projects but the problem was that it ended up borrowing short and lending long. Most of the marquee road projects were structured and funded by IL&FS. In this business, you need access to low cost funds to make infrastructure projects financially viable. Ironically, IL&FS borrowed short term funds from banks, insurance companies and mutual funds and deployed all these monies in long gestation infrastructure projects where returns would not start coming before the 8th or 10th year. This was fine as long as funds were available on tap. But things changed drastically when lenders started getting wary of IL&FS after its first default.
If default was the issue, the rating agencies worsened the problem by a sudden downgrade by several notches from AAA to Junk. That meant, at least 50% of the value of the bonds had to be written off. As IL&FS was classified as Junk, the fund taps were shut and it could not access the CP market any longer. Therein began the real problems for IL&FS. These defaults spell trouble not only for the firm but also for its investors, which include banks, insurance companies, and mutual funds. In fact, there are large institutions like Orix of Japan and LIC which have a major stake in the company. The sharp correction in the stock markets was also triggered by IL&FS.
Problem was the opaque holding company structure
Over the years, IL&FS had built a complex web of subsidiaries, associates, JVs and what not. For example, as of 2018 IL&FS sits atop a web of 169 subsidiaries, associates, and joint-venture companies that makes the default even more worrisome. In fact, when the rescue committee was set up under the leadership of Uday Kotak, the finding was that the subsidiaries were closer to 400 and counting. Nobody knows how big the actual hole is and how much of the contagion could really hit the financial markets. IL&FS is a non-bank financial intermediary that provided services similar to traditional commercial banks. Since these are not deposit-taking companies, they are not as stringently regulated. That made the fudging task easier for IL&FS.
IL&FS really has a liquidity problem, but there is a lot more
Till date, IL&FS and its subsidiary companies have defaulted numerous times already. IL&FS Financial Services also delayed payments on ICDs and commercial papers, instruments that mature in less than a year. In addition, it has nearly $500 million of payables in the second half with cash in hand of just $27 million. Monetizing assets in the near future looks unlikely considering the sticky nature of the infrastructure assets and the liquidity situation of the NHAI and other government bodies. Most of the group’s assets include financial claims on infrastructure projects such as roads, tunnels, water treatment plants, and power stations, etc. which cannot be liquidated at short to medium notice. Monetization of assets in case of IL&FS is easier said than done.
Why the government cannot afford to let IL&FS go bust?
The stakes are just too high, so the government will not let it go down. IL&FS’s defaults can have a significant impact on India’s credit markets. In fact, liquid funds income funds saw total redemptions to the tune of nearly Rs.3 trillion in the bond fund market after the IL&FS fiasco broke out. The firm’s outstanding debt is nearly 3% India’s domestic corporate debt according to Moody’s Investor Services. Then there is the ownership worry. Life Insurance Corporation of India (LIC), which owns a 25.34% stake in IL&FS, is its largest shareholder, followed by Japan’s Orix Corporation (23.54%). Other key shareholders are Abu Dhabi Investment Authority (12.56%), HDFC (9.02%), Central Bank of India (7.67%), and State Bank of India (6.42%). Borrowings from banks are around Rs.57,000 crore that is nearly 0.7% of banking system loans. Banks are already battling a huge toxic loan pile of $200 billion and an IL&FS default can only worsen the situation.
SEBI is worried because it is about retail investor interest
Any default by IL&FS will affect individual investors in a big way. This is because mutual funds invest in CPs, which are generally supposed to be relatively secure investments. Even the value of unit-linked insurance plans, endowment plans, the National Pension Scheme, etc. will be hit. Even projects, like the Bengaluru Metro could be delayed. But the bigger worry will be if this was to spread to other NBFCs and HFCs via the debt markets. We already saw signs of that and the SBI and other banks had to intervene and increase their funding limits to NBFCs to avoid a liquidity crunch in the system. A contagion could lead to large scale destruction of wealth, something the government may not be too happy to have in an election year.