On 21st September, 2018, price of Dewan Housing Finance Ltd (DHFL) fell almost 50%, wiping out close to 12000 crores of market cap. The management of DHFL was dumbfounded –it seemed they had been hit by a speeding truck. What had really happened? One of the DSP mutual fund debt schemes sold a bunch of commercial paper issued by DHFL at a discount to the prevailing price resulting in a higher yield. DSP mutual fund had to resort to a fire sale as there was pressure for redemption in the scheme. This pressure came about as the ILFS Financial Services had defaulted on one of its bond payments and DSP investors had pressed for redemption. Sale of DHFL paper led the market to believe that there was a domino effect and DHFL was affected by ILFS default. Soon, the entire market was engulfed by rumors and shares of banks/ NBFCs/ HFCs went through a massive correction. It was as if the entire NBFCs/ HFCs edifice was a house of cards that was just waiting for a strong whiff to collapse.
The management of DHFL went on air to dispel fears. DSP issued an explanatory statement. ILFS kept quiet, knowing that they had started the fire- no point in stoking it. Finance Minister issued a statement assuring adequate liquidity. RBI and SBI went into a huddle to come up with soothing sound-bytes. To no avail, it would seem, the markets continued to be in a turmoil. DHFL, even after repeated assurances, continued to trade around its new found price band of 50% drop from the 52 week high.
Mind you, all the papers and bonds of both DHFL & ILFS were rated by credit rating agencies, and were supposed to update on any extraordinary events. As on 21st September there was no re-rating for DHFL paper. For that matter, there was no re-rating in ILFS bonds by the agencies till the default actually happened. This ‘house of cards’ event has several lessons in store for us:
- Do not believe in rumors.
- Do not believe the media- they too help spread the rumors.
- The world of finance is highly inter-connected.
- And so is the world of internet- news spreads fast.
- Do not rely on credit ratings- this was amply demonstrated during the 2008 global financial crisis. Even after a decade, nothing has changed – neither the agencies’ performance nor the regulatory stance. (but who rates the raters?)
- The world of debt securities is highly opaque and only a few insiders know the real story.
- Debt schemes of mutual funds do not undergo the same scrutiny as equity schemes do. Several debt schemes continue to have high exposure to single group, hold zero-coupon securities or even privately rated instruments. These are all a big no-no for any prudent fund manager.
- Price discovery in debt instruments continues to be poor and a post facto reporting rather than online negotiation.
- Stratospheric price to book valuations cannot sustain, for the simple reason that all that NBFCs/ Banks own or owe are rupees. High price to book means valuing one rupee at ten rupees and that is irrational, to say the least. These companies too should be valued on their earnings and not on the size of their book.
- You may own a great company, but if the valuations are irrationally high, even a small push can lead to a big fall.
- Unlike in equity, a fall in the price of a corporate debt instrument does not recover, easily or quickly. It’s more or less permanent.
- As an equity investor, the best course of action would be to wait on the sidelines till the air gets cleared.
But wait, what about ILFS? Well, that’s going to be a long drawn story to resolve. ILFS has deep pocketed shareholders like LIC, Orix Corporation, Abudhabi Investment Authority- they will figure out a way to save it and their own reputations in the process.
Please learn all this today and forget about it till the next crisis happens, when you will again read a series of such articles.