Suspended Loans and the Rolling Indian Banking Crisis

Plus: Lemonade, Quicken Loans, Conferences

Welcome to issue #4 of Net Interest, my newsletter focused on financial sector themes. Judging from his tweet Nassim Taleb isn’t impressed. If you disagree and like what you are reading, then please invite friends and colleagues to sign up to receive Net Interest direct to their inboxes every Friday. Thanks!

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Suspended Loans and the Rolling Indian Banking Crisis

All over the world loans are going unpaid. 

In the UK, a sixth of all mortgages are currently on ‘payment holiday’. In the US one in twelve are. It’s the same across all loan categories. Whether it’s credit cards (4% in the US), auto (12% in the US) or – most striking of all – small businesses (over 20% in the US) whole loan books have been placed in suspended animation. 

While the details vary by country, the broad picture is similar across the world. In some countries debt moratoriums have been imposed from on high. In Hungary borrowers only have to make payments on loans this year if they want to. Unsurprisingly over half of them have chosen not to.

In other countries policymakers have provided guidelines and in yet others lenders have developed their own schemes. In most countries schemes require borrowers formally to seek approval for loan payments to be suspended. Such schemes are not without risk to the borrower. Even though payments are not being made, interest is still accruing and in some cases interest is compounding on the interest. When the UK extended its mortgage deferral scheme to the end of October, the industry body UK Finance warned that borrowers’ overall debt costs would end up higher if they extended unnecessarily. 

The degree to which borrowers have embraced deferral schemes depends on the economic shock they face in their respective markets and the bureaucracy involved in deferring. In the US and the UK it looks like deferral applications peaked with Covid cases. In the last week of May a net 35k new US mortgage borrowers were given a pass on loan payments. That compares with 50k the week before and 100k the week before that. Most deferrals in the US and the UK were granted at the back end of March and the first few weeks of April. In contrast, in some markets like Spain, Thailand and Indonesia, they’re still processing a backlog.

Regardless of the specifics, banks across all these markets are united in a single question: How will these suspended loans perform once their deferral periods end? It’s a critical question not just for banks but for all participants in the economy since consumer strength hangs on it.

The problem is that no-one knows the core reason why borrowers are deferring loans. If it’s to conserve liquidity, that’s fine. If it’s because of genuine financial distress, that’s a problem for the banking system. But if it’s because borrowers simply don’t want to pay, then that’s a problem for the whole system inasmuch as it reflects a moral hazard.

There are some positive signs. Although the headline numbers look scary, it’s not clear that all borrowers seeking a deferral necessarily need it. JPMorgan said in May that a third of clients asking for loan forbearance never actually use it. (Although they also said that they had several people with US$5 million or US$10 million asking for forbearance on their mortgages as if it were an entitlement.) Other US banks have noted that 25-40% of borrowers on a break have continued to make payments. “People want to pay, right?” said the CEO of Wells Fargo.

UK Finance goes further. It estimates that around 60%-70% of mortgage borrowers taking a payment holiday can demonstrate affordability to resume full payments at the end of their current deferral.

But the historical record is mixed. While there is no direct precedent for this, we’ve seen localised debt moratoriums introduced around the world before.

The experience in hurricane affected regions of the US has been positive. The Atlantic hurricane season in 2017 was the costliest on record. Banks granted many of their affected customers payment breaks on their loans. One year later, roughly 82% of their loans were back on track and an additional 15% had prepaid in full, leaving just 3% in serious delinquency.

The situation was not so rosy in Greece, however, in the aftermath of the financial crisis. The government there introduced a foreclosure moratorium on properties in June 2010. Shielded from the penalty of losing their homes, many borrowers chose not to pay. Estimates suggest that by the end of 2013, 28% of defaults consisted of so-called ‘strategic defaulters’. (Sadly the highest concentrations of strategic defaulters were found “in the industries of law and finance”.)

The Rolling Indian Banking Crisis

All of which brings us to India. Nowhere is the question of how borrowers will emerge from debt suspensions more critical than it is in India. 

In May the Reserve Bank of India extended a loan moratorium that had been in place since the beginning of March through to the end of August. During this six month period borrowers do not have to make loan repayments; meanwhile their interest compounds. A few keystrokes of a standard issue financial calculator shows that a six month holiday now, with interest compounded, means more than six months of installments need to be added to the overall repayment amount. Not sure that this is fair, The Supreme Court has turned its attention to the issue and will make a ruling next week.

So far banks and other financial institutions in India have granted moratoriums on between a quarter and three-quarters (yes, three-quarters) of their loan books. Indian banks sit on the largest book of suspended loans in the world.

And if there is a financial system that was ill-prepared coming into this situation it was India. 

There are many ways a bank can court disaster. It can attract fraud (which risk managers call ‘operational risk’); it can lose access to cash (which risk managers call ‘liquidity risk’) and it can make bad loans (risk managers call this ‘credit risk’).

In the past two years the Indian financial system has experienced all three.

Fraud: Punjab National Bank vs Nirav Modi

Nirav Modi was once one of the richest men in India, worth an estimated US$1.75 billion. Born into a diamond trading dynasty, he launched an eponymous retail brand in 2010 and opened stores across the world. But his business was built on a fraud. Over the next eight years Modi colluded with bank officials at a branch of Punjab National Bank in Mumbai to obtain letters of undertaking for making payments to overseas suppliers. By the time it was uncovered in 2018 the fraud had cost the bank a staggering INR143.57 billion (US$2.23 billion).

Modi was arrested in March last year and currently sits in a London jail cell awaiting an extradition hearing. Yet Punjab National Bank does not seem to have learned. Since the Modi case it has gone on to uncover two further material incidents of fraud. Without the financial capacity to absorb the losses, it received dispensation to defer the costs and its most recent balance sheet reports a INR15.8 billion build up of fraud-related charges. 

If one fraud is a misfortune, and two is careless, three is systemic. 

Punjab National Bank may be the most impacted, but it is not alone. Bank fraud has been rising in India for the past several years. What makes India different from other markets is the role its state banks play. In developing countries, state banks generally make up the minority rather than the majority of market share, typically around 20%. In India they make up 70%. As an extension of the public sector, governance practices in these banks can be quite poor. Boards lack an understanding of risk, the banks are under-resourced in expertise and relevant monitoring technology, and employees are not offered sufficient incentives to prevent or detect fraud early. It is no coincidence that state banks comprise over 90% of bank frauds by value

Liquidity risk: A classic balance sheet mismatch

In the aftermath of the financial crisis, when Indian banks retrenched to mend their balance sheets, shadow banks emerged to finance the Indian economy. These shadow banks, or Non-Banking Financial Companies, borrowed short-term from banks and mutual funds and lent long-term on real estate and other assets. In the ten years following the financial crisis they provided ~35% of financial resources to the commercial economy with rising market shares throughout.

Problems came to a head in 2018 when one of the shadow banks – IL&FS – defaulted, leading to a liquidity squeeze on them all. Since then, regulators have closed some of the loopholes that gave shadow banks advantages and funding markets welcomed them back. But because capital markets are not as developed in India as they are in the US, shadow banks remain reliant on banks for funding. Currently banks provide around a quarter of Non-Banking Financial Company funding.

Such interconnectedness injects risk into the system. India’s was once the second most intertwined financial system in the world. It has untangled itself since then but there are fears that the current environment is exposing remaining linkages. In times of stress any lending that shadow banks have done can reverse back into those banks that lent to them. Like in many corners of financial markets, there’s an asymmetry here: in good times the shadow bank wins, in bad times the entity behind the shadow bank loses. 

Credit Risk: A rolling crisis

Indian banks came into the year with one of the highest rates of non-performing loans in the world. Not as high as Greece, but higher than Portugal, Italy and even Argentina. Even before Covid emerged, the Reserve Bank of India warned that bad debts could rise to 9.9% of total credit by September 2020, up from the 9.0% it had predicted six months earlier. 

Originally a lot of the credit risk sat with the public sector banks. However it went on to circulate around the entire system. When the public sector banks pulled back on credit around five years ago, shadow banks picked up the baton. And when they hit liquidity issues, private sector banks took over.

The newest, most aggressive private bank was Yes Bank. It grew its loan book by 2.7x over the three years to March 2018. When economic growth began to slow, its loans started to go bad. Unable to raise enough capital, Yes Bank was rescued in March by State Bank of India. A fifth of its loan book is now marked as bad.

Ironically the credit issues faced by the system didn’t emerge from too much lending. India’s credit-to-GDP rate is 51%, which is low by global standards, even while its gross domestic savings rate is in line with peer countries. The credit-to-GDP ‘gap’ is one of the indicators global regulators use to assess vulnerability and India looks OK. Rather, credit issues emerged from the wrong kind of lending.

Unfortunately the Indian credit cycle is turning before any of the vulnerabilities to fraud, liquidity risk and credit risk have been fully resolved. India is suffering particularly acutely from coronavirus with no peak in sight and so the moratorium relief may be necessary to ease the burden while the health emergency is being addressed. But once it is over India may have a financial emergency to deal with.

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More Net Interest

Lemonade

Insurance is the original subscription business. And so when Lemonade filed its S-1 prospectus this week I was excited to look inside to see how its unit economics stack up with more recent iterations of the subscription model. Unfortunately there’s not much to see. The company reveals that its one and two year customer retention rates are 75% and 76%, excluding customers they kick out themselves. Incorporating those customers, retention rates drop to 62% and 71%. As Dan McCarthy highlights, these rates represent an aggregate over an indefinite lookback period. Subscription companies proud of their retention would provide them every quarter. He’s got a point: even though the company’s platform “is designed to delight consumers”, the numbers aren’t that good. Hastings, a UK motor insurance company which sells through price comparison websites, had customer retention last year of 71%. 

Having come for the unit economics, though, I stayed for the founders’ observations on the insurance industry. And these are delightful. Take this:

“Since the dawn of time, insurance has both propelled progress and been revolutionized by it…The Agricultural Revolution transformed risk pooling from an adaptive instinct to a facet of trade…A slew of inventions in the 14th century triggered the Commercial Revolution, which saw the ousting of lenders from insurance, and the inauguration of the first insurance companies. These thrived until the Scientific Revolution, when the discovery of probability theory signaled the toppling of every insurance company that predated it, and the emergence of the insurance dynasties that have reigned ever since. A new revolution now threatens these hegemons.”

I highlighted a few more on Twitter.

Quicken Loans

Another financial company planning an IPO is Quicken Loans, the largest mortgage lender in the US. This company is one of the most efficient vehicles of monetary transmission in the world. Its core product is the American refinanceable fixed-rate mortgage. Every time the Fed cuts interest rates to new lows millions of borrowers come into the money and can refinance at cheaper rates. Quicken helps them do it. At the end of May the average 30-year mortgage rate hit a record low of 3.15%, bringing 14 million mortgage-holders into the money. Collectively these people could save US$3.95 billion per month in mortgage payments by refinancing, representing a significant potential economic stimulus. Inertia prevents many of them from doing so, but Quicken sits at the gateway.

Conferences

This week both Morgan Stanley and Goldman Sachs hosted conferences for investors in financial services stocks. One of them was meant to have been held in New York, the other somewhere in Europe but given current conditions they were both held at home.

Ben Evans describes conferences as a bundle of experiences and suggests that while the content piece can be moved online, the other components can’t. In the case of investor conferences those other components include sharing stock tips with other investors and participating in 1-1 or small group meetings with company management. The first of these went online years ago via Bloomberg messaging and sites like SumZero. The conference format provided an efficient setting for the second, allowing companies to do lots of meetings in a day (out of a hotel bedroom) but it’s no more efficient than doing them online. After Reg FD the investor conference became marginally less useful; after coronavirus it may be considered a luxury.