Fintech should be a lot of tech and a little bit of fin. The successful models so far have been on payments and other transactional elements where technology can make things faster, cheaper and more reliable.
But when techies start dabbling into areas like lending and designing investment portfolios, things are no longer that simple or reliable.
The latest mantra of a few of them appear to be to give retail investors access to products that can yield higher returns. Gold loan securitization, access to forms of high yield lending through a platform/pooled model are a couple of examples. The new age online only advisors/distributors are more than happy to showcase these offerings to their incumbent customer base, after all don’t innovative products get the eyeballs?
In investing, especially in fixed income, the devil is always in the details. It is extremely important to figure out the intent of why something is being done, the next important thing being what form of legal structuring is being used to protect whose interests. When you see complicated legal terms and structuring in fixed income, you should always ask the question “On whose back is the monkey sitting?”.
There is a simple rule in financial structuring – If you cannot see the monkey, it is most likely on your back.
Let’s look at a few of the products that these fintech intermediaries are selling and identify potential pitfalls.
Gold Loan Securitization
This is pitched as an alternative to fixed deposits where an investor can get a higher yield p.a. and the collateral is available to be repossessed in case something goes wrong, thereby making this a low-risk investment.
Not quite, anyone who has spent time in credit underwriting understands that there are qualitative differences within the same category of lending. Within the category gold loans, the following categories are possible –
· Self-employed folks who are using this to get access to working capital
· Salaried employee who needs immediate cash (health emergency)
· Those who lost their income and need money to live their life
Common sense tells you that the risk for each of these categories is very different. Each of these categories are seen differently and priced differently by the lender making the loan. Regulating the Loan to Value is one measure, the other one is to vary the interest rate to reflect risks better.
Fundamental principle – No lending institution would like to sell off loans that are low risk but offer high yield over the entire tenure.
When an NBFC wants to down sell the gold loans it wrote, what does that tell you? An NBFC will only want to down sell those gold loans that carry a higher risk in its assessment. When a business that underwrites credit for a living wants to get a few loans off its balance sheet to a few retail investors seeking a higher yield, who is likely to get the shorter end of the stick?
What liability does the fintech intermediary have in this transaction? They act as the distributor for such an endeavor to provide liquidity to the NBFC and pocket a fee for their efforts. A loan made out at say 12% p.a. by an NBFC to its end consumer ends up at the retail investor level who is happy to get a yield of 9% p.a. Where has the other 3% p.a. gone? Structuring charges, legal and other operating expenses, trusteeship charges to hold the asset and the intermediary fee.
At a macro level, isn’t this the same thing that investment banks did in the US in the lead up to the 2008 MBS crisis? Lenders were underwriting crappy loans with the knowledge that those would be down sold after a year to an investment bank which would layer these crappy loans and hide the risk to the best of their abilities. Recollect the bank salesman explaining how AAA, AA, A, BBB and below papers were all bundled together and sold as an instrument that was as good as AAA in the movie “The Big Short”? In exchange for a fee, these intermediaries were transferring the lax underwriting skills of the lenders into investment risks for the retirement portfolios of retail investors.
If I don’t have to live with my mistakes, why would I care about making a few more? Giving a lender the flexibility of getting possible mistakes off the balance sheet and not dealing with the consequences is the root cause of every single credit crisis in history. History may not repeat, but it does rhyme.
The only saving grace in gold loan securitization is that gold tends to preserve its value over time, especially in India where the local currency depreciates over time and inflation is 4-6% p.a. However, you could have made the same argument about home prices in the US till 2007. Though the probability of something going wrong isn’t high, when it does go wrong it gets ugly.
As a product this is not a particularly bad one unless the loans being packaged and sold off are sub-standard, just that pitching it as a low-risk alternative to a fixed deposit is a sales pitch that hides more than it reveals. What determines the actual risk in the product is not whether the gold price holds up or not, it is that whether the particular set of end borrowers will continue to make their interest payments. Repossessing assets and liquidating the same to recover capital works well in theory, but rarely works well in practice in India. Even when it does work, it takes years for the process to be completed.
Structured Products from highly rated issuers
This is an easy one. About 6 years ago the bulk of structured product issuances in India were from three players. Here is where they are today
- Reliance Capital – No comments
- Citi Financial – No major problems with the business but they want to exit India
- Edelweiss – Market perception has soured after the 2018 NBFC crisis
Trading market risk for credit risk is best left to people who know what they are doing. Wealth managers and other intermediaries (barring a few exceptions) don’t even understand some of the products they sell. Their success depends on finding enough customers who know less than they do.
Giving retail investors access to “innovative” high yield products
In this case the intermediary pools funds from many investors and buys equipment/vehicle etc and leases it out to a user for a specific tenure in exchange for monthly payments. The asset is now held in an SPV/LLP which receives these monthly payments and distributes those to investors in the proportion of the capital brought by each.
Now what is the catch in such a model? Many in my view
- The asset being bought is a depreciating one, unlike gold or a house. It makes this form of lending so risky that many banks/NBFC’s want nothing to do with it
- The intermediary once again has no skin in the game, it pockets a 2% annual fee inclusive of management fee and other operating expenses. Anything goes wrong, it does not hit their balance sheet at all
- There is no interim exit possible, you have to stay the tenure. The only thing you can do is to find another investor to buy this off your hands which is never easy in illiquid assets
- If the asset gets damaged and the lessee has no use for it, it files a court case and gets on with life. At best the investors get insurance payout (which is the depreciated value of the asset) or they get possession of a damaged asset
How is this sold to retail investors? By showing illustrations that tend towards 18%+ return p.a. in the ideal situation, never uttering a word about what can go wrong. But then caveat emptor says that buyers have to look out for their own interests. The intermediary is protected by law unless misrepresentation can be conclusively proved.
When the shit hits the roof in credit, the market freezes and counterparties renege on their contractual obligations. Credit market is not like equity market when you have enough liquidity to take a haircut and exit. Equity is not binary like credit, in credit things either work out or they don’t. And when a deal goes bad, you are toast; especially with the legal system we have in India.
Our largest banks have been running from pillar to post since 2012 to get their rightful due from a few Chor promoters who have reneged on their debt repayment obligation.
What chance does a retail investor have if a risky lending arrangement goes bad?
The influx of techies into the world of lending & financial structuring is only getting started in India. Most of them do not understand how to evaluate and to hedge credit risk; if and when a tail events hits them, 95% of them will not survive to tell the tale. The Savings & Loans crisis in the US around 1990 sunk so many seasoned players, the NBFC crisis in India towards the end of the 90’s left very few players unscathed. Credit underwriting is dangerous and can decimate your net worth if not done well.
The potentially dangerous part of the fintech movement doing financial structuring is that it sells to retail customers and socializes risk rather than letting the loan issuer deal with the consequences of bad underwriting. VCs are only willing to fund business that can scale 10X in 3 years, as a result most of these businesses go the B2C way and focus mainly on distribution and customer acquisition. Product control and risk evaluation can often take a backseat in the quest for more growth.
For all the legal clauses that can protect investor interests, the pace of resolution is very slow in India. When Yes Bank got into trouble the regulator stepped in and did enough for depositors to be able to withdraw their money within a few months. On the other hand, it has been 14 months since a well-known AMC wrapped up a few of its fixed income schemes overnight, investors are yet to see their money in full. Banking is seen an essential service while investing in high yield funds is not. Regulators see these two activities very differently though investors think they are the same, parking surplus to earn a fixed return.
When Uday Kotak talks about managing credit risk, we can take comfort in the fact that he has survived many a crisis and emerged stronger. His superior judgement is based off managing credit underwriting well across market cycles.
When a 30 something fintech founder starts yapping about how businesses in India are starved of capital and it is his life’s vision to make capital available to them, we should take it with a pinch of salt. We can applaud him for his vision but we should also make enough allowance for the fact that he hasn’t survived a credit crisis yet.
But when a 30 something fintech intermediary salesman pitches you an “innovative product” that can work as an alternative to a fixed deposit and can give you a better yield at “low risk”, turn around and run for the hills. Especially when the said intermediary has never invested his own money in the market and doesn’t have skin in the game to begin with. Don’t get carried away by the presence of a reputed legal firm in their list of partners, the lawyers are there to protect their interest (and not yours) when the shit hits the roof.
In financial structuring the monkey is omnipresent. Always watch out for the monkey and never let it out of your sight.