Govt may allow higher foreign play in bad asset business

An FII may be allowed to pick up 49% in a bad asset bought by an ARC from a bank from 10% earlier.

Aveek Datta.

Mumbai: The government may raise the level of foreign direct investment, or FDI, in asset reconstruction companies (ARCs) and allow foreign institutional investors, or FIIs, higher investment limits in security receipts (SRs) which such companies typically issue against a pool of bad assets.Both proposals are critical to boost the asset reconstruction business in India at a time when bad loans in the banking system have been on the rise in a slowing economy.

A long-standing demand of the sector, the changes could be part of the government’s budget for 2012 to be presented in Parliament by finance minister Pranab Mukherjee on 16 March.
The finance ministry is considering a proposal to hike the maximum permissible stake a single FII can pick up in a bad asset bought by an ARC from a bank to 49% from 10% earlier, according to two people familiar with the matter. The maximum collective stake that multiple foreign entities can hold in such an asset may also be increased to 74% from 49% earlier, they added. None of them wanted to be identified.
FDI in ARCs can also go up from 49% to 74%. Even though there is no sub-limit within the 49% permissible limit, typically the Reserve Bank of India (RBI) does not allow one single entity to hold more than 10% stake in an ARC currently.
Barring Asset Reconstruction Co. (India) Ltd (Arcil), India’s oldest and largest ARC, none of the other 12 companies in the sector has been able to acquire substantial bad assets from banks due to paucity of funds.
“An advisory group comprising executives of asset reconstruction companies had made a recommendation to the government (for raising the limit of foreign investment),” said Birendra Kumar, managing director and chief executive of International Asset Reconstruction Co. Pvt. Ltd. “It will be a positive development if the government were to allow this.”
RBI and the finance ministry have been discussing both the proposals.
Typically, ARCs set up separate trusts to acquire individual assets. These trusts issue SRs against the bad assets bought. The SRs are bought by banks themselves as qualified institutional buyers, or QIBs, as well as other investors. Banks do ask for upfront payment in cash, too, instead of SRs.
There are several regulatory restrictions put by RBI on the source of funding that ARCs can tap. Out of the available sources, banks, notified financial institutions and non-banking financial companies do not lend much to ARCs. Another source of liquidity for ARCs could have been domestic funds, but there are a very few in India focused on distressed assets.
P.H. Ravikumar, managing director and chief executive of Invent Assets Securitisation and Reconstruction Pvt. Ltd, said that if there were more funds from foreign investors at the disposal of ARCs they would be able to bid for more assets.
“Over the last two years, all the ARCs put together haven’t managed to acquire assets worth more than Rs. 1,000-2,000 crore,” Ravikumar said. “If the limit of foreign investment is increased to these limits, we can buy assets to the tune of Rs. 5,000-7,000 crore.”
Since these foreign investors are minority shareholders at present, they don’t take an active part in the revival of assets. The situation may reverse if they were allowed a sizable stake, Ravikumar added.
ARCs will play a crucial role in reducing the burden of bad loans on banks, at a juncture where non-performing assets (NPA) in the banking system have grown rapidly.
A 6 February Mint analysis of 34 listed banks that had announced their December quarter results showed that their gross NPAs had grown to Rs.76,644 crore, a 30.51% year-on-year increase. The analysis didn’t include NPAs of State Bank of India (SBI) since India’s largest bank was yet to announce its December quarter earnings as on that date. SBI said on 13 February that its NPAs at the end of December touched Rs. 40,098.43 crore, or 4.61% of its total advances, the highest proportion since September 2005.
Many corporate and retail borrowers have been unable to repay debt as economic growth slowed to under 7% this fiscal from 8.4% in the previous one. After declining continuously between fiscal years 1995-96 to 2007-08, the total stock of bad loans has seen a sharp rise, RBI deputy governor Anand Sinha said in February.
“From 15% in 1995, NPAs came down till 2008, but they have risen sharply by 91%, or Rs. 46,670 crore, between 2005-06 and 2010-11,” Sinha said atMint’s annual banking conclave in Mumbai.
Another policy intervention that ARCs have been hoping for to incentivize the effort and resources required to buy and revive a distressed asset is to allow them to covert a portion of the debt attached to it into equity.
At present, there are regulatory restrictions on ARCs picking up a stake and they make money by earning a fee in lieu of managing the trust through which the asset is acquired and the debt, recovered.
Kumar of International Asset Securitisation said that an amendment to the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002, to allow conversion of debt to equity had been moved in the winter session of Parliament in 2011 and is pending before a standing committee.
The SARFAESI Act provides the framework in which ARCs operate.
aveek.d@livemint.com


http://www.livemint.com/2012/03/13125635/Govt-may-allow-higher-foreign.html 

Risks in lease rental discounting loans: Fitch Ratings

Fitch Ratings has come out with its special research report on 'risks in lease rental discounting (LRD) loans'. As per the rating agency the failure to appreciate the inherent risks of LRD loans may leave market participants exposed to stress in commercial rental market in an economic downturn.

Percieved as Less Risky: Lease rental discounting (LRD) loans are widely perceived by lenders to have lower risks than construction loans or direct lending to real estate corporates. The structure of a typical LRD loan ensures relatively higher availability of cash to service the loan and easier access to collateral in the event of default. Furthermore, anecdotal evidence suggests that the performance of such loans has been significantly better than other real estate loans (see Appendix 1: Survey of Institutional Lenders of LRD Loan).

Lenders Underestimate Risks: While LRD loans have a lower risk profile than other real estate loans, most such loans are unlikely to have medium to high investment-grade credit profile. As shown in Fitch Ratings survey (see Appendix 1) in some cases, the pricing of such loans is comparable to the loan pricing of high investment grade corporates. Strong linkage of a typical LRD loan to the corporate owner of the property and a relatively low cash cushion may limit the credit profile of such LRD loans.

Credit Linkage of LRD loans: Long-term lease contracts with high quality corporate tenants provide strong cash flows to service debt, while mechanisms such as rent deposits in an escrow account reduce commingling risk. However, linkage of the LRD cash flows with the credit of the borrower (who is often the owner of the building and is a real estate corporate) remains strong in a many LRD transactions. As such, if the borrower enters into bankruptcy proceedings or debt restructuring, the LRD cash flows would be affected by a time lag.

Low DSCRs: In many transactions, the implied debt service coverage ratio (DSCR) may be lower than the DSCR of similar structures rated investment grade. This is because the typical implied DSCR range of 1.1 to 1.3 seen in Indian LRD loans may not provide a sufficient cushion to debt payments during (even moderate) economic downturns. As such, over the last 10 years the Indian market has experienced downward rent revisions in the range of 10% to 40% (depending on location).

CMBS vis-vis LRD Loans: Significant similarities exist between Indian LRD transactions and CMBS transactions, particularly in the Asia-Pacific region. CMBS transactions with investment-grade ratings usually have a DSCR above that of a typical Indian LRD loan. As such, they are able to withstand much higher volatilities in rental cash flows. However, many CMBS transactions are exposed to refinancing risk at maturity, since the principal is usually not fully amortised.

LRD Loan StructureFitch has been presented with a wide variety of real estate financing structures. In addition to LRD loans, proposals include CMBS and construction-linked loans (also known as progress payments in other jurisdictions). To develop a complete view of the variety of LRD structures in the market, Fitch surveyed market participants.
The typical LRD structure consists of a real estate loan with a charge on a commercial property, along with an assignment of the future lease receivables. Thus the debt obligation is serviced by the rent/lease payments of tenants occupying the commercial property. These features ensure significant cash flow visibility for debt servicing, particularly if the tenants are financially stable corporates and are likely to remain in the property well beyond the initial lock-in period. Additionally, if the lender is a bank, the lender then draws comfort from its ability to enforce security (the underlying commercial property) under SARFAESI Act in the event of default.
Such features result in LRD loans having a relatively lower likelihood of default than a loan extended directly to a real estate corporate. The key structural features of an LRD loan are provided below.

Discounted Rent Value (DRV)The rent contractually received from the tenant (also known as gross rent) is adjusted for taxes, maintenance and other administrative costs to calculate the net rent. Where there are separate payment arrangements by means of a Common Area Maintenance (CAM) agreement between the tenant and the owner, less weight may be given to maintenance and administrative costs. However, while calculating net rent for LRD loans with a tenure greater than five years, not all lenders explicitly consider major maintenance expenses. As such, periodic capital expenditure will likely have a significant impact on cash flows. The net rent, thus calculated, is discounted by the interest rate of the loan over the life of the loan to determine the discounted rent value.

Volatility in Occupancy LevelsCorporate tenants in India typically stay the full term of their contract, owing to lock-in periods (usually three years), high upfront set-up costs (ranging from 18 months to 40 months of rent) and social costs (eg proximity to business partners/customers and employee convenience). To ensure occupancy levels are maintained over the tenure of an LRD loan (particularly loan tenures exceeding five years) it is important to evaluate the attractiveness of the business district and the supply of commercial real estate in the locality. An excess supply of commercial real estate at relatively lower rental rates is likely to result in a downward renegotiation of rents, or an increase in vacancy rates; either would affect the DSCR of an LRD loan.

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To read the full report click on the attachment
Risks_LRD_Loans_Fitch_091211.pdf