Risks in Indian Loan-Against-Shares Based Securitizations

Fitch Ratings India Private Limited

“Risks in Indian Loan-Against-Shares based Securitizations”

Conference Call

December 19, 2008

Moderator: Good evening ladies and gentlemen. I am Sandhya, the moderator for this conference. Welcome to the Fitch Ratings Conference Call. Today’s topic is “Risks in Indian Loan-Against-Shares based securitizations.” For the duration of the presentation, all participants’ lines will be in the listen-only mode. I will be standing by for the question and answer session. Now, I would like to hand over to Mr. Dipesh Patel. Thank you and over to you sir.

Mr. Dipesh Patel: Thank you moderator. Good afternoon everyone. My name is Dipesh Patel and I head the structured finance team here in India. I am joined by my colleague Deep Mukherjee, the author of the LAS-based securitization report that we published on Tuesday. Deep and I would like to welcome you to today’s teleconference which will be in three parts. First, I will provide a brief introduction and I will then hand over to Deep to highlight the key risks that we see in LAS-based securitizations. Deep’s remarks will then be followed by the Q&A session.

By way of an introduction, for the last year or so, a number of arrangers have been discussing LAS-based securitization. For the arrangers, the securitizations provide a way of managing their balance sheet risk exposure to a particular obligor or industry, while for promoters, they are able to obtain funding by essentially monetizing their existing shareholdings. These motivations that I have just mentioned have led to many LAS transactions being done, some of which have been rolled up and converted into LAS-based securitizations. With the sharp fall in Indian equity markets, many of these LAS-based securitizations have been exposed to a number of risks, not just credit and market risk but also execution and legal risks that previously may not have been fully appreciated. There is even being confusion amongst the parties to the securitization as to which party is supposed to do what and when. As such, LAS-based securitizations are complex in nature and expose several inherent risks. With that, I am going to hand over to Deep who will talk you through the key risks that we see in LAS-based securitizations.

Mr. Deep N.

Mukherjee: Thank you Dipesh. I would like to welcome everyone once again. LAS securitization is different from a conventional single loan sell down and the key differences arise because of the underlying nature of the asset which is LAS. It is significantly different from corporate loans, be it secure or unsecure which ultimately go through single loan sell-down and the second point of difference is once securitized, LAS requires a much higher involved level of monitoring and actioning than would be required for a conventional corporate loan. Having said that, let’s focus on how LAS as an asset class is different. There are four key points that we have identified where LAS is significantly different from a corporate loan. The first one being the seniority level of LAS. Now, this transaction in the event of default of the underlying corporate whose shares are kept as collateral, this loan would be no senior to the equity holders of the company. So, there is the inbuilt structural subordination in case of LAS transactions. Whatever obligation or loan repayment obligation remains is not of the corporate but of the promoter. So, that is one thing which lot of times there may be some confusion. Second is the nature of the collateral. Now, a conventional collateral, be it cash or real estate assets or bank guarantee, the probability of default of the borrower and the value of the collateral is not correlated in most cases or if at all there is a correlation, it is very nominal, but in case of LAS, the probability of default of the borrower and the value of the collateral or the share collateral shows a high negative correlation. To explain, if the promoter to whom the loan was extended is likely to default or the probability of default increases, it is often found that the value of the share of the company owned by the promoter significantly takes a hit. To that extent, the collateral value is eroded. So, the key take away from this is that the comfort level associated with a share collateral may not be in most cases as much as that associated with a conventional collateral, be it a real estate asset, cash, bank guarantee, and the like. Third point how LAS is different is the recovery process. Now, one of the key arguments in favor of LAS that is typically forwarded is the ease of recovery in the event of default of the borrower. Now, there is some truth in this understanding, but this truth is usually validated under benign market conditions and when the stake that is being or when the collateral forms a very small percentage of the overall market cap of the stock. If either of this gets violated which is to say if the market condition becomes very stressful or even in benign market conditions, the quantum of stock that is to be offloaded because the promoter has defaulted is a significant portion of the overall market cap of the company, then recovery process in terms of recovery rate as well as recovery timing becomes difficult to predict. To that extent, there have been cases reported in the media that it was difficult to obtain a suitable value of the share as there were no buyers or there were very limited buyers as seen in the last one year. Last but not the least point of difference in LAS-based transactions is pointed by Dipesh, the execution risk. Now, this typically arises out of two or three factors. One is since the collateral and the triggers associated with LAS is market value dependent. A constant monitoring is required. Once the triggers are called, how the borrower responds to it, based on which followup actions maybe required. A lot of times it may have been experienced that the infrastructure either by the trustee or by the lender may not have been fully attuned to the efforts of monitoring the transaction or raising timely triggers or following up on that triggers in the event the borrower has not been able to meet that trigger call. So, all these things almost create or add to the set of risks that is found in the usual corporate loan. So, having looked at the four points and how LAS differs, we would now dig deeper into the five assets of risks which we have identified which are found to asset such transactions.

The five types of risks that we would be talking about are credit risk, market risk, structural risk, execution risk, and legal risk. Now, at this point of time let me tell you whereas we would be discussing the risk in a discreet sort of fashion, more out of trying to put a structure to the conversation, the fact remains that all of these interplay and influence one another. So, that has to be kept in mind. As I progress through the discussion, I would definitely endeavor to bring out the interaction between the various risk factors.

I would start with the credit risk. What we strongly believe is that irrespective of the structure, one of the most important things remains at evaluating the financial strength and resources of the borrowers. Now, it may have been the experience of market participants that in lot of cases, the financial strength of the borrower was not fully ascertained because of the lack of information, but the fact remains that irrespective of the value of the share collateral, and the share collateral to loan ratio, one needs to thoroughly ascertain whether the borrower would have money on his own to pay the loan in a timely fashion. What we would usually like to focus apart from the financial strength is the ability of the borrower to meet the share calls as and when they arise which is basically evaluating the quantum of unencumbered, unpledged shares available to the borrower, whether the borrower can garner other resources in which to pay back the loan, whether the borrower has access to nondiscretionary cash flows, which is whether the borrower has access to operational cash flow from either the existing corporate or some other corporate by which it would likely to repay the loan. The second point on the credit risk we would focus is on the credit worthiness of the underlying corporate whose shares are placed at collateral, the key reason being that in the event of default of the underlying corporate, the value of the share collateral for all practical intents and purposes become zero. So, to that extent, it is essential. For promoter lending, there, the added value for rating is one can find some comment and some idea on the corporate governance as well as the managerial capability of the promoter by means of an evaluation of the credit worthiness of the underlying corporate whose shares are pledged as collateral. Third point is the nature of the borrower’s stake. By nature of the borrower’s stake, we would mean the size of the stake the borrower has in the company and the strategic importance of the stake. Now, talking of size of the stake, it is not like a monotonous or unilateral factor. To explain, it necessarily doesn’t mean that higher the stake of the borrower in a particular company whose share has been placed as collateral the lower is the risk profile. On the contrary, there can be several cases. Let me explain. Say a promoter has a very low percentage of stake in the company, understandably the corporate control that the borrower would exercise on the corporate is low, but to that extent since the borrower has a very low percent of stake in the company, if a borrower defaults and it is unlikely or the likelihood is lower that the share price as such would tank very significantly. On the contrary, if the borrower has a overwhelmingly high stake in the company and if such a borrower defaults, it is likely that the share price or the price of the collateral in this case would fall very significantly to the extent that recovery would become very difficult. Similarly, other aspect that we would focus is a strategic importance. Strategic importance, a lot of times, it is almost independent of the size of the stake to the extent that even a very small stake can be important to the sense that say someone owns say hypothetically 28% or 29% of stake in a company and has placed, and I am just making up this number as a matter of example, 5% of the stake has been placed as share collateral. Now, losing that 5% stake would make the holding of the promoter or that entity at any rate less than 26%, so there is a strong motivation behind the corporate, that borrowing entity to retain the control of the shares. On the contrary, if someone owns 85% or 90% of the stake or so for that matter losing 5% wouldn’t significantly reduce the corporate control. The strategic importance of the stake is not only restricted to the motivation of the borrower to pay back, it is also essential as sometimes the in the event of default of the borrower ,a stake of strategic importance is likely to find ready buyers which would ease the recovery process significantly.

Coming to the next key risk factor that we will discuss is the market risk. Now, at this point of time, let me tell you that there is a huge linkage between the credit risk in this structure and the market risk. For example, a borrower has taken a loan for a period of one year and has paid his or her stake and the reason possibly they have taken the loan is because there is a cash flow issue in the first place. Now, had anyone waited for a whole year, chances may have been that the borrower would have been able to pay up, but say two months down the line, an adverse market movement erodes the collateral value, the loan recall trigger or the cash call trigger may be activated, and then the borrower would not be in any position to pay up the loan, so here we see an example where the market risk is actually triggering credit risk and this is a very key aspect of such structures. One of the things that affect the market risk is, of course, the collateral to loan value which we are given to understand is quite a popular measure of evaluating such structures. What Fitch believes is that we would like to stress, we would like to put more focus on the collateral or share collateral to loan value at the point where the structure starts to unwind as opposed to the share collateral to loan value at the time of origination. What it would mean is that the first time when money starts coming into the structure because the collateral value has eroded, the collateral to loan value at that point of time is more important as opposed to the point where you keep on getting more and more shares of the company. So, that is one view and second thing that we would like to focus here is that the ratio of collateral, share collateral to loan of various LAS structures needs to be standardized with some measure of market risk. The paper as a matter of example discusses how the share collateral to loan value needs to be standardized by the VAR (Value-at-risk) of the share so that one can compare between two structures, which is to say, as mentioned in the paper, share collateral to loan value of 3 for a company whose VAR is 8% would provide significantly more cushion as opposed to a share collateral to loan value of 3 for another company whose VAR is say 20%. Other elements of market risk which affects subsequently the recovery in the event of default are the liquidity of the stock and distribution of the interest in the stock.

We have discussed so far two aspects credit risk and market risk. We would now like to focus on the structural risk. The structural risk the way we want to define is the risk that the LAS structure faces because of the very nature or the very fashion in which the structure has been created. Of course, one of the key factors of such structure is the collateral to loan ratio which I think we have already discussed on the market value. The other aspect of the structure that one needs to focus is, is there a inbuilt curing period in the structure, which is to say that if on day T the loan, the original underlying transaction of the asset, the LAS asset has a scheduled maturity on day T and my PTC maturity is on day T plus 1, in the event that on day T I find out that the borrower has defaulted, I will have very minimal time to pay back the PTC investors which would lead me to a distress sell of the collateral to the extent that I may not be able to recover the amount that I was expected to. This can be to a sense mitigated if it says that there is a gap of say X number of days between the scheduled maturity of the underlying LAS assets and the scheduled maturity of the PTC. Other factors that go into the structural risk is the quantum of pledged shares, I mean if you end up with a very high portion of pledged shares from say a very high portion of the overall market cap, it is unlikely that you would be able to recover the money or the recovery rate or the recovery timing would unlikely to be very satisfactory, even if the market conditions are slightly swift.