Creation of Bad Bank/Selling NPAs to ARC: BAD IDEA

Instead of Plugging the leaking hole, putting more water in the leaking Vessel:

Ever since (last 2-3 weeks) PSBs have reported massive Losses with unthinkable deterioration in their asset qualities, there have been repeated statements from our Finannce Minister as well as from different sections of media that Govt is planning to create Bad Bank where NPAs of PSBs will be transferred. And also reports that some banks are planning to sell their NPAs to ARCs.

Such reports have created an impression that such measures will relieve PSBs of their sickness and put them on path of recovery and there are talks of bottomfishing of PSBs for multibagger returns in 2 years. Such reports are emerging as investors have not understood REAL concept of BAD BANK and also of how NPAs are sold to ARCs

1.  Selling of NPA to ARCs: Whenever any bank sells any NPAs to any ARC, same are at subtantial discount to their book value. No ARC ever buys NPAs at their face value. ARCs do their due diligence in terms of good NPAs and Bad NPAs.  ARCs consider those accounts as good NPAs where such bad loans are covered by ADEQUATE security ( e.g. land) and here ARCs feel that they will be succeed in recovering decent amount of good NPA through sale of assets like land (because by that time,share price of such listed entities crumbles by upto 90% and share sale may not fetch even 5% of NPA, a la Kingfisher). Good NPAs normally are acquired by ARCs at 20-30% discount to book value. However, bad NPAs are the real problem. Bad NPAs are those accounts where security may be hardly 5-15% of loan exposure (e.g. promoter pledged only shares, value of which crumbled) and in case of NPAs , majority of NPAs are bad NPAs (that is why, recovery ratio of NPAs amongst all PSBs is around5% of NPAs). ARCs acquire Bad NPAs at50-70% discount to their book value.

Now, suppose a PSB want to sell 3000 crore worth NPAs to an ARC. Looking at combination of bad NPA (ratio of which is much higher and that is why bank want to sell)and Good NPA (Ratio of which is much lower), ARC normally acquires 3000 crore worth NPAs for around 1500 crores. That works out to nearly 50% discount.  It means that PSU Bank will have to immediately MAKE PROVISION OF 1500 CRORES in its books (loss of 1500 cr on selling NPAs). However, story does not end here. Even if ARC acquiring 3000 crore worth NPAs for 1500 crore, entire 1500 is not paid UPFRONT to PSU Bank. ARCs PAY ONLY 15% UPFRONT. It means PSU Bank immediately will get fund infusion of 225 crores ( 15% of 1500 crores) and ARC issues SECURITY RECEIPT for balance amount (which is paid as and when there is recovery of NPAs).

Thus,prima facie, investors get impression that selling of NPA is damn good and main revival tool for PSU Banks. Selling NPAs is shirking of the responsibility (to recover NPAs themselves) and shift the burden to another shoulder (by taking big hit). Doesnt it work as incentive for PSU bankers to remain reckless in future credit disbursal/appriasal?

2. BAD BANK: Firstly we are fairly confident that Mr Rajan will not agree for creation of Bad Bank (as per our interaction with some seniors in RBI). Second, even passing bill for creation of BAD Bank in Parliament will be extremely difficult proposition. Moreover, these appear to be political statement as idea of Bad bank was floated/mooted during Congress rule as well. Still as hypothetical case, if we assume that Bad Bank is created, then what?

Let us look back at REAL LIFE EXAMPLE OF IDBI: As on March 2014, IDBI had accuulated NPA of roughly 9000 crores. In order to relieve IDBI of NPA burden(to show to the world that Balance Sheet is clean), govt of India created SASF (just like a bad bank). Please note that SASF was created in 2004 i.e. 12 years back. And now please understand scheme of things put in place by GOI.  GOI provided a loan of Rs 9000 crores to SASF and SASF in turn invested entire amount in ZERO interest Govt Special Securities floated by GOI and REDEEMABLE AFTER 20 YEARS. Thus this transaction did not involve ACTUAL CASH OUTGO FROM GOI. And SASF (akin to bad bank) acquired 636 NPA assets with a net loan outstanding of Rs 9004 crores.

Transferring NPAs to SASF was akin to UNDERWRITING OF NPAs of IDBI. Even though arrangement did not involve any cash outgo but it has CREATED A LIABILITY FOR THE SAME WHEN THESE SECURITIES ARE DUE FOR REDEMPTION IN 2024. Thus GOI effectively took over burden of NPAs of IDBI. And even after 12 years, as per our reports, so far SASF has recovered less than 4000 crores of NPAs( out of 9004 crores). Balance

5000 cr worth NPAs not yet recovered. What could not be recovered in 12 years, it may take another 12-24 years to recover or may be no recovery.

Even though GOI cleaned up balance sheet of IDBI in 2004, fresh NPAs continued to evolve, grow and mount. What we want to convey is that transferring of NPAs to ARC or SASF does not deter bankers from fresh NPAs. Selling of NPAs and transferring to Bad Bank is just TEMPORARY MEASURE to calm down everyone.

Bad bank will be exactly on lines of SASF created for IDBI in 2004 and hence, entirely unviable.

And we are fairly confident that bad bank may not materialize even upto 2017.

Finally : Infusion of funds by GOI:  It is like putting more water in a leaking vessel, rather than to seal/plug the leaking holes of the vessel. In last 2 years, GOI had infused more than 59000 crores in diffferent PSUs. Despite that, financial condition of PSU Banks has become worse with deteriorating asset quality. Govt putting more money (although looking at GOI's stressed liquidity, infusion will not be significant) will again be a small and temporary measure. Rather, GOI should focus as to how delinquent bankers are taken to task, how research/ credit quality assessment of borrower/ due diligence is done more effectively so that in future loans are not disbursed to unworthy

In view of our above practical approach, we feel strongly feel that WORSE for PSU banks is still to come. Losses and NPAs of large no of PSU Banks for Q4 WILL be more worse. And we are pessimistic even about entire FY17 due to weak outlook for credit intensive sectors (and big exposure of PSBs to these sectors) which will keep PSB's Credit cost at elevated levels. Moreover, COST TO REVENUE of PSBs is much higher than private sector banks and PSBs are at definite disadvantage vis-a-vis private sector banks.

INVESTMENT ADVICE: Although PSBs share prices touched new low in last 2 weeks, but likely to make new low in next 2 months. Hence, one should stay away from buying shares of PSBs (not to catch a falling knife).

As per our analysis,  BOI, UCO Bank, Central Bank and IOB are worst placed