Sorry TV pundits - ILFS is not a Lehman moment

The ILFS situation is a reminder that memories in Financial Markets are short. Mistakes have been made. However, this is no Lehman moment if managed right. 

Lehman Brothers had a Debt/Equity ratio of ~30.  That meant a 4% decline in the value of its Assets would have made the firm bankrupt as its Equity would be wiped out. The true value of Assets Lehman held were valued far lower than its Liabilities. Its Assets were predominantly Home mortgages sold to borrowers with limited ability to repay, who just walked away from their homes when the value of the home fell below the value of the loan.  Importantly, it had no “promoters” who could take a long term view and infuse cash.

ILFS has a Debt/Equity ratio of ~10. It has Infrastructure Assets which have underlying value. One can debate what the true debt is if one includes off Balance Sheet liabilities – however, a fair share of these Assets have real value eg Toll roads. It has a blue chip shareholder roster under whose aegis this has happened – LIC, SBI, HDFC, among others. This shareholder roster, is the crucial difference between Lehman and ILFS. 

ILFS is in a situation of over adventurism and a cash flow duration mismatch. While i am not making any insinuations, one may also discover some fraud or siphoning of funds through SPVs. However, the crux of the matter is that its Assets are long duration and the nature of its business – Infrastructure – means cash flows can get stuck. However, as no market for long duration liabilities exists in India, it has to borrow short term and keep rolling over its funding.  And market participants seem to have lost faith in ILFS as reflected in the precipitous drop in its Credit rating. If short term liabilities cannot be refinanced a liquidity crisis occurs, which is what we are witnessing at present.

A liquidity crisis can evolve into a solvency crisis if shareholders don’t have the ability or intent to infuse more funds.  However, unlike Lehman, shareholders have the ability to infuse Equity and provide bridge financing to manage the Liquidity issue which provides time to sell Assets to reduce debt to a more manageable levels. The RBI will be reading the riot act to shareholders at the next meeting that they also have the obligation to do so. There is no walking away from a mess that one is partly responsible for creating.

The one lesson regulators have learnt from Lehman is that one cannot risk a financial institution’s uncontrolled collapse due to interconnections which can set off a Domino effect. Hence, RBI is unlikely to let this issue fester for long. I do hope however, they let the situation fester a wee bit longer to teach market participants lessons on risk management. 

Long term investors should not waste the opportunity this crisis offers.