IL&FS default: Did rating agencies' failure to connect dots lead to crisis?

Did rating agencies again trip up in their assessment of IL&FS, leaving the markets with little time to adjust to the unravelling of the infrastructure company? Or do you accept the rating wisdom that at least three non-banking financial companies (NBFCs) are AAA, and more than one public-sector banks have slipped down to AA minus or even lower on their Tier-I bonds? It means these banks are more prone to default than the highest-rated NBFCs. To get a sense of what goes when a paper is rated by a credit rating, let us examine a typical one in the case of an IL&FS subsidiary.

In February this year, India Ratings had affirmed an AA minus rating for a debt paper of IL&FS Education & Technology (IETSL) Services Limited. Despite recognising that the company had Rs 17.29 billion overdue for 180 days (double the time period for recognition of bad debt by banks and NBFCs), it noted that this risk was mitigated through “an unconditional and irrevocable line of credit facility of Rs 300 million from IL&FS, sponsor and parent of IETSL, to tide over the collection shortfall”.

One makes it clear that these problems are not unique to any one rating agency and is used only for illustrative purposes. After the IL&FS issue, Dewan Housing Finance Limited, one of the NBFCs that has got an AAA rating from both Icra and CARE had to issue a press release following a brief market scare, stating “the company has neither defaulted on any bonds or repayment of its financial obligations, nor has there been any instance of delay on any repayment of any liability”.

Why did the equity market get spooked despite an AAA rating for DHFL? Or why did the market take no note in February when the IETSL rating was reaffirmed. It was a debt paper and IETSL is not listed. But did markets shrug off the assessment of the parent IL&FS because the rating agency did not connect the dots. This is where rating agencies slip up, according to a top source in one of these companies. Much of what follows is based on discussions with officials of some of these agencies, but strictly on the condition of anonymity.

While each subsidiary of IL&FS like IETSL often has an unconditional line of credit to the sponsor, the rating agency often does not factor in others. In this case there were nearly 200 of them, each tugging at the balance sheet of the parent company. It works well when the markets are well-behaved. The risk was classified as “moderate”, despite 90 per cent of it being concentrated with only two states, Odisha and Rajasthan.

In this case, the rating agency had also not asked why the promoters’ line of credit had not been invoked despite the dues being already so delayed. An AAA-rated company was delaying making good the line of credit, but no agency had taken that into cognisance. No warning bells were rung, considering that a line of credit is not even the equivalent of, say, a bank guarantee, but a lesser degree of support in financial terms. In response to queries from Business Standard, India Ratings noted: “The LoC (letter of credit) was an extra layer of support that the parent agreed to bring in when the total overdue in the secured receivables reached Rs 17.29 billion as on 31 December 2017. However, this was to be only when credit enhancements to the extent of Rs 360 million was fully depleted; that did not happen as the payouts to the investor were always made on a timely basis...”.

Instead, the rating agency made other arguments to classify the debentures as AA minus. For instance, it argued that IETSL has been in the business for more than two decades, since 1997. The papers, non-cumulative debentures, had an additional layer of security to assure the trustees — two banks, Axis and Yes Bank. The layer was a debt service reserve account of Rs 300 million, or 9 per cent of the size of the debt. The repayment is supposed to be from a diversified basket of “IETSL’s income arising out of identified receivables under nine ICT contract agreements with six different states (Bihar, Gujarat, Maharashtra, Odisha, Rajasthan and West Bengal)”. India Ratings, in response, says: “IETSL is not an NBFC, so the norms for NPA recogntion for banks do not apply to them and, like many other non-financial corporates that typically have receivables from government departments, the receipt of the payments of some contracts were delayed.”

Clearly, IL&FS had built in thin but cumulative buffers to keep the markets interested in the IETSL papers. None of them were enough, per se, but taken together they gave an impression of solidity. India Ratings also thought so. “The invocation of all available support under all circumstances in the responsibility of the trustee, which in any case was not required of the trustee”. The rating of the paper was, therefore, investment grade for insurance and pension companies. That was until a black-swan event occurred, as it did in August this year.

The ability of the parent company, IL&FS, to execute such lines of credit has now become suspect. An Icra report putting it under ‘Watch with Developing Implications’ notes as much. “The rating revisions take into account the company’s elevated debt levels, owing to the funding commitments towards group ventures.” Ventures like IETSL, for instance.

It is not the first time that this has happened in Indian markets. The problem is that the higher a company is rated, perversely the more is the pressure on the market when there is a “jump to default”. Though investors do recognise that even a double- or triple-A rated company does face this risk. In six years, there have been at least three such cases — Amtek Auto, Deccan Chronicle and now IL&FS. CRISIL, Icra and India Ratings have rated one or more of these companies at some time or the other. As one of the official said, an invoking of promoters’ guarantee could be a sure-shot way to alert the market of a possible trouble, but it has never been executed in Indian markets. CRISIL, for instance, notes in its annual default action report that no company rated AAA by it has ever defaulted. Regulators do step in as the Securities and Exchange Board of India (Sebi) did in the case of Amtek Auto. As a Business Standard report noted, this was the first time Sebi was taking up the matter against a credit rating agency.

Even banks, which are the principal consumers of such rating action, do not ask for such action. Rather, when the numbers start looking bleak, they often encourage the rating company to hold back ratings action instead of putting out the bad news.


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