Mutual funds cannot borrow their way out of redemption trouble

Indian mutual funds have been facing redemption pressure for some time now and the policy response to this was to allow them to borrow more easily. The Reserve Bank of India early this week created a special repo facility of Rs 200 billion to enable banks to meet the liquidity needs of banks. This facility has thankfully not been very popular so far and I hope that it does not become popular because it is a prescription for disaster.

A mutual fund is very different from a bank. When a bank borrows to repay depositors, there is a capital cushion that can take losses on the assets side. When this capital is gone, the bank also needs to be recapitalized and cannot solve its problems by borrowing from the central bank. A mutual fund does not have any capital separate from the unit holders. This means that the only prudent way for a mutual fund to repay unit holders is by selling assets. If it borrows, then it is exposing remaining unit holders to leveraged losses.

Imagine a mutual fund with assets of Rs 1,000 (worth par) and 100 units of Rs 10 outstanding. The net asset value (NAV) of the fund is Rs 10.00 at this point. Suppose now that some of the assets deteriorate in quality and the true value of the assets is only 88% of par value. If the instruments were liquid and well traded, the mutual fund would mark its holdings down to market value, and the NAV would drop to 880/100 = Rs 8.80 per unit. But because the instrument is illiquid and not well traded, the mutual fund would avoid doing this by pretending that the assets are all good. The NAV would on paper remain as 10.00 instead of 8.80. If the mutual fund borrows 200 to meet a redemption request at the old NAV then only 80 units are remaining to absorb the loss on the assets. The true NAV at this point is only (880-200)/80 = 680/80 = Rs 8.50. Every unit holder who remains in the fund has lost Rs 0.30 in order to allow the redeeming unit holder to exit without a loss.

What this means is that every intelligent unit holder now has the incentive to redeem and exit at 10.00 rather than wait and be left with only 8.50. It is far better to force the fund to sell assets at distress prices if necessary. Suppose in the above example, the market prices are distressed and the assets which are truly worth 88% of par can be sold only at 80% of par. In this case, the NAV of the fund drops to 8.00 by being marked to market. Suppose 20 units want to redeem and the fund sells assets with a face value of Rs 200 at 80% to pay out the NAV of 8.00 x 20 or 160. Suppose the remaining unit holders sit out the distress and hold on to their units till the assets rise to their fundamental value of 88% of par, the assets of the fund at this point would be Rs 800 of face value which are worth 88% x 800 = 704. The NAV of the remaining 80 units would then be 704/80 = 8.80. Thus the remaining unit holders have a gain of 0.30 per unit at the expense of the redeeming unit holders. This is as it should be. Those who demand liquidity during troubled times should pay for it and the patient capital that sits out the storm should be rewarded. What this would also do is to reduce the incentive to redeem. Only those with pressing liquidity needs would redeeem.

The questions therefore is whether Indian mutual funds are facing only a liquidity pressure or whether they are also facing the problem of hidden non performing assets. I think the latter is clearly the case today. The liquid funds and fixed maturity plans that are facing redemption pressure today have broadly four clases of assets in the portfolio:

• Bank Certificates of Deposit: Under the current global scenario where exposure to banks is effectively sovereign exposure, it is reasonable to assume that these assets are not impaired.
• Securitized paper mainly pertaining to auto loans. The underlying loans are witnessing high delinquencies and it is fair to assume that this paper is impaired significantly beyond their carrying values.
• Securities of Real Estate Companies. It is fair to assume that this paper is impaired significantly beyond their carrying values.
• Securities of Non Bank Financial Companies: These companies in turn have large exposure to real estate, home loans, auto loans and other retail assets. It is fair to assume that this paper is impaired significantly beyond their carrying values.

In the current scenario, therefore, the NAVs of many debt oriented mutual funds today are not very credible. The only way to establish true NAVs is if the underlying paper is sold. Giving the mutual funds a credit line delays this day of reckoning. The danger is that the sophisticated corporates who are redeeming today get a good deal and the unsophisticated retail investors still holding on to their units will be left with all the rotten assets.

All of this is not to deny that a policy response is needed to the liquidity problem of mutual funds. If lending them money is not the answer, then what is the solution? There are two models available.

• The US solution of providing a sovereign guarantee to liquid mutual funds is one alternative. Part of the costs of this guarantee can be recovered by simultaneously withdrawing the tax break that the debt mutual funds get today.
• The solution adopted by Korea during the 1999 crisis in their mutual funds (ITCs) after the bankruptcy of Daewoo. This involved purchase of bonds from the ITCs by government entities (this was a purchase and not a loan), recapitalization of the ITCs and partial redemption freezes.

At the very least what is required today is a partial redemption freeze to ensure that nobody is able to redeem units of mutual funds at above the true NAV of the fund. Anybody who wants to redeem should be paid 70% or 80% of the published NAV under the assumption that the true NAV would not be below this. The balance should be paid only after the true NAV is credibly determined through asset sales. If this is done, then the Rs 200 billion line of credit would make sense to avoid distress sale of assets.

Posted at 5:18 pm IST on Fri, 17 Oct 2008         permanent link

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