Mutual Fund Fiasco: Link Bailout to Disgorgement of Fees and Bonuses
As the global economy goes into a tailspin and India’s growth rates nosedive, dirt from the mutual fund (MF) industry has been the first to hit the fan. On 23rd April, Franklin Templeton India Mutual Fund (FTIMF) announced the winding up of six debt schemes that collectively managed over Rs27,000 crore. FTIMF will neither accept new money nor allow an exit to investors because it is unable to sell its illiquid investments to meet redemption demands. But FTIMF is not alone in spooking the market.
 
Under the benign eye of the regulator, who permitted the utterly fake industry slogan – Mutual Fund Sahi Hai (implying all MF schemes are absolutely safe), MFs garnered huge amounts of public money taking their total assets under management (AUM) to over Rs22 trillion by March 2020. 
 
 
So now the industry calls the shots and is lobbying hard for a bailout by blaming all its problems on a virulent virus. COVID-19 provides the perfect excuse for everybody to wash their sins—a clueless government, failed regulators, reckless lenders, investment managers and corporate houses. 
 
The MF industry aggressively demanded a bailout and the Reserve Bank of India (RBI) has already responded with a Rs50,000 crore ‘Special Liquidity Facility for Mutual Funds’ by way of a 90-day repo funding to banks to be used to extend liquidity to local MFs or purchase debt and commercial papers from them. 
 
The scheme will be available from 27th April to 11th May, but the rating agency Fitch has already said that it will not serve the purpose as more ‘credit risk funds’ close their doors and go the Franklin way. But will the industry ever learn any lessons or keep blowing up public money every few years?
 
History Repeats?
On 25th April, we wrote Neir Barote writes in The Mint how BOI Axa Credit Risk Fund has suffered a vertical drop in net asset value (NAV) to the point that its returns, since launch, now stand at -17.86%. Its disastrous investments include IL&FS, DHFL, Sintex BAPL, etc. BOI Axa is a joint venture between Bank of India and the French insurer AXA, whose unique selling proposition was a tie-up with KKR India, an increasingly controversial finance group for investment advice. 
 
Some say that many shady schemes in the portfolio were acquired on its advice; but KKR is quick to wash its hands off. In an email to me, it says, “The advisory is limited and in the form of recommendations with respect to certain structured credit assets” and that it was not involved in “investing decisions, portfolio construction and management, portfolio and asset valuation, liquidity management.”
 
Those of us who had a ringside view to the ‘cowboy banking’ of the 1990s, which culminated in the massive securities scam of 1992, recall how every public sector bank (PSB) and insurance company, in cahoots with stock brokers and riding high on a booming market, subverted regulations. MFs took advantage of a regulatory vacuum and lured retail investors by promising ‘assured returns’ that were higher than bank term deposits.
 
These assured returns schemes were modelled after the mammoth Unit Trust of India (UTI) which eventually crashed and had to be bailed out by the government. Far from earning any returns, several MFs suffered capital losses and tried to renege on their commitment. A legal battle by Virendra Jain of Midas Touch Investors Association forced sponsoring banks and insurers, like Canara Bank, Bank of India, General Insurance Corporation, etc, to take the hit and pay up the returns assured by their asset management arm. 
 
Debashis Basu’s book Face Value has a chapter on the reckless behaviour of government-owned MFs. BOI Mutual Fund has either forgotten history or learnt no lessons from the mid-1990s.
 
Mr Basu says, “Bank of India’s BoI Double Square Plus faced the biggest shortfall among the guaranteed return funds—over Rs800 crore” when an unequivocal promise to pay “4 times plus of the face value of each BOINANZA held” after 10 years. It initially claimed a relative small shortfall of Rs55 crore, which, after a central vigilance commission (CVC) investigation blew up into a Rs300-crore scam in the asset management company (AMC). This came to light only in 1998. 
 
FTIMF’s problems too are less due to COVID-19 than the reckless bets of its high-profile fund manager. A big part of the problem was its exposure to debt of private, unlisted companies or promoter funding without a clear exit. It wrote off Rs2,000 crore exposure to Vodafone; it had an exposure to zero-coupon bonds issued by Wadhawan Global Capital, the personal holding company of promoters, as well as to Yes Captial, Rana Kapoor’s personal holding company. According to B&K Securities, it was the sole lender to 26 out of the 88 entities in its debt schemes’ portfolio. It also owned low-rated commercial paper from companies such as Vedanta Ltd, Clix Capital Services Ltd, Five Star Ltd, Indostar Capital and DLF, said the brokerage firm. What motivated such high risk-taking at investors’ cost?
 
 
History repeats in the financial markets every few years. Starting with the IL&FS failure in September 2018, there has been plenty of public information on the deep involvement of fund managers in scandalous investments in league with promoters of entities such as Zee/Essel, Anil Ambani companies, DHFL and Yes Bank founder Rana Kapoor’s private companies. Funds actively colluded to hide information about promoter lending from the stock market and had the temerity to announce a unilateral ‘standstill’ over sale of Zee group’s shares. 
 
We have yet to see any significant action by SEBI (Securities and Exchange Board of India) to claw back bonuses of AMCs’ managers, disgorgement of fees earned on the basis of AUM or sacking of trustees, other than an occasional slap on the wrist. Moneylife has repeatedly written that nothing will change as long as MF fees are based on AUMs and not on performance; but the powerful industry lobby prevails.
 
Today, the MF industry is gigantic and there are no sponsoring banks to take the hit; so the buck stops with SEBI and RBI that need to focus on avoiding a more pervasive ‘systemic’ collapse.
 
Ajit Dayal, a veteran fund manager who ran among the cleanest AMCs (Quantum Asset Management), writes, “The mutual fund industry has become a veteran at seeking bailouts. First they create the mess, then they get into trouble, they put the entire financial system in jeopardy and then they stand in the bread line for a bailout!”And they have got it too. 
 
In 2008, after the global financial crisis, while SEBI wanted to be firm, the then finance minister P Chidambaram was happy to offer a bailout through RBI without touching fees and bonuses. Ironically, he is at the forefront demanding a bailout for the industry again. The situation today is vastly different from 2008; then, India took pride in having escaped the global financial crisis, but only ended up postponing it, because the government and RBI opened credit lines to all and forgot to demand repayment causing bad loans to balloon. 
 
This time around, we were already in the middle of a serious economic slowdown when the COVID-19 crisis hit us. MFs may lobby to dump all these dubious investments on to the central bank; but there isn’t enough money, even if RBI’s printing presses work overtime. The Centre and state governments have no funds and have bigger concerns like feeding the hungry who have been left without jobs or a livelihood by the lock-down.
 
Although a bailout may be inevitable from the larger systemic perspective, it will be scandalous if this is done without segregating dubious investments, forcing AMCs and their immensely well-paid fund managers to disgorge fees, stock options and bonuses collected over the past few years and, maybe, even cancel a few AMC licences after winding up their businesses.  
 
Why can’t the precedent set by ICICI Bank in clawing back the salary and bonus paid to Chanda Kochhar be applied to dubious investment decisions by MFs? Prof JR Verma of IIM Ahmedabad, also a former regulator, has also offered a sort of ‘bail-in’ solution which requires the industry to participate in the rescue. 
 
He writes in his blog: “My preferred solution is for the mutual fund industry itself to create the buyer of last resort with only limited support from the sovereign. It is guided by the principle that whenever we bail out the financial sector we do so not to help the financiers but to protect the real economy which depends on a well functioning financial sector. In these troubled times, the real economy cannot afford the loss of any source of funding.”
 
This involves the creation of a special purpose vehicle (SPV) funded by the MF industry which will buy illiquid bonds. However, he suggests that the SPV has to be funded by investors, just like the controversial ‘bail-in’ for banks from depositors’ funds. If this includes retail investors whose money is blown up, there is bound to be a furore, but it may find acceptance if restricted to institutional investors.
 
The Yes Bank bailout could also offer a model worth considering. In that case, private banks stepped forward to participate in bailing out a private bank when it was clear that the loss could not be fully dumped on a public sector bank again and a systemic crisis needed to be averted. They stepped in even as global commentators and research firms were pushing for a public sector bailout. 
 
Something similar should be demanded from MFs as well. Creating an SPV to hold viable illiquid shares is a sound idea; but the money probably ought to come from AMCs and from fees and bonuses disgorged from fund managers and trustees and not their investors. Especially in those AMCs which sold debt schemes like fixed-income securities or term deposits. 
 
COVID-19 has created a massive economic problem at multiple levels—the powerful MF industry cannot be allowed a bailout without AMCs and fund managers putting their money in the basket. 
 
 
 

 

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    India's Mutual Fund Support Plan May Struggle To Be Effective: Fitch
    The official support measures announced for mutual funds (MFs) in India may struggle to be effective, as undercapitalised banks are unlikely to be tempted to extend liquidity to the sector without capital relief on the facilities, says Fitch Ratings. It added that the announcement follows the implementation of support facilities in multiple jurisdictions in 2020 to date and highlighting global regulators' focus on providing liquidity support to financial markets during the coronavirus pandemic.
     
    The Reserve Bank of India's (RBI) Rs500 billion ($6.6 billion) special liquidity facility for mutual funds (SLF-MF) will provide 90-day repo funding to banks, to extend liquidity to - or purchase commercial paper and debt securities from local mutual funds. 
     
    This followed the suspension of redemptions (gating) in six Franklin Templeton bond schemes, with combined assets under management (AUM) of approximately $4.1 billion equivalent, on 23 April 2020, and outflows from other funds in March 2020. The scheme will be available from 27 April 2020 to 11 May 2020, or until its funding is exhausted.
     
    Fitch says, "The success of the SLF-MF will hang on banks' appetite to take up the risks involved, against the system-wide backdrop of low capital headroom and a likely increase in fresh non-performing loans. The facility's structure places the onus on banks to absorb the associated credit and capital risk, which may hinder their willingness to participate."
     
    "If the SLF-MF does not achieve its aims of supporting liquidity or restoring market confidence, Fitch believes more fund gatings could occur. Indian open-end mutual funds saw aggregate outflows of almost 20% in March. Within this, overnight funds, the most conservative variant in India, saw assets jump by almost 50%, whereas most other fund types saw outflows," the ratings agency added.
     
     
    Fitch says it believes funds classified as credit risk funds are most at risk if redemptions continue (their AUM declined by 10% in March), particularly where funds have exposure to less liquid securities, such as unlisted securities, and/or have demonstrably higher risk appetite through exposure to defaulted entities such as Infrastructure Leasing and Financial Services (IL&FS), Religare Finvest, and/or Dewan Housing Finance Ltd (DHFL). The size of the SLF-MF appears broadly commensurate with the scale of the schemes most at risk, it added.
     
    Mutual funds form a conduit between retail and institutional investors and financial markets. Most mutual funds assume liquidity risk, through offering investors the ability to redeem daily, while investing only a limited portion of their portfolios only in risk-free assets or cash. 
     
    "This liquidity mismatch is most acute in mutual funds investing in illiquid assets such as property. An interruption of, or reduction in, funding provided by mutual funds to major entities or sectors, due to outflows or redemption suspensions, can have material credit implications for entities more reliant on wholesale funding," Fitch says.
     
    According to the ratings agency, funding conditions for Indian non-bank financial institutions (NBFIs) remain challenging. It says, "If the RBI's support measure fails to restore market confidence, leading to intensified redemption pressures for other funds, this could further narrow funding options for the sector. That said, NBFIs' dependence on mutual fund borrowing has fallen amid the tighter debt market conditions of the past two years."
     
    Fitch-rated issuers' dependence on mutual funds as a source of borrowing differs. "Short-tenor gold loan financiers such as Muthoot Finance and Manappuram Finance tend to source a meaningful portion of funding from commercial paper about 15%-25% of funding at end-September 2019, largely from mutual funds. However, they have continued to find favour among investors, even in recent difficult markets. Meanwhile, mutual funds provided just 4% of funding for IIFL Finance as of end-December 2019," the ratings agency concludes.
     
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    Franklin Mutual Fund’s FoFs Schemes Lose 25% in a Day
    As investors cry over the winding down of six of Franklin Templeton India Mutual Fund’s (FTIMF) debt schemes, the fund house announced another blow to its FoFs investors. FIMF marked down the net asset value (NAV) of its Fund-of-Funds (FoFs) schemes by 25%, which had invested in the aforementioned debt schemes being wound up. 
     
    Fund of Funds (FoF) is a type of scheme which invests in other schemes. FTIMF has six such FoFs which saw sharp declines as they all had invested in some or the other debt schemes of the fund house that were wound up on 23 April. 
     
    Here are the six schemes and the change in their NAV post the mark down.
     
     
    On Thursday night, FTIMF announced that it is winding up six of its debt schemes. These will neither accept any fresh subscriptions nor allow any exit. The fund house will liquidate the portfolio as and when the debt papers mature, or earlier if there is liquidity, and return the money to investors.
     
    FTIMF had invested in low rated debt securities and also purchased structured, complex debt to get high returns in the affected six schemes. The high credit risk portfolio of its schemes could not sustain well in the face of a global pandemic and recession.
     
    The six schemes collectively managed Rs30,000 crore of assets as on 31 March 2020, and were getting high redemptions due to investors taking the exit. The assets had fallen to nearly Rs27,293 crore by 22 April 2020, according to data published on AMFI website. The fund house could not sell the risky debt papers to meet redemptions as demand had dried up, and investors had turned risk averse. This led the fund manager to throw in the towel and shut down the schemes.
     
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