How Indian credit rating agencies missed an epic fail at IL&FS Group

Indian credit rating industry has come under scrutiny after the firms that assessed IL&FS, including the local partners of Moody's Investors Service, failed to see the financial troubles brewing

Indian authorities have spent the week containing the collateral damage from a major infrastructure lender struggling to service $12.6 billion in debt. Next up: Figuring out why the nation’s credit rating agencies didn’t see the crisis coming.

IL&FS Group is a vast conglomerate with a complex corporate structure that funds infrastructure projects across the world’s fastest-growing major economy. The financier, set up in 1987, and its listed subsidiaries have powered India’s infrastructure boom-- including the Chenani-Nashri road tunnel, India’s longest--and raised billions of dollars from the country’s corporate debt market.

In July, company founder Ravi Parthasarathy stepped down, citing health reasons. In August a default within the group rattled India’s money markets, added to pressure on corporate bond yields and sparked a sell-off in the stock market. The Reserve Bank of India has initiated a special audit, given the potential systemic risk the group poses to other non-bank lenders and worries about $500 million of repayment obligations coming due over the next six months.

The nation’s credit rating industry has come under scrutiny after the firms that assessed IL&FS, including the local partners of Moody’s Investors Service and Fitch Ratings, failed to see the financial troubles brewing at the financier. The group’s debt burden jumped 44 per cent in the year ended March 31 from 2015.

"Rating agencies need better market intelligence and surveillance rather than depending upon historical data and some structure based on past estimates." said Nirmal Gangwal, founder of Brescon Corporate Advisors Pvt., a distressed asset turnaround specialist. "They also need to factor changes on the ground like change of leadership, cash flow management in recent past and market environment."

Great Unraveling
 

The Indian credit rating companies’ failure to foresee the great unraveling at IL&FS has left Prime Minister Narendra Modi’s top economic policymakers, including Reserve Bank of India Governor Urjit Patel and Finance Minister Arun Jaitley, facing contagion risk to the broader financial sector.

“There is definitely a case for revisiting ratings standards and the whole rating framework,” Rajiv Kumar, India’s banking secretary said in an interview. “Some kind of accountability needs to be there. It has to be made more robust.”

IL&FS is a huge borrower, accounting for 2 per cent of outstanding commercial paper, 1 per cent of debentures and as much as 0.7 per cent of banking system loans. The group itself, in turn, acts as a key source of capital to non-bank lenders. Another worry is a stampede by individual investors out of fixed-income mutual funds that will force portfolio managers to sell other companies’ debt securities to cover redemption requests, setting off a vicious cycle.

"We have not had this kind of a systemic event of this magnitude in the bond market before in India, and so we don’t really have a precedent as to how to deal with it," said Kunal Shah, a debt fund manager who oversees nearly $1.7 billion at Mumbai-based Kotak Mahindra Life Insurance Co.

Until July, India’s credit rating companies had investment grade ratings on billions of dollars of corporate debt raised by the IL&FS Group and its subsidiaries. The first signs of trouble came in June, when the special purpose vehicles tied to IL&FS Transportation Networks Ltd., a group subsidiary, defaulted on its debt obligations. More defaults in other parts of the empire followed in August and September.

In August, major credit rating companies such as ICRA, a unit of Moody’s, Fitch-owned India Ratings & Research and CARE began to cut their rating for the group’s parent company, Infrastructure Leasing & Financial Services. More rating downgrades to default status came in September. All three rating assessors declined to comment.

The burning question now is whether credit analysts should have seen the financial reckoning at the IL&FS group earlier. It was no secret that funding costs for companies in India surged as the interest rates in the nation’s credit markets hit multi-year highs. For IL&FS, short-term debt increased 30 per cent to 135.6 billion rupees ($1.9 billion) in the year to March 31, according to the company’s annual report.

The pace of new infrastructure projects has slowed down in India, and some of IL&FS’s own construction projects, including roads and ports, have faced cost overruns amid delays in land acquisition and approvals. Disputes over contracts have locked about 90 billion rupees of payments due from the government.

Indian credit ratings companies rely on the same “issuer-pays” model common in the US that allows the entity issuing a financial instrument to pay credit analysts upfront to rate the underlying securities. S&P Global, Moody’s and Fitch were criticized for placing profits before investors when rating mortgage securities in the run-up to the US financial crisis in 2008.

The “issuer-pays” model affords the rating companies access to the borrower’s management and helps to factor in regular inputs about the issuer, according to S&P’s India unit, which said it collects fees upfront and hasn’t assessed IL&FS. Other models such as “investor-pays” and “regulator or government pays” haven’t been tested, it said in an emailed statement.

"Where we have gone wrong in India is where regulators have written regulations that force regulated entities, such as banks, mutual funds, to use the rating," said Professor Ajay Shah with the National Institute of Public Finance and Policy in New Delhi. "A rating company should be just a research company, which has to sink or swim based on the value that it contributes to the institutional investor."

IL&FS group’s investment grade rating was based on the strength of the investors in the parent company, according to an official at a rating company. The lender’s investors include Life Insurance Corp., India’s largest life insurer; State Bank of India, its largest bank; and Housing Development Finance Corp, its largest mortgage lender. Japan’s Orix Corp. is the company’s second-largest shareholder.

India’s central bank deserves some of the blame, the person said, because it tolerated the excessive dependence on debt used for project funding in India.

Shriram Subramanian, the founder of Mumbai-based proxy advisory firm InGovern Research Services Pvt., says Indian credit analysts aren’t skeptical enough and assume wrongly that big investors will bail out companies in a jam.

"In most cases, they take into account projections given by managements which tend to be rosy," said Subramanian. "Rating companies have a role to play in rating the various securities, but they need to increase their sophistication by developing models that account for various scenarios."

Regulatory measures should be on the table, according to the head of a rating assessor. “The regulators should seriously consider mandatory rotation of the rating agency of an issuer just like the rotation of auditors," Sankar Chakraborti, chief executive officer at Acuité Ratings & Research Limited, a local ratings company. "This will allay the concern that a very long association between issuer and rating agency may allow scope for complacency.”

Credit rating firms in India’s big Asia economic rival, China are also facing increasing scrutiny as authorities look to rein in risks and foreign investors have long cited inflated ratings offered by local firms as a key reason for not buying onshore corporate notes.

While penalties had previously been restricted to discreet warnings, regulators in August banned a rating company for a year from assessing bonds. China opened the door for foreign rating companies last year. Yet so far, no international raters have set up wholly-owned units in the country.

For IL&FS, rating company ICRA, flagged the group’s “elevated leverage” in March but kept its investment grade rating because of “experienced senior management team and its significant track record of operations in the infrastructure domain.”

The company’s shareholders are scheduled to meet on Saturday to vote on increasing its authorized capital, which will start its plan to “restore normalcy,” Vice Chairman and Managing Director Hari Sankaran said in a note to employees this month.

“Certain conflicts of interest inherent in the current structure prevalent in India need to be reviewed,” said Sunil Sharma, executive director & chief investment officer at Sanctum Wealth, which manages $1 billion. “Greater disclosure and access to information needs to be mandated.”