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There are decades where nothing happens, and there are weeks where the decade happens. Vladimir Ilyich Lenin
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Vallum Notes on Global Events and Volatility surrounding it.
Lenin said this referring to the Russian Revolution, oblivious of the fact that a century later the interconnectedness of the global ecosystem will produce such outcomes for all of us. The global stock market witnessed unparalleled volatility due to the spread of Covid-19 in India and global markets, a series of unprecedented news on the commitment of a bazooka of oil supply by Saudi Arabia in the global markets. The global markets took an ugly turn during this course shedding 15-20% of market value across the globe. The domestic events on the failure of Yes Bank, recurring failure of the governance & oversight by Banking Regulators and their aftereffect of the repercussion on financial markets have set us thinking as to whom we look up to in such times for an answer. Is it Viktor Frankl, a Man’s Search for Meaning, or Fritjof and Pier for their Systems View of life and its interconnectedness of philosophy, life, the fragility of markets or Nassim Taleb on The Black Swan? Are we now living in one of these periods of temporal acceleration?
Firstly, the global oil war has begun. Russia has a clear advantage in this in terms of its preparedness. It has defeated both Napoleon and Hitler and it coped well with the array of the U.S. sanctions. It has $570 billion of the foreign exchange reserves and a rainy-day wealth fund in excess of $150 billion. It holds the world’s fifth-largest official gold reserves of 2,242 metric tons, having nearly doubled in the last five years. Its fiscal break-even oil price is less than $50—nearly 40% below Saudi Arabia’s estimated fiscal breakeven level of $80. The US Shale is a long term threat to the oil prices, and the Covid-19-induced dip in demand offers the chance to precipitate bankruptcies and eliminate capital spending in the Capex-heavy US oil industry for the decade to come. This was the chance Russia had missed during 2008. This is also a befitting reply to the European countries embracing greener technologies that threaten long term Russian oil supplies, agreements.
Is the US vulnerable due to a slump in oil prices? To gauge where the balance lies between negatives and positives, the most obvious thing to do is look at the 2014-16 slump in oil prices and its effects, then to work out what is similar today, and how things differ. Between mid-2014 and early 2016, the price of WTI fell by three quarters, from US$107/bbl to US$26/bbl, inflicting heavy damage on the US oil industry. The growth rate of Capex in the sector sank from 28% YoY to -54%. The onshore US rig count plunged -80% from 1,864 to 374, and US crude production fell for the first time since 2008. As a group, the eight of most oil-dependent US states went into recession, and their payroll growth fell almost to zero on mass job losses across the oil patch. All this contributed to a slowdown in overall US GDP growth from 5.5% QoQ annualized in 2Q14 to just 0.1% in 4Q15. In the financial markets, yield spreads for energy credits spiked sharply higher. However, shale gas has diversified its funding profile to equity, bonds and less on the banking sectors. The US dollar being a magnet of capital has attracted global capital in the energy boom of the last few years thereby the jury to my mind is not yet out if this can be collateral damage for them.
Secondly, I am no expert on COVID 19 and do wish that this painful ordeal comes to an end as soon as possible. The action now will shift to the containment of COVID 19 and measures taken to revive the economy by the developed world. Till then, the action taken in such time will determine what in store for all of us towards the end of this year. The Chinese market has achieved its calmness with the reporting in the fall in virus cases by the last month and hopefully, coordinated policy action in the developed world contain this pandemic. As soon as the market gets a whiff of this, the ascent in the markets will start again.
Lastly, the Indian Stock market is hostage to Foreign Institutional Investors (FII) owning more than one-third of the free float in Indian listed stocks. They sold stocks worth $5bn over the last month. It will be naïve to assume that our markets will not remain correlated to the global developments. However, the tail risk of failure of Yes Bank and Voda-Idea seems to be tamed by the active navigation of situation by the government and collapse of oil prices by more than 40%, a commodity which has led to the transfer of wealth from India to the Middle East, seems to be priced in favour of the country. The student of history knows that the Indian government took the most of the gains from the decline in oil prices in the Year 2014, thereby improving the fiscal deficit. I think fortune is smiling again for this government. Many investors seem to have forgotten that the Indian stock market has witnessed fall on an intraday basis by 5% or more, around 94 times and around 10% by 9 times but has risen by 5% or so by 76 times and more than 10% by 76 times. The volatility is a by-product of investing in Equities for the investors, none of us can avoid. For the weak-hearted one, SBI has started offering a volatility free product – saving deposit rate of 3% p.a. History suggests that patience has always rewarded long term Investors.
(Manish Bhandari, CIIA, is CEO and Portfolio Manager of Vallum Capital Advisors, Mumbai based Investment firm providing Portfolio Management Services)
“What lies behind us and what lies ahead of us are tiny matter compared to what lies within us“. Henry David Thoreau
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Must Read : Is SBI in Yes Mam Game ? Colleagues at Vallum Capital Debates Implication of SBI Investment in Yes Bank
Three colleagues of Vallum Capital gathered on Saturday for lunch to discuss an important event that took place this week in the financial markets “State Bank of India investing in the Yes Bank”. During the lunch philosophy of a moral hazard, haircut to Bond Holders, the role of regulators and whether SBI landed a golden goose, was discussed. We are producing the notes of the debate to you.
Participant A: In the olden days, in China, doctors were paid once a year by their patients to keep them healthy. The doctor would come up with various potions and exercise routines to minimize the likeliness of getting sick. In the Western world, medicine evolved very differently with patients only calling their doctors once they were really ill. In India the regulators, MoF, and others have failed to bring the desired supervision. We have become a bailout nation. The list of crises ridding financial institutions has become never-ending. The Year 2000 onward, GTB, UTI, IDBI, IL&FS and the endless list of cooperative banks have failed. Malaise is spread between private and public sector entities. Yes bank is another such fallen angel. I don’t understand what SBI is doing here as a knight saving damsel. Who pays for whose lunch? I am struggling to find the alignment of interest in this whole episode between a private sector entity and Nationalism. How does one know what the hell is happening?
Participant B: I hear your argument. A couple of lifetimes ago, I played football in school but I never got injured, that’s because I was playing as a defender and a little slow. Meanwhile, the guys who were fast and agile were playing in the center-forward position ended up tearing the ligaments of their, straining a hamstring or sustaining one of the many injuries one can pick up during such a game. The Banking business finds a lot of familiarity with this situation. Every economy has and does go through a banking crisis. India is not immune. However, looking at the sunny side, after a long time I see unison in the efforts of the MoF and the regulators, SBI in bringing two years of chaos to order. Also, I was wondering, in the long run, won’t Yes Bank benefit from the SBI’s parentage; I believe the quasi-sovereign guarantee will enable Yes bank to reduce its cost of funds in the medium term of 3-5 years, which will eventually start reflecting in yes Banks NIMs.
Participant A: Then why has the capital raising exercise failed for the last few months? Investors who have done due diligence know more than the investors who are here for national service. The hole in the books can be significantly higher than god’s own estimate. LIC has done somersault many times with such investment and the jury is out in front of us. Why we should believe that this time it’s different.
Participant B : I agree that capital raising has not taken place but I believe the reasons for not being able to raise capital are different. I suppose without the backing of a state-owned bank, investors were wary of the deposit franchise crumbling. we must also consider that none of the investors have yet got an opportunity to pump in money under the draft RBI resolution scheme under the RBI moratorium period at a steal deal of 10 Rs a share. I was hearing the SBI chairman this morning, he says there has been a lot of interest by Investors to go along with SBI on this deal. This deal was initially only offered to SBI to instill depositor confidence. Now with the safety of deposits, I believe a lot of entities will be willing to pump in Capital into Yes Bank. Also what I find quite hilarious is that the so-called sophisticated Institutional Investors who were ready to value the bank in excess of $10 bn a couple of years ago with analyst price targets running northwards for years together are now doubting SBI’s investment argument at $ 1bn. Take a look at the $2bn capital raised by Yes capital over the last few years from marquee investors. I still remember when Satyam failed and Tech Mahindra took over, the situation and media noise was quite similar. I hope history will judge SBI, kindly. As an Investor, we are prisoners of recent history.
Capital Raising Data of Yes Bank
| of issue | Close Price | Issue Price (Unit Curr) | Issue Value | Latest Price (Unit Curr) | Change % |
| 14-Aug-19 | 76.6 | 83.6 | 1930.5 | 16.2 | -80.6 |
| 31-Mar-17 | 1549.1 | 300.0 | 4906.7 | 16.2 | -94.6 |
| 05-Jun-14 | 574.3 | 110.0 | 2942.1 | 16.2 | -85.3 |
| 27-Jan-10 | 235.8 | 53.9 | 1033.9 | 16.2 | -69.9 |
Investment as a financial investor by LIC is vastly different from an investment by operating entities like SBI in a Bank. Moreover, the SBI chairman has been very picky with his words, 3-4 months back when this topic first emerged, he made it clear multiple times that SBI does not have the appetite to merge with any bank. So when we put things into perspective SBI’s chairman has maintained his stand of not merging with Yes bank, nor misguided investors. I think what he did was that he took an opportunity and clung on to it, by investing in Yes Bank at dirt-cheap valuations, thereby not letting it fail and he also stuck to his word of not merging with SBI, I think he killed 2 birds with one stone. Banking is about the confidence of depositors and I believe the chairman has been able to maintain the confidence of the shareholders and the system in the bank. I am sure Adam smith must be smiling in his grave when he said there is no free lunch and write off to be taken by bonder holders proves this. This also effectively proves that the regulator has freed himself of a moral hazard.
Participant A: I agree to all that you have said, but let me highlight the fact that Yes Bank’s BB and below book, which has become 8x the size in 2 years, Yes Banks BBB and below book which has doubled in the past 2.5 years, who knows where this ends. As of today, we are going by Yes Bank’s own internal disclosures of BB and below and BBB rated books. What gives me a guarantee that there won’t be further slippages into this book and books represent the factual position. What will the Loss Given Defaults (LGD) be in his existing stress book? To sum it all can we believe in the numbers disclosed by Yes bank? With limits on withdrawal, there should be a run on the bank. I believe the uncertainties are plenty and the answer only a few.
Participant C : Arthur Miller wrote in The Crucible, “An hour before the Devil fell, God thought him beautiful in heaven” Investors have gone wrong in the past and hence they will take some time to come to their senses with regards to how good or bad this deal is for a strategic investment. To understand Yes Bank’s actual issues, let’s take a deep dive into the bank. The stress that actually persists in the bank and its current capital position, and then we one should make a reasoned judgment.
Yes Bank has a BB and below the book of Rs 314bn. BBB book of Rs 500 bn and exposure in Vodafone idea of 40 bn is not included in either of the above. Let’s assume the entire BB and below book is stressed, around 10% of the BBB book is stressed and there is no government respite for Vodafone’s idea, then the total amount of the book under stress is approximately Rs 400 bn. With additional stress of Rs 50 bn from his better-rated book that takes the total amount of stress to approximately Rs 450 bn. Assuming, Yes Bank has strong collaterals and the Loss Given Default (LGD) in these accounts will be 75%. That means the total amount of provision required will be 75% of Rs 450 bn, which is close to 340bn, on this Yes bank would get a tax benefit of 25%, so the extent of a hit to be taken on the capital will be close to Rs 250 bn. Besides this Yes bank would also want to bump up its existing Provision coverage ratio (PCR) to 60% from nominal levels of 43%, this would require additional provisioning of Rs 60 bn, so post-tax benefit, the hit on the net worth would be close to Rs 45bn. To sum it up the entire hit on net worth would be 250bn+45bn, i.e. approximately Rs 300 bn.
Yes Banks Capital Position
* With reference to Guidelines on the implementation of Basel III capital regulations in India, under Appendix XII, paragraph 2.15, Section 45 of the Banking Regulation Act allows write off of AT1 capital when a bank is approaching non-viability, and the trigger points are deemed to be activated. (Please refer to Appendix 12, paragraph 3.2, the definition of a non-viable bank)
In my calculations, I have aggressively recognized and provided for stress. I have assumed the entire stress book to be provided for in the next 6Qs by the end of FY 21 and Yes Bank to only earn a nominal operating profit of Rs 75bn during the same period. Putting all this into perspective, I believe State Bank of India acquiring 49% of Yes Bank at Rs 10 per share, at a mere multiple of ~0.3x FY 21E Adjusted Book value per share makes it a wonderful deal for the shareholders of SBI. Yes Bank has a robust branch network with close to 1221 branches along with a strong deposit franchise with CASA close to Rs. 600bn (~30% CASA ratio), a solid retail franchise on the assets side growing at ~25-30% and a strong employee base consisting of 21136 employees. Are you guys suggesting to me that employees will leave? why they haven’t in the last two years.
If we take a look at evidence from the recent past, a lot of banks who have got the small finance bank tag have had a tough time raising deposits and getting CASA. Banks like Ujjivan and Equitas in 2-3 years have raised around 12-15k crore of deposits with a meager 10-20% CASA ratio. In Yes Bank SBI gets a liability franchise of ~2 lac crore and 60k crore, CASA (30%) on day 1. Besides, newer banks who are trying to create a network effect are doing it at a high opex burn rate, with opex to assets in the range of 5-7%; here we have an established franchise with opex to assets in the range 2.2%.
In terms of the above argument, I believe the SBI has a steal deal with Yes bank at 0.3 x -0.5 x FY 21E ABV, on a conservative value. With the SBI coming in, depositors’ confidence will also be re-instilled which will protect the deposit franchise. The SBI is taking the advantage of pumping in fresh capital under the RBI moratorium period, where the board of the bank is superseded by RBI’s choice of board,* which allows them to acquire Yes Bank at a steal deal of Rs 10 a share as prefixed by RBI under their draft resolution scheme. Any fresh capital to be infused post the RBI moratorium period must adhere to SEBI guidelines of issue of Capital which would include a proposal by the board of directors and approval by shareholders in the form of a special resolution (who ideally wouldn’t dilute themselves at 10Rs a share).
* With reference to the Banking Regulation Act, 1949, Section 45(. Power of Reserve Bank to apply to Central Government for suspension of business by a banking company and to prepare a scheme of reconstitution of amalgamation) Link:
I have seen fewer investments fail in life when done during a distressed business cycle and more which have been done during booming business cycles. Thereafter, the debate shifted to delicious DimSums which were enjoyed by all of us.
