India's 'Lehman moment' seems closer than ever as top mutual funds defer dues to investors

• Market regulator SEBI has sought explanation from mutual funds for delaying payments due to investors.
• Top mutual funds in India are citing reasons to delay repaying investors' money.
• The crisis in India's shadow banks caused by massive defaults by IL&FS and Essel Group is unraveling.
• The Economist had warned of such a crisis earlier calling it India's 'Lehman moment'.

When an investor buys a mutual fund, specifically invests in a fund that lends money to corporate borrowers, for a fixed period of a time, it is expected that the fund would return the money to the borrower at the end of the tenure based on the agreed terms. That trust that keeps the mutual fund market running is being tested in India.

Two of the country's biggest fund houses, that invest the money pooled in from eager investors, have sought to delay the payments due to the clients. Market regulator, the Securities and Exchange Board of India, has finally swung into action and has written to Kotak Asset Management Company and HDFC Asset Management Company seeking clarification regarding delays in repayment to investors of fixed maturity plans, according to a CNBC-TV18 report.

On Monday, Kotak Mutual Fund informed its investors that it would not be able to redeem the securities held by the investors because one of its loans, to the struggling Zee Group has soured. The borrower has sought additional time to repay the debt, and the investors who had trusted their savings with the fund have become collateral damage.

HDFC Mutual Fund, the country’s largest, said it would roll over one of its fixed maturity plans, which is due for redemption on April 15. However, this financial services major that manages billions of people's wealth, has given the payment delay an ironic twist. “The purpose of rollover/ extension is due to current interest rate scenario and portfolio positioning, the yields prevailing in the short maturity bucket present an option for investors to lock in their investments at current prevailing yields,” HDFC MF told its investors.

Break it down

In simple words, the company is citing high interest rates for short-term loans as an opportunity to reinvest the money that is due. However, can they take that decision unilaterally, without the investors' consent?

"Extensions are not possible unless the investors agree. Something like 75% of the investors in that particular scheme have to agree to a rollover. Otherwise a close-ended debt fund has to mature and the money has to be given," Ananth Narayan, professor of finance at SP Jain Institute of Management and Research, told a television channel.

The question to ask is will a bank give you more time to pay your dues because someone else failed you? No.

Similarly, the fund house is trusted to repay the investors' at maturity, the end of a previously agreed time period. At that point, the choice is with the investors if they want to roll-over the investment for a longer duration or redeem it right away.

"We will have to wait for more details. It seems similar to the Kotak situation where some papers might not be liquid enough which is why this option is being provided to investors. I will be very happy if I am wrong and the company clarifies very soon.," Narayan added in his comments.

If indeed HDFC Mutual is in a hurry to make the most of rising short-term interest rates in the market, it could start a new fund and investors can be invited to pool in money again based on a new agreement. What seems to be missing in the fund's offer is an explicit consent.

Lehman moment

The fear in the market is that an increasing number of mutual funds are trying to brush their bad investments in companies like IL&FS, Essel Group etc. under the carpet. In late 2018, many bad business decisions of the past led a set of Indian behemoths to default on their loans leaving behind a financial mess that the Economist called India's Lehman moment.

The reference is to the collapse of the global investment bank, Lehman Brothers, in 2008 that led to the global financial crisis and a widespread panic that shut all taps for credit across the world. The fear was more Indian financial firms may face losses in the days to come that may lead to a cash crunch and panic within the country, something that seems increasingly plausible with the recent sequence of events.

The shadow banks, non-banking financial companies and mutual funds, which had lent money to IL&FS and Essel Group to stand have their backs broken by the massive unpaid dues. IL&FS had a debt of $13 billion when it defaulted on some of it. About 10 fund houses had lent to 16 companies belonging to Essel Group with the promoters' shares as security. To their surprise, the fund managers found out later that some of those shares were already pledged to other lenders.

India's problem with unpaid loans, and those at the risk of default, is much bigger than these two. In February this year, the country beat Italy to bag the infamous of having the world's highest proportion of bad loans. What was earlier seen as a problem limited to the banks, it is now becoming evident that the damage may be far wider.

Now, the small investors fear for their money that is stuck with the stressed mutual funds. The market regulator SEBI that is expected to protect small investors is still silent.

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