While gold loan companies are sanguine, actual behaviour of borrowers, lenders and other participants under the stress of sharply falling gold prices remains to be seen. One clue: gold loan companies have never been so big, gold prices have never been so high. This article is the third in a series

As we have seen, gold companies are essentially securitising their receivables over the short-term of gold loans to create liquidity. Securitisation in small doses is a good strategy to generate liquidity but carries obvious dangers when it becomes the main source of funding for growth.

A steel manufacturing company may securitize a small part of its export receivables to create temporary liquidity but can the steel company fund its entire business of steel manufacturing by securitising its export receivables? A bank can securitize a small part of its loan book (say, auto loans) but can it run the whole bank and expansion of loan book only by this, if it has no access to stable and low-cost current accounts and savings bank accounts?

What are the issues gold loan companies would actually face under stress if the bulk of their funding is securitised receivables? Remember, it’s the mortgage-backed securities, which fuelled the housing bubble in the US. Shaky home loans were securitised, bundled and accorded higher rating which investment banks sold to “smart” hedge funds while “smart” insurance companies like AIG insured them. Underlying this chain of transactions was a key assumption. House prices in the US never fall all across the country for a prolonged period. It is the same assumption for gold loan receivables too — gold prices never fall in India. In the US, when house prices crashed everywhere in 2007 and 2008, the securitised loans and the insurance written on it (credit default swaps) started to blow up. Massive losses, bankruptcy and financial panic followed in a quick succession.

There is no question of that kind of panic here because the gold loan market is too small and localised. But to assume gold prices do not crash or that it will leave no impact are both dangerous. A sharp drop in gold prices is likely to set off a chain of events that may wreck havoc on the financial structure of gold loan companies. If gold prices fall by 30%-40%, the loan provider would either need the borrower to put up more gold or make good the margin in cash. What if the customer is unable to meet the shortfall and starts defaulting on her loan? The company will be forced to auction off the pledged jewellery at a much lower price in the market. Selling used household jewellery in a falling market will invariably lead to a still lower realisation. What will creditors (the banks) to gold loan companies do in such a situation? They will be left holding receivables from housewives of Kerala which would have declined in value and which they would find it impossible to liquidate. A small panic would ensue.

At the very least, there is a possibility of a temporary asset-liability mismatch in the company’s books. Gold loan companies would find it difficult to meet short-term payment obligations towards creditors, the banks. In short, if gold price were to crash there could be a sudden pressure on cash flow and balance sheets. New borrowers would also hold back from lending (if the need is not pressing) now that she would get a lower amount thanks to a declining value of gold. The overheads of gold loan companies, however, are fixed in nature. Branches, staff and other expenses cannot be cut down overnight, just because gold price is down 40%. All expansions would come to a halt. It would be chaotic. If the loan book shrinks, profits would decline as sharply as they went up.

I Unnikrishnan, managing director of Manappuram Finance points out that such imbalances, if any, would only be temporary and will be ironed out. “We maintain a margin of up to 25% on the gold loan value, plus the making charges of around 15%, giving us a cushion of up to 35-40%,” he says. “Most of these loans are taken for bridge financing purposes, where customers need funds to take care of short-term mismatches. These loans are taken for tenure of up to 1 year, but borrowers mostly prepay the loans within 3 to 3.5 months. So even if this price correction occurs in this 90-day period, we are covered to that extent.”

Countering our scenario of default on the customers’ part and the likely impact on the company’s receivables, Mr Unnikrishnan said, “Normally, these loans are secured against family jewellery, which belong to the women of the family. Family jewellery carries a lot of sentimental attachment. When the men take the loan, there is a pressure from the women to redeem the gold as soon as possible. Most of these borrowers choose to prepay the loans and the chances of default are very unlikely. In India, gold is not a commodity for the common man; it is ‘Lakshmi’ (the Hindu goddess of wealth). They would think of losing that jewellery only if they are in severe difficulty. So this question of risk in terms of imbalances does not arise.”

Manappuram claims that it has provided for an adequate cushion against a sudden liquidity crunch in the form of a high capital adequacy ratio (CAR), which is around 22%. Muthoot Finance’s CAR is considerably lower at 14.79%. For NBFCs without the support of adequate capital, this business model does appear to have some structural weaknesses.

What Mr Unnikrishnan says is the best-case scenario. It would be nice if this is what actually happens in real life. It is not clear whether all gold loan companies do have a margin of 35%-40% of safety. Especially since they do not assess the purity of gold and seem to assume that the gold being pledged is of 22 carats. If it turns out to be inferior quality of gold, say 22 carats, it means that a 10% margin of safety is gone. Also, under the pressure to deliver continuous scorching growth, margin of safety is likely to be sacrificed. New borrowers would shop around for the highest loan-to-value and it would be remarkable indeed if all gold loan companies show great discipline to stick to a wide margin of safety. Most importantly, the actual behaviour of borrowers, holders of securitised receivables and buyers (of auctioned jewellery) in a situation of falling gold prices (how shocking, after a decade of humungous rise) remains to be seen. The fact is, gold loan companies have never been so big, gold prices have never been so high and gold loan companies have never had such huge overheads. If gold crashes, whatever happens would be for the first time. Especially since it is conventional wisdom that gold prices never fall. How robust is that assumption, based on simple extrapolation of the past trends? We will deal with that in part four of this series - which would be on gold prices.