If gold prices fall sharply, what happens to gold loan companies, their borrowers and their lenders?
Debashis Basu  and  Sanket Dhanorkar 22 November 2010

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.

1 decade ago
There is never ending craze for gold in India and hence falling of gold prices do not affect so much in India.
k a prasanna
1 decade ago
The bubble will burst. The loanees will forfeit their gold, the financier gold companies will default the bank. The promoters of these companies will continues to live like Maharajas. Banks, mostly PSUs will write-off the loans.
puneet vij
Replied to k a prasanna comment 1 decade ago
nothing will happen , no need to worry, all these things is fictious gold prices never down by more than 5% . all companies are financial strong & regulated by R.B.I.
K Narayanan
Replied to puneet vij comment 1 decade ago
Let us not be misled by the false notion that some entities are regulated by RBI,dept of company affairs,Govt of India etc.and our money is safe with them.Though limited companies are regulated by dept of company affairs many companies raised capital from the public and vanished.The dept is unable to do anything except publishing a list of vanishing companies.RBI does not have time to manage forex reserve,monetary mgt and plethora of activities like inflation mgt..They cannot manage the day to day affairs of the entities they are regulating.RBI provides a shoulder to cry and if possible they may help.That is all.So many industries and business houses have borrowed from the banks and some have failed to pay off the amount(in some cases it is genuine business problems and in some cases they are wilful defaulters-to use RBI language..The NPA in the banking system is Rs100000 crores.That doesn't mean that banks shd stop lending.If gold finance companies get refinance from the banks against the loan borrowed by their customers pledging gold, it is for the banks to monitor the co.If they run away -may be in some cases it might happen-it is the headache of the banks-you cannot run a bank without any bad loans.Risk taking is their job.If the promotors run away then also the customer lose only about 20% of the margin stipulated by the companies(of course the sentimental value attached the item pledged is a different matter).Moneylife can only caution but it is upto the customers to decide where to take the gold loan.
puneet vij
Replied to K Narayanan comment 1 decade ago
u r right but as mr prasanna said that in 1980,s some companies defaulted. now after gap of 30 years R.B.I. regulates in much effective manner by learning from past mistakes. also economy has changed rapidily, consumer is much more aware unlike past. it is the fastest way of getting loan without going to banks with their difficult procedures. the worst scenario is that customer will loose 20-25% of money(gold) as u said. but it does not means gold loan companies should not be here. AUTHOR only highlighted some negative point but this is not reality. i personally visit to muthoot finance branch in new delhi & i saw nothing wrong. people r happy for getting fastest loan & there is various schemes which money life did not raised. this artical tries only to malign gold loan companies image. thanks
k a prasanna
Replied to puneet vij comment 1 decade ago
During 1980s many finance companies like CRB capital, Prudential and others, who were financially strong and which were regulated by RBI, collapsed. The most respected finance company of the south - the Pais of Manipal group, defaulted to its depositors.
Tony Joe
1 decade ago

Your third part has come out more balanced, mature, and technically far better than the first two parts. Please note that securitisation is not the only source of funds for well rated companies like Manappuram. In fact, securitisation is all set to evolve as the minor part in the coming quarters and years. Your fourth part on gold prices would be great if you can include three aspects - their sophisticated and almost real-time stop-losses, the gold price hedges through ETFs/Futures, and how unlikely is gold to fall in the face of the exponential money-supply growth post-2008 and the resulting inflationary trends. In fact, there are technical studies that gold would double from present levels within the next 2 to 3 years, solely on the excess liquidity that the world governments are unable to suck back from the system. If this happens, companies like Manappuram will rock, and many private and PSU banks would jump into the fray, much like how HDFC Bank and Syndicate Bank have now turned bullish on gold loans.
pushkar kulkarni
1 decade ago
when was the last time in world ghistory the gold price crashed y by 40%?? we can say 10 , max 15 % price reduction wd be there, again this shd be taken care by the available margin. the only worrying part is how can the company be sure that it is 22 carat gold?? it can be lower grade gold , passed as 22 carat ,,then it is a big problem. if the gold price really crashes, there wd be more buyers in india!! for such case the usd shd become much stronger(@rs 40??? a dream!) more gdp growth, no wars, etc
Madhur Kotharay
Replied to pushkar kulkarni comment 1 decade ago
Pushkar saab,

Where did you get this profound knowledge about Gold prices? Do some basic homework before giving confident explanations.

Gold prices have dropped 40% many times in last 31 years, 1979-81, 1982-84, 1987-92, 1995-99. If you add up, 15 years of these 31 have seen falls, i.e. downtrends. That is 50% of the time.

Are you sure it cannot happen in near future? Remember, Black Swans exist.
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