All you wanted to know about haircuts

Of late, it is not just magazines offering lifestyle and beauty tips that have been featuring discussions on haircuts. The pink papers have been devoting plenty of space to them too. News reports talk of lenders hesitating to take a telecom giant to bankruptcy court because they fear a ‘very big haircut’. In a conference on insolvency law, the NCLAT Chairman urged creditors to be ‘good barbers’. Mutual funds are said to be chewing their nails about AMFI providing a new haircut matrix for their debt securities.

A haircut, used in the business context, refers to the extent of sacrifice a lender needs to make on a loan while getting a defaulting borrower to cough up his pending dues. Banks, as we all know, extended large project loans to steel, power, telecom and other infrastructure players during the boom times. When these industries fell on hard times, the borrowers stopped servicing their loans. Banks, with some nudging from the RBI, began to recognise them as non-performing assets (NPAs) and hauled some of them to the bankruptcy court for recovering their dues.

In a majority of these cases though, the assets on the borrower’s books are today substantially short of his liabilities, dashing hopes for a full recovery by lenders. In such situations, lenders usually arrive at a compromise formula where the borrower offers to pay part of his loan amount as a one-time settlement. The ‘haircut’ here is the permanent sacrifice made by a lender to recover whatever he can from the loan-taker in distress.

When banks, financial institutions or mutual funds find borrowers delaying the repayments on loans, they usually follow standard regulatory norms to recognise them as doubtful loans in their books. Banks, for example, are required to treat loans as sub-standard and set aside 15-25 per cent as provisions if the borrower fails to service them beyond 90 days from due date. If the loan remains sub-standard for over a year, the provision climbs to 40 per cent and a further delay may require higher provisions going up to 100 per cent. Now, a bank providing for 25 or 40 per cent on a doubtful loan is no guarantee that the it will recover the remaining 75 per cent or 60 per cent. When the assets of the borrower are valued in real life, they may not be enough to repay his dues in full. Stretching the repayment period further may serve no purpose for the lenders, as the assets will lose more value leading to poorer recoveries. In such situations, lenders often reckon that a bird in hand is worth two in the bush and sit across the table with the loan-taker to thrash out a haircut.

In the case of mutual funds, schemes are expected to immediately reflect the realisable value of their bonds in their net asset values. Therefore, SEBI rules require a scheme holding a defaulting or downgraded bond to immediately reflect its true market value. Till recently, there was no standard practise on the size of this haircut in different situations. But after SEBI’s nudging, industry body AMFI has now come up with a haircut matrix that tells funds the extent of losses they must budget for on their non-investment grade bonds in different situations.

Bad loan provisioning rules in the case of banks or write-down rules in the case of debt funds are only accounting entries that try to approximate the losses for investors, when a loan goes bad. On final resolution of the case, the actual amounts realised may be very different from those recorded in the books. So, if you are an investor in banking stocks or in debt funds, keep an eagle eye on those final haircuts, as they decide how much of a hit you’re going to take from a bad loan.

Haircuts on loans, unlike those in salons, don’t make you feel good. But they are essential to cut your losses and move on.

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