Basket pledge of midcap shares may have widened damage

Santosh Nair
moneycontrol.com

What began as a sell-off in a couple of midcap shares late last week rapidly spread to many other stocks, taking the market by surprise. Some of these stocks have fallen 50-80 percent in less than two weeks. Something similar had happened in November 2011 and again in July last year. Brokers tracking the midcap space and officials at some non-banking finance companies say the contagion has been caused by group pledging of shares by companies who were unable to raise funds against these shares, individually. Below is an extract from the article that appeared in Moneycontrol.com in July last year, explaining the modus operandi: "After the steep fall in many midcap shares in November 2011 , NBFCs tightened their lending norms and became choosy about the promoters they would loan money against pledged shares. This put many promoters in a fix. Their reputations were such that traditional routes of funding were closed to them, and they would have to pay ruinous rates to borrow from unofficial channels. This situation presented a good business opportunity to some dubious broker/operators who are resourceful when it comes to raising funds at reasonable interest rates. Promoters starved of funds would form a group and approach such a broker/operator X, adept at fixing deals. Broker X would ask all the promoters of this group to pledge a portion of their shares, and would then approach an NBFC, offering this basket of shares as collateral. The logic was simple: even if the stock price of one company in the basket declined, the NBFC would not have to resort to a fire sale, because the other stocks would provide the cushion. The NBFC would lend the money to this broker, who would pass the funds to the promoters after taking his cut. In theory, this model should have worked well for everybody concerned. But when there are too many doubtful characters involved, even the best of plans fail. The syndicate of promoters approached more than one broker, pledged their shares and borrowed money. Some of the promoters were in dire need of funds as their foreign currency convertible bonds (FCCBs) were coming up for redemption, and they had to maintain their stock price above the conversion price so that the lenders would convert their loan into shares. Else, the lenders would demand repayment of the loans, which most companies were not in a position to do so.” If price of one or two stocks in the basket is under pressure, the broker/operator would ramp up the price of some other stocks, so that the overall value of the basket was not affected, and there were no margin calls. But when managing the prices of other stocks became a problem, the value of the basket fell and there were margin calls from the NBFCs. When the additional margin is not provided, the NBFCs dump the most liquid of stocks to recover the money. And in many cases, there were more than one lender in equation. So the moment one of the lender started selling, other lenders too followed suit, causing a domino effect across stocks. * Here is how the share pledge mechanism works. Assume a promoter wants to raise money by pledging his shares, and the NBFC is willing to give him 50% of the value of the shares. If the promoter wants to raise Rs 50, he has to pledge Rs 100 worth of shares. The amount loaned against the collateral depends on the liquidity in the stock, the company’s financials and the promoter’s track record, and could vary from 40-70 percent of the collateral. If the loan-to-value limit is 50 percent, the promoter borrows Rs 50 by pledging Rs 100 worth of shares. If the share value falls to Rs 90, the promoter has to either return Rs 5 (so that the loan to value stays at 50%) or put up another Rs 10 worth of shares as collateral. If the promoter fails to deposit the additional margin, the NBFC will dump Rs 10 worth of shares to maintain the loan to value at 50%.