Thread by @balahla

Here's a thread on how some NBFCs fund projects. This may also help explain why they may have low NPA's but are still in trouble. (1/n)

Let's say you are a builder. You need to procure land, buy material, bribe people (ummm... expedite permits) and so on. But no bank will give you funding at this super early stage. (2/n)

But as a real estate NBFC, you know the landscape well enough to trust this builder. So you fund this man (always a man). Of course the terms would be really onerous. 24+% rates aren't uncommon (3/n)

But we all know how real estate works. People tend to buy ready to move in homes and not under construction ones. This means that builders are likely to only generate free cash at the end of a lengthy construction cycle (say 5 years) (4/n)

How does the NBFC manage this then? Simple! Let's have a principal repayment moratorium. This is pretty standard for most project finance proposals (and education loans) But what comes next is not as common! (5/n)

The interest is also not collected upfront. Instead the rates are nominal / negligible in the first 3 years or so. Then it slowly starts going up. On repayment of the principal, the bullet repayment includes all the interest foregone in the first few years. (6/n)

This leads to a balloon bullet repayment of principal+ interest that leads to a total return of > 24% pa in the payment schedule. (7/n)

So why is a bullet repayment bad? Simple. As long as the company is paying the nominal interest payments periodically, the NBFC really doesn't know whether that big fat bullet is going to actually come in after 5 years. (8/n)

You only get to find out when the entire principal + all the juicy risky return interest defaults. This leads to very lumpy NPA numbers. And more importantly, very low visibility of the borrower's actual position. (8/n)

Note that in absense of very strong covenants and pre-emptive monitoring, this is also completely invisible to the lender. So their own ability to evaluate their loan book is suspect. And one of the reasons why NBFC numbers aren't being given much credence. (End)