FMP SCAM

Opaque Portfolios

November 18, 2008

How opaque portfolios, misuse of mandate and misrepresentation, shortchanged inv
estors of Fixed Maturity Plans and created a crisis. Sucheta Dalal explains

When the whirlwind of global financial turmoil hit the Indian shores in late Sep
tember, it wasn t Indian banks that were rocked. Barring, of course, ICICI Bank wh
ich became the target of speculative short-selling. None of the Indian insurance
companies, investment banks or broking firms had large holes in their books lik
e the most famous names on Wall Street. Instead, from what is known so far, trou
ble brewed in one odd corner of the financial marketplace the bland-sounding fix
ed maturity plans (FMPs) of mutual funds.
As the stock market went into a free fall in September and October, major US fin
ancial institutions went bankrupt and a severe crisis of confidence erupted, som
e savvy FMP investors worried about their investment and demanded their money ba
ck. This put fund companies in serious trouble. The pressure was so strong that
KV Kamath, managing director of ICICI Bank, warned on 2nd November that mutual f
unds and non-banking finance companies (NBFCs) with an exposure of Rs630,000 cro
re could crumble. When asked if mutual funds and NBFCs needed a bailout rather t
han banks, he said: Exactly. There is no need for a bailout package for the India
n banking system but the bailout package could be required for mutual funds and
NBFCs We have a situation where the two have a corpus of debt or money lent out a
t around Rs630,000 crore. The number I have, roughly on mutual funds debt side is
around Rs250,000 crore and NBFCs, non-deposit taking is Rs380,000 crore. What he
did not mention was that funds, through the FMPs, NBFC and the real estate sect
or were all locked in a downward spiral.
For years, FMPs have been a useful product for mutual funds and their corporate c
lients . They allowed fund companies to channel surplus money from companies and h
igh net worth individuals to the corporate sector when in need of quick money. S
ome were for short durations (like 15 days) while others were for 13 months or m
ore. Every financial advisor and mutual fund company furiously hawked FMPs as th
e ideal vehicle for retail investors which offered the safety of fixed deposits
with lower taxes. At the end of September 2008, the corpus under FMPs was Rs67,2
76 crore accounting for nearly 16% of total assets under management of mutual fu
nds amounting to Rs 4,26,669 crore. What went wrong with FMPs? Several things, m
ainly a combination of dubious market practices and regulatory failure.
FMPs were supposed to invest their corpus in a pre-determined basket of rated an
d unrated securities allowing them to project indicative returns (and risks) to
investors at the time of investment. But, as happens during a long bull run, mar
ket practices embraced higher risks and ran far ahead of rules set by the regula
tor. Some of these practices, which are being discovered every day, were as foll
ows:

* Many FMPs were lured by new opportunities that spring up in long bull mark
ets: funding the subscription of initial public offerings (IPOs), funding promot
ers holding in their listed stocks and funding real estate companies. These inves
tments, made through non-banking finance companies, rested on shaky grounds afte
r the stock market indices dropped more than 50% from their January 2008 peak an
d the real estate bubble was quickly losing air. When redemption pressures hit I
ndian mutual funds forcing them to borrow funds at steep interest rates, they ra
n to the authorities for liquidity.
* At one time, investment banks and finance companies were floating 15-day
paper for IPO funding. Credit rating agencies were happy to boost their income b
y rating this short-term paper (usually top grading) which was quickly placed wi
th mutual funds. This allowed NBFCs to create excitement in the primary market b
y holding out the promise of quick and hefty profits.
* FMPs did not have simple mark-to-market rules, although their investments
included very short maturity investments as well as structured derivative instru
ments. So funds were hit with a liquidity crisis because they allowed institutio
nal investors to exit at high net asset values (NAV) based on the yield at matur
ity.
* As per SEBI guidelines, a scheme is allowed to invest up to 15% of its ne
t assets in debt instruments issued by a single issuer. However, this 15% restri
ction can be raised to 20% of net assets of the scheme with the prior approval o
f the Board of Trustees and Board of the AMC. So, theoretically, a fund can have
its entire money in just five instruments, which makes for a huge concentration
.
* The bigger issue is that this investment restriction does not apply to mon
ey market instruments through which a fund can have its entire money parked in j
ust one instrument of one company! This is exactly the case with Templeton Fixed
Horizon Fund 15 Months Growth, which has invested 97.7% of its net assets in a
single instrument of a single company - Reliance Capital. This is legal, but is
it sensible? It allows an entire mutual fund scheme to become a fund-raising ins
trument for a single company, while investors are clueless about the risk involv
ed. It negates the very concept of a mutual fund reducing risk by distributing i
nvestments in a basket of selected securities.
* FMPs offered indicative returns a euphemism for assured returns -- which the r
egulator frowns upon. But it did not interfere with FMPs probably on the assumpt
ion that each scheme had secure back-to-back investment in a basket of fixed-ret
urn investments. The Securities and Exchange Board of India (SEBI) apparently ne
ver inspected specific schemes or found out if this was, indeed, true.
* Most FMPs vary in maturities between three and 13 months. Since FMPs are s
hort-term funds, they ought to invest in short-dated instruments. But, in their
quest for higher yields, fund managers bought long-term securities (maturity of
one year or more).
*
Investors Short-changed
So, when the financial tornado hit India and savvy investors started to re
deem FMPs despite a steep exit load, it exposed the can of worms. As redemption
pressure mounted in September and October, FMP investors found themselves short-
changed. The indicative returns turned out to be myths and most funds imposed rest
rictions on redemption. In many cases, the actual investment was either complete
ly different from the indicative portfolio or the AAA-rated paper of finance and
realty companies was looking a lot less secure. In many cases, investors can t ev
en make sense of the underlying securities. Many are Pass Through Certificates (
PTCs) which, they are told, are guaranteed by banks or their issuers.

Almost every FMP has exposure to an industry sector that is badly hit by t
he global financial turmoil or has invested in a shaky or opaque paper that inve
stors know little about. Some have even invested in unrated debt paper which was
never a part of the indicative portfolio.

The biggest problem is that many FMPs have a direct and indirect exposure
to stock markets, finance companies, realty and to hybrid, securitised paper rep
resenting unknown pools of mortgage-backed receivables. HDFC Mutual Fund s 370-day
FMP June 2008, for instance, has 12.27% invested in Corporate Loan Security SR
I 2006. It is a privately-placed debenture. It is difficult to figure out what t
his is. It also has 16.47% in Corporate Loan Trust 2008 and another 16.67% in Lo
an Receivable Trust A1 7. All FMP portfolios have such kinds of securities. Thes
e are not very easy to decipher and track and even a single bad investment (any
NBFC or a real estate company can default) will cause a sharp drop in returns. F
or instance, an 11% indicative return will drop to around 4%.

Investor complaints being directed to the media suggest that many FMPs att
racted investment by indicating one basket of securities and actually invested i
n an entirely different set of riskier securities. Does this amount to misrepres
entation, diversion of funds or outright fraud? SEBI has apparently not gotten a
round to examining that as yet.

The Economic Times reported that an investor who put money into HSBC s Fixed
Term Series 52 FD (total scheme was worth Rs275 crore) in March 2008, discovere
d that its actual investment was vastly different from the indicated portfolio.
HSBC s response to the newspaper was: an indicative portfolio is always broad-based
. This means that there was absolutely no sanctity to the indicative portfolio or
the indicative returns. Shouldn t the regulator have noticed this and fixed it wi
th proper regulation before it blew up into a problem? Instead, SEBI is still st
udying the issue while savvy investors are taking their money out of FMPs even i
f it means paying a big exit load and taking a hit on expected returns. It is re
sidual investors who will bear the brunt of FMP mischief. SEBI now plans to plug
early exits from FMPs and to make secondary market listing mandatory for them.
That is for the future; at present, the horses have already bolted.

Rajiv Malhotra is another aggrieved FMP investor fighting a long battle wi

th ABN Amro over redemption of Rs1 crore invested in FMPs that had offered a 11.
5% yield and redemption in two days (as per SEBI rules). First, ABN Mutual barre
d exit and unilaterally reduced redemption to Rs1 lakh per day. Consequently, it
has waived the exit load during a pre-defined exit option period, but calls tha
t a service gesture . That is only part of the problem. The main issue is that actu
al investments were very different from the indicative basket of companies. For
instance, Thomson Press was never in their original universe of companies but w
as subsequently included. He was told that the maximum exposure to AA-rated pape
r will be just 10%; in fact, it was 27%. When Malhotra asked for portfolio detai
ls, he was shown some Corporate Debt Trust (CDT) series as the underlying invest
ments. On questioning the fund, he was told by an official that the CDTs are gua
ranteed by banks like Axis and Standard Chartered. Malhotra recorded that conver
sation. However, the head of client services (whose emails are copied to us) den
ies that the banks have guaranteed the CDTs. Malhotra charges that this amounts
to cheating and misleading the public and his real return is less than half of w
hat was indicated to him. Clearly, he has a point and, in fact, he is lucky not
to take a hit on his original investment too. Thanks to a combination of the fin
ance minister s swagger about global confidence in India s capital market, the regul
ators slumber and soaring stock indices, malpractices by funds were never anticip
ated or investigated.

Despite all the publicity attached to the instrument and the fact that the
y garnered over Rs132,000 crore (September-end data) or a quarter of all mutual
fund assets under management, the regulator did not feel the need to re-examine
mutual fund regulation. Had it done so, it would have noticed all the ills we ha
ve described above.
 On 12th November, the media reported that SEBI was planning to make it tou
gher to exit from FMPs offered by mutual fund companies. It is also undertaking
a structural review of mutual funds and intends to curb exposure by FMPs to a sing
le sector. As far as retail investors are concerned, the move comes long after t
he horse has bolted and FMPs have far bigger problems than early exits or exposu
re to a single sector.

The warning signs were available for anybody to see. As far back as Februa
ry 2007, at an interaction of the prime minister with senior journalists, I had
pointed out that the government must take a close look at mutual fund regulation
, if it was exhorting retail investors to take the mutual fund route to equity i
nvestment as a policy. In February 2008, I had emailed prime minister Manmohan S
ingh s office about how short-term paper (even 15-day paper), with a high credit ra
ting is apparently used by mutual funds to divert debt funds to illegally invest
in equity. I had pointed out that debt funds (we now know they were short-duratio
n FMPs) subscribe to 15-day paper issued by finance companies which have obtaine
d a high credit rating and the entire money is used to apply to initial public o
fferings. Clearly, such paper is risky. Any delay in the allotment and refund pro
cess could lead to trouble; but, in a ferocious bull market, any worry about mind
lessly sanitised financial paper would have been dismissed by the mandarins in De
lhi. In fact, right until early October, the finance minister continued to exude
enormous confidence about India s economy and the capital markets, apparently obl
ivious to the coming storm.

Who should have rung the alarm bell? The community of financial advisors o
ught to have known what is going on. But they probably believed that fund houses
had acted in good faith and invested in line with their indicative portfolio an
d returns. The distributors community ought to have known what was happening. But
mutual funds and distributors are in a close nexus. What better proof of this t
han the Bajaj Capital story. On 11th November, The Economic Times reported an in
ternal communication from Bajaj Capital, India s largest mutual fund distributor,
advising its clients to exit nine specific FMPs (whose portfolios were considere
d weak) and switch to safer ones. It also suggested a cautious hold on another and
categorised a couple of others as safe investments. The nine that it recommende
d exit from were: Kotak FMP 12M Series 3, HDFC 15M March 2007, HDFC FMP 370(2),
HDFC FMP 26M Aug 2006, DSPML (now DSP Blackrock) 15M Series 1, Birla FTP Series
AT, Kotak 15M Series 5, ABN Amro (now Fortis) Series 10 Plan F and Series 11 Pla
n B. But this late attack of conscience was also short-lived. The very next day
, Bajaj Capital, apparently, cracked under pressure from the fund community and
withdrew/disowned the communication and its assessment. It said that it has not ex
amined the portfolios of these FMPs and offered no comment regarding their safet
y.
How they handle the FMP imbroglio would be a good test for the regulators,
the fund industry, the distributors and also the retail investors. Tough new re
gulations must be matched by investors asking tough questions regarding the qual
ity of advice they got from fund distributors and financial advisors.

Tax Benefits for Whom?

Mutual funds (MFs), as an investment vehicle, are meant for retail investo
rs. The government, especially finance minister P Chidambaram, does not miss any
opportunity to ask individuals to invest through MFs and has also made the retu
rns from equity MFs tax-free. Returns on FMPs are taxed as per capital gain whic
h allows for indexation benefits. This gives products like FMPs a major advantag
e over bank fixed deposits. Bank interest rate is fully taxed (subject to minor
tax concessions) while some FMPs with indexation benefit were giving a post-tax
yield of 8% or more (at a time when bank deposits yielded 6%-7% pre-tax). Who to
ok advantage of this? Not the retail investor, because MFs were not even selling
FMPs to them, leading one of our readers to complain (see MoneyLIFE 5 June 2008
). The fund industry has been conveniently using this tax loophole to build a bu
siness of managing over Rs60,000 crore of assets. The tax incentives were meant
to encourage retail investment in the market. Instead, it is banks and corporate
treasuries who are reaping the benefit, usually at the cost of retail investors
. SEBI needs to separate the retail plans from the institutional funds. After al
l, the government has been pushing retail investors to MFs without checking whet
her the interests of funds are aligned with those of retail investors. Only when
retail and institutional funds are separated, along with different tax treatmen
t for both, will MFs focus on growing the retail market.
*