The Good and The Bad of EPF Accounts

The idea for this post came from P.Gunasegaram latest article which mentioned that RHB Capital apparently has been given a lot of businesses from EPF since it taken over by them. So, I downloaded their annual report (credits to EPF for coming up with an English version). To be honest, I am quite impress with the level of disclosure. There are some useless and meaningless information, but, I blame the auditors rather than EPF.To cut the story short, I can't find how much fees they paid to RHB Capital as they define "related party transaction" in a very narrow sense. 

I always think that we have probably more people (e.g. analysts) looking into the accounts of pariah companies like KNM and Perisai compared to some very important non-listed institution like Petronas (the unlisted parent), EPF and Khazanah. So, since I have downloaded the account, I might as well take a look into the EPF financials. I spent roughly 30 minutes looking into their accounts, so, it is not in any way an extensive detailed look into their financials. But, I do manage to find some red flags. Regulars readers would know that I am a rather critical person (sometimes I feel that I am not critical enough:-)), so, do expect more emphasis on the bad stuff compare to the good stuff. The juicy stuff come at the end of this post. So, you either jump to the end or read it till the end.

Before I proceed, please take note that the size of EPF balance sheet is RM459b. This will give you a sense of the relative size of the numbers I am writing.

Good Stuff

• Disclosure is quite detailed and transparent. The English version make it easier to understand the accounts. Seriously, some Malay accounting jargon is incomprehensible like Nilai Saksama Terlunas..wth is that..lol...
• At a glance, no aggressive strategies, do not have a big derivatives book.
• External fund manager fees is very reasonable at RM92m. As a probably unfair comparison, the Norweigian Government Pension Fund (around 5x the size of EPF) paid more to ONE Malaysian fund manager than EPF paid to all its external fund managers. In fact, I think the fund managers are underpaid.
• Equities performance is actually pretty decent. Bad investment normally include companies that are their subsidiaries, i.e. more than 50% ownership. It said something about EPF should focus on managing funds rather than managing companies.
• Not sure where to put this, it is good if you are EPF employees. EPF, I think, has one of the highest average wage in Malaysia at RM8965/mth. Please take note that this is the AVERAGE wage. EPF exec to non-exec ratio is 9:41 (18% are executives). So, the executives must be making some very good money. Please take note that this include bonuses. So, that may tone down the pay by a bit as wage bill increase by 22% from 2009 with roughly stagnant staff numbers.I am not sure why the increase in wage bill though as the majority of the out performance seems to be generated from the external fund managers. So, not sure whether should reward them that much for choosing the RIGHT fund managers. In total, EPF paid out RM572m in wages on a staff size of 5319. If they are performing, I do not mind paying for performance. 

Bad Stuff 

• A significant portion of their foreign portfolio is actually internally managed. In fact, the majority of their foreign portfolio is internally managed. I am not sure whether they have the expertise in managing foreign portfolio. It is one thing investing in Bursa, totally different thing to invest in other countries.
• Their investment holdings are shown as fair value, without showing the cost base. This will prevent us from judging the performance of each categories. Due to accounting classification, some increase and decrease in value may not gone through P&L, so, it is possible that the good profits has already been milked, leaving only the bad stuff. It is however, better than some PNB books which shows investment in cost basis only. I am being told that the reason PNB is showing their investment in cost basis is due to some SC regulations on fixed price fund. So, no complains there.

Very Bad Stuff- Questionable Loans, Advances and Financing

This item deserve a special section due to its massive size as well as poor performance. The annual report discloses an item known as loans, advances and financing which is really a mixture of bad stuff that is on a gross basis amount to RM97.5b and RM 93.7b on a net basis (roughly 21% and 20% of the size of EPF balance sheet respectively).  Here's a detailed breakdown of the bad stuff (Click on the table to have a better view) :

Regular readers would know that I am very critical of the use of quasi-government entity to further government causes. This is why I am so against the PLUS takeover by EPF. PLUS, in its original toll deal, is a fantastic assets. But, PLUS, in a new, less profitable toll deal, may not be the fantastic assets that it used to be. So, after the takeover, the value of PLUS will decrease. EPF member will suffer from the diminution of their asset value without even knowing it. Instead of charging based on those who use the toll, part of the wealth of EPF members, which mainly consist of employees, will be transferred to the employers through the reduction of transportation cost to the latter without any signs of price reduction. Another example of the poor subsidizing the rich. But, on a more important note, I am against the deal because, once the moral threshold is cross once, it is easier to cross it for the second time. It is like it is easier to lie for the second time compare to your first time. It may set the precedent for any government, be it PR or BN, to have seemingly unlimited spending power to buy up IPPs and Water Companies to change their screw up agreements.

If you take a look at the table, it has RM82.8b in guaranteed loans. What loan they are guaranteeing that is at such a massive size? Is it other quasi-government entities with lesser credit strength? Do we charge a decent rate for that guarantee? Then, take a look at some other items. What the heck they are doing in providing housing loans for housing programs? It smell government initiative to me. Then, on the islamic loan breakdown, there is one item known as "personal loan" worth RM3.9b, up from RM1.3b in 2009 and RM341m in 2008. Is EPF in the business of providing personal loan? Who is on the receiving end of this personal loan? Is EPF some sort of ATM machine for some person?  EPF members may be interested in borrowing these personal loan from EPF as part of the interest may go back to themselves. It is like you feel good losing in a Genting casino if you are a Genting shareholder. EPF should stick to managing funds rather than be in the business of advancing government interest.

All this loan would be still okay if the loan is good. Due to financial disclosure standards, they have to disclose the credit quality of all the loans they have given out at about the end of the annual report. So, those who are not familiar may not catch this as we need a side-by-side comparison. Here's the credit quality disclosure ( Click on the picture to have a better view. Focus on the highlighted part)

At first glance, it seems that all this loan are good loans as it is under the "Strong" category which stands for non-sovereign bonds listed AA and above. On an unrelated note, the categorization based on sovereign and non-sovereign bond is misleading. A sovereign bond may be a bad bond if it is issued by Greece, a non-sovereign is a good bond if it is issued by Microsoft. We may not know if EPF is holding some Greece exposure and put it under sovereign section to signal high quality. Back to the topic, if we look strictly at this disclosure, we may thought that the loan extended is good loans. But, if we look properly, around RM82b of bonds is classified as strong. The size of loans extended with EPF guarantee is also around RM82b. In other words, these loan are rated highly by the rating agencies because they receive an EPF guarantee. If EPF do not guarantee such loan, these may be shit loan. So, the credit rating do not reflect the quality of the loan portfolio that EPF is holding. This credit quality disclosure is misleading. (See corrections below)

If we analyse this loan portfolio on a different method. A very scary picture will emerge. EPF discloses the aging of this loan portfolio. The aging is shown below (Click on the picture to have a better view. Focus on the highlighted part) :

The aging analysis is on a net basis. So, it do not include the already impaired loan. If we take a look at the gross loan to impaired loan ratio based on the numbers in Table 2, RM 5 bil of the loan is impaired or a ratio of 5.1%. This is a shockingly high figure. As a relative comparison, the latest non-performing loan ratio in our banking system is 2.3% based on EPF financial year end.(Note: I am taking the leap of faith that NPL= Impaired Loans, there may be some technical differences between the both as NPL, I believed, do not take into account of recovery but impairment includes recovery of asset value. In any case, by taking NPL=Impaired Loans, I am being conservative. Not sure though, I am not well-verse in banks.). So, on average, the loan portfolio of EPF is around 2.2x as likely to default as a regular loan in our banking system.

This is not all, if we look at Table 3, the aging analysis. There are roughly RM9.5b of loans that is past due for more than 6 months. I do not know how long these loan are past due as comparative figure is unavailable for 2009 in the 2010 Annual report and the 2009 annual report do not disclose the item. Assuming that all this RM9.5b will not be recovered and is impaired, it will bring the impairment rate to 14.8%, a very high number.  In another words, the loan portfolio of EPF is 6.4x more likely to default than a regular loan in our banking system if we define the RM9.5b loans that are past due for more than six months as impaired (Note: If I am not mistaken, BNM definition of NPL is more stringent by classifying non-payment of interest and principal of more than 3 months as NPL. So, I am being conservative again).

With 5.1% of impaired loan and 14.8% if we include past due loan of more than 6 month, this do not seems to be the high investment grade AA to AAA rated loan portfolio that EPF claimed to be in its disclosure. In fact, if we based it on the 2008 S&P Corporate Default Rate (note: 2008 is a very bad year, so default rate is higher than usual. Thus, it is more conservative.), at 5.1%, the loan portfolio should be rated B to B-. At 14.8%, it should be rated between B- to C. Anything less than BBB is junk bond. So, even at 5.1%, the loan portfolio of EPF should be rated at non-investment grade, junk bond. I am not sure whether the investment charter of EPF allow them to hold junk bonds, but, surely this loan portfolio really consist of a lot of shit loan. (Note: I am again taking the leap of faith of default loan=impaired loan and past due loan in this paragraph.)

If this whole bloody loan portfolio goes bad (to be honest, this is highly unlikely), 20% of the EPF members contribution would be gone. But, if we limit the case to the RM5b impaired and the RM9.5b past due for more than 6 months, 63% of this year net profit would be gone (note: Figure is exaggerated as RM5b had already been recognize as losses but this is necessary for comparison.). EPF have a very good year in 2010 achieving record profits. So, the numbers may totally wipe off the entire year of net profit in a normal or bad year.

No matter how you spin it, this loan portfolio is one POS.

P.S.: Do inform me if I get anything wrong as I am not really familiar with banks and this is to some extend, a bit like banks.

Corrections:

1.The previous version of this blog post contain an error which state the wrong NPL ratio. Hat tip to Shihong for leading me to the mistake.

2. I think I make a mistake by asserting that the Guaranteed loans is guaranteed by EPF. If it is guaranteed by EPF, EPF should record a liability. Since no liability is recorded, the loans are not guaranteed by EPF. But, I wonder what entity in Malaysia have the ability to Guarantee RM82b of loans.Is it our government? But, the default rate indicates it is not government. So, who is guaranteeing such accounts. Regardless of that, I stick with my comments on the quality of the loan portfolio of EPF based on their high default rates.

3. Upon further investigation, the personal loan and housing loan are provided to their staff as a perk on top of their relatively high salary. But, the average loan size per staff is indeed huge at an average of RM1.5mil per staff. I am not sure many Malaysian (apart from those of upper middle class) can have such a big outstanding housing loan. If this is loan to the staff, it means that credit quality would be good as repayment can be deducted from salary. It also means that, the default rate of the remaining pool is much higher, the quality is worse.