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IIM INDORE Adarsh Manish Tigga 2011PGP511 RETAIL BANKING: REPORT Dsouza Aaron Mario PROJECT 2012PGP107

Housing Omkar Shishir Bibikar 2012PGP237 Finance Sane Nachiket Shrihari 2012PGP331 Market in Srinivaas G 2012PGP373 Yevalkar Aniket Ashok 2012PGP449 India : Gunreet Kaur Thind 2012PGPM011 Lessons from US sub-prime Crisis
Hitesh Kumar Chand 2012PGP137 PRESENTED TO: PROF. K RAMESHA Michael Lalhriapuia 2011PGP724

Contents

INTRODUCTION Housing is a basic necessity. Still a large number of families dont have access to decent houses, particularly in a developing country like India. Considering the importance of housing, an important element in public policy has been to encourage house ownership largely through fiscal incentives like subsidies and better availability of housing finance. At the same time, the demand for housing finance has encouraged financial innovations, at times resulting in financial crisis like US Subprime Crisis. The expansion of housing finance by the formal financial sector in India is relatively recent. The factors responsible for this expansions are the demand-supply gap, our favorable demography, increasing urbanization and better growth prospects and the demand for housing finance is expected to grow. But this expansion of housing finance to a wider section of the population may bring about the subprime like situations. Hence the challenge is to preserve financial stability by putting the necessary safeguards. PURPOSE OF THIS PROJECT REPORT With this background, we will touch upon the US sub-prime crisis with the objective of learning the lessons for the development of housing finance. We will then talk about the development of housing finance in India especially referring to banks. We will also discuss the statistics on housing finance, particularly house price indices. We will conclude with the way forward for development of housing finance in India. SUBCRIME CRISIS BACKGROUND The term Sub-prime lending refers to the practice of making loans to borrowers who do not qualify for market interest rates due to various risk factors, such as income level, size of the down payment made, credit history, and employment status. Sub-prime borrowing was a major contributor to an increase in home ownership rates and the demand for housing. The overall US homeownership rate increased from 64 per cent in 1994 (about where it was since 1980) to a peak in 2004 with an all-time high of nearly 70 per cent. This demand helped fuel housing price increases and consumer spending.

Some homeowners used the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending. US household debt as a percentage of income rose to 130 per cent during 2007, versus 100 per cent earlier in the decade. Between 1997 and 2006, American home prices increased by 124 per cent.

HOW IT ALL SHAPED UP The crisis began with the bursting of the US housing bubble and high default rates on sub-prime and other adjustable rate mortgages (ARM) made to higher-risk borrowers with lower income or lesser credit history than prime borrowers. Loan incentives and a long-term trend of rising housing prices encouraged borrowers to assume mortgages, believing they would be able to refinance at more favourable terms later. However, once housing prices started to drop in many parts of the US, refinancing became more difficult. Defaults and foreclosure activity increased dramatically as ARM interest rates reset higher. During 2007, nearly 1.3 million US housing properties were subject to foreclosure activity. The issue is not only of lending, it is also about borrowers providing misleading or wrong information to be eligible to borrow, such as boosting their income. STRUCTURAL GAPS WHICH LED TO SUBPRIME CRISIS

In USA the bankers presumed that the housing boom which was less than that in countries like Australia and UK would not be difficult to be managed. However, during 2005-06 when the boom was nearing its end they loosened the norms for client selection and financed even those who otherwise would not be getting the loan (subprime borrowers from which the crisis got its name).

Underestimated the impact of the problem of housing loan foreclosure rate which was according to them 1.50% and the default rate of 5 % which is a very small percentage of the mortgage market. Generally in times of a boom problems are not seriously addressed looking at their size.

Since the mortgaged housing loans were repackaged into MBOs and sold, the eventual investor did not know what they are holding and this is lack of transparency.

HOUSING SECTOR AND ECONOMY There are different channels through which housing affects the economy:

First, housing wealth constitutes a significant portion of total wealth of households in the most of the economies. For instance, housing wealth accounted for about one-half of household net worth in the US and over two-thirds in the euro area. Hence, any variation in it may have significant impact on households consumption and thereby aggregate demand in the economy. Second, housing markets have implications for the supply side of the economy as labor mobility and employment is affected by the housing economy. Third, house prices, like any other asset prices being interest rate sensitive, affect transmission of monetary policy. Finally, boom and bust in house prices have implications for business cycles and hence financial stability.

Historically, sharp increases in house prices have been followed by sharp declines after the price bubble bursts. In the decade preceding the sub-prime crisis, not only did the house price increased substantially, it was also more synchronous across the most of the economies (Chart). Thus, sharp increases in house prices over a prolonged period are often predictive of crises in the future.

GOVERNMENT PARTICIPATION IN HOUSING FINANCE SECTOR The Government helps the housing finance sector in following few ways.

Subsidies to first time buyers Provident Funds early withdrawal Government Agency providing Guarantees Tax deductibility of Mortgage Interest Capital Gains Tax Deductibility

POST CRISIS CHANGES IN REGULATIONS Post-crisis it has been argued that central banks should also use macro tools along with normal interest rate policy to pre-empt excessive rise in house prices to mitigate risks. The instruments that are generally suggested fall under three broad categories:

capital-based tools such as, countercyclical capital buffers , to retain a decent share of profits and build up reserves for recessionary period Liquidity-based tools such as, countercyclical liquidity requirements Asset-side tools such as, caps on loan-to-value (LTV) and debt-to-income (DTI) ratios.

HOUSING FINANCE INDUSTRY IN INDIA SALIENT FEATURES Let us now turn to housing in India. Growth in Housing Stock - As per the Census, during the decade of 2001 to 2011, while housing stock increased by 51 per cent, number of households has increased by 47 per cent. Notwithstanding recent improvements, urban India in 2012 had an estimated shortfall of about 19 million houses. Most of the housing shortage is obviously for economically weaker section (56 per cent) and low income group (39 per cent) people. Dominance of Banks - Institutional financing for housing in India is dominated by commercial banks. As on March 2012, outstanding housing loans by banks and housing finance companies was Rs.6.2 trillion, of which about two-thirds were accounted for by banks. Growth in credit to Housing Sector - The share of credit for housing in aggregate credit rose from under 5 per cent in March 2001 to 12 per cent by March 2006. Thereafter, the rate of growth in housing credit has moderated. Consequently, its share in total bank credit has declined gradually to about 8 per cent by March 2012. This was facilitated by a number of favorable factors:

Sustained reduction in inflation resulted in lowering of lending rates.

Removal of the restriction of prime lending rate (PLR) as the floor rate for pricing housing loan coupled with reduction in risk weight from 100 per cent to 50-75 per cent for housing loan to individuals aided competitive pricing of such loans. The acceleration in GDP growth raised the demand for housing.

Movement in Weighted Average Lending Rate - The weighted average lending rate (WALR) on housing loan first declined from 12.8 per cent in March 2001 to a low of 8.6 per cent in 2006 before rising to 11.1 per cent by March 2012. Though the interest rate on housing finance has gone up since 2006, it has remained below the overall weighted average lending rate of banks (Chart).

The moderation in growth of housing credit after 2006 could be attributed to the following factors:

Slowdown in housing credit growth could be expected after the initial catch-up phase as the pent up demand is met. GDP growth also moderated following the global financial crisis which dampened the demand for housing. The tightening of prudential norms of increasing risk weights to a range of 50-125 per cent, higher provisioning against standard housing assets and prescription of LTV norms to mitigate risks could also have led to some moderation.

GOVERNMENT PARTICIPATION

Priority Sector Loans - Direct housing loan of up to Rs. 2.5 million and indirect bank finance to government agencies for rehabilitation of slum dwellers, and to housing finance companies (HFCs) for rehabilitation of slum dwellers as well as for construction of individual dwelling units of up to Rs. 1.0 million are treated as priority sector loans.

Income Tax Concessions - Government also allows deduction from income up to Rs.0.1 million per annum for principal repayment and Rs. 0.15-0.25 million for interest component for income tax purposes.

Various Schemes and Subsidies - In addition, there are several specific government schemes for housing for the underprivileged.

HOUSING PRICES TREND IN INDIA Reserve Bank issues a composite house price index, covering 9 cities such as Mumbai, Delhi, Chennai, Kolkata, Bengaluru, Lucknow, Ahmadabad, Jaipur and Kanpur, with a base 2008-09 on a quarterly basis. As per the Reserve Banks composite HPI, house prices have nearly doubled since 2008-09 (Chart).

Furthermore, the Reserve Bank is also developing a housing asset price monitoring system covering such details as LTV ratio, EMI to income ratio and price to income ratio based on housing loan data from select cities collected from select banks and HFCs. WHAT ARE THE LESSONS THAT INDIAN HOUSING FINANCE SECTOR CAN TAKE FROM US SUBPRIME CRISIS? The Indian Banks had little exposure to the US market couple with the sound and conservative pillars on which they lie. But there may be a possibility of a financial bubble bursting in the Indian Retail Lending market if enough care is not taken. It is only prudent for Indian Banks to take a wise look at the recent crisis and incorporate the lessons for survival in the future.

No Excess of Financial Innovations In Indian mortgage markets, there has been less of a tendency to indulge in excesses of the kind that US markets engaged in. The Indian housing lender is, by and large, more cautious and does not strive to take on the sub-prime markets, although in the pursuit of inclusive banking, there have been suggestions to banks to search out those below the poverty line for lending. While we have gone some extent in encouraging loans on limited documentation, the stress of looking for persons without a known income or job is not there.

Caution and Prudence in growing the housing loan book Indian Banks should be cautious and prudent even in our pursuit of growing the housing loan book. The lenders should not resort to unconventional and imprudent offers of too attractive terms of interest and repayment. Reckless lending must be avoided.

Customer Assessment and Education Customers need to be educated about all the hidden costs and such hidden costs should be included when evaluating the credit capability of the customer. Customers should also be advised

on their financial needs and strengths so that a healthy relationship can be maintained from both sides.

Strategic Retail Lending Banks need to devise strategies and look at retail lending in the future from a structured and balanced viewpoint. Banks have to now focus on Strategic Retail Lending. This implied having well defined allocations for different segment of lending so that risk limits specified for each sector can be adhered to. Upper limits needs to be defined and strictly followed in accordance with the retail portfolio that the bank intends to have in accordance with its risk appetite.

Credit Appraisal System and CIBIL Banks could also look at implementing a Credit Appraisal System where a credit rating is given to individuals and it can be consistent across all banks. CIBIL can play a major role here with it already having started the process of forming a database of the credit history of individuals. These credit scores can also be used by banks to look at the possibility of risk based pricing where interest rates are charged based on the risk profile of the customer. This will also be beneficial for an individual with excellent credit history who can then negotiate for a lower interest rate.

Financial Inclusion In the rural segment, where probability of defaults are high given high dependence on monsoons, the banks can act as facilitators. Given the increasing need for financial inclusion, apart from giving loans, banks can provide value based services like tie ups with farming equipment manufacturers and encouraging non-agricultural sources of income. This would not only ensure a better living standard for farmers but also ensure a constant source of cash flow for banks that have lent out, reducing default probabilities.

Proper Documentation, Supervision and Timely Review RBI needs to take action to ensure that lending practices are properly documented, supervised and not lost in competitive pressure. The rate of growth of credit should not be reduced out of fear of runaway increase in borrowers. The role of the RBI has to be to nurture growth as well as stability. That is the abiding lesson that one takes away from the sub-prime crisis.

Control on Off Balance Sheet Securitization of Loan Assets Securitisation of loans has developed over the last decade in India. This is a device that enables the lender to create securities out of its loan assets and sell it to willing investors. These assets get off the balance sheet, releasing that proportionate share of capital for fresh lending. The investor in the securitised assets gets hold of assets with good returns. The risk is transferred from the lender to the investor.

The securitisation of loans in India is covered by a number of rigorous guidelines. The fact that the sub-prime bust originated in securitised loans should not induce further restrictions on this. It is a useful innovation and the RBI rules should take care not to scare it away totally. It is more important to ensure that the originator of the loan practises the appropriate procedures of lending adequate security and monitoring of repayments in time.

Regulating the Credit Rating Agencies

Investors must take good care of the underlying assets and their creditworthiness. Here is where the rating agencies come in. Unfortunately, the rating agencies have been unregulated so far. There is also need to evaluate how good rating agencies are at anticipating likely troubles. Rating agencies serve a useful economic purpose and should be regulated in the best manner, following international best practices.

No drastic increase in interest rates by RBI One of the causes of the crisis was the rapid increases in interest rates by the US Fed, which, in turn, led to sub-prime borrowers finding it impossible to maintain repayments on adjustable rate mortgages as the rate was reset from time to time. This is partly because in their inflation fighting role, central banks tend not to take into account established borrowers who are locked into floating rates. Some safeguards are needed to ensure that the unfortunate many who are linked to flexible rates are protected from unanticipated consequences.

CONCLUSION The future outlook for the Indian Retail Banking Industry (including Housing Finance) looks good. Given the huge untapped market of semi-urban and rural areas, the opportunities are huge. The future will see Banks with well-defined systems and procedures emerge as leaders. Learning lessons from events like Subprime Crisis at every step and moving with a well-developed strategy would certainly be the key to success.

Sources & References

1. http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=800 2. http://www.thehindubusinessline.com/todays-paper/tp-opinion/why-subprime-is-not-a-crisis-inindia/article1622521.ece

3. http://www.bis.org/review/r130416d.pdf 4. http://content.indiainfoline.com/Newsletter/wkly769.html 5. http://www.eslgold.com/win/subprime_lending.html 6. http://economicsofcrisis.typepad.com/Presentations/CrisisPresforStudents.ppt 7. http://www.world-crisis.net/realestate-crisis.html 8. http://www.academia.edu/3362298/EKONOMI_MONETER_I 9. http://www.enotes.com/homework-help/what-our-usa-most-important-current-economic-401513 10. http://www.ftkmc.com/newsletter/Vol4-06-Apr22-2013.pdf