The Hindu Business Line The boom in housing finance Tuesday, Aug 24, 2010

C.P. CHANDRASEKHAR JAYATI GHOSH Housing finance provided by scheduled commercial banks has risen at a scorching pace over the last decade, making housing loans an important component of total bank credit. This edition of Macroscan examines the factors underlying the sharp expansion of housing credit and the implications this has for risk profile of the banking system. Globally, a significant component of the process of financial expansion and an important site for financial innovation has been the housing finance or mortgage market. The reasons for this are obvious. Every individual or family would like to own a house of their own if it can be afforded. Given the relative costs of housing within the desired asset basket of a household, it constitutes one among the larger investments or the single largest investment that many households can make. Given the life-span or durability of that investment and its liquidity characteristics, this is an asset which is most eligible for debt financing, since foreclosure due to default can in most circumstances be followed by easy liquidation to compensate the lender. This makes housing finance one of the largest, feasible, mass markets for debt. That market can be made even larger if explicit or implicit government guarantees of housing loans are provided, as happened, for example, in the US with the creation of Fannie Mae in 1938 and Freddie Mac in 1970. More recently, financial innovation that has permitted the transfer and spread of risk has also helped expand the number of eligible borrowers. Securitisation by transferring risk while allowing investors in securities to choose the bundle of risks considered appropriate facilitates the expansion of the housing finance market. It encourages the relaxation of lending norms, so that the threshold ratio of house prices to annual incomes at which a household becomes eligible for credit is lowered. Developments such as these expand the universe of borrowers to cover some borrowers considered subprime earlier. Credit regime

Given the consequent increase in the number of less affluent borrowers in the housing finance market, the demand for housing credit tends to be sensitive to the interest rate. Hence, an easy credit regime with low interest rates and lax monetary control triggers a sharp increase in the demand for housing and the volume of debt. The consequent increase in housing investments and the demand it generates contributes in turn to the overall growth. In other words, the effectiveness of monetary policy as an instrument to drive demand and growth increases with the expansion in the relative size of the housing market. This encourages the government to find ways of expanding the market for housing as part of a strategy of promoting growth. There is, however, one difficulty in all this. Since housing requires land, a scarce resource, as an input, and housing demand tends to be unevenly distributed geographically, with a concentration in urban areas as urbanisation proceeds, increases in demand often results in sharp increases in prices. This, on the one hand, increases the ratio of house prices to annual incomes and dampens housing demand. On the other, it encourages speculative investments in housing, especially since the pre-existing stock of housing, the value of which is rising, can to differing degrees be used as collateral. Most often the speculative impact dominates, resulting in spiralling prices, till a debt overhang, government action or a change in investor sentiment halts or reverses the rise. Liberalisation feature One fall-out of these features of the housing market is that financial liberalisation which permits securitisation and the creation of complex instruments that help transfer and distribute risk, and thereby, expands the universe of borrowers with access to the housing finance market, inevitably leads to a housing boom and a speculative spiral. If such liberalisation is accompanied by a loosening of monetary policy and an engineered reduction in interest rates this tendency is only strengthened. Often, therefore, these elements combine to transform the boom into a bubble that must finally burst, as happened in the run up to the sub-prime crisis in the US. When that happens, the value of the housing stock that constitutes the collateral for much of this lending collapses, with extremely adverse consequences for the financial system and the real economy. Financial liberalisation, however, is not restricted to the developed countries. Over the last two to three decades most developing countries have liberalised their financial policies and transformed their financial structures in ways that make those structures approximate the Anglo-Saxon model created through liberalisation in the US and the UK since the 1980s. Thus, just as much as the mortgage market and its derivatives have come to play a role in the metropolitan countries, so have they in the developing countries. This has been true in India as well since the early 1990s. Banks exposure to retail This has led to a relatively rapid transformation of banking in India, with growing exposure of commercial banks to the retail credit market with no or poor collateral and a growing tendency to securitise personal loans. Total bank credit grew at a scorching pace from 200405 till 2007-08, at more than double the rate of increase of nominal GDP. As a result, the

ratio of outstanding bank credit to GDP (which had declined in the initial post-liberalisation years from 30.2 per cent at the end of March 1991 to 27.3 per cent at the end of March 1997) doubled over the next decade to reach about 60 per cent by the end of March 2008. Thus, one consequence of financial liberalisation was an increase in credit dependence in the Indian economy, a characteristic imported from developed countries such as the US. The growth in credit outperformed the growth in deposits, resulting in an increase in the overall credit-deposit ratio from 55.9 per cent at end March 2004 to 72.5 per cent at end March 2008. Not surprisingly, these changes were not primarily driven by an increase in the commercial banking sector's lending to the productive sectors of the economy. Instead, retail loans became the prime drivers of credit growth. The result was a sharp increase in the retail exposure of the banking system, with personal loans increasing from slightly more than eight per cent of total bank credit in 1992-93 to more than 23 per cent by 2005-06 (Chart 1). Though there has been a decline in that ratio subsequently, it still stood at 19.4 per cent at the end of 2008-09. The decline appears to be the result of an overall correction in bank lending growth, which too declined in this period, with the adjustment being much sharper in the case of personal loans when the transition occurred in 2004-05. Residex index Of the components of retail credit, the growth in housing loans was the highest in most years. As Chart 2 indicates, the rate of growth of housing loans gathered momentum at the end of 1990s and remained at extremely high levels right up to 2006-07. As a result, the share of housing finance in total credit rose from five per cent in 2001-02 to 12 per cent in 2006-07 and was still at 10 per cent in 2009-10. By all accounts, the credit-financed boom in the housing market has triggered a spiral in housing prices, which then feeds the boom even more. Unfortunately, till recently India had no reliable index of housing prices, with available figures being from stray private sector real estate consulting firms. But the Residex Index, now being collated by the National Housing Bank with 2007 as base (100), shows that even during the period when the boom was tapering off, prices in most metropolitan centres (Delhi, Mumbai, Kolkata and more recently Chennai) were rising quite significantly. Thus, the conclusion derived from experiences elsewhere in the world that easy credit accompanied by low interest rates leads to a sharp increase in housing finance and an increase in house prices fed by speculation seems to be true of India as well. It is to be expected that the rapid increase in credit and retail exposure would have brought more tenuous borrowers into the bank credit universe. A significant (but as yet unknown) proportion of this could be sub-prime lending. To attract such borrowers, banks had offered attractive interest rates below the benchmark prime lending rate (BPLR). The share of BPLR loans in the total rose from 27.7 per cent in March 2002 to 76 per cent at the end of March 2008. This increase was especially marked for consumer credit and reflected a mispricing of risk that could affect banks adversely in the event of an economic downturn. More recently, banks, including public sector banks, have been opting for the scheme of initial teaser rates

on housing loans, which tends to attract borrowers of doubtful repayment capacity into the housing market. RBI warning Further, rapid credit growth meant that banks were relying on short-term funds to lend long. From 2001, there was a steady rise in the proportion of short-term deposits with the banks, with the ratio of short-term deposits (maturing up to one year) increasing from 33.2 per cent in March 2001 to 43.6 per cent in March 2008. On the other hand, the proportion of term loans maturing after five years increased from 9.3 per cent to 16.5 per cent. While this delivered increased profits, the rising asset-liability mismatch increased the liquidity risk faced by banks. Faced with these risks the central bank has been periodically warning banks against excessive increases in exposure to the housing finance market. In its Annual Policy Statement for 200607, the Reserve Bank of India increased the general provisioning requirement for residential housing loans exceeding Rs 20 lakh from 0.40 per cent to 1.0 per cent. More recently, the RBI has warned banks against resorting to teaser interest rates, given the experience with the consequences of such rates in the US and other contexts. However, the risk weight on bank exposure to housing loans has been kept low and a substantial segment of home loans falling below Rs 20 lakh has been kept within the ambit of favoured priority sector lending. This is partly because the Government has not been able to provide adequate volumes of affordable housing, especially in urban areas where the demand from a burgeoning middle class is substantial. But it is also substantially because credit-financed housing demand is seen as an important driver of growth in the new context, creating a lobby in its favour within the Government. However, in the process India may be encouraging a trend that increases the fragility of the housing market, and therefore, of the financial and the real economy. India's Fannie Mae in the making S. Murlidharan THE HINDU Guarantee Fund for small home loans must not lead to defaults and write-offs. House for all' is a fine catchphrase, but the notion that the taxpayers would pick up the tabs should never be encouraged. After the Great Depression, one of the steps taken by the US government to revive the moribund economy was setting up of Fannie Mae, the secondary mortgage company, in 1938 though it became a Government Sponsored Enterprise (GSE) in 1968 when it was listed.

In 1970, another GSE secondary mortgage company Freddie Mac was promoted to take forward the noble idea of house for all. The Indian government in pursuance of its aam aadmi concern wants to do its bit on the housing front. The Budget 2011 proposes to set up Mortgage Risk Guarantee Fund (MRGF), perhaps as India's equivalent of Fannie Mae and Freddie Mac. The two secondary mortgage twins had between them underwritten close to $5 trillion till 2008 mainly by buying mortgages from primary mortgage companies with funds being raised through the convoluted securitisation route. Everything was hunky-dory till 2008 when the US economy was rattled by a financial disaster with its subterranean linkages to sub-prime loans, and the twins lost a whopping $11 billion virtually bringing them to bankruptcy calling for an official bailout. The US mortgage loans were without recourse in nature, spelling enormous troubles for lenders should the house prices crash. The prices indeed crashed and the hapless mortgage finance companies were left holding the can with borrowers thumbing their nose at them and laughing up their sleeve at the naivete of the law that did not cast a personal liability on the borrowers. Would MRGF meet with the same fate? One shudders to think of the consequences. This country is not new to loan melas and the resultant inevitable loan waivers. Heavy price for write-offs When a couple of years ago, the government wrote off a mammoth Rs 1,00,000 crore of farm loans to marginal farmers, critics were silenced by citing that in the past industrialists had left banks and financial institutions bleeding through defaults in servicing their loans. Such huge write-offs might have paid electoral dividends, but the exchequer has had to pay a heavy price. What MRGF proposes to do is to stand guarantee for small housing loans whose number is likely to exceed 2.5 crore. One does not know the minutiae of the scheme, but from the contours it does appear that the small borrowers are likely to get greater indulgence than their US counterparts. House for all' is a fine catchphrase, but the notion that the government (read the taxpayers) would pick up the tabs should never be encouraged. The former SBI chairman, Mr O.P. Bhatt, was heckled by the Reserve Bank of India for his teaser loans to wannabe house owners on the ground that it encourages brinkmanship on the part of borrowers without means. But housing loan, teaser or otherwise, after due scrutiny of the repaying capacity is any day better than the mindless system of guarantees. The US insurance major AIG was brought to its knees in the sub-prime crisis precisely for this reason. Its Credit-Default Swap (CDS), an euphemism for insurance against bad debts, was issued with gay abandon on the back of AAA ratings given to mortgage securities by

credit rating agencies which in turn were blithe and slack in their work, attracted by huge fees for rating without due diligence. Mortgage financing to be sure needs a leg-up. Housing is one economic activity that spawns myriad activities in what economists call the multiplier effect. But let us not encourage the notion that borrowers can forget their obligations sooner than later. Let the loans to the poor enjoy greater latitude in terms of its tenure and interest. Free electricity bankrupts the electricity boards besides making them callous and the beneficiaries speechless and tongue-tied. When one pays for what he avails, he gets the courage to question the supplier. (The author is a Delhi-based chartered accountant.) (This article was published on April 28, 2011)

How rising interest rates impact housing finance Anil Kothuri Robust demand for homes in the long term. August 13, 2011: The home loan market has been on a high growth trajectory over the past decade. It has increased from annual disbursements of Rs 20,000 crore in 2000 to Rs Rs 1.7 lac croretoday. This is poised to double to over Rs Rs 3 lac crore) by 2015. The views of those on the lookout for a property, has however altered over the last nine months. The giddy price rise that characterized the real estate markets in the middle of 2010 has now given way to some moderation. Further, over the past year and a half the RBI has increased the policy rates 11 times. Consequently, the home loan rates for prime borrowers have increased from 8.25% in early 2010 to 11% now. This has implications on the demand for home loans as well as the portfolio management strategies of Housing Finance Companies, as follows. Impact on Demand There have been two factors that have made the purchase of property more expensive. Firstly, prices have increased significantly since the last correction in 2008, even doubling in some places. Secondly, the increase in interest rate mentioned above has lowered the loan amount that the borrower can avail of by 17%. The combined effect of these factors has caused prospective home buyers to pause and take stock of their changed situation. The decision making cycle has got elongated and demand has got deferred.

However, the demand for home will continue to be robust in the long term, despite some short term undulations. This is because buying a house is a stage of life decision, determined by individual customer events and circumstances, rather than extant prices or interest rates. Also, there is a shortfall of 2.5 million dwelling units in urban India. With the population in urban India slated to increase from 28% of the countrys population now to 40% in 2030, this shortfall is only projected to increase. Some banks/Housing Financing companies are using the current environment to aggressively acquire customers who can transfer their loans from other entities. Such a Balance Transfer program benefits both the customer who will save on the relatively high interest rate on his loan as well as the acquirer who will get a customer with a proven repayment track record. Loan providers as well as the agencies that represent them have begun to actively educate customers about the value in leveraging their properties for a loan. This has seen an increase in Home Equity loans over the past six months. This has substituted the lower home loan disbursals in some markets like Mumbai. Housing Finance Companies The rapid rise in interest rates would impact existing loans in one of two ways either the loan installment goes up or the tenure of the loan increases, with the installment constant. For some borrowers the increase in installment could prove too high. This could cause him to tip over and default. This is especially true of borrowers with low incomes, given the inflation in food and various other household products. Thus, higher interest rates could precipitate defaults in hitherto good borrowers. Prepayments of home loans tend to be higher when interest rates are high. Some borrowers with surplus cash will choose to prepay their loans to minimize their interest outgo. Banks and other diversified financial companies can provide other avenues to customers which will offer comparable interest rates so that the amount earmarked for prepayment is invested elsewhere. Margins are normally lower in a rising interest regime and higher when interest rates are falling. This is because the cost of funds tends to correct quicker than the portfolio interest rate. Also, since most borrowings for Housing Finance is long term, the current high borrowing rates impose long term costs on the business. In summary, home loans are long term assets and managing the interest rate cycle is central to the business model. The lower end of the interest rate cycle provides more options to manoeuvre. However, the strategies adopted by lenders to deal with the variables listed above will separate the more profitable players from the rest.

(The author is Head, Retail Finance, Edelweiss Group and CEO of Edelweiss Housing Finance Limited)