Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Can a US style financial crunch happen in India?

Can a US style financial crunch happen in India?

When people ask me what impact the global turmoil would have on
India, my response is that the relevant question to ask is whether a
similar crunch could happen in India. The first point to emphasize is
that the US turmoil has nothing to do with CDOs and securitization and
everything to do with the bursting of a real estate bubble (see for
example this,
and this).

Real estate prices are sticky (particularly downward) and therefore
the bursting of the bubble is a very slow process – it is more
like a leaking balloon than a bursting balloon. On the other hand, a
liquid financial asset whose value is linked to real estate prices
will decline sharply reflecting not merely the current fall in real
estate prices but also the entire anticipated fall in real estate
prices. This is why the first signal of problems in the US real estate
came in the derivative markets (the ABX Index contracts). From there,
the problems spread to the mortgage securities and CDO tranches that
were most sensitive to real estate prices. To blame CDOs for this
crisis is really no different from blaming the messengers for the bad
news that they bring. I am fond of saying that the deadliest financial
innovation that brought about the global turmoil is a millenia-old
innovation called the mortgage loan. We have had plenty of that in

In India, the only liquid financial market related to real estate
is the stock market. If we want to throw light on the boom and bust in
real estate prices, it is to the stock market that we must turn. The
stocks comprising the BSE Realty Index lost over 65% of their value
between December 2007 and September 2008 while the broader market lost
only 35-40% of value. Since the market value based debt-equity ratio
of the realty companies was quite small (of the order of 10%), and the
realty companies were valued in the stock market on the basis of the
estimated value of their land bank, it is clear that the implied drop
in nation-wide land prices is very steep. The implied drop is much
higher than the 20% drop in selected pockets that is often mentioned

Just as the ABX Index prices (and housing futures prices at CME)
have been the beacon of light in the US market in assessing the true
state of US real estate, the realty stock prices are the beacon of
light in understanding the true state of Indian real estate. The broad
picture that we see is of an ultimate drop in real estate prices that
is comparable to what is expected in the US. Since Indian mortgage
loans are not marked to market (unlike the US mortgage securities) the
impact of the problems in Indian real estate are hidden from the
public view and are likely to manifest themselves in financial sector
balance sheets only over a period of time.

Another way of looking at the Indian situation comes from reading
Ellis’ paper “The housing meltdown: Why did it happen in
the United States?”, BIS Working Paper
. Many of the factors mentioned by Ellis are equally applicable
to India:

  • The supply elasticity of real estate construction has been very
    high in the current boom (compared to the past) and this supply
    overhang has the potential to deepen the correction that is
  • There has been a significant easing of credit standards in retail
    lending in the last few years. We have anecdotal evidence that the
    retail unsecured lending portfolio of some large finance companies
    (including some foreign owned ones) received exit valuations of as
    little as 30% of face value early this year, and are probably worth
    even less currently.
  • The cumulative loan to value ratio (CLTV) has been around 100% in
    many cases because of furniture loans and other similar loans that
    were added on to the basic housing loan.
  • The tax system in India encourages mortgages in the same way as in
    the US.
  • By affordability measures, Indian housing would be more expensive
    than in the US particularly but not only in cities like Mumbai.

All this implies that the housing price correction and associated
mortgage defaults could be a serious problem in India. The key
imponderable is the trajectory of monetary policy as well as GDP
growth in India.

What is worse is that unlike in the United States, commercial real
estate (CRE) is probably as badly (or even more badly) affected than
residential real estate. There is of course a lag between dropping
footfalls in malls to rising vacancy rates and falling CRE prices, but
the trends are clearly in evidence.

Problems in commercial real estate are a serious problem for the
banking system because a great deal of the improvement in non
performing assets in recent years has been due to rising real estate
prices. Many corporate defaulters queued up for settling the defaulted
loans because the real estate value exceeded the value of the

Moreover, the entire infrastructure sector which has received a lot
of bank credit in recent years is largely a real estate play. If
commercial real estate collapses, the viability of many of these
projects would be seriously in doubt.

In a modern economy, lending of 80% of the value of real estate is
a prescription for disaster when real estate prices come down. Real
estate finance globally is in serious need for reform as I argued in a
several months ago. Real estate leverage ratios need to be
brought down to more realistic “corporate finance”
levels. (It is possible to achieve 80% or higher debt levels in repo
markets and margin trading, but that requires the discipline of daily
mark to market which is impossible in illiquid assets like real


2 responses to “Can a US style financial crunch happen in India?

  1. Ritwik September 26, 2008 at 2:03 am


    While it is true that blaming CDOs may be tantamount to shooting the messenger, can they (or the people who packaged them the way they did) not be held responsible for exacerbating the problem, or for luring people into a false sense of security about the creditworthiness of the underliers?

    In my internship, I was told that the way money is made out of CDO packing and selling has nothing to do with the premium on complexity and financial innovation – instead it’s a simple credit rating arbitrage. People willingly or unwillingly underplay the correlation in the defaults of the underliers.

    As for Indian real estate, it is often argued that since India’s population density is more inline with Europe than with the US and so that is the market we should be comparing ourselves with.

    I believe most of the compnanies listed in the BSE realty index have more exposure to commercial real estate than to hosing anyway – housing is in most places in India a very local developer based phenomenon. Real estate in India will definitely be hit just as bad, if not worse, than US, but I wonder if the turmoil in the US (which in my view is essentially due to leveraged play on leveraged assets) will be replicated.

    To the extent that a lot of financial innovation tends to encourage and exacerbate the risks of high leverage, do you think there is an argument for being a little wary of financial innovation?

  2. jinesh September 26, 2008 at 10:11 pm


    I am real estate valuer by profession. I agree with you that mortgage loan itself is a risky instrument. And lending of 80% value of asset is practical in liquid asset compared to illiquid asset like real estate.

    But there are few points which makes indian real estate industry different from US.

    1)Amount of Black Money prevailing in Indian real estate market has proved to be an added advantage.

    2)Mentality of ‘major’ number of Indians is that they would rather die than ‘defaulting’ on debt. As defaulting has its own ‘social taboo’ in India.

    3)As pointed out by other blogger that indian housing industry is more dependent on ‘local’ developers than ‘listed’ companies. BSE price of those stock doesnt reflect ‘actual’ market scenario.

    4)Low Standard of Living and relatively High income gives a strong “holding” capacity for ‘small’ investors & builders in non-metro cities. Non-metro cities form a large chunk of Indian Real estate market.

    Thus even though cities like pune-mumbai etc are seeing correction in real estate prices by 10-20 % its not happening in small cities like rajkot, jamnagar, aurangabad, bhuwaneshwar…etc..

    Sir, I would like to get your opinion on above mentioned view points.


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