Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Bubble in our backyard

I wrote a piece
in the Financial Express on Saturday about India’s
home grown financial bubble.

While Indians have been worrying about the spillover from the global
financial crisis, a homegrown crisis has been brewing gradually. Like
in the US, this crisis has its origins in a bursting real estate
bubble and its effects are likely to be similar.

It is a mistake to assume that the US financial crisis was caused by
the kind of securitisation and financial innovation that has been
repressed in India. The deadliest financial innovation at the heart of
the global financial crisis is a millennia-old innovation called the
mortgage loan. We have had plenty of that in India.

During the last few years, India experienced a bubble in both
residential and commercial real estate fuelled by easy availability of
credit. Indians have been buying expensive houses almost completely
financed by banks. The cumulative loan to value ratio including
“furniture loans” and other forms of financing has been
close to (and has sometimes exceeded) 100%. Unlike in the past, many
of these transactions have been largely free of black money and
therefore there is no hidden cushion in the loan to value
ratio. Moreover, our young upwardly mobile professionals have been
taking on large mortgage payments (EMIs) assuming that these would be
affordable on the basis of projected salaries one or two years down
the line. With declining salary growth, the affordability of these
mortgages is now questionable.

Commercial real estate has been equally if not more frothy. Much of
recent corporate lending by the banks has been to sectors like
infrastructure, SEZs and retailing that have been essentially real
estate plays. The real estate bubble has also helped banks to reduce
non performing assets as companies have been eager to settle old
problem dues in order to monetise their real estate.

The real estate bubble in India is clearly bursting. Anecdotal
evidence points to declines of 20% or more in key markets. But this
understates the severity of the problem. Real estate prices are sticky
and they fall only gradually. Hidden discounts are more common than
public price cuts. Evidence from the stock prices of real estate
companies indicates that the value of their land bank has fallen by
over 50%. Even if this is exaggerated, it is clear that a 30-40%
nationwide fall in real estate prices from peak to trough is very
likely.

Under this assumption, a large fraction of recent home buyers would
have negative equity in their homes. They would also face increasingly
unaffordable mortgage payments as the job market deteriorates. As in
the US, we too have witnessed 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. If credit standards in mortgages were
similar, the home loan portfolio of the banking system could see
severe losses as home prices fall.

I do hear people argue that while property loans in the US are without
recourse, this is not the case in India. Actually, only in a few
states of the US is it true that mortgages are without recourse to the
borrower by law. However, elsewhere in the US and in other countries,
where legally the lender has recourse to the other assets of the
borrower, this makes very little difference in practice. The part of
the loan that is in excess of the sale value of the house is an
unsecured personal loan whose recovery in default is quite low and
often lower than the costs of litigation.

Globally, therefore prudent lenders regard mortgages as being without
recourse in practice. The lenders’ best bet is to modify the mortgage
terms to persuade the borrower to stay on in the house and keep paying
the reduced EMIs. This is because a house is typically worth more to
the existing owner than to a potential buyer.

The picture in Indian commercial real estate is even worse because of
the greater possibility of negative cash flows and acute liquidity
stresses. There is of course a lag between dropping footfalls in malls
to rising vacancy rates and then to negative cash flows, but the
trends are clearly in evidence. It does appear that the situation in
Indian commercial real estate is worse than that in the US.

Indian banks, mutual funds and other intermediaries have large
exposures to residential and commercial real estate and there is a
significant risk of their facing liquidity and solvency stresses
similar to those faced by global banks. A “quiet run” is
already beginning on some of these institutions. The question is
whether Indian policy makers would respond to these stresses with the
same speed and flexibility that the Americans and Europeans have
exhibited.

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One response to “Bubble in our backyard

  1. Socket Set December 2, 2010 at 5:18 pm

    you can avail of home loans from several companies that offer low interest rates *”‘

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