Wednesday, November 20, 2013

Why US like sub-prime (housing) crisis will not happen in India?

Author: Sachin Gupta | Find me on Twitter

If one were to observe the recent trends across real estate sector in India, he/she would realize that market is slow. Damn slow. From increasing unsold stock of housing units to slowdown in office space absorption across major cities in India, the trend has been depressing to say the least. Will it lead to price correction? Yes, we predict so, read "Real Estate Bubble in India" to get a sense.

However, question to be asked is “will prices fall so dramatically that it leads to US like sub-prime crisis”? And the answer is BIG ‘NO’. Why? Let us explore!

First of all what is a sub-prime crisis?

It was about 5 years ago, some of us were in business schools and the shocking news of Lehman Brothers going bust filled the classroom. Most of us were new to business jargon like ‘sub-prime’, ‘securitization of home loans’, ‘derivatives’ and therefore could not grasp the solid reasoning behind the banking crisis. However, as days passed by, we began to understand this better by discussing with professors; peers; and reading articles. One of the better anecdotes that explains US sub-prime (housing) crisis goes like this:

“Linda is the proprietor of a bar in the city. In order to increase sales, she decides to allow her loyal customers - most of whom are unemployed alcoholics - to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans). Word gets around and as a result increasing numbers of customers flood into Linda's bar. Taking advantage of her customers' freedom from immediate payment constraints, Linda increases her prices for wine and beer, the most-consumed beverages. Her sales volume increases massively.

A young and dynamic customer service consultant at the local bank recognizes these customer debts as valuable future assets and increases Linda’s borrowing limit. He sees no reason for undue concern since he has the debts of the alcoholics as collateral. At the bank's corporate headquarters, expert bankers transform these customer assets into DRINKBONDS, ALKBONDS and PUKEBONDS. These securities are then traded on markets worldwide.


No one really understands what these abbreviations mean and how the securities are guaranteed. Nevertheless, as their prices continuously climb, the securities become top-selling items.


One day, although the prices are still climbing, a risk manager (subsequently of course fired due to his negativity) of the bank decides that slowly the time has come to demand payment of the debts incurred by the drinkers at Linda's bar. However they cannot pay back the debts. Linda cannot fulfill her loan obligations and claims bankruptcy.


DRINKBOND and ALKBOND drop in price by 95%. PUKEBOND performs better, stabilizing in price after dropping by 80%.


The suppliers of Linda's bar, having granted her generous payment due dates and having invested in the securities are faced with a new situation. Her wine supplier claims bankruptcy, her beer supplier is taken over by a competitor.


The bank is saved by the Government following dramatic round-the-clock consultations by leaders from the governing political parties (and vested interests). The funds required for this purpose are obtained by a tax levied on the non-drinkers”.


Well, simply, replace unemployed alcoholics by home loan seekers, Linda with a housing company, and throw in a mortgage company and investment banks with all their financial engineering skills. And what you had was major financial crisis.


Why can’t it happen in India?

Reason 1: Black money
Yes, it’s actually true that no matter how much we curse the existence of black money into the real estate sector, but it actually won’t allow a sub-prime (housing) crisis to happen in India. In US, banks started to lend 100% of home value at lower rates in initial years (known as teaser loans in India) to borrowers and this led to default when home prices fell. However, in India, even if a bank lend 100% of home value to its borrowers, a borrower will still have to pool in the equal amount of cash to buy the house at market value. 

For example:
A housing deal takes place between a buyer and seller and the market price is Rs 80 Lacs. However, as per the government circle rates, the home value on paper is 35 Lacs. Due to high stamp duty charges, the buyer will not report the actual value of Rs 80 Lacs to the registrar office. And the seller will not report the actual value of 80 Lacs in order to save on capital gains taxes. Therefore, what we get is a property which is worth Rs 80 Lacs, is actually registered at Rs 35 Lacs. The remaining 45 Lacs is paid in cash by the buyer to the seller. So, even if the buyer’s bank offered 100% of home value which is 35 Lacs on paper, the remaining 45 Lacs is arranged by the buyer. And who on earth would walk away from this home where he/she has invested 45 Lacs of their cash even if the home prices dip.

Reason 2: RBI Policies
Reserve Bank of India (RBI) has put in place certain policy measures which until a few years ago looked conservative to many people. But these very measures will not allow the Indian banking system to lend aggressively and these measures are:
  • In India Banks provide home loans for about 70-80% of property value. The remaining 20-30% has to be arranged by the buyer. Whereas, in US this norm was relaxed and banks began giving loans equal to the entire value of the house.
  • In India, banks check the credit worthiness of the borrowers and lend only to people who have income records and have the capacity to pay EMIs. Whereas in US, home loans were granted to people with no documented income, job or assets. 
  • In US, banks came up with teaser loans (interest rates are low in initial 4-5 years and then are aligned to market rates). Borrowers were happy to get home loans at sub-prime rates; however, they found EMIs too hard to pay as soon as the interest rates were realigned to market rates. And they simply walked away. In India, the concept of teaser loans is not allowed.
  • Non-recourse debt in US. This kind of debt is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender's recovery is limited to the collateral. However, in India, the borrower is personally liable. In other words, banks can seize his/her other assets to recover their claim.

Add to these above reasons, the fundamental issues of housing shortage and emotional attachment of owning a home will make sure that housing sub-prime crisis will not happen in India.

In a nutshell:





Have any Questions?

21 comments:

  1. Your contents are too straightforward to browse and easy to understand. Goldy

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    Replies
    1. Thanks and if you found it useful please share it with others!

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  2. Yes it is true that currently there is a crisis situation prevails in real estate market as many of flats, apartments are remain unsold even after full development

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    Replies
    1. True...its mostly true for cities except for Bangalore.

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  3. Hi, thanks for the post. I agree to you that real estate prices have boomed in the past year and residential properties and land have become very costly. But a good relief is that RBI has decreased the interest rates on home loans and housing finance has become cheaper. Companies like PNB housing finance limited, SBI, Canara Bank offer housing loans at low interest rates.

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    1. Hi Manish, however, recently, RBI increased the lending rate by 20 basis points and if you happen to listen to rajan's interview recently....he clearly said that his target is to bring down inflation to about 5%. And yesterday's number showed that inflation actually increased to 7%. In this scenario, we are not hopeful of low interest rates.

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  8. Waht about the scenario after demonetization...as the black money(for now) is not a factor anymore

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  9. Waht about the scenario after demonetization...as the black money(for now) is not a factor anymore

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