Prof. Jayanth R. Varma's Financial Markets Blog

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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.

Posted at 3:46 pm IST on Wed, 15 Oct 2008         permanent link