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, this, 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 India.

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 anecdotally.

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 259. 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 required.
• 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 debt.

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 blog post 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 estate.)

Posted at 8:36 pm IST on Thu, 25 Sep 2008         permanent link

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