At the Indian Banking Conclave (Bancon) in Mumbai on January 12, Reserve Bank of India (RBI) deputy governor Usha Thorat warned against what she considers risky mortgage lending practices. In the area of housing loans, teaser rates are increasingly being offered, which is a cause for concern, she said. I hope banks are ensuring that borrowers are well aware of the implications of such rates and the appraisal takes into account the repaying capacity of the borrowers when the rates become normal.
Teaser rates were introduced by banks last year to boost demand for housing finance in a slowing economy. The first off the block was the public sector State Bank of India (SBI) with its Easy Home Loan. Launched in January 2009, when home loans were on offer at interest rates between 8.5% and 11% depending on the amount and the tenor, SBI's rate was 8% for the first year and 8.5% for the next two years. After three years, the terms are highly confusing. According to SBI, the interest rate after three years may be fixed or floating as per the borrower's choice at the time of sanction. If the floating rate option is chosen, then the rate will be 2.75% below SBAR. If fixed rate option is chosen, then the rate will be 1.25% below SBAR prevailing on the third anniversary date from the date of first disbursement, and shall have a reset frequency of five years from the third anniversary date of the loan. Fixed interest rate shall be subject to [a] force majeure clause.
SBAR refers to the State Bank Advance Rate or the Benchmark Prime Lending Rate. And what is the Prime Lending Rate? Beginning June 29, 2009, it was revised to 11.75% per annum; it depends on the RBI's rate and other factors. In other words, the borrowers' monthly payments or equated monthly installments (EMI) three years from now will depend on the SBAR at that time. Little wonder borrowers are befuddled, regardless of whether they opt for fixed or adjustable rate mortgages.
It is partially correct to state that loan terms are not fully explained to the borrowers, says Sudip Bandyopadhyay, group president of Spice Finance. It is important to be transparent while providing loans. This does not happen in case of teaser loans. But even the banks have no clue about how much the EMI could be. It depends on the interest rate, and banks are obviously not going to talk about worst-case scenarios.
While documentation necessarily has to be detailed, there is a strong case to be made for banks being compulsorily required to provide simple illustrations on how floating rates are pegged and what the precise implications are, says Jayesh Desai, national director (infrastructure, real estate and government services), Ernst & Young (E&Y). But it would be unfair to say that banks are taking customers for a ride, he adds.
Thorat's statement about repaying capacity and clarity on obligations drew an immediate response from SBI chairman O.P. Bhatt. I don't know what the RBI means by teaser loans, he told morning newspaper DNA at the same Bancon a few minutes after Thorat spoke. It is not right to refer to the 8% home loan scheme as a teaser ... there are no hidden costs in these loans or any add-backs.
On February 5, RBI deputy governor K.C. Chakrabarty added another dimension to the debate. Talking to journalists at a seminar on infrastructure financing in Mumbai, he said: We have no concern [about] teaser rates. In a lighter vein, he quipped: What we are telling banks is that you should tease everyone. Don't just tease new customers; also tease old customers by charging a uniform rate for both.
Five days later, on February 10, the RBI stepped in with a circular to make credit pricing more transparent. Beginning April 1, housing finance can no longer hide behind a wall of banker-speak. A new Base Rate system will be introduced. According to the circular, Since transparency in the pricing of lending products has been a key objective, banks are required to exhibit the information on their Base Rate at all branches and also on their websites. Changes in the Base Rate should also be conveyed to the general public from time to time through appropriate channels. Banks are required to provide information on the actual minimum and maximum lending rates charged to major categories of borrowers to the Reserve Bank on a quarterly basis. Apart from transparency, banks should ensure that interest rates charged to customers in the above arrangement are non-discriminatory in nature.
High Interest Rate Regime
The problem for banks is that the country is moving to a high interest rate regime. The RBI credit policy announced on January 29 did not raise interest rates; it only increased the cash reserve ratio (CRR) by 75 basis points. This squeezes liquidity out of the system and helps temper inflation. (See Will Rising Inflation Deflate India's Economic Recovery?) But interest rates are bound to go up; the only question is when. Teaser loans could then become uneconomical for banks. To add its earlier customers to this category will make things worse. On the other hand, if interest rates rise too much, EMIs will climb, squeezing borrowers further.
Bankers say a bubble in India is unlikely for another reason. In the U.S., loans were given based on the value of the asset (the house). In India, the primary yardstick is the capacity of the borrower to repay. Besides, banks in India have been traditionally conservative about lending to individuals.
Despite the insistence of the banks that they check on borrowers' ability to repay, one key issue is how much they are paying for the home in the first place. At the height of the boom two years ago, a mid-market apartment in Mumbai had a price tag of $200,000. This tumbled to $100,000 (in some cases). Buyers who had $170,000 in bank loans suddenly found themselves with a lot of negative equity. For the banks, they would be making significant losses even if they were able to seize the property and sell it off.
Another issue most borrowers don't realize is that most loans have a Depreciation of Security clause. A buyer is expected to contribute 15% of the cost of the house or apartment -- $30,000 in the example given. If the price falls to $100,000, the bank will still finance only 85% of the current cost -- $85,000. The borrower will have to pay the shortfall ($85,000) to avoid being labelled a defaulter. (In loans where shares are pledged as collateral, this has happened very often. Banks ask borrowers to top up their securities when prices fall. If they fail to do so, they sell the shares.)
So why are banks offering teaser rates? The reason is they make money through lending, and today there are limited takers. Banks have too much money sloshing around in their coffers. According to RBI data, by November 20, 2009, personal loans were up a meager 0.7% for the year. Advances against fixed deposits were down 11.80%; on credit cards they were down 24.70%, and on consumer durables down 11.80%. The saving grace was education, where loans went up 31%, and housing, where loans increased by 7.30%. The increase in housing loans was essentially the effect of teaser rates, without which mortgage lending might have declined. Loans to the real estate sector were up 15.30%. This looks fine until compared with the 49% growth of the previous period.
In this environment, once SBI took the plunge, everybody followed suit. When SBI launched its Easy Home Loan, Deepak Parekh, chairman of Housing Development Finance Corporation (HDFC), the country's biggest mortgage lender, declared it a gimmick. A few months later, HDFC itself was offering a similar product. But Parekh continues to insist the teaser loan is playing with fire. In an interview with business daily Mint, he said: It's not a very healthy way of lending. It can create problems in the future, particularly if the rates shoot up. Today what we are saying is, if the rate is 8% or 8.25% for the first two years, the rate will be 9% afterwards and so the gap is very small. Suppose interest rates in India shoot up in the next three years, then what will happen? These are all floating rate loans and fixed only for the first two years. So, 8% interest could become 12% or even more. Then, the gap will be too much and it's a problem for the individual homeowners.... Financial innovation doesn't take time; if one does it, everyone copies. It can be done in 24 hours. Now most banks have this product. More than 20 banks and housing finance companies in India have launched some variant of the teaser loan.
Competing for Borrowers
These loan programs have proved to be extremely popular, and any large bank would be interested in getting on such a winning bandwagon, says Anuj Puri, chairman and country head of Jones Lang LaSalle Meghraj, a real estate services firm. In the end, a successful business entity will not steer away from taking a leaf out of the competition's book. Adds Bandyopadhyay of Spice: I guess competition forced HDFC to follow this route. They obviously did not want to lose customers.
Banks as well as HDFC have always had variants of the teaser loan programs, says Desai of E&Y. They always had floating loans, which were linked to prime lending rates, so you have had situations in the past, too, where interest rates start out low and then move up. Parekh's comment was probably linked to pricing loans initially below the cost of funds.
Business daily Business Standard agrees with Parekh's views about the risks of teaser rates. Teaser rates are doubtful in themselves, but the experience of the recent global financial crisis makes them more so, the newspaper says in an editorial. The U.S. sub-prime crisis, where defaults by a large number of home mortgage owners led to the collapse of the housing bubble, which in turn led to the overall financial crisis, was essentially a matter of those who could not afford to service a loan of a particular order for its entire life being lent funds. And this was facilitated by the offer of teaser rates which were to be reset at not-too-late a date, a provision that was part of the fine print which many borrowers initially ignored. With antecedents of this nature, teaser rates should not have been allowed (in India) in the first place. It is not clear why the regulators should have allowed this to happen even while sounding warnings that it is not a good thing. The banks' response, particularly that of SBI, is that it was awash with liquidity at the particular period when the practice was initiated and the stratagem has served its purpose. But this still leaves open the issue of quality of assets which will not be known unless the higher reset rates kick in.
Following the RBI's warnings, some banks have changed course. Two major banks, Canara Bank and Union Bank, have decided to end their teaser loan programs. Axis Bank has withdrawn the teaser loan program it had introduced as recently as January 6. Even Bhatt of SBI seems to have had second thoughts. We will review the special home loan scheme sometime in March and see what kind of credit offtake has taken place, what kind of liquidity we have, what is the view on lending to various sectors and where we think the cost of funds is heading, he told the Business Standard Banking Round Table in early February.
Bhatt's concern is primarily the SBI's bottom line, not the borrowers' capacity to repay. Still, the two are linked because the quality of the bank's assets depends on the latter. The points of contention are the short-term impact of low margins of teaser loans on bank balance sheets and the long-term impact on the quality of the loan books the banks build, says Bundeep Singh Rangar, chairman of IndusView, an advisory firm for multinational companies looking at business opportunities in India. While the short-term pressure on margins is reflected in the debate between Bhatt and Parekh, the differences between SBI and the RBI stem from asset quality issues. The interest rates of such teaser loans automatically reset after the initial relief period. This resetting character of the interest rates is being compared to sub-prime mortgages in the U.S. The key difference, though, is that even these low rates are not being offered to unqualified buyers, only to people with predictable and documented incomes and repayment capacity. The consensus view is that there are dangers, but Indian banks have been much more careful. And the RBI should be able to head off the trend before banks get into serious problems.
Is a bubble building up in real estate prices? Opinions differ. There is a recovery in certain pockets only, says Desai of E&Y. Agrees Rangar of IndusView: The real estate industry is picking up, but slowly and unevenly. Bandyopadhyay of Spice, however, says that the prices of both commercial and residential properties have gone up significantly and they are close to their peaks. The sharp increase in real estate prices during past six-eight months is definitely a cause of concern, he adds. A calibrated approach needs to be taken by the regulator in consultation with the banks and the industry to slow down the pace, thereby ensuring more sustainable long-term growth.
The residential market is currently still largely end-user driven, says Puri of James Lang. While there is a fresh complement of investors on the market as well, wholesale speculation such as we had seen in previous years is definitely not in evidence. It is speculators who create bubbles, not genuine investors. Adds Rangar of IndusView: We don't believe there is any bubble in the Indian real estate sector.
Rating agency Fitch sees demand picking up but no dangers of overheating. After a difficult period in early 2009, residential market demand picked up in the second half of 2009, as reflected by the absorption of new projects that were launched at a 25% to 30% discount versus prices during the previous peak in the second half of 2008, says a January 2010 report. Developers reacted to the fall in demand by reducing prices and lowering unit sizes, and the focus shifted from high-value housing to the more mid-income affordable segment. Any significant increase in property prices by developers, and a tightening monetary policy, could have an adverse impact on future demand. With some recent launches already indicating an increase in residential prices, there is a risk that volumes may moderate if prices continue to appreciate. The commercial segment, says Fitch, continues to remain under pressure.
The sizzle is evident elsewhere. Nearly 20 real estate companies have lined up initial public offers (IPOs) totaling more than $6 billion. Some have already gone through and done remarkably well. During the boom of 2007, there were nine real estate IPOs. Today, only one of them has shares that trade above their offer price. Even if the homeowner has been a winner, investors in real estate stocks and speculators in property have been clear losers.
Published: February 11, 2010 in India Knowledge@Wharton