The Hindu Business Line : An `interest'ing study

A CRISIL study reveals that the housing finance sector's overall profitability could come under pressure since the incremental return on equity (RoE) is very low. The incremental RoE for banks (on their housing finance business) is at best 9.01 per cent compared with RoE of 18.8 per cent in the financial year 2002-03. It is even lower at about 6.93 per cent for housing finance companies (HFC) as against 20.53 per cent in fiscal 2002-03.

Crisil believes that such low returns are unsustainable in the long run and could push up interest rates by 50 to 100 basis points. This increase could be lower if the players are able to contain their non-performing loans (NPL) in the housing finance portfolio. The incremental returns are low because competitive pressures in the housing finance industry have driven down yields and as NPLs are fairly high.

Housing loan rates have fallen by about 675 basis points since April 2000, which is higher than the 582-basis point decline in the benchmark 10-year government securities (G-sec) rate (taken as the risk-free rate).

In the last year itself, as competition has intensified, rates declined by 250 basis points. NPLs too are quite high at about 3.3 per cent today. In contrast, housing finance players in a developed country such as the US have NPLs of only 0.78 per cent.

Expanding market but...

Competition in the housing finance industry has intensified, especially after banks renewed their thrust on this business because of its high yields and low NPLs. Banks, which had a market share of only about 20 per cent in fiscal 1999-00, are the largest financiers today with a market share of over 50 per cent.

Competition has contributed to a sharp decline in housing finance rates and an improvement in service standards, which in turn has led to the expansion of the market (sharp growth in disbursements - 76 per cent in fiscal 2002-03 and an estimated 35 per cent in fiscal 2003-04).

Since April 2000, interest rates have declined by 675 basis points. Of this, a 250-basis point decline occurred in the last year itself.

The decline in housing finance rates is more than the decline in G-sec rates Apart from pushing down lending rates, competitive pressures have also compelled players to reduce their administrative costs and processing fees. These fees are even waived off in several cases.

All these factors have put significant pressure on the lenders' spreads.

High non-performing loans

Traditionally, the housing finance segment has been associated with very low risks. But empirical evidence suggests that NPLs in the Indian housing finance sector are much higher than those experienced in a developed market such as the US. Apart from genuine economic problems, such as loss of jobs and life and illness, domestic housing finance players say NPLs also arise in India because of willing defaulters and an emerging population of fraudsters, especially over the last two years. This is a reflection of the industry's aggressive marketing tactics and some inadequacies in appraisal standards and systems.

Such high NPLs have a two-fold impact: They depress yields and entail a credit cost in the form of provisioning and write-offs.

Crisil has assessed the NPL problem in the housing finance sector by studying a housing loan portfolio of over Rs 45,000 crore, encompassing a broad-based set of 13 banks and nine HFCs, excluding HDFC. The portfolio's reported NPLs were 2 per cent as on March 31, 2003. In the portfolio under study, NPLs of HFCs are higher than those of the banks, as their portfolios are relatively more seasoned.

Crisil, however, believes that this NPL number does not truly reflect the portfolio's current asset quality.

This is because the portfolio has grown at a very high rate of 63 per cent in the last year and is unseasoned.

Additionally, a housing loan typically turns into a NPL only after over a year. Crisil has thus lagged these reported NPLs by one year (that is, NPLs as on March 31, 2003, as a proportion of outstanding housing loans as on March 31, 2002) to assess the quality of the current portfolio.The lagged NPLs, which are more representative of asset quality, are at 3.3 per cent today.

Delinquencies in the Indian housing finance sector compare adversely with those in countries such as the US. In the US, delinquencies as measured by 90-day past due (NPLs or delinquencies in India are measured on 180-day past due basis) are merely 0.78 per cent (Source: National Delinquency Survey, Mortgage Bankers Association, US, 2003).

Moreover, the performance of some of entities in India has been particularly bad. Nine out of the 22 housing finance players that Crisil studied had lagged NPLs of over 4 per cent. While the agency does not envisage a systemic crisis in the near future, it will watch out for factors that may lead to such an event.

Some of the key factors that Crisil will monitor are:

Economic activity, as downtrends are associated with unemployment and defaults,

Property prices, as a sharp decline could result in negative equity, which acts as a disincentive to repayments, and

Interest rate shocks, which necessitate passing on higher rates to variable rate credits.

Low returns

Low yields on housing loans and high NPLs are adversely affecting the players' profitability. Crisil's analysis of the incremental profitability on housing loans reveals that banks and HFCs are not generating adequate returns for their shareholders.

Crisil uses the net profitability margin (NPM) to measure the profitability of a lending business. In terms of a parametric definition, the NPM is equivalent to the yield on the fund-based business less cost of borrowing plus non-fund (fee) income and less operating expenses.

The agency believes that the NPM is superior to traditional methods as it is not influenced by the leverage (returns from the business funded by equity capital are ignored); tax rates (for instance, banks are taxed at 35 per cent while HFCs are taxed at 20 per cent) or different provisioning norms.

Banks and HFCs have very low incremental NPMs of 0.33 per cent and 0.44 per cent, respectively. This is much lower than the banking sector's average NPM of 1 per cent.

This low profitability has also suppressed the housing finance players' RoE significantly. On an incremental basis, banks and HFCs are generating RoE of 9.01 per cent and 6.93 per cent, respectively. The incremental RoE of both groups are less than half their RoE in the financial year 2002-03.

Interestingly, banks have higher RoE than HFCs despite their lower NPM. This is explained by the higher leverage permissible to banks as compared to HFCs.

One of the reasons for these low returns is that banks are flush with funds but have limited deployment avenues. Since the housing finance segment is showing good growth rates, banks are diverting funds here. Also, the sector is a better alternative to parking funds in G-secs, where the RoE is negative.

Moreover, a large number of players seems to be looking at only the marginal cost rather than the full cost of their housing loan products.

Rates to firm up

In Crisil's opinion, these low returns are negatively impacting shareholder wealth and are hence unsustainable. Interest rates may remain at the current levels if banks and HFCs can contain their NPLs significantly and bring them in line with countries such as the US. Should they achieve an NPL of 0.78 per cent (as in the US), even at current rates, the banks and HFCs' RoE will improve to 13.8 per cent and 13.5 per cent, respectively.

Crisil, however, feels that housing finance players have a limited potential to reduce their NPLs in the short to medium term since this requires measures such as a substantial upgradation of their systems and effective information exchange via credit bureaus.

Hence, interest rates are bound to firm up in such a scenario as players are not making adequate profits for their stakeholders. For instance, a 100 basis points increase in interest rates would improve the HFCs' incremental RoE from the current 9.01 per cent to as much as 19 per cent.

For the agency's analysis, it has assumed maximum permissible leverage of 16x for HFCs. If the leverage were to be a moderate 8x, however, the RoE would fall to 12.85 per cent. Likewise, if banks operate at a moderate leverage of 16x, their RoE shall be 13.39 per cent and at an assumed leverage of 46x (the theoretically permissible limit), their RoE will be 30.3 per cent. If the leverage is ignored and look at the core profitability, as measured by the NPM, a 100-basis point improvement in the yields would push up the banks and HFCs' NPM to 1.03 per cent and 1.38 per cent, respectively.

Thus, Crisil believes that if housing finance players do not contain their NPLs significantly, interest rates may firm up by 50-100 basis points to ensure moderate returns to shareholders. If, on the other hand, housing finance rates do not increase, the players' incremental profitability would come under significant pressure as their portfolios grow.

Source: Crisil

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