The Hindu Business Line : Home loans: Fixed vs floating Racy Cases

The real estate fiasco in the US has a lesson or two for prospective property buyers in India, and strategies for the lending institutions, too. Enthusiastic lenders could at times tend to be complacent and advance loans to buyers who may have a higher-than-average risk of defaulting.

A discussion at an institute on the economics of property finance:

Anindya: But sir the loan application forms are exhaustive. Probing details are sought to give a lender a good base to assess the borrower’s repayment capacity.

Prof: Indeed, Anindya, indeed, but the lending institutions also can override certain sections, and decide to advance the loan.

Amlan: (stammers) But s-s-ir, it-it-it’s a sim-simple case of cal-cal-calcu-cu-lating the net wo-worth of th-th-the borrower.

Prof: Absolutely, Amlan. But the lender can choose to overlook some questionable aspects of a borrower’s net worth. This tends to happen at a time when the market is surfing the wave of low interest rates.

Nilanjana: Sir, what is the possibility of a lender going wrong on a majority of loans it extends?

Prof: Low, I guess, because all said and done lending institutions have to maximise the yield on their available funds over and above the mandatory CRR (cash reserve ratio) with the Reserve Bank. And higher the risk, the higher the yield.

But I don’t think any banker would place all eggs in one basket and issue all available credit to the booming housing sector — including risky borrowers who could default on the repayment. The equated monthly instalments, I mean.

Anindya: Here is a question from Amlan, sir. He asks “If the bankers are so clever, how did the sub-prime crisis happen in the US?”

Prof: (smiles at Amlan) Good question. There is a passing-the-buck game that thrives in the US. Banks extended loans to borrowers who would have been ineligible for credit had the banking norms been followed strictly. The so-called sub-prime mortgages. The borrower mortgages his property with the lending institution, pays the builder and moves in. The mortgage is passed on to another financial institution which buys the mortgage and forms it as a part of its portfolio, mainly but not exclusively, for derivatives.

Anindya: There is nothing wrong with that because an institution is free to sell its liabilities to anyone willing to buy them, sir.

Prof: Everything takes off from there. When the market conditions dictate an upward revision of the interest rates, the borrowers feel the squeeze. Suddenly the repayment quantum, if I may use the term, increases because the interest component of the loan outstanding goes up, and the borrower is saddled with an EMI higher than he can handle, given his monthly disposable income. This happens with adjustable home loan interest. There is absolutely no problem if the loan is mutually agreed at a fixed rate, that is, dictated at any point in time by the basic prime lending rate.

Nilanjana: A few hundreds this way or that may not make much of a difference …

Prof: Nope. It can. For a borrower whose monthly disposable income and monthly aggregate outlay just about equal — a knife-edge balance, so to say — he will suffer a shock. He may not be able to spare the higher EMI, unless he compromises on other aspects of his life: food, clothing and other parameters of his quality of life. As long as the EMI is salary-deductible he is helpless, but if it is not and he pays the EMI every month, then the possibility of his default increases sharply with spiralling interest rates.

Nilanjana: Okay, suppose the borrower defaults once or twice, the lender does not lose much, right sir?

Prof: What if many borrowers default? (pauses and looks around the classroom) The lender will then sell the mortgaged property and recover the dues.

Jyoti: But what as you say, he has already passed the buck to another institution?

Prof: The ball begins to roll downhill. The buyer of the liability will try to dispose of the property in a hurry to minimise its losses. And if you wish to sell property in hurry, you will not get a good price, right? (students nod their heads) So risk-takers who expected high yields, especially the hedge fund operators holding derivatives, suddenly begin to unload their holdings to minimise the losses. This sparks off a liquidity crisis because the demand for liquidity far exceeds the available funds. The market begins its slide. There is an excess supply of real estates that drives down prices. Whoever holds real estate mortgage will try and liquidate the holdings for cash. This is what happened in the US.

Anindya: And the crisis spills over to India.

Prof: May or may not, depending on what hold the foreign institutional investors have in the market, and what fraction of their asset portfolio comprises sub-prime mortgage originating in the U.S.

Jyoti: So what is the lesson for home loan borrowers here in India, sir?

Prof: Forget about adjustable interest home loans, even if the interest is high. Keep a tab on the interest rates, and convert the loan into fixed rate once the interest rate reaches around 8 per cent, even if it means the borrower has to pay the conversion penalty. It will pay off in the long term, given that home loans are usually long term.

Amlan: An-an-and wh-wh-wh-what lesson is th-th-there for ban-ban-ban-bankers, sir?

Prof: They mustn’t extend loans to credit-unworthy customers, especially whose long-term prospects of pay rise are poor. And they mustn’t brainwash customers to take home loans at floating rates of interest. The borrowers may be led to unbearable hardship in the long term, though the bank would stand to gain.

Banks also have a social responsibility that is not restricted to lending to priority sectors at discounted rates of interest. Assignment for tomorrow: A paper on today’s discussion on the sub-prime crisis to be handed over by 11 am.

Racy@TheHindu.co.in

http://Racycases.blogspot.com

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