US Sub Prime Debacle & Its Impact In India

We have already felt the heat of woes of sub prime market in the US, if the indirect impact could create such a dent on Indian market just think if this calamity was to strike Indian banks.

Sub prime market- The US story: Definition of sub prime market means “lending to borrowers with poor credit history”.  It implies that the lender is aware of the fact that the profile is poor; this risk has been hedged by charging higher rate of interest primarily and also the underlying collateral. We need to understand that mortgage loans repayments are equated over installments spreading over tenure ranging from 1 to 15 years. These bad accounts were booked say 4-5 years back when the US economy was doing well and everything was looking lucrative for lenders as well as fund managers. What has changed since then? Nothing substantial changed in the macro economics that could have lead to the sub prime debacle. Rising interest rate, fall in real estate prices could be reasons but let us not undermine the principal cause which is the poor underwriting standards. People became owner of house without having adequate income level to support their daily livelihood, forget about paying housing loan installments.

It all began on 7 February 2007, when HSBC said it had fired its head of North American operations, after its bad debt – much from subprime ‘piggyback’ loans – rose to $6.8bn. It continued when New Century Financial, America’s second-biggest subprime lender, carrying $23bn in debt, came crashing down. The stock fell from $66 down to near zero, losing 43% in just three days in February, and most of the rest when the New York Stock Exchange halted trading last week.  HSBC was forced to issue the first profit warning in its 142-year history because of a sudden $1.8 billion blowout in sour loans to Americans with poor credit records. Stephen Green, the HSBC chairman, has acknowledged that mistakes were made both in supervising the US operation and in assessing borrower risk.

Until 2000, house prices and rents in the U.S. moved together. Thereafter, house prices surged ahead of rentals. Easy availability of credit and tax breaks was the principal reasons. Mortgage money became plentiful. Securitization diversified the risks away from the original lenders. Lending standards might have become lax. Buying a home became an ‘irresistible’ investment opportunity for most Americans.   It has been surprisingly easy for people buying a new house to borrow hundreds of thousands of dollars by simply telling the bank how much money they make - without any proof.  It's called a "stated income" loan, but many people inside the housing industry call it something else:  a “liar loan” or a “NINA” (no asset, no income verification).  Forty percent of the subprime market (about $400 - $500 billion of loans), is made up of these loans.  At best estimates, half of all subprime mortgages had no income verification.  This is no small problem!

Bitter Home Loans: A home is advertised for sale at a foreclosure auction in Pasadena, California, U.S., last month. The number of homeowners receiving foreclosure notices hit a record high during spring, driven up by problems with sub-prime mortgages. (Source Money Week-25.06.2007)

The sub-prime loans were given to borrowers who did not have the capacity to service them. At the height of such lending, it was said, the borrowers were in the NINJA (no income, no jobs also) category. To lure such borrowers, some lenders adopted ‘predatory’ practices. They lent deliberately knowing that there will be default and, when it occurred, seized the houses mortgaged and sold them off to make a profit.

The whole arrangement crumbled when things turned adverse with falling home prices and rising interest rates. In early 2007, when New Century Financial, a large sub-prime lender, collapsed, it resulted in Barclays Bank taking over sub-prime loans of about $900 million. In February, HSBC, another big British bank, reported steep losses in sub-prime lending in the U.S. Many Canadian, German and French banks followed suit. Many of the big investment banks in the U.S. also reported large losses.

There is now almost ten months’ inventory sitting on the market, a 16-year high. And the adjustable interest rates on mortgages worth $750bn will rise over the next year, implying further rises in default rates.

US Sub prime debacle-Its current and future impact in India

When NASDAQ sneezes BSE catches cold. Faced with the brunt of pumping in liquidity in the American market it’s obvious that the foreign investors would be keen in selling in their investments in India to realize cash. The selling spree would bring bearish sentiments in the market and the market is going to fall.  Neither this impact can be quantified nor projected how long it’s going to continue because nobody is aware as to the extent of exposure by Banks and Fund Managers in the US Sub Prime market. Secondly, it also cannot be predicted how long the slump in property prices would continue and what control measures the Federal Reserve has got to reign in the increase in interest rate. It is pertinent to note here that many European and Asian banks also have an exposure in the US sub prime market; if at all the situation is to worsen further this could have severe impact in terms of crashing stock market, inflationary trend in the economy and decline in FDI’s  across all markets including India.

Do we have sub prime market in India?

 Let us restrict ourselves to discussion on retail lending front. The problem here is grave as no such tools is available which can rate the credit worthiness of the applicant. Retail loans proposals are considered basis the Bank’s internal policies, risk appetite, market interest rate situation and appraisal done by individual banks. We do have CIBIL and Satyam MCNF (Master Card Negative Feedback) database, speaking about the credit history of an individual based upon his residential address, DOB, PAN No, etc. However these databases are crippled with their own limitations. MCNF contains data for only Master card credit cards issued by banks, CIBIL takes into account the credit history of the applicant, his repayment track and declared obligations. However this is restricted to information’s pertaining to location specific and it comes with the caveat that a CIBIL NIL report that is “No record found” is to be presumed as a favorable report. Most of the banks have designed there underwriting policy basis the CIBIL.  We also have banks own verification and collection agency that provide input about credit history of an individual basis their own database. Technically speaking we do not have any borrowers who can be classifies as Sub Prime. Wait the story just begins; we have a bigger problem here, which is the problem of “over-leveraging”.

If we talk about unsecured lending we have virtually all the players, Indian and Foreign banks lending personal and short term personal and business loans. The major chunk of the business comes from surrogate lending, means loans given on the basis of repayment track performance on loans of other banks by the applicant. Based upon market feedback the below table depicts the pattern of personal and business loans lending amongst leading Foreign and Indian banks

Under surrogate lending profile are mostly self employed small businessmen who require short term fund. If you dig deeper into these cases, the applicants have multiple loans running; banking habit does not indicate good business volumes and support his ability to meet his total obligations. It is imperative for us to understand that the applicant has evolved the habit of rolling money and is walking a tight rope till the time he falls. Are we doubting the underwriting standard of the banks, aren’t the banks factoring these issues before decisioning the applications?  Yes they are doing but they also have certain limitations, no proper credit history, income obligations mismatch, the turnaround time factor, competition in the market, etc. The profiles under surrogate lending are overleveraged, yet they qualify for fresh loan as their repayment track on the declared target loan track is good. However we don’t have any tool to judge whether the applicant has declared all of his obligations. These are the cautious profile and constitute major chunk of the existing delinquency problem for personal loans. 

What is the situation in secured retails loans segment, principally comprising of mortgage loans and vehicle loans. The problem with mortgage loans has been with the sharp escalation in property prices as compared to the income growth.  This mismatch is clearly evident if we are to compare the rental value of the property with its cost. Say a property has been purchased at Rs.25 lacs on loan, the person is paying EMI’s of Rs 25k per month, if the same property is let out it hardly fetches rent of Rs.6k, where is the disconnect? This put pressure on the interest rate resulting in steep increase in interest rates.

 Banks do consider the Income/Obligation ratio of the applicant but they have no control over the property prices and this actually leads to a debt trap for the loanee.  We have instances like the EMI’s amount now being insufficient to cover the interest component forgets about repayment of principal amount. Consider the example as below:

If we calculate the interest element alone at the revised ROI on the principal outstanding which amount works out to be Rs.16, 862/- . This is more than his existing EMI; here it implies that whatever EMI he is paying now is insufficient to cover the interest element in loan forget about repayment of the principal component.  To adjust this either the EMI amount can be increased, which the loanee’s are usually reluctant to, his income level has not gone up and there is high mismatch in income/obligation ratio. The other option available is increasing the tenure of the loans which is certain cases go beyond the life expectancy of the individual. What do the banks do?

Factors like over leveraging, lack of proper credit history, legal complicacies, valuation of the property, not so strong recoveries laws raises the speculation surrounding the success of mortgage loans in India. We have no control over the end usage of the fund; don’t be surprised to learn that most of the funds could be invested in speculative business like the stock market.

Housing Loan                          (In Rs. Crore)

(Source: ASSOCHAM)

Despite of increase in the rate of interest and spiraling property prices the retail mortgage industry is optimistic of Y-O-Y growth of 25% and the cumulative disbursement figure is expected to cross Rs 325,000 crores. Increase in competition has squeezed the profit margins of the banks; they are now operating on a gross spread as less as 3 per cent. It therefore becomes imperative for them to build healthy portfolio by tightening their lending norms.

CONCERNS:

v  What is the increase in demand of loans that the banks are talking about? One reason for increase in demand is the easy availability of loans. Are people actually in need of money or are banks tempting them to take loans?

v  Do we have any capping on the number of personal loans, business loans or mortgage loans an individual can take from one bank and from multiple banks?

v  Banks, especially private sector banks and MNC banks have been instrumental in boosting the demand for loans; however this has lead to increase in ROI as well. Rising interest rate is the principal reason for default in housing loans.

v  Whenever there is a hike in ROI, does the bank study their existing portfolio? Whether their existing customer would be able to repay their loan enhanced EMI’s, unfortunately this aspect is ignored.

v  No accountability on the usage of fund, lots of personal and business loans entering into stock market, especially for all unsecured loans and loan against property.

v  Legal issues, in most of the cases it has been found that no proper security document is available with the banks in case of mortgage loans. Difficult to take punitive action upon default as no security has been created.

v   Banks currently might reflect a very low delinquency percentage but it’s important to note here that the denominator is quite huge and is expanding exponentially. It would be interesting to watch the delinquency figure once the demand saturates/slows down and the loan portfolio starts maturing.

SUGGESTIONS:

v  CIBIL to be made more comprehensive, other vital information’s like individual’s utility bills payment history to be incorporated. Perhaps database from the telecom and electricity department   could be integrated with CIBIL. I think no bank would be willing to provide loan to applicants who have defaulted in paying his telephone or electricity bill.

v  Banks to be more responsive in sharing of their data amongst themselves and with the credit rating agencies.

v  Product and NOT Policy should be tailor made to suit market requirement. We know that both are correlated but that does warrant to compromise on underwriting policies.

v  RBI mandate for all banks that are into retail lending to publish quarterly portfolio status report, which should include product/region wise delinquencies and the corrective measures taken.

v  Upon selling an asset product try and also build a liability relationship with the customer. Like say when a Business loan is being sold tries and also convinces the customer to open a current account with the bank OR perhaps savings account for other family members.  

v  Banks should refrain from getting close to the builder and real estate community. It may help in generating revenue and sourcing business however if we look at the larger picture it makes the bank the selling agent of the property developed by builders and that too at prices commanded by them. Do bank have any control over the property prices fixed by the builder? This indirectly leads to bubble in the property prices.

v  Banks to emphasize on training of employees and business associates, remember quality comes with a price. The Sales fraternity in retail business should learn the tough way of doing business rather than choosing the easy was out.

The Road Ahead:

We should be happy with the fact that existing delinquency percentage of Indian Banks are well within control. However banks need to wake up to the problem of over-leveraging and ensure that their underwriting standards are strict. It’s a clear message for all the banks “lend money to people who actually deserve credit, not only because they want money”