The Prime Minister’s December 31, 2016, speech announced subsidies for some categories of housing loans. This has been followed by rate cuts by banks. There are strong rumours that larger tax breaks will be offered for housing loans. If this coordinated initiative works, it would stimulate the real estate market, help placate some victims of demonetisation and improve credit disbursals at banks. But, the market response was negative. The Nifty Bank index got hammered on Monday in the first session after the PM’s speech, losing 1.4 per cent. The Nifty PSU Bank index was hit even harder, losing two per cent. There was subsequent recovery. But, here are some reasons why the market has been cautious. Many banks have stretched balance sheets, with huge non-performing assets (NPAs). Most, if not all, banks will see NPAs climbing further in the third quarter (Q3) of 2016-17.
A focus on housing loans means exposure to a risky asset class, which could push weaker banks closer to crisis. Another issue is potentially large mismatches between assets and liabilities. Mortgages are long-gestation. Banks are flush with funds. But, most of those funds consist of enforced deposits in savings accounts, which may be withdrawn at will.
Even if controls restricting cash withdrawals remain in place, cheque and bank transfers can clean out savings balances instantly. Arundhati Bhattacharya, chairman, State Bank of India, says she expects 40 per cent of the new deposits to remain in the banking system. She could be wrong by a huge margin, in either direction, the same way estimates of cash returning to the banking system were wildly off-base.
It’s also a moot point if thin net interest margins will allow banks to profit from lending at low rates. The Reserve Bank of India (RBI) started cutting rates in January 2015. Banks were reluctant to pass those onto consumers. However, the rate cuts last week were significant. Subsidised housing loans will cut interest rates even more in those specific categories. Banks enjoy substantially reduced cost of funds due to the enforced deposits. However, net interest margins could be low, due to the combination of subsidies and rate cuts. If overheads are taken into account, the margins might be wafer-thin.
There are other worries. The rate of default could be higher than normal, given the poor shape of the economy. The housing sops are aimed at income segments, where the ability to pay is less certain, and enforced lending of this sort can lead to banks easing off on the due-diligence processes. One horrible example of real loans gone wrong is the US subprime crisis, where NINJA (No Income, No job, No assets) loans became notorious.
Apart from defaults caused by inability to service loans, falling realty values could spark wilful defaults. If property value drops enough, it is rational to default and “rational default” is more likely if there is a low black component. This is one case where black money is a useful buffer. Say, the official value of a property is Rs 1 crore, with no black component. A mortgage is taken for Rs 75 lakh, or 75 per cent of the value. The borrower puts up Rs 25 lakh of white. Now, suppose the value drops to Rs 65 lakh. (Corrections like this occurred in 1995-1998, and after 2008). The borrower sees no sense in paying Rs 35 lakh plus interest over the market value, and defaults. The lender takes a big hit.
Instead, suppose the official value of the same property is Rs 60 lakh and the black component is Rs 40 lakh. The bank lends 75 per cent of the official value, or Rs 45 lakh. The borrower puts up Rs 55 lakh, of which Rs 40 lakh is black. The borrower has much more skin in the game. If overall value drops to Rs 65 lakh, the cash component could be wiped out but the official value is less affected. The lender is less exposed and the borrower less likely to default, due to higher sunk cost.
Demonetisation has hit the real estate sector hard and will result in price corrections. That’s well and good. But, the clean-up period and the reduced black components could actually trigger a higher rate of defaults while the corrections occur. Banks are already struggling with massive NPAs, and coping with the possibility of big withdrawals make asset-liability mismatches awkward. A push to offer more low-end mortgages could create new revenue streams but it could, equally, add a new dimension of strain.