Why sub-prime is not a crisis in India

R. VAIDYANATHAN

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The amounts in the form of black money are large and mostly invested in real-estate and gold, two major areas of passion for the Indian middle-class. As long as a good portion of our economy and asset financing is by black income we need not worry about sub-prime, says R. VAIDYANATHAN

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Just like our fashion industry is affected by US trends, so also is our financial industry. Whether it is relevant or applicable is not material. If it affects US citizens then it should affect us since we are a major economy having all the ills of a developed economy.

In the medical field it is no longer fashionable to talk about malaria or TB or leprosy, but, instead, obesity and cosmetic surgery. So also in our financial system irrelevant issues are focussed upon and inconsequential matters occupy the centre-stage with the participants not knowing what they are talking about.

The sub-prime is the current fashion and even my milk-man, when queried the other day why he was late, answered that it was due to the sub-prime crisis.

The sub-prime (mortgage) crisis is an ongoing economic problem, manifesting itself through liquidity issues in the banking system owing to foreclosures which accelerated in the US in the last two years.

The background

The term sub-prime lending refers to the practice of making loans to borrowers who do not qualify for market interest rates due to various risk factors, such as income level, size of the down payment made, credit history, and employment status.

Sub-prime borrowing was a major contributor to an increase in home ownership rates and the demand for housing. The overall US homeownership rate increased from 64 per cent in 1994 (about where it was since 1980) to a peak in 2004 with an all-time high of nearly 70 per cent. This demand helped fuel housing price increases and consumer spending.

Between 1997 and 2006, American home prices increased by 124 per cent. Partly this is due to the encouragement for the consumption economy after the 9/11 disaster to boost activities based on consumer spending.

Some homeowners used the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending.

US household debt as a percentage of income rose to 130 per cent during 2007, versus 100 per cent earlier in the decade.

The crisis began with the bursting of the US housing bubble and high default rates on “sub-prime” and other adjustable rate mortgages (ARM) made to higher-risk borrowers with lower income or lesser credit history than “prime” borrowers.

Loan incentives and a long-term trend of rising housing prices encouraged borrowers to assume mortgages, believing they would be able to refinance at more favourable terms later.

However, once housing prices started to drop in many parts of the US, refinancing became more difficult. Defaults and foreclosure activity increased dramatically as ARM interest rates reset higher.

During 2007, nearly 1.3 million US housing properties were subject to foreclosure activity. The issue is not only of lending, it is also about borrowers providing misleading or wrong information to be eligible to borrow, such as boosting their income.

Let us look at the Indian scenario. In India, banks provide at most 40 per cent of the credit requirements of the household, including for consumption purposes. A large portion of the requirements is met by non-bank institutions, including money lenders.

Also, a large portion of organised lending is with public sector banks, which are under the control of Government, and in any event Government is not going to allow them to go under.

Unlike the US situation, where the Government or Federal Reserve has to save banks from going insolvent by providing additional capital, here in India, they are owned by Government, which will facilitate with additional funds in the form of bonds or shares if need arises.

Role of Black Money

The housing sector in India is significantly different from that of the US. A good portion of the house financing is undertaken with black money.

In other words, the proportion of black to white may vary from 20 to 40 per cent depending on the location, registration charges, bribery to local authorities, etc. This is applicable to both commercial and residential real-estate and flats.

The borrowing from banks is based only on the white portion as it should be. The banks also lend on the basis of the earning potential (past earnings record) of the client.

The income-tax assessments of many individuals present a lower picture than the actual situation. In the US, banks need to discount the claims of the borrowers while in India, banks may have to boost the claims of the borrowers since assessed income is only a part of the picture. Hence the actual position of the borrower is much better than what is shown on the paper and the margin amount; the one financed by the borrower, is substantially higher than what is shown in the book due to financing of the asset (the house) partly by black income.

In such a situation, there is no incentive for the borrower to lose the asset since his stake is much higher than shown in the book of the banks. This is the real situation.

The problem with our banking sector is different. If operational risks are due to thousands working in our banks and if credit risk is due to hundred persons then market risk is due to ten or so in the treasury.

Some of our public sector bankers who are not very good in lending and credit risk management visualise themselves to be market wizards and are active in products they are not familiar with.

Some private sector banks are aggressive sellers of these products and the CEO of one of the companies that lost heavily due to exotic derivative products, claimed that his CFO is an “innocent” person who has been tricked into buying these exotic products.

Lending based on ‘calls’

The presence of black money or what one may call the hidden net worth of India has tremendous advantages in times of asset based lending and borrowing since only a part of the price of asset is seen, like the tip of the iceberg.

The other portion of the asset finance by the borrower from black fund makes it imperative for him to protect his position by meeting the obligations.

Then the obvious question is regarding NPA in these assets. That has to be understood by the elementary issue of lending for clients knowing well that it will turn in to an NPA.

This is called telephonic banking traditional style — where the telephone call from influential netas makes the lending possible. That has got nothing to do with sub-prime crisis. It is called lending based on calls — meaning telephone calls and not on credit-worthiness.

Borrowers’ stake

Actually, given our legal processes, which are very slow, there is an incentive for the borrower to walk away.

But given his stake he is not enthusiastic to do that. Hence the default rate in the home market may be due to wilful frauds or deliberate issues of connivance by the lender.

Even in the commercial property market, it is, again, not due to sub-prime but due to bad decisions of the bankers knowing fully well the non-viability of the project or due to “external pressures”.

The amounts in the form of black money are large and mostly invested in real-estate and gold, two major areas of passion for the Indian middle-class. As long as a good portion of our economy and asset financing is by black income we need not worry about sub-prime.

The stakes are high for the borrower to let go his asset. As it is said, there is a silver lining to every dark cloud — like the strength of our hidden net worth in dealing with sub-primes.

(The author is Professor of Finance, Indian Institute of Management-Bangalore, and can be contacted at vaidya@iimb.ernet.in. The views are personal and do not reflect that of his organisation.)

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