Very good comment by Bhaskar, to my last post:
RM by definition is a floating rate loan. However, Hybrid ARMs are common products in the US and is the significant source of the problem.
5/1 ARM – Fixed for the first 5 years and floating rate adjusted once every year after that.
2/28 ARM – Fixed for the first 2 years and floating rate adjusted once every year after that.
The US banks entice customers with a significantly low fixed interest rate that grows to a much higher floating rate when the fixed term resets. There are “caps” specified in the contract that limit the increases at the end of fixed term (for ex. 3%) and every year after that (for ex. 1%).
The Hybrid ARM products were well received since the customer believed he could just refinance into another hybrid ARM at the end of the fixed term. It worked for the past 8 years or so, when the RE prices continued to increase. Now, with RE prices falling, it is another story.
Additionally, the use of Home Equity Lince of Credit (HELOC) (essentially a credit card with the additional home equity as collateral) is rampant. The interest rates for HELOC are 7.5% compared to 14% for credit cards. (Source: bankrate.com). HELOC has been funding the customer spending in the past few years.
In India, Hybrid ARMs are not common. Fixed rate loans are revised periodically, but they do not come with initial teaser rates. HELOCs are not used commonly, though similar products are available. This is the significant difference, which allows users to hold substantial equity in their house. Also, the savings rate of a household in the US is almost 0% compared to 40% or so in India.
(Click here for Graph)
If someone did publish the graph for India, I bet it will be very different.
What you say is very interesting, thanks! I agree – we don’t have teasers in India or hybrid ARMs. There are equivalents but yes, our system is different. The problems in the US can perhaps be attributed to teasers or hybrid ARMs, but the underlying issue was that a price decline was simply not accounted for. And in a way, neither have we.
I think the problem in India is perhaps different – and not fuelled by lower equity ownership of houses like in the US. The problem in the US is unfettered securitised lending, which is affected by the high foreclosures, which in turn is affected by lower owned equity. In India, it is really a reversal of the real estate market and therefore an effect to the fortunes of those closely associated with it.
The problem could start from the fact that the foreclosure system is very weak and slow. Banks therefore may try to hike or “margin-collect” earlier, and RBI may tighten definitions of NPAs here. Renegotiations are more difficult and less organised.
And it’s not really the first time homeowners that are affected – since they will try to keep their houses. A rabidly large set of people, even those without the capability to do so, have bought multiple properties on margin financing. Because they could.
The other, and perhaps bigger problem is properties bought during construction – a large part of new sales. These involve even lesser margin (just a lakh or so upfront for a 50 lakh property, and then payments on a month/bi-monthly basis). A very large part of these were sold to speculators, and those that could leverage on bank loans, and of course, with prices going up, no one cared.
So technically I could buy a 40 lakh house, get 90% financing (in 2005), and need to put down only 4 lakhs. But not even that much – if the house was under construction over say 20 months, the builder expects me to pay say Rs. 4 lakhs every second month. Of that I put in only 40 grand – the banks fund the rest.
For 20 grand a month – 40K every two – I get a 40 lakh house, plus I only need to pay “interest” to banks until the house is complete. Meaning, I would pay say 8% on only that part of hte loan which is paid out – which as you can see is next to NOTHING.
With 20 lakhs in cash I could easily buy 10 houses and survive a few months (planning of course to roll over one house every couple months till I profit enough to keep the rest) For this prices should only go up – and for a long time, they only went up.
With prices actually coming down, such guys are hosed. They expected to roll over and get some profits to pay the next slab on the remaining houses, and now they don’t have that leverage. So they don’t pay the builder.
The builders are therefore slowing down the apartment construction, because they don’t have the cash they planned to get on each slab.
With construction slowing, others who bought are paying bank interest for no reason, without the tax benefits either – they eventually get ticked off and could decide to liquidate and buy a ready house instead. That lowers prices more, and so on. Banks can’t foreclose – they don’t even have the property ready yet – and they’re now facing increasing NPA pressure that they can’t do much about.
Demand for ready houses increases temporarily but slows down as people realise how the underfunded developers have cut corners to provide possession – and the market prices of those houses stay low (until someone goes in, fixes the place and then resells – a long cycle)
At some point, prices spiral downwards. Pressures can seem to come from cement prices, or some RBI regulation or something external, but it was the build-up that was designed to crumble – and it will.
The cycle has happened at least twice in my lifetime in Bangalore, and I’m sure it will happen again. This time, the situation looks grim because the volume is so much higher, but at this point I’m not unduly worried because it could still be an urban and local phenomenon as high quality construction has not really picked up in the smaller towns.
Note: I have no links because a) I’m lazy and b) there isn’t an organised source. I’ll try to collect some. I’m talking about what I see, hear and read, a consolidation of sorts. If you have links, please post them in the comments. I deeply appreciate them!
