Monday, September 12, 2011

Indian Banks - Risk Free???

I am personally a fan of the way Indian banks conduct risk management. Let us take the concept of home loans alone to begin with. Barring the mania of 2006-2007, the framework of home loans from Indian Banks has been pretty straightforward.

85% of the Home Value To Be Disbursed as Loan Amount
20 Years Tenure Maximum [That later allowed for some flexibility for extension in case of floating rates]
Floating Interest Rates @ 8.5% plus PLR Adjustments

The value of the EMI should not exceed 40% of NET TAKE HOME SALARY of borrower [relaxed by 5% to 10% in case of favorable age and/or income level of borrower] All of this was good until 2008 Lehman Brothers debacle took place. Then in 2009-2010, Indian stock markets were roaring and the real estate prices escalated over the roof [almost doubling or tripling from 2005 prices]. With that came inflation and RBI tightening the noose raising interest rates by almost 600 bps in the period from 2008 to Q2011.

Here are the basic assumptions I have put forth in this forecast for the Great Indian Banking Crash - Coming XYZ [As of now I have no clue when this is going to burst and hence made a separate page for this one single article. Will revisit it and update it if I get some insights on the timing or when it really happens. Till then, this is probably one of my hawkish nightmares which I hope turns wrong]

Average Size of The Home Loan = 35 Lakhs
Average Interest Rates = 10% [adjusting for the floating rates]
Interest Income = Principal Amount for Banks
Stock Price of Bank = Book Value
Average Middle Class Population = 300 Million
25% of Middle Class Population falls under conditions above
[This is just a rudimentary analysis rather than a Big 5 Consultancy model that goes into the nitty gritties of adjusting everything for maximum statistical accuracy. The 25% and 35 lakhs will by and large offset each other should there be a cry about 25% of 300 million is too much as around 3% to 5% have taken home loans exceeding 80 lakhs to 1 crore in principal. The weighted average will eventually come around this figure. Also I don't want to get into the financial modelling principles of discounting cashflows as that will worsen the forecast below. Simple and straightforward time bomb sitting in the Indian economy to be discussed for the mango people of India] {Mango People a pun for 'Aam Aadmi'}

This implies that on Housing Interest Income alone, our banks have accumulated a book value of
INR 2,625,000,000,000,000
10 Million = 1 Crore, 1000 Million = 1 Billion, 1000 Billion = 1 Trillion
This implies we are looking at home loan book value of INR 2625 Trillion Trillion or USD 54.687 Trillion Trillion [assuming a Rollar rate of 48]

All of this has entered the books of our dear banks as Assets due to the fact that they lie under 'Accounts Receivable' section. The appropriate discount rates have been applied and the underlying assumption is that housing prices will keep increasing, people will keep honoring the EMIs and 'Aall izz well'. So far so good, RBI does not allow banks to go excessively on leverage and whilst banks fume over this, the whole system is working well. Thanks to lower retail participation in stock markets given the volatility and high level of fixed deposits, things look well.

Fundamental Flaws that have not been factored in the entire Indian Housing Loan Market

I - The average borrower who has borrowed in the period 2001-2010 is not going to work until the age of 60 or 65. In all likelihood, by personal choice or economic circumstances forced by corporations to leave the workforce by 40-45 years of age. Given the inflation rates we have, the floating rate system will either force the borrower to increase tenure of the loan to keep the EMIs constant or hike the EMI to such dramatic levels that the only possible thing s/he can pay back is the EMI without any food or means of transport. Even a young borrower who is in the 30-35 year age bracket today and has paid off 3 years to 4 years of the loan has only been servicing the interest obligations. Now to cope with the inflation, gloom cycles [post Lehman Brothers the average pay hike has been no more than 8% which just about pays off for the inflation at WPI levels. If we take the CPI levels, the mango man has been witnessing over 20% inflation YoY for the last 5 years] s/he takes the convenient option of keeping the same EMI and increasing the tenure. Banks are happy to book additional interest income but we are slowly coming to a stage where a huge proportion of these home loans will not be serviced completely till the time the person reaches the age of 65!

II - Housing prices will increase in perpetuity regardless of economic boom and bust. During bear markets, there will be some reasonable correction in the property prices and everything will be good to great again.

III - Since there is no leverage taken by Indian banks and there is no sub-prime lending, the risk of default is minimal.

As far as the first flaw is concerned, I think the point is self illustratory. As far as the second point is concerned, we have enough evidence from housing markets of the globe that at some point of time, it stops growing and starts adjusting itself against inflation. Over heating of real estate prices goes to maniac proportions of vanity and then comes crash landing to levels of sanity. The entire price escalation is working at the moment because of the demand-supply imbalance and relatively easy lending that is coming through. The third point is fundamentally flawed because India's leverage has automatically entered the banking system courtesy high population and a flawed model of perpetual rise in property prices.

In the relentless hunger to fatten the Interest Income [which is the fundamental business model of a bank], the Indian banking system has set itself and the economy of India in jeopardy that will have the same proportion of another Lehman Brothers debacle if not more. The simple reason is that there are only 2 logical ways forward for a majority of the people who are servicing home loans for now

1] They are not a part of the workforce anymore and still have high amounts outstanding with the bank. The only way for banks to recover this would be to initiate a 'Sell' by rights of hypothecation and return the differential to the borrower. The first few deals might go through well and then we will have a domino effect of too many sellers to the extent that prices will keep pushing lower and lower [and as this goes on the interest income that has been accrued for in the banks' books have to be adjusted thereby driving book value lower, thereby leading stock price lower and it is a known fact that when banks start dropping, there is mayhem in an economy]

2] The banks themselves in a bid to recover at least the principal having gulped significant interest income already say we are not going to feast on interest income further. Yet again, this will have the same effect of writing off future interest income i.e. decreasing the book value and thereby decreasing the stock price and mayhem in the economy again.

And all of this we are simply taking from the retail home loan point of view. This does not take into account the astronomical loans made to the realty sector most of which has been siphoned off in benaami transactions, blown up already on the stock markets and have very little probability of coming back to the banks.

So one of the most secure lending practices country has somehow walked into a quicksand that is almost in a point of no return now. It is hence not surprising at all that there was a lot of ruckus on the teaser rates proposal by the banks. As I put this up, I know for a fact that most experts on our economy will rubbish these claims. It is almost obvious that we will see a phase of slow growth in 2012/2013 and then bounce back in 2014 and all of this will be completely forgotten. The only thing is that with passage of time, these problems are simply going to aggravate and at some point of time hit us so hard that there will be no place to hide.

2 critical events last week that alerted me to the possibility of a gross failure in the Indian banking system

1] I happened to read an article in Times of India, Business Section online where there was one article on how the tenure of a home loan increased to 34 years to keep the EMI on the home loan constant [whew - from 20 years to 34 years of home loan tenure]

2] I had an issue with a payment regarding my HSBC Credit Card. The person following up on the issue did not seem to talk like a regular HSBC Credit Card Customer Service Executive. I was quite vociferous in the way the case was being handled and I told the person, 'Sir, please put me on to the person in the REAL HSBC as I do not want to waste my time with some sub-agency who is confused as to how this issue needs to be resolved'. Pat came the reply, 'Sir, HSBC has sold a huge chunk of its Credit Card portfolio to us [TCS in this case] and I as the Manager of Risk Management team am the right person
[and this has set me thinking that at some point of time, this is all starting to follow the path followed by the US banking crisis where the big banks had mortgage agencies in between to keep the risk off their books only to collapse at some point of time earlier. I would not be surprised to see articles in future talking about mortage portfolios being sold off to other agencies or NBFCs or Private Equity players but still a collapse can be imminent]

To see how an agency comes in between the end borrower and the end lender with everything supposedly ok, watch this video made by CNBC Videos digging out the anatomy of the US Housing Market crisis titled
'House of Cards'.

This is the Link 'House of Cards'

Let us leave ideologies aside and as a mango person of India think what needs to be done for securing our future

If you have not yet bought a house and are living on rented property, by all means continue to do so. There is absolutely no point in buying a house now at these astronomical prices. Assuming that even in the next 2 years, this financial mess won't surface [i.e. we will just re-witness 2008], it still leaves enough room for 15% to 20% correction in the next 12 to 18 months. Make sure that you are high on cash to pay off the downpayments. Keep some additional cash at hand and use significant dips on the bourses to buy some stocks. If indeed we are going to simply re-witness the 2008-2010 scenario, we are looking at doubling or tripling our net worth in 2 years time at which time profits can be booked and used to pay off huge chunks of the home loan.

If you already have a home loan and have a loan outstanding against your home, take a hard look at the current situation of the principal and interest. Banks will go on telling you don't pay off your home loan quickly as it is money coming at cheap rates to you and can be deployed elsewhere. This premise is true when there is a bear market situation and good fundamental stocks are also badgered to the core. However, when bull market conditions prevail, it is prudent to book profits on the bourses and pay off the banks. The tax shield on the interest is hardly anything compared to the interest.

In fact 3 people I am extremely thankful to in this regard are my father, my aunt and my uncle. My father's philosophy from the beginning has been even if it is just 1 match box house, go ahead and take it. Your income may double in 5 years but you won't be able to buy a house at the astronomical prices then. So I was lucky to get into a deal in 2005 at reasonable prices. Whilst my broker keeps reminding me from time to time that the price of the house has more than tripled now, I hardly give any credence to it. I need that place to stay eventually when I return to India. If I have to sell the place and take a bigger price, the prices of the next house are also going to be astronomical. My uncle who stays in the country side always says a loan against your name is akin to carrying a mountain on your head. and a pot of water with holes all over. No matter how much you fill the water, there is significant leakage. My aunt says that a loan outstanding is akin to insomnia. It deprives people of peace and is a prime cause of mental depression.

I still have a loan outstanding in my name and since I am outside of India, I have let out my place. The rental income is just enough to take care of the mortgage and that helps me repay off some extra amounts from time to time.

This brings me to the next major flaw in people buying houses beyond what the pocket permits thinking that the rental income will offset the EMI. Sorry, those days are gone. Only for houses purchased before 2005-2006 does this hold true. Given today's astronomical prices, the rental won't cover even 50% of the EMI in most cases. In one of the interviews last year, Ms Chanda Kochar of ICICI Bank very proudly said that Indian Banking systems are good enough and do not allow the use of a house as an ATM machine. I totally agree with her on that and at this point of time, India is really lucky that such practices are not allowed. There have been instances of financing arms of various banks and arms come and lure people into Mortgage Loans, Restructuring Options but the bottom line today is that the entire model on which the home loan concept has grown in India is wrong.

The risk management aspects have only taken care of known variables but have not factored a reasonable sum when it comes to systemic risk. As with any Capital Asset Pricing Model, there is a certain degree of systemic risk that cannot be avoided be it any asset class. Unfortunately, whilst we have good models for systemic risk on stock markets and credit cards, the same is not the case with our housing markets. Sooner or later this bubble is going to burst and no government is going to bail us out. The west is already collapsing and will continue to do so for another 25 years.

The Great Indian Banking Industry will at some point of time join the Extra-Ordinary Hall of Shame like all western banks have done so. I am a proud Indian but certainly a very disappointed Indian with the way our own banks are ruining our financial future for a long time to come. If the current inflation was not enough for us, our banking system has completely set us up for hyper-inflation and we the mango people have no where to hide. First, our banks robbed us of genuine interest due in SB accounts with some strange calculations of average balances. This entire gamut of averaging out on monthly quarterly basis meant that even if for 1 day in a month or quarter we had a balance less than the stipulated amount, we were deprived of interest rightfully due to us. They added up layers of bureaucratic structures that simply bloat the costs for banks so much that there are hundreds of bank branches that cost far more than the business they generate. Who pays for all of this? We the mango people and we pay thrice - once through taxes, once through interest and once through inflation. At some point of time, we will be paying for the fourth instance - bailouts!!!

Indian Banks Today = Hall of Fame
Indian Banks Future = Hall of Shame
NBFCs = Shameless Forever

Date: 12th September 2011
Time: 20:43
Place: La Coruna, Spain