Pricing: Loan against property v/s home loan

Simplified Definitions

Mortgage Loan/Loan Against Property (LAP):A mortgage loan is given for an open end use and is given against the lien of a property.

Home Loan: is given for a restricted purpose of buying/ constructing a house to stay.

Typically a mortgage loan is often the most common way of raising funds for growing the business. Banks typically get comfort from the availability of fixed collateral to be able to recover from in case of loan default.

The rate of interest charged on a Loan Against Property is higher (much higher) than a Home Loan.

Historically, default rates of LAP (for business purposes) have been high justifying a high rate of interest.

Why?

Question 1: Is the assessment of loan eligibility for LAP done assuming that cash flows from the business will grow due to utilisation of the funded amount for capex/WC use? If that is not the case, why would the default happen?

Question 1 a.) why can’t we give the loan based on existing cash flows?

People say that the loan size would be too small and not meet the requirement for the capex. My comment on that response would be “Oh common! let’s grow step by step. Give me some other reason”.

Question 2: Why doesn’t the “emotional attachment” story that works in case of home loan doesn’t work for LAP?

Question 2. a.) Does the person seeking a LAP have multiple properties and so property offered on mortgage has lesser “Emotional attachment”?

Guess so.

(Also, the question is how enforceable is the mortgage? In a lot of cases, especially developing countries, legal recourse may just be too cumbersome/ inefficient. So, isn’t the collateral acting more as a deterrent. I guess it is.)

Question 3: Would a LAP given based on existing cash flows AND after taking the owners current residential home as collateral completely change the loan performance?

That is what a number of financial institutions are now trying out with the lower income/informal sector entrepreneurs. Assess loan eligibility based on current cash flows and take the residential property of the entrepreneur as collateral. However, the interest rates continue to be higher going with the notion that LAP has generally resulted in high defaults. Interestingly, last 3 year’s history in these kind of loans show very low (between 0.5- 1 % delinquency in the 90 days past due bucket). Off course, three years is not enough time but these 3 years have been the roughest phase for business in India in general as well. The other key reason for good portfolio performance could be that this type of lending is new and the good quality selection could be due to the initial “start-up precautions” taken by the financial institutions starting this product.

Assuming loan performance does show improvement in this kind of loans, is there a reason to suggest lower interest rates and hence greater affordability?

At last but very important, one oft stated reason for low home loan interest rates is that the purchase of home does not generate additional revenue but LAP for small business does and hence the borrower can pay a premium. For all practical purposes, this reasoning silences all the discussion and the confusion around the pricing by simply stating that the lender wants his pound of flesh! That’s all!

What do you think?

Advertisements

Housing and Housing Finance (Part-3)

In addition to the points discussed in the earlier post, there are a few other key elements that go a long way in ensuring access to finance. Two major aspects are discussed in this last post of this series.

Credit Infrastructure: In addition to the above, comprehensive credit information systems, reliable information on house transactions and prices and mortgage registries improve transparency in the process of credit evaluation for housing loans and thereby improve the ability of housing finance companies to build a less risky portfolio.  Interestingly, a lot of work has been done in these spaces over the last couple of years. Significant growth in borrower information in credit bureau databases and mortgage registries like CERSAI as well as measures like the RESIDEX are great beginnings.

Customer Protection: While all of the above are important in increasing the flow of credit to the lower income or informal sector households, an associated issue is that of customer protection. A robust financial architecture is built on strong customer protection norms and this can be achieved only if the originator is directly liable for the appropriateness of the financial product being sold by them to their customer. This becomes all the more important in the case of the informal sector and lower income borrower because the cash flows and risks faced by such a borrower are very different from a standard salaried home loan customer.

At this point of time, all of us in the financial sector need to take a hard look at the issue of customer protection and frame appropriate guidelines for the same. Regulators are best placed to initiate such measures which look at a shift from the conventional financial literacy and disclosure based approaches of customer protection to a more involved engagement of the originators, where they take responsibility for ensuring the right housing finance product is offered to each class of customer.

(While thoughts are mine, I can’t deny that a lot of these thoughts have been shaped by the organisation I work for. I owe a lot of the thinking to IFMR Trust. IFMR Trust does extensive work in the access to finance space and has built several high quality institutions that enable access to finance.)

Housing and Housing Finance (Part -2)

The Indian policymakers and regulators have been fairly active in ensuring that through a mix of adequate policies and regulatory measures there is the right kind of stimulus to keep the housing finance market growing in India. In fact, with the expansion of housing finance institutions and regulatory and fiscal support, mortgage interest rates have come down from 16% in the mid 1990’s to 9% in the early part of the last decade, especially for the middle and higher income segments. The mortgage industry has consistently grown at an average rate of 40% annually. Increased availability of affordable housing finance has resulted in home ownership amongst a much younger group of citizens. Studies reveal that the average age of a house owner has come down by twenty years in the last decade. However, this phenomenon has been limited to the middle class and high income segment of the country and the lower income groups and economically weaker sections have remained almost completely out of this growth story.

High Quality Origination: The households falling under low income and economically weaker sections category, especially from the informal sector have little or no means to access finance from an organised channel. The current structure and processes within large housing finance companies and banks do not permit them to lend to these segments primarily due to lack of evidence of income. Recently, a number of specialised housing finance companies have come up that are catering to the housing finance needs of the economically weaker sections and lower income informal segment households. Such housing finance companies have developed well defined processes that help them to evaluate the informal sector customer. This is something that banks and large HFCs find difficult to do. Such new and specialised originators are fairly small in size but are growing at a rapid pace. They understand the real cash flows and risks faced by the low income or informal sector borrower and have better capability to underwrite the loans given to an informal sector customer. This is a good sign and more such institutions need to be promoted on the ground.

Risk Aggregation and Orderly Risk Transfer: While these specialised housing finance companies have developed expertise in evaluating the low income informal sector customer, what many of them  lack is the balance sheet strength to hold on to the risk, especially since housing loans are also of longer tenor.  There is also a great need to diversify funding sources for each of these originators to reduce the shocks that these companies might face due to drying up of limited sources of funding. There is significant opportunity in this space for larger financial institutions to activate triggering the growth of smaller financial institutions by lending to the smaller HFCs or participating directly in the process of lending to the lower income and informal segment borrowers through adequate risk sharing mechanisms with the small HFC. In addition, off balance sheet structures like securitisation need to be considered for a well-rounded risk management strategy for such small entities. It is essential that there is regular and orderly flow of assets from these high quality specialised originators to larger debt capital market investors who have the capacity to hold on to risk and have long-dated liabilities, thus enabling the smaller specialised originators to reach out to more and more borrowers in the informal and low income segment.  Strengthening the domestic debt capital markets through participation of institutions/investors such as insurance companies and mutual funds in mortgage-backed securities will go a long way in complementing the efforts of domestic commercial banks.

NHB has an important role to play in the development of these markets and may wish to explore further its role as a market maker of these securities and loans, act as a second-loss provider or guarantee provider for bonds of smaller lower rated but high quality originators to add to its role as a direct lender and re-financier. Significant work also needs to be done on rationalising the legal framework around mortgage backed transactions to permit more cost efficient and flexible structures. The legal framework around mortgages has held back the development of mortgage backed securitisation market in India. This has to be altered to lead to a more conducive environment.

Housing and Housing Finance in India (Part-1)

Housing is a significant engine for growth and development of any economy. Safe, hygienic and affordable housing has a direct impact on the quality of life and health of households, leading to a better civil society and higher productivity at work. Moreover, the housing construction sector itself leads to direct and indirect employment to a large number of people in several associated industries. The Government, the RBI and the NHB have been consistently working towards achieving the goal of housing for all.

A major policy concern, however, with respect to housing has been the severe mismatch between the demand and supply of housing units especially for the economically weaker section and lower income groups. As per Technical Group on Urban Housing Shortage (2012-17), more than 95% of such housing shortage in urban areas is in the EWS and LIG category. The Working Group on Rural Housing for the Twelfth Five Year Plan (2012-17) has estimated the total housing shortage in rural areas at 43.67 million units. It is also of major concern that 90% of the rural housing shortage (approximately, 39.30 million units) are in respect of Economically Weaker Sections.

In this backdrop we have to note a few key underlying issues. There has been large scale migration of people from rural and smaller urban centres to a handful of large cities over the past few decades. This has resulted in extremely high demand for housing in these cities leading to escalation of property prices and thereby making most housing in big cities beyond the reach of even the middle class. This has not only led to the peculiar problem of large number of highly priced unoccupied/unsold houses in spite of the country having a large housing shortage, it has also led to severe challenges to the civic infrastructure and service delivery capabilities of these cities adding to the exclusion. It is imperative that for a more inclusive future, in addition to direct measures like improving affordability of housing in the larger cities and enabling easier home finance options, alternate strategies like building rental housing options for economically weaker sections and development of smaller urban centres would be key.

While there are a host of issues to be addressed in order to create an enabling environment in the country that results in adequate and proper housing for all, let us focus on the access to housing finance challenge in the next few posts.

Interest Rates

When the interest rates are high, the manufacturing industries slow down capital investment to avoid bearing high cost of investments and hence lead to flattening of long term growth.
When the interest rates are low, the manufacturing industries intensify capital investments, leading to higher levels of automation and hence leading to increased levels of unemployment in the long term.
Off course, it is much more complicated than that but what is the right interest rate to have?

Insights from G2012 Mexico Financial Inclusion Twitter Conference

On 25th July, 2012 I was invited to participate in the G2012 Twitter Conference on Financial Inclusion organised by Ashoka Changemakers and G2012 Mexico. There were three back to back sessions over six hours focused on technology and financial inclusion, financing livelihoods, and the future of financial inclusion innovation. I participated in the Session on Livelihoods Financing. Overall, it was quite an interesting conversation. Here is a blog post on the conference summarizing the key discussion points.

Interestingly, the blog says ” The Twitter conference gathered more than 150 experts, thought leaders, social entrepreneurs, and innovators from different parts of the world. It reached almost half a million Twitter accounts and involved simultaneous conversations in English, Spanish, and Portuguese.” That is huge!

Access to Credit: Financing Options for Farmer Producer Organisations (FPOs)

FWWB and SFAC organized a Round  Table Discussion (RTD) forum on July 31st, 2012. I had the opportunity to attend the RTD and talk about the possibilities of enabling innovative market based financing solutions for Producer Organisations. Needless to say, it was one of those rare gatherings with everybody from policymakers to practitioners being present in the same room. The RTD was very well represented by Academia, FPO promoting organisations, Financial Insitutions, Donor Organisations and others.

The minutes of the meeting can be found here. (RT- Delhi – July 31 2012)

The organisers:

Small Farmers’ Agri-Business Consortium (SFAC) was set up in 1994 by the Governement of India. SFAC has emerged as a Developmental Institution with its core aims and objectives focused on increased production and productivity, value addition, provision of efficient linkages between producers and consumers. SFAC deals with agriculture in its wider connotation, including fisheries and horticulture.

Friends of Women World Banking (FWWB): In 1982, promoted by SEWA, Friends of Women’s World Banking, India (FWWB-I) was created as one of the first few affiliates of Women’s World Banking.

Why go cashless?

We want to make cashless payments to farmers, rural labourers directly to their bank accounts and hand them over a card which they can use to transact “business”.

By removing cash from the system, we have managed to remove chances of “middlemen” (our very own people handling payments) siphoning money out of the system before it reaches the farmer or the labourer.

But then, what does the farmer do with the card? Where does he get the cash? Nobody in his immediate neighbourhood accepts cards! He needs to pay cash to buy his food!

He has to go to the bank which is in the next town to draw cash from the bank. All the farmers/labourers in his area get the transfer on the same day and so on one day of the month the bank branch in the nearby town is packed with villagers looking to withdraw their cash. It is a nightmare for the bankers and the villagers because they have to wait for hours and they have spend money and one full day to go the town.

To solve the problem, we got agents who carry a small authentication device and a bag full of cash. The agent then delivers the cash to the farmers at his doorstep. What if the agent gets the authentication and then does not pay the full amount of due like the earlier “paymaster”. Off course, the agents are “recruited” by organisations and hence the villagers have an institutional “back-end” to file complaints and given that this institution is smaller than Govt, it should be more responsive compared to the big Government machinery. But, does it really happen that way?

Moreover, the agent runs the risk of being robbed/killed because of the amount of cash that he is carrying. How do you prevent that?

What is the way out? Carry on with this till the kirana shops in the villages accept cards for payments? Given that mobile is now ubiquitous, how about mobile payments? How complicated is that?

An interesting article on the PSD World Bank blog: Read