Themes > Current Issues
09.02.2011
Teaser Mania
C.P. Chandrasekhar
It
may have been the mood evoked by Davos. Or it may be the ''confidence''
that comes at the fag end of a successful tenure. But State Bank of
India Chairman Om Prakash Bhatt took many by surprise when he defended
the ''teaser'' loan scheme for housing that the Reserve Bank of India
has been advising banks to withdraw (See Indian Express, 31 January
2011).
Teaser loans, which gained in notoriety in the run up to sub-prime crisis in the United States, offer loans for housing that involve relatively low interest rates during the early phases of the loan. These rates are then reset and instalments on the loan hiked substantially to cover the full charges due on the loan during its tenure at the appropriate interest and amortisation rate.
It should be obvious that teaser rates are offered to attract borrowers, some of whom may have stayed out of the market if higher rates were applicable immediately. The difficulty is that some of these borrowers may be making erroneous projections of future incomes or not even calculating the burden they would have to carry when rates are reset. In addition, if the rates charged when they are reset are floating rates, borrowers may not have factored in the danger of an increase in the interest costs that may ensue. In the event, borrowers who may not be in a position to carry the repayment burden may be drawn into the universe of borrowers.
Bhatt’s defence of the scheme in India is four-fold. First, that when checking the eligibility of a borrower, what is examined is his or her ability to repay the loan at the higher interest rate that kicks in during the later phases of the loan. Second, that (for reasons that are not clear) for ''anyone who takes a home loan, repayment is generally difficult in the first two-three years.'' Third that since teaser rates are being charged on loans of smaller sizes (less than Rs. 10 lakh), they benefit the aam admi. And, finally, that NPAs on home loans are the lowest and the bank has the benefit of the client’s house as collateral to ensure the safety of the credit asset.
The first two of these arguments are without substance. If clients are those who are seen as being able to cover the higher rate, the reason why they are being offered a teaser in the first instance is not clear. And if they are worthy borrowers of this kind, the argument that they would find it difficult to pay their instalments in the first year or two and then feel comfortable to do so is also a bit difficult to swallow. The point is that Mr. Bhatt should know otherwise. The debate on teaser loans is no invention of the Reserve Bank of India. It has arisen out of what experience has taught us in other contexts, including during the recent sub-prime crisis.
From the point of view of banks opting for teaser rate loans, such rates are essentially a means of expanding their retail lending business. If that is the motivation, driven by say access to additional cheap liquidity, banks may be less diligent when assessing the eligibility of borrowers. This has consequences both positive and negative. Lending practices that seek to attract borrowers kept out of credit markets in the past are indeed democratic, inasmuch as they deliver credit to those who could not access credit before. When this occurs in the housing market, it does, through market mediated mechanisms, expand the population that is able to own their own homes. However, one fall-out of this tendency could be an increase in lending to less creditworthy or sub-prime borrowers and therefore in the proportion of defaults and foreclosures. When defaults are not too high foreclosures permit recovering the capital lent out by the banks. But if defaults and foreclosures proliferate, housing markets are bound to be depressed making it difficult for banks to recover their capital. Hence, when loan pushing is stretched beyond a point and continues for long, default percentages can rise to levels where they could affect the viability of individual banks and the banking system. This is what partly happened during the sub-prime crisis.
It is in this background that we need to assess the apprehensions expressed by India’s banking regulator, the Reserve Bank of India, regarding lending for housing purchases in general and lending based on teaser loans in particular. It has been known for some time now that, facilitated and encouraged by financial liberalisation, Indian banks have been following international trends and expanding their retail lending substantially, so much so that well above a fifth of commercial bank advances are now to the retail sector. A very high proportion of those advances have been to housing, which finances an asset that serves as the best collateral. Hence, early into this trend the RBI had cautioned banks against excessive exposure to the housing market. Yet banks not only expanded such lending but opted to push credit for housing using schemes such as teaser rate loans.
In response, the regulator has through a series of measures sought to rein in such ending. In its Annual Policy Statement for 2006-07 the Reserve Bank of India increased the general provisioning requirement for residential housing loans exceeding Rs 20 lakh from 0.40 per cent to 1.0 per cent. Subsequently, the RBI warned banks against resorting to teaser interest rates, given the experience with the consequences of such rates in the US and other contexts. However, the risk weight on bank exposure to housing loans continued to be kept low and a substantial segment of home loans falling below Rs. 20 lakhs were kept within the ambit of the ''priority sector'', which consists of a combination of sectors like agriculture and small-scale industry to which a specified minimum percentage of total lending is required to be directed by the banks (40 per cent for the scheduled commercial banks). This treatment of housing as a priority sector is partly because the government has not been able to provide adequate volumes of affordable housing. However, in the process India may be encouraging a trend that increases the fragility of the housing finance market and therefore of the financial and the real economy.
That the RBI fears such a trend emerges from its monetary policy review for the second quarter of 2010-11, in which it sent out a strong signal that it wants the commercial banking system to rein in the boom in housing finance. The RBI’s concern could be traced to the evidence of a spike in lending for housing. Over the period April 1 to September 25, 2010, for example, housing credit increased by Rs. 16,195 crore as compared to Rs. 7,891 crore over the corresponding period of the previous financial year. What is more, during the 5-month April to August period net credit provided by the housing finance companies also rose by Rs. 7,519 crore as compared with Rs. 3,581 crore during six months stretching from April to September 2009. Among the techniques used by banks to expand this market was, of course, the practice of offering these loans at lower ''teaser'' interest rates during the first few years, with the rates being subsequently reset to much higher levels.
Realising that such practices tend to attract sub-prime borrowers the RBI opted for four sets of measures. First, it put a ceiling of 80 per cent on the Loan to Value (LTV) ratio, which reduces leverage by requiring borrowers to commit their own equity to the extent of at least 20 per cent of the value of the asset at the very beginning. This reduces the risk burden on the lender. Second, in a reversal of policies adopted earlier it has decided to raise the average risk weight associated with larger housing loans. A higher risk weight requires banks to set aside a larger volume of regulatory capital for a given loan size. When the risk weight on a particular credit type is 100 per cent and the capital adequacy requirement is 12 per cent, capital equivalent to 12 per cent of the loan has to be invested in specified ''regulatory'' assets. Since regulatory capital is supposed to be in forms that are safe and relatively liquid, the return on such assets is lower and reduces average bank revenues. So increasing risk weights on any kind of lending is expected to discourage that kind of lending.
Third, the RBI sent out a strong cautionary signal with regard to the practice of offering teaser rates. In its view: ''This practice raises concern as some borrowers may find it difficult to service the loans once the normal interest rate, which is higher than the rate applicable in the initial years, becomes effective. It has been observed that many banks at the time of initial loan appraisal do not take into account the repaying capacity of the borrower at normal lending rates.'' Finally, having recognised that loans offered with teaser interest rates have higher risk associated with them, the RBI decided to increase the provisioning required for these assets categorised as standard assets from 0.40 per cent to 2 per cent, so as to take care of that subset of loans that turns non-performing. The message from the central bank is clear. India may have avoided a crisis of the sub-prime type, but it remains prone to such crises. Regulation and control are, therefore, a must.
If Mr. Bhatt is peeved by these measures it could be due to two reasons. First, he possibly would prefer to lend more to housing when seeking to meet his priority sector targets, since that would allow meeting a social responsibility while ensuring a decent return. Second, it is an area of lending outside the productive sectors that assures a good return, which he feels that the SBI should exploit. As he put it: ''Everybody knows, I got a surplus of Rs. 1 lakh crore then. If I have to park it at the RBI, I get only 3.5 per cent. What I did was reduce the rate of interest to 8 per cent and removed the cap on loans, so (borrowers?) could even take Rs 1 crore. What wrong did we do?'' Perceptions like this amount to saying that the State Bank of India whch has always been a publicly owned bank and presented as a trend setter for social banking should be allowed to behave like any private bank with a thirst for speculative profit. Thankfully, the RBI does not think so. What is unclear is why Bhatt has decided to go public on this at this stage in his tenure.
Teaser loans, which gained in notoriety in the run up to sub-prime crisis in the United States, offer loans for housing that involve relatively low interest rates during the early phases of the loan. These rates are then reset and instalments on the loan hiked substantially to cover the full charges due on the loan during its tenure at the appropriate interest and amortisation rate.
It should be obvious that teaser rates are offered to attract borrowers, some of whom may have stayed out of the market if higher rates were applicable immediately. The difficulty is that some of these borrowers may be making erroneous projections of future incomes or not even calculating the burden they would have to carry when rates are reset. In addition, if the rates charged when they are reset are floating rates, borrowers may not have factored in the danger of an increase in the interest costs that may ensue. In the event, borrowers who may not be in a position to carry the repayment burden may be drawn into the universe of borrowers.
Bhatt’s defence of the scheme in India is four-fold. First, that when checking the eligibility of a borrower, what is examined is his or her ability to repay the loan at the higher interest rate that kicks in during the later phases of the loan. Second, that (for reasons that are not clear) for ''anyone who takes a home loan, repayment is generally difficult in the first two-three years.'' Third that since teaser rates are being charged on loans of smaller sizes (less than Rs. 10 lakh), they benefit the aam admi. And, finally, that NPAs on home loans are the lowest and the bank has the benefit of the client’s house as collateral to ensure the safety of the credit asset.
The first two of these arguments are without substance. If clients are those who are seen as being able to cover the higher rate, the reason why they are being offered a teaser in the first instance is not clear. And if they are worthy borrowers of this kind, the argument that they would find it difficult to pay their instalments in the first year or two and then feel comfortable to do so is also a bit difficult to swallow. The point is that Mr. Bhatt should know otherwise. The debate on teaser loans is no invention of the Reserve Bank of India. It has arisen out of what experience has taught us in other contexts, including during the recent sub-prime crisis.
From the point of view of banks opting for teaser rate loans, such rates are essentially a means of expanding their retail lending business. If that is the motivation, driven by say access to additional cheap liquidity, banks may be less diligent when assessing the eligibility of borrowers. This has consequences both positive and negative. Lending practices that seek to attract borrowers kept out of credit markets in the past are indeed democratic, inasmuch as they deliver credit to those who could not access credit before. When this occurs in the housing market, it does, through market mediated mechanisms, expand the population that is able to own their own homes. However, one fall-out of this tendency could be an increase in lending to less creditworthy or sub-prime borrowers and therefore in the proportion of defaults and foreclosures. When defaults are not too high foreclosures permit recovering the capital lent out by the banks. But if defaults and foreclosures proliferate, housing markets are bound to be depressed making it difficult for banks to recover their capital. Hence, when loan pushing is stretched beyond a point and continues for long, default percentages can rise to levels where they could affect the viability of individual banks and the banking system. This is what partly happened during the sub-prime crisis.
It is in this background that we need to assess the apprehensions expressed by India’s banking regulator, the Reserve Bank of India, regarding lending for housing purchases in general and lending based on teaser loans in particular. It has been known for some time now that, facilitated and encouraged by financial liberalisation, Indian banks have been following international trends and expanding their retail lending substantially, so much so that well above a fifth of commercial bank advances are now to the retail sector. A very high proportion of those advances have been to housing, which finances an asset that serves as the best collateral. Hence, early into this trend the RBI had cautioned banks against excessive exposure to the housing market. Yet banks not only expanded such lending but opted to push credit for housing using schemes such as teaser rate loans.
In response, the regulator has through a series of measures sought to rein in such ending. In its Annual Policy Statement for 2006-07 the Reserve Bank of India increased the general provisioning requirement for residential housing loans exceeding Rs 20 lakh from 0.40 per cent to 1.0 per cent. Subsequently, the RBI warned banks against resorting to teaser interest rates, given the experience with the consequences of such rates in the US and other contexts. However, the risk weight on bank exposure to housing loans continued to be kept low and a substantial segment of home loans falling below Rs. 20 lakhs were kept within the ambit of the ''priority sector'', which consists of a combination of sectors like agriculture and small-scale industry to which a specified minimum percentage of total lending is required to be directed by the banks (40 per cent for the scheduled commercial banks). This treatment of housing as a priority sector is partly because the government has not been able to provide adequate volumes of affordable housing. However, in the process India may be encouraging a trend that increases the fragility of the housing finance market and therefore of the financial and the real economy.
That the RBI fears such a trend emerges from its monetary policy review for the second quarter of 2010-11, in which it sent out a strong signal that it wants the commercial banking system to rein in the boom in housing finance. The RBI’s concern could be traced to the evidence of a spike in lending for housing. Over the period April 1 to September 25, 2010, for example, housing credit increased by Rs. 16,195 crore as compared to Rs. 7,891 crore over the corresponding period of the previous financial year. What is more, during the 5-month April to August period net credit provided by the housing finance companies also rose by Rs. 7,519 crore as compared with Rs. 3,581 crore during six months stretching from April to September 2009. Among the techniques used by banks to expand this market was, of course, the practice of offering these loans at lower ''teaser'' interest rates during the first few years, with the rates being subsequently reset to much higher levels.
Realising that such practices tend to attract sub-prime borrowers the RBI opted for four sets of measures. First, it put a ceiling of 80 per cent on the Loan to Value (LTV) ratio, which reduces leverage by requiring borrowers to commit their own equity to the extent of at least 20 per cent of the value of the asset at the very beginning. This reduces the risk burden on the lender. Second, in a reversal of policies adopted earlier it has decided to raise the average risk weight associated with larger housing loans. A higher risk weight requires banks to set aside a larger volume of regulatory capital for a given loan size. When the risk weight on a particular credit type is 100 per cent and the capital adequacy requirement is 12 per cent, capital equivalent to 12 per cent of the loan has to be invested in specified ''regulatory'' assets. Since regulatory capital is supposed to be in forms that are safe and relatively liquid, the return on such assets is lower and reduces average bank revenues. So increasing risk weights on any kind of lending is expected to discourage that kind of lending.
Third, the RBI sent out a strong cautionary signal with regard to the practice of offering teaser rates. In its view: ''This practice raises concern as some borrowers may find it difficult to service the loans once the normal interest rate, which is higher than the rate applicable in the initial years, becomes effective. It has been observed that many banks at the time of initial loan appraisal do not take into account the repaying capacity of the borrower at normal lending rates.'' Finally, having recognised that loans offered with teaser interest rates have higher risk associated with them, the RBI decided to increase the provisioning required for these assets categorised as standard assets from 0.40 per cent to 2 per cent, so as to take care of that subset of loans that turns non-performing. The message from the central bank is clear. India may have avoided a crisis of the sub-prime type, but it remains prone to such crises. Regulation and control are, therefore, a must.
If Mr. Bhatt is peeved by these measures it could be due to two reasons. First, he possibly would prefer to lend more to housing when seeking to meet his priority sector targets, since that would allow meeting a social responsibility while ensuring a decent return. Second, it is an area of lending outside the productive sectors that assures a good return, which he feels that the SBI should exploit. As he put it: ''Everybody knows, I got a surplus of Rs. 1 lakh crore then. If I have to park it at the RBI, I get only 3.5 per cent. What I did was reduce the rate of interest to 8 per cent and removed the cap on loans, so (borrowers?) could even take Rs 1 crore. What wrong did we do?'' Perceptions like this amount to saying that the State Bank of India whch has always been a publicly owned bank and presented as a trend setter for social banking should be allowed to behave like any private bank with a thirst for speculative profit. Thankfully, the RBI does not think so. What is unclear is why Bhatt has decided to go public on this at this stage in his tenure.
© MACROSCAN 2011