Banks

India’s Big and Messy Real Estate Ponzi Scheme, Just Got Messier

 

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Over the last few years, many real estate companies across the country, particularly in Delhi and the National Capital Region (NCR), have taken money from home buyers and not been able to deliver promised homes on time.

Some of these companies have also taken loans from banks and defaulted on those loans as well. Basically, these companies have taken money from home buyers, they have also taken loans from banks, and still been unable to deliver the promised homes. In some cases, real estate companies have already booked sales on homes they are yet to deliver.

The question is where has this money gone?
I think there are two answers to the question. 1) Promoters of real estate companies have siphoned off a part of the loans they took on from banks and the money they took from buyers. 2) This money has been diverted for other uses, like completing previous projects and buying more land (or to put it in real estate parlance for building a formidable land bank).

Banks are now looking to recover their bad loans from real estate companies. And at the same time, the buyers are also hopeful that someday their dream homes will be delivered to them.

There are several interesting issues that crop up here:

a) It is now more or less clear that the real estate companies had been happily running a Ponzi scheme. A Ponzi scheme is basically a financial scam in which investors are promised very high returns. The money being invested by the second set of investors is used to pay off the first set. The money invested by the third set of investors is used to pay off the second set and so on. A Ponzi scheme runs until the money being invested in the scheme is greater than the money that is going to redeem the investment of the early investors. The moment this reverses, the scheme collapses.

The real estate companies essentially followed this model. They announced a new real estate project and then raised money against it. This money was then used to buy more land or simply siphoned off. Then a new project was announced. The money raised against the new project was used to complete the earlier project. Of course, I am simplifying things a bit here, but that was the basic modus operandi.

The key in this method of selling homes was the ability to keep launching new projects. Over the years, as real estate returns fell, the ability of real estate companies to launch new projects came own drastically. Once this happened, they couldn’t raise enough money to complete their existing projects. And this led to many buyers being left stranded in a rented home.

b) The inability to deliver on promised homes along with low returns has put off people from investing in real estate. The falling interest in owning real estate becomes clear from the savings figures as well. As per the recently released annual report of the Reserve Bank of India, in 2012-2013, savings in physical assets made up for 14.4 per cent of the gross national disposable income (GNDI). By 2015-2016 this had fallen to 10.7 per cent of the GNDI. GNDI is a concept similar to GDP which also takes remittances from abroad and food aid into account. India’s GNDI is around 1.03 times its gross domestic product.

c) A bulk of the buyers had bought homes by taking on home loans from banks. They are currently paying EMIs against these loans. They are also paying a rent to live in the homes that they currently do. Given this, they are monetarily stretched. Further, they are paying an EMI for an asset which they haven’t got as yet and will probably never get in the form they had originally envisaged.

d) When prospective buyers take a home loan from a bank, the home they are buying is the collateral or the security against the loan that is taken. In many cases, the real estate companies have offered these homes against which home loans had already been taken, as a collateral to the banks, and taken on more loans. So, the buyers have been taken for a ride here. Also, the question is how have banks allowed dual financing on the same asset?

It is worth remembering here that many real estate companies which have defaulted on banks loans and delivering homes, worked on a pay as you build model. This basically meant that these companies got paid in instalments from the buyers at every stage of construction.

Hence, the homes were technically owned by the buyer (or to put it more specifically the bank from which the buyer had taken on a home loan) and could not have been offered as a collateral, without the consent of the buyer. Nevertheless, that seems to have happened. This is something that the banks need to explain. (In case you want to understand dual financing in even more detail click here and here).

e) So, where does that leave the buyer? Recently, bankruptcy proceedings have been started against Jaypee Infratech which took money from more than 30,000 buyers and did not deliver on the promised homes. At the same time, it has defaulted on bank loans. The Supreme Court has stayed these proceedings.

The Bankruptcy and Insolvency Code in its current form does not leave anything for the buyers. The buyers are not on the list of entities that will be compensated for payment of what is due to them once the company is liquidated. From the legal point of view this makes sense given that the money that the buyers had handed over to the real estate companies was basically an advance and not a loan. But then given that thousands of families are involved, should only the legal view prevail is a question even though tricky, worth asking.

Of course, the bureaucrats who wrote the bankruptcy code did not take the real estate sector and the way it operates, into account. This is something that the government should hopefully correct for in the days to come.

f) Suggestions are now being made that like the banks, the buyers should also be ready for a haircut (i.e. be ready to accept a part of the money they had invested with a real estate company to buy a flat and not the entire amount). The trouble with this argument is that for the banks, the bad loans of real estate companies are just a part of their overall bad loans. For the buyers, the money they invested with real estate companies was probably the biggest investment they ever made and if they have to take a haircut on it, they will probably never recover financially from it.

The Supreme Court now needs to decide whether the buyers are financial creditors or not. This is a tricky question, which I shall elaborate on later in the days to come.

g) In all this, the real estate promoters seem to be having the last laugh. A part of the money they borrowed from banks and took from real estate buyers, has been tunnelled out. It is hardly likely that the bankers will be able to go after their other assets (i.e. the land bank they built by tunnelling out money) in order to recover their loans. Hence, they have clearly managed to limit their losses.

In fact, in a fair world, the balance sheets of these real estate companies would have been subjected to forensic accounting in order to figure out where did the money go. But the bankruptcy code has no such provision. If it did that would inevitably delay the resolution process.

And this brings me back to the point that I keep making for all my readers who forever seem to want solutions to all problems; everything in India does not have a clear solution.

Of course, now the central government will have to get involved if this issue has to be sorted at any level. I only hope that they try and arrive at a private sector solution and the taxpayer money is not used in any form. Already, a section of the real estate sector is talking about a government bailout. If the builders in India don’t have money, who does?

To conclude, the mess in the real estate sector in India is an excellent example of what follows when a Ponzi scheme goes bust. And as they like to say in Hollywood films, you ain’t seen nothin’ yet. Keep watching.

The column originally appeared on Equitymaster.com on September 11, 2017.

The Bank Ponzi Scheme

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Every six months the Reserve Bank of India (RBI) publishes a document titled the Financial Stability Report . In the December 2011 report, it pointed out that at 55 per cent, loans to the power sector constituted a major part of the lending to the infrastructure sector. It further said that restructured loans in the power sector were on their way up.

Restructured loans are essentially loans where the borrower has been given a moratorium during which he does not have to repay the principal amount. In some cases, even the interest need not be paid. In some other cases, the tenure of the loan has been increased.

This was nearly five and a half years back, and the first time the RBI admitted that there was a problem in the bank lending to the power sector. In the December 2012 report, the RBI said: “There are also early signs of corporate leverage rising among the several industrial groups with large exposure to infrastructure sectors like power.”

When translated into simple English this basically means that many big industrial groups which had taken on loans to finance power projects had borrowed more money than they would be in a position to repay.

In the years to come by, other sectors along with the power sector also became a part of the RBI commentary on loans which were likely not to be repaid in the future. In the June 2013 report, the central bank said: “Within the industrial sector, a few sub-sectors, namely; Iron & Steel, Textile, Infrastructure, Power generation and Telecommunications; have become a cause of concern.”

In the December 2013 report, the RBI said: “There are five sectors, namely, Infrastructure [of which power is a part], Iron & Steel, Textiles, Aviation and Mining which have high level of stressed advances. At system level, these five sectors together contribute around 24 percent of total advances of scheduled commercial banks, and account for around 51 per cent of their total stressed advances.”

Dear Reader, the point I am trying to make here is that the RBI knew about a crisis brewing in the industrial sector as a whole, and power and steel sector in particular, for a while. In fact, in the June 2015 report, the RBI pointed out: “the debt servicing ability of power generation companies [which are a part of the infrastructure sector] in the near term may continue to remain weak given the high leverage and weak cash flows.”

The funny thing is that while the RBI was putting out these warnings, the banks were simply ignoring them and lending more to these sectors. Between July 2014 and July 2015, banks gave out Rs 86,500 crore, or 71.5 per cent, of the Rs. 1,20,900 crore that they had lent to industry to the two most troubled sectors, namely, power and iron and steel.

What was happening here? The banks were giving new loans to the troubled companies who were not in a position to repay their debt. These new loans were being used by companies to pay off their old loans. A perfect Ponzi scheme if ever there was one. If the banks hadn’t given fresh loans, many of the companies in the power and the iron and steel sectors would have defaulted on their loans.

Hence, the banks gave these companies fresh loans in order to ensure that their loans didn’t turn into bad loans, and so, in the process, they managed to kick the can down the road. In the process, the loans outstanding to these companies grew and if they were not in a position to repay their loans 2-3 years back, there is no way they would be in a position to repay their loan now.

Many of these projects, as Raghuram Rajan put it in a November 2014 speech, “were structured up front with too little equity, sometimes borrowed by the promoter from elsewhere. And some promoters find ways to take out the equity as soon as the project gets going, so there really is no cushion when bad times hit.”

The corporates brought in too little of their own money into the project, and banks ended up over lending. Over lending also happened because many promoters in these sectors were basically crony capitalists close to politicians to whom banks couldn’t say no to.

Over and above this, the steel producers had to face falling steel prices as China dumped steel internationally. In case of power producers, plant load factors (actual electricity being produced as a proportion of total capacity) fell. Along with this, the spot prices of electricity also fell. This did not allow these companies to set high tariffs for power, required for them to generate enough money to repay loans.

All these reasons basically led to the Indian banks ending up in a mess, on the loans it gave to power and iron and steel prices.

The RBI has now put 12 stressed loan cases under the Insolvency Bankruptcy Code, in the hope of recovering bad loans from these companies. Not surprisingly, steel companies dominate the list.

The column originally appeared in the Daily News and Analysis on June 23, 2017.

 

The Budget Fails India’s Demographic Dividend

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The Economic Survey released on January 31, points out: “Over the next three decades… India… seems to be in a demographic sweet spot with its working-age population projected to grow by a third.”

Estimates suggest that a million Indians enter the workforce every month.  They are India’s demographic dividend. The hope is that as these Indians work, earn and spend money, India will grow at a faster growth rate than it currently is.

This theory works if and only if India’s demographic dividend can find jobs. And the question is where are the jobs?

As per the Report on Fifth Annual Employment – Unemployment Survey, the unemployment rate in India during 2015-2016 stood at 5 per cent. If a person is employed for 183 or more days during the year, he is considered to be employed.

Further, only 60.6 per cent of those who were available for work for 12 months of the year, found work all through the year. Hence, India’s problem is underemployment and not unemployment. There aren’t enough jobs going around for everyone. And in this scenario, the single most important focus of the Indian government should be to facilitate policies and create an environment in which jobs are created.

This should have been the focus of the annual budget of the central government as well. But the budget failed miserably on this front.

Take the case of public sector banks(PSBs) which are sitting on a huge amount of bad loans. In fact, in 2009-2010, 58.7 per cent of all banks loans went to industry. By 2015-2016, it was down to 13.4 per cent. In the last one year, industrial credit has contracted.

Unless, banks give loans to industry how will industries expand and jobs be created? But banks are in no mood to lend to industry given the huge amount of bad loans they have accumulated over the years by lending to industry. The budget makes no effort to come up with a holistic solution for bad loans of banks. Many piecemeal solutions have been tried and they have failed.

These banks require a large amount of capital to continue to function. In the budget for 2017-2018, the government has allocated just Rs 10,000 crore towards their recapitalisation.

An estimate made by Viral Acharya (now one of the deputy governors of the RBI) and Krishnamurthy Subramanian, suggests that in a prudent scenario PSBs would require around Rs 9,97,400 crore of capital. The government clearly doesn’t have this kind of money. In this scenario, it should be looking at exiting out of the ownership of most of these banks. But nothing of that sort has been suggested either in the budget or otherwise.

Over and above the PSBs, the government also continues to run loss-making companies which include an airline, a couple of telecom companies as well as a company which used to make photo-films. There was no mention in the budget about getting out of these companies.

In 2014-2015, the total losses of loss-making public sector enterprises stood at Rs 27,360 crore. Given the government’s total expenditure that is not a lot of money, but at the same keeping these companies going, does take away the focus and attention from other more important areas like education, health and agriculture.

At the same time, another factor that continues to hold back India are its labour laws. The Economic Survey talks about generating jobs in the apparel sector. The sector should be employing a large number of unskilled Indians entering the workforce. It has the ability to generate close to 24 jobs per one lakh rupees of investment. Rapid export growth can create close to a half a million jobs every year in the apparel as well as the leather goods sector.

But that is not happening primarily because an average Indian apparel and leather firm continues to be small and thus lacks economies of scale to compete globally. As the Economic Survey points out: “Indian apparel and leather firms are smaller compared to firms in say China, Bangladesh and Vietnam.”

This situation can be handled by ensuring that we simplify our labour laws. But no government worth its salt has been able to do anything about it till date. Nevertheless, if the government wants to handle India’s demographic divided well, it needs to simplify the labour laws and in the process help companies grow and create jobs.

If that does not happen, it is worth “remembering that demography provides potential and is not destiny”. And the budget was as good an opportunity as any to set this right.

The column originally appeared in Daily News and Analysis on February 2, 2017

 

Demonetisation: Can Indian Banks Handle Low Interest Rates?

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One of the benefits of demonetisation that is being bandied around is lower interest rates. Suddenly, banks are flush with a huge amount of deposits. The demonetised Rs 500 and Rs 1,000 notes need to be handed over to banks as well as post offices by December 30, 2016. The total value of demonetised currency is Rs 15.44 lakh crore.

Between November 10, 2016 and December 10, 2016, Rs 12.44 lakh crore has made it back to the banks. Banks have issued new notes as well as notes which continue to be legal tender of Rs 4.61 lakh crore to the public over their counters and through their ATMs.

What this means that the deposits with the banks have gone up at a very rapid pace. Between November 11 and November 25, 2016, the aggregate deposits with banks went up by 4 per cent. This increase was within a span of just 15 days. (This is the latest figure that is available.)

Given this, huge and sudden jump in deposits, it is but natural that the banks will cut the interest rates that they offer on their deposits. At the same time, the overall lending by banks (non-food credit) during the 15-day period fell by 0.9 per cent.

Hence, a rise in deposits and a fall in loans will lead to banks cutting interest rates on their deposits and then on their loans. At lower interest rates both businesses as well as consumers will borrow and spend more. And this will help economic growth. Or so we are being now told.

This, as I have often argued in the past, is a very simplistic argument. (You can read one such argument here in the Letter that I write every Friday). Lower interest rates for borrowers are just one side of the equation. We also need to consider lower interest rates for savers, who form the other side of the equation. There can’t be any borrowers without savers. Look at Table 1.

Table 1: Financial Saving of the Household Sector.As can be seen from Table 1. Deposits form a bulk of the household financial savings. Between 2011-2012 and 2015-2016, the share of deposits in the household financial savings has come down. Nevertheless, it remains a major part of how people save. If interest rates on deposits come down, people need to save more to meet their savings goal. This means lesser consumption, which has an impact on economic growth. There is also a possibility of not saving enough and not meeting their savings goal, which again is not a good thing. This could mean not having an adequate amount of money for the education of children, among other things.

Further, in a country with very little social security, the senior citizens use fixed deposits to generate regular monthly income. A sudden fall in interest rates hurts them the most. This is another thing that needs to be kept in mind. Hence, fixed deposit interest rates at any point of time should be at least 150 to 200 basis points higher than the prevailing rate of inflation as measured by consumer price index. This is not a perfect formula, given that each one of us has our own rate of inflation, but then something is better than nothing.

Given that it is the largest borrower, it is understandable that the government keeps batting for lower interest rates. But lower interest rates are not necessarily good for everyone and mindlessly advocating lower interest rates as many experts and industrialists tend to do, is not good for anyone.

Take the case of banks. How responsibly can we expect them to lend? If we look at the recent record of the banks, they don’t inspire enough confidence. In fact, this is precisely the point made by Pallavi Chavan and Leonardo Gambacorta in the RBI Working Paper titled Bank Lending and Loan Quality: The Case of India. The paper was published on the RBI website on December 14, 2016.

The major point that Chavan and Gambacorta make is as follows: “We find that a one-percentage point increase (decrease) in loan growth is associated with an increase (decrease) of NPLs over total advances (NPL ratio) by 4.3 per cent in the long run.” What does this mean in simple English? It essentially means that for every one per cent increase in loans the bad loans ratio goes up by 4.3 per cent.

This basically means that when the times are good, Indian banks go easy on the lending and end up giving loans to even those who don’t deserve a loan. As Chavan and Gambacorta point out: “Banks tend to take on more risks during an upturn in credit growth and be more cautious whenever there is a downturn.”

So why do banks go overboard while lending while times are good? The simple reason is that when times are good there is far greater competition to lend and in this scenario, the lending conditions tend to get relaxed.

But there is another reason as well-crony capitalists. As Chavan and Gambacorta point out: “Well-capitalised banks tend to take on less credit risk”. What does this mean? It means that banks which have more capital tend to take less risk when it comes to giving out loans. Hence, banks which have less capital tend to take more risk while giving out loans. The question is which banks have less capital? Public sector banks.

The new generation private sector banks, which form a bulk of the private sector banking in India, are much better capitalised than the public sector banks. So, what is it that leads to public sector banks going easy on the lending? While Chavan and Gambacorta don’t say so, the answer perhaps lies in crony capitalism.

Politicians force public sector banks to lend to their businessman friends or crony capitalists. The projects are poorly financed with the businessmen putting very little of their own money at risk. As Raghuram Rajan said in a November 2014 speech: “The reason so many projects are in trouble today is because they were structured up front with too little equity, sometimes borrowed by the promoter from elsewhere. And some promoters find ways to take out the equity as soon as the project gets going, so there really is no cushion when bad times hit.”

To conclude, those talking about lower interest rates leading to higher lending to businesses, should also keep this in mind. Public sector banks are not adept at lending, at least not as long as they remain public sector banks, which allows politicians in power to interfere

(The column originally appeared on Equitymaster on December 16, 2016)

How Black Money Helps Indian Banks Finance Real Estate

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Black money or money which has been earned and on which tax has not been paid, is a common phenomenon in India. The fact that only around 3-4% Indians pay income tax explains this. This hurts the government given that it is not able to raise as much tax as it could, if everybody or a substantial portion of Indians paid income tax. It also means that the government has to borrow more in order to meet its expenses, and this pushes up interest rates.

It is also not fair on those Indians, typically the salaried class, who have no option but to pay income tax. What has also happened over the years is that instead of trying to expand the tax base, various governments have tried to milk those who pay tax, for more and more tax.

But not everyone is hurt because of black money. In fact, in case of home loans, banks and housing finance companies benefit because of black money. As Kaushik Basu, current chief economist at World Bank and former chief economic adviser to the ministry of finance, writes in his new book An Economist in the Real World – The Art of Policymaking in India: “A lot of the buying and selling of homes in India occurs with a part of the transaction being made in cash with no record kept of this in order not to leave a trail of evidence.”

Basu then goes on to explain how this benefits banks and housing finance companies issuing home loans. As he writes: “You want to buy a house valued at Rs 100 from the private market. The chances are the seller will tell you that he will not take the full Rs 100 paid in cheque, but will ask for a part, maybe Rs 50 or Rs 60, in cheque with the rest paid in cash with no evidence of this payment. The latter is called a black money payment.”

And how does this help? As Basu writes: “This helps the seller not to have to pay a large capital gains tax. Even many buyers want to pay partly in cash and to show the value of the house to be less than it actually is in order to avoid having to pay too much property tax.”

In fact, what Basu misses out on is the fact that in many cases buyers also have black money and they need to put this to use. And real estate is the best place to put it use given the totally opaque way in which the sector operates.

The black money payment essentially helps banks because the risk they take on in giving out the home loan, essentially comes down. How? “Since mortgage loans [i.e. home loans] can only be taken on the “declared” part of the house price, a house valued at Rs 100 would typically be bought with a mortgage of less than Rs 50. This means that when house prices [fall], unless the price drops [are] extraordinarily large, banks [will] not have a balance sheet problem,” writes Basu. In simple English what this means is that unless home prices fall dramatically, the value of the home (which is a collateral for the bank) will continue to be greater than the home loan outstanding.

He further philosophises that “Economics is not a moral subject”. “Often what is patently corrupt, like the pervasive use of black money can turn out to be a bulwark against a crisis.” In fact, Basu feels that the black money payments ensured that Indian banks did not have their own version of the subprime home loan crisis that hit the United States in 2008-2009.

Let’s understand this phenomenon in a little more detail. The December 2015 investor presentation of HDFC, the largest home finance company in the country, points out that the average home loan that it gives out is Rs 25 lakh. The average loan to value of a home stands at 65%. This means that the average price of a home financed by HDFC stands at around Rs 38.5 lakh (Rs 25 lakh divided by 0.65). The borrower/buyer makes an average down-payment of Rs 13.5 lakh(Rs 38.5 lakh minus Rs 25 lakh).

Over and above this there is a black payment to be made as well. It is very difficult to estimate the average amount of black money that gets paid every time a home loan is taken on to buy a home. Let’s assume that a black money payment of Rs 11.5 lakh is made. This means the real price of the home works out to Rs 50 lakh(Rs 38.5 lakh plus Rs 11.5 lakh).

Against this, HDFC lends Rs 25 lakh. Hence, the real average loan to home market value ratio stands at around 50%. This also when we assume that black money forms around 23% of the total value of the transaction (Rs 11.5 lakh divided by Rs 50 lakh). Black money payments in large parts of the country, especially in the northern part, can be considerably larger than this.

Hence, what this clearly tells us is that banks and housing finance companies end up lending half or less than half of the market value of the homes they are financing through home loans. And this makes it a very safe deal. Home prices need to fall by more than 50% for the value of the home to be lower than the home loan outstanding.

What also helps is the fact that home loans in India are recourse loans. This means that in case a borrower decides to default on the home loan by simply walking away from it, the lender can go beyond seizing the collateral (i.e., the house) to recover what is due to him. He can seize the other assets of the borrower, be it another house, investments, or money lying in a bank account, to recover his loan.

This along with black money payments explains why home loans are such good business for banks and housing finance companies. In case of HDFC, the non-performing loans formed around 0.54% of the individual home-loan portfolio. In fact, even when loans go bad, the institution is able to recover a major part of what is due and this explains why “total loan write-offs since inception [for HDFC]  is less than 4 basis points of cumulative disbursements.” One basis point is one hundredth of a percentage.

In case of State Bank of India, another big home-loan lender, the non-performing loans formed around 1.02% of overall retail loans. The bank does not give a separate non-performing loans number for home loans.

The column originally appeared in the Vivek Kaul Diary on March 2, 2016