Dual financing

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.

Demonetisation Impact: If Real Estate Prices Fall, Dual Financing Might Be Next Big Headache

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The demonetisation of Rs 500 and Rs 1,000 notes is expected to lead to a fall in real estate prices. I had discussed this point in detail in a column last week.

I think that real estate prices will fall, but I am really not sure whether they will crash. The reason for that is straight forward. Every time in the past, real estate prices have started to slowdown, lending from the banks to the sector has gone up.

Banks probably fear that the real estate companies will default on their loans, if prices fall. The loans ensure that the real estate companies do not need to cut prices and the real estate bubble continues to stay inflated. My guess is that the public-sector banks are essentially forced to lend to these companies by politicians.

Hence, my point is that the real estate prices will come down dramatically, if the government wants them to fall. If public sector banks are not forced to lend to these companies, then real estate prices can come down.

Having said that there is another issue that needs to be discussed here. It’s called dual financing and doesn’t get discussed much in the media.  Let’s try and understand this through an example.

A builder wants to build apartments. He takes a loan from a bank for construction. He offers the project (basically the land) in which the flats are to be built as a collateral to the bank. At the same time, he starts selling flats which are yet to be built to the prospective buyers.

The genuine buyers take a home loan from the bank and hand over a portion of it to the builder. The buyers offer their flats that will be built as a collateral to the bank from which they are taking on the home loan.

So, what is happening here? The builder before marketing the project had taken on a loan from the bank against the project. What happens after that? The buyers take on home loans offering the flats that are being built in the project as a collateral.

Basically, the same asset has been offered as a collateral twice. This is referred to as dual financing. If the apartment is built and handed over to the prospective buyer, there is no problem at all. Everyone lives happily ever after.

But if the builder defaults on the loan he had taken from the bank to construct the flats, there is a problem. The project has been offered as a collateral to a bank. The flats on the other hand are collaterals against which buyers have taken home loans from other banks.

Given that the builder has taken the loan first, the first charge is created in favour of the bank which gave the loan to the builder. A first charge ensures that the loan given by the bank to the builder takes precedence over the home loans that have been taken on against the same collateral.

The Reserve Bank of India(RBI) has reiterated the same in a letter to the banks dated January 20, 2016, wherein it said: “if builders/promoters fail to repay the loan availed from the bank… the bank would have first charge over the property”.

This basically means that if the bank seizes the flats to sell them to recover its loan in case the builder defaults, there is nothing much that the buyers can do about the same. This is because the bank giving the loan to the builder has the first charge.

What happens to the buyers? They must fight a legal battle trying to establish their ownership over the flats. Meanwhile, they must continue paying their EMIs on the home loans that they had taken on. If they stop paying their EMIs, their banks will come after their other assets. In India, home loans are recourse i.e. the banks can go after the other assets of the borrower as well, other than the home offered as a collateral, to recover their loan.

What are the safeguards built into the system to protect the prospective home-buyers? Banks giving loans to builders need to make sure that the builder tells the prospective buyers very clearly that he has already borrowed money against the project.

In fact, as the RBI Master Circular on Housing Finance for Scheduled Commercial Banks points out: “while granting finance to specific housing / development projects, banks are advised to stipulate as a part of the terms and conditions that:

(a) the builder / developer / company would disclose in the Pamphlets / Brochures etc., the name(s) of the bank(s) to which the property is mortgaged.
(b) the builder / developer / company would append the information relating to mortgage while publishing advertisement of a particular scheme in newspapers / magazines etc.
(c) the builder / developer / company would indicate in their pamphlets / brochures, that they would provide No Objection Certificate (NOC) / permission of the mortgagee bank for sale of flats / property, if required.
(d) Banks are advised to ensure compliance of the above terms and conditions and funds should not be released unless the builder/developer/company fulfils the above requirements.”

What the circular basically says is that the builder taking a loan from the bank needs to tell the buyer buying a flat about the project being mortgaged with the bank. Also, it is the bank’s job to ensure that the builder is following this instruction. Further, if the builder does not follow this instruction then the bank should not release funds to him.

If this regulation was being followed, the borrowers would have known that something called “dual-financing” exists. But most home loan borrowers continue to be unaware about this part of our financial system. As the RBI letter to the banks dated January 20, 2016, cited earlier in this piece points out: “It has been observed on several instances that banks are not insisting builders/promotors who avail the credit facilities for their building projects disclose the details of mortgage/terms and conditions of the bank loan availed by them to the borrowers/potential borrowers purchasing the flats through advertisement/pamphlets.”

The point being that builders are not telling the flat buyers who are taking on home loans, that the project is already mortgaged. If the builder does not reveal these details, it is very difficult for the prospective buyers to go figuring out details on their own.

The interesting thing is that the RBI does not allow Urban Cooperative Banks to carry out dual financing. As the Master Circular on Housing Finance for Urban Cooperative Banks points out: “Builders/contractors generally require huge funds, take advance payments from the prospective buyers or from those on whose behalf construction is undertaken and, therefore, may not normally require bank finance for the purpose. Any financial assistance extended to them by primary (urban) co-operative banks may result in dual financing. Banks should, therefore, normally refrain from sanctioning loans and advances to this category of borrowers.”

The question is how can one logic apply for Urban Cooperative Banks and not apply for the Scheduled Commercial Banks? This is something that the RBI needs to explain.

So, the question is why am I discussing this in today’s column? The dual financing problem has been around for a while, and did not crop up recently. The answer lies in the fact that dual financing becomes a problem only when the builders default on the loans they have taken from banks.

The demonetisation of high-denomination notes has led to a lot of talk about real estate prices falling. A major reason for this lies in the fact that people won’t be able to put together the black component of the payment, given that the old high-denomination notes are invalid and there aren’t enough new ones going around.

This is likely to lead to lower prices, the experts who follow real estate have been saying. One risk that this runs is that lower prices may lead to builders defaulting on their loans to banks. In this situation, the banks will seize the collateral and want to sell off the flats to recover their money.

This is likely to lead to problems for those buyers who have taken on home loans to buy these flats. It will also lead to problems for those buyers who haven’t taken a home loan to buy these flats. This is one fall out of low real estate prices because of high denomination notes which is possible.

And if anything like this were to happen in the days, the middle class is likely to get hurt. When the middle class gets hurt, it tends to make a lot of noise. It’s extremely possible that such a thing can happen in the time to come. The Modi government needs to be prepared for this because it is important the real estate prices fall, to improve the affordability of real estate in the days to come.

The column originally appeared in Vivek Kaul’s Diary on November 16, 2016

Taking a home loan? This is how dual financing by banks might hurt you

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Paul Volcker, the Chairman of the Federal Reserve of the United States, the American central bank, is once said to have remarked: “the only thing useful banks have invented is the ATM”. I would like to add “home-loans” to the list as well.

Home loans allow people to buy a home at a point of time in life when they are really not in a financial position to buy a home by making the entire payment upfront from their savings. Home loans allow individuals to buy a home and repay the loan over a period of time.

This essentially ensures that an individual can enjoy the benefits of owning a home much earlier in life than if he would have had to simply depend on accumulating enough money to buy a home.

But what if the home loan turns into a nightmare? And believe me it can. How, you may ask?

In the recent past, there have been many cases of builders collecting the money from prospective buyers and disappearing. This, other than leading to a situation where a buyer does not get the home he has already paid for, also leads to other problems.

Let’s try and understand this through an example. A builder wants to build apartments on a piece of land that he owns. He offers this land as a collateral to a bank and takes on a loan. After he has taken on the loan from the bank he starts marketing the project and starts collecting money from the prospective buyers as well. The buyers who want a home to live in, obviously take on home loans to pay the builder.

The builder is supposed to complete the project by a certain date, but doesn’t complete the project. At the same time he defaults on the loan he had taken on from the bank. The buyers are stuck because their homes are nowhere near completion. And there is another problem.

The builder before marketing the project had taken on a loan from the bank against the land on which apartments were to be built. What happens after that? The buyers take on home loans offering the apartments that are being built on that land as a collateral.

What is happening here? Basically the same asset has been offered as a collateral twice. But given that the builder took the loan first, the first charge is created in favour of the bank which gave the loan to the builder. A first charge ensures that the loan given by the bank to the builder takes precedence over the home loans that have been taken on against the same collateral.

What happens next? The bank which gave the loan to the builder goes after the collateral following the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFESAI Act).

What happens to the buyers? They will have to fight a legal battle trying to establish their ownership over the apartments. Meanwhile, they will have to continue paying their EMIs on the home loans that they had taken on. If they stop paying their EMIs, their banks will come after their other assets. In India, home loans are recourse i.e. the banks can go after the other assets of the borrower as well, other than the asset offered as a collateral, in order to recover their loan.

This situation is referred to as “dual-finance”, where multiple loans have been taken against the same collateral. This leaves the home-buyers in a total mess. The Reserve Bank of India (RBI) does not allow primary urban cooperative banks (UCBs) to carry out this kind of lending. As the Master Circular- Finance for Housing Schemes – UCBs points out: “The builders / contractors generally require huge funds, take advance payments from the prospective buyers or from those on whose behalf construction is undertaken and, therefore, they may not normally require bank finance for the purpose. Any financial assistance extended to them by primary (urban) co-operative banks may result in dual financing. The banks should, therefore, normally refrain from sanctioning loans and advances to this category of borrowers.”

The term to mark here is “dual financing”. The situation is exactly similar to the example that I took earlier in the column. The problem is that while the urban cooperative banks are not allowed to carry out dual financing, there is nothing that stops scheduled commercial banks from doing the same.

As the Master Circular—Housing Finance for scheduled commercial banks points out: “In view of the important role played by professional builders as providers of construction services in the housing field, especially where land is acquired and developed by State Housing Boards and other public agencies, commercial banks may extend credit to private builders on commercial terms by way of loans linked to each specific project. However, the banks are not permitted to extend fund based or non-fund based facilities to private builders for acquisition of land even as part of a housing project.”
The phrase to mark in the above paragraph is that: “commercial banks may extend credit to private builders on commercial terms by way of loans linked to each specific project.” This is something that the RBI does not allow urban cooperative banks to do. The moment a bank is lending against a specific project, the collateral offered by the builder to take on the loan is the same as the collateral that will be offered by prospective buyers who will borrow home loans from banks in the days to come.

And this creates the problem of dual financing. In the recent past, there have been many cases of builders disappearing and leaving buyers in a lurch. Interestingly, the RBI Master Circular on housing finance points out: “In a case which came up before the Hon’ble High Court of Judicature at Bombay, the Hon’ble Court observed that the bank granting finance to housing / development projects should insist on disclosure of the charge / or any other liability on the plot, in the brochure, pamphlets etc., which may be published by developer / owner inviting public at large to purchase flats and properties.”

Hence, banks need to make sure that builder tells the prospective buyers very clearly that he has already borrowed money against the land on which apartments are being built. Further the circular also points out: “While granting finance to specific housing / development projects, banks are advised to stipulate as a part of the terms and conditions that: (i) the builder / developer / company would disclose in the Pamphlets / Brochures etc., the name(s) of the bank(s) to which the property is mortgaged. (ii) the builder / developer / company would append the information relating to mortgage while publishing advertisement of a particular scheme in newspapers / magazines etc.”

The point being that the builder has to communicate very clearly that he has borrowed money against the project from a bank(s). As the Master Circular points out: “Banks are also advised to ensure compliance of the above terms and conditions and funds should not be released unless the builder/developer/company fulfils the above requirements.”

While, this sounds very good on paper, such disclosures are rarely made. And my guess is that even if they are made, there are not many buyers going around who have the wherewithal to understand these things. Further, at the point of buying a home there are so many terms and conditions that a buyer has to go through that it is worth asking whether it is possible to mentally process and understand everything.

In this scenario, it is important that the RBI works towards stopping this practice of dual financing and making life slightly easier for a prospective home buyer.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on July 28, 2015