scheduled commercial banks

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