Connecting the dots…Global economy to Indian Real Estate

Published in The Hindu - Sunday Magazine on Oct 26, 2008

The fallout of global financial turmoil is a potential bargain hunting opportunity in Indian Real Estate. The patient homebuyer may be able to avail cheaper property rate as well as lower interest loan going forward.

Opening Scene, India

Take any newspaper…this Diwali, there are more ads from real estate companies than from retail shops. “Assured 21.47% Return on Investment” claims one ad. Another claims the builder will pay your full home loan EMI for the first 18 months. Yet another builder promises to buy back your apartment after two years, at an assured higher price – “just make your booking today with 15% down payment”. Are these hard sell campaigns telltale signs of desperation among developers?

Occupancy levels in many recently completed residential complexes in key metros hover around 50%. Those who have bought homes in last few years have seen interest rates gallop faster than an Arabian purebred. Many middle class families that stretched themselves to buy a home are barely able to make ends meet.

Banks have turned paranoid that the Indian economy would slow down and loan defaults would increase due to high interest rate levels. Consumer loans have trickled down…you might have stopped getting those annoying tele-marketing calls for personal loans. Some bankers don’t even want to speak to real estate or infrastructure companies anymore (it’s an irony that the same companies, until a few months back, were the focus segment). Many on-going real estate projects are hanging in mid-air due to lack of capital, both from buyers and from bankers. Some builders have already defaulted on delivery date commitments made to advance reservation customers.

The fund situation turned so grim over the last two weeks that it appears Banks don’t even believe each other any more; Inter bank lending rate (the rate at which banks lend money to each other) touched 20% p.a. (on Oct 10, 2008). Many leading banks are just hoarding cash and playing a wait & watch game.

Scene 2, Rest of the World

Loan defaults in U.S. housing market has increased to unanticipated levels. Investors, Investment Banks, Commercial Banks (those that give loans to companies), Consumer Banks (those that give loans to you and me) and Managed Funds across the world with stakes in U.S. mortgages, are grappling huge losses that threaten their survival. Financial Institutions have started collapsing like a deck of cards.

Global banks have drastically slowed down lending due to lack of trust and lack of cash. Even genuine companies are not getting funding from banks – resulting in a slow down in new investments. Leading Investment Banks and other International Financial Institutions have embarked on a desperate survival attempt by selling their holdings in stocks, bonds, and commodities markets in order to release cash. The Federal Reserve (equivalent to our own RBI) sensing trouble has lowered interest rates rapidly to make money cheaper and more easily available – but the damage doesn’t seem to ease.

Massive job losses have been triggered by the global services sector – dominated by financial services. The fear of job loss has taken a toll on consumer spending as well. The combination of a rapid sell off by financial institutions and the prospect of economic slowdown have pulled down the stocks and commodities market world over to new lows. The Dow Jones Index (New York Stock Exchange) has retreated to year 2002 levels.

Scene 3, following the dots to India

Prolonged FII (Foreign Institutional Investors) selling and conversion of their holdings from rupees to dollars for repatriation (English translation: selling lock, stock and barrel and running back to their country with the money) – has resulted in the rupee falling to nearly Rs 49/ dollar as against a high of Rs 39/ dollar. The Sensex has dropped below 10,000 as I write – because of an expected slowdown in earnings growth by Indian companies, disproportionate FII selling, Indian Investors panic or all of the above.

Due to the fall in rupee, Indian companies that had borrowed overseas are suddenly faced with higher repayment in rupees for their dollar loans. Foreign banks have drastically reduced fresh lending to Indian companies, because of their perceived risk. Indian companies, particularly real estate ventures now look to Indian Banks to fulfill 100% of their loan requirements.

But the Banks in India have displayed a knee jerk reaction to the global crisis and significantly curtailed lending to corporates and individuals. Defaults in personal loans have reached 10%-15% levels compared to earlier levels of 2%-5%. As a result, many Banks and NBFC’s have stopped lending in this segment – including biggies such as Reliance Consumer Finance.

With access to funds drying up for our companies, job loss, hit in export demand due to problems in U.S./ European economy, rise in cost of imports due to rupee depreciation (as importers will have to pay more in rupees for the same dollar value), loss in investors confidence in the stock markets, and drop in real-estate demand – the Indian economy seems headed for a slowdown

Real estate companies seem to be among the worst hit in the current situation. Developers who got used to selling out even before the project started (the trend that prevailed during the past few years) are now facing the prospect of investing significant amount of their own money to complete the project. Unfortunately, banks are not too eager to fund the developers at this point.

I guess the dots across the world economy are connected after all.

* Epilogue* What is in store for the future?

There are only two exit routes from the current deadlock. One, the real estate developers will reduce the pricing. Two, the RBI will ease money supply. The latter has already started happening with the recent announcement that allows banks to use a larger portion of their money for lending purposes. Going forward one can reasonably expect interest rates to come down.

The implication for the retail homebuyer is that home prices may not appreciate for some time to come. Those who wait for the current situation to pan out may not only be able to negotiate a discount on property rate but also get a lower interest loan. So watch out before you hastily book a home this Diwali. Happy Diwali!

* The End*

Merry go round the Mulberry Bush…

I appreciate that some of you have pointed out that the $700 Billion bailout is not exactly a "grant" in the literary sense. Guess I got too carried away with my cynicism:) I agree that the U.S. Govt will get a share of ownership in these banks or in their "troubled assets" (toxic mortgage related securities such as CDO's whose value only God can ascertain at this point) in return for the money that they are giving away. Whether this is a judicious thing to do -either as an investment or even as a gesture – only the future will tell. I hate to imagine a CEO of the same bank, 5 yrs down the line say: "I can do whatever I want because mommy (U.S. Govt) will bail me out, even if I lose all my money through creative lending/speculation/ trading". Then the Govt would have achieved exactly the reverse of what it set out to do.

It would be good for the taxpayers if the money that the Govt is spending to invest in troubled U.S. Banks, appreciates in value. But the issue is: if the banks in question are such juicy investments at this point – then why are the leading investors around the world, including Warren Buffett, not buying up all the banks in trouble? (Warren Buffett is a legendary billionaire investor, who has smartly offered $5 Billion to a popular U.S. Investment Bank - Goldman Sachs, not in return for equity shares but at 10% p.a. interest rate).

It looks like investing in the troubled U.S Banks or in their toxic mortgage securities today, in return for getting ownership shares in them, is an extremely risky bet that many prospective investors (or other banks) are not ready to take on their own – so the Govt has offered to stick its neck out as an investor of last resort – which is not really the best position to be in.

The other worrisome part is…in addition to the hefty bailout package by the Govt., the Federal Reserve Bank (Fed) in U.S. (similar to RBI in India) has cut its interest rate to 1.5 % on Wednesday (Oct 8th, 2008) , to save the economy. This means that once again (after the 2002-2004 period) funds have become artificially cheap for borrowers, tempting them to load up on cheap loans. Remember, I had written in my previous article that the beginning of the chain of events that ended in the current mess was that, after the Dot com bust, the interest rates were cut to an abnormal low of 1% to perk up the economy. Now it’s like déjà vu all over again…does this mean in the future when the Fed increases its interest rate to the normal level, the entire episode will repeat? That would make it a perfect vicious circle. I don't know why I suddenly feel like humming “Merry go round the Mulberry Bush…Mulberry Bush…Mulberry Bush…”

Okay, enough cynicism for the day – I bet the economics experts running the show would know better than us. Let’s not distract them with our common sense. Hope all these billions can somehow buy peace :)

Summary of your comments to ‘When the Bubble Burst’/ ‘The cost of financial ingenuity’

Totally surprised (floored in fact) by the overwhelming and unexpected response. Glad that the essay was useful to most of you and thanks for your comments. It is going to take me a really long time to revert to you individually. In the meantime, following is a summary of the feedback received so far:

Concerns:
* What is going to happen to Rohit? Shall I try and get him a job?
* Recent apartments built in Bangalore have only 30% - 40% occupancy levels
* When will things start looking up again?
* Financial Services firms have become too aggressive, shortsighted and only concerned about competitors
* Credit cards are being used to pay off housing loans in the U.S.
* The real estate scene in India seems ominously similar to what happened in the U.S.
* Could a similar crisis happen in India - with real estate prices having rapidly increased from 2003 to 2007?
* How safe is the Indian banking system?
* Indian banks have lately been pushing home loans aggressively, beyond people's needs – what are the repercussions?
* Indian banks have also operated in the sub prime space esp. personal loans? What will happen to them?
* Many shady real estate projects have cropped up and are being peddled as investments with assured returns
* With home loan interest rates increasing to 13% in India, people who took variable interest rate loans at 8% just a few yrs back are now facing significant EMI increase or tenure expansion; many Indian families are already struggling to meet their home loan EMI payments

Questions:
* Is it worth going to the US to pursue an MBA? Will the job market improve in next 2 yrs?
* Why did the interest rates rise between 2004-2006?
* What is meant by bailout?
* What is meant by sub-prime?
* How do credit rating agencies fit into all this?
* Why did the investment banks not give out home loans themselves instead of buying from banks?
* How are hedge funds involved?
* Is this the right time to invest in the equity markets in India?
* What is the reason for India's inflation in double digit? And what way American economy or Iran's Crude oil price is responsible?

Glimmer of Hope:
* Sub prime loans do play an essential link in the system; it only shows that there are participants who are willing to finance risky assets
* What has happened is nothing more than a temporary crash due to panic
* Financial engineering will go on and the financial system will get cleansed on its own
* Financial innovation has also brought in convenience (credit/debit card) and made loans (credit) easily available to people; Unfortunately it is the regulation that is slow to catch up with innovation and hence the chaos


Other Comments:
*"Perasai Perum Nashtam"
* All that glitters is not gold!
* Intentions matter the most in any business
* Indian stock market fall is not only because of FII's pulling out their money, but also due to global economic slowdown
* ‘High Leveraging’ (taking loans up to the neck without enough breathing space) and ‘Derivatives’ (complex instruments such as CDO’s) are the root cause for all evil
* Hubris and Hedonism are the underlying drivers
* Conservatism is the best guardian against such crisis
* Indian markets are no longer insulated from the world
* I can finally explain to my wife about the crisis
* I could explain it to my daughter in 10th standard
* You should write a book
* I felt as if I were watching a movie, when I was reading your article
* The article read like a mystery novel
* Even layman could understand
* The article was simple and succinct

The cost of financial ingenuity…$700 billion represents merely a fraction of the real damage

Published in The Hindu - Sunday Magazine on Oct 5, 2008
The bursting of the speculative bubble in the U.S. housing market has destroyed billions of dollars in investor wealth across the world, crippled the banking system, expunged close to a million jobs…and India has not been spared either. With banks failing by the day…definitely, these are uncertain times for the financial services industry. While many people who have lost their jobs, are faced with permanent shrinkage of their lifestyle, others in the industry are going through the trauma of not knowing if and when their turn would come. Who is to blame?

Flashback to year 2003:
Rohit (name changed to protect identity), a good friend of mine and someone who was officially considered to be a genius with an IQ of 150+, graduated from one of the leading IIM’s. Rohit managed to make it into the New York Headquarters of the most sought after firm that had arrived on campus for the first time – Lehman Brothers – a top U.S. Investment Bank (then). On joining, he was assigned to Lehman’s mortgage securities desk that dealt with Collateralized Debt obligations (or CDO’s).

Following is an extracted transcript of a chat session I had with Rohit back in 2004:

Me: So man, you must feel like you are on top of the world.
Rohit: Yes dude, the job here is amazing, I get to interact with people around the world, investment managers – who want to invest millions of dollars

Me: great…so tell me something interesting. What’s your job all about?
Rohit: You know there is a great demand for American home loans, which we buy from the U.S. banks. We then convert these into what is called as CDO’s (Collateralized Debt Obligations). In plain English – this refers to buying home loans that banks had already issued to customers, cutting them into smaller pieces, packaging the pieces based on return (interest rate), value, tenure (duration of the loans) – and selling them to investors across the world after giving it a fancy name, such as ‘High Grade Structured Credit Enhanced Leverage Fund’.

Me: Wow! I would’ve never guessed that boring home loans could transform into something that sounds so cool!
Rohit: hahaha…actually we create multiple funds categorized based on the nature of the CDO packages they contain and investors can buy shares in any of these funds (almost like mutual funds…but called Structured Investment Vehicles or SIV’s)

Me: Dude, you make your job sound like a meat shop…chopping and packaging. So, in effect when an investor purchases the CDO’s (or the fund containing the CDO’s), he is expected to receive a share of the monthly EMI paid by the actual guys who have taken the underlying home loans?
Rohit: Exactly, the banks from whom we purchased these home loans send us a monthly cheque, which we in turn distribute to the investors in our funds

Me: Why do the banks sell these home loans to you guys?
Rohit: Because we allow them to keep a significant portion of the interest rate charged on the home loans and we pay them upfront cash, which they can use to issue more home loans. Otherwise home loans go on for 20-30 years and it would take a long time for the bank to recover its money.

Me: and, why does Lehman buy these loans?
Rohit: Because we get a fat commission when we convert the loans into CDO’s and sell it to investors

Me: Who are these investors?
Rohit: They include everyone from pension funds in Japan to Life Insurance companies in Finland

Me: But tell me, why are these funds so interested in purchasing American home loans?
Rohit: Well, these guys are typically interested in U.S. Govt bonds (considered to be the safest in the world). But unfortunately, Mr. Alan Greenspan (head of Federal Reserve Bank – similar to RBI in India) has reduced the interest rate to nearly 1% to perk up the economy after the dot-com crash & Sep 11 attacks. This has left many funds looking for alternative investments that can give them higher returns. Home loans are ideal because they offer 4-6% interest rate.

Me: Wait, aren’t home loans more risky than U.S Bonds?
Rohit: We have made home loans less risky now. In fact they have become as safe as U.S Govt bonds.

Me: What are you saying, man? What if the people who have taken these underlying home loans default? Then the investors would stop getting the EMI’s, and their returns would take a hit. Wouldn’t it?
Rohit: Boss, may be some will default, but not definitely more than 2-3% of them. Moreover, we have convinced AIG (a leading insurance company) to insure our CDO’s. This means that even if there were big defaults – the insurance company would compensate the investors.

Me: that’s amazing. What are these insurances called?
Rohit: Credit Default Swaps

Me: Definitely you guys are the most creative when it comes to naming.
Rohit: Thanks

Me: and why has this AIG guy insured millions of home loans?
Rohit: see man, the logic is simple. Home prices in the U.S always go up. In fact over the last 3 yrs alone they have doubled. So even if someone defaults paying the EMI, the home can be seized and sold for a much higher price. So there is no risk. Insurance companies are actually competing to insure this, because they can earn risk-free premiums.

Me: no wonder investment managers from all over the world want to put money in your CDO’s. *end of conversation extract*

NINA and the Housing Bubble

A global financial cobweb started getting built around the American dream of purchasing a home and it rest on the assumption that “home prices will keep rising”. As demand for the CDO’s started growing across the global investment community, the investment bankers (like Lehman) who were meant to sell these instruments also started investing a significant portion of their own capital in these. I guess after selling the story to the whole world, they themselves got sold on the seemingly foolproof concept. Gradually the markets for CDO’s and Credit Default Swaps started expanding with traders and investors buying and selling these as if they were shares of a company, happily forgetting the underlying people behind these products who took the home loans in the first place and on whose capacity to repay the loans, the safety of these products depended.

As Wall Street firms like Lehman were churning more and more home loans into CDO’s and selling them or investing their own money, there was a pressure on the banks to issue more loans so that they can be sold to the Wall Street firms in return for a commission. Slowly banks started lowering the credit quality (qualification criteria) for availing a home loan and aggressively used agents to source new loans. This slippery slope went to such an extent that in 2005, almost anyone in the U.S could buy a home worth $100,000 (45 lk INR) or more – without income proof, without other assets, without credit history, sometimes even without a proper job. These loans were called NINA – ‘no income no assets’.

The U.S. housing market went into a classic speculative bubble. Home loans were easy to get, so more and more people were buying houses. The increased demand for houses caused the price to increase. The rising prices created even more demand, as people started to look at homes as investments -- investments that never went down in value.

When I touched base with my friend Rohit in late 2005, he was on cloud nine. During the previous one year, he managed to buy a home in Long Island (a posh area near New York City) worth almost a millions dollars, and got himself a Mercedes. All this was interesting to hear, but what shocked me was that although he was earning close to $20,000 a month (that is what CEO’s in India make) he was not able to save anything because his lifestyle expenses where growing faster than his salary.

The popping of the Housing Bubble

In late 2006, Mortgage lenders noticed something that they'd almost never seen before. People would choose a house, sign all the mortgage papers, and then default on their very first payment. Although no one could really hear it, that was probably the moment when one of the biggest speculative bubbles in American history popped. Another factor that lead to the burst of the housing bubble was the rise in interest rates from 2004-2006. Many people had taken variable rate home loans that started getting reset to higher rates, which in turn meant higher EMI’s that borrowers had not planned for.

The problem was that once property values starting going down, it set off a reverse chain reaction, the opposite of what had been happening in the bubble. As more people defaulted, more houses came on the market. With no buyers, prices went even further down.

In early 2007, as prices began their plunge, alarm bells started going off across mortgage backed securities desks all over Wall Street. The people on Wall Street, like Rohit, started getting calls from investors about not getting their interest payments that were due. Wall street firms stopped buying home loans from the local banks. This had a devastating effect on particularly the small banks and finance companies, which had borrowed money from larger banks to issue more home loans thinking they could sell these loans to Wall Street firms like Lehman and make money.

Everyone got into a mad scramble to seize and sell the homes in order to get back at least some of the money. But there were just not enough buyers. The guys who had insured these loans thinking they had near zero risk (e.g. AIG) could not fulfill the unexpectedly huge number of claims. The best part was that since these insurance policies (credit default swaps) could themselves be traded, multiple people had bought and sold them, and it became so tough to even trace who was supposed to compensate for the loss.

Back to 2008: The carnage

The global financial cobweb built around mortgages is on the brink of collapse. Firms, large and small, some young some as old as a 100 years have crumbled as a result of suing each other over the dwindling asset values. Lehman’s India operations- that employed over a thousand staff is up for sale and many of the employees have been asked to leave. The Indian stock market has crashed almost 50% from its high (and so have markets around the world) as the Wall Street giants sold their investments in the country in an effort to salvage whatever is good in order to make up for the mortgage related loss. Hedge funds, pension funds, insurance companies all over the world have lost billions in investor’s money. Many Indian Bschool graduates with PPO’s (pre-placement offers) in the financial sector (India and abroad) have either received an annulment or indefinite postponement of joining dates. IT firms that built and maintained software for the U.S. mortgage industry or the related Investment Banks, have shut down their business units, laid-off people or transferred them to other verticals.

For all the hoopla over the sharp and sophisticated people on Wall Street, the current financial crisis has exposed the fragility of the system. Wall Street is blaming the entire episode on people who could not repay their home loans. But the reality seems to point towards the stupidity of people who lent all this money, financial institutions that built fancy derivative packages and in effect facilitated billions in trading and investments in these fragile low quality loans.

The U.S. Govt is planning to grant 700 billion dollars to the Wall Street firms to compensate the financial speculators for the money that they have lost. Isn’t this like rewarding greed and stupidity? The head of a leading Investment Bank has stated, “This is necessary to sustain financial ingenuity. We don’t want to spend this money on ourselves. We just want this money to go into the market so that we can carry on trading complex securities, borrowing and lending money.” (Yeah…right, so that one can act as if nothing had happened without analyzing too much into it). The real question is: who is going to compensate the common investors across the world who have lost their wealth in the resultant market meltdown? (either directly or through pension funds).

After being unreachable for a month now, finally I heard back from my pal, Rohit, saying he is back in India to take a break from the roller coaster ride that he had lived through. After Lehman’s collapse he has lost his job and probably the house that he had bought by taking a hefty loan. I really don’t know whether to feel happy for him, for getting an opportunity to learn a lesson or two from the experience or to feel sad for him for losing his job. May be I’ll get a better sense of things once I meet him next week.