Sunday, April 30, 2006

Risk premium on housing loans

I want to draw attention of the equity analysts in the group to a
puzzling proximity in the housing lone rates and rates on govt. bonds.
As you all know the govt. bond are the safest form of fixed income
instruments and housing loans suffer from the risk of defaults.

Here follows a comparison of Govt bond rates and housing loan rates:
Loan rates for tenure to 5 years : 8.50%
5 year govt. bond rate : 6.81%
Risk premium charged : 1.69%

Loan rates for tenure to 5-15 years : 9.00%
15 year govt. bond rate : 7.52%
Risk premium charged : 1.48%

Loan rates for tenure to 15-20 years : 9.25%
5 year govt. bond rate : 7.80%
Risk premium charged : 1.45%


The risk premium ranges from 1.45% to 1.69%. Especially in short term
loans the figure seems low. For instance if 7.5% of the housing loans
default the banks/housing finance companies(HFCs) would get returns
less than the govt bonds. Any further rise in interest rates will
change the equation further.

Here I have not taken into account the selling and administrative
expenses incurred by banks on selling these loan products.It would be
interesting to gather data on whether the banks/HFCs are able to get
the promotion /selling/ administration expenses from the upfront fee
they charge apart from the interest. In personal loans it's quite
common to charge 2% upfront and I'm unable to get data about the
upfront fees in housing loans.

Thus every thing depends on what is the level of risk in housing loan.
The risk in any fixed income security is covered in 2 ways.
1) By securing loans with assets. This means that a bank/HFC should
give a loan worth less than the value of property. Considering high
prices of real estate the banks should keep adequate margin of safety
2) The income of the person purchasing loan product: The person
availing the loan should have an income sufficient to meet his
interest payments. In case of corporate customers income to interest
ratio (interest cover) of less than 3 is considered risky. In case of
individuals I thing that the interest coverage should be more than 5.
Another point to consider here is that the earning of a
company is net of all costs where the income of a person is gross.
While giving loans only the income is counted and any accounting of
expenses, though logical, is impractical.

On both these counts, I think, banks/HFCs are throwing caution to the
wind. In a competitive market where the employees have to meet their
targets such a result is not unnatural. I have read in the papers that
the banks are now giving loans up to 80-90% of the value of property.
They are giving loans to persons who have income barely twice the
interest payment.

RBI has also cautioned the banks in a measured way. The Monetary
policy contained the following statements
"The fast growing housing and consumer credit sectors also represent
some degree of higher penetration, but the quality of lending needs to
be ensured".... It is observed in the recent past that the growth of
housing and consumer credit has been very strong. As a temporary
counter cyclical measure, it is proposed to put in place, risk
containment measures and increase the risk weight from 50 per cent to
75 per cent in the case of housing loans and from 100 per cent to 125
per cent in the case of consumer credit including personal loans and
credit cards"

If such concerns are really valid and remain unaddressed, the retail
credit boom may well leave banks with similar amount of NPAs which
they accumulated on industrial credit boom in 90's.

Posted: Nov 27, 2004

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