Home Loan Lending Will Not Be A Super-Safe Business From Now

One of the beneficiaries of all the black money that exists in India have been banks and housing finance companies giving out home loans. Black money is essentially money earned through corruption or legal means, but on which tax has not been paid.

So how have banks and housing finance companies benefitted from black money over the years? Most real estate transactions in India have a black component. A part of the payment is always made in cash. There is no record of this payment being made.

The proportion of the black component in the entire payment depends on the part of the country where the transaction is taking place. If you are in Delhi, you are likely to pay/receive a higher black component than if you are in Bengaluru. Typically, it can vary anywhere from 20 to 50 per cent of the payment being made.

The basically makes overall lending safer for banks and housing finance companies giving out home loans. Why? The bank or the housing finance company gives a loan to finance a certain portion of the official value of the home.

Let's say if the official value of a home is Rs 100. On this the bank gives a loan of Rs 65. This means the loan to value ratio stands at 65 per cent. The official value of the house does not take the black component of the house, into account. Let's say the black component is a further Rs 25.

The real value of the home stands at Rs 125, with the black component making up for 20 per cent of it (Rs 25 expressed as a percentage of Rs 125). This basically means that the real loan to value ratio of the bank or the housing finance company giving out the home loan, is lower than 65 per cent. The real home to value ratio is 52 per cent (Rs 65 expressed as a percentage of Rs 125). Hence, the real home to value ratio is lower than the official value that the banks and housing finance companies, report.

This makes their home loan lending even more safe than it already is. Let's try and understand this further with some real data. Take the case of the housing finance company, HDFC. The company has a loan to value ratio of 64 per cent on origination. This means that for every Rs 100 of official value of a home, it finances Rs 64 on an average.

Once the black component of the payment as well as the home value is considered, it is safe to say that HDFC's real home to value ratio must be something around 50 per cent or lower.

In case of State Bank of India, the average loan to value is around 52.9 per cent. Again, it is safe to say that the real loan to value will be something around 40 per cent once the black component is considered.

This is how black money has benefited home loan lenders, both banks as well as housing finance companies, in India. The margin of safety built into the home loan because of the black money is extremely high.

Looking at the examples of HDFC and State Bank of India, it is safe to say that most lenders in India, give home loans worth only around half of the real value of the home being bought. This makes home loan lending extremely safe lending.

Even if the borrower defaults, the home can be repossessed and sold to recover the dues. Look at the non-performing asset ratio of home loans of HDFC and State Bank of India. They are at 0.61 per cent and 0.68 per cent of total loans, respectively.

Nevertheless, this should change in the days to come, in the aftermath of demonetisation of Rs 500 and Rs 1,000 notes. The idea is that with the Rs 500 and Rs 1,000 notes being demonetised, people will not be able to put together the black element for the home-buying transaction. Hence, prices will fall to that extent. Estimates have been made that prices will fall to the extent of 30 per cent.

As Yashwant Dalal, president of the Estate Agents Association of India told The Economic Times:

“Property markets will see around 30 per cent correction in prices...Apart from big property markets, tier II and III cities will be worst affected." Property prices in tier II and tier III cities will fall more because the black component while buying a home is higher in these cities.

Further, as Anuj Puri, chairman and country head, JLL India, told Mint:

We have just witnessed a tremendous step towards increased transparency in the Indian real estate industry...The effects will be far-reaching and immediate, and shake up the sector in no uncertain way.

Rajiv Talwar, CEO of DLF, was a little more direct than Puri when he told The Economic Times:

There is bound to be a downward pressure on prices of everything including real estate.

What does this mean for the banks and housing finance companies in the business of giving out home loans? It will essentially mean that their real loan to value ratios will go up. At the same time the loan to value ratios that they report will be closer to the reality.

Let's extend the example taken earlier. The total value of the home with the black component of Rs 25 was at Rs 125. If we take the black value out of the equation, the value of the home falls to Rs 100. Against, this the bank will still give a loan of Rs 65. This means a real home to value ratio of 65 per cent. In the earlier case, it was at 52 per cent. While the real home to value ratio will go up, the reported home to value ratio, will continue to remain the same. Of course, the extent to which the price will fall will also depend on the circle rate of the area and the extent to which the state government cuts it, quickly enough.

To conclude, what this essentially means that while home loan lending business will continue to be a largely safe business, it will not be as super-safe as it was in the past.

This article was originally published in Vivek Kaul’s Diary — a newsletter that cuts through the noise and presents actionable views on socio-economic developments in India and the world. He is the author of a trilogy on the history of money and the financial crisis. The series is titled Of Banks, Black Money and Home Loans.