Housing Finance

• Due to scarcity of Finance, Housing remains a distant dream for many people.

• To boost investment in the housing industry, the Government established the Housing Development Finance Corporation in 1977.

• Numerous tax concessions were announced like currently interest and repayment of borrowed capital and capital gains rollovers.

NHB

• In July, 1998, the government announced the setting up of National Housing Bank fully owned by RBI with the objective of providing Housing finance to all sections of society.

• The NHB also functioned as a regulatory body for the housing finance industry and issued regulatory directions and guidelines to the Housing Finance Companies (HFCs)

• Till the 1990s , it was largely a seller’s market.• With the entry of commercial banks and

private sector banks, marketing began to play an important role.

• HFCs marketed their schemes through agents known as DSAs (Direct Selling Agents)

Disbursing a house loan

• The first step is determining whether or not, the applicant satisfies the eligibility criteria.

• HFCs consider factors such as an applicant’s age, income level and stability of income streams.

• Generally three types of appraisal are conducted by the HFCs

Credit Appraisal

• This is conducted to assess the applicant’s repayment capacity over the loan tenure.

• The factors considered are:• Income• Age• Academic Background• Employment stability

• Family background• Assets and liabilities• Etc.

Legal Appraisal

• The documents submitted are verified by a lawyer to confirm whether the holder will be able to generate a mortgage in favor of the HFC or not.

Technical Appraisal

• The applicant’s original documents are verified.

• All other information submitted is also verified.

• Checks to ensure of the quality of the material of the house.

Loan amount

• Loan amount can be disbursed in entirety or in instalments.

• Repayments are by way of EMIs• Disbursement is generally done on the basis of

fixed or floating rate of interest.

Fees charged

Processing fee

• Charged at the time of processing the application.

• Generally 0.8% to 1% of the loan amount.

Administrative Fee

• Charged when the loan is sanctioned.• Generally 1-2% of the loan amount.

Early redemption charges

• For prepayment of the loan.• Generally 2% of the outstanding balance

• Bank may waive any of these fees for specific categories of customers.

• The registration papers of the property are held by the HFC till the loan is fully repaid.

• The primary source of funds for any HFC is the interest on loans disbursed.

• HFCs make money on the spread between the cost at which they source their funds and the rates charged to customers.

Fannie Mae

• Fannie Mae was a Depression-era creation of the federal government that had been charged with establishing a secondary market for home loans.

• By purchasing qualifying residential mortgages• from home-loan issuers, it provided these

institutions with funds for the continued issuance of mortgages, thereby promoting the government’s goal of increased homeownership.

• In November 1931, President Herbert Hoover outlined a plan for the creation of twelve regional Federal Home Loan Banks (FHLBs) with the capacity to lend upwards of $2 billion to member mortgage institutions.

Fannie Mae.

• Originally chartered as the National Mortgage Association of Washington in February 1938, the agency was renamed the Federal National Mortgage Association (FNMA).

• Over time, the FNMA would come to be known also as Fannie Mae.

• The FNMA opened its doors with “an initial capital of $10 million” supplied by the Reconstruction Finance Corporation, its supervising agency.

• Its role was primarily buying, holding, and selling “FHA-insured mortgage loans which had been originated by private lenders,” thereby allowing the latter to remove the loans from their books and use the income to finance further mortgages

Federal Housing Administration (FHA).

• The FHA challenged this status quo. For a small premium (fee), it offered to insure “the repayment of principal and interest” on any mortgage “held by any authorized lending institution,”

• but only so long as the mortgage conformed to FHA standards.

• To be eligible for FHA insurance, properties needed to be examined by a local FHA agent.

Other government-sponsored enterprises (GSEs)

• The Federal Home Loan Mortgage Corporation (FHLMC), or Freddie Mac.

• The Government National Mortgage Association (GNMA), also known as Ginnie Mae

SUBPRIME MORTGAGE CRISIS

VIKRAM SINGH SANKHALA

2000-2001

• Dot Com Burst and Sept 9/11 attacks• US Govt. adopted a policy of Credit Driven Consumption led

Growth.• Interest Rates were slashed to ease liquidity from 2001• By 2003 the Fed Funds rate (Fed rate) had gone down to as

low as 1%.• Lower interest rates made Home loans cheaper• High demand in Housing Markets lead to Real Estate Prices

rallying.

Aggressive Lending

• Real Estate as an asset class became very attractive.• Returns generated were very high.• Banks were Flush with liquidity because of Low Fed

rate.• Prime rate went down to 4.25% in January, 2003

from 9.05% in January 2001.• However Prime market did not give the banks the

high credit growth they had targeted.• Started lending to subprime borrowers.

Aggressive Lending

• Bankers assumed real estate rates were set to appreciate further.

• Aggressive Lenders went to the extent of Financing with more than 100% of the Asset Price.

• Subprime borrowers were offered Mortgage Loans as ARMs.

• Higher Risks – Higher Premiums.

Mortgage Brokers

• Lending operations were carried out by Mortgage Brokers.

• Were paid Commission for underwriting Mortgages

• Were not responsible for recovering those Loans in case of a default.

• Often underwrote Mortgages even when there was no proper documentation.

SECURITIZATION ROUTE

• Banks took the Securitization route to transfer the Risk off their Balance Sheets.

• Sold the Mortgage Loans to GSEs and Investment Banks

• Funds generated from securitization were again extended as Mortgage Loans.

BORROWER BANK INVESTOR

SECURITISATION MODEL

LOAN TRANSACTIONSALE OF LOAN BACKED

SECURITIES

BANK ORIGINATES AND ADMINISTERS THE LOAN. BANK SELLS LOAN TO SECURITISATION VEHICLE WHICH ISSUES LOAN ASSET BACKED SECURTIES. FUNDING

AND CREDIT RISK OF BORROWER IS BORNE BY INVESTOR.

SECURITISATION VEHICLE

SALE OF LOAN TO SECURITISATION VEHICLE

MBS

• Banks created MBS – A Bond.• Were entitled to cash flows from the

Mortgage payments.• Bunched MBS into several Tranches – Pooling

and Tranching.• Many Hedge Funds and Institutions invested

in High Risk – High Return MBS.

FROM MBS TO CDS

• An MBS Investor could buy a CDS issued by other FI’s by paying a premium.

• In return the FI guaranteed the cash flows from the MBS.

• CDS market was unregulated.• Till 2000 the Number of CDS players was limited.• Early 2000 saw a number of players including

Investment Banks, insurance companies and speculators entering the CDS Market.

What is Credit default swap?

Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits).

The "buyer" of protection pays a premium for the protection, and the "seller" of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified "credit events."

BORROWER BANKINVESTOR/

OTHER BANK

RISK TRANSFER MODEL

LOAN TRANSACTION CREDIT DEFAULT SWAP OR CREDIT LINKED NOTE

BANK ORIGINATES, FUNDS AND ADMINISTERS THE LOAN. CREDIT RISK OF BORROWER IS TRANSFERRED TO INVESTORS OR OTHER BANKS.

Example

Suppose Bank A buys a bond which issued by a Steel Company.

To hedge the default of Steel Company: Bank A buys a credit default swap from Insurance

Company C.

Bank A pays a fixed periodic payments to C, in exchange for default protection.

Exhibit Credit Default Swap

Bank A BuyerInsurance Company CSeller

Steel companyReference Asset

Contingent Payment On Credit Event

Premium Fee

Credit Risk

The Bubble

• Estimated size of CDS Market in 2000 was USD 900 Billion.

• Estimated size of CDS Market in 2007 ballooned to USD 45 Trillion.

• This was three times the size of the GDP of USA.

2003

• US Proposed Budget for the IRAQ war – USD 60 Billion

• Actual expenditure had reached over USD 500 Billion.

• Heavily borrowed short term funds.• Had to rely on the Money Market.• Allan Greenspan – US Federal Reserve Chairman –

increased interest rates.

2003 - 2006

• In 2003 the average short term borrowing rates on three month Treasury Bill was 1% when the average 10 year T-Bill rate was 4%.

• In 2006, the average three month Treasury Bill rate went up to 4.85% whereas the average 10 year T-Bill rate was 4.79%.

• Normally short term rates are less than long term rates.

IMPACT

• The cost of funds for lending institutions increased.• They raised the rates on ARM.• With increasing interest rates, the housing market

started witnessing a decline in Demand.• Liquid money started flowing into commodities.• Led to a surge in commodity prices and therefore

Inflation.• To control Inflation, Interest rates were increased

further.

IMPACT

• Borrowers started defaulting on their payments because of increasing interest rates.

• Losses for Investors and institutions dealing in MBS.

• Rating agencies downgraded several MBS.• This made the MBS Market illiquid.

IMPACT

• Investment Banks had to face significant losses.• Decline in share prices.• Few of them which had invested heavily started

defaulting on their obligations.• FI’s which had underwritten CDS faced the pressure

of payments.• This led to Bankruptcies of several FI’s involved in the

Trading of MBS and CDS.• Led to a liquidity crunch and the subprime crisis.

TARP

• The Troubled Asset Relief Program (TARP) is a program of the United States government to purchase assets and equity from financial institutions in order to strengthen its financial sector.

• It is the largest component of the government's measures in 2008 to address the subprime mortgage crisis.

• TARP allows the United States Department of the Treasury to purchase or insure up to $700 billion of "troubled" assets.

IMPACT ON INDIAIndicator Period 2007-08 2008-09

Growth, per cent

Real GDP Growth April-December 9.0 6.9

Industrial production

April-February 8.8 2.8

Services April-December 10.5 9.7

Exports April-March 28.4 6.4

Imports April-March 40.2 17.9

GFD/GDP April-March 2.7 6.0

Stock Market (BSE Sensex)

April-March 16,569 12,366

Rs.per US$ April-March 40.24 45.92

National Housing Bank

• NHB was set up in 1988.• It is the principal housing finance agency in

the country.

Three Roles

• Promotional• Regulatory• Financial

Promotional Role

• The promotional role includes • promotion of HFIs/HFCs• Coordination with Government and other

agencies in securing necessary amendments to the existing laws to remove impediments in the housing sector

Regulatory

• The regulatory powers exercised earlier by the RBI relating to HFCs are now the domain of the NHB.

• It regulates them through directions and guidelines.

Financial

• The financial support by the NHB to HFCs is in the form of equity capital and refinance promotion of loan linked savings instruments and mortgage backed securitization.

NHB Directions cover

• Registration• Net owned funds• Period of deposits• Ceiling on Deposits• Information in the reports of the Board of

Directors• Accounts and Auditor Reports etc

Acceptance of Public Deposits

• Any HFC having Net owned funds of less than Rs 25 lakhs cannot accept public deposits.

• A HFC having NOF of Rs 25 lakhs and above and having a minimum credit rating of ‘A’ from any of the approved rating agencies as well as complying with all the prudential norms, can accept/renew deposits upto five times its NOF.

• In the absence of credit rating, there is a ceiling of two times the NOF or Rs 10 crore, subject to

• Compliance with prudential norms• Capital adequacy ratio of 15 per cent and

more.

Mortgage Backed Securitization

• Packaging of designated pools of Mortgage loans originated by a primary lending institution/HFC and the subsequent sale of these packages to the investors in the form of securities which are collateralized by the underlying mortgages and associated Income streams.

• Sale of specific loans to a special purpose Vehicle.

• Which in turn issues securities• The securities are rated by an independent

rating agency.

• Government has enjoined upon NHB to play a lead role in starting MBS and development of a secondary mortgage market in the country.

• It placed the first ever MBS issue successfully in the Indian Capital Market during August, 2000.

• The NHB will purchase from the originator, a pool of retail housing loans that constitute receivables.

• The individual loans repayable in EMIs will then be packaged and offered to investors by way of securities in the form of pass through certificates(PTCs) without recourse to the issuer.

• The issue proceeds will then be used by NHB to pay part consideration for the receivables purchased to the originator.

• NHB will appoint itself as the sole Trustee and will hold and administer the receivables as Trust Property for the benefit of PTC holders.

• The originator will continue to administer the housing loans as Servicing and Paying Agent (S&PA)

HUDCO

• Established on 25th April, 1970• Fully owned Government of India Enterprise• Principal mandate was to ameliorate the

housing conditions of the Low Income Group and economically weaker sections.

• To finance or undertake• Housing and Urban Development

programmes.

Questions for Revision

• What are the different types of appraisals carried out by Housing Finance Companies ? Describe some of the fees charged ?

• Write a short note on– Securitization– Mortgage backed Securities– Subprime Crisis– National Housing Bank

The End