Fri, 07 Nov 2008
Land as an asset
The doyen of Indian housing finance, Deepak Parekh is today quoted as saying that land is no longer an asset (“There is no need for irrational pessimism”, Business Standard, November 7, 2008). Parekh says “Land prices have collapsed, land is no longer an asset – people don’t want land as a security. Today, there is surplus land, low demand ... the value of land is probably half of what it was ...”
This explains why real estate companies reportedly have to pay 35% interest after providing collateral (land) notionally equal to three times the value of the loan.
Another interesting statement in this context is in a speech by Fed Governor Kevin Warsh (hat tip Calculated Risk) “We are witnessing a fundamental reassessment of the value of virtually every asset everywhere in the world.”
Posted at 14:58 on Fri, 07 Nov 2008 6 comments permanent link
Comments...
Gaurav wrote on Sun, 09 Nov 2008 00:08
Re: Land as an asset
Prof, This is a fascinating paper by Gary Gorton titled "Panic of 2007" (https://www.kansascityfed.org/publicat/sympos/2008/Gorton.08.04.08.pdf). He is a prof at Yale and was the brains behind the risk models of AIG.
What Gorton says is that there were some unique design features in subprime mortgages that caused the crises, which are not there in other mortgages. We might criticize subprime mortgages for their high LTV's and their option ARM features today. But lets step back to figure out why they came in the first place.
In late 1990's, US legislators wanted banks to make housing loans widely available - even to the poorest people. Now these people can neither put down a downpayment, nor can they pay a high interest rate - commensurate with their risk profile. So the only possible way to design these subprime mortgages was to have high LTVs (close to 100%), and low risk-adjusted interest rates. To make money on these mortgages, banks thus put an optionality in these mortgages (the option ARMs) - whereby the bank stood to benefit if house prices appreciated. Effectively, the subprime borrowers sold call options on their homes to the banks to get attractive mortgages. This feature is not present in prime mortgages.
The implication of this is huge - for Indian real estate market. We might not see massive mortgage defaults because of negative home equity here - there are no option features in mortgages. Defaults would be driven by traditional factors - overleveraging, job loss, health problems, divorce etc. The problems will be more on developer side - as we are already witnessing.
Would appreciate your comments, considering you are very negative on Indian real estate market.
Prof. Jayanth R. Varma wrote on Sun, 09 Nov 2008 13:18
Re: Re: Land as an asset
Yes. I have read Gorton's paper and there is merit in what he says. But, we must remember that ARMs were 30% of prime mortgages in the US and therefore there must have been other reasons for ARMs.
As for India, most of Indian home loans were floating rate and not fixed rate. This puts them about mid way between fixed rate mortgages and ARMs.
I think both in US and India, the old equation still applies: negative home equity + negative life event = default. Real estate bust plus economic slowdown gives lots of both.
Hrisheekesh wrote on Mon, 10 Nov 2008 16:02
Re: Re: Re: Land as an asset
As far as I know, Option ARMs are ARMs with flexible payment options for the borrowers. The problem is that they begin with low introductory interest rates (typically for 1-3 years) and then suddenly shift to the fully-indexed rate causing a payment shock. Moreover, these low introductory rates are present only for payment purposes but the interest is calculated at the fully-indexed rate from the outset, resulting in negative amortization. This is fine in periods of booming asset prices but strongly increases the likelihood of default when house prices are falling.
In the case of India, I think there is no fixed benchmark across banks (like the LIBOR or COFI in the US) which is used to set the rates on ARMs. This allows banks to change their rates independently of each other, thus increasing the risk of adverse interest rate shifts for the borrowers. Also, there are huge pre-payment penalties which make it more difficult for the borrowers to take advantage of differing interest rates across banks. How can this apparent inefficiency in the market be tackled (other than through government intervention)?
Gaurav wrote on Wed, 12 Nov 2008 21:51
Re: Re: Re: Re: Land as an asset
A friend of mine who has a loan from HDFC tells me that their prepayment penalty is only 0.25%.
Madhu wrote on Mon, 10 Nov 2008 10:27
Re: Land as an asset
Prof are we seeing drastic reduction in prices in India?. I've been planning to purchase a house but i dont see BIG price cuts by developers. There is a cut in built up area which makes the flat affordable and stimulates demand. But per sq ft prices remain almost the same (atleast in chennai).
Are you foreseeing deeper price cuts in India going forward? Is 35% reduction imaginable?
BizBlogged1 wrote on Tue, 25 Nov 2008 05:58
Re: Land as an asset
Real estate has been there. In India, it's been red hot since tech boom. Now is the time to evaluate if it is a bubble or not? The share prices go up and down. But real estate values come down in very very rare circumstance.
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