Should banks be allowed to tease? Financial Express: 1st May 2010

For those of us who enjoyed listening to Cliff Richard croon “I’ll give it to you straight right now, please don’t tease” in the 1970’s may be tempted to say the same about the rates being charged by banks today on housing loans. The most recent monetary policy announcement of RBI is over a week old and while one would have expected banks to raise interest rates, they have actually not done so. They had already buffered in a 25 bps increase in rates and hence these policy enhancements do not matter. The concern of RBI today is on the teaser rates being offered by some banks, which means that instead of increasing rates some have actually lowered them on mortgages, albeit for the first year. Is this a serious issue, especially at a time when it appears that rates would be increasing, and not decreasing, in the next few years?
The concept of teaser rates became fashionable post financial crisis. In rudimentary language, when interest rates came down to historically low levels of 1% in 2003, driven primarily by Alan Greenspan, banks and other mortgage institutions disbursed housing loans at very low rates with little due diligence. People borrowed heavily and bought houses and contributed to the boom in the economy. Simultaneously, housing prices went up, but with prosperity everywhere it did not matter. Loans were given at low interest rates for the first year and then linked to the market rate at a subsequent date—the classic floating rate scheme.
But problems surfaced once rates hardened as the Fed rate climbed to 5.25% by June 2006. As demand fell, home prices came down and those who had taken loans at the teaser rates had to pay as much as 500 bps more on their loans as rates had virtually doubled leading to large-scale defaults. When they tried to sell their houses, the crisis was exacerbated. The original lenders had moved away from these assets through the securitisation business and the rest, as the cynics would say, is history.
Today housing prices have started moving upwards quite sharply. Teaser loans come at 8.25% in the first year, 9% in second and then at the market rate subsequently. Clearly we have an issue on hand. People may jump into the fray to buy houses before prices rise further. Rationality dictates that with low interest rates today and an increase of 100 bps in the second year and probably something higher subsequently, one should enter the fray today that will, in turn, drive up housing prices in urban areas.
RBI’s concern is two-fold. First, banks may just be compromising quality in remaining ahead of competition and while India was quite insulated from the subprime crisis, that scenario remains a grim reminder of caution that should be exercised today. Second, there is a lingering question of ‘what if there is failure’. The country is in a unique spot with inflation being quite resilient and growth on a high trajectory. In this high growth-inflation scenario, rates tend to harden, which needs to be understood by anyone who is attracted to a home loan.
Hence, it is not a coincidence that RBI has also come out with a report on securitisation where the ground rules are laid. There is a minimum holding period of one year by the originator as well as a clause that makes it mandatory to retain 10% of the loan on its own books. This is to eschew the possibility of such teaser loans being bundled and resold to other investors. While securitisation of home loans is not really popular and has been confined mostly to deviant assets of banks, this move is certainly welcome as it does make RBI appear more proactive with the process of prudential regulation. Alongside, RBI is also going to get in the base rate concept, which is good, so that there are certain limits placed on banks in fixing their lending rates without compromising on prudence.
There is a curious game that is unfolding in the banking arena. Banks are back to getting more competitive, with home loans coming to the forefront once again. Personal loans account for around 20% of non-food credit (as on Feb 2010), of which home loans constitute 50%. Corporate loans follow a set pattern with limited manoeuvrability for banks. However, for the retail segment, there would be a tendency for banks to push forth their chances by offering competitive rates.
This is where RBI has come in with cogent moves at regulation, thus ensuring that the growth in credit is in accordance with the global best norms that have come into play in the aftermath of the crisis. But, yes, these are signals of competitive action picking up in this sector after a lull of two years.