Saturday, August 22, 2015

Teaser Loans - The Madness of Middle Class Economics

I am in India (again) and have the opportunity to follow a conversation about teaser loans, which, in my mind, goes on to show the madness of middle class economics. (Read the news here)

Teaser Loans are loans offered below the base rate (which is 9.70% for State Bank of India, for example) and which banks to want to give out. The idea is not to change the eligibility criteria in anyway (anyone remember subprime?) but offer loans at an attractive rate for the first few years.

The reason why this is back in conversation is because the Indian Real Estate market is close to breaking point. The transactions are at all time low and the inventories are at all time high. However, despite the lack of transactions, realtors refused to reduce the prices - so prices are at all time high - hoping for the Central Bank to bail them out with a rate cut.

The Central Bank (Reserve Bank of India, as it is called in India), under the very able leadership of Raghuram Rajan, has so far resisted the political pressure to reduce rates. Indeed, the RBI is fishing in very troubled waters, with Rupee declining sharply, the volatility of the international currency markets with the Chinese devaluation and its possible follow-up plans, and the food grain and other essential prices remaining high in India (and with an uncertain prospect of Monsoon). This is no climate for a rate cut, despite the decline of world oil prices, but it seems that the retail banks and real estate companies are making a case for it.

Dr Rajan stood his ground so far stating that reducing the base rate would only make sense if the real estate prices come down, because otherwise it would interfere with the market mechanism and help keep the prices artificially high. The retail banks, particularly SBI, is making a case for offering loans under the base rate, arguing that the home loans are the safest assets in their portfolio. The government is obviously keen on a consumer boom, and created pressures on RBI and started interfering with its decision making process.

So, here is the madness of middle class economics, as we should ask the following questions

1. Why do banks really think home loans are safe assets when they can see that there are real pressures on house prices and many of the inflatedly priced properties may soon start accruing negative equity for their owners?

2. Why does the government think reducing interest rates is a good idea, when the inflation outlook remains uncertain and the currency is volatile?

3. Why would anyone take on a teaser loan because their very existence may signal a downward price pressure on real estate?

4. Why dont real estate companies start reducing the prices and hope that the government would kick-start the market by reducing rates?

I find this conversation fascinating because this shows the intersection of politics and economics and where it really get murky. So far, the Governor Rajan is standing firm, but the political agenda is quite clear. The idea that monetary policy can be used to bail out irrational investment decisions is now an essential part of economic thinking, or what can be called the madness of middle class economics as we have come to know it. The old discussion - that real estate prices would be linked to middle class income - is passe. In fact, that link may now have been permanently broken, as developed countries continue to shore up the real estate sector with cheap money.  There are some important and rather scary bylines - the state of real estate sector in India and the prospect of a weakening currency - but the fascinating story of the base rate politics highlight how we fail to learn and self-inflict economic crisis, again and again.



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