A confidence trick

MARKET INSIGHT

The RBI will have to ensure that the lenders use transparent benchmarks for floating rates.

Whenever there is a liquidity crisis, commentators start to debate the existence of lenders and buyers of "last resort". Essentially all market theories are based upon the assumption that the market will exist.

That is, at some price level, the market will clear and there will be transactions. So long as that is a possibility, the crisis will be weathered. Without that assurance, in the absence of last resort players, every theory and model breaks down.

During both the Asian Flu and the Long-Term Capital Management (LTCM) crisis in Russian bonds, the market effectively ceased to exist. When a liquidity crisis sparks this total loss of confidence, any outcome is possible.

I find it strange however that last resorts are already been mentioned in the context of the US subprime issue. Yes, there is a problem. No, nobody knows the exact dimensions of the crisis because subprime mortgages have been parcelled, securitised and sold off.

True, the market in subprimes may well cease to exist and players with large exposures in that market may join the dodos in the museum of natural history.

But while the exact dimensions are unknown, it is also apparent that it is unlikely to cause an over-reaching crisis. Even given the cascading and infectious nature of such situations, the subprime market is simply not big enough to knock the global economy off-track.

One pointer is the instantly positive response to the Fed's (and other central banks) opening of liquidity taps. This would not happened if the crisis was of mega-dimensions.

However, the subprime situation shows the essentially hollow foundations of markets driven by consumer finance. When it comes to consumer-driven situations, confidence is all.

If Joe Blog doesn't believe that he can service a given obligation, the market collapses. Home finance is perhaps the market most dependent on consumer confidence and the subprime crisis has dealt confidence a blow.

The Reserve Bank of India (RBI) has probably taken that loss of confidence into account before releasing its recently bearish prognosis. The effect of the statement however, could be counter-productive.

Financiers may become over-cautious and pessimistic simply because the RBI is bearish. In that case, due diligence and qualification norms for borrowers may become so stringent that the home-finance market fades away.

As of now, no such effect is apparent. HDFC has had no problems raising cash from overseas investors. While the mortgage market has slowed, this is more a consequence of rising rupee interest rates than due to vague fears of infection. However, Indian markets are not divorced from the US and further tremors overseas could have a knock-on effect here.

Rising rates are cyclical and the cycle could peak soon. That is fine. Any loss of valuations in listed housing finance institutions as a consequence of a slowdown will be rational. It will represent a buying opportunity since the long-term structural factors and demographics suggest secular growth in housing.

The Warren Buffett disciples believe in summing predictable future cash-flows to arrive at a net present value. In the case of Indian housing finance, growth rates of 20 percent plus appear assured over the next decade due to favourable demographics. HDFC, ICICI and LIC Housing are therefore all available at attractive valuations and a 10-15 per cent dip in shareprices would make them even more attractive.

However a knock-on effect from an US crisis may cause irrational drops in valuation in financial institutions. That would be a huge buying opportunity. The only issue would be confidence. If Aayaram loses faith in his ability to meet EMI demands and his animal spirits are depressed, he won't buy a house.

This is where the RBI has a big role to play and so do law courts and legislators. The RBI has to ensure that the housing market remains transparent. Borrowers must not feel snow-jobbed by the fine print or fearful about their obligations in the case of floaters.

One way to do this would be to insist that lenders use clearly-mandated benchmarks for their floaters, rather than creating opaque internal benchmarks. This could be a long-term T-Bill yield or government security rate, or MIBOR-plus, or whatever "� so long as the rate can be independently tracked.

Courts and legislators on the other hand, need to develop dispute-resolution mechanisms that work quickly. If lenders felt a degree of assurance about quick foreclosure, they would be more willing to drop rates. In the end, it could all boil down to confidence.