The realty sector is tempting for a trader. But it lacks a hedge.
One of the interesting stories of the US Subprime crisis centres on the few traders, who got it right. As early as 2004-05, a few hedge funds (and some economists) were alarmed by overheated US housing market. Flush with liquidity, the US realty industry was handing out mortgages on terms guaranteeing high defaults to non-credit-worthy individuals.
Those low-rated mortgages were mixed with higher-rated mortgages and sold off as “Subprime” bonds. It isn’t easy to short bonds. Shorting realty-driven stocks was risky. There was no telling how long it would take for the bubble to burst. In fact, it took four years.
Scion Capital was among the first hedge funds to find an efficient way to profit from a meltdown. Scion started the trend of buying “credit default swaps” (CDS) on subprimes. CDS are insurance policies on specific bonds. The CDS buyer pays a premium, while the seller offers collateral and accepts default risk.
If the bond defaults and market value crashes, the seller compensates the buyer. It was possible to buy CDS without owning the underlying. Premiums were 1-2 per cent of face value. Hedge funds like Scion that bought CDS made multiples of their premiums, while sellers went bankrupt.
Indian real estate is not so frothy and mortgage structures are vanilla. But bubbles do occur. Real estate values more than doubled between 2004-08. In the past 18 months, rates have fallen 30 per cent or more. A typical retail realty customer is salaried. The mortgage is for about 70-80 per cent of official value. The usual structure is floating rate with fixed equated monthly installments (EMIs). Lenders prefer to extend tenure rather than up EMIs, which is 35-40 per cent of income.
The slow legal system makes foreclosure practically impossible. But unlike the US, there is a black component to Indian realty and that is paid upfront. The “black” means very committed buyers. Developers depend on that cash flow to fund operations as well as capex.
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Negative equity situations arise if prices drop enough to make outstanding mortgage larger than the property value. Then, the only hope is that borrowers will go on paying. Home loan defaults did rise through 2009, but remained under control.
The correction, coupled to a general slowdown, meant lower demand for loans. It led to a massive cash-crunch for developers holding surplus inventory. There was a negative impact on developer toplines and bottomlines and to a lesser extent, on the financials of housing financiers.
The stock market correction was strong and coincident with realty price correction. By March 2009, the CNX Realty Index had dropped 91 per cent from its Jan 2008 peak. Most realty majors are available in the derivatives segment. Traders could profit by selling stock futures. However, the futures margin is roughly 10 percent and monthly rollover is required. So this is much less efficient than CDS.
As in the US, bubbles can build up over long periods in India before the stock markets correct. There is no certain way for a trader to profit from a early recognition of problems. At best, he can stay on the sidelines and wait for a reaction.
The CNX Realty index had a 200 per cent rebound in the past 12 months and it's now “only” 75 per cent from the peak. Most real estate majors are hoping to raise more money through QIPs and ECBs. Quite a few have reduced debt exposure.
Some housing financiers are experimenting with sophisticated structures such as “teaser” mortgages. In a teaser, the first 2-3 years is fixed rate, with a switch to floating rates after the specified lock-in period. A smart borrower may opt for a teaser if the initial lock-in is low-rate. An unwary borrower could be trapped by high initial rates, or hurt subsequently if the switch to floating rate raises EMI. US teasers were missold and contributed to the mess.
The RBI has expressed misgivings about teasers.
It has raised provisioning norms and risk-weightage for real estate-related loan exposures. This is prudent and anyhow, interest rates are hardening, making teasers less attractive.
Nevertheless, if the job market recovers quicker than real estate prices and this is likely, home loans could rebound strongly in 2010. Housing financiers will be gainers. As things stand, the balance sheets of real estate developers will remain under pressure though they should improve. Realty majors do offer more potential upside than housing finance stocks. So the sector is tempting for a trader. The problem is the lack of a hedge.