Note. Sovereign-guaranteed housing finance bonds: An alternative to interest subsidy. Nidhi Bothra 12 th February, 2015

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1 Sovereign-guaranteed housing finance bonds: Nidhi Bothra 12 th February, 2015 Check at: for more write ups. Copyright: This write up is the property of Vinod Kothari Consultants P. Ltd. and no part of it can be copied, reproduced or distributed in any manner. Disclaimer: This write up is intended to initiate academic debate on a pertinent question. It is not intended to be a professional advice and should not be relied upon for real life facts.

2 Executive Summary: Government is currently providing interest rate subsidy for low cost housing finance. Subsidies are burden on the exchequer, and eventually, on the tax payer. Instead, the same effect can be achieved by housing finance lenders raising cheaper funding from the capital markets by issuing bonds, backed by sovereign guarantee. If the bonds are issued in international markets, with exchange risk as well as credit risk on the government, the cost can be brought down to very low levels. Eventually, this low cost of funding may be mandatorily transferred to the borrowers by specified caps on the interest rate margin. Benefits are two-fold: o A guarantee, which effectively amounts to interest rate subsidy, does not put a burden on the exchequer at all. The contingency that housing finance lenders default and the government has to pay under the guarantee is quite remote, given the regulated nature of housing finance lenders. o At the same time, the bond market develops, with a new instrument carrying sovereign guarantee.

3 Background Affordable housing for all has been a policy initiative by the government and the government has been launching several schemes in order to facilitate the growth of low cost housing sector in India. Amongst such schemes, few of them provides interest subsidy to the customers seeking housing loans with the intent of making housing loans affordable. Some of the subsidy schemes launched by the government of India facilitating affordable housing for all include the Interest Subsidy Scheme for Housing the Urban Poor (ISHUP), Rajiv Rin Yojana by Ministry of Housing & Urban Poverty Alleviation, Government of India, 1% Interest Subsidy Scheme by NHB etc. Even though these subsidy schemes are beneficial from the customer perspective as they facilitate low costs for housing, one cannot ignore the fact that such subsidies are a drain on the exchequer. On the other hand, housing finance companies in India rely on several sources of funding which includes: a. Owned Funds b. Debentures c. Foreign investments by way of a. Foreign direct investment b. External Commercial Borrowing d. Commercial paper e. Refinancing by NHB f. Securitisation The cost of funds along with the operational and overheads costs and thin margins lead to the cost of lending being as high as 14% and more. Thereby impacting the affordability of owning the house; causing the government to offer interest subsidies to lower the cost of housing loan. Housing finance companies are also on a constant look out for cheaper funds. National Housing Bank being the apex institution facilitating the business of housing finance in the country has been providing refinancing facility to these housing finance companies.

4 However availing refinancing facilities of NHB is also constrained by several factors such as number of years in business, HFCs borrowing powers etc. NHB had also published a scheme 1 for guaranteeing bonds of HFCs, wherein AA- and above rated bonds of HFCs could avail guarantee from NHB to bring down the servicing cost of the bonds. This scheme however has remained dormant largely with no takers largely due to the guidelines not incentivizing enough for the existing HFCs. The scheme requires: a. Bonds to be AA- or above rating. Most of the HFCs with such high ratings may not be in need of NHB guarantee. The pressing need of such guarantees is higher in lower rated HFCs for who the guarantee may provide a rating upliftment, making it commercially viable for them to consider bond issuances. b. The asset cover ratio is 1.25 times which may be very high, typically a 1.1 times asset cover is considered to be satisfactory. c. The guarantee fees is 75 basis points per year and is payable upfront. Apart from this the HFC will be required to create redemption reserves necessary as required under the extant regulations. d. The tenure of the bonds being 5 years. HFCs are typically in need of long term modes of finances. e. Other conditions with regard to three years of profits, NoF of Rs. 30 crores or more, NPA levels being less than 2% etc are to be complied with as well. In essence in absence of means to reduce of cost of funds for HFCs, the interest subsidy schemes offered by the government are necessary and continue to have an impact on the tax payers funds. We hereby propose a structure which will be able to address the above issues in hand. Proposed Solution The government may consider offering guarantee against bond issuances of HFCs. While there is an existing scheme by NHB on guaranteeing bonds/ debentures of HFCs the same needs to be more facilitating for the smaller HFCs to be avail the benefit of. The Guarantee scheme shall have the following advantages: a. Reduces Cost of funds for HFCs Bonds that are guaranteed by the Government will be less costly for the HFCs. In case the HFC is able to tap funds 1

5 from overseas by subscription to the bonds which are backed by the government guarantee, the cost of debt can be reduced substantially. b. Capping of interest rates to borrowers -- Similar to the regulatory interest cap made applicable in case of priority sector loans and micro lending can be made applicable to housing loans as well. Once the cost of debt for the HFCs is lowered, the government can put a cap on the interest rate charged on home loans and do away with the interest subsidy scheme. This will ensure that the benefits made available to the HFCs by way of lowered cost of debt is passed to the borrowers appropriately. c. Reduced cost to the Government The guarantee provided by the government will only be invoked where the default has occurred. So the drain from the exchequer will be reduced to the extent that there is default in repayment of loans. This will ensure: a. That there is no immediate impact on the exchequer b. The government will be able to charge guarantee fees to the HFCs. Hence the expenses caused due to interest subsidy will be replaced by immediate flow of income. d. Promoting housing finance and bond markets The above scheme will enable the government to meet its twin objective; one, of promoting affordable housing for all and two, promoting growth of bond markets as more and more HFCs will be incentivised to issue bonds. Modus operandi briefly: The scheme may be made available for housing finance lenders (HFIs) including banks/ registered housing finance companies. The funds raised under the scheme can be used only for low cost housing definition of affordable housing currently being used by MHUPA may be used. The scheme provides for issue of bonds by HFIs into (a) domestic or (b) international markets. In either case, the bonds are guaranteed by the NHB/ Government of India. The HFI undertakes that the funds raised by the issue of bonds will be utilised for on lending to low cost housing with a maximum margin of 2%.

6 Conclusion The Government may consider replacing the interest subsidy scheme with a Guarantee scheme. Basis a certain selection criteria set by the Government, every debenture issuance of an housing finance company shall be backed by a sovereign guarantee. However the policy must be such that it creates an enabling environment for bond market to flourish. Furthermore, the arrangement will be beneficial to both, the borrower as well as the government, as the borrower will get housing finance loan at a much lower cost and the government will have to pay only in case the guarantee is invoked and will be able to convert an immediate expenses into income. The ultimate objective of the government behind such schemes is to provide financial support to the customer. The guarantee arrangement will help in the fulfillment of the objective in a cost effective manner. The following table compares the advantages and disadvantages of both the arrangement. S.no Particulars Interest Subsidy Guarantee 1. Low cost for customer Yes Yes 2. Drain on the exchequer Yes Relatively low 3. Government Intervention Yes Yes 5. Outflow of Govt. money Yes Only if Guarantee is invoked as reduced by the guarantee income fee Thus, based on the above pretext, we are of the opinion that the arrangement of guarantee to be provided by the government will be more beneficial that the subsidy schemes provided by the government and may be considered appropriately. Our other write ups on similar topics can be viewed at: Details of our book Guide to Housing Finance, can be viewed at: