Nobody should be surprised with the article in the 2012/10/04 issue of Kantipur that had a write up on real estate borrowers taking on new loans away from the banking sector at rates as high as 365% per year among others to meet their payments on their outstanding loans in the banking sector and the rise in the number of delinquent checks written by such real estate borrowers. While standard economic principles assume humans act rationally we all know that this is far from the truth. Irrationality is quite often the norm and this is just one example - paying 365% per year to hold on to assets that are going to decline in value. Irrational behavior also describes why people were willing to pay exorbitant values for land with no link to economic fundamentals and its earnings power when prices were rising. The article also included comments made by bankers and regulators that the crisis in the real estate is not going to affect the financial system and that the crisis is manageable. While I have doubts about this let us hope that they are right.
If you look at all financial crises around the world, most if not all have been precipitated by excessive lending in real estate. The US savings and loan crisis in the 1980s and 1990s, the Japanese crisis beginning in 1989 and the recent global crisis beginning in 2007 which started from the US all have a common theme - excessive lending in real estate assets. The Japanese asset bubble burst in 1990 and real estate prices in Tokyo and Osaka two of the largest cities in Japan are yet to stabilize 23 years later. The sub-prime crisis in the US happened in 2007 and prices have not yet bottomed out in many parts of the US. For Nepal, it has only been about two and a half years and there is very little reason to expect the prices to stabilize and rise.
Let us hope that banks and regulators are on their toes monitoring the situation. While licensed banking institutions are probably the most transparent corporate entities in Nepal, in a country where there are a lot of questionable practices and corporations are known to keep several accounts, one has to look at published accounts with some degree of skepticism.
As of 2069 Baisakh, licensed class A, B and C banking institutions had 763.6 billion rupees in credit of which class A banking institutions accounted for 77.6%. Product wise only 142.8 billion rupees (18.7% of total credit portfolio) were invested in retail and corporate real estate. There is, however, 125.7 billion categorized as overdraft and another 178.4 billion categorized as demand and working capital loan. Together they constitute almost 40% of the banks' credit portfolio. That corporations world-wide window-dress their balance sheet and income statement is a well known phenomenon and Nepal would be no exception to that. How much of that overdraft or working capital loan is actually going towards payment of interest and principal of prior real-estate loans are anyone's guess but we can be sure that some of it is being done so. Similarly, how much of the loans categorized in other sectors have been diverted towards real estate projects is also a matter of concern. Nevertheless, we can with some certainty say that licensed banking institution's real estate exposure is much more than what is provided in their official periodic financial statements.
The bigger picture, however, is that 85.6% of all credit is against property as collateral. For class B and C banks this is almost 90%. In an abnormally rising market such as that experienced by Nepal in the last few years, this means that many of the later loans have been made against inflated collateral values. While banks apply a hair-cut to market values when extending credit, in a market where prices are several times higher than what they should be, these haircuts may not be sufficient putting them at a greater risk. That banks are finding it difficult to get buyers for their seized collateral at distressed values is an indication of this. In an environment, where banks still follow the practice of basing their lending on collateral values and the person bringing the proposal rather than the economic viability of the proposal itself, it is highly likely, that some credit has been extended to unviable projects that will eventually fail and the banks have to resort to seizing and disposing of the collateral not a very good situation to be in today's market context.
If you have been traveling around various part of the Kathmandu valley, you will have observed many unfinished or partially completed housing developments. Some have begun offering substantial discounts. An ad in the Kantipur issue of 2012/10/09 had Downtown Housing offering a discount of 24% on its original prices. For the high-end penthouse originally priced at 152 lakhs this is a reduction of almost 36 lakhs. While this was couched as a dashain/tihar offer, most likely it will be a permanent offer and there is no reason why more discounts may not be offered by this and other housing developments as pressure to pay the banks keep rising. So for those of you who are looking to buy, you might want to wait until the dust settles. You might also want to focus on ready-to-move units in finished developments rather than risk your funds on units in unfinished developments.
While some have begun to argue that real estate prices have begun to stabilize, this is far from the case. In fact, we are probably at the beginning phase of a real estate induced financial crisis which will only get worse before it gets any better. The flow through impact of the real estate crisis has not yet been fully felt in the financial performance of Nepal's banking system because of practices highlighted in the Kantipur article and window dressing at financial institutions that distort the true nature of the credit risk carried by financial institutions. Whether we like it or not, we are in for some turbulent times in the financial industry.