Column: Disguising NPAs

Regulators need to specify clear risk-weightage guidelines on repossessed properties

Amid growing concerns about the deteriorating quality of bank loans, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (Sarfaesi), was enacted to aid in debt recovery, especially from wilful defaulters.

Since the 2006 Supreme Court judgment allowing banks to simultaneously initiate multiple proceedings against the defaulters, the use of Sarfaesi by banks has significantly increased. While the possession of mortgaged property was facilitated by Sarfaesi, the liquidation of repossessed property proved a challenge, resulting in an amendment in December 2012. A specific component of this amendment is to allow banks to purchase properties placed under auction in the absence of other buyers, with the objective of reducing NPAs.

This clause may have serious implications. According to existing accounting standards, banks cannot recognise the value of repossessed collateral in their books until the actual sale through auction. First, permitting banks to place a property on auction and then purchase it themselves contradicts the very principle of an arm?s-length transaction. Second, since banks have to book the shortfall between the sale realisation and the loan outstanding as a loss, there is a possibility of banks manipulating the reserve price to minimise losses, even by colluding with the borrower. Actually, in fixing reserve prices, conflicting interests prevail. The borrower, who has to authorise the reserve price, has no incentive to reduce it because she is personally liable for the shortfall between the asset?s sale value and the outstanding loan. In contrast, the bank needs to complete the auction to reduce NPAs. If the reserve price is higher than the real market value of the property, it implies that the loss has been taken over by the bank from the shoulders of the borrower.

In general, as banks can hold a repossessed property for about seven years depending on the asset class and use of property, they can time the sale in the hope of maximising profits. Instead of lowering the reserve price to the actual market value and booking an immediate loss, banks can now hold on to the property at inflated prices and hide the true value of NPAs as the actual risk exposure on the asset would only be known when the property is sold. In this manner, a bank may end up accumulating substantial repossessed properties in its balance sheet, exposing it to high risk.

The price discovery in a property auction can fail, because of absence of bidders or under-bidding due to cartelisation amongst buyers. Property auctions ideally should be a good indicator of current market prices; however, by allowing the bank to bid at the reserve price, the process of price discovery is defeated; there is no feedback mechanism to incorporate current market expectations into the reserve price of the asset. This amendment could lead to opaque property markets.

The amendment also raises a number of related issues that need to be addressed, such as the management, maintenance, utilisation and protection of these properties; generation of additional funds to manage these properties; handling litigation on these properties; and fundamentally changing the role of a bank from a financier to a market player.

In this context, India may benefit from examining well researched evidence from international markets. In the US, some states allow waiver of personal liability (deficiency judgement waiver) to borrowers who, on default, surrender their mortgaged premises without contestation. If foreclosure auctions fail due to bids being lower than the opening bid (usually the value of loan outstanding), the property, known as real-estate-owned (REO), is purchased by the bank. REOs are known to be overvalued when the bank buys them: in falling real estate markets where transaction volumes are low and reserve prices are dated, banks take a higher loss when they re-sell REO properties (Fed, Cleveland, 2011). The banks tend to shift losses from their active loan portfolios to REO since solvency tests place less emphasis on these. REOs can be held for up to five years and rented too, but the Federal Reserve has asked banks to limit their REO portfolios and to refrain from engaging in real estate brokerage and/or services. The Fannie Mae also has detailed guidelines on property preservation of REOs.

To improve price discovery and to manage risks in repossessed assets, a few suggestions can be considered: auction design needs to change, and mechanisms such as e-auctions or pooled auctions across various banks and branches in a specified local region at regular intervals may be considered. Greater information dissemination, including through branch-level advertising of auctioned properties, may attract bidders in larger numbers and reduce probability of cartelisation. Regulators also need to specify clear risk-weightage guidelines on repossessed properties as also prescribe limits so that banks do not build alarmingly large portfolios of REOs.

Madalasa Venkataraman is Research Consultant, Real Estate Research Initiative, IIM Bangalore. Charan Singh is RBI Chair Professor in Economics, IIM Bangalore