A reading of the article ( LAP – a ticking time bomb ) suggests that it does not follow the standards of a good argument. Here’s why.
When the author invites us to read the article with a headline that something is questionably a time-bomb ticking away, it means that something dangerous is questionably happening that is more likely than not to end in calamitous outcome. He further gives possibly his main premise as “The biggest risk factor is the fact that some of the LAP customers have been using it as a loan in perpetuity”
Why should use of a loan by borrowers in perpetuity be a ticking time bomb? Working Capital loans, the basic bread-and-butter of many banks are also more-or-less loans in perpetuity. In other words there are existing loans that have the key characteristic of LAP (Loans Against Property) and have not been time-bombs to my knowledge.
But let us read further into the article:
The beginning two paras establish the fact that lending as such is slow among categories of lending. Home lending although very small in size is growing robustly. Then the author goes on to say that this category of lending is the safest; but within this safest category LAP, whose popularity is increasing, is according to some, a ticking time-bomb.
So one wonders how can something that is within a very small category of lending and within the safest category be a ticking time-bomb.
The author then goes on to describe the features of LAP, that it is secured, it is used for business purposes, for special events or exigencies and for closing another loan. He says it is also safer to lend because it is lent for a shorter time, has a lower amount in relation to the secured property.
The premises that the author uses to justify the claim and my refutation are as below:
A customer willing to borrow at a high rate (14 – 15%) is most likely to be facing financial stress.
The author is possibly implying that a customer facing financial stress is likely to default on the loan thus contributing to making this LAP a ‘ticking time bomb’. But there are defaulters in every category of loans including a highly rated loan. The risks of default are compensated by a higher rate of interest sought and that is how various products on the scale of risk are priced. A category of loans with a high expectation of default (say 3% or so) is priced in such a way to compensate the bank for this risk. It is evident that the industry is doing this here by making LAP much costlier than home loans by 4-5% as the author himself says. This begs the question, why is this a ticking-time bomb? Maybe it’s because the default rates are much higher than the rates at which the loans are priced. If that is the case then the banks would secure the property that is, atleast on paper, 67% higher than the amount lent, which covers for 4 years of default – enough time to act!
In other words, this is not a sound premise.
“Lenders also do not have any control over the end use of the money. LAP is essentially a cash out of primary residential and/or commercial property, often the core asset of a small and medium entrepreneur (SME)—a segment which is under huge stress primarily due to cash flow issues in business following the delay in payments across the supply chain in both manufacturing and servicing sectors”
The author is suggesting that lenders do not have control over end use and that those who seek this loan are under stress and possibly using it as borrowing of a final resort by using their “core” asset.
In other words lenders are using this loan in ways that make them unlikely to repay. This would not have happened if bankers had control over end-use.
If I think about it, bankers make various other loans without control on end use, like Loan Against Securities for instance. The bank protects its interest on default by way of a higher cover on the property, in this case.
So how is it that by not having control over its end-use the loans become a time bomb?
“A few banks and housing finance companies have already been hit by frauds in the LAP segment. One such company, based in Maharashtra, has sacked its entire top brass which was overseeing the LAP business.”
Frauds are to be expected in any lending activity including the safest one. Thus to say that a few firms have been hit by fraud does not make it a ticking time-bomb. The author cites the instance of a company sacking everyone associated with the business. But we need to know if the circumstances that led to such an action were specific to the firm (like extremely lax standards, collusion etc) or one that indicates likelihood of such possibilities in the LAP segment. The author has not given any indication of the size of the business that was affected. Remember that LAP is a portion of a small portion of overall bank credit. So it is reasonable to assume that being hit by frauds will not lead to a time-bomb that is now ticking away.
“The biggest risk factor is the fact that some of the LAP customers have been using it as a loan in perpetuity. Riding on the rise in housing prices, they are taking fresh LAP to pay off the existing lender. It’s simple arithmetic. For a Rs.1 crore property, a borrower can raise Rs.60 lakh today and a few months down the line, when the property price goes up to Rs.1.1 crore, they can raise Rs.66 lakh and pay off the first lender. The cycle can go on till the property prices crash. If indeed that happens, most loans will be close to the actual value of the property and in case of defaults, exit will not be easy for the lenders.”
The author cites the biggest risk or the key ‘lighter’ of the time-bomb – a loan in perpetuity. This in itself has been addressed earlier. But the author adds some more logic to support his argument. He says that borrowers in a rising property market can keep increasing the borrowed amount as a fixed percentage of the rising property value. However when property prices crash then “most loans will be close to the actual value of the property” and thus defaults won’t be easy.
If banks keep a 1/3rd margin between the property prices and the amount lent, in all markets, then the property prices will have to crash by 1/3rd before the loan amount exceeds the quoted property value. Generally speaking property prices do not crash to such levels fast enough to escape notice or to take action. That doesn’t mean they won’t but that it is highly unlikely. But the author’s core premise is that LAP is a ticking time-bomb because its customers take loans in perpetuity against property that may eventually crash.
To sum up:
In other words, the core premise of the author is that property prices will eventually crash leading to explosion of the LAP segment.
But is that core premise true? Will property prices crash? Why? The author does not address these questions to prove the validity of the core premise.
In other words the author’s argument is supported on a premise that is not proven to be true; in other words it is not a valid argument.