REVERSE MORTGAGE - WHAT YOU SHOULD KNOW

Reverse Mortgage is a loan against security of home (a self occupied house) that gives cash advances to a homeowner, requires no repayment until a future time, and is capped by the value of the home when the loan is repaid. The loan is extended by mortgaging the property and the loan amount is worked out using reverse annuity table based on valuation of the property. Therefore it is called “Reverse Mortgage”.

Conceptually, a ‘reverse mortgage’ is a special type of loan that can be used by the senior citizens to convert the equity in their homes into cash. The money from reverse mortgage can provide senior citizens with the financial security they need to meet their different requirements and lead a decent life.

It is a concept originated in USA & Europe. There are four ways to receive a payment:
• A lump-sum payment,
• A monthly payment,
• A line of credit or
• Some combination of these three.
In most instances, there is no restriction on how the cash is used and it's not subject to income tax.

It’s different from traditional mortgage loans where the loan is paid back in instalments or on lump sum basis. While in case of RM, the repayment of loan is done only when
• Owner dies, or
• Owner sells home or
• Owner no longer use it as its primary residence
whichever comes first. The recovery of loan is done either by selling the property, or the person or its heirs pay back the loan amount.

The amount payable to a person depends on the following factors:
• Age
• The level of interest rates,
• The valuation of house assessed by the lender
• Borrowing limits that are set by lenders.

In case the realized value by sale of property is more than the amount of loan received by the person, the excess amount is given back to either the person if he/she is alive or its legal heirs.

Pros & Cons
On one side, it guarantees a source of money for as long as you need it, even if you live beyond your life expectancy. But you pay for that guarantee however, through interest, higher-than-usual closing costs, and servicing fees and in many cases insurance premiums that protect the lender from the possibility that the loan payments will exceed the value of your home.
All interest on your loan balance is tax-deductible, but you or your estate may only take that deduction when the loan is paid back.
Further in an Indian context, elderly people are emotionally attached to their house with their various memories associated with it. They’ll opt for a reverse mortgage scheme if leaving an inheritance behind is not important; or their adult children wish to see them live in greater comfort today. Since they spend part or all of their home equity before they die, a reverse mortgage reduces what they are able to leave for their heirs.

The Indian Scenario

The budgetary constraints in meeting the Old Age Social and Income Security (OASIS) needs and increasing expectations on quality of life amongst the elderly people have fuelled a massive demand for financial products specially developed for them.

Presently, the senior segment of the population is normally not eligible for availing financial assistance from any Bank/FI as per conventional loan schemes due to lower income/cash flow. Although a lot has been discussed about the Reverse Mortgage Loan Scheme during the last few months in the country, the concept has received impetus following the Budget pronouncement made by Hon. Finance Minister in this regard.

National Housing Bank, a subsidiary of Reserve Bank of India, introduced the concept of Reverse Mortgage in India. In context of Indian market, following points are noteworthy:
1. Lesser availability of old age social security schemes in the country.
2. Lesser urban population.
3. Largely elders are living with their family & hence less scope for RM.
4. Possibility of relatively higher rate of appreciation making RM attractive for lender.
5. Under valuation of real estate properties can cause lesser loan amount receivable.

The following issues regarding the RM loans are there in India which needs to be addressed:

Legal, Regulatory, Taxation and Transaction Cost Related Issues

The specific product features and required supply-side alliances to offer RM loans have to be designed with a thorough understanding of the following:

• Entry restrictions under banking and insurance laws
• Capital adequacy, reporting and provisioning by lenders as required by banking/ insurance regulation.

• Legal protection for the RM lender against claims from other secured creditors and under insolvency laws.
• Tax treatment of interest and capital gains in the hands of borrower and lender.
• Protection to the lender to ensure ‘arm’s length’ pricing at the time of disposal of property.
• Location specific real estate related laws and transaction costs, including title search, property valuation, stamp duties etc.\
• Counselling services to potential borrowers, by independent agencies to protect adverse publicity from legal suits.
• Absence of secondary markets, mortgage backed securitization or insurance for RM loans

Potential Market Segments

The potential market is those home owners
• Who are more than 60 years old, and
• Current levels of income are insufficient to afford their desired standard of living.

Within this segment people with the following characteristics are our target audience:
• Long Tenure at current home
• Lack of other supports
• No significant bequeath motive
• Independence & quality of life.

Conclusions and Suggestions

1. Reverse mortgage offers an attractive option to the elderly to finance their consumption needs on their own, without the necessity of moving out or worrying about indebtedness or repayment.
2. RM, if widely available, might in fact encourage more people in the working population to increase the proportion of their savings invested in housing.
3. This segment is likely to attract increasingly favourable public policy attention, given the projected importance of this segment in the electoral politics of all democratic countries.
4. The actual size of the RM markets is nowhere near its estimated potential, for a variety of reasons.
5. Any interested RM lender in the Indian market must proceed with caution.
6. Psychological issues like emotional attachment with property may be a barrier.

-- Nikhil Vatrana

Sovereign Wealth Fund

Heard of Temasek Holdings and GIC recently? If not, they were in news because of attempt to acquire 10% stake each in ICICI bank. Temasek Holdings and GIC are investment funds that are not owned by any private enterprise. Rather it belongs to Government of Singapore. These are what, today, we know as sovereign funds. Following is an attempt to simplify the meaning of the term and later on discuss why India, again, have not yet boarded the bus of Sovereign Wealth Fund.

SWF is an investment fund owned and controlled by the government in order to better utilize its budget and trade surplus for the benefit of the economy and its citizen. The funding can come from any of the following –

1. Foreign currency reserves
2. Budget surplus
3. Accumulated funds in the course of fiscal management
4. Revenue generated from the export of natural resources.

(The above list is only illustrative and not exhaustive)

Thus SWF is a source of tapping the surplus savings of developing countries. When countries accumulate more reserves than it feels it needs, Govt. creates SWF to manage these ‘extra’ reserves.

Purpose of creating such a fund

Government uses SWF for following purposes –

1. Stabilize revenues from commodity exports – The SWF is generally created by the governments whose revenue depends on sale of one commodity. Then this investment fund is seen as the means of diversifying the revenue streams.
2. Invest foreign exchange reserves – Surplus foreign exchange reserves can be invested in the income producing assets rather than allowing them to remain idle as non income generating assets.
3. Savings for future generations – SWFs permit nations with abnormally high income in a particular year to save for the future. People will prefer smooth level on consumption rather than starving one year and gorging the next. Thus the fund allows the government to save high current income for future spending when the income may be lower.

SWFs investment is not restricted to risk free securities. These funds have the capacity to undertake risk and looks for higher returns. Their investment portfolio may include shares, commodity, land, etc.



Sovereign funds have existed since 1950s, but the total assets under management have increased in the last 10-15 years. Till June 2008, the total asset under management of the SWFs is around $4 trillion. Currently more than 20 countries have these funds, India (as expected) is not one of them. Some prominent examples of SWFs are Norway’s Government Pension Fund, Abu Dhabi investment authorities, Tamesak holdings, China Investment Corporations and the list continues.



Indian Perspective

With around $ 306 billion in its foreign kitty, India is sitting on piles of free reserves which it currently invests in the risk free US government treasury bills or bank deposit @ 5%, when other countries, with the help of SWFs, are making 16% - 18% on the same. Thus creation of SWFs to manage this reserve and yield higher return is highly warranted. Still India is now one of the few countries with large foreign asset holdings that have not created a sovereign wealth fund ("SWF") to enhance its investments.(See Note)

However, creation of SWF in India faces a number of issues to be dealt with.
The nature of fund with India is different from that of other sovereign fund countries. Foreign portfolio flows into the stock markets, external commercial borrowings and short term borrowings are the single largest component of capital inflows. These are all capital flows whereas China’s or Singapore’s reserves are created out of their trade surpluses and on current account. Thus while deploying the foreign exchange reserves; it is important to keep in mind that all these capital inflows are not of stable nature. Thus committing the resources into avenues of long term nature will pose problems. Further, SWF should be well and independently managed. Unless it is done so, there would be complaints of nepotism, corruption, not to speak of underperformance. Given the governance in India and the amount of sum involved it is expected that SWF will be subject to corruption and mismanagement and could be misused to promote domestic political or foreign policy objectives.

Therefore the luggage of problems that India has is too heavy to carry and board the ‘bus’ of SWF.

Note - SWF means investment made out of funds which are disclosed to be surplus reserves with the government, with the intention (at least on paper) of utilizing the gains for public welfare. In many countries investments are made out of these surplus reserves by the politicians, but they are not disclosed to have been made out of these reserves. Any investment made in the market by a politician, even though out of these surplus reserves, in order to earn income without having to invest any money cannot be termed as SWF. Therefore India still does not have a SWF.
- Ashish Gupta

Exotic Derivative not understood by India

pagalguy speaks about prahelika 2008



The following article is written in high spirits by our very own :
Ashish Gupta( Sallu).All those who feel they can add to these topic or criticize this are welcomed...

After the ‘subprime’ mayhem the next buzz word around is the ‘exotic derivative’. The same is being touted as the subprime of Indian market. Let us look at the reasons for a sudden increase in the usability of the word among the group that call themselves as ‘financial experts’.

When the Indian currency touched Rs. 40/ dollar, several banks wooed exporters and convinced them to trade in derivatives to hedge foreign exchange risk. It is very well known that traditionally, companies with huge foreign exchange exposures hedge their foreign exchange risk by entering into simple option contract that would guard them against any adverse price movement of the home currency vis-à-vis the foreign currency.

However, in recent times, exotic options, known for not being easy to understand, came into demand. Notwithstanding their complex nature, banks and companies took exposures in these products. Banks were happy with their bulging commission and the companies were happy with their small ‘other income’ that these derivatives provided apart from hedging their foreign exchange risk. The inherent motive that was their for companies in buying those exotic derivatives was not only hedging, rather it was coupling hedging with profits, which is better known as speculating. The company didn’t know that by doing this they were actually taking exposures in the currencies in which they had no business dealings. They were speculating on USD to strengthen against other currencies such as yen, euro and swiss franc.

However these currencies soared against the dollar, resulting into huge mark-to-market losses for the companies. Their position became worse when they couldn’t cancel the option as it would require them to take these losses to their books of accounts. Not to mention that they were also unable to comprehend the implications of the new accounting standards issued by The Institute of Chartered Accountants of India stating procedures for companies to account for their mark to market losses on derivative products in their books of accounts. Thus the losses accumulated and then started the ‘blame game’.

Companies instituted legal suits against the banks that they have mis-selled the products to them, i.e., they were not informed of the speculative nature of the product and were ‘lured’ into these bets by projecting them as mere hedging instrument. They claim that the banks didn’t inform them about any downside risk. To which banks replied that in the past when the companies made huge profits, no such complaints of misselling were aired. Moreover they questioned the contracts on legal grounds terming these contracts as ‘wagering’, prohibited under the Indian Contract Act, 1872. Thus they claim the contract to be void ab intio, i.e. the contract is null since its inception. Thus the banks are under a huge risk of losses as many companies have refused to pay for their mark to market losses and this may be aggravated if the court rules in the favor of the companies. A silver lining for the bank is that most of such contracts were entered into by large size corporate houses having regard to their credit worthiness and it is only the mid size or small size companies who have refused to pay for the MTM losses. Apart from this a lot depends on the decision by the court.

Recently, many companies which have filed cases against the banks have opted for the out of court settlement with the banks.

This exotic derivative can thus also be termed as the financial ‘Titanic’ for the Indian financial market, which though appeared to be very beautiful at the start, ultimately met with the ‘iceberg’ of financial illiteracy.

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