Page 46 - Banking Finance August 2021

ARTICLE

from the grace period, an embedded letter of credit clause Caution Ahead!
shall be in force where the builders' bank will have to make
A good amount of discussion on the observable benefits
good the loss to the buyer. The compensation can be worked
though contentious have been listed out but the use of
out on case to case basis as factors like opportunism and
financial derivatives doesn't come without its fair share of
replacement costs will also have to be incorporated. Also,
risks.
the builder will have to enter into an offsetting deal to cancel
/terminate/repudiate the existing futures contract. The
The focus here is the target group i.e. the home buyers.
length of the futures contract may be set at 2 years
Investing in real estate involves lot of research, investigation
excluding grace period or as deemed convenient. The period
& apprehension on the part of the buyer. In short a buyer
between 21 to 24 months are normally required to
undertakes his /her own due diligence. A complex
complete a mid-sized project.
arrangement of a forward contract in Real Estate can have
its own share of complications. Some of them are as under:
The presence of a futures contract will deter the builder to
Y Pricing - Real Estate belongs to an illiquid asset class
not become complacent and closely monitor the progress
and the pricing of it in the exchange is going to be very
of the project. However the idea shouldn't be solely to paint
difficult. Ideally to price an illiquid asset, one selects
all the builders with the same brush and penalize them even
proxy on the run assets that are in close proximity to
if the delay is on account of abnormal situations. The builder
the illiquid assets and the prices are established on the
will largely have 2 broad benefits, less of unsold inventory
basis of relativity. The factors to be taken into
and the other being arbitrage benefits. The term arbitrage
consideration to price them is another challenge. For
here will mean legitimate profits on account of forming a
e.g. - let's say one has to price a bond & the factor
bearish view on most counts.
chosen is interest rate. It is an established fact that
higher interest rates will bring the bond prices down
Now for long we have addressed the concerns of the buyer
and hence one can have a short term and a long term
but what about the builder's bank? The excessive payout
view of interest rate (upward sloping, flat, downward
ratio can render the builder's bank insolvent in the long run.
sloping term structure) and arrive at the spreads. But
The situation envisaged could be very similar to what AIG for a real estate, the interest rate sensitivity might not
had experienced during the Global Financial Crisis (GFC)
be as elastic as for bonds because in most cases a house
during 2007-08. This situation would entail addressing the
is a basic necessity rather than a luxury. So the interest
idiosyncratic risk only but not the systemic risk.
rate movement may be nonlinear in certain cases.
A need to set up a central guarantee house (CGH) for real Y Valuation - The forward contracts are valued as per
estate can be mandated where the banks can be a member mark to market phenomenon. As the pricing is
on paying an annual fee. Basically by paying for the services apparently difficult to arrive at, so will be the valuation
of the guarantee house, the banks will essentially enter into and the margining requirements. This will represent an
a credit default swap and the guarantor house can be the inaccurate assessment of the off balance sheet exposure
protection seller /insurer. The CHG can be likened to an SPV of the banks. This is turn might also lead to window
of the NHB or similar entities of the Government. dressing by banks to doctor their performance.

The CHG could be bailed out by the contributions by the Y Information Asymmetry - The knowledge of the
members banks much like what happens in the case Central product may not be uniform across all buyers and sellers.
Counterparty. The banks will also have entered into The bank entrusted to enter into or book forward
offsetting deals where a loss in one transaction could be contracts is merely an agent of its client. The acumen
mitigated by the profits in another. This will reduce the and involvement of the banker is limited here. So the
exposure through netting and the CHG would relatively be onus lies upon the buyer to get to the root of this
protected from a collapse, thereby reducing the chances of product before committing to it. A real estate firm will
hurtling the economy into a tailspin. have in depth information about the sectorial trends and

46 | 2021 | AUGUST | BANKING FINANCE