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Jul 11, 2013, 12.51 PM IST | Source: Moneycontrol.com

Impact of falling gold prices on gold loans

Nitin Vyakaranam of arthayantra.com explains on how falling gold prices have imapcted the gold loan borrowers and companies. He discusses on how companies have been paying the margin in cash due to the fall in its value.

Nitin Vyakaranam
arthayantra.com

In the past few weeks, there is lot of talk around how gold has lost its shine significantly since the start of January 2013. Most of the investors are placing their faith and money in recovering markets over gold. Gold funds have experienced huge sell offs during the past three months. Apart from the investors, the gold loan lenders are expected to take a hit because of the falling gold prices.
 
Basics of Gold Loan

Before analyzing the effect, it is important that we revisit a few basics of such loan. How do you avail a loan while pledging an asset? The value of asset is estimated as per the prevailing market rates and a certain percentage of the value of asset is granted as a loan. The percentage of loan given is called as "loan to value" ratio.

Also read: Supply tightens; gold borrowing rates hit 2009 highs

The lender expects to make profit on it in the form of interest rate paid by the borrower. The default risk is countered under the assumption that the pledged asset will gain in terms of its value over the loan tenure. Once the borrower defaults on his loan repayment, the lender can then redeem the money he borrowed by selling the asset.

The problem

The current issue with gold loans is the “loan to value” ratio at which they were evaluated at the time of processing the loan. During the times when the gold rates were high, the gold loan companies were on a credit spree. They started issuing loans at higher “loan to value” ratios. Some companies even issued nearly 80 - 90  percent of the value as a loan amount.

RBI had to step in March 2012 to cap the maximum limit to 60 percent of the value of the asset.

The fall in gold prices has implications on the gold loans which were taken at higher "loan to value" ratio. The collateral i.e. the gold has diminished in value. In order to make up for the margin of current value of collateral and amount of loan issued, the loan provider would either need the borrower to pledge more collateral or pay the margin in cash.

If the borrowers fail to match the margin, the probability of default risk increases.  The lender will be forced to auction the pledged gold in open market. The realization value of used household gold in falling markets will be lower compared to the loan amount. If the lender wants to hold this for a longer period in anticipation of improved market conditions, they will be facing a liquidity crunch.

It is testing times for the age old assumption that gold prices will never fall. It is the same phenomena in which both the lender and borrower of a gold loan always believed in. The growth of gold loan companies kept pace with the gold prices till now.

During the past decade, gold prices experienced new highs and gold loan providers posted strong numbers in their books. The finance ministry has asked all the banks to review their loans backed by gold and call their customers for more collateral if the prices fall further. It has to be seen whether the customers will match the margin or opt for default route.

Authored by ArthaYantra.com , an integrated online personal finance company.

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