Black Money Saves Our Financial Sector

India has experienced a real estate boom in the last few years whereas the US had its share of a real estate boom but as of today their financial sector is in crisis. The share prices of real estate companies in India have fallen. There is a bearish sentiment in the Indian stock market, so does that mean the Indian financial sector too will face a similar crisis?

First let’s understand why the US financial sector is in a crisis situation. Traditionally, US mortgage lenders checked the creditworthiness of borrowers and then provided 80% of the home loan amount; the remaining 20% had to be paid by the borrower. So, even if the price of the house dropped it would still be higher than the bank’s loan thus giving an incentive to the borrower to repay it. However, in the recent years in order to increase lending volumes and profits the US banks followed a relaxed approach (many lenders even stopped checking the creditworthiness of the borrowes) by giving loans that were EQUAL to the entire value of the house, so the borrowers had no personal stake at all. Ultimately, this led to loans that were given to people who did not have any documented income, job or assets.

The US financial system created something called securitisation of home loans. Instead of retaining loans on their own books, banks sliced and bundled thousands of loans and labelled them as mortgage-backed security (MBS). These MBS were then sold to investors who earned a high return provided borrowers paid regularly. As we all know bankers have known to be smart (fooling people?), so in effect the banks originating home loans re-sold those loans and had to no longer worry about the defaults. Now, many banks started to offer loans that initially carried very low interest rates which after a few years were re-set to much higher rates. Many low income people borrowed loans because the monthly installments were low initially. But when the loans re-set higher some poor borrowers could not repay. The banks did not bother much coz they had already sold those loans to investors.

Result? US home lending and prices shot up. Eventually housing prices rose and then fell. Owners who had taken 100% loans started feeling the pinch coz their homes were valued at prices that were less than their outstanding loans. Many borrowers simply opted out, did not pay back their loans and gave up their home keys to the bank. This put the US banks in a tight situation where on one hand borrowers couldn’t pay due to lack of income or due to their pay back amount being higher than the property value. As home loan defaults rise the value of mortgage-backed securities are falling. This has inflicted huge losses on the mortgage-back security holders including the biggest banks in the world – Bank of America and Citibank.

Here in India, banks do finance 100% of the entire property value. But borrowers here do not walk away from their homes and handover the keys to the banks. This is because a large proportion of home buyers pay up almost half the of the money in black. If a house is sold for Rs 60 lakhs, the official registered value will typically be only Rs 30 lakh, with the balance paid under the table in cash. Thus the owner’s contribution is not zero and in order to preserve that black investment, he will keep paying his installments even if house prices dip.

US banks give non-recourse loans, that is, the loan is secured only by the mortgaged property, and the borrower becomes debt-free if he returns the property. This is not so in India, where the borrower remains personally liable even after returning the mortgaged property, so the bank can seize his other assets. And this is the very reason that discourages default. The Indian legal system is slow yet we don’t see people defaulting. The reason is banks enjoy this cushion provided by the black money that’s paid by every home owner. And to sustain this very black investment, borrowers will do their best not to default and lose their property. Ironically, black money enforces loan discipline in India, far more effectively than formal contracts or legal processes.