Black Money Saves Our Financial Sector

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.

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There are 14 comments. Leave a comment!

  • ¬ Black Money Saves Our Financial Sector
    #11 April 3rd, 2008 at 3:18 am

    [...] marylandrealestateagents wrote an interesting post today onHere’s a quick excerpt 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 cre [...]

  • ¬ Eric Hundin
    #12 April 3rd, 2008 at 3:48 am

    I found your blog on MSN Search. Nice writing. I will check back to read more.

    Eric Hundin

  • ¬ Austin
    #13 April 3rd, 2008 at 4:16 am

    Thanks Eric!

  • ¬ Black Money Saves Our Financial Sector
    #14 April 3rd, 2008 at 4:33 am

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    #15 April 4th, 2008 at 2:56 am

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  • ¬ 148th Edition of the Carnival of Personal Finance!
    #19 April 14th, 2008 at 9:13 am

    [...] Orange Paper presents Black Money Saves Our Financial Sector – Austin provides a comparison of the India housing market to the US market and some perspective on [...]

  • ¬ Jeff Miller
    #22 April 19th, 2008 at 8:27 am

    You missed a key point in the US housing/loan problem.

    Yes, it would have been bad if the banks were lending 100% and the housing market turned down but that wasn’t the actual cause of the crises. If fact, while we might have had a bit of a bumpy road, we would have been able to ride the high prices for another few years before a relatively minor correction happened.

    The problem is that the 100% loans were able to satisfy the US demand for Mortgage Backed Securities (MBS). The MBS were generally bought in people’s IRAs. Supply of MBS generally equaled demand.

    The problem arose when foreign investors saw how well the MBS were doing and started investing in them. Suddenly, the demand was much higher than the supply. The investment houses were almost begging for more loans. However, the loan market was saturated by then (from a big refi boom). They needed another loan product that would create another refi boom. So they created one: the minimum payment loan (sometimes called an option pay).

    The minimum payment loan was just another version of a negatively amortized loan (Neg-Am Loan). In general, if the interest only rate was 6%, the minimum payment was 1-3% (with the rest of the interest being tacked on to the principle). All in all, this type of loan isn’t a bad loan. It also wasn’t anything new and it didn’t offer anything that would cause people to jump on it.

    The problem came from the broker’s being pressured to make more product available for the MBS. They started qualifying people, not on the real payment based on 6% interest but on the 1-3% interest payment.

    This did a number of things. It created a new refi boom, it provided enough product to satisfy the foreign investment in the MBS, it fed the real estate boom and it set us up for a crash.

    The real estate boom happened because more people could afford houses and people could afford bigger houses than they already had. Since house building lags so far behind demand, this created a surge in house prices. People were then refiing their houses at the new higher prices and facing lower loan payments than they had before the refi.

    Then the shoe dropped. Most of the minimum payment loans were set to recast in 3 or 5 years. That means that 3 or 5 years after they were created, the loans jump to the current interest rate. If a person could, according to the brokers, afford a house at 2% interest and the rate jumps to 6%, they are now expected to pay 3x what they were paying before.

    THAT is what caused the bust.

  • ¬ Austin
    #23 April 19th, 2008 at 8:58 am

    @Jeff: Thanks for your input. I really appreciate it.

  • ¬ Jeff Miller
    #24 April 19th, 2008 at 9:40 am

    You know….

    I spent so long with that comment that I decided that it needed to be an article.

    Then I didn’t know where to post it. So I created a new blog for it and others like it.

    Thank you for inspiring yet another blog.

  • ¬ Jeff Miller
    #25 April 19th, 2008 at 9:42 am

    Argh… I can’t edit the comment.

    I didn’t know if you cared for me to list my site in your comments. It is linked to my name.

  • ¬ Austin
    #28 April 19th, 2008 at 10:40 pm

    @Jeff: I’m happy to know that this post served as an inspiration for you to create another blog. I wish you the very best.

    I’d like to extend an invitation to you for a guest post on this site. Let me know if you’re interested.

    Cheers!

  • ¬ Investment Musings | Saving Money, Personal Finance, Investing in the Stock Market, Wealth Building, Taxes and more | The Orange Paper
    #29 April 19th, 2008 at 11:30 pm

    [...] It’s feels great when a blog post is a source of inspiration for others to start a new blog. And that’s precisely what happened with this post Black Money Saves Our Financial Sector. [...]

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    #32 April 24th, 2008 at 1:18 pm

    [...] This guest-post is by Jeff Miller. He is an Economist by training, a tech geek by inclination, and an IT Manager and a Real Estate Investor by experience. Jeff also knows a number of people who are smarter and better connected than he is and he hopes to share what he has learnt with you in a series of articles that will complement his somewhat lengthy comment to my post Black Money Saves Our Financial Sector. [...]

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    #672 November 10th, 2008 at 12:28 am

    [...] to what caused the crisis. Imagine having Rs 2 lakh in your bank account, no regular income, yet buying a house worth Rs 65 lakh, in the hope of selling it for a higher price. Even if the price of the house fell [...]

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