Negative equity could bring more trouble
I had just had a great lunch and was about to snatch a snooze on the chair when the mobile phone rang.
“Tell me what ‘negative equity’ means. And why’s everyone talking about it in the US and the UK?” She was such a perfect timer of things, or was it only with me, I wondered.
“Hello?”
“Yes, yes… but can we talk later? I am in the middle of something.”
“Lier, I can see you snoozing on your chair,” she asked.
I sat up. How on earth did she know that? I felt a pat on my shoulder and turned around. There she stood.
“How did you get in?”
“Well, I have my way with things. Now tell me what negative equity is,” she said, taking a chair.
“Well, it’s a situation in which the market value of an asset you own is less than the amount of loan outstanding on it. Let us say you buy a house by taking a home loan. The loan outstanding at this point of time is $250,000 and the market value of your house has fallen to $200,000. So you are in a situation where your house has negative equity.”
“But what is the impact of that?” she asked.
“You know the bank that has given you the loan is not into charity. And at any point of time they would like to ensure that value of the house, which is the collateral they have, is greater than the loan outstanding. And if that is not the case, they would want you to make up the difference. So in this case, you would have to pay the bank $50,000,” I explained.
“Hmmm. That’s interesting. But how did banks and borrowers end up in such a situation?”
“In a low-interest rate regime that prevailed in the United States and other countries in the western world, bankers had an incentive in lending to as many people as possible. And in such a situation, their lending standards started to fall. Earlier, while giving out a loan, banks used to insist on borrowers also making some downpayment towards the house. So let us say a particular house cost $300,000. The bank would insist on a downpayment of 20%. The bank would then give a loan of $240,000 and the borrower would put $60,000 (20% of $300,000) himself for buying the house. This ensured that the bank was protected to some extent if the market value of the house fell,” I explained.
“I’m sorry, what was it about the bank being protected?” she asked.
“You see, the bank has given a loan of $240,000 on a collateral that is worth $300,000. That gives the bank some leeway. Even if the market price falls by 20% immediately after the house is bought, the bank still has sufficient collateral. But if the bank had given a 100% loan of $300,000, even if the price of the house had fallen by 1% immediately after the borrower had bought the house, the bank would be in a situation wherein the value of the collateral would be less than the loan given out.”
“Now I understand. But how will it affect us?”
“See, in a negative equity situation, if the bank demands that the borrower make up for the negative equity, the borrower may or may not have the money to pay up. In the example that we had taken, the negative equity was $50,000. Now if you don’t have that kind of money, you might just default if the loan is a non-recourse loan.”
“A non-recourse loan? What is that?” she interrupted.
“In a non-recourse loan, the lender can seize only the collateral. He cannot go beyond that and seize your other assets and money in bank accounts. The borrower is not personally liable for it. In the United States, home loans are non-recourse loans. So, a lot of borrowers who are in a situation wherein they have negative equity on their loans, and are not in a position to make up the difference, might just default. Also, a major portion of these borrowers had bought homes in the last few years more for investment reasons rather than to stay in them. They had assumed that real estate prices would continue to go up and they will be able to sell out for a profit. Now, if they try to sell out, they will get a lower price for the house and since their loan outstanding is higher, they will have to pay from their own pockets to make up the difference with the bank that gave them the loan. Estimates suggest that over 10 million home borrowers in the United States right now have negative equity on their loans. Other than this 25% of auto loans are also in a negative equity situation.”
“What about the UK?”
“Loans in the UK are full recourse loans, so there is less incentive on the part of borrowers to default.”
“Still, how does that impact us?” she asked.
“God, haven’t you been listening? I have told you more than once that most of the banks giving out home loans securitised them away instead of holding on their own books. They bundled together similar home loans and made financial securities out of them. These financial securities were then sold to savvy financial investors, most of whom were based out of Wall Street in New York. This way, the bank or financial institution giving out the home loan could avoid carrying the risk forever and could free up the money reserved against the risk for lending. A major part of the equated monthly instalments (EMIs) paid by the borrower was passed on to the financial institution that bought these securities.”
“I get it now. Once borrowers stop paying their home loan EMIs, people who bought the financial securities are in trouble. Most of them are large investors and invest pretty much around the world. In such a situation, they will have to get out of their investments in emerging markets to make good the losses they would face from home loan borrowers defaulting in the US. And when they sell, as we have seen time and again, there is hardly any buying in the emerging markets, and the markets fall big time. And that is how it might affect us,” she went on.
“You are a genius,” I said.
“Keep the sarcasm. I could do with some coffee though...”
k_vivek@dnaindia.net
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