Fenil's Library

By encouraging consumers to borrow and spend, rather than save, the US govt is taking on a huge risk

Vivek Kaul. Mumbai

"The definition of insanity is doing the same thing over and over, expecting a different result" — James Quinn

"Why do we make the same mistakes again and again?" she asked me.

"Well I really love the coffee you make," I replied, rather matter-of-factly.

"Oh. I did not mean that. You know the United States has been trying for sometime to get its banks to lend and its citizens to borrow again. Don't you think that's kind of stupid?"

"Why do you say that?"

"Well, didn't excess borrowing cause the problems in the first place? Interest rates were low, which encouraged banks to lend more and people to borrow more. The borrowed money was used to buy homes, cars and other stuff. In case of homes, as home loans were easily available, more and more people borrowed to buy homes. Since demand was greater than the supply of new homes, prices started to shoot up. This encouraged even more people to buy and so the cycle continued. Banks did not keep the loans on their books. They converted these loans into financial securities and sold them to investors for a commission. Every time the borrower repaid the loan through an equated monthly instalment, a major part was passed on to the investor. That's how the investor made his money. And everybody was happy. Then, interest rates started to go up, and many of those who had borrowed beyond their capacity to repay started to default on their EMIs. When that happened, those who had invested in financial securities stopped getting repaid as well and so the crisis snowballed. Soon enough, the defaults had spread to credit card and auto loans too."

"I know all that. What's the point?

"Oh, don't you get it? In 1980, the US national debt was $930 billion, amounting to nearly a third of the country's gross domestic product (GDP). Today, the US national debt is $10.7 trillion, a little over three-fourth of the US GDP. The average debt on credit cards is currently around $16,600. With all the increased borrowing, the personal savings rate fell from 12% of the income earned in the early 1980s to -1% in 2006. Over the last few months, it has come into positive territory again, and is currently at 2%. And why is the savings rate in the positive territory again, if I may ask?"

"That's simple. People are spending less and trying to pay off the debt that they taken, which I feel is the sensible thing to do."

"Yeah, but what is that doing?" she asked.

"You tell me, since you seem to have figured this entire thing out."

"It is slowing down the economy. The aggregate demand or GDP of any particular country is made of four distinct elements and can be represented in equation form as Y = C + I + G + NX, where C stands for private consumption or money that you and I spend on buying goods and availing services; I stands for investment made by the private sector in setting up factories or any other thing that helps in producing stuff that can be consumed in future; G stands for government spending; and NX is the difference between exports and imports, assuming the money earned through exports comes back into the country and the money spent on imports leaves the country."

"Where are we headed?"

"Patience. In case of the US, private consumption accounts for 72% of the GDP. Now, when banks stop lending and people stop borrowing, the private consumption goes down. People don't buy homes, cars or other stuff. When private consumption goes down, the aggregate demand or GDP goes down. As you would know by now, the last two quarters have seen the US GDP shrink, which means the US economy is in a recession. When that happens, companies suffer because they earn less and then they go about firing their employees.

Now, an employee who has been fired will hold on to whatever money he has rather than go and buy things. And so the cycle continues. And what is the US government trying to do in order to break this cycle?" she asked.

"The US government is spending a lot of money and at the same time trying to ensure that people start borrowing again, for only if they borrow will they go out and buy things. This in turn will revive private consumption. And that you say is getting into dangerous territory."

"The right thing to do for Americans right now would be to reduce spending, save money and try and pay off as much debt as they can. But the government is trying to dissuade them from doing so because it impacts immediate growth. It wants them to borrow more and spend their way out of trouble," she explained.

"I get it now. The trouble with trying to spend your way out of trouble is that you will have to keep spending, much like a Ponzi scheme, which is a type of investment fraud where there is no business model in place and older investors are paid using the money brought in by new investors. The Ponzi scheme keeps running as long as the money being brought in by new investors is greater than the money needed to pay off older ones. Similarly, Americans will need to keep taking on more and more debt in the days to come in order to keep spending more, so the economy keeps growing."

"And as we know all too well, Ponzi schemes go bust one day," she quipped. "The US may be headed that way."

(The example is hypothetical)

 

References: 'Turning Japanese -The Audacity of Reality' by James Quinn, January 28, 2009, ww.dollarcollapse.com; 'Inflationism: The Bane of Capitalism', Doug Noland, January 29, 2009,www.prudentbear.com.

Existing customers should insist that banks do not treat them as the proverbial 'wife'

Harsh Roongta

"SBI drops home loan rate to 8%. Rate war expected," screamed a Sunday morning headline.

The detailed interview mentioned that unlike the 9.25% package announced in December 2008, home loans at this rate would be available to existing home loan customers of other banks shifting their loans to SBI. "After all they are new customers as far as we are concerned," the chairman of State Bank of India (SBI) was quoted as saying.

What about SBI's own home loan customers? Well they will have to be satisfied with getting a new loan (which they may not need at all or may not be eligible for) equivalent to 10% of their existing loan amount at the new rates though on their existing loans they will continue to pay the old high rates, which are just a tad lower than the all-time highs reached in August 2008.

Clearly, the wife (existing loan consumer) and girlfriend (new consumer) syndrome is alive and kicking even for public sector banks (see article "Wives and Girlfriends" at http://www.apnaloan.com/home-loan-india/On_wives_and_girl_friends.html).

This is not to suggest that SBI or any other public sector bank is the worst offender in this respect. They clearly are not. In fact, quite a few private sector home loan lenders continue to charge their existing consumers at 13% or higher even while they have dropped rates to single digit (or low double digits) percentage for new consumers.

The disregard for existing consumers is all-pervasive and not a single player (whether public sector or private sector) can claim to have treated its existing consumers fairly whenever they have dropped interest rates for new consumers. In fact, whenever this issue is raised by the media, none of the lenders even bother to defend the practice given its completely indefensible nature.

So why does this continue? It's because the consumers allow it to continue. Only a very few consumers take a little pain and research the market and get alternative offers to take over their home loan. They then call their existing lenders for a letter giving details of the loan amount outstanding and the amount required to be paid for making a full and final settlement of the loan amount to enable them to shift their home loan. If the consumer has been regular in paying his EMIs he is a prime customer and no bank likes to lose his business. In many cases therefore his existing lender agrees to match the interest rates that the consumer is getting from the new lender. Even if the existing lender does not do so the consumer still benefits by shifting his loan.

We get a lot of queries on this subject from existing home loan consumers asking us for the legal options available to them to compel the existing lenders to pass on the benefit of lower rates to them. Our answer is always the same. Economics can always trump law. Stop expecting the mai-baap sarkar to do everything for you. Vote with your feet. Go to the cheapest provider on your own. You do not need any legal help for this. If enough consumers do it the lenders will stop treating you like the proverbial "wife".

The RBI can also do a lot to ensure more transparency in this regard. The following suggestions do not require any change in the law but can help will introduce a level of transparency: • They can make it mandatory for the lenders to disclose on their websites all the reference rates used by the lenders for pricing floating rate loans, including the history of movement of such reference rates in the past as well as the spreads (from minimum to maximum) from such reference rates charged from quarter to quarter after taking into account all loans sanctioned in that quarter. This will make it easier for consumers to decide on the past history of the lender in passing on the benefit of rate cuts to its existing consumers.• Make it mandatory for the lender to specify the basis of fixation of the floating rate. This means the lender will have to specify which reference rate is being used and the spread from that rate. Surprisingly, there are quite a few home loan agreements where the interest rates are just mentioned as floating without mentioning the basis.• A slightly more controversial suggestion is to force the lenders to use publicly determined reference rates such as the yield on government securities of a certain maturity instead of an opaque internally determined reference rate.

In fact, the window to make this market more transparent is not a large one. Some smart politician is going to pick up this issue to make far more stringent rules as law. After all lenders don't have votes, the loan consumers do. And now the loan consumers have reached a mass that justifies taking up of such issues by the politicians.

While the regulator (or a politico) takes up this issue, the consumer should stop behaving like a martyr wife and threaten to become the girlfriend of another. That's the only thing that will make their husbands (existing lenders) behave well towards them.

 

The writer is CEO, ApnaLoan, a website that allows consumers in India to compare the EMI, interest rates and other fees for home loans, car loans, personal loans, business loans and credit cards.

There may be complications in terms of tax deduction and tax on the maturity amount

Vivek Kaul. Mumbai

Single-premium unit linked insurance plans (Ulips) are a popular mode of investment today, what with the last date for making tax-saving investments, March 31, approaching fast.

But there are a few things the tax saver should keep in mind while investing in a single premium Ulip.

As the name suggests, the individual taking the policy needs to pay just one premium. The majority of the premium after deducting for the premium allocation charge, which is used to pay the agent a commission, is invested. The portion that is invested is referred to as the investment fund. The premium allocation charge for such Ulips is typically around 2-5% of the amount invested.

The policy also provides a certain amount of life insurance cover, called the sum assured. The minimum sum assured on a single premium Ulip has to be 1.10 times the single premium.

Now, take an individual who pays a premium of Rs 50,000 and opts for the minimum sum assured of Rs 55,000 (110% of the single premium amount of Rs 50,000). If the policyholder expires, his nominee would get at least Rs 55,000 from the insurance company. But, for the family of an individual who is in a position to pay a single premium of Rs 50,000, it is doubtful Rs 55,000 would mean much. The individual would do better to analyse his insurance needs and perhaps get a term insurance policy, so that his family is better protected against the income uncertainty in his absence.

In India, insurance is typically sold on the premise that the premium paid can be claimed as tax deduction and the maturity amount would be tax free. But, there are certain complications in case of single premium policies.

Tax deduction

Sub-section 3 of Section 80 C of the Income Tax Act 1961 clearly states that a deduction is available only to so much of the premium, which is not in excess of 20% of the sum assured on the policy.

In the example taken above, the premium paid is Rs 50,000 and the individual has opted for the minimum sum assured of 110% of that, i.e. Rs 55,000 lakh. In this case, the single premium of Rs 50,000 works out to around 91% of the sum assured, whereas the allowable tax exemption is a maximum of 20% of the sum assured, which works out to Rs 11,000 (20% of Rs 55,000). Thus the individual cannot claim a deduction on Rs 39,000 (Rs 50,000 - Rs 11,000) of the single premium paid. If the individual is in the 30% tax bracket, the tax on this amount would be Rs 11,700 (30% of Rs 39,000).

The insurance company, of course, will not tell you this.

A typical line in the brochure of a single premium policy reads like this: "Contributions made towards the premiums will be eligible for tax deduction under Section 80 C of the Income Tax Act". This is correct in letter, not in spirit.

Individuals looking at single premium policies as a tax-saving investment should therefore opt for a sum assured at least 5 times the premium paid. The individual in our example should thus opt for a sum assured of Rs 2.5 lakh (5 times Rs 50,000) to be able to avail a deduction on the full premium amount.

Maturity amount

Those opting for the minimum sum assured of 1.1 times must note that the entire maturity amount is not tax free. This is because, as per Section 10 (10D(c)) of the Income Tax Act, the entire amount is tax free only if the premium paid is not more than 20% of the sum assured, in any year of the policy. Otherwise, the entire amount at maturity gets lumped with the income for that particular year and gets taxed accordingly.

Even this, most insurance companies do not reveal in their sales brochures or at the time of selling the policy. In fact, it might be pertinent to ask how many insurance agents even know that such a provision exists.

Difficulty for nominee

The typical reason for buying a single premium policy is that the premium needs to be paid just once. However, if tax saving is the purpose, the individual must remember that such investments have to be made every year. Thus, someone buying a single premium policy in a certain year will have to buy another policy the following year in order to continue saving on tax. God forbid, but if something were to happen to him, his nominee would have a harrowing time claiming the sum assured on different covers, filing separate claims for each. Imagine a situation where the covers are from different companies and each insurer insists on getting the original document to clear the claim!

k_vivek@dnaindia.net