Fenil's Library

Vivek Kaul. Mumbai

“When things get as bad as they are now; one tends to look at the good within the bad. Is that what you said last night?” she asked. “What did you mean?”

“It’s early in the morning M. The sun’s just about up and the coffee you have made is really nice. 

Can we discuss this some other time?” I said.

“That time has come,” she said with a smile. 

“Oh, has it?” I said, gathering myself up. “OK, I told you that the US gross domestic product (GDP) fell 6.1% annualised during the first three months of 2009, after a 6.3% drop in the preceding three months, the steepest in 50 years. Now, economists and experts have gone to town pointing out that the rate of decline in GDP has slowed down. That’s what I meant when I said people tend to look at the good within the bad. Yes, the rate of GDP fall has slowed down, but it hasn’t slowed down significantly,” I said. 

“Is that all there is to it? 

“I have other examples as well. Take the case of home sales. In February, home sales went up 4.4% from a year earlier. Now this number was tom-tommed about a lot in the media. But what wasn’t pointed out is that 45% of these were foreclosure sales. The banks and financial institutions were selling houses of people who couldn’t keep repaying their home loans. This obviously does not augur well for the homes that have been built and are lying unsold. In the days to come, the sale of foreclosed homes is expected to go up as home loan defaults go up.” 

“But why will home loan defaults go up?” she interrupted. 

“See, the rate of unemployment was at 8.9% of the total workforce in April, the highest since November 1983. As I told you yesterday, it is set to top 10% as job cuts continue. Job losses result in foreclosures 10-15% of the times, which does not augur well for banks. Sooner or later, the ‘prime borrowers’, meaning borrowers who have the best credit risk and are least likely to default, will start getting affected. Such borrowers account for 1.8 million home loans. Of these, nearly 5% have already missed one equated monthly instalment payment (EMI), as per estimates of the American Bankers’ Association.” 

“Are you done with scaring me?” she asked. 

“I am sure you remember subprime home loans, which were the root of the entire crisis. Banks and financial institutions gave out a lot of home loans to individuals who were not creditworthy. Such borrowers are referred to as the sub-prime borrowers. In order to attract these borrowers, banks offered home loans with teaser rates. The interest rates would be lower for the first one year or three years or five years, translating into lower EMIs. Afterwards, a higher interest rate would kick in and that would mean higher EMIs. Then there were interest-only loans, in which only the interest had to be paid in the initial few years and principal repayment kicked in only later. The borrower was completely sold out on the idea of housing prices continuing to go up and planned to sell the house to make a profit before the higher EMI kicked in. In late 2007-2008, the first set of resets happened and we have seen the impact of that. In 2011, the second wave of subprime loans is expected to be reset, leading to increased EMIs. The number of defaults on home loans will go up again. Currently, the number of subprime loans stands at 1.2 million and the rate of default on these is around 22%. It is not looking good, though 2011 seems far off right now,” I said. 

“But home loan rates in the US are currently very low. Wouldn’t that help?” she asked.

“Well, you are right. The interest rates on 30-year home loans are currently around 4.85%, the lowest in 53 years. The US Federal Reserve had been cutting interest rates in the hope that people will start taking home loans again. At the same time, the hope was that at lower rates, people would refinance their outstanding home loans. Lower interest rates would mean lower EMIs, which could entice borrowers to spend their savings, and this in turn would help revive the economy. But what the Fed forgot was that economics isn’t an exact science. A certain change in input may not lead to a similar change in output. Meanwhile, home prices in the US have fallen. Going by a Bloomberg estimate, nearly 25% of the US homes are in negative equity and so most home owners are not in a position to refinance.” 

“I didn’t quite get that…” 

“Say an individual bought a house for $250,000 in mid 2006, when property prices were at their peak. Since the going was good, the bank gave him a 100% loan. Over the last few years, he has managed to repay around $25,000 of the loan. Meanwhile, the property market in the US has crashed. Say the price of the house has fallen by 30% to $175,000 ($250,000 - 30% of $250,000). At the same time, the individual has a loan outstanding of $225,000 ($250,000 - $25,000 repaid so far). No sane banker would be willing to give a loan of $225,000 on a house which is worth $175,000. So, even though interest rates have fallen, a lot of people are not in a position to refinance. Also, banks have stronger terms and conditions for giving out loans than before, making it that much more difficult to get a loan. As if that wasn’t enough, people in the US are trying to save more and pay off all the debt that they have accumulated. The savings rate has shot up to around 5% of income from a negative rate last year. So, even if people are able to refinance a loan, and get some savings because of it, they are more likely to save the money and pay off the accumulated debt than go out and spend as the government wants them to.”

“Whoa. Are we done?”

“There is one more point I want to make. People have been saying that the rate of fall in housing prices has slowed down. What they forget is that home prices in the US are still falling at a rate of 14% per year. And as the prices continue to fall, the amount of defaults and hence foreclosures will only increase.” 

“But what has a decrease in home prices got to do with increase in defaults?”

“Home loans in the US are non-recourse loans, in which the lender can seize only the collateral. A lender cannot go beyond the collateral and seize the borrower’s other assets and money in bank accounts. The borrower is not personally liable for it. So, a lot of borrowers who are in a situation wherein they have negative equity on their loans (i.e. the value of their homes is lesser than their outstanding home loan) and are not in a position to continue paying EMIs, might just default. A major portion of these borrowers had bought homes in the last few years more for investment reasons 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. It’s much simpler to just default.”