Black money saves financial sector

A housing boom-and-bust has engulfed the US financial sector in crisis. India, too, has experienced a runaway real estate boom, which in a few areas is going bust. The share prices of real estate companies have crashed. Yet, India has no mortgage crisis or financial sector crisis.

Why not? Mainly because of the huge amount of black money in Indian real estate. This has saved the Indian financial sector in unexpected ways. Traditionally, US mortgage lenders checked the creditworthiness of borrowers, and then made the borrower pay at least 20% of the house value, loaning the remaining 80%. So, even if the price of the house dipped, it would still be higher than the bank’s loan, and the borrower had an incentive to repay it.

However, in recent years, US banks relaxed loan conditions to increase lending volumes and profits. They began giving loans equal to the entire value of the house, so borrowers had no personal equity stake at all. Many lenders stopped checking the creditworthiness of borrowers. Ultimately, this led to loans to persons with no documented income, job or assets. Very risky!

Moreover, the US financial system created something called securitisation of home loans. Instead of retaining loans on their own books, banks chopped and bundled together thousands of loans, calling the bundle a mortgage-backed security. These securities were then sold to investors, who earned a high return provided borrowers paid regularly. In effect, banks originating home loans re-sold these, and no longer had to worry about defaults.

This led, inevitably, to malpractice. Many banks offered ‘teaser’ loans. These initially carried very low interest rates, which re-set after a few years at much higher rates. This attracted many low-income people since the monthly installments were initially low. But when the loans re-set higher, some poor borrowers could not repay. The bank originating the loan was unconcerned, having already sold the loan.

In this way, US home lending — and prices — shot up. As long as the economy and housing market were sunny, borrowers paid installments regularly. But eventually housing prices peaked, and then fell. Many owners with loans covering 100% of home cost now found that their homes were worth less than their outstanding loans. So, many borrowers opted to give up the property and rid themselves of the accompanying bank loan. They simply posted the home keys back to the banks.

US banks now face borrowers who can’t pay for want of income, plus those who won’t pay for properties worth less than the accompanying debt. Mortgage-backed securities are falling in value as underlying defaults rise. The fall in value was initially estimated at $100 billion, is now estimated at $600 billion, and will exceed a trillion dollars if home prices keep falling (as seems likely). This has inflicted huge losses on holders of the mortgage-backed securities, including the biggest banks in the world — Citibank and Bank of America. Many holders of these securities — such as investment bank Bear Stearns — will die or be forced to merge with more solvent entities.

Why does this not happen in India? Here, too, banks have increased lending aggressively for housing in the last five years. Here too, many banks finance the entire house value.

But Indian borrowers do not walk away from their homes — and loans — if prices dip. This is because a large proportion, often half, of almost all home purchases is paid in black money. If a house is sold for Rs 100 lakh, the official registered value will typically be only Rs 50 lakh, with the balance paid under the table in cash.

A bank may loan Rs 50 lakh, covering the entire formal price. However, the owner’s contribution is not zero: he has paid Rs 50 lakh in black. 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 Europe, where the borrower remains personally liable even after returning the mortgaged property, so the bank can seize his other assets. This discourages default. Hence, European banks are not suffering the way US ones are. Ditto for Indian banks.

When economic conditions get tough, defaults go up. In the last year, defaults have risen in Indian real estate, but mainly on account of commercial builders. The default rate remains modest for home-owners.

Now, the Indian legal system is so slow that borrowers have little fear of even their mortgaged homes being seized, let alone other assets. Yet, they do not default, and India’s financial system remains strong.

The reason is that banks enjoy, without asking for it, a huge safety margin provided by the black money invested by every home owner. To preserve this black investment, borrowers will do their level 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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