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Disaster in making: Financial crisis, Excessive borrowings & distorted financial modelling

, May 7, 2019, 0 Comments

financial-crisisThe genesis of the financial crisis of 2007-2009 lies in the housing loan market of the U.S.A. A housing/mortgage loan in the U.S.A during the 1930s had extremely unusual structure biased towards the lenders – floating rate interest with 5 to 10 years maturity, the payments typically covered only the interest, and the principal balance due at the maturity. The mortgage loan amount to property value, Loan-to-Value (LTV) ratio, was usually less than 50%.

We often hear the word the economy is in bad shape and this happened because to a world-wide financial crisis who origin lies in the USA and it has impacted India too. Ever since the financial crisis, the world economy is yet to fully recover. Indian economy is also effected due to world-wide slowdown.

What is this financial crisis? How it has impacted the world economy as well as India’s? How it has impacted a common man, a housewife, and a college going student? What are lessons for today’s aspiring managers?

In the part of the series, we will understand how the seeds of this crisis was sown!

Due to difficulty in saving the principal amount in short maturity period, the borrowers very often use to renegotiate the loan. The lenders had the option to terminate the relationship at maturity and demand full repayment. Failing such repayment, the lender could seize and sell the property to recover its principal amount which was only half of the value of the property. After the Great Crash of the October 1929, many banks became bankrupt resulting in depositors losing their deposits, the value of household property fell to about 50%, and mortgage loan banks were unable or declined to refinance the loans at all, and the borrowers could not pay their interest amounts and/or principal loan. During 1931 to 1935, there were typically 250,000 foreclosures every year. This experience led the federal government to transform the mortgage finance market in the United States.

To stimulate mortgage lending & give good access to mortgages to potential home buyers, the U.S. federal government enacted National Housing Act of 1934 and 1938 which helped in creating a number of government sponsored entities (GSE) like Federal Housing Administration (FHA), the Federal National Mortgage Association (FNMA, Fannie Mae), the Federal Home Loan Mortgage Corporation (FHLMC, Freddie Mac), and the Government National Mortgage Corporation (GNMA, Ginnie Mae).

The structure of the mortgage changed with the typical mortgage (called touchstone mortgage) has a 30-year life, a fixed rate of interest, level payments, requires a down payment of about 20 percent, and self-amortizing (interest as well as principal loan is paid during the life of the loan in EMIs).

Savings and Loan Association (S&L) (also called Thrifts), are typically home loan lenders in the U.S. When an S&L grants a loan to the borrower, it would typically hold the loan for its life and service the loan itself by collecting payments on the loan, along with payments for taxes and insurance.

This mortgage production method is known as Originate-to-Hold (OTH) model. In this OTH model, the S&L deposits tied up in funding a particular mortgage represented ‘dead money’ during the life of the loan and as such those deposits could not be used to expand home financing any further. In order to help the originators – S&Ls to free their tied-up capital, the (GSE – Fannie Mae and Freddie Mac buy the loans which were guaranteed by Ginnie Mae.

However, these GSEs use to buy only so called conforming mortgages, which should meet four essential requirements – monthly mortgage payment for principal and interest, property taxes, and property insurance should not exceed 28% of the borrower’s before tax income. The total payment on the mortgage along with other obligations such as credit card payment, auto loan payment, etc. should not exceed 36% of before-tax income; there should not be more than one late payment within the previous year & the borrower should have a specific level of credit score; the borrower should pay the closing costs and down payment along with cash in the bank to meet an additional two months of loan payment; and the loan size was also limited.

Mortgages that do not meet these requirements are nonconforming mortgages. Mortgage loans fall into two categories: prime and non-prime. Prime loans are conforming loans. Non prime mortgages are of three types- Alt-A, Subprime, and HEL or HELOC. The non-prime loans come under nonconforming loans.

Read: Disaster in Making: Role of Monetary contracts in creating mortgage crisis

The mortgage crisis was a consequence of excessive borrowing and distorted financial modelling, mostly based on the presumption that house rates generally go up in prices. Moreover, materialism and counterfeit also played important parts in the crisis. The financial sector became extremely volatile, and the after effects and turmoil lasted for several years.