How the American housing dream went bust

By | May 25, 2012

Optional Adjustable Rate Mortgage, is a loan product which, in addition to having a very low down payment (usually 5% of the home value), gave the borrower an introductory period during which he could choose to pay the interest due alone for the month or to pay an even lower repayment termed “minimum payment”. Making only minimum payments would result in an ever increasing outstanding loan amount resulting in the “principal” growing large, which is known as “negative amortization”. The US housing boom, which occurred around 2001-2005 attracted a lot of curiosity and interest. The people and the banks of United States, wondered how to make the most of this consistently escalating prices in the real estate market. People were interested in buying homes and selling them at a profit. The subprime borrowers, who had a poor credit score felt they had an opportunity to pay off all their outstanding loans by cashing in on this boom. Banks decided to cater to this segment as well. One such product, which became a rage during this boom season was Option ARM. The product pioneered by World Savings Bank, run by the Sandlers seemed like a miracle loan that could help people, particularly subprime borrowers aspiring for a change in fortunes. This subprime mortgage has been the subject of intense discussion, ever since it came into the limelight revealing shocking details and appalling truths of the intense drama of a lending operation gone berserk. Optional Adjustable Rate Mortgage, is a loan product which, in addition to having a very low down payment (usually 5% of the home value), gave the borrower an introductory period during which he could choose to pay the interest due alone for the month or to pay an even lower repayment termed “minimum payment”. Making only minimum payments would result in an ever increasing outstanding loan amount resulting in the “principal” growing large, which is known as “negative amortization”. One of the main USPs of this miracle loan is the fact that you can pay the low minimum payment in the first year, which is calculated at an interest rate of as low as one per cent, and for a few years the monthly payment rises by only 7.5 per cent. The flip side for those choosing the minimum payment option is that after the introductory period, their monthly payment will suddenly double or increase even further. This will happen under two circumstances: The first circumstance is that after the introductory period of about 5 years, the monthly payment gets “recast” to adjust the amortization to its full limits. The monthly payments will then be recalculated at the prevailing interest rates for the remainder of the loan tenure. This happens irrespective of the extent of increase in the amount to be repaid. The second circumstance is when the outstanding loan exceeds a negative amortization maximum, which is about 125 per cent of the original loan amount. If the balance hits this limit, which can happen before a period of 5 years, when interest rates rise, the payment is increased to its full amortization level. Both the recast clause and the negative amortization cap can result in a rude “payment shock”. The Option-ARM terms run something like this: $500,000 loan, 1.5% start rate, 2.80% margin over cost of funds, 11.95% lifetime cap, 125%/10-year reset cap The minimum payment is based on the 1.5% start rate, and changes +/- 7.5% per year. In this example, that minimum payment is: 1st year – $1,725.60 2nd year -$1,855.02 3rd year – $1,994.15 4th year – $2,143.71 and so on. However the fully-amortized payment on the $500,000 is $3,296.35. This means that during the initial years, the principal gets larger and larger. When the loan balance reaches 125 per cent of the original loan amount, the loan resets, causing the monthly payment to more than double as now the amount owed is much larger and the payment needs to be increased to a level, which enables the principal to be paid off. Right from the early days of Option ARMs, it was clear that borrowers would not be able to afford the monthly payments once the loans reset, however banks made these loans in the hope that housing prices would continue to increase rapidly. As long as housing prices rose, borrowers could sell their houses for a profit before their monthly payments were increased and pay back the bank, thus making a healthy profit for both the bank and the borrower. However once housing prices started to stagnate, borrowers were stuck in houses that they could not afford to keep but could not sell either. This is when the US housing bubble started to burst. When the real estate markets crashed, many of banks had to declare bankruptcy. Two noteworthy examples of such lenders include Wachovia Corporation and WaMu (Washington Mutual). The former acquired the bank from World Savings, which was earlier run by the Sandlers, who pioneered the attractive loan product Option ARM. By the time Wachovia bought over World Savings, the days of profitability were being counted and when Wachovia demanded more growth noticing the slackening market, an aggressive and indiscriminate selling of the loan product led to a sudden surge in the lending figures. The sale of this product increased dramatically and the year 2005 recorded $238 billion made in option ARM loans nationally, out of which World Savings issued about $52 billion! Of course when the market crashed a lot of subprime borrowers felt cheated and argued the logic of such a lending product, while the Sandlers who pioneered the concept kept saying in their defense that if only the market prices did not crash, the scenario would be the exact opposite. WaMu on the other hand was promoting their loan shop aggressively and one notable ad campaign they ran was the “Power of Yes” campaign, which practically sums up their loan business model. They said yes to every loan purchase inquiry, without conducting a stringent quality check on the loan consumer’s ability to repay the loan. In the bid to make the most of the real estate boom WaMu started ignoring even the basic eligibility factors like the compatibility check between loan and income. There were examples of people claiming salaries that were ridiculously high for their professions. A popular newspaper in the United States , cites the incredible example of a “Mariachi Singer” ( a profession that one usually did not hear of) getting a loan approval and the documented proof for her profession that went into her file, was a photograph of the singer in her mariachi outfit! It’s no wonder then that when the real estate markets crashed in the United States, WaMu eventually had to shut down its sub prime lending operations, recording a $67 million loss in 2007. The lending scenario in India A subprime crisis of this nature and magnitude is unlikely to occur in India, thanks to some very strict bank policies that are in practice. As a general rule the borrower needs to pay a down payment that covers 15-20 per cent of the cost of the property. This by itself is a test of the borrower’s credit worthiness and enables him to have a stake in the property. Also, the bank safeguards its lending interests by ensuring that the money lent is below the market value of the property making allowance for a nominal dip in property prices. Another important factor is the initial screening banks conduct to confirm the eligibility of the loan seeker for the requested loan amount. Banks make sure that the EMI of their loan applicants does not exceed 50-55 per cent of their monthly incomes. This ensures that as long as the borrower is able to maintain his current income levels, he will have no trouble in making his monthly payments. Moreover the Indian sentiment revolves around buying a house and spending a lifetime there. Home buyers looking to live in the house purchased rarely change homes i
n short time frames while in a place like America embracing change is second nature. A situation like this may be far away for India, as we are a growing economy, where mortgage levels are not comparable to developed economies. We also have strict regulatory bodies like the Reserve Bank of India, which ensures that loan products that could produce systemic risk never make it to the market. Besides this aspect, a favourable market does not exist in India for similar loan products like the Option ARM. The psyche of the Indian consumer does not easily accept debt instruments and a loan is usually high priority and the focus is usually on closing it as early as possible.

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13 thoughts on “How the American housing dream went bust

  1. Deva Bakthan

    i think this situation ……….is like what happened in Bible times………when Joseph was made a prime minister…..using the situation he quickly took all the citizens lands for food grains and made the King more richer than before………………..

    the lands belonging to the poeple were now in kings possession. and the subjects the slaves………

    this has what happened in USA.

    Reply
  2. Milind

    Hi Deva Bakthan,
    Here i totally agree with "The lending scenario in India"
    Thanks to Government of India & Reserve Bank Of India for maintaining strict policy.
    Now at this tough time when US government has increased TAX for outsourcing from US , iNDIAN GOVENMENT expected to take appropriate steps to save economy as well jobs in India.
    Warm Regards
    Milind

    Reply
  3. saeed

    well I dont think so the situation is os good in India as well, I am sure it will chnage very soon with IT Industry shares falling, reduced interests of investors specially NRIs from US.Actually It is not 100% true that the banks were identifying the documents and issuing loans carefully, there were one part of the investor bankers who were in hurry and neglected details, That is another story that these people have made so much profit that even if they people default they would not loose.
    The same way is Real estate market if you consider the prices when the land was bought they are no where near to reality evn after this down turn another down turn and another it would not compensate.

    Specially DLF who has made so much out of nothing, the whole realty game was played by some investors and Politicians who have enough for the rainy days ahead, the one who continue to suffer is the common people, they will invent some schemes or the other evrery time and the common man is bound to fall in it, as they are looking to make 2Rs out of 25paise with their limted source of income.

    B,Regards
    Saeed AHMED

    Reply
  4. Mayur

    I don't think that the India Scenario is as good as mentioned in Article. We didn't witness the effects as sever as in USA because factors below,
    1. The Property prices in India did not moved downwards. They became stable only when Property Market in USA busted.
    2. The Salaries of IT Guys in India never reduced or Layoffs never happened. This purchasing power remained same. Hence no problem of skipping EMIs.

    Reply
  5. Ash Ghose

    We can not imagine the extent of American greed and the way most of the people can be duped in USA by the so called elite educated 5%. Declaring bankruptcy is a way of life and people do live in abject poverty although from outside it may look like a big house and all those big things. This scheme was like a multi level marketing thinking that the chain will go on perpetually which can not happen.
    Also Indians are very proud people and we believe that it is better to die than live under debt or declare bankruptcies. So this can happen only in USA. The problem was that these bankers lodged the scheme and then hedged them with most of the global banks as ABCP. But it is good that the bubble busted so soon and it will take a few years for US to get over this. But they will do it again as there is no discipline and no regards for principle of life-atleast for most of them.

    Reply
  6. Bharat

    The real estate prices in India have also seen a sharp increase during the last 2-3 years. The reason for the same was enough liqiudity in the system, which lured the banks and other financial institutions to finance the market. The real estate players such as developers made most out of it by expanding relentlessly. Some also benefitted by getting cheap funds from capital markets.
    Currently, the real estate markets in india are facing an oversupply problem, which will cause the prices to deflate. The prices have not corrected much, and developers are searching for ways to get back there investments. This year revenue collection from sale/purhcase of real estate by Govt of Delhi has seen sharp decline as compared to corresponding period last year, which clearly indicates the slowdown in momentum. Indian think tank are trying their best to keepup the momentum by reducing the interest rates on housing loans, to lure investmentors. Banks such as State Bank have already started offering differential rates on thier HL products.
    It may not be completly assumed that Indian Real estate sector is unaffected or may not behave in a manner the US markets have behaved. Although the loan products and variants differ with markets, but their is always a single principal on which money rolls i.e profits.

    Reply
  7. richard

    Indians will never be affected by by this economic upheaval. In India, if a person enters a home, he will leave it only when he is carried away by four. Then also we believe that his soul remains haunting that place. Changing house is tentamount to changing religion.

    Reply
  8. Dilip Karekar

    In India un accounted i.e.cash transaction is done at the time of booking.So the house owner share increase by 20% i.e.margin money+cash payment 15% =35 to 40% margin money. Finance 65% to 60% of house cost is always safe .Due to this ,we are not facing US like financial problem.

    Reply
  9. rock

    Great article…One thing no one should forget…nothing can stay on top…there will come a time when the flow has to come down ….like a dam we all fill up water and once it is fully, we have to open the shutters to let the water flow…the affordability for common man has gone over the roof…you don't find homes less than 20 lacs now a days…do you think is it possible for every indian in a city to pay off even 20 lacs…is it possible that he can maintain his level of salary upwards…is it possible that inflation or afforability of general things in life stays at a level that is comfortable for everyone..NO..so there will come a time when people will say…NO to buying at any level for a property…the prices will go down then…NOTHING CAN REMAIN AT THE TOP FOREVER…

    Reply
  10. Ram

    Well researched and explained in great detail. A little late in its coming from bankbazar, though.

    So what's the next bubble? – gold / silver / commodities – bankbazar's call ?

    Reply

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