With borrowers using credit cards to repay, defaults will rise on ‘better’ home loans, too
MUMBAI/ HONG KONG: As Henry Merritt ‘Hank’Paulson Jr, the US treasury secretary, tries to clean up the sub-prime home loan mess with a $700 billion bailout, there is trouble brewing at other ends.
“Subprime is yesterday’s news,” says Robert Ward, director, global forecasting, Economist Intelligence Unit, told DNA Money.
“The poison has spread to the mid-prime and prime mortgages as well and so the $700 billion bailout will not be enough,” he adds.
“Mid-prime loans have a peculiar structure. For the first two years, only the interest on
the loan has to be paid. After that, the principal portion kicks in. And that has started to happen now,” says Ward.
As the US economy enters into a recession and the principal portion to be repaid also kicking in, the chances of mid-prime borrowers defaulting have gone up.
The US home loan market is estimated to be around $11 trillion dollars. Of this $1 trillion is the sub-prime market and the mid-prime market is around $1.4 trillion.
“Mid-prime, as we can see, is a bigger market than the sub-prime market. And as more borrowers default, we could have more trouble brewing ahead. As this unravels, we will have a problem bigger than sub-prime,” said Ward.
Home loans are referred to as mortgages in the US.
The prime home loan market is the best part of the market where in borrowers with good credit ratings are given home loans.
Mid-prime is the next level of home loans. It is not a fully documented home loan and hence borrowers a higher rate of interest of around 0.5% vis a vis a prime home loan.
Sub-prime market is the lowest level of the market and consists typically of borrowers who have a very bad credit history and wouldn’t be given a loan in the normal scheme of things.
In fact, borrowers seem to be already running out of capacity to repay their home loans, and are using credit cards to repay.
Satyajit Das, an internationally renowned risk consultant and the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives says there is anecdotal evidence that cash-strapped mortgagers are using credit cards to make mortgage payments.”
“This has been happening for sometime and the credit card companies and banks have gained for sometime because of this,” says Ward.
Dr Robert Manning, author of Credit Card Nation: The Consequences of America’s Addiction to Credit and an authority on consumer finance issues in the US, says refinancing of credit card debt into home mortgages temporarily reduced the short-term risk and enhanced credit card profits.
“With the collapse of the housing market, credit card delinquencies are rising and more people are using their credit cards to pay for adjustable rate mortgages.”
“This is similar to industry strategy of offering multiple credit cards to pay one with another,” adds Manning, a research professor at the E Philip Saunders College of Business at Rochester Institute of Technology.
However, this strategy of repaying home loans through credit cards cannot continue forever. Once credit card holders start running out of the maximum credit allowed, trouble will erupt at two levels: they will start defaulting on their home loans and if they are not in a position to repay their home loans, it is highly unlikely that they will be able to pay up their credit card bills either.
By using credit cards to repay their home loans, borrowers are just delaying the inevitable. “The problem is delayed but eventually it all catches up,” says Das. To cut a long story short, the $1 trillion US credit card industry will be in for a tough time ahead.
This also means that anybody who bought the securitised paper on credit card receivables and home loans would be in more trouble. Banks in the United States and other parts of the developed world typically do not keep loans on their own books; they securitise it away by issuing financial securities and selling them to investors from all over the world. This ensures that banks do not carry any risk on their books and get their money back upfront. Every time the borrower repays, a major part is passed on to the investors who buy the financial securities.
“Securitarisation of credit card receivables will be one of the next financial ‘bubbles’ to burst,” says Manning.
The sub-prime home loan crisis was similar in nature. When sub-prime home loan borrowers, who had been given home loans much beyond their repayment capacity, stopped repaying, investors who had bought the securitised paper on those loans, ended up with huge losses. The impending defaults will create a new credit card crisis and will extend the current home loan crisis.
As the economy slows down, even individuals who are not using their credit cards to repay their home loans are likely to default. Estimates suggest that an average US household owes nearly $9,700 on its credit cards.
Credit card companies, says Manning, will face pressure on their credit card receivables due to federal US legislation, which will limit their ability to increase fees and interest rates; in addition, rising delinquencies will compound the companies’ problem. Banks and credit card companies seem to be preparing for the tough times ahead.
“Credit card providers are all boosting loan loss provisions. A number of banks have begun to boost reserves against anticipated losses,” says Das.
But the crisis, Manning says, can be averted. One of the initiatives he has pioneered is to create a framework for consumer debt relief. “My national programme, Responsible Debt Relief is the first algorithmic assessment of consumer debt repayment capacity and offers consumers a range of options including full, partial, and bankruptcy payments.” It will also help with refinancing mortgages, he adds.
If the US does not embark on a consumer debt relief programme, warns Manning, “the recession will be prolonged and may lead to stagflation.”
Also as a recession kicks in, there might be trouble in other financial markets as well. “I think consumer debt, auto loans look vulnerable. I also think on the wholesale side — commercial property, private equity loans and infrastructure — looks extremely vulnerable as the economy slows,” says Das.
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