Question

10. Suppose the minimum downpayment on a house is currently 5%. But, the government suddenly passes a law making the minimum downpayment 25%. How will this affect the likelihood of “defaults” and foreclosures? Explain.

11. Bill is borrowing money for a house and puts down a 20% downpayment. The bank representative is worried that Bill does not have the ability to make payments; in fact, the bank representative thinks it is very likely that Bill will default. But, the bank decides to finance the mortgage for Bill anyway. From the bank’s perspective, would it better for the value of Bill’s house to rise or fall after this mortgage occurs? Explain.

12. In the lecture video, I discussed that economists are concerned that the banking system may be in a “moral hazard” scenario due to the government’s choices after the Great Recession. Briefly discuss this potential problem.

Answer 1

Part A)

Down payment reflects that part of a loan which is paid upfront to the seller and the remaining amount is financed by the bank themselves. This acts as a shield for the bank that the person taking the loan has the required worthiness to avail the same.

As banks increase the minimum down payment, only those people that hold larger reserves are able to pay the same. Those that take high percentage of loans are at a higher risk of default. This is because their paying capacity is only 5% of the value of the asset which they were purchasing using the loan. As this extends to 25% the chances of default or foreclosure due to an asset being sold off and the person not having sufficient money to pay for the same shrink.

As loans are then taken by people who can pay up to 25% of the value up front, it means that their ability of making the purchase is much more than someone who was taking 95% of the money via the banks. This ability to pay back is the reason why loan defaults and other related issues shrink as down payments go upwards.

Part B)

Property loans are given away in exchange of a guarantee which usually is the house or the commercial property itself which is bought using the banks money. In case of a default, this property is sold off to potential buyers to recover the money. Often, banks are unable to recover the full amount along with interest if the property falls down in value. This primarily took place in the year 2008, when the loan vale was much higher than the underwritten or guaranteed property value.

It is good for the banks, if the value of the property increases as it brings in additional gains for business and they are able to recover higher amounts inclusive of the interest payments due in case of a default as represented by the case. Any addition in the property value of a defaulted loan would mean that the bank gets higher collections and higher profits from the sale of such an asset.

Part C)

A moral hazard problem takes place, when a company or an individual takes a higher degree of risk, knowing that the risk and its related negative impacts would be covered by others to a large extent. A prime example of this is the insurances which we purchase for our vehicles which give us added protection and we may tend to take a tad bit higher risk due to the same.

Since the Great Recession, banks are well protected by government intervention which adjusts interest rates, taxes and their aggregate supply of currency to make sure that the currency in circulation can be corrected during an inflation or a recession cycle in the economy.

This phenomenon creates a moral hazard situation for banks, wherein they begin taking higher risks and grant loans to people much easily than the otherwise would as they are insulated by the government as well as the Central Bank who by regulating the flow of money in the economy give banks an additional cushion or a guarantee that they won’t let the banks fail which allows them to become more risk taking in their behaviour towards granting loans respectively.

Please feel free to ask your doubts in the comments section if any.