My Tax Form Info

US mortgage crisis: A subprimer

This article was published in TOI on 16/09/2008 which is being reproduced because it very nicely explained that I thought it should be published. What is a sub-prime loan?

In the US, borrowers are rated either as ‘prime’ indicating that they have a good credit rating based on their track record or as ‘sub-prime’, meaning their track record in repaying loans has been below par. Loans given to sub-prime borrowers, something banks would normally be reluctant to do, are categorized as subprime loans. Typically, it is the poor and the young who form the bulk of sub-prime borrowers.

Why were sub-prime loans given?

In roughly five years leading up to 2007, many banks started giving loans to sub-prime borrowers, typically through subsidiaries. They did so because they believed that the real estate boom, which had more than doubled home prices in the US since 1997, would allow even people with dodgy credit backgrounds to repay on the loans they were taking to buy or build homes. The government also encouraged lenders to lend to subprime borrowers, arguing that this would help even the poor and young to buy houses. With stock markets booming and the system flush with liquidity, many big fund investors like hedge funds and mutual funds saw sub-prime loan portfolios as attractive investment opportunities. Hence, they bought such portfolios from the original lenders. This in turn meant the lenders had fresh funds to lend. The subprime loan market thus became a fast growing segment.

What was the interest rate on sub-prime loans?

Since the risk of default on such loans was higher, the interest rate charged on subprime loans was typically about two percentage points higher than the interest on prime loans. This, of course, only added to the risk of subprime borrowers defaulting. The repayment capacity of sub-prime borrowers was in any case doubtful. The higher interest rate additionally meant substantially higher EMIs than for prime borrowers, further raising the risk of default. Further, lenders devised new instruments to reach out to more sub-prime borrowers. Being flush with funds they were willing to compromise on prudential norms. In one of the instruments they devised, they asked the borrowers to pay only the interest portion to begin with. The repayment of the principal portion was to start after two years.

How did this turn into a crisis?

The housing boom in the US started petering out in 2007. One major reason was that the boom had led to a massive increase in the supply of housing. Thus house prices started falling. This increased the default rate among sub-prime borrowers, many of whom were no longer able or willing to pay through their nose to buy a house that was declining in value. Since in home loans in the US, the collateral is typically the home being bought, this increased the supply of houses for sale while lowering the demand, thereby lowering prices even further and setting off a vicious cycle. That this coincided with a slowdown in the US economy only made matters worse. Estimates are that US housing prices have dropped by almost 50% from their peak in 2006 in some cases. The declining value of the collateral means that lenders are left with less than the value of their loans and hence have to book losses.

How did this become a systemic crisis?

One major reason is that the original lenders had further sold their portfolios to other players in the market. There were also complex derivatives developed based on the loan portfolios, which were also sold to other players, some of whom then sold it on further and so on. As a result, nobody is absolutely sure what the size of the losses will be when the dust ultimately settles down. Nobody is also very sure exactly who will take how much of a hit. It is also important to realise that the crisis has not affected only reckless lenders. For instance, Freddie Mac and Fannie Mae, which owned or guaranteed more than half of the roughly $12 trillion outstanding in home mortgages in the US, were widely perceived as being more prudent than most in their lending practices. However, the housing bust meant that they too had to suffer losses — $14 billion combined in the last four quarters – because of declining prices for their collateral and increased default rates. The forced retreat of these two mortgage giants from the market, of course, only adds to every other player’s woes.

What has been the impact of the crisis?

Global banks and brokerages have had to write off an estimated $512 billion in subprime losses so far, with the largest hits taken by Citigroup ($55.1 bn) and Merrill Lynch ($52.2 bn). A little more than half of these losses, or $260 bn, have been suffered by US based firms, $227 billion by European firms and a relatively modest $24 bn by Asian ones. Despite efforts by the US Federal Reserve to offer some financial assistance to the beleaguered financial sector, it has led to the collapse of Bear Sterns, one of the world’s largest investment banks and securities trading firm. Bear Sterns was bought out by JP Morgan Chase with some help from the Fed. The crisis has also seen Lehman Brothers – the fourth largest investment bank in the US – file for bankruptcy. Merrill Lynch has been bought out by Bank of America. Freddie Mac and Fannie Mae have effectively been nationalized to prevent them from going under. Reports suggest that insurance major AIG (American Insurance Group) is also under severe pressure and has asked for a $40 bn bridge loan to tide over the crisis. If AIG also collapses, that would really test the entire financial sector.

How is the rest of the world affected?

Apart from the fact that banks based in other parts of the world also suffered losses from the sub-prime market, there are two major ways in which the effect is felt across the globe. First, the US is the biggest borrower in the world since most countries hold their foreign exchange reserves in dollars and invest them in US securities. Thus, any crisis in the US has a direct bearing on other countries, particularly those with large reserves like Japan, China and – to a lesser extent – India. Also, since global equity markets are closely interlinked through institutional investors, any crisis affecting these investors sees a contagion effect throughout the world.

(TOI)

INCOME TAX – AN OVERVIEW- I

QUICK LOOK

• Income tax is levied on the ‘total income’ of the assessee.
• Income of the ‘previous year’ is taxed in the ‘assessment year.’
• Income is classified into and computed under five categories called ‘heads of income.’
• The basic scheme of income tax is the principle ‘pay as you earn.’
• One must pay his taxes in advance and by the due dates, in the prescribed percentages.
• Deferment in the payment of advance tax would result in the payment of interest.

The income tax basic scheme is explained in brief as:

• Income tax is levied on the ‘total income’ of the assessable entity which is computed under the provisions of the Act.
• The income which are pertaining to the ‘previous year’ is taxed, but in the ‘assessment year.’
• Income tax is charged at the rates being fixed for the year by the annual Finance Act. But the liability to pay the tax is based on the principle ‘pay as you earn.’

Also check Taxable Heads of Income for the definition of

Salary, wages, pension, allowance, etc.

Pay as you Earn

A person is not allowed to wait until 31 March to pay his/her taxes. The Income Tax Act has the provision of ‘pay as you earn.’ This does not pinch a tax payer at the end of the year making a lump sum payment. Such payments are done during the previous year in the form of ‘TDS’, ‘TCS’

and ‘advance tax.’

TDS (Tax deducted at source)

This tax is deducted at the source from the income of the employee by the employer or the payer and paid to the government. It includes salary, interest, commission and contract fees, rent, professional fees, etc. This type of deduction is popularly known as TDS.

Such tax is subject to certain limits and certain conditions.

TDS has to be deducted in respect of payment of income is by way of interest on a term (fixed) deposit in a bank/ co- operative bank & with housing finance company, TDS at 10% +Surcharge (if any) + education cess at 2% + higher secondary education cess at 1%i.e. a total of 10.3% will be deducted at the time of credit or at the time of payment, whichever is earlier. TDS has to deducted if amt exceeds Rs.5000/- up to 31/05/2007 and Rs.10,000/- from 1^st June 2007.

No TDS would be deducted if amt of interest is up to Rs.5000/- up to 31/05/2007 & Rs.10000/- from 1^st June 2007 (per financial year, per branch)

In case of senior citizen, if he/she estimates that the tax on the income is nil, Form No.15H duly filled and signed is to be submitted in duplicate to the bank. So, no TDS will be deducted. If the total income is less than the threshold limit, Form No.15G (for other than Sr. citizens) is to be submitted to the payer to prevent TDS from such interest. The recipient may apply to the Assessing Officer (A.O) in Form 13 and obtain a certificate authorizing the payer to deduct tax at lower rates or no TDS. If Debenture interest is paid by an A/c payee cheque & does not exceed Rs.25000/- & in case of only notified securities no TDS would be deducted.

TCS (Tax collected at source)

Unlike tax deducted at source, TCS is collected by a seller of certain specified goods at the specified rates on the purchase of the goods and it is remitted to the treasury on behalf of the buyer. In the same way, a person granting a lease or licensee in a parking lot, toll-plaza, etc. collects the taxes at the specified rates as tax paid on behalf of the lessee.

Advance Tax

Advance Tax is paid by the income earner during the previous year. The computing of the liability of advance tax is done by estimating the ‘total income’ for the year, calculating the surcharge and taking into consideration the rebate that will be available. The advance tax is required to be paid in three installments.

Schedule of Advance Tax:
A	On or before 15 September	Not less than 30% of advance tax.
B	On or before 15 December	Not less than 60% of advance tax as reduced by amount paid earlier.
C	On of before 15 March	Full advance tax as reduced by the amount or amounts if any, paid in earlier instalments.

If the assessee does not pays the advance tax as described above, an interest of 1% is charged per month for 3 months for the deferment of advance tax installments.

If the total amount of advance tax is not paid on or before 15 March, an interest of 1% is charged

for one month.

Further, if the total advance tax paid is less than 90% of the advance tax payable, the interest at 1% per month is charged for the shortfall in the advance tax paid for the period commencing from 1 April of the assessment year and ending on the date of payment or assessment, whichever is earlier.

HALF YEARLY INTERNAL AUDIT MANDATORY

Half yearly internal audit has been made compulsory for stock brokers by SEBI. SEBI a premier body which regulates the securities related issues. The internal audit should be done only by an independent qualified Chartered Accountant, company secretaries, or cost and management accountants who do not have any conflict of intrest. For more log on to SEBI Website