Film Review FAULT LINES For Sale - Fall of the American Dream

Subject Contracts II Submitted to Mr. Rajesh Kapoor Professor, Contract Law.

Submitted by Surya Karan Sambyal Second Year, Semester III Roll No. 2012-64

NALSAR University Of Law, Hyderabad

Contents I. Introduction ........................................................................................................................ 3

II. Contract of Guarantee ......................................................................................................... 4 III. IV. V. VII. The Documentary: Fault Lines ....................................................................................... 6 ANALYSIS ..................................................................................................................... 8 Conclusion ...................................................................................................................... 9 Bibliography ................................................................................................................ 10

I.

Introduction

Since time immemorial, owning a piece of land, especially a house, has been a cornerstone in anyones life. In the contemporary world of unprecedented increase in population and stagnant incomes, owning a house or a mere accommodation to live has gained paramount importance. Affordable housing has been an alarming concern for more than a decade across the globe. In recent years of globalisation, investors across the world have unfathomably developed the sector of real estate, aiding the state machineries to provide housing to people across the green. One such incident associated with the United States which has been regarded as the reason for economic meltdown across the nations is the Housing Bubble Crisis, the fall of American dream, that led to over two million foreclosures,1 leaving innumerable families with no place to go to. The most intriguing aspect of these crises is the role of the loan contracts that functioned as the catalysts to the bursting of the housing bubble. The government sponsored private investment companies such as Freddie Mac2 and Fannie Mae3 played a crucial role in the overturning of the real estates reality i.e. the unprecedented increase of the housing prices and the subsequent fall of the same to negligible values. Owing to the curiosity to know the various reasons that led to the economic meltdown, I came across the documentary, Fault Lines-Fall of American Dream which forms the base structure of my project around which revolves my entire research. The directors of the documentary have approached the entire issue of the Housing Bubble in a subtle manner eloquently foreshowing the role played by the private companies Freddie Mac and Fannie Mae through the Contract of Guarantee4. Through my project I will try to bring out the essential role played by the Contract of Guarantee in the overturning of the field of the real estate itself. The most crucial aspect of these contracts was the role played by these companies as the surety to the various low credit rated communities that led to the unprecedented increase in the housing prices creating a bubble which insured people of a house and huge profits to the companies; and subsequent collapse of the real estate market.
1. 2. 3. 4.

http://www.downsizinggovernment.org/hud/housing-finance-2008-financial-crisis www.freddiemac.com www.fanniemae.com Section 126 of the Indian Contract Act.

II.

Contract of Guarantee

First, I would explain the contract of guarantee in general and then I would proceed to the specificity of the contract under issue. According to section 126 of ICA5, a contract of guarantee essentially includes three parties6, namely, Principal Debtor (one who takes a loan), Creditor (one who lends the loan to the principal debtor) and Surety (one who guarantees the repayment of the principal amount in case of a default by Principal Debtor). Hence, the contract of guarantee is a trilateral contract, where the primary liability rests o n the principal debtor and the liability of the Surety is secondary as it is contingent to the default by the principal debtor. Usually, in a case of house loan, the principal debtor mortgages the house against which the loan is issued and in addition to it provides the creditor with a security, who in turn promises to pay the creditor in case of a default by the principal debtor in the repayment of a debt. The film revealed that the above companies stood as the sureties for the various low income families and settled the principal loan amount with the crediting banks even though there was no default in the repayment by the principal debtor as of then. This assured profits to the banks as well as the Freddie Mac and Fannie Mae. 7 Thus, the surety under section 140 of ICA8, steps into the shoes of the creditor and has same rights as the creditor had against the principal debtor.

5. 126. "Contract of guarantee", "surety", "principal debtor" and "creditor"- A "contract of guarantee" is a contract to perform the promise, or discharge the liability, of a third person in case of his default. The person who gives the guarantee is called the "surety", the person in respect of whose default the guarantee is given is called the "principal debtor", and the person to whom the guarantee is given is called the "creditor". A guarantee may be either oral or written.

7. For e.g. when the interest amount is less the company paid off the total amount and entered into the shoes of the creditor and gained profits out of the principal amount and the interest levied on it. 8. Section 140 Indian Contract Act - Where a guaranteed debt has become due, or default of the principal debtor to perform a guaranteed duty has taken place, the surety upon payment or performance of all that he is liable for, is invested with all the rights which the creditor had against the principal debtor.

III.

The Documentary: Fault Lines9

The documentary begins with an assumption owning a home has been the central piece of the American dream. After the foreclosure crises, a cumulative of 75% of the American owed more to their mortgages than their houses were worth. The episteme of the crises lie in the stature accorded to real estate in America. The real estate has been long considered as the backbone of the American economy. For decades, any surplus wealth of an individual was invested in real estate. The government of America incentivised the owning of the houses by backing the companies like Freddie Mac and Fannie Mae. Their operational structure formed the nucleus of the collapse of the real estate. The banks in the present structure sold off the mortgages to the investment companies and hence had no risk at all. All the risk was transferred upon these companies. These companies followed this practise in all the loans where they stood as the suretys creating the phenomena known as the Sub Prime Mortgages (SBM). In SBMs, the interest rates were brought down significantly from 10% to almost 6% backed by the government assistance. This involved a lot of risk to the investors due to the low credit worthiness as most of the houses owned under the plan were by low income communities. It is imperative to bring forth the fact, that most of these families had applied under this scheme to re finance their existing debt bonds. With stagnant real incomes and increasing prices of the real estate, the returns became impossible and large number of them defaulted on their returns. As the number of the defaulters increased manifolds, the companys profits soared and hence, they were bailed out. The inconsistency in the payments by the principal debtors led to over 2.2 million foreclosures over a financial year, as a result of which this housing bubble busted and the value of the houses soared immensely. Once the foreclosures became the norm of the US housing reality, there was no refuge for the economy to bounce back. The houses were auctioned at throw away prices to the vulture investors.10 The documentary has lucidly brought forth an important aspect of the entire Sub Prime Mortgage Crises (SBMs), that the unintended target of the bubble burst were the communities with low credit rating as the banks in a way sold of their loan contracts to the investors, the status of the bank thus reduced to a mere servicer.
9. 10. http://www.youtube.com/watch?v=S3rzN42HE00 The investors who bought the auctioned houses at throw away prices from the banks.

Once the loan contracts were sold by the Banks in America to these private investors, they ceased to have a say in the foreclosures. These companies, at their volition decided the houses that were to be foreclosed upon. Hence, indirectly the government didnt have any say in the matters of foreclosure. The documentary in particular has extensively studied the impact of the housing bubble crises in California. The state of California had largest number of foreclosures as almost 60% of the housing market in California was owned by the company Freddie Mac and Fannie Mae. There was no legislation in California that could regulate the functioning and action of these companies which didnt take into consideration the welfare of the general population.

IV.

ANALYSIS

In this part of my project, I would majorly focus on the role of contracts of guarantee that led to the housing bubble crises that triggered the worst financial crises that the world had ever seen. The dealing in regard to the loan agreements were fundamentally manipulated, as the banks sold off the debt bonds to the private investors who bought these loan bonds in bulk and created a box which is regarded as the CDO (collateralized Debt Obligation) which were the outcome of subprime mortgages. This increased the risk of these companies to unprecedented levels as the CDOs mostly consisted of the subprime mortgages of the low credit rating communities. As the prices of the housing market first increased enormously and subsequently crashed to negligible values, the defaults by the principle debtor became usual, overturning the profits of Freddie Mac and Fannie Mae into huge losses. Once the investors bought the loan bonds, they stepped into the shoes of the creditor under section 140 of the Indian Contract Act, exercising all the rights available to creditor in case of a default by the Principal Debtor. Once the defaults rose to unexpected levels and the investors bailed out the opted to foreclosures, evicting the families out of their dream homes on a short notice and putting them for sale. Foreclosures, thus, became the norm of the American reality and the rose to 2.2 millions in a financial year. The values of these homes dipped and were auctioned at throw away prices. Another reason for the financial meltdown lay in the policies of the then government. There was no law that could restrict the whims and fancies of the investors and they recklessly sold their shares and auctioned innumerable prices. The documentary meticulously revealed the bursting of the housing from the perspective of a lay man, explaining the complex in the most simplistic manner. Once these companies bailed out and the national economy accumulated debts, the financial meltdown became inevitable. This situation and the loss caused to the structural power of the American state could have been mitigated if the interest rates remained constant and if the loan agreements were acted upon in the usual manner.

V.

Conclusion

The documentary has very eloquently portrayed the reality of the real estate market in America during 2006-07. We can relate the emergence of the housing bubble crises in the deviance of the banks from the orthodox form of the contract of guarantee. Once the banks sold the debt bonds to the private investors they manipulated the loop between the three parties to the loan contract namely the Principal Debtor, Creditor and Surety. The settlement of total amount with the banks by these private investors in a number of cases led to the creation of Collateralized Debt Obligations (CDOs) which involved high risk stakes as these were comprised of low credit rated principal debtors. In many cases the subprime mortgage provided a large section of the society especially in California to refinance their existing loans as the interest rates were brought down to almost 6%. As noted above, the real income for most of the Americans had remained stagnant since late 1970s and looming prices of the housing industry made it nearly impossible for the principal debtors to pay monthly instalments resulting in defaults. Once these defaults took place in large numbers, the companies made huge losses and eventually bailed out. This was followed by foreclosure whose number went up to 2.2 million and people were evicted on short notices. To minimize the losses, these companies especially Freddie Mac and Fannie Mae auctioned the foreclosed houses at throw away prices. Thus, happened the housing bubble burst leaving millions of Americans homeless and without a shelter. The Subprime Mortgages, CDOs and the manipulation of the Contracts of Guarantee provide for the most devastating recession the world had ever seen. The major question that remained unanswered was that In reference to ultimate social reality, was it actually the companies that were bailed out or was it the general population that was actually bailed out?

VII.

Bibliography

1. www.youtube.com 2. http://www.rhsmith.umd.edu/cfp/events/2011/GSE2011/papers/Explaining_the_Housi ng_Bubble.pdf 3. http://www.milkeninstitute.org/pdf/riseandfallexcerpt.pdf 4. http://www.forbes.com/fdc/welcome_mjx.shtml