Negative equity - what to do?

Negative equity is back in the headlines in Ireland again over the last couple of days. Here is a paper from the ESRI on this issue released this week.

Negative equity is when people pay too much to capitalise their future housing costs. This can be because:

• They over estimate the likely rate of increase in real rents, or
• Under-estimate the discount rate over the long term.

In Ireland, it is likely to be a function of both. People were expecting low interest rates over a long time that would, by the miracle of compound interest, make future rental payments very high in today's money. This is the fallacy of the "affordability" approach to property. Low short-term interest rates certainly make it easy to finance a variable mortgage, but to work out the price of a house you need to consider what interest rates will be in 5, 10, 15, 20, 25 and sometimes 30 to 40 years time.

When you get a decision like this wrong, by that I mean the decision to buy a very long series of cash flows (when you buy a house you a buying a lifetime of market rents), the ramifications are significant. Small changes in the actual increase in real rentals, or changes in expected interest rates will cause a large change in the capital value - i.e. the price of the house. A bond trader knows this. House buyers should also.

So Ireland now finds itself in a position where too large a proportion of the population got caught "on the wrong side of the trade". And they have a capital loss. What are the potential implications for the economy?

• The loss in wealth. Those people with no debt against their homes have suffered little. They were perfectly hedged - they had enough capital to finance their future rental costs and they still do. Those with mortgages have suffered because they were geared. They never had sufficient capital to pay for their future rental costs, they borrowed to do that and paid to much.
• The loss in mobility. This occurs geographically and demographically. Growing families need more room. Unemployed people need to go to where the work is. And people get together and separate.
• Lack of well functioning property market. People in negative equity can not sell their house for less than the mortgage. It is a legal impossibility unless the lender agrees to it. And no lender is willing to agree to it on this scale (size of potential shortfalls and number of borrowers affected). That means there is a significant proportion of the housing stock that has a an artificial price floor. The market wants to adjust to lower prices (there is excess supply), but sellers are not free to drop prices as far as they need to clear the market.

Those are the big ones. So what can be done? About the first, nothing in aggregate. You could transfer wealth from those not affected (the sensible/prudent) to those who have suffered loss. The loss hasn't vanished, it has just been redistributed. Would that be sensible? I would be most concerned about the clear message that sends to people making decisions in the future - don't worry about the risk. That is the "moral hazard" problem. So I think it a bad idea. People made a decision, a bad financial one and lost. It happens all the time. They can work hard and rebuild. It will be better for everyone in the long run if they do that.

What about the second. This is tricky. The benefits of mobility are not explicit. It is no doubt important that people are able to change their circumstances, but how important is not really quantifiable. Qualitatively, I would say it is pretty important.

The final point is perhaps the most transparently important one. Ireland is in for a long period of real house price deflation if nominal prices have a floor under them due to the extent and size of the negative equity problem. Like he removal of a band aid, getting you pain in one short burst is usually the best. So it is with prices. Just ask the Japanese.

Thinking about those points on balance, my default position is typically that public policy has a limited role. People need to save their way back to solvency.

However, I am ready to be convinced that there is a social and economic benefit to finding a way to facilitate a much faster resolution to the negative equity problem, due to the mobility and price adjustment issues, but would object to a policy based on wealth transfer.

On that basis I would strictly oppose some of the following, which are all a variation on a theme of wealth transfer:

• Debt forgiveness
• Government subsidies
• Any public funded sale and lease-back type agreements

So what would I propose? I would suggest a government financed unsecured loan, to the value of the negative equity. This would have the following characteristics:

• It would be a charge against the owner logged against their tax number by the Revenue.
• Recovery would come in the form of a levy on all income (say 5%, but could be more) through the tax system, until the debt is repaid.
• Interest would be charged at long term fixed rate at a modest premium to the current 30 year government bond yield.
• Repayment in full could be made at any time without penalty.
• An optional charge on the estate at death could also be include to strengthen the recovery.

That type of arrangement would keep the proper incentives in place:

• You would still want to get the best price possible for your house.
• You would not be getting a bail out, helping to mitigate against moral hazard problems.
• It would allow more efficient adjustment in the property market, by allowing losses to be crystallised by sellers at price buyers are willing to pay.
• Tax payers would not be bailing anyone out, although more public debt is required in the short to medium-term.
• With the correct interest rate, this could self financing - noting that some people will never repay all of their debt in their lifetime.