Wednesday, 23 June 2010

Negative equity loans

ADDENDUM 24 June 2010:
Something worth adding from a "macro" perspective. Current policy with regard to the banking sector in Ireland should be to support and facilitate an orderly shrinking of balance sheets. This simply means allow banks to reduce the amount they have out on loan on one side and the amount they owe (now increasingly to taxpayers) on the other.

What is described below allows that to happen, without banks taking any loss. To date balance sheets have been adjusting by writing off, rather than retiring debt (as below) and passing the loss to the taxpayer. How could you not love that?


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An interesting announcement this week in the press in Ireland. Negative equity loans. Simply floating the idea seems to have initiated a rash of negative comment, some from people who I wouldn't rate as knowing their financial or economic onions, and surprisingly others who do.

It led me to think because my first reaction was; this is an interesting development. Because among all the loopy ideas that people have been spouting that invariably require taxpayers' money to be used to redistribute wealth from people who have made good decisions to those who have made bad ones, this one is a purely voluntary option designed and entered into by those parties who are relevant - the lender and the borrower.

I also had a favourable initial impression because it was my idea a long time ago.....

So firstly what are the objections? Obvious really.
  • Allowing people to enter into a financial agreement that leaves them knowingly insolvent is just plain stupid - no objection there.
  • It replays all the stupid risk management that got us in this mess in the first place by lending to people who couldn't wouldn't afford it -that it does if available to all comers.
  • People would increase their negative equity and debt problems (see my first link above for an example) - that is true for the hypotheticals posited.
So it is a stupid and reckless idea after all then.

Well, no. It's a good idea and here is why.

What you have above is a knee jerk response based on fears of what might happen if such an mortgage was arranged inappropriately. That is a risk, no doubt. Did you read my post on "Risk versus Uncertainty"? If you did, you will know that having identified what might happen we have risk and risk can be mitigated against.

And what is the risk mitigation tool we have? Yes we have a freshly minted Head of Financial Regulation with new and improved ADDED BALLS(TM). And the appropriate responses to the early information we have on these mortgages have already appeared. Those BALLS(TM) seem to be more than the normal marketing blurb.

So all that is good. But why on earth do I think this stupid idea has some merit? I can think of at least two.

It can address the real problem in some instances. The real problem is of course the gross indebtedness of a household not the red herring of "negative equity" that is being bandied around. While providing such a mortgage to someone who wants to buy a more expensive house (or a new house) would be a bad idea, providing such a mortgage to someone who wants to buy a cheaper house could be an extremely good idea because they could reduce their debt. If you have a mortgage of €600,000 and a house now worth €500,000 and are struggling under the weight of the debt, would it really be a bad thing to sell up and buy a house for €300,000 with a mortgage of €400,000? And what about the bank? Would it be reckless to provide such a mortgage to a customer who is trying to reduce their debt? The risk position of the bank has surely improved, with exactly the same exposure to negative equity, but a mortgage that is now more likely to be repaid in full (including the negative equity!!).

And what about from the debt servicing side. What if the borrower loses their job, or finds a better paying or more secure job and needs to move to avail of the opportunity. Would providing a mortgage that facilitates that move, but does not increase the gross debt burden of the borrower any further be prudent or imprudent for both parties concerned.

In both those circumstances I would argue it is imprudent and extremely poor risk management to rule out such a "negative equity mortgage", because to do so would keep the debt burden higher, or make the debt servicing more difficult and hence increase the likelihood of default.

So this is what I suggest:
  • There should be no blanket ban on such mortgages.
  • The Financial Regulator should demand of any bank wishing provide such a mortgage that specific pre-agreed criteria need to be met by the borrower
  • Such a mortgage can not be granted to a new customer (i.e. current mortgage holders only)
  • Such a mortgage must not be greater than the present mortgage outstanding,
  • Such a mortgage can be of no greater term than the current outstanding mortgage (this might be open for negotiation).
  • The Financial Regulator should review the operation and experience after an initial period and reassess the rules and policy.
  • Such mortgages should be allowed for a specified period only (next 5 years say), which may be extended by the Financial Regulator if deemed beneficial and prudent.

In effect, these are extraordinary measures for extraordinary times. And this is one of the very few sensible ideas to float in the country that addresses our problems:

WE HAVE TOO MUCH DEBT!!!!!!!!

It may be appropriate at the margin only, but that would make it 100 times more effective than any other "initiative" I have seen advanced in Ireland to date.

56 comments:

Damo Mackerel said...

Ok, let me see if I can get this straight.

Original House: €600,000
Now worth: €500,000 and sell for that.

NE: €100,000

New smaller house say €300,000 + €100,000 = €400,000.

So I pay back your NE plus I'm €100,000 up, with a smaller house but in oh say a better jobs location.

Am I missing something?

karl deeter said...

I hope I'm on that list that know their onions! :-)

My opinion of being against it is that I believe it to be designed specifically for those who are increasing their debt levels. The points about reduction of debt are spot on [and in line with some comments I made on radio].

However, the prime targets are those in negative equity who are not downsizing, to be in N/E you are far more likely to have been a ftb c.2002-2007 who wants to move (often due to having a family) upward in the property market, from apt-> house for instance

That would normally indicate an increase in debt - you might buy a cheaper house because prices have dropped, but the target market in this case is for trading up and increasing the debt, if the pattern here follows that of the UK then it will be a niche product with virtually no take up but it will give the banks lots of PR saying they are doing cartwheels for the consumer.

Damo Mackerel said...

Right I see where I've gone wrong, face palm. Lols.

I originally owe the bank €600,000 + €300,000 (for new house). That's €900,000. I sell the house for €500,000, so now I owe the bank €400,000. I will also have to pay stamp duty plus other fees. Finally, it's unlikely that the bank will let me stay on tracker, so they'll but me on a higher fixed rate.

Where that leaves me in the scheme on things I'm not sure.

Geckko said...

Karl,

I don't know why you immediately jump to the specific hypotheticals rather than consider the general.

I don't doubt that banks might wish to provide such mortgages to allow customers to increase their borrowing, or to attract new customers. But as with any financial product, that is why we have (supposed to have) regulation.

That is no different to saying mortages are a stupid idea because someone might borrow more than they can pay back. Doesn't mean we ban mortgages does it?

We simply state those are the things you can't do and enforce that.

I thing my argument is sound. There is a massive problem with people who have too much debt. Negative equity is currently the trap that stops them reducing that debt.

Judiciously allowing a negative equity mortgage could be one way out of that trap.

Joe said...

I think I understand this from the point of view of the homeowner. They started with a mortgage of 600 and ne of 100, and they finished with a mortgage of 400 and ne still 100.

But how about from the bank's point of view? They started with an asset of 600 and corresponding liabilities of 600. After they have an asset of 400 but liabilities only come down to 500.

Geckko said...

Joe,

The bank's asset is always tohe loan. The house is only ever contingent security.

I think your accounting is getting a bit mixed up. From the bank's POV it is quite simple:

The bank simply lends the new sum, €400,000 (asset go up €400,000). The old loan is repaid (assets go down €600,000).

So from the starting point you get 600+400-600=€400k

Joe said...

Hi, I'm not an accountant or finance guy, so no doubt I'm mixed up and missing something here. But how is the bank going to pay off the 600 to its creditors? The sale of the house is only going to get 500. Thanks.

Geckko said...

Joe,

Forget the bank for a moment. Imagine someone owes you €600. They manage to seel something that raises €500, which they pay to you in part repayment (€100 left). They then want to buy something for €300, which you lend to them (they now owe you 100+300=€400).


You got €500 in and then lent €300 out again. The €200 balance you could use to pay off some of your debt.

Same with the bank. Its assets shrink by €200k (now a €400k mortgage instead of €600k) and its liabiilties shrink by €200k (the difference between €500k repayment in and the €300k loan out again can be used to pay off a bondholder for example).

Make sense now?

Joe said...

yep, I get it now, thanks. The bank only needs to give back 300 to buy the new house.
Seems like a good plan then. Both home owners and banks can reduce their debt levels without the tax-payer getting involved.

Geckko said...

Exactly.

Sal said...

This plan does not address the fundemental underlying problem - that homes were (and are) overvalued and that banks need to recognise write downs in order to address the problem of confidence in their balance sheets.
Two main problems with this solution (one technical the other on principle):
1) The bank's LTV on a loan by loan basis will get worse through the plan - therefore there will be less likelihood that the bank's asset will be recovered due to the non existence of underlying collateral. This means (a) less confidence in the banks balance sheet, (b) higher loan provisions and capital requirements to support the book of loans. Result - Credit crunch.
2) On principle - both lenders AND borrowers should be exposed to the house price adjustment. This plan maintains the obligation to pay the bank in its original amount and transfers ALL of the pain to the borrower (through moving to smaller accomodation). This doesn't make sense - the borrower is already in negative equity - it is just a matter of time before borrowers wake up to the reality that they do not own the homes that hey are living in and that it is cheaper to rent the house next door - Result: bigger write down for the bank on foreclosure.

Geckko said...

Sal,

As I outline, the likelihood of recovery would be increased.

The increase in the LTV you observe is a red herring. The borrower has less to repay and their debt servicing costs are lower. Hence the risk of default is lower.

Also the LTV is a red herring because it doesn't matter what the ratio is, the actual shortfall in security (the "negative equity") is unchanged. The banks exposure is the same.

Also, I suspect from your approach that you are American. In Ireland, as with a number of other countries, borrowers can not walk away from their mortgages. "Jungle mail" is not an alternative, because you remain liable for the entire mortgage outstanding.

Sal said...

Hi Gekko,

I agree with you that the borrower's debt burden would be lowered - and that if you define 'recovery' as maintaining short term roll rates on a loan then yes this goal will most likely be achieved.
Where I disagree with the proposal is that a) it does not remedy the underlying problem and b) it places 100% of the burden on the borrower.
If you look at house prices as a multiple of rents and household earnings then they have been overvalued and are currently falling despite the low interest rate environment (which is unsustainable in the long term).
The current proposal only really works if you believe that house prices will rebound and remedy the negative equity problem in the short to medium term.
Otherwise - the proposal maintains borrowers' debt at >100 LTV and in fact increases the period that this will be so.
My point is that eventually - Irish borrowers will wise up to their options (or will start to seek advice).
I agree with you that Irish law is somewhat punitive as regards the debtor - but foreign experience (US and other territories) suggests that borrowers will look to more aggressive tactics to release themselves from obligations that they have no hope of repaying.
Couple this with the current shift in regulatory attitudes (and potential for legislative reform) and the reality that banks will not chase residual unsecured debt into a bankruptcy - then we get back to the conclusion that the banks will be taking greater write downs in the future.

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