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.