Economics 15/06/2010: Negative equity 3

Here is the third and last post in the series on negative equity based on my TCD speech (see here).

Rising negative equity has implications for financial stability:

Domestic mortgage lending by the major banks represents over x5 times their core Tier 1 capital in the UK and roughly 10 times in Ireland. Even post disposal of its assets (assuming rosy valuations), AIB’s multiple will be over x11 of its risk-weighted assets. BofI – x7-8. And these are the better ones of the Irish banking lot. In addition, around 40% of all outstanding UK mortgage debt has been used to back securities.

Large losses on these mortgage loans and associated securities can erode banks’ capital positions, affecting both lenders’ willingness and ability to lend and, in extreme cases, their solvency.

Both of the above effects can have implications for aggregate demand and the supply capacity of the economy, highlighting the interdependency of financial stability and monetary policy. Again, in the case of Ireland, the two effects are reinforced by the large exposure of the Exchequer to banks balancesheets and to the property markets.

The defining feature of the materialised losses, and their associated economic effects, is the value of debt at risk (loss given default) and the coincidence of that with the probability of default.

Rising negative equity has implications for loans default probabilities:

In economic literature, negative equity is a necessary condition for default to occur since borrowers with positive equity can sell their house and use part of the proceeds to pay off their mortgage. Transaction costs (high in Ireland) and transaction lags (also extremely long in Ireland) act to further increase this effect. For example, a household with positive equity of ca 10% will still trigger a partial default on the mortgage if it takes a year to close the sale (8% funding opportunity cost per annum) and if closing costs add up to 2% of the sale price.

However, negative equity is not a sufficient condition for default to occur, as discussed in “Negative Equity and Foreclosure: Theory and Evidence” by C. Foote, K. Gerardi and P. Willen (June 05, 2008, FRB Boston Policy Discussion Paper No 08-03). Similarly, in the UK, May and Tudela (2005) find no evidence that negative equity increased the likelihood of a household experiencing mortgage payments problems between 1994 and 2002, although their sample does extend over a lengthy period of robust economic growth and rising incomes. The latter two aspects of the sample are not present in today’s Ireland.

But, as Heldebrandt, Kawar and Waldron (2009) highlight, “if a household is experiencing difficulties meeting their mortgage payments, negative equity can increase the probability of default by reducing the household’s ability to make payments by preventing equity withdrawals.” Benito (2007) found that households are more likely to withdraw equity from their homes if they have experienced a financial shock. Negative equity can affect a household’s ability to do that because of credit constraints.

Furthermore, negative equity can increase the probability of default by reducing household’s willingness to make mortgage payments, since defaulting can reduce the debt burden of the household. In Ireland, despite our anachronistic bankruptcy laws, this option is still available for anyone willing to emigrate. You might as well call this www.book-your-one-way-ticket.ie effect, as households leaving Ireland fleeing bankruptcy will have:

1. a very strong incentive to emigrate; and
2. a very strong incentive never to return for the fear of debt jail.

Negative equity may significantly increase the probability of default of buy-to-let mortgages over and above that of owner-occupiers as costs of defaulting on a buy-to-let mortgage may be lower because defaulting does not lead to loss of residence. In addition, buy-to-let mortgages are, at least in some cases, registered via businesses, implying no recourse on family homes and wealth.

Overall, available economic evidence does suggest that negative equity plays a significant role in mortgage defaults:

• Coles (1992) presents results from a 1991 survey of lenders in which a high LTV ratio was frequently noted as an important characteristic of borrowers falling behind in meeting their mortgage payments.
• Brookes, Dicks & Pradhan (1994) and Whitley, Windram & Cox (2004) find that a reduction in the aggregate housing equity in the UK was associated with an increase in arrears.

Overall, Heldebrandt, Kawar and Waldron (2009) conclude that “evidence suggests that the level of household defaults, and the impact of negative equity on financial stability, is likely to depend on conditions in the broader macroeconomic environment”. And Ireland is at a clear disadvantage since the combined macroeconomic shocks (decline in GDP/GNP, rising unemployment and contraction in private sector credit) are much more severe here.

Rising negative equity has implications for the size of the expected banks losses:

When bank borrowers face negative equity, as probability of default and the value-at-risk in default rise, banks have an incentive to stave off the actual mortgage default. To do this, banks engage in:

• Renegotiations of covenants (loans extension, provision of a grace period, interest only repayments etc)
• In extreme cases – joint equity ownership in asset (though banks will usually engage in this type of transactions under regulatory duress)
  

All of these measures aim to put the borrower into a position to eventually repay the loan in full.

However, in cases where default in unavoidable, the loss to be realised by the bank on any given loan depends on the recovery that can be achieved if the borrower defaults. Negative equity, or positive equity that does not exceed the sum of the cost of carrying the loan during the sale, plus the cost of sale, will imply a net loss on the default. From the bank point of view, the problem is not in the actual level of individual defaults, but in the combined level (aggregate) of negative equity net of costs and recovery values.

Such net losses impact not only the actual mortgage book, but also securitised pools that can be held off balance sheet, as current negative equity puts at risk future revenue against which the book is securitised. The end result on mortgage backed securities side is to reduce the value of MBS asset and, as Heldebrandt, Kawar and Waldron (2009) point out this can induce a second order effect of changing risk perceptions and investors’ sentiment “regardless of the actual performance of any given portfolio of loans”.

Both types of losses lead the banks to record write downs on their mortgage books and securities held. If these are large enough, banks’ capital ratios will be reduced.

In the case of Ireland the problem is compounded as the banks are actively delaying recognition of losses on negative equity. These delays mean that banks are likely to pay elevated costs of external funding over longer period of time. In addition, these delays lead to losses compression – the situation where banks recognize significantly larger volumes of impaired assets later in the crisis cycle. Bunching together losses creates a much more dramatic investors’ loss of confidence in the bank.

In addition, negative equity-driven impairments, plus delayed recognition of such impairments lead to suboptimally high demand for capital from the banks. If this coincides with the period of severe credit crunch, monetary policy aimed at increasing economy-wide liquidity flows can become ineffective, as banks park added liquidity on their balance sheets, creating a liquidity trap. This is evident throughout the crisis, but by all possible monetary policy metrics, it is much more prevalent in Ireland, where even today credit available to the private sector continues to contract. Irish banks are hoarding liquidity and are raising lending margins to offset expected, but undisclosed writedowns. This problem is compounded by Nama which induces greater uncertainty onto banks balance sheets through its hardly transparent or timely operations.

Negative equity and generational asset gap:

In Ireland, the problem of negative equity is further compounded by the generational spread of negative equity to predominantly younger, more productive and more mobile (absent negative equity) households. These households today face higher probability of unemployment (thanks to our unions-instituted and supported ‘last in – first out’ labour market policies). They also much deeper extent of the negative equity because of higher cost of financing their original mortgages and entering the housing market.

The generational effects of negative equity are compounded by geographic distribution of the phenomena – with younger households being more likely to reside in the areas of excess supply of new housing, with poor access to alternate jobs, should they experience unemployment.

Finally, it is the younger households that are subject to twin effects of higher probability (and deeper extent) of negative equity and depleted savings (due to high cost of entry into the housing market). This implies that it is the very same households which have the greatest incentive to engage in precautionary savings motive.


So traditionally, economies grow by:

• encouraging the young to acquire new assets (invest and save); and
• encouraging the old to consume (divest out of savings).

With negative equity, Nama and pressured banks margins, Ireland is:

• forcing the better (more productive today and in the future) young to emigrate;
• keeping the remaining young deep in the negative equity (neither capable of investing in the future, nor of moving to find a lost job today);
• underwriting - at the expense of younger, tax paying generations - continued excessive provision of pensions to retired public sector workers;
  
• forcing younger families to cut deeper and deeper into their children education budgets and own training and education funds in order to assure they continue paying on the asset that will never have net positive return on investment; and
• incentivising the old to remain in their highly priced (if only rapidly losing value) homes backed by slacked consumption due to inability to monetize their pensions savings.

In what economics book is this scenario better than any moral hazard problem that can be incurred in the short run by reforming our bankruptcy system to an American-styled 'restart' button?