About a year ago a good friend of mine came up with an excellent policy idea. I said it was unworkable. After several months of reflection, I realised I was wrong. The idea is in fact excellent – it makes economic sense, political sense and seems morally correct. I only wish I could claim the credit.
So here it is: let’s make negative equity illegal.
Or, more formally, let’s legislate to make mortgages in the UK non-recourse. I.e. if a mortgage is taken out against a property and the borrower defaults, then the borrower is only responsible for handing over the property, not any other sum.
So if I borrow £250,000 to buy a flat (and just typing that makes me remember how silly London property prices are) and then fall into difficulties (say if I lose my job), it doesn’t matter if the flat is now only worth £220,000. I just hand back the keys and the bank takes the £30k hit.
In other words, negative equity is not possible. At any time I want I can simply hand back the keys and the debt is gone.
This is already the case in multiple jurisdictions, including about half the US.
The rational is simple – a bank employs a legion of economists, statisticians, loan officers etc, who should be better able to work out the direction of house prices and the ability of a borrower to meet payments than any individual. So they should carry the risk.
What would be the side effect (other than the gratitude of thousands saved from negative equity and the threat of bankruptcy)? Obviously banks would have to be far more cautious in their lending. Loan to value ratios of over around 85% would become much harder to get. This would not only make bank loan books safer going forward, but also put a break on house prices. Both good things.
I argued that this would make it much harder for first time buyers to get on the ladder. I now see that if house prices were lower this would be less of an issue.
There is a very good article in the Economist on the state of the Irish economy.
Ireland is having a deeper recession than any other euro area country. The economy probably shrank by 2.5% in 2008 and may contract by another 6.5% this year. Unemployment has jumped from 5% to 10.4%, a faster rise even than in America. Irish banks may be free of the toxic securities that have poisoned rivals’ balance sheets, but they are blighted by souring property loans.
The symptoms are familiar: a burst property bubble, broken banks and highly indebted consumers. The response is very different.
In February, in the teeth of union opposition, the government introduced a levy on public-sector pensions that cut take-home pay by an average of 7.5%. The pain will intensify in April. Income-tax rates seem certain to rise, some capital projects may be put on ice and more current spending will be cut. The Irish insist on keeping their 12.5% corporate-tax rate.
In addition VAT has been hiked to 21.5%. With no central bank of their own the Irish cannot cut interest rates to a more appropriate level, the ECB was raising rates as recently as July last year. With no independent currency, the Irish can not devalue externally to support their exporters.
The only possible response is fiscal policy and here the government has chosen to try and cut public debt rather than support the economy. This ‘Treasury View’ policy has gained support from the usual suspects:
Ireland, which is taking the austerity route out of the crisis, slashing government spending, is attracting an entirely private sector solution to recapitalising banks. Property prices are becoming reasonable, tax rates are lower and big British run businesses are relocating to Ireland.
Ireland will probably be out of recession long before an economy crippled by Brown starts to recover – whoever wins the next election.
I disagree. The government is openly aiming for a policy of deflation to regain international competitiveness. It wants nominal wages to fall. It is betting that after a swift fall of GDP, in the order of 10%, things will stabilize at a lower level. All this seems a very large risk. Embracing demand deficit deflation is not a sensible policy.