Duncan’s Economic Blog

Radical, popular and right

Posted in Uncategorized by duncanseconomicblog on March 23, 2009

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.

7 Responses

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  1. CharlieMcMenamin said, on March 23, 2009 at 5:14 pm

    Snowflake disagrees – see http://snowflake5.blogspot.com/2009/01/problem-of-american-non-recourse.html. I found the comments debate which followed his piece interesting. It all focused on the issue of moral hazard.

    however, even if one agrees with you rather than Snowflake – which I think I do – switching to non recourse mortgages (which would inevitably be priced more highly than traditional ones, to reflect the banks increased risk) does nothing if it only means one can hand back the keys and still have nowhere to live. In the States people move around a lot more than here and there is a vibrant-ish private rented sector in many parts of the country. Not so in most parts of Britain – social renting is far more important. Giving back the keys wouldn’t qualify anyone for social housing. So this suggestion might be, at best, a part of a wider solution, rather than an solution in and of itself.

    • duncanseconomicblog said, on March 23, 2009 at 5:26 pm

      Charlie,

      I think the problem in the States came when non-recourse mortgages were combined with securitisation. If the lending institution can simply unload the mortgage to someone else, there is less incentive to be cautious. I think this is the primaery source of moral hazard, rather the non-recourse nature of the mortgage. I think this element was missed in the discussion over at Snowflake’s.

      I also agree that mortgages would become more expensive, although again if house prices were lower this would be less of an issue – higher interest but lower price.

      I totally agree that this is not a magic bullet. You are totally correct that we need more social housing and better access to it. But I think this is a step in the right direction.

      There would of course also be issues in contract law with converting current mortgages to non-recourse status. I suspect that it would simply have to be for new mortgages. Although there may be ways around this.

  2. CharlieMcMenamin said, on March 23, 2009 at 5:42 pm

    i don’t disagree with any of that – but who ,exactly, has negative equity?

    This chart ,which I’m told comes from Lord Turner’s FSA report, http://3.bp.blogspot.com/_-VeC39yh6nc/ScUSn87MUGI/AAAAAAAACZ0/IRFzfSUY9X8/s1600-h/mortgage-use.gif seems to suggest that by 2007 c40% of all mortgages were actually undertaken for equity withdrawal purposes. That sounds like lots of folk doing up their kitchen or adding a conservatory to me. They’re not going to be helped by the proposal.

    & another quarter were buy-to-let mortgages. Not all of these will be genuine private landlords of course, some will be people who move but can’t sell, and let out the old home for a bit. But some will be would be property magnates. What we probably need there is a mortgage with a condition that non recourse is linked to compulsory sale (or first offer of sale) to the tenants or a housing association or Council at prevailing market prices.

  3. Will M said, on March 24, 2009 at 12:58 pm

    3 thoughts.

    1. a “brake” on house prices would probably be better 😛

    2. it will be an empirical question as to whether house prices fell by more than the difficulty of getting a mortgage increases

    3. it further alleviates the buyer from taking responsibility for their future. i’m not a fan of this.

    • duncanseconomicblog said, on March 24, 2009 at 4:08 pm

      I’ll accept point 1.

      On 2, it would be. On 3, (if coupled with a reform of securitisation) it would make the bank take more responsibility for their future. Which is a good thing.

  4. tory boys never grow up said, on March 24, 2009 at 1:53 pm

    Yes the banks should be able to manage and carry the property equity risk better than the borrowers – unfortunately, isn’t one of the main reasons why we are in the current mess because they patently couldn’t price or manage the risk – and their attempts to do so through ABS actually destabilised the who market. Perhaps until we find some real ways of hedging housing market price risk (and a lot of people have tried without much success) – perhaps the best solution is to stop throwing petrol on the fire – and do more to develop a sensible rented housing sector as an alternative as in much of Continental Europe.

    • duncanseconomicblog said, on March 24, 2009 at 4:08 pm

      Fully agree on the need for a sensible rented housing sector. Let’s build some houses.


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