Tuesday, 6 October 2009

There are worse things than 'negative equity'

Nat O'Connor: There continue to be stories about falling housing prices (for example). We need to get some sense of what are reasonable housing costs and use this as a basis to co-ordinate policy and aim for stable housing costs.

Earlier in this blog, An Saoi has suggested that the current incarnation of NAMA is dependent on reinflating the property bubble. It's not the only state policy that may inflate property prices: the state pays the rent of over half of the private rented sector, it uses major tax expenditures to incentivise development and home ownership, and the move to leasing as the main source of social housing will also have a major effect on the rental market. None of these policies may have the explicit goal of propping up property prices, but there is no denying that huge state involvement in the property sector will have a significant effect.

High property prices sustained through public expenditure would be wasteful and are unsustainable. So, we need some kind of objective yardstick that might give us a sense of what housing costs would be reasonable. It is difficult to objectively identify a 'market' price when the state has such an influence on prices.

In the US housing market, long-term house prices appear to settle between 12 and 20 times annual rental yield value. In other words, if I can rent a house for 10,000 a year, it is worth somewhere between 120,000 to 200,000.

Irish house asking prices vary between 20 and 34 times their annual rental yield, for 3-bed houses in County Dublin, Galway City, Waterford City and Cork City. (Comparison based on DAFT house prices versus rent snapshot, Quarter 2, 2009). This suggests that they have further to fall before we get to some kind of sustainable position.

The above Irish Times article concludes (despite the weakness of the available data) that "it is likely that most people who acquired their home in the past five years are now experiencing some degree of negative equity."

Yes. There can be little doubt that the overdue, massive correction in the housing market means that house prices may have to fall a great deal and they may never again rise to anything like the equivalent of their inflated value. Remember, we had a crazy unsustainable situation where we generated a massive surplus of housing stock and yet prices rose steeply. So, 'negative equity' is definitely going to happen for many people.

But is negative equity such a bad thing? Well, first of all we need to separate the whole concept of housing-as-equity from the more basic concept of housing costs; that is, how much it costs to live somewhere in terms of rent or mortgage and associated charges.

If a lot of people cannot keep their housing costs to a reasonable proportion of their income, then that is a big problem. How much is a reasonable level of housing costs? It is suggested that housing costs shouldn't be more than a third of net household income. A household might choose to pay more in order to own or to live in a bigger house/nicer area, but this should be a choice. The state's goal should be for households to have the option of reasonable housing costing no more than a third of their income.

When households have high housing costs, it dampens their ability to do other things (which lessens overall economic activity). High housing costs also lowers Ireland's competitiveness. And when households cannot afford housing, the state currently expends resources assisting them: e.g. rent supplement, social housing, etc. It would be perverse for the state to also be expending resources that (intentionally or not) artificially maintain high house prices and rents. Essentially, the state would be raising costs that push more people to seek state assistance to meet those costs! That's unsustainable, but perhaps not so far from the current situation.

The only way out is for the state to allow a lot of households to enter negative equity; in the sense of the state avoiding actions that will inflate house prices. If households can meet their housing costs, then they will remain housed. So, that's problem number one taken care of.

If housing costs can be met (at a reasonable proportion of income), what is the remaining problem with negative equity? There seem to be three aspects to this: One is that the mobility of the household is constrained; Two is the loss of households' capital; and Three is that owner occupiers may end up paying unreasonably high housing costs.

1: A lot of people are perhaps realising that their 'starter home' may be for more than a few years. It's a pity we built so many small houses. The problem of mobility is really one of lack of uncertainty in the market, combined with a lack of credit, exacerbated by lower incomes. In other words, people are hanging on to see if they can sell for more and/or buy for less. However, if the house you sell and the house you buy are both down say €100,000, then you don't really lose out. But only if you can find a buyer for your house and only if the banks will remortgage you in your new house on the same terms as the old one.

2: The second aspect of negative equity is that people lose money that they could have spent elsewhere. Worse, they haven't lost it yet, but will continue to 'lose' it over the years where they pay more in mortgage payments than they would either in rent or if they bought when prices crashed. There is really not a lot the state can do about this. The news, like for bank shareholders, is that "the value of your investment went down, not up". Depending on how interest rates turn out, some people might actually be better off selling, write off their losses now and start again; although that may mean renting for life. Having said that, once the cost of the mortgage is even close to the cost of renting, the mortgage holder still gets to keep an asset at the end of the day, which the renter doesn't. The asset just ends up being more expensive than initially hoped for.

3: There is a risk that some owner occupiers will end up paying way above a third of their income on housing costs. Especially the newly unemployed, those who took out sub-prime mortgages or those who have lengthy fixed-rated high interest periods built into their loan. And if people get into arrears, penalty charges and a higher rate of interest can apply.

Which brings me back to the beginning. There would be a lot to be said for a state target of stable house prices in the long term. So, the state needs to examine carefully all the ways in which its actions affect the property market. Above all else, we must avoid another property price bubble, or we'll just repeat the madness all over again.

Now for the bad news, for a small number of mortgage holders in arrears, negative equity is part of a worse situation; that is, negative equity plus the inability to meet housing costs. Due to unemployment, a 100%+ mortgage or 'equity release' loans, or because their home was particularly high priced, these mortgage holders' property is not worth as much as what they paid for it AND they are unable to make their payments on it. The risk here is that these households will throw everything they've got into trying to pay arrears and punative interest rates, but in the end, despite years paying far too much for housing, they will eventually be repossessed. Not only that, but they are likely to still owe a large sum to a lender, which will not only prevent them buying again, but will take a chunk of their net income and limit their life options in many ways.

The state should have access to data about arrears and the level of household indebtedness, either through the Financial Regulator or through asking lenders directly for it.

It is the nightmare scenario of a combination of negative equity plus an inability to pay that will affect hundreds, maybe thousands of households; often those who signed up to sub-prime mortgages or who were pursuaded to 'release equity' from their homes. Yes, there was individual choice in this - but the lax regulation of credit certainly did not help. Those who get foreclosed in this above manner will end up seeking housing assistance from the state (either through rent supplement or social housing). There is an opportunity for the state to act now, to save these families much hardship and to help them restructure their debt while they still have more ability to manage it.

For example, the state (or NAMA) could act now to freeze their penalty payments, restructure their debt, and maybe fund the local authorities to buy half their property in a reverse version of the current shared ownership scheme. This will cost money, but it could be cheaper than waiting for them to become impoverished and then housing them; and it would certainly be more decent.


Mack said...

We'd be better off reforming the bankruptcy laws, or better yet making mortgage loans non-recourse that probably help us find a bottom in the housing market as homeowners in NE walk away and the lenders - the other half of the equation - get jingle mail (and of course we'd not bail out the profligate banks either)..

Bailing out homeowners who over-stretched themselves is immoral. In some cases, you are asking taxpayers who made do with less (made purchasing choices within their means) to subsidise their neighbours who went for that bigger house, or that more plush finish. Not to mention the fact that the government deficit is ballooning as it is, but whatever, let's heap more debt on our children...

Nat O`Connor said...

@ Mack,
Thanks for your comment. Just to be clear, I'm not suggesting that we bail out homeowners.

State intervention to help people manage and restructure their debt (maybe extending it over a longer time period or by unbinding people from high fixed interest rates) is sensible, especially if it saves the taxpayer money that would inevitably be spent on rent supplement, social housing, etc. Any major state assistance (like a shared ownership scheme) should involve the local authority gaining an asset, at current market value not "inflated", so the taxpayer doesn't lose out.

tgmac said...

I find the immoral argument all but moot at this stage. It's immoral for an individual to make a mistake and make provision for their financial plight but systemically important to keep the institutions and developers who've made mistakes afloat at taxpayer cost. We can't have it both ways. With possibly a 1/3 of homeowners experiencing negative equity combined with job loses and reduced income, the second shoe, foreclosure, will have to rear its ugly head at some point in the future. Only then will people realise there are two standards at work - one for the individual and one for the politically connected. The mantra of saving our economy at the expense of foreclosed individuals and taxpayers will ring very hallow.

As for the Irish property market. It's a pure enigma to me. I underwrote mortgage in NYC many moons ago. This covered city dwellings, suburbs and rural areas. Every decent sized mortgage bank had an in-house appraisal department because values within a few minutes drive in any given area could change dramatically based upon dwelling type, amenities, curb appeal etc. Not so much in Ireland. Yeah, there are price distinctions - expensive, very expensive and hyperbolically expensive.

Ok, enfored re-regulation (ie standard underwritng criteria) and cohernet non-inflationary govt policies are desperately required. But, there is something in the modern Irish pysche that is drawn to home ownership at any cost. I've recently come across a home buyer that claims he's "saved" €20k on a new home purchase. It is only about a 10% reduction from peak prices! As long as the credit is proferred, there are willing buyers at any price.

Govt's can change human behaviour through policy implementation. The ease and acceptability of borrowing has certainly changed the landscape - literally. The rhetoric of our small open and dynamic economy is well roosted. Have we simply opened up a pandora's box which we cannot close until individual risk aversion returns?

tgmac said...

Sorry for the mixed metaphors.

Nat O`Connor said...

More analysis of negative equityfrom John McManus writing in the Irish Times.