Monday, 19 August 2013

Fun with functions: who's afraid of the big bad nequity?

1. One of the excuses which The Powers That Be use to prop up house prices is "the spectre of negative equity", which they know did for the Tories after 1992.

2. Now, as we remember from our lessons in finance, there is a fixed mathematical relationship between four variables: the principal amount of a loan, the term, the interest rate and the annual capital and interest payments required to pay it off. And these calculations are exactly the same for annuities (i.e. what you are supposed to spend your pension pot on). So if you know three of these variables, you can can calculate the missing one.

3. It is not very pleasant having a mortgage which is bigger than the value of your home but this is purely psychological.

4. The annual repayments have to be paid out of your annual income, not out of the value of the house - a mortgage doesn't automatically cost you more just because you are in nequity (glossing over the fact that the banks will bump up the interest rate). And banks don't like negative equity either, as only part of the loan counts as "secured", even though ultimately, loans are only secured on their borrowers' future earnings.

5. So what "the government" could do is allow house prices to fall by (say) a quarter and take any nequity-tainted mortgages off the banks' books. Borrowers are given a smaller replacement mortgage equal to the value of the house, and banks are given new government bonds with a nominal value equal to the existing principal (they do not have to recognise losses because there aren't any).

6. This need not be a get-out-of-jail-free card for borrowers... because the government can set the interest rate on the new loans slightly higher, so that the annual repayments (receipts, from the government's point of view) over the rest of the mortgage term are the same as they would have been at the old lower rate.

7. And the government could make a small mark-up on the deal as well. The interest rate which it has to pay (or which banks will demand) on government bonds is (say) 1% lower than the interest rate which normal borrowers were paying (because of better credit risk), and it can pool all these mark-ups to cover it against any actual losses incurred.

8. Here's the spreadsheet for you to muck about with. You can change the figures in the yellow boxes, the rest is functions (PMT and RATE).

13 comments:

Curmudgeon said...

In the early 90s, most relatively new mortgage holders had endowment mortgages where you don't regularly chip away at the outstanding capital as with a repayment mortgage. This made the perceived problem worse.

Mark Wadsworth said...

C, good point but we can apply the same general principal to them as well.

Mark Wadsworth said...

"principle" not "principal" obviously.

Bayard said...

"So what "the government" could do is allow house prices to fall by (say) a quarter"

What, and get kicked out at the next election? No chance.

Mark Wadsworth said...

B, the idea that house price rises = getting re-elected is not only inherently corrupt, but is actually a relatively modern notion, it only became the prevailing thinking over the last thirty years or so.

All these f-ing baby boomers and poor widows in mansion were voting for lower house prices when they were young.

Curmudgeon said...

I think it basically stems from the hyoer-inflation of the mid-70s. Before then, more people were interested in getting on the housing ladder than pulling it up after them.

James Higham said...

3. It is not very pleasant having a mortgage which is bigger than the value of your home but this is purely psychological.

And a tad financial at the same time.

Mark Wadsworth said...

C, yes, but think about cause and effect here.

The Homey's justify "investing in bricks and mortar" on the grounds that "it's the only thing that beats inflation".

Truth of the matter is, inflation is something deliberately engineered by Homeys (and bankers and over-spending governments) to wipe the debt-slate clean and start again.

In current terms, what this means is robbing savers and bailing out banks.

JH, I can guess what you mean but I think you missed out a word or three.

Kj said...

MW: How many mortgages do you think this could apply to? And presumably, business loans secured on land would also need to be included.
What's a rough estimate of what govt would be securing? I think I remember you did a post that said so a while ago, but couldn't find it through searching.

Mark Wadsworth said...

Kj, do you mean this one?

Kj said...

That's the one. Thanks.

Bayard said...

"B, the idea that house price rises = getting re-elected is not only inherently corrupt"

I didn't say that, I said that falling house prices meant that the party of government was kicked out. This has been historical fact since the general election of 1959. with the exception of Maggie's 1982 victory, but she had just distracted the voters' attention by winning a small war. So it's more than just an idea.

Mark Wadsworth said...

Kj, my pleasure.

B, aha, I didn't realise it went that far back, I did once look this up and the relationship only seemed to hold from the dawn of Home-Owner-Ism, i.e. early 1970s.