Sunday 26 May 2013

Economic myths: Negative equity [Square law of negative equity]

Yes, being in negative equity is horrible, whether that resulted from greed, recklessness, gullibility or sheer bad luck. So let's assume it would be a good idea to "help" people out of negative equity.

There are of course two ways of doing this in the short term*:
a) by pumping up house prices or
b) by writing off the element of any mortgage which is in excess of the potential selling price of the house (unsecured).

Let's look at the relative "costs" of doing this, and see what would happen if we went for option (c), allow house prices to fall and then write off all unsecured elements. We can illustrate this in diagrams.

As it happens, the distribution of mortgages by loan-to-value is almost a straight line (and even if it isn't, it makes the maths a lot simpler). In other words, one per cent of mortgages are almost paid off and represent only one per cent of the original principal/purchase price; one per cent of mortgages represent two per cent of the original principal/purchase price and so on. We also know that there are about 12 million outstanding mortgages with a total principal of £1,200 billion and about 12 million privately-owned homes which are owned outright.

To get the ball rolling, let's assume that a tenth of mortgages are in nequity (the official figure is half this, because of Funding for Lending and Help to Buy subsidies, but let's keep the maths simple). As things stand, there are 1.2 million mortgages with average unsecured principal of £10,000, that's total nequity of £12 billion (shaded red), which equals one per cent of total outstanding mortgages of £1,200 billion (0.1 x 0.1 = 0.01).

Under option a) we introduce a subsidy worth £20,000 per home/mortgage and eliminate nequity entirely (in the short term: this merely increases the risk that people will get into nequity in future). The total cost of the subsidy (shaded blue) required is twelve million homes x £20,000 = £240 billion - and we can double that for the twelve million homes which are mortgage-free = £480 billion. Which seems like a high price to pay for eliminating £12 billion of nequity. That means basically that future purchaser and taxpayers will end up net £468 billion worse off:

Under option b) the total cost of simply writing off all unsecured principal is a one-off cost of £12 billion.

What about option (c)? Let's withdraw some existing subsidies to land ownership and allow prices to fall by twenty per cent. The amount of nequity which now has to be written off is now 3 million mortgages x average £25,000 = £75 billion. This sounds like a lot, but in relative terms it isn't. £75 billion is only about one per cent of what UK bankers claim are their total/gross assets/liabilities (which are said to be five times UK GDP = £7,500 billion). This is 6.25% of total mortgage principal (0.25 x 0.25 = 0.0625).

And there is an even bigger saving to future purchasers and taxpayers: the total principal value of the subsidy withdrawn is 24 million x £30,000 = £720 billion. So there is still a net gain to them of £645 billion (and that's even assuming that they would bear the cost of the initial mortgage write off):

All of this leads us to Wadsworth's Square Law of Negative Equity - when you multiply numbers less than one, you end up with a smaller number than you started with.

Even allowing house prices to fall by fifty per cent and writing off all the unsecured amounts would only "cost" 0.5 x 0.5 = 0.25 x £1,200 billion = £300 billion. The reduction in the cost of the subsidy would be £80,0000 x 24 million = £1,920 billion, which is an overall saving to future purchasers of £1,620 billion.

If you take it to extremes and withdraw the subsidy to land values entirely and allow house prices to fall to £zero, the "cost" is £1,200 billion and the saving is £200,000 x 24 million = £4,800 billion, an overall saving of £3,600 billion.
* The mainstream view is that a) is far better, as pumping up house prices creates or at least preserves "wealth" and that b) would lead to the banking system somehow "imploding" or that it leads to moral hazard. Method a) does not create or preserve "wealth", it merely preserves "privilege" (i.e. the flow of wealth from the productive economy and non-landowners to large land owners and bankers) and on closer inspection, b) does no such thing.

The longer term (and ultimately only sensible) way is to get the economy going again by e.g. reducing the tax burden on people with large mortgages relative to income. These will be largely recent younger purchasers who own, relative to their earned income, lower value houses, so shifting taxes from earnings to the rental value of land will benefit them particularly. But let's gloss over this for now.


Anonymous said...

That's also the original derivation of the Laffer Curve.

Mark Wadsworth said...

RA, few people have attempted to plot the actual Laffer curve because it's different for different people and different businesses.

I've done my best using real life examples, and broadly speaking, it's a cube law. To work out the dead weight costs, take the tax rate to the power of three, then to get revenues, multiply the reduced size of the economy by the tax rate.

So a tax rate of 50% reduces size of economy by 0.5 x 0.5 x 0.5 = 0.125 = new size of economy 0.875. Then times that by tax rate to get revenues of 0.44.

Using this approach means that the Laffer maximising rate of income tax is about 60% with total revenues of 0.47, but the price you pay is that the economy is 0.6 x 0.6 x 0.6 = 0.22 = 22% smaller than it otherwise would be.

Bayard said...

I would have thought that nequity is really only bad for bankers, which, I suppose is why so much fuss is made about it. If you owe money, what does it matter to you if the collateral is worth less than the amount owed. However, as far as the lender is concerned, there is the very real danger that you will walk off and abandon the property, leaving them with a big loss.

Mark Wadsworth said...

B, ultimately yes, but being in significant negative equity is quite horrible for the borrower as well, whether it's "their own fault" or not. Under UK law (as I understand it), you can't just walk away.

So making the banks write off the unsecured bit is double plus good. We ease the burden on the little guy and get one over the bankers.

James Higham said...

All of this leads us to Wadsworth's Law of the Square Root Of Negative Equity (it's not a square root law at all, but when you multiply numbers less than one hundred per cent, you get a smaller number than what you started with).

Creative accountancy? :)

Mark Wadsworth said...

JH, nothing creative about it at all. 50 x 50 is a big number, 50% x 50% is a small number.

Bayard said...

"We ease the burden on the little guy and get one over the bankers."

which is why it will never happen. People do just walk away from over-mortgaged properties: I know because I bought one that had been repossessed and I paid less than half what it had been mortgaged for. It's difficult to track someone down when the only address you have for them is the property you've just repossessed and AFAIK, the banks don't try very hard.