Could this be a lifeline for those in negative equity?

PERSONAL FINANCE:Are negtive equity mortgages a way out for people trapped in properties that no longer suit their needs or just another minefield waiting to blow up?

COULD A SOLUTION to the negative equity nightmare currently facing hundreds of thousands of people finally be in sight? No, it’s not a rebounding property market, but rather a number of proposals aimed at lightening the load of those who bought during the boom, are now struggling to meet their monthly repayments and are stuck with properties they cannot sell.

For those with underwater mortgages, the difficulty in selling arises because the sale of the property will not generate enough to pay back the lender. For example, if you bought a property for €400,000 with a 95 per cent mortgage during the boom, regardless of the fact that the apartment will now only make €280,000 on the open market, you are still obliged to repay your lender the full €380,000. So, to be able to sell the property, you will need to pay off the outstanding €100,000 yourself – an unlikely proposition for most.

Now however, our banks are considering introducing negative equity mortgages – albeit on a limited basis and subject to strict regulatory oversight – thereby enabling borrowers to sell their properties and move on.

So, in the above example, if the homeowner wanted to purchase a new property for €400,000, using a negative equity mortgage they could do so by selling their own home for €280,000 and theoretically borrowing €500,000 (€100,000 of negative equity plus €400,000 purchase price). As such, the introduction of such products into the Irish market could free up people who are at present stuck where they are living.

However, negative equity mortgages are likely to have only limited applicability, given that so many people are already struggling with their existing mortgage payments, without taking on the burden of additional debt. Moreover, if property prices were to fall further, homeowners could actually exacerbate the extent of negative equity in which they find themselves by taking out a new mortgage.

For those looking to trade down however, a negative equity mortgage could be just the thing. If the person with the property valued at €280,000 wanted to buy a new apartment worth just €200,000, by taking out a mortgage of €300,000 to cover the new property plus their existing negative equity, they could benefit from a substantial decrease in their monthly repayments.

Another possible solution comes from a change to the legal structure of lending in Ireland.

In the US, it’s not an unusual scenario for homeowners to simply send the keys of their properties back to their lenders when they run into financial difficulties. Although the practice isn’t possible in all states, in those which allow non-judicial foreclosure, such as California, a lender can repossess a house without going through the courts and cannot impose a deficiency judgment on the borrower, requiring them to make up the short-fall on the sale of the house.

In Ireland however, the outlook for those running into difficulties with underwater mortgages is very different. Why? Because lenders only sell full recourse mortgages, which means that the homeowner is fully liable for the total debt due on the loan agreement. This may be significantly in excess of the actual market value of the property, thereby leaving a significant shortfall which must be covered by the borrower.

For the Irish Brokers Association (IBA), such a scenario is “unreasonable and anti-consumer”, and instead, it is calling for a ban on full recourse mortgage lending.

“The mortgage holder cannot simply short sell the house, repay the bank and move on, as is the case in the US. In fact, he/she has to carry the cross of that mortgage for the rest of their lives. This practice hugely undermines confidence for those affected, resulting in a curtailment of consumer spending and an extended recession,” says Ciaran Phelan, CEO of the IBA.

Instead, it is calling on the banks to take some of the hit for their “imprudent lending practices” through the introduction of non-recourse lending, where the lender only has a claim over the asset, rather than the individual. Going forward, according to the IBA, banks would then underwrite mortgages based on two key factors – the borrower’s ability to meet the monthly repayments and the security offered.

So it’s got to be a good thing for the beleaguered homeowner, right? Well, while it may have its merits in setting the indebted free, before you cross your fingers in the hope that non-recourse lending may be on the agenda of the Expert Group on Mortgage Arrears which is due to report shortly, you should first consider the implications of switching to a new system.

Karl Deeter, operations manager with the Irish Mortgage Corporation, doesn’t think it’s the all-encompassing solution as has been suggested. “It doesn’t solve everything, just part of it,” he says. First, it will put up the cost of borrowing, as banks re-adjust to cope with the increased riskiness of their transaction from their perspective – and this at a time when homeowners not on tracker mortgages are already bearing the brunt of high rates.

“Lending will become more risky if the only recourse is the asset not the individual,” says Deeter, adding that higher loan-to-values will also become a thing of the past. As a result, prospective homeowners will have to save up to 25 per cent of the purchase price of the property themselves. Most significant is the fact that however the loan is legally structured, it will not prevent a homeowner who has run into financial difficulties from being dispossessed.

“Non-judicial foreclosure is pretty aggressive, it happens within a month or two in some states in the US. If the court is taken out of the process then the lender can lean heavily on you,” says Deeter. So, while the current Irish court process may seem cumbersome, it does actually offer the consumer some protection.

So what of the banks? Are they likely in any case to agree to a system of lending which would offer them reduced protection in the case of default? Already there have been calls to better protect lenders’ interests by introducing mandatory mortgage indemnity insurance (MII) on all loans where the LTV is greater than 70 per cent.

Insurance company Genworth wants the Government to make this cover obligatory, to protect lenders against losses due to borrower defaults under high LTV mortgage loans, where sale proceeds are insufficient to pay off outstanding debt.

While many lending institutions already take out such policies, the practice of passing on the cost of these to mortgage-holders – at a one-off price of about €900-€1,500 – stopped as the property boom took off. Instead, banks typically apply a higher interest rate to higher LTV mortgages. However if it was to become mandatory, it is likely that prospective homeowners would once more be hit with the charge.

Before you think a €1,000 insurance policy as opposed to a €100,000 shortfall on your mortgage is by far the more preferable option, think again. The very clear distinction which should be made between MII policies and non-recourse lending is that a MII is designed to protect the interests of the lender – not the consumer. So even if the lender has a MII policy in place which will pay out in the event of a shortfall, the lender can still go after the borrower for the outstanding shortfall.

Late last week, the International Monetary Fund joined the debate and called for support measures to protect vulnerable homeowners burdened with mortgage arrears. It said new measures could limit the social and economic fallout of the current crisis, provided they were narrowly targeted.