Short sales – solving the problem of negative equity?

With perhaps as many as 150-200,000 householders presently in negative equity and with some pundits forecasting negative equity may grow to affect 350,000 householders if prices drop 45% from peak (we’re presently 35% off peak) and with negative equity averages estimated around €50,000, our State might consider the application of a procedure which is growing in popularity in the USA which has its own serious problem with negative equity.

Short sales – this is where a householder with negative equity agrees with their bank on a sale price which is less than the amount outstanding on the mortgage. The property is offered for sale at that agreed price and if achieved, the bank writes off the loss. Eg John buys a property for €300k with a €200k mortgage. Prices collapse and John wants to sell. John agrees with the bank a selling price of €175k and the property is sold at that. The bank writes off a loss of €25k. Now the bank may in some US states try to get you to make up the €25k loss – in other States the bank must take the loss. In the US short sales affect credit ratings like foreclosures. By avoiding foreclosure the property should not be seen as distressed and may achieve a better price. What’s in it for John? He gets to move on with his life without having a debt over his head. What’s in it for the bank? They get to sell the property in a non-distressed state which should see a better price and they may realise more cash than if John was to be bankrupted. What the State gets is a freeing up of the housing market and a quicker consumer economy recovery as John’s life and his spending isn’t blighted by negative equity that may last a decade. You can find further information on property short sales here and here and here. Commentators estimate that short sales may comprise one fifth of all property sales in the US today.

Now in Ireland banks generally have the right to pursue a borrower for the full amount of a loan even if the bank has foreclosed and sold the property. So in the above example John would remain in debt to the tune of €25k even after selling the property. However part of the deal is that the bank writes off part of its debt with the intention that John can start his life anew.

At 350,000 mortgages in negative equity with an average negative equity value of €50,000 banks would be exposed to €17.5bn of write-offs if all of the losses were to be realised at once. The average home fell by an average of €3,500 per month in January, February and March 2010 (based on the Permanent TSB/ESRI index falling a national average of 4.8% over the first quarter of 2010 on property which on average was worth €213k at the end of December 2009). Average national rents are about €1000 per month. It has been estimated that upto 90,000 mortgages are presently impaired to some degree – officially 30,000 mortgages have been restructured and are operating in compliance with new terms and 30,000 others have some degree of impairment – less than 500 properties have been repossessed (foreclosed).  Unfettered short sales in Ireland could well see an overwhelming burden on banks already struggling with the prospect of €40bn of losses on NAMA-bound loans in addition to other provisions for impairments. However if realistic projections of property prices can be produced (which in turn will need realistic projections of demand and wage levels as well as a proper audit of overhang) then a scheme could be put in place which might allow a gradual realisation of negative equity losses over a manageable timeframe and those losses would hopefully be mitigated by a recovery in prices. The alternative is the prospect of a lost decade, according to the ESRI, as negative equity scotches consumer spending, labour mobility and a free-flowing property market.

The bottom line with short sales – banks would mitigate losses by avoiding firesales of distressed assets and will profit from a quicker recovery in the consumer economy and property market. Those in negative equity will regain financial freedom and will not rein in spending to the extent it causes permanent damage to the economy. The State benefits from unblocking the severe problem of negative equity in the economy. The downside? Banks may end up realising losses before the possibility of a full recovery of the debt if the borrower doesn’t default and property prices improve. Whether the advantages outweigh the disadvantages is worthy of study, but I leave you with this thought – if the US, probably the most business-centric and entrepreneur-friendly society there is, has adoped short sales then shouldn’t we at least be considering it.