Wednesday, 25 February 2009

Negative Equity and Distorting Mirrors

People who have bought expensive houses on a mortgage, at rising interest rates, will be relieved to experience falling interest rates at last. But at the same time house prices are falling faster than the fall in interest rates, eroding their equity stake - if they had positive equity in the first place. At some point their equity becomes zero turning them purely into tenants of their own property. Further house price falls make their equity negative, turning them into tenants paying an exorbitant rent. Thus, instead of rejoicing at falling nominal interest charges, economics 101 would suggest they should rush to sell before their equity becomes negative. Sackerson commenting on an earlier post sets this out beautifully, but it is worth a post of its own to say it again .

Economics is full of distorting mirrors. Magnitudes that seem perfectly unambiguous actually move in different directions depending on the units in which they are measured - e.g. monetary units (in pounds or euros or dollars, each going its own way) or real units (in terms of one or another basket of goods, also moving differently). And what counts is the relative speed at which they move, and therefore how the ratio between different magnitudes move. And it's easy to miss the whole picture, and to forget to compare only like with like.

One moment you rejoice because your nominal interest payments are falling and are easier to cope with. This is what the New Labour regime turns your head to look at, and uses to pretend that green shoots are appearing. The next moment, or month, you realise you are bankrupt, but by then it is too late to do anything about it.

And Northern Rock is being reset to drag more, and poorer people into the trap. Such wickedness.


Blue Eyes said...

Yup. I think there is a strong argument for tightening up the banking rules so that they cannot lend in the same way again. The problem is, of course, that the short-term result of that will be economic carnage - and we are rapidly approaching an election.

hatfield girl said...

I'm keeping up at the back here, Blue. I really hadn't thought how bad it's going to get. Never mind posters for what to do after the country has capitulated appearing everywhere.

Anonymous said...

BE, I don't think there will be any need to tighten up the banking rules: (a) the banks won't lend like that any more, seeing what it leads to and (b) the customers won't borrow like that any more, seeing that it leads to.

Any of either who do, can we just agree now that they should be allowed to go bust and won't be rescued by the rest of us having our currency debauched? Just to avoid disappointment, as they say.

And a general point - whatever happened to buying a house in order to, well, live in it?

I have never tried to work out what my equity is in the property (other than "all of it" since I paid off the mortgage), but then that wasn't really the point. It's a nice place to live, otherwise I wouldn't have bothered.

I'm unfashionable like that; it seems to have worked out OK.

electro-kevin said...

Well said, HG.

I hadn't thunk of it like that.

electro-kevin said...

It all depends on where 'bottom' is for most people. And if their wages hold out too.

In the 1930s depression many people lived like kings.

Caronte said...

A great economist - whose name now escapes me - said once that there are only two essential banking rules:
1. Any bank going bust must be rescued;
2. Any banker must be absolutely convinced that no bank going bust will ever be rescued.

hatfield girl said...

This is not a 1930s-like depression though, E-K. Which is why it's all so dishonest to produce solutions for the 1930s and pretend they will work now. And that 'this time round' lessons have been learned and what happened then will not be suffered again. No, it won't, entirely new twists of horror are being put in place by a statist fool like Brown.

hatfield girl said...

Dunno, C. Sounds sub-keynesie.Kahn?