Key Post A guide to “Debt for equity” mortgages

Brendan Burgess

Brendan Burgess

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Many commentators have suggested some form of debt for equity as a possible contribution to solving the overindebtedness/negative equity problem


  • [broken link removed] in the RTE programme - Future Shock May 2010
  • The FF/Green revised programme for government
  • The Labour/FG programme for the current government
  • [broken link removed] Sunday Business Post April 2011
  • Deputy Thomas Pringle and Deputy Stephen Donnelly May 2011
  • Mike Soden who is a member of the board of the Central Bank
  • Karl Whelan – Sunday Times 28 August
  • Denis Naughten TD – Sunday Times 28 August
  • Ciaran Lynch - Labour TD [broken link removed]
  • Patrick Honohan [broken link removed]
  • Pearse Doherty, Sinn Féin responding to Keane Report
  • Fianna Fáil 12 October 2011
  • The Sunday Times editorial 16 October 2011

What is striking about all these proposals, is that they are all vague using expressions such as “some form of debt for equity swap”. I have not seen a detailed proposal including the pros and cons of their proposals and what they offer over the alternatives.



Interest rate| 5%|2.5%
Mortgage|€300k|€300k
House Value| €200k|€200k
Repayments based on 20 year mortgage|€1980|€1,589
Repayments on 30 year mortgage|€1,610|€1,185
Interest only repayments|€1,250|€625
66% of interest|€825|€410
Note: The Standard Variable Rate is around 5% as of September 2011.
The ECB rate is 1.5% so those on cheap trackers are paying around 2.5%. Around 50% of home owners are on cheap trackers

A mortgage is sustainable if the borrower can pay the interest on that mortgage
Ideally a borrower should pay off the loan on their home before retirement so that they can live mortgage free. But this is a very Irish obsession. In many other countries people are happy to rent property all their life. Even in Ireland, many people can never afford to buy their own home and rent from private landlords or from the state.
During the life of a 20 or 30 year mortgage, many people will encounter a period when they can’t make capital repayments. If they are able to meet the interest on their mortgage, then their indebtedness is not increasing and they should not worry unduly. When their financial situation improves they can resume paying down the capital on their mortgage.



Under the Deferred Interest Scheme, the lender will accept a payment of 66% of the interest for up to 5 years
The Expert Group on Mortgage Arrears proposed a Deferred Interest Scheme which has been implemented by most lenders. So in the example above, a borrower on a standard variable rate who can pay €825 a month, will be given up to 5 years to get back on track.

Debt for equity 1 – The bank(or the state) buys half the house at market value - no debt forgiveness

|Before|After
Mortgage|€300k|€200k
House Value| €200k|€100k
Negative equity|€100k|€100k
Negative equity %|50%|100%
Interest @5%|€15k|€10k
Rent|0|€5k
The bank has bought half the house so as the tenant, the borrower must now pay rent on that half. So while the interest payments have reduced, the reduction has been replaced by rent. But worst of all for the borrower, house prices must now increase by 100% for them to escape negative equity.



Debt for equity 1A – The banks buys the whole house at market value - no debt forgiveness
|Before|After
Mortgage|€300k|€100k
House Value| €200k|zero
Negative equity|€100k|€100k
Negative equity %|50%| -
Interest @5%|€15k|€5k
Rent|0|€10k
This is a logical extension of option 1. But this is what we have at the moment – it’s just that we call it voluntary surrender. The borrower has lost the ownership of their home.



Debt for equity 2 – The bank (or state) buys half the home for half the mortgage - partial debt forgiveness
|Before|After
Mortgage|€300k|€150k
House Value| €200k|€100k
Negative equity|€100k|€50k
Negative equity %|50%|50%
Interest @5%|€15k|€7.5k
Rent|0|€5k
.
Debt for equity 2A – The bank buys the whole house for the mortgage amount - full debt forgiveness
|Before|After
Mortgage|€300k|zero
House Value| €200k|zero
Negative equity|€100k|zero
Negative equity %|50%|-
Interest @5%|€15k|zero
Rent|0|€10k
2A is simply another form of repossession but with debt forgiveness of €100k.

2 is debt forgiveness of €50k

If government policy dictates that the banks should forgive debt, then that is fine, but it should be called “debt forgiveness” . It should not be called “debt for equity”

This is, of course, great for the borrower. They get forgiven their negative equity. They are a tenant of the bank and can stay in the house or move to another house as they see fit.

It is terrible for the banks. The banks are not set up to be landlords. They have to make excess capital provisions for property assets over loan assets. They take on the risk of price falls and tenants not paying rents. Of course, they get the benefit of any price increases, but only if they could sell the property.

The role of the taxpayer
The taxpayer owns around 50% of all home mortgages. If the government directs AIB, EBS and PTSB to forgive debt, then so be it.
However, the government will not be able to direct the other banks such as Bank of Ireland, Ulster Bank and KBC to forgive debt and become landlords. If the state owned banks forgive debt, then the mortgage holders in the other banks would demand that the taxpayer subsidise their negative equity also.
 
Where a borrower can service the interest on their loan, then they don't need any form of debt forgiveness or futher intervention.

Where a borrower can service 66% of the interest on the loan, then they should be given time to get back on track.

Where a borrower cannot service the 66% interest on the loan, then the loan is unsustainable and they should voluntarily surrender their home and the mortgage shortfall should be settled.

Talking of debt for equity only distracts people, and especially the government, from facing up to the reality that 10,000 people have unsustainable mortgages.
 
One argument commonly put forward is that the bank gets a stake in the house and so can benefit from any future increase in the value of the house.

I don't get this at all. If the bank wants to take a stake in the housing market, then they can buy houses on the open market. There are thousands of willing sellers. They would be much better off buying blocks of unsold apartments from their own property developer clients and handing them over to a management company to run.

It makes no sense for a bank to own 50% of various houses and apartments all over the country.
 
"Where a borrower can service 66% of the interest on the loan, then they should be given time to get back on track."

Yes I see the logic of this and agree that while one could argue whether a 66% ratio is a correct cut-off point, the broad tenet of your arguement holds good. The debt for equity issue is one that I can also understand and to some extent agree with. The issue of the Bank's taking over full ownership of the properties makes no sense from the perspective of a Bank for the reasons outlined by you. However there would be no real need for a Bank to take this course of action. The existing mortgage on the property (being in most cases an "All Moneys Charge") gives a Bank effective ownership of the property. As such the value of the charge will increase with any rise in value of the property prices. Whatever we may think at the moment property prices will rise over time and as you say provided interest can be substantially covered by the borrower(s) in the interim the net negative equity position will improve over time. In effect the Rising Tide will lift all ships. The proposal makes sense on this basis and will benefit both the Banks and the borrowers. By repaying partial capital payments borrowers can over time re-claim their rights over the property and while the mortgage periods may be extremely pro-longed this in itself should not be a major concern. The current difficulties in arriving at such a pragmatic solution is Bank management intransgence and lack of leadership. This will change over time.
 
Debt for equity swaps have a few issues that I tried to cover here

http://www.mortgagebrokers.ie/blog/index.php/2011/07/26/mortgage-debt-for-equity-swaps/

Effectively the person becomes more leveraged (Brendan twigged that already!), their negative equity doesn't go away and it isn't so much a 'resolution' as an operational nightmare that will also cause mass confusion in the property market.

The blog post looks at the situation with a few pictures thrown in (if you are like me you need all the props you can get!) - hope it helps to clarify the basis of why Debt for Equity is a banger.
 
Great post Brendan, it certainly puts all the dubious ideas into perspective. It always baffled me how how the debt for equity swaps were actually meant to work. The only way I see this improving people's situations is if the banks took on say 50% of equity and then didn't charge rent to the half owner/occupier. But then the bank is left with assets that are not generating any income.
 
Chris said:
Great post Brendan, it certainly puts all the dubious ideas into perspective. It always baffled me how how the debt for equity swaps were actually meant to work. The only way I see this improving people's situations is if the banks took on say 50% of equity and then didn't charge rent to the half owner/occupier. But then the bank is left with assets that are not generating any income.
Click to expand...

+1. A great post Brendan. I agree with Chris..the last thing a bank wants to do is be chasing people all over the country for rent. Better take a non-rent ownership of the asset. If this is done and the remaining mortgage is put on interest-only then this would really help people. The mortgage owner should also be able to buyout the banks 50% stake at some period in the future also as this will help the home owner to regain their "home". This would probably work like a share option.

I would also like to raise a related point if I may. The state owns the vast majority of some of our main banks, but this is NOT the same as them being nationalised. We need to be very careful of political influence/interference here as the "where do we drawn the line" phrase comes to mind. Once the line is crossed....
 
How debt for equity works in the UK

This is the UK government's scheme. Scotland has a similar scheme. The key point is that there must be equity in the property i.e. the ltv must be less than 75%

http://www.enfield.gov.uk/info/200039/grants_financial_help_and_benefits/618/mortgage_rescue_scheme/4

Shared Equity loan


  • Shared equity is most suitable for vulnerable families who are in serious financial difficulty, but who will be able to keep up with lower mortgage payments over the long term.
  • A homeowner has a minimum of 25% equity and a maximum of 40%
  • A registered Social Landlord gives a loan of between 25% and 75% of a homeowner's current mortgage direct to the homeowner's lender.
  • This loan is secured against the property as an equity loan.
  • The homeowner's outstanding mortgage is reduced in line with the equity loan.
  • Monthly repayments are made by the homeowner on the remaining mortgage and the loan.
  • An interest fee of 1.75% pa (increasing by RPI plus 0.5% pa) is charged on the equity loan, payable in monthly instalments by the homeowner.
  • An equity loan contribution of 3% of the value of the loan is paid by the homeowner to take part in mortgage rescue.
  • Once rescued, repairs and maintenance continue to be the responsibility of the homeowner.
  • The homeowner can pay off the loan, in full or in stages, at any time. The amount payable increases if the value of their home increases.

Shared Equity Example:
|| Brendan’s notes
Value of Home|180,000.00|

Outstanding Mortgage|130,000.00|

Monthly Repayments|787.00|

Pre existing equity|50,000.00|180 - 130
Intervention -50% of Mortgage paid in Equity Loan| 65,000.00|130/2
*Homeowner equity contribution|1,950.00|Not paid in cash, but added
Total equity loan|66,950.00|@1.75% = 1171
Outstanding Mortgage|65,000.00|Mortgage reduced
Retained equity|48,050.00|50,000 - 1950
New monthly mortgage payment|380.00|
Monthly shared equity fee|95.00|1171/12
Total new monthly payment|478.00|
Monthly saving|309.00|

*Note: this is not a cash contribution
 
To some extent this would have similarities with the "Fair Deal" scheme. It is a workable option but reliant on here being satisfactory equity in the properties. Of the 55K plus mortgages currently in arrears >90 days how many would fit the criteria outlined above? I suspect numbers would be low but acknowledge that the deal does have its merits.
 
I have added Governor Honohan to the list of those who support debt for equity swaps.

From his opening remarks to the Dail committee (emphasis mine):
"Banks need to work harder to bring a wider range of options for dealing with affordability to bear on this problem particularly to take account of individual cases where there is little prospect of servicing the original loan terms. On the one hand, the banks must husband their available capital in a prudent manner. On the other hand it may be possible to arrange that, even very stressed, owner-occupier borrowers who have to surrender ownership could stay in their house on a rental basis; and there could be intermediate shared equity type solutions. All of this would need to be on a case-by-case basis without imposing avoidable costs on the State, which has, after all, provided the necessary capital. Ideas along these lines are being considered by the banks, and would not require legislative or regulatory action."
Click to expand...


http://www.centralbank.ie/press-area/Documents/Opening%20Statement%20JOC%202%20September%202011.pdf

And to repeat:

What is striking about all these proposals, is that they are all vague using expressions such as “some form of debt for equity swap”. I have not seen a detailed proposal including the pros and cons of their proposals and what they offer over the alternatives.
 
Stephen Kinsella in the last week

? Debt for equity swap. Suppose the €400,000 mortgage is in default. A reasonable mortgage restructuring might be to cut it to a serviceable €250,000 and create a €150,000 property appreciation option held by the bank.
The borrower agrees to pay off the property appreciation option out of future price increases on the existing home, if any.
Click to expand...
or

? Converting a mortgage to rent. These schemes are running in the UK now. The bank takes on John and Jane's house, and rents it back to them, giving them an option to buy it back in a few years. Here again shared equity arrangements are possible.
Click to expand...
 
England also has a [broken link removed] Scheme.

This is where there is less than 25% equity in the house and up to 20% negative equity.

A Housing Association buys the house from the borrower and pays the proceeds to the bank. If there is a shortfall, the lender and the borrower must come to some arrangment on the shortfall.

The mortgage holder then becomes a tenant of the Housing Association.

It seems to be aimed at vulnerable people including families with children, the elderly and people with disabilities. The main response to unsustainable mortgages in the UK is repossession.



The scheme has been slammed by the National Audit Office.

The mortgage rescue scheme, introduced in January 2009 by the Department for Communities and Local Government (DCLG), helped 2,600 households in two years, less than half the 6,000 expected. It also exceeded the budget of £205m by £35m, meaning the average cost of each rescue was £93,000 compared to an expected cost of £34,000.
Click to expand...
Housing minister Grant Shapps said: "One of my first decisions in government was to insist on better value for money from this £240m scheme. In the last government, ministers believed that all you needed to do was throw money at a problem. The great sadness is that more people could have been helped to stay in their homes had they spent the money more wisely."
 
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