How do debt for equity swaps work?

[orka]

2. What I mean by debt for equity swap is that the bank take part ownership of the house in exchange for a reduction in the loan outstanding. Again the mortgagee could always reverse this in the future or they could sell the property in the future as joint owners with the bank.

How would this work? Would the bank look for rent on their part-ownership? In Johnny's case, the amount of negative equity could be the current value of the house so to get rid of negative equity, the bank would end up owning the whole house and the owners would still owe the negative equity amount. And as this thread seems to bear out, the negative equity problem is at its biggest when the owners want to sell and move on, not when they want to stay in part-ownership with the bank.

|before|after
"owned" by borrower|250|125
"owned" by bank|0|125
Mortgage|500|375
Negative Equity|250|250

Ignoring the small capital repayments which would have paid down the mortgage a bit since it was taken out: mortgage 500K, value 250K, NE = 250K. So bank buys half the house for 125K thereby reducing the mortgage to 375K but there is still NE of 250K. Some big problems I see – (1) the bank (taxpayers) should be entitled to rent on their investment otherwise it is just another form of handout, (2) the banks don’t want to be in the business of owning and maintaining small properties (who pays for house insurance, who pays for upkeep, home improvements etc.), and (3) fast forward a few years and maybe the owners want to sell – what sort of veto do the bank have over the price they get for their part-share? Can they say, no, we want to hold out for more money or do they just accept what the owners can sell for? I would foresee massive hassles which the banks, frankly, can do without.
I would have no problem with the banks lengthening the term of a mortgage – but the banks don’t really want to be in the business of evicting OAPs when they no longer earn enough to service a mortgage. It’s all very well thinking that everyone will be honourable and do the right thing, look after the house well and sell when the time comes but they won’t.

 

[Brendan Burgess]

Matt Cooper has promoted the idea on his blog:

[broken link removed]


But he does not explain how it works.

Is "debt for equity" simply a euphemism for "the banks should write off some of the debt?"

If I have a property worth €600,000 and a mortgage of €400,000 but I can only afford repayments on €300,000, then I could understand how the bank could take a 20% stake in my house for €120,000 and reduce the mortgage accordingly.

But you can't swap debt for negative equity?

 

[WinWin]

Would this scenario work;
House value 200k.
Mortgage remaining 250k
Bank takes 50% of value, i.e 100k
leaving person with loan of 150k, but only 50% ownership.

I could only see banks taking this on if there are signs of life in the property market, as in, the market has bottomed out. Even at that, i cant see banks jumping for it.

 

[orka]

Would this scenario work;
House value 200k.
Mortgage remaining 250k
Bank takes 50% of value, i.e 100k
leaving person with loan of 150k, but only 50% ownership.

It works in that your maths is correct but the LTV ratio would increase from 125% to 150% which the bank won't be keen on. The negative equity stays the same in absolute € terms but the owner has a smaller asset than before. If mortgage payments are reduced to match the 150K mortgage (which is presumably why the owner would be doing this in the first place if they were having problems with payments), the negative equity will take years longer to erode.

 

[cartman1]

It would work out as laid out by Orka and in answer to your questions:
1. no the bank don't get rent - they are being asked to help out for a mess that they were partly responsible for by providing a radical solution
2. the mortgagee should be responsible for all of the outgoings you talk about - the conditions could be similar to a standard lease to protect the bank's interests
3. if they owners want to sell in the future then the same rules would apply as they would now with a house with negative equity

 

[orka]

1. no the bank don't get rent - they are being asked to help out for a mess that they were partly responsible for by providing a radical solution

If this is the way it works, then there IS a cost to the bank and, by extension, to tax payers. If the bank has 125K to buy half the house, that's 125K they could put to work elsewhere earning a return. If the 125K doesn't earn a return beyond house price inflation, that's an opportunity cost - this is not a 'free' solution.
The only solutions which are costfree to the banks (and taxpayers) involve paying all capital and all interest until the loan is repaid - so going interest free for 10 years would be an option - but the loan is still waiting to be repaid at the end of the 10 years. Debt for equity could work so long as a commercial rent is being paid for the bank's share (think about it - what if the bank owned 99% of the house, should that still be rentfree? 75%?)

 

[cartman1]

orka, again I wouldn't disagree with your point on opportunity cost but at the end of the day everyone is going to pay for the whole mess through higher taxes whether you caused it or not. If we don't come up with alternatives then we could be faced with an even worse situation domestically if thousands of people were forced to sell their homes in a fire sale market. The whole world economy has been bailed out at the end of the day by printing more money and everyone (even the sensible people!) have benefitted from that indirectly.

 

[Brendan Burgess]

Richard Curran proposes this again in today's Sunday Business Post. But in common with all previous suggestions, they miss out one key point. You can't swap debt for equity, where there is no equity! I have yet to see anyone who has proposed such a scheme come up with a worked example, which works.

Why a debt for negative equity scheme can’t work

|Before| After bank swaps 100k debt for “equity”
House value|100,000|100,000
bank stake||100,000
Mortgage|180,000|80,000
Negative equity|80,000|80,000

For simplicity, the bank has bought the house at its current value and so paid down that element of the mortgage. The negative equity remains.

You can sell your house and use the proceeds to pay off the loan.
The bank can write off debt and so reduce the negative equity.
The bank can warehouse part of the loan and treat it differently.
But you cannot swap debt for equity, if there is no equity in the house.

Scottish and English schemes
Scotland and England have schemes where the government can buy a share in the equity in a person's home.

Both schemes require the owner to have at least 25% equity in the house.

I rang the guy in charge of the Scottish scheme to find out how they operated in practice. In practice, there were exactly two completed transactions. I think that the numbers in England are higher, but there is no demand for such schemes.