I was reading about the sub-prime mortgage crisis and got to know about this concept called “Negative Equity aka Underwater”. However, I am not able to understand what are its implications for a firm and an individual.
My understanding about Negative equity with regards to a firm is that a firm is bankrupt and is not able to pay back what it owes to its creditors. But I can’t understand what would it mean for an individual (in context of a mortgage).
For example, I have taken a floating mortgage, the interest rate shoots up and I have negative equity. (Suppose, I don’t lose my job so the there are future cashflows to service the monthly payments) What’s the harm in it?
Also, please explain why so many people defaulted on their loans (both those who could afford to make payments and those who could not)? and why did the FED increase rates if it knew that so many people had taken floating mortgages?
I’m afraid you don’t understand what negative equity is. A rise in interest rates won’t create a negative equity situation. Negative equity is when the loan value is higher than the value of the property. This is a problem in that the bank cannot fully collect on its mortgage if you decide to skip town.
In many countries, mortgage debt is recourse to the borrower and this doesn’t pose as much an issue. In the wild west (aka the USA), much mortgage debt is non-recourse and people can just mail the keys to the bank and say buh bye when negative equity occurs. Get enough people bailing out on their homes and you’ve now got a problem.
On the corporate side, you could have negative book equity, but still have some fundamental firm value if assets are priced at historical cost rather than replacement cost or fair value. It doesn’t necessarily mean a bankruptcy is coming. I can think of some infrastructure plays that actually have negative book equity, albeit on the private side (can’t think of any public examples).
I borrowed $250,000 to buy a house in 2007. (Because, you know, real estate prices never go down.)
In 2008, real estate prices went down. My house was only worth $175,000.
So my note that I owed the bank was $250,000, but my house was only worth $175,000. I had -$75k in equity. (That’s NEGATIVE $75k.) That is, I am “upside-down” or “underwater”, because I owe more than my house was worth.
I know the acc. equation (liabilites higher than assets) but I am unable to comprehend it in a practical sense. I could see why banks/mortgage lenders lost big time but can’t understand from homeowner’s point of view.
So would it be right to say that if you have the patience and cashflows to make monthly payments, then you could just wait for the house prices to climb again and then you are back into postive equity territory (assuming asset prices rise enough to exceed liabilities)?
And Yes to 1BigStudMuffin, too, although if you live in a country where mortgage lenders customarily have recourse over and above the home as collateral, you might be forgiven for missing this (barely).
What this highlights is the difference between liquidity and solvency. When your house is underwater (the mortgage is larger than the value of the home), you aren’t necessarily in trouble if you can still make payments for a while. That’s a case of being insolvent but still liquid. You need to find a way to raise capital or just pray that things get better before your liquidity runs out.
Then there is being illiquid but solvent… that’s where your home has appreciated and has equity, but you don’t have the cash on hand to make payments (and presumably can’t secure another loan on the home, which is why banks providing credit in exchange for collateral is also called “providing liquidity”). In this case, you may not be technically bankrupt, but you may be forced to sell your home to cover debt.
One key point here is that bankruptcy procedings can happen for a company when it is merely illiquid and cannot make payments. If it is solvent and could be reorganized or renegotiated to be profitable, the company can be “reorganized,” where equity holders are wiped out, and bond holders are forced to take a haircut (forced to accept lower principal or interest payments, or deferred payments) in exchange for new equity in the company. If the company is completely screwed, it will be “liquidated,” with assets sold and bonholders paid from the proceeds in order of seniority.
It’s really when a company is insolvent and illiquid simultaneously that all this bankruptcy stuff happens. However, it’s pretty common for a company (or individuals) to claim that they are solvent, just not liquid, because solvency implies extra bad management decisions, whereas illiquidity is easier to blame on bad luck.
A big portion of the nation’s mortgages are underwater, meaning more is owed on the loan than the property is worth. However, a California business has a novel repair in mind, which requires local governments using the power of eminent domain to push a refinance. Since investors would fund the entire action, no taxpayer money would be spent; all any governments in California would be doing is turn in the paperwork for eminent domain actions. Negative equity, or owing more on a loan than the asset is worth, is dangerous to homeowners as it puts them at higher risk for falling into foreclosure.
