Negative equity and phantom income
You have to ask. How can the same house with little to no changes be worth so much in a booming economy, then so much less when an economy has declined?
It can be argued this is a normal outcome of the ebb and flow of an economy, and can be totally ignored if the home is owned outright, debt-free.
But, when a mortgage is attached to the property, there is a significantly different set of circumstances. Buy a home in a red-hot economy, the mortgage amount will encumber the borrower based upon current market valuations. What happens in a down economy is a real downer, pardon the pun, for the homeowner. Same home, same mortgage probably paid down somewhat, but property valuation is now below the remaining mortgage balance.
That is negative equity — on paper.
Such a paper challenge can be ignored if the homeowner is solvent, fully employed, and consistently reducing the mortgage principal balance — a financial equilibrium.
However, economic disruptions can change this dynamic, even with careful homeowner planning.
An example: a true tale in another time and place. In the spring of 1996, a man, totally distraught, walked into an accounting firm waving a piece of paper from the United States Internal Revenue Service.
Nine years after the 1987 US capital market crash and the debilitating recession that followed, the IRS had finally caught up with him to assess taxes on “his phantom income.”
A few details emerged. He lived in a Northeast state; worked construction. Economy booming, the family saved enough to buy a home.
When the economy nosedived, construction, ancillary industries and thousands of other businesses closed.
He lost his job, depleted his unemployment benefits, was unable to pay his mortgage and could barely afford food; he was insolvent. So, with no employment prospects in sight the family walked away, literally leaving the keys in the door. He moved south where he had heard jobs were plentiful.
The family home was sold for a fraction of his originally-owed mortgage balance by the revamped bank. Then, it was turned over a twice more, each time with an increasingly elevated purchase price as housing demand returned with the now recovered economy.
The paper he was holding was a taxable income bill for the amount of the mortgage that the family could not pay ($60,000).
The US IRS calls this phantom income — their position being that the bank loaned you the money, you enjoyed using the money, but you did not pay it all back.
While it took almost ten years to send him that bill, there was total indifference to the primary fact that this homeowner, due to an economic disaster beyond his control, could not possibly make mortgage payments without a stable job.
The family was still treading water. A huge income tax bill would set them back to zero.
There was no “enjoyment” whatsoever, just years of financial stressors.
Eventually, US politicians in their infinite wisdom (sometimes they do have that) passed The Mortgage Forgiveness Debt Relief Act of 2007 designed to relieve small property owners from phantom income taxation, assist them with restructured or forgiven loans — in concert with participating mortgage lenders.
Good grief. You think to yourself. Why am I telling you about these family circumstances in another country?
Who cares? You have enough to worry about your own finances here in Bermuda.
Because readers, the premises and the situations are similar here.
Remember the glory years? Hot economy, hot housing market, prices bid up and over the asking price. Borrowing costs and mortgages reflected these increasing home valuation purchase prices.
Now, ten or more years later, home valuations are rather different.
Again, one has to ask? How can the same house with little to no changes be worth so much in a booming economy, then so much less when an economy has declined?
I call negative equity “thermometer vapourware” because it all depends on the market temperature at any point in time. Sell your property, or the bank sells it, in a declining market, the sale price may not cover the remaining mortgage balance. Negative equity, no home, and you still owe on that uncovered mortgage.
Sell in an up market, well, you know the answer — the seller pays all debt back to bank, and may still walk away with a tidy profit.
Yet, the history is there. Economies decline but do recover, have recovered, and will continue to recover. However, it takes time.
Time for a property to return to a decent valuation above the mortgage balance.
So, what can be done here in Bermuda?
Mortgage foreclosures do not benefit anyone. Banks have requirements to manage for their shareholders. Capital reserves have to meet certain threshold levels where continuing to hold non-performing mortgages may change that ratio. Non-performing loans tie up lendable capital.
Lowered economic conditions tend to affect many aspects of a community.
No one individual can manage all positive outcomes in a recession, or a pandemic when people become sick, emergency cash dries up, health insurance is inadequate or nonexistent, retirees cannot manage on lowered pension outcomes, community stops spending, jobs are unavailable, salaries are decreased, redundancies or layoffs occur.
People will often say (and write) in total frustration — why aren't governments and politicians more proactive?
We voted for a government and a governing body for many reasons.
What a government can be good at, and is absolutely necessary for, is to protect the community:
To step in when the economy is dire.
To maintain due process.
To manage and uphold the law.
To implement structural legislation to keep families on their feet.
To help those who are financially struggling through no fault of their own.
To increase financial sustainability.
To be the final backstop when there is no other recourse.
To have the confidence to effect positive change.
To have the pure conviction that things will improve.
Government is the last resort of the people. This is why we pay taxes.
• Martha Harris Myron CPA JSM: Masters of Law — international tax and financial services, dual Bermudian/US citizen. All proceeds from these columns are donated to The Bermuda Salvation Army. E-mail: firstname.lastname@example.org