Tuesday, May 06, 2008

Negative equity on cars - is it damaging?

Felix Salmon in his excellent blog at portfolio.com discusses Why negative equity in car loans is not a problem? To me the post looks at the perspective of financial institution rather than a household that is in debt.

Ideally, asset backed debt is safer for the debtors as they can sell the asset and square-off the debt at any point. In case of negative equity the debtor is in lose-lose situation. If they sell off the asset they loose a tool for income generation, while simultaneously retaining a part of the liability. This puts the household further into the debt trap. I guess Prof. Elizabeth Warren will have to downgrade her forecasts even further. This implies that consumption will suffer for longer than anticipated period.

Such situations elaborate the difference between debt and equity. When the worst strikes - equity vanishes but debt sticks on! And it creates problems. Hence I believe, the appropriate title should be Why negative equity on car loans is not a problem for banks? What say ye?