Lenders are starting to use terms to represent the bad situation with which they are now faced. We are hearing terms like "deleveraging" and "negative equity," both relating to the decline in value of assets that were used as collateral in loan transactions. Basically, "negative equity" is the outstanding loan amount minus the value of the collateral securing the loan. In normal times, lenders want the value of the collateral to be greater than the outstanding loan amount, so they are protected. But these are not normal times and many lenders are holding collateral that has declined in value, leaving them with a loan amount greater than the value of the collateral.
In a legal context, courts are treating "negative equity" in different ways. One of the interesting issues is whether "negative equity" can be used to secure a purchase money security interest. For example, Seller A sells a machine to a Debtor on credit, using the machine as collateral. The machine declines in value, but perhaps faster than anticipated, so that the amount owed to Seller A is greater than the value of the machine. Seller B then decides to sell a similar, but newer, machine to the Debtor, taking Seller A's machine as a "trade-in." Debtor's obligation to Seller B is secured by Seller B's machine and Seller B pays Seller A, adding the amount paid to Seller A to Debtor's debt to Seller B. The difference between the value of Seller A's machine and the amount of Seller B's payment to Seller A is "negative equity."
If the Debtor then goes into bankruptcy or default, the amount of Seller B's secured credit becomes an issue. Should Seller B's entire payment to Seller A be considered "purchase money?" As used in the Uniform Commercial Code, "purchase money" is the value given to enable the debtor to acquire the collateral. (UCC 9-103) This is the amount of Seller B's secured debt to the Debtor.
One could say that Seller B's payment to Seller A was necessary for Debtor to buy Seller B's machine. So, of course, it is "purchase money." Many courts take this approach.
But other courts disagree. They cite a comment to the Uniform Commercial Code that ". . . a security interest does not qualify as a purchasemoney security interest if a debtor acquires property on unsecured credit and subsequently creates the security interest to secure the purchase price."
(Comment 3 to UCC 9-103) (A comment is commentary on the law, but not the actual law.) Isn't that what happened here? By paying Seller A the entire amount, Seller B basically converted unsecured debt (i.e., "negative equity" or the portion not secured by the value of Seller A's machine) to secured debt. So some courts are requiring secured lenders to reduce the secured portion of the amount owed by their debtors by the amount of "negative equity."
This seems like a very esoteric and technical issue, but it is actually a very current one. When government officials or candidates talk about "buying" mortgages to save banks or to save homeowners from foreclosure, the treatment of "negative equity" becomes very critical. What happens to the portion of the loan which exceeds the home value? Is it funded by the government, lost by the lender, or some combination? The question is more than a financial one. The answer may depend on a person's view of the causes of the crisis. Is it caused by greedy lenders who permitted borrowers to over-borrow against inflated assets? Or are lenders and borrowers a victim of an unanticipated downturn which put at risk conventional and conservative loans?
Whatever the answer, it is important to pay attention to the "negative equity", because that is where the losses will occur. When the music stops, the party holding the "negative equity" will be the loser and the party holding the true equity will come out much better. Courts are not in agreement as to who should bear the loss for the "negative equity" and it is likely we will see the same debate at the national level