Bermuda residents are still coping with stressful financial hurdles as the country starts some recovery from the sixth year of recession (or more, depending on some people’s perspectives).

The following negative equity situation is a composite-generated case that is not specific to the Bermuda environment or any individual’s particular financial profile, although anecdotal comments indicate these situations have and are happening here. Note also the maths are just estimates — individual circumstances vary.

Recently, a resident got a call from his local bank to attend a meeting with his mortgage officer. He was told: “We’ve analysed the current value of your home. You now have negative equity. You are current in your mortgage payments and we request that you continue to meet this obligation.

“At this time, however, in addition to your monthly payment, we are also directing you to make a lump-sum mortgage principal reduction in the amount of five per cent of your unpaid mortgage balance, with several more at scheduled intervals.”

He is simply stunned. He and his spouse have no savings; they are just getting by — hoping for better days.

He has been unemployed for almost four years. He received a redundancy notice in 2011 when the company he had served for many years hired a new CEO and finance team. He has applied for every position he was professionally qualified for (and many that he was not — just to get work), but without luck. He also realised that jobs where he was able to obtain an initial interview now offer significantly reduced employment compensation and benefits compared to the salaries of a few years ago.

The strategic compensation tightening in his field immediately got his attention, because he now understood that he was in an even tougher financial situation. When he finally obtains a new position, he could not possibly begin to qualify to even purchase his present home or mortgage.

His spouse’s efforts with a small business have helped them manage to get by. He does work hard at helping there wherever needed, paid at a basically minimal wage because that business, like many local retail operations, is struggling to stay afloat.

So, how does real estate end up having a negative value to the owner?

According to the Merriam-Webster dictionary, equity is defined in finance as the net value of a piece of property, such as a house, after any debts that remain to be paid for it, such as a mortgage, have been subtracted.

Negative equity in real estate is generated by market conditions. The entire concept is often a terrible surprise to the real estate homeowner.

Example: A local real estate market is exuberantly buoyant with property values climbing rapidly. Everyone wants to buy a home. Our composite couple fall in love with a special house, listed for $680,000. The couple are both working full-time and, with the help of parents, just barely summon the required 10 per cent down-payment of $68,000. The mortgage, to be paid over 30 years, is $612,000. The couple know they can do this with careful budgeting. They move into the wonderful home.

Then, things change. Global markets become volatile; international business profitability decreases and business cost implementation models are put in place. Local employment uncertainty arises and redundancies become prevalent.

While savvy governments exercise spending restraints, others not sufficiently focused on the economic horizon become complacent, then fail to anticipate economic change signals. Credit ratings fall. The local economy starts to hesitate, decreasing in money-flow volume.

Individuals and families experience pay cuts, job redundancies, severe budget tightening, then survival mode trying to avoid defaulting on their debts.

No one wants to take on any major purchases. Banks require larger down-payments making it even more difficult for the ordinary family to save the required home down-payment.

Five years on, the property market has fallen. There are many sellers, but few buyers. Real estate sales values drop. The composite case couple’s home in this devalued environment is now worth an appraised value of $425,000, but their remaining mortgage balance is $550,000. The family home is in negative equity because the mortgage debt is higher than the sales value of the home, by $125,000.

Banks need to protect their investment and are always monitoring for the worst case scenario. Can the couple sell their home and pay off the remaining mortgage balance with the proceeds? No. Can the bank sell their home in the event of default and settle the full mortgage? No.

Thus, the mortgage principal call. The bank can demand under certain circumstances — defined in most mortgage contracts — that the borrower pay the difference, which in this example is $125,000.

What will our composite homeowners decide to do?

Discouraged, they review their finances again, but they already know the answer. Any additional repayment is a financial impossibility until the husband can get another job. So, with regret, they inform the bank that their home will revert to the bank’s ownership.

The bank replies: “Oh, by the way, while we repossessed your home, you still owe that $125,000.”

In the United States this liability can become a double whammy — the unsatisfied balance is considered “phantom income” to the family, and possibly taxable.

But, what happens if the real estate market reverses, suddenly turns upward, and your home is again worth more than the mortgage?

More on this topic to come.

Martha Harris Myron CPA CFP JSM Masters of Law: International Tax and Financial Services, appointed to the Professional Tax Advisory Council, American Citizens Abroad, Geneva, Switzerland; president of The Pondstraddler* Life™ Consultancy: international financial planning, publications, presentations for the challenging lifestyles of multinational individuals and their families residing, working, crossing borders, and straddling ponds in the North Atlantic Quadrangle. Specific focus for residents of Bermuda, the premier international finance centre. Contact: martha@pondstraddler.com