Irish Mortgage Brokers Blog

Paul Colgan from RTE covered this story about the proposed Personal Insolvency Bill which will update Ireland’s dated debt legislation. This is a more humane approach to dealing with debt issues and we are pleased to see it coming to fruition. Any legislation will have teething issues and will not be perfect, but this is definitely a step in the right direction.

Our foremost concern (as echoed in the clip) is about the regulation and oversight of any plan.

In this piece by Stephen Murphy of TV3 we spoke about the issue of Regulators enforcing pricing and the fact that it is not a common practice.

I put on my thinking caps last week and drafted a paper called ‘Designing a Debt Relief programme with minimal moral hazard to address the Irish household debt overhang‘.

We were every happy with the write up it got in the Sunday Independent via Carol Hunt.

There is far too much talk of ‘moral hazard’ in the public debate to date, instead we should be also considering ’separating equilibrium’ (which is kind of the opposite of moral hazard - it’s the ‘pain’ that comes with moral hazard ‘gain’).

To do this you have to create a programme which works within some of the parameters of the existing laws (new legislation must still take account of what exists before it), look at the operational aspects of the scheme (how it functions in real life), design a general algorithm of the process and most importantly have an ‘incentive alignment’ which means that neither party voluntarily makes an action to the intentional detriment of the other.

So I failed if you take every metric together, but what does come out of this is that you could have a somewhat prescriptive debt solution that works rapidly, uses established methods and that is fair to both bank and borrower.

The statement that we ‘can’t afford the cost’ is a legitimized fallacy, one that if you repeat it often enough becomes true. Contrary to that is the fact that loans that cannot be repaid will not be repaid - if you accept that then there is a cost, the question is whose lap does it land in? The banks via writedown/writeoff or the taxpayer via additional welfare costs?

An easier way to think about this is as follows: A cost is a cost, and the question is really about who bears it rather than whether it exists or not. This is just another example of the banking system hoping to offset their costs on other parties, it is the ultimate rent-seeking behaviour.

I am hopeful that a few people will read this and critique the heck out of it (please critique here or post a link to where we can find the critique), because this is HOW the subject advances, to date it has all been on subjective stances as to what is ‘right’ or ‘wrong’. On the cost front we used a simple comparative cost rather than a macro-economic one.

If nothing else, this paper will cure insomnia!

Our regular piece on The Morning Show with Sybil & Martin was about debt forgiveness this week, great conversation in an easy to interpret manner.

We were delighted to help out again on The Morning Show on TV3 with Martin King & Aisling O’Loughlin who was sitting in for Sybil Mulcahy. We spoke about credit cards and then ran a live ‘twitter personal finance clinic’ afterwards.

David McWilliams hit an interesting point in today’s piece in the Independent about having ‘too much regulation’, and how it may repel new banks from coming here.

in late 2009 I was picked as part of a team that approached PostBank with a view to turning it into an SME business bank - our proposal never even made it as far as board meetings because they were determined to close down rather than continue, we found the whole process perverse at best.

Instead the same investor group will be setting up in the UK, meaning SME’s in Ireland lose out on funding.

It isn’t that new banks don’t want to come here, it is that they are routinely put off from doing so via the Central Bank and the way in which we grant banking licences in this country.

The other regulatory issue is Basel III.

Asking a bank during a time like this to hold more capital makes sense from a risk perspective, but from every other angle it is a noose.

Banks are being asked to deleverage (have fewer loans versus deposits), market forces are making them pay more for deposits than is healthy, they have huge tracker mortgage books that even when they perform create a loss and at the same time we want them to lend.

Simply put, these are not compatible objectives.

Banks HAVE to become zombies in order to continue because it is only with huge liquidity & capital injections at low prices that they could hope to work normally again - and we have already spent all of the money we have on saving them; so their alternative is to grind along trying to make whatever money they can and in a very very long time they will eventually be breaking even (think Japan)

That is the true tragedy of the crisis, if we had let Anglo close (I argued for this here) and only tried to save a few good banks (even though AIB is a banger it is still the owner of half of the payments system that the likes of EBS sit on top of) then we could have had a chance - it would have also required going right down the order of liabilities as follows:

Sharholders - wiped out
Preference Shares - wiped out
Mezz & SubOrd - wiped out
Senior bonds - turned into new equity
Depositors - saved (in order to maintain confidence)

Then we could have given 25bn in low cost money to the banks to make them healthy. Naturally hindsight is 20:20, we are never so prepared for anythin we are for yesterday!

But the new point is clear - regulation in itself is actually a risk, and a systemic one. Regulatory Risk will be a common word in banking vernacular of the future.

The entire justification of regulation and the bearing of its cost on the financial system (which ultimately gets built into consumer prices) is the avoidance of the systemic risk it is meant to mitigate. It didn’t and it won’t in the future so why is more of it now the solution?

Mainly because it sounds good…

If you look at the dynamic of the crisis to date you see the following flow (broadly but not exactly)

1. Sub-prime mortgages in the USA started to go under
2. Interbank lending froze as banks liabilities were unknown & collateral was of unknown quality
3. Interbank rates shot up
4. The crisis was not contained, culminating in the fall of Lehman which triggered a series of world events
the most substantial aspect of which was a loss in confidence.
5. Markets fell rates were dropped to record lows in the EU, USA and Britain.
6. Recovery began with several bailouts in the majority of nations affected.

and then….

7. This is critical - bank and private debt effectively became public debt, in Ireland’s example this was via our banks, in other countries it was in the same manner or via quantitative easing. Across Europe the ECB was a key facilitator of liquidity.

The debt has now, in many countries become a public debt issue, in Europe specifically it is a Sovereign debt issue, the like of which the US is not immune to having been downgraded by Standard & Poors rating agency.

This means that there is only one fall-back left… namely Central Banks.

We are at a cross roads in which about four outcomes are available

1. Default
2. Inflate (default via the back-door)
3. Extreme austerity - which hurts the poor/middle class the most
4. Grow your way out

In Ireland the fourth option is not available as it would mean getting growth above the rate of interest we pay on debt (because otherwise the trajectory of debt does not change). While we may run a current account surplus the issue here is of a Fiscal deficit that is still weighing down on the country.

The second option is unavailable because we don’t control our currency as do any of the PIIGS.

Austerity in the absence of growth has a negative growth affect on a nation, this may or may not be in our future - while it doesn’t make sense, it is also not an option that is or isn’t within our control so it may be the road we find ourselves on; it may make our Debt/GDP ratio worse, but it may also solve our debt/revenue ratio which could in time service the former.

While we often look at the macro-picture, it is worth considering the micro. Households are the ultimate economic unit and if we examine total private sector debt over private sector income we can get a picture of the ability of the private sector to endure…

If total private sector credit is c. €335Bn and there are about 2m people in the work force earning €35,000 per year then your average person is leveraged almost 4.8 times. Using mortgage criteria - you would be hard pressed to get a loan. Then strip out the unemployed and the situation looks worse.

The clean-up is only part of the greater ongoing issue, now the developed world will have to increase living standards at a time when growth prospects are low and governments are looking to cut deficits and spending.

There is a book called ‘great waves’ by John Fisher Hackett and points out long super cycles, normally inflation is followed by deflation then price stability, if history is to repeat itself we may be looking at a 20yr run of general deflation leading to price stability.

The ‘muddle through’ solutions that will be the likely political outcome, where definitive solution after definitive solution fail to work fully will be the order of the day unless we get the ‘big bang’ solution.

What?

It can’t just be Eurobonds because Europe is one of several key world players that are interlocked with everybody else, it would have to be Europe, the USA, Japan, China, Australia, Britain and Canada and c. 20+ other countries with strong reserve positions.

The USA is the engine of the world, while that may change in the future, it is the case in the here and now - and on a Gross debt basis if you factor in all state and local government debt the US is over 100% debt to GDP. Like all debt this must be balanced against the borrowers ability to service the debt.

Thus it is our belief that only a massive multi-lateral approach by several central banks might work - this is the ‘big bang’ we mentioned earlier. This would involve a multi-trillion swap line with all participants bailing in (lead by BIS/IMF with everybody else taking part - Fed&Treasury/BOE/ECB/BOJ etc.)

In a nutshell, there is too much debt in the world, the only viable players left are central banks, and unless we are going to explore options 1 & 3 listed above (or perhaps worse option 2?) then the massive wall of funding is the only way to do it, stop the panic once and for all, put out every potential fire by flooding the entire land.

Or we can just sit back and watch?

A popular idea that has been discussed in the past (and if Niamh Hennessy’s article proves correct may become working reality) is that of banks taking equity in the family home in exchange for reducing the debt on the property.

I’d like to go through this by looking at the differences in cost, the difference to the mortgage holder and to take a look at why it may not be a great idea.

The bank balance sheet currently looks like the picture to the right, the value of the asset (the loan) is based upon the amount of finance advanced, not the value of the underlying security.

Remember: When you put in your deposit, you are the first equity owner, if prices fall the owners equity is wiped out first which is why ‘negative equity’ is a talk about current value versus the mortgage secured and not just current value versus market value.

People who’s property fell 40% but who have no mortgage cannot crystallize that loss in the way that a person who can’t repay a loan can potentially do.

When you get a property crash the situation looks like this new scenario. As long as the borrower makes every repayment on time then the underlying property (which is the security - the loan is the asset) remains valued in full.

The borrowers LTV is now 200%, which you get by dividing the loan amount by the property value (normally this is a positive figure) 200k/100k = 2 x 100 (to get %) = 200%.

However, if the person is having trouble repaying then it changes the situation, in some cases (depending on the size of the arrears) the loan will be written down in value but generally there is forbearance and other measures which aim to prevent a repossession and sale.

If the solution was to reduce the loan & take equity in the property then the following situation arises (see picture 3 if you prefer images): The person has value of 100k and they give away half of it (50k) and in return the bank reduce the loan amount by 50k and take equity of 50% of the property.

The repayment on that loan (we’ll say that it is 200,000 at 5% over 25yrs) goes from €1,169 per month on a repayment basis to €876 (the bank own half of the property but their savings don’t equate to 50% obviously).

On an interest only basis the cost goes from €833 to €625, a mere €208 per month for giving up half ownership, but what have the bank given up?

Their position is a €150k loan plus half ownership of the house (50k) meaning that their net position is still €200,000 while the borrower is down half ownership and in terms of LTV where are they?

Back to that calculation! now it is 150k/50k = 300%

They have become even more leveraged! They gain a small amount of reprieve but the bank doesn’t take a fair share of the burden.

So we move onto the fourth picture…

Not only that, but it doesn’t improve the banking position because by doing this they create an even more illiquid asset, you can’t securitize part ownerships, it doesn’t create a deposit which can be lent out, it has no effect other than to make an accounting trick in the banks favour.

Now we’ll consider that the person who can’t pay still can’t pay and the bank make a move on them.

Their situation in the first example was that they were €100,000 underwater - that would be the shortfall they have to make up if the house was sold from under them.

In this new situation does it improve?

No, they still have the same 100k shortfall because of the bank owning 50% of the collateral.

Wild as it may seem we are likely through the worst of the bad news, I’m not saying its over, but that we are definitely deep into the 2nd half.

The latest OECD data suggest this.

As you can see from the table we are down almost 39%, which is not as far as many other estimates say we are (up to 50% according to Sherry Fitz).

Even if Japan is to be our proxy then there is about 13-14% more to go. ‘We’ll be worse!’ I hear you say, but I doubt it, at the height of the Japanese bubble a 3m square closet in Ginza (you couldn’t build or even place a kiosk on this) sold for $600,000. It got stupid here, but not that stupid. Japanese real estate was valued at 4 times the entire USA at one point!

The other downside is if there is an eventual return of the market, the charts below show that on average it will take about 4-5yrs to get through the blow-out. Then something interesting happens, property stays below fundamental value for c.7yrs, a big driver of this being sentiment and the credit cycle post crash.

Above we see the effects  in the UK, Finland and Sweden, the final graph is all of them together. If the person was able to hold out for long enough (bearing in mind the worst is over) then their odds are better by being a full owner of the property and getting some kind of sweetheart deal - but that is costly and will definitely represent a transfer from either taxpayers or other borrowers/users of the banks (via operational costs passed on).

So perhaps the best thing to do is rush through the Personal Insolvency Bill 2012 which is being drafted up as we speak, give people an out and some method that does it humanely. For those who have no chance of repaying the debt will need to be wiped out or it eradicates a motivation to return to work (why do it if a bank has claim on you once you make some money?).

We’ll need to see repossessions, lots of them, we need to get to market clearing prices and let people who can’t make it through fail in a manner that doesn’t destroy their future. Failure is not wrong, rather it is the excessive punishment of failure which puts people in a situation where they won’t try again which is the mistake.

You can’t hope for isolated solutions in world where everything is bound together, which is the foundation for taking a more pragmatic look at a solution for Irish Banks and households, because one inherently is reliant upon the other.

That our banks were underwritten by all of our citizens (minus any consent in that debt bondage process) is a given, however, it would be a mistake to think that there can only be a one way flow of funds or solutions between the two parties.

The conundrum thus far is that the ECB don’t want to see any bond holders ‘burned’, while at the same time this nation should not be guaranteeing any facet of the securities markets any more than we should have protected bank share holders; and then we have the third and fourth legs on this table of madness, the IMF who (counter to the ECB) want burden sharing and an overly indebted society incapable of paying back the money they borrowed.

Somehow within this morass we also need to de-leverage our banks while making credit available to businesses and home buyers, literally every rung of this ladder is a contradiction to the preceding step.

Up to now, core nation support for the periphery is not entirely altruistic, many of the largest creditors of the PIIGS are French and German banks, and a debt should ideally be honoured where possible or you create genuine moral hazard so how can we find a solution that keeps a smile on every face?

A practical solution is to tick every box in the most broadly acceptable manner while bypassing narrow self interest within the groups that constitute every stakeholder party.

Unfortunately this will involve a credit event, but one that has a sensible work out attached, naturally bondholders will scream about it – just remember, nobody gets there legs hacked off and dances a jig at the results of same. However, it is possible to deliver some painkiller with the pain…

We repay the bondholders in full, but not with cash, instead with another bond which is made up of mortgages, the largest asset remaining on bank balance sheets, an idea that is similar to what Arthur Doohan from offsetdebt.net was proposing. A swap of sorts which is hived out into a non-bank debt collection company – not entirely dissimilar to what Bank of Scotland have done with Certus.

Neither the existing bonds or mortgages can be reasonably valued at 100% but in this process bondholders are actually likely to do better than they would currently if we applied a market price ‘burn’ to their holdings. The recent Liability Management Exercise (LME) by Bank of Ireland is testament to that, bondholders may well have preferred a book of highly distressed loans.

In this process the bondholders take some losses and at the same time we reduce the liabilities of our banks (bond holders) while bringing down the level of assets (home loans). In this new ‘work out company’ there is considerable incentives for both parties to work with each other for a mutually acceptable end, this will result in creative debt solutions.

If a bondholder is expecting 25c on the Euro (or could only obtain that on the secondary market) then a mortgage backed bond with a potential value of 90c on the Euro is an attractive proposition, albeit the interest earned and maturity date may change versus their current position (I take 90c as being loan value minus 10% impairment which is the general proxy in our stress tests)

So €20bn of bonds are removed from the banks debts and the bondholders are given €20bn worth of mortgages to manage. They might only reasonably expect to obtain 70c on the Euro with some loans (a better option than the bond work outs to date), but in return they may offer mortgage holders a debt writedown of a certain percentage if they successfully make payments – a process already working in the USA via the ‘Loan Value Group’ who orchestrate such schemes. They might give the person a 20% reduction in their loan if they make timely payments which still puts them far ahead of the 25c/€1 position they were in prior to this.

Households get a better deal, bond holders get a better deal, the immediate writedown is containable if the Europe wide stress tests are to be believed and most importantly we get some of the heavy lifting of de-leverage out of the way and move on with a more robust economy to boot in which debt and banks are less of a drag on output.

Between July and August €660m in bonds will mature and be paid to bank creditors, €660m is about 40% more than the annual Jobs Initiative costs (€470m) it is almost one tenth of the €7bn due to mature this year, and yet there is still time, because the real battleground will be from 2012 to 2014 during which  €66bn of bank bonds will mature and be paid out by the Irish taxpayer.

It is literally insane to continue on the path we have chosen to date, and yet the mantra has become one of ‘if at first you don’t succeed then get a bigger hammer’. Banks are edging up margins where possible forcing bad bank lending costs onto the shoulders of the few.

At the same time we are not going to see legislation passed in a time-frame that will likely aid the 100,000 and more mortgage holders who are either in total default, arrears or renegotiating to paying only the interest.

Our salvation was, and is perhaps, the IMF. They have set a fair course looking for realistic demands which may not sit well with an entitlement oriented populace but which do seek to address some of the hard structural imbalances we have such as the difference between the taxes we raise and the money we spend.

It surely is a curious world when the IMF are the only good guys left…

We were talking about Debt Forgiveness on The Morning Show with Sybil & Martin yesterday. The two guest were Angela Keegan of MyHome.ie and Karl Deeter of Irish Mortgage Brokers.