Irish Mortgage Brokers Blog

When a bank creates a loan that becomes an asset, the property it is secured upon is the collateral (sorry my teaming millions, I know I repeat this eternally). So if NAMA decide to become a brand of lender this October as we saw from an article in today’s Independent; then how does it work? Where does the money come from?

Take a property that they are putting up for sale (1st picture: pic not related). We’ll say for the sake of this example that it is worth €200,000.

The NAMA position may be that they paid more or less for this particular property but it doesn’t really matter; what does matter is that for the sake of them selling it the property may as well be unencumbered, there is no lien above that held by the NAMA.

This means they can give a title deed to the buyer when they sell it - but don’t forget, when a person takes out a mortgage there are two sales/purchases, the individual buys from the vendor (1st sale/purchase) then they sell it to the bank in exchange for the money [we call the 'mortgage] to complete the transaction (2nd sale/purchase) and the bank then take the ‘1st lien’ or ‘right’ on the property.

Prior to this they put in their deposit (10% or €20,000) which becomes their own, this is their ‘equity’, which is why ‘negative equity’ is described not as value versus the market (that’s called ‘price’), rather value versus the mortgage secured on the property.

What NAMA have indicated is that they will provide a kind of ‘bridging finance’ for buyers, so a certain portion will be made up of Bank borrowing, just a regular mortgage (we’ll speculate that it will be 60%).

This has a key advantage for the bank who will have 1st lien (because NAMA have said that there is some loss sharing mechanism which would indicate that at best they hope for 2nd lien). First of all they have a low loan to value (LTV) mortgage - considered lower risk because before the property gets into negative equity from the banks perspective (60% of 200k is €120,000) the price would have to fall a further €80,000. Secondly it means that they can lend a little more freely because their risk in this instance is reduced, it doesn’t mean ‘lax standards’ but it shouldn’t be as stringent as the lunacy that prevails now where it is so difficult to obtain credit.

So working through the example: The buyer puts in €20,000 (10%), the bank forward €120,000 (60%) leaving €60,000 (30%) to cover.

Thus we have the NAMA input; but where does this money come from?

Quite simply it comes from nowhere.

How? Because the property is unencumbered so what NAMA do is draw up a loan agreement (that then becomes an asset) and they give you the keys, along with an agreement that (speculating) might say that if prices fall then after 5 years there is some kind of loss sharing mechanism.

This means that they go from a situation of having an empty apartment generating nothing into the following:

Buyers input: €20,000
Mortgage: €120,000
Loan written: €60,000

The first two give a cash input of €140,000 which can then be invested (we’ll assume they get 5% p.a.) and they also have a loan of €60,000 which is a future claim on earnings of the buyer (again, we’ll assume 5% interest rate).

If there is ‘loss sharing’ don’t forget, the buyers equity gets wiped out first so it is not a case that if values fall that NAMA are onto a loser, rather it is if they fall greater than 10% over the next 5 years, and that may well be likely but don’t forget, they have money in hand today which will generate profit elsewhere.

That 140k over 5yrs at 5% will give them €178,679 (compound interest being [M=P(1+i)n]), the 60k loan will bring in €16,567 in cash meaning that they have €60,000 at risk but €55,246 in cash-flow, and let us not forget that if prices did fall and fall that the €120,000 bank loan has no loss sharing and would put NAMA in a better position than if they held out and sold at a later date - but I see that as an Armageddon scenario.

If prices fell a further 20% (which could happen and was hinted at in the Central Bank paper ‘Scenarios for Irish House Prices‘) then NAMA only have €20,000 to worry about and depending on the loss sharing scheme put forward all they do is write down the value of their loan on that basis giving the following:

€120,000 underlying bank loan
€20,000 deposit (now wiped out as buyers equity goes first)
€200,000 - 20% = €160,000 so the €60k loan they advanced becomes a €40k loan from that day forward.

Not a bad deal (for them) all said.

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.

We reaffirm our commitment to the euro and to do whatever is needed to ensure the financial stability of the euro area as a whole and its Member States. We also reaffirm our determination to reinforce convergence, competitiveness and governance in the euro area. Since the beginning of the sovereign debt crisis, important measures have been taken to stabilize the euro area, reform the rules and develop new stabilization tools. The recovery in the euro area is well on track and the euro is based on sound economic fundamentals. But the challenges at hand have shown the need for more far reaching measures.

Today, we agreed on the following measures:
Greece

1. We welcome the measures undertaken by the Greek government to stabilize public finances and reform the economy as well as the new package of measures including privatisation recently adopted by the Greek Parliament. These are unprecedented, but necessary, efforts to bring the Greek economy back on a sustainable growth path. We are conscious of the efforts that the adjustment measures entail for the Greek citizens, and are convinced that these sacrifices are indispensable for economic recovery and will contribute to the future stability and welfare of the country.

2. We agree to support a new programme for Greece and, together with the IMF and the voluntary contribution of the private sector, to fully cover the financing gap. The total official financing will amount to an estimated 109 billion euro. This programme will be designed, notably through lower interest rates and extended maturities, to decisively improve the debt sustainability and refinancing profile of Greece. We call on the IMF to continue to contribute to the financing of the new Greek programme. We intend to use the EFSF as the financing vehicle for the next disbursement. We will monitor very closely the strict implementation of the programme based on the regular assessment by the Commission in liaison with the ECB and the IMF.

3. We have decided to lengthen the maturity of future EFSF loans to Greece to the maximum extent possible from the current 7.5 years to a minimum of 15 years and up to 30 years with a grace period of 10 years. In this context, we will ensure adequate post programme monitoring. We will provide EFSF loans at lending rates equivalent to those of the Balance of Payments facility (currently approx. 3.5 percent), close to, without going below, the EFSF funding cost. We also decided to extend substantially the maturities of the existing Greek facility. This will be accompanied by a mechanism which ensures appropriate incentives to implement the programme.

4. We call for a comprehensive strategy for growth and investment in Greece. We welcome the Commission’s decision to create a Task Force which will work with the Greek authorities to target the structural funds on competitiveness and growth, job creation and training. We will mobilise EU funds and institutions such as the EIB towards this goal and relaunch the Greek economy. Member States and the Commission will immediately mobilize all resources necessary in order to provide exceptional technical assistance to help Greece implement its reforms.

The Commission will report on progress in this respect in October.

5. The financial sector has indicated its willingness to support Greece on a voluntary basis through a menu of options further strengthening overall sustainability. The net contribution of the private sector is estimated at 37 billion euro. Credit enhancement will be provided to underpin the quality of collateral so as to allow its continued use for access to Eurosystem liquidity operations by Greek banks. We will provide adequate resources to recapitalise Greek banks if needed.
Private sector involvement

6. As far as our general approach to private sector involvement in the euro area is concerned, we would like to make it clear that Greece requires an exceptional and unique solution.

7. All other euro countries solemnly reaffirm their inflexible determination to honour fully their own individual sovereign signature and all their commitments to sustainable fiscal conditions and structural reforms. The euro area Heads of State or Government fully support this determination as the credibility of all their sovereign signatures is a decisive element for ensuring financial stability in the euro area as a whole.
Stabilisation tools

8. To improve the effectiveness of the EFSF and of the ESM and address contagion, we agree to increase their flexibility linked to appropriate conditionality, allowing them to:

• act on the basis of a precautionary programme;

• finance recapitalisation of financial institutions through loans to governments including in non programme countries;

• intervene in the secondary markets on the basis of an ECB analysis recognizing the existence of exceptional financial market circumstances and risks to financial stability and on the basis of a decision by mutual agreement of the EFSF/ESM Member States, to avoid contagion.

We will initiate the necessary procedures for the implementation of these decisions as soon as possible.

9. Where appropriate, a collateral arrangement will be put in place so as to cover the risk arising to euro area Member States from their guarantees to the EFSF.
Fiscal consolidation and growth in the euro area

10. We are determined to continue to provide support to countries under programmes until they have regained market access, provided they successfully implement those programmes. We welcome Ireland and Portugal’s resolve to strictly implement their programmes and reiterate our strong commitment to the success of these programmes. The EFSF lending rates and maturities we agreed upon for Greece will be applied also for Portugal and Ireland. In this context, we note Ireland’s willingness to participate constructively in the discussions on the Common Consolidated Corporate Tax Base draft directive (CCCTB) and in the structured discussions on tax policy issues in the framework of the Euro+ Pact framework.

11. All euro area Member States will adhere strictly to the agreed fiscal targets, improve competitiveness and address macro-economic imbalances. Public deficits in all countries except those under a programme will be brought below 3 percent by 2013 at the latest. In this context, we welcome the budgetary package recently presented by the Italian government which will enable it to bring the deficit below 3 percent in 2012 and to achieve balance budget in 2014. We also welcome the ambitious reforms undertaken by Spain in the fiscal, financial and structural area. As a follow up to the results of bank stress tests, Member States will provide backstops to banks as appropriate.

12. We will implement the recommendations adopted in June for reforms that will enhance our growth. We invite the Commission and the EIB to enhance the synergies between loan programmes and EU funds in all countries under EU/IMF assistance. We support all efforts to improve their capacity to absorb EU funds in order to stimulate growth and employment, including through a temporary increase in co-financing rates.
Economic governance

13. We call for the rapid finalization of the legislative package on the strengthening of the Stability and Growth Pact and the new macro economic surveillance. Euro area members will fully support the Polish Presidency in order to reach agreement with the European Parliament on voting rules in the preventive arm of the Pact.

14. We commit to introduce by the end of 2012 national fiscal frameworks as foreseen in the fiscal frameworks directive.

15. We agree that reliance on external credit ratings in the EU regulatory framework should be reduced, taking into account the Commission’s recent proposals in that direction, and we look forward to the Commission proposals on credit ratings agencies.

16. We invite the President of the European Council, in close consultation with the President of the Commission and the President of the Eurogroup, to make concrete proposals by October on how to improve working methods and enhance crisis management in the euro area.

We were featured on ‘The Morning Show’ and spoke about ratings agencies and the bond markets in plain English for the viewers because so often the topic is discussed with an assumption that everybody understands the jargon and lingo.

Afterwards we ran a personal finance ‘twitter clinic’ for the viewers

We were delighted to feature on the ‘PropertyWatch’ section of ‘The Morning Show with Sybil & Martin’ on TV3 this week.

The topics were auctions (including the upcoming Allsops auction) and ECB rates along with general finance.

We were pleased to feature on RTE 1 O’Clock news to talk about the ECB meeting where rates remained unchanged.

This is an example using the USA’s figures, but it raises some interesting issues for every nation that is deeply in debt (like Ireland!)

We were pleased to feature in studio with Sharon Ni Bheolain of Six One news on the topic of the CSO Property Price index.

I’d pass by this bridge and see architecture and engineering, Fred sees a greater social ill that needs to be addressed, his idea of ‘infrastructure gifting’ is compelling and well worth hearing.