Irish Mortgage Brokers Blog

We have been talking about the idea that the Chinese ‘miracle’ could not last indefinitely, in this clip from Bloomberg, Harvard Economist Kenneth Rogoff (co-author of ‘This time it’s different’) talks about China having a real estate bubble in the making, the bursting of this bubble is not about ‘if’ but when… Watch this space! [If the clip doesn't play for you then follow this link ]

I was interested in the front page of today’s Independent in which Charlie Weston broke a really big story about Irish banks being in advanced stages of designing ‘Negative Equity Mortgages’ (this is vastly different than the Negative Equity Loan/Short Sale Loan we have discussed previously). Essentially the bank will allow an individual to carry negative equity out of one property and move that onto another one within certain parameters.

This practice has already existed in the UK and is offered by Nationwide, Coventry and RBS, the schemes have not proved to be very popular, in part because of the stringent underwriting required. It is one thing for a client to fall into negative equity but another to actually facilitate them in compounding that fact and taking a further bet on their ability to repay. What do I mean by that?

First Loan: €200,000
Value: €150,000
Neg/Eq: €50,000

Then the €50,000 shortfall is passed into a second loan of (for example) €200,000 (which by nature will essentially be a 100% mortgage) and now they owe €250,000 with €50,000 negative equity in place the day they close.

In this case the borrower now owes more but they have a different property which they are more happy with and underwriting will ensure that they can still service the loan, but how many people will be willing to take up such a product? And who will the bank be willing to lend to on this basis? Credit is already tight, to trust a person with yet more money and negative equity in advance is a gamble, this beast is the evil love child of 100% mortgages - the very brand of lending that was a factor in the property bubble.

The sole saving grace is that people won’t opt for it, in the UK the uptake has been incredibly low, it is a niche product with little in the way of demand, it will help the people who are happy to use it and will be of little use to the average borrower, having said that, the Regulator recently said that banks have failed to learn their lessons from the crisis and that they don’t lend enough to business and rely to heavily on property, if this is the latest in financial innovation can we truly say they are learning anything at all?

I used to be in a Chess Club, and one thing it taught me (apart from how to lose using the Kings Gambit) is that you can often see a general result long before you see it exactly, when you are a piece down and can’t control the centre of the board you know you are in trouble, but how and where the checkmate occurs is unknown, game theory can’t tell you precisely and reverse integration from the end game may not bring you to where you started from, but the player knows instinctively that they are up against the wall.

Sometimes appearances can be deceiving, you might think you are fine and you are not (2003-2009), other times you can get caught up about losing a pawn but you are in fact gaining ground (2010), albeit painfully and slowly.

I believe the same can often apply to markets. Today we will look at the reasons for why we believe the banks are going to survive and furthermore, what the results will be of their survival.

The core belief in this firm is that market rules should apply, the banks should have to stand on their own or or shut down or find a buyer, its just that simple, however, we have not allowed that to occur so we now have to find our way through having avoided that option. In chess this is the equivalent of trying to save the Queen instead of Castling - the Queen is just too important, or is she? Depends on who you ask. We think not, but the decision makers made the play.

Our primary belief is that the banks will survive. Sometimes the noise is hard to ignore, but this time last year there were many commentators saying that our banks would be nationalised within a month or two, then the we should leave the Euro, last month the Euro was going to collapse and now we are once again on the road to hell minus the Chris Rea soundtrack, the truth is we’ll muddle through and come out the other side one way or another.

So why will the banks make it? For no other reason than because we have pinned the hopes of this country upon their survival, to the point of no return. In the absence of a ‘Plan B’ the success of ‘Plan A’ becomes highly incentivised. The current big issue that some people are pointing to is that of the bond credit that has to roll over by the end of 2010, the figure was c. €74bn (previous calc’s said €71bn) which is made up of Interbank Lending €16,405m, Senior Debt €57,791m and Subordinated Debt €866m.

We’ll focus on the bond holders as they represent a foundational risk to the system, so… Will the bond holders stay the course and support Ireland? I would imagine the answer to be ‘yes’, but I’ll qualify it.

Reasons:

1. Guarantee
2. What failure would mean
3. ECB support & approach thus far
4. Shareholder support
5. Euro implications
6. Effect on cost

1. Guarantee: We have made a guarantee to world markets, world markets like that kind of thing, the state will ensure that no institution will not be able to come good on their liabilities and it is underwritten by the state guarantee (taxpayers), this kind of ‘can’t lose’ situation is preferable to fixed income markets, it is the reason the USD is a safe haven when you can’t trust much else (bar gold or perhaps Yen). No bondholders have been burned and they are generally satisfied that their capital values are safe, over and above coupon payments, bond buyers want to know that they are going to get their capital back (in full and on time). No bank has yet defaulted nor will they, as a default on a state guaranteed bank is essentially a sovereign default - it ain’t gonna happen.

Some people think a sovereign default might be just the answer, it is hard to disagree in many cases, it sounds like a nice plan to go and shaft those big faceless bond-holders, and many countries do, Greece (for instance) has made a career of it - which is why everybody there is so angry at the concept of actually having to get their house in order. Would it be a good idea for Ireland?

I doubt it - there is not only the implications of default to consider, firstly, the ECB would likely force non-default, taking up the slack and forcing us to pay eventually anyway, secondly, we export a lot of financial services and nobody wants to deal in serious finance services with a country that defaults (except of course those that make a profit from restructuring etc.).

Uruguay is a country that people point to as being evidence of the ‘correct’ way to default, having been to that country six times and studied it extensively I can safely say that we don’t want to go down that path (yet). The guarantee will stand and thus the Irish banks will stand. The one outlier in this is if there is some substantial credit event (either large institution or sovereign).

2. What failure would mean: An inability to refinance would be read internationally as a country being broke, believe it or not Ireland doesn’t matter to the international marketplace as much as we’d like it to. I speak to traders in the US regularly enough and they don’t know the difference between Anglo, BOI or AIB - nor do they really care, something bad happens in Ireland and the whole place is tarnished. Oddly we actually have earned great respect internationally for how we are handling our issues (I’m not talking about the OECD/IMF/WorldBank etc. - I’m talking about the opinion of the people who actually buy our bonds as opposed to those who make economic forecasts/comment), a credit event now would spell disaster, we wouldn’t be even be able to finance our public services.

Strangely, the Public Sector Unions are quite vociferous on how ‘angry’ the are about the ‘bank bailout’, failing to see that if the banks fail that their paymaster won’t be able to borrow to pay them, they didn’t cause the crisis but they are one of the primary beneficiaries and if one domino falls the next will follow, it isn’t different this time. Uruguay is testament to that.

3. ECB Support & approach thus far: Name a bank in Europe that was allowed to go to the wall? … Still thinking? After Lehman the banking bluff was seen for what it is, namely a ‘fairly real threat’, banks are not joking when they say ‘if we fail we can bring down the system’, that type of event may not bring the four horsemen charging out of the sky earth-bound and ready for destruction, but it can cause systematic distress which is far beyond the price of avoiding it.

This may not have been the case if we went for this option originally, but certainly now - as it would involve breaking our sovereign promise -it would ensure a far larger bank run than necessary and likely collapse. Bailouts sicken me, especially when I see competitors bailed out who are then able to unfairly chase the same clients we chase, trust me, nobody is angrier than intermediaries when it comes to life support to banger businesses that should have shut down but are instead artificially supported.

4. Shareholder Support: Bond holders are at the very end of the risk queue - the most senior ranking on par with depositors, shareholders on the other hand are the ones playing with dynamite, and despite this, the BOI rights issue was 93% subscribed with buyers for the remaining 7%. That means that people are more than happy to take the most risky asset available, that is the market speaking loud and clear that they trust in BOI’s ability not only to survive but to prosper, if people and institutions are willing to back the equity you can be damn sure they’ll back the bond debt. While the buyers are often of different mind sets (shares v.s. bonds), the fact is that it means there is a bigger buffer of safety for the bond holders, and a pre-auction phone call from the desk will likely help to assuage any fears ensuring that the debt rolls. Saying otherwise is like thinking a person wouldn’t drive a car when there are people trying to get to the same destination on uni0-cycles, the bonds are safe and will remain as such.

CDS’s are often news makers, hard to think that only a decade ago almost nobody even knew what they were, and a decade and a half ago they didn’t exist. CDS’s are like a secondary thermometer: let me ask you - is 30 degrees hot? Yes if you are in Ireland, yes if you are in the North Pole, but no if you are in Brazil and definitely no if you are trying to cook a turkey, but we often see CDS’ prices reported as if they are the one cooking the goose, it isn’t the case, often issuers realise that higher yields players will happily sacrifice some coupon for a hedge, and almost all the CDS’s are settled materially or manually (the actual asset passes to the issuer) rather than via a direct insurance payment.

The likelihood of a qualifying credit even for the reference entity doesn’t have to occur, it just has to be perceived as ‘a risk’, prices can be a reflection of yield sacrifice for a hedge, CDS’s are a secondary measurement, they are not the reference entity and cannot be seen as such, capital values are a better tool in our opinion than looking at the derivative values or bids where that capital value is the reference entity. If an LT2 bond is paying c. 11% then a CDS of 5% isn’t the end of the world, having said that, you would always wonder what might prompt an 11% payment to begin with! However, the main thrust remains - Shareholders have stepped up and that is like a wave of infantry charging over the top, which makes the bondholders who are still in the trenches feel much safer.

5. Euro Implications: Despite the hullabaloo being caused, the EU and even Germany all want a devalued euro, granted, German savers will be angry, but everybody else wins, low rates, quantitative easing and monetary policy that encourages exports will be of benefit to everybody, Germany gets their exports and output back up, Greece gets their bailout, everybody else gets some inflation which will hopefully feed into new employment faster than wage increases for existing employees and we all muddle on through.

This latest test isn’t testament to the failure of the Euro, it is rather testament to the success that it represents in converging largely disparate nations and economies- the USD does the same thing. While the current issues represent a test, it doesn’t represent a ‘failed test’, if a member leaves it won’t be the end of the world, but don’t bet on it, if you could just kick people out of monetary unions then Louisiana would have been kicked out and California would have seceded long ago, don’t doubt the staying power of EU members.

6. Effect on Costs: Far from seeing the present storm as a sign of imminent collapse, I see it as a signal that we are in for a period of much higher financial costs on any credit or financial transactions, banks are going to have to retrench, build deposits, build assets carefully and find operational gains (fire lots of people). The most likely outcome isn’t that a bank will fall, it is that they will find a way through via operational profits and price increases. Much of the past losses are paid for, NAMA has taken away a huge amount and they are jacking up mortgage rates to cover the lagging residential issues. It’s easy to cry ‘Uncle!’ now, or to believe it is upon us, but the fact is that we made it this far and both Ireland, and its banks are probably going to find a way to stagger through, punch-drunk and beaten, to the other side of this mess, I’m not saying it won’t hurt in the mean time, or that there won’t be further slaps to the head, but we’ll muddle through in spite of it, the markets have already spoken, it’s time to listen.

I have maintained for some time that new world orders don’t occur overnight, and that even trends that may appear to be secular don’t necessarily work out if you extrapolate them into the future. Let me explain, in the 70’s everybody said Brazil was going to rule the world by the late 1980’s, they came up with all of the reasons for this, demographic, growth, the education and markets in place etc. then it just didn’t happen.

By the end of the 80’s when Brazil was meant to be the new world power they had been usurped, this time by Japan, now it was the turn of the Japanese to be ruling the world within the next 20 years, then far from taking over Japan imploded and they have struggled ever since.

Today we are told that it will instead be China who rule the world by 2020, and frankly, I don’t believe that this can happen without massive painful adjustment that would set them back years, and it also doesn’t accommodate for the fact that the USA views the world as having only one power, theirs, and they will find ways to dethrone any who stand to pass them by.

In this video there is some commentary you may or may not agree with, in terms of the bet on China, time will tell who is right or wrong, but it is important to remember that for every reason ‘for’ there is an ‘against’ and conversations on the Chinese economy are often lacking in the latter.

In the first clip, James Galbraith (son of the famous JK), economics professor at University of Texas, discusses whether a new tax on big banks is justified. Ken Bentsen, of the Securities Industry & Financial Markets Association, and Mark Calabria, of the Cato Institute, share their insight as well.

In the second clip Mark Walsh, of ‘Left Jab,’ and Dan Mitchell, of the Cato Institute, discuss taxing banks based on their risk to the system.

Financial innovation has meant you can make money from many things which may or may not be considered morally correct, there are ’short sellers’ who make money when the price of a stock drops, some people consider that a bad thing, others feel that it is proof of an efficient market working correctly. Then you have the likes of ‘vice funds’ which invest only in things considered immoral such as weapons manufacturers, liquor distilleries, beer brewers and gambling. Then there are those that literally make money from death and today we will consider that group of investors, the SLS traders [naturally there are other non-market groups such as those dealing in blood diamonds but they are not tradable and fall outside of the remit of our description].

There is a thing called a ’secondary life settlement’ (SLS), and it is a financial trade where an investor buys a persons life insurance policy from them and continues to pay the premiums on it, then when the seller dies the buyer gets the money from it. Naturally this sounds pretty grim, especially when you see some of the buy side criteria - such as looking for ‘medically impaired’ policies, translation: the seller has cancer and is unlikely to survive for long.

SLS’s are therefore portrayed as a fairly macabre way of making money, even more so than the companies that sell insurance for death, and that is an odd thing, because a SLS investor is really only seeing out the duration of an assurance policy to its natural end of contract (and payout) that may have occurred anyway and in the meantime the seller makes some money from it.

Secondary settlements are actually a good idea for several reasons, first of all is that it infers certain property rights onto the owner of a policy, currently an insurance policy isn’t considered property that you can sell and that undermines the value of even paying for it in the first place, it is after all a type of asset albeit one that most of us never want to cash in!

It would be a good thing if people who were old were able to realise a cash settlement in life from a utility point of view, so rather than look at the example of paying off a granny with 6 kids who is dying of cancer, consider it another way - what if getting a cash payment for selling her life insurance gets that granny the best palliative care available that the kids (who may not have the money to pay for it) can’t afford, and this means that despite the inevitable conclusion, that this person passes away in the best and most comfortable surroundings possible.

Some might say - well… this isn’t really any different to ‘reversionary loans’ [which I jokingly call 'revulsionary loan' because people are so put off by them] where a person sells a stake in their home that they never pay back and then when they die the reversionary lender sells the property (offering it to next of kin first) and gets their money plus interest back.

The key difference is the asset, and in particular the validity of the asset, you see, a house can be used long after a person is dead, it can be rented out if they are in long term care and passed on as an asset that may eventually appreciate etc. A life insurance policy on the other hand stands several serious risks that may prevent it from realising a meaningful end, mainly that of premium cessation, where the person gets ill or in old age can’t afford the indexing premiums (many SLS are on policies where they get more expensive as you get older) and if they stop paying it becomes void and invalid.

In that example the policy now becomes worthless, you could argue that an old sick person might miss mortgage payments and get repo’d but experience tells us that the majority of people don’t have a mortgage after age 65 so while one asset becomes increasingly expensive to service (life policy) the other becomes less, and then negligible (house).

Take this example a bit further, imagine the person who is old and sick wants to give children a gift of money while alive but they only survive on a pension, a secondary settlement can do that, it can also help to cover the gap left by financial storms such as our 2008/09 crash which have left many who held dividend paying equities or other investments with catastrophic capital and cash flow losses.

When you consider every facet of a secondary settlement you can start to see that far from being a mercenary thing, it is in fact the market finding a way of offering people what they want. A person may have many perfectly good and rational reasons for wanting to take the money now rather than leaving it as a benefit to others after they die, most simplistic of all: what if they have no beneficiaries?

The secondary settlement market may be a partial solution to our pending pensions crisis, if the funding for this is not available in the public purse perhaps there is a market solution to providing income for the aged and this could be a part of that. Obviously, not everybody will ever continue to pay premiums or hold a policy large enough to provide a meaningful payout in the future and there are some restrictions that will weed out some participants, but SLS’s are not ‘bad’ by nature, they merely reflect a transaction between a willing seller and buyer, each have their motivations and each take from the transaction what they can but it is not inherently ‘wrong’ or ‘right’, if it is wrong then explain that to the buyer and see if they change their mind?

There are some important controls in place such as an auction system which ensures that people are not underpaid for their policies, and the buyers are regulated heavily as well. The one thing that could cause big problems in what is a totally uncorrelated investment market (to markets, there is obviously correlation to actuarial longevity tables) would be something like a cure to cancer, but frankly, I think even the losers in that example would be pleased with that because it would serve them in the future better perhaps than their profits would.

Roger Bootle notes that markets do quite well at the end of a recession and at the start of a recovery by drawing the benefits of the future down into the present. Roger has a lot to say on the topic of banks, in particular that of banker bonuses - he states (and we agree) that when banks become ‘too big to fail’ they essentially are oligopolies and hence they are able to pay so well. From an Irish perspective the domination of AIB and BOI put some stock in this theory.

Sometimes when I’m having a rough day I decide to reach out to some of the people that I see on TV or read about in the press and talk to them, it’s part of a greater ideal in which I believe people should have as many mentors as possible, spending time around the people whom they hope to emulate, if you can’t meet them in person then call them on the phone. It works (in my opinion!).

Anyway, today I was reading something Dan Mitchell from the Cato Institute wrote and decided that it would be best to give him a call, his receptionist obviously mistook me for somebody important (pigeon American/Irish accent works wonders!) and put me through and all I can say is that in person Dan Mitchell is a joy to talk to, while somehow managing to make a lot of sense in an easy to digest manner. That particular talent is a rarity.

I wanted to talk about taxation, the Commission on Taxation Report that came out this week has been playing in my mind, the idea that it is ‘revenue neutral’ is a myth in my opinion, simply because 1. it is state run and that means it will either be run badly (and not take in money) or run as most of the bureaucracy is run here meaning it will cost much more than expected.

Dan had an interesting point on this, his research has suggested that it is virtually impossible to have a positive and healthy tax system when a government gets too large, specifically, if they are responsible for spending any more than (when we mention ’spending’ you can replace it with ‘borrowing’ because the money they are spending recently is essentially coming from elsewhere) 20% of GDP, at which point it actually slows down an economy. We are (in Ireland) well above that mark unfortunately.

In considering a taxation system he said that there was a ranking of the ‘general approach’ and it is broadly as follows:

1. Consumption taxes (best).
2. Property taxes (middle ground).
3. Income taxes (worst).

While some commentators such as Fred Harrison are advocates of (essentially) a property only/asset only taxation system, it has yet to be tried in real life or in any country so the jury is out although it is definitely considered a better option than taxing incomes.

The Singaporeans try to avoid ‘tax and transfer’ and instead put much of the responsibility on the individual rather than using it to fund entitlement schemes. However, they also manage the money and that is why (according to Mitchell) the Australians have it right: mandatory participation in an individual pre-funding scheme.

This is currently only used for retirement, but similar schemes could equally be set up for health or unemployment, the obvious obstacle is that of trying to convince people to take responsibility for their own future, while that may seem cruel, it is equally cruel to sub-contract this out to the state who have a deplorable record (internationally) of getting things right individually.

There is a rare opportunity at the moment in Ireland to radically re-think the way we have been doing things and sadly, I believe that opportunity will be largely missed and the tenet of a ’simplified tax system’ (as suggested in the report) will not become a reality, nor will the horizontal equity it purports to bring about.

Dan is a well known commentator on CNBC, Bloomberg, and every other business channel of note, I was really delighted he took my call and some time out of his day to talk to me (so if you ever read this: thanks!). We hope to bring you more on Dan’s thoughts in the near future, for now, here is one of the snippets from the past.

This is a video on the fall of Bear Stearns, it is based upon the book ‘House of Cards’ by William Cohan, it is a six part interview so rather than post them all on our blog, if you want to watch the rest go here. Minyanville is also a site worth bookmarking!

The most popular question I am asked as of late is whether or not we are at the bottom of the housing market, and the answer is ‘no…. but perhaps closer than we think’. Today we will consider a few of the things we will need to see in order for ‘recovery’ to occur.

First of all we need to see a reduction in the massive overhang of housing stock, even if the number reduces, they all need to be sold and a degree of scarcity will need to develop in order to make prices go up again, currently supply is swamping demand and that dynamic will leave uncertainty in its wake.

However (and here is part of the ‘perhaps closer’ bit), NAMA will likely take a lot of housing off the market, in particular it will take it off the market and drip feed it back in, if this happens then it will avoid devastating fire sales, it might also lead to stagnation however if people believe that there is still more price drops to come and they are not arriving due to NAMA holding them back. In any case, it is fair to say that NAMA will change the market landscape in the near future.

Currently the market is in a position where buyers think the prices are too high and sellers can’t afford to drop their prices (unless they realise a loss in the process), so the two sides of the equation are at odds.

Jobs will need to recover as well, I can’t think of a single property market that went into an upswing during a period of rising unemployment. Housing also needs to recover its confidence, as well as job market growth we’ll also need to see wealth grow too.  Unfortunately the precipitous drop in the jobs and housing markets have been accompanied by an equal erosion in wealth.

There are four key pillars we will need to see improvements in before widespread recovery comes along:- employment, production, personal income, and sales. At the moment it doesn’t seem there are any indications that any of these factors are improving.

Of course, that doesn’t mean the property market is totally dead any more than the stock market is, there are profitable ventures out there, the trick however, is to find them and to make the right choices from the outset of the project, if you want to call and talk to us about what those decisions are feel free to call on 01 679 0990.