Irish Mortgage Brokers Blog

We are delighted at the prospect of having another contributor to our blog, this post will be the first using a thesis put forward by our guest Frank Quinn. We have worked with Frank on numerous reports from our Rent or Buy report to the Investment Property Reports.

This is a paper he wrote from 2003 examining whether the Irish housing market at the time was fundamentally sound or whether there was evidence of a speculative bubble at that time. This is one of the few papers I have read that literally spelled it out and quantified the belief showing the disconnect between historic prices and yields, there were many commentators expressing similar opinions [and I would ask that anybody who has similar resources from around that time to post links] but this paper brought many facets of the argument together in a way that was not being widely looked at during the time.

There were three major elements to the report.

Part 1 Used a forecast model to examine the property market from 1978 to 2002 to determine whether the large price increases which occurred from 1996 could be explained by fundamentals or by a speculative boom. It concluded that a large part of the house price increases could be explained by fundamental factors such a low mortgage rates, increases in income sand population levels.

However there was a gap of about 16% between actual house price since 2002 and where they should have been
based on the fundamentals. This may have been a sign of a speculative bubble.

Part 2 Was a co-integration analysis of House prices and Rents. The aim was to determine whether there was any divergence of the market value from its annual income during the property boom. There appeared to be divergence of house prices away from rental incomes and this may have been an indicator that the fundamentals no longer controlled the property  market.

Part 3 Examined the changed in the lending criteria of the banks which had occurred during the start of the property boom. It demonstrated the dangers of increasing the amounts people could borrow. It concluded that the huge increase in mortgage lending had created potential dangers for purchasers and also for the banking sector.

Below is a graph from the report (I had to hand write in the red/blue lines because it didn’t photocopy across very well) showing the growing disconnect in prices that started in the mid 90’s. The full paper is available here

You can contact Frank Quinn at Senior College Dun Laoire where he is a lecturer in Valuations, or by email at
fquinn(at)scd(dot)ie

This is a parody, any resemblance to people in real life is merely coincidental.

The ‘Rent or Buy?’ report was featured on RTE1 ‘Drive Time with Mary Wilson‘ yesterday, it was prepared by Dr. Peter Stafford (Independent economist recently taken on by the Society of Chartered Surveyors), Karl Deeter (of Irish Mortgage Brokers) and Frank Quinn (of Senior College Dun Laoghaire). In the report we ran six different future scenarios with a view to determining whether it made better sense to rent or buy a property.

The findings are in the report, you can download it by clicking on the image to the left.

Our findings were fairly consistent, showing that in almost every future scenario that renting makes better sense from a cost perspective than buying does. The times that buying is better is in an upward only market and a flat market.

That may help to put numbers on behaviour, because during the boom people thought prices would go upwards only and it is therefore reasonable to see why so many jumped into the market. It doesn’t get into the deeper causation but it helps to demonstrate this albeit ex ante evidence.

I want to give a very big thanks to the other authors, Peter and Frank, without them this report never would have happened, Peter keeps a great blog/site and his monthly macro reports are well worth signing up to check out his site. Frank teaches valuations in Senior College Dun Laoghaire and although he doesn’t keep a site himself, we have been chatting about him contributing on this blog from time to time, the prospects of which we are very excited about!

‘Research on Real Life’ is (in my opinion) the best kind there is, we hope that this report helps readers to make a decision that they may otherwise find difficult to answer, of course, not everybody buys a house based on minimum cost to themselves, if that were the case we’d all cram into bad neighbourhoods and rent there [albeit that paradoxically that would drive up rent prices in those areas!], having said that, this report should help to debunk some of the property spin you may hear from time to time.

If you want to get a calculation done you can contact us and we’ll send you the report all you have to do for any scenario is the following

1. Send the price of the property you are considering
2. The rental price of a similar property, or the one you are renting now
3. The rental price scenario you envisage over the next ten years in terms of % change per year.
4. The purchase price scenario for the same period, giving the % change per year +/-

From there we can let you know the cost of buying now, waiting five years, or renting only for the next ten years. There are some flaws in our calculations as there are in any calculation that makes assumptions but we can tell you about them so you are aware of them.

Happy reading!

We were featured on the RTE news yesterday on a piece about negative equity, property prices and the Irish market.

The second piece is in studio, where David Duffy joins Brian Dobson, talking about property prices in Ireland and discussing the recent report which shows that the rate of decline in prices has been slowing.

I waited a long time for a conversation with Tony Boeckh, his newsletters are a must read for anybody looking to keep a finger on the pulse of the markets both in the USA and internationally, you can sign up for free at the homepage.

Tony’s career has spanned over 40 years and during the entire time he has focused on banking and credit, starting in the Canadian central bank, then taking over the helm at the industry stalwart publication Bank Credit Analyst. His recent book ‘The Great Reflation‘ is a culmination of thoughts on the future of finance and what trends we can expect, and perhaps more importantly, the trends that investors can profit from.

My questions are in bold.

You look at the world in a very macro sense, what indicators, given the span of your career, have you found to be the best guides? Interest rates? flow of funds?

“That’s a never ending question, I am every eclectic, and look at a number of things, liquidity and the rate of change of liquidity in particular is important and that is what drives markets, but how do you measure it? There are different ways to do that, but it is a slippery concept and the measurements are subject to difficult constraints, data can be wrong, or the financial system evolves in ways that your old harvesting methods don’t pick up”.

So what do you watch for in liquidity?

“For what are banks doing with their assets and liabilities, watching the banks gives you a much better handle on what is happening in the system because, at least years ago, banks were the main part of the financial system 70% or more but that is reducing so we have had to constantly change our approach. Corporate liquidity matters as well so we look at liquid assets to total assets, for market measures a good one is the US Treasury yield curve”.

“When it is very steep it tends to be a good indicator, flat or inverting means there is trouble coming”. He focuses on the Treasury Yield curve, or the commercial paper/corporate sector yield curve, believing that generally they tend to give a similar answer, but that any one measure on its own can be very deceptive, he used to look at the debit/loan ratio [cheques cashed against bank deposits], but that is no longer possible.

“in 1930 the debit loan ratio showed the economy was getting worse. Then the Fed stopped publishing that series which was a real pity because it took a key metric out of the market. A lot of people look at money supply and from time to time that has been a good thing to watch, but which measure do you look at? M0 (monetary base), or M2 then M3/M4? Money supply can be misleading, and often random”. For the most part he is a big fan of looking at the asset side of the bank balance sheet and looking at what they do with their money.

“Bank holdings of securities as a percentage of total bank assets is important, if they are adding to liquid assets its an indication the system is becoming liquid and is good for financial markets, on the lending side, if institutions are selling securities to expand loans it means money is getting tighter, if the Fed is lagging behind on rate movements they may not be raising rates but the system is getting tighter, and that shows up in liquidity long before it is evident anywhere else”.

Banks in Ireland are more likely to sit on bonds and make better returns than they are to extend lending at lower margins, what do you think of that?

“Sitting on paper after a recession is typical, so they [banks] buy bonds instead of extending loans, they increase the least risky assets, that is actually a bullish indication, the system is becoming more liquid, after a time lag they start lending. Liquidity is a leading indicator, some forecast by taking a view on the economy, but don’t forget: the market forecasts the economy not the other way around, that is the biggest issue that people face in trying to understand the economy”.

So is there a danger in trusting economists too much?

“Absolutely, a lot of people are pure economic forecasters, and some are very good but the good ones look at different things: talk to David Rosenberg sometime- he is brilliant (and also Canadian!) he has moved back to Canada and he’s a very good economist, but he stayed bearish during the entire recovery over the last 18 months. I think he did this because economic indicators are only one side of the market, he may yet be right, but he missed a huge rally that was staring liquidity watchers in the face”.

“The stock market, ultimately is determined by profits, which is driven by the economy but catching the cyclical swings makes you late if you watch the economy only. Don’t worry about where the stock market is, worry about where profits are, watch that and you are watching the real indicator”.

O.K. but where do you look for that?

“Bank balance sheets, household balance sheet, corporate sector balance sheets. A series of indicators relate to liquidity, sometimes the reading is good, other times it is confusing”, then he looks at other sets, valuation as an adjunct to other things, but he readily admits that it doesn’t always tell you about turning points.

“Negative changes in liquidity with market decreasing means you’ll want to pull the plug a lot faster. The fourth key thing is psychological factors, which tell you a lot about risk. At the bottom of the market in 09′ the valuation was good, the psychology was as bearish as possible and liquidity was going straight up while the technicals looked washed out… That was a screaming ‘buy’!”

Is the reflation going to be monetary? If so how is gold in a bubble at the same time?

“Nobody knows how this will play out, the great reflation is an experiment. Private debt became public debt and now we are in act 2, Greece is the canary in the coal mine, it told the world what happens when you have too much debt, there is a huge shift toward austerity and that is happening to different degrees in different countries. If we get the fiscal restraint required it will put huge downward pressure on the economy, and that impacts on monetary policy, with a ZIRP you can’t go lower so government’s can buy debt to drive down interest rates which will ultimately lead to much higher inflation. Gold bugs who have been forecasting this see it as the buy signal”, but he thinks that the risk is much further down the road, the big threat is deflation and will remain so for some time. “Gold might come through eventually, but for now its a crowded trade”.

Do you believe in locomotion? where large economies recovering will pull smaller economies with them.

“It is happening, in particular in developing countries, the balance of power is shifting and doing so rapidly, that is going to continue, there is no way around that, western countries will be at 1-1.5% growth a year. most of Asia will be at 7-8%, the Chinese are trying to diversify into real assets with their dollars, they are buying companies, mining, energy, so if the US goes the inflation route then the Chinese will ride that wave up indirectly”.

“There is an unspoken dance between to the two nations (US and China), the US might devalue but China will hold companies and assets that benefit from that, ultimately it is political, if it wasn’t they’d (the USA) let unemployment go to 20% go back to fiscally orthodox solution, but politically they can’t do that.

Was the crisis was driven by the ex ante expectations of bailouts for ‘too big to fail’ institutions?

(This is a very economics based question which was put forward by Trinity College maestro Constantin Gurdgiev, so in plain-speak it is as follows: was the crisis partly created by a belief beforehand that investors were sure that even if things went wrong, that the government would intervene with a rescue or bailout package for financial institutions and therefore it gave them the confidence to take bigger levered risks)

“The moral hazard factor… ‘Yes’ and it has been building for 30 or 40 years, there has been a progressive pattern of governments bailing out the economy, after the Great Depression the government was perceived to have responsibility for full employment, there was even a full employment act in 1946. Since then during every recession they run in, pump money and run deficits. The deficits started in the 60’s, Penn Central, then Franklin National Bank were saved, in the seventies it was car maker Chrysler, so it was evident that the government would bail everything out, then in 87′ Greenspan pumped the markets. This trend has been building, meaning people took on more and more risk, the recessions became shallow and that made people think the system was stable so it was o.k. to take more risk, it all falls down and what do they do?… The biggest bailout in history”.

How will balance be restored in the world? My belief is that the USA will eventually rip off china via a devaluation which will drive up exports and reduce deficits, it cures all ills and has hegemony to back it - what do you think?

“Ultimately the rubber meets the pavement on China and the USA, at the moment there is a ‘balance of financial terror’, the US are saying ‘don’t like our currency? don’t hold it! The Chinese don’t want devalued Dollar but then Euro collapses, so now they think ’should we hold yen or sterling? At the same time Russia is buying Canadian dollars for reserves, China can’t do that (they missed the boat so to speak) so they are stuck with the USA and they have all these dollars and they can’t dump them, if the dollar tanks then China tanks.

“Currently Dollar is the best looking horse in the glue factory. This is the fascinating issue; ‘how does this play out?’. The international monetary system and how governments approach them are THE story, the developed countries economies are going to be gravitating toward 1-1.5% GDP growth. With low growth and real interest rates of 2-2.5% the debt/gdp ratios are hard to control”.

“When you try inflating away the debt the average term to maturity gets shorter and shorter, at present its around 4 years, in a fiscal orthodoxy they should be issuing long term bonds, that is the sensible idea, it also gives them protection against inflation, the shorter the term and the more the perception of inflation the quicker it inflates interest rates and that is where you get the death spiral. The US government won’t go there willingly, central banks don’t inflate because they want to, they do it when it is the least bad alternative. If the US goes for orthodox policies while unemployment is going up then you have a big problem, debt monetization etc. In 2009 they started that but they will have to go back and do it again”.

How closely linked or correlated do you believe the housing cycle and business cycle to be?

“In the past they were closely correlated, but that seems to have broken down, the US one is not very different from that in Spain and Ireland, some are more extreme, it will take years to bring that out of the system, then you have demographics working against the housing market, so many people bought homes based on rising prices and now they are under water, pension funds are down, and there is nowhere to bounce from, people will start selling their home earlier in this scenario to raise money because their pensions are not worth what they expected them to be, supply will swamp demand for a long long time, we  simply overbuilt”.

If you could give three golden rules to people who wanted to delve into the kind of inisight you have what would they be?

“That’s a tricky one, I suppose in terms of early training- work at a central bank, that is the best way to learn how the financial system works”. His training at Bank of Canada was invaluable. “Be eclectic and flexible, the business of analysing and forecasting is more of an art than a science”, he has always been sceptical of people building models, he wasn’t into the quantification/quantitative systems but people tend to accept them or believe them because modelling is hart to refute, but equally it just doesn’t work in real life, hence his profound belief that its an art, not a science. “The different schools of economic thought matter, Keynesian’s, Austrians, Monetarists, but you must apply the best of each one depending on what is happening at the time, and never under estimate the stupidity of central bankers and government officials, the paradox is that these people are bright, high IQ’s, PHDs, and they can make the biggest blunders you can think of. the Federal Reserve is a great example”, he catalogues their mistakes in his book, “the only periods when it worked well was by luck”.

“Politicians also have huge capacity to do stupid things, and work out of self interest. It’s like they (the USA) have a permanent minority government, nothing ever gets done until there is a crisis”, Churchill once said ‘You can count on the yanks to do the right thing, but only after they have exhausted the other possibilities’. “Go on what they do not what they say, ignore the verbal noise, for investors you have to be the CEO of your own portfolio, don’t run with the herd”.

Do you find any economic school of thought represents the lunatic fringe?

“The core of the Austrian view is solid but the supporters can sometimes be a little out there, the problem with Keynsians or Monetarists is that they never look at the balances sheet. Supply side guys can also be crazy”. He also thinks that (especially in the US) the system is flexible, that below the surface there are hard working americans looking to correct things, get efficient, looking for new opportunities, the micro can be far better than you think, don’t ever dismiss the micro or anecdotal. “The best thing the government can do is not screw it up”.

ENDS

I didn’t get to type everything Tony said, the conversation lasted about 45 minutes and was a really interesting one to be part of, getting a world view from such a well known analyst, and in particular some insight into how he thinks is a huge benefit for a practitioner and I hope that to some degree that I have shared that with our readers. His book ‘The Great Reflation’ will be reviewed here in the near future.

Below is a press release from the Financial Services Authority in the UK. This is how they deal with executives who cross the line, while we can praise reform in Ireland it is clear to see that we do not come anywhere near the standards set in the UK when it comes to discipline in the market, while over 90% of complaints are against banks, they have the fewest sanctions and yet this is the same banking system which nearly pushed the nation over the edge. The people in charge now are the same people that lead us here and it is shocking that we laud ‘new regulation’ when in fact we are still behind the times.

It is becoming evident that our own banks may have not been totally forthcoming in how they presented their own statements of affairs in the past, will similar sanctions therefore follow?

SA/PN/126/2010

27 July 2010

FSA bans and fines former Northern Rock finance director £320,000 for misreporting mortgage arrears figures

The Financial Services Authority has fined David Jones, former finance director (FD) of Northern Rock PLC (NR) £320,000 and prohibited him from performing any function in relation to any regulated activity [emphasis mine].

Jones’s misconduct started in mid January 2007 when he agreed, along with David Baker (former NR Deputy CEO), to allow false mortgage arrears figures to appear in explanatory text published with the 2006 annual accounts. Reporting correct figures would have either increased arrears by over 50% or possessions figures by approximately 300%.

For nearly a year, Jones was responsible for the continued misreporting of arrears and possessions figures on a monthly basis to NR’s assets & liabilities committee (ALCO) and, on a quarterly basis, to the Council of Mortgage Lenders (CML).

Margaret Cole, FSA director of enforcement and financial crime, said:

“Even though other senior directors within the firm were involved in the misreporting of arrears and possessions figures, as a senior director himself and as an FSA authorised person, Jones had a duty to reveal the true position to the public and to important internal committees. He had numerous opportunities to put things right, but failed to do so.

“This is a message to all FSA approved persons, that they must take their individual responsibilities seriously at all times, or suffer the consequences.”

Background

From 2005, NR staff were under pressure to report arrears figures at half the CML average. To achieve this, a series of improper actions were taken which were outside NR’s stated policy. For example, cases where a possession order had been made against a property, but where physical possession had not yet been taken (pending possessions cases) were excluded from all arrears and possessions figures. Although Jones was not involved in the actions that gave rise to their existence, by January 2007 1,917 such cases had been omitted.

Jones was FD (designate) between 10 January 2007 and 1 February 2007. During this time, David Baker informed him of the existence of the pending possessions and asked whether they impacted the firm’s stated provisions for bad debts. Jones assured himself that the provisions were correct and agreed not to reveal the pending possession cases.

As FD from 1 February 2007 to 22 February 2008, Jones was responsible for the debt management unit (DMU) and the credit management information unit (CMIU) at NR. Amongst other things, these units were responsible for reporting arrears.

Jones received a 20% discount for settling in Stage 2 of the FSA’s executive settlement procedures. Were it not for this discount, Jones would have been fined £400,000.

Trinity Economist Kevin O’Rourke received a lot of attention recently which centred around a paper he wrote with Agustin Benetrix and Barry Eichengreen that featured on VOX.

The Sunday Tribune picked up on it with the headline ‘House price fall could be worst in history‘. Fairly powerful statement that! Kevin O’Rourke is a man who I personally have a lot of respect for (an example of his work is in a talk he gave to the CFA last year here) so we were delighted when he kindly took a call today while on a working holiday in France.

My questions are in bold, the main thrust of his answers follow them.

You say a rapid adjustment would be best, what can be done to facilitate that?
“You have to start by wondering ‘do we think the Irish adjustment is rapid or not?’. In general one thing that comes out of international experience is that property prices are quite sticky downwards, vendors take property off the market and new properties stop being built as well. Can policy speed price falls up? I’m not sure, but you don’t want to have policy that slows them down, that much is for sure”.

Should we therefore get rid of TRS? That is just a Government/fiscal incentive toward home ownership right?
“First it might be better to at least get rid of the asymmetric policy of subsidizing home ownership but without property taxes”.

Does restrictive credit therefore help as opposed to hinder the adjustment? If a rapid journey towards a bottom is a good thing?
“Statistically – the more credit is available the more likely it is that the market bottoms out, and the more prices fall the more likely it is to bottom out. We didn’t think about the possibility of restricted credit speeding up price decline, which may get us to the bottom faster. Increasing rates will have a downward effect on prices, reduced credit availability the same. On the other hand they may be helping by allowing the bottom to be reached faster”.

How much further is required (from the index of average prices) to hit bottom?
His opinion – “I agree with Morgan Kelly. In particular there is a total disconnect between rent and prices. There is one property I saw in Dublin recently that had a renting price of €4,000 per month but an asking price of €3.8 million!” (that’s a 1.3% yield if you are wondering).

If our GDP issues are affected structurally (in terms of decreased government spending) and not just by the business cyclical then how will that affect housing?
“One thing that would help for house prices is a resumption of growth, but I think that the ESRI projections of last week were optimistic. Their low growth scenario is perhaps somewhat of a high growth rate when you look at Ireland, I don’t forecast on that topic but if you want to look at different scenarios you could be more pessimistic, there are worrying indicators coming out of the States, the Baltic Dry Index is lower”.

“Austerity across Europe hasn’t kicked in yet. We are committed to taking more out of the economy every year for the next 2-3 years. The British housing market is also back into decline”. The main reason he thought the ESRI was too optimistic was their growth figures of c. 3% over 2011-15. Per capita growth in the USA over the last 100 years has been a little more than 2% per annum. There were ups and downs but on a smoothed basis 2% per annum is about right. You can grow faster when catching up, as we did in the 1990s, but once you’ve caught up on the technological frontier 2% is about as good as it gets per capita.”

Do you think that if we cut deep and hard enough that we could make anaemic growth look good? That it would perhaps represent 2+%?
“That is quite cynical… Something like that might occur if you cut very very deep, output collapses even more, and once that stops you get a bigger rubber band effect. I’m not sure why you’d want to do that. Furthermore, other issues also suggest low growth in the future, for example unemployment – if it lasts too long it can make it difficult for people to get back into work”.

How will rate increases by lenders affect the market? Given that the value is not being passed or maintained, and that banks are actually capturing the value in the market?
Higher rates would have a downward effect on prices, and our results show that low rates affect the probability of bottoming out positively. It’s a crude correlation, the lower the real interest rate the more likely it is that the market bottoms out. Interest rates are going up meaning we can expect an acceleration in housing price deflation.

Any plans to stop renting?
No.

What parameters did you use in the calculations? Where are the weaknesses in your calculations
“Perhaps we haven’t adequately accounted for the five core variables interacting with each other to the degree that they might have, they were actually viewed as being somewhat independent”. The calculations were based on a group of countries including Ireland and then the average results were applied to Ireland, as opposed to being based on Irish experience alone.

“We took conditions in other countries: the regressions looked at what correlated in those countries with the end of housing slumps, and what we found was that the higher was GDP growth and credit growth, and the lower were rates, the more likely it was that the slump stopped. Smaller prior bubbles and larger price declines during the slump had the same effect. Our approach was a binary yes or no one: did the slump end in a given quarter? Monetary policy is factored in (via real rates and credit availability).
Why do different countries bottom out?

“Different countries bottomed out for different reasons. In the States there’s a 1 in 8 chance of a bottom, and there is a 16% chance in Japan and  in Germany. In Germany this is based on the bubble not being too big to begin with, in the US and Japan it’s due to the very large price decline to date, low rates and signs of higher growth . But remember: one in eight is less than one”.
ENDS

Youtube version of the clip available here

A recent report by Moody’s pointed out that increased negative equity will cause a rise in arrears. The commentary surrounding this (in Ireland) takes the view that correlation is not necessarily causation. That people in negative equity won’t automatically go into arrears unless they cannot pay, that negative equity of itself is only an issue if you lose your job or have to sell. This is a valid opinion but it ignores the operational aspect of a household in respect of the way that they react when financial difficulty occurs.

There are several hundred thousand households in negative equity, and about 35,000 in serious arrears, how many of those people would not be in arrears if they were not in negative equity? The answer is: how ever many would have sold their house as a solution.

The first thing many people do if they know they are going to be headed for a situation where they stand no chance of paying their mortgage is to put their home up for sale, in the past this simple act disqualified you from receiving mortgage interest supplement (MIS), and that has thankfully changed, but you can’t put your house up for sale when you are in negative equity because the sale will not clear the mortgage and in many cases the bank will prevent this from happening. They will instead push for full repayment of the debt, an application for mortgage interest supplement and while this happens the individual goes further and further into arrears.

In the past the majority of people had some equity in their home, and that meant that arrears might eat into the equity, and if they decided to sell then they would be out from under the debt and the arrears. However, this is no longer happening, which is why 21,000 households are more than 6 months behind in payments and a further 7,000 have not made a payment in a year. They are stuck where they stand and little can be done about it.

And that is the way in which negative equity and arrears are perhaps more closely tied to one another than we often hear about, where one actually can cause the other.

Youtube version of the clip is available here

Prime Time did a show on the 15th of July about Negative Equity. Michael McGrath, Fianna Fáil, and Karl Deeter, Irish Mortgage Brokers, discuss the situation facing homeowners in negative equity