Mortgage debt forgiveness is essential to recovery
Economists Constantin Gurdgiev, Brian Lucey, Stephen Kinsella, Ronan Lyons, Karl Deeter, Shane Whelan, David Madden, Brendan McElroy, Valerio Poti and John D Masson suggest a way to help mortgage defaulters
THE BURSTING of the boom has left tens of thousands with debts they will never be in a position to repay. These debts are poisoning the balance sheets of Ireland’s banks, preventing the emergence of an economic recovery, as well as causing untold social misery. As a society, we must face up to this.
Two main problems exist: first, hundreds of thousands of people now find themselves in negative equity, where the value of their primary residence is less than the loan secured on it; and second, more than 100,000 also find themselves in difficulty paying the interest costs on their personal home loans.
With house prices continuing to fall, interest rates set to rise, after-tax disposable income falling and unemployment remaining high, there is a massive socioeconomic problem to be addressed.
Current asking prices suggest that 200,000 households are in negative equity, the majority of 270,000 people who bought between 2005 and 2008. Figures from June show 36,000 mortgages were in arrears of three months or more, with collective arrears of just over half a billion euro. These figures do not account for tens of thousands who have renegotiated, switched to interest-only repayments or obtained a reduced repayment schedule for a period of time.
If house prices fall by 55 per cent from the peak, half of buyers in 2004 and a quarter of those in 2003 would enter negative equity and 200,000 households would face negative equity of more than €50,000 and there would more than likely be 60,000 households in arrears.
Their arrears of €10 billion would compare to total mortgage debt outstanding in the Republic of €115 billion. In the context of an overall bank bailout scheme of €50 billion and rising, it is relatively small but at the individual level and, equally importantly, at the level of the real economy, it is a very large problem indeed. We suggest that this makes full or partial debt forgiveness a viable consideration. From an economic perspective the key question is: how would partial debt forgiveness affect the Irish economy?
Individual households in debt do not spend, they do not invest: they attempt to pay down debt when and where they can and they hoard cash. Arrears and negative equity lead to reduced entrepreneurship in the long run, as distressed households face both less wealth against which to borrow and more uncertainty about their income and safety-net savings.
In Ireland this is compounded by the draconian, outdated and entirely inappropriate laws on personal bankruptcy, the lack of non- recourse mortgages and the effect bankruptcy judgments have on an individual’s ability to engage in business.
These cumulative economic effects can be tackled through a debt forgiveness mechanism. Banks must allow private home borrowers to revert to pre-crisis debt burdens. Ireland’s banks must acknowledge that current debt levels are unrealistic and that timely write-offs are necessary.
Unable to control the external value of our currency, we need to replicate the effects of a devaluation internally to regain international competitiveness. The problem with deflation (and we are experiencing a brand of it) is that as price levels fall, the pain of the debt increases. Generally a policy choice is to inflate the debt away, but in Ireland, we typically do not issue loans on long fixed rates so, even if we could devalue our currency, borrowers would still be crippled as rates shot up. In the long run, socially and economically, debt forgiveness is the best option.
Internationally, more advanced menus for systemic mortgage default crises cover a wide range of options. Successful debt resolution regimes set the cost of restructuring at levels where households’ ability to pay preserves the value to lenders, in excess of what can be achieved in an immediate foreclosure.
In the case of Ireland, such a formula would most likely lead to an implicit writedown of at least 30 per cent of the more recent mortgage amounts on average, yielding an expected total cost to the entire system of circa €37 billion to €49 billion.
In Ireland, there were two initial responses to the crisis. The Government forced banks into signing, then extending to February 2011, a moratorium on repossessions, meaning lenders must wait at least a year from the time arrears first arise before applying to the courts for a repossession order.
Privately, people have been exhausting their savings, and that of family and close friends, to stave off slipping into arrears. Both of these are stop-gap measures and new approaches are emerging.
Publicly, the Expert Group on Mortgage Arrears has proposed reforming bankruptcy and introducing non-judicial debt settlement. Privately, Ireland is seeing more and more “accidental landlords” as people rent out their home and either move back in with parents or become tenants elsewhere. These are, in the end, only temporary and partial measures.
We suggest that as there are three parties to the problem – the banks, the regulator (ie the State) and the individual – these three must also be part of the solution.
For persons in negative equity, or where the loan is so large that it is becoming distressed, we suggest some degree of individual debt forgiveness and restructuring.
There is an argument of moral hazard that must be addressed – if individuals do not suffer the consequences of their actions, then there is a reduced incentive for them and for others to behave in a sensible fashion. We argue that the existing levels of distress, plus the partial nature of the debt forgiveness help to mitigate this. People have already been burned and this lesson will not, it is to be hoped, be lost.
In addition, the banking and regulatory systems have collapsed and are in the process of being rebuilt. Central to the new systems must be a set of regulations, rigorously implemented, which prevent this problem from recurring and which will realign incentives properly to price risk in lending by shifting some of the burden off the shoulders of the borrowers and onto the lenders.
In order to implement this burden-sharing, a binding arbitration process needs to be put in place, to allocate the excess burden. In addition, we need urgent changes to the bankruptcy laws and to introduce the non-recourse mortgage option.
The request for entry into arbitration can be initiated by the borrower or lender. The arbitrators, which could be Mabs or some other independent organisation, would be empowered to determine either the allocation of any negative equity burden or to alter and adjust the mortgage terms.
For lenders who refuse to enter into arbitration, alterations to the mortgage code or ultimately the withdrawal of licence are appropriate responses. The public good is best served here by forcing the banks to take the great part of the losses for which they were responsible, not forcing the hard-pressed homeowners to take an unbearable burden into the future where they will inevitably buckle under the strain of repayment with disastrous social and economic consequences.
The losses that will be crystallised in the banks can be filled with additional Nama bonds – now that we have Nama, we may as well make some use of it. This will increase the interest burden on the taxpayer, or in the end perhaps on the ECB but we argue that, in the overall socioeconomic context, debt forgiveness to the maximum feasible extent is a first step to restoring the economy and society.
Dr Constantin Gurdgiev, lecturer in finance, TCD;
Prof Brian Lucey, school of business, TCD;
Dr Stephen Kinsella, lecturer in economics, University of Limerick;
Ronan Lyons, Oxford University and Daft.ie;
Karl Deeter, Irish Mortgage Brokers;
Dr Shane Whelan, actuary, UCD school of mathematical sciences;
Prof David Madden, school of economics, UCD;
Dr Brendan McElroy, department of economics, UCC;
Dr Valerio Poti, lecturer in finance, DCU;
John D Masson, lecturer in economics, UCC.