Mortgage debt move a brave if unorthodox fiscal decision

BUSINESS OPINION:Forgiveness will need agreement from 75% of secured creditors, which will mean the banks

THE DECISION by the Government to include mortgage debt in its proposed insolvency regime is as welcome as it was unexpected.

What was surprising about the move is that it goes against conventional financial wisdom which sees the forgiving of secured debt in anything other than the most extreme of circumstances as the road to fiscal perdition.

Banking is based on people repaying their debt and believing that the consequences of not repaying them are always worse than the pain of meeting repayments.

This, in a nutshell, is the argument being made for the State honouring the debts of Anglo Irish Bank. If you applied this logic to domestic personal debt, then allowing an estimated 30,000 walk away from at least some of their secured debts could undermine an already fragile banking system.

If you accept this argument, it is a brave move indeed to introduce State-brokered debt forgiveness. Even if you don’t accept the argument it’s still a brave move because you are flying in the face of banking and financial orthodoxy.

Interestingly, the last time the Government was faced with such a choice – the issue of upward only rent reviews – it went with the orthodox view that what was good for banks and financial institutions (and the National Asset Management Agency) was good for taxpayers and not what was good for businesses employing thousands.

This time around there appears to have been a victory for common sense. The short-term compassionate arguments and long-term economic arguments for debt forgiveness seem to have outweighed the apocalyptic warnings of the banks.

That is not to say, however, that the banks have been totally overruled in this matter. Any forgiveness of debt under the proposed personal insolvency arrangements will require the agreement of 75 per cent of secured creditors, which in most cases will mean the banks.

Thus it remains within the banks’ power to stymie the whole initiative by simply refusing to agree to any six-year personal insolvency arrangements (PIA) that involve the writedown of mortgage debt.

If the Government’s plan is going to work, the banks must play ball.

The good news in this regard is that the Government owns the banks or has a strong hold over them via their dependence on Central Bank funds. The bad news, however, is that the Government owns the banks or stands behind them.

The Government can and no doubt will try moral suasion to get the banks to co-operate. It will be interesting to see how they get on.

They can also try reason and enlightened self-interest. The banks desperately need to put some sort of certainty around the potential losses in their mortgage books in order to give credibility to their balance sheets.

Agreeing PIAs with 30,000 or so hapless souls will not in and of itself do that. But it will provide a baseline for the thousands of other deals the banks will have to cut over the next few years as the overborrowed run out of road.

This in turn allows the mortgage books to be priced, restructured, sold or hived off into a run-down vehicle or otherwise dealt with.

Another reason for the banks to co-operate is that they have already put money aside to meet mortgage losses.

John Moran, head of the banking section at the Department of Finance, said last week that the banks had the capital to meet €5.8 billion of estimated mortgage losses following last year’s stress tests and the subsequent recapitalisations where the cash mostly came from the State.

Those losses were calculated on the basis of banks eventually having to bring an end to the existing policy of forbearance and in the process force respossesions and bankruptcies. By doing case-by-case deals with some debt forgiveness, they could end up with a bill well short of €5.8 billion, he said.

The danger, of course, is that once the banks go down the road of widespread forgiveness of mortgage debt, they may be taken somewhere they and the Government do not want to go.

What if the losses are bigger than was thought? What if the banks’ worst fears about perverse incentives and moral hazard prove to be well founded?

Well, then the banks may require even more capital than the €5.8 billion allowed for under the current programme agreed with the troika.

This would put further – and possibly unsustainable – pressure on the national finances and undermine much of the progress made over the last year towards fiscal rehabilitation.

There is a real, but at the same time, unquantifiable risk that State-sponsored debt forgiveness will set in train a course of events that will spiral out of control.

This might well stay the Government’s hand if push comes to shove and it has to force the banks to engage in the new insolvency process.