State must not bank on bailout of bad mortgages
OPINION:GROWING UP beside the seaside, one becomes familiar with the sea and its actions. One thing that becomes clear is that while the first wave of a storm may do great damage, it is the subsequent waves that complete the destruction, writes BRIAN LUCEY
Irish banks are on the rocks, badly damaged by the wave of losses on commercial and speculative property lending. What is now evident is that a second wave of losses is heading towards them. While this is likely to be lesser in magnitude than the first wave, the system is so compromised that it is much less able to take a blow.
There are two interrelated problems. First, we have negative equity, where borrowers have outstanding a mortgage loan greater than the value of the property on which it is secured. A second problem is that of stressed mortgages, where individuals find it hard to meet the repayments on mortgages, whether they are in negative equity or not. Facing into at least another year of depressed economic activity, increases in unemployment, decreases in real wages and increases in interest rates, this problem will only grow.
So what is the extent of the problem of negative equity? Part of the problem is that we do not (officially) know. Despite the importance of property in the Irish psyche and economy, it is startling that there are no good property price indices available.
In a classic case of the law of unintended consequences, the Data Protection Act appears to prevent estate agents from supplying details of sales to third parties. No authoritative database of property transactions is available, which leads to inference being our only guide.
Two excellent works from different perspectives, using overlapping but distinct sources, have recently suggested that as of the third quarter of 2009, 130,000-150,000 households were in negative equity. Ronan Lyons suggests the lower figure, while David Duffy of the ESRI suggests the higher one. These figures are now almost certainly higher, so we could be looking at 200,000 borrowers whose mortgages are greater than the value of their homes. That is one in seven households. These papers point out two other issues – the greatest problem is in first-time buyers who purchased from 2004 onwards and the problem is compounded for up to 50,000 people who face both negative equity and unemployment. It is heartening to see that the Government, or at least Eamon Ryan, is now suggesting that “something must be done”. What is clear is that the Government has no moral authority to ignore the issue.
Apart from its political duty, a Government that has presided over successive attempts to allow the providers of risk capital to the banks to escape the consequences of failure has no moral right to say to thousands of small-scale borrowers that they are less important and no help will be extended.
What appears from the musings of Ryan is that persons in stressed mortgages would be given some sort of payment holiday, or that a Nama arrangement for them, whereby Nama II would take over part of the loan, might be arranged. Laudable as this is, there are several interlinked problems that need to be sorted before any solution is put in place. Top of the list is a need for more timely and accurate data. Beyond that other issues lurk.
The first problem is one of moral hazard. Moral hazard is where an incentive is created for people to act imprudently. Borrowers took out mortgages that in many cases were far too high for them to repay under any realistic circumstance. While it is true that lax regulation, estate agent hyping, bank loan pushing and a general bubble mentality left many with a feeling that they had no choice but to so borrow, the fact remains that bailing them out causes problems.
Any bailout, no matter how socially desirable and no matter how structured, will involve transfers from persons who did not borrow excessively to those that did.
There is then less of an incentive for the prudent to remain prudent in future, as a precedent has been set. This is not to say that we can or should on economic or moral grounds ignore the massive looming plight, it is to recognise that we need to structure the rescue in such a way as to mitigate this and other issues.
A populist solution might be to say that the banks must take the pain. After all, they were the ones doing the lending and should have known better. As of the end of 2009, there was something of the order of €75 billion outstanding in residential mortgages, the vast majority owed to the guaranteed banks. If only 10 per cent of this is ultimately likely to be lost, then that is another €7.5 billion of losses that the Irish banking system will have to absorb. It cannot do this and face its other losses without massive State intervention, nationalisation in effect. And again there is a transfer issue.
A payment holiday or any other solution which interrupts the flow of income from the mortgages runs into other difficulties. First, it merely defers the problem.
Lurking in the mind of those that propose this may be a feeling that the housing market will turn up, and that the increased debt will eventually be eroded by increases in value of the housing stock. This assumption is subject to severe challenges, but a further problem may arise in regard to securitisation.
In December, a plan to offer Italian homeowners a payment holiday was queried by ratings agencies. Mortgages are typically pooled and the income stream used as collateral by the banks to obtain funding for other lending. Any move that resulted in the downgrading of these flows would impair the banks’ ability to raise this funding and further tighten borrowing conditions for business.
What then about people “walking away” from negative equity? Apart from the issues of the banks’ ability to bear the losses, the effect on securitisation and the social issues, this would ultimately result in the mortgagee becoming bankrupt.
It is generally recognised (without much being done about it) that our personal bankruptcy laws are archaic and unsuited to a modern economy. Without widescale reform, this option would result in a generation of persons unable to access credit and with a major stain on their personal record.
No easy solutions present themselves. It is good that Ryan is at least talking about the problem, but we have seen from this Government that recognition of a problem in banking and swift action is not its strong suit.
It is to be hoped that facing this second wave swifter action will be taken, before the third wave, of distressed personal non-mortgage credit, rolls over the hulk of the Irish banking system.
Brian Lucey is associate professor of finance at the school of business studies in Trinity College Dublin and a research associate at the TCD Institute for International Integration Studies