Defusing ‘The Mortgage Timebomb’

In this weekend’s Sunday Business Post, commentator David McWilliams has an article under the title “It’s time to defuse the mortgage timebomb”.  The piece concludes with:

“In addition, the longer this goes on, the more the banks become zombie banks incapable of breathing credit into the market.  A deal must be done right now.

The banks set aside €16 billion in the last capitalisation round to cover bank loans in the residential market.  Taking the total mortgage lending book of €112 billion, the implied total default on the entire book is where we are now in terms of arrears, 16 per cent.  However, not all these arrears will be total write-offs, so there is enough cash in the tank now to do a debt for equity at 50/50 right now.  The gives the punter a break and the bank an upside option over time.

But maybe the reason the banks have been tardy in moving – after all, they were dressed down by the Central Bank last week – is that they think €16 billion isn’t enough.  If it isn’t, we need to go back to Frankfurt and come up with a figure that covers all bases and say to the ECB: “We need more cash and you will have to cough up”.

We know the Germans need a success in Ireland.  We know that we can only have success if the total banking problem is solved, and we know that the pending mortgage crisis has not been addressed yet.

Wouldn’t it be sensible to put it all in one big bang solution?”

The trouble with “big bang” or soundbite solutions is that they are rarely effective for complex problems.  At the top-level it seems the problem in the residential mortgage crisis is simple – too much debt – but there are a number of subtle complexities that mean top-level solutions will be ineffective.

At the end of June this year, the total amount of residential mortgages in Ireland was just under €112 billion.  This is down from €119 billion in September 2009.

The banks did not “set aside €16 billion in the last capitalisation round to cover bank loans in the residential market”.  Table 9 on page 21 of the stress tests document from March 2011 shows that the consultants BlackRock Solutions estimated that the banks could make total lifetime losses of €10.2 billion on their Irish residential mortgage book in the adverse scenario.  The Central Bank took this total adverse scenario loss over the next two decades or so  and estimated that there would be €5.7 billion of losses in the three-year horizon used for the recapitalisation calculation. 

The stress tests included €5.7 billion for the recapitalisation of the banks due to losses on their owner-occupied mortgages in Ireland.  This is a long way from €16 billion.

Table 9 also shows that the €5.7 billion was 7.6% of the December 2010 loan book on which the loss estimates were based.  Assuming a conservation average recovery rate of 50% on the defaulted mortgages this means an estimated default rate of 15.2% on residential mortgages.

This 7.6% figure also means that the total amount of residential mortgages looked at the stress tests was just under €75 billion.  This is confirmed in Table 7 which puts the Irish owner-occupied mortgage book for the stress tests at €74.4 billion.  Separate data from the Central Bank show that there was €116.7 billion of owner-occupied mortgages outstanding in Ireland at the end of 2010.

This is one of the subtle complexities that can sometimes be ignored.  The March 2011 stress tests concerned only four banks – the four viable covered banks – BOI, AIB, PTSB and EBS.  The non-viable covered banks, Anglo and INBS, as well as all the non-covered banks such Ulster Bank, National Irish Bank, KBC and the now-defunct Bank of Scotland (Ireland) were excluded.  The stress tests also excluded sub-prime mortgage lenders such as Start Mortgages. 

One-third of the Irish residential mortgage market is outside the covered banks.  Any top-level solution must be applicable to both the covered and non-covered banks.

The solution proposed is that “there is enough cash in the tank now to do a debt for equity at 50/50 right now”.  Any debt-for-equity proposal has very little going for it as a solution to the mortgage crisis in Ireland.  The problem with it is that in the most severe cases there is no equity to swap for.  The most severe cases are those who are in the double bind of significant mortgage arrears and substantial negative equity.

Consider the case of an arrears household with a €300,000 mortgage outstanding on a house with an estimated value of €200,000.  Assume now that the bank does a debt-for-equity swap on €100,000 of the loan.  This involves the bank reducing the mortgage by €100,000 in return for 50% equity in the house (€100,000/€200,000 = 0.5).

This might improve the arrears situation as the household now needs to service a mortgage of €200,000.  However, the value of the asset supporting the loan has also fallen and 50% of the house means they have an asset worth €100,000.  The household are still €100,000 in negative equity.

In the original scenario, assuming no capital repayments on the €300,000 mortgage, they would need nominal house prices to rise by 50% (€200,000 x 1.5 = €300,000) to eliminate their negative equity. 

After the debt-for-equity swap with a €200,000 mortgage and a 50% stake in the house they would need nominal house prices to rise by 100% (0.5 x (€200,000 x 2) = €200,000) to eliminate their negative equity.

The question the household must answer before accepting this proposal is whether it better to repay €300,000 on an asset worth €200,000 or to repay €200,000 on an asset worth €100,000? 

In the first case every €100 of capital repaid gets them €66 of the asset.  In the second case every €100 of capital repaid gets them €50 of the asset.  Neither is great, and in time, nominal price growth would reduce this negative equity gap, but I know which one is better.

The only way a debt-for-equity swap can offer anything to these households is if it is not a debt-for-equity swap at all.  Assume instead that the bank writes down the mortgage by €200,000 in return for a 50% stake in the house. 

After this the household is left with a €100,000 mortgage and their 50% of the house is also worth €100,000.  They have no negative equity and a much smaller mortgage to service.  The household also gets 100% of the use of the house with only half the ownership so it is win-win-win for the household.

However, from the banks’ perspective a €200,000 asset has been written off the original mortgage and in return the bank has received a stake in the house worth €100,000.  The bank has paid €200,000 for something worth €100,000.  The bank is in negative equity.  Also unless they can charge rent, their 50% ownership stake is worth much less than €100,000. The bank will also be being interest on the €200,000 money used to “buy” this asset.  For the bank it is lose-lose-lose.

The banks are going to make substantial losses on the mortgages they provided during the boom years that are now unsustainable but this sort of 2 debt-for-1 equity swap is little more than debt forgiveness in fancy dress.

Cases between these two extremes can be considered such as a €150,000 mortgage reduction for a €100,000 stake in the house.  The is equivalent the 50/50 proposal suggested by McWilliams as it involves a 50% writedown in the mortgage in return for a 50% stake in the house. 

It is easy to work through the numbers for this as above and it would be seen that this proposal doesn’t eliminate the problems for the households and the banks but it does split them more evenly between them.  Most of the problems persist and in cases where there is no equity a debt-for-equity swap cannot solve them.

The key problem that needs to be addressed in the Irish mortgage crisis is the problem of unsustainable mortgages.  Writing almost a year ago I said:

The group that are in real danger are those who are in negative equity and in mortgage arrears. Using September 2011 house prices this group is estimated to be contain between 25,000 and 37,500 households. The deteriorating trend in house prices and mortgage arrears means the number of households in danger will increase.

However, it is likely that some people in this group will be able to get back on track but it is undeniable that there are many borrowers who have unsustainable mortgages – loans that will never be repaid.

Some commentators have claimed that there are 200,000 mortgages in serious trouble. There are not. There are many mortgages in some trouble, but there are probably around 20,000 to 30,000 households in serious trouble who need a dramatic intervention.

These unsustainable mortgages will never be repaid no matter what short-term forbearance measures are provided by the banks.  The losses on these mortgages need to be faced up to.  This can only be achieved in one of two ways:

1. The house is surrendered and the realisable value of the house is set against the mortgage balance.  There will be a shortfall, and in some cases it will be substantial, but it should written off in no more than two or three years and the person allowed make a fresh start.
2. The current mortgage is written down to a level the borrower can afford.

It is up to the banks to choose which of these options they use but they must use one of them because no matter how long they wait the money will not be repaid.  The losses are there and must be faced up to.

Option 1 involves repossessions but is objective and there is little doubt that repossessions will have to form a greater part to the solution of this crisis.  Option 2 is subjective and may distort the incentives for other participants in the market.  The non-covered banks can use whichever option they want but the covered banks must also take into account the owner of the capital that these losses will erode.

For people who are in arrears but who, in time, will be able to meet their mortgage commitments a suite of measures can be offered to help them.  These include relatively straight-forward things such as interest-only periods and term extensions etc. and more involved measures such as split- mortgages and debt-for-equity swaps for those in positive equity.  In many cases these will be sufficient to allow people to get back ‘on track’.

The key issues have got to be to reduce the pressure on those who are struggling with their mortgage repayments now and to identify those who have unsustainable mortgages which will never be repaid.  This is not easy and a “big bang” solution will not address the complexities involved.  Although written nearly 12 months ago the piece for the Irish Independent linked above highlights some of these complexities and is still relevant now.

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