Tuesday, October 30, 2012

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.


  1. Hi Séamus

    McWilliams loves this type of magic wand solution. Here is what he said about the bank guarantee before it was announced

    "The beauty of guaranteeing deposits is that you use no money – not a penny. Instead, the government is using its sovereign credit as the country with Europe’s lowest debt/GDP level to restore confidence in the system. The civil service view appears to be that such a guarantee would subject Ireland to the risk that people withdraw money, disbelieving the state."

    Here is what he said after Brian Lenihan took his advice against the advice of his civil servants:

    "In time, Brian Lenihan’s move yesterday will be seen as a masterstroke and a practical blueprint for the new financial architecture which will emerge from this global crisis."

    A simplistic solution which led to disaster.

    The mortgage problem is a complex problem or complex series of problems.

    It is argued that wholesale debt forgiveness will put money into people's pockets which will stimulate the economy.

    But, someone has to pay for that debt forgiveness.

    The banks are zombies - but if we write down their assets further through unnecessary write-downs, they will be further zombiefied.

    Tracker loans are a huge problem for the banks - but they are great for the borrowers. Are we to give them the same write-downs as borrowers with SVR mortgages?

    McWilliams tries to simplify the problem and the solution for his audience. As a result, he is thinking in very simple terms himself. He ignores any of the complexities.

    Brian Lenihan faced a terrible decision in September 2008. There was no easy solution. Every option had its downsides and risks.

    Likewise there is no easy solution to the mortgage crisis and the struggling economy. It is unfair to struggling borrowers to pretend that there is.

    Brendan Burgess

  2. I think he is very entertaining, DMcW, but he really does fall down imo when he tries to use real figures to make a point.

    Solid post Séamus, I dare say the people who argue for widespread blanket writedowns haven't recognised that we don't own all the banks.

    I wonder what kind of leeweigh we actually have in BoI - practically none I wager. So it is probably (and I say probably loosely because the Government are loath to directly interfere) only 50% of mortgages the Government have some degree of control over.

    I really hope the next quarter arrears figures confirm the slowdown in people entering arrears that the last quarter's figures hinted at.

  3. Seamus

    Allow me to pick up on one point you make above.
    "But, someone has to pay for that debt forgiveness".

    It would be regrettable however if the only people who paid were owner-occupiers who were in difficulty with mortgaged property.
    The prospect of repossessing up to 30,000 houses and putting the occupants onto the road, if that is what the banks propose, would be met with stern resistance.
    You need also to consider the PIB bill and in particular the DSA or Debt Settlement Arrangement, designed for unsecured debt in excess of €20,000 with, as far as I can tell, no upper limit.
    Section 63 of the bill proposes in relation to DSA;

    "63.—(1) In formulating a proposal for a Debt Settlement Arrangement a personal insolvency practitioner shall, insofar as reasonably practicable, and having regard to the matters referred to in subsection (2), formulate the proposal on terms that will not require the debtor to dispose of an interest in or to cease to occupy his or her principal private residence and the personal insolvency practitioner shall consider any appropriate alternatives to such vacation. (2) The matters referred to in subsection (1) are
    (a) the costs likely to be incurred by the debtor by remaining in occupation of his or her principal private residence (including rent, mortgage loan repayments, insurance payments, owners’ management company service charges and contributions, taxes or other charges relating to ownership or occupation of the property imposed by or under statute, and necessary maintenance in respect of the principal private residence.

    As to what type of person would have been able to get an unsecured bank loan of up to €3million?

    S 99 Proposes the same restriction in relation to a Personal Insolvency Arrangement (PIA) for secured properties. PIA has an upper limit of €3 million.

    We should also ask why BTL properties in arrears cannot be tackled before owner occupier properties, as a matter of policy.
    In BTL repossession cases there should be no need to discommode tenants and there is no 'business' as such.
    One also gets the impression that many BTL landlords would still have 'equity' in the property portfolio but in fact are hanging on until the market turns and going interest only r not paying in the interim.

    My general point is that there is a lot of work to be going on with, before prioritising owner occupiers in arrears.

    1. Hi Joesph,

      It was the first comment from Brendan Burgess above that contained the quote "But, someone has to pay for that debt forgiveness." Maybe he will follow up on it.

      I don't think dealing with unsustainable mortgages is one of "putting the occupants onto the road". The priority has to be to keep people in 'a' home, it doesn't have to 'the' home.

      An unsustainable mortgages is one where the borrower is not going to get back on track no matter what forbearance measures are applied. These measures going from basic term extensions right up to split mortgages (and especially those with no interest charged on the warehoused component) can help a lot of people.

      As I said above one approach to dealing with completely unsustainable mortgages is to reduce the balance to a level that the borrower can sustain. There is nothing to stop any or all of the banks doing this now.

      As suggested, another approach is for the borrower to surrender the house with the mortgage shortfall quickly written off. They have the option to rent suitably sized and located accommodation for their needs. If they cannot afford to rent it is very hard to see how they would be able to pay a mortgage. These people would not be put onto the road.

      This year the government will spend €450 million on Rent Supplement. Local authority expenditure on housing is also significant. The expansion of mortgage-to-rent schemes with housing agencies can also be expanded.

      These people are in severe difficulty and something needs to be done for them. I would make this group the priority. Removing the burden of an unpayable mortgage from them and allowing them to make a fresh start would be a big step forward.

      I am all for forbearance measures that will allow people to keep their homes. Some of these will cost money in the short run but will be beneficial in the long run. However, I don't know any country that allowed unsustainable mortgages to continue. Unsustainable mortgages are almost always foreclosed.

      There has been some coverage recently given to what the US did in the 1930s. For example, in a follow-up piece our friend from the post above wrote

      "In the US in the 1930s they introduced a scheme whereby the bank and the individual did a deal. The person's mortgage was reduced and the bank was compensated by being offered half of the potential equity in the house, so that when the house is eventually sold in 10 or 15 years, the bank get first call on half the value of the house."

      The US introduced no such scheme. They established the Home Owners Loan Corporation (HOLC) which took on just over 1 million home mortgages (10% of non-farm residential properties). The primary aim was forbearance through reduced interest rates and term extensions. The HOLC offered no principal forgiveness and most loans were bought from the banks at par (with bonds paying a certain 4% rather than the 6% the banks were hoping to get from the mortgages).

      The HOLC only bought loans for up to 80% of the appraised value of the property. The HOLC did not accept loans with a higher LTV relative to its valuation and offered little for borrowers in negative equity. The banks could accept the HOLC's offer of a bond of 80% of the appraised value but, in the case of a higher market price it would be in the bank's interest to foreclose themselves and try to realise that market price. The average LTV to the appraised value of the loans transferred to the HOLC was 69%.

      Anyway, the HOLC took on just over one million of these loans and provided the borrowers with lower interest rates and longer terms.

      Of these one million loans the HOLC foreclosed and repossessed the property in 200,000 cases. This was around 2% of all non-farm residential properties in the US at the time.

  4. Seamus

    Thanks for reply and apologies for attributing the quote to yourself.
    "These people are in severe difficulty and something needs to be done for them. I would make this group the priority. Removing the burden of an unpayable mortgage from them and allowing them to make a fresh start would be a big step forward."

    Agreed on that. But why not a ownership to rent scheme.
    After all the State will end up giving rental subsidy to a private landlord, if the existing owners are moved from the property.
    It sounds to me that such an ownership to rent policy would achieve the objective of mortgage resolution (at an agreed valuation between bank and State), while allowing the occupant to remain and pay rent to the State. In addition all the disruption of to family/school/work/ childminders/and importantly extended family and social involvement would be avoided.

    What I cannot understand, and it seems neither can most people, is why BTLs are not being dealt with. According to Table 7 of the report you linked to above BTL mortgages accounted for 23.2B as against owner occupied of 74.4B or about 25% of covered bank mortgages. What is the problem with repossessing these properties?

    It is difficult not to have the suspicion that these are not being dealt with until the PIB and specifically the DSA piece of that legislation is in place. Why you may ask?
    Because if a landlord is left with a residual debt of say €5 million after disposal of the mortgaged BTL properties, then the DSA will allow that person to continue to not only live in their own house,possibly unmortgaged, but to continue to discharge 'reasonable' expenses in the course of both their work and and personal/family lives.

    Personally I do not wish to see people impoverished, but that section with an unlimited DSA unsecured ceiling is not being designed for people on minimum, average, or indeed slightly above average wage. And possibly for people who gambled, not on property, but on shares, including bank shares etc.

    1. Hi Joseph,

      I think you are right that a mortgage-to-rent scheme has a lot going for it. This could be achieved by ramping up the Housing Finance Agency. This proposal was in the Keane report and some trial-outs have been undertaken. This can be a useful solution for many of those with unsustainable mortgages, provided the property is suitable for their needs.

      It can help the most pressing cases but it must be accompanied with a quick write-off of the outstanding balance once the property is bought by a housing association.

      The buy-to-let sector is a mess but it is hard to know what is really going on. Distress in the BTL sector is not the same as in the owner-occupied sector. For BTL mortgages the key is whether the rental income is greater than the sum of mortgage interest, maintenance costs, taxes and charges. Repaying capital is akin to saving.

      Although arrears in the BTL sector remain high it would be useful to know how many of the properties are generating income above the costs. This could be shown with figures on how many investment mortgages are not having the interest paid. If the interest is being paid on an investment mortgage I would not consider it in distress.

      This would not suit the banks would who prefer to have full mortgage payments made. The arrears are probably based on contracts with payments for the interest and capital to be repaid.

      I cannot see how the rental sector is in mass distress. The number of household renting from private landlords rose from 145,000 in Census 2006 to 305,000 in Census 2011. If a BTL investor has a property to rent they should be able to do so.

      It is also the case that many of these will have tracker rate mortgages. These will be at very low rates and will be a further disincentive to repay capital. Why would an investor repay capital borrowed at less than 2% when they can put that money on deposit at more than 3%?

      And there are tax advantages to not repaying the capital on an investment mortgage. Under current rules 75% of the mortgage interest can be offset against rental income for Income Tax purposes. Lower interest means a higher income tax bill.

      Figures for the NPPR show that most are "small" landlords (noting the some of the people in the first category here will be owners of holiday homes rather than landlords).

      1 property: 99,000 people
      2 - 10 properties: 35,000
      11 - 20 properties: 970
      21 - 30 properties: 230
      31 - 40 properties: 100

      I think the main problem with the BTL sector, and this is only a guess, is that the banks cannot get the landlords to make capital repayments. There will be some cases where the rent does not cover the costs (interest + maintenance) and others where negative equity may erode the willingness to pay of the borrower but in many cases I do not think arrears equals severe distress.

      The banks would like to commandeer the rent to force capital and interest repayments. There may be attempts through the courts to force this. The problem now will be the motivation of the landlords to actively manage the property as the profit will now be going to repay a mortgage (that they don't want to repay) rather then to them.

  5. @Seamus

    Some very interesting thoughts, particularly on the BTL sector. Many thanks.

  6. "In the US in the 1930s they introduced a scheme whereby the bank and the individual did a deal. The person's mortgage was reduced and the bank was compensated by being offered half of the potential equity in the house, so that when the house is eventually sold in 10 or 15 years, the bank get first call on half the value of the house."

    The US introduced no such scheme.


    Surely there must have been such a scheme. David McWilliams hardly made it up!

  7. I have emailed McWilliams to clarify this, but he has not replied yet.

    On McWilliams own site, a user has posted the following, but again, McWilliams has not yet responded:


    "Pat Flannery says:
    November 4, 2012 at 8:33 pm


    Debt-For-Equity Swaps between banks and individuals in the U.S.?

    You write: “In the US in the 1930s they introduced a scheme whereby the bank and the individual did a deal. The person’s mortgage was reduced and the bank was compensated by being offered half of the potential equity in the house, so that when the house is eventually sold in 10 or 15 years, the bank get first call on half the value of the house.”

    I never heard of such a U.S. “scheme” in the 1930s or any other time for that matter. Where did you pull that one from? Do you have any references to back it up? The only bank related debt-for-equity deals I ever heard of in the U.S. involved businesses, never private individuals.

    You better back this claim up or I will seriously begin to doubt your entire credibility and move on.

  8. As a possible alternative, using the example of the 300,000 loan against a house valued at 200,000; the loan could be written down to 200,000 but the bank only takes an equity piece on any value subsequently crystallised over the 200,000 level (but capped at 300,000). The bank now has a loan matched with an asset (albeit at 100% LTV) and some prospect that there will be a gain in future. The householder can now afford to pay down his mortgage and is free to sell should he wish to do so (to the extent that he sold below 200,000 he would not be able to walk away from that element of the negative equity - i.e this is a one-off deal).

    I am well aware that this doesn't scenario doesn't deal with all of the issues (AIB vs BOI; moral hazard etc etc) but worth some thought?

    1. This does not make much sense for the banks. If they want to take a bet on the future value of property they should just buy some.

      If someone has a house now worth €200,000 and offered you the same option, how much would you pay? How much would you pay to have a call on any upside between €200,000 and €300,000 in a possible subsequent sale?

      If I was such a homeowner offered this, and not tied in some to the house in question, I would sell for €200,000 as soon as the writedown has been applied and use the money to fully pay-off the mortgage. The bank's option would have generated a zero return and I would have had €100,000 of debt written off.

      If I wished I could then buy a similar house for €200,000. I would have incurred transactions costs but I would own the same house without any call on the rise in value above €200,000.

      Even if a sale was prevented for a number of years I doubt the option you describe would be worth much. The house might never be sold by the current owners and it could be 50 years, or more, until their passing means the claim can be made against their estate.

      Let's assume the option is worth €20,000 (which is probably a bit high). At this valuation the bank would be indifferent between writing off €100,000 of debt in return for the option and simply writing off €80,000 of debt for nothing. Because of the complications it introduces the bank should simply write-off the debt rather then accept the option.

      There have been property/housing/credit crashes right around the world. If the solutions which get a lot of airtime in Ireland were effective in resolving such a crisis there would be examples and instances that could be cited of their use; in most cases there is none.

      We face a crisis that other countries have and are going through. What has been used is forbearance for those with sustainable mortgages and foreclosure for those with unsustainable mortgages. The forbearance measures are relatively simply such as interest rate reductions, outright interest forbearance, term extensions etc. The foreclosures can be repossessions but can also involve mortgage-to-rent solutions via housing agencies.

      In the US 1 million houses were foreclosed on in 2010 and 800,000 in 2011. The figures for the UK were 40,000 and 35,000.

      Translated in Irish terms the US figure for 2011 would imply 12,000 repossessions in the year. The UK figure would be the equivalent of around 3,000 repossessions a year here. In Ireland there was 600 repossessions last year and nearly two-thirds of them were voluntary. The rate here is one-fifth that of the UK and one-twentieth that of the US.