Thursday, November 11, 2010

Mortgage Debt Forgiveness

The Irish Times carries an article today signed by 11 economists (including two affiliated to UCC) on the topic of debt forgiveness for mortgage holders.  I was asked to sign my name to the article but did not.

Here is my reply to a post by one of the signatories earlier in the week.  It is below the fold.

Hi Stephen,

I can agree to some extent with the problem you are diagnosing here but I cannot agree with the proposed cure. Apologies for the length. I should have escaped to bed before Vincent Browne came on. It is possible the empty rhetoric there got me even more worked up!

You are right, that this has very little to do with moral hazard, as it is usually defined. Those who are facing a mountain a debt are unlikely to want to be in this gut-churning situation again, while those who have avoided the debt glut this time around are unlikely to be encouraged to over-borrow because of a partial debt-forgiveness scheme in this instance.

So if moral hazard is not the problem, how else could one oppose a partial debt-forgiveness scheme?

It is clear we face the real prospect of a mortgage meltdown as this crisis prolongs. However, a mortgage is a long-term agreement (25 years plus) and most of those in negative equity are in the early part of these contracts. They expected to be able to pay back the full amount (plus interest) over the full life of the contract, but obviously are in severe difficulty meeting these repayments now.

While there are people struggling to pay their mortgages, there are many, many people who are meeting their mortgage obligations (and maybe even overpaying). Per Central Bank data there was €124.7 billion of loans for house purchase outstanding to Irish households in January 2008. The most recent figures (Sep 2010) show that this has reduced to €107.8 billion. This is a substantial reduction in just 2.75 years.

Some of this may be due to write-downs and revaluations, but I suggest that the vast majority of this is due to people paying off their mortgages. With a savings rate of 12% this is where the money is being put. Obviously, this is only being done by people who are in a surplus-income position to do so, but there are many people out there meeting their mortgages and we have to assume that many of these people are reducing their negative equity position because of this.

Should these people, who have borne the cost of their mortgages, lose out simply because they have committed their money to paying their mortgages rather than using it elsewhere? Can we equitably discriminate between those people who have met their mortgages payments and those people who have not?

What about those people who saved a large deposit to begin with for a house purchase and have repaid their mortgage since to the extent that they have reduced the negative equity they face? Can we fairly ask them to pay the mortgage of their neighbour who took out a 110% loan and has only being making interest-only payments?

I cannot also see how this scheme will have much of a positive effect on economic growth. As the figures suggest there are thousands of people who are not paying their mortgages. They are committing little, if any, of their income to their mortgage. If some or all of their mortgage is annulled this does not give them any extra money for consumption. They have gone from spending no money on a huge mortgage to no money on a not-so-huge mortgage. Where is the consumption gain from these people? Should we give them some spending money as well?

If there is to be a consumption gain, it will only be from those people who are paying their mortgage to begin with, but benefit from a reduced payment to a partially-forgiven mortgage. Why would be want to forgive the mortgages of those people who are actually meeting their mortgage payments? This might be placing a huge burden on them, but should we forgive their debt because we think they made a mistake and we feel sorry for them?

As I said right at the start [way up there and they end is still way down there!] I do agree that we face a potential mortgage meltdown but I would be opposed to forgiving billions of euro of mortgage debt and adding it to our mounting national debt. Like Nat proposed above, I see the merit in some form of ‘clawback’, but Nat’s suggestion only comes into play if the house is subsequently sold. Again why should we discriminate between people who sell their house versus those who don’t?

Do we know how much money is involved? Per latest released statistics to the end of June there was €6.9 billion on mortgage balances that were in arrears of 90 days or more. This is not small beer. There is probably a comparable amount being paid on an interest-only basis. This figure is not available. And this is only those are not meeting their repayments.

The proposed scheme is for those in negative equity which is likely to be a multiple of this. A debt-forgiveness scheme could see €15 billion (a complete guess on my part) transferred to the national debt with an accompanying €1 billion per annum interest payment. It would take more than promissory notes to creatively account our way out of that one.

My suggestion would not be a debt-forgiveness scheme where the State assumes the burden of the principle and interest payments of a portion of someone’s mortgage. In my view, someone has taken out a mortgage so it should be that every effort is made to ensure that they pay it back. I suggest that if we need to help people with mortgage debt in the current crisis, that the state assume the interest cost of a portion of the mortgage.

So using your example of the €600,000 mortgage. I would split this loan into two. Say €300,000 remains with the mortgage holder and they make principle and interest payments on this over an agreed term. The other €300,000 is split away and the State covers the interest payments on this loan – and only the interest payments!

The scheme lasts for a certain period, possibly anything from say 5-10 years. At the end of the period, the €300,000 is added to the outstanding balance of the mortgage that remained with the householder and they resume full repayments. By that stage, it is likely that inflation will have reduced the real value of this debt and hopefully the householder will be in a better position to meet the mortgage obligations they signed up to. In essence, this is what the current benefit of mortgage interest relief does but this scheme is much more explicit.

Using the, admittedly back of the envelope, aggregate numbers outlined above, this would impose an annual €1 billion interest cost on the State. It could be less as most mortgages are at lower rates than the State can borrow! This would be a substantial cost but we would avoid the €15 billion principle cost as we transfer the principle back to the original mortgage holder at the end of the scheme. There is a pre-determined stop on the period for which this interest cost must be carried, whereas the full debt-forgiveness scheme can see this cost carried in perpetuity.

This scaled-down or temporary debt-forgiveness scheme offers some short-term benefit to those currently in dire straits. It is essentially a zero-interest offer for a number of years that would give them a manageable repayment on the remaining debt. There may even be a consumption gain if the repayments of some of those who enter the scheme is below their existing payments. Of course, these people may save this amount in expectation of the returning debt amount, but if they can afford to save this money they probably weren’t in such a bad spot to begin with.

I have not given sufficient thought to how entry to the scheme would be administered. How would entry to your proposed debt-forgiveness scheme work?

Per your last paragraph, I cannot see how the benefits of a debt-forgiveness scheme can exceed the costs. In fact, where are the benefits? We cannot magic away the debt. We will not have “a large swathe of Irish society out of debt”. We will simply have transferred individual private debt to social public debt that Irish society still carries. The country will still have the same aggregate debt burden but we will have just changed who will have to pay it. Any increase in spending by those who benefit from the scheme will have to be offset by increased (future) taxation on those who have to pay for it. We have assumed the gambling debts of our developers into the national debt and I cannot see that working out too well for us.

Of course, we could renege on the debt entirely and “burn the bondholders!!” You might be able to sell me that one. But paying someone else’s mortgage. No thanks. Thanks, though, for raising an important issue and stoking debate. It is very necessary.

1 comment:

  1. Seamus

    I cannot understand how a shared ownership is not considered for people who are in involuntary default on mortgages.
    A simple scheme. The banks take a 25% hit on the full loan.The remaining 75% is divided equally between the State and the owner/Bank mortgage.
    The owner pays full revised mortgage to bank for his now 50% ownership on house. The State charges interest only as rent on the other half.A scheme like this would remove the terrible human cost of eviction etc and would also remove the accusation that people got away with it. There would be a cost to the State but it would be far less than the cost of eviction and rehousing the tenant at State expense.
    If the house is sold, the State owns 50% and get 50% of proceeds.

    Despite the fact that Shared ownership schemes were quite common in the UK in 1990s, I have not heard of these even being discussed as an option to the impending mortgage disaster. Made more disastrous by the USC/Tax hikes this month.