Anatomy of a Repossession Case

For the past few years the escalating mortgage crisis has been analysed using aggregate figures for mortgage arrears published by the Financial Regulator’s Office in the Central Bank.  The latest figures show that there are around 80,000 households in mortgage arrears of 90 days or more. 

In virtually all cases we have no insight into the individual circumstances behind these figures but occasionally there is a specific case that catches media attention and provides a snapshot of the hidden details.  One such instance arose this week with the efforts of the Cork County Sheriff, Sinead McNamara, to effect a repossession order granted by the High Court for a home in Kanturk.

From the details the borrowers have provided to journalists and various media outlets we can try to piece together the anatomy of a particular repossession case.

The borrowers bought the house in April 2007 and took out a mortgage with Permanent TSB for €150,000.  They made payments on this loan and by 2009 the balance was reduced to €146,000.

In 2009, they remortgaged the house with Start Mortgages increasing the loan to €180,000 and used the extra €34,000 borrowed to pay business debts in the husband’s plumbing enterprise which had gotten into difficulty.

The borrowers have said that they made payments to Start Mortgages for 12-18 months but began to fall into arrears in 2010 and haven’t made any payment for "about two years”.   Start Mortgages issued legal proceedings against the borrower in December 2010, and a repossession order was made in March 2013, almost two and a half years after proceedings were issued.  The borrower did not attend court and the order was granted uncontested.  The order was renewed on May 22nd last.

At some point the borrower made an offer to Start Mortgages to pay €150 a month "as a feeler" but no payments were made.  A subsequent offer to repay €400 a month was made though it is not stated when this offer was made.  Again no actual payments were made.

The county sheriff issued a formal repossession notice two weeks ago and attempted to carry out the court order on Wednesday afternoon but left because of the presence of a group of protestors. 

If this is actually the reality of the situation then almost all of the evidence points to a repossession being the logical conclusion of this mortgage arrears case.  The mortgage is unsustainable and should be ended.

The borrower had a loan with a prime mortgage provider in PTSB.  They sought a remortgage to release equity from their home to pay some business debts.  Presumably because of problems with their credit history they could not get the remortgage with PTSB or another prime lender.

They turned to sub-prime lender Start Mortgages for the remortgage but this would undoubtedly have meant a higher interest rate.  If the interest rate on their existing borrowings went up by two percentage points that would have meant an increase in their interest bill of almost €3,000 for €146,000 they had already borrowed from PTSB but then remortgaged with Start Mortgages.

The purpose of the remortgage was to get an additional €34,000 to pay business debts but in order to get this money they had to accept a much higher interest rate on all their mortgage debt. 

Assuming an interest rate of 6% on the loan from Start Mortgages the interest cost of the extra money borrowed would have been around €2,000 per year.  This means the borrower signed up to pay an extra €5,000 a year in interest to borrow an extra €34,000, implying an effective interest rate on the additional borrowing of around 15%.

There was probably genuine intent when paying the business debts but the interest cost of doing was very large and the prolonged recession has undoubtedly hindered their ability to pay.   However, it is difficult to make a case that the mortgage lender should be the one left carrying the loss of the collapse of the plumbing business.

Start Mortgages was formed by four Irish business people in 2004 and ultimately came to be 100% owned by the South African bank, Investec through an initial investment in Start by the UK sub-prime lender, Kensington Mortgages, a subsidiary of Investec.

As it is foreign-owned Start Mortgages has received no money from the Irish government as part of the bank bailout and, because it is no longer lending in the Irish market, it is not subject to the Mortgage Arrears Resolution Targets (MART) set this year by the Central Bank.

The clearly stated objective of recently-appointed Start Mortgages CEO, Alan Casey, is to maximise the current value of the loan book from the legacy of the boom where over half of all loans are delinquent.  Start Mortgages is under no obligation to offer term extensions, split mortgages or reduced interest rates on its loans.  Of all the lenders with mortgage arrears, Start Mortgages has been the most aggressive in seeking repossession orders, but is doing so within the law. 

Start Mortgages signed a contract with the borrower and they are entitled to have the terms of the contract adhered to.  In this case there is nothing to indicate that Start Mortgages have broken any terms of the loan agreement.

The borrowers agreed to the loan from Start Mortgages in 2009 but it only took until December 2010 for Start to be a position to issue court proceedings.  Under the Code of Conduct on Mortgage Arrears that was in operation at the time lenders had to wait for 12 months after a loan fell into arrears before they could issue court proceedings.  All borrowers who cooperated with their lenders were entitled to this 12-month stay.

A borrower was deemed non-cooperative if they failed to make a disclosure of their financial position or failed to provide financial information sought by the lender or failed to respond to communication from the lender during a three-month period when full payments were not made.  The level of engagement from the borrower in order to be considered ‘cooperating’ was very low.

Given that Start Mortgages were able to issue legal proceedings in December 2010 it is clear that the borrowers were not cooperating unless they began to default on the loan almost as soon as it was drawn down.

As an aside it should be noted that this mortgage was not subject to the lacuna in the law that resulted from the ‘Dunne Judgement’.  This ruling prevented repossession orders being issued against mortgages issued before 1st January 2009 if the proceedings had not been issued before that date.  As the mortgage in question here was issued after 1st January 2009 it was not subject to this ruling.

There is little to suggest that the cooperation from the borrower improved after court proceedings were issued.  The borrower made an offer to repay €150 a month which wouldn’t even come near to covering the interest on a debt of €180,000, but has acknowledged that this offer was made “as a feeler”.

At an interest rate of 6%, the annual interest bill on an loan of €180,000 would be €10,800 a year or €900 a month.  With a payment of €150 a month the loan balance would increase each year by €8,000.  To actually repay the mortgage over a 20-year term a monthly payment of around €1,300 is required. 

It seems that no payment has been made on the mortgage for “about two years” and possibly since the repossession proceedings were issued in December 2010.  An improved offer of €400 a month was made but absent any actual repayment the offer does not mean a whole lot.

But even a payment of €400 a month would not make this loan sustainable.  If the interest rate was zero it would take nearly 40 years to repay €180,000 at €400 a month.  Lenders to not give money with zero interest and particularly not sub-prime mortgage lenders.

No landlord would be expected to accept a payment that was a third of the agreed rent and such offers made by tenant are unlikely to get the support of protest groups. Tenants who fail to pay their rent have their tenancy agreement terminated.

The proposed €400 payment would be less than half the interest amount at a rate of 6%.  Any credible offer has to get close to covering the interest and offer a possibility of the capital being repaid.  If €400 was paid on a €180,000 loan at 6% each month the balance would go from €180,000 to €210,000 after four years.   

The repayment offers made by the borrower in this case would not be considered credible by any lender and particularly not one that is as aggressive as Start Mortgages.  The optimum solution in this instance is for Start Mortgages to take possession of the house and offset its value against the outstanding loan.  If there is any shortfall, agreement should be reached to write this off in a short period of time.

If €400 per month is the most that the borrower can offer then there is no prospect of making a loan with a €900 monthly interest bill sustainable and it should be ended.  A situation where somebody has spent three years in a house without paying anything and with little prospect of getting back on track cannot continue.  The family will have to move to suitable accommodation that they can afford.

Repossession must be the last resort with any mortgage arrears case.  In the majority of cases it will be possible to get borrowers on sustainable repayments through term extensions, split mortgages and interest-rate reductions that allow the loan to be repaid. 

However, there will be a minority of cases where the numbers just don’t stack up.  This is an example where that is clearly the case.  If the term was set at 30 years and the interest put at 3.5%, a loan of €180,000 could be repaid with monthly repayments of €800.  That is still twice what the borrowers have offered. With nothing paid for the past few years the accumulated interest has probably already pushed the outstanding amount close to €200,000 meaning an even larger payment would be required.

By thinking that a partial interest payment is credible the borrower is ignoring the reality that this will just see them smothered under an ever-growing mountain of debt.  They need to get rid of the debt and make a fresh start.  This will mean conceding possession of their home.  This is a traumatic event and the use of a €110,000 deposit and the time of purchase makes the loss appear even greater. 

Start Mortgages will also incur a loss from their lending as the repossessed property will only provide a partial repayment of the debt.  They should not be allowed to pursue any shortfall indefinitely.  They lent money to someone who can’t pay it back and have to accept the losses resulting from that.

How many of the arrears households are in the same situation as this?  It is impossible to know.  It is definitely in the thousands.  Many will be with lenders who are not as aggressive as Start Mortgages who have a myopic perspective of trying to disengage from Ireland.   Start Mortgages are willing to absorb the upfront cost of repossession rather than adopt a wait and see strategy.

Other lenders will take a more long-term perspective and will be more amenable to split mortgages and interest-rate reductions.  But these are not useful options in cases such as this where the borrower can only afford a monthly payment that is less than half of the monthly interest. 

When the repayment potential is low and there is little prospect of an improvement the mortgage should be ended with all sides accepting a share of the costs that such an outcome entails.  The costs of allowing an unsustainable mortgage to continue will be even greater.

Retail sales slip back

After heating up in July, retail sales slipped back slightly in August.   Here is the retail sales index excluding the Motor Trades since January 2010.

One feature in the August figures is the difference in the performance of the value and volume series.  The volume series is down about 0.2% on the month but the value series is down 1.4%.  The CPI was flat in August with monthly prices decreases for some categories that feed into the RSI such as food (-0.6%), alcohol (-0.6%), medical products (-0.9%), furniture (-0.3%). 

These changes mean that the volume of retail sales is up 1.3% on last year, while the value index is down 0.2%.  This augurs well for the contribution retail sales make to real GDP (around half of the final consumption expenditure component of GDP is reflected in the Retail Sales Index) but the prospects for nominal GDP remain muted.  The link between nominal GDP and deficit targets was addressed in a previous post.

The recent volatility in the monthly changes is evident from the following chart.

Employment patterns – numbers employed and new FTE data

There has been some talk recently of an improvement in labour market conditions.  This narrative has support from patterns such as this from the Quarterly National Household Survey.

In the year to Q2 2013 employment is up around 33,000 and speculation of a turn in the labour market is not outlandish.  There have, however, been concerns raised about this improvement because of a caveat the CSO put with the figures in relation to the Agriculture, Forestry and Fisheries sector.  The last few QNHS releases from the CSO have said:

In the case of the Agriculture, forestry and fishing sector it can be noted that estimates of employment in this sector have shown to be sensitive to sample changes over time. Given the continued introduction of the sample based on the 2011 Census of Population as outlined in the note on the front page of this release, particular caution is warranted in the interpretation of the trend in this sector at this time.

This is the trend.

Employment in this sector is recorded as being up around 16,000 in the year, equivalent to half the overall increase.  So is the increases in employment merely the reflection of a measurement issue in the CSO data? No.

The CSO note tells us that caution is only warranted for the “trend in this sector”; they do not suggest such caution carries through to the overall figures.  This is a result of a way the figures are compiled.  The sectoral data from Agriculture and other areas do not contribute to the calculation of the total employment figure – they are a distribution of it. 

The CSO determine the total number employed and then divide that across the different NACE categories.  The number of employees allocated to the Agriculture sector is under question at the moment, the figure provided for the total number of employees is not.  But the 33,000 increase in employment does warrant further scrutiny.

The breakdown between full-time and part-time employment is important.  Here are the seasonally adjusted full-time figures.

Full-time employment is up about 22,000 on the year so accounts for around two-thirds of the increase.  By definition, part-time employment provided the remaining increase in employment.

Apart from the 12,000 increase in part-time employment in the past year, the other noticeable thing is that part-time employment shows a consistent upward trend since 2008, even as full-time employment was falling rapidly.  One concern with part-time employment is that it may include people who would prefer to be in full-time employment and there are “under-employed”.

The CSO provide data on such a measure although only back to Q3 2008 and also not on a seasonally adjusted basis.

This has also been steadily increasing, though over the past 12 month is actually down around 7,000.

One big issue with looking at changes in the number of people in employment is that it might fully reflect changes in the amount of employment people are actually engaged in.  Existing employees could be getting more (or less) hours which reflects a change in labour market conditions not reflected in the numbers employed data looked at above.

To little reaction the CSO have put together a complementary data from the QNHS that provides labour market data in full-time equivalents.  In the CSO’s own words:

The FTE employment measure for a respondent is the total actual hours worked by the respondent, divided by the average number of hours worked by respondents working in similar (gender, industry sector and employment status) full-time jobs.  While changes in the number of persons employed will typically be the primary driver of changes in FTE employment, it will also be affected by other factors.  These include increases or decreases in the proportion of total employment accounted for by part-time employment, the number of hours worked by people in employment and other changes.

FTEs give a measure of the amount of work as opposed to the number working.

The amount of work has increased and there are around 30,000 more FTEs in employment now than a year ago, though all of that increase is down to the jump in the last quarter for which data are available, Q2 2013.

Using the new FTE data we can compare the reduction in the numbers employed since the peak to the reduction in the amount of work (the FTEs).

It is clear that the loss of work has been greater than the reduction in the numbers employed.  There are people in jobs but they are working less than their equivalents did before.  This reflects the increase in part-time employment.  Numbers employed are down 14% from the peak in 2007, while FTEs are down 17% over the same time. 

As outlined earlier both measures have turned positive in the most recent data but it will take something similar over subsequent releases before we can see that a trend has become embedded.

New emphasis on the primary balance

The repeated calls of what should be done with the Promissory Note “savings” is likely why we have seem the Minister for Finance try to put some emphasis on the primary budget balance in recent weeks.  The primary balance excludes interest costs so is the difference between government revenue and government expenditure on goods and services. The primary balance was unaffected by the Promissory Note restructuring discussed in the previous post.

At the time of Budget 2013 in December 2012, the projected primary balance for 2014 was for a surplus of €0.6 billion. April’s Stability Programme Update had an overall balance that showed a €1.2 billion improvement from the budget day figures (mainly because of the Promissory Notes restructuring) but the projection of the primary balance for 2014 was little changed with a primary surplus of €0.8 billion expected.

The SPU states that the improvement was “mainly driven by better than expected taxes in 2012 which have a carryover effect into later years”.

The target of fiscal consolidation is the primary balance. There are no budget measures that directly effect interest expenditure. The effect will be indirect through the interest rate charged by lenders and the size of the debt. This article written for Independent.ie back in April discusses the relationship between the primary deficit and austerity.

Excluding once-off measures such as the bank recapitalisation payments, the recent primary balances and near-term projections are:

• 2007: +€2 billion
• 2008: –€10 billion
• 2009: –€16 billion
• 2010: –€13 billion
• 2011: –€9 billion
• 2012: –€6 billion
• 2013*: –€3 billion
• 2014*: +€1 billion

The process of restoring a primary surplus after the collapse of the public finances in 2008 will have taken seven years and the accumulation of nearly €60 billion of primary deficits. Since peaking in 2009, the primary deficit has been steadily reduced. In most cases running primary deficits in response to an economic downturn is the appropriate policy but we ran up against the immutable element of all maximisation problems in economics – the constraint. In this case it is having someone lend the money to allow you run the deficits.

The reduction in the overall deficit has been slower because interest expenditure has risen from €2 billion in 2007 to €8 billion now – running €60 billion of primary deficits does not come cheap.  Based on figures from April’s Stability Programme Update, the 2014 deficit will be an €8 billion interest bill less a €1 billion primary surplus or €7 billion.

Although the deficit limits set out in the EDP are in terms of the overall general government balance it is the primary balance that matters in a debt sustainability analysis (i.e. the path of the debt/GDP ratio).

If a country runs a primary balance then the debt ratio will be constant if the average interest rate on its government debt is equal to the nominal growth rate of GDP.  This is because both the numerator and denominator in the ratio debt/GDP are growing at the same rate. For a country that wishes to reduce the debt ratio (as Ireland does) then one avenue for this is if the nominal growth rate exceeds the average interest rate.

The average interest rate on Ireland’s government debt is around 4.25%. As discussed in an earlier post on deficit targets this is greater than the current nominal growth rate and debt sustainability is further exacerbated by running a primary deficit. Unsurprisingly, Ireland’s debt ratio will rise this year, but most predictions are that 2013 will give the local peak of the debt ratio after which it will fall. Here is a chart from the IMF’s Tenth Review.

There are some stock/flow adjustments that mean the debt ratio is likely to fall next year almost regardless of economic conditions. This is mainly the €30 billion of pre-borrowing the NTMA has accumulated in advance of our expected exit from the EU/IMF programme this year. Of more importance, though, are the underlying debt dynamics: do the interest rate, nominal growth rate and primary balance satisfy the conditions of a declining debt ratio?

With a 4.25% average interest rate on government debt and current evidence suggesting that a 4.25% nominal growth rate for 2014 may not be achieved the underlying path for the debt ratio is up – unless a sufficiently large primary surplus can be run offset the difference between the interest rate and the growth rate.

While the interest rate on Ireland’s government debt is low by historic standards and a 4.25% nominal growth rate is below the long-run average, there is likely to be a gap between them and not one that favours debt sustainability. If the gap between them was 0.75 percentage points (4.25% interest rate versus 3.50% nominal growth rate) then given current Irish public debt levels at just north of 120% of GDP it would take a primary surplus of around 1% of GDP to stabilise the debt ratio.

With the €3.1 billion of adjustment in Budget 2014 the April SPU projected a 2014 primary surplus of 0.5% of GDP. This is not sufficient to stabilise the debt ratio in 2014 under the assumptions used here. Of course, it is almost guaranteed that the gross debt ratio will fall in 2014 as some of the cash resources built up will be used to finance the deficit as opposed to new borrowings.

It is the underlying debt dynamics that matter and these have yet to move in the right direction. Given the low interest rates, the size of the primary surplus necessary to stabilise the debt ratio is not large. With a further budgetary adjustment of €2 billion planned for 2015 the SPU projects a primary surplus of 2.7% of GDP in 2015.

That is well in excess of the level required to stabilise the debt ratio and, even with lower than projected nominal growth, by 2015 it is likely that the underlying debt dynamics will be for a declining debt ratio. This assumes that the improvement in the primary balance seen over the past few years is maintained.

The importance of primary surpluses for a high-debt country was emphasised in Moody’s statement last Friday on its revised outlook for Ireland:

Why did they improve their outlook on Ireland?

The rating agency expects the government to re-establish debt-stabilising primary surpluses in 2014 and for those surpluses to expand subsequently, resulting in declines in the government's headline debt-to-GDP ratios as well as improving the affordability of its debt.

How might their outlook further improve?

Upward pressure would develop on Ireland's government ratings and/or rating outlook if the government continued to comply with its fiscal consolidation targets, and growth were to resume at a pace that, together with consistent primary government budget surpluses, would be sufficient to firmly position the government debt metrics on a downward path and ensure debt sustainability over the medium to long term.

Conversely, downward pressure would develop on Ireland's government rating and/or rating outlook if the country's fiscal consolidation process were to falter to the extent that Moody's projected that government net debt metrics will increase significantly above their current level of roughly 100% of GDP.

It is all about the primary surplus.  Michael Noonan may be accused of “shifting the goal posts” by now talking about primary surpluses but the game is changing. Under the EU/IMF programme the targets were adopted from the Excess Deficit Procedure and were to reduce the underlying general government balance with little emphasis given to the debt levels that resulted.

Upon exit of the programme the objective will be to obtain funding from financial markets and one of the key parts of their approach is debt sustainability analysis. The change in emphasis to the primary surplus is merely a reflection of the changed position the country will be in but with little emphasis on the primary balance over the past few years it may be a necessary move that does not get much traction.  Especially when people are convinced they have €1 billion of savings to distribute!

The Promissory Note “savings” revisited

As outlined in the previous post it was projected in the Budget last December that the 2014 deficit would be €8.9 billion.  Just four months later the forecast of the 2014 deficit in April’s Stability Programme Update was €7.7 billion, a decrease of €1.2 billion.

The improvement was due to two things.  The first was around €200 million of revenue buoyancy from taxes that performed better than expected in the final 2012 outturn with carryover effects into 2013. 

The other €1 billion of deficit reduction in the projections was due to the “saving” from the Promissory Note restructuring. This arrangement did have the effect of improving the general government deficit for 2014 by around €1 billion (and subsequent years by declining amounts of around €100 million lower) but the change would not necessarily satisfy the dictionary definition of a saving.

The Anglo/INBS disaster resulted in a capital shortfall of around €35 billion in order to cover their massive loan losses and satisfy their depositor/bondholder liabilities that were repaid. A €4 billion cash injection was given to Anglo in 2009 with the other €31 billion being provided through Promissory Notes (a promise to pay in the future) in 2010. Two payments of €3 billion were made on the notes, one in 2011 and 2012, though the 2012 payment was made with a 2025 government bond rather than cash, meaning that there was around €25 billion of the Notes remaining when the restructure was put in place back in February.

Under the old arrangement, the Exchequer paid interest to the IBRC (the merged entity of Anglo/INBS) as the holder of the Promissory Notes. The IBRC was able to use this money, and the capital repayment portion of the €3 billion payment, to reduce its Exceptional Liquidity Assistance (ELA) liabilities with the Central Bank.  The IBRC used the ELA money from the Central Bank to repay its depositors/bondholders and as the loans it held were not going to be repaid sufficiently to, in turn, repay the Central Bank the money from the Promissory Notes was set to make up the shortfall.

Although the IBRC was outside the general government sector for Eurostat deficit measurement purposes, it was a 100% state-owned entity so the interest payment on the Promissory Notes was not going to an external third party.

The IBRC was itself paying interest to the Central Bank of Ireland for access to the ELA and some of that interest was returned to the Exchequer via the Central Bank surplus on its operations. The net external cost of the arrangement was the interest the Central Bank had to pay into the ECB for the facility to create money under the ELA scheme. The cost of this was the ECB’s Main Refinancing Operations (MRO) rate. This is currently 0.5%.

The interest on the Promissory Notes was high (around 8% from 2013) and fixed but was paid to the IBRC which in turn used it to pay down its liabilities with the Central Bank who then used it to reduce the amount of ELA it had forwarded. The interest rate on the Notes was largely meaningless and as Prof Karl Whelan usefully explained the €3 billion repayment would have resulted in the ELA liabilities to the Central Bank being fully repaid by 2022 even though the Promissory Note repayment schedule extended to 2030.

The IBRC was making a massive interest profit on the Promissory Notes and could use this to repay its only remaining liabilities – to the Central Bank of Ireland. As the IBRC was 100% state-owned the extra interest because of the high rate on the Promissory Notes was merely allowing the repayment of the money used to bailout Anglo/INBS depositors to be repaid quicker. 

The high interest rate on the Promissory Notes did not result in any additional direct costs, so a lower interest rate could not result in any direct savings.

Upon the liquidation of the IBRC, the Promissory Notes were cancelled, and the €25 billion owing to the Central Bank under the old arrangement was replaced with €25 billion of long-term bonds. As with the Promissory Notes the Exchequer is liable for the interest due on these.

Under the Promissory Notes the high interest rate on the €25 billion meant around €1.8 billion was due to be charged to the general government sector in 2014. Under the new arrangement the Central Bank holds €25 billion of long-term government bonds and the floating interest rate on these (currently around 3%) means that an interest bill of around €0.8 billion will be due to the Central Bank next year.

The difference between the figures is the €1 billion “saving” from the Promissory Notes restructuring.

However, just like the ELA arrangement the Central Bank will return any profit it makes from holding the bonds to the Exchequer through the Central Bank surplus. The Central Bank is a state-institution but as the monetary authority it is outside the definition of the general government sector used by Eurostat.

The net external cost to the broader or overall government sector is the cost to the Central Bank of creating the €25 billion to ‘buy’ these bonds from the government. The net external cost is just as it was under the old Promissory Notes/ELA arrangement; it is the ECB’s MRO. There is no actual interest rate saving from the restructuring, so the €1 billion “saving” is illusory though it does appear in the general government accounts. The  cost of the debt to the State disaster remains the same.

There is, though, a saving because the repayment schedule of the €25 billion has changed. Under Promissory Note arrangement the relatively cheap Central Bank funding (at the ECB’s MRO) would have been repaid by 2022. Under the new schedule which gives the minimum rate at which the Central Bank must sell the new bonds access to the funding at the MRO will be extended to 2032. See this earlier post.

There are benefits from the restructuring but they come about because of the slower rate at which the Central Bank sells the new bonds (meaning the interest is paid to a third-party and not recycled back to the Exchequer) compared to the repayment schedule on the former Promissory Notes (requiring borrowing to fund the €3 billion annual payments and thus interest to be paid to a third-party).

The new arrangement delays the rate at which a low-cost Central Bank liability (ELA/money to hold bonds in trading portfolio) is transformed into ‘normal’ government debt with the associated interest costs. The actual savings will be at their greatest roughly between 2016 and 2023 (assuming the minimum resale schedule is adhered to).

Of course, for the Excessive Deficit Procedure it is the general government deficit as defined by Eurostat that matters when it comes to the budget. But some consideration can easily show that the government moving from paying €1.8 billion of interest to the former IBRC to €0.8 billion of interest to the Central Bank doesn’t matter in the broader scheme of things as both have the government as their sole shareholder.

There is no “extra” €1 billion because of the Promissory Note arrangement.  The capital hole in Anglo/INBS was not reduced because of the change.  Nobody said we had to pay €1 billion a year less to pick up the bill.  The interest on the Promissory Notes was not a cost so a reduction in that interest is irrelevant.  It is the ECB’s MRO and how long funding at that rate can be accessed that matters.  There will be a small saving in 2014 on that front because of the Promissory Note restructuring but it will probably be around €100 million.

If there is to be a reduction in the fiscal consolidation in next month’s budget the argument has to be framed about why we should run a larger primary deficit now so that future generations can carry our “legacy of debt”.  And it is to primary balances that we turn next.

Deficit targets and nominal GDP

The upcoming budget is set to be framed around a general government deficit limit of 5.1% of GDP for 2014.  This was set as part of the EU’s Excessive Deficit Procedure (EDP) in an Council Recommendation to Ireland from December 2010.

There was much comment last week on the performance of real GDP in Ireland (up 0.4% in the quarter apparently) but debt contracts are written in nominal terms.  And last week’s National Accounts release from the CSO was not very positive on that front.

In this year’s budget from December 2012 the following GDP/GNP projections were used.

The current estimate is that nominal GDP in 2012 was €163.9 (thus exceeding the figure above) but the increases necessary to reach the subsequent levels seem unlikely.

In the Stability Programme Update published in April the projected general government deficit for 2013 was put at €12.575 billion.  If the actual outturn is close to this, nominal GDP will have to be around the €167.7 billion as projected in order for the deficit to satisfy the 7.5% limit set under the EDP.

The two quarters of 2013 data we have give the following estimates of nominal GDP:

• Q1 2013: €39,106 million
• Q2 2013: €41,679 million

These sum to give a half-year figure of €80.8 billion.  In 2012 (when nominal GDP was €163.9 billion) the figure for the first half of the year was €82.0 billion.

To meet the 2013 deficit target, nominal GDP needs to be nearly €4 billion higher than last year, but it is already running over €1 billion behind the 2012 level.  With revisions, nominal GDP of €87 billion is required in the latter half of the year for the €167.7 billion level to be reached.  The equivalent figure for H2 2012 was €81.9 billion, so year-on-year growth of just over 6% in H2 is required.

There are some indications that economic activity will pick up in the second half of the year.  Employment seems to be edging higher, retail sales were up in July and the change in car registrations all point to some improvement in Q3 and Q4.  Nominal figures are a combination of real changes and price changes and, on the consumption side at least, inflation is heading ever lower and is approaching zero.

Of course, Irish national accounts data is inherently difficult to predict.  A couple of intra-company changes in the MNC sector can have a huge impact on the figures (MNCs account for 90% of the export figure in the national accounts).  Nominal GDP of €167.7 billion could be reached but if it came up short at, say, €165 billion then a €12.6 billion general government deficit (as projected in the SPU) would give a deficit of 7.6% of GDP – in breach of the EDP limit set for Ireland, albeit by a very small amount (0.1 pp). This overshoot is actually the same as the 2013 deficit-increasing impact of the Promissory Note restructuring which took place in February.

It will be March of next year before a first estimate of the 2013 deficit/GDP ratio is known and no extra fiscal efforts will be introduced if it is felt the EDP limit will be breached this year.  It is also possible that developments since April will result in a smaller deficit than the €12.6 billion projected in April.  Whatever about 2013, it is definitely the case that the nominal GDP figures will have an impact on the fiscal effort required for 2014.

Last year’s budget included a NGDP projection of €174.1 billion for 2014.  The indications from the data released since then are that this projection will need to be revised down.  The 1.5% real GDP growth forecast for 2013 is unlikely to be met and the implicit GDP deflator resulting from the CSO’s chain-linking method may be less than 1.3%.  For 2014, real growth of 2.5% is projected with a GDP deflator of 1.3% again expected.

NGDP for 2013 is likely to be behind the budget projection and the 3.8% nominal growth rate for 2014 may also be underachieved.  A €165 billion outturn for 2013 and a 3% nominal growth rate for 2014 gives a 2014 figure of €170 billion.

If this is the case satisfying the EDP limit of 5.1% of GDP requires a general government deficit of no more than €8.7 billion.

Absent the Promissory Note arrangement, this lower nominal GDP would have meant achieving the 2014 EDP limit with a budgetary adjustment of €3.1 billion would have been difficult.  In last year’s budget projections an underlying deficit (i.e. excluding direct banking measures) of €8.9 billion for 2014 was projected.  This was sufficient to met the EDP limit when NGDP of €174 billion is used but would be in excess of the limit if NGDP was actually around €170 billion.  Using last December’s figures it is possible to see that an adjustment of more than €3.1 billion would be necessary to stay under the EDP limit.

There have been changes since then, of course, most notable the Promissory Note restructuring.  By April, the projection for the 2014 deficit (again with an assumed €3.1 billion adjustment) was down to €7.7 billion.  Even with lower NGDP this will be inside the EDP limit of 5.1% of GDP.  At €170 billion such a deficit in 2014 would be 4.5% of GDP.

It may be the case that next month’s budget will have a smaller package of tax increases and expenditure cuts then envisaged at the time of last year’s budget.  However, this not because of any unexpected improvement in underlying economic conditions.  In fact, the numbers last week suggest that more should be done if the fiscal consolidation plan is to remain “on track” not less.

The reason why less can be done is all down to the Promissory Note restructuring and some comments on these “savings” are presented in the next post.

Mortgages in the Covered Banks

The level of arrears in the quarterly statistics produced by the Financial Regulator continues to climb.  The latest figures are for Q2 2013 (30 June) and this is the bleak picture they paint for the €140 billion Irish residential mortgage market.

Only two-thirds of mortgages are being repaid under the terms of the original mortgage contract.  Immediate concern can be directed at the €27.3 billion (19.5%) of mortgages that are at least 90 days in arrears (of which around two-thirds are actually more than 360 days in arrears).

Solving the problem at the level of the borrower should be the priority but a related issue at the level of the bank is whether this level of mortgage delinquency will lead to a further recapitalisation requirement for the covered* banks – and more specifically whether it will lead to one that has to be filled by the State.

[* The group of banks was called ‘covered’ because they were the banks covered by the bank guarantee introduced in September 2008.  The original guarantee expired as planned in September 2010 and the Eligible Liabilities Guarantee (ELG) introduced in January 2010 was phased out this year.  Although the guarantees are no more the covered grouping is still used here to represent the domestic banks the State has an ownership interest in.]

The remaining covered banks are Allied Irish Bank (now merged with the Educational Building Society, EBS), Bank of Ireland and Permanent TSB.  Irish Nationwide Building Society and Anglo Irish Bank were originally part of the covered group but they merged to form the Irish Bank Resolution Corporation which was subsequently liquidated in February of this year.  Irish Nationwide had around €1.8 billion of mortgages while Anglo had no mortgage book of note. 

AIB and PTSB are almost fully state-owned while there is a 15% public ownership in BOI.  Here are their mortgage books in this country (with the percentages representing the proportion of the overall market the banks have).

The first point to note is that €90 billion (64.5%) of the €140 billion across all mortgages are in the covered banks.  The remaining €50 billion are banks in which the state has no ownership interest such as Ulster Bank, KBC Bank, Danske Bank while there are also the remnants of the loan books of lenders who have left the Irish market such as Bank of Scotland (Ireland), Start Mortgages and INBS as mentioned.

If not all of the mortgages are in the covered banks it stands to reason that not all of the mortgage arrears are in the covered banks.  Here are the Irish mortgages in arrears of more than 90 days in the covered banks (with the percentages representing the proportion of non-performing loans the banks have). 

[The figures come from the banks’ mid-year reports and also include loans which are impaired. In general, most of these will already by 90 days in arrears but a loan may be judged by the bank as impaired and not be 90 days in arrears because, for example, of concerns about loan-to-value levels.]

The covered banks had nearly €18 billion of impaired Irish mortgages at the 30 June 2013, with AIB’s buy-to-let loan book looking particularly bad with 48% in 90 day arrears and/or impaired.

In the case of AIB it should be noted that the current figures are for the combined AIB + EBS loan book.  In December 2011, AIB home mortgage loans had 6.6% in arrears of 90 days or more, while for EBS the equivalent figure was 16.6%.

As a side note the last figures on the INBS mortgage book (June 2012) showed that €1.1 billion of the loans were past due and/or impaired – giving a non-performing rate of almost 60%.

What capacity do the remaining covered banks have to absorb losses on their mortgages?  Again we can look to the banks’ financial reports and look at the stock of provisions they have on their balance sheets for losses on these loans (the percentage represents the amount of non-performing loans (NPLs) the banks have as a proportion of the totals in the previous table).

The banks have made a provision of almost 40% against their non-performing mortgages.  The banks can cover over €7 billion of loan losses on their mortgages without having to make a charge on their income statement, reduce the carrying value of the loans and thus reduce their existing capital.

The rate of provisioning varies across the banks with AIB having set aside 33% of NPLs while the cover for PTSB is almost 50%. 

The ability for the banks to be able to have such large provisions on their balance sheet is largely a result of the round of recapitalisation that took place following the PCAR results published in March 2011.  The level of loss provisions the banks now have is fairly close to the Central Bank loss projections that the banks were recapitalised against at the time.

In the PCAR exercise, BlackRock Consultants came up with estimated lifetime losses that the banks might make on their loan books under both a ‘base’ and ‘stress’ scenario.  The banks were recapitalised using the stress scenario with the Central Bank projecting “three-year losses” from the BlackRock figures for the recapitalisation requirement. 

Here are the figures for Irish residential mortgages based on a December 2010 loan book of €98 billion meaning there has been a reduction in the outstanding amount of €8 billion in the past two and a half years.  Most of that is because of capital repayments exceeding new drawdowns.  Anyway here are the loss projections from the PCAR on the banks Irish residential mortgages.

The €16.3 billion of lifetime loan losses estimated by BlackRock under the ‘stress’ scenario was scaled to €9.0 billion of projected losses in the three year recapitalisation horizon used at the time by the Central Bank.

As we have seen the covered banks have €18 billion of mortgages in 90 day arrears and/or impaired.  It would take a very large increase in this and a very low recovery rate (on repossessed properties) for €16.3 billion of losses to materialise.

It can be seen that the provisions for mortgage losses remaining on PTSB’s balance sheet is almost the same as the three-year loss projection used in the March 2011 PCAR (€2.55 billion provision now versus €2.59 billion projection then).  The figures for BOI are reasonably close (€1.69 billion provision now versus €2.02 billion projection then) but their is a big game in AIB (€2.95 billion provision versus €4.39 billion projection).  This likely reflects AIB’s less conservative provisioning highlighted above.

Should this divergence in the AIB figures be a concern? Possibly, but it is still a bit of a guess what the actual level of losses on Irish residential mortgages will be.  The figures don’t have to be the same.  The banks may have crystallised losses in the interim using some of their provisions.  At a recent Oireachtas Committee hearing AIB confirmed that it had written down €93 million of mortgage debt over the past 18 months.

We know the banks have €7.2 billion of provisions set aside.  The process that will result in these provisions being used for specific loans is, five years since the lending bubble burst, still uncertain.

With €9.8 billion of Core Tier 1 Capital, AIB has a CT1 rate of 15% so there is some buffer against losses in excess of those provided for.  A return to operating profitability in the near future would also help.

The tables from each banks’ mid-year reports used in the above analysis are posted below the fold (click to enlarge).

Irish Examiner – 06/09/2013 and 13/09/2013

The Irish Examiner have carried two pieces from me over the past week.  They are available at the following links.

• Facing up to the arrears problem, 6th September
• Getting banks back on track, 13th September

Two minor points on the external trade figures

The CSO have releases the goods trade data for July.  Two minor points spring to mind.

1. The balance of trade in food is lower than last year.
2. Wide-bodied passenger aircraft have a big impact on the figures.

More details on these below.

ONE: Some emphasis is put on the positive performance of food exports with a total of €4,911 million of export in the year to July compared to €4,513 million in the equivalent period last year.  This is an 8.8% increase but it is a nominal rather than real figure – price effects are included. 

It is also worth noting that food imports have similarly increased: from €3,058 million in 2012 to €3,477 million this year.

Thus, the balance of trade in food and live animals has actually decreased slightly, falling from €1,455 million in the first seven months of 2012 to €1,434 million this year.

TWO: Although food imports (and also chemical imports) are up overall imports are down.  There was €29.0 billion of goods imports in the period to July 2012 compared to €28.5 billion this year.  The source of the drop is primarily category 79 in the SITC (Standard International Trade Classification).  SITC 79 is ‘Other Transport Equipment’. 

By this time last year imports for this category were €2,025 million.  This year they have fallen to €778 million.  What other transport equipment have we imported €1.2 billion less of this year? Ans: Wide-bodied passenger aircraft.

Here is an extract from the more-detailed Trade Statistics (to June) for category 792.40

In the first six months of 2012 there were 40 aircraft larger than 15,000kg imported worth €1,823 million compared to just 18 such aircraft this year worth €638 million, with such imports from Brazil and the US substantially down.

This reduction will provide a boost to the balance of trade this year but in reality it is little more than the timing of purchase decisions of some of the aircraft leasing companies who are based here.  The improvement in the balance of trade will be offset by a reduction in Investment as measured in the national accounts (GNP/GDP).  There will be no discernible impact to the economy on the ground.

Inflation approaches zero

Yesterday’s CPI release for August from the CSO shows that general inflation over the past 12 months has been very low.  The following chart has the 12-month changes in the overall CPI and in a ‘core’ measure of inflation (the 85% of the index excluding mortgage interest and energy products).

Core inflation is running slightly higher than the overall inflation rate as both mortgage interest (-5.9%) and energy products (-0.7%) showed price declines over the year.

The core deflation that was seen for two years up to the start of 2011 and the relatively low level of inflation since then has resulted in a substantial narrowing in price differences between Ireland and other countries. 

Here is the Harmonised Index of Consumer Prices (HICP) for Ireland the EA17 since 2002. [The chart says nothing about relative price levels as both indices are set to 100 in January 2002; it merely allows differences in relative price changes to be seen.]

Here is a similar HICP chart for Ireland and the UK showing that the relative gap over the last four years or so has been even greater.

Eurostat does provide some comparative price level data.  The following chart shows comparative prices for HFCE (household final consumption expenditure) for the UK and the EZ17 relative to Ireland (=100) for the past decade.

In all the years shown Ireland has had a higher price level than the other two areas.  The gap to prices in the Euro Area was greatest in 2008 and has narrowed since then.  The gap to UK prices was widest in 2009 and the rate of convergence has been even greater.  As the inflation data above has shown this has continued into 2013 and, although Ireland still has higher prices, we can expect the lines to get closer still in subsequent releases.