## Wednesday, March 5, 2014

### Arrears Capitalisation

Among several interesting developments in the mortgage arrears update from the Central Bank released yesterday is the emergence of ‘arrears capitalisation’ as the most used restructure on the loans covered in the statistics.

Here is a summary of the year-end positions for the type of restructures used since 2010.

Over the past year the proportion of arrears capitalisation in the restructure figures has increased from 12.2 per cent to 22.0 per cent.  The largest drop is for interest-only restructures (prior to 2013 interest only agreements were not broken down by those < or > 1 year).

One question that arises is what exactly does arrears capitalisation mean and what has happened to the 18,516 accounts to which it has been applied?

In their release the Central Bank (in footnote 2) say :

Arrears capitalisation is an arrangement whereby some or all of the outstanding arrears are added to the remaining principal balance, to be repaid over the life of the mortgage.

However, this does not reflect what happens.  Arrears capitalisation does not add any of the arrears to the balance; it sets the arrears to zero and recalibrates the payment based on the principal outstanding and the term remaining on the loan at the time of the restructure.

This new payment will be higher than the payment set out under the original payment but this is not because arrears are added to the balance.  The new payment will be higher because a greater principal amount and more interest needs to be repaid over the remaining term of the loan.  This is undoubtedly because the borrower missed payments and went into arrears but the higher payment can be calculated automatically and is not the result of any arrears being “added on”.

Consider a 20-year, €200,000 mortgage at 4% fixed interest which is five years into its term.  The monthly repayment is €1,212 and after five years the balance should be reduced to €163,800.

Assume that in year 4 the borrower missed 12 full payments in a row and then resumed making the “full” payments of €1,212 in year five.  The borrower is 12 x €1,212 = €14,544 in arrears and the balance owing at the end of year five will be approximately €179,250.

At the end of the third year the balance would have reduced to €179,180.  During the fourth year of no payments the interest will be added as per usual and with no offsetting payments this will bring the balance up to around €186,400 at the end of year 4.  The resumption of the monthly payments of €1,212 for a year will reduce the balance to €179,250 at the end of year 5.

The borrower owes €179,250 and has arrears of €14,544.  It should be noted that the amount of arrears has nothing to do with the amount owed.  They are calculated separately.  The amount owed is the principal plus daily interest (added monthly) less any repayments made.  The arrears are the amounts of missed repayments relative to those set out in the original contract.

So what to do with the €14,544 of arrears?  The borrower has failed on a necessary contractual obligation so they need to make good the shortfall.

One option is for the borrower to pay €14,544 in a lump sum and have that amount offset against the balance immediately clearing their arrears.  The amount owing would drop to €164,706 (close to where it should be under the original contract) and the borrower could continue making the monthly €1,212 payments to repay the loan over the original 20-year term.

A second option is to repay the arrears, or catch up on their contractual obligation, in instalments.  If the borrower paid an additional €500 per month on top of the €1,212 payment they would have the arrears of €14,544 cleared in 29 months and would be roughly back on track and could again continue with the original €1,212 payment for the remaining 12.5 years or so.

The concept of arrears capitalisation is similar to this but it has the borrower catch up with the repayments right at the end of the original  term so is based on time rather than some monthly overpayment amount on the arrears.

In our case the borrower owes €179,250 after five years of the original 20-year term.   At the 4% interest rate this cannot be repaid with monthly repayments of €1,212 over the remaining 15 years.  In fact if the borrower continues to make these monthly repayments there will still be around €41,000 owing at the end of original 20-year term.

An alternative is to recalibrate the repayment so that the €179,250 owing at the end of year five is repaid over the remaining 15 years of the mortgage.  To do this at the 4% interest rate would require a monthly repayment of €1,326.  If the borrower makes this monthly repayment to this level the full amount owing will be repaid over the original 20 term of the loan set out in the original contract.

The monthly payment has increased but it is not because any “arrears are added to the remaining principal balance”.  The arrears figure was not used to calculate the new repayment.  The arrears figure is a memo item that reflects the level of missed repayments and, by itself, does not feed into the principal, interest and repayment calculations on the loan.

The new repayment figure is higher because the borrower has borrowed more money for longer than originally intended.  The borrower owes more interest.

Instead of having the balance down to €163,800 by the end of year five; the balance was only reduced to €179,250.  Obviously the difference is because of missed payments (and a small amount of interest on interest) but regardless of the level of arrears the amount owing will be automatically calculated - interest is usually calculated on the closing balance each day and added monthly or quarterly.

Arrears capitalisation is simply recalibrating the monthly repayment so that the balance owing is repaid over the remaining term of the loan.  It also involves setting the arrears to zero as the contractual obligations have changed rather than having them cleared by a once-off or temporary overpayment.

It is also possible to combine the arrears capitalisation with other restructures, primarily term extensions.  In the above example it would be possible to keep the repayment at €1,212 and instead repay the loan over 17 years instead of the remaining 15.

The borrower loses nothing from the arrangement.  It is a win-win for the borrower.  There is nothing added to their loan balance and their credit record will be restored faster with the arrears cleared.

Here is a summary of the case outlined here: balance owing

1. Draw down mortgage at outset: €200,000
2. Make agreed €1,212 payments for 3 years: €179,180
3. Make no payment for a year: €186,400
4. Make €1,212 payments for a year: €179,250
5. Reset the arrears to zero and fully repay the loan with a recalibrated payment of €1,326 for 15 years: €ZERO

If the borrower had stuck to the original repayment schedule the full amount repaid over 20 years (240 months) would have been:

€1,212 * 240 = €290,880

As a result of the missed payments and the recalibration at the end of year five the amount to be repaid over the 240 months will actually be:

(€1,212 * 36) + (€0 * 12) + (€1,212 * 12) + (€1,326 * 180) = €296,856

If the arrears capitalisation is combined with a two-year term extension the total repayments are:

(€1,212 * 36) + (€0 * 12) + (€1,212 * 12) + (€1,212 * 204) = €305,424

In the latter two cases the borrower has to repay more but it is not because any arrears were ever added to their balance it was because they had borrowed money for longer and dditional interest is added in the standard way that interest is calculated.

The description of “arrears capitalisation” is a bit of a misnomer.  It is possible that “arrears amortisation” might be a better description as the borrower has agreed to catch up on their repayments over the remaining term of the loan.

So why is this approach proving so popular now?  If the borrower can stick to the recalibrated payment it has the advantage of returning the loan to the performing category and removes the loan from the arrears statistics.  Are the borrowers meeting the new repayments.  Some are, but many aren’t.

The Central Bank provided a new table of the “success” of each type of restructure.  For the main restructures used on PDH accounts “arrears capitalisation” is the least successful – less than 60 per cent of borrowers are sticking to the new terms.

The restructure that is the most popular is also the one that has the lowest success rate.  In saying that if 57.9 per cent of the 18,516 accounts to which arrears capitalisation was applied are cured that is over 10,700 accounts that are back “on track”.  This depends on what ‘meeting the terms of the arrangement’ actually means which is unclear.

Of course, there are 42.1 per cent who are not meeting the new terms.  There is some underlying reason why they fell into arrears in the first place.  Unless that was temporary in nature and the borrower’s repayment capacity has been restored they will not be able to meet the new repayment, which will almost certainly be higher (depending on interest rate movements for tracker and SVR mortgages).

In many cases the reduction in repayment capacity is enduring so a restructure to reduce the monthly repayment is necessary and split mortgages which can achieve this are now being rolled out at an accelerated rate.  There still is a long way to go.  The majority of accounts in arrears have yet to restructured.

1. good post, one thing worth mentioning is policy underneath the arrears capitalisation, we saw this happening a lot more last year and some ppl getting it without consultation - were told by a few sources it was a way to make sure targets were hit.

With some lenders though it is an offer made after the loan starts performing, so (for instance) with Ulsterbank after 6 months you can capitalise arrears and it may be that this is a genuine sign of curing in some loans or a sign of making the numbers fit.

1. Hi Karl,

That is interesting. I saw in yesterday's annual report from AIB that the number of accounts on which they are capitalised arrears increased from 3,139 to 7,067 during 2013. That gets them a lot of the way to the MART requirement.

And I agree, arrears capitalisation won't (or at least shouldn't) be applied to an account on which no/low repayments are currently being made. It achieves nothing. The example I used was a bit complex because I wanted a situation where a borrower missed payments for a temporary period and then went back to making the original full repayment. There is benefit in an arrears capitalisation because the repayment capacity is there.

It is also probably the case that arrears capitalisation will come with a probabationary period, i.e. the new payment is calculated and if the borrower sticks to it, as you suggest, for six months then the arrears are capitalised (set to zero) beginning the time period during which the borrower's credit record can be cleaned. It will take five years for this to happen and the quicker the arrears are cleared the quicker this period can begin. Though I think for most distressed mortgage borrowers their credit record is a minor consideration.

2. I'm disappointed that Irish Economists, that includes you Seamus, are dancing around this issue.

Arrears capitalisation of no benefit to the debtor, apart from credit rating, but of major benefit to the bank execs' who can justify the profits, dividends and bonuses.

I'm no economist but aren't bank profits a fairly tale based on a bankers view of the level future bad debts.

Optimist banker = low bad debts = increased profits = increased bonuses.
Pessimistic banker = high bad debts = low profits =- no bonuses.

Isn't the reality that the banks are doing what they have always done, massaging the figures to give the fat cat accountants a fig leaf to justify the overstated profit figures.

The only place I see this reality documented is in the Phoenix which regularly calls the banks on there fairly tale profits.

1. Yes, it is possible to say that arrears capitalisation is "of no benefit to the debtor, apart from credit rating" but there is definitely no cost to the borrower. If a borrower is offered arrears capitalisation they should accept it. Of course, the loan will only stay out of default if the borrower can keep up with the repayments but the application of arrears capitalisation has little impact on that.

I am not sure it has much impact on the banks' profit figures. A loan will only be performing if the borrower can keep up with payments. Even if they are the loan can still be distressed if the payment is close to the maximum capacity of the borrower.

I think there is little doubt that the banks applied arrears capitalisation to accounts that it was inappropriate to do so. But if the payments continue to be missed the loan will continue to be counted as a non-performing loan.

The numbers show that arrears capitalisation is not the best performing restructure but it has improved. When the above was written 12 months ago 58 per cent of the account that has this applied were "meeting the terms of the restructure". The figure is now 71 per cent.