What If Ireland Defaults? (26 page)

13

A Mortgage Broker's Perspective on Debt and Default

Karl Deeter

Karl is operations manager of Irish Mortgage Brokers and a radio and newspaper commentator.

When I was a kid we used to play this game where you would stand in a circle and everybody would sit down at once; if you timed it just right everybody suddenly had a seat on the lap of the person behind you; if it didn't go right then you all ended up falling over in a mess of limbs and laughter. The mortgage market of the last five years reminds me of when that game didn't turn out right – minus the laughter part. If Ireland had a large credit event (in normal language it's called a ‘default') what might the mortgage market look like in the aftermath? If we left the Euro what might happen to mortgage holders? How should mortgages work in the future? And should we ever ‘forgive' debts? These are all questions I hope to put some perspective on in my contribution to this book; I cannot offer ‘answers' because any prediction falls prey to the combined forces of the unforeseen, timing and the unique nuances that are particular to individual nations, markets and the formation of history. What I can do is lean upon historical precedent.

Taking the first idea of a sovereign default, we are likely to go into some form of negotiation in the future, not because we'll want to but because we'll have to. In part this has happened already with a reduction in our borrowing rates. However, in order to credibly access the markets again future lenders will need to be assured that we have the capacity to repay the debt. For now just be sure to add the acronym MYRA (Multi-Year Restructuring Agreement) to your vocabulary.

That a peripheral country could borrow at German rates was perhaps a mistake, but, equally, we won't have high odds of repaying if we borrow at high single digit rates either, nor will future lenders be willing to repeat that previous error of mistaking us for Germans when it comes to pricing credit. How this issue is resolved raises questions: will we get better terms such as longer maturities or more discounted rates? A partial write-off or accelerated amortisation (repayment of the loan) upon meeting certain criteria? Do we default?

The myriad of options boil down to a binary choice: do we repay our debts or not? If we do then it will need adjustment from its present guise, because things that can't happen don't happen, and we can't pay back the money we owe in full and on time under the present structure, so we'll likely face multiple rescheduling agreements in the future or go bang.

So what's on the other side for mortgages if this happens? I'll do my best to give you an idea ….

I have spent a little time in nations that have defaulted or had banking crises that brought them to the brink. Places like Indonesia, Argentina, Mexico, Brazil, Belize and a little more in Uruguay. One thing I have learned about default is that it is far from a ‘painless' procedure, albeit at times a necessary one. And after default the mortgage market is generally all but defunct.

What happens to the mortgage business in the aftermath of a credit event? Normally lending to anybody becomes a bigger risk than not lending at all, a credit contraction occurs that would make our current 95 per cent drop-off in mortgage finance seem tame by comparison. Margins on lending shoot up – we have seen some of this already – but it is the ‘pre-cyclone' version; credit-starved small and medium enterprises (SMEs) would go from a diet of bread and water to just water.

On my first trip to Uruguay I was going from the airport to downtown Montevideo; passing under a big cantilever bridge I remarked that we had two similar bridges in Ireland (the one near Drogheda and another in Dundrum). The taxi driver laughed; ‘I helped design it', he said before producing his university degree papers, which he kept in the glove compartment. ‘It wasn't always this way', he told me. I don't even know what the lesson in that is, but I can bet he didn't work on that bridge with a dream of one day driving an old beaten-up black and yellow cab.

If we default mortgage credit evaporates, and your humble analyst will become idle overnight. Even with the emerging duopoly that may happen, do people really need an intermediary to pick between two choices? In seeking two ‘pillar' banks (one of which is only €9 billion ‘less toxic' than Anglo) we will eradicate competition, allowing margins to rise to the point where an outside lender will come in and profit by charging less. That will stir competition, but there is no timeline on how long that takes. In the meantime expect to pay more for less, with higher charges on all aspects of finance.

And that is a frustrating thing about it: no matter how you deal with banks they can put up a toll on every road in the financial and payments system and extract money back out of an economy; in geek speak it is called ‘economic rent'. Banks are the unforeseen monetary power in some respects, a second layer of interest rate setters.

Combined with a default, a sudden halt in credit for mortgages will damage confidence to the point that property prices plummet; we would probably overshoot the ‘market clearing level' and that has benefits, but it would be at the cost of total household wealth destruction for a lot of people in the process.

We all lament the bank bailout, and that we won't burn bondholders, but nobody says the same thing about the final liability on bank balance sheets – the depositors. So let us not overlook that the government guarantee on deposits would be meaningless if we default, and if we reverted to the punt they might keep the guarantee but it would be in a devalued currency (no different than the traditional way of losing money). In the run-up to default and devaluation politicians would do all they can to play down the risk, but people would still panic and take their money out in Euro while they could. Thus far deposits in Irish banks are actually holding up well on the domestic front; it is the institutional international depositors who have fled. Regular people would follow suit if they got wind of a default, and this would in effect ‘create' a second banking crisis, for which there would be no bailout, just financial collapse; and as we saw from Asia in the late 1990s, decapitalised banks are also open to external shocks or speculative attacks, not a space one would ever envy.

There is something romantic about the idea of totally wiping the slate clean, but something quite impoverished about the reality of doing so; that's taking from first-hand experience. The upside is that the downside doesn't last forever, but the ensuing upside doesn't necessarily bring with it calm waters. The idea of ‘leaving' the Euro on our own (as opposed to doing so if the Euro broke up) would put us in the driving seat, but of what car and where is it going? My inclination is that we'd be jumping into the back seat with Thelma and Louise during the final scene.

For the 400,000 tracker mortgage accounts a reintroduction of the punt and subsequent efforts to raise finance on international markets (bearing in mind that even within the Euro we are looking at high single digits at present) would destroy them, along with every standard variable rate holder. The vast majority of mortgage loans (circa 80 per cent) in Ireland are subject to changes in interest rates, meaning all of the interest rate risk is carried by the borrower. That is not to be confused with the ‘cost of funds' to banks, that is a reflection of their own institutional risk and how the world sees them in terms of credit ratings versus their ability to raise finance on open markets, rather we are talking about interest rates being set by the European Central Bank (ECB) and (if we left the Euro) potentially the Central Bank of Ireland. A sudden spike in those rates would be crushing; banks have the legal right to de-peg trackers from the ECB base rate if it is no longer an acceptable reference rate. It may be worse if there were grounds for continuing to pay in a new more expensive Euro versus our devalued punt! There is about €113 billion in home loan mortgage finance floating around this country, so the fall-out could be severe.

In the UK, Finland and Sweden property prices all remained undervalued for six to seven years after the bust hit their respective bottoms. In Finland the seven years after their crisis started were all years of deleveraging; we seem to be following that course. Finland didn't default, but it did devalue, and interest rates from 1989 to 1992 averaged 13 per cent. The experience in Mexico when interest rates shot up (due to currency devaluation in 1996) was that delinquent mortgages suddenly went from 4.1 per cent to 33.7 per cent, a massive 720 per cent increase!

From 1990 to 1994 unemployment in Finland went from 3 per cent to 18 per cent and resulted in a permanent increase in long-term unemployment and poverty. We are in a situation now where many people will simply never ‘bounce back'. The debt to gross domestic product ratio in Finland increased almost fivefold from 13 per cent to 57 per cent in four short and very hard years; and it have never gone back to where it started; credit losses at banks were at 15 per cent. From 1991 there were seven years of budget deficits, with four of those years being over 10 per cent in the red. Look far away at Japan, currently more than half of mortgage loans are greater than 95 per cent loan to value (LTV), and even with borrower incentives like low interest rates and high LTV lending total mortgage lending is in decline, and property prices, after twenty long years, still haven't reached their previous levels.

But property prices be damned; I believe employment matters more. Employment in Finland has never recovered, and that is perhaps the worse fate. Even now unemployment is still twice as high as the pre-crisis 3 per cent. Since 1991 it has never dropped below 6 per cent (and has spent most of its time far above that figure). And the real kick in the teeth for the Finnish? Despite devaluation – which is oft trumped as an economic miracle – they still had six years of deflation and the same after that of disinflation. It's downsides like this that are conveniently brushed over in many debates. A big beneficiary was industrial production: the question for Ireland is do we have a manufacturing base that will do for us now what the Finnish one did for them nearly twenty years ago?

Reversing interest rates (along with currency devaluation) was vital for Finland, and in some respects we have benefited from this already via the ECB – current interest rates are at all-time lows. Simply put, if devaluation and default were as attractive in practice as they are on paper everybody would be doing it. It will hurt and hurt bad; that isn't to say it can't be a last-ditch option. Getting electrocuted isn't any fun (learned that the hard way) but defibrillators have saved a few lives too (thankfully haven't needed that yet!).

Which brings us to the next question – what about mortgages in the future?

If I had the ability to create their set up it would be as follows: mortgages are currently advanced at the outset on a ‘one property – one loan' basis; granted you can split a loan with part on a fixed rate, part variable, but what I mean is that the loan is not tiered internally or spread amongst institutions. The structure of lending and the way people get paid to lend are the two things I would concentrate on the most. Imagine this: you buy a house for €100,000 and put down a 10 per cent deposit. Of the €90,000 borrowed is the riskiest bit the first €50,000, the ‘middle' €30,000 or that final bit from €80,000 to €90,000? If property prices fall the borrower's €10,000 deposit is wiped out first and after that it is eating into the lender's money –
if
the loan goes sour and is never repaid. This doesn't encourage sensible risk pricing, the last (most risky) part of the loan is priced the same as the first (least risky) part. We don't think of a loan being broken up into sections, but what if they were?

What if you borrow 50 per cent of the purchase price with the rate at x per cent, and the bit from 50–60 per cent is x
+
1 per cent and so on? The banks are pricing risk more effectively, and borrowers have an incentive to borrow less where possible and get a better price by doing so. Banks do ‘tier' based on loan to value, but it's for the entire loan rather than for various strata of the loan. What if loans were split between recourse and non-recourse elements of the LTV? So the first 70 per cent is full recourse to the borrower but above that it isn't? The banks would then charge more for the loan over 70 per cent and would be more likely to insure against loss (as they largely stopped doing by opting out of mortgage indemnity guarantee bonds). If lending over 70 per cent was done on a non-recourse basis – meaning that if the lender repossessed the property the portion over this amount could only be realised via the property and not the person – they would share the risk with the buyer, which is far fairer than the present set-up.

It would result in future foreclosures forgiving parts of a debt over a certain amount. The national debate has proven this is a contemptuous topic; but it's damn effective. That is according to BlackRock, one of the world's largest advisory firms with over $3.5 trillion under management, which has shown that in every jurisdiction it has operated that reducing principal amounts works best when trying to avoid default and re-default. This is echoed by the behavioural finance experts in Loan Value Group – a company made up of mortgage bankers and behavioural economists from Wharton Business School – which offers back-ended incentives to borrowers who have not defaulted yet in order to avoid potential default.

Such a change may increase the likelihood of a strategic default, but acknowledgement and pricing of risk is precisely the point. It would also give investors in the bank a better idea of the type of lending they are doing because it could be broken down in the balance sheet. This would also mean that the cards are not stacked entirely in the bank's favour when people get into trouble with their mortgage, as it presently stands. Or they could spread it out, with different banks underwriting different parts: ‘Bank A' shows the first lower-risk part of the loan on their balance sheet, with ‘Bank B' offering the second unsecured lien and showing it on theirs. People can then gauge the risk of the institution in terms of their ‘risk lending profile'. If one bank is saying ‘all of our lending is less than 50 per cent LTV' that would make it a safer bet than one which is always in the 90 per cent or more LTV bracket, would it not?