Friday, April 9, 2010

Economics 09/04/2010: Bank of Ireland: strategic insanity

And so, as I predicted in the press some months ago and confirmed (also in the press) following the AIB rate hike and previous BofI hike in the non-mortgage rates, Bank of Ireland had succumbed to the temptation to destroy its own paying clients in order to plaster up the gaping hole in its capital base.

There are, as you have noticed, a number of things going on in the above statement. Let me briefly explain:
  • A hike of 50bps on variable rate mortgages announced by BofI is a short-sighted strategy: the bank holds ca 25% of all mortgages in the country (about 190,000) of these, more than 20% are already in negative equity (over 40,000). BofI should be concerned about preserving those mortgages that are currently at risk - in other words, the bank should focus on helping (or at least not hurting) those who are close to the margin of defaulting. Variable rate hike will most severely impact those households with higher LTV ratios, who are younger and thus at higher risk of unemployment. Thus, the interest rate elasticity of the mortgage default rate is the highest exactly for this category of clients. Put in 'can my grandma understand this' terms - BofI move today is equivalent to destroying that parts of its performing loans book which it should be focusing on saving.
  • A hike of 50bps on variable rate mortgages will do absolutely nothing to BofI's balancesheet. Bank might be estimating that it can get few million worth of funds from the move. But the wholesome destruction of its own client base and their loans, in my view, will cost it more than it will bring in in the longer-term.
  • A hike of 50bps will further amplify the already destructive force of precautionary savings wrecking destruction across the Irish domestic economy. This effect will be driven by two forces. First, any money the banks take in higher mortgage rates will not be recycled into the economy through higher investment or new lending because the banks will force the new cash into capital reserves to pay down defaulting debts. Thus, every penny taken by the banks in will mean a one-for-one contraction in direct consumer spending and household investment, amplified through the usual multiplier effects 3-4 fold in the course of just one year. Second, households will now rationally expect more hikes in mortgage rates, thus increasing further their saving. For every €1 that BofI, AIB, ptsb, and the rest of the gang collect from mortgage holders, consumer spending will therefore decline by at least €4-5.
The BofI move today is, therefore, equivalent to a deranged asylum patient having fallen off the cliff, hanging onto the last available branch of a tree frantically sawing off the said branch with a fervor.

And since we are on the theme of deranged asylum patients, why not mention the latest, and perhaps the most comical idea our state-backed financial engineers can conjure: the Anglo Irish Bank taking over Quinn Insurance. That one is equivalent to AIG being taken over by General Motors. A bank that is as full of bad loans as Hindenberg was full of hydrogen is taking over an insurance company that is so disturbingly short of capital - sparks are flying from underneath its wheels.

What can possibly go wrong here? Oh, just about countless more billions from the taxpayers wasted...

3 comments:

laughingbear said...

A bank that is as full of bad loans as Hindenberg was full of hydrogen is taking over an insurance company that is so disturbingly short of capital - sparks are flying from underneath its wheels.

LZ 129 Hindenburg, yeah, a truly appropriate analogy!

Only difference, the Hindenburg more than likely was sabotaged,

LZ000 Ireland has a captain and officers who could not steer a tiny sailboat on the Liffey without causing mass accidents, but were given a super tanker to take care for.

Myles Duffy said...

Constantin, I find it hard to believe that only 20% of mortgages are impacted by negative equity. I assumed that the bulk of mortgage debt outstanding originated in the past 7 years. If that is the case the proportion suffering negative equity would be significantly higher. Could this be the case?

TrueEconomics said...

Myles, you are correct to be skeptical - BofI estimates refer to their own books. In recent years, they have shoved quite a few lower quality mortgages into ICS. In addition, these do not reflect collateralized mortgages, I suspect, which are of more recent vintage. Top this with the assumed rates of property prices declines and neglecting the premium on asking prices in 2005-2007 swing to a discount in 2008-today. I am slo not sure if they include mortgages in arrears, and mortgages that are inetrest-only as the latter more often included significant redevelopment/retrofit components. Do BofI use the base of all mortgages (including equity withdrawals) or just primary mortgages, thus increasing artificially the base of mortgages to yield lower ratio? Finally, some people borrowed at, say, 60 LTV from BofI and got a top up from a credit union and parents, who took out second mortgages.