Economics 31/10/10: Mortgages, relief and stimulus

David McWilliams' idea of deferring mortgage repayments for 2 years is continuing to generate some discussions in the 'new' media. Here are my thoughts on the topic.

David's idea starts from the right premise that households are currently suffering from mortgage/debt repayment burden that is non-sustainable in the current economic conditions and acts to depress consumption and household investment. But in my view, it is not going to yield any significant impact on the economy.

As expected incomes fall due to:

• continued recession in the economy (courtesy of the insolvency crisis we face across the entire economy);
• elevated risk of unemployment (ditto);
• rising tax burden on households (courtesy of the Government's perverse logic which puts the needs of financial services and Exchequer ahead of those of the real economy - households and firms);
  
• heightened risk of further tax increases in the future (ditto);
  
• behavioral implications of the severe and deepening negative equity (being further reinforced by the FR and Government denial of the problem and asymmetric treatment of development debts and household debt); and
• continued increases in the cost of mortgages finance and credit (courtesy of the Government approach to dealing with the banking crisis)
  

Irish households are indeed under a severe financial stress. This stress is amplified by the adverse selection of younger (and thus more heavily leveraged) households into the higher risk of unemployment. These very households are also more important contributors to future private investment side of the economy, as older households are dis-saving to consume.

Collapse of consumption and household investment we are witnessing today is the direct outcome of the above forces and it will continue to worsen as long as households' disposable after tax incomes continue to decline and remain at risk of further pressure. In addition, non-discretionary segment of consumption (energy, education, transportation and health) show no signs of price deflation, implying that discretionary disposable after tax income - the stuff we get to spend in the shops or invest - is even more distressed.

The problem here is not that we face a temporary shock to our income. The problem is of debt overhang - basically, the insolvent nature of our households' balancesheets.

Thus, any solution to this problem will require a permanent debt writedown. It cannot be resolved by temporarily suspending mortgages repayments for several reasons:

1. Temporary suspension of mortgages repayments will not draw down the overall debt burden, as banks will reload increases in mortgage finance costs into the future to offset for losses incurred during the holiday even if there is no roll up of interest during the holiday. In other words - suspending mortgage repayment for 2 years will likely lead to banks pushing even higher cost of mortgages interest into years 3 and on for all households concerned;
2. Any rational household will anticipate (1) above to take place and will ramp up precautionary savings to compensate for expected cost increases in their mortgages, withdrawing even more cash from today's consumption. A mortgage holiday in these conditions will lead to zombie banks turning into zombie households;
3. Any rational household will, also in anticipation of (1) withhold any purchases of property until the full realisation of true future mortgage finance costs takes place post holiday;
   
4. If any suspension of mortgages finance involves rolling up of the interest for 2 years, the burden of future mortgage liabilities will increase dramatically, which, once again will be anticipated by the rational households. As a result, households will take 2 years worth of 'free' rent and then default at the point of interest roll up kicking in. We can expect a wall of mortgages defaults in 2013;
   
5. In order for the repayment holiday to have any real effect, the long term growth rate in personal disposable income will have to exceed: increase in the cost of mortgage finance post-holiday + inflation - tax increases expected. This, using current growth estimates etc suggests that in order for a 2 year holiday on repayment of mortgages to have any positive effect, our aggregate expected growth rate in personal income should be in excess of 50% in years 2013-2018. This is clearly not anywhere near being realistic.
   

Once again, the problem we face is the size of leverage taken on by the Irish households. Whether reckless lending or borrowing or both caused this problem is irrelevant. Households become long-term insolvent when their total debt liability rises above 4-5 times their earnings even in the moderate growth in income environment.

We have - on aggregate - households facing:

• current long and short term debt burden of ca 145% of GNP, and
  
• expected (2014) sovereign debt burden of ~140% of GDP or ca 165% of GNP (under rather optimistic assumptions on GDP/GNP gap) - at least 80% of this will have to be repaid out of the pockets of our households.
  

The problem is that these headline figures conceal imbalances in distribution of debt.

While on per-capita basis the overall household debt liabilities amount to ca 310% of our national income, in real terms what matters is the incidence of the debt on productive households. We currently have ca 41.3% of population in employment (or 1,859,000). Of these, 552,900 are in the age group of 25-34 years of age, 469,600 are in 35-44 years of age and 393,900 are in the age group 45-54 years of age. Assume that the demographic pyramid does not change (for better or worse) in the next 10 years. Total employment pool of those that can be expected to carry the debt burden is actually closer to 1.42 million or 31.5% of the total population of the country.

This raises public and household debt leverage ratio on population that can be expected to repay it to a whooping x10 times household income. This, folks, is a bankruptcy territory for roughly speaking 1/3 of our entire population or for nearly 100% of our productive population.

A 2 year holiday from mortgages repayment will simply not solve this problem. Only significant debt write-off of household debts or full restructuring of our sovereign debt and deficit (to eliminate the need for future tax increases and reverse recent tax increases) or a combination of both will be able to correct for this severe debt overhang.