13/10/2011: Mortgages report - offensive & ineffective failure

Inter-Departmental Mortgage Arrears Working Group report, released yesterday is a truly abysmal document that neither delivers meaningful solutions to the problems it sets out to tackle, nor provides any really new solutions that were not already discussed in the Cooney report of 2010.

Let’s consider the ‘solutions’ advanced by the Report. Let us also juxtapose these ‘new’ proposals against the existent means for alleviating stress on households finances arising from the excess debt or lack of debt affordability, which are enumerated in the Report.

An excellent additional analysis of the report is provided by Namawinelake blog (here) and I am broadly in agreement with its author conclusions.

Note that, unlike the Report authors, I view two problems as separate, but related.

The problem of debt overhang is the problem of too much debt carried by the household preventing this household from accumulating pensions and precautionary savings, reducing its ability to provide insurance cover for catastrophic losses of income due to illness or unemployment, restricting reasonable investments in household members’ education and skills (children education, but also adult education – both of which require outlays from the household finances), extending care for incapacitated relatives, saving for potential investment in family business etc.

The problem of debt servicing is the problem whereby debt to income ratios rise to levels whereby debt financing becomes unbearable for the household. This can arise due to any of the following factors or a combination of several factors, such as: loss of income due to unemployment, loss of income due to wage cutbacks or decline in bonuses and commissions, loss of income due to higher taxation burden, loss of income due to illness, increase in expenses due to birth of a new child or arousal of new dependency from, for example, ill close relative, etc.

What solutions does the Report propose?

Solution 1: Forbearance.

This is not a new solution and the Report states that as a part of the “wait and see approach” already adopted by the Government, they are not always appropriate. In other words, one of the solutions presented by the Report is already deemed by the very same Report not to be sufficient. Forbearance is ‘extend and pretend’ type of a ‘solution’ that temporarily reduces the mortgage burden in the hope of short-term return to affordability. It does not deal with the problem of excessive debt carried by the household. Instead it actually exacerbates the problem by accumulating retained interest and extending over time the period of principal repayment, as in the case of forbearance households are mostly excluded from counting their repayments against the principal. It is a very short-term measure (extending the period of forbearance will have a compounded effect of increasing the overall debt level of the household).

As an extension of the Forbearance scheme, the Group notes that Deferred Interest Scheme has already been introduced in the state. The Group fails to provide any meaningful assessment of the scheme claiming that it is too new to allow for such assessment. In reality, deferring interest repayment implies accumulation of higher debt over time through compounding and roll up of interest into the future and has exactly the same shortcomings as the general forbearance scheme discussed above.

Another major issue with both schemes is that they do not alter life-time affordability of the mortgage, which is reflected in their temporary nature. Temporary nature of these schemes, in turn, implies that households entering into these arrangements cannot be expected to meaningfully engage in the economy as savers and consumers. They are suspended in a debt hell limbo for the duration of the scheme and face uncertain future as to their ability to return to normal functioning.

What we need is: conversion of the existent mortgages pool into non-recourse mortgages only for the amount of negative equity. To deliver this, mortgages outstanding should be seen as split between those covering 90% of the current value of the asset (10% cushion provided for future decreases in valuations) and the residual. The 90% current value of the mortgages is recoursed against the value of the home. The excess amount of mortgages outstanding is non-recourse.

Solution 2: Mortgage Interest Supplement.

A measure that provides cash flow support to households that are on public assistance due to unemployment or disability. The Group identifies this scheme as in the need of alteration and suggests that mortgage-to-rent (MTR)schemes (see below) can be used to move long-term recipients of MIS off the temporary measure. This implicitly suggests that the Group sees MTRs as a long-term default option.

Amazingly, the Group provides un-backed and un-specified estimates for writing down the entire pool of negative equity or writing down the most severe negative equity cases (2006-2008 mortgage originations) at €14 billion and €10 billion. The Group states in a blanket fashion that “scheme would not be an effective use of State resources and would not solve the problem”.

Worse than that, the Group has managed to produce not a single meaningful or even token debt relief measures. The Group “examined the proposal to increase mortgage interest relief to 30% for First Time Buyers in 2004-08 but it was considered that this change should not be recommended. The proposal would give increased relief in an indiscriminate manner as it would give benefits to all who took out mortgages in the relevant years, regardless of their economic circumstances. The proposal would cost the Exchequer approximately €120m in a full year and it would not be appropriately targeted at those who need the support.”

This is an extraordinarily bizarre statement. The Group on objective – as stated – included to consider measures “to reduce the drag on the economy from a significant cohort of over-indebted people whose spending is constrained by mortgage debt obligations.” And yet, the Group passed on the only solution they considered to deliver some relief here. Reducing effective cost of mortgages interest financing would have improved significantly many, more stretched, households cash flows, especially for those early into the process of mortgages repayment. In other words, it would have had a compounded effect of reducing interest payments when these payments are the largest proportion of the mortgage itself, potentially improving repayment of capital. The scheme would have had no adverse impact on moral hazard and would have been politically acceptable as a partial compensation for tax increases suffered by the very same households. It is cheap (could be financed for 6 years out of just one unsecured unguaranteed bond repayment by Anglo due this November at €737 million) and effective in reducing the most egregious share of the debt incurred – interest charges. It also could have served as a buffer for future interest rate increases, thus effectively helping more, in the longer term, those on the adjustable rate mortgages who are currently subsidising tracker mortgage holders.

The fact that these considerations were omitted by the Group shows that the Group was not fit for purpose – its members had no sufficient financial insight into the debt issues and mortgages finance to make any reasonable assessment of the situation.

What we need is: extended Interest Tax Relief scheme covering all first-time mortgages for principal residences issued in 2004-2008 with extension for 5 more years at 50% of the total interest paid. The cost of this scheme should be in the neighbourhood of €250 million per annum and it should be financed through writedowns of unsecured bondholders in Irish banks.

Solution 3: Introduce New Bankruptcy Legislation.

This is hardly a new solution and as such the Group was expected to provide more robust guidance as to the terms of reform of existent bankruptcy laws. The Group correctly identifies one major part of the problem with existent legislation as: “Given the full recourse nature of mortgages there is no current insolvency option for many mortgage holders who are in difficult or unsustainable mortgages – they could face permanent bankruptcy”. In other words, the problem is in the full recourse nature of the mortgages and the long-term or permanent nature of the bankruptcy.

The Group comprehensively fails to address both sides of the problem in its recommendations.

With respect to the length of the bankruptcy status and associated claim on the debtor income, the group states:

“The group understands that the automatic bankruptcy discharge period under the judicial process could be set as low as 3 years”. In other words, the Group fails to make any proposal as to the length of bankruptcy period. It simply defaults to 3 years as the only option because it is what it being discussed elsewhere.

What we need is a two-tier approach to the bankruptcy reforms:

Tier 1: Emergency level legislation covering mortgages taken prior to 2009 which will have automatic release after 12 months of compliance with court-ordered repayment schedule and zero recourse thereafter. In the case of non-compliance with repayments, the bankruptcy period can be extended to 3 years and then to 5 years. There should be no recourse on assets outside the mortgage, but access to bankruptcy should be granted only to those unable to pay their mortgages through current income as supplemented by a reasonable drawdown of existent assets. For example, a household savings should not fall below 20% of annual pre-tax income so as not to deplete insurance buffer against household loss of income in the future due to illness or unemployment. The households can be required to sell any other property assets they hold if this releases funds to aid repayment of mortgage. The legislation should apply only to primary residences and can be staggered to reduce its applicability to ‘trophy’ homes, so that only part of the family home mortgage under, say, the threshold of €500,000 can be covered by such process.

Tier 2: Long term legislation covering all mortgages taken since 2009 that will include, 3 year term for automatic release, recourse against other assets and restriction on mortgages issued in the state to non-recourse mortgages only, for all new mortgages going forward.

Instead of robust proposal for reforming the bankruptcy law, the Group report produces extraordinarily woolly wish list of non-judicial process proposals for dealing with defaults.

This includes a non-judicial settlement process that is not backed by any compulsion on behalf of the lender to engage in such a process or to deliver any specific targeted means for reducing overall debt burden of the household. Instead of specifically calling for lenders being required to write down some minimum share of debt, or some debt linked to, say, income and affordability metrics, the proposal simply waffles on about “mortgage lenders will need to make allowance within their mortgage solutions, on a case by case basis, to make some funds available to facilitate unsecured debt settlement”.

And there’s more: “Uncertainty exists as to how the courts will deal with an income earning bankrupt – it could require them to make payments to the creditors beyond the discharge period.” Now, this begs a question: why on earth did we need the Group report if all it can tell us is that the courts will decide? And how can the report make a claim that this entire strand of bankruptcy resolution has any whatsoever validity as a tool for alleviating currently draconian bankruptcy conditions if it is left up to the courts to decide?

Another ‘measure’ proposed by the Group is Debt Relief Order (DRO), which will “allow persons with “no assets – no income” to fully write-off unsecured debt within a short period of time”. How? No information is given. How long is the ‘short period of time’? Unspecified. But the Group refers to the UK DRO equivalent of €17,000. So, let’s summarize this ‘measure’ – under DRO, once you are bled dry, the Government will facilitate (legislatively, presumably) an up to €17,000 writedown of your debt alongside the loss of your home, your assets and your income, while levelling you with the very same bankruptcy burdens as above. The whole mechanism would constitute a reasonable measure only in a lunatic asylum.

Solution 4: Mortgage to Rent Scheme (MTR)

This implies converting existent mortgage to a lease with the mortgage holder losing all future claim on equity in the property.

The problem is that, as the Group states: “The group recommends the introduction of two mortgage to rent (MTR) schemes aimed at those people who would qualify for social housing if they lost their home and where their house is appropriate to social housing”

So explicitly, there is no cover for anyone who does not qualify for social housing. In brief – you are either broke or you are not covered. Which automatically means the scheme does no work to alleviate constraints on future savings and investment, pensions provision, education investment etc.

“The schemes should be subject to an initial review after 12 months and a value for money review after 24 months” In other words, the scheme is non-permanent and cannot be considered a solution to the long term problem. It is simply ‘extend and pretend’ type of a solution with the worst possible outcome – all future uncertainty is loaded onto the mortgage holders.

A person entering the scheme, in effect, surrenders any legal claim on the asset and any leverage for dealing with the default-related loss once he/she signs the papers as the state can simply deny the benefit in 12 months or later.

Worse than that, “There may be a mortgage shortfall that will still need to be dealt with” in other words, the negative equity component of the mortgage remains unaddressed, i.e. it remains the liability of the original borrower. This provision is simply mad, given the Group set out to resolve the problem of defaulting mortgages.

Solution 5: Trade-down Mortgages (TDM)

Trade down mortgages is in itself not a solution to the debt crisis, but an affront to those currently struggling under the weight of debt. It ignores the fact that majority of those heavily indebted (relative to their incomes) are younger families who bought their first homes – small, usually out of town, lower-end-of-the-market dwellings trading down from which is an equivalent to telling them to pitch a tent in a bog and call it a “more modest home”.

Worse, the proposal admits that the scheme would increase, not decrease, the overall debt burden carried by the mortgage holder as LTVs are going to rise and not just by the amount of negative equity carried over, but also by the closing costs which the Group has no grace to advocate forgiveness for. Negative equity is then crystallized into real debt. In medical terms, it is like advocating cutting both limbs for a patient with one gangrened arm!

The Group’s brain-dead - and I cannot call it any other – ‘logic’ is such that they actually state: “While the increased LTV is relevant, so long at the mortgage holder can afford the new mortgage and the ratio is not so high as to be a disincentive to the mortgage holder, it is a secondary factor”. In other words, higher debt is a secondary issue from the Group’s point of view, despite the fact that it clearly contradicts their own objective of reducing the negative debt effects on the economy.

What we need here is an explicit cap on carry over of negative equity under TDM scheme. In other words, cap the amount of negative equity to be carried to new ‘smaller’ dwelling mortgage to not exceed 10-20% of the total new loan, with additional ceiling on combined new mortgage not to exceed 110% of the current value of the new property bought. This will provide both an incentive to engage in trade down for the household and a finite cap on debt limits. It will also reduce future default risk for lenders.

Solution 6: Split Mortgages (SM)

Split mortgages proposal allowing the household to split existent mortgage into ‘affordable’ part to be subject to continued repayment and the ‘unaffordable’ part to be either warehoused until repayment environment (income) improves or until the mortgage holders is forced into other types of arrangements.

This, of course, presents a number of problems. Firstly, it is another extend-and-pretend measure not dealing with debt overhang, as the overall level of debt carried by household remains identical to pre-restructuring. Secondly, it introduces an incentive for the banks to hold mortgagees in constant fear of foreclosure, especially if the property prices rise or if the banks find capital to writedown the foreclosed mortgage. Thirdly, there is no provision for the interest rate relief in the scheme, implying that interest rate will roll up on both sides of the split mortgage. This means, the banks can ‘warehouse the principal’ while forcing households to pay interest on full amount of the mortgage. In other words, effective interest rate payable on mortgages will rise and the present value of the lifetime debt will rise as well.

The Group failed to see any of these possibilities in their report.

What we need here is a New Beginning type of a solution with added caveat that the warehoused part of the loan does not involve roll up of interest for 3 years and that the part of the loan due for continued repayment be structured in such a way as to payments covering at least 50:50 the interest due on overall mortgage and repayment of the principal. In other words, at least every €1 of each €2 of repayment has to be used to reduce principal amount under mortgage. Furthermore, we need protection of borrowers from increases in the interest rates, with warehoused mortgage converted to fixed rate or tracker mortgage at inception.

Overall, therefore, the Keane report utterly and comprehensively fails to deliver any new and/or meaningful measures for dealing with the crisis. The Report is extremely weak on analytical details (using nothing more than publicly available data from the CB of Ireland, without even applying CBofI own model for dynamics of future mortgages distressed available from the PCAR/PLAR exercises). It is a lazy, write-off piece of work by people who appear to have no understanding of the realities of the problems they discuss.

The failure of this report is so comprehensive and represents such a direct affront to the nation burdened with unprecedented debt overhang that the entire report must be binned – publicly and irrevocably – by the Government and a new, independent and broadly authorized commission should be set up to produce real measures aimed at alleviating both problems:

Problem 1 – financial sustainability of currently distressed borrowers, and

Problem 2 – overall debt overhang in the household economy.

Some of the possible measures aiming at dealing with the above problems are already outlined in my comments above. More proposals will follow on this blog in the future. Stay tuned.