7/6/2012: Sunday Times May 27, 2012

This is an unedited version of my Sunday Times article from May 27, 2012.

Slowly, but with punctuality and certainty of a German train system, Irish mortgages crisis continues to roll on.

This week’s comments from the Central Bank of Ireland, the Financial Regulator and the Department of Finance have exposed the reality of the problem. Our banks’ extend-and-pretend ‘solutions’ to dealing with defaulting mortgagees, was only compounded, not ameliorated, by the State prevarication on core crisis resolution measures, such as personal bankruptcy reforms, developing robust measures to compel banks to deal with the owner-occupier loans arrears and putting forward an infrastructure of supports for Irish mortgagees.

Now, pretending that capital injections based on year-old PCAR tests were sufficient to manage ‘the isolated cases’ of defaults no longer works for the Government. As revealed in the Central Bank comments this week, mortgages arrears have now spread like a forest fire, overwhelming the banking system. Per Central Bank admission, almost one quarter of all mortgages in Ireland are now at risk of default or defaulting, with mortgages in arrears 90 days and over accounting for 10.2% of all mortgages outstanding or 13.7% in terms of the amounts of mortgages involved.

Based on the latest available data, 77,630 mortgages across the nation were in arrears over 90 days in Q1 2012. Using the trends in figures to-date, that would imply de-acceleration in the quarterly rate of arrears build-up from 11.5% in Q4 2010 to Q1 2011, to 9.5% in Q1 2012, although in absolute numbers, arrears increased by 6,719 in Q1 2012 on previous quarter, against a rise of 5,101 a year ago.

There are more ominous signs in mortgages data that are likely to be confirmed in the forthcoming Q1 2012 report.

The main one is the rate of deterioration in the quality of already restructured mortgages. In Q4 2010, 59.4% of all restructured mortgages were classified as performing. In Q4 2011, only a year after, that number was 48.5%. This doesn’t even begin to address the bleak reality of previously restructured mortgages that are currently ‘maturing’ out of the temporary interest-only and reduced payment periods.

Courtesy of the Central Bank of Ireland, we do not have any meaningful data for mortgages restructured in 2008-2009, nor do we have any data on what exact vintages and arrangements these restructurings cover. But we do have some information on the matter from the four state-backed banks annual reports. In the case of these, 10.8% of owner-occupied mortgages were in arrears at the end of 2011, while the arrears rate amongst the mortgages that have been previously restructured was running at close to 33%. More significantly, the rate of arrears build up amongst restructured mortgages was running at 77% over 2011, outstripping a 59% rise in overall number of mortgages in arrears.

Now, recall that the entire Government strategy for dealing with mortgages defaults rests on the extend-and-pretend principle of delaying the recognition of the losses. This is done through imposition of forbearance period, introduction on the voluntary basis of a repayments reliefs. Thus, the restructured mortgages are supposed to be cheaper to maintain than ordinary mortgages. Presumably, the restructured mortgages are also closely monitored by the banks, allowing for earlier flagging of growing problems with repayments and potential additional restructuring before the arrears build up.

Yet, as counterintuitive as it might be, the overall strategy is patently not working exactly for those who were supposed to have benefited from it. The menu of solutions developed by our reformed Financial Regulator and the Central Bank and the policy-active Government departments, alongside numerous working groups and task forces is both woefully short of tools and largely ineffective in scope.

The belated realisation of this has now led the Central Bank of Ireland and the Financial Regulator to make repeated calls for the banks to proactively engage in driving up foreclosures and repossessions, appointments of receivers and enforcers. The problem, from the consumer-conscious, yet banks-supporting Dame Street institution is that its estimates for mortgages-related losses produced back in March 2011 are now at a risk of being overrun by the reality. The problem from the economy’s point of view is that these calls come at the time when we have no new tools for dealing with negative equity involved in such foreclosures, thus risking accelerated foreclosure process to become nothing more than an extension of the crisis itself.

Back in March 2011, the Central Bank estimated base-line scenario 2011-2013 banks losses on residential mortgages books of the four core banking institutions to reach €5,838 million. The adverse scenario is for losses of €9,491 million. Taking into the account changes in house prices since the beginning of the crisis, the current running rate of arrears can put losses on mortgages, if the delinquent properties were to be foreclosed, closer to the levels that would wipe out the capital cushion provided for mortgages losses. And this just for the first two years of the three-year programme. Thereafter, either capital for mortgages losses will have to come from other assets cover (such as Commercial Real Estate or SME loans or corporate lending), or fresh capital will have to be injected.

The irony, of course, is that as I suggested in my analysis of the PCAR results a year ago, the Blackrock original adverse case scenario for life-time losses on residential mortgages – put at €16,898 million – was probably closer to what can reasonably be expected to materialize in the current crisis. Incidentally, the difference between Blackrock’s estimates and Central Bank provisions would mean an injection of €2-4 billion of new capital into the banks to deal with worsening mortgages losses over 2013-2014. This is exactly the volume of additional capital required as estimated by the Deutsche Bank analysts in a note published last week.

So the crisis has now crossed or is about to cross the lower bound of PCARs-allowed losses. And the Central Bank is spurring on the banks to more aggressively foreclose on defaulting mortgages. A major issue with such calls is that absent reforms of personal insolvency regime, accelerated foreclosures will mean lower banks losses at the expense of households. Central Bank’s vision for ‘more robustly addressing the crisis’ would put more people into a perpetual serfdom to the banks in order to undercut banks losses.

Instead of forcing banks to foreclose on defaulting and at-risk mortgages, the Central Bank should create a series of structural incentives that will compel banks to share burden of negative equity with households in financial distress.

CB should shed their pro-banks stand and force banks to take on deeper losses on defaulting mortgagees for owner-occupiers. They should re-evaluate banks capital allocations, and ring-fence specific funds, well in excess of those allocated under PCAR to mortgages writedowns only. In the case where mortgages are at risk of default bit not yet defaulting, banks must be forced to restructure these with a haircut on overall debt relative to equity.

One of the vehicles for restructuring can be the model deployed in the 1920s under the land purchase annuities. Funding a combination of interest relief and mortgage maturity extension can be secured via Central Bank underwriting for a ring-fenced distressed mortgages pool. In addition, it is crucial that banks are forced to consider both the current and the expected future taxes and charges increases in computing mortgages affordability.

Mortgage-to-rent scheme and split mortgages are valid tools in some cases, but these are not being deployed fast enough and the banks have no incentive to structure these in favour of the households. Short-term forbearance should be replaced by measures aimed at achieving long-term sustainability.

A functional and robust mechanism must be put in place to independently oversee the on-going restructuring of these debts. Having sided with the banks all the way through the crisis, existent State bodies cannot be trusted to deliver on this. Instead, a transparent and fully independent entity, involving the non-profit sector operating in the areas of assisting people in mortgages difficulties, plus the strengthened Financial Services Ombudsman and the National Consumer Agency, should be put in place to police the resolution process. Legacy institutions, such as Mabs, should be reformed, if not reconstituted top-to-bottom. Alongside the reform, their resources, professional and board-level, should be strengthened.

Simply talking tough at the banks, as our Financial Regulator and the Central Bank are doing, will not resolve the crisis we face.

CHARTS:

Source: Author calculations based on data from the Central Bank of Ireland

Box-out:

A recent World Bank research paper “Performance-Related Pay in the Public Sector: A Review of Theory and Evidence” surveyed the literature on the theoretical and empirical studies of performance-related pay schemes in the public sector spanning the fields of public administration, psychology, economics, education, and health. The authors found that, based on a comprehensive review of 110 studies of public sector and relevant private sector jobs, a majority of studies (some 60%) found a positive effect of performance-related pay, with higher quality empirical studies generally more positive in their findings (68%). However, these studies predominantly covered jobs where the outputs or outcomes are more readily observable, such as teaching, health care, and revenue collection. There is insufficient evidence, positive or negative, of the effect of performance-related pay in organizations characterized by task complexity and the difficulty of measuring outcomes. Several observational studies identify problems “with unintended consequences and gaming of the incentive scheme”. With a number of caveats in place, this evidence strongly suggests that Irish Government approach to ‘reforming’ the public sector within the confines of tenure-based, rather than performance-based salaries and bonuses, as enshrined in the Croke Park agreement, is a false start on achieving meaningful productivity improvements in the sectors where outputs can and should be measured and cross-linked to actual performance.