This is an unedited version of my Sunday Times column from September 1, 2013.
As the great 17th century German mathematician and philosopher Gottfried Wilhelm Leibniz said: "There are two kinds of truths: those of reasoning and those of fact. The truths of reasoning are necessary and their opposite is impossible; the truths of fact are contingent and their opposites are possible." In other words, facts can be contradicted, properly structured reasoning cannot.
Recent debate in Ireland surrounding the issue of mortgages arrears and strategic defaults is the case in point. Based on simple extrapolations of evidence collected in the economies with regulatory and social environments largely alien to Ireland, it clashes with the very logic of the regulatory and policy changes we have put in place.
The conjecture is that between 20 and 40 percent of all mortgages arrears in Ireland are 'strategic' in nature. Most likely, this is an over-exaggeration, although we do not know with certainty. However, the incontrovertible truth that this conjecture helps to obscure is that the mortgages arrears crisis is structural and unyielding to the solutions proposed so far. The reason tells us that the mortgages arrears crisis can only be dealt with through the means of a systematic resolution approach.
To-date, no bank in Ireland has completed a full assessment of the extent of strategic defaults amongst the mortgages in arrears held on its books. In the end of Q2 2013, Irish banks held 100,920 restructured mortgages loans. We do not know how many of these relate to strategic defaults. The banks failure to report actual hard numbers suggests that they have not succeeded in identifying many such cases. Thus, factually, five years into the mortgages crisis, we have no evidence as to whether or not strategic arrears are a widespread problem. This lack of evidence is either down to the banks own choices not to analyse the data or their unwillingness to report the results of their analysis.
As the result, we lack not only the crucial evidence to tell how many borrowers are tempting to game the system, but also any knowledge as to what might be driving them to do so.
Finance literature defines strategic defaults as a scenario where mortgagees can afford to pay their mortgage bill, but opt not to do so because walking away from the loan offers them a chance to reduce their financial losses over time. Under this definition, strategic defaults generally arise in the cases of severe negative equity.
Do we have strategic defaulters in Ireland? Reason suggests the answer to this question is yes we do. Is the problem as large as to cover 20 to 40 percent of all distressed borrowers? Logic implies that the answer to this question is no.
Suppose the claim of massive strategic defaults was true. Given property prices dynamics in Ireland over the last 6 years, this means that the bulk of such defaults should have occurred back around the 2010-2011, before the rate of property prices declines slowed down substantially. In terms of mortgages arrears data, the above suggests that arrears of over 360 days duration would be more likely candidates for representing strategic defaults. This is further supported by the fact that over the last 12-15 months, Irish authorities have stepped up the rhetoric against the alleged abusers of the system, and implemented well-publicised legislative and regulatory changes, such as the Personal Insolvency Bill, limiting the incentives for such behaviour.
Now, let's do some sums. Based on the Central Bank data, if strategic defaults were really covering between 20 and 40 percent of total mortgages arrears in Ireland, the number of such cases will be somewhere between 36,000 and 73,000 accounts. These would amount to between 48 and 96 percent of all accounts that are in arrears for over 360 days in the country. In other words, based on these claims, at least half of all longer-term arrears in the country could be suspected of being in a strategic default.
That's pretty extreme of a statement to be plausible. Crucially, such a claim is not consistent with what we can expect from the changes in policies and increased banks scrutiny. More likely, strategic defaults problem is more prevalent in the buy-to-let segment of the credit markets and here it might reach, say 20 percent of all loans in arrears. This would suggest that across all mortgages, including primary residences, there may be some 22,000-25,000 suspect mortgages or just 12 percent of all accounts in arrears. This would be a significant number, but a far cry from the claims put forward by the banks and some analysts.
However, the strategic arrears argument is just a red herring, designed to draw our attention away from ‘the truth of reasoning’, to use Leibniz’s terminology, that clearly shows that Irish mortgages arrears crisis is continuing unabated.
Quarter on quarter, defaults are up across all categories of mortgages, by numbers of accounts, outstanding volumes of loans and levels of built up arrears. Year on year the arrears are rising at double-digit rates. Total arrears now number 182,840 accounts, representing EUR36.6 billion in outstanding loans. The latter figure is growing at almost 10 percent annually. Given current property valuations and the costs of recovery on foreclosed mortgages, reported by the banks to-date, these represent a system-wide loss of ca EUR11-12 billion, hidden on the books. That is before we factor in the inevitable adverse impact of mass-repossessions on the market prices or high costs of personal insolvency resolution.
For Irish banks (as opposed to foreign banks) the above potential losses are closer to EUR6.5-7.5 billion. March 2011 stress tests were based on the Central Bank 2011-2013 projected losses of EUR5.8-9.5 billion for mortgages across Irish banks. In other words, the scenario that the 2011-2013 actual losses booked by the banks, plus the potential losses built up in the arrears will exceed the 2011 stress tests' capital allocations is now highly probable.
The only hope of avoiding another banking crisis, therefore, is that the system can somehow delay recognising the arrears-related losses. The argument that there are huge strategic default numbers hidden in arrears figures helps this, as it suggests that the banks can recover the losses associated with these abuses.
Alas, the strategic defaults are unlikely to be significant enough to help the banks. At the same time, it is hard to imagine that a significant delay to losses recognition can be brought to bear by the policy changes put in place to deal with the mortgages arrears.
Currently, banks hold 1,503 repossessed properties, a number that is still tiny compared to the overall default rates, signaled by mortgages over 720 days in arrears, which number 39,093 accounts and amount to EUR9,358 billion in lending. Thus, over a quarter of all mortgages in arrears are now in default for more than 2 years continually. Many of these are non-reparable. The rates of recovery on these mortgages are unlikely to be more than 40-50 cents on the euro.
Amortising such losses over six-to-seven years period - as envisaged under the reformed personal insolvency regime - may not be an option as to-date the regulators and the banks have been serially failing to deliver sustainable, long-term solutions to arrears.
Data on mortgages that have been restructured by the banks shows that restructuring of the loans is proceeding without any major change in either the mix of solutions offered or the rates of improvement on arrears achieved. At the end of June, only 55 percent of all restructured loans were not in arrears, which is virtually unchanged compared to Q3 2012, the earliest quarter for which we have comparable data.
The risk of default for restructured mortgages is even more significant when we consider the types of arrangements put in place in restructuring. Some 50 percent of all restructurings involve temporary switches to interest only payments or reduced payments of capital component. Eight out of ten restructured mortgages give only temporary reprieve to the borrowers. In effect, of the total of 21,563 principal residences accounts restructured through the end of June 2013, around 20,520 accounts have been restructured so as to potentially either increase or leave unaltered the overall volume of debt over the life-time of the mortgage. Instead of reducing debt burden, our 'solutions' to the mortgages crisis are increasing it.
The overall levels of mortgages that are at risk of default or defaulted continues to climb. Total number of mortgages at risk currently stands at 239,834 accounts, up 11.3 percent year on year in Q2 2013. These represent ca EUR47 billion worth of mortgages or more than one third of all residential lending in the country, up on 29.5 percent a year ago. The systemic risk to the system is rising despite some nascent stabilisation experienced in the property prices and overall macroeconomic conditions, and despite the historically low cost of credit.
The economy is hurling at a breakneck speed toward mass households insolvencies and large scale repossessions over the next 1-3 years. The logic of reality is constantly negating the factoids of the official analysis.
To break this vicious cycle we need to change our modus operandi.
Firstly, we must produce an independent and credible assessment of the problem of strategic defaults. The end-game here should be putting in place a system of evidence-based monitoring and evaluation of defaulting borrowers that is transparent, independent of the banks and accessible to all those involved in structuring long-term solutions. Anyone found genuinely guilty of gaming the system must be forced to bear the full burden of their actions.
Secondly, we need to set a mandatory, clearly priced and transparently administered menu of long-term solutions. All banks must be compelled to offer these to their borrowers.
Thirdly, we need to put in place a system of independent oversight and arbitration over the solutions offered by the banks.
Without swiftly dealing with the strategic defaults and with the problem of structuring, pricing and deploying long-term solutions, Ireland is risking a repeat of the acute banking crisis over 2014-2016. Navigating the world of contingent facts requires more than extrapolating foreign studies to domestic environment. It requires proper logic and reasoning as the backing to policies and systems we deploy.
BOX-OUT:
This week, the OECD published an assessment of the effects of immigration on the member states economies. On average, across the OECD, immigrants contribute positively to the host countries' exchequers, with a net contribution of 0.4-0.57 percent of GDP. In today's Ireland immigrants' contribution to the state purse, net of benefits received, is negative at -0.23 to -0.39 percent of GDP. There is no discernible difference between native and foreign born employment rates in Ireland in 2012. There is a relatively large difference in unemployment rates between the native- and foreign-born sub-populations, that is especially pronounced for women. OECD data puts Ireland in the 8th worst position in the OECD in terms of labour markets effects of immigration and the second worst position in terms of the immigration effects on public finances. Given the fact that Ireland is continuously attracting large numbers of highly-skilled, fully employed, young and tax-compliant professionals, the above findings suggest that Irish aggregate figures are more reflective of the economic impact of the two other major cohorts of immigrants. These are: immigrants who arrived in 2001-2008 from the EU Accession states and those who arrive for family reunification reasons. However, per OECD data, the latter cohort, actually makes a larger positive contributors to the state finances any other type of the household, including the native households. This leaves immigrants from the EU Accession states, most severely hit by the collapse of building and construction and domestic services sectors in Irish economy during the crisis, as the cohort behind the overall negative findings. The point is that, traditionally, stock of immigrants in a host economy acts as one of the automatic stabilisers - a factor that adjusts on its own to reflect the prevailing economic conditions, shrinking in the recession and expanding in recoveries. In modern Ireland, one of the legacies of the 2001-2007 bubble, is that instead of stabilising economic activity, immigration might have acted to amplify the crisis.
As the great 17th century German mathematician and philosopher Gottfried Wilhelm Leibniz said: "There are two kinds of truths: those of reasoning and those of fact. The truths of reasoning are necessary and their opposite is impossible; the truths of fact are contingent and their opposites are possible." In other words, facts can be contradicted, properly structured reasoning cannot.
Recent debate in Ireland surrounding the issue of mortgages arrears and strategic defaults is the case in point. Based on simple extrapolations of evidence collected in the economies with regulatory and social environments largely alien to Ireland, it clashes with the very logic of the regulatory and policy changes we have put in place.
The conjecture is that between 20 and 40 percent of all mortgages arrears in Ireland are 'strategic' in nature. Most likely, this is an over-exaggeration, although we do not know with certainty. However, the incontrovertible truth that this conjecture helps to obscure is that the mortgages arrears crisis is structural and unyielding to the solutions proposed so far. The reason tells us that the mortgages arrears crisis can only be dealt with through the means of a systematic resolution approach.
To-date, no bank in Ireland has completed a full assessment of the extent of strategic defaults amongst the mortgages in arrears held on its books. In the end of Q2 2013, Irish banks held 100,920 restructured mortgages loans. We do not know how many of these relate to strategic defaults. The banks failure to report actual hard numbers suggests that they have not succeeded in identifying many such cases. Thus, factually, five years into the mortgages crisis, we have no evidence as to whether or not strategic arrears are a widespread problem. This lack of evidence is either down to the banks own choices not to analyse the data or their unwillingness to report the results of their analysis.
As the result, we lack not only the crucial evidence to tell how many borrowers are tempting to game the system, but also any knowledge as to what might be driving them to do so.
Finance literature defines strategic defaults as a scenario where mortgagees can afford to pay their mortgage bill, but opt not to do so because walking away from the loan offers them a chance to reduce their financial losses over time. Under this definition, strategic defaults generally arise in the cases of severe negative equity.
Do we have strategic defaulters in Ireland? Reason suggests the answer to this question is yes we do. Is the problem as large as to cover 20 to 40 percent of all distressed borrowers? Logic implies that the answer to this question is no.
Suppose the claim of massive strategic defaults was true. Given property prices dynamics in Ireland over the last 6 years, this means that the bulk of such defaults should have occurred back around the 2010-2011, before the rate of property prices declines slowed down substantially. In terms of mortgages arrears data, the above suggests that arrears of over 360 days duration would be more likely candidates for representing strategic defaults. This is further supported by the fact that over the last 12-15 months, Irish authorities have stepped up the rhetoric against the alleged abusers of the system, and implemented well-publicised legislative and regulatory changes, such as the Personal Insolvency Bill, limiting the incentives for such behaviour.
Now, let's do some sums. Based on the Central Bank data, if strategic defaults were really covering between 20 and 40 percent of total mortgages arrears in Ireland, the number of such cases will be somewhere between 36,000 and 73,000 accounts. These would amount to between 48 and 96 percent of all accounts that are in arrears for over 360 days in the country. In other words, based on these claims, at least half of all longer-term arrears in the country could be suspected of being in a strategic default.
That's pretty extreme of a statement to be plausible. Crucially, such a claim is not consistent with what we can expect from the changes in policies and increased banks scrutiny. More likely, strategic defaults problem is more prevalent in the buy-to-let segment of the credit markets and here it might reach, say 20 percent of all loans in arrears. This would suggest that across all mortgages, including primary residences, there may be some 22,000-25,000 suspect mortgages or just 12 percent of all accounts in arrears. This would be a significant number, but a far cry from the claims put forward by the banks and some analysts.
However, the strategic arrears argument is just a red herring, designed to draw our attention away from ‘the truth of reasoning’, to use Leibniz’s terminology, that clearly shows that Irish mortgages arrears crisis is continuing unabated.
Quarter on quarter, defaults are up across all categories of mortgages, by numbers of accounts, outstanding volumes of loans and levels of built up arrears. Year on year the arrears are rising at double-digit rates. Total arrears now number 182,840 accounts, representing EUR36.6 billion in outstanding loans. The latter figure is growing at almost 10 percent annually. Given current property valuations and the costs of recovery on foreclosed mortgages, reported by the banks to-date, these represent a system-wide loss of ca EUR11-12 billion, hidden on the books. That is before we factor in the inevitable adverse impact of mass-repossessions on the market prices or high costs of personal insolvency resolution.
For Irish banks (as opposed to foreign banks) the above potential losses are closer to EUR6.5-7.5 billion. March 2011 stress tests were based on the Central Bank 2011-2013 projected losses of EUR5.8-9.5 billion for mortgages across Irish banks. In other words, the scenario that the 2011-2013 actual losses booked by the banks, plus the potential losses built up in the arrears will exceed the 2011 stress tests' capital allocations is now highly probable.
The only hope of avoiding another banking crisis, therefore, is that the system can somehow delay recognising the arrears-related losses. The argument that there are huge strategic default numbers hidden in arrears figures helps this, as it suggests that the banks can recover the losses associated with these abuses.
Alas, the strategic defaults are unlikely to be significant enough to help the banks. At the same time, it is hard to imagine that a significant delay to losses recognition can be brought to bear by the policy changes put in place to deal with the mortgages arrears.
Currently, banks hold 1,503 repossessed properties, a number that is still tiny compared to the overall default rates, signaled by mortgages over 720 days in arrears, which number 39,093 accounts and amount to EUR9,358 billion in lending. Thus, over a quarter of all mortgages in arrears are now in default for more than 2 years continually. Many of these are non-reparable. The rates of recovery on these mortgages are unlikely to be more than 40-50 cents on the euro.
Amortising such losses over six-to-seven years period - as envisaged under the reformed personal insolvency regime - may not be an option as to-date the regulators and the banks have been serially failing to deliver sustainable, long-term solutions to arrears.
Data on mortgages that have been restructured by the banks shows that restructuring of the loans is proceeding without any major change in either the mix of solutions offered or the rates of improvement on arrears achieved. At the end of June, only 55 percent of all restructured loans were not in arrears, which is virtually unchanged compared to Q3 2012, the earliest quarter for which we have comparable data.
The risk of default for restructured mortgages is even more significant when we consider the types of arrangements put in place in restructuring. Some 50 percent of all restructurings involve temporary switches to interest only payments or reduced payments of capital component. Eight out of ten restructured mortgages give only temporary reprieve to the borrowers. In effect, of the total of 21,563 principal residences accounts restructured through the end of June 2013, around 20,520 accounts have been restructured so as to potentially either increase or leave unaltered the overall volume of debt over the life-time of the mortgage. Instead of reducing debt burden, our 'solutions' to the mortgages crisis are increasing it.
The overall levels of mortgages that are at risk of default or defaulted continues to climb. Total number of mortgages at risk currently stands at 239,834 accounts, up 11.3 percent year on year in Q2 2013. These represent ca EUR47 billion worth of mortgages or more than one third of all residential lending in the country, up on 29.5 percent a year ago. The systemic risk to the system is rising despite some nascent stabilisation experienced in the property prices and overall macroeconomic conditions, and despite the historically low cost of credit.
The economy is hurling at a breakneck speed toward mass households insolvencies and large scale repossessions over the next 1-3 years. The logic of reality is constantly negating the factoids of the official analysis.
To break this vicious cycle we need to change our modus operandi.
Firstly, we must produce an independent and credible assessment of the problem of strategic defaults. The end-game here should be putting in place a system of evidence-based monitoring and evaluation of defaulting borrowers that is transparent, independent of the banks and accessible to all those involved in structuring long-term solutions. Anyone found genuinely guilty of gaming the system must be forced to bear the full burden of their actions.
Secondly, we need to set a mandatory, clearly priced and transparently administered menu of long-term solutions. All banks must be compelled to offer these to their borrowers.
Thirdly, we need to put in place a system of independent oversight and arbitration over the solutions offered by the banks.
Without swiftly dealing with the strategic defaults and with the problem of structuring, pricing and deploying long-term solutions, Ireland is risking a repeat of the acute banking crisis over 2014-2016. Navigating the world of contingent facts requires more than extrapolating foreign studies to domestic environment. It requires proper logic and reasoning as the backing to policies and systems we deploy.
BOX-OUT:
This week, the OECD published an assessment of the effects of immigration on the member states economies. On average, across the OECD, immigrants contribute positively to the host countries' exchequers, with a net contribution of 0.4-0.57 percent of GDP. In today's Ireland immigrants' contribution to the state purse, net of benefits received, is negative at -0.23 to -0.39 percent of GDP. There is no discernible difference between native and foreign born employment rates in Ireland in 2012. There is a relatively large difference in unemployment rates between the native- and foreign-born sub-populations, that is especially pronounced for women. OECD data puts Ireland in the 8th worst position in the OECD in terms of labour markets effects of immigration and the second worst position in terms of the immigration effects on public finances. Given the fact that Ireland is continuously attracting large numbers of highly-skilled, fully employed, young and tax-compliant professionals, the above findings suggest that Irish aggregate figures are more reflective of the economic impact of the two other major cohorts of immigrants. These are: immigrants who arrived in 2001-2008 from the EU Accession states and those who arrive for family reunification reasons. However, per OECD data, the latter cohort, actually makes a larger positive contributors to the state finances any other type of the household, including the native households. This leaves immigrants from the EU Accession states, most severely hit by the collapse of building and construction and domestic services sectors in Irish economy during the crisis, as the cohort behind the overall negative findings. The point is that, traditionally, stock of immigrants in a host economy acts as one of the automatic stabilisers - a factor that adjusts on its own to reflect the prevailing economic conditions, shrinking in the recession and expanding in recoveries. In modern Ireland, one of the legacies of the 2001-2007 bubble, is that instead of stabilising economic activity, immigration might have acted to amplify the crisis.
