4/4/2013: IMF Analysis of Recent Personal Insolvency Reforms in Europe

In the previous post, I covered in 4 charts (via IMF research paper) the extent of the European debt crisis (link: http://trueeconomics.blogspot.com/2013/04/442013-real-debt-european-crisis-in-4.html?spref=tw ). Here, based on the same source, proposed solutions for dealing with the household debt crisis.


Per IMF:

"A number of European countries have introduced or refined personal insolvency regimes to achieve orderly resolution of the debt overhang over time." Note that here, "personal insolvency law may also cover natural persons who are engaged in business activities (traders or merchants)", which is of course something unaddressed explicitly in Irish reforms despite the fact that current system of insolvency effectively spells an end to the careers of many professionals and businessmen and businesswomen.

"For example, Estonia, Iceland, Italy, Latvia, Lithuania, and Poland adopted or amended the personal insolvency law. The Irish Parliament recently adopted an entirely new personal insolvency law to, inter alia; shorten the discharge period from 12 years to 3 years subject to certain conditions. [The bill also allows the court to require repayments for up to five years in the bankruptcy process.]

Here's a very interesting bit: "The German government is also considering a reform of the personal insolvency regime that includes a shortening of the
discharge period. [The proposal envisages to reduce the discharge period from six years to three years provided that at least 25 percent of all debt must be repaid by an individual debtor]." Now, again, interestingly, Irish reforms provide for no set bounds for repayment, thus implying that there is no set limit resolution to the post-bankruptcy liability.

"In designing such regimes, these countries have faced a number of challenges. First, unlike corporate insolvency, there is no established international best practice at all in this area, especially with regard to the treatment of residential mortgages in insolvency proceedings. Second, as individuals are involved, the design of the law is inevitably driven by social policy considerations; these include the goal to reinvigorate individual productive potential in the mainstream economy and to reduce the social costs of leaving debtors in a state of perpetual debt distress. [Note: this is obviously not a core objective for the Irish reform, as it provides virtually no protection to the borrower during the voluntary arrangements period prior to bankruptcy.] Third, the law needs to keep an appropriate balance between maintaining credit discipline and affording financially responsible debtors a fresh start. Finally, the design of the law needs to take into account institutional infrastructure that is critical to the predictable and transparent implementation of the law, including the availability and quality of judges and trustees, administrative capacity, accounting, and valuation systems. [Note: in the Irish reforms case, none of these objectives are met and in fact some are directly violated by the reforms.]"

"A number of basic design features for an economically efficient personal insolvency law have emerged from the early cross-country experience:

• Allocate risks among parties in a fair and equitable manner; [Not delivered in the Irish case at all]
• Provide a fresh start through discharge of financially responsible individuals from the liabilities at the end of insolvency proceedings (typically after 3-5 years); [Provided in the Irish reforms]
• Establish appropriate filing criteria to make insolvency procedures accessible to individual debtors while minimizing abuse; [Irish reforms maximise potential for abuse in pre-insolvency processes of so-called voluntary arrangements by ensuring the banks have asymmetric veto power over arrangements, the banks have sole power of determination of terms and conditions for voluntary arrangements workout period, the banks control and own arbitration process, the banks are not compelled to transparently disclose their solutions and conditions for accessing these solutions, etc].
• Impose automatic and temporary stay on enforcement actions with adequate safeguards of creditor interests; [This is contradicted by the stated Government intention to speed up forced foreclosures as a part of restructuring of the banks mortgages books]
• Set repayment terms that accurately reflect the debtor’s capacity to repay to ensure an effective fresh start; and [Note: it is hard to imagine how this can be achieved in the environment of Irish reforms as outlined in the bullet point 3 above]
• Recognize foreign proceedings and enable cross-border cooperation to avoid bankruptcy tourism. [It is unclear how Irish reforms can reduce incentives to avail of the UK system given the conditions for insolvency in Ireland involve up to 6 years of voluntary work-out plus insolvency process, against 12 months in the UK].

What's happening beyond the above menu?

"The unprecedented challenge of excessive mortgage debt has prompted some European countries to introduce special legislation. [Norway, when facing its own banking crisis and recession in the early 1990s, adopted the Debt Reorganization Act in 1993 to provide debt relief to debtors who are unable to meet their obligations for a period of time. The law provides for voluntary debt settlement and compulsory debt settlement (e.g., reduction of principal of a residential mortgage to 110 percent of the market value of the residence). Now, wait, we were told that such measures (also deployed in Iceland) have never been tried and would lead to a wholesale collapse of the economy...] "

"Faced with wide-scale household mortgage distress in the aftermath of the recent crisis and the bursting of the real estate bubble, Greece, Spain and Portugal have introduced special legislation to address unsustainable residential mortgage debt burdens on households while limiting adverse effects on banks’ balance sheets and minimizing moral hazard."

All of these regimes differ in several respects:

1. "...While the Spanish regime allows financing institutions to opt into the scheme [Once a financial institution opts in, it must implement for at least two years a Code of Good Practices which provides for measures aimed at achieving a viable mortgage restructuring for debtors covered by the regime., banks’ participation is mandatory for Greece and Portugal]. 
2. ... Spain and Portugal allow mortgage debtors, subject to certain conditions and as a last resort, to transfer the mortgaged property title to the bank (or a government agency in Portugal) and obtain cancellation of the mortgage debt (up to the assessed value of the residence in Portugal). [Under the Spanish regime, the transfer of the property title and the cancellation of the debt can only happen after it has been proven that neither restructuring of the debt nor application of a partial release is viable.] Greece, on the other hand, allows the court to grant a full discharge of the mortgage debt if the debtor repays up to 85 percent of the commercial value of the principal residence determined by the court over up to 20 years. It is yet too early to assess the effectiveness of the Spain and Portugal regimes, but the Greek authorities are revisiting their framework due to its low rate of successful restructuring to date."

"A number of countries have adopted measures to facilitate out of court settlement for distressed mortgages. For example, Iceland, Ireland, and Latvia adopted voluntary guidelines or codes of conduct that provide guidance on mortgage restructurings for borrowers in financial distress. In 2012, Portugal introduced voluntary out of court guidelines for banks to restructure household debt including residential mortgages more generally with the assistance of debt mediation facilities. Estonia adopted a law effective in April 2011 aimed at supporting the out of court restructuring of debt obligation, including mortgages, of natural persons facing financial difficulties — although the procedure relies heavily on court input. To reduce the burden on the court system, the personal insolvency law recently adopted by the Irish Parliament introduces three non-judicial debt settlement procedures for household debt including a personal insolvency arrangement for settlement of secured debt up to €3 million and unsecured debt (no limit) over six to seven years. The effectiveness of these approaches in tackling mortgage distress remains to be seen."

22/10/2012: Financial Crises: Borrowers Pain, Creditors Gain

A very interesting paper on the effects of the financial crises on imbalance of power (and thus the imbalance of the incidence of costs) between the borrowers and the lenders. The paper is a serious reality check for Irish policymakers in the context of the 'reforms' of the Personal Insolvency laws currently being proposed. In fact, the Irish proposed 'reforms' actually tragically replicate the very worst implications of the study summarized below.

"Resolving Debt Overhang: Political Constraints in the Aftermath of Financial Crises" by Atif R. Mian, Amir Sufi, and Francesco Trebbi (NBER Working Paper No. 17831, February 2012 http://www.nber.org/papers/w17831) shows that "debtors bear the brunt of a decline in asset prices associated with financial crises and policies aimed at partial debt relief may be warranted to boost growth in the midst of crises. Drawing on the US experience during the Great Recession of 2008-09 and historical evidence in a large panel of countries, [the study explores] why the political system may fail to deliver such policies. [The authors] find that during the Great Recession creditors were able to use the political system more effectively to protect their interests through bailouts. More generally we show that politically countries become more polarized and fractionalized following financial crises. This results in legislative stalemate, making it less likely that crises lead to meaningful macroeconomic reforms."

Mortgage recourse:

"The higher level of recourse and tougher rules for declaring bankruptcy are likely to prevent borrowers from declaring default. As a result, debtors in European countries are more likely to absorb financial shocks internally than declare default. …We investigate this …by comparing the change in default rates across Europe and the United States during the 2007 to 2009 global housing crisis. Since the bankruptcy regime is relatively more lax in the United States, one would expect a larger increase in default rates." Controlling for rates of decline in house prices and the level of indebtedness of the borrowing households (LTVs at origination) the authors test explicitly data for US, U.K., Spain, France and Ireland from 2007 to 2009 using data from the European Mortgage Federation. 

Figure 1 

"The change in default rate (red bar) for USA between 2007 and 2009 is 5.9 percentage points. While the default rate level in 2007 is not shown in Figure 1, it is quite low and similar across the five countries (0.4%, 1.2%, 0.7%, 1.9%, and 2.1% for France, Ireland, Spain, the United Kingdom and the United States, respectively). …All European countries in Figure 1 have high recourse and tough bankruptcy laws relative to the United States. The very large increase in default rates for the US is consistent with the notion that lower level of recourse and easier bankruptcy legislation helps indebted borrowers declare default. …A collective look at the three housing market variables in Figure 1 shows that the United States experienced the highest increase in default rates by far, despite some of the European countries experiencing very similar (if not stronger) decline in house price (e.g. Ireland) and having similar housing leverage (Ireland and the United Kingdom)."

  

The Political Response to Financial Crises and Debt Overhang:

                                                

"The 2007-2009 US financial crisis provides an interesting case study to examine the political tug of war between debtors and creditors. …[In the US], housing assets were the main asset for low net worth individuals, and their housing positions were quite levered. As a result, the collapse in house prices disproportionately affected low net worth individuals. Mian, Rao, and Sufi (2011) show that at the 10th percentile of the county-level house price distribution, house prices dropped by 40 to 60% depending on the house price index used. This decline would completely wipe out the entire net worth of the median household in lowest quintile of the net worth distribution. CoreLogic reports that 25% of mortgages are underwater; for the low net worth individuals in the US, this effectively means that their total net worth is negative." 

"It is in this context that Mian, Sufi and Trebbi (2010a), henceforth MST, document the political economy of two major bailout bills that were passed in the US Congress in 2008. The first of these bills, the American Housing Rescue and Foreclosure Prevention Act (AHRFPA), provided up to $300 billion in Federal Housing Administration insurance for renegotiated mortgages, which translated into using public funds to provide debtor relief… At the same time, creditors--i.e., the shareholders and debt-holders of large financial institutions--pushed a second bill which was closely tied to protecting their own interests [the $700 billion Emergency Economic Stabilization Act (EESA) which eventually led to TARP]…"

"While both debtors and creditors were effective in passing legislation in their favor, there were two important differences in the magnitude of their effectiveness. First, the debtor friendly bill provided fewer resources ($300 billion versus $700 billion) than the creditor friendly legislation… [despite the fact that] debtors faced substantially larger losses …than creditors in the face of the US housing crisis. Second, while the creditor friendly EESA bill was fully implemented and executed, the housing legislation was a miserable failure. As of December 2008, there were only 312 applications for relief under the program and the secretary of Housing and Urban Development was highly critical of the program. … When Obama Administration …implemented the Home Affordability Modification Program under AHRFPA, their initial goal was to help 3 to 4 million homeowners with loan modifications. In July, 2011 President Obama admitted that HAMP program has “probably been the area that's been most stubborn to us trying to solve the problem.”" 

"It is worth noting that one of the main reasons for the ineffectiveness of the HAMP program has been the lack of cooperation from creditors. The initial legislation made creditor cooperation completely voluntary, thereby enabling many creditors to opt out of the program despite qualifying borrowers. In fact, as Representative Barney Frank noted, banks actually helped formulate the program in the summer of 2008."

Need I remind you that in Ireland's reform bill to alter the draconian personal insolvency laws currently on the books, the banks not only have an option of voluntary participation, but an actual veto on resolution mechanism deployed.

"Cross-country evidence on financial crises and change in creditor rights The seminal work of La Porta et al (1998), followed by Djankov et al. (2007), introduced cross-country index of “creditor rights” from 1978 to 2002. The index captures the rights of secured lenders under a country’s legal system. A country has stronger creditor rights if: 

1.  there are restrictions for a debtor to file for reorganization [In the case of Ireland's Insolvency Law reform, this factor is actually made worse than in the current legislation since the reform law is going to force debtors to undergo a period of compulsory arrangements dictated solely by the banks before they can file for bankruptcy]; 
2. creditors are able to seize collateral in bankruptcy automatically without any “asset freeze” [again, my reading of Ireland's 'reform' proposals suggests automatic seizure of assets once bankruptcy is granted]; 
3. secured creditors are paid first [as is the case in Ireland]; and 
4. control shifts away from management as soon as bankruptcy is declared.  

"Overall, while creditor rights promote the origination of more credit, a financial crisis that results from excessive debt tends to reduce creditor rights. These results highlight a fundamental tension between the benefits of stronger creditor rights ex-ante and the debt overhang costs associated with giving creditor too much power in the financial crisis state of the world. Ex-post relaxation of creditor rights is not the norm after a financial crisis. …More specifically, we show that financial crises are systematically followed by political polarization and that this may result in gridlock and anemic reform. …Financial crises polarize debtors and creditors in society. On the one hand, debtors are weakened by a fall in the value of assets they hold. On the other hand, creditors become more sensitive to write-offs during bad times …and possibly more reluctant to converge onto a renegotiated platform because of their increased reliance on the satisfaction of the original terms of agreement."

7/9/2012: Psychological effects of debt

For our brilliant minds in politics and their 'intelectual' parrots who constantly remind us (albeit with, thankfully, decreasing frequency) that negative equity only matters when people need to move, here's one piece of latest research on links between debt (unsustainable) and mental health.

Link.

So, nothing to worry, then. The results are:

• "...Results provide strong evidence  that respondents’ reactions to problem debt have a non-negligible social dimension in which the prevailing local level of indebtedness impacts on individual psychological stress." In other words, other's debt is not just their own problem.
• In a multivariate model "individuals who report they face ‘difficulty’ meeting their housing payments (mortgage or rent) are at least two months late on their housing payments, or who report that meeting their consumer credit repayments presents a ‘heavy burden’ to their household, exhibit worse General Health Questionare scores and greater propensity to suffer from depression". now, note - this is not just about those who are defaulting, but also those who are facing difficulty meeting their repayments.
• Secondly, "...selection into problem debt on the basis of poor psychological health accounts for much of  the observed cross-sectional variation in psychological health between those with and without problem debts. ...individuals who are observed to move into arrears on their housing payments or into reporting a heavy burden of debts between two waves of data exhibited, on average, worse psychological health than those not moving into debt problems in the first wave of data." In my opinion, this is likely the effect of buildup of stress prior to arrears actually arising formally and as households work through their savings, cuts to their budgets and borrowings from relatives on their way into arrears. If so, the longer the delay in dealing with problem debts (and in Ireland it is now counted in years, not months), the worse the psychological outcomes.
• Per negative equity: "...it is shown that mortgage holders who enter into arrears on their mortgage debts in localities where house prices are growing (and so their home equity ‘buffer’ is increasing) suffer less deterioration in psychological health compared to individuals who enter into arrears in localities where house prices are falling (and so their home equity ‘buffer’ is decreasing). Home equity buffers have been shown to be important forms of consumption insurance for households facing adverse income shocks (Hurst et al. 2005; Benito, 2009)." Need I say more.
• "Individuals who exhibit the onset of  problems repaying their unsecured debts in localities with a higher bankruptcy rate ...experience less deterioration in psychological health compared to individuals exhibiting the onset of problem repaying their unsecured debts in localities with lower bankruptcy rates." This is most likely accounted for by much faster and more lenient personal insolvency resolution regime in the UK in general, leaving lower stigma on those defaulting on unsecured debt.
• "By contrast, individuals who exhibit the onset of problems repaying their secured debts in localities with higher mortgage repossession rates are shown to experience more deterioration in  psychological health compared to individuals ...in localities with lower mortgage repossession rates." Again, the UK more developed and more lenient regime for resolving secured debts insolvencies is also at play here, in my view, as repossessions are signals of the deepest form of insolvency, and non-repossession solutions are well advanced. This implies that localities with higher rates of repossessions are more likely to have experienced much greater declines in income, rises in unemployment and/or prices declines in the property markets.

All in, I read the above evidence as the urgent signal that Ireland needs:

1. Immediate reform of its bankruptcy laws to facilitate speedier resolution of debt problems;
2. The reform should focus on pre-bankruptcy resolution mechanisms (as the current Government proposal does suggest) but these mechanisms must be robust and not left to the disproportionate capture by the lenders (as the current Irish Government proposed legislation does).
3. The reform must carry emergency measures to deal with the unprecedented crisis we are facing today - in other words, the reform should not attempt to set a singular new regime for the perpetuity, but have two different regimes - Firstly: a reform to address the emergency situation with much more lenient bankruptcy arrangements for those who have acquired the unsustainable debts in the period 2002-2008, Secondly : a reform to address the future bankruptcy regime, post-emergency. The current legislation is better served for the second purpose, but it does not meet the requirements of the first objective.