5/9/2013: Sunday Times, September 1: Mortgages Defaults & Arrears

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.

12/8/2013: Sunday Times August 4, 2013: Troika Programme Exit vs Fiscal Reforms

This is an unedited version of my article for Sunday Times August 4, 2013.


Irish political leaders are not exactly known for making logically consistent policy pronouncements. The current budgetary debates are case-in-point. On the one hand, minister after minister from both sides of the coalition benches are repeating ad nausea the tired cliches about their successes in managing the economy. On the other hand, the very same ministers are talking tough about the need for more pain, more adjustments, and more 'reforms' to secure the said recovery and deliver us from the clutches of the Troika. Only to turn around and start praising Troika support as the source of our recovery.

In reality, there are good, if only rarely voiced, reasons for these exhortations: seven hard budgets down, we are not really close to shaking off past legacy of wasteful fiscal practices. The state is still insolvent. The structure of the state policies formation is still dysfunctional. The legacy of pork barrel party politics continues unreformed.

Nothing exemplifies this better than the stalled structural reforms of social welfare and the resulting temporary, risk-loaded nature of much of our fiscal adjustments to-date.


Take a look at the top-line data coming from the Merrion Street.

In the first six months of 2013 tax revenues collected by the Government were EUR3.17 billion ahead of the same period three years ago, while the total voted current expenditure by the Exchequer was up EUR391 million. In other words, the only difference between the current budgetary approach and that practiced by Bertie Ahearn is that today's tax collections are starting from the low levels. Aside from that, current spending continues to ride well ahead of our economy’s capacity to fund it. The 'boom is not getting “boomier”, but the two main current spending lines: social protection and health, are still running at 65.2 percent of the total voted current expenditure, up more than 4 percentage points on 2010.

Things have changed, over the years, to be fair. There have been reductions in current expenditure during the crisis, overshadowed by tax hikes and dramatic cuts to capital spending. Thanks to tax hikes, in H1 2013, Ireland marked the first half-year period when the current spending by the Super-3 Departments: Education and Skills, Health and Social Protection, combined, was below the total tax revenue collected by the State. A significant milestone, but hardly a salvation, as three departments' current expenditure in January-June 2013 still counted for 95 percent of total tax receipts. Thus, even with all the cuts to-date, shutting down all current voted expenditure, excluding the Super-3, will only half our Exchequer deficit from EUR6.59 billion to EUR3.31 billion.

Which exposes once again the five-years-old policy dilemma: to balance the books, Ireland will require at least a EUR2.7 billion worth of further cuts on the spending side on top of what is being planned for 2014-2015. Most, if not all of these will have to come from the Social Protection and Health

Sustainability of savings achieved to-date presents a further risk. So far, cuts to the Exchequer spending that dominated the last five years were heavily concentrated on the sides of capital expenditure and public payrolls. Both are at a risk of reversal in the future.

Any return to growth will require heavier capital investment in public infrastructure, schools, medical equipment and facilities and so on. In other words, capital savings are an illusion on the longer time scale.

Meanwhile, much of the current spending cuts fell onto the shoulders of temporary and contract staff, leaving permanent and more expensive staff protected. This protection came at a cost of increased demands on their productivity. With staff feeling the bite of higher taxes and pensions contributions, while being forced to work more and outside their comfort zone of life-long assignments, public sector unions are already itching to get a new wave of wages increases going.

Back in December 2012, the Troika has pointed out that the savings delivered in public sector pay bills under the Croke Park Agreement cannot be deemed sustainable in the long run. The Haddington Road Agreement for 2013-2016 further confirms this assessment. The insolvent state is now fully committed to more rounds of increments payments, no matter what happens to the economy or exchequer finances. Virtually all ‘savings’ to be delivered under the Haddington Road Agreement are to be automatically reversed at the end of the agreement term or earlier.

The risks of policies reversals on capital and public sector pay, relating to the above measures, are non-trivial. IMF forecasts through 2021 showed the current path of fiscal adjustments taking us to a debt to GDP ratio of just over 95 percent in 2021 from the peak of 2013. Using IMF assumptions, my own estimates suggests that reversing budgetary policies to 2013 levels after 2015 can result in our Government debt to GDP ratio stuck at 108 percent in 2021.


All of which points to a simple but uncomfortable fact: to achieve long-term sustainability of our fiscal policies, Ireland requires a longer term reduction in public spending well in excess of what can be delivered without significantly cutting into current health and social welfare expenditures. Given the fact that health spending is already stretched, the above cuts will have to happen on welfare side.

The reforms, to be undertaken across a period of, say 2015-2016 will have to be sweeping and permanent, building in part on some of the piecemeal changes already in place.

To reduce the risk of replay of the devastating 2008-2010 effects of unemployment shocks on exchequer and economy at large, we need to separate unemployment benefits from other welfare supports.

Unemployment Insurance (UI) should provide a temporary, but generous safety net, sufficient to sustain reasonable family commitments to mortgages and children- and health-related expenditures. Thus, UI should be paid as a percentage of the end-of-employment salary, starting with 2/3rds of the salary up to a maximum of the median wage, with payments declining with duration of unemployment. Payments should terminate after 9 months.

Social welfare payments (SWP) to able-bodied adults can kick in following the expiration of the UI scheme on a means-tested basis. A low monthly personal SWP rate should be supplemented with access to childcare and healthcare, as well as educational grants for children, but only in the cases where recipients engage in training and/or active job searching. A recipient cannot turn down a reasonable offer of a job without facing a financial penalty. All benefits should be subject to a life-time cap of 6-7 years to prevent formation of permanent welfare dependency, while providing a broadly sufficient safety net..

All benefits payments above the monthly personal SWP rate, benchmarked for provision under the scheme, such as health, public services and transport allowance, should be cashless to reduce potential misuse of funds. To encourage better health attitudes and more careful utilisation of public services, a share of unused allowances, say 10-20 percent, accumulated in the account at the end of each year can be paid out as an annual bonus.

We also need to reform our state pensions. Given the fallout from the property bust, large numbers of Irish families are facing the prospect of pension-less retirement. They will require significant state supports - something we cannot afford while carrying the burden of unfunded state pensions.

All statutory state pensions should be means-tested to generate immediate savings and remove absurd subsidisation of the better-off at the expense of those in genuine need. Ditto for age-linked medical cards.

Automatic benchmarking of legacy public sector pensions should end and all current public employees’ pensions should be converted into defined contribution schemes. This will require a legislative decision to alter employment contracts. It will also require recapitalization of the public pensions fund, which can be done gradually over the period of, say, 10 years.

Savings to be targeted in the above measures should apply gradually, over 2014-2017, to generate new substitutes for temporary measures adopted in previous budgets.

However, even with gradual improvements in the labour markets and economy from 2014 on, implementing the above reforms will be nearly impossible. Current political system, with policy decisions based on consensus of the interest groups, is subject to stalling on big reforms and the risk of future reversals by governments seeking popular mandates. This means that we need to take a National Unity approach to structuring and enacting the new legislation dealing with reforms of the social welfare and pensions. Such a consensus is feasible, once all political parties in the Dail realise that Ireland will continue to face subdued economic recovery, elevated unemployment and anemic asset markets well into 2020-2021. With these headwinds, the pressure to carry on with prudent fiscal policies will remain. Thus, the only way of avoiding the contagion from the current long-term economic crisis to the political and state balance of power is to enact irreversible, legislatively protected structural reforms of the social welfare on the basis of bi-partisan legislative engagement.

Box-out:

A note from Davy Research on Mortgages Arrears, published this week, represents a good summary of the current crisis and draws some sensible and well-argued policy conclusions on the subject. Alas, the report commits one common, unnecessary and unfortunate error. Strategic non-payment of mortgages debt is cited in the report eighteen times. Yet, there is no direct evidence presented in the report, or in any study cited in the report, as to the true extent of the problem in Ireland. Instead, like all other analysts, Davy team references unsubstantiated statements by the banks and banking authorities, and simplistic extrapolations of other countries’ studies to the case of Ireland as evidence that "mortgage delinquency has continued to grow despite better-than-expected labour market  conditions” and that “strategic default is now a problem." Like other researchers, Davy team cites increases in employment in Q1 2013 as the evidence of a 'growing problem' with strategic non-payments.  Alas, in Q1 2013, seasonally-adjusted full-time employment (jobs that can sustain payment of mortgages) dropped 4,500 year on year. Broader measures of unemployment reported by CSO also posted increases. This hardly constitutes a material improvement on households' ability to fund mortgages repayments and it certainly does not support the thesis of significant and growing strategic defaults. Of course, absence of evidence is not evidence of absence; the employment data cited above does not prove that there are no strategic defaults in Ireland. It simply shows that absent real, direct evidence, one should take care not to fall into the trap of convincing oneself that an oft-repeated conjecture must invariably be true.