Wednesday, 7 July 2010

The 'Prodigal Son' Dilemma in Irish Mortgage Debt

Nat O'Connor: Mortgage payments are on a lot of people's minds these days, and there has been a fair deal of coverage in the media about negative equity. One stark snippet from the Irish Time's today is that "Irish households are among the most indebted in the world – more so than any of their euro zone counterparts. The vast bulk of their debt is accounted for by mortgages." This should worry us all greatly.

The interim report of the Mortgage Arrears and Personal Debt Expert Group suggests some good practice guidelines for lenders. The detail of these has been reported elsewhere (e.g. Irish Times gives an outline, a Q&A, and an analysis, as well as reporting the Financial Regulator's reaction).

I think there is a background assumption around the perception of state intervention in personal debt that needs to be teased out. An extreme contrast illustrates what I see as the 'prodigal son' dilemma. The story is something like what follows. John worked for ten years, saved €500,000, and bought himself a house. That house is now worth €300,000. John can kiss goodbye to €200,000. The value of his investment went down, not up. Meanwhile, Seán got a 110% mortgage to buy an identical house priced at €500,000, next door to John. He borrowed the extra €50,000 (10%) to do up the house, but managed to fit in a holiday and several cases of champagne while he was at it. Seán's house is also now worth €300,000. Both John and Seán are complaining of negative equity. Seán is looking at the spectre of rising interest rates in the medium term and his ability to pay is coming under strain. John would be sickened if Seán got bailed out in some way, as he paid the full price for his house and €200,000 of his money is gone and no one is suggesting he should get it back. State intervention to help Seán often invokes the term 'moral hazard' – that is, encouraging prodigal, reckless, extravagent behaviour.

Some version of this prodigal son idea seems to me to vex a lot of people. Yet, like the original parable, envy or spite might be masking a more reasonable reality.

John has no monthly payments to make, and so he is comfortably off. He lost €200,000 on his investment, but he must take some personal responsibility for choosing to buy when and where he did. Meanwhile, Seán borrowed €550,000, but with interest rates over a long period (say 30 years), Seán will pay back at least €800,000 in total (assuming interest at a relatively low level, like 3 per cent). And Seán could well pay back over €1,000,000 if interest rates go to 5 per cent, and they could go much higher. Meanwhile, house prices may not make any significant rise for the next 30 years. After all, other countries, like Germany, have a very stable market. So Seán could be paying €1,000,000 for a house that in 2040 will still be worth something like €300,000, maybe €400,000, in today's money. Of course, not all of that €1 million will be paid in 2010 prices, but it is still a lot more money than the house is now worth or will be worth. In sum, Seán has 30 years of steep payments to make, while John can live comfortably, save money and make other investments. In the long-term, it was Seán who made a worse investment than John.

It would be one thing if John were to shrug his shoulders, say 'you win some, you lose some' and look to tomorrow. John lost money on his investment, and equally the bank (as a business) will lose money on the loan to Seán if they have to write off part of it. But banks are no longer operating as purely private businesses. John knows that the banks are all being bailed out by the taxpayers. So John is, in a real sense, being asked to swallow his own losses and then help his ‘prodigal’ neighbour too.

Yet clarity on this issue may again be blinded by envy and spite. John is not a heartless capitalist. He believes that the state has a role in providing people with their human rights, such as education, access to healthcare and housing. This is where John needs to put aside his emotions and think business again. He is willing to pay tax to house people who need to be housed. And if the state has to rehouse Seán in social housing or through rent supplement payments, this may represent worse value for taxpayers’ money than assisting him to pay his mortgage. Even if that means writing off €100,000 or €200,000 of his debt.

John might initially think that instead of writing off €200,000, why doesn’t the state buy a house with that amount of money and stick Seán in it. The problem is that if this happens, Seán may default on the whole €550,000 mortgage. And the banks won’t absorb that loss, the taxpayer will – including John.
The best scenario is thus for Seán to be kept going in his house, paying as much of his debt as he can afford, while still living a reasonable quality of life. ‘Affordable’ for housing costs is typically defined as a third of after-tax income.

And because the state is different from commercial entities, it doesn’t even need to write off any amount of Seán’s debt. Instead, the state can take a long-term equity stake; effectively freezing a large chunk of Seán’s mortgage but clawing it back whenever Seán sells the house. The state can even wait until Seán dies and, like the tax inspector, have first claim on Seán’s estate. The state won't make the kind of profits banks make from charging compound interest, but Seán's debt to the state could be linked to house price inflation to avoid it dwindling away.

All of this can be worked out in a businesslike way. What blocks this kind of transaction is the ‘prodigal son’ culture, which could otherwise be termed class prejudice. John doesn’t want to live beside Seán. If Seán is getting state assistance, John wants him to live in inferior quality housing, in a less desirable location. Or at least, John feels that he should get better quality housing in a better area because he paid for it all by himself.

Yet, housing studies consistently argues that social mix creates the most thriving residential areas, with busy shops, less crime, etc. There are also sound economic as well as social arguments for keeping people in their homes, while making their mortgages more affordable.

Ireland can solve its crisis of mortgage debt. But it can only do so through solidarity. The example of John versus Seán is extreme, but as people nurse their wounded pride (and their ‘loss’ in their ‘investment’ in housing), they need to be persuaded of the rationality of helping their prodigal fellow citizens, while also reassured that more responsible borrowers in negative equity will also benefit.

And don’t forget that one in four households pay rent in private or social housing, and they all pay tax too. These are the citizens who are not too interested in the jealousy between one middle class homeowner versus another, as they wrangle over bailing out themselves and the banks. The renter households in Ireland need to be convinced that any mortgage rescue for others, will also involve a whole new national housing policy that will benefit them. That means the state’s role in providing housing must be to ensure everyone receives equally good housing, in a good location with good amenities. We have the means through NAMA, massive quantities of vacant housing and plenty of skilled people who can build the amenities like schools, transport infrastructure, etc that are required to add ‘locational value’ to Ireland massive stock of badly located housing.

And it is the locational value – proximity to services like schools, shops, playgrounds, public transport, green space, etc. – that is the real fundamental in the housing market that will determine quality of life through quality of the built environment.

In this context, the Mortgage Arrears Group’s recommendations really pale into insignificance. They are taking some steps to stop the banks making the situation worse some people by getting them off lower interest tracker mortgages. But the group’s remit does not extend to dealing with the massive crisis in Ireland’s housing system.

In fairness, it is an interim report. The Irish Times reports that “It had been hoped by those struggling with excessive mortgages that the group would recommend some element of debt forgiveness, or introduce debt-for-equity swaps, which would help them to reduce the overall size of their loan. However, this report makes no such suggestions ... In a follow-up report, which is due to be completed by the end of September, the group indicated that it will address the issue of ‘borrowers with unsustainable mortgages’.” But this is not just a problem for those borrowers. The cost will be passed by the banks to all taxpayers. Hence, we need a radical rethink of how we as a society will respond to a crisis that affects all of housing policy.


Mack said...

Nat -

If Sean's loan was made non-recourse he could walk away from the property without bankruptcy.

I'm not necessarily sure why Sean will become dependent on state aid (at least other than temporarily?). So I'm sure he could rent somewhere nice? Perhaps even the house he used to own (minus the decades of debt servitude)?

One advantage of this is that all home owners in serious negative equity could walk away. (Yep - all of them!). Which would hopefully bankrupt the banks entirely. Load as much of the debt up onto the public balance sheet, default (10c on the Euro) and start over from a place of reduced private and public debt with cheap housing?

It's probably going to happen anyway, but we'll still have extraordinarily high household debt..

Nat O`Connor said...


I think the key question is who 'defaults' and for how much money. Mortgage defaults by individuals will create bad debt that will get passed on to the state. So, are you talking about a massive state default to clean out the system?

At the base of all this, Irish banks owe major eurozone banks in Germany, France, etc truly massive sums of money. For example,"Data compiled by shows that holdings of Spanish debt by euro zone core banks grew from less than €100 billion a decade ago to more than €600 billion at the end of last year. The banks’ holdings of Irish debt increased from €60 billion to almost €350 billion over the same period."(2 July 2010, Irish Times) Ireland is a tenth of Spain's size, but has over half of its level of debt to eurozone banks. Ireland is now 'too big to fail' for major banks in eurozone countries.

And the governments of those countries are not going to let us wrap up all our personal mortgage debt into one giant national debt that we then collectively default on. It just isn't politically possible if Ireland wants to have any kind of functional relationships within the EU.

Mack said...

Nat -

So, are you talking about a massive state default to clean out the system?

Essentially yes.

You are proposing that some people in negative equity get bailed out, by the rest of the Irish citizenry, including others deep in negative equity who can just about make payments.

I think it fairer that the other half of the equation here - the lender - take some of the hit, rather than Irish citizens. (10c on the €1 is probably over dramatic, but we can negotiate).

I can see only 2 ways out.

1/ We inflate away our debt.

The ECB could do this for us one way or another. But the Germans are opposed to this.

2/ We deflate our way out.

I can't see how we can deflate our way out without defaulting on debt. A first step would be wholesale reform of our bankruptcy laws so the delinquent banks and not our citizens take the hit. After that we can negotiate with the Europeans.

If they've ruled out #1 that leaves #2.

It's their choice.

By the way, remember the bullying of Iceland?

Mack said...

And the governments of those countries are not going to let us wrap up all our personal mortgage debt into one giant national debt that we then collectively default on

We've already done this with the bank guarantee and NAMA.

Nat O`Connor said...


"You are proposing that some people in negative equity get bailed out, by the rest of the Irish citizenry, including others deep in negative equity who can just about make payments."

Not really. I'm suggesting that Seán in my example pays as much as he can and that the state recoups the rest at a later stage as this is the cheapest way for the taxpayer of housing him. The only cheaper option is to force him into homelessness or permanent emigration. And the latter does seem to be some people's preferred option.

As for a massive state default, I'm not against it if private banks and investors are going to bear the cost of the reckless lending that went on. But if it gets dumped on the citizens of other European countries, then we would be playing 'beggar thy neighbour' combined with 'pass the parcel' - with the citizens of the last country standing taking the collosal debt incurred by a near-decade of folly across Europe.

We've already done this with the bank guarantee and NAMA.

Oh, they'll let us wrap the parcel alright. Just not pass it!

Mack said...

Nat -

The European banks were overleveraged.

The current situation means Irish citizens take the hit, protecting German citizens. German savings clubs appear on RTE news explaining why they refuse to spend more (purchase goods from their European partners) and bemoaning that they'll have to pay for any bail outs. We're already bailing them out! We've taken responsibility for the recklesness of banks that happen to be domiciled here and are keeping them afloat at great expense in order to protect them and their savings.

The parcel is a bomb, and unfortunately some of those responsible for making the bomb threw it onto our lap (Irish Bankers). Their European partners in crime (European bankers) have walked away, and our European partners think this is our issue & our fault. I think you've explained pretty well that it's everyone's problem.

Bit of a rant I know. But 4% inflation or so could make short work of that debt (half-life of approx. 18 years). Or could the ECB purchase the debt from the overleveraged banks / governments, with newly generated money, as part of a one-off bailout and write it off?

Nat O`Connor said...


...could the ECB purchase the debt from the overleveraged banks / governments, with newly generated money, as part of a one-off bailout and write it off?

The crisis could well turn out to be a test of European solidarity versus national self-interest. Some sort of ECB-led EU-wide rescue might be the best way forward, but would never be without political consequences... perhaps a stronger EU hand in economic policy? Tax harmonisation? EU-wide regulation? All prices we might be happy to pay if the EU was made more strongly democratic at the same time. But it could tip the balance towards a federal system.

More technically speaking, if the ECB were to print money, the euro would devalue greatly, which would probably drag down non-euro EU currencies with it, but not necessarily in a nice co-ordinated way.

Likewise, euro devaluation could harm trade and give outside governments an opportunity to pay off their debts to EU banks at half price before then devaluing their own currencies to counteract any competitive advantage the EU might gain.

At the very least, it would be a big move for the ECB, with a lot of consequences which are difficult to predict or control. And the ECB is meant to be independent of political pressure, so the Council of Ministers - at least of the eurozone - would have to agree unanimously on such a radical step. And that's where the blame and horsetrading would take place, with either national self-interest or European solidarity emerging victorious...

Seamus Coffey said...

The example of John versus Seán is not extreme, it's absurd. There is no real difference between their situations.

You argue that Sean is in a worse position to John because Seán will end up making €800,000 and possibly €1,000,000 in mortgage repayments for the €500,000 home that is now worth €300,000.

John saved the price of the home and paid €500,000 for it. However, that is not the end of it. By using the money to buy the house he gave up the interest he could have earned by keeping the money on deposit.

The full cost of the house to John is the €500,000 he paid for it and the interest income he forfeited had he not spent the money. Over the lifetime of Seán's mortgage, John's €500,000 lump sum could grow to €800,000 or €1,000,000 depending on interest rates.

Seán faces monthly repayments on the money he has borrowed. John forgoes monthly interest income on the money he has spent. The net effect on the two is the same.

It is incorrect to argue that there is a difference between these cases simply because one person saved and one person borrowed.

This is why the type of 'bailout' suggested is inappropriate.

Nat O`Connor said...


You are assuming that interest rates are the same for savings and borrowing. In fact, borrowing has attracted a significantly higher rate of interest. But to extend your example, I agree that John is indeed facing opportunity cost from a variety of other investments that would have served him better than putting all his savings into his family home.

But there is a significant difference between his situation and that of Seán in my other example. That is their position today. John is probably ten years older than Seán, having saved for all those years. But as of today, he is relatively flexible. He can sell his house at current prices if he wants. If he loses his job, he won’t risk losing his home, because he owns it outright. Seán on the other hand is trapped. His bank won’t let him sell up at such a loss, and if he loses his job, or even has decreased income, he could have difficulty keeping his home.

And that’s the scenario that a significant minority of people face today: the risk that they will lose their home and be pursued to their grave with the outstanding balance of their mortgage debt. At best they will keep their homes but pay unaffordable levels of housing costs for decades, which will reduce their quality of life and their opportunities.

I argue that this is a problem for all of us. Even if only one in twenty households is facing this situation, it is too many people. It will have a negative drag on the economy for decades. And the free market option of letting people default and banks take the hit is not available to us, because of the blanket guarantee given to our banks by the Government. Plus, if people are paying huge debts post-repossession, they will need housing assistance from the state.

We could say ‘tough’, these people made bad decisions. And I agree that some personal responsibility must remain with those who bought houses at inflated prices. But other factors were completely out of ordinary people’s control. There was market distortion from a host of factors, and a lack of information for consumers. So I think some of the problem needs a co-ordinated state-led response to ensure everyone is decently housed (with best value for tax money) and that people pay their debts up to, not beyond, an affordability threshold. I’m not even suggesting writing off the debts, just freezing them - much like the Fair Deal for nursing home care. So it's a mild bailout compared to other propositions.

By the way, I called the examples “extreme” because they are at two extremes of the mortgage market: John has no mortgage, where Seán has a 110 per cent mortgage. The reality is that most mortgages were likely to have been given as 70-90 per cent loan-to-value. Plus, many mortgages are nearing the end of their life, with an effectively much lower current loan-to-value and probably no negative equity.

antoin O Lachtnain said...

Why not give a large tranche of extra tax credit over two or three years and a stamp duty break to people who have negative equity and want to trade up? For people who can't pay, give them some sort of payment holiday.

They can borrow on the strength of the extra tax credits they will get. There is little moral hazard in this, it is just softening the blow. It stimulates activity in the economy too, which is the main thing. For sure, it means that the losses gets split out between the borrower, the lender and the taxpayer rather than falling on the borrower alone, but it seems like a worthwhile cause to get the economy moving.

Nat O`Connor said...


I'd be wary of giving tax credits, as they won't benefit people on lower incomes as much. And I'd be more likely to suggest a stamp duty break for people in negative equity who want to trade down, rather than up, in order to reduce their overall mortgage by say €50,000 or €100,000 - which would make a significant difference in the long run.

"it means that the losses gets split out between the borrower, the lender and the taxpayer rather than falling on the borrower alone, but it seems like a worthwhile cause to get the economy moving."

This is an important point because if the economy doesn't get moving, there will be real losses for most people. So the taxpayer is faced with making the best of a bad situation, based on cost-benefit analysis. The more indebted people will still pay the most, so the 'moral hazard' issue really could be turned around to ask: how much are we willing to make people suffer for bad judgements in areas where most of them had little competency and were badly advised?

Michael Doherty said...

The real question is what type of society do we want in Ireland.

A society with a social character: Persistent unmanageable debt ultimately leads to poverty. So too will the consequences of not providing tangible solutions to individuals in dealing with mortgage arrears. In cases of repossession what happens with residue debt in negative equity situations? Residue debt will lead to social exclusion as those holding it will be excluded from participation in financial services. Research has shown that financial exclusion contributes to poverty.

Therefore what to do?

The solution requires a range of fixed; revision of bankruptcy laws, legislating for a defence for borrowers where lending has been reckless, implementation of sale and rent back schemes, much more sharing of the pain by the financial institutions, i.e. breaking fixed interest contracts without penalties, reducing interest rates to tracker rates to ensure mortgages are viable. It is also essential that programs be put in place to take sub-prime lenders out of the market place. Mortgages are a long term contract, it is essential that financial institutions begin to take a longer term view of arrears and the resolution of same.

The alternative: A purely capitalist society in which we allow all struggling with arrears to face repossession and the inevitable consequences of this route. Equally the banking sector should have been allowed collapse in this scenario, which would have led to the whole financial system collapse and essentially the economy.

Yes we could start again, but not as a first world country! and in such an economic breakdown both Sean and John would most likely be equally destitute.

Anonymous said...

A lot of talk on here as if any of you have any say in what will happen.

The theatre playing out before us has a script and an outcome.

Within 12 months it will be announced that the recession is over. We will be told that house prices have risen again and soon after modest growth in GDP & GNP will help to underpin Government borrowings.

Meanwhile a number of state assets will have been transferred to German, French or British ownership. I give you one recent example. AIB's key Grafton Street branch has been bought by a German investment firm recently for €28M. AIB's Polish arm will soon be sold too.

Bord Gais and other state assets may also be sold.

What you are witnessing is a managed process of asset stripping of a small subservient state by its money printing masters.