Tuesday, October 9, 2012

Ireland's plan to fix housing and buoy economy: forgive mortgage debt

The New York Times Dealbook carried an article on how Ireland plans to fix its housing and buoy its economy by having its banks forgive mortgage debt.

While this sounds like Ireland is taken a page from the Swedish Model for addressing a bank solvency led financial crisis, it must be remembered that Ireland received money from the EU to recapitalize its banks.

When Ireland recapitalized its banks, it effectively nationalized the bad debt.  Now, Ireland is simply forcing the banks to own up to the losses that the Irish taxpayers are going to be paying for as the national debt is paid down.

Under the Swedish Model, the banks are not recapitalized by the government.  Either they have the capacity to generate earnings and rebuild their book capital levels through retained earnings or equity issuance or the don't have the capacity to generate earnings and need to be resolved.

With its economy still reeling from the housing crash, Ireland is making a bold move to help tens of thousands of struggling homeowners. 
The Irish government expects to pass a law this year that could encourage banks to substantially cut the amount that borrowers owe on their mortgages, a step that no major country has been willing to take on a broad scale.
Actually, there have been several major countries that have been willing to require their banks to substantially cut the amount that borrowers owe on their mortgages.  In prior financial crises, this was done by Sweden, Finland and Norway.  In the current crisis, this was done by Iceland.
The initiative, which would lower a borrower’s monthly payment, could prevent a tide of foreclosures, an uncertainty that has been hanging over the Irish housing market for years.
Preventing the tide of foreclosures protects the real economy.  This is one of the reasons that the Swedish Model works to end a bank solvency led financial crisis.
If it works, the plan could provide a road map for other troubled countries.... 
 A roadmap that your humble blogger has been talking about since the beginning of the financial crisis.
Most countries that have suffered housing busts, including the United States, have made limited use of so-called mortgage write-downs, the process of forgiving a portion of the principal on the loan. The worry has been that some borrowers who can afford their mortgages will stop making payments to take advantage of a bailout. Banks have also been reluctant since they could face unexpected losses.
The reason most countries have made limited use of mortgage write-downs is they decided to protect bank book capital levels and banker bonuses at all costs.
Ireland is different from the United States and most countries. During the financial crisis, Ireland bailed out the banks, and the government still has large ownership stakes in some of the biggest mortgage lenders. So taxpayers are already responsible for mortgage losses.
Clearly, Ireland directly socialized the losses and its taxpayers are going to be paying for them for years.

What is less clear is that the US and most countries have also socialized the losses and their taxpayers are going to be paying for them for years.  These countries socialized the losses indirectly by shifting the burden of servicing the debt to the real economy.

One way to shift the debt service burden is regulators engaging in forbearance so that banks can use 'extend and pretend' to create 'zombie' loans out of the bad debt.  To facilitate this and reduce the banks' cost of pretending the loans are performing, central banks run zero interest rate policies.

I have documented extensively the negative consequences, like the Retirement Fund Death Spiral, triggered by zero interest rate policies and how these consequences reduce demand.  Demand that debt funded fiscal stimulus then is used to offset.  Debt that the taxpayers are going to be paying for years.
In other countries, the burden of principal forgiveness would largely fall on privately owned banks.
The burden of principal forgiveness falls on privately owned banks only if the government does not recapitalize them.
But the debate is the same: whether to push lenders to take losses now, in hopes that things will get better faster, or wait for the housing market to heal on its own, which could cloud the economy for years to come....
As shown in an earlier post, the Irish central bank economists think it could take 22 years for Irish house prices to recover to their pre-crisis peak.  This reflects the fact that the government chose to protect bank book capital levels.

For countries that don't protect bank book capital levels and require the banks to take their losses now (adopt the Swedish Model), house prices take anywhere from 7 to 13 years to recover to their pre-crisis peak.

Please note that we are 5 years into the crisis and the UK, US and most countries in the EU could still adopt the Swedish Model and speed up the time to recovery of their housing markets.

2 comments:

mortgage housing said...

"The Irish government expects to pass a law this year that could encourage banks to substantially cut the amount that borrowers owe on their mortgages, a step that no major country has been willing to take on a broad scale", this looks interesting. I don't what the effect would this be on the lenders, but one thing is for sure, many people will be benefited on this for sure.

Richard Field said...

The lenders will experience a decrease in their book capital levels as a result of the principle reduction.

Your are right that it will benefit many people. I recall seeing a statistic that there might be 165,000 households that would benefit directly.

The indirect beneficiaries are the Irish economy and the Irish taxpayers. The economy benefits because the households are able to spend more money on goods and services and less on debt service. The taxpayers benefit because as demand increases, so does government tax revenue. An increase in tax revenue helps to repay the national debt sooner.