Forbearance and Frontrunning in Irish Property Markets

The most recent Financial Stability Report from the Bank of England warns about the danger to U.K. economic stability from excessive debt forbearance by U.K. domestic banks. The governor of the Bank of England, Mervyn King, put stress on this risk in his speech introducing the report (although he also noted that this does not mean that forbearance is always a bad thing). In the report, only the potential UK fallout from the Euro crisis ranks more highly than excessive debt forbearance on the list of risks to the UK banking system. This should ring alarm bells in Ireland, since the level of debt forbearance in Ireland at present is much higher than in the U.K.  Encouraging debt forbearance is a deliberate Irish government policy, and the extreme level of forbearance by domestic Irish institutions is storing up potential problems for the future.

There is a considerable overhang of unwanted or distressed (in some cases unfinished) property assets in Ireland (see Ronan Lyons and Namawinelake for discussion). The smart-money players (foreign-owned banks with Irish property assets) might front-run the slower-footed players (domestic, taxpayer-owned banks and Nama) by selling relatively quickly, leaving the Irish taxpayer to fund any eventual shortfall. (I am including the IBRC, the vestiges of Anglo Irish and Irish Nationwide, in my definition of domestic banks.) So loan forbearance and front-running in Irish property markets could interact to the detriment of taxpayers.   

 

Loan forbearance can be a beneficial strategy both from the perspective of the bank and the wider economy, and of course for the debtor. Lengthening or restructuring of debt terms to the benefit of the borrower, in recognition of the borrower’s inability to meet the contractual terms of the existing loan contract, can be profit-maximizing if the alternative to receiving “too little, too late” is receiving “next-to-nothing” via foreclosure. Evergreening is a perjorative term for the same thing, when forbearance is used for deception (such as hiding losses) or for the self interests of bank management. Bank management has strong incentives to roll over and continue to finance bad loans in order to hide and/or delay the realization of loan losses.  

The current Irish situation is not easy; the banks and Nama have tough decisions to make. With a huge potential sales stock and little trading volume, releasing too much property for sale at once will flood the market and drastically lower prices for their remaining stock. The institutional temptation to wait is magnified by unusually debtor-friendly Irish law which makes the repossession process slow and costly. Better to hang on and gamble for resurrection, particularly if one’s shareholders are slow-footed taxpayers and their politically-focussed representatives.

Front-running as a trading strategy has a bad reputation; in many contexts it works so well that it is illegal and/or unethical. In the case of Irish property market overhang, it is legal, ethical, and makes good business sense. Risk-averse, smart-money foreign banks might rationally seek to front-run other players in the Irish property market, in particular the domestic banks and Nama.  Nama has the financial wherewithal to hang on the longest.  See the graph below.  

 

 

In this graph the foreign banks act first, working their way down the demand curve as they repossess and unload their unwanted property portfolios; they are followed by the domestic banks at lower prices; last comes Nama which gets the lowest prices of all. In this scenario, Allsops/Space can look forward to a multiyear stream of commission income, as long as they are smart enough to repeatedly lower their reserve prices as time passes.

An alternative forecast is the “firesale” scenario – property prices are only temporarily depressed by current selling pressure and will rebound to the benefit of the later sellers.  The next graph compares these two scenarios by using a time path of property prices. In the firesale scenario, Nama does the best since it holds out until prices rebound.  Please note that the x-axis is “time” in this graph, not “quantity” as in the previous one.

 

Which future price path is more likely? I am interested in others’ opinions, but IMHO the front-running scenario is more likely. It is more consistent with the disposition effect, which evidence shows is quite strong in property markets. Asset owners (both individuals and institutions) have an irrational tendency to hold on to money-losing positions.  This induces a predictable slow downward trend in property prices after a negative price shock (together with decreased trading volume) since current owners have an irrational aversion against crystallising the lost market value of their assets.

41 thoughts on “Forbearance and Frontrunning in Irish Property Markets”

  1. Starting vs finishing price assumptions make a difference to the apparent desirability of the version in which a market bottom is established (the unhelpfully termed “fire sale” one that is).

    Maybe it is time to level out the spin on this and call one option “extend and pretend”( E&P) if the other is going to be “fire sale”.

    What effect does a declining property market over a decade or two have on an economy? How do you factor that into the E&P choice?

  2. Notwithstanding the front running argument, is there a case for saying that if you apply E&P to significant parts of the economy (Croke Park is E&P for example, there is E&P for bank bond holders) then you have to do it for the whole lot otherwise you get dislocations?

    Say you let property bottom years before you do anything about, for example, recently retired public servants – especially the highly paid ones. Would you hand over too much property ownership to groups like that?

  3. It’s worth noting that the foreclosure rate in the UK is eight times higher than that in Ireland. I think that one was in one of the central bank reports.

  4. I’m with Gregory, I think RBS via Allsops/Space are getting out ahead of the real blood letting.

    Reasons to be bearish:
    ECB are ‘protecting the currency’, so another 1.5% on moartgages easy, which also need to take account of loss making trackers.
    Mortgage interest relief and porperty reliefs in general are to be abolished.
    Banks are soon to be deleveraging.
    Unemployment to remain high.
    It’s difficult for the average private sector employee to get a mortgage. Banks likely to be lending lower multiples of salaries in the future.
    Taxes are on the rise.
    Wages are stagnant.
    Supply is high, though being hoarded.
    High individual and SME debt levels or the ‘balance sheet recession’ affect.
    The lack of desire for debt even by those that have little to none (they hear the horror stories and don’t what their life ruined) or the ‘exit affect’.

    Reason to be bullish:
    CSO population stats.

  5. @Gregory

    If you look at the outcomes to the holders of the equity in the listed Irish banks I think it tells you all you need to know. Your opinion is correct the front loading option was a significantly more profitable strategy for would be long equity holders when wobbles appeared i.e. in simple terms sell now and ask questions later.

    This strategy yielded far better outcomes than hopelessly optimistic hangers on. The mirror image of banks equity being the property market will prove to be no different. I’ve suggested in these posts for sometime that property is just an equity type asset class except it operates in the slow lane. Unfolding events are suggesting this to be the case.

    As the property market lives and dies by the availability of bank leverage and as a result of there being no leverage in the system the market will continue to contract until that dynamic reverts. Unless I’ve missed something lately I don’t see that situation changing anytime soon.

    Prices will continue to fall and sooner or later cash only buyers will realise that upside in a leverage driven market will only come when the providers of that leverage can afford to risk lending in that market again. At the moment the Regulator has ensured this will not happen for a very long time and pricing will ultimately follow the banks actions not the consumers in such a marketplace because banks price property not consumers.

    The ALLSOPS auction results (in the main) are as a result artificial in nearly every respect because they represent approx 2% of the ‘normal’ transaction type in the marketplace i.e. cash only transcations.

    Ordinarily 98% of residential property transactions require a bank to complete the trade. If ‘normal’ leveraged buyers were in the market at the current time I’d safely suggest prices would probably be lower as the additional financing risk would have to be considered in any yield calculation. In most ALLSOPS transactions of late this additional risk element is absent so returns have been artifically inflated.

    So I believe prices will continue to fall until the supply demand dynamic sees net rental yields at c7% for the market as a whole. It must be stressed once again that the CBI PCAR exercise has at the adverse assumptions yields rising to 5.6% – at the minimum this is c20% off and it didn’t cost €30m to find that particular stat out.

  6. @John
    The Phenomena is actually reducing the potential for violence or action – without it many people could not externalise their anger in a safe manner
    Watched OMF getting quite rationally mad on another blog and then get a irrational dressing down from the moderator.
    Its not irrational to get pissed off you know and perhaps point out the absurdity of analysing quite absurd monetory movements..
    Many of the technical commentators here I presume come from the financial industry and are far too close to the Hive whether they realise it or not. – they seem completly oblivious to how the industry has become disconnected from the productive physical economy – pointing out how absurd everything is gets between their teeth sometimes and thats bloody fantastic in my opinion.

    Its healthy that outsiders can point out the extreme Stockholm syndrome held by what we ,whoever we are consider to be financial moderates.

  7. What do you believe will happen if you have a (somewhat) extreme property bubble? A gentle deflation? A POP! How about excrement all over the place? Property bubbles end BADLY! QED.

    I have mentioned this before (and no contrary comments yet!) but we are in the second phase of a economic Regression – not a recession or depression. You do not exit a Regression. You stat: (stand still). The idea of ‘recovery via growth’ is so absurd that when I hear it, I cringe. Actually Joe Durkan got it right with his comments on RTE this mornng.

    This will have significant knock-on effects in the property market, which YoB correctly asserts is ‘welded’ to our (taxpayer- owned) financial institutions. These latter are on life-support. And the donors are ‘ditto’.

    Brian Snr.

  8. @Brian Sr.

    Do you really think Ireland is big enough to sustain its own ‘regression’?

    @ Yields

    I see property falling in Ireland until there is a functioning bank system… so for a long time, but

    “Ordinarily 98% of residential property transactions require a bank to complete the trade. If ‘normal’ leveraged buyers were in the market at the current time I’d safely suggest prices would probably be lower as the additional financing risk would have to be considered in any yield calculation. In most ALLSOPS transactions of late this additional risk element is absent so returns have been artifically inflated.”

    surely if normal buyers were in the market they would be in addition to existing demand and so would only raise prices?

  9. The original post from Gregory Connor presents this scenario as one that “might” happen. Has it not already happened?

    I remember seeing numerous TV shows even a couple of years ago where ACC and other foreign owned banks were namechecked for foreclosing on small commercial developers and “selling houses for far less than their real value”. They almost certainly got much more than they’d get today.

    Similarly, even the stories we recently hear of mortgage suppliers accepting short-sales are foreign lenders that have substantially exited the market.

  10. @ ZD: Thanks for your comment.

    I have used Regression (recession and depression are not apt for our current economic predicament) to mean that the economy will – for a while, ‘re-set’ to a lower level of economic activity (say mid 1990s), but will never grow out of this in the contemporary meaning of ‘growth’.

    The situation is highly volatile, but res property is an example of a ‘Bright Shining Lie’ and many folk (buyers and sellers) are heading for some very nasty shocks. It cannot, and will not be otherwise. Mind you, the unfortunate decision to use the taxpayers to backstop private financial instuituions which are now insolvent was very helpful for the financials, but a future horror story for the taxpayers.

    “Debts that cannot be paid (income stressed borrowers), will not be paid”.

    So, what we have is a bad political predicament and legislators who (so far) do not appear willing to admit to the sheer scale of the debt problem and enact reasonable legal processes to permit those incapable of paying, a way out of their unpayable debts. So far… …

    The Allsops ‘market’ is artificial. It is completely un-representative of the pre-bubble market. Check the prices of res property in 1995. There is also the matter of the volume of sales. I do not have data for this, but I suspect that currently it may be a fraction of ‘normal’. The dopey buyers will figure out in about a year’s time that they were somewhat impetuous, when they observe their ‘bargain’ real estate equity value decreasing nicely.

    Brian Snr.

  11. @kennyK

    Someone might wanna revise JTO’s E grade!

    http://ftalphaville.ft.com/blog/2011/07/26/635011/demographics-and-destiny-us-housing-edition/

    JTO again:

    Very interesting article. Seems to support what I say about Ireland. Not at all surprising, as US and Ireland demographics have many similarities, but very different to continental Europe.

    One minor difference. Average household size in Ireland is higher, but falling (as the recent census shows). The article seems to be saying (which I didn’t know) that it is rising temporarily in the US, because of the recession and general lack of feel-good factor. Apparently, couples are living with their parents for now, rather than getting a place of their own. I predict that this won’t last. There comes a point when the unsurpassable pleasure and joy, that one invariably experiences from living in the same house as one’s mother-in-law, eventually wears off. At that point, average household size will start to fall again in the US. So, in addition to rapidly-increasing population, the US housing market has this to look forward to.

  12. @Zhu De

    Whilst I agree these two statements do somewhat contradict each other my reasoning is very simple, as it relates to investors particularly.

    In todays property market banks who are lending which is virtually non existant I know, but what I’m seeing on the ground, is that they have changed their models somewhat to a rental yield model as opposed to capital appreciation hope model. This matters because the additional financial risk inherint in the ‘normal’ leverage transaction is now actually being appreciated by the banks. This additional financial risk (over and above cash only investors) will require additional returns to compensate.

    Returns in property can only come by way of additional rentals or lower initial capital costs. With incomes likely to come under increasing pressure over the next number of years I don’t hold out too much hope for a spike in rents so I would have expected the additional returns to be achieved by way of lower capital costs i.e. lower house prices.

    I know this sounds very strange in that the banks are now begining to fully appreciate that property is an extremely risky investment, but be that as it may, the current cash only market as pertains to the Allsops customers is not to my mind alive to this new(ish) lending scenario.

  13. 7,330 new residential and commercial buildings were identified across the country in the first six months of 2011, according to figures released today by GeoDirectory. The number represents a year-on-year decrease of 10% compared to the same period in 2010, when 8,119 buildings were added to the database. However, the decrease is substantially smaller than the 40%, 49% and 57% drops recorded in 2010, 2009 and 2008 respectively.

    Separately, commercial property capital vales fell again in Q2 but at an accelerated pace and prices are back to 1999 levels.

    http://www.finfacts.ie/irishfinancenews/article_1022817.shtml

  14. @ Yields
    “The ALLSOPS auction results (in the main) are as a result artificial in nearly every respect because they represent approx 2% of the ‘normal’ transaction type in the marketplace i.e. cash only transcations.”

    Are you sure that none of the 200 or so properties sold were not sold on the basis a pre approved loan?

  15. @Gregory, very interesting contribution and I have not seen any examination of the “front-running” concept at all in the context of our property market, so well done for shining light on the subject.

    Are the present sales by Allsop fire sales? There is certainly a lack of mortgage credit from Irish banks at present and there is much negative sentiment surrounding property, and indeed the economy. On the other hand, the Allsop sales in particular are very well marketed, and there is apparently a strong international presence amongst bidders and to a lesser extent, buyers. It is also a transparent sales process with even access to information. I don’t think you can conclude either way.

    Is there any further information to support the concept of a rapid bounce in a firesale scenario. Minister Noonan referred to a 20% bounce but he was apparently citing a Seattle Washington study. Evidence in our neighbour’s market in the late 1980s and 1990s doesn’t appear to support Min Noonan’s contention.

  16. To an extent the State has a trump card…it can redesignate chunks of Dublin as true high rise zones. This would make the footprint of existing city centre buildings much more valuable. Some of that gain would be genuine societal gain, the rest ‘cannabilizing’ the commuter belt. Interestingly such rezoning would spur a mini building boom also….now if the State was to front load and sell off the commuter belt muck firstly….

  17. @Everyone

    Thanks for so many thoughtful and informative comments — obviously I do not agree with every one of them but lots of good insights.

    @Jagdip Singh

    My little contribution was fairly simple-minded compared to the difficult, more data-intensive analysis on namawinelake. In addition to the frontrunning concept, probably even more important in my mind, is to highlight the notion of a downward-sloping demand curve, and what this could imply about the dynamics of the price path. Also, Ireland property market 2007 – present provides a classic example of the disposition effect.

    I think that Ireland 2000 – 2011 from the perspective of economics as a social science provides an enormously rich body of unusual data which will be mined for decades.

    @Desmond Brennan

    To me that seems an unattractive proposition – making a bit of easy money for a few developers etc by despoiling a beautiful European capital city which has an attractive architectural heritage. But I do not know that much about urban design to be honest – it just sounds bad to someone who likes walking about Dublin.

  18. Something which is often forgotten in discussions of the housing market is that shelter is described as a basic human need – in the UN declaration of human rights along with clothers and food.
    Global wheat and cotton markets are protected against speculation. If speculators push up or fix prices of wheat and cotton then people on 1 dollar a day cannot afford to eat or buy clothes.
    Shelter should also be protected against speculation.
    So I disagree with the point made above that front running is etichal in the Irish or any property market. Another word for front running is “colluding ” or fixing prices above market prices.
    Those excess houses on the banks balance sheets should have had their price reduced and been sold in 2006. If they had been Ireland would be in a much better position now.
    New legislation should be introduced in Ireland similar to Italy and Shanghai limiting the number of residential properties a person can own to 2. This would help stop speculation and has helped to dampen houses prices in Shanghai and Italy avoid a housing boom and bust.
    Irish houses should be put on the market after this law is introduced. Then people who need shelter might be able to afford it. There are over 100,000 on housing waiting lists and 200,000 empty properties in a rigged market.
    Unfortunatly

  19. What sums up Ireland and the crisis for me is that democracy is not about 2 wolves and a sheep deciding what is for dinner.
    Ireland has been like this for the last 10 years and continues to be like this. The 2 wolves are the property owners and people invested in property in Ireland. The Sheep are the 20 somethings and those who do not own properties.
    The wolves have been only thinking of themselves in driving up house prices and now bankrupting the country in desperation to maintain their house values and investments based on housing.
    This little similar to what the Icelandic gentleman found in his anaylsis of the herd.
    Solution – don’t vote and live for maintaining you house value, this is not sustainable, if house prices go up others can’t afford it.

  20. I have much sympathy with those recently married or trying to start a family who bought at the top of the market. They were robbed by a criminal collusion and price fixing by banks, developers and real estate agents. If those people were found guilty of that those people could have their mortage reduced.

  21. @Eamon

    No I’m not sure of course but what I’ve read and heard from people on the ground was that on Day1 90% were for cash and on Day2 it was between 80% to 85% cash buyers.

    If these numbers are anyway close to accurate it suggests a very changed property buying fraternity has suddenly fallen in love with the asset class. This would reverse the trend established over many years of the norms of property buying dynamics.

    I’m prepared to hold the view that normality will resume in time hence the view that this is artificial.

  22. @Jagdip

    “Is there any further information to support the concept of a rapid bounce in a firesale scenario. Minister Noonan referred to a 20% bounce”

    He said wot, exactly?

  23. Front-running has a rather specific, and highly pejorative, meaning which doesn’t seem at all appropriate in this context.

  24. There was little criminal collusion and price fixing. There was the ongoing Irish obsession with land. It used to be with plots to grow vegetables on. As we prospered over the past forty years it expanded to include all forms of real property. The hunger for real property could not be assuaged in the past unless one had cash or cash and collateral worth more than double the amount of the loan. The Euro Zone changed all that in one fell swoop. Central banks had access to funds at rates less than 1%, retail and commercial banks at rates less than 2%. The combination of “money for nothing” or so close to the inflation rate that it appeared to be a cast iron certainty that if one bought real property which appreciated at more than the rate of inflation it would be the same as being on a perpetual motion machine. Without profligate bankers to enable reckless borrowers the run up in values and out of control building boom would not have occurred. The firmly held belief that property had never depreciated in Ireland was widespread and accepted dogma from coast to coast and by all levels of society.

    The major break down occurred in Gov’t who continued to provide stimulus long after the danger signs were flashing red and ear drum splitting loud. Bank regulation did that exist in Ireland? There is plenty of blame to go around, the Central Bank, the retail and commercial banks, the developer/builders, the buyers. Abroad we could focus on banks in England, France, Germany, Netherlands and other countries for believing that the Irish Banks were competently managed and that there was a functioning government with bank regulation. We could focus on the ECB for keeping interest rates low if their legal mandate was not to ensure sustainable growth and an inflation rate of 2% or less for the Euro Zone as a whole.

    We could have behaved responsibly and voted for people who had an inkling about what responsible governance entailed. Instead we carried on as usual and voted for people who could deliver the goodies and get our passports renewed in five days or less. In many cases the criminal colluders and price fixers are us.

    We should be focusing on our TD now and disabusing them of the idea that goodies and personal favours as opposed to tangible efforts to get us back on track will ensure their re-election.

  25. @ grumpy

    Namawinelake refered to it in one of his posts in June. Noonan made a reference to a 20% bounce from trough in passing I think.

    I can’t find any evidence of it ever happening though, hasn’t happened in any of the big houses price crashes anyway, Japa or England. I’d love to know where he got it from.

  26. @ The Dork of Cork

    I’m not saying those that don’t use there real names contribute less, far from it, and as Sahra Carey pointed out there are those that have sensitive jobs and have a lot to contribute.

    However on balance I think use of real names should/would increase the quality of debate on this and probably most blogs.

  27. I presume that we will, at some future date (close to the next gen election?), have to have a set of res property debt resolution (writedown, writeoff, whatever …) procedures put on a legislative footing. So the discussion will have to be about how the unpayable mortgage debts will be sorted out. If this is done then the res property market will ‘revert to mean’ at about mid 1990s valuations. If not, then the present problems will worsen and may become so intractable that a most unwise solution may be forced onto the political stage.

    I suspect that the present gov has this sort of timing in mind. Introduce the new residential valuation scheme and any new charges. Let the debt mess stew and ferment a few years, then observe which way the breeze is blowing.

    Brian Snr.

  28. @The Other Andrew

    What would be a better term? I know that front-running is usually (but not always) used to refer to illegal trading from insider information about the direction of upcoming trades (such as a broker trading before executing his customers’ orders) but what do you call that type of trading strategy when it is legal? Traders who observe public information that some other trader will likely soon unload a big block are not acting unethically or illegally by trading before that, but they are (in my definition) front-running the expected trade. Another term?

  29. @the other andrew

    “Front-running has a rather specific, and highly pejorative, meaning which doesn’t seem at all appropriate in this context.”

    It can in certain contexts – eg in a compliance department – but it is a generally used term also for dealing ahead of expected trades.

    For example dealing ahead of an equity index reclassification of of a futures roll of an ETF is standard trading strategy. If there are any objections it should be to the methodologies of the index funds and ETFs. The term seems appropriate to me in this case – and the fact there are no market makers in the property market to mark prices in anticipation means it is a market asking to be front run. All you need is a view about direction and a book to unload.

  30. @grumpy and The Other Andrew

    I agree with grumpy on this one — my use of the term “front-running” is allowable and was crystal-clear in the context. I mentioned right at the beginning that I was not referring to the definition of front-running in the context of illegal strategies but rather trading prior to expected trades with a likely price impact.

  31. Another small remark – noting the frontrunning activity was the less important contribution of my blog entry — much more important is appreciation of the risk build-up associated with extreme forbearance and the impact of the disposition effect in Irish property markets.

  32. @yeilds

    understood, though I think the unusual nature of housing as both necessity and investment needs to be considered. This is one of the reasons it is so prone to bubble given loose credit. People fear they will not be able to afford something they believe they need if they forgo purchase as prices escalate sustaining irrational investments.

    @Brian Snr.

    agree the need for better debt resolution if Ireland is to recover

  33. You are right when you say front running is buying ahead of the herd using insider information. Dumping property on the market is usually a stampede for the exits in what is expected to be a rapidly declining market. There is an old saying that applies to declining markets and it is “an early loss is your best loss”. Property does not decline in a predictable manner there can be false rallies. flat years, slight declines, significant dips all alternating over 15 to 20 years. In comparison the used car business is one where a steady decline is assured.

  34. Could there be a tipping point triggered by front runners becoming more active? The UK mortgage delinquency to possession rate (which is 3.8 times lower than here) indicates we should expect to see c3,200 home possessions a year. PCAR loss rates extrapolated to the full market (allowing for BoI apparent flexed rates) at e50% peak to trough realisable values, allowing for costs = 50,000.

  35. @John
    Fair enough point John but I am comfortable with my own Dork alter ego – I am sure many of the moderators here feel it suits me.

  36. Looks like NAMA, with its new mortgage scheme, might be trying to get out ahead of many in the market.

  37. And if Nama was able to pull such a stroke and get the backing and clearance for such morgages – even it if it is just a glorified insurance scheme with so many precondtions to make its worth questionable – what effect would it have on private second-hand market sales?

    As far as the front-loading v firesale argument goes, I’m all for the short-sharp-shock approach – get it over with and let the market find its own shape more quickly. But will that happen? No. The clue is in the “slow footed shareholders” with no say in how their taxes are used by the State’s intervention in the market.

  38. Bloody hell… the IT has a piece on this. I hadn’t realised they have got the go-ahead – even covering investors! They are looking for banks to “come on board”. Has the regulator given the go-ahead for this? Who picks up the tab for price drops, does anybody know?

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