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.