New mortgage lending in Ireland in 2011 is on course to set record lows, with the number of new mortgages lower than any year back to the early 1970s. The conventional wisdom is that this is due to a temporary reluctance on the part of Irish domestic banks to issue normal amounts of normal-quality residential mortgages. Under this conventional view, Irish domestic banks must currently pass up otherwise profitable mortgage opportunities because of the banks’ temporary shortage of liquidity and the need to shrink their balance sheets. They are operating under a liquidity constraint. They cannot issue many residential mortgages even though they would profit from doing so. In the circumstances they are rationing their constrained liquidity, only issuing unusually high-quality (that is, super-safe) “gold-plated” residential mortgages to the first tier of very-low-risk applicants. Under this conventional view, once liquidity in the Irish domestic banks is back to normal, the banks will return to issuing normal amounts of normal quality mortgages, servicing a much broader range of customers.
The conventional view may be correct, but I wonder? Is it possible instead that the “normal” Irish residential mortgage is gone forever? Might the “gold-plated” mortgages of 2011 become the only ones available? If so, there are many policy implications, hence it is advisable to consider the possibility. I will give three reasons for speculating that “normal” Irish mortgage contracts might not come back until after Godot.
It is important to note that the random cash flow distribution from a residential mortgage, from the perspective of the issuing bank, has a small fixed upside and a large variable downside. The bank can at best profit modestly from issuing a mortgage, but it can lose disastrously. If events turn out well, the mortgage pays a fixed amount, spread out in equal monthly instalments over multiple decades. These cash flows provide a modest net premium over the cost of funds plus administrative costs. If events turn out badly, the bank can lose almost all of its capital invested. In an extreme case where legal and administrative costs outweigh any repossession receipts it can lose more than 100% of invested capital. This skewed cash flow distribution pattern means that the bank should issue a mortgage to a customer only if the probability of a bad outcome is very low. At mortgage issuance, weighted by long-term probabilities, the big prospective losses under bad outcomes must outweigh the small prospective gains under good outcomes. This analytical point about cash flow skewness is central to my argument. So why might the Irish mortgage market never return to “normal?” Here are my three reasons.
Reason #1: The probability of Eurozone economic and financial instability has increased permanently. This does not depend upon what happens in Greece or Brussels tomorrow or next year; it does not depend upon whether the Eurozone survives fully or partially or not at all. There is a considerable probability of an economic boom in Ireland, but there is and will remain a significant probability of another crisis. We are living and will remain living in economically interesting times. Bankers issuing long-term residential mortgages dislike interesting times (see the cash flow pattern above).
Reason #2: Recent legislative and regulatory changes, such as in the Land and Conveyancing Law Reform Act of 2009 and the Revised Code of Conduct on Mortgage Arrears of 2011, have altered the terms of all Irish residential mortgage contracts, both existing and prospective, lowering their cash flows in bad outcomes. These changes have been made to help currently distressed borrowers, but have the side effect of making banks less willing to provide new mortgages to any households that might possibly become distressed in the future under any foreseeable circumstances. Also, with a multi-decade cash flow horizon, it is necessary for banks to factor in the possibility of future legislative or regulatory changes that might make the value of extant mortgages even lower, for example by making the existing contracts completely non-recourse or without repossession value.
Reason #3: Over the long term, funding risk for Irish banks has increased and will likely remain so. This is no one’s fault; it is just a feature of the changed global environment. The institutional bank runs of 2007-2008 opened up new sources of funding contagion. Irish banks’ funding risk is not nearly as high now as it actually was during the property bubble, when they were reliant on the interbank-lending market for long-term funding, but they did not realize the risk then. Now, the banks understand clearly their funding risks, and the external environment has raised these risks, at least relative to pre-bubble periods.
Where is the positive spin in this dreary message? Perhaps Ireland needs to come up with alternatives to the “normal” mortgage market. In many continental countries, long-term renting is a widespread choice. Or are there new mortgage designs or banking innovations that could reopen the market?