How Large Are Strategic Arrears in the Irish Mortgage Market?
This post was written by Gregory Connor
Strategic arrears denotes the amount of funds voluntarily not paid on mortgages by homeowners and buy-to-let investors who have the ability to meet the payments but choose not to do so. The available funds are spent on current (non-necessity) consumption or redirected elsewhere, outside the control of the mortgage-holding bank. Distressed arrears are the “can’t pay” component of mortgage arrears and strategic arrears are the “won’t pay” component.
Since 2009, Irish mortgage arrears have grown dramatically (see Central Bank of Ireland, Chart 1). As of third quarter 2012, the mortgages with 90 day + arrears on principal private residence totalled €16.8 billion. Mortgages in arrears accounted for 15.1% of outstanding mortgages (expressed as a proportion of mortgage value rather than mortgage numbers). In the buy-to-let sector there are €7.9 billion of morgages in 90+ day arrears, and the mortgages in arrears accounted for 25.5% of outstanding mortgages (by value).
Not coincidentally, the dramatic growth in Irish mortgage arrears coincides with the Law and Conveyancing Reform Act of 2009, which made property repossession more difficult and time-consuming, and the subsequent Dunne Ruling, which resolved that the Act was flawed, and put a stop to virtually all new repossessions until such time as the Act was amended to remove the flaw in its construction. This legal flaw has not yet been removed, but the Troika has made it an explicit condition of its financial support program that the flaw is finally removed by March 2013.
Statistically measuring strategic arrears is difficult, but not impossible. As Guiso, et al. state
“The main problem in studying strategic defaults is that this is de facto an unobservable event. While we do observe defaults, we cannot observe whether a default is strategic. Strategic defaulters have all the incentives to disguise themselves as people who cannot afford to pay and so they will be difficult to identify in the data.”
Strategic arrears are a major policy concern in the USA following its own mortgage crisis. Over the last few years there has been a flurry of US-based research to measure strategic arrears and to explain what policy choices tend to encourage or discourage them. Strategic arrears can be statistically measured either using large questionnaire samples (asking people about the strategic behaviour of themselves and/or acquaintances) or by forensic examination of panels of household income/budgets and mortgage payment choices. See Ghent and Kudlyak for a survey of the many US studies. There are some interesting recent findings from all this recent US-based research. Strategic arrears went up sharply as US property prices fell. They rose from 26% of total arrears in March 2009 to 35% of total arrears in September 2010 following the decline in US property prices (Guiso, et al.). The proportion of strategic arrears (relative to total arrears) is strongly dependent upon property prices, and in particular on contemporaneous loan-to-value ratios. The contemporaneous loan-to-value ratio is the current book value of the mortgage (that is, the original amount minus cumulative principal repayments) divided by the current market price of the house. Bhutto, et al. find that for the subset of households with a contemporaneous loan-to-value ratio above 162% the proportion of strategic arrears reaches 50%.
The contemporaneous loan-to-value ratio depends upon the original and current price of the property, the original loan-to-value ratio, the age of the mortgage, and the principal repayment schedule. Consider an Irish mortgage taken out in the 2005-2007 period with an original loan-to-value ratio of 85% and no principal repayment so far (or a higher original loan to value ratio adjusted downward to 85% to account for cumulative principal repayments). If the value of the property has fallen by 48% or more, then such a mortgage has a contemporaneous loan-to-value ratio of 162% or higher, since .85/(1 - .48) = 1.62. This class of mortgages encompasses a nonnegligible proportion of Irish mortgages-in-arrears and among these, according to US-based research, 50% of arrears are strategic.
The US research is not definitive when applied to the different circumstances of Ireland. Social and psychological influences play a big role in strategic arrears decisions. Most people consider strategic non-payment of mortgage debt ethically wrong, but express moral relativity. If home equity losses are sufficiently big, the majority will engage in it. It could be that these ethical/social/psychological influences differ between Ireland and the USA since they are culture-dependent. There is another extremely important difference between the US and Irish environment. In the USA, strategic arrears are inevitably followed by property repossession within a one to three year period, with the specific time length depending upon the State jurisdiction and particular circumstances. In Ireland, repossessions have been effectively blocked since 2009, and the new Personal Insolvency Act continues to block them in most but not all circumstances for principal private residences. US repossession laws differ substantially across US states. Gent and Kudlyak find that cross-state differences have an influence on state-by-state proportions of strategic arrears. Given Ireland’s extremely restrictive regime regarding repossession, this predicts a relatively higher proportion of strategic arrears in Ireland.
Now it comes time to tentatively answer the question in the title. It seems likely that the proportion of strategic arrears in Ireland is greater than 35%, which was the measured proportion in the USA in 2010. Ireland has experienced a greater cumulative property price fall than the USA, and its repossession laws are much stricter, which strongly influences upward the proportion of strategic arrears. Among the buy-to-let subset, the proportion of strategic arrears in Ireland is likely higher than 35%, and may be greater than 50%, reflecting the particular features of this sub-market (wealthier households, a larger proportion purchased near the height of the boom). Cultural and psychological influences could go either way in a US vs. Ireland comparison so I am using conservative guesses, taking into account the influence of very strict Irish repossession laws.
Using the 35% figure, the new personal insolvency regime begins its life with an overhang .35 times (16.8 + 7.9) = €8.645 billion of mortgages with strategic arrears, along with €16.055 billion of mortgages with distressed arrears. Much of the distressed arrears will be lost (as they should be) and much of the strategic arrears will also be lost (as they should not be). The funds will be subtracted from the proceeds on the government-owned commercial banks when they are eventually sold into private ownership.