The Economic Rationale for the Insolvency Service of Ireland

The economic rationale for the new Insolvency Service of Ireland is well-founded in economic theory. It hinges on the concept of Pareto improving bargains. The idea is that a debtor, with the guidance of a personal insolvency practitioner, can construct a Pareto improving bargain to everyone’s benefit: the debtor, the lender, and society as a whole.

Consider a debtor with unsustainable debt who, to avoid the personal and social costs of bankruptcy, goes to a personal insolvency practitioner (PIP). The PIP objectively examines the debtor’s situation and suggests a payment scheme which offers only part-repayment of loan value. Let the offered proportion of loan value be denoted by OFFER where OFFER < 1.  If OFFER = 1 then the debtor is not insolvent since he/she can afford full-value payment and the PIP has no role.  The PIP describes the offered repayment plan to the lender (or lenders).

The lender knows that the alternative to a personal insolvency plan is bankruptcy for the borrower, and that bankruptcy entails large financial costs, most of which will be borne by the lender. The uncertain proportion of loan value received by the lender after accounting for bankruptcy costs will be denoted by RECOVER.  The debtor will accept the PIP offer if it provides higher expected value of total payments:

OFFER > E[RECOVER],          (A)

where E[ ] denotes the expected value.

The economic rationale for this process is that it can make all three interested parties (debtor, lender, and society) better off. The debtor avoids the personal/social costs of bankruptcy; the lender gets a loan recovery amount which is higher than the expected bankruptcy-cost-adjusted amount received otherwise.  Society avoids administrative bankruptcy costs and gets the benefits of a debtor freed more quickly from debt distress. Of course the PIP has lots of other duties (counselling the debtor, dealing with multiple lenders, administrative duties) but dealing with equation (A) is very fundamental.

The banks understand equation (A); the politicians understood equation (A) when they set up the enabling legislation. Does anyone in the Insolvency Service of Ireland understand equation (A)?  It is fundamental to the Service performing its important task competently.

The Primetime news show recently highlighted a young couple whose PIP offer was rejected.  I do not want to focus particularly on the individual case, keeping in mind the adage “hard cases make bad law.” According to the discussion in the show, the couple owed a mortgage-related debt of €276,000 and their PIP constructed an alternative loan repayment of €2,000. That is, relying on the numbers as discussed in the show, they made an offer of:

OFFER = 2,000/276,000 = 0.0072.

It is important for clarity to note that this does not denote a concessionary interest rate of 72 basis points; rather, 72 basis points is the total proportion of repayment including all principal repayment. Unsurprisingly, the PIP offer was rejected by the lender.

One could argue that the bank could just forgive the couple the loan debt as a gift (skip the 0.0072 partial payment which is too miniscule to consitute a meaningful debt settlement arrangement).  That is, the insolvency system can be brought in as a useful component of parish pump politics, in the good sense, of parish pump politics as using the political system to create unfunded sources of benefits for local causes.  There is certainly a case for doing this, but it was not actually the intention of the legislation. Doing so would greatly increase the effective political power of the ISI as controller of this new source of unfunded social benefits.

A technical feature of equation (A) is a convexifying effect for OFFER proportions close to zero. OFFER is known with certainty whereas RECOVER is a random proportion. Since RECOVER has a lower bound at zero, Jensen’s inequality means that the expected value of RECOVER is much higher than its maximum likelihood value in the region near zero. Is seems extremely difficult to create a scenario where E[RECOVER] could fall as close to zero as 0.0072.

The head of the Insolvency Service of Ireland was on the Primetime show, but he did not seem to be familiar with equation (A), or did not consider it relevant. He did seem to understand that if the ISI had the power to force deals without worrying about (A), then parish pump political considerations would give the agency much greater power. Yet equation (A) was extremely relevant and the absence of any appropriate analysis associated with it detracted considerably from the clarity of the discussion. The staff at the Irish Insolvency Service could benefit from the 30-minute lesson in the economic rationale for their agency’s existence.

[I added a few edits to correct typos, respond to comments (thanks to Sarah Carey and to other commenters who induced me to think more carefully). There may be some time-inconsistencies between the earlier comments below and the later edits.]

Comments

comments

24 thoughts on “The Economic Rationale for the Insolvency Service of Ireland”

  1. I’m sorry – I don’t understand this. Can you have another go for the those of us down the back? As I recall the bank sold the house out from under the couple, for a vastly lower sum than the full amount of the loan, and was still going after the couple for the remaining amount. So the couple had no house and still had a considerable debt. Not sure what the equation is for that.

    What kind of offer would persuade the bank to take less money, when they have the legal right to pursue the couple forever for all the money owed? It seems to me the lender’s costs of rejecting the offers are very small. Flog the house and keep churning out the demand letters.

    I’m not so sure they banks are using the equation. I think you have to include all the behavioural stuff, the level of vindictiveness, the desire to be seen to be tough so word doesn’t get out and of course, the total disregard for the human cost of their bad lending decisions.

  2. @Sarah — They were a classic example of a couple who were bankrupt pure and simple. It was absolutely not a credible personal insolvency arrangement, not even close, but no one on the show was honest and straightforward enough to tell them that. It would be better for the bank to donate the loan to them for a sum of zero, rather then pretend that this was a PI arrangement. But then the system changes fundamentally. The PI system (despite the impression given on the show) is not actually supposed to be a method for banks to donate funds to worthy hardship cases. Such a system could easily be constructed but it is a different activity.

    I couldn’t find any typos in your contribution above.

  3. ok. Point taken.

    I’ll have to go back and watch it.

    But, could you explain the formula bit again please? Maybe with another example? merci.

  4. “The economic rationale for the new Irish Insolvency Service is well-founded in economic theory.”

    It may indeed be so. But upon what empirical observations is that theory founded? I’ll bet none. That’s nice for some, but certainly not for any distressed borrower.

    “The economic rationale for this process is that it can make all three interested parties (debtor, lender, and society) better off.”

    Better off than what? This is another piece of theoretical economic claptrap. Are human persons (in economic terms), just objects? If so, those theorists have poor minds and little wisdom.

    “OFFER = 2,000/276,000 = 0.0079.”

    Is this the sum of a human life? A damned mathematical equation! JMJ! Economics should be drowned!

  5. @ Gregory Connor

    That’s a very worthwhile analysis but I would always look at resolving systemic issues like this right from the root.

    For money comes from bank loans and is destroyed as the loans are repaid. Banks only create the principal of each loan but expect the principal plus interest back. Equation (B) could read:

    P + I > P => Defaults are inevitable.

    This is the case no matter how hard-working and wise everyone in the system is, including bank managers.

    I understand the theory that it is possible for all loans to be paid according to plan because banks only delete the principal of loans before repayment.

    However, when you look at the extent of the mortgage and SME arrears problem surely the fact that we owe more to banks than exists is the crux of the matter?

    Some statistics:

    Personal bankruptcies increased in the US more than 3 fold between 1980 and 2005. By that year, one in 55 American households applied for bankruptcy.1 Could that number of households really be that poor at budgeting their books compared to their parents? Or could the proportional reduction in state-issued cash explain this phenomenon?

    When 1 in 3 Australian start-ups fail within the first 3 years, could it really be the case that entrepreneurs are becoming less business savvy compared to yesteryear?2 Of course not. Systemic issues are at play. We have to suspect the waning of cash and the prominence of debt-based forms of money for this.

    1 in 7 American students default on their student loans.3 These are the best and brightest who’ve had their loan applications approved by both the banks and their parents. Could that proportion of university-goers really be that unwise after all? Or could equation (B) explain things?

    Given that defaults and bankruptcies are systemically inevitable, how can we possibly expect to run a stable, proficient economy under this system?

    If we could return the power to create money solely to the central bank, dealing with defaults and formulating equation (A) and so on would not be an issue.

    Furthermore, going into the future, let’s imagine we find a resolution to every PIP case. Why should we ‘start again’ with another round of this debt-based system when the same crises will reoccur?

    Paul

  6. @GC

    whatever the ‘economic rationale’ – the ‘political rationale’ was clearly to provide a ‘get out of the lush €3,000,000 jail’ for the usually politically connected professional/propertied classes.

    How many of those really struggling at the mo have three million €uro mortgages on their family homes?

    & why the three(3)year? Why not one(1)? or 2?

  7. I think Gregory your single biggest problem with regards to the mortgage issue is that sadly you still don’t get it. (I’ve argued with you on this issue on many occassions over the past number of years).

    In a normal asset market your equations do make sense. The property market as I’ve suggested here before is far from normal because the prices charged in the marketplace are not, when you drill down a bit, determined by the action of property consumers but rather they are almost always determined in the main by the action of the lenders. This makes the property market and the residential property market in particular different to nearly all other asset markets. It carries significantly bigger risks for all concerned.

    The nomal nonsense ones hears in the media and elsewhere is that a house is only worth what someone is willing to pay for it, sounds sensible but believe me makes zero sense. Primarily because what someone is willing to pay for it (on an average LTV of 85%) is provided by a third party lender. In other words (in about 95% of resi transactions) there is no actual consumers without the availability of credit – the number of transctions since late 2008 is telling you and anyone willing to read the numbers that the market without credit is far from ‘normal’. Trying to normalise this market without taking this rather odd dynamic into conderation is like adding apples and oranages and getting pears as the answer.

    The bottom line here is that the original prices for property sold in the market for the years 2001- 2009 were by any long term measure, wrong. Using any other asset class comparable and using long run yield analysis etc will tell you the prices were nuts. Who really priced the market and still does and will probably always price it? you guessed it, the lenders. The lenders control the credit and its distribution which controls the demand and the supply (particularly for new builds) and ergo the lenders control the prices.

    If ther lenders got their prices wrong – and we know they did – all their business models failed as a direct result, lest we not forget, then asking novice property consumers to repay 100% of stupid debts on the back of mispriced houses or else vacate or even worse allow banks to control the process as the current legislation allows is a really stupid way to deal with a mispricing issue created, born and bred by the lenders themselves is a really stupid way to proceed.

    I’d say fix the mispricing issue – write down the debts to the correct level and move on. Winners and losers in the process? – nobody. Matters pursuant to the night of 29th Sept 2008 and associated events leading up to same has ensured we all lost.

  8. @ Gregory Connor

    Their intervention would also be needed to come up with a solution to housing bubbles.

    http://www.ft.com/intl/cms/s/0/ccfc57b4-d781-11e3-a47c-00144feabdc0.html#axzz31RAiZDJ1

    My ersatz amateur equation would be the following;

    X Desire to own one’s own home + Y inability (of most people) to do so on any basis other than extended credit + Z capacity of those providing the credit to impact the market (as pointed out by YOB) = VHBR (Very High Bubble Risk).

  9. I think the problem here is that the new insolvency scheme has been marketed by the government as being applicable in all cases of insolvency, while (as Gregory rightly points out) there are cases where bankruptcy is actually a better answer for the creditor.

    The head of the insolvency service must be aware of this, but should he have been more open and analytical about it on Prime Time? Perhaps, perhaps not. Given the limited number of cases that have gone through at this point, all of the players including the insolvency service must be unclear as to where the boundary lies between cases where the regime we now have favours the new insolvency scheme and cases where it favours our new bankruptcy arrangements. From the perspective of the insolvency service, it might be damaging to go off-message before the location of this boundary emerges from the operation of the system.

    My own gut feel is that because the new Irish bankruptcy arrangements are loaded in favour of creditors the share of cases where new insolvency system will produce outcomes acceptable to value-maximising creditors will be less than for comparable systems in many other countries. This may, however, be obscured by non-value-maximising state controlled creditors being more generous to debtors.

  10. @ GC

    “OFFER is known with certainty whereas RECOVER is a random proportion …It seems extremely difficult to create a scenario where E[RECOVER] could fall as close to zero as 0.0079”

    I fear you might be over-complicating things…

    Recovery in bankruptcy is the sum of the net proceeds of any asset sales and the debtor’s payments on a five-year payment order. My understanding of this case (from the programme) was that the asset was already sold and, as the debtors were living on less than the allowed reasonable living expenses, creditors would not get a payment order against them. So a recovery of nil is precisely what creditors should expect in this case – and the tens of thousands of others like them.

    That the bank turned down the €2,000 represents sheer bloody-mindedness on their part.

  11. @fravo – You are using the word “expected” in the sense of “most likely” — I was trying to differentiate this from another technical meaning of expected value, which is always greater than zero in this case, except in the case of zero variance. So yes the “expected” payment in the sense of “most likely” equals zero. I was more concerned that that head of the ISI did not seem too clued in about the system as it was constructed, or did not want to let on that he was and describe it clearly.

  12. Off topic (mostly), but those interested in the Irish economy might consider perusing:

    http://c0.dmstatic.com/549/report/Daft-Rental-Report-Q1-2014.pdf

    Intro

    “On the other hand, rising rents are caused by a lack of accommodation in urban centres and reducing rents will discourage the provision of new accommodation, thereby making the problem worse. What we have seen in both sales and rental markets is reasonably robust demand for accommodation in Dublin and other cities, which has pushed up both rents and prices. These should be acting as a signal to bring about new supply – so why has significant new building not started in Ireland’s cities?

    Whether construction of new homes takes place depends on whether revenues exceed costs. Revenues come from rents and house prices, which both appear to be at the cusp of affordability given incomes in Ireland. Therefore, if rents and prices are high enough, the solution is about reducing costs in construction – not about capping rents and thus further discouraging the very construction that would alleviate the accommodation crisis.The cost base in construction includes capital, labour, land and regulation, as well as materials, whose prices are typically set on world markets. What is needed now is for the Government to go through each element in the cost base and develop actions to lower costs. It may surprise some readers to learn that the cost of building a house is 3.3% higher now than in 2007.

    Labour costs in construction fell once, in March 2011, when hourly rates were reduced by 7.5%. But in an economy where the average disposable income fell by 25% between 2006 and 2012, and where there are significant numbers of long-term unemployed construction workers, is that enough? More importantly, the minimum hourly rate for a basic operative in Ireland at €13.77 remains a quarter higher than in West Germany (€11.05, a figure which will rise to €11.30 by 2017). Department of Environment figures indicate that for every €1 of materials, €2 is paid in wages, so the wage rate in construction has a real effect on levels of construction.”

  13. @DAFT.ie

    Why are you continuing to allow discrimination by the ‘landlord class’ against those on ‘rent allowance’ on your web-site?

  14. @ grumpy: Off topic maybe, but by no means irrelevant. I presume there will be a specific posting about this report. We’ll see.

  15. @ Yields or bust

    I’ve linked to a graph of house prices, population growth versus housing stock and lending towards dwellings before.

    Here it is again. It shows how abnormal a market we’re dealing with.

  16. @Gregory Connor:
    “the couple owed a mortgage-related debt of €276,000 and their PIP constructed an alternative loan repayment of €2,000. ”

    The reality here is that the bank now has an unsecured loan of €276,000, owed by people with little income and no assets, the ‘mortgage-related’ being now a distant memory.
    The amount of the offer may offend but is presumably based on the ability to pay- but the bank will get few sympathisers. This is especially so in the case of BOI where, if we are to believe Richie Boucher, and offer by the couple to pay €275,999 euros over their lifetime, would still be rejected.

    @Grumpy/ DOD

    Looks like Daft would like to increase the supply of housing by cramming down on the builders labourer’s princely sum of €13.77 per hour.
    Meantime, other rentiers, landowners and landlords in particular can gouge to their hearts content.
    “Labour costs in construction fell once, in March 2011, when hourly rates were reduced by 7.5%. But in an economy where the average disposable income fell by 25% between 2006 and 2012, and where there are significant numbers of long-term unemployed construction workers, is that enough?”
    Surely, in economic discourse, it is not ok to compare reductions in gross wage rates in one sector with a fall in net wages or disposable income in the general economy, or is it?

    “Department of Environment figures indicate that for every €1 of materials, €2 is paid in wages, so the wage rate in construction has a real effect on levels of construction.”
    That relationship used to be 50/50 and, if anything, the labour content would have lessened due to improved tools, equipment and machinery. I do not, even based on on my own recent experience, accept the 2:1 relationship, believing the labour/material split to be approx 45:55.

  17. @Brian Woods Snr

    Bankruptcy, insolvency and arrangements to manage and, where possible, to mitigate their harmful effects on debtors, creditors and society are as old as economic activity, and have been studied for a comparable period. No theory, however outlandish (almost), has any excuse for being bereft of supporting empirical data, and the onus is on sceptics to show that it is.

  18. @ FO’R: ” …to mitigate their harmful effects …”

    Exactly, harmful being the operative word. All suffer. Jubilee anyone?

    The cognitive relationship between the Theoretical and the Empirical has been succinctly illustrated by D Bob Gowin in ‘Educating’. He shows the relationship by means of a graphic, the Gowin-Vee heuristic. The base of the V connects the two (theory to the left, empirical to the right). A focus question, derived from your hypothesis, directs your attention to specific and particular objects and events which are to be observed, characterized and transformed into a coherent statement of fact. That fact may, or may not refute your Null Hypothesis. That’s Science.

    It appears that 20th Century economists cropped off the lower part of the Vee, abstracted their theories from abstract, mathematically logical premises and then predicted real economic outcomes – even when the observable economic objects and events were showing otherwise. But that’s Economics.

    I wonder how many economists have read, and intellectually digested Milton Friedman’s essay, ‘The Methodology of Positive Economics’. Its weird. And it attracted a well-deserved demolition response from Karl Popper.

    Brian.

  19. That is an interesting article and self explanatory. However perhaps far too simplistic. What if the Bank in question in earlier years had decided to securitise ithe debt& sell it too investors. Because investors would want some security it insured the debt against a credit event such as bankruptcy. Using credit default swops, why then would the Bank wish to do any deal?

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