A gap in current policies for Irish financial stability

In a recent speech, the Deputy Governor of the Central Bank of Ireland, Sharon Donnery, floated the prospect that the CBI might impose Counter Cyclical Capital Buffers (CCyB) on Irish banks, in order to guard against an unstable credit build-up in the currently strong economic environment. She also used the speech to discuss current conditions in the Irish financial system and review the macroprudential regulation policies of the CBI.

In many ways, Irish macroprudential regulation has been exemplary, but there is a glaring defect. Stanga et alia (2017 and 2018) compare 26 countries regarding mortgage arrears, financial stability and macroprudential policies, and Ireland’s profile is remarkably poor. As Stanga et al. note, controlling mortgage arrears is a key objective of macroprudential policies, and Ireland has very poor performance by this metric.

Ireland’s intractable mortgage arrears problem stems in large part from its defective legal system regarding loan security, with extremely limited lenders’ rights to collateral repossession. This defect in turn limits the reliability of Ireland’s quite restrictive macroprudential policies. As Stanga et al. state in their international overview:

“Better institutions – which improve judicial efficiency and make it easier for banks to enforce their rights – reduce the level of mortgage defaults. We consider several proxies for institutional arrangements and compile an index of institutional quality (IQ). We find a significant and negative relationship between IQ and mortgage arrears, both before and after the onset of the financial crisis – the higher the average quality of institutions, the lower the average mortgage default ratio (Figure 3). Moreover, the effects of macroprudential policies and institutional quality on mortgage defaults are mutually reinforcing. As illustrated in Figure 4, the effect of the MPI [Macro Prudential Index] on defaults becomes stronger in countries with better institutions. This result suggests that the effect of tougher macroprudential policies (that reduce household leverage and ultimately deter defaults) is amplified in an institutional environment conducive to an efficient judicial system with better protection for lenders’ rights and better enforcement capabilities.”

In addition to making banks more cautious, the limited-repossession system in Ireland makes the CBI more stringent in its macroprudential squeeze on credit flows. The prospect of a future spike in mortgage defaults is a key concern for the CBI, along with the high average loss-give-default in such a scenario. Because of this, the CBI is correct to stamp down hard on any signs of substantial credit flow into the domestic housing market.

When it comes to tackling the underlying defect in the Irish system (the too-limited repossession rights of lenders) the CBI has taken the line that this is somebody else’s problem. The CBI harangues the government endlessly on tax and spend policies (which are also not strictly the CBI’s problems) but when it comes to addressing the big defect in the Irish system regarding repossession, the CBI is as quiet as a mouse.

Who is paying for this unusual Irish system of extremely-limited repossession rights? Nondelinquent mortgage borrowers pay for the limited-repossession system since their mortgage interest rate includes the expected cost of default, capturing both a high probability of default and a high loss given default. Households looking for mortgages suffer in two ways: one, the Irish limited-repossession system makes mortgages more difficult to obtain; two, the system has a knock-on effect on housing construction: property development is a high-risk business and with no guarantee of mortgage-ready buyers, developers are extra-cautious.

The net effect of the Irish limited-repossession system on housing prices is indeterminate since there are opposite effects on the demand and supply sides. Cash buyers might benefit or lose on a net basis: they lose from the decrease in house construction (hence higher prices) but benefit from reduced bidding competition against mortgage-based buyers. Existing mortgage holders (other than defaulters) lose, and prospective mortgage holders lose twice over.

At the conclusion of her speech Donnery states:

“While there are uncertainties placing a precise value on the short-term benefits and costs, in the longer-term, increasing the margins of safety in an uncertain world is of benefit to all.”

Consider a young Irish household wishing to buy a family home using mortgage finance. In exchange for a mortgage loan, they might be willing to take a chance that they lose the house in some future scenarios if things turned out badly and they could not pay the loan back. They want a house now and are willing to take a chance on the future. Such a mortgage contract is not legally available to them in Ireland nowadays, since repossession can only be enforced in ridiculously limited circumstances and, due to this legal reality, banks are not allowed to issue mortgage loans unless they are virtually default-risk-free. The young household will have to rent or live with parents, for many years into their future.

The Irish financial system, where there is virtually no chance of receiving a default-risky mortgage and even less chance that such a loan could end with repossession, is not of benefit to all. For many people in many circumstances, risk is good.

14 thoughts on “A gap in current policies for Irish financial stability”

  1. Although it’s a related effect, there’s also the political fact that the lack of repossessions minimises the political pressure to build more homes. The in-place families are kept in situ and not evicted. This minimises the need to have somewhere (anywhere) for them to go. Which minimizes the pressure for new accomodation to be built. Renters, after all, are a less powerful political constituency (at least partially because they’re disproportionately immigrants) and new buyers are, after all, supposed to stop buying avocados so they can save up for a deposit. Everyone else gets screwed, and the unpaying occupier gets fully protected. Injustice across the board.

    And lack of repossessions was also a key mechanism in keeping prices up. Everyone got to pretend that a house bought for (say) €750k was actually worth €750k, despite the fact that no-one was actually paying €750k for it. And the poor bugger who was overbid on the house was permanently kept out of it.

  2. Hold on Gregory and Hugh. Ms Donnery’s talk was about macroprudential policies in an uncertain financial environment. She (inappropriately in my opinion) lumped commercial loan risk and residential mortgage risk together. You guys appear to have a bee in yer bonnets about Irish residential mortgage problems – and while ye both are shooting at a genuine target it just ain’t the right target. Residential mortgage loans are unique in that the lender carries almost zero risk: the borrower’s risk is almost 100%. Please think about this. If Irish property law appears to favour borrower over lender, maybe there is a very good reason.

    The current Substantive Issue is the massive increase in the values of many (but not all) Irish private residential properties during the last two decades. OK, rising residential rentals are a nasty matter also, but some other time.

    Its Tulipmania time (again!) for Irish residential properties. That’s the issue. And its a Frankenstein financial monster created, and sustained, by the lenders themselves. For over 50 years Irish mortgage lenders kept themselves on a very tight leash. Their mortgage default rates were approx 0.5% – now they are close to 20%! Back then, banking leaders knew what would happen to their business if they lent recklessly: in a financial downturn they would be liquidated. Now of course, they know that their bad-loans will be bailed out and they can continue BAU. Risk off!

    Strange as it may seem, one of the key causes of the imbalance between supply and demand in the domestic residential market is that credit money is so incredibly cheap. This may appear counterintuitive. But a careful historical analysis will reveal the causative mechanisms. Sure, high interest rates do retard overall economic activity. Whereas low interest rates result in the diversion of economic activity from productive output to financial churning. Lateral thinking is needed.

    A secondary cause of the supply – demand imbalance in Irish domestic housing is the continual sharp divergence (since 1996) between median property prices and medium incomes. Historically, credit money was expensive and median residential property prices and median incomes closely tracked each other. Correct two of these latter imbalances: that is, increase interest rates and allow median incomes to increase three-fold and hey-presto residential property prices will auto-correct and supply and demand will slowly re-balance.

    That’s delusional thinking on my part – but that’s what would need to happen.

    What will actually happen – but probably not for a decade, is that overall economic rates-of-growth which have been slowly declining from their long-term average of 3% – will eventually attain zero. At that time Government spending (health, welfare, education) will be significantly restrained – possibly even reduced. These things take time. I’d place an each-way bet on 2021.

  3. It is my suspicion – and will have to remain so, as data, amazingly, is and was unavailable – that house repossessions by credit institutions from 2008 to 2016 ran way behind the experience of the preceding 20-year period. I could be wrong, but have never been able to find the level of foreclosure, via legal means or voluntary surrender, in the pre-crisis era which one could use as a yardstick for post-2008 comparison purposes.

    To be sure, after 2008 there were things like the (O’Donnell?) judgment behind which banks could initially shelter; more to the point, they were individually unwilling to acknowledge the scale of their losses – and that’s what they were, whether by by way of diminished collateral or NPV on performing trackers – until forced, not by our own institutions, but by the ECB fundmaster, to acknowledge the scale of their losses.

  4. Hi Greg

    “The Irish financial system, where there is virtually no chance of receiving a default-risky mortgage”

    A borrower in Ireland can still get a 90% mortgage on 3.5 times their joint income. That is very “default-risky” for the bank. It’s not risky for the borrower, in that there is no penalty for default.

    This would make no sense in a normal market charging eurozone-average mortgage rates. But as Ireland’s lenders charge almost double the eurozone average mortgage rates, they can afford a high level of defaults of these mortgages.

    So I am not sure that the lack of repossession has reduced the supply of mortgage finance. It has just pushed up the price for everyone.

    Brendan

    1. Brendan….a higher price essentually equals a restriction of supply if you’re looking at the market from a customer’s point of view. If cars are more expensive, I can afford less of a car or fewer cars. If houses AND mortgages are more expensive (unnecessarily in both cases in Ireland) then people can afford less and fewer.

  5. it’s rare to see anyone raise the repossession issue in this manner, as the usual narrative is redolent of evictions by absentee landlords in the nineteenth century.

    The scale of repossessions is extraordinarily low relative to experience elsewhere, notably the UK. which is a similar market. The flow is rising, to 3,400 last year, from 2,800 in 2016, although more than half are voluntarily surrendered. Last year’s flow figure equates to some 3.5% of arrears, against a figure of 8-9% in the UK.

    It suited the banks to allow arrears to mount, as they needed time to rebuild capital when house prices were falling. Politically too, it suited the authorities. For example, it took over two years to legislate for the Dunne judgement in 2011, which according to the Central bank precipitated a jump in strategic defaults.

    The low repossession rate may be socially desirable but does have economic consequences. Much is made of the need for more competition in the Irish banking system but for potential entrants the issue is whether a mortgage is actually a secured loan or not.

    On mortgage rates the cost of a new mortgage here is much higher than the euro norm although the rate for existing borrowers is much closer to the average (2.6% against 2.25%). Moreover, the current floating rate average is 2.3% because over 40% of outstanding loans are trackers, with an average of around 1.05%. So I suspect the higher cost of new loans has more to do with seeking higher margins to compensate for the low rate on trackers than default risk.

    One final point. It still appears to be the case that new mortgage lending accounts for less than half of housing transactions, so how much has QE been a factor?.

    1. The low repossession rate is not socially desirable.

      It’s desirable if you’re not paying the nominally ludicrous price of the house you’re living in. But it’s undesirable if you’re the one locked out of the house you would have actually paid a more sensible amount for or the renters/new buyers affected by the lack of political desire to build more houses. But that desirability to the people NOT paying their bills is hugely outweighed by the cost to others.

  6. Repossessions of private residential properties is not really a problem – its surely an undesirable state of affairs. But a financial or economic problem they are not. Not!

    The problem is the persistent reckless lending which caused a Tulipmania-style asset bubble in all categories of property (Its being going on since 1996). Its still going on! Unless this matter is properly understood (and its quite complex) there cannot be any resolution of the supply-demand imbalance. If every defaulting or stressed-out residential mortgage were, magically, resolved in the next 24 hours and the residents all turfed out on their ears – what would this achieve? OK, it would resolve the default issue – but it would make some other issues a great deal worse. And it would not go anywhere solving the supply-demand imbalance. As I mentioned above, its Lateral Thinking that has to be deployed in this matter.

    A key issue is that Irish mortgage lenders (we have far too many and zero competition) is that they have a zero % risk wrt residential mortgages. That’s right 0.00%! Please think carefully about this. The borrower on the other hand, is carrying a 100% risk. That’s right – the entire risk. You must all really try to get your heads around this absurd imbalance. It never used to be like this, and mortgage defaults were at 0.5%. So why are they now at near 20%? Could some of you please attempt to explain this almost forty-fold differential for me. Its completely insane!

    The supply-demand imbalance in Irish residential properties is an intractable matter. Its a highly complex, deeply interconnected mess. It cannot be corrected: well, partially maybe. But that’s it. Period.

    General interest rates are too low to encourage large-scale residential construction. However, if they were to be to increased sufficiently to discourage financial churning and encourage construction, then existing borrowers would be well and truly shafted. If existing borrowers could (just about) afford a 300,000 euro mortgage @ 2.5% – then @ 5% they could only afford a 150,000 mortgage. It would be repossession Friday, everyday. And would residential property prices then decline? Now that would be lots of fun if it did.

    1. Brian – I either don’t understand your post or you don’t understand basic project/construction finance. I strongly suspect the latter.

  7. Hugh, its a matter of the marginal returns on construction versus finance and their inter-relationships with low or medium interest rates. Basic anything – production, construction, financing, or whatever, has been sidelined in favour of extracting as much economic rent as possible in the least possible time. Basic construction is fine – but its time consuming. And the marginal returns are, currently anyway, less than basic financing. So you only construct what you have no alternative but to do. And stop there.

    If general interest rates were triple what they now are, basic construction would boom; property values would stabilize, or perhaps decline somewhat and …. we would need median wages and salaries to (at least) triple as well, to ensure residential mortgage default rates decline back to less than 1%. Defaults are the problem? Or is it stagnant medium incomes?

    As I wrote. Its an intractable mess. And I am still awaiting a plausible explanation for the 40-fold (or so) increase in residential mortgage defaults. Building 40,000 residential units per annum, in the existing financial scenario may actually ease our supply-demand imbalance in the short-run – but what about those default risks?

    My posts are directed at the lack of meaningful explanations of how we have arrived in the residential housing supply-demand imbalance. The mortgage arrears and repossession problems are in-your-face symptoms of some fundamental, underlying problem(s). So we focus on the symptom, not the underlying cause. OK?

      1. Thanks Hugh. If you believe I don’t understand basic finance then fine. I recognize two different forms of basic finance – the first is pre-1970 and is the one taught in ECON 101. Its also the one which gave residential mortgage defaults of 0.5%. The second is post 1980 and its the one which is giving us residential mortgage defaults of 15% or above. Which version have you in mind?

  8. Gregory: “When it comes to tackling the underlying defect in the Irish system (the too-limited repossession rights of lenders) the ICB has taken the line that this is somebody else’s problem.”

    I recall highlighting the lack of determination on arrears on here repeatedly five years ago. I have a note that the previous central bank governor even said he did not believe in the concept of strategic default which, if my note is correct, seems to have been an extreme view. But can you expand on the “somebody else’s problem” part?

    The near unenforceable nature of Irish residential security:

    1. Increases mortgage rates
    2. Deters competitors from entering the market
    3. Encourages the regulator to impose more stringent macroprudential limits on credit availability (LTV, LTI) than would otherwise be the case, since it knows the mortgages are not really “secured” since the security cannot really be enforced.
    4. Are miles more borrower-friendly than other comparable countries.

    These are however not arguments that will advance your media profile in a positive way…

  9. Before this comment-line is closed, permit me to make the following observations.

    Lenders (into the Irish residential mortgage sector) operate within a set of specific schedules of recourse, residential mortgage loan origination – schedules which vary slightly from lender to lender. These schedules are ‘approved’ by our CB – which recommends (but cannot mandate) citing specific macroprudential limits. Its not apparent what is the nature of the influence government ministers and senior civil servants exert on residential mortgage lending practices, but its certainly not zero.

    The lenders, (who originate tens of hundreds of residential mortgage loans) have a fiduciary duty towards borrowers to ensure that each individual borrower will be able to meet the financial terms of their recourse, private residential mortgage loan contracts. Also, that these borrowers will, other than in exceptional and statistically unlikely circumstances, find themselves in arrears and later having to contest a civil law repossession order.

    The statistical probability of the occurrence of arrears should not exceed 0.01, nor that for civil law repossession exceed 0.005. These statistical limits were consistently met until ………. Now, private residential mortgage arrears can reach 0.3 and civil law repossessions 0.16. Anyone like to dispute this? Or better still, explain that large divergence. This divergence is not coincidental – its deliberate.

    Several commentators (above) have criticized Irish lenders for being ‘slow’ to correct delayed mortgage arrears payments and our archaic legal procedures for civil law repossessions. Fair enough. But I argue that by making such critiques you are also accepting that the Irish lenders are deliberating originating recourse private residential mortgages that, with a known level of probability, will default and will require civil proceedings to obtain possession of the property. Is this argument valid?

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