This is a expanded version of my column with the Irish Examiner of October 12 2013. With the budget around the corner we are hearing soothing noises all round about the economy. Apparently things are grand, or about to be. We are to be grateful that in an inversion of 1 Kings 12:11 we are not to be beaten with the scorpion of 3.1b but merely with the whip of 2.5b in cuts. Hooray… Although the Fiscal Council still suggests exemplary discipline, the government has decided to show some mercy. We also see the ESRI coming out very bullish on the economy, particularly with regard to employment, which is rising. This, and they are right, represents an improvement in the domestic economy. How much of this is a dead cat bounce and how much a sustained improvement we will see, but one thing is clear, we are by no means out of the woods. At best we have worked out on what side of the dead tree we should look for the lichen to aid us in getting out. The real domestic economy remains mired in deep recession and persistent questions remain about the reality of the export figures especially for services, which are subject to the vagaries of international tax arbitrage.
The budget will act as a drag on the economy. There is no doubt about that. We have long since passed the point of no return for the myth of expansionary fiscal contraction, in fact that was exploded in the Irish case by Karl Whelan in 1997. What remains to be done however on the fiscal side is, by comparison to what has been done, small (but still painful). We are still however looking at a structural deficit – that is to say that abstracting from interest payments on debt we are still running a deficit. Until we are in structural balance we are still liable to fall into fiscal wardship. So the domestic economy will struggle on.
For many persons with mortgages, particularly buy to let mortgages on investment properties the next few years are likely to be the most difficult of all. Having taken cuts and tax rises, incomes are tight. We now know that the buy to let market is in the horrors. Of the 150,000 mortgages outstanding 40,000 are in arrears. That is an astounding figure – one in four loans in distress. Arrears are rising by 3% every quarter with arrears over two years rising by 15% every quarter. The sector is bust.
Typically buy to let mortgages in the boom were on a interest only basis. Thus the mortgagee repaid interest and expected that in 20 or 25 years time the capital value of the property when sold would meet or exceed the initial sum borrowed. Fully 50% of a sample of recent BTL investors noted that they were not getting rental income sufficient to cover the interest. Thus in addition to these mortgages slipping further into arrears there is a growing cohort of investors who are building up further arrears on capital. The same investors do not see the property market recovering, in the sense of outperforming for its level of risk, in the short or medium term. Despite all that a large percentage of these investors refuse to sell for less than the price at which they purchased. In the face of a 50% fall in capital values where there is likely to be at best modest nominal increases in value in the medium term, this is while understandable from a psychological perspective simple delusion from an economic perspective. Not selling in hope of nominal prices returning is called Anchoring. While it may be stable something anchored can also have its guts ripped out if the anchor is overly strong, and of course being tied to an anchor is a wonderful way to drown. Tying oneself to something while underwater is generally contraindicated.
The banks refuse to engage with this problem . With 150000 mortgages of which 40000 are in arrears we have a paltry 500 in repossession. There are 10000 buy to let mortgages in arrears of over 2 years. These are never going to be repaid. The 700m of accumulated arrears of these defaulters are gone. The €3.3b of mortgage value represented by these two year defaulters is impaired by at least €1-2b. The banks refuse to move to write down these loans, repossess and move on. They too are anchored to unrealistic expectations. This is down to their petrification that when they start to do this, to repossess investment properties, they will cause a cascade. Part of that cascade will be that as repossessed houses come onto the market this will further depress the prices which, Dublin aside, remain in decline. A more worrying element for some is that there are an unknown, but presumably non-trivial, number of these which are cross secured on residential properties. While there is some faint appetite for repossessing investment property there is much less for principal private dwellings. More worryingly, a large percentage of these property investments seem to have been secured on other property investments. Kicking away the props from a shaky house rarely results in a neat outcome. So despite rents beginning to rise, which would make these properties more attractive for banks in their capacity as landlords, there remains a massive blockage. At the bottom of an interest rate cycle, with a depressed economy at best recovering very haltingly, with little prospect of fiscal loosening in the medium term, the outlook for these BTL investors is bleak as it is for the banks.
Sitting on the problem and hoping that it will go away will not work for the BTL investors. Nor will it for banks. While individuals may be excused for anchoring to past prices and for displaying psychological traits such as cognitive dissonance (wanting to sell, not seeing the asset as attractive but not wanting to sell for less than purchase) there is no real excuse for a large commercial organization to do so. These are investments. People took them for such. If the Irish banks refuse to deal with these then there is scant hope that they will deal with the larger problem of residential mortgage arrears. The residential mortgage market is 4x the size of the buy to let but has ‘only’ 2x the arrears. Together however the banks are sitting on mortgages in arrears totalling a stunning €35b, with €4b in total arrears. Looking at the over two year arrears we have mortgages of €10b with accumulated arrears of just under €2b. These are for the most part lost. But the banks refuse to move on them.The result is that the banks will be crippled for decades. We need functioning banks and right now they are dysfunctional.