Nobody knows at this juncture the scale of the losses for bank balance sheets from mortgage write-downs. But the EU-IMF deal had to set aside a certain amount for contingencies relating to future losses – including those from mortgages – and chose €25bn. This post attempts to shed some light on the potential scale of mortgage write-downs. Given that purpose, it almost completely sidesteps the broader economic and social impact of negative equity, arrears and repossession, not because these are not important topics, but because they are worth their own research, not as sidepoints in a discussion about bank balance sheets.
The Morgan Kelly question: three types of bank assets
Morgan Kelly has been the most vociferous on the apparent “time bomb” for banks in Ireland’s mortgage arrears. His estimates stem from his “realistic loss” scenario, published on the Irish Economy website in May, where he estimated that of €370bn in all lending by Irish banks, a figure that includes loans abroad, €106bn would be lost. In truth, his estimate is driven almost entirely by Irish bank lending within Ireland, so he is predicting bank losses of €100bn off a loan book of €235bn.
Based on these figures, he then wrote an article in early November, entitled “If you thought the bank bailout was bad, wait until the mortgage defaults hit home“. One could legitimately assume from this that if losses from loans that went to NAMA were bad, those from mortgage foreclosures would be worse. Indeed, this was the general conclusion: this is an article that spooked markets around the world. I know, as I was out of the country at the time and saw the immediate reaction from a non-Irish perspective.
Given that Morgan has been right on so much over the last five years, including his prediction in that very article that Ireland would need an EU-led loan, is there nothing to do now but brace ourselves for the mortgage arrears time bomb that will surely make the bank bailout look like peanuts? To shed some light, it’s worth thinking about three main types of bank asset and therefore three main types of potential losses: NAMA, arrears and SMEs.
- NAMA losses are losses from big property speculation. Irish banks lent out about €100bn in large chunks (i.e. typically more than €5m) for land and development which is now falling under NAMA’s remit.
- Arrears losses will stem from residential properties that the banks have to foreclose and sell for less than the mortgage outstanding. Total residential mortgage lending in Ireland stands at about €115bn.
- SME losses are where small businesses go under and banks have to take their place in the queue to get money out of the assets that are being liquidated. Corporate lending in Ireland stands at about another €100bn.
On the face of it then, it seems reasonable to say that if we’ve been focusing almost exclusively on the €100bn or so in NAMA-related lending, then the €100bn or so in mortgage lending is indeed an elephant in the room. (I will have to leave for the moment the issue of SME losses, both because I’m not an expert on that issue and because that was not the focus of Morgan’s article.) On NAMA losses, banks face somewhere in the region of €40bn of losses on NAMA-bound properties, in round numbers and allowing for past efforts at external recapitalisation.
Estimating the number of borrowers at risk
Is this €40bn in bank losses from land and development going to be small compared to the losses from bank balance sheets due to mortgage arrears? Suppose there are three types of people with mortgages: (1) new borrowers, with large debt which more than likely swamps their equity, (2) old borrowers, with small amounts of debt and (relatively) large amounts of equity in their homes, and (3) topper-uppers, who are probably in the main similar in profile to old borrowers. The risk category for banks is almost exclusively new borrowers, because it is unlikely that they will have to repossess the homes of old borrowers or of topper-uppers, and if they do, the equity in the house will very likely cover the debt.
So how many new borrowers are there? To be safe, we should assume that anyone who has borrowed since 2003 is at risk, whether they are first-time buyers or not, apart from topper-uppers. Why since 2003? If prices fall 55% by 2012 – which may just be enough to bring the rent-price ratio back to normality – prices will be back at levels seen in 2000, broadly speaking. This is about 20% below 2002 levels, so if someone who bought in 2002 had to sell in 2012, they could, as on average they will have paid off about 25% of the principal by then. By looking at quarterly IBF data, which go from 2005, and a similar Dept of the Environment series, it is possible to estimate there have been about 435,000 borrowers since 2003 who are either first-time buyers or mover-purchasers. This is out of a total of 800,000 mortgages.
In truth, given the loan-to-values and outstanding debt involved, it’s reasonable to think that 2003 and 2009 borrowers are of different types to their 2006 and 2007 counterparts. Using a combination of IBF, Dept of Environment and county-level Daft.ie data, it’s possible to estimate the number of households in negative equity. If house prices fall 55% from the peak, about 330,000 households would be in negative equity, compared to about 200,000 households now, including two thirds of all 2006-2007 borrowers and more than half of 2004, 2007 and 2008 borrowers.
But even then, we can’t just multiply 330,000 by, say, an average mortgage of €200,000 and assume that €65bn of the mortgage loan book is at risk. Many of those borrowers will remain employed and – perhaps grudgingly but consistently – pay off their mortgage each month. They may represent a threat to economic growth, as people feel less wealthy when their homes are worth less, but such households are not a threat to bank balance sheets.
Estimating how much of the loan book is at risk
Instead, we need to look at the proportion of negative equity households at risk of foreclosure, i.e. where circumstances such as unemployment lead not just to arrears and Court proceedings but ultimately foreclosure. The first step is to look at mortgages in arrears: there are currently 40,000, a figure that may rise to 100,000 in a pessimistic scenario. With an average mortgages of €200,000, this suggests that a maximum of €20bn of the mortgage loanbook is at risk.
(sorry Mr.Lyons even Brian Cowen acknowledges that 70,000 are currently in arrears and the average amount is more like 260,000 not 200,000)
Even then, the underlying asset, the house, will not have lost all its value. Very few properties would have only get half their loan-value back, the back of the envelope figure that Morgan uses. For this to be the case, the average borrower would have to have bought at the peak with a 100% interest-only mortgages. This is not the average – this is the upper bound. A more reasonable rule of thumb is that banks will recover two-thirds of loan value on average. So the upper bound in mortgage-related write-downs is now perhaps €7bn.
This figure still needs to be scaled down again, not just to reflect the fact that not everyone in arrears of less than 180 days progresses to deeper arrears, but also to reflect that not everyone in six months or more of arrears has their home repossessed. At the moment, about one in four mortgages in arrears goes from the 90-180 days category to the 180-days-plus category. This may rise to one half over time, as people run out of outside options, but I’m not sure anyone is actually going to predict anything like 50,000 mortgages having Court Proceedings issued.
Currently, repossessions are running at a rate of about 300 a year. This will almost certainly rise as some of those currently scraping by fall victim to the ongoing recession and as the moratorium on repossession passes. But are we seriously expecting an average of 5,000 repossessions every year from 2011 to 2020? Suppose repossessions instead jump from 300 this year, to 1,500 next year, 5,000 in 2012 and 2013, and then falls back gradually to about 500 by 2020. That would be a calamitous scenario for all those affected. But what would it mean for the bank balance sheets? The graph below recaps the figures discussed in this post. The punchline is that repossession of 20,000 homes and their resale by banks for two-thirds of their loan value would mean balance sheet losses in the order of €1.3bn.
sorry again Mr.lyons but even the banks themselves expect multiples of this figure and we all know that the figures they themselves have given have always turned out the be to low !
stop trying to flog more overpriced houses !
This is a far cry from claims that mortgage arrears will cast losses on banks that will make NAMA look like a sideshow. You could be three times as pessimistic about the number of repossessions and more cautious about final values and still struggle to get above €5bn in bank losses. You might even somehow be able to construct a case that I’m out by a factor of 10. But I struggle to see how someone could make the case that the figures above are out by a factor of 50, let alone 100.
Morgan’s article is full of depressing vistas: a “torrent of defaults”, a “social conflict on the scale of the Land War” and the rise of a “hard right, anti-Europe, anti-Traveller party”. Perhaps I am young and naive, or excessively fond of the Simpsons, but this reminds me of an exchange in the Simpsons, where TV host Kent Brockman asks his expert guest: “Hordes of panicky people seem to be evacuating the town for some unknown reason. Professor, without knowing precisely what the danger is, would you say it’s time for our viewers to crack each other’s heads open and feast on the goo inside?” To which the Professor responds: “Mmm, yes I would, Kent.”
That is perhaps the point. By basing his predictions for losses on the idea of 200,000 mortgages hitting the wall, Morgan is making a social prediction – i.e. that people will lose faith in society and all hell will break loose – not an economic one. He may yet be right, but if all social fabric is rent asunder, then probably most economic bets are off.
But wait a minute Finfacts don’t agree with your figures
|Irish non-financial sector credit including residential mortgage lending outstanding continued to fall in April
By Finfacts Team
|Source: Central Bank|
Irish non-financial sector credit (NFC) credit, excluding valuation effects and the impact of transfers to the State toxic property loans agency NAMA, fell again in April, but at a slower pace than previous months so far in 2010. Residential mortgage lending outstanding (including securitised mortgages) declined by €348 million during April, bringing the annual rate of change in residential mortgage lending to minus 1.6 per cent.
The Central Bank said today that net flow of credit transactions during the month was just minus €109m (0.1 per cent), compared with minus €1.3bn (0.9 per cent) in March and minus €842mn (0.6 per cent) in February, implying repayments continue to exceed new lending. NFC credit outstanding on the aggregate balance sheet of Irish resident credit institutions was €134.2bn at end-April 2010, down from €139.5bn at end-March, with the transfer of loans to NAMA and an increase in impairment provisions accounting for almost the entire decline in outstanding amounts. The annual rate of change in NFC credit was minus 4.5 per cent in April, following a 4.6 per cent annual decline in March and a 3.6 per cent fall for the twelve months ending February 2010.
Residential mortgages (including securitised mortgages) declined by €348m during the month, and stood at €146.1bn at end-April 2010. The annual rate of change in mortgage lending fell to minus 1.6 per cent.
Then today we have this in the Irish independent
By Emmet Oliver Deputy Business Editor
Tuesday December 14 2010
Ireland‘s economy will shrink again next year and unemployment will head toward 16pc, a gloomy report on the country’s prospects from Ernst & Young has said. Further austerity measures may be needed, it says.
While the Department of Finance expects growth of 1.75pc next year, the global accountancy company is forecasting a contraction of 2.3pc in terms of GDP.
The Government’s projections were “overly optimistic” and further austerity measures would be needed to rein in the deficit, the company claimed.
While the Government is expecting average growth of 2.75pc between 2011 and 2014, Ernst & Young estimated growth of just 0.8pc was more likely.
The company said it would be a challenge for the Government to fix the banks once and for all and to also control what it called “civil unrest”.
Early elections may delay the latest cuts and tax increases and a new government “may even back away from some of the announced measures”, claimed Ernst & Young.
“These factors increase the likelihood of some form of debt restructuring by the Government and banks,” claimed the company in an analysis included in its eurozone outlook.
Eventually Ireland should bounce back and become one of the fast-growing economies, but Ernst & Young sees major challenges before this happens.
“This seems a long way off and the Government and economy will have to overcome numerous hurdles,” it said.
The key plank of the company’s outlook is that consumer spending will not recover in the way the Government expects.
“The main drag on Irish GDP growth in the next two years will come from domestic demand,” it said.
Ernst & Young said this demand would be hit by a range of factors, including the austere budgets, but also by the scale of migration from the country and a likely rise in interest rates. The company pointed out that those leaving would be bringing with them skills and purchasing power.
“As such we do not expect the domestic economy to recover until a number of years into the fiscal adjustment cycle and until after the banking system is restored to health,” it said.
Ernst & Young wondered whether the €35bn of funding earmarked for the banks would be enough. “This will depend on the results of banking tests and stress analysis,” it said.
Extra austerity measures may be needed if the deficit reduction plan goes off track.
now look at figures from the USA
Cascading home values after an era when lenders let borrowers buy homes or refinance old loans with little or no downpayment has created a large class of property powners with “negative equity” — a polite phrase for having a mortgage bigger than the home’s worth. (Less polite? “Under water” or “upside down” mortgages!)
According to number-crunching CoreLogic, 17.5% of Orange County homes with a mortgages — or 98,518 residences — were in a negative equity position in the third quarter. Yes, that means roughly 1-in-6 O.C. mortgages are bigger than the value of the real estate collateral behond the loan. Another 4.1% of homes with mortgages, or 22,942 residences, were “near” negative equity. (That’s within 5% of negative equity.)
So, all told, 21.6% are underwater or nearly upside-down locally. As bad as that sounds — and it’s not pretty — we offer some comparisons:
- 22.5% of all U.S. homes with mortgages were in negative equity territory with an extra 5% of residences near negative equity. That’s 27.5% combined!
- 32.8% of California residences are in negative equity; another 4.1% are near negative equity. Combined: 36.9%.
And the local trend itself is a tad encouraging:
- In 2010’s second quarter, 18.1% of homes with mortgages were underwater; 4.1% were near negative equity. Combined: 22.2% — slight higher that Q3.
- In Q1, negative equity rate was 19.2%; near negative equity was 4.1%. Combined: 23.3%.
- In 2009’s fourth quarter, negative equity rate was 20%; near negative equity was 4.1%. Combined: 24.1%.
Mark Fleming, chief economist with CoreLogic, on the national scene: “Negative equity is a primary factor holding back the housing market and broader economy. The good news is that negative equity is slowly declining, but the bad news is that price declines are accelerating, which may put a stop to or reverse the recent improvement in negative equity.”
Last lets take a look at the UK
Home owners face repossession amid struggle to sell properties
Home owners are falling behind with their monthly mortgage payments at an alarming rate, charities warn, as estate agents reveal the struggle to sell properties.
Almost a million households are in arrears with their rent or mortgage, twice as many as a year ago, according to homeless charity Shelter.
Charities warned numbers would rise in the New Year and that those with children are most at risk of falling behind with their basic housing costs.
Campbell Robb, chief executive of Shelter, said: “Every two minutes someone faces the nightmare of losing their home and this research paint a disturbing picture of sharply rising numbers of people who face a daily struggle just to keep a roof over their head.
So what does this all mean well I would be of the opinion that 4.5% impairment provisions by the banks are woefully inadequate and a provision of 12% would be more like what is needed?
In every other country the average impairment on mortgages is in the area of 10 – 15% why would Ireland be different?? I’m sticking with Morgan Kelly he has a better track record that you Mr.Lyons