Friday 19 December 2014

Banks bad, borrowers good won't help the recovery

Excessive indulgence for strategic mortgage defaulters is a recipe for further misery, says Colm McCarthy

Published 07/07/2013 | 05:00

HELP: ECB boss Mario Draghi says rates to stay low
HELP: ECB boss Mario Draghi says rates to stay low

The two-month sell-off in world bond markets was halted during the week by central bank announcements promising a continuation of low interest rates. But it has been clear since early May that the eurozone sovereign debt crisis can flare up again very quickly. Unfortunately, the eurozone has yet to be redesigned, five years into the financial crisis, to withstand these recurring pressures on struggling peripheral members.

When a sub-group of the European Union's member states decided on the misnomer called Economic and Monetary Union in the 1990s, they created no more than a common currency zone without the necessary architecture of a true monetary union. The detailed design fell to a reluctant Germany which chose a central bank modelled on its own. Crucially, there was no centralised supervision of banks, no plan for resolving failed banks and no common system of insurance for retail deposits.

The absence in the Eurozone's design of the critical elements which would have avoided fragmentation has imposed high, avoidable and arbitrary costs, not least on Ireland. The Eurozone now consists of a grouping of non-co-operating nation states, several in severe depression, responsible for their own dodgy banks, lacking ready access to sovereign credit and reduced to exclusive reliance on budget-tightening to re-attain financial stability.

This is not an Economic and Monetary Union. With credit conditions and interest rates differing dramatically across the component states, this is no more than a common currency area. Tiresome references to Europe's 'monetary union' will not turn this pumpkin into a golden carriage, and it has become clear over the past few weeks that there is no political will to commence the construction of the desired conveyance. There is agreement only on a limited move towards centralised bank supervision, the least important component of the banking union. There has been no meaningful progress towards a centralised system of bank resolution. Failing banks will remain a national responsibility. As for centralised deposit insurance, this is not even on the agenda.

These policy failures mean that, even if the eurozone survives the current crisis, no redesign is being contemplated that would guarantee a durable system. Surviving the crisis means ensuring that no too-big-to-fail country (Italy or Spain) gets into serious trouble in the sovereign debt market. Thursday's guidance from ECB President Mario Draghi, to the effect that policy interest rates will remain low into next year, has stemmed the selling pressure in peripheral bond markets. But a smooth exit from bailout for Ireland at year's end and for Portugal in mid-2014 are no longer assured. As for Greece, the second bailout has been no more realistic than the first, and a further default is inevitable.

Failures to regain market access in Portugal (increasingly likely) and in Ireland (not certain but possible) would mean none of the three initial EU/IMF rescues would have succeeded. The countries concerned are small, and Band-Aid 'solutions' could be manufactured a la Grecque. This would not really be an option should Italy or Spain join the bailout club. Italy has yet to form a viable government, and fresh elections remain a possibility. Spain has unresolved banks, no sign of broad-based economic recovery and a government corruption scandal for good measure. Both countries will have been reminded these past two months that a relapse into unsustainable borrowing costs is a permanent threat.

Greece has already defaulted on its privately held sovereign debt as part of Greek Bailout II. The economy has little or no prospect of a recovery big enough to make any difference, so Bailout III will have to come soon. But there are so few private sovereign creditors left that the official Greek creditors (European countries, Eurozone funds and the IMF) will have to take a haircut. This would be a first – no European official creditor has written-off one cent to date. A further complication is that the IMF does not take haircuts (it imposes them), and non-European IMF members will resist writing off debts in (wealthy) Europe when it will not do so in Africa. So Greek Bailout III will set a precedent for European official sector write-downs whenever it comes.

During the six-month Irish presidency of the European Council just ended, there were several developments in the eurozone with negative implications for Irish debt sustainability. The European rescue fund, the ESM, will not be buying any shares in fragile Irish banks at over-the-odds prices, or at all. Moreover, the amounts earmarked for future bank re-capitalisations are tiny relative to the concealed holes believed to lurk in the balance sheets of continental banks. There has been effectively a German veto on a bank resolution scheme that would break decisively the bank-sovereign doom-loop, which means Ireland will have to deal unaided with any renewed requirement for bank rescue.

Next autumn and winter, eurozone bank supervisors will be busy with a new set of stress tests, ostensibly designed to uncover at last the true condition of the banking system. Previous efforts have twice failed to convince the markets and have destroyed the credibility of the euro-quango that undertook them, an outfit called the European Banking Authority (EBA). The European Central Bank is to play the lead role, which makes sense since it is to host the new supervisory function, in the next set of stress tests, but the EBA will no doubt be found an indefinite role as a kind of zombie-quango.

In Ireland, the State owns most of the surviving banks' equity and is on the hazard for the lot should fresh estimates of loan losses exceed the amounts provided in 2011. The economy has been performing below expectations and this inevitably weakens the quality of bank loan assets. Popular sentiment appears to be wholly sympathetic to those in mortgage arrears, regardless of the facts of each case. Banks are bad, mortgage borrowers are good. Trouble is, the banks largely belong to the State, and all of the downside risk will have to be managed by the State. If you would like to pay extra taxes over the coming years, and to have a longer public finance crisis, then go for maximum debt forgiveness and fight repossession.

There is a further and widely ignored angle on the pros and cons of repossession. Mortgage lending is secured, that is, the asset belongs to the lender in the event of failure to pay. Secured credit is cheaper than unsecured credit. Your car loan costs more than your mortgage, and your credit card balance costs more again. There is a reason for this. These borrowings are unsecured. When people do not pay up, there is no asset that the lender can take over, and the bad debts have to be factored in to the interest rate charged. If mortgage lending in Ireland is to become, in effect, unsecured, through dilution of the lenders' security over assets, there can be no more mortgages at single-digit interest rates.

If no viable new mortgages can be extended, there will be no buyers for distressed, including re-possessed, residential property. Excessive indulgence for strategic defaulters means no floor for prices and no prospect of solvency for the banks. Sympathy for mortgage defaulters needs to be restricted to those who cannot pay.

Irish Independent

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