Unprofitable trackers hide full extent of bank losses
The banks are far more bust than you think, as many of their loans are not worth full value, says Colm McCarthy
Published 24/05/2015 | 02:30
It remains to be seen what will be the outcome of Friday's news, from the Government, that holders of variable-rate mortgages will see reductions in their monthly repayments. The Central Bank has prepared a valuable report on the complex issues involved, which was released to coincide with the Government's declaration of victory. This is a wearingly familiar pattern: the report on which any kind of coherent public debate might be based is withheld, apparently to suit the Government's convenience.
The Central Bank, as we are entitled to expect, has produced a solid report, available on their website only since Friday. The coincident timing of the report's release and the Government announcement that variable-rate mortgage holders are about to see cuts in their monthly bills is another example of doing policy backwards. The value of any report on a difficult policy issue is to inform the public debate, not to validate news releases from the Government press office. I imagine that there is some unhappiness in the Central Bank at this, sadly familiar, cart-before-the-horse procedure. Senator Feargal Quinn, Fianna Fail's Michael McGrath and Sinn Fein's Pearse Doherty have all initiated bills designed to address the issue, all three blindfolded through the delay in releasing the Central Bank's study, apparently at the behest of Government spinpersons. All three should object to being treated like this.
A functioning banking system will charge mortgage and other borrowers a sufficient margin to cover three items - operating costs; the cost of borrowing the necessary funds; and a further margin to cover the reality that there will be some defaults: some customers will not repay their loans. During the bubble, the Irish banks charged too little - they extended too much credit, but they also charged too little. It was inevitable that the margin of lending rates over the cost of funds would rise as the banking system returned to normality. Unfortunately this has happened in a highly dysfunctional manner.
The Irish banks, over the last 30 years, have become the principal intermediaries in the market for housing loans, borrowing short-term funds from retail and wholesale depositors to match long-term lending to home buyers. This has been a pattern internationally and has come to be taken for granted. It is, however, a problematic business model for retail banks, whose key functions are the management of the money transmission system and the provision of a safe repository for the public's liquid funds. Housing finance was not always provided through the retail banking system: at one time, in Ireland and in many other countries, specialist institutions with distinct legal and supervisory status were the dominant long-term lenders to home buyers. These were called building societies in Ireland and the UK, savings and loans (S and Ls) in the United States. The worldwide deregulation of credit markets from about 1990 onwards saw retail banks in many countries take over the functions of these housing-finance specialists with, in some countries, unforeseen consequences. The principal consequence was concealed risk in the banking system's balance sheet.
Banks should naturally be short-term lenders. Their liabilities (mainly deposits) are short-term and if they use these to acquire very long-term and illiquid assets (residential mortgage loans) they have a built-in mismatch which makes them vulnerable. If they are allowed to operate with too little loss-absorbing risk capital (they were) and are poorly managed and supervised (they were, both) they become fragile by design. There are many reasons why the Irish banks went bust for the first time in their long history, but exposure to housing loans was a large part of the story. The Irish banks did not go bust during the politician-induced depression of the 1980s; they were not involved then in mismatched housing finance. They were also run by dull, boring, bank managers on modest salaries.
The banks are now the principal intermediaries in the biggest credit market - the market for long-term housing finance - and wistfulness for a less fragile bygone age is not a substitute for a new policy that works. But nobody in Ireland, or in the UK and many other countries, should fail to understand that to concentrate so much long-term lending in the clearing banks is to create a permanent challenge to financial stability.
The immediate problem in Ireland is the understandable anger of variable-rate mortgage borrowers, currently the source of a cross-subsidy to those lucky enough to have opted for tracker mortgages during the bubble. What happened is this: some banks, around 2004, decided to offer a very dodgy lending product, the tracker mortgage. The lending rate was pitched, typically, at around 1pc ahead of the European Central Bank policy rate, recently about zero. The retail banks offering this product were, in their own and the market's estimation, perfectly solvent at the time and able to borrow wholesale funds at little more than the ECB rate. If every mortgage borrower paid up and the cost of funds stayed low, the tight 1pc margin on trackers would have been enough. The banks had gambled on the indefinite persistence of a favourable interest spread over which they had no control, and which they could not hedge.
But the banks went bust, can no longer borrow cheaply, and have found themselves locked into unprofitable long-term lending contracts. But lo and behold, some borrowers, denied the knowledge and financial expertise of €1m-a-year bank executives, chose to borrow on the variable-rate basis through the bubble years, or had already done so pre-bubble. The variable-rate mortgage is loaded against the borrower. The bank (or hedge fund to whom the mortgage has been assigned by the bust bank without borrower consent) can hike the interest rate constrained only by the pressure of competition. The borrower can move the debt to a less demanding competitor bank, if such exists. But in a bust banking system, the discipline of competition is removed and the variable-rate borrowers have no escape. They are currently paying two unlegislated taxes: a tax to subsidise the lucky tracker borrowers, and a tax to help re-capitalise the surviving banks (or to boost hedge fund profits, as the case may be). The value of housing collateral as security for long-term loans has been reduced by the policy actions and inactions of government in Ireland these last few years. It is not clear that the 4pc or so currently being charged on variable-rate mortgages is excessive, given the riskiness of mortgage lending in the new banking environment.
What is crystal clear is that the 1pc or so being charged on trackers is ridiculously low. There is no banking system in the world that could survive this burden without rescue. The banks, if the asset value of the trackers was marked to market properly, are far more bust than you think. These loans are assets to the bank, but they are not worth full value, since the lending bank is locked into a loss-making interest rate.
The banks have been rescued by taxpayers overtly, but are being rescued continuously by captive borrowers who can no longer escape to friendlier competitors, since there are none. Since the Government owns shares in the banks, these captive borrowers are involuntary investors in these shares. Why not acknowledge the reality of Irish-style bank re-capitalisation and reserve some free shares for the variable-rate losers in the Great Irish Mortgage Lottery?