David McWilliams: Mortgage debt deal can prevent 'default disease' from spreading
Published 19/12/2012 | 17:00
BY far the most important statistic to come out in Ireland in the past few days is yet more evidence of the relentless rise in the number of people falling into mortgage arrears. Since 2006, this column has been arguing that the inverse of a house price bubble is a debt bubble and, as night follows day, when the house price bubble bursts, so too will the debt bubble.
The biggest myth of the boom was that house prices always go up. The second biggest myth was the soft landing in prices. The biggest myth of the bust is that the debt is sustainable. The second biggest myth is that there will be a soft landing in debt defaults. The soft landing in defaults suggests that defaults will be limited to very exposed borrowers.
In the same way as wishful thinking in the boom was nonsense; wishful thinking in the bust is similarly misplaced.
Central Bank figures show that 86,146 private residential mortgage accounts are in arrears of more than 90 days. Over 67,000 are in arrears of more than 180 days.
Unless this is arrested, we are likely to see a pattern in mortgage default much like we see contagion in a disease. Defaults go viral.
Think about the way viruses spread. Initially, incidents of the disease are isolated to what are called high-risk groups. Those not in the high-risk group content themselves that they are not really at risk and that they can carry on like normal. But gradually the disease tips over into the general population, creating the conditions for a pandemic.
The way in which defaults tip is one part financial and economic and one part psychological or social.
The key to the economic part is income. If your income is rising faster than the cost of debt or your overall ability to meet debt and other bills, all might just be okay. If not, you are goosed.
This is where yesterday's GDP figures come in. There is good news in the income data. Forget GDP, which measures output and focus on GNP, which measures income.
Yesterday, the GNP figures were strong. This newspaper reported that "Gross national product fell 0.4pc in the third quarter from the second quarter but rose 3.7pc from the year earlier period.''
So here we have a conundrum. The national income is going up, yet the defaults on mortgages are rising rapidly. What does this mean? It implies that the total income of the country is not percolating down to wages, which is the main source of income for most of us. So what is happening?
Well, when you break down income it can be either wages, that is the proportion of income that goes to workers or it can be profit, which is the proportion of income that goes to capital. Could it be that profitability in Ireland is recovering quite rapidly? This is what you would expect after five years of downturn. Typically profits recover much faster than wages, as an economy stops contracting.
This might be the best interpretation of the disparity between domestic income rising and mortgage arrears also rising.
The other factor is, of course, taxes – both direct and indirect – and the labour market.
If your mortgage is taking a significant proportion of monthly income, then two factors determine whether you will have enough at the end of the month to pay it.
The first is obviously work. The better chance you have of working, keeping your job or moving to a better one, the better chance you will have of paying your mortgage.
Looking out to 2013, the outlook for employment is not rosy, while the chances of getting a pay rise are equally slim. In contrast, we now know that taxes are rising across the board, this reduces take home pay, which reduces the amount of money left to pay the mortgage.
Consequently, the squeeze on households will remain vice-like in 2013 even if company profitability recovers.
This may lead to the strange and seemingly counterintuitive picture emerging over the next 12 months where corporate investment recovers as it has been these last few quarters, yet household incomes and defaults continue to rise.
If this is the picture that emerges, we can actually figure out a way of manipulating the economic cycle to the betterment of society.
Arrears are a sign that debt is simply too big and needs to be reduced. Cyclical upswings in investment mean that the corporate balance sheet is beginning to mend itself. Meanwhile, rising profitability is what should be now happening.
This means a mortgage debt deal is more necessary than ever because that part of the economy, which wasn't in huge debt before the crash, is healing. This is a huge positive and this crucial change is what can be gleaned from the cumulative national income statistics.
In fact, if it could be executed, a debt deal could use the banks as a skip for bad debt. For the first time the banks, which have dragged the economy down for the past five years, might actually be used as a quarantine zone.
They would take on all the debt, rather than the people taking on the debt.
Here's the deal. A large debt for equity swap needs to be done for the mortgages to prevent more arrears and defaults. If the ECB, which is proving itself much more inventive, can be convinced of the merits of this, we have a chance.
The banks take 50pc ownership of homes. These homes are sold in 20 years' time. The banks get paid then. In the meantime the people pay half the mortgage, which is affordable. They don't default now but get on with the business of living. The ECB takes as "collateral" the potential equity upside that banks are holding. In effect it gives the banks a price today on Irish houses which are not worth much today but will be in 20 years.
This is a large debt for equity swap where the ECB acts as the lender of last resort for the Irish banks, who in turn act as a quarantine mechanism for the toxic Irish household debt. This prevents the default disease from spreading and becoming a financial pandemic.
All the while the embryonic recovery we may be seeing in national account figures is given a chance to take hold.
David McWilliams' new book The Good Room is out now.