Our massive tracker mortgage debt is a ticking timebomb waiting to be set off by an ECB rate hike
Published 03/08/2016 | 02:30
What is going on in the Irish banks? It's perplexing that after all the billions of euro pumped into the banks, they are still fragile and - according to the latest European stress tests - Irish banks are among the weakest in Europe. How could that be when the economy is growing at three times the EU average, when the demand for credit is strong and when interest rates are at their lowest level in years, underpinning local demand?
The latest tests looked at what would happen to Irish banks if there were a massive economic shock to the system, with the Irish economy contracting by over 10pc.
The bad news is that the banks would not have enough capital to withstand this eventuality. The good news is that this eventuality is quite unlikely.
However, if there is no problem, why are Bank of Ireland shares down 50pc this year alone?
To me, that fall in the share prices sounds about right because the very nature of banks has changed, thankfully. Bank shares are a bet on the future prospects of the bank. Years ago, banks were leveraged profit machines - risky, short-term, profit machines but profit machines nonetheless. By lending hand over fist, the banks booked massive profits without any real attention to the underlying quality of the loan. This all looked good, until the borrower started to default because the clients - the borrowers - were bull****ing the banks about their ability to repay and the bank - the creditor - was bull****ing itself about the quality of the loans it had made.
Profits soared and so too did bank share prices.
Today, banks are heavily policed by regulators and they are debarred from making these crazy loans, and bank share prices will behave more like the share prices of utilities such as privatised electricity or gas companies. So their share prices should not ever again soar to the skies.
Therefore, bank shares - everywhere, not just in Ireland - are likely to remain fragile and the higher the possibility of the banks having to raise more new capital, the lower the share prices.
When we stand back, we can see three remaining problems for the Irish banks: one is technical, one more economic and the third is geo-political - that is, Brexit-related.
Let's examine the technical issue first. Back when the banks were going bust, and had to raise money from anywhere possible, they desperately issued IOUs.
The stress test looked at what would happen if interest rates went up rapidly. If you have issued very high-yielding bonds, the prices of these bonds will fall dramatically and the cost of repayment will rise significantly if base rates rise. Therefore, the Irish banks, because they owe so many of these bonds, would find their position very fragile if interest rates moved up suddenly.
The good news is that the banks are paying back all these IOUs quickly, so they should be off their balance sheets before any shock to the system. But they are a cause for concern.
In my opinion, a much more worrying source of fragility in the Irish banking system is the tracker mortgage problem. This is because trackers are long term and people have got used to repaying them at very low rates; if that changed, all bets are off.
A tracker mortgage pandemic spread like a virus though the homes of Ireland from 2001 to 2007. When the tracker virus crossed into the general population, it multiplied extraordinarily swiftly. Today, the figures are startling.
Today, trackers account for 60pc of Permanent TSB's €26bn book of Irish residential mortgages. They account for 54pc of AIB's €27bn book and 23pc of the €16bn book at its subsidiary EBS. Some 62pc of Bank of Ireland's €28bn book is made up of trackers.
All told, that works out at €51bn, or about 52pc of total residential mortgages at the four main banks. A higher proportion of buy-to-let mortgages, about 70pc, are on tracker rates.
Some 85pc of trackers were lent between 2004 and 2008, when they financed the vast majority of the new estates that were built in our suburbs.
The banks knew they would lose money on trackers, but were confident that once they had you on a tracker, they could make money by lending to you for cars, kitchen extensions or holiday finance on top of your overdraft and credit card.
The number of people affected was staggering. The tracker went from 0pc of all Irish mortgages in 2001 to 15pc in 2004 and over 50pc by 2008. This enormous debt is the great unexploded financial timebomb ticking away in Ireland, waiting to be detonated by rising ECB interest rates.
If either rates increased or the economy contracted rapidly, defaults on trackers would increase significantly and the banks would end up with more bad debts.
The third adverse issue for the banks is Brexit. The Irish banks have significant businesses in the UK and, of course, the UK economy is extremely important to us. So any material slowdown in the UK would have a knock-on impact here.
When you take all these factors together, you can see how a massive shock to the economy or a significant crisis or rapidly rising interest rates could knock the banks backwards.
Does this mean the Irish banks are going bust again? Definitely not. Does it mean the share prices are far too low? Possibly, but all bank shares are performing poorly. Does it mean we should be chilled about the latest news? No, it does not.
But, for now, a bit of perspective is required. There is no new Irish banking crisis on the horizon, not yet at least.