The nation's mortgage mess may lead to huge bank losses, whether borrowers default or not
The great Irish wit, Oscar Wilde, famously confessed that he could resist everything except temptation. His words could serve as a fitting epitaph for the Ireland that existed in the first decade of the millennium, where bankers, property developers, politicians, and ordinary citizens engaged in a credit-fueled spending spree the likes of which few, if any, countries have ever witnessed. Seemingly overnight, the "Celtic Tiger" transformed from a garden box of legitimate business growth to a property-inspired, carnival success story to a cautionary tale of excess. Now with its economy in shambles, the country is struggling to dig itself from the rubble of a nationwide housing bust.
A number of problems plague Ireland following the bust: home prices have cratered, down 40% from their mid-decade highs; consumer spending has plummeted; the unemployment rate has skyrocketed to almost 15%; an estimated 50,000 people a year are emigrating. Last year, the country sought and received a $113 billion bailout from the International Monetary Fund to recapitalize its failed banks. Soon, it will have to make onerous repayments on this debt. In short, despite a healthy export economy, Ireland stands on the precipice of financial disaster.
Despite a healthy export economy, Ireland stands on the precipice of financial disaster.
Much of recent Irish public debate has centered on whether and how the country can renegotiate its debt repayments to the IMF. Yet events in the Irish residential mortgage market suggest that debt renegotiation is not the only example of how the Irish are in a fix that offers no easy solution and is likely to get worse.
In Ireland, variable rate mortgages make up the majority of all mortgage loans. The rates on many of these mortgages are influenced by the European Central Bank rate. Some, known as "tracker mortgages," which comprise roughly 50% of the residential mortgage market, are specifically tied to the ECB rate. In April, to address concerns about rising inflation within the European Union, the ECB raised its interest rate for the first time in almost three years by a quarter of a point, to 1.25%. As a result, hundreds of thousands of Irish borrowers have seen their monthly payments rise by roughly $20 a month for each $150,000 they owe.
Experts are forecasting two similar rate hikes in the coming months, which means that many borrowers, especially those who purchased their homes with no money down at the height of the property bubble, when Dublin home prices rivaled those in New York and London, could see their monthly payments jump significantly by the end of the year, in some cases by hundreds of dollars.
The problem in Ireland, of course, is that the property bubble has burst. Many homeowners owe far more than their home is worth, and thus have little, if any, chance to sell or refinance into a new loan with lower payments.
Does this sound familiar? The interest rate hike the Irish are enduring now is reminiscent of those experienced by tens of thousands of Americans in 2006 and 2007. At that time, the London Interbank Offered Rate, to which many U.S. adjustable rate mortgages are indexed, rose from previous lows. Absent effective loan modifications, Irish borrowers who received high debt-to-income, high loan-to-value variable rate loans are likely to fall into default and possibly foreclosure, just as many Americans burdened with similarly risky loans have.
Given Ireland's high unemployment rate and austerity measures its government has adopted in connection with the IMF bailout, this new pinch to the pocketbooks of Irish homeowners comes at the worst possible time for the country. And consider this: tracker mortgages are generally believed to be the best thing Irish homeowners have going for them at the moment. Even with the ECB's rate hike, borrowers with tracker mortgages are paying just over 2% interest on their loans, which is roughly half what borrowers with standard variable rate loans are paying. For some borrowers, the low interest rate of their tracker mortgage is the only thing preventing default.
Indeed, the most dramatic financial harm resulting from tracker mortgages is to the banks themselves, which are receiving less than half of their finance costs back through interest payments made by borrowers. To curb their losses, Irish banks have started offering cash payments to borrowers to trade in their tracker mortgages for standard variable or fixed rate mortgages. This has led to recriminations that banks are pressuring borrowers to sell off their greatest protection against default. Last month, Bank of Ireland was forced to transfer more than 2,000 borrowers back to their tracker mortgages after it failed to provide them with required disclosures about the financial implications of their decision.
This mortgage morass, where borrowers and banks both stand vulnerable to the whim of the ECB, highlights two of the main hurdles to an Irish economic recovery. First, the fate of the Irish is, to a large extent, in the hands of others. Decisions made by the EU, the IMF, and the ECB -- entities over which the Irish exert limited influence, and whose concerns are broader than the fate of Ireland alone -- are just as important as, and inextricably linked to, Irish decisions about how to jumpstart a recovery. Second, even where banks and borrowers are seemingly at odds, as with tracker mortgages, they are also inextricably linked and cannot take great solace in any perceived benefit gained over the other.
Bankers and borrowers are stuck in a perverse marriage where losses are losses and gains are ultimately losses, too.
At the dawn of the financial crisis in 2008, the Irish government guaranteed the debts of the nation's banks, a decision that has been widely criticized. Recently, in the wake of stress tests that revealed that Irish banks are in even worse shape than expected, the country has agreed to pump an additional $35 billion into them so they can withstand projected losses, including those related to residential mortgages. That means that Irish borrowers are on the hook not only for their own mortgages, but for the mortgages of the entire country.
As a result, it is impossible to view the battle between banks and borrowers as a zero sum game. Each increase in borrower payments will potentially reduce the banks' losses on tracker mortgages, but will also result in hardship for borrowers. If the hardship is too great, borrowers may not be able to make payments to banks. Meanwhile, should the ECB's interest rate remain low, borrowers with tracker mortgages will benefit in the short term, but banks, whose debts the borrowers have backed, will incur even greater losses.
This is the Irish predicament. Bankers and borrowers are stuck in a perverse marriage where losses are losses and gains are ultimately losses, too. The situation calls to mind the words of James Joyce, "Think you're escaping and run into yourself."
For now, with the ECB rate hike in effect, banks that originated tracker mortgages will continue to lose money, and borrowers will struggle more than they have at any point since the Irish crisis began. Will borrowers be able to withstand the strain of increased monthly payments, or will banks offer them effective loan modifications to ease the pain? Without such measures, Ireland could see a residential foreclosure epidemic similar to that witnessed in the U.S.'s hardest hit states, placing it again at the center of the European debate about how to respond to distressed countries within the EU's purview and causing incalculable suffering for tens of thousands of families caught without means to stay current on their loans.
Image Credit: REUTERS/Cathal McNaughton
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