August 3, 2005

How secure will you be when the credit runs out?

Posted in Celtic Tiger · 11 comments ·
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Have you ever heard the expression ‘Irish pricing’? It is a new term used in banking circles to describe the fact that Irish banks are offering large corporate borrowers money on much better terms than the British or continental banks.

Irish banks are giving away money.

They are undercutting other banks and slashing margins aggressively to get business. So, in big deals of €50 million or more, the Irish banks are offering lower interest rates, longer repayment terms and less onerous covenant demands. This is �Irish pricing’. It is great news for the lender and for the bank that gets the business; it looks good on the balance sheet initially as it boosts the bank’s assets, its projected revenues and its market share.

But it also means that Irish banks are taking more risks than others. To generate the same return, they now have to do bigger deals and lend more money.

So to gain market share, they have to gamble a bit more than they did last year. They are running to stand still and, in the process, the quality of their loan book deteriorates. But when credit is ample, no-one bats an eyelid.

This type of thinking dominated corporate analysis during the tech bubble. Back then, the only thing that mattered was the growth in revenues, rather than the quality, sustainability or, in cases where dodgy accounts were later uncovered, whether the so-called �business’ existed at all. In the late 1990s, nobody really examined what would happen if trading conditions changed.

We are seeing similar carry-on in Irish banking circles, and it is happening across the board. Irish pricing is not limited to the big guys; the little guys are getting in on the act as well.

On Friday, the Bank of Ireland introduced a 100 per cent 35-year mortgage for first-time buyers – the littlest of the little guys. This move follows the First Active 100 per cent mortgage that was announced two weeks ago.

The bank says that this is necessary, and that most little guys will be able to service the higher borrowings. It has put some fairly cosmetic restrictions on who can qualify, but in reality it is throwing money at anyone who comes through the door.

Rather than making houses more affordable, this type of product simply pushes the price of Irish houses up further, forcing the banks to lend even more cash against the same asset this time next year. Friday’s central bank figures showed more than �2 billion was extended in mortgage credit in June, the highest ever monthly total.

Let’s examine how the credit system works, how loose credit reinforces the upward pressure on house prices and how the banks ultimately become the slaves, rather than the masters, of the housing monster. It might also be helpful to entertain what could happen and who might pick up the tab when things go pear shaped.

The key to the system is collateral, and this is also where the systemic fault lies. When it comes to collateral, the Irish banks have always had faith in the housing market. In recent years, this faith has intensified to blind faith, and now, with a 100 per cent mortgage culture, we are observing new levels of Moonie-style devotion.

Moonie economics is quite straightforward and it works as follows. Take an average person, doing what thousands of Irish people have done in the past few years – buying an investment property.

The latest figures suggests that as much as 40 per cent of houses sold in Ireland in the past 12 months were either second homes or investment properties, so this is a fairly hefty chunk of the market, and by extension, of the banking business in Ireland.

So in this example, a house worth �400,000 is used as collateral to borrow �370,000 to buy another apartment for investment. The extra �370,000 goes into the system. The golden rule of monetary economics is that the more money in the system, the greater the upward price pressures on all other things.

Thus, the extra cash sloshing around in the system puts upward price pressure on houses, because there is too much money chasing too few houses.

This makes the original collateral now increase in �value’ to �400,000. The bank extends another loan on the same collateral, failing to distinguish the chicken from the egg. This is the blurred hazy world of Moonie economics.

It is a state of mind characterised by financial back-slapping and corporate high-fiving, where each new loan begets another and the banks and the borrowers waltz blindly up a financial cul-de-sac.

Back in the real world, the only fundamental reason for house prices to rise is if the income from rent is rising. This is not the case in Ireland.

Rents have been falling, according to the Central Statistics Office for over 18 months now. If the income from the asset is falling relative to the value of the asset, then we have a problem. But because of the enormous amount of credit in the system and the way in which the system reinforces the original loan with another one, real world economics is suspended and moony economics takes over.

Moonie economics is the financial equivalent of a confidence trick. When things are going up, Moonie economics accelerates the upswing. When that confidence is punctured, banks pull in their loans, shut up shop and the opposite of Irish pricing occurs – a credit binge is replaced by a credit crunch.

It was interesting last year to hear one of our most senior bankers musing aloud at a conference about the need for Irish banks to remain under Irish management. He made the distinction between ownership and management – which struck me as highly instructive.

He went on to explain why. He suggested that in the event of a property crash we would need a national plan to prevent a credit crunch. It would be the banking equivalent of the countrywide reaction to foot-and-mouth, where everyone would pull together.

In these circumstances, it would be critical that the government could sit down with the country’s main bankers and cut a deal. In the past, countries like New Zealand that allowed its banking system to be taken over by foreigners found that in its property crash of the early 1990s, the foreign owners simply cut lending limits, which had the effect of exacerbating the original downturn.

In the case where the management is Irish, there would be a much greater sense of the impending disaster, because all of us are tied up in the property game in one way or another, whether it is ourselves, our children or our close friends. Laudable and all as these sentiments are, how would such a plan work?

Think about it. In the event of a crash, Irish banks would see their loan books decimated. This would affect their ratings, their share prices, and ultimately their ability to raise new funds.

We, the public, would be in negative equity territory, so would be both unwilling and unable to borrow.

Traditionally, in such cases, the central bank of the afflicted country would slash interest rates dramatically to kick start borrowing. But we could not do this, as our interest rates are set in Frankfurt and might actually be rising.

Do you think the ECB would cut rates to bail out Ireland -1 per cent of the EU’s population? No, I don’t think so either!

The only thing that we could do is let the state borrow enormously by issuing Irish banking bonds to international investors. This cash could then be given to the crippled banks in the form of a 30-year swap, on the condition that the increased liquidity be squeezed into the system, preventing a credit crunch from taking hold.

But who would pay for this? Well, we would, because a special tax would have to be levied initially to pay the repayments of the bonds until the banks’ balance sheets recovered. It is a scary prospect and one that the 100 per cent 35-year mortgage brokers or the guys involved in �Irish pricing’ dare not contemplate.

Awhile back I heard one of our most successful bankers musing about national plans, financial war cabinets and credit crunches. And if you know he is worried about the ramifications of Moonie economics, you should be too.


  1. Conchubhar

    Sounds like the banks are involved in very sophisticated
    pyramid selling…

  2. Sean Doyle

    I am one who has resisted buying an over inflated house in
    this country. Howevever, if the banks’ scheme of lending
    hand over foot comes back to bite them where it hurts, I
    shalln’t be staying around to pay tax to bail out those who
    created the conditions for the property bubble, that goes
    for banks & investors.

    I see RTE news did a story on the slowing down on house
    prices in Dublin. As usual they got their expert commentary
    from a bank official who predicted a 5% rise in house
    prices. I thought we had enough of Baghdad Bob. I wonder who
    they’re aiming t=comments like “market will increase 5%” at?
    Is it investors so taht they dont all try to flog their
    houses at once or to attract new investors, new investors
    arent exactly constrained to just invest in properties here
    in the land of saints and scholars.

  3. Aidan O Neill

    I heard on the radio this morning from an economist talking
    about the proportions of tax being taken in by the
    government and how they compare with 1997 when this
    government came to power. In 1997 Corporation tax comprised
    12% of government receipts, I think it rose to 14% in 2000,
    today it is less than 10%. In contrast stamp duty has risen
    from 2% in 1997 to 7% today. VAT receipts as a proportion
    of total taxation are also up a lot.
    This clearly shows that corporations which in Ireland’s
    case comprise mainly of foreign multinationals are not
    doing aswell as they were in 1997 and considerably less
    well than they were in 2000. The homebuyers, consumers and
    borrowers are what has been driving the irish economy for
    the last few years. The question is how long this
    consumption and borrowing can continue to outpace business
    activity in the irish economy. It also shows that
    businesses are operating in the global economy where
    competition is getting fiercer with every passing year and
    more and more businesses are now operating in the harsher
    global climate. How long more will it be before this new
    global environment is felt by the ever optimistic irish
    borrower and irish consumer. In terms of statistics I think
    tax receipts taken in by revenue are by far the most
    reliable barometer of activity in the irish economy. They
    have far more weight than reports from either the CSO or
    ESRI.

  4. eoin

    Clearly the house price issue is heading to a crunch. We would have massive
    excess capacity this year were it not for the unprecendented number of
    immigrants – a number which will have to continue to repeat at 100K+ a year
    to guarantee the smallish rise in house prices. The whole thing stands on a
    pin. Ireland needs immigrants to stock retail outlets which are booming due
    to a massive 25% per year increase in non-mortgage private spending, most
    of which is people borrowing on the assumption that they have equity in their
    houses: The houses increase in equity, despite massive supply, because of
    the migration of 100 thousand people: the continued boom in house supply
    provides construction jobs, many of which are peopled by immigrants, to
    provide new housing which will continue to rise only if immigrants continue
    to come.

    jesus wept. Lets hope that we can continue to keep increasing private sector
    borrowing at a 25% rate of increase per year : after all that rate merely
    doubles every 3 years.

    Were it not for the SSIA’s I would expect the crunch next year, but because of
    that increase in liquidity – which would offset lower borrowing – I expect it
    the year after – or any year the ECB raises rates.

  5. Garry

    Good article, Aidans comments are spot on

    But you’ve been a skeptic of the housing market for a long
    time. So far you’re analysis, while it sounds rational has
    been wrong. Anyone who refrained from buying a couple of
    years ago and is renting has just seen themselves priced
    out of the market, and lost a good few thousand in rent..
    Short of an absolutely massive property crash in the next
    year or so, buying has proven to be the right decision.
    I’ll cheerfully admit to being wrong also, I dont have
    your knowledge but thought housing prices were at
    ridiculous levels from at least 2002 onwards. I think even
    then rents had peaked.

    Can you try to put a date as to when the party stops or if
    it has indeed stopped? When it’ll stop is anyone’s guess,
    but it would be good to hear your opinion …
    Or what the government could do to keep the party going?

    Its a wild guess but I’m sure there was probably one or
    two conversations about construction in the FF tent in
    Galway last week! . the building scheme tax breaks are
    expiring… and that the plain people of Ireland arent
    putting enough into their pensions …

  6. john

    you’ve been on about this for years now, and the house
    prices have not dropped.

  7. andypandy

    I think it’s unfair to criticise david on his long term
    predictions of gloom and doom for the irish housing market.
    The fact is the situation has been out of control for a
    number of years now, but there are tendencies in the irish
    market (and the global economy) that have meant the credit
    bubble has continued to grow despite the dangers of over-
    indebtedness.

    Something will have to give. The downturn will come, it’s
    just a matter of when. Capitalism is inherently prone to
    these cyclical movements. Normally (as is the case in the
    US and GB) counter-cyclical “keynesian” measures can be
    used with varying degrees of success (due to the inherent
    unpredictability of the market) to keep things on an even
    keel. Because of the centralisation of interest rate
    management with the EMU, the Irish government has no
    ability to lower and raise rates in the same way that
    greenspan and brown have done, and they are thus left to
    fiddle with tax rates in order to manage the economy. In
    this regard, FF/PD have been true to their class roots in
    prioritising the profits of irish Capital (or US
    Imperialist Capital if you like!) over the welfare of Irish
    citizens. They have given a free hand to the banks to
    massively over-extend credit as at the end of the day this
    means more consumption and greater profits for their
    buddies.

    As you can probably tell, I don’t agree with David’s
    politics, but I think his analysis of the irish market over
    the past few years has been spot-on!

  8. Tom Farrell

    A recent Economist issue (June 18th – 24th) can provide
    some facts on the scale of the global housing bubble. Some
    highlights include:
    1. The total value of residential property in developed
    countries increased from $40 trillion to over $70 trillion
    over the past 5 years – an increase equivalent to 100% of
    those countries’ combined GDPs. This is the biggest bubble
    in history (1990s dot com bubble was equivalent to 80% of
    combined GDPs; US stockmarket bubble in late 1920s was
    equivalent to 55% of GDP).
    2. Some housing booms have already started to fizzle out,
    e.g. prices have flattened in Australia and have fallen in
    Sydney itself (can any Sydney residents comment?), the
    market has cooled significantly in Britain. Unsurprisingly,
    the central banks in these countries have delivered both
    verbal warnings and interest rate increases in recent times.
    3. There is a diverging relationship between prices and
    rents (kind of a price/earnings ratio for the housing
    market). The price/rent ratio is at all-time highs in US
    (35% above average level during 1975-2000),
    Britain/Australia/Spain (50% above long term average), New
    Zealand, France, Netherlands, Belgium, and Ireland.
    Furthermore, prices are also at record levels in relation
    to incomes in all of these countries.
    4. Rental yields have fallen below current mortgage rates
    but investors are prepared to rent at a loss because they
    think prices will keep rising (capital gain) – just as
    investors bought shares in profitless dot coms, simply
    because prices were rising.
    5. Finally, the IMF studied 20 housing ‘busts’ from 14
    countries and found that all but one led to a recession. It
    is no coincidence that Germany and Japan, the 2 countries
    where prices have fallen for most of the past decade, have
    had weakest growth in consumer spending of all developed
    economies in that period.

    So if you believe 1) the current housing market is a huge
    financial bubble, and 2) all financial bubbles eventually
    burst, then house prices will fall. They will not collapse
    over night like stockmarkets – a slow puncture is more
    likely since house prices tend to be ‘sticky’ downwards
    (people have to live somewhere, it takes time to sell out
    at a loss due to the pain, etc.). The conundrum for Ireland
    is that rates will never rise until the large EU economies
    start to roar (Germany, France, Italy, etc.). If recent
    events are anything to go by, it will take many many years
    before the structural deficiencies in the EU economy are
    resolved (if ever!). So I believe the fatal Irish property
    party will continue for some time to come (unless some
    other major catalyst occurs, e.g. huge unemployment, but
    this is unlikely). Could we even see a situation where the
    bubble deflates as predicted apart from countries under the
    EMU for whom rates are inappropriately low (e.g. Ireland)?
    Now that truly would be a case of moving from the
    ridiculous to the sublime!

    Tom

  9. Geri Wiseman

    Where most american s will be homeless if they can get a loan at all. i am disabled ,with a grandchild who is disabled also we cant live so where do you think fwe will be when credit runs out

  10. DiarmaidM

    Clearly this is all nonsense – our banks are, er, rock solid and house prices can only ever go up. I think everyone now knows enough to understand that building an economy based on swapping three bed semis between each other at ever inflating prices is clearly the way to go. Why waste time on creating new businesses that actually produce products and services that people might want?

    (please wake me up when this nightmare is over)

  11. [...] group’s thoughts were coloured by the Irish experience — recently converted as we were to the McWilliams school of naysaying — we recognised many correlations between the market performance and the stakeholder behaviour [...]

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