November 23, 2008
As the banks move to sort out their bad debts, it’s imperative that the state also tries to alleviate negative equity problem facing young workers.
Just in time, the cavalry have arrived. On Friday, it emerged that some US-based private equity funds are interested in buying some of our banking assets. Bank of Ireland issued a statement suggesting that it had been approached and the state breathed a sigh of relief.
The first part of Brian Lenihan’s plan seemed to be beginning to work. The Minister for Finance gambled that if he waited long enough, some buyer would emerge because bank share prices would fall to such a low level.
Realising that he would have to write a cheque at some stage, Lenihan, by playing awaiting game, could at least avoid making the same mistake as Gordon Brown, who obviously bought stakes in the British banks too early and has lost a fortune of taxpayers’ money as a result.
Lenihan wanted to ensure Irish bank shareholders – not the Irish state – were exposed to the dramatic falls in share prices of the past few weeks. His judgment here was spot on.
Now that share prices are in cent – or as close to it as makes no difference – the state can begin to move, knowing that the downside is minimal. In fact, it might be well advised to wait a little longer before committing cash, because the banks might get even cheaper.
If you want to understand why banks might get even cheaper, look at the accompanying chart. This tells the story of the US banking system in the past year. It shows that banks are invariably always wrong when it comes to bad loans, because they underestimate the difficulties in their loan books. As you can see, the difference between the banks’ forecasts and reality was enormous.
When the banks realised that something was wrong, they went out and raised equity to cover the losses. To see the disparity between hope and reality, take the example of 2007.
In the second quarter of 2007, US banks realised that there was a bad debt problem of $5 billion. So, in the third quarter, they went out and raised $11 billion to cover these losses, believing that by raising $11 billion they would more than cover themselves for even a doubling of the bad debts from second to third quarter. But bad debts not only doubled, they increased by a factor of ten to $48 billion. In the fourth quarter, bad debts increased again to a whopping $184billion.
This chart is telling you that, whatever the banks are saying now, you can be sure that the problem will be much, much worse. Whatever the PricewaterhouseCoopers report is saying, a prudent investor can be safe to assume that the bad debts in Ireland over the course of the recession will be much worse.
Therefore, there is a huge risk in putting money in now because we have no idea what the true picture will be in a year. If you doubt this, just look at what happened to one of the savviest investors in the world, David Bonderman, the chairman of Ryanair. Bonderman put $7 billion into Washington Mutual last March, because he thought that the bank’s share price had fallen too far and it must be a bargain. By September, Washington Mutual was bankrupt and Bonderman lost all of his $7 billion.
Let this be a cautionary lesson to people who are committing money today – the minister included. The state will have to put money into this recapitalisation to match the private cash.
However, the question remains: what are we buying? For example, if the bad debts are admitted now by the banks to be â‚¬7 billion, recent history suggests they are likely to be three times that at least, meaning that the bailout will have to have a warchest of over â‚¬20 billion to succeed.
To raise that type of money, Lenihan will need to return to the idea of ‘war bonds’ where he opens up the recapitalisation to the Irish people, so that we can all participate in the upside as the economy recovers. But the recovery won’t come on its own. While numbers like â‚¬20 billion are extraordinary, we are living in extraordinary times, which call for extraordinary measures.
One extraordinary measure that has to be considered by the minister as part of any restructuring of the banking system has to be some alleviation of the negative equity problem faced by hundreds of thousands of young people.
Many people would see such an initiative as heresy, as it rewards the bad behaviour of those silly enough to scramble into a housing loan when prices were at their most ludicrous. A large part of me agrees with this, but for future social cohesion we cannot tolerate thousands of young people (in many cases, young families) defaulting on their mortgages and being kicked out of their houses. Neither can we entertain the prospects of those people languishing in negative equity for a decade.
Make no mistake about it: Ireland is likely to see massive mortgage defaults in the years ahead. The reason is simple: unemployment is rising rapidly and will be in double-digit figures by the end of 2009 or early 2010. Many people who lose their jobs will not be able to pay and the banks face a choice, either take the houses back or renegotiate the mortgage.
Instead of waiting for that in an ad hoc way, why not now, as part of the restructuring of the banking system, reset the principal of these mortgages down to, let’s say 50 per cent, of their peak value? The banks’ shareholders would take on the lion’s share of this pain, with the state taking a proportion.
But such debt forgiveness doesn’t mean the lender is off the hook. They pay later. As people move houses over their lifetimes and tend to trade up, the capital gain when the mortgage holder sells on the starter home to the next generation goes to the state.
Therefore, the state is protected, the system is preserved, the banks take the hit and the mortgage holder keeps his house today at the price of significantly lower capital gain tomorrow. It is a bitter pill for the banks to swallow, but so be it. Better to have someone paying some interest on a smaller amount of principal than paying nothing on a big loan.
The other main reason negative equity has to be addressed is that people with negative equity will not spend no matter how well the banks are capitalised. Without spending, the recession gets worse, unemployment rises further, tax revenues fall further and the negative cycle perpetuates itself.
Equally, what reason is there to stay in Ireland if you lose your job and your home? This is a possible future for an entire generation. The property boom enriched the middle-aged and indebted the young in a ‘generational scam’, which is now becoming increasingly evident. Without some really imaginative thinking from our politicians, this generation will move away from Ireland and mass emigration and social unrest is a likely prospect.
Therefore, a move to alleviate negative equity for our young workers is not only advisable, it is imperative. The banking crisis and its subsequent restructuring, gives us the opportunity to sort this out. No matter who eventually owns the banks, this is going to be a cost. This idea might not be for the financial purists, but it is for the social realists, and facing up to reality is what recessions are all about.
[23/11/2008, 11:40am]: chart added