October 6, 2014
Ireland is about to move into the Repo Man phase of its credit and debt cycle. This phase is not pretty, because when the repossessor comes to get you, things can turn very nasty, very quickly.
If you saw the 1984 movie Repo Man with Emilio Estevez, you’ll know what I mean. Now the Repo Man is coming for the professional classes. Houses and assets will be seized, causing a massive dislocation in the higher, respectable echelons of Irish polite society.
Over the past few weeks, there have been numerous stories about large sections of the professional classes in Ireland going bust. The tales involve sketchy details about professionals – doctors, dentists, lawyers, accountants, bank managers and senior heads in the financial outfits all around the country – who got in over their heads in boom-time investments which went sour.
It may be difficult to feel sorry for some people who borrowed big in the hope of a quick buck. The professions are not the obvious recipients of sympathy in Ireland, but bear with me, because the story of what happened next to Ireland’s mid-ranking property players is an interesting and cautionary one.
In reality, the still-solvent mid-tier property investor is in a worse position than the big developer who went spectacularly bust. When the mega-developers went wallop, they did so in grandiose style and, after a year or two in bankruptcy purdah, they are back again.
For the professional classes, so obsessed with respectability and outward signs of success, the ramifications of their money mistakes have been ongoing and are not yet over. Not nearly.
Now that foreign vulture funds have come in to buy many of these assets at a discount, the presumption is that, while these professionals have taken a hit and are now out of pocket, they are off the hook. After all, haven’t those assets that they owned been sold, albeit for way less than they were valued at in 2007?
So the barristers and doctors and the like who owned the assets are sore, but at least they’re out of the woods. Right?
Wrong. This is not the case.
The banks have sold the assets to the foreigners and the difference between what the assets were sold for and the original value on the banks’ balance sheets is covered by Nama bonds. This is what the taxpayer is picking up. Nama hopes to minimise this bill, over time. This debate is a topic for a different day.
What interests me now is what happens to the money that was borrowed in the first place. Where does that go? Who is responsible? And why is it important, in these cases, to follow the money?
To understand the lasting legacy of the credit collapse in Ireland, we need to understand the dynamics of this debt.
The reason this lesson is important now is the fact that the “property thing” might start up again, and people’s memories are short. In order to prevent a second generation being beguiled and ultimately destroyed by property schemes, it is important to understand what happens when the market turns.
A building bought with debt in the boom separates in the bust between the asset itself and the debt associated with it. Because the vast majority of the deals done in the boom were debt-financed, the debt element remains, for the original investor, the anvil around his or her neck.
When the professional could borrow at 5 per cent and was promised a 50 per cent return if the market kept going up, you can see easily how they could get into debt in huge amounts.
To see what is happening, take the following hypothetical situation, dealing with round numbers.
Let’s say the original building was bought for €100,000. The professional bought this using a split of debt and equity. He put in €20,000 in cash and borrowed €80,000. He borrowed the €80,000 from the bank in a normal loan which, in the event of the deal going pear-shaped, would have to be paid. These were personal loans maybe pledged against the family home or some other assets. Although they appeared to be linked to the building in question, they were loans.
In the crash, the value of the building falls by, say, €60,000. So it is now valued at €40,000. This means that the equity the investor had is totally wiped out. It was wiped out when the price of the building fell below €80,000.
The bank sells it for €40,000.
At this stage, the building is split between the asset and the loans. The loans are now assets in themselves. The bank tries to recover some value for the building, and then something strange happens: the loans are sold to a vulture fund.
The professional still owes €40,000 to the bank, but the bank knows that it won’t get the money back in the short term. During the past few years, the bank has had a steady-as-she-goes approach with these loans, stretching out credit terms, putting the loans on interest only, and making sure that the loans don’t default.
But now we are into a very different stage of the debt repayment cycle. It is a stage that may see thousands of professionals pushed into bankruptcy. There is a new player on the block who wants his money back and wants it quickly.
Getting back to our example, a bank exiting Ireland or closing down – such as IRBC or Danske Bank – sells the over hang loan – €40,000 – to a new vulture fund for, say, €20,000. Then the vulture fund pursues the professional for the full €40,000, hoping to make €25,000 in the process.
This is where the change has come in recent months – and, in a sense, we are now in the final phase of the great Irish property crash; the Repo Man phase. These new debt collectors are a totally different proposition to Irish banks. The guys who are coming to get paid in full have a similar 3-30 rule to the vultures who are buying assets. They want to be here for three years, and want a minimum of 30 per cent return for their efforts.
If they can get more, it will be a bonus – but they won’t settle for less.
And after years of forbearance, we are now moving into the final liquidation phase, where houses and other assets pledged as collateral for the boom-time move into property will get repossessed.
It’s not going to be pretty on the leafy greens of Ireland’s swankier golf clubs.