April 13, 2015
Perhaps the best description of the journey from solvency to bankruptcy comes from Hemingway in his novel The Sun Also Rises. Two characters have just met and are talking intently, each trying to figure out what the other is doing in rural Spain in the 1920s. One of them asks the other, ‘How did you go bankrupt?’ The other responds, ‘Two ways. Gradually, and then suddenly.’
When we look at how countries, firms and individuals go bankrupt, we see that Hemingway got this right. Initially, it is a gradual process, and the parties tend to be in denial. When dealing with a new reality – a difficulty in meeting a mortgage payment, or a drop in the value of your home – most of us tend to expect that things will return to normal. It takes a while to get our heads around a permanent fall in prices or incomes.
Over time, though, it becomes apparent that there is a monumental shift occurring under our feet. At the point when bankruptcy can no longer be avoided, things move rapidly. The run-up to bankruptcy is a panic situation: the creditor tries to get his hands on as much as possible and the debtor tries to preserve something for himself.
Up to now, the Irish banks that have been bailed out using state capital have been exercising a moratorium on mortgage foreclosures: this was the price exacted in return for the state’s financial infusion. But it can’t go on forever and if AIB is to be sold, and some of the state’s capital recouped, something has to change.
AIB will only be sold if investors are certain that the bad loans have been sorted out and that there are no nasty surprises hidden in the balance sheet. Who would invest in a bank knowing that the new capital invested would merely be filling the hole?
However, the cost of mortgage default or write-downs is eviction, because if banks write down the loans, they will want to sell the underlying assets – the houses – to recoup some cash.
Despite the recovery in the economy, the debt burden hasn’t gone away. While some people are buying new cars at a rate not seen since 2006, many more are still mired in mortgage debts – and this is when interest rates have never been lower. What happens when rates rise?
According to figures the Minister for Finance cited in the Dáil in late 2011, household debt in Ireland is at a breathtaking 140 per cent of GNP. Any upward movement in interest rates will have a devastating impact on people’s ability to repay mortgage debt.
Together with interest rates – a major factor in the trajectory of debt dynamics – defaults and evictions is the attitude of the banks. As long as they don’t insist on getting their money back immediately, there is a chance that a mass mortgage-default episode can be avoided for an extended period. This has come to be known as the “delay-and-pray” strategy. But this is coming to an end.
In order to linger in this state, the bank will need a shareholder who doesn’t care about the value of their investment. This may be possible under government ownership. However, this is not a plausible long-term prospect. Banks must return to profitability at some stage, a necessity that may prove incompatible with the current moratorium on foreclosure.
We have now reached that point, as the state wants to sell the banks. The status quo – in which people can’t afford to pay their mortgages, and the banks can’t afford to write them down – is now not sustainable. The trajectory of bankruptcy – gradually, then suddenly – comes into play.
But is there an alternative to the cycle of default, debt write-down and eviction?
At the height of the Great Depression, US president Roosevelt, recognising that the economy was being held back by debt and understanding that mass eviction was not tenable, stated it was his objective to “relieve the small home owner of the burden of excessive interest and principal payments incurred during the period of higher values and higher earning power”. He embarked on a programme of debt relief, setting up the Home Owners’ Loan Corporation (HOLC) to buy mortgages from banks in exchange for bonds. The government then restructured the mortgages, writing off significant amounts of principal. In all, one million mortgages were restructured.
Starting in 1933, the HOLC bought up mortgages and then waited. Over time, as US conditions improved, and the mortgages started to perform profitably, it sold them back to the banks. Thus, a million Americans, who might otherwise have been kicked out of their homes, got back on track and paid off their loans.
Could we do something similar here? Could we write down and not evict?
Yes we could, but where would the money come from? There can be no more taxpayers’ money going to the banks. So how? What if we used the age-old debt-for-equity mechanism?
Given that house prices rose rapidly during the bubble years, the write-downs might be administered on a sliding scale, with those who bought at the peak getting the biggest break. Let’s imagine an average loan write-down of one third. Picture a mortgage with €300,000 outstanding. The mortgage holder applies for relief, and is accepted. Her mortgage is written-down to €200,000, with repayments restructured accordingly.
This leaves a hole of €100,000 on the balance sheet of the bank. This hole could be filled by giving the bank an equity stake in the house. When the house is sold, a percentage of the proceeds – perhaps matching that of the write-down – would go to the bank. This is a debt-for-equity swap: the bank takes equity and the borrower gets debt relief.
The equity stake would not wholly solve the bank’s new balance-sheet problem, however, because a large proportion of the homes covered by the relief scheme would be in negative equity. The banks would need an infusion of capital from somewhere else in order to keep their balance sheets intact.
Where could this new capital come from? We would have to convince the ECB to accept housing equity as collateral for a massive Irish banking bridging loan.
At the beginning of the debt crisis, when the ECB was behaving like the central bank of a solvent continent, this move would have been impossible. But now with the ECB embarking on QE, anything is possible.
Debt for equity is the only way you can have (1) write-downs without (2) evictions and (3) still sell AIB. If these are the state’s objectives, debt for equity is what it has to do. It is time to get back to the European negotiating table because Hemingway’s iron law of bankruptcy simply can’t be avoided any other way.