ANALYSIS:TO EXPLAIN how the personal insolvency regime might work, the Department of Justice gave a useful example of a fictional character, "John", who might be eligible to have mortgage debt written off in an out-of-court deal.

John has a mortgage of €300,000 on a home worth €200,000, a buy-to-let mortgage of €250,000 on an apartment worth €150,000, and unsecured debts such as credit card debt and personal loans of €50,000.

A Personal Insolvency Arrangement for John, as proposed under the new regime, could involve a €50,000 write-off on his home mortgage, a €60,000 write-off on his buy-to-let loan and a €30,000 write-off on his unsecured debt.

He must be unable to pay his debts in full but he could be solvent again within five years.

The arrangement means that John gets to avoid bankruptcy and get to stay in his home but he must sell his rental property and disclose his financial position, which can be checked with the Revenue.

If, over the six-year term of the arrangement, he makes more income or sells his home benefiting from an uplift in property values, he must pay over more money to his home lender.

John’s deal must be agreed by an independent “personal insolvency trustee” and be approved by 75 per cent of his mortgages lenders in terms of value of debt.

So, in many ways, the banks are still calling the shots.

The risk for the borrower by seeking this arrangement is that if the creditors fail to agree, they could end up bankrupt (albeit for a reduced term of three years) and they could lose their home.

If they secure a deal, they will be on an insolvent register for five years after the arrangement ends, which would damage their ability to borrow again in the future.

The Government is seeking to cut out most professional property investors from the out-of-court deals where mortgage debt can be written down. It is limited to a maximum debt of €3 million.

However, the inclusion of “John” and his buy-to-let property loan would suggest that minor speculators can avail of write-offs.

The potential for mortgage debt being written off outside the courts raises alarm for banks as it offers borrowers a means to write off debt that the banks regard as secured and value accordingly.

The Irish Banking Federation, which had lobbied to have mortgage debt excluded from out-of-court debt settlements, gave a lukewarm response. “In supporting the case for reform, IBF will, however, be concerned to ensure that a number of important principles are taken into consideration so that the appropriate balance is struck between the interests of debtors and creditors,” said the group.

The inclusion of mortgage debt in the arrangement sets a precedent that doesn’t exist elsewhere. But the proposals create options between the unworkable extremes of forbearance or foreclosure that banks are currently using.

The Personal Insolvency Arrangement is the one the banks will be poring over. Last year’s stress tests of the banks estimated that AIB, Bank of Ireland, EBS and Permanent TSB would face losses of €5.8 billion on their residential mortgages. But this was measured only on the all-or-nothing (forebear or foreclose) approach that the banks are being forced to work now.

Just as the proposals contain carrots and sticks to help borrowers deal with unsustainable debt, the Government is keen to encourage and compel the banks to change their behaviour and engage with customers outside the formal insolvency process.

“What’s in it for the banks?” asked Department of Finance head of banking John Moran.

“If they see people walk away and go into bankruptcy, we are going to see the sale of a house in a foreclosure situation. It is going to cost them a lot of money and everybody loses. If we go into the personal insolvency arrangement, we have an amicable resolution.”

Outside of the proposals, the Department of Finance and the Central Bank are examining the bank’s case-by-case strategies to resolve distressed mortgages.

The banks have been asked to provide for bad mortgage debt sitting on their books, which will encourage them to agree deals with customers and write-off debt.

“It will ensure that the banks may recover more money than may be the case and will allow individuals to retain their home,” said Minister for Justice Alan Shatter. Limiting out-of-court deals on mortgage debt to six years (though it can be extended by a year) – and not rest-of-life earnings – could mean heavier write-offs for the banks, though clawbacks could help them recover more later.

How the arrangements are operated and who is eligible will ultimately determine whether these proposals offer better prospects for borrowers than for the banks.