Debt forgiveness: who wins, who loses?

Struggling mortgage holders who have their debt 'forgiven' by banks could end up being subsidised by their tax-paying neighbours. Is debt forgiveness fair or just another dig-out?

WHEN AIB said this week that it would consider writing off debts for some people who cannot repay their mortgages, it created a fresh ripple in the debate on debt forgiveness that began almost as soon as the housing market crashed.

Is debt forgiveness a moral hazard, a catalyst for economic recovery, only fair, deeply unfair or a necessary evil?

The chorus of people in favour of formal debt-forgiveness policies as a means of stimulating the economy and lessening social misery include Constantin Gurdgiev, Brian Lucey and Stephen Kinsella, who were among a group of 10 economists who argued in The Irish Timeslast November that the banks "must allow private home borrowers to revert to pre-crisis debt burdens". They cited the vicious circle of an economy where debt-swamped householders hoard cash and the inappropriateness of Ireland's outdated laws on bankruptcy. In other countries substantially less onerous personal-insolvency regimes already involve an element of debt write-offs, if creditors agree.

The central bank’s stress-test exercise has forecast vast mortgage losses at the banks, although these in part relate to unprofitable tracker rates. Bad mortgage debts could run as high as €9.5 billion between now and 2013, while over the full term of the loans the losses could reach almost €17 billion. Some €10 billion of this will come from Irish owner- occupier loans that will have to be written off.

Despite the scale of the problem the government-appointed expert group on mortgage arrears and personal debts last November recommended against debt forgiveness for homeowners deep in arrears.

Until this week Bank of Scotland Ireland was the only bank to admit even vaguely considering debt forgiveness (for some buy-to-let customers in “exceptional circumstances”). Other banks were quick to distance themselves, with KBC Ireland’s chief executive, John Reynolds, describing debt forgiveness as “a daft idea”.

AIB’s executive chairman, David Hodgkinson, said debt forgiveness was just one option being considered, and even then it would “depend on the situation of the customer, how transparent they are with us on their financial affairs and how deep a hole they are in”.

Bank of Ireland’s more diplomatic-sounding proposal – loan restructuring on a case-by-case basis – is also likely to involve elements of write-offs and losses that add to the bill.

Among people who were lucky and/or wise enough to avoid financial calamity the words “debt forgiveness” prompt a level of unease. Considering the potential social and economic benefits, spending billions on “bailing out” certain homeowners should in theory be less galling for taxpayers than pouring many more billions into now-defunct financial institutions.

Although it does not use the term, Nama has effectively offered debt-forgiveness packages to developers who, unlike the average modest mortgage borrower, were in a high-stakes property/gambling game. Meanwhile, economists in favour of debt forgiveness say moral hazard can be avoided as long as only part of the debt is written off. It’s the difference between scalding householders and burning them.

FOR THE BANK, debt forgiveness and its many cousins – temporary debt relief, forbearance, moratoriums on repossession, and loan restructuring – all have one facet in common: realism.

The bank’s major shareholder, the State, would, in theory, benefit from permitting mortgage holders to return to their pre-crisis levels of debt, as it would free up income that could be spent in the domestic economy, thereby curtailing further job losses that could in turn add to Ireland’s burgeoning rate of mortgage defaults.

Debt forgiveness also makes economic sense to a bank that thinks it can attract private capital in the future – investors are more likely to be impressed by a bank that takes an upfront hit on bad, bubble-era loans rather than keeping defaults artificially suppressed by forbearance policies.

However, for the bank (and by extension the State and taxpayers in general), there is the risk that as borrowers who are currently coping with repayments hear stories of distressed borrowers having their debts written off they might – as the central bank’s head of financial regulation, Matthew Elderfield, put it – have a “perverse incentive” to stop paying.

To try to avoid this, the bank would have to stress, as AIB has, that any debt forgiveness would be granted only to people who are fully transparent with the bank about their financial affairs.

James and Kate: In arrears

The recession has not been kind to James and Kate. They bought their home in February 2007, right at the peak in the market, for €350,000, using a 100 per cent mortgage taken out on the basis of their joint incomes. In 2008 James’s employer went bust. Anxious not to lose their home, they managed to scrimp together their mortgage repayments for the first few months, until Kate was also made redundant.

By September 2010 their mortgage was one of the 40,000 in the State that were in arrears by more than 90 days. They can’t sell their house, as it’s now worth only about €200,000. Their lender has complied with the State’s policy of forbearance, which means it must wait until James and Kate are in arrears for 12 months before it can start repossession proceedings. That time is almost up, however, and the couple now desperately hope that their lender will restructure their loan.

Debt forgiveness would certainly help, but that might mean giving the bank a share in their home. What they really need is a longer period of forbearance, which would give them the crucial time to try to find work. Their mortgage already had a term of 35 years, giving little room for an extension of the term, unless their lender was to consider offering the kind of inter-generational mortgage cited by AIB.

House cost€350,000 in 2007.

Value now€200,000.

Outstanding mortgage €345,000.

What debt forgiveness means to themWrite-offs would help, but it is forbearance that will give them time to get back on their feet financially.

Anna and Chris: Mortgage paid off

In 1992, on the cusp of retirement, Anna and Chris traded up to their current house for a sum of €80,000. They then watched as property values on their street more than quadrupled over the following decade and a half.

Encouraged by their lender, which was quite keen that they “release equity”, Anna and Chris took out a small second mortgage in 2001 and used it to do an attic conversion and replace their decaying kitchen. However, they made sure to increase their monthly repayments, rather than extend the term of their 20-year mortgage – as a result, they have just made the final repayment on their loan.

Anna and Chris are proud to be mortgage-free. When Anna hears about the hardship faced by younger borrowers, she can’t help remembering the double-digit interest rates that put such a strain on her and Chris in the 1980s – every generation faces some economic pain.

Anna thinks some mortgages advanced during the height of the banks’ delusion will have to written off, but she believes blanket debt forgiveness would be a moral hazard. Chris blames the extraordinary inflation in house prices on politicians, not the public, and believes the current financial crisis, like the one that forced most of his generation to emigrate, was beyond the control of the ordinary borrower.

House cost€80,000 in 1992.

Value now€220,000.

Outstanding mortgageNil.

What debt forgiveness means to themMorally hazardous compensation for others who, sadly, had too much trust in the powers that be.

Sarah: Unrealised negative equity

Sarah’s house is identical to that of James and Kate, but she was a little luckier in that she bought it in 2005, paying €300,000. Property prices powered ahead during 2006, which gave Sarah a bit of a cushion once they started to tumble.

A recent report by Sherry FitzGerald indicating prices are now back at levels last seen in 2002 gave Sarah the shivers, but she tries not to think about it too much. Negative equity would only be a problem if she were to lose her job, and, thankfully, she doesn’t work in construction, retail or financial services.

Although her take-home pay has shrunk, the payments on her tracker mortgage also fell from €1,500 to €950 when the European Central Bank cut interest rates. Sarah thinks she can absorb the ECB’s recent rate hike by cutting back on other spending. She’s never missed a repayment and isn’t about to start doing so now.

Even though she doesn’t need to avail of it herself, Sarah is in favour of either debt forgiveness or relief for the thousands who are struggling, because she agrees it is vital if the Government wants to kick-start the economy. Sarah would quite like to move and is intrigued by the idea that lenders may allow people to shift their negative equity from one property to another.

House cost€300,000 in 2005.

Value now€200,000.

Outstanding mortgage€250,000.

What debt forgiveness means to herShe doesn't need it. But she's aware that if she lost her job it might be a different story.

Leo: Tenant with no mortgage

Leo is renting his house. During the bubble he had wanted to buy his own place, but prices soared so high that not even the reckless lending policies of the banks were sufficient to give him a mortgage big enough to buy a place in the city. Leo sagely decided against borrowing to buy on the fringes of the commuter belt, an option that had seemed affordable. Having made the right financial decision, Leo is irritated that people who knowingly borrowed many multiples of their salaries may now be forgiven some of their debt. Didn’t they know what they were getting themselves into? Couldn’t they have foreseen the possibility that they might lose their jobs?

He’s now wondering why his income should be slashed and burned because of other people’s mistakes.

After the property crash Leo was able to negotiate lower rents and take his pick of properties – another financial triumph. The phasing out of rent relief over the next eight years is, admittedly, a source of discontent.

Leo was never happy paying tax at the best of times, but being forced to bail out banks through higher taxes has made him especially sore. And although he naturally feels sorry for people caught up in the unemployment crisis, he’s incensed by what he sees as a bailout for his neighbours too.

House cost€1,000 per month in rent.

Value nowTo him, nothing.

Outstanding mortgageNil.

What debt forgiveness means to himA roundabout subsidy of the poor financial decisions of property-obsessed borrowers through higher taxes.