Government must respond to consumer debt crisis

Without the correct response, the crisis could inhibit economic recovery and prevent far too many people from becoming productive members of society, writes Bill Hobbs

JUST when is Government going to respond to the consumer debt crisis? Its mandatory stay on home repossessions is a stop gap, principally designed to temporarily protect banks rather than provide appropriate solutions for people who can no longer afford to make their loan repayments.

Debt forbearance, moratoriums on house repossessions and regulatory codes of conduct simply don’t cut the mustard.

Ireland’s consumer debt crisis will worsen this year as people’s disposable income shrinks further. And the crisis may reach a tipping point beyond which it could spiral out of control.

Household financial vulnerability and unaffordable indebtedness is causing serious distress for tens of thousands of people who are struggling to make repayments on their mortgages and other loans. 

How big is the problem? No one knows as no one Minister, Government department or state agency is responsible for understanding what’s going on and figuring out how to deal with it.

So what do we know of ? With over €147bn in mortgage borrowings and €34bn in other borrowings, Irish consumers are the most indebted in Europe and reported as being the most financially vulnerable. (These figures exclude small business owner’s personal liability for billions in business borrowings.)

Hundreds of thousands of people borrowed to buy overpriced houses at high loan to value ratios, far too many at 100% and many others topped up mortgages using unsecured loans. The most indebted cohort is those under 40, married, with young children.

Ratings agency Moody has highlighted rising loan defaults on banks securitised mortgages. Last October an ESRI paper estimated that should property values fall by 40% from 2007 levels, upwards of 196,000 mortgage holders would owe more than their house was worth – including some 125,000 first timers. And should values drop by 50% this figure would rise to about 350,000.

The consensus is house values have already breached the 40% level and are still heading south. On top of this there are some 250,000 empty domestic dwellings looking for a buyer or renter at a time when bankers are rationing loans and people are too frightened to borrow.

It’s likely that by year end over half of Ireland’s 645,000 mortgage holders will owe more than their property is worth – be living in negative equity.

However, on its own, negative equity doesn’t cause a consumer debt crisis to occur. While a recognised trigger, two other things have to happen. There must be a decline in household incomes and a rise in unemployment. We are of course experiencing extremes of both. Household incomes have permanently fallen by at least 10%. Unemployment is close to 430,000 and only stabilising at this level as people emigrate.

Worse is to come, as state aided banks, the main mortgage lenders, will follow foreign owned banks and increase mortgage rates by upwards of 1% and the ECB may increase rates later this year by another half percent. The effect of a 1.5% increase on average dual income take home pay amounts to a reduction of at least 8.5% in disposable income. For many it means their loan repayments have or will become unaffordable. As income declines, any increase in interest rates dramatically effects loan repayment affordability notwithstanding the reduction in living costs as some consumer retail prices drop.

It is widely understood this dangerous combination of high loan to value mortgages sliding into negative equity, declining real incomes and joblessness causes consumer debt defaults to rise to crisis levels.

Furthermore negative equity means people feel poorer, stop spending, pay down their debts and save more. There are many studies of the enormous economic, social and psychological costs to society and individuals of indebtedness. Yet the scale of the consumer debt crisis remains hidden from view. 

Banks are known to under provide for their consumer bad loans. One reason is they have paid less attention to measuring risk on consumer loans than their larger business loans. And while they may account for troubled consumer loans, they do not account for good loans yet to go bad. Still, even the banks published accounts provide a glimpse of the crisis.

Loan loss provisions on housing loans (both home and buy to let properties) have risen by over 300% since 2008. Loan defaults on largely unsecured personal loans are also rising, with for example credit unions reporting large increases in bad debt provisions.

 It’s known that mortgage arrears lag personal loan arrears as people prioritise their mortgage repayments. Any increase in mortgage arrears is indicative of serious problems with other loans. The courts are seeing increasing debt collection and repossession activity with unsecured debt judgments escalating.

MABS, the tax payer funded debt advisory service for financially excluded, low income people has been inundated as banks refer their indebted customers to its offices. Some observers maintain this behaviour by banks smacks of a shirking of responsibility to fund the costs of responding to a consumer debt crisis they caused through their own reckless lending practices. They say the cost of funding debt advisory services should be borne by those who lent and borrowed money and not the tax payer.

 And this is a key issue. Who should pay for what will have to be a comprehensive effective debt repayment and debt forgiveness programme for people who, through no fault of their own, are no longer able to repay their debts in full? Who should be responsible for designing, implementing and overseeing a national consumer debt relief programme including a just and equitable non-court based personal insolvency system? Ordinary people owe more than €180bn and many can no longer afford to repay their loans in full.

There is an urgent need for Government to wake up and respond to the consumer debt crisis, to identify its scale, to identify the solutions and to implement these solutions. Without a co-ordinated response the consumer debt crisis will inhibit economic recovery and prevent far too many people from becoming productive members of society for years to come.

This article appeared in the Irish Examiner, Business Section, Monday 25th January 2010

Bank enquiry must examine causes not symptoms

Is the fear of discovering the underlying reasons for the financial crisis behind the delay in any enquiry, asks Bill Hobbs

Should the soon to be announced banking enquiry focus only on the symptoms and not the underlying causes, politicians may sow the seeds of another crisis worse then the one being experienced. The power of banking to expropriate and destroy financial resources has to be controlled, with the domestic banking sector shrunk to a size where it can never again wreak such economic damage.

Having concluded and published a number of enquires; the British have not only identified the causes, but are busy implementing change. Why the procrastination and obfuscation here?

Is it the case our public institutions do not have the independence, objectivity, intellectual resources or capacity to enquire and report into what went so badly wrong? Or is the case that some fear that the known underlying causes will be officially unearthed? Can our public institutions and its political leadership honestly and openly enquire into and appreciate the root causes of the banking crisis? Or will the enquiry be skewed towards conveniently determining negligence of a handful of retired bankers, regulators and civil servants?

Lauded as a benchmark model, the DIRT enquiry officially exposed a scandal privately known of for years. It allowed the state to retrospectively determine negligence and extract tax revenue foregone - knowingly - by previous Governments. But it did not lead to any real reform of the relationship between banking, the state, its public institutions and their weak public governance of banking.

It is known as Irish banks increased both the size and leverage of their balance sheets they threatened the stability of the whole system and were not prevented from doing so. And it was known that in a crisis they would become extraordinarily dependent on the state and tax-payer for support.

Mervyn King, Governor of the Bank of England recently asked “why were banks so willing to take risks that proved so damaging to themselves and the rest of the economy?” In answer he said “one of the key reasons is that incentives to manage risk and increase leverage were distorted by the implicit support or guarantee provided by government to creditors of banks seen too important to fail”

His reasoning is just as relevant here where Irish banks and their creditors knew that if they were sufficiently important to the economy and the financial system, and if things went wrong, then the Government would always stand behind them. They were “too important to fail” and were proved right in September 2008. Since then massive, unsustainable state support has created a huge dilemma. In Mervyn King’s words “the too important to fail problem is too important to ignore”

Irish bank owners and their managers benefited enormously when things went well. But limited liability status means their losses are for the tax payer’s purse. Governments worldwide have found out that their banks have become so big in relation to their economies that they cannot rescue them without seriously damaging economic growth. Many say that unless bank’s historical destructive tendency to cause economic crisis is controlled, an even bigger, more expensive crisis will happen.

Current wisdom holds that “too important to fail banks” should either be controlled so the probability of failing is extremely low or ways found to allow them to fail without imposing additional costs to society.

What are the implications for banking policy here? Our three main banks are in the “too important big to fail” category. And given inhibitive costs to society, Anglo Irish Bank cannot be safely allowed to fail. Irish banks have become too big for the state to support. The domestic banking system will have to be shrunk to an affordable size before long term financial stability will be achieved.

Our economic crisis was caused by a bursting property bubble, overexpansion in credit by Irish owned banks and their excessive risk taking. But beneath the surface of the banking crisis and its symptoms lies a serious issue that may not be enquired into. Our public institutions both political and regulatory were far too weak to prevent the expropriation of financial resources by two powerful elites – banking and property speculators. Weak public governance cannot prevent boom/bust cycles and causes frequent crisis which become more severe. Irish political and institutional leadership did nothing to control and effectively encouraged bank moral hazard behaviours to drive an unsustainable economic boom.

The Irish state became subsidiary of banking rather than the other way round. We are not alone in this. Across the world discussion is focussed on the power of banking and finance and how to control for its tendency to destroy whole economies. People are struggling with the too important to fail and too expensive to bail out dilemmas.

If a small regional economy can never afford to bail out its banks without incurring massive economic and social costs then what size banking system can the state fiscally support and what form this should take? In effect a new “fit for purpose” banking system has to be synthesised, designed and constructed.

If we are not to return to a time when we exported people we must once again become an export driven economy. Domestic wealth creation through property based boom/bust cycles must be a thing of the past. For this to happen, our banking system has to subsidiary to the national interest. No longer should banking and finance exercise disproportion economic power nor can its managers and owners trade recklessly off the good name and standing of the state and its citizens. This will require a new form of regional bank, ring fenced and controlled to craft a banking system that works in the national interest.

Will the enquiry ask the hard questions; establish the brutal facts and the Oireachtas subsequently act resolutely to effect changes? In the quest to find out who was responsible for the crisis politicians may be determined to attribute negligence of others. Should their public enquiry focus only on the symptoms and not the underlying causes the seeds of another crisis worse then the one being experienced may be sown.

Banks could prove too costly for the state in 2010

Capital, liquidity and rising bad debts will pose serious this obstacles to Irish banking this year, writes Bill Hobbs

2010 could well be the year when Irish banks may finally prove too costly to save by the State using its own resources.

NAMA, which has yet to establish the true underlying value of builder and developer loans, continues to worry many observers. Some maintain Government has reached the limit of its ability to rescue banking on its own. They point to the emergence of a second wave of bad debts that could, despite NAMA, swamp bank balance sheets.

For now Government is maintaining NAMA will get credit flowing again. Indeed politicians may claim what little lending is done by Irish banks in 2010 will have resulted from the NAMA intervention. But this is not necessarily the case. Banks will prudently lend what little they can as they continue to struggle to survive. Capital, liquidity and rising bad debts remain quite serious issues challenging the entire domestic banking system in 2010. NAMA may well solve for the worst of property loan assets but bank funding and capital adequacy remains extremely problematic.

Nearly 16 months after the fateful night of the 29th September 2008, when the state guaranteed its banking system, banking stability has only been partly assured. The banking system is only surviving due to this unprecedented state guarantee and subsequent infusion of ECB funds. Both these extraordinary supports cannot continue indefinitely. In particular ECB forbearance in funding Irish banks will come to an end this year.

Undercapitalised, over lent and overly reliant on wholesale market funding, banks have yet to realise the full cost of the imploding credit bubble. In adjusting their highly leveraged business model, banking credit might well decline to late 90’s levels as banks reduce their reliance on wholesale funding and shrink their balance sheets. The key is whether or not remaining credit creation capacity will be enough to fund domestic consumer and business borrowing needs. If banking is unable to operate efficiently then credit starvation will seriously inhibit economic growth.

But bankers will not find it easy to convert loans to cash to pay off those that have lent them money. €110bn remains owing in family home and investment property mortgages – much of which was borrowed between 2003 and 2008 at peak property prices. And the bad news for banks and Government is that mortgage defaults are escalating – both home and investment property loans.

Socialising the mortgage trap of a generation of Irish borrowers is a serious challenge to the Irish state. With worsening household financial vulnerability due to declining real incomes and increasing joblessness, mortgage default rates will continue to rise in 2010. And selling off repossessed property, the text book banking response, is not available for economic and social reasons. Allied to this is the problem of unsecured consumer debt and small business loans also showing rising default levels.

Meanwhile NAMA’s due diligence on builder and developer loans may establish a far lower base line forcing Government to effectively nationalise the two main banks. But what happens when defaults on other loans emerge? Can banks weather another round of debt write downs? Many believe that, even after the state injects capital post-NAMA, the main banks may well require further injections of tax payer’s funds.

What form of banking will evolve? In the first instance banks will revert to a traditional model of funding their lending largely from retail deposits. The era of cheap abundant short term availability of wholesale funding is over. Banks will not be permitted to leverage up on funding and will be required to build larger capital buffers. Reducing leverage and building higher capital reserves will force them to shrink their balance sheets dramatically. Secondly they will adopt traditional prudent lending criteria to exorcise behaviours developed through their over-optimistic engagement in property lending.

It’s almost certain that banks will develop an aversion to property lending lasting well into the foreseeable future. Such risk adverse behaviour, some say, could result in property prices eventually stabilising at about 40% of peak prices. While apparently a worse case scenario it is based on the compelling logic that Irish banks and borrowers will fundamentally change their behaviours in both creating and using bank credit and will never again speculate optimistically in investing in bricks and mortar.

The banking crisis starkly illustrates the risks inherent in a small regional banking marketplace. And there is little evidence that national or foreign control matters as both types of banking has suffered. Market share remains significantly concentrated within locally controlled banks. Bank of Ireland and AIB have dominated Irish banking for decades even allowing for the incursion of foreign banks in the recent past. If, as it is likely, the domestic banking system will enter a period of near total state ownership then how it will be controlled and reconfigured needs to be addressed.

Apart from the dominant Irish joint stock bank or shareholder model other forms of banking exist that are worthy of consideration. The inherent financial stability of co-operative banking has proven resilient during the global credit crisis due to its prudent levels of capital and longer term orientation. Many consider co-operative banking systems to be resurgent as regulators begin to truly understand how their unique organisational form helped to underpin financial stability and keep credit flowing elsewhere when commercial banking had all but collapsed.

How will the State govern and restructure a banking sector it almost wholly owns? A national banking commission charged with the oversight of state controlled banking system may be required to remove risks of undue political and sectoral interference in commercial banking. It should be possible to design a system in which individual banks operate within defined public interest parameters and compete with each other in the marketplace. It might also address what ownership form of banking is required by this State into the future. It may be possible to allow for both co-operative banking and joint stock banking forms which may go some way to ensuring local control of consumer and small business banking needs into the future.

© Examiner Publications (Cork) Limited

Financial Consumer Protection Agency Necessary

A watchdog to aid borrowers in weighing up the riks would avoid repetition of the current crises writes Bill Hobbs

What sense if any can be made from the lessons of the banking crisis and the fundamental change in use of debt by ordinary people? Is there a need for a new form of consumer protection that protects consumers from themselves and from banks and other financial service firms’ excessive market power and risky innovation?

Discussion on the banking crisis has largely focussed on the role bankers played in making far too much credit available to too many people who ought not to have borrowed the amounts they did. But what made so many people borrow so much and take on such high risks? For sure bankers were at fault in abusively marketing credit. But human behaviour and those that encouraged a change in how people used debt were equally at fault.

We live in a society that promotes the notion of consumer sovereignty which holds that ordinary people who have reasonable access to relevant information are the best judges of what will promote their own welfare. It is a form of anti-paternalism which sits at the heart of our economic model and policy maker’s attempts to engineer consumer behaviour in desired directions. Take for example the emphasis on ordinary people taking responsibility for their own careers and financial futures in providing for their own health care and retirement. Gone are the days when the social welfare state promised the job for life and provided a financial safety net for its citizens. The modern social contract requires people to live two conflicting lives – the current self and future self.

Rarely discussed this conflict between the current and future self is important to understand, as it is central to appreciating how people use money more especially its most dangerous form – bank credit. Satisfying the current self through borrowing today effectively locks in future income and exposes many people to excessive financial vulnerability. Yet few ordinary people realise they are being manipulated by powerful forces that engineer the availability of bank credit and promote its use. Fewer still appreciate how their own and collective patterns of human behaviour draw them into debt traps which in hindsight should have been obvious.

Some of these human behaviours include; using heuristics or rules of thumb such as “property investment is a safe bet”; suffering myopia or short sightedness; herding, where people collectively move in the one direction. As individuals, people are highly prone to over optimism believing they are not as exposed to a negative outcome as the average person is. People also tend to underestimate risks to themselves. These are but some of the behaviours present in how individuals and groups use money and debt. Faced with complex sophisticated financial products, people use mental shortcuts leading to predictable mistakes. Those who at the height of the boom, borrowed to invest in overpriced property at unsustainable rent levels demonstrated two of the most enduring of human behaviours – over optimism and underestimation of risks.

Central to Government policy and bank regulatory thinking is the idea that the rational informed educated consumer will take time to assess all available options and select the optimal one for their circumstances. It’s believed this process will result in a form of meta-regulation where consumers acting en-masse will pressurise banks to behave themselves and provide quality products at reasonable prices.

But providing people with more information and educational support has proven to be largely ineffective. People have been shown to have an insufficient ability to accurately process information they have in so far as it bears on their own risks – having information doesn’t imply optimal behaviours, judgements or decisions in using debt.

Rather a new approach is evolving that recognises three things : regulation is imperfect, consumers are not financially literate and financial service firms will either lean towards their customers or away from them – in other words suit themselves when it comes to making products available.

If it is accepted that a new approach is required to protect consumers from themselves and from banks which would exploit consumer behaviour, then a different model of consumer protection emerges – one where products themselves are regulated and licensed as being safe and sound for consumer use.

At the forefront of this thinking is Professor Elizabeth Warren who has long advocated for product licensing and is now heading up the new US Financial Consumer Protection Agency. Professor Warren says we don’t expect our TV’s to explode in our living rooms – consumer safety standards ensure they are safe. She asks why we should accept unsafe financial products? Here in Ireland many people who were aggressively marketed credit and investment products have justifiable cause to question the safety of the products they were being enticed to buy.

Banks and others who argue that product licensing will stifle innovation miss the point. Innovation is good when it benefits consumers but bad when it exposes them and banks to undue risks. Banks innovate not to provide greater value to people but to extract more value from people’s wallets.

If as believed, banking will become a utility – then why the need to market sophisticated, complex products few people understand and are sold by advisors who don’t actually understand the products themselves?

Consumerism needs one important ingredient to make it work – bank credit. And without bank credit, modern economies misfire and fail to work as is happening here. Fixing the banking system requires a reformed central bank and regulatory authority to monitor individual bank risk and overall system risk. As banking consolidates, fewer larger banks will restrict consumer choice for some time to come. Balancing the market dominance and power of banking requires an agency charged with acting in the best interests of consumers. What is needed is a properly constituted financial consumer protection agency with powers to set and police safety standards for consumer products.