The cosy herd mentality needs to end

How could so many smart people have been so stupid? The Nyberg banking report hints at an answer - we are hard-wired to act stupidly when we act together.

Our business, banking, public administration and political leadership failed abysmally to act on warning signals. Influential journalists and analysts acted as gate-keepers of a cosy consensus by not appreciating the warnings signs that all was not well. No one wanted to take the punch bowl away during the party as the rule of thumb “safe as houses” prevailed.

It’s not surprising. With limited computational skills and seriously flawed memories we create rules of thumb to get by and we use recent experiences to create them. As we do so, we underestimate risks and overestimate good results.

We use language to craft compelling stories which in turn dictate our actions and reactions to news. We selectively hear only what we recognise, interpret it based on past views and draw conclusions much like those drawn before. We become immune to contradictory information that tells us we are wrong to continue doing what we are doing. Together we all herd in the one direction, to a blind spot we hardly realise exists. What’s more, senior decision makers have known of these shortcomings for years.

The Nyberg banking report mentions one well known shortcoming, “groupthink”, twenty nine times. It happens when a group makes faulty decisions because group pressures lead to a deterioration of “mental efficiency, reality testing and moral judgement”. It causes amongst other things; an illusion of invulnerability which creates an excessive optimism that encourages taking extreme risks; a collective rationalisation where assumptions are not critically examined and dangers are discounted; a belief in inherent morality, where groups believing in the righteousness of their cause, ignore the ethical or moral consequences of their decisions; pressure on dissenters not to express arguments against any of the group’s views; self-censorship where personal doubts are not expressed and self-appointed “mindguards”, others who protect the group from information that is contradictory to their consensus.

Nyberg highlights symptoms such as “the pervasive assumption of continuing growth”, “failure to see growing indebtedness as a serious policy problem” “the soft landing scenario” and “unwillingness to recognise the existence of long-standing problems in some banks”. He appears to vindicate the banking guarantee decision makers as they couldn’t have known of the true extent of banking failure.

Yet the crisis was made worse by one of the most stupid groupthink decisions ever made. Good leaders guard against the dangers of groupthink by including for diverse views, testing assumptions and enquiring into alternatives when reaching decisions. The guarantee decision makers should have realised the extent of their collective blind spot. They should have realised they were suffering from groupthink and acted to guard against it.

Nyberg hints at people’s leadership culpability for not asking the hard questions when they had doubts. Some may have seen that a new reality was emerging. Some may have seen their own part in maintaining the fiction of riskless banking. Yet they did nothing. There is no more damning indictment of bad leadership than to see there is a problem and do nothing.

In all crises there are three distinct positions that can be heard. Some say “let’s return to the order of the past”. Others say “let’s just keep doing more of the same and muddle through”. Others ask “is there a way to break the patterns of the past?”

Nyberg proposes breaking from the patterns by removing the threat and danger of groupthink. Banks should no longer be too big to bail out and should have narrower mandates than before. Rules should be used to limit their risk taking and act as a break on excessive optimism.  

But is there a risk that a new form of groupthink will take hold as political populism dictates a new orthodoxy? Could state owned and directed banks become excessively risk adverse, unwilling to lend at all?

The Nyberg report should signal the start of a proper dialogue on the design of the new banking system. The danger is it will be used as the excuse to ignore the lessons and blame the past on people who inhabited the past. Yet many of those who bought into groupthink consensus have been promoted to higher levels of influence and authority without being required to publically account for their behaviours and actions.

One wonders if within current leadership a new groupthink is emerging. One that insists banks are made whole without equitably and morally forcing losses where they lie.

Today is seems gatekeepers are protecting the bank bondholders who bought into the groupthink consensus, willingly ran with the herd and now expect a free lunch.

A version of this article appeared in the Irish Examiner, Business Edition, Monday 25^th April 2011

RTE "This Week" programme coverage on credit unions

RTÉ News Player: This Week coverage on credit unions fast forward to 34.44 minutes into clip

Sunday’s “This Week” programme coverage included a segment in which a somewhat evasive ILCU chief executive declined to say how much he expected credit unions loan losses will be, what their current holdings in junior bank bonds are and what bail out funds were left available for use by the ILCU.
One would have thought that as ILCU projects itself as a prudential monitor under its SPS role, it should know all the aggregate numbers. It is fair to say that it has consistently downplayed and at times denied problems when a growing number of individual credit unions are known to be in quite serious trouble. 

ILCU declared charges €48m on its €118m bail out fund in supporting just thirteen credit unions in its 2010 accounts. 
                                  

It's notable that €11m investment losses have been incurred since 2008. According to this chart which is drawn from ILCU's published accounts, net funds available at the end of 2010 were €73m with indications that at least a further seven were to be supported. With more looking for help, estimates since of its uncommitted bail out funds indicate the amount left available are said by some to be c€30m. This is why ILCU will try to get its members to double their annual contribution to the bail out fund. 

Some but not all credit unions debit their annual bail out fund fee and their annual affiliation fees to their customer’s accounts. In any event the amount of money it has to bail out troubled credit unions, which everywhere else would be closed or merged with others, is wholly insufficient. I have estimated that government could be required to provide well over €500m in capital support to credit unions – but it will only do this on the basis that credit unions reform their business model. Indeed reform is a specific requirement under the IMF programme.
How bad is the credit union sector stability problem? The aggregate estimate of loan losses is between €1.15bn and €1.45bn. 
As yet further investment losses have still to materialise. Credit unions are said to hold about €1.3bn in Irish bank bonds of which e€300m is in junior bonds –these are exposed to the real risk of significant haircuts which could amount to 75%. They have already incurred an estimated €200m+ in losses in other instruments invested in during the boom. Many were high risk products credit unions elsewhere are not permitted to invest in. 
One in five credit unions could not pay any dividend to savers last year and another two out of four paid less than 1%. As dividend rates are a critical financial performance benchmark or safety threshold, these numbers indicate that three quarters have problems. 
The outcome of financial stress tests soon to be announced could well trigger the need for government intervention to provide capital and insist on the closure and merger of troubled credit unions. 
Consolidation could see numbers reduce to about 50 or so credit unions. Recent banking stabilisation laws permit government to order a credit union be taken over by another credit institution including a bank. 
Perfectly designed for an Ireland that no longer exists Irish credit unions alone amongst their international peers have failed to transition into modern credit co-operatives. 
Yet it’s possible to imagine a credit union sector reformed as a modern European style credit co-operative. In return for state aid and support, credit unions would cede independent autonomy to become members of a federated network owning a central finance facility which would provide them with the resources to modernise and deliver on a better range of affordable financial services to ordinary people.  

Scaremongering is little excuse for doing nothing

Financial institutions need to face up to debt forgiveness sooner or later, writes Bill Hobbs

Following AIB’s reference to debt forgiveness, the airwaves were full of shrill, uninformed, misleading commentary that forgiving debt is unfair, inequitable and an unbearable cost to the taxpayer. But debt forgiveness will have to be faced up to and paid for. Bankers know this. They realise there must be an organised and effective debt settlement system through which they can plan for the billions they will have to write off as uncollectible debt.

The scale of the debt forgiveness required was starkly illustrated in the Central Bank’s recapitalisation programme which provides for consumer loan losses of upwards of €12.1bn. The total sum could amount to over €20bn when other banks, credit unions, utility companies, credit card companies and finance and leasing outfits are factored in. Home mortgage losses alone could amount to a conservative €5.5bn. Translating figures into real people is difficult. With 100,000 home mortgage loans in trouble upwards of 30,000 may have to be repossessed.  Last week’s Irish League of Credit Unions’ disposable income index estimated that 735,000 people were seriously financially vulnerable.

Other countries have long provided for debt forgiveness through structured processes in which people can earn it. People negotiate a collective agreement with all their creditors to pay what they can for a fixed period of time. During this time they must live off a basic income calculated to allow them live life with dignity. The balance of what they earn is paid to their creditors. If they stick to the plan, when it concludes any balance owing is written off. Such a process has been designed by the Law Reform Commission (LRC) and should be implemented without any further delay as reforming our bankruptcy laws is part of the IMF/EU programme.

Yet AIB’s mention of debt forgiveness sparked a negative public reaction. The shrillest anti-debt forgiveness voices last week included boom time cheerleaders who now tout themselves as “experts” on consumer indebtedness. They are people who promoted and sold 100% interest only loans to first time house buyers while gagging any critique of dangerous credit products and the property boom. They are now talking up debt forgiveness “moral hazard”. They warn that people will deliberately plan to benefit from debt forgiveness. It’s a bit like saying people would willingly contract a terminal disease to get a free medical card.

Many others say “I should not have to pay for the sins of my neighbour”! But this flies in the face of reality. The vast majority who bought into our credit fuelled consumerist economy did so naively without realising the risks they were taking. Had they realised they could lose their jobs and have their incomes savagely cut, they would not have borrowed as much. Are they to be denounced as sinners for being too human? It is nonsense to suggest that people should be forced to live non-productive, miserable lives to assuage others misplaced outrage.

It’s important not to mix negative equity with loan affordability. Many can afford their loan repayments even if they are in negative equity. These people, through accident rather than design, are able to pay their way even if their neighbour cannot. As their home may not be worth what they paid for it until at least 2025, it should be possible to create a financial product through which they can manage negative equity, freeing them up to sell and move home.

If implemented the LRC’s system will allow people earn the right to get out from under the crushing weight of unaffordable debt. But its system does not deal with mortgage debt save to say that any balance owing after a house is repossessed could become part of its debt settlement process.

Current attempts to deal with unaffordable mortgage debt will fail as they do not address the core problem. People owe too much. Temporarily reducing repayments simply kicks the can down the road. The only way to deal with the problem is to write down loans to affordable levels. If people can afford to repay a loan equivalent to the current value of their home then they should retain possession. The balance could be written down through a debt settlement agreement or parked until it can be repaid. Qualifying would require rigorous stress testing using a maximum affordability level such as say 30% of gross income. Should a person be unable to make repayments then only one realistic option exists – short selling, where the home is sold for what it’s worth and the balance is written off immediately or through a debt forgiveness programme.

Whichever way you look at it, billions will have to be written off through some form of debt forgiveness programme. Moral hazard scaremongering is a thin excuse for doing nothing.

A version of this article appeared in the Irish Examiner, Business Section, Monday 18^th April 2011.

Short-term solutions produce long-term problems

Banks need to address the profit taking behaviours that caused their demise, writes Bill Hobbs.

Has the curtain finally been brought down on the Great Liberalisation epoch in Irish Banking? It was a time when, thanks to Euro zone membership and friendly regulators, our banks accessed a boundless supply of cheap wholesale money to fuel a property lending boom. It was also a time when banks deliberately produced complex products to ensure consumers remained blind to the risks they were induced to take.

A consumer debt crisis is an inevitable outcome of abusive credit marketing. In the hands of abusive bankers who persuaded unsophisticated, financially illiterate consumers to buy into their misleading and negligent marketing hype, mortgages became weapons of social destruction. Irish bank’s dangerous financial innovation played a large part in causing the catastrophic property bubble.

Their marketing of cheap affordable credit induced far too many people to borrow far too much.  One the canards promoted during the boom was that more banks led to greater competition and lower prices. In fact, competition between financial service firms tends to drive prices higher as firms deliberately increase product complexity as a ruse to increase prices. The more complex they make their products, the less likely people will try to educate themselves on different offerings and the more likely they will buy from the most familiar brand. 

The size of the debt problem is evidence of not only a failure in bank regulation but an abject failure to protect consumers. The scale of home repossessions required to clean up bank balance sheets is finally becoming public.  Faced with repossessing close to 30,000 homes, there are two generic solutions. Either banks possess and sell off these homes or they write down people’s loans to affordable levels.  

Thanks to the ECB’s small interest rate increase last week, media and public attention is now focussing on home owner’s debts. Yet for over a year, banks have steadily increased their mortgage lending rates. You will now pay €4,500 more per year on a €150,000 mortgage than if you were living in Germany. Overall, Irish banks are likely to charge an additional €1.5bn per year on variable rate mortgages. It’s an indiscriminate banker’s tax, hitting those that can least afford to pay it most. Home mortgage holders are being scalped without any concern for controlling the cost of mortgage credit. It seems that protecting consumers is not on the bank restructuring agenda for now.

Released last week, redacted briefing reports for the incoming Minister for Finance, Michael Noonan are strangely mute on how to deal with the scale of the consumer debt and consumer protection problems.

How big is the debt problem? Adding consumer losses together – home mortgages, “buy to let” and other personal loans - the total bill could reach €15bn. This is the money that will not be collected. At crisis recovery rates, the underlying loan amounts exposed to losses will be many times higher. These losses will be translated into higher fees and interest rates as bank customers will be forced to cross-subsidise bank losses.    

Banks and their gatekeepers say they have to pass through their cost of funds to borrowers. But they are passing these costs through bloated operations built during the boom times.  

Government policy has not yet considered how best to protect consumers in what will become a banking oligopoly. Ignorance is a source of oligopolistic power that banks will exploit to drive up profits at the expense of their customers. Unless there is a willingness to insist banks and other financial service firms produce simpler, less complex products, profit gouging will become a feature of the marketplace for years to come. 

Financial institutions love complex products as they can pack them full of tricks to induce people to buy and traps to enforce loyalty. Will banks and other financial service providers be allowed to continue making it harder and harder for people to understand what it is they are selling? Or will the financial regulator insist that banks treat their customers fairly and replace complexity with easily understood terms?

Should price controls be introduced? There is nothing preventing interest rates and fees being capped. And there is nothing preventing Government from insisting that bankers live within tighter margins.

The great liberalisation of Irish banking led to a marketplace full of complex and quite dangerous credit products. Unless challenged by a robust consumer protection agency with the powers to insist on fairer prices and terms, a banking oligopoly could embed unnecessary complexity and excessive profit taking. So far it seems that Government and regulators are only concerned with restructuring banking and haven’t addressed the profit taking behaviours that caused their demise. It should be possible to insist that products are regulated and prices are controlled.             

A version of this article appeared in the Irish Examiner, Business Section, Monday April 11th 2011

Home repossessions will soar if bank plan works

By the end of last year nearly 45,000 loans were over three months in arrears, writes Bill Hobbs


If Government’s bank restructuring plan is to work, we could be facing home *possessions of somewhere between 10,000 and 20,000 homes a year.

Clearing the decks to get banking working again means the inevitability of wholesale possessions and sales will have to be faced up to.

The section in the Central Bank’s “Financial Measures Programme Report” dealing with mortgage loan loss assessment to 2013 starkly points to the sheer number of home possessions and sales required to make banking work again.

Between €3.5bn and €5.7bn of losses were assessed of four banks which have €74bn or 64% of outstanding mortgages. In addition to mortgage losses, the Central Bank assessed non-mortgage consumer loan losses of upwards of €2.6bn.

Curiously unexplained, Bank of Ireland’s figures were considerably lower than AIB, PTSB and the EBS. Either it was a more cautious lender or its figures are being flexed for other reasons.

As total mortgage loans are €116bn, losses could come to between €5.5bn and €8.7bn. Tellingly, last year Professor Morgan Kelly’s predictions indicated losses of €5.8bn.

Since the Central Bank did not translate its euro losses into the number of loans, the full story remains hidden from view. No detail was provided on the model it used to estimate loan losses which probably also estimated the number of expected possessions and losses per loan.

Throughout last year the numbers of troubled mortgages increased every quarter. By December close to 45,000 loans totalling €8.6bn were over three months in arrears. With arrears levels roughly equal to 2.5% of loan balances, it’s a critical stress threshold beyond which possessions become inevitable.

The Central Bank mentions that Britain’s possession experience was considered in assessing loan loss. If British experience applies then we could expect about 9,600 possessions or 3,200 a year. But any comparison is tentative as the numbers of loans in arrears were 3.8 times higher than in Britain at the end of 2010. And while British arrears were declining, ours were increasing throughout last year.

While stress test experts, Blackrock used a loss assessment model driven by negative equity, the Central Bank’s assessment was directed by household income predictions. Declining affordability drives the numbers of troubled loans and underlying property values will drive loan losses on these troubled loans. Worsening affordability and loan to property values means larger losses. By stalling possessing and selling today, forbearance increases losses.

What does this mean? The Central Bank’s three year loan loss assessment hints at how many homes will need to be possessed and sold off. In a forced sale and credit crunch environment, realised prices will be lower than current market values. Elsewhere “forced sale” discounts are between 20% and 40% of current market values. It’s not clear if the bank factored in the discounts needed to offload large numbers of possessed homes.

Using Central Bank arrears data and loss estimates, it’s possible to form a view of what the numbers of possessions will be. Estimating the loss per loan using both arrears data and loan loss assessments, under its base case economic scenario the possible number of possessions required to clear the decks comes to 59,000 from now until 2013 which is 19,600 a year for three years. It’s clear that as the number of houses in possession last year was only 585, forbearance has built up a mountainous volume of possessions that must now occur.

Putting it all together, at the very least 10,000 possessions a year would be needed to clear banks loan books on British experience. Factoring in anticipated Irish experience, possessions jump to 19,600 a year.

Inevitably property bubbles and bank crisis can only be solved by possessing and selling off houses people can no longer afford. If Government’s bank restructuring programme is to work, the current mortgage forbearance policy which was designed to hide the true scale of bank losses will have to end.

But the state has no mechanism to work out the scale of possessions required. In most cases the residual loan left after a house is possessed and sold will simply have to be written off as uncollectable. Any possession scheme must deal with the reality that as banks crystallise their losses, people will have to be given the chance to earn debt forgiveness.

Until now previous government policy was to forestall the inevitability of wholesale possessions. That policy will now have to change. Government’s plans to introduce a meaningful personal debt forgiveness regime and fairer bankruptcy laws will also have to provide for an effective and fair mechanism to deal with the scale of possessions needed if its bank restructuring programme is to work.

*possessions is the technical term for repossessed homes

A version of this article appeared in the Irish Examiner, Business Section, Monday 4th April 2011.