Patrick Honohan: Household indebtedness - context, consequence &
correction
Address by Mr Patrick Honohan, Governor of the Central Bank of Ireland, to the Limerick
Law Society, Limerick, University of Limerick, Limerick, 14 March 2012.
* * *
How quickly the lubricant of credit turns into the millstone of debt, the slingshot of leverage
into a lethal boomerang.
Dealing with debt has, throughout history, been a central - and frequently fraught -
challenge for economy and society. Early Ireland provides some of the more colourful
examples: debts having been measured (according to some of the Brehon Laws) in units of
cumail - female slaves - a point made much of by one recent academic commentator
abroad using the example slyly to elide the difference between debt and slavery. Slavery did
indeed exist as a possible penalty for non-payment of debts in early Ireland; apparently as an
alternative to death! As Fergus Kelly, the premier scholar of early Irish law, has drily
remarked, "the economic inducements for the wronged party to opt for enslavement rather
than execution are considerable".
Fast forward a thousand years or so and, as the accumulation of debt through borrowing
grew into a major force driving the direction and scale of economic development worldwide,
so society's approach to dealing with situations of overindebtedness have also tended to
evolve, and this is so in the great crisis of debt generated in the new millennium.
The Irish private sector was not alone in accumulating debt during the first decade of the new
millennium. But, easily sourcing the funds from abroad - thanks to the impeccable national
credit rating - the banks in Ireland readily accommodated the demand for credit from (a) big
developers and from (b) house-purchasers who bought the houses they were building, in
many cases risking over-extension in order to get onto the bottom rung of a property ladder
that seemed to be soaring out of reach; in other cases scrambling up that ladder, or
branching out into the buy-to-let market, at home and abroad as a seemingly promising
investment in the rising market. [Charts: Household debt-to-income ratios over the years,
international comparison; (ii) bank net borrowing from abroad as % GNP 1999-2011]
First to feel the cold draft of creditor withdrawals were the banks. Their borrowings from the
international market had been mainly at short-term, and the market's growing reluctance
after 2007 to roll over these funds in light of well-founded concerns about the banks'
solvency led the Government to assume the liabilities.
As has often been remarked, there is plenty to criticise in the way in which the
September 2008 guarantee was put in place, including the extent of the guarantee, its
cast-iron nature, and the lack of consultation with official partners who might have agreed to
share the burden. But what cannot - in light of subsequent events - be doubted is that there
would, in any case, have been irresistible pressure from those partners to ensure that losses
would not fall on depositors or senior bondholders, given the fragility of banking worldwide in
those frenetic weeks of September and October 2008, and indeed thereafter. Whatever
about the merits of such an international policy, it has been in place ever since, greatly
expanding the indebtedness of the Irish State.
Although the burden it imposed was what tipped Ireland into losing the confidence of the
bond markets, and triggering the need for the EU-IMF Programme, it would be unwise to
focus too exclusively on the debt assumed by the State from the banks as a determining
factor for Irish economic prospects and the current situation of the Irish economy. Indeed,
much of the deterioration in the net fiscal position of the Government in 2009 is for reasons
other than the jump in debt (though of course associated with the unwinding of the
credit-driven property bubble). And equally or even more important as the public debt per se
is the fall in the numbers at work and the surge in unemployment, and the consequence that
[Chart:
has had on wellbeing, and on the affordability of debt assumed by households.
numbers at work and unemployment rate 1960-2011]
The jump in debt certainly began to hang over the economy. In the public accounts, debt
reached the point where foreign investors lost confidence in the certainty of Irish Government
debt, leading (against a background of wider concerns on public debt in the euro area) to the
need for official financial assistance from the EU and IMF. For the private sector, the debt
burdening many firms and families, who have got caught up in unaffordable levels of debt,
hampers their ability - and even, in some cases, motivation - to resume their economic role
in society at full potential.
Not all economic crises have left as substantial a legacy of personal debt as has the current
global crisis. In other crises initial levels of personal debt have typically been a lot lower than
in Ireland. Furthermore, many of those crises were accompanied by currency devaluations
and surges of high inflation which, albeit hugely disruptive and costly in themselves, had the
side-effect, beneficial to debtors, of lowering the real value of their debt (at the expense of
others in society). In less severe situations Government and banks could dig into capital or
reserves to absorb losses coming from unrecoverable debt. The sudden emergence and
severity of the banking losses in Ireland since 2008 has greatly exceeded the banks' capacity
in this regard, and has pushed the Government to its limit.
Thus, as far as the banks are concerned, they have run through their entire stock of initial
shareholders' capital, which has had to be topped-up by the State or by foreign shareholders.
[Chart: loss-sharing for banks]. This process, along with the rest of the deterioration in its
finances, has pushed the Government towards the limit of what it can sustainably borrow.
The topping-up to the banks' balance sheets has given the banks enough of a capital buffer
to absorb what can be clearly foreseen as potential losses for the next few years, but not
enough for any broad strategy of debt forgiveness. That's why we have been saying that the
banks must husband their capital and work out their problem loans in a measured and
realistic way that deals promptly and sensitively with the unrecoverable, but does not shrink
from ensuring that affordable debts are properly pursued.
The economic crisis has adversely affected most people in Ireland. Since the peak in
2007-8, average living standards have fallen by some 17 per cent, and aggregate wealth
has fallen by an estimated 59 per cent (the decline in the wealth of the household sector was
smaller). The peak activity levels reached by the economy were, of course, altogether
unsustainable, and it is unwise to expect too much sympathy from outsiders for the fact of
having fallen back after such a rapid run-up. [Chart: 5-yearly bar chart: GNP growth and per
capita personal disposable income growth]
Some people have, however, been affected more than others. This is not only a question of
there having been an increase in inequality. Survey data1 does in fact show a jump in
inequality in 2010 reversing a downward trend which had been noted since 2005. Two large
countervailing forces have influenced measured relative poverty rates since the peak: the
rise in unemployment and the offsetting growth in social transfers (job-seekers' supports and
the like). Had it not been for the social transfers, the percentage of the population whose
income is less than 60% of the national median (and as such deemed to be so low as to
place them "at risk of poverty") would have increased dramatically. In fact, this percentage,
[Chart: from CSO SILC
though it has increased, is still lower than it was before 2007.
survey 2010].
Of course, the poor are less able to cope with a given percentage fall in their spending power
than the rich, so even a uniform percentage reduction in living standards bears more heavily
on the poor. And of course, the impact has not been uniform.2 Among those who have lost
disproportionately are families hit by job losses including in construction and other sectors
which have seen a dramatic shrinkage in demand, those who are self-employed in such
sectors (some of them hit by bad debts from their customers), those who had been relying on
dividends from bank shares, and those who had taken leveraged investment positions in
assets whose value has declined, notably property. Except for the last group, debt per se has
not been the driver of the deterioration in their circumstances, though - depending on their
access to savings, assistance from family or other forms of support - indebted persons who
lose their job are likely to be in a worse position than those without debt.
There has been a lot of talk about negative housing equity, but of course this is a symptom
which can be experienced both by those who have truly been placed in a difficult position by
the crisis, and by those who have emerged relatively unscathed. There are people who,
though they paid a lot more for their house than it is now worth, have not experienced any
decline in living standards since the crisis began.3 As a result, the increase in negative equity
for owner-occupiers is not a reliable indicator of stressed living standards. By the way, even
in those parts of the United States where mortgage lenders do not have recourse to the
borrower beyond the ability to foreclose on the mortgaged property, most borrowers in
negative equity do continue to service their loans; as of course indeed happens here in
Ireland. To quote some of my colleagues "Equity considerations have not been a major factor
driving Irish mortgage arrears, and it is affordability issues, along with changes in the general
macroeconomic environment, that is driving developments here".4 [Table: crosstab showing
negative equity and arrears]
Moving forward decisively from here calls for sensitivity to household circumstances, as well
as maintaining a clear vision of how the economic recovery can be strengthened so that the
national capacity to deal with the myriad aspects of debt is maximised. A full discussion
could range very widely. I am not going to talk here about such aspects as the currently
topical issue of central bank-related debt. Nor do I want to go more into the treatment of the
indebtedness of the big players, including those whose bank debts are now owed to NAMA
and others besides. Ensuring that these debtors are held to their contracts and that as much
as possible can be recovered for the benefit of the State in these cases is an important task
which has been engaging many legal and financial minds for quite some time now.
Instead I want to focus the remainder of my remarks on the policy actions being adopted to
deal with the far more numerous cases of debt distress on the smaller-scale. Here too there
are distributional issues: public policy could hardly countenance any debt relief arrangements
that in practice discriminated in favour of middle and high income people when so many
households - debtors and non-debtors - have had to fall back on social protection payments.
No doubt the necessary increase in taxation and lowering of wages and salaries in some
jobs especially in the public sector has contributed debt distress, and indeed, the CSO's
SILC survey showed a relatively large number of non-poor5 households cutting back on what
would previously have been considered normal expenditures. For example, 17 per cent of
those in non-poor households reported themselves to have been unable to afford an evening
out in the previous fortnight, up from 6 per cent in the boom; 9 per cent went without heating
for some time (up from 4 per cent); and over 18 per cent couldn't afford to replace worn-out
furniture (up from 10 per cent). Not measured in these statistics are the stress and other
health issues and their ramifications for the wellbeing of the overindebted.
Against such a background, the policy challenge facing any Government is to ensure that
arrangements for dealing with unaffordable debt are fair and technically efficient, and offer a
viable pathway for over-indebted individuals and families to re-establish their solvency and
resume their role as productive members of society. It should on the one hand avoid
resulting in families losing their homes where this is not necessary, and on the other avoid
creating a perverse incentive for those who can afford to pay their debts to exploit the system
at the expense of the rest of society. The last caveat is especially relevant in the present
situation where, although the banks have been provided with enough capital to allow for loan
modifications in respect of loans that are clearly unaffordable, unnecessary debt forgiveness
could quickly erode that buffer, placing a further burden on the Government finances, which
they are in no condition to absorb.
The approach sketched by the proposed legislation on personal debt, draft heads of which
have been announced by the Government, is consistent with this approach. But banks
should in most cases be able to arrive at arrangements with their debtors that do not require
use of the new legislation. Admittedly it is a major and complex task for the banks to
implement at sufficient scale a programme of effective engagement with troubled borrowers.
The banks have all been progressively moving towards this, encouraged strongly by the
Central Bank which has ramped up its monitoring of these efforts. Early engagement, fair
procedures, tailored forbearance or rescheduling adapted to individual debtor circumstances
and which respect the current and future ability to pay are watchwords in the development of
a sufficient response. That has not yet been achieved by the banks. Until it is, there is the
risk that far too many debtors will bypass what should be in most cases a more efficient way
of working out their problems and proceed directly to the new insolvency procedures being
set up according to the draft legislation that has been published. Ideally, only cases that
prove impossible to resolve in bilateral negotiation, including some situations of complex
indebtedness involving multiple creditors, would so proceed.
For its part, the Central Bank is reviewing the Code of Conduct for Mortgage Arrears to see if
any elements need to be refined to avoid hampering the fair and effective bank engagement
with borrowers which is essential to a successful outcome for all. (Many other initiatives are
under way including the establishment of a comprehensive credit registry which, looking to
the future, will help improve the precision of lenders' decisions, ensuring that credit is going
to where it can be repaid and not otherwise.)
The legislation streamlines bankruptcy and shortens both the period before discharge and
the post-discharge period during which a payments order can be in force. At last there will be
a clear option for those who truly cannot pay to escape from unreasonable creditors.
Nevertheless, the fact that the family home would be forfeit would alone continue to make
bankruptcy in Ireland very unattractive to debtors. Furthermore, a very strict interpretation of
the "reasonable expenses" that the bankrupt is left with will no doubt continue to be applied
to the bankrupt before discharge (even if the post-discharge payments order might be
somewhat less onerous).
The non-judicial Personal Insolvency Arrangement holds out the prospect of a better
balance, though the devil is in the detail. With its combination of debt modification and a
period of six years during which the debtor must pay a sum - potentially income-related - to
the creditors, the proposed arrangement is flexible enough to allow a reasonable incentive
for the debtor to get back on their feet as productive members of society, while not gifting a
quick escape for those who have been offered a reasonable and affordable long-term
mortgage arrangement. Much of the practical detail remains to be worked out, especially
- how to define "affordability" of a payment arrangement, in the short and in the long
run (in particular whether it leaves the debtor enough to live with dignity) and
- assessing both (i) the degree to which subsequent increases in income - and in the
value of the home - might be partly clawed back, while still offering the debtor the
opportunity to make a fresh start and (ii) practical ways of doing so.
Since we in Ireland have very limited experience of such arrangements, these issues
deserve detailed public discussion and debate. (The PIA in particular is a home-grown
innovation tailored to the reality that mortgage debt is the major problem; getting the various
elements ideally balanced will not be easy.) The parameters that are arrived at would also, of
course, inform the debt modification arrangements offered by banks bilaterally to
overindebted debtors before they get to thinking about seeking access to the new formal
procedures, thereby avoiding what could become a large administrative burden on the
proposed Insolvency Service. In addition to the point I made earlier about distributional
consequences, administrative challenges abound in this area, and there will have to be an
evolving system of review, feedback and learning as a fair, efficient and effective system is
constructed.
Other countries faced with similar problems are also struggling here. The US HAMP (Home
Affordable Modification Program) programme was intended to incentivise lenders to provide
realistic loan modifications thereby avoiding unnecessary foreclosures and repossessions.
However this and other programmes have not succeeded in reaching their target coverage,
and repossessions in the US have soared. In Ireland the number of repossessions has
traditionally been low, and while it has increased in the past two years, in 2011 it still
amounted to less than 1 per cent of the number of mortgages. For owner-occupied houses
the traditional Irish reluctance to foreclose is certainly not misplaced. There is every reason
to play long when it comes to managing a distressed owner-occupier mortgage: versions of
the split mortgage concept mentioned by the Keane Committee, which reduce current
servicing costs of the debt to manageable levels for households that have had suffered
adverse income shocks but with the potential for some clawback if house value and
household income recover, while a bit complex to implement, could be the key to a
satisfactory solution for all, including the State.
The buy-to-let sector is more complex, including as it does a wide range of different
circumstances, sometimes including extended family arrangements. It would be unwise to
generalise, but there are many circumstances in which there is less reason to be inhibited
about repossessing buy-to-let properties. Where loan delinquency relates to pure investment
type "buy-to-lets", it is surely now past time for the banks to be dealing more proactively with
the situation of overindebted buy-to-let borrowers no longer able to service the debts they
assumed in order to take investment positions - now loss-making - in property. It is in the
long-term interest both of the banks (and therefore the State) and the borrowers that the
banks continue to ramp-up their capacity to engage with and process such debtors in order
to determine, on the basis of actual and prospective income, what repayment they can
realistically be expected to service fully, repossessing the collateral where necessary. While
this may involve the banks in having to manage a portfolio of repossessed buy-to-let
properties, this is not an insurmountable task and should in any event facilitate the improved
functioning of the property market and getting closer to a market-clearing price by bringing to
the market (in an orderly and managed way) many of those properties which at present are
implicitly hanging over it as an excess supply.
Overall, systematic and effective engagement can bring predictability to hopelessly
overindebted borrowers, restoring their ability and motivation to become productive members of
society.
With almost €100 billion of mortgage debt in the Republic outstanding in the banks
guaranteed by the Government, the working-out of troubled mortgage debt is a matter of
immense national importance. Achieving the right balance between realism in what can be
collected and prudence in managing the limited but adequate capital resources that have
been provided to the banks by the Government is vital. Failure in this regard would press on
the already fragile finances of the State. The new personal insolvency arrangements could
underpin a good outcome here, but the final form of their precise architecture and especially
the operational parameters (how to define affordability etc.) will be crucial. Much also falls on
the banks, whose role in ensuring a realistic and effective approach to loan recovery - in
effect for the benefit of the State - must continue to be developed alongside the resumption
of a less timorous approach to new loan approval, including for the newly approved negative
equity mortgages for movers.
Step-by-step the challenges of this crisis of overindebtedness will be overcome, and it is
crucial that, in the process, the fabric of Irish society and the contractual underpinnings of our
economy are protected. Thus, fairness is a key objective, which means both that debtors
who can afford to pay do pay and that efficient and effective arrangements for ensuring that
those who cannot now pay fully are given a clear and coherent path forward that is
consistent with affordability and sustainability.
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