Patrick Honohan: Household indebtedness - rhetoric and action
Address by Mr Patrick Honohan, Governor of the Central Bank of Ireland, at the MABS (Money
Advice and Budgeting Service) Annual Conference, Dublin, 8 November 2014.
* * *
Introduction
I do not have to remind this audience that household over-indebtedness is still at record levels:
you see it in your daily activities. For many over-indebted households, MABS is a vital resource
assisting people to make the best of difficult - sometimes desperate - situations and deal
coherently with the financial pressures they face.
Debt is a very emotive subject, and one which requires more than the slogans that are
sometimes bandied around: some by partisans of the debtor perspective, some by those
favouring creditor interests. What is striking is the degree to which, in rhetorical discussion, a
moral judgment is attached to the mere status of being a debtor or a creditor, depending on the
stance of the observer - or, nowadays, of the social media contributor. In an over-indebted
country, we are probably more aware of the pro-debtor narrative, but this is not universal. Nor is
the moralising new. Much of the emotive language around financial debt derives from
longstanding perceptions about right and wrong, sin and guilt, and more generally the reciprocal
obligations of the individual and society.1
I noticed an op-ed in the Financial Times last week on this theme of the ever-shifting moral
evaluation of debtors and creditors in language and literature; claiming that the stigmatisation of
debtors in much current public debate (think of the way in which the entire population of Greece
has often been portrayed in the media in recent years) contrasts with the way in which authors
such as Goethe, Marlowe, Dickens and Shakespeare generally portrayed creditors as evil.
Judgmental language or attaching blame is usually not the most constructive way of dealing
with the acute practical problems that result from the emergence of over-indebtedness. I am
inclined to share the conclusion of the op-ed writer in this regard: "credit is morally neutral.... it
should entail neither stigma nor penury".2
Our role at the Central Bank is not to sloganise, but to seek pragmatic and effective solutions:
and in particular to make sure that lenders discharge the duties placed on them by virtue of the
privilege of having a public license to provide a responsible service and products that are useful
throughout their life-cycle. Thus, through our Code of Conduct on Mortgage Arrears, and the
overall Consumer Protection Code, we focus firmly on the needs of the debtor. At the same
time we all need a well-functioning economy. That in turn needs a stable and efficient financial
system; and finance cannot work if borrowers who can afford to do so do not repay debts. Our
policies thus reflect society's need for contracts to be respected.
Two key questions - not unrelated - present themselves. There is the before (ex ante)
question: how can the risk of over-indebtedness be reduced? And then there is the ex post
question: how to deal with over-indebtedness? In offering a few thoughts about both questions,
I am acutely aware of the fact that they are at the heart of the activities of MABS and that all of
you here have more hands-on experience about them than any other group in the country.
Preventing over-indebtedness
Lenders' responsibility
In seeking to limit the emergence of new cases of over-indebtedness the Central Bank attaches
a high expectation to the behaviour of authorised lenders. The need for responsible lending is
critical, and is a feature of our Consumer Protection Code requirements. What this means in
practice is not only a creditworthiness assessment but also (learning from experience) the need
for an ongoing relationship between borrower and lender, offering the prospect of emerging
problems being addressed early.
Our increasing focus, as reflected in our Codes, is on product design and the related
governance. Especially when one considers the life cycle of a long-term product such as
mortgages, what is needed is that each product is designed to meet customers' needs, i.e.,
designed appropriately for its target market. The same is true for non-mortgage debt - and I am
very conscious of the fact that much of MABS' work is with customers who are not
owneroccupiers, and do not have mortgage debt. It is also true for other financial products. When the
product is sold, it is sold on the basis of suitability for the individual consumer; and when
something goes wrong the consumer gets a proper follow up service (whether that is handling a
complaint, paying out an insurance claim or indeed managing arrears - an aspect to which I will
return).
Helping build the lenders' capacity in this regard will be the Central Credit Register, now in
preparation at the Central Bank (though this is an inherently slow-burning project which is not
due to go live until early 2016).
Financial literacy?
I need hardly remark that this is not to ignore the role of the borrower! Over-indebtedness is
usually attributed to either bad decisions or to bad luck. As far as decisions are concerned, it is
clear that most people do not behave as rationally and logically in relation to financial decisions
as the elementary textbooks of finance say they should. Surveys across the world confirm that
financial literacy is low - too low to ensure safe financial decisions in an increasingly complex
environment.3 And even financially knowledgeable people are prone to making serious errors of
judgement in regard to financial decisions (that includes providers of funds as well as users). It
seems that consistently good financial decision-making is not something our brains are wired to
do.4 (By consistently good, I mean avoiding decisions whose predictable consequences include
regret that we made them.)
Some of the writing on financial literacy smacks of blaming of the victim. Many of the most
acute household financial problems come from misfortune and lapses of judgement. Probably
some of this could have been avoided if individuals (lenders as well as borrowers) had been
better informed to make good financial decisions under conditions of uncertainty. This is
something that continues to deserve attention in school curricula and in public information
campaigns.
Disappointingly, though, from the international experience it does not seem to be easy to
improve financial decision-making through programmes of financial literacy education. It is one
thing to communicate facts about finance, quite another to overcome the mental hardwiring -
observed at all levels of education - that gives the potential for disastrous outcomes.
Nudge and more
Several authors have suggested that, while leaving the final decision on financial matters up to
the individual, public policy should nudge people in the direction of better decisions. This idea
has been applied, for example, to making it easier to opt in to an optional occupational pension
scheme (e.g. box already checked) than to opt out. This idea is not necessarily unproblematic
for a variety of reasons. For instance, nudging practices may not always be devised in the
interest of the individual, as anyone navigating airline ticket booking sites will know. Indeed, at
its worst, manipulating known behavioural biases in order to increase profits can get to the point
where the Central Bank would seek to outlaw it as an unfair practice.5
Many of Ireland's over-indebted individuals and families are in this position because they were
caught up in a systemic event. It includes people who borrowed too much because they feared
getting left behind, people who borrowed too much because they saw a profitable (buy-to-let)
opportunity and underestimated the risk, people who borrowed an affordable sum but their
income circumstances deteriorated unexpectedly because of unemployment, business
contraction, health problems or other misadventures.
One way of limiting the likelihood or extent of a recurrence is to reduce the exposure of new
borrowers to the threat of over-indebtedness. Many scholars have discussed how this could be
done through contracts that share risk more effectively between the provider and user of
funds.6 Even in the United States, home of financial innovation, though, the kinds of
macromarkets that would allow home-owners to hedge the risk of a downturn in the economy, or in
their sector, or in house prices, have not really emerged. There also, borrowers are stuck with
conventional mortgage debt contracts, albeit often with no recourse to the borrower for a
shortfall in the case of repossession of properties after default.
Mortgage insurance?
Though not having recourse to the borrower, the main mortgage lenders in the US have
generally sought a second signature - mortgage insurance provided to the lender by an
insurance company - in the case where the initial loan-to-value ratio exceeds 80 per cent.
Specialised mortgage insurers providers in the US did rather badly in the crisis of 2008-10 and
there were failures. But mortgage insurance is a method that has been used in that country
(and others) for almost a century to enable borrowers to obtain finance for housing without
actually having to save the 20 per cent that would otherwise have been insisted upon by the
lenders and their regulators.
The Central Bank's recent consultation paper pointedly raises the question of whether
adequately insured mortgages should be allowed to exceed the general 80 per cent rule which
has been proposed - this might cover up to 90 per cent, for example. While we point out that
too liberal a use of such insurance can have the effect of neutralising the effectiveness of a
ceiling on loan-to-value ratios as a mechanism for preventing house price bubbles (and while it
typically provides no protection to the borrower), this would be less a concern if limited, for
example, to relatively small loans and/or first time buyers. Of course, mortgage insurance would
achieve relatively little if it merely shuffled systemic risk around within the domestic economy:
external insurance from solid insurers would be needed. I look forward to the responses on this
matter, including on the practical issues of implementation that might be entailed.
Meanwhile, by limiting the quantum of mortgages that can be made at high loan-to-income
multiples, it could be argued that we at the Central Bank are moving into the nudge territory at
the macro level. It doesn't mean that no borrower will become over-indebted. For one thing we
do envisage continuing to allow high LTIs - just not too many of them. For another, current
income is not a perfect predictor of future income. So our proposed macro-prudential measures
will not substitute for good loan appraisal decisions by banks (who are not, according to our
code of conduct, supposed to make loans except they be affordable and suitable for the
borrower), and good financial decisions by the borrower. But limiting the volume of high LTV
and LTI loans for macroeconomic and financial stability reasons should have a beneficial
consumer protection side-effect in reducing the re-emergence of over-indebtedness.
Meanwhile we at the Central Bank will not shirk our responsibility to do what is in our power to
deliver on our mandate to protect the new generation establishing households - and the nation
at large - from the risk of a repetition of what happened before. We seek to do so with the
minimum of adverse side-effects.
Dealing with over-indebtedness
Let me turn now, though, to the ex post problem; dealing with over-indebtedness.
While mortgage indebtedness accounts for by far the biggest volume of debt, in terms of the
numbers of people affected, debt problems are not actually as concentrated in the mortgage
sector as is often thought. The 2012 Survey on Income and Living Conditions (SILC) showed
that about 22% of local authority renters cited debt repayments as a "heavy burden" - the same
percentage as for mortgage debtors. (In both cases the percentages are of course much larger
than before the crisis). Likewise for the percentages of households reporting payments arrears
- though in this respect the experience of local authority renters was almost as bad in 2006.
I am not going to wring my hands yet again in acknowledgement of the long-drawn out nature
of the resolution of this problem. You know all too well at first hand the debilitating effect on
families who have been trying to cope with over-indebtedness - something which has affected
a much wider and more diverse segment of society than at any time in our history.
Unresolved over-indebtedness also has a first-order effect on the performance of the economy.
I am not only referring here to the constraints which high household indebtedness place on
aggregate consumer spending. This is a point which has been emphasised in an influential
recent book by Mian and Sufi7 who, despite their concentration on the United States (which has
also been slow to find the right solution for their - proportionally less acute - mortgage
overindebtedness problem), point out the cross-country evidence of contraction in aggregate
consumer spending in the downturn being related to the level of household indebtedness, with
Ireland being one of the top two exemplar countries.
In addition, though, an overhang of debt in a household can have the effect of chilling all
initiative and discouraging enterprise, and in other ways impeding the economic recovery.
Finding - or better implementing - workable ways of addressing this unprecedented problem
will continue to challenge the institutions of state in all sorts of ways.
Guiding principles
The reformed legislation on personal insolvency has brought a degree of clarity and, I believe,
convergence of the law with Irish society's expectations regarding over-indebtedness. While
offering significant new channels of relief to the over-indebted, the legislation also reflects a
general societal adherence to what has long been generally regarded as "a cornerstone of the
European approach to over-indebtedness relief ... [namely] ... that debtors should fulfil their
obligations if at all possible, and freedom from legitimately incurred obligations is a privilege,
potentially subject to abuse, that should therefore be a carefully guarded last resort"8.
The insolvency legislation includes innovations with respect to the treatment of secured debt
which - even though they retain considerable voting power in respect of personal insolvency
arrangements - lenders have found controversial.
Despite some teething problems in its implementation (which I trust will continue to be ironed
out), I believe that the main features of the new personal insolvency framework do provide a
broadly accepted formal legal framework consistent with this cornerstone for cases where
borrowers are unable to pay. It goes some way to addressing the imbalance of power that is
often inherent in the creditor-debtor relationship.
It should also provide a reference point for borrower-lender negotiations outside of the
framework itself, though as mentioned I know that many of you remain sceptical about its
effectiveness in this regard.
Finding acceptable solutions
Hampering these borrower-lender negotiations are suspicion and fear of making concessions
that are more costly than they seem.
For the lender, the fear is that concessions to one under-water borrower may trigger strategic
behaviour on the part of others who might masquerade as less solvent than they really are.
This has certainly deterred banks from offering more definitive debt relief in many cases. It is a
pity that the banks still do not have more confidence in their ability to distinguish and triage their
delinquent borrowers, an ability which has undoubtedly improved.
Cases of multiple lenders have also presented similar difficulties. At the Central Bank we tried
to broker an agreement on principles for a shared approach between secured and unsecured
lenders. Ultimately it seems that a fear of conceding more than they realised caused some of
the participating unsecured lenders in this pilot to retreat from an agreement. The result of this
failure is that more cases will have to be dealt with through the formality of the PIA or through
bankruptcy.
Lenders have had to adapt their way of thinking. Dealing with a defaulted loan is, for the lender,
not the same as underwriting a new loan. The borrower proves not to have been as
creditworthy as the lender thought. To be sure, the lender has property rights, but the borrower
also has rights, including those codified in the Code of Conduct on Mortgage Arrears. The
lender might not wish to continue a tracker arrangement, but the CCMA insists that this change
can only be made if no option that would allow the borrower to retain the tracker interest rate is
appropriate and sustainable for the borrower's individual circumstances. Likewise, although
many subscribe to the maxim that "interest-only is the bank's route to perdition", we have
clarified that where the borrower wishes to remain in his/ her home, long-term interest only
payment arrangements with lifetime tenure may be sustainable where the sale of the property
provides sufficient surplus funds on death to redeem the outstanding mortgage balance.
How it's working
Despite the comprehensive nature of the CCMA, and our ongoing monitoring of bank systems
and practices to ensure compliance, I am sure that each of you at MABS has observed
experiences of unsatisfactory performance of lenders in dealing with these cases. We at the
Central Bank cannot attempt to oversee each case - though we are shortly embarking on a
further probe to detect any systematic deviations from this code and we will continue to hold
regulated lenders to account for any deficiencies in their policies and practices in this regard.
But I think it is fair to say that the main lenders have now put in place policies and procedures,
supported by increased staff resourcing, that are at least approaching what could be
considered an adequate level to process the accumulated arrears.
While a large block of cases remains unresolved and moving through a legal process rather
than being restored to on-track payment performance (principally involving borrowers classified
by lenders as non-cooperating), over half of the 100,000 cases that have now been processed
involve sustainable payment restructures.
When I refer to a sustainable restructure, this means sustainable for the borrower, which must
mean, for example, that it offers an outcome that is at least as good as could be obtained by
the borrower going into a PIA (or indeed bankruptcy).
Besides, in order to induce participation, the lender will have to consider all resolution options
for the over-indebted borrower under the shadow of PIA as an alternative which is likely only to
increase losses. Likewise, lenders rationally know that the worst outcome in dealing with a
nonperforming loan is bankruptcy; so it is in their interest to look for better outcomes for
themselves, and their borrowers, sooner.
I know that there has been impatience about the small number of PIA cases to date, and
concerns that too many sensible PIA proposals could be blocked by lenders aggressively using
their voting power. I would be critical of some of the statements made by lenders in this regard.
Progressively, though, mortgage lenders understand that society will insist that lenders do not
abuse the voting rights that they have been granted in the legislation on personal insolvency
arrangements.
That the sustainability of restructures is improving is evidenced by the sharp drop in re-entry
into arrears following restructures that have been negotiated in the past couple of years. The
latest available data indicates that terms are being met for 88% of this more recent wave of
restructures - much higher than what was being experienced with earlier restructures, most of
them offering only very temporary relief. The Central Bank's audits do suggest that the
restructures are now being designed in a more credible way, though of course it's early days
yet and not all of them will work in the long run.
Personally I would prefer the lenders to err on the side of liberality, in order to help speed an
assured resolution of the problem of arrears. Furthermore, as a group, the lenders will benefit in
their business from the improved national economic environment that will result.
Cases going the legal route
An inevitable consequence of speeding-up and making concrete the process of tackling the
unresolved arrears cases has been that lenders have not been allowed to neglect or long-finger
the numerous cases of non-cooperating borrowers. This has had the undesirable side-effect of
crystallising into legal proceedings cases of non-cooperation for which a negotiated cure could
have been arrived at (and may still be achieved).
Now that this process has begun it is vital that the lenders redouble their efforts to re-engage
with non-cooperating borrowers to try to ensure that unnecessary and unwarranted losses of
ownership do not occur.
It is in this area where the existence of trusted advisors, such as you at MABS represent, can
perform a vital function in helping the borrower formulate their stance and build the knowledge
and confidence to engage with the lender. This need for trusted third-party advice and support
for borrowers who are struggling is evident. Recall that, as a "nudge", we have embedded in
our Codes the requirement for lenders to provide information on MABS and the ISI at key points
in the mortgage arrears resolution process.
In most of these cases, arrears amount to two years or more. Even so, sustainable restructures
may still be possible for many, fully employing the tools of split mortgages and other innovative
solutions. Even where loss of ownership appears unavoidable, the potential for mortgage-to-
rent conversions whether with the involvement of local authorities or housing associations
seems underexploited.
Conclusion
Slogans and emotive language around debt are uniformly unhelpful in addressing what is a
very serious and divisive problem, not only at the national level in respect of households at the
national level, but for small and large businesses and internationally for governments. The
recession has had a bad effect on many who had no involvement in borrowing, lending or
trading in property. But the degree to which the events of the boom and bust have resulted in
what must often appear to be arbitrary redistributional effects resulting in over-indebtedness of
a significant section of society, has raised operational and policy challenges for many actors in
society which are likely to be only imperfectly met.
At MABS, you are in the frontline of these challenges, and I know that you are far from shirking
them. I salute your work. Meanwhile at the Central Bank, we will continue to explore what more
we can do at the outer limit of our mandate to speed an improved overall outcome.