Patrick Honohan: Sustainable mortgage modification
Remarks by Mr Patrick Honohan, Governor of the Central Bank of Ireland, for the FMC2
Conference (The Financial Mathematics and Computation Cluster), Dublin, 23 May 2013.
* * *
Introduction
Though the vast majority of mortgages are still being fully serviced, the persistent rise in
cases of prolonged arrears over the five years of the crisis undoubtedly presents one of the
biggest economic policy challenges of our day.
Wait-and-see may have been an appropriate or sufficient initial position to take as the great
crisis unfolded, but the time for passivity is long past. The longer term welfare of borrowers is
at stake here, but so is the welfare of taxpayers and users of public services, given that bank
losses affect the Government because of its ownership of banks.
As they now recognise, mortgage lenders need to address the problem of non-performing
mortgage debt more energetically than has been the case in the past. They need (i) to stem
the inflow and get those that can be fully serviced back on schedule, and they also need
(ii) to find ways of modifying mortgages that involve unsustainable levels of
overindebtedness. Identifying those that "can't pay" from those that are merely "reluctant to pay"
is a key operational task for the banks.
No discussion of the problem of mortgage arrears should neglect this dual character: some
need to brought back on track, others need alternative sustainable solutions.
Responding to escalating regulatory pressure (including the new Targets regime), banks are
now working hard to meet specific targets that should bring the payment performance of their
mortgage books back under control in a sustainable manner. The Central Bank will shortly
publish a revised Code of Conduct on Mortgage Arrears (CCMA) to help ensure effective and
appropriate resolution of each arrears case.
In a parallel response to the crisis of debt distress, and to the ineffectiveness of the existing
outdated law, new personal insolvency legislation has been enacted which inter alia
streamlines the existing personal bankruptcy regime and introduces a non-judicial procedure
for resolving insolvency involving mortgage debt, the Personal Insolvency Arrangement
(PIA). The PIA can restructure unsecured and secured debt, including mortgage debt,
provided there is agreement by a majority of relevant creditor classes. This new legislative
framework has shifted the balance in favour of borrowers, which is welcome and needed;
and this needs to be factored-in to bank decision-making. There will be an interplay with what
can worked out bilaterally, and the alternatives that might arise in a PIA or in bankruptcy.
We now enter a phase in which much of the uncertainty should begin to be resolved, with the
insolvency legislation coming into force, and the shortened timeline for banks restoring the
arrears situation to sustainability.
How can the public good be best advanced in this process? What could now be considered
both attainable and socially ideal in terms of the pattern of resolution of the arrears problem?
It will help if policy discussion recognises the two sides to the mortgage arrears problem. The
Central Bank's policy has sought, and will continue, to navigate a balanced course,
recognising both the need to husband the capital that has been provided to the banks at
such crippling cost to the State, and the need for households who are truly unable to support
the level of debt that they have accumulated to be dealt with in a fair and realistic manner.
Today I would like to speak about four aspects of this complex issue. First, the economic
context in which arrears have mounted; second, the steps that are needed to restore
sustainability to arrears cases; third, features of the different types of measure that are
employed; and finally, some design aspects of debt modifications, where these are needed.
Among many important details, three over-arching themes emerge in the discussion.
 Despite the anger and disappointment felt by so many who have suffered a financial
loss from housing investments, permanent debt relief is not something that can be
offered to all, but has to be limited to those who are truly over-indebted to the point
of insolvency. In particular, despite the fact that households in negative equity do
seem to be over-represented among the arrears cases, negative equity is not in
itself a viable rationale for providing debt relief. The new legislation reflects this: it
restricts access to insolvent debtors, namely those who are unable to pay their
debts in full as they fall due. Indeed, it would be unwise for anyone to think that not
paying one's debts is a matter of choice; non-cooperative mortgage borrowers really
are at risk of losing their homes. (Non-cooperative borrowers also lose some of the
protection of the Code of Conduct on Mortgage Arrears (CCMA), and their eligibility
for a PIA may be restricted).
 On the other hand, repossession is less likely to be a good solution where the
overindebtedness is coming from the owner-occupied home than for cases where
overindebtedness comes from an investment property or "buy-to-let" (BTL). In current
Irish conditions, especially given how far property prices have fallen, a well-designed
debt modification that enables the distressed over-indebted borrower - for example,
those whose ability to pay has been eroded by unemployment - to keep their home
if they want will often be the best attainable solution for borrower, lender and
society.
 Balancing the need to remove unserviceable debt overhangs with the need for
banks to husband capital in such circumstances calls for contract innovation.
Several features of the Irish situation suggest that a split mortgage concept could
provide a sustainable solution for a significant number of stressed borrowing
relationships, by both (a) removing the threat of imminent bankruptcy, and
(b) retaining the potential for economic recovery to reduce prospective loan losses
of the banks (and their impact on the taxpayer). I'll take a bit of time to explain why
this is so.
A cornerstone
Let me begin with a proposition which I take to be true and relevant for Ireland. Indeed, few
in Ireland will dispute the proposition, put well recently by a widely acknowledged expert, that
"a cornerstone of the European approach to over-indebtedness relief has been and always
will remain 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".1 Indeed, it bears repeating that the vast majority
of Irish borrowers do continue to service their loans. Long-term debt modification involving
permanent debt relief is only relevant for cases of over-indebtedness involving or bordering
on insolvency.
Economic drivers of arrears
Distinctive features of the economic environment surrounding the personal insolvency
situation in Ireland include, on the downside, declines in:
1. employment rates to levels not seen for many years;
2. real after tax income even for those who have retained salaried jobs, as tax rates
increased 2008-12, and many suffered pay cuts (with the pension levy also eating
into the pay of public servants);
3. residential property prices - now over 50 per cent off their peak levels of about six
years ago, with the result that a very high percentage both of performing and
nonperforming mortgage loans - whether owner-occupier or buy-to-let - are in negative
equity;
On the positive side, at present ECB policy interest rates are low, which has helped keep the
servicing costs of mortgages low, especially tracker mortgages of course, but also standard
variable rate (SVR) mortgages, even though these have become relatively insensitive to the
policy rate2 and now embody higher spreads over the banks' marginal cost of funds than
used to be the case.
Each of the three negative features is associated with distinct consequences for both
borrowers and lenders leading to stress in many cases. Of the three, on the face of it, loss of
employment could be expected to have the most acute impact on a household's ability to
pay. Interestingly, though, the preliminary findings of a Central Bank survey of household
income and indebtedness (details forthcoming)3 suggests that income declines unassociated
with unemployment, and negative equity, are also strongly associated with arrears in Ireland
today.
 The decline in employment rates means that many households have a reduced
number of income earners at present. While this will be a temporary situation for
some households, for many recovery will not come soon enough. This will result in
mortgages being unaffordable. If the household has a good chance of getting back
into full employment, the relief can be temporary, but if the prospects are not good,
then a more lasting loan modification will be needed, and this should be faced up to
sooner rather than later.4 Indeed, the survey suggests that having some
unemployment in the household is econometrically linked with arrears, but
interestingly it is far from being the only factor or a decisive one. Indeed, the survey
data suggest that, while unemployment is much more prevalent among those in
arrears, almost two thirds of those in arrears are employed.
 The decline in after tax incomes for most employees has been significant, but
aggregate data suggest that in the bulk of cases this decline is not so large as to
make the continued servicing of debts impossible. Unless the household was
already over-borrowed, a relatively moderate adjustment of spending patterns in
response to lower income would allow the average household to remain on track.
Nevertheless, the new survey finds that a somewhat higher proportion of
households in arrears reported a recent decline in income (79% compared with 70%
for those not in arrears); furthermore, although median household income is about
€10,000 less for those in arrears than those who are not, it is still around €45,000.
Preliminary econometric analysis of the survey data suggests that income declines
unassociated with unemployment have contributed significantly to the incidence of
mortgage arrears.
Households in deep negative equity are somewhat more prone to be found in

arrears in the survey data, all other things being equal. It's not as obvious as you
might (at first sight) think why this should be. After all, negative equity is not in itself
a proof of inability to service a debt. True, negative equity may be associated with
high levels of indebtedness and hence with affordability issues if income and other
assets are not correspondingly high. Furthermore, negative equity can limit access
to further credit, and adversely affect geographic mobility, potentially creating a
demand for a high LTV loan to allow the households to "take some of the negative
equity with them" when they move. Negative equity in a BTL indicates a leveraged
investment decision that has worked-out badly, but again is not per se a measure of
affordability.
These survey findings highlight that the position of households in arrears varies widely. It is
unwise to generalise from isolated cases. The solutions need to reflect this on a
case-bycase basis.
Steps to restoring sustainability
Don't wait for arrears
A long understood maxim in retail banking is that early engagement with distressed
borrowers is a valuable tool for improving ultimate recoverability. In particular, emerging
inability to pay instalments in full can induce a borrower to pay nothing at all, thereby risking
a spiral into an unsustainable level of indebtedness. Identifying pre-arrears situations and
engaging with them and with early arrears cases can be very cost effective in arresting this
spiral in the level of indebtedness arising from arrears. Therefore, although what follows is
about dealing with 90-day plus arrears cases, efforts to address and stem the early cases
should not be neglected.
New legislation
The new Personal Insolvency Act offers new avenues of recourse for insolvent persons,
including importantly the PIA which could allow insolvent debtors to earn a "fresh start"
through a period of being subject to what will likely be a relatively onerous payment plan, but
without necessarily having to surrender an owner-occupied home. Importantly, this avenue
by construction is available only to insolvent borrowers, and therefore not to those who "can
pay". The terms of the legislation should help anchor some of the expectations of distressed
borrowers and their lenders in arriving at bilateral solutions. Given what international
experience shows of how little is often recovered in net terms by creditors from payment
plans, a well-designed loan modification bilaterally arranged between borrower and insolvent
debtor can be better for both than the net outcome of a PIA or bankruptcy.
The different elements of the cure process
There are several successive tasks for the lender in the typical mortgage arrears cure. It
begins with the lender engaging with the borrower. The lender needs to assemble updated
information in order to discover the customer's current circumstances and how it has differed
from the position at the original underwriting. Then, taking account of current and prospective
circumstances, if the contract is, or can be put on a sustainable basis, the lender needs to
decide what revised schedule of payments (if any) should be offered. (The attempt to cure a
distressed mortgage may not always avoid repossession or voluntary surrender.) And then
the lender needs to ensure that the customer complies with the revised schedule.
In the CCMA, designed to provide appropriate and effective consumer protection measures
and to ensure that borrowers are treated in a fair and transparent manner, the Central Bank
has created and supervised a process, the five-step Mortgage Arrears Resolution Process
(MARP)5 especially focusing on engagement and information assembly. The CCMA has the
goal of protecting vulnerable borrowers against aggressive, unfair or opaque collection
practices. It has not been intended to hamper the process of getting the borrower back on
track. Refinements to the Code are now being finalised which are equally designed to
maintain the intended level of protection for the consumer, while ensuring that that the
framework is facilitating and promoting the effective and timely resolution, by lenders, of each
borrower's arrears situation.
The final element mentioned above, ensuring continued compliance with the revised
schedule, is conventionally assumed to be governed by repossession and insolvency
procedures. Although the situation here has been rather opaque, while the Dunne judgement
issue was pending, and with uncertainty about the impact of the insolvency legislation, clarity
should improve dramatically in these two respects in the coming months.
Designing the modification
Here I want to focus on one element of this multi-step activity, namely the design (where
necessary) of a revised schedule of payments. Though widely discussed, this element still
remains unsettled and largely unsatisfactory. Each distressed mortgage case must be
triaged and mapped into a proposed long-term sustainable solution which is (i) matched to
the circumstances of the borrower, (ii) offers a better overall prospect of recovery for the
bank, taking a realistic view of the probabilities involved, in particular (iii) taking account of
the need for the modified payment schedule to be incentive compatible for the borrower
given the availability of the PIA and revised bankruptcy rules and other options; and (iv) it
should minimise moral hazard.
To be sure, the triage process needs to start with the question: is this a distressed case, or
one in which the borrower does have the capacity to come back on track? It is evident that a
significant proportion of current arrears cases fall into the latter category, as seems to be
confirmed by the measured characteristics of households in arrears, as well as the practical
experience of lenders in engaging with borrowers. Getting these cases back on track is a
crucial part of what is now needed. However, for the rest of what I have to say today, I will
deal with the unsustainable cases.
Measures for dealing with unsustainable mortgage debt
Temporary measures are not enough
The banks have dealt with the emerging situation largely by means of two devices:
capitalisation of arrears, and a temporary move to an interest-only type payment schedule,
sometimes accompanied by an explicit extension of the term to maturity. Such temporary
forbearance measures do provide cash-flow relief to the borrower and have the merit of
bringing their payments back onto a schedule and avoiding the arrears spiral.6 But they do
not deal with situations where the actual and prospective circumstances of the borrower
mean that full recovery of the loan cannot realistically be assumed.
Leaving the borrower in an unsustainable situation, where fully servicing the loan would
leave them unable to maintain a reasonable living standard, or where there is debt overhang,
i.e. where any improvement in the borrower's circumstances would go solely to the lender, is
good neither for the borrower nor the lender. Unresolved debt overhang clearly chills the
borrower's incentive to improve their situation and can have devastating effects on borrower
wellbeing. If a lender does not deal with such situations, their loan-loss experience is likely to
be worsened.
Many Keane options not available at scale
The Government's Keane report (2011) set out a number of options for long-term
restructuring which could be employed by banks. Several of these involved
Governmentfinanced subsidies to the banks. In view of the constrained condition of the public finances,
the availability of these subsidies will be quantitatively small, and they are likely to be
focused (as they should be) on households in low income circumstances. Therefore most of
the mortgage restructuring (in terms of total value) will have to be done without subsidy.
Taking account of the unsecured creditors
Complications arise where there is multiple indebtedness. Credit unions are unsecured
creditors of many distressed borrowers; unsecured debt on credit cards is also found to be
high for many borrowers; utility arrears are also commonly observed. A mortgage loan
modification which leaves borrowers with insufficient resources to deal with their arrears with
credit unions, credit cards and on utilities is unlikely to remain fully serviced. This inhibits the
mortgage lender from making an effective modification proposal. Therefore agreements with
other creditors are likely to be an essential part of any effective and sustainable mortgage
modification.
It is for this reason that the Central Bank has been facilitating dialogue between the main
creditors with a view to enabling them to arrive at an operational framework for dealing in a
manner that is satisfactory to all with multiple indebtedness situations.
In essence, the main creditor needs to take a holistic view of the borrower's position
including other indebtedness and ensure that the entire debt is sufficiently restructured (a
point explicitly made in the CCMA). To be sure, the main secured mortgage creditor can
enforce their security, but as this is certain to leave a large unsecured amount owing to the
main creditor, the main creditor still needs to have regard to the position with regard to
unsecured debts of the borrower.
One way of seeing the potential here is to recognise that the ultimate alternative that faces all
parties, in the event that no agreement (even PIA) can be reached, is the debtor's
bankruptcy. Bankruptcy will inevitably involve deadweight losses - procedural expenses,
losses through foreclosure sales, etc. The different creditors should therefore assess the
possibilities of any deal relative to the position they would experience in a bankruptcy. Many
classic analyses of bargaining suggest that participants should generally expect to share the
gains of any deal broadly proportionately relative to what each creditor would get from the
bankruptcy. Although this is not exactly the way in which bankers and credit unions frame
arrangements that they can envisage employing for such circumstances, I expect that the
restructuring "waterfalls" (or decision trees) that they have been discussing will in the end
amount to much the same thing.
Furthermore, this approach can be extended to the PIA. After all, a Personal Insolvency
Practitioner proposing a division of the recoverable amounts that is consistent with this
framework can expect that the creditors will accept it. Indeed, in cases where the unsecured
creditors have not signed-up to a cooperative framework agreement, a pre-packaged PIA
consistent with this approach could be given effect through the PIA legislation.
Repossession and voluntary surrender - owner occupier
What role can repossession and voluntary surrender be expected to play in the overall
solution? While most borrowers wish to repay their debts if they can, the ultimate sanction for
lenders is repossession of the security and obtaining judgement mortgages on other property
of the borrower. Such actions are considered quite aggressive in Ireland, and the courts have
tended to be sympathetic to debtors, especially if they seem to be in straitened
circumstances. The Dunne Judgement situation, shortly to be resolved through legislation
being enacted, has also been an obstacle for lenders seeking to repossess.
Ultimately, though, repossession is an available option for the lender. It would be unwise to
imagine it otherwise. If the banks were unable to make repossessions then the incentive for
the borrower to cooperate would be greatly weakened.
Some borrowers who are residing in a house whose current market value is very high will
actually prefer to surrender the property and trade down, if this allows them to make a deal
that reduces the shortfall, i.e. the unsecured part of the loan. This will be the case if they owe
far more than they could fully service.
Nevertheless, the heavy fall that has occurred in Irish house prices increases the number of
cases in which banks can do better by making deals that leave a cooperating owner-occupier
in their home.
Ideally, in dealing with a cooperative borrower who wishes to continue to live in the
mortgaged property but cannot fully service the debt, both parties may find it advantageous
to make a deal that does not require the property to be surrendered or repossessed. Even if
the borrower's long term ability is sufficient only to service a debt equivalent to 75 per cent of
the property's estimated current market value, the lender should be able to make a proposal
that both protects the lender's capital and leaves the borrower in the home.
Repossession and voluntary surrender - BTL
As far as buy-to-let (investment) properties are concerned, voluntary surrender at a current
valuation can make sense for a stressed borrower having difficulty in servicing the loan - for
example if the rental income is nil or smaller than the interest outlay on that part of the loan
corresponding to the current market value of the property. By surrendering, the borrower's
monthly outlays will be reduced, though not necessarily eliminated, to the extent that the
borrower remains liable for the remaining (negative equity) part of the loan. Of course, the
borrower will also lose the possibility of benefiting from any future upside to the value of the
property. In considering whether to make an offer involving voluntary surrender, the bank will
want to decide if the BTL borrower might be more likely to continue to service the de facto
unsecured part of the loan if he were left with all or part of the ownership.7
Where BTLs are actually being let, this whole process can introduce uncertainty for the
tenant also - as indeed does the appointment of rent receivers by mortgage creditors of
delinquent loans where even the rental income has not been passed on in debt servicing.
Different types of long-term loan modification
The three ways of doing loan modification
Any long-term modifications of unsustainable mortgages can be thought of as a combination
of three transformations of the time-structure stream of promised payments. Thus, the overall
duration of the stream can be lengthened; the payments can be back-loaded; the overall
level of payments, measured for example by net present value (NPV), can be lowered.
Duration and back-loading help with distress that is perceived as temporary. An increased
duration is used in combination with a lower annual payment: this can suit a borrower whose
income-expenditure situation has deteriorated but has enough working lifetime left to pay off
the full outstanding debt with interest over a longer period. Back-loading is suitable where the
income position of the borrower has deteriorated but there is a reasonable chance of future
recovery.
Most loan modifications in Ireland, such as temporary moves to interest only, term
extensions, or arrears capitalisation can be assessed as combinations of these two.
A lot of discussion of the options for modifying mortgages can be couched in terms of one or
other of these three changes in the time-path of contractual payments.8 But limiting the
options to these is missing some important opportunities for borrower and lender. That's why
conditional payment schedules need to be kept in mind. These envisage a different sharing
of risk between borrower and lender, and as such can improve prospects for both, albeit at
the cost of greater complexity and management requirements.
Conditional easing (e.g. in a split mortgage)
Conditional easing of the repayment schedule of an otherwise unsustainable mortgage can
be explicitly built in, whereby an easing lasts as long - but only as long - as some objective
condition such as low income or unemployment prevails.
Conditionality can help where the distress could be righted if objective circumstances
improve.
An example of conditionality is in the split mortgage concept mentioned in the Keane Report.
A split mortgage with the level of servicing payments conditional on borrower circumstances
is intended to provide protection and certainty for a borrower, whose chances of fully
servicing the loan are in doubt, while enabling the lender to recover an additional portion of
the loan should the borrower's circumstances improve. In the classic split mortgage, a
modification to the regular payment is put in place by means of applying a standard
amortisation schedule to only a part of the principal. The remainder of the principal is
notionally warehoused and not treated as requiring servicing unless and until there is a
material and objective improvement in the borrower's situation. A split mortgage thus divides
the sum owed into a base loan (A) and a warehoused loan (B).
The advantage to the lender of the split mortgage, over a permanent and unconditional NPV
reduction sufficient to make the initial payment schedule clearly affordable for the borrower,
is that it gives the lender some chance to share in an improvement in the borrower's
circumstances. A major issue for lenders in assessing whether to offer a split mortgage is
their capacity to monitor improvements in the capacity of the borrower to make service
payments. Indeed, the difficulty in tracking those improvements is the main reason why
income sharing repayment schedules are rare enough in banking around the world.
The advantage to the borrower of a split mortgage is that it can (a) bring the borrower back
on track by setting the unconditional servicing payments at a level which allows reasonable
living standards to be protected and (b) remove debt overhang (as defined above).
Lenders have been experimenting with a variety of split mortgage type solutions for cases
which seem otherwise likely to be unsustainable. The differences in design are not
immaterial and can have an impact on whether or not the modification can really be
considered to have made the loan sustainable.
In considering whether a particular type of split mortgage could be considered as sustainable
one would have to look at both the affordability of the initial payment schedule and the
treatment of the warehoused loan at maturity. Sustainability must apply for the lifetime of the
arrangement and not just at the outset. Transparency to a borrower of the terms and
conditions of a split mortgage at the outset of such an arrangement is essential to
sustainability of this solution, in particular how the bank will treat future increases in income
and other economic circumstances, and the treatment of the warehoused loan (B) (including
interest charged, where applicable), and the security, at maturity.
Treatment of the base loan of a split mortgage: To be considered sustainable, the new term
and interest rate on the base loan (A) would have to result in a newly contracted payment
schedule which leaves the borrower with sufficient funds at least equal to the Insolvency
Service of Ireland (ISI) minimum Reasonable Living Expenses. In order to reduce the
incentive for a borrower to reject a particular offer in the hope of receiving something better
through the PIA process, lenders will want to consider how much more the schedule should
allow to the borrower.
More generally, for a split mortgage to be considered sustainable, the lender should be able
to demonstrate that, given their current and prospective economic circumstances, the
borrower will be able to service Part A fully throughout the term or, failing that, will be able to
cover any servicing shortfall of Part A from the borrower's other resources at the end of such
term.9
Treatment of future increase of income: A conditional payment schedule would link future
payments to a review or to some indicator of changing ability to pay. For this to be
considered sustainable, though, the claw-back mechanism should be sufficiently moderate
that the borrower is not too much disincentivised from improving their income. Put another
way, the claw-back mechanism should not entail too high a "tax rate" on additional income;
50% is often mentioned, including in the new Insolvency Act. Consistent with the need for a
sustainable solution to be affordable in the long run as well as in the short run, a claw back
arrangement should not put the long term financial sustainability and wider economic
prospects of the borrower at risk.
Treatment at term of warehoused part of split mortgage: I can't see how a modification could
be considered sustainable if, after paying all the newly contracted payments (including
conditional amounts), the borrower could end the term still in debt. Accordingly, at the very
least, recourse at term should be limited to the collateral value. In other words, the
modification agreement should specify that, at the end of the term, any shortfall in the
warehouse after sale of the property would no longer be owed.
But, consistent with the idea in the new insolvency legislation (Insolvency Act, S. 104(1)) that
a PIA should not require the debtor to cease to occupy their home, a sustainable
arrangement should typically provide for lifetime security of tenure, in other words that, at the
end of the term of the new arrangement, the borrower may remain in the property until death
in exchange for reasonable rent payments.
Lenders may do well to go further by providing that, where the modified payments are fully
paid, their recourse at term is limited to a fixed proportion of the property value. If this
proportion is, say 30-50 per cent, it could leave the borrower with enough equity to purchase
step-down accommodation. Such an arrangement serves to enhance the borrower's stake in
continuing to service the new contractual arrangement and could work out better in the
longrun for both borrower and lender.
A split mortgage that requires the borrower to stay at ISI minimum living expenses for
decades, or that fails to make clear in advance what will happen in respect of the unserviced
warehouse debt at maturity, can hardly be considered sustainable.
Concluding remarks
No discussion of the problem of mortgage arrears should neglect its dual character: some
cases need to be brought back on track, others need alternative sustainable solutions.
Furthermore, contrary to what is sometimes thought, the existence of negative equity is not in
itself a sufficient criterion to warrant a loan modification, unless associated with inability to
pay.
Over the coming months, as the systems the banks have been putting in