Mortgage Arrears: Can the banks cope?

By Eoin Fahy, Wednesday, 22nd February 2012 | 0 comments

Last week the Central Bank published statistics that showed that about 12% of mortgages are  in arrears, which is obviously a very high proportion and a source of great concern.  But even that very high level of arrears is still well below the "stress test" assumptions used last March to determine how much capital the 'covered' banks need.  The hard-pressed Irish taxpayer still seems unlikely to need to plough even more money into the banks.

Mortgage arrears are a source of great concern to any society.  They show the extent to which families face, in a worst case scenario, having to give up their homes. But even beyond that social issue, they also indicate the extent to which banks may face such large losses that they will need capital injections, which in current circumstances are highly likely to have to come from the taxpayer.  So the Central Bank's quarterly arrears statistics are hugely important and merit close attention.

Last week's publication of Q4 arrears statistics showed, yet again, a rising trend.  More than 12% of banks' mortgages, by value, for owner occupiers, were 90 days or more in arrears.

However, we should also remember that the bank stress tests, last March, resulted in the banks being given very large amounts of capital from the taxpayer, precisely so that they could cope with losses on mortgages.  So from a purely financial point of view (leaving aside for now the social impact), the really crucial issue is not what the level of arrears is, but how the level of arrears compares with what was assumed in the stress tests.

Here, the news is not as bad.  The stress test assumed that the covered banks (Bank of Ireland, AIB, EBS, Irish Nationwide and Irish Life and Permanent) would between them make losses of €10.1bn over the lifetime of those mortgages (or €5.7bn in the three year period being considered in the stress tests).   And the banks got a further €5.3bn as a "conservatism buffer", just in case losses turned out to be higher than expected.

So how does that compare with the arrears numbers to date?  Well, the total banking system has arrears of €13.9bn, but it's estimated that only about half of those arrears 'belong' to the covered banks, so the arrears of the covered banks currently amount to about €7bn.

What does that mean in practice?  Well firstly we have to note that the €7bn of arrears is higher than the €5.7bn of assumed losses [over three years], which is a concern.  But arrears don't convert to losses on a 1:1 basis.  Some people that are now in arrears will eventually get back on track, perhaps as a result of regaining a job, or with the help of family etc. In such cases the lender may lose nothing.  In other cases the bank may agree to write off part of the loan, or make the loan interest-only, or extend the duration of the loan.  In all of those circumstances, the bank may lose money of course, but will not lose the entire value of the loan. 

And even in the worst case scenario for both the lender and the borrower, where the house is reposessed, the bank will get at least some value for the property when it sells it, even if that value will be less than the value of the mortgage.  As an approximation, house prices are down  50% from the peak, so even in the case of a borrower who had a 100% mortgage, bought right at the peak of the market, theoretically the bank should recover 50% of the value of loan in a repossession situation, less an amount to cover legal, sales and other costs, but plus whatever capital had been repaid on the loan before it got into arrears.

To put it another way, the capital injection by the taxpayers into the banks as a result of the stress tests is enough for the banks to lose 81% of the value of all mortgages that are currently in arrears.  If we add in the "conservatism buffer" available to the banks, they have enough capital to deal with losses amounting to 157% of the current level of arrears. That looks fairly comfortable.

All that said, arrears do continue to rise, quite quickly, so we cannot rule out the possibility that arrears will rise so much over the next couple of years that the stress test assumptions appear too optimistic.  But for now, at least, the Irish taxpayer can take some comfort that the banks are sufficiently strong to be able to deal with the current level of arrears.

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