Ronan Lyons | Personal Website
Ronan Lyons | Personal Website

The Irish Bank Sandwich: Time for the EU to face up to reality

It is hugely ironic that President Sarkozy called last week for Ireland’s corporate tax rate to be increased, as some sort of quid pro quo of the EU-IMF loan to Ireland. It is ironic, because it completely misses the point of who’s doing who a favour. Let’s leave aside, for the moment, the fact that the rate is a huge revenue raiser, that such things are a sovereign right and that Ireland is not being picked on for its low rate but for the fact that its rate is clear. (Other countries in the EU have effective rates than go lower than Ireland’s, depending on the FDI deal being dangled.)

One could certainly understand Mr. Sarkozy’s pronouncements if France and the other EU member states were gifting Ireland a large amount of money – some give and take would be expected. But what has happened is something designed to be a win-win for France, Germany and other EU states. Not only do their banks – the bondholders of the Irish banks – get off scot-free, while Irish taxpayers foot the bill, they as European governments earn a tidy little profit from the interest rate differential, middlemen between the markets and Ireland. In that context, the irony is the general perception that European taxpayers are helping to bailout Irish banks, while it is in fact Irish taxpayers helping to bailout European banks.

The “I Didn’t Do It” School of Thought

The Great Financial Crisis has given birth to two excuses: “I didn’t know what I was borrowing” and “I didn’t know what I was lending”. Ultimately, both cannot be true: in an economy with the rule of law, if neither the borrower nor the lender is responsible for their actions, something has gone wrong. So we know that at least one and possibly both of those arguments has to fall.

As more and more homes go “under water” into negative equity, it is easy to feel sympathy for the argument “I didn’t know what I was borrowing”. Given that they are the professionals, banks have at least in some sense a duty of care entering into a transaction, in the same way a doctor or solicitor has. This is in fact the thinking behind, which has been founded to help people who were clearly failed in the duty of care they were owed.

However, it’s not as simple as that. There were certainly, for example, public servants who felt as though they were forced into buying a two-bedroom apartment 80 miles from Dublin because they thought they’d never own their own home. But there were others who, looking around and seeing construction workers take home €100,000 a year, thought the whole thing was madness and avoided buying till it all blew over. A bank’s duty of care can be a convenient cloak under which to hide an abdication of personal responsibility.

What about the lenders to the Irish banks, the bondholders? The first rule of lending is that there is some risk of not being paid back in full. Despite this, the bondholders’ argument, when it has surfaced, has been that money was lent in good faith and borrowers were trusted to only take as much as they could manage sustainably. This is the “I didn’t know what I was lending” argument: why should they – as lenders – have to take a hit due to someone else’s mistake?

This only makes sense if Irish borrowers were so irresponsible as to undermine any responsibility the lenders had. Indeed, given that wealth is often destroyed and lenders have to take a hit, they would have to be so wilfully irresponsible that the Irish taxpayer had to step in to plug the holes created.

The Folly of the Irish?

So perhaps Irish households were silly? Perhaps they were so silly that not only does the “I didn’t know what I was borrowing” argument not stack up, but we can actually give 100% credence to the “I didn’t know what I was lending” argument by bondholders to Irish banks – i.e. European and US banks – and let them off on their merry way unharmed.

It’s pretty clear from even a cursory glance at the statistics that while Irish households may have been silly, Irish households were no more in the thrall of credit than other “more qualified” sectors of Irish society. The business sector in Ireland – people with business plans, shareholders and financial advisors – borrowed almost penny for penny the same amount as households did: while outstanding debt for households in Ireland rose from €57bn in 2003 to €153bn in late 2007, business debt rose from €47bn to €157bn in the same period. So, it’s clear from the statistics that it was not just Irish households.

Not only that, Irish households were no more in the thrall of credit than households in other countries. For example, as the graph below shows, in 2007, residential mortgage debt in Ireland was 75% of GDP, compared to 85% or more in the UK, Denmark and the Netherlands. Instead, Ireland must be viewed as a microcosm – perhaps an extreme one, but one nonetheless – of the global financial environment over the last ten years. As all bubbles eventually do, the seemingly unending flow of money made it harder and harder to ignore the allure of cheap credit.

Mortgage debt, as percentage of GDP, selected countries (Source: Hypostat)
Mortgage debt, as percentage of GDP, selected countries (Source: Hypostat)

The Meat of the Sandwich

Irish banks – now owned by the Irish taxpayer – are in the middle of a sandwich. On the one hand, they have Irish households saying: “I didn’t know what I was borrowing.” On the other hand, they have international bondholders saying: “I didn’t know what I was lending.” Of course, Irish banks themselves could have tried to use either of those excuses up or down the line… but everyone knows that Irish banks have got to live with the consequences of their actions.

So will Irish households: the vast majority of Ireland’s mortgage debt will have to be – and will be – repaid. So this all comes down to whether anyone honestly believes 100% in the argument “I didn’t know what I was lending” on the part of bondholders – whether anyone honestly believes that while Irish banks and Irish households have to live with the consequences of their actions, international bondholders don’t.

This is not a call for default in knee-jerk reaction to austerity. Ireland needs austerity to bring its public finances back into line. The Irish Exchequer lived for many years precariously and in recent years well beyond its means and that is something all major political parties are committed to resolving in the coming years. The Irish taxpayer has to live with the consequences of its actions.

Similarly, bondholders must live with the consequences of their actions. That is the argument here. There are other arguments. Normally, I’m a number cruncher and there are plenty of analysts who think bank bondholders would be far better off taking an orderly restructuring of the debt than taking their chances down the line when Irish debt is 150% of GNP. But the argument here is a moral one.

I am just about old enough to remember ads in the Irish newspapers in the 1980s with 17% interest rates. With all that’s happened in the last generation, it can be easy to forget that Ireland is not a country used to low interest rates. When it got them, for better or for worse, it assumed that plain sailing and easy credit was what it was like to be in a low and stable interest rate environment. Ireland got it wrong and will have to its price. And so did – and should – the people who lent to Ireland.

  • david mc williams ,

    Great Article Ronan,

    Thanks. One small thing, I am not too sure that mortgages will be repaid or should be in total. For me, the combo of deleveraging and deflation/price stability plus slow growth means much of this stuff simply can’t be paid.

    Hard to see where the money will come from and whether its the best use of the scarce resource.

    Best D

    • Stephen Hamilton ,

      Another well thought out and common sense article. At some point bondholders will have to wake up and smell the cornflakes. I have to agree with D McW above though that I do think some mortgages will have to be written down at some point.

      If Wilbur Ross gets his hands on EBS he has already said he will look at writing down some unaffordable mortgages. Hopefully others will follow.

      • Jacco Thijssen ,

        Good article Ronan. As far as the banking issue is concerned I’d agree with what you say (appreciating David McW’s caveat). Understanding the fundamental difference between the cirses in banking and the public finances seems to me crucial to any solution for Ireland.

        • Arthur Doohan ,

          Great post Ronan.

          Can I just point out a typo in the second last line, a missing word, possibly ‘meet’…..sry for nit picking, trying to be helpful (no need to publish this comment)

          • Tyrone Slothrop ,

            Orange, brown and tan?

            That colour scheme smacks of Leaving Cert History and the Free State’s economic policies, both foreign and domestic.

            Oh, and good article.

            How do I go about getting my mortgage written-off while still keeping my house?

            • Johnny Waldron ,

              Great article. Your argument should be irresistibly persuasive to any rational consideration.

              I fear that those with the power to accept an orderly restructuring are not open to a rational consideration. They are playing to the gallery on the continent which applauds austerity and has little appetite for debt forgiveness. The irony is that it is the self same “austerity mania” that destabilised Germany and lead to the 2nd World War.

              A real test for Europe

              • Mary Davey ,

                Very witty!

                • John Mack ,

                  The EU let the bank bondholders off the hook at the expense of the Irish taxpayer because they could The EU could get away with it, given the buddy-buddy system that the Irish call politics and government, and the deal a few buddies worked out with the Irish rime Minister, who is still in office instead of thrown out.

                  • John Mack ,

                    The mortgage relief programs that have worked in the USA have involved reducing the principal owed and the interest rate. Some houses will still be loss due to non-payment but many others will stay in the hands of paying householders.

                    What would be the point of a bank’s taking possession of a house that could not be sold?

                    • Ronan Lyons ,

                      Hi all,
                      Thanks for the comments. I agree that there will have to be mortgage write-downs but the scale of mortgages write-down will be completely different to the write-downs on land loans.

                      The biggest write-downs would come if there were retrospective introduction of no-recourse mortgages (so people in negative equity could send their keys back and walk away), which would effectively let those who made bad decisions get off scot-free at the expense of others. Even then, it’s difficult to see mortgage write-downs coming close to €20bn, let alone the €50bn or so in write-downs on land.

                      • ibis ,

                        “the irony is the general perception that European taxpayers are helping to bailout Irish banks, while it is in fact Irish taxpayers helping to bailout European banks.”

                        Surely the irony is that that’s the general perception in Ireland, and one for which the only proof offered thus far is the Basel BIS statistics – which include the subsidiaries of European banks in Ireland, none of whom are being bailed out.

                        If you have proof of who owns what bonds in the Irish covered banks, I’d be very interested to see it – and I’m sure you must have such proof, to make such a definitive statement.

                        • Anthony Layng ,

                          Responding to

                          “A bank’s duty of care can be a convenient cloak under which to hide an abdication of personal responsibility.”

                          My perspective is a legal one, not an economic one, and perhaps out of line with others. It is not mainstream.

                          The Banks, the Central Bank of Ireland, IFSRA, the Minister for Finance and the State collectively and severally failed in their duty of care to the consumers of bank lending in respect of principal private residences.

                          It would take a 60 page statement to outline the various breaches (including statutory breaches) and to explain the specific bases of the various breaches.

                          A cursory outline is that the purchase price of homes, new and second hand, was almost entirely a function of excessively liberal capability to borrow, not a matter of capitalisation of predicted rental value, not a matter of supply and demand and not a function of the input costs such as construction, services and site acquisition costs etc.

                          The Banks dismantled the principles of responsible lending. Fractional reserving was ignored. The DoE Certificate of Reasonable Value was dispensed with, the limit of repayments, not exceeding 35% of net after tax income, was cast aside, the limits on multiple of gross income were ignored. The fact that there was an obvious housing bubble and over supply ignored. Residential property values quadrupled in the 10 years from 1996 to 2006. The multiple warnings from FDI sources that Ireland was becoming too expensive because of residential rents and residential propperty values were conveniently ignored, residential propery values on a per square metre actually over took prime property in the UK and in major European cities. There was a contrivance, encouraged and induced by Bank lenders, to have prospective borrowers over state incomes for borrowing purposes. There was no risk distribution of lending. Bonuses, over time and discretionary benefits, were taken into account for loan eligibility purposes.

                          I can identify another 10 major and egregious breaches of care. The worst was giving 100% and even 105% mortgages and ignoring LTVs. The security value became the primary consideration, not capacity to repay. The ordinary house buying consumers were hyped into buying at excessive prices, artificial queues were created and lenders and mortgage brokers urged the ordinary financially unsophisticated, non expert consumer buying her/ his home, to buy as early as possible and to go in as deep as possible.

                          The unfortunate consumer naively thought that the Irish Banks were subject to prudential supervision. Put baldly, and I can say this as a non victim, the first time buyers and the buyers trading up were missold inflated value assets. They paid extortionate and uneconomiclly sustainable prices for their homes. State policy encouraged this. Efforts to slow down the asset value inflation were set aside.

                          The reality is that the well remunerated and bonus driven bank lenders and the rather comfortably remunerated Regulators acted recklessly and irresponsibly. The victims were the non experts.

                          It is not an abdication of responsibility to say that the experts must bear the primary, if not the entire legal responsibility for what happened. Anyone who bought a home from 2002 to 2007 paid a grossly excessive price for their home, comparing the purchase price to a multiple of the likely annual rent.

                          Sadly, the number of people in arrears and the amount in arrears will inexorably and steeply increase over the next three years. The victims were subjected to an improvident, oppressive and unconscionable bargain. Eventually, but it will take a lot of time for the full realisation slowly to dawn, it will be sadly and lately realised that the mortgage debt burden is unsustainable as net incomes reduce or disappear, where the housing market is frozen, new lending is drying up and residential properties are continuing to decline, not having reached the bottom.

                          Unless or until there is radical intervention in the form of significant mortgage principal write down (subject to tight eligibility criteria), those people unfortunate enough, due to age and circumstance, to have bought from 2002 to 2007 in particular, will be burdened with a permanent yoke of debt.

                          Even as far back as 594 BCE, Solon the Law Giver of Ancient Athens understood the concept of the shaking off of the burden of debt.

                          I accept that it will take time for many to come to the realisation that we are facing amassive wave of mortgage debt impairments which will cause a crisis of confidence in the capital robustness of the Irish banks. Even if you ignore legal considerations, laugh dismissively about ethical and moral considerations, harden your heart and seek to extract maximum repayment from distressed morgagors, the fact is that even an innumerate and economically illiterate lawyer can understand that “can’t pay” is its own answer and its own undeniable reality.

                          Every distressed mortgagor would be well advised, in defending mortgage repossession cases, specificially to plead a breach of duty of care on the part of the Bank lenders contributed to by so many others. To borrow from a more original and far more perceptive commentator, the Pope’s children were betrayed.

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