Wednesday, 13 April 2011

Considering all the talk recently of mortgage debt forgiveness it got me thinking is it worth the banks while. For lots of reasons it makes absolute sense.

Traditionally banks got money in off depositors and lent this money to other customers. They charged the borrower more than they paid the depositor and they made a profit.

As the banking system progressed (I use that term loosely) banks started to use the depositors money as security to borrow more money to lend out. So the upward spiral begins.

Lets take an example:

Joe owns a piece of land and also has €100,000 in the bank. Joes’ land is for sale.

Paddy wants to buy the land from Joe.

At the outset neither Paddy nor the bank has any money.

Joe deposits his €100,000 into the bank. The bank goes to Europe and borrows €250,000 on the strength of the fact they have €100,000 in deposits.

The bank lends €250,000 to Paddy who gives it to Joe who gives him the land.  

Joe Deposits the €250,000 from the sale of the land into the bank who then use it to go to Europe to borrow more money on the strength of the €250,000 deposit they hold and so the cycle goes……

The land devalues to be worth €30,000. Joe whips his €350,000 out of the bank and fecks off to the sun for the rest of his days.

Now the bank is left with an asset worth €30,000 as security, a loan to Paddy who can’t pay it and no deposit. Europe won’t give the bank anymore money because the bank does not have the deposit to back it up nor is the loan performing because Paddy has given up paying it.

If however the bank could get Paddy back on side and he started paying the loan back then there might be options for the bank to sell that debt to someone else.

Let’s assume that Paddy feels some sense of responsibility for the loan and let’s say his current income can justify a repayment of €150,000. The bank agrees to write off €100,000.

Before they did this they were owed €250,000 that they were potentially never getting back. Now they have a loan that Paddy is able to service, albeit €100,000 less than the original amount, but hey presto some of the bigger European banks just might come in and buy up such a loan particularly because when the bank wrote off the debt they most likely moved Paddy’s rate up.  

So at the moment the banks have a loan book that very few believe will ever be paid back in full and until there is evidence to the contrary it’s unlikely any other banks will touch it with a barge pole.

However if the bank can readjust their loan books with loans that are more obviously affordable they dramatically increase their chances of being able to offload the loan book to other banks. They will Increase their liquidity and they can write of the bad debts in the current year rather than having to wait for it to happen over the next 20-30 years.

If it makes sense on non performing loans think about what it does on the tracker loans. Most Irish banks are currently paying 5% for the funds they are borrowing. If someone has a mortgage of €300,000 at a tracker rate of 0.75% above ecb they are currently paying 2% on that.

Ignoring capital and interest payments for a moment and assuming interest is only being met. It is costing the bank 3% or €9000 a year for the bank to keep that loan on its books. If that’s a 25 year loan (again in simple interest terms) your talking over €200,000 total cost to the lender. Would it not make absolute sense for that lender to write off €100,000 of that €300,000 loan in this accounting period and “persuade” the customer to move to a variable or fixed rate?

The other option banks have is to get government to change the legislation and allow them to force tracker rate customers onto the variable rate. Based on the mutterings from theTaoiseach today and the word coming from AIB yesterday I think it is more likely they will go the debt forgiveness route but lets just wait and see.

Eoin McGee QFA is the owner of Prosperous Financial services and can be contact on 0876445533 or 045841738 or eoin@festinosolutions.com