February 2007 will always be seen as a watershed month for Irish banks. It was in this month that residential house prices finally turned downward after years of inexorable inflation. The history of Irish banking should really be broken into two eras – what went before February 2007 and what came after.
Since that inflection point, the fallout from lower house prices has mainly been confined to losses associated with commercial property loans. The state has pumped €11bn of taxpayers' cash into AIB, Bank of Ireland and Anglo Irish Bank, ostensibly to deal with provisions and write-offs associated with commercial property loans.
Nama is being set up also for the purpose of removing commercial property and land bank loans from the guaranteed institutions. But there is another large and growing threat forming at the margins of bank balance sheets, and that is the loans used to secure those houses in the first place.
Described loosely as the 'second wave', these are loans expected to arise in the mortgage books of the main Irish banks and foreign lenders. Traditionally, these losses arise after commercial property losses as they are tied closely to unemployment, and home-owners usually have a cash cushion they exhaust before they run into arrears.
While mortgage defaults were relatively low during the British property crash of the 1990s, the global recession of 2009 is an altogether different phenomenon. Last week's Bank of Ireland results illustrate the growing threat posed to the capital buffers, already hugely depleted, of the Irish banks.
While the problem has not attracted sufficient attention from domestic bank-watchers, the international economic community is starting to sit up and take notice.
The chief economics commentator with the Financial Times, Martin Wolf, even told the Sunday Tribune last week that Irish mortgage debt is so precarious that a mass "debt forgiveness" programme may have to be considered by the government, with banks forced to take huge hits on the carrying value of their mortgage assets thereby being forced into nationalisation or worse.
It has not reached that stage yet, although the Nama bill does allow the finance minister to use public money to purchase other forms of loan assets such as residential loans. The reason that was included in the legislation is the sheer scale of the mortgage liabilities out there. According to the ESRI, there are €148bn worth of mortgages in the system. That compares to just over €120bn of property and development loans.
Clearly, the pain from commercial and property lending has been front-loaded in this recession, but Bank of Ireland's six-month results last week showed that mortgage impairments are starting to make their presence felt. In just six months to the end of September, the bank posted €142m of loan impairments on mortgages. What is an impaired loan in this context?
Bank of Ireland classifies an impaired loan as a loan with a "specific impairment provision" attaching to it. Also included in this category are loans that are more than 90 days in arrears.
The €142m is up from €15m in the previous year and €112m in the six months to the end of March. While bank executives like to tell themselves that "Irish people always pay the mortgage", nobody in Ireland ever took on the loan-to-value ratios that this generation did. Also, no previous generation of borrowers extended themselves so much in the ratio of post-tax income to mortgage debt.
The impairments for Bank of Ireland's mortgages in its latest results represent 8% of the total impairments for the bank in the six months to the end of September. While the bank's consumer loans are performing alarmingly badly (€117m of impairments) the potential for damage there is quite limited in some respects, with this segment just making up €5.2bn of its entire loan book. Say 40% of this loan book becomes impaired; that would produce impairments of just over €2bn.
However, just a 4% impairment charge on the mortgage book (which would be very high by international standards) would leave the bank nursing impairments of €2.3bn. There is the added problem that the value of the security underlying these loans is collapsing fast and repossessions are not common to Irish banking culture.
But the biggest problem is that the mortgage impairments being booked by Richie Boucher's Bank of Ireland, plus AIB and Irish Life & Permanent, are being taken in a low interest-rate environment. Because of this, the number of households in negative equity is less important. In fact, history suggests that falling interest rates provide a 'cushion' to falling house prices and negative equity.
However, within the next year the ECB will embark on a period of monetary tightening, not to mention the Irish banks themselves which have pledged to "restore" their interest margins. This will mean a huge increase in mortgage servicing costs for Irish borrowers and an upward movement in mortgage impairments and eventual write-offs. This is the 'second wave'. While previous generations might have felt committed to paying their mortgage, it's not certain that younger, unattached people today will have the same desire to keep pumping money into what will effectively be a wasting asset.
By inserting a mortgage debt provision in the Nama legislation, it's clear the government also has doubts about whether the old patterns will reassert themselves in a recession as painful as this one.