Fergus Murphy of EBS: right to be concerned

With the advent of Nama, the banks finally have a cure for their biggest headache: billions in balance-sheet-crippling boomtime property loans that borrowers had long ago stopped making payments on. Once those loans are shifted, a major source of financial risk and uncertainty will disappear from the banking sector.

But the banks' problems are far from over. Although replacing €77bn of bad development loans and their associated assets with €54bn in government bonds should – all going to plan – help the banks get back to the business of lending, Nama may not be the end of banks' bad debt woes. In fact, financial institutions are already bracing themselves for post-Nama losses arising as a consequence of Ireland's ongoing economic deterioration.

That's because generous as the government's rescue plan might be, it does nothing to insulate the banks from the growing number of problem loans in their commercial investment, business banking and mortgage books. While these lines of business have nothing like the apocalyptic default rates seen in development lending, the numbers are getting worse.

Moreover, the scope of non-Nama loans is nearly five times bigger than the Nama portfolio, which means even relatively low loss rates can have a big impact on profits and capital.

To take one example: EBS, which has been the most aggressive of the guaranteed banks in terms of recognising and providing for impairments in its small property development loan book, warned just over a week ago of "second round effects of economic deterioration" which would put its commercial property investment book under pressure over the next two years. According to chief executive Fergus Murphy, these are so-called "dry investments" – loans for income-producing commercial property with strong tenants on long leases.

At the moment, this book is "holding", according to the building society. To date EBS has taken impairment provisions of 2.14%, or €25.7bn, on this type of loan. Compared to the 16.5% EBS has written down on development loans, the amount seems small. But there are two reasons Murphy is right to be concerned. First of all, at €1.2bn, EBS's commercial property book is more than twice the size of its land and development book, which magnifies relative losses. About a third will go to Nama, mitigating the risk somewhat, but €800m will be left with the building society.

The second concern is the trajectory of impairments. Slightly more than half of the impairment provisions were taken in the first half of this year, a steep rise which indicates things are getting worse – not better. EBS took much of its development hit upfront in its 2008 accounts – expected to be the peak year for losses in the cycle – so incremental provisions were smaller for the first half on that book. The performance of commercial property loans – given out mostly for retail and office space – is expected to get worse as the effects of high unemployment and depressed consumer spending filter through to the banks' profit and loss accounts.

EBS is just one example. The big two banks have much higher proportions of straight commercial property loans than the mutual, which is primarily a mortgage lender. Bank of Ireland, for instance, warned last Thursday in a post-Nama trading statement that the recession was hurting not only its property development loans, which account for two-thirds of its impairment charges, but other areas as well, especially small business and corporate lending. Over the next 18 months, the bank said its prediction of €6bn in loan losses could get worse by 10%-20%.

Bank of Ireland did not dive nearly as deep into the cesspit of speculative development lending as its peers AIB and Anglo Irish Bank, but it is a bigger lender to the corporate/SME market than either were. Indeed, BoI increased business lending by €7bn between 2008 and 2009 while shrinking its property and construction book by €4bn. Impairments doubled in the last year, too, and account for 20% of troubled assets at the bank — a proportion that is sure to rise once the Nama-bound loans exit the bank. The fact that Bank of Ireland is now raising red flags over corporate/SME lending is a warning not just to its shareholders, but to the sector in general.

The other major area of concern, of course, is mortgages. As of now, arrears rates are rising but are still low, especially compared to the really distressed assets in development and commercial lending. But with unemployment not expected to peak until well into 2010, when as much as 15% of the workforce could be idle, mortgage defaults may be a latent problem that rears up precisely when the banks are putting Nama behind them.

Again, scale is the big issue. Irish banks have more than €140bn in mortgages outstanding. At even low levels of impairments, these could pose problems for weak balance sheets. Considering operating profits will also be under pressure at the banks over the next couple of years anyway, retained earnings will not be as available to absorb these kind of losses.

The banks may have reluctantly agreed to a moratorium on repossessions early in the year, but the stay of execution helps them too because it forces them to work out new terms for problem loans and delays the recognition of impairments.

The IBF/MABS code of conduct, which puts customers into a formal process for coping with tough debts, also helps banks put off the day of reckoning for delinquent mortgages. However, at some stage that wave will break and the losses on hopeless cases will have to be booked.

The banking panic may be coming to an end, but the economic and financial crisis has a long road ahead of it.

Mortgage Timebomb

For the moment, borrowers in trouble with their mortgages are reasonably protected from the banks. First of all, the government has imposed a code of practice that prevents the banks from initiating repossession proceedings on delinquent loans until after a 12-month grace period.

This is meant to allow the bank and customer to work out some kind of arrangement that allows the bank to get paid – perhaps less and over a longer period – while the borrower keeps a roof over their head.

Secondly, interest rates are extraordinarily low, which means repayments – at least on variable rate mortgages – are easier to cope with. This is a godsend for borrowers facing pay cuts or, worse, unemployment.

But these favourable conditions won't last forever. Some industry sources are predicting a wave of repossessions starting in the first half of next year as customers who were in trouble in early 2009 reach the end of their 12 months of grace. This theory suggests that, having sewn up their rescue with Nama, banks will have less to fear from a popular backlash and will go after overdue customers. To make matters worse, it is virtually certain that mortgage rates are going to rise in the new year, via the banks themselves rather than the ECB.