If anyone wanted a seminar in how the problems of Irish banks go far beyond Nama, they need look no further than the presentation by Permanent TSB (PTSB) chief executive David Guinane delivered to the Oireachtas Joint Committee on Finance and the Public Service last Wednesday.
In the course of explaining why his bank raised rates on variable mortgages by 0.5% in July, Guinane laid out why even fairly non-Nama, conservative retail lenders like PTSB are losing money.
First they have to make extra loan-loss provisions on soured mortgages and secondly they have to pay more for the funding which supports those loans. Without improved margins, he explained, banks like PTSB would not be able to earn profits, which means eventually they will not have the money to set aside to absorb losses on loans they have already made.
Banks have to walk a fine line on this issue though because impairments and higher margins pull in opposite directions. Raising the price on your core product – in this case mortgages – makes it harder for your customers to pay for it, which can lead to higher arrears and, later, impairments and write-offs. With nearly €150bn in Irish residential mortgages alone, even relatively small levels of impairment could put balance sheets under serious strain – especially post-Nama.
Some industry sources are predicting that the banks, once they have offloaded their riskier assets to Nama and recapitalised, are preparing to raise rates en masse in the knowledge that their capital can absorb any new losses that result. Furthermore, as we approach the one-year mark from the institution of the Code on Mortgage Arrears, which stipulates a six-month grace period (12 months for AIB and Bank of Ireland) before repossession procedures can commence, the most troubled borrowers are falling out of protection.
Even without banks charging more or chasing debts more aggressively, borrowers are now coping with an enormous amount of financial stress. Tax increases over the last year have taken up to an extra €1,774 out of the average annual pay packet, while many workers have been forced to take pay cuts. Worse, unemployment has reached 12% and is on the way to peak at 14%-16%. There is simply less money around to pay back loans.
Evidence of this is beginning to appear in financial data. To take one example, a credit report two weeks ago by ratings agency Moodys showed that nearly 4% of mortgages issued by ICS Building Society, a subsidiary of Bank of Ireland (B of I), were in arrears. That means one in 25 borrowers had missed at least one payment. Many had missed more than one and 0.75% were at least a year or more behind – effectively in default.
Mortgage-industry sources say ICS and B of I have had virtually identical lending criteria for years. So the read across to the parent bank is significant, not least because it has €28bn in Irish residential mortgages and €59bn in total. In fact, B of I's end-of-year figures from March show 4.7% of its mortgages were past due. According to a recent trading statement by chief executive Richie Boucher, its bad-loan numbers will be getting worse in the months to come.
This worsening arrears and impairments profile, which is affecting all banks, is occurring in an environment where interest rates have been falling. Starting last October the European Central Bank instituted a series of cuts to the base borrowing rate totalling 2.75%. The domestic banks passed on the cuts and mortgage payments for borrowers on variable rates and trackers fell by hundreds of euro on average, mitigating the effects of the recession somewhat.
But now those same banks are indicating that lending rates are unsustainable and will have to rise. Permanent TSB has already put up prices by 0.5% on its 72,000 variable-rate customers. EBS chief executive Fergus Murphy has made no secret of his expectation of price hikes. There is, in fact, a consensus across the financial industry that the banks cannot afford low mortgage rates any more.
So two things are happening to borrowers: arrears are going up and banks are planning to raise rates on mortgages. But the banks are between a rock and a hard place, too. As PTSB's Guinane pointed out to the finance committee, banks are losing money because impairments are rising and the cost of getting money into the bank is unusually high. So the banks have to walk a delicate tightrope: keep rates too low and lose money on margin; push rates too high and lose money on higher impairments.
The key to all this, analysts say, is unemployment. The higher it goes and the longer it stays high, the worse mortgage arrears will get. PTSB suggested in its interim results last month that "through the cycle" losses could reach 1.6%.
In the meantime, banks are restructuring loans by extending terms to reduce payments or switching borrowers to interest-only. The Irish Banking Federation has even been proactive in aggreeing a new protocol with Mabs, effective this week, to formalise a loan work-out process. This has the benefit of limiting provisions in the short term, but it risks creating large numbers of 'zombie mortgages' which are technically performing, but not really paying off.
Ultimately, like the problems with bad loans to broke developers, the coming mortgage difficulties will have to become a policy issue. The social consequences of huge debt and negative equity will make it politically necessary to do something to save borrowers. Otherwise, sooner or later, the strapped banks could reach the limits of forbearance.