The ticking timebomb of strategic defaults

Was just having a think about this last night on the back of a friend of a friend who is currently strategically defaulting on a mortgage took out in 2006. I'm well aware of the consequences of his actions and don't agree with them one bit as we all end up paying in some form or other. But I'm looking to begin a discussion on the realities of this scenario rather than the morality of it.

So basically his mortgage was €500k, he had a 10% deposit. Now five years on the guys line of thinking is that he is better off to go to the UK for a year and claim bankruptcy. At first I thought of it as a stupid idea but having had it explained to me I can see how he is taking the single least worst option.

So I just want to tease this out because if it is as I think it is then this is probably going to be the single biggest factor that will push Ireland as a nation over an economic cliff edge.

So for example if someone took a mortgage in 2006 for 35 years then their term is until 2041. Lets say it was the €500k talked about earlier. So with interest payments the total repaid is going to be somewhere in the order of circa €900k-€1m. Putting €500k through a mortgage calculator with a 35yr term and 4% interest gives a repayment of €2,213 per month and a total repayment of €929,000 over the lifetime of the loan.

So five years into the loan period they have paid 60 months x €2213 = €133,000 plus their initial €50k deposit, so they've spent €183k in total. Now they look at the economic mess all around them and things have changed drastically. Depending on who you listen to house prices are down somewhere in the order of 50-60%. Morgan Kelly, who has been on the money so far, is on record as saying that they will level out at 80% of peak prices. He is obviously talking about the market as a whole so while houses sold in Ranelagh for €1m in 2006 are unlikely to drop to €200k that will be balanced out by houses in rural areas which were selling for €300k now being worth €30k, we've had a few in Donegal already and I think that ghost estate in Kerry went at auction for €13k per house so its not outside the bounds of possibility that many units will experience a 90-95% drop in value.

Our homeowner is now sitting down digesting all the negative news in the economy and they are acutely aware that they're in huge negative equity. Now negative equity during a loan period (in theory) shouldn't matter if at the end of the loan the house is worth more than you bought it for. But theory goes out the window in the current situation and the homeowner takes the view that his house, now worth €250k is likely to level out at 30% of initial purchase price. That's a midpoint between Morgan Kellys 80% drop and others who are calling a bottom or near bottom right now at 60% of peak. So lets say we bottom in 2015 and the original €500k house is worth €150k 9 years after purchase.

So our homeowner now has a stark and frightening situation in front of them. They have a loan of €939k on which they have repaid €133k, leaving them a liability of €806k. The asset on which the loan is secured on is soon going to be worth a sum total of €150k in 2015, leaving the fully paid asset worth €735k less than what has actually been repaid. Plus another €50k which went on the initial deposit. Pretty quickly the figures are looking extremely depressing.

But it could get even worse- the counter argument to negative equity is that (in theory) over the course of the next 30 years the value of the property should increase beyond the level of inflation, thus closing this gap. Its a proven economic counter weight of property crashes. But I am thinking that in itself it is premised on the original property being purchased within some range of actual value to its utility and potential income stream as a rentable commodity rather than a valuation informed by its potential future price as banking were doing here, especially since 2002 onwards.

So my logic is leading me to think that there is a double whammy contained within this crash and when those in the worst negative equity realise the second part of the the problem they will engage in strategic defaults, in huge numbers. The second part of the whammy occurs because of the folly of the banks for lending at the levels they did (12 times salary in some cases) and because lenders didn't question this then even the supposed safety net of current negative equity getting wiped by property increases over the next three decades looks like it might actually be unattainable.


In other words any hope the homeowner may have had in the long term could turn out to be useless and financially costly to think that way now and down the road (again just my opinion, open to correction here)

Because there was little 'normal' about lending practices and the prices paid from 1999-2008 but especially c.2003 and definitely 2005 onwards were not based on any kind of economic value system it stands to reason that that mistake must then have a severe knock on consequences for arriving back to the initial purchase price. The banks were not following established historical international norms of property being only ever worth a multiple of potential rental yield, despite acres of economic research being written on it and the witnessing of crashes in the UK, Finland, etc within the previous 15 years. Instead they ripped up of the rule book of lending on houses, the standard formula of lending 3-4 times salary went out the window. They lent you whatever the price of the house you wanted was and that itself was grossly inflated by bidding wars. No-one seemed to realise that bidding wars would go on forever if both bidders were being lent sums by banks not based on ability to repay but on some insane valuation of a piece of land and some bricks. It got to the point where freshly graduated students on €30k were getting loan approval for €300k. It meant that they were valuing houses that rented (even in the boom) for €15k per year at a price of €500k to purchase, something that would give a paltry gross yield of 0.75% a year. In hindsight when that lunacy was occurring it was no wonder that experienced institutional investors exited the Irish market, (including BOI who in 2005 sold all their branch properties and leased them right back) taking all the profits and running. (The BOI analysts seemed to know something was coming down the line, why else would you sell an asset that was going to continue to rise in value except if your predictive models and research told you otherwise. The Bank of Ireland decision is bizarre- on one hand someone in the bank took the view that 2005 was a great time to sell property and (wisely) sold up lock stock and barrel but on the other they continued to expose the entire bank further to the property market, especially in 2006 when prices rose 26% in under a year as the bubble gave its final push- its for another discussion but its interesting to note that BOI could have avoided the worst of the property crash if they'd followed the same strategy that they did believed in when selling their own branches and matched that with severely curtailing mortgage lending from '05 onwards)

The alternative was to stay in a property market that had now become one where profits were entirely dependent on the continuation of tax incentives to invest initially and then tax breaks on loan interest and also for capital gains tax to remain at a historic low of 20% from its usual level of 40%. The whole buy to let market was created out of thin air by of McCreevy and Cowen, a return on investment was dependent on three things that are far from reliable- having good tenants who always make the rent and don't wreck the place, for prices to continue to rise unsustainably and for tax policy to remain unchanged. They used agents to shore up the first as best as possible, hoped for the best on the second and lobbied Cowen and Bertie for the third. But as soon as any of those conditions changed then the BTL investor was going to be caught with their pants down, especially at a 100% exposure.

So in other words the market was far from normal, especially when viewed against global property prices over the previous 100 years in Western Societies. Consequently those who vastly overpaid for houses may not (I'm open to correction here) be saved by price increases over the next 30 years. I'm thinking this not only for the reason that they bought in an abnormal market but also because that when this recession begun in 2008 it looked (to me at least) like it might be a 5-6 year event. We're now four years in and the general feeling right now is that this crises is a minimum of a 12 year event, especially as the last 4 years of 'solutions' to the crises has been a complete and utter failure (both here and at EU level) and now things seem to be getting worse than they've ever been in the entire 4 year period. The EU has stagnated with 0% growth and here in Ireland soaking up a plethora of price increases on essential unavoidable services on an almost weekly basis, Bord Gais just a few weeks back, CIE back at the begging bowl soon, resulting in far less disposable income. Both sides are being hit, the level of income you've left after tax and then another whammy of increases in the price of goods you then want to spend your money on.Neither condition is exactly conducive to people being able to afford to pay higher house prices. Also as far as I remember there is a strong economic correlation between the level of unemployment and house prices- without unemployment going down it is an economical anomaly for house prices to rise, the report I read a few years back mentioned how a 10% unemployment rate typically has c25% of the a population genuinely scared for their job, their spending virtually seizes up as they save as much for a rainy day. It went on to say if 40% aren't spending in an economy then you'll house prices can't rise sustainably. There are lots of conditions conspiring against prices increases and little to inspire confidence they are going to arrive soon and also be sustainable for decades to come.


But lets get back on the topic of strategic defaults. Lets take €150k as the bottom value of the initial €500k purchased house, which is a total drop from peak of 70% (which is not an not an outlandish figure considering even the chief house price cheerleaders at the Irish Independent, who have remained permanently bullish about property, have reluctantly conceded that the current level of decline is 55% nationally)

So next we then assume (very generously I'd add) that the market immediately returns to being normal* in 2015
*by normal I'm referring to the following happening, all by 2015:- fresh lending begins with one or two foreign banks entering the Irish market, transaction volumes of house sales leave their current historic low, unemployment abates down to at least 9% (but 7% being more desirable), salaries rise and outstrip inflation, and the costs of living & transport reduce from current 2012 highs. These are all necessary conditions to deliver modest annual increases in house prices similar to historical price increases recorded long term in global markets


So the next assumption is that house prices increase from 2015 onwards and sustain their increases at 2% annually. (which lets assume is net of inflation of 1% for arguments sake, I'm being overly generous here) Assume that this 2% increase is after inflation is accounted for then continues to occur every single year for 30 years in a row. This would be seen by economist as a healthy & functioning property market,i.e. slow steady gains a la Germany. In fact if this did occur it would be a better performance than US house prices over the last 100 years of indexing real estate and adjusting it for inflation. So by US historical prices it is unlikely but I'm playing devils advocate here to illustrate how even a well performing market over the next 30 years may not be enough to save those in trouble right now.


So the 2012 house, bottoms to a value of €150k in 2015 but from then onwards has consistent increases of 2% annually compounded together for 30 straight years. Then that house that was valued at €500k in 2006 and €150k in 2015 is now worth a total of €271k in 2042, which is still far below the initial purchase price of €500k and a long way from the total €929k repayment. I'm using the compound interest calculator here to arrive at that figure of €271k
http://www.howtoretirestrong.com/default.aspx
The assumptions made are on the generous side given global historic data on real estate prices.

Now maybe I'm missing something here and someone will fill me in. But it appears that a homeowner in this situation is likely to come in for a large loss by paying their mortgage off between now and 2041. Of course I haven't allowed for mortgage interest relief which does reduce the total repaid, but only somewhat. I'm not familiar with how it works so it would be good if someone could adjust these figuers to reflect the discount. But I'm guessing its impact is less than €30-40k saved over the mortgage's life and I think the government are phasing it out down the road. Like any tax incentive or break it should be viewed as a bonus rather than cast in stone as it can be withdrawn at the stroke of a Minister pen.

At a rate of 4% interest the owner will have paid a total €929k (less the savings from interest relief) for an asset which is going to be worth, given the above (optimistic) assumptions a total of €271k in three decades time, 2041, Of course they will have had the benefit of living in the house for 35 years, something which is difficult to put a concrete cash figure on in order to do a direct comparison with someone who rented for 35 years. We can put a value on the costs of paying rent Vs paying a mortgage but that wouldn't account other variables such as the many thousands of people who bought homes from 2003-2008 and because of abnormal prices at the time now live in a commuter belt with longer journeys and the associated higher transport costs compared to someone who rents nearer their workplace in a city or town and can get a bus to work for €4 return daily or better again, walk to work. Other things to consider if comparing renting to buying property are maintenance costs, refuse and water charges, the new property tax, insurance and finally costs associated with the risks of ownership, i.e. flooding that insurance won't re-insure after the first instance, very real risk of pyrite, subsidence from poor structural work, etc.


When you tease it out and work some basic figures as above you can quickly see the incentive there is for people to strategically default on their mortgages, all other things being equal and even if their job is relatively secure, in fact you would have to factor in 1-1.5yrs lost net salary to any calculation as a safety net. But for each and every person mortgage holder who doesn't have a tracker there must come a tipping point where it is financially worth their while to default. It is just a matter of calculating their costs over the duration of the mortgage and allowing for what they think the house will be worth at the end, adjusted for inflation. No doubt people are already weighing things up and for those who bought late in the boom the savings to them could be potentially north of €400k over 30 years. That is approx €33k annually, which is not an insignificant sum to even a couple with a combined income of €100k. Especially as in order to have €33k cash in your pocket every year you'd have to earn somewhere in the region of €45k gross before tax before it ends up in your hands as €33k net.

For anyone who bought from 2004ish onwards and doesn't have an ECB linked tracker mortgage there is likely going to be a strategic money saving opportunity for them. As I said at the top of the thread I don't agree with the morals of this but anyone who subscribes to the notion of rational choice theory and basic human nature to protect ones self interests above all else then it is difficult to see how there isn't going to be a huge volume of defaults that didn't necessarily have to occur. Especially when the potential upside is savings that are nearly the same as the current prices of houses in their locality.

Of course a justification is needed for any strategic default, mainly as people will have to explain it to family & friends, humans have an inner need to feel accepted by those close to us and part of that is acceptance of our actions, choices, morals and values. It sounds like a difficult task at first, you are telling friends and family that you're basically doing a runner on a debt you signed up to. On some level there might be fear of exclusion from a group and also the paranoia of 'what will they think of me, will they trust me, etc. But in reality we can justify almost anything if the outcome is in our own self-interest and the interests of others around us.

So very neatly a mother or father of a strategic defaulter has their own self interest served by not being asked to help pay part of the children's mortgage themselves, a practice that is happening right now, I'm aware of two friends whose parents are currently paying their mortgage due to unemployment & cutbacks, one to 50% for the last 3 years, the other to 100% for 6 months now. In their individual scenarios the incentive to default is even higher as it can be justified as for the greater good; their reneging on their debt is saving their parents money, which they know is not sustainable in the long term. Finally they could also get a bit Machiavellian and reason that the money paid now by their parents means their eventual inheritance gift would be less as a result; and if you're thinking of defaulting then an inheritance payout down the line which falls outside the time frames of bankruptcy takes on greater importance than it did before the parents were helping pay the mortgage, all of which incentives the decision to default even further. It is easy to see how once a person has made up their mind that paying the entire mortgage makes bad financial sense then the easiest thing it to find a jusrification that fits some sort of moral code which is shared with your social circle for the approval you need to carry it out.

At the moment Sean Quinn justifies in his own mind the denial of €2.8bn to the Irish taxpayer for his costly and irresponsible gambles. He does so by saying he wasn't treated fairly by Anglo, he was conned by Sean Fitzpatrick, etc any number or reasons to allow his conscience do what he is currently doing, which is essentially a form of theft from every citizen in the country, all on a mammoth scale. As we're talking about nearly €3bn his actions can be directly linked to the consequences of hospital closures, cuts in education. The budget for the new Childrens Hospital is €1bn, but yet Quinn manages to justify moving assets valued at half its entire cost beyond Anglo and subsequently the taxpayer. On some level Sean Quinn must have thought that he is costing the country half the price of the children's hospital which is to the detriment of a lot of sick Irish children who currently dont get the care or facilities they need but he has a clear conscience, mist likely justifying it as a hospital for 'that lot up in Dublin who never did anything for Cavan, I did it all and got no thanks'. Even though he is clearly to blame here he can sleep soundly at night and doens't lose a wink as his own self interest is satisifed.

In order for the normal home owning citizen to justify a strategic default all they need do is find some injustice, whether real or perceived, to counter balance their crime. And when you consider the other side of the equation there is plenty of injustice about in Ireland at present. Since the person took the initial mortgage their circumstances have changed dramatically, and not due to anything they themselves have done. Since 2008 and as a result of the banking crises we have been hit with a USC at 4-7% of salary, a 0.6% levy on private pensions, 2% levy on insurance, about a 30-40% increase in the costs of car fuel and electricity, VAT gone up to 23%, road taxes going nowhere but up, water charges coming down the road and a full blown property tax which will probably lump them with a further bill of €30k over the next 30 years. All of which is a consequence of bailing out bankers, the incompetence of politicians, etc. In light of all that it is actually quite easy to justify a strategic mortgage default to yourself and those around you. The line will be that you were willing to pay it but then circumstances outside your control changed and "well why should I, I didn't cause this mess but I'm paying higher taxes while those politicians who're responsible have huge pensions and the bankers are in the Bahamas,etc, etc"

I'm scratching my head and thinking that when people do the maths on what they owe and how much its going to cost to pay off then we're going to see big numbers of ordinary people heading to the UK for bankruptcy. Of course bankruptcy isn't a silver bullet but it is fast becoming the single least worst option from a purely financial point of view. If going bankrupt would save someone €400k versus staying and paying the whole mortgage then there is a real incentive to do so. Especially when you consider that in order to pay that €400k they will have to earn €800k before tax. They're frightening sums.

There is already some anecdotal evidence coming through that (some) people are already taking this option. They've presumably done the math and it stacks up for them. They've considered the consequences of never being able to get credit again and they're willing to accept that, seeing it as preferable to paying out hundreds of thousands into an asset unlikely to reach its initial value again.

Of course there are other considerations like leaving the kids for a year, giving up the family home, a life of renting, leaving a secure job and finding one again. It is not as easy as just saying feck it and put it in motion. But the financial costs of not doing it may be too much for a fair amount of people. If it comes down to something like a choice between paying a bank or affording to send your kids to university or even living your retirement in practical poverty despite 40 years of honest work then it soon becomes a no-braner.



So are we soon going to be getting to that trickle of strategic defaulters becoming a flood? Its seems that anyone who bought post 2003 might gain long term from doing so but is it likely they'll try? And what are the worst consequences for them, is this ever likely to be an offense that could see people in prison? Or just swept under the carpet in the usual Irish way ?

I am not aware of exactly how many people have big mortgages from 2003ish onwards and who are also not on a tracker (which are the cheapest form of credit, given they're pegged to the ECB rate which is at a historically low level of 1% right now, they're actually affordable mortgages for most and have saved many from being in arrears) It'd be interesting to know the total number of mortgages who are paying variable rates in the order of 4-5.5% as this is the group who are most likely to strategically default, with those who purchased closer to the market peak having a higher likelihood and greater financial gain than those at the 2003 end. According to Ronan Lyons 1 in 7 mortgages is in arrears of 6 months or more, which is considered a danger zone at which recovering to repay it becomes less likely statistically.

So far in Ireland there has been virtually no firesales or repossessions, despite us being 4 years into a price crash where salaries are down significantly and taxes and the cost of living is consistently rising. In 2010 in the UK there were 36,000 repossessions which when adjusted on a per capita basis was 15 times more than the number in Ireland for the same period. The Uk is dealing with mortgages in arrears whereas we seem to be kicking the can down the road, perhaps a fear of evicting people given the historical context of landlords and tenents in Ireland
But something has to give soon and I'm thinking when it does a flood gate will open, strategic defaulters will see their opportunity and grab it too and the sum total of unpaid debt will be unsustainable for the country to manage.

It is difficult to see it panning out any other way, there has to be an end game to all of this.