The Morgan Kelly Archive

2006 - PDF

Irish House Prices: Gliding into the Abyss
Morgan Kelly
21st December 2006

Offering no evidence except wishful thinking, estate agents and politicians assure us that we have nothing to worry about: the Irish housing market can look forward to a soft landing. If, however, we look at what has happened to other small economies where sudden prosperity and easy credit drove house prices to absurd levels, we should be very worried indeed.

If the experiences of economies like ours are anything to go by, we may be looking forward to large and prolonged falls in real house prices of the order of 40–50 per cent, and a collapse of house building activity.

Two housing booms are especially sobering for being so similar to ours: Fin- land in the 1980s and the Netherlands in the 1970s. Finland boomed after oil was discovered off the coast in the mid-1980s. With low interest rates and loans available for the asking, house prices soared.

Then, as the Soviet Union collapsed, unemployment rose and house prices started to fall, creating problems first for builders, then for home owners, and finally for banks. The Finnish banking system effectively disintegrated under the weight of bad housing loans, and had to be rescued, at huge expense, by the state. Unemployment rose from 5 to nearly 20 per cent. The real price of houses fell by over 40 per cent.

A Finnish discussant in an online board captures the spirit of the times. "In 1991, a friend of mine offered about $120,000 on a lovely house that had cost:
$240,000 to build just three years previous. With over 20% unemployment, it was not surprising that the owner and his wife had both lost their jobs and were about $12,000 behind in their mortgage payments. Obviously, the owner refused my friend’s offer, but the bank manager called back in just a few hours with a counteroffer: he’d accept the $120k if my friend also paid the delinquent $12k in mortgage payments. That’s it, the other family was left without a house and still owed the bank about $70k."

The Netherlands shows how house prices can collapse even when banks are large enough to absorb large losses. In the 1970s, thanks to the discovery of natural gas, the Dutch economy was the wonder of Europe. Once again, low interest rates and relaxed lending criteria led to a housing boom. Then in 1979, the international recession bit, interest rates rose and prices tumbled. By 1985, the real price of houses had fallen by 50 percent.

Table 1 shows some of the major house price collapses in the past 30 years. Among industrialized economies, there have been 16 episodes where the real price of houses has fallen by more than 20 per cent. Unlike stock market crashes, house price crashes are typically prolonged, lasting from 4 to 8 years.

There is an iron law of house prices. The more house prices rise relative to income and rents, the more they subsequently fall.
To see the iron law in operation look at Figure 1. It shows, for every industrialized economy between 1970 and 2000, how a rise in house prices relative to income is followed by a proportional fall. Economic theory predicts that house prices should be very volatile and prone to “rational frenzies”, and that is what the data show.

But how about Ireland? Surely our house price rise is simply due to our rising income, and the shortage of houses in places where people want to live?

Neither reason is valid: while incomes have risen, house prices have risen faster. Since 2000, house prices have risen 30 per cent more than income. Similarly, were there any shortage of housing we would see rents rising as fast as house prices. In fact, compared with income, rents have actually fallen since 2000.

The importance of what has happened to rents cannot be over-emphasized. If the housing boom were due to rising incomes and more people forming house- holds, what economists call fundamentals, rents would also have risen. The fact that rents have fallen shows conclusively that our housing boom is a bubble, pure and simple.

But why can’t we just have our soft landing, where prices stay fixed or rise slowly for a while? Definitely not: a soft landing is not so much unlikely as contradictory.

Suppose that house prices really were expected to level off. Then the owners of the tens of thousands of empty houses and apartments can expect no further capital gains, and should cash in their investments. Why pay a mortgage on an empty apartment that has stopped rising in value? As speculators rush for the exit, prices will crash.

Secondly, if prices stop rising, it makes no sense to buy a house. Compared with mortgages, rents are ridiculously low. For e2,000 a month you can pay a mortgage on something in a muddy field on the wrong side of Celbridge, without nearby shops or schools, and a 2 hour commute to Dublin. For the same amount you can rent a million Euro house in southeast Dublin, close to the Dart line and surrounded by good schools. Once people put off buying in favour of renting, prices will not stabilize, they will crash.

Just as rising prices generate self-fulfilling expectations—you have to buy now before prices rise further, causing prices to rise—so falling prices generate their own momentum.

Buying in a falling market is a guaranteed way to lose a fortune. Even if prices fall by only five per cent, a e500,000 house on which you paid 10% in stamp duties and fees will leave you e75,000 poorer.

It is a lot less nerve wracking to sit things out and rent for a year or two. And when everyone does that, prices fall further.

How far are prices likely to fall when the bubble bursts? If we suppose, optimistically, that prices were more or less in equilibrium with income and rents around 2000, then house prices are about 25 per cent over-valued now. Unfortunately, when house prices fall they generally overshoot and end up undervalued. It is not implausible that prices could fall, relative to income, by 40–50 per cent.

House prices can halve relative to income without huge falls in the selling price of houses. If the price of houses falls by 5 per cent each year, while prices rise by 3 per cent, and real incomes by 2 per cent, then after 5 years house prices will have fallen relative to income by 50 per cent.

This is an average: some places will have larger falls, others smaller. After the last British housing bubble, for example, when prices fell on average by 10 per cent, prices in East Anglia fell by 40 per cent.

The ratio of prices to rents is a measure of the return to investing in housing. Rossa White has shown the ridiculous levels of prices compared with rents in different parts of Dublin (his report can be downloaded from In Sandymount, for instance, annual rent is barely 1 per cent of purchase cost.

This is a price-earning ratio above Google’s, and can only be justified if we believe that future incomes will rise forever at around 6 per cent a year. Is this possible? Well, if it is, in 25 years time we can look forward to being almost 3 times as rich as the United States.

Rossa White’s estimates of rent to price ratios show that the middle of the market in Dublin is less seriously overvalued than the top and the bottom. International experience shows that the worst houses in the worst places always experience the worst falls.

We can expect the biggest falls in apartments as speculators try to sell before getting roasted alive, and in dismal outlying towns with long commutes to Dublin. And at the top of the market, where prices need to fall by perhaps two thirds to bring them back into line with rents.

House price collapses affect the wider economy in three ways. First, house- holds lose wealth and start to repay loans instead of spending. Secondly, banks reduce lending as they lose money on bad loans.

While banks are reluctant to foreclose and try to reschedule instead of taking an immediate loss on a loan, borrowers with negative equity will walk. For many with hundred per cent mortgages on apartments that have fallen in value by e150K (the sort of falls that have occurred in Washington, DC lately), it will make sense to leave the keys in the door and relocate to London for a while.

The third, and potentially catastrophic, effect of a house price fall is on building activity: more houses get built as prices rise, and fewer as prices fall. As our exports have stalled since 2000, the Irish economy has come to be entirely driven by house building. Between building new houses and selling existing ones, housing now generates almost one fifth of our national income. In effect, the Irish economy is now based on building houses for all the people that have got jobs building houses. Economists call this a multiplier-accelerator process, and it is very unstable.

To see how rapidly a building boom can evaporate we can look at Arizona. Rising population led to a building boom that should sound familiar: people queuing overnight to buy houses in new developments; builders increasing prices by a few thousand a week; people paying a down-payment of $5,000 on a house and selling it on for a $100,000 profit a few weeks later.

A few months ago, however, rising interest rates brought it all to a halt. Despite incentives like free swimming pools and fancy kitchens, and even at prices below the cost of labour and materials, builders cannot sell, leading to vast empty developments that have been called the new ghost towns of the West.

The parts of America that had the biggest housing boom are now experiencing falls in house prices of around 15 per cent. The United States is now facing a possible recession as house building falls towards its usual bust level of around 4 per cent of national income, from a boom level of 6 per cent.

In Ireland, if and when the fall occurs, it will be from around 18 per cent of national income. We could see a collapse of government revenue, and unemployment back above 15 per cent.

We have spent the last 5 years learning to believe that exports and competitiveness do not matter, and that we can get rich by selling houses to each other. We are likely to spend a painful few years as we unlearn that lesson.

Pilots define a soft landing as one that you can walk away from. Looking at the price collapses in places like Finland and the Netherlands, and the building bust in Arizona, Ireland could be heading for something closer to what they call CDIT: controlled descent into terrain. You are happily descending through cloud, thinking yourself at a safe altitude, until suddenly you smack into a hillside.
How the housing corner stones of our economy could go into a rapid freefall
Morgan Kelly
December 28, 2006

Offering no evidence except wishful thinking, estate agents and politicians assure us that we have nothing to worry about: the Irish housing market can look forward to a soft landing.

If, however, we look at what has happened to other small economies where sudden prosperity and easy credit drove house prices to absurd levels, we should be very worried indeed.

If the experiences of economies similar to ours are anything to go by, we may be looking at large and prolonged falls in real house prices of the order of 40-50 per cent and a collapse of house-building activity.

Two housing booms are especially sobering for being so similar to ours: Finland in the 1980s and The Netherlands in the 1970s.

Finland boomed after oil was discovered off the coast in the mid-1980s. With low interest rates and loans available for the asking, house prices soared. Then, as the Soviet Union collapsed, unemployment rose and house prices started to fall, creating problems first for builders, then for homeowners, and finally for banks.

The Finnish banking system effectively disintegrated under the weight of bad housing loans and had to be rescued, at huge expense, by the state. Unemployment rose from 5 to nearly 20 per cent. The real price of houses fell by more than 40 per cent.

A Finnish contributor to an online discussion board captures the spirit of the times.

"In 1991, a friend of mine offered about $120,000 (€91,464) on a lovely house that had cost $240,000 to build just three years previous. With over 20 per cent unemployment, it was not surprising that the owner and his wife had both lost their jobs and were about $12,000 behind in their mortgage payments.

"Obviously, the owner refused my friend's offer, but the bank manager called back in just a few hours with a counter-offer: he'd accept the $120,000 if my friend also paid the delinquent $12,000 in mortgage payments.

"That's it, the other family was left without a house and still owed the bank about $70,000."

The Netherlands shows how house prices can collapse even when banks are big enough to absorb large losses. In the 1970s, thanks to the discovery of natural gas, the Dutch economy was the wonder of Europe.

Once again, low interest rates and relaxed lending criteria led to a housing boom. Then, in 1979, the international recession bit, interest rates rose and prices tumbled. By 1985, the real price of houses had fallen by 50 per cent.

There is an iron law of house prices. The more house prices rise relative to income and rents, the more they subsequently fall. To see the iron law in operation look at figure 1. It shows that for every industrialised economy between 1970 and 2000, how a rise in house prices relative to income is followed by a proportional fall. Economic theory predicts that house prices should be very volatile and prone to "rational frenzies" - and that is what the data show.

But how about Ireland? Surely our house-price rise is simply due to our rising income and the shortage of houses in places where people want to live?

Neither reason is valid: while incomes have risen, house prices have risen faster. Since 2000, house prices have risen 30 per cent more than income.

Similarly, were there any shortage of housing we would see rents rising as fast as house prices.

In fact, compared with income, rents have actually fallen since 2000. The importance of what has happened to rents cannot be over-emphasised. If the housing boom were due to rising incomes and more people forming households, rents would also have risen. The fact that rents have fallen shows conclusively that our housing boom is a bubble, pure and simple.

But why can't we just have our soft landing, where prices stay fixed or rise slowly for a while?

Definitely not: a soft landing is not so much unlikely as contradictory. Suppose that house prices really were expected to level off, then the owners of the tens of thousands of empty houses and apartments can expect no further capital gains and should cash in their investments.

Why pay a mortgage on an empty apartment that has stopped rising in value? As speculators rush for the exit, prices will crash.

Second, if prices stop rising, it makes no sense to buy a house. Compared with mortgages, rents are ridiculously low. For €2,000 a month you can pay a mortgage on something in a muddy field on the wrong side of Celbridge, without nearby shops or schools and a two-hour commute to Dublin.

For the same amount you can rent a €1 million house in southeast Dublin, close to the Dart line and surrounded by good schools.

Once people put off buying in favour of renting, prices will not stabilise, they will crash. Just as rising prices generate self-fulfilling expectations - you have to buy now before prices rise further, causing prices to rise - so falling prices generate their own momentum. Buying in a falling market is a guaranteed way to lose a fortune. Even if prices fall by only 5 per cent, a €500,000 house on which you paid 10 per cent in stamp duties and fees will leave you €75,000 poorer.

It is a lot less nerve-wracking to sit things out and rent for a year or two and when everyone does that, prices fall further.

How far are prices likely to fall when the bubble bursts? If we suppose, optimistically, that prices were more or less in equilibrium with income and rents around €2,000, then house prices are about 25 per cent overvalued now. Unfortunately, when house prices fall, they generally overshoot and end up undervalued.

It is not implausible that prices could fall - relative to income - by 40-50 per cent.

House prices can halve relative to income without huge falls in the selling price of houses. If the price of houses falls by 5 per cent each year, while consumer prices rise by 3 per cent and real incomes by 2 per cent, then after 5 years house prices will have fallen relative to income by 50 per cent.

This is an average: some places will have larger falls, others smaller. After the last British housing bubble, when prices fell on average by 10 per cent, prices in East Anglia fell by 40 per cent.

The ratio of prices to rents is a measure of the return to investing in housing. Rossa White has shown the ridiculous levels of prices compared with rents in different parts of Dublin (see his report at In Sandymount, annual rent is barely 1 per cent of purchase cost.

This is a price/earning ratio above Google's and can only be justified if we believe that future incomes will rise forever at about 6 per cent a year. Is this possible?

Well, if it is, in 25 years we can look forward to being almost three times as rich as the United States. Rossa White's estimates of rent-to-price ratios show that the middle of the market in Dublin is less seriously overvalued than the top and the bottom. International experience shows the worst houses in the worst places suffer the worst falls.

We can expect the biggest falls in apartments as speculators try to sell before getting roasted alive and in dismal outlying towns with long commutes to Dublin and at the top of the market, where prices need to fall by perhaps two-thirds to bring them back into line with rents.

House-price collapses affect the wider economy in three ways. First, households lose wealth and start to repay loans instead of spending. Second, banks reduce lending as they lose money on bad loans. While banks are reluctant to foreclose and try to reschedule instead of taking an immediate loss on a loan, borrowers with negative equity will walk.

For many with 100 per cent mortgages on apartments that have fallen in value by €150,000 (the sort of falls that have occurred in Washington DC lately), it will make sense to leave the keys in the door and relocate to London for a while.

The third, and potentially catastrophic, effect of a house-price fall is on building activity: more houses get built as prices rise and fewer as prices fall. As our exports have stalled since 2000, our economy has come to be entirely driven by house building.

Between building new houses and selling existing ones, housing generates almost one-fifth of our national income.

In effect, the economy is based on building houses for all the people that have got jobs building houses. Economists call this a multiplier-accelerator process and it is very unstable.

To see how rapidly a building boom can evaporate, look at Arizona. A rising population led to a building boom that should sound familiar: people queuing overnight to buy houses in new developments; builders increasing prices by a few thousand a week; people paying a down payment of $5,000 on a house and selling it on for a $100,000 profit a few weeks later.

A few months ago, however, rising interest rates brought it all to a halt. Despite incentives like free swimming pools and fancy kitchens, and even at prices below the cost of labour and materials, builders cannot sell, leading to vast empty developments.

The parts of America that had the biggest housing boom are now experiencing falls in house prices of about 15 per cent. The US is now facing a possible recession as house building falls towards its usual bust level of about 4 per cent of national income, from a boom level of 6 per cent.

In Ireland, if and when the fall occurs, it will be from about 18 per cent of national income. We could see a collapse of Government revenue and unemployment back above 15 per cent.

We have spent the last five years learning to believe that exports and competitiveness do not matter, and that we can get rich by selling houses to each other. We are likely to spend a painful few years as we unlearn that lesson.

Pilots define a soft landing as one that you can walk away from. Looking at the collapses in Finland and The Netherlands and the building bust in Arizona, Ireland could be heading for what they call CDIT: controlled descent into terrain. You are happily descending through cloud, thinking yourself at a safe altitude, until suddenly you smack into a hillside.

Morgan Kelly is professor of economics at University College Dublin

2007 - PDF

On the Likely Extent of Falls in Irish House Prices.
Morgan Kelly
February 14, 2007

Looking at house price cycles across the OECD since 1970, we find a strong relationship between the size of the initial rise in price and its subsequent fall. Were this relationship to hold for Ireland, it would predict falls of real house prices of 40 to 60 per cent over a period of 8 to 9 years. House price falls tend not to have serious macroeconomic consequences, but the unusually large size of the Irish house building industry suggest that any significant house price fall that does occur could impose a difficult adjustment on the economy.

The purpose of this paper is to look at the likely behaviour of Irish house prices based on the experience of economies that have gone through similar booms. Looking at nearly 40 booms and busts in OECD economies since 1970, we find that the size of the initial boom is a strong predictor of the size and duration of the subsequent bust.

Typically, real house prices give up 70 per cent of what they gained in a boom during the bust that follows. This is a remarkably robust relationship, holding across very different OECD housing markets over more than 30 years.

Were this relationship to hold for Ireland, it would predict a fall in real house prices of around 40 to 60 per cent, over a period of 8 or 9 years. Assuming an inflation rate of 4 per cent, this would translate into an annual fall of average selling prices of around 5 per cent.

Falls of this magnitude and duration are not unprecedented internationally. For example, the real price of Dutch houses fell by 50 per cent between 1979 and 1987, while the price of houses in Britain relative to real income also fell by 50 per cent between 1948 and 1957.

Britain and the Netherlands illustrate a general point: house price falls, although uncomfortable for some households who bought around the market peak, do not usually have serious macroeconomic effects. Consumption falls as household feel less wealthy, banks experience an increase in bad loans, and fewer houses get built for a while; but the cumulative effect on growth tends not to be large or long-lasting.

Internationally, house prices boom and crash frequently, as economic theory predicts they should. Anytime an economy experiences a period of prosperity and low interest rates, house prices boom for a while, and then fall. The only unusual thing about Ireland in the past is that, thanks to the success of governments in insulating the economy from any risk of economic growth, it has never had a housing boom before.

While house price falls tend not to have serious macroeconomic consequences (the one exception is Finland at the start of the 1980s, where bad housing loans caused the banking system to collapse), they may pose some risk for the Irish economy. Typically, an industrialized economy gets around 5 per cent of its income from building new houses, around the same that it gets from household spending on recreation. Ireland currently derives nearly 4 times this amount from building and selling houses. Any sudden fall of residential investment to normal international, and national historical, levels, could have a substantial impact on national income.

What might trigger a house price collapse? The answer is that nothing is needed: price falls can occur endogenously as buyers revise their expectations of the distribution of reservation prices of other buyers. The increase in Irish housing prices has in large part been driven by expectations of future price increases: this is why house prices have doubled relative to rents since 2000.

Potential buyers can now rent for less than the interest cost of a mortgage (a million Euro house, which involves a monthly interest payment of around e4,000 can be rented for under e2,000) and need be in no hurry to buy once they no longer expect prices to keep rising. Similarly, owners of rental properties are getting returns below the rate of interest: 4% if they rent, or zero if, as in many cases, they leave the property empty (Fitz Gerald, 2005). Once they no longer expect capital gains, they should sell. The decision of potential buyers to wait and see, and for investors to sell, while supply continues to grow rapidly, will put pressure on prices. It is interesting to note that the collapse of housing booms in several US cities in the last few months was not triggered by any economic slowdown, or increase in mortgage interest rates (while US short rates have risen, long rates, on which mortgages there depend, have not), but by the feeling that houses had come to cost more than they were worth.

The rest of this paper is as follows. Section 1 rehearses the relevant economic theory of rational frenzies and wisdom after the fact in asset markets. Section 2 looks at the nearly 40 cases since 1970 where OECD economies have experienced house price rises followed by falls, and shows that the magnitude of the boom is a strong predictor of the size and duration of the subsequent bust. Section 3 shows how the stagnation of rents since 2000 while house prices doubled means that the Irish housing market has not been driven by strong fundamental demand but by a bubble. Section 4 looks at the possible magnitude and duration of house price falls, and their potential macroeconomic effects.

1    Economic theory.

The familiar efficient markets hypothesis predicts that changes in asset prices are unpredictable. The price reflects individuals’ information about asset’s present value, and changes as this information changes. Agents with good information buy, driving up the price, and those with bad information sell, driving it down.

However, instantaneous revelation of information through trade is not possible in house markets due to the very large transaction costs involved. In addition, the market lacks means for individuals to convey negative information through short sales.

As a result, housing markets are better modeled as information cascades: the actions of other agents signal their private information and can cause individuals to ignore their own signals and follow the herd (Bikchandani, Hirshleifer and Welch, 1992). Two models in the cascade literature are particularly useful for understanding the dynamics of housing markets: the rational frenzies model of Bulow and Klemperer (1994) and the wisdom after the fact model of Caplin and Leahy (1994).

Bulow and Klemperer (1994) model rational frenzies in auctions where partici- pants reveal their valuations by bidding. Suppose that there are k items available. If individual reservation prices were known with certainty, everyone would wait until the price fell to just above the reservation price of the k + 1-th highest person, and then all buy together. In practice, only the probability distribution of reservation values is known, and by bidding, or failing to bid, individuals reveal information about their valuations, allowing all participants to update their estimates about the value of the k + 1-th highest reservation price.

As a result, bidders with very different valuations have very similar willingness to pay. Price drops until one person bids. The information this reveals about the true distribution of willingness to pay can set off a bidding frenzy among the other bidders, driving up price again until it becomes clear that price is again above willingness to pay. Bidding then stops, causing prices to collapse until another bidding frenzy starts. To the extent that individuals depart from Bayesian rationality, altering reservation values in response to observed trends in prices, these effects will be amplified.

Caplin and Leahy (1994) look at investment where individuals have Gaussian signals. If the true state is bad, individuals continue to invest, driven by the domi- nating effect of past actions. Eventually, however, because signals are not bounded, a few agents get sufficiently bad signals to induce them to stop investing, causing priors rapidly to move to a belief that the state is bad, leading to a market crash and “wisdom after the fact”.

2    Mean Reversion in House Prices.

Economic theory then predicts that house prices should not follow a random walk, but should be a mean-reverting process of booms and crashes around a slowly increasing trend reflecting the growth of household income. This is what the international data show.

Large falls in real house prices in the aftermath of housing booms are common internationally. Table 1 shows the 18 cases since 1970 where OECD economies have experienced falls in real house prices of at least 20 per cent, along with the previous price rise, and the duration of the fall. It can be seen that, in contrast to stock or currency markets, falls are prolonged, usually lasting 5 to 7 years, with the Netherlands, Switzerland, and Japan all experiencing more than a decade of falls. This reflects the reluctance of sellers to cut nominal prices, meaning that inflation does most of the work in reducing real prices.

Shiller (2006) looks at three long series of real house prices: Amsterdam from 1628 to 1973, Norway from 1819 to 1989, and the United States from 1890 to 2005. In all cases he finds that although there are substantial and long lasting peaks and troughs, there is scarcely any upward long-run trend in prices.

Figure 1 shows the same pattern for smaller OECD economies: the Nordic countries, the Netherlands, and New Zealand, since 1970. The diagram shows the ratio of average house prices to disposable income but real house prices show a very similar pattern. Again, as economic theory predicts, there is considerable volatility and no sign of long-run trends. In contrast to stock price data, the tendency of prices to return to their long run average means that the size of price falls can be predicted from the size of the price rise that preceded them.

Figure 2 plots the size of increase in house prices for 17 OECD economies, against its subsequent fall.1 To estimate the peaks and troughs in each series for each country, we first calculated percentage changes for each quarter. A Friedman supersmoother (implemented in the R statistics package) was then applied to the percentage changes to eliminate short-run fluctuations. Peaks and troughs were then identified as the end of runs of positive or negative changes in the smoothed series, and actual price changes calculated between these points.
Percentage rises and subsequent falls are calculated relative to different values: troughs and peaks respectively. Remember that a rise of p per cent only needs a fall of p/(1 + p) per cent to reverse it. To eliminate this complication, all rises in Figure 2 and subsequent regressions are expressed as a percentage of peak values: for example a rise from 50 to 100 is treated as a 50 per cent rise, rather than a 100 per cent one.

Figure 2 shows that there is a strong linkage between rises in real house prices and subsequent falls. There is one evident outlier corresponding to a dip in house prices in Spain that occurred in the early 1990s in an otherwise continuously up- ward trend that saw real prices quadruple between the mid 1980s and the present.

Table 2 shows a regression of the percentage fall in house prices against their previous rise, both including and excluding the Spanish early-1990s outlier, for real house prices and the house price to income ratio. The slope of −0.7 for real house price means that 70 per cent of the rise during a boom (expressed relative to the peak value) is lost during the subsequent bust.

What is notable about the diagram and regressions is how strong the relation- ship between price rises and falls is. Across very different housing markets in very different economies over a period of more than 30 years, there is a common relationship between the magnitude of booms and subsequent busts. Rent-price series show similar mean reversion but because of the small size of the rented sector in many economies, and the presence of rent controls in part of the period, the data are not as reliable as the real price and price-income series.

As always, national averages conceal substantial variations across regions and types of property. During the last British housing crash, for example„ while selling prices nationally fell on average by 10 per cent, they fell in East Anglia by 40 per cent.

As Table 1 suggests, there is a relationship between the magnitude of real price falls and their duration. Table 3 gives the results of a regression of the average annual rate of house price falls on their magnitude, and shows the two to be closely related. If p is the proportionate price fall, so prices fall from 1 to 1 − p over t years, it follows that r = ln(1 − p)/t is the average rate of decline. Table 3 gives the results of a regression of r on p. For every 10 per cent extra decline in real prices, the annual rate of decline rises by 1.5 percentage points.

3    The Irish housing bubble, causes and consequences.

The evidence of nearly 40 cycles in house prices for 17 OECD economies since 1970 shows that real house prices typically give up about 70 per cent of their rise in the subsequent fall, and that these falls occur slowly.

Before looking at what these numbers may imply for Ireland, it is necessary to dispose of the idea that Irish house prices merely reflect strong fundamentals: rising income and increased household formation due to the age structure of the population, declining household size, rising employment, and immigration.

This argument is hard to sustain. If the rise in house prices were due to increased income and more people needing somewhere to live, we would have observed rents rising alongside house prices. Figure 4 shows how house prices have risen far faster than either rents or income. In fact, while rents doubled relative to income between 1995 and 2000, the ratio has remained unchanged since. The failure of rents to rise, along with the number of recently built units that have been bought but are lying empty (Fitz Gerald, 2005), suggests that the Irish housing market has left the dull world of fundamental values far behind it.

A back of envelope calculation of the fundamental price of housing is the following. Abstracting from maintenance costs (which typically run around one month’s rent) suppose that housing generates an annual rent of n. This is a fraction ν of disposable income y which is expected to grow through time at rate g. The present value of this infinite income stream is then
p= νy/(r−g)
where r is the discount rate. As Figures 1 and 2 and Table 1 show, housing is not a risk-free asset, and this discount rate needs to exceed the risk free rate by an amount reflecting the fundamental risk of the asset. For housing, fundamental rise is large: housing is the largest item by far in most people’s asset portfolio and price changes are strongly correlated with income growth. To be conservative, however, we can assign a value of r of 8 per cent, equal to the long run real return on equities.
The ratio of fundamental price to rent is 1/(r − g). To explain why Irish house prices have doubled relative to rent since 2000 we need to ask if there is any reason to suppose that new information has arrived causing long run estimates of (r − g) to be rationally halved. Ireland’s stagnant exports, diminishing competitiveness, and the increasing structural problems of sectors such as IT and pharmaceuticals, would suggest that estimates of long run income growth for the Irish economy g should have fallen in this period. While it may be the case that increased international demand for quality assets may be driving down equilibrium returns (Caballero, 2006), there is no reason to believe that long run expected returns on risky assets r
have halved in the past 7 years.

As White (2006) has observed, there is considerable variation in price-rent ratios within Dublin, with values in the range 80–100 at the top of the market. These values recall the peaks of the dotcom bubble and can be rationalized, with a dis- count rate r ≈ 0.08, only with real long run growth of income of 6 to 7 per cent, equivalent to a doubling of real income every 10–12 years. This is the rate achieved by Korea during its transition from effectively the stone age to an industrial economy but has not been remotely approached by any rich economy. Alternatively, assuming an equilibrium price-rent ratio in the region of 15, it suggests that large falls in prices, of the order of 85 per cent, might be needed for the top of the market to return to fundamental value.

While other parts of the market appear less over-valued, they are still expensive by international standards. The Global Property Guide website reports that the average Dublin apartment rents for around 4% of its purchase price. Only Madrid among major cities has a lower ratio. By comparison, London apartments return nearly 6%, and Amsterdam and Paris over 8%.

4    International Perspectives on the Irish Housing Bubble.

Were Ireland to experience the same housing dynamics as every other OECD economy, except Spain in the early 1990s, what sort of price changes might be expected? Recall that Table 2 predicts a 7 per cent fall for ever 10 per cent rise (relative to peak values) of real prices from their trough level, with a standard error of 10 per cent.

Since the mid 1990s, real house prices have risen from an index level of 100 to around 350, and increase in terms of peak value of 70%. If seventy per cent of this rise were to be subsequently lost, the predicted fall in real house prices would be 50 per cent with a standard error of 10 per cent. In other words, a 68 per cent confidence interval for price falls would be in the range of 40 to 60 per cent. There would be one chance in eight of a price fall of only 30 to 40 per cent, just as there a predicted one chance in eight of a fall of 60 to 70 per cent.

Similarly, Table 2 predicts, given an approximately 70 per cent rise in the price income ratio, that the price income ratio will fall by around 60 per cent, with a standard error of around 12.5 per cent.

A fall in real prices of 50 per cent from Table 3, implies a predicted annual rate of decline of around 9 per cent, with a standard error of approximately 1.5 per cent. This translates into a decline of around 8 years, of the same order of magnitude as that experienced in the Netherlands in the 1980s or Britain in the 1950s. Assuming an inflation rate of 4 per cent, this implies an annual fall in selling prices of 5 per cent.

These estimates may be unduly optimistic. In all the housing cycles on which the regression was based, housing stock was, for practical purposes, fixed. In Ireland, by contrast, the number of housing units is growing at around 5 per cent per year, which would suggest the potential for larger falls than those experienced in other OECD housing slowdowns.

The prediction that Ireland may experience house price falls in the range of 50 per cent, is a good way from the OECD estimate (Rae and van den Noord, 2006) that Irish houses are overvalued by only around 20 per cent. However, the OECD methodology, and that of similar studies, is problematic. Such studies run a regression of house prices on interest rates, disposable income, employment and other fundamental variables. The regression residuals are then equated with the degree of over- or under-valuation in the market.

To see the difficulty with this approach, suppose that Irish house prices had increased twice as fast as they did, so the regression residuals would double in value. Instead of saying that house prices are over-valued by one hundred and twenty per cent, the residual approach would say that they are overvalued by only forty per cent.

House price falls have three effects. First, households feel less wealthy and consume less. Evidence from the United States points to a final long-run marginal propensity to consume from housing wealth of around 10 per cent: a $100,000 rise in property values, increases household consumption eventually by a total of $10,000 (Carroll, Otsuka and Slacalek, 2006). Secondly, banks face more bad loans, and become more cautious in their lending, leading to further falls in credit- worthiness through the standard financial accelerator. Finally, the value of Tobin’s q for residential investment falls, reducing house building. Most countries devote about 5 per cent of national income to building houses and in a typical housing bust, this falls to around 4 per cent of national income.

In most cases then, housing busts are uncomfortable, but not macroeconomically disastrous events. How about Ireland? There is some evidence that the wealth effect on consumption might not be as strong as in the United States: there has been no fall in personal saving in Ireland during the housing bubble, and households have not consumed home equity through second mortgages. Similarly, the larger banks which dominate lending are well capitalized and the banking system has, until recently at least, avoided the worst excesses of the sub-prime mortgage market, although it is likely that many interest-only and 100 per cent mortgages could go sour, especially given the ease with which delinquent borrowers can relocate to England.

It is the scale of the Irish house building industry that makes a fall in house prices potentially troubling. While most economies derive only 5 per cent of their income directly from residential construction, in Ireland house building accounts for around 15 per cent of national income, with another 3 per cent coming from selling houses.

Effectively, the recent growth of the Irish economy looks similar to the unstable case of an old-fashioned multiplier-accelerator model. The employment growth in the Celtic Tiger period of the 1990s led to increased demand for housing, reflected in rising real house prices and rent to income ratios. This stimulated house building, which generated more employment, leading to more demand for housing, and so on. Effectively, the Irish economy has come to be driven by building houses for all the people whose jobs have come, directly or indirectly, from building houses.

It is hard to envisage how a fall in house building from 18 per cent to 5 per cent of national income might be achieved without considerable macroeconomic dislocation. Building booms, moreover, tend to end suddenly: the example of Arizona in the summer of 2006 shows how a housing market can move in the space of a few months from buyers queuing overnight to buy, to empty tracts of new houses being priced below construction cost and still failing sell.

5 Conclusions.

This paper has taken an international perspective on the Irish housing boom. We have shown that there is a close relationship historically across very different economies and housing markets between the size of increases in real house prices, and subsequent declines. If this relationship were to hold for Ireland, the expected fall in average real house prices is in the range 40 to 60 per cent, over a period of around 8 years. Such a fall would return the ratio of house prices to rents to its level at the start of the decade. Given the unusual reliance of the Irish economy on building houses, the effects of any such fall on national income may be somewhat larger than that experienced at the end of other housing bubbles.

Policy implications are straightforward. Booms and busts are a normal part of property markets. The government did not cause the current boom, and is power- less to do anything about a subsequent bust.

Blanchard (2006) has observed that Euro-area economies appear at risk of ro- tating recessions: increased domestic demand drives up real wages and erodes competitiveness, but the impossibility of devaluing means that prolonged rises in unemployment become the only means to reduce real wages. Notable current ex- amples are Italy and Portugal. There may be some risk that the sharp fall in Irish competitiveness since 2000, which has been disguised and, to some extent, caused by the construction boom, may require a lengthy period of high unemployment to reverse.


Bikchandani, Sushil, David Hirshleifer and Ivo Welch. 1992. “A Theory of Fads, Custom, and Cultural Change as Informational Cascades.” Journal of Political Economy 100:992–1026.
Blanchard, Olivier. 2006. The Difficult Case of Portugal. Working paper Department of Economics, MIT.
Bulow, Jeremy and Paul Klemperer. 1994. “Rational Frenzies and Crashes.” Jour- nal of Political Economy 102:1–23.
Caballero, Ricardo. 2006. On the Macroeconomics of Asset Shortages. Working Paper 12753 NBER.
Caplin, Andrew and John Leahy. 1994. “Business as Usual, Market Crashes, and Wisdom after the Fact.” American Economic Revieww 84:548–565.
Carroll, Christopher D., Misuzu Otsuka and Jirka Slacalek. 2006. How Large Is the Housing Wealth Effect? A New Approach. Working Paper 12746 NBER.
Fitz Gerald, John. 2005. “The Irish Housing Stock: Growth in the Number of Vacant Dwellings.” Quarterly Economic Commentary pp. 42–63. Spring.
Rae, David and Paul van den Noord. 2006. Ireland’s Housing Boom: What Has Driven It and Have Prices Overshot? Working Paper 492 OECD Economic Department.
Shiller, Robert J. 2006.    “Long-Term Perspectives on the Current Boom in Home Prices.” The Economists Voice 3(4).    Available at
White, Rossa. 2006.    Dublin House Prices Heading for 100 times Rent    Earned.    Technical    report    Davy    Stockbrokers.    Available at

The great property debate
Sunday, April 15, 2007

With wildly varying predictions about the future of the housing market, The Sunday Business Post asks two experts if there will be a crash.

Yes: Housing market is sailing into a perfect storm
By Morgan Kelly

Now that ‘for sale’ signs have become permanent fixtures on the landscape, and even the dimmest cheerleaders for the property sector have given up pretending that there is going to be a soft landing, it is worth asking how far house prices are likely to fall, and what effect this will have on the Irish economy.

It is hard to be optimistic. Based on the experience of other economies that have had similar bubbles, we can expect the real price of houses to fall by around half over the next eight or nine years, and possibly by a good deal more.

This fall in house prices will cause a sudden collapse in house-building activity, which now accounts directly for an astonishing 15 per cent of our national income.

First we need to dispose of the transparent myth that the boom in Irish house prices simply reflects the strong fundamentals in the market. To see that this is false, we need only look at what has happened to rents. If fundamental demand for housing were strong, we should have seen rents rise along with house prices.

In fact, while real houseprices have doubled since 2000, rents have remained more or less static. You can rent a million-euro house in Dublin for well under €2,000 a month.

Were you foolish enough to buy it, the interest alone on the mortgage would cost more than €4,000. The average rent-to-price ratio in Dublin has fallen to about 4 per cent- a low return on what people are starting to discover to be an asset with considerable fundamental risk and barely above 1 per cent at the top of the market.

This recalls price-earnings ratios at the peak of the dotcom bubble. And rents are likely to fall as vendors realise they are unlikely to sell any time soon and start to let properties to pay some of the mortgage.

By how much can we expect house prices to fall? Looking at 40 housing booms and busts since 1970, I found a remarkably consistent pattern across very different economies (the report, On the Likely Extent of Falls in Irish House Prices, can be seen on my website in UCD).

Adjusting for inflation, housing markets typically give up 70 per cent of what they gained in a boom during the subsequent bust.

For Ireland, where real house prices in the mid-1990s were only 30 per cent of what they are now, this would imply a fall in the range of 40 to 60 per cent.

This is a prediction for average prices: typically properties at the bottom and, especially, the top of the market fare much worse than those in the middle.

Falls of this magnitude are far from unprecedented internationally: both the Netherlands in the 1980s and Finland in the early 1990s saw real house prices fall by half. Unlike stock price crashes, housing busts are extremely prolonged: more like the flooding of New Orleans than a tsunami.

Just as Republican officials kept denying there was anything wrong until the water was up to their necks, we can start looking forward to estate agents telling us that the worst is over; a necessary correction to an overheated market has taken place; there has never been a better time to buy; and so on, until most of them go out of business.

Busts of the magnitude that we are beginning to experience typically last eight to ten years. Assuming our inflation rate goes back to about 2 per cent, a halving of real house prices would entail annual falls in the selling price of houses of about 6 per cent, lasting for about nine years. Aside from the anguish that will be endured by those who have been conned into mortgaging their lives away to buy houses at grotesquely inflated prices, the macroeconomic reason to be terrified of a housing crash is its effect on the building industry.

Most economies, including Ireland until a few years ago, get only about 5 per cent of their income from building houses: less than households spend on recreation.

In Ireland now, house building accounts for almost one sixth of national income. And that is not counting the jobs processing new mortgages, insurance and title transfers; retailing furniture and carpets; advertising houses; or the indirect effects of these incomes on the rest of the economy.

When house building returns to its equilibrium level of 4 to 5 per cent of income, the effect on employment and government finances can only be catastrophic.

Building contractions are sudden: Arizona’s building boom looks eerily similar to ours - between May and November last year, housing starts fell from 8,000 per month to 3,000. Given the recent 25 per cent fall in planning applications, we can expect large falls in employment in the building sector, once current projects are completed.

Contrary to popular belief, more than 80 per cent of building workers are Irish: they are not going to get on a plane to Gdanskand disappear from the unemployment statistics.

Because the Irish economy has come to be based on building houses for all the people that have got jobs building houses means that our estimate of a 50 per cent fall in house prices may be unduly optimistic.

Other economies that experienced large housing bubbles had stocks of houses that were more or less fixed. By contrast, 15 per cent of our housing units are empty, bought by speculators to realise capital gains, while the supply of housing is growing at about 5 per cent a year.

The supply of houses on sale is likely to explode, as speculators scramble to unload the 210,000 empty units they are holding, along with the 80,000 or so new houses that will be built this year.

As this enormous supply collides with falling demand caused by expectations of further price falls, and falling employment in building, Ireland may be heading for a fall in house price that is without international precedent.

Along with our sharp fall in competitiveness and the structural problems of the IT and pharmaceutical sectors, the likelihood of further rises in interest rates, and the possibility of a hard landing for the US economy, the Irish economy is sailing blithely into something that is starting to look like a perfect storm.

Morgan Kelly is an economics professor at UCD.

No: Expectations of a soft landing are realistic
By Pat McArdle

House prices have been rising for longer than most of us can remember.

Since buying a house is usually the biggest financial decision of one’s life, it is understandable that the fear of a collapse in prices is a very real one.

And the reality? In my opinion, we are well on the way to a soft landing, but you would expect me to say that wouldn’t you? Well let me outline my thinking and then draw your own conclusions.

House prices across the developed world have surged since the mid1990s - with the exception of Germany and Japan, which are both still suffering the after effects of spectacular bursts early in that decade.

There is no room for complacency - housing collapses do occur. In fact, someone has calculated that, of the 37 booms between 1970 and 1995, no fewer than 24 ended in downturns which wiped out between one-third and 100 per cent of previous real gains (ie, inflation-adjusted).

This foreign experience provides a handy starting point for some commentators. As booms are usually followed by busts, surely the same fate will befall us.

It is, however, the lazy man’s approach, invariably with no attempt being made to examine the peculiarities of the Irish situation or the possibility that we might have a soft landing in common with the other third of our neighbours.

We will call it the lazy foreign comparison approach. Needless to say, I have little time for it. Another approach could be termed the academic model.

This involves the use of large, frequently complex models such as those developed by the IMF, the OECD and the ESRI, to derive a ‘fundamental’ value for housing. Some such models presented in recent Central Bank Stability reports show that house prices are overvalued by anything from zero to 70 per cent.

In its latest Quarterly Economic Commentary, the ESRI opined that the figure was 15 per cent.

Last year, the OECD produced a model which concluded that prices were 20 per cent too high. It will be immediately obvious from the range of results that something is amiss with this approach.

Data inadequacies and imperfections render such exercises speculative at best.

These limitations and qualifications usually show up in the overall assessments that accompany these studies, but which get less publicity. For example, the OECD stated that ‘‘a soft landing appears the most likely prospect’’ in its synopsis of the study in question. Similarly, the Central Bank concluded that house prices were not out of line with fundamental factors.

The reality is that model-based approaches have yet to overcome data limitations and, indeed, may never do so. Consequently, the margin of error associated with anything they produce is quite large.

All this is not very helpful, but could be summarised by saying that the academic model approach points to some, perhaps modest, overvaluation in the Irish housing market. This is a conclusion which would strike many as reasonable. It does not necessarily mean that a fall in prices is imminent as such overvaluations can be eradicated over time as house prices rise by less than incomes.

The third, and most common, approach is the ‘‘next man at the bar counter’’ analysis. Proponents of this usually look at loan to income ratios and reminisce about the good old days when a mortgage of two and a half times income was the most one could aspire to.

With multiples of five or more times salary now common, it is surely only a matter of time before the roof caves in.

These simple comparisons are still surprisingly common. The first to use them, as far as I can recall, was the Economist Magazine, which concluded in 2002 that prices were overvalued by 42 per cent.

Banks use affordability as the key lending criterion. This captures not only the increase in incomes but also the improvement in affordability that results from interest rates that are still way below the double-digit levels that were common in the past. It also reflects the improvements that arise from the radical overhaul of the income tax system.

These days, a married couple, each on the average wage, can expect to take home almost 90 per cent of their gross earnings. In the late 1980s, the corresponding figure was about 73 per cent. Any assessment of housing which ignores these changes is not much use.

Irish house prices have been static for several months. The annual rate of increase may be 9 per cent, but the monthly rate of increase has averaged less than 0.1 per cent since last autumn. This may partly reflect speculation about stamp duty, but that is only one factor.

The decline in the rate of growth began as far back as last May.

The cause can be traced to affordability and, in particular, to the impact of rising mortgage rates, which squeezed the first-time buyer.

The third major influence was the remarkable response of the construction industry. Unlike Britain, where supply is a problem, Irish builders and developers raised housing output nearly fivefold since the early 1990s.This combination has brought supply and demand finally into balance, with the result that prices are no longer rising.

The three main risks to housing are interest rates, unemployment and oversupply. The first two are not serious risks, given that interest rates are still low and we have full employment.

As regards the third, it seems that housing output is contracting modestly - evidence of a continued flexible response by the construction sector, which realises that a housing slump is in nobody’s interest. So it is a case of ‘‘so far so good’’.

My view is that fundamental economic conditions are broadly unchanged over recent months.

However, what has changed is the reporting of events, with a focus on the downside that was not there previously.

At this stage, the biggest risk to housing may well be confidence. That apart, I believe that the demographic and other influences are such that we can reasonably look forward to a soft landing and, with it, more modest but reasonable levels of activity in the future.

Pat McArdle is chief economist at Ulster Bank.

April 17, 2007

Banking on very shaky foundations
Morgan Kelly
Fri 09 Sep 2007

Economics: [i]While there has been a lot of interest lately in the possible risk to banks from subprime loans, nobody seems terribly concerned by the large and rapidly-growing exposure of Irish banks to property speculators, writes[/i] [b]Morgan Kelly[/b].

Irish banks are now owed almost as much by builders and developers as they are by mortgage holders, and are now more exposed to commercial real estate than Japanese banks were when they crashed in 1989.

While mortgage lending has slowed since the middle of last year, lending to builders and developers continues to grow rapidly and now stands at almost €100 billion, an increase of €20 billion on last October.

To put this in perspective, €20 billion is twice the market value of Bank of Ireland shares; while €100 billion is the approximate value of all public deposits with retail banks. Effectively, the Irish banking system has taken all its shareholders' equity, with a substantial chunk of its depositors' cash on top, and handed it over to builders and property speculators.

In fact, if you leave out the quarter of mortgages that are for buy-to-let property, itself a small-time form of property speculation, lending to developers is now €20 billion more than lending to people to buy their own homes.

In 2000, lending to construction and real estate made up only 8 per cent of Irish bank lending, much like other European countries. Now it has risen to 28 per cent. By comparison, just before the Japanese bubble burst in late 1989, construction and property development had grown to a little over 25 per cent of bank lending.

Increased lending for construction and development is driven by banks' urgent need to meet earnings expectations and is unavoidably risky.

While most home owners will continue to pay mortgages, even with negative equity, international experience shows that developers will walk when markets turn down, leaving banks, and often governments, to pick up the pieces. Diversification for lenders is difficult, moreover: when one developer goes bust, they typically all go bust.

While lending to builders, at €25 billion, is a good deal smaller than the €75 billion lent to real estate speculators, many of the loans appear to be in difficulty already.

During the property boom of the last decade, a mutually profitable symbiosis emerged between banks and builders. Banks would provide lines of credit at a generous mark-up over wholesale interest rates for builders to buy and develop sites, and builders would pay off the loans once they sold the new property, which they were often able to do before a single brick had been laid.

The arrangement between banks and builders was fine so long as sales of new houses did not slow, leaving builders unable to repay loans. Since the start of this year, sales of new houses have not slowed, they have entirely collapsed.

A Dublin estate agent told me that whereas last year they sold more than 3,000 new units, this year they have sold fewer than 100. They are about to try to launch one of their new developments for the third time, the first two launches having netted exactly no buyers.

While the market for secondhand houses still limps along, people have stopped buying new houses because they are afraid that developers will eventually slash prices and leave them with negative equity. They are right.

My contact told me of one heavily marketed development where they have taken deposits on €750,000 apartments and are now anxious to get the buyers to sign contracts so they can cut the prices of the many remaining units to €600,000.

It is ironic that the Government's abolition of stamp duty for first-time buyers has allowed them to escape entirely from the new housing market.

What was intended as a dig-out for the building industry may turn out to be one of the last nails in its coffin.

Given that nobody wants new houses, it is natural to ask who is going to buy the 80,000 or so units that will be completed this year and the 60,000 on stream for next. The answer, though they may not know it yet, is the shareholders of Bank of Ireland, Anglo Irish and other builder-friendly banks.

While we can see banks starting to make a show of turning up the heat on smaller developers, they have lent too much to large builders to allow them to fail. It is one thing to chop a developer off at the ankles if he owes you €16 million; it is quite another to admit that a developer in south Dublin owes you €160 million, let alone to force him into bankruptcy.

Were any one of the several Dublin developers, who are reputedly unable to service any of their large borrowing, to be driven into bankruptcy, the ripple effect on Dublin house prices and the value of other loans would be unpleasant.

Along with the many loans to builders that are already in the non- performing category, the exposure to commercial real estate poses a grave threat to bank solvency, because of the large sums involved and the highly leveraged nature of the borrowing.

Commercial real estate borrowing during booms follows the same pattern everywhere. You put up 20 per cent of the price of an office block or warehouse and borrow the rest. As prices rise, you use the equity gained in the first property as collateral for an 80 per cent loan on a second property and so on, as long as prices keep rising.

In Dublin, the 5 per cent rental yield allowed banks to charge a 5 per cent interest on commercial real estate loans so investors could use rental income to cover interest payments while they sat back and enjoyed double-digit capital gains.

With lending rates based on five- year euro swaps now risen to over 6.5 per cent and rental yields fallen to 4 per cent, new investors cannot cover interest from rent and are entirely reliant on capital gains from rising prices. With commercial property prices slowing rapidly, and loans taken out a few years ago needing to be rolled over, there is a strong risk of a sudden exodus from the market and a collapse in prices.

The large exposure of Irish banks to property speculators does not mean large losses are inevitable. If a crash occurs, or even if already nervous overseas bond markets cut off liquidity to Irish banks (foreign banks have over €400 billion on deposit with Irish banks and hold another €200 billion of bonds), it will be very costly to fix, dwarfing the bailout of AIB in the 1980s.

A partial bail-out of Japanese banks cost their government 10 per cent of national income, while refloating Finnish banks cost its government nearly 15 per cent of national income. In Irish terms this would translate into a €15 to €20 billion bill for taxpayers.

You probably think that the fact that Irish banks have given speculators €100 billion to gamble with, safe in the knowledge that taxpayers will cover most losses, is a cause of concern to the Irish Central Bank, but you would be quite wrong.

At a recent Irish Economic Association discussion of house prices, the Central Bank official in charge of financial regulation (whose publications with the ultra-libertarian Cato Institute strongly oppose any form of bank regulation - a real case of an atheist being appointed an archbishop) stopped the proceedings to announce that the view of the Bank was that, as long as international markets were happy to buy debt issued by Irish banks, there could be no problem with their lending policies.

We can only hope that this insane logic is correct and that the refusal on ideological principle of bank regulators to regulate banks does not lead to the same debacle here that occurred with savings and loan institutions in Reagan-era America.
Head to Head
Monday, October 8, 2007

Are we heading for a property crash?  Morgan Kelly says we can expect prices to halve in real terms over the next few years while  Austin Hughes disagrees, saying we are seeing a healthy, short-term correction in property prices.

Yes - Morgan Kelly:

As the Bertie Bubble of 2000 to 2006 fades into the distance, the question is no longer whether the Irish property market will have a soft or hard landing, but what kind of hard landing it will have. Will prices fall gradually over a decade, or rapidly over two or three years? And as the building industry sinks, will it drag the banks under as well? Property bubbles are nothing unusual: sudden affluence invariably leads to a collective lapse of rationality where people start to believe the utterances of estate agents, developers and other spivs. House prices boom for a while and then, as common sense gradually filters back, fall back to their previous level.

In Ireland between 2000 and 2006, house prices doubled relative to income and rents. Based on what happened after other European booms we can expect prices here to halve in real terms over the next few years.

Ten per cent of housing units in Irish cities are vacant, and almost none of the 70,000 or so new units built this year have been sold: a Dublin estate agent told me that whereas last year they had sold over 3,000 new units, so far this year they have sold fewer than 100. With Dublin house prices down about 10 per cent already, there is a real risk that panic-selling by investors and builders will spark a price crash.

Eliminating stamp duty will not help: so long as there is a large stock of unsold houses, buyers will stay out of the market for fear of further price falls, and these expectations will be self-fulfilling.

Commercial property also looks shaky: investors are now borrowing at 7 per cent interest to buy offices and warehouses that yield rents of 4 per cent. With rising vacancy rates and increasing supply, we can expect sharp price falls.

On the face of it, a fall in house prices should not be a disaster. The value of mortgages to buy your own home is only 50 per cent of national income here, compared with 75 per cent in Britain and the US, and 125 per cent in Switzerland. Massive transfers of wealth from the young to the old in Ireland are a figment of journalistic fantasy.

(Admittedly, mortgages to buy investment apartments and join commercial property syndicates equal another quarter of national income, but the gambling losses of the rich and greedy should not be near anyone's conscience.) But a large minority of borrowers have crushing, unsustainable mortgages and large negative equity will force many borrowers into bankruptcy As competitiveness has fallen, the prosperity of the Irish economy has come to be based on selling houses to each other. Nearly 15 per cent of our national income comes directly from building houses, three times as much as other industrialised economies. Large falls in employment are inevitable as building slows to a saner level, and do not forget that only 15 per cent of building workers are foreign born.

With spending on house building 10 times as large as spending on roads, no conceivable increase in infrastructural spending can compensate for job losses in residential construction.

While housing starts have halved since last year, the surprising thing is that any new houses are being started at all given that few, if any, are going to sell. The reason is that banks are owed so much by large developers that they cannot allow them to fail, and are allowing them to go on borrowing as if nothing is wrong.

Irish banks are now more exposed to property speculators than Japanese banks were when they imploded in 1989. Banks have lent almost €100 billion to developers, compared with only €80 billion to people to buy their own houses.

With no new houses being sold, it is unclear how developers are coming up with annual interest payments of around €6 billion (or 4 per cent of national income). Were one large developer to be allowed to go bankrupt, the value of the land used as collateral by other developers would collapse in value, setting off a spiral of bankruptcies.

The Irish economy is now looking eerily like the Nordic economies in 1992. Norway, Finland and Sweden all had house price and building booms in the late 1980s that encouraged banks to lend heavily to developers. But as house prices fell, developers walked away from their loans and banks collapsed.

The Finnish collapse was particularly spectacular, with unemployment going from 3 per cent to 20 per cent, national income falling by 15 per cent, house prices and share values down 50 per cent, and land prices falling by over 75 per cent. Recapitalising its banks cost the Finnish government over 20 per cent of national income.

While our football and rugby teams have disappointed lately, our builders and bankers may yet do us proud and effortlessly clear the bar for catastrophic avarice and stupidity raised by the Finns nearly 20 years ago.[b] Morgan Kelly is professor of economics at University College Dublin[/b]

No - Austin Hughes:

We are now seeing a marked slowdown in the Irish housing market. For many, familiar only with the exceptional buoyancy of recent years, this is a strange and scary experience. However, it doesn't mean we face a collapse in house prices.

We live in a world where every reversal seems to threaten a major calamity. But not every shower brings with it a flood. Not every cough threatens a fatal ailment. Not every sporting defeat spells catastrophe for the nation. In spite of headlines and hysterics, life usually goes on. Although this is a testing time for the housing market, the risks of a collapse shouldn't be exaggerated.

The main reason why a house price collapse is unlikely is that the key driver of the current slowdown - a sequence of interest rate increases every two or three months since December 2005 - now appears to be at an end. Although the European Central Bank may continue to threaten further increases, falling US interest rates, record highs for the euro against a faltering dollar and weaker business sentiment in continental Europe combine forcefully to argue that the next substantive ECB policy change is more likely to be downwards rather than upwards. Before long, interest rate changes should support rather than soften Irish house prices.

Another reason why Irish house prices should not collapse is a surprisingly sharp and speedy response by builders to softer sales. A substantial drop in housing starts means that the bulk of the current correction in the housing market is likely to occur through weaker activity levels rather than markedly lower prices. If house building falls to around 65,000 units next year, it will keep Irish house prices roughly 10 per cent higher than would have been the case if building remained at last year's levels.

It is sometimes suggested that, even if building is curtailed, the market still faces a problem of too much supply. Without doubt, there are mismatches in terms of location and/or type of accommodation that make for excess supply in some areas. In the near term, this will keep prices soft. However, double-digit rent increases suggest that underlying demand for accommodation remains strong and supply is not excessive. Indeed, compared to most European countries, Ireland's housing stock is still low relative to our population.

While alarmist noises are often made about the number of "empty" houses, last month's IMF report on Ireland shows the proportion of unoccupied dwellings here is slightly below the EU average. A surge in spending power that made ownership of holiday homes and accommodation for children at college almost commonplace is one element in this rise in so-called "empty" homes.

The scale of house price increases Ireland has seen may make some readers nervous. However, the Irish economy has undergone a transformation that is extreme in many ways. If it seems crazy that new house prices are now nearly 50 times higher than they were in 1970, it is even more astonishing that the money value of activity in the Irish economy is more than 70 times greater.

Increased prosperity has naturally translated into more expensive property. A surge in population in the past decade associated with a virtual doubling of employment, a halving of borrowing costs and dramatic gains in after-tax incomes have contributed forcefully to higher house prices. The unique transformation experienced by the Irish economy also means that many simple cross-country comparisons of house price changes can be dangerously misleading.

The slowdown is sharper than I expected. Softer house prices owe a great deal to higher interest rates. However, the fiasco surrounding stamp duties and some doom-laden predictions have also had a significant impact. As a result, there is a strong case for confidence-enhancing measures in the upcoming budget, not to avoid a normal correction in the market, but to prevent unnecessarily nervous conditions persisting through early 2008.

On average, Irish house prices are now around 2 per cent below the levels of a year ago. This conceals a range of circumstances. It is sometimes suggested that a definition of a downturn is when someone else loses their job, whereas a depression is when you lose yours. In the case of the Irish housing market, the personal experience of some would-be sellers may now be approaching what they would describe as a "collapse", but across the market as a whole, the softening is more limited.

The broad slowdown we have seen is, in general, a healthy correction, and in the next few months, softer prices could well persist. However, with better news on borrowing costs, a sensible budget, lower levels of building and a resilient Irish economy, I would be confident that a house price collapse will be avoided. Indeed, a modestly improving trend in house prices in a more stable market should become evident during 2008.

Austin Hughes is chief economist with IIB Bank

2008 ... 95499.html 
Property market approaching critical point
18 Jan 2008

The economy may be about to enter a period of prolonged recession, writes Morgan Kelly , the economist who predicted the property slump

Writing in this newspaper a year ago, I suggested that, in the light of past property booms abroad, Irish house prices were at risk of falls of around 50 per cent in real terms. At the time I imagined, again based on what had happened elsewhere, that selling prices would stabilise at their peak values for a year or two, and then fall slowly by a few per cent a year for up to a decade.

My forecast has turned out to be wildly optimistic. In the past year Irish house prices appear to have fallen by around 10 to 15 per cent. While still short of the 20 per cent fall in Finland in 1991, this is on a par with the largest falls experienced during the Dutch and Swedish collapses.

However, the Irish property market is giving signs of approaching a critical point where vague individual anxieties coalesce into a general panic and prices collapse. Should a collapse occur in 2008, it is most likely to start among heavily-indebted builders, many of whom have not sold a house in over a year, coming under pressure from banks to liquidate their large amounts of unsold inventory.

What has made the Irish house price boom different from any other (apart from the concurrent boom in Spain) is that it has occurred alongside a building boom. In most economies, the housing stock is overwhelmingly second-hand houses whose owners are reluctant to accept price cuts. When a downturn occurs, most people refuse to sell and the market effectively dries up for a few years until prices rise again. In Ireland, by contrast, the supply of houses has expanded rapidly: at the peak of the boom in 2006 we built almost 90,000 units, or one for every 16 households. This fell to around 70,000 last year and, ominously, a large proportion of these failed to sell.

This raises the question of why, given the number of unsold houses, builders are planning to build another 50,000 or so units this year? Once we know the answer to this question, we are in a position to understand why Irish house prices are now at risk of sudden and large falls.

To start, we need to remember that, because of delays in the planning process, this new building represents projects undertaken by developers in the very different climate of two years ago. There are now two distinct groups of developers.

The first group own land, typically have vivid memories of how their fathers and uncles went bankrupt in the 1980s, and have all stopped residential construction. The second group, who are by no means the smallest developers, have borrowed heavily to buy land and have no choice but to keep on building.

If you are a builder who borrowed €20 million in 2006 from a bank and some mezzanine investors to buy land for 100 houses and have just received planning permission, you have no option but to go ahead and use your remaining €11 million credit line to build the houses and hope for the best. However, at some stage this loan will have to be repaid, at least in part, and the only way to do this is by selling houses at whatever price you can get.

For their part, banks are now in the position of throwing good money after bad: having lent money for land which has depreciated in value, they are lending more money to build on it in the hope that they can recoup their losses, or at least delay the inevitable change in value that may leave some of them with solvency problems of their own.

However, with the recent bankruptcy of McEnaney Construction, banks have sent a definite signal to developers that their patience and liquidity are finite. Despite their understandable reluctance to initiate a downward price spiral, in the next few months increasing numbers of developers will be forced to follow the lead of Capel Construction and cut prices by 20 per cent and more.

However, just as expectations of price rises were self-fulfilling, so now are price falls. Buyers know that the longer they delay the less they will pay, and have the added fear of negative equity to keep them out of the market.

It is appearing increasingly unlikely that builders will be able to move their inventory at any price that can remotely cover their borrowings, making a wave of bankruptcies inevitable.

The houses built by a bankrupt developer become the property of the lending bank, which would typically auction them off, in one or more lots, to other developers.

However, for these developers to be able to bid, they need loans from banks. With Irish banks already having sunk €100 billion into property development, and needing to conserve liquidity as the international financial system moves towards a major solvency crisis, such loans may not be forthcoming. It is not hard to imagine a scenario where tens of thousands of new units built by bankrupt developers are sold for a fraction of their construction cost or simply boarded up, leaving most existing apartments and commuter-belt houses effectively valueless.

Any collapse at the bottom end of the market will roll upwards to reduce second-hand prices sharply, while the presence of large number of families who cannot move house because they have negative equity will ensure that the second-hand housing market remains frozen for a very long time.

With rising unemployment, falling tax revenues, and sharp falls in stock prices, it is becoming evident that the problems of the Irish economy run a good deal deeper than a few overpriced houses.

The building boom of the last eight years has deeply distorted the economy, leaving us with worrying numbers of mis-skilled workers, heavily indebted households, unaffordable Government programmes, and over-extended banks.

Most importantly, as the Irish economy moved from one driven by exports to one based on selling houses, its international competitiveness has fallen sharply.

While the word competitiveness had vanished from our national vocabulary, the examples of Germany, Italy and Portugal are there to show how a domestic boom with falling competitiveness tends to be followed by prolonged recession. ... 71568.html
Loans to builders big threat to banks
April 7, 2008

Credit default swaps underwrite banks' risks when they borrow money. As this cost rises, institutions are left vulnerable, writes MORGAN KELLY

WHILE THE recent roller-coaster ride of Irish bank stocks has been grabbing attention, more important and potentially more worrying developments have been taking place in a market of which few people have heard: the market for credit default swaps (CDSs).

Just as people buy insurance against default when they take out mortgages, so do banks when they borrow in the wholesale market from other banks. The rate of insurance they pay is determined in the CDS market.

Last summer, it was costing banks less than 30 cent to insure every € 100 they borrowed. Now insurance is costing Irish-owned banks between €2 and €3.20. Given a base borrowing rate in wholesale markets of just more than 4 per cent, Irish banks are having to pay from 6 per cent to more than 7 per cent to get funds.

This steep rise in insurance rates reflects two things: the growing nervousness in financial markets about the bad lending of US banks; and concerns about the exposure of some Irish banks to loans to builders and developers.

Lending to developers is risky. As property markets slow, banks quickly go from having hardly any impairments on these loans to suffering very large losses indeed. In the last, and far from apocalyptic, downturn in the US in 1991, banks lost 12 per cent of what they had lent to developers.

To operate profitably, banks hold little capital compared with the loans they make, usually about 7 per cent. This means that relatively small losses on loans are enough to seriously impair their functioning, and so banks usually lend cautiously to developers.

Irish banks, however, have given nearly 30 per cent of their loans, some €105 billion, to builders and developers. A loss of 12 per cent on these loans would halve their effective capital, leaving them in need of heavy recapitalisation.

Exposure to developers, moreover, varies widely across banks, from zero to more than 90 per cent. There is a risk that difficulties in one heavily exposed institution might set off a domino effect of depositor panic (current levels of deposit insurance are wholly inadequate) and forced asset sales across the entire system.

It is not inevitable that banks will suffer such heavy losses. Bankers are paid to manage risk, and we must hope that they have done so competently. However, two things will prove particularly testing for banks in the coming year: loans to house builders and the narrowness of the Irish market for commercial property.

During the housing boom of 2000 to 2006, banks lent freely to builders, and loans rose in step with housing starts. Now, although housing starts have fallen sharply, loans to builders have continued to rise, to €25 billion. This could suggest that some builders with unsold houses are having difficulty repaying loans.

Despite some of the highest commercial rents in Europe, rental returns in Dublin, at below 4 per cent, have long been below interest rates, and the market came to be a classic bubble driven by expectations of capital gains. These capital gains were generated in turn by bank lending: with a more or less fixed number of properties coming on the market each year, by increasing their lending annually by 20 per cent, a handful of banks could effectively drive up prices by 20 per cent.

In its heyday then, the market worked like this: developers would buy a property and pay the difference between rent and interest for two to three years as the price rose ("adding value"). Then they would sell on to other developers (often syndicates of affluent amateurs capitalised by second mortgages) or a property fund.

The first signs things were going wrong appeared earlier this year when property funds, which had been the main final buyer in the market, were forced to freeze withdrawals. With the potential of large sales by property funds, rising vacancy rates, a large supply of new properties, and the difficulties of some large lenders in the market in raising funds; there is a real prospect of sharp falls in commercial property prices.

Should we suffer a recession, high rents will drive many firms out of business. This will leave some developers who now have adequate rental income unable to service their borrowings.

Does it matter that Irish banks are finding wholesale funding more expensive? Can they not just borrow from the Irish public? Certainly they are trying - some institutions are offering higher rates of interest on deposits than others are charging for mortgages.

However, the Republic has for several years been running a current account deficit which means that we are net borrowers from the rest of the world, with banks acting as the conduit.

At a time of increased anxiety, it is vital regulators introduce measures to handle impaired loans to builders; overhaul our inadequate system of deposit insurance; and monitor the real solvency of those banks that lent aggressively for speculative land purchases and building, and may now be finding themselves dangerously out of their depth. ... 21594.html
Buyers beware: sharp falls in house prices are likely to continue
August 15, 2008

The fundamentals of the Irish housing market point to more sharp falls over the next two to three years, writes MORGAN KELLY

WITH HOUSE prices falling fast and likely, come the autumn, to fall even faster, no sane person would currently even think of buying a house. But this immediately raises the question of how long the crash will last. In other words, how long will it be before you can buy a house and not regret the decision for the rest of your life?

Looking at past collapses in house prices abroad, we can see that they fall into two broad groups. In the first group, that includes Japan and Switzerland, prices suffered a long, slow decline of a few per cent a year for a decade. The second group, that includes the Netherlands and Finland, saw real prices halve in three to four years, and then fall gently for a few more years.

If this second pattern repeats in Ireland, given that we are already one year into the crash, we can expect two to three more years of sharp falls. After that, prices should stabilise and it will be safe for buyers to return to the market.

But between now and then, to paraphrase a former taoiseach, the crash will get even crasher. The reason is that, alongside self-fulfilling expectations of continuing price falls, all of the fundamentals of the Irish housing market - income, population, credit and housing supply - are pointing to sharply lower prices.

The building boom allowed Ireland to enjoy Scandinavian levels of consumption and Government spending despite scarcely better than Mediterranean levels of productivity.

We are facing a decade of recession, of the sort Germany is just emerging from, as our incomes are brought back into line with our productivity.

With prolonged recession, emigration will resume, further reducing housing demand. In fact, as Brendan Walsh has pointed out, the collapse in the birth rate during the 1980s means that, even with zero net emigration, the prime housebuying population of 20 to 40-year-olds will fall by 10 per cent in the next decade.

The house price boom of the last decade was in large measure due to loose bank credit. It would not have been possible for house prices to double as they did relative to disposable income without banks sharply increasing the amounts they were willing to lend to people.

However, banks are now returning to their old policies of 80 per cent mortgages of a maximum of three to four times income, and house prices will fall accordingly. This rediscovered prudence has little to do with tightness in international credit markets, and everything to do with the realisation that, short of living on bread and water, no one can afford to repay mortgages of five or six times their salary.

Based on the US experience, where each stage of the crash has happened about a year ahead of here, more and more people will stop paying their mortgages as their houses fall in value and they slip into negative equity.

However, the immediate threat to the economy comes from the scarcely believable €25 billion that banks lent to builders back in the days when nobody thought the boom would ever end. As new houses stopped selling, builders have been unable to repay these loans, and banks are now pressuring them to pay up by the autumn or face bankruptcy.

Builders usually borrow with recourse, which means that if they cannot repay a loan they lose literally everything, bar the fillings in their teeth. Facing personal ruin, builders desperate to sell will slash new house prices in the coming months and this collapse in prices will ripple through the entire market.

Taking its cue from the Health Service Executive policy that the best way to deal with a problem is to deny that it exists, the Central Bank has quietly been approaching banks and asking them to go easy on builders.

Whether banks pay any heed is immaterial. Either way, they have a €25 billion hole in their balance sheets, and an autumn banking crisis is a real possibility. Banking crises are like pile-ups in the Tour de France: one careless rider suddenly goes over and brings the rest down after him.

While media attention has focused on banks, the first casualty is more likely to be any lending institution that has over-extended loans to the building industry - perhaps by as much as 15 per cent. In this worrying situation, what advice can we offer to house buyers and sellers?

For sellers, the important question is to ask: do you really want to sell? This means, are you willing to accept a good deal less than the guy down the street got two years ago? If you are not, save yourself a lot of grief and stay out of the market. If you are, then find an estate agent who understands the importance of selling quickly.

It is vital not to delay for months, and above all not to rent out, in the hope of a better offer. With prices falling about 1 per cent a month, every week you postpone selling a €400,000 house will cost you €1,000.

Advice to buyers is easy: stay out of the market. With prices on course to halve, the hundreds of thousands you save will more than cover any rent you pay for the next two or three years. And, just as valuable, you will sleep a lot better at night.

September 30, 2008 ... 57103.html
Bailout inept and potentially dangerous
October 2, 2008

OPINION: The Government has acted in haste and the banking bailout will be regretted at leisure, writes Morgan Kelly

THIS IS the wrong solution to the wrong problem. It has put the Irish taxpayer at risk of considerable losses, and does nothing to solve the real problem of Irish banks, which is a shortage of capital.

Irish banks get about one-third of their funds by borrowing from foreign banks. What precipitated the crisis on Monday was that foreign banks stopped lending to them. What we need to understand is what caused foreign banks to stop lending to Irish banks while they kept lending to most other banks in Europe. Once we understand the answer to this question we will understand how inept and potentially dangerous the Government's attempted bailout really is.

The reason that foreign banks started to shun Irish banks is that international investors have gradually become aware of the scale and recklessness of Irish bank lending to builders and property speculators. Irish banks are currently owed €110 billion by builders and developers. Of every €100 that Irish residents have deposited in banks, €60 has been lent for property speculation.

As the property bubble has burst, it is looking increasingly unlikely that banks will get back more than a fraction of this. In particular, very little of the €25 billion lent to builders to construct the ghost estates and vacant apartment blocks that now blight the landscape will ever be seen again. Foreign banks know of these toxic loans - even if Irish banks are still trying to disguise them - and are frightened by them. That is why they stopped lending to our banks, and why the Government was panicked into taking their place.

The difficulty that Irish banks had in raising funds was a symptom of the bad debts that foreign investors know have eaten up most of their capital. By treating the symptom, the Government has ignored the cause which is the shortage of bank capital.

The failure of Government policy can be seen in the share price of banks. On Tuesday evening after the bailout had been announced, the shares of the three retail banks were still slightly lower than they had been on Monday morning before the panic. If all that was wrong was a shortage of liquidity then they should have roared back to their levels of a year ago.

Is this just abstract carping? Surely deposits are again flowing into Irish banks, and all their troubles are behind them. Unfortunately not.

The amount that a bank can lend is proportional to its capital: the amount of money that its owners have invested in it. As banks suffer bad debts, this capital falls and the amount that they can lend contracts.

Effectively the Irish banks are heading in the same direction that the Japanese banks were in the 1990s: zombies that are kept on life support by the Government, but without the capital to provide firms and households with the borrowing that they need. However this cosy Japanese solution to an Irish problem could come unstuck if bank auditors refuse to sign off on the valuations that banks are still putting on their dead assets. This would precipitate a new crisis that would make last Monday seem like a picnic.

The Irish Government should have done what the Swedes did in 1991. The Swedish government stepped in and, in return for banks' admitting the scale of their losses and firing the senior managers that had caused their problems, provided capital in return for a share of ownership.

As the Swedish economy recovered, the government was able to sell off its share in the banks, with the result that the Swedish taxpayer lost nothing on the bailout. In Finland, by contrast, the government denied that there was any problem until their banking system had collapsed and was then forced into a ruinously expensive bailout. The Government should have offered new capital to four of the institutions, and left the others, where the real problems lie, to fend for themselves.

Not only does the Government guarantee of bank borrowing fail to solve the underlying problem of bad loans; it faces the Irish taxpayer with a real risk of enormous losses.

By insuring the borrowing of banks with toxic assets, the Government has taken up where the collapsed American insurer AIG left off. It was by guaranteeing to cover any losses to institutions that lent to client banks, what was called monoline insurance, that the world's largest insurance company went bankrupt. The particular risk that the Government now faces is that Irish banks will package toxic loans as asset-backed securities and sell them off with a Government guarantee, passing on their losses to the Irish taxpayer.

Suppose that you are a bank that has lent €100 million each to 10 developers who are having problems meeting their repayments. What you do is bundle the loans into one asset and sell it, with Brian Lenihan's signature on the bottom, on financial markets for €1 billion. When the borrowers default, the taxpayer will be left taking up the tab.

The following months will see a battle of wits between banks and the Financial Regulator, as banks try to offload bad debts on to the taxpayer and the regulator tries to stop them. As this realisation dawns on investors we can expect bank shares to soar in the coming weeks, and the cost of Government borrowing to rocket.

Irish banks were facing potential losses on their property lending of the order of €10 billion to €20 billion. Thanks to Brian Lenihan's master stroke it looks as if it will be you, rather than bank shareholders, who will be taking the loss. ... 15931.html
Things are going to get much worse
Fri 10 Oct 2008

ANALYSIS:This is the future: without immediate Government funding, bank lending will fall by three-quarters, driving most companies in Ireland out of existence, writes Morgan Kelly

BY SHOOTING itself in the other foot over the Budget, the Government has temporarily diverted attention from its botched bailout of the banks, but the problem has not gone away. While financial markets across Europe are beginning to stabilise, Irish banks continue to sink deeper beneath the waves and are starting to drag the rest of the economy under with them.

What makes bank crises economically catastrophic is that they cause credit squeezes which drive profitable firms out of business. Every company in Ireland relies on a credit line to pay wages and other expenses between payments from its customers.

Established firms (outside construction) rarely go out of business because they are unprofitable, but because they have problems with cash flow; and any firm that loses its bank credit line is effectively dead.

The amount that a bank is allowed to lend is proportional to its capital. When a bank loses capital through bad loans, as Irish banks have done spectacularly through their lending to builders and developers, it must reduce its lending. Already many smaller firms are finding it harder to get overdrafts, and the worst is yet to come.

If we suppose that the current stock market valuations of Irish banks are a rough indicator of the true book value of their capital, then in the next year we can expect banks to write off more three-quarters of their capital as bad debts. This means that without immediate Government action to recapitalise the banks, bank lending will fall by three-quarters, driving most companies in Ireland out of existence.

The Government claims that the merit of its scheme is that it costs nothing. Unfortunately, international experience shows that when banks get into trouble, the choice is not whether you spend money, but when. Either you pay the money up front to recapitalise banks; or you pay far more over the next decade in bankruptcies, unemployment and lost output.

It was knowing how credit contractions wreck economies that led the British government, followed by the French, Germans, Spanish, Swiss, Dutch, Swedes and Americans, to do the right thing and move swiftly to recapitalise their banks.

These measures appear, thankfully, to be working. The hope among economists here was that good policy would drive out bad, and that the Government would abandon its ill-conceived bailout and follow suit.

In the event, the Government chose to persevere with a scheme that serves only to keep zombie banks going while starving their customers of credit; and helps nobody apart from some developers and bankers.

Irish bank executives can continue to draw their pay and hope eventually to trade their way out of their problems.

In a few months, they assure us, people will again be flocking to buy in ghost estates, deserted office blocks will be thronged, and our troubles will be behind us.

It is worth recalling that the last time Ireland's wealthiest businessman and his dodgy personal bank got into financial difficulties - Patrick Gallagher and Merchant Banking Ltd in 1982 - both were allowed to go bankrupt. Gallagher eventually did two years for fraud in Crumlin Road Prison, Belfast.

I predicted early last year that falling sales and property prices would cause the building industry to collapse, which would in turn leave banks practically insolvent. However, I could not have conceived how, faced with a cancer of bad loans that had eaten through our financial infrastructure, the Government would slap on a band-aid of liability guarantees and walk away, leaving the Irish economy to its fate.

The liability guarantee leaves Irish banks in precisely the position of Fannie Mae before it was nationalised: alive but economically useless. In effect, the Government has chosen to inflict a Japanese-style lost decade on the Irish economy.

What the Government should have done was to offer substantial capital to the four worthwhile banks that Irish firms and households rely on for credit; and to close down the other two which were effectively conduits for real estate speculation with no role in the wider economy.

Instead, it guaranteed the liabilities of even the worst two "banks" without checking what, if anything, their assets are worth. By doing this, the Government has put the taxpayer at risk of substantial losses, and compromised its ability to provide adequate capital to the banks that need to be saved.

These points are so obvious that it is almost embarrassing to repeat them. Even with the strikingly poor quality of economic advice available to it, the Government knew what should be done, but decided to do otherwise. What impelled these politicians to make the worst economic decision of any Irish government in the last 30 years?

In the last decade, Fianna Fáil came to see developers and the banks which funded them as the real heroes of the economic boom: the men whose drive and vision had given us an economy that was the envy of Europe. From bywords of ineptitude, Irish builders and bankers were transformed into masters of the universe. What was good for Anglo Irish Bank was good for Ireland.

Three weeks ago, bubble turned irrevocably into bust. Brian Lenihan was faced with a choice between rescuing two banks and the handful of developers through whom they placed real estate bets, or recapitalising the financial infrastructure on which the other four million of us depend.

He chose the former. The grave consequences of this extraordinary decision, both political and economic, will ensure that in the coming months we shall all get to live in interesting times."

A quick look at the Estimates shows some strange priorities spared the cuts (greyhound stadia, co-located hospitals), many of which include a large element of captial investment in construction, while soft "human capital" is heaped onto the pyre. Its an attempt at a builders' bail out and a builders' budget. Our grandchildren will be paying for it, and it won't even work. ... 73144.html
Better to incinerate €1.5bn than squander it on Anglo Irish Bank
December 23, 2008

For this Government, the bailout follows a compelling political logic: Anglo Irish funds developers, and developers fund Fianna Fáil, writes Morgan Kelly

FOR THE current Government, a month without a catastrophic policy error has come to seem like a month wasted. After the bank liability guarantee in September and the medical card fiasco in October, the Government had a quiet November but has now come roaring back to form with the bailout of Anglo Irish Bank. Attempting to recapitalise Anglo Irish is not only expensive and economically pointless, but futile.

Some simple arithmetic shows the hopelessness of what the Government is trying to do. In the typical property bust over the last 30 years, US banks have lost on average about 20 per cent of what they lent to developers.

Let us suppose that Anglo Irish is no more incompetent or dishonest than the average bank and will also lose up to 20 per cent of what is has lent.

Then, given lending of about €80 billion to developers, it follows that Anglo Irish is facing losses on the order of €15 billion. The true figure could easily turn out to be twice as large.

With likely losses of this magnitude, the Government's proposed investment of €1.5 billion will vaporise in months, forcing it either to continue pouring good money after bad, or to repudiate Anglo Irish's liabilities. For all it will achieve, the money might as well be piled up in St Stephen's Green and incinerated.

Anglo Irish epitomised the Irish bubble economy. Its rise began a decade ago as the boom created a demand for houses and commercial property. As prices started to rise, banks made a miraculous discovery: the more they lent, the more prices rose; and the more prices rose, the more people wanted loans to get into the booming market. And the more loans that bankers made, the bigger the bonuses they could award themselves.

It was brilliant while it lasted. One of Bank of Ireland's stable of developers would buy an office block for €100 million, and sell it on a year later to one of Anglo's for €120 million, and so on: a process known to bankers as adding value.

Everyone was a genius and nobody could lose.

As a senior executive of Anglo Irish once assured me, there was no risk involved. All of the loans were guaranteed by the enormous property portfolios of the borrowers.

What concerned me at the time was not that he was spouting transparent nonsense - that, after all, was what he was paid to do - but that he clearly believed it himself.

Sadly, like any pyramid scheme, it contained the seeds of its own destruction.

Once banks stopped lending, as they were forced to do earlier this year, the market collapsed. Developers were left holding properties whose rental incomes were a ruinously small fraction of their interest payments, and banks discovered that their collateral was worthless.

All Irish banks have been injured by the collapsing property pyramid, some fatally so. Unfortunately, as international experience shows, banks that have been overwhelmed by bad property loans do not simply fade away. Their final act typically has three scenes.

First, the bank starts to admit that a certain fraction of its loans are receiving active management, it increases its bad loan provision but by an unrealistically low amount, and its share price collapses.

In the second scene, evidence of malfeasance starts to appear, as senior bankers are found to have had difficulties in distinguishing the bank's assets from their own, and to have been acting as poachers as well as gamekeepers in their dealings with developers.

It is to be hoped that any Irish bankers in this situation have heeded the cardinal rule of Irish finance and kept their more imaginative dealings within the jurisdiction. As Patrick Gallagher discovered, the British judicial system takes a less indulgent view of lapses of fiduciary responsibility than does our own, and seems to harbour a particular antipathy towards charming Irish rogues.

In the final stage, as the bank slides over the brink of collapse, senior managers loot its assets. Looting a bank involves nothing so unsubtle or easily traceable as driving away with carloads of cash.

Instead, each bank has a filing cabinet with personal guarantees written by borrowers and deeds to property pledged as collateral (large property deals involve surprisingly little paperwork); and these documents have a tendency to find their way into the briefcases of departing executives who can later negotiate their return to their original owners.

So much for the future. Right now, in the "nothing in the last six months has really happened" world of the Government, the bailout of Anglo Irish follows a compelling political logic. Anglo Irish funds developers, and developers fund Fianna Fáil.

By any other criterion, a bailout of Anglo Irish is senseless. Institutions such as AIB and Bank of Ireland fulfil an economically vital role of clearing payments and lending to households and businesses; Anglo Irish and Irish Nationwide were purely conduits for property speculation.

They fulfil no role in the Irish economy and their absence would not be noticed.

By using taxpayers' money to acquire Anglo Irish's portfolio of dingy shopping centres and derelict development sites, the Government is squandering scarce resources that are needed elsewhere. Just as the State is putting too much money into Anglo Irish, it is putting in too little to recapitalise AIB and Bank of Ireland on which, whether you like it or not, large sectors of the Irish economy depend.

Governments tend to forget whose interests they are supposed to serve. Our Government was not elected to look after the managers, shareholders and bondholders of recklessly mismanaged banks.

Its sole duty is to Irish taxpayers: to ensure that banks that serve a useful economic purpose continue to operate, while those that serve none are swiftly closed down.


The Irish Property Bubble and its Consequences
January 12, 2009 - PDF ... 61333.html
Piling Anglo losses on to national debt risks bankrupting the State
January 20, 2009

ANALYSIS: Anglo Irish is poisoning the banking system and is of no systemic importance. It must not be nationalised; it must be allowed to collapse and with it the developers at the heart of the problem, writes Morgan Kelly

YESTERDAY’S CATASTROPHIC collapse of Irish bank shares stems directly from the Government’s proposal to nationalise Anglo Irish Bank. With the Government’s finances already buckling under the collapse of our bubble economy, financial markets began to fear that with the added burden of Anglo’s debt, the Irish State cannot afford to finance itself, let alone support the remaining national banks.

Facing the imminent collapse of the national financial system, the Government needs to perform a ruthless triage. The worthwhile banks need to be maintained by any means necessary, including nationalisation, while Anglo Irish and Irish Nationwide must be allowed to collapse.

What began as farce has turned swiftly to catastrophe. Last September the Government casually decided to give a small dig-out to some developer pals by guaranteeing the liabilities of Anglo Irish Bank. This spiralled into a proposed nationalisation that would saddle Irish taxpayers with Anglo’s bad debts, which could easily exceed €20,000 per household, and starve the other, worthwhile, banks of the capital they need to survive.

At the original crisis meeting on September 29th, Brian Cowen claimed that the blanket guarantee to all six banks was given “on the basis of the advice from those who are competent to so advise the Government”.

That does not appear to have been the case.

According to a source of mine very familiar with what happened at the meeting, extending the liability guarantee to Anglo Irish and Irish Nationwide was strongly opposed by representatives of the Central Bank and the Department of Finance (who reportedly came into the meeting with a draft Bill to rescue only four institutions). However, I am told they were overruled by the Taoiseach and the Minister for Finance, who were supported by the Financial Regulator and the Governor of the Central Bank on the grounds that a sudden liquidation of Anglo’s assets would not be in the national interest.

It is still worth asking what would have happened if Brian Cowen had listened to the Department of Finance and allowed Anglo Irish to sink? The answer is: very little.

Developers would have gone bust and commercial property would have become more or less worthless, but that is going to happen anyway, with or without Anglo Irish. Depositors of Anglo Irish would have been paid off in full, and the hit would have been taken by the international financial institutions that hold around €22 billion of its bonds.

These bondholders are professional institutional investors who signed up for higher returns on Anglo debt in the knowledge that they were facing higher risks. They are, moreover, insured against their losses through insurance contracts called Credit Default Swaps.

This is the central point about the bailout of Anglo Irish, and one that has not received any attention: the only effect of a bailout is that the Irish taxpayer will make up the losses of Anglo Irish’s bondholders instead of the insurers who had already been paid to underwrite the risk.

Why it is necessary to transfer Anglo’s losses from the writers of Credit Default Swaps to the Irish taxpayer is something that the Government has not thought to justify.

Indeed, what has been disturbing about the entire Anglo affair is that at no stage has the Government felt it necessary to explain why any bailout was needed, beyond inchoate mutterings about the “systemic importance” of Anglo Irish.

The reality is that Anglo has no importance in the Irish financial system. It existed purely as a vehicle for a few politically connected individuals to place reckless bets on the commercial property market. These property speculators may be of systemic importance to the finances of Fianna Fáil, but their significance ends there.

In ordinary times, piling €30 billion of Anglo Irish losses on to the national debt would be painful and pointless but not impossible. These however are not ordinary times. International debt markets are flooded with governments trying to borrow. The other Irish banks are dangerously short of capital. Most importantly, the Irish economy and government finances are collapsing.

Ireland’s growth during the last decade was largely illusory, generated by a property bubble fuelled by reckless bank lending. In 2007 an incredible 20 per cent of our national income and employment came from building houses and commercial property. Next year, the percentage will be approximately zero.

The only industrialised economy that has endured a property and banking crash remotely comparable to what we are beginning to experience was Finland in 1991, where national income fell in total by 15 per cent and unemployment rose by 12 percentage points. As the private sector haemorrhages jobs it is hard to see how Irish national income will fall by less than 20 to 25 per cent in the next few years. Unemployment will easily reach 15 per cent by the end of the summer, and 20 per cent by next year, and will not start to fall until recovery in Britain and elsewhere permits mass emigration to resume. The economy will not begin to grow until real wages fall to competitive international levels, a process that will probably take a decade.

In other words, the Irish economy is facing a decade of stagnation and mass unemployment of the same magnitude as the 1980s, with the difference that the unemployed now have mortgages, car loans and maxed-out credit cards. Faced with an irreversible contraction on this scale, the Government will have grave difficulty borrowing to fund its ordinary expenditure, even after draconian cuts in spending and increases in taxation. In the view of international investors, piling Anglo Irish’s gambling losses on top of a spiralling national debt could easily suffice to sink the Irish State into bankruptcy.

In this national crisis, what should be done? The answer is simple. The State must do everything to rescue AIB, Bank of Ireland and Permanent TSB, and let Anglo Irish and Irish Nationwide sink.

The Government must continue to guarantee all deposits at Anglo Irish while announcing that, in the light of continuing revelations of misconduct in the bank and shortcomings in its auditing procedures, it will enter into negotiations with senior and unsecured bondholders.

The proposed Anglo nationalisation marks a decisive watershed in Irish democracy. With it, an Irish government has coolly looked its citizens in the eye and said: “Sorry, but your priorities are not ours.”

It is to be hoped that the collapse of other bank shares will serve as a warning to deter the Government from this catastrophic course. I would therefore urge any TDs and Senators who still believe that the Irish State exists to act in the interests of its people to vote against the nationalisation of Anglo Irish and do everything to protect the other banks.

Morgan Kelly is professor of economics at University College Dublin.

Corrections & Clarifications - Published January 22nd

In this article, it was stated that the Minister for Finance Brian Lenihan had failed to follow advice received from representatives of the Central Bank and the Department of Finance at a meeting on September 29th 2008 at which the Government decided to guarantee the deposits and certain identified liabilities of six named financial institutions.

It was also stated that a Bill to rescue only four institutions was before the Government on that occasion. In fact, the Bill was the same as that passed by the Oireachtas this week, being a Nationalisation Bill. The Irish Times notes the unequivocal statement by the Minister for Finance in the Dáil on Tuesday confirming the correct factual position and we are happy to set the record straight and withdraw any suggestion of corrupt motives on the part of the Minister. ... 78003.html
Bank guarantee likely to deal a crippling blow to the economy
February 17, 2009

ANALYSIS: Government borrowing is not an immediate problem, but the extent of banks’ bad debts may prove catastrophic, writes MORGAN KELLY

BETWEEN COLLAPSING house prices, bankrupt banks and spiralling unemployment, you might be forgiven for thinking that fate has already dealt Ireland every misfortune in its hand. However, there may be one more unpleasant surprise in store for us, the prospect that international investors unexpectedly stop lending to the Government.

Economists call this a “sudden stop”. The original sudden stop occurred in 1998 when a default by Russia panicked lenders away from Latin America and plunged their economies into prolonged crisis.

The consensus among Irish economists is that government borrowing is not an immediate problem. Ireland has a low level of public debt by international standards, and even a few years of heavy borrowing will still leave it below Greek and Italian levels.

To understand why this view is too complacent, imagine that you are a bank manager and somebody that we will call Brian (not his real name) comes in looking for a loan.

Brian’s income is €30,000 and he would like to borrow €20,000 to cover living expenses. This sounds like a lot in these nervous times but, because Brian is not carrying much debt, you think you might lend to him.

However, Brian then lets it slip that, because his income is falling sharply, he will need to borrow at least as much each year for the foreseeable future. He also admits that, late one night and for what seemed like good reasons at the time, he somehow agreed to insure the gambling losses of some “banks”.

Brian has no idea how large these losses might be, but is starting to fear that they might be substantial. At this stage, you realise that Brian is on a trajectory into bankruptcy and show him the door.

Multiply the numbers in this story by a million and you begin to understand why Ireland makes bond markets nervous. First, the Irish economy is heading into a severe and prolonged slump that will force the Government to borrow heavily at a time when markets are increasingly reluctant to lend heavily.

Secondly, the Government’s delay in revealing how much its bank liability guarantee is likely to cost is making markets suspect that the final bill will be crushing.

After a decade of a credit-fuelled property bubble, the economy is not so much crumbling as vaporising: were we the size of Britain, January’s rise in unemployment would have been over half a million.

As the economy collapses, so does the Government’s tax revenue. This year the Government will have to borrow about €20 billion – everything it spends on wages or on social welfare – or about 15 per cent of a falling national income.

With no chance that the hopelessly uncompetitive economy will recover in the next five years and little sign that the Government has any appetite for serious cuts in spending or increases in taxation, borrowing looks set to continue at around this level for the foreseeable future.

If this borrowing was the limit of the Government’s liabilities, Ireland would probably just about weather the storm in the bond markets. Unfortunately, an elephant is lurking in the corner in the form of the bank liability guarantee, and this looks increasingly certain to sink the economy.

In my view, the Government has made insufficient effort to estimate how much its banks have lost. We have therefore had the bizarre experience of nationalising Anglo Irish Bank and recapitalising Allied Irish Banks and Bank of Ireland without knowing precisely the extent of their bad debts.

The Government has not updated its estimate of losses since Brian Lenihan’s boast that the liability guarantee was “the cheapest bailout in the world so far”, an assurance that already ranks in the annals of supreme political irony alongside Neville Chamberlain’s “peace in our time”.

The ability of the State to continue funding itself ultimately depends on the size of these bad debts. If they are of the order of €10–€20 billion, we will survive. If they are of the order of €50-€60 billion, we are sunk.

Irish banks could easily lose this much. If we suppose that most of the €20 billion lent to builders will not reappear this side of Judgment Day, along with 20 per cent of the €90 billion lent to developers, and 10 per cent of the €120 billion in mortgages, then we are already up to €50 billion.

These are only guesses. However, the continuing stream of revelations from Anglo Irish – which bear out the old investment dictum that there is never just one cockroach in a kitchen – suggest that they could be optimistic guesses.

To see what would happen to Ireland if foreign lenders suddenly pull the plug, we only need to look at what happened in Latvia last December. We would be forced to seek an international bailout, with the International Monetary Fund and European Union playing bad cop and good cop. We could expect cuts of one-quarter to one-third in public sector wages and social welfare benefits, and draconian tax rises to bring the deficit back to around 5 per cent of national income in two years.

There is actually a worse scenario where international bond markets suffer a general panic, like 1998. Not only does Ireland gets torpedoed, but also Portugal, Italy, Greece, Spain and Austria. The IMF and EU simply would not have the resources to bail out so many economies and we would be entirely on our own.

In circumstances where the Government could not even pay public sector salaries, the bank guarantee would immediately become worthless and we would see an uncontrollable run on all the Irish banks.

Watching the ineptitude and complacency of Lenihan’s bank bailout, we can understand increasingly how the people of New Orleans must have felt as they watched George Bush rescue their city: “Brianie: you’re doing a heck of a job.”

Particularly galling are the Government’s efforts to feign surprise and indignation at the behaviour of the banks, when the reality is that this is how we have always done business here. All that the Anglo affair has done is to hold up our grubby brand of crony capitalism for international ridicule.

For increasing numbers of ordinary people, the Irish economic miracle has turned out to be as worthwhile as a share in Bernard L Madoff Investments.

In return for working hard and paying their taxes, the lucky ones who keep their jobs can now look forward to pay cuts, negative equity and savage tax rises; while the unlucky ones face prolonged unemployment and losing their homes, their cars and everything for which they have worked.

If, on top of this, we suffer a sudden stop, people will see their pensions and Government spending slashed to pay off the gambling losses of Seán FitzPatrick and his pals. The Irish social fabric would certainly rip and unprecedented civil disorder ensue.

Bill Clinton’s feared enforcer James Carville once said that he would like to be reincarnated as the bond market, because that way you get to intimidate everyone.

Without decisive and intelligent Government action in the next few weeks, by the end of this year we will understand exactly what he meant. ... 65637.html
Brought to our knees by bankers and developers
July 3, 2009

OPINION: Nama is in effect Fianna Fáil’s shrine to the property bubble for which the party still yearns. Prepare to pay 10 per cent more in income tax for the next 10 years to pay for it all . . . we are headed for national bankruptcy, argues MORGAN KELLY

WRITING HERE two years ago, I pointed out that the exuberant lending of Irish banks to builders and property developers would sink them if the property bubble burst. Since then, the bubble has burst, the banks have sunk, and we are all left wondering how to salvage them.

Two ideas for fixing the banks have been suggested: a bad bank or National Asset Management Agency (Nama) and nationalisation. While these proposals differ in detail, their impact will be identical. Irish taxpayers will be stuck with a large bill, and in return will get an undercapitalised and politically controlled banking system.

A far more efficient and cheaper alternative to Nama is to copy what Barack Obama did with General Motors, and transfer ownership of Irish banks to their bond holders. In this way we can achieve well capitalised banks, run without political interference, at minimal cost to taxpayers.

By converting a portion of Allies Irish Banks’ approximately €40 billion of bonds, and Bank of Ireland’s €50 billion, into shares, each institution can be recapitalised. Transferring ownership to bond holders will not cost the taxpayer a cent and will avoid interminable legal battles over the transfer of assets to Nama.

While the shaky state of Irish banks had been worrying investors since early 2007, when the crisis finally broke in late September the Government was taken completely by surprise and reacted with blind panic. Faced with a run on Anglo Irish Bank by institutional depositors on September 29th, the Government was stampeded into guaranteeing virtually all liabilities, except shares, of the six Irish banks.

This guarantee contained two obvious but fundamental flaws. Everything that has happened since – the proposed recapitalisation of Anglo, the nationalisation of Anglo, the establishment of Nama – can be understood as the Government scrambling to catch up with the consequences of these two errors.

The first mistake was to guarantee not only deposits – which had to be guaranteed – but also most of the existing bonds issued by banks to other financial institutions. Bond holders receive higher returns in the knowledge that they are accepting the risk of losses on their investment. In addition, unlike depositors who can scarper, existing bond holders are effectively stuck.

It made no sense for the Government to insist that taxpayers would take the hit on any bank losses instead of the financial institutions that had already entered legal contracts to do so.

The second mistake was to extend the guarantee to Anglo Irish and Irish Nationwide. As specialised property development lenders with incompetent management, they were at risk of heavy losses as their market collapsed, and fulfilled no role in the wider economy.

In making the guarantee on September 29th, I do not doubt that the Government believed that the difficulties of Irish banks ran no deeper than temporary liquidity problems stemming from the international crisis. However, as it has become apparent that Anglo was a mismanaged wreck, with AIB and Bank of Ireland scarcely better, the Government has stuck with the mantra that all banks are equally important and equally worth saving at any cost to the taxpayer.

Brian Lenihan and Brian Cowen are happier to dice with national bankruptcy than lose face by admitting that they were misled about the state of Irish banks last September.

Nama, then, is the latest twist in the Government’s increasingly bizarre efforts to save the Irish banking system while claiming that it does not really need to be saved.

Underlying Nama is the delusion that the collapse of our property bubble is a temporary downturn. In a few years time when the global economy recovers we will be back building houses like it was 2006. All the ghost estates, empty office blocks, guest-less hotels and weed choked fields that Nama has bought on our behalf will once again be worth a fortune.

The reality is that, because of our surfeit of empty housing, there will be almost no construction activity for the next decade. Empty apartment blocks in Dublin will eventually be rented, albeit at rates so low that many will decay into slums. However, most of the unfinished estates that litter rural Ireland – where the only economic activity was building houses – will never be occupied.

Nama is a variant on the “Cash for Trash” scheme briefly floated in the United States last year where the government would recapitalise banks by overpaying for their bad loans. Our Government is proposing to buy €90 billion of loans and will reportedly pay €75 billion for them.

The International Monetary Fund (IMF) guesses that Nama will cost us €35 billion, and this is probably optimistic. The narrowness of the Irish property market meant that banks effectively operated a pyramid scheme, bidding up prices against each other. Now that banks cannot lend, development assets are effectively worthless.

The taxpayer is likely to lose well over €25 billion on Anglo alone. Among its “assets” are €4 billion lent for Irish hotels, and almost €20 billion for empty fields and building sites. In fact, I suspect that the €20 billion already repaid to the casino that was Anglo represents winners cashing in their chips, while the outstanding €70 billion of loans will turn out to be worthless. And it is well to remember, as the architects of Nama have not, that although the problems of Irish banks begin with developers, they do not end there.

The same recklessness that impelled banks to lend hundreds of millions to builders to whom most of us would hesitate to lend a bucket; also led them to fling tens of billions in mortgages, car loans, and credit cards at people with little ability to repay. Even without the bad debts of developers, the losses on these household loans over the next few years will probably be sufficient to drain most of the capital out of AIB and Bank of Ireland.

Brian Lenihan’s largesse to bond holders could cost you and me €50 to €70 billion. What do numbers like these mean?

The easiest way to put numbers of this magnitude into perspective is to remember that in 2008 the Government generated €13 billion in income tax. Every time you hear €10 billion, then, think of paying 10 per cent more income tax annually for the next decade.

In other words, the fiscal capacity of a state with only two million taxpayers, and falling fast, is frighteningly thin. Ten billion here, and ten billion there and, before you know it, you are talking national bankrutcy. Even without bankrupty, Nama will ensure a crushing tax burden for everyone in Ireland for decades.

The tragedy is that, were it not for the Government’s botched efforts to save financiers from the predictable consequences of their own greed, the Irish economy would have recovered far more quickly than most people, including the IMF, expect.

Recovery for the Irish economy will not be easy – there is no painless way for an economy to move from getting about 20 per cent of its national income from construction to getting about zero – but the flexibility of the Irish labour market would have ensured that our incomes and share of global trade would have rapidly recovered. Now, however, any fruits of recovery will be squandered on Nama.

Aside from the fact that Nama will spend huge sums to achieve little, its governance is problematic. Here, the fog of secrecy that has quietly settled over Anglo Irish since nationalisation sets an unsettling precedent.

After revelations of financial irregularities forced the resignation of three executive directors, Anglo moved decisively to replace them with . . . Anglo insiders. Most astonishing, in the light of the scandal over Irish Nationwide deposits, was the decision to replace Anglo’s disgraced financial director with his immediate subordinate, Anglo’s chief financial officer.

It is hard not to conclude that a deliberate decision has been made at the highest level of Government that what happened in Anglo, stays in Anglo. And we can expect Nama to be run in the same tight manner.

While there has been considerable speculation about dark motives for bailing out developers and banks, I do not believe that the Government’s behaviour has been corrupt: it has been far worse. At least corruption implies a sense that you are doing wrong, and need to be paid in return. Our Government actually thought it was doing the right thing in risking everything to safeguard the interests of developers who had given us an economy that was the envy of Europe.

Instead of recognising bankers and developers as parasites on our national prosperity, the Government came to see them as its source. While everyone else in Ireland has come to see the past decade as an embarrassing episode of collective insanity to be put behind us as soon as possible, the Government still sees it as the high point of our nation’s history. Nama is effectively Fianna Fáil’s shrine to the bubble, and likely to be an expensive and enduring one.

What should be done instead of Nama? First, we need to understand how the idea of Nama follows from a mistaken analogy with the Swedish banking crisis and bad bank of the early 1990s. The Swedish banks differed in one fundamental way from ours: they only had deposits as liabilities. If their government had not taken over their bad debts, ordinary depositors would have suffered. By contrast, Irish banks had borrowed heavily from other financial institutions through bonds, and these bondholders originally agreed to take losses if Irish banks got into difficulties.

By placing the costs of the banking collapse primarily on existing holders of bank bonds, the State can improve its credit rating and pull back from the edge of bankruptcy. Knowing that taxpayers are not liable for the losses of AIB and Bank of Ireland will make capital markets more willing to lend to the Irish State.

Instead, like a corpulent Tooth Fairy gently slipping billions under the pillows of sleeping bond holders, Brian Lenihan has chosen to extend the liability guarantee and further weaken the bargaining position of the State.

The drift into national bankruptcy looks increasingly unstoppable. ... 55311.html
Overpaying for Nama may hit taxpayer for €30bn
September 15, 2009

ANALYSIS: Government estimates of Nama valuations appear implausible, are out of line with other property collapses and may impose massive losses on the taxpayer

WHAT HAS been dismaying about the recent acrimonious exchanges over Nama is that neither side seems to feel it necessary to produce any evidence to support its assertions about its likely cost to the taxpayer. Like most discussions in Irish public life, the Nama debate seems set to generate more heat than light.

If we want to make sensible predictions on the likely course of Irish property prices over the next decade, we need to see what has happened historically in the aftermath of similar booms. In other words, we need to find property booms where sharp increases in bank lending caused real prices to more than double.

In Ireland, between 1995 and the peak of the boom in 2007, the average price of housing and commercial property roughly tripled, adjusting for inflation, while disposable incomes increased by one half.

Two previous booms fit this pattern closely: Japanese urban land in the 1980s, and Irish agricultural land in the late 1970s.

In Japan between 1985 and 1990, the real price of commercial land in major cities tripled, while the price of residential land doubled. What makes the Japanese case particularly relevant to Ireland, as I pointed out here two years ago, is that at the peak of their bubble, Japanese banks had the same extreme exposure to development and construction loans – 30 per cent of their lending – as Irish banks did in 2007.

As Japanese banks buckled under bad property debts, lending fell sharply and prices with it. By 2005 – 15 years after the peak – residential land had fallen back to its pre-bubble level, while commercial land had fallen by nearly 90 per cent. Given that many people are claiming that Irish property prices will recover once the economy starts to grow again, it is interesting to note that Japanese property prices collapsed while the economy continued slowly to expand: real output in Japan rose 20 per cent between 1990 and 2007 and did not fall in any year during this period.

The next case is much closer to home but almost forgotten: the boom and bust in Irish farmland prices in the late 1970s. After joining the EEC in 1973, Irish banks began to lend heavily to farmers. As a result, the inflation adjusted price of agricultural land tripled between 1975 and 1977, reaching a peak equivalent to €14,000 per acre in 2009 prices. Real Irish GNP in 1977 was about one third of its present level, so this price is roughly equivalent to €50,000 per acre in current purchasing power for land with no development potential. For comparison, during the recent boom, when agricultural land prices were driven by demand for potential development, prices peaked in 2006 at an average of €21,000 per acre nationally.

The bubble quickly burst as farmers ran into difficulties servicing loans: between 1977 and 1980 real prices fell by around 75 per cent, and remained at this level, more or less where it had started in 1973, until 1995, 18 years after the peak.

These examples illustrate a general principle: property bubbles are the consequence of abnormal levels of bank lending. Once the bank lending that fuelled the boom returns to its usual levels, prices return roughly to where they started before the boom.

In ordinary times, property prices grow at the same rate as national income: people in industrialised economies spend much the same fraction of their income on housing as they did a century ago.

However, a surge in prosperity, which drives property prices higher and encourages banks to lend more on appreciating assets, can lead to a self-reinforcing cycle of rising prices and rising lending.

Eventually, banks get a fright and return to levels of lending they used to regard as prudent, causing prices to fall back to where they were before the bubble. Just like Irish farmland in the 1970s, and Japanese property in the 1980s, our recent property boom was the product of unsustainable bank lending.

Between 2000 and 2007, while nominal GNP rose by 77 per cent, mortgage lending rose from €24 billion to €115 billion, lending to builders from €2.4 billion to to €25 billion, and to developers from €5 billion to €80 billion. Should the usual post-bubble correction occur in Ireland, it would suggest that real prices of residential and commercial property would return to their levels of the mid-to-late 1990s, two thirds below peak values.

Already the Irish property market has seen unusually sharp falls by international historical standards. The Sherry FitzGerald house price index is down 35 per cent nationally, and 42 per cent for Dublin; while the Society of Chartered Surveyors estimate that commercial property prices have fallen 48.6 per cent from their peak; and Knight Frank estimate that farmland prices, which were driven by their development potential, are down 45 per cent from their peak but are still twice those of comparable UK land.

Despite these large falls, which already exceed the one third haircut on Nama assets rumoured to be proposed by the Government, the property market remains moribund. Property transactions, measured by stamp duty receipts, are two thirds down on this time last year, and 80 per cent lower than two years ago.

In other words, if nobody is buying despite large falls in price, then price needs to fall considerably further to reach its long-run equilibrium.

The impression that Irish property prices are still considerably above long-term value is reinforced by rental yields: the ratio of the rent you get from a property to the price you paid for it. As many of you have discovered to your cost, property is a risky asset that performs particularly badly during economic downturns. To compensate for this fundamental risk, property should earn a long run rental return of at least 8 per cent.

Despite some of the highest rents in the world at the peak of the bubble (according to Lisney, Dublin ranked as the second most expensive location for industrial property and ninth for offices, with Grafton Street coming in as the fifth most expensive retail street on earth), new residential and commercial property was earning a paltry rental yield of 3-4 per cent.

This means that, to restore long-run equilibrium, prices needed to halve from peak levels, or rents to double.

Suppose for a moment that the Government’s assertions are correct, and the long-run value of Irish property is two thirds of its peak value. In order for rental yields to rise from an unsustainable 4 per cent to a long-run equilibrium of 8 per cent, the Government needs rents to rise one third from their already extreme peak values.

In fact, instead of rising, rents have fallen, and nearly as sharply as prices. The Irish Property Watch website estimates that residential rents have fallen by 32 per cent since May 2008; while Lisney estimate that commercial rents have fallen 24 per cent from peak, with office rents down 35 per cent and now lower than they were a decade ago.

Again, these large falls have not been sufficient to restore equilibrium. The number of rental properties listed on has risen from 5,000 at the start of 2007 to nearly 25,000 now, while the average time to rent a property is now 76 days.

For offices, HWBC estimate that lettings are running at one fifth of their rate last year; while Lisney calculates that one fifth of Dublin offices are now empty (something they describe as “startling”) and one third in west Dublin.

The usual post-bubble correction in property prices is likely to be aggravated in Ireland’s case by large falls in national income, and the dislocation in the banking system and Government finances, caused by the collapse of our unusually large construction boom.

The effective ending of new construction activity, collapsing consumption, rising taxes and cuts in Government spending all make the 15 per cent contraction in GNP forecast by the ESRI and others look optimistic. The fall in national competitiveness and likely continuing difficulties in the banking sector make the prospect of a swift national recovery seem problematic.

What we have seen then is that as the abnormal lending that fuelled the property boom returns to its normal level, Irish property prices should fall back to their pre-bubble values, at around one third of their peak values.

In the absence of evidence to support it, the Government’s claim that €90 billion in developer loans are backed by €120 billion in assets appears implausible. While five-year developer loans were the norm, properties were usually flipped on after two years, meaning that existing loans were mostly taken out at peak prices.

In addition, while loans were supposedly 70 per cent of property value, the collateral supplied was usually equity in other property or personal guarantees, both now worthless.

It appears, therefore, that, by paying an average of two thirds of the face value for Nama assets, the Government is likely to impose severe losses on taxpayers of the order of €30 billion, or one fifth of national income.

Morgan Kelly is professor of economics at University College Dublin. During the recent High Court case involving the Zoe group of companies and ACCBank, he gave property valuation estimate evidence on behalf of the bank ... 08947.html
Turning bank debt into equity will save us from Nama ruin
October 13, 2009

History shows Nama-style bad banks are profoundly corrupt and corrupting institutions. If Nama didn’t happen, the alternative would involve minimal cost to the taxpayer and banks would manage their business without political interference

WHILE MOST economists by now simply dismiss Brian Lenihan’s utterances on the economy as “not even wrong”, this is to miss the Minister’s almost eerie ability to predict exactly the opposite of what is going to happen. Merely to contradict Brian Lenihan is virtually to guarantee that you will later be credited with supernatural prescience.

Who else, as Irish bank shares plunged 13 months ago, could conclude: “Our banks uniquely have weathered this storm . . . We are in a zone of financial stability in a very troubled financial world.”? Two weeks later, having been panicked into his catastrophic bank liability guarantee, the Minister assured us that we had “the cheapest bailout in the world so far”, and six weeks later averred that: “It is not the function of the Government to fund or bail out the banks.”

The effortless miscalculations, the assured non sequiturs, the lofty indifference to facts: all reveal Brian Lenihan as a master of what Princeton philosopher Harry Frankfurt defined succinctly in his 1986 paper, On Bullshit .

The Nama legislation, as expected, piles up this material on an Augean scale. Prices have fallen 47 per cent; the long-term economic value of property is 30 per cent below its peak value; the loan-to-value ratio is 77 per cent; prices only need to rise by 10 per cent in 10 years for the State to break even.

To subject these almost poetic flights of ministerial imagination to any sort of rational analysis will seem to many like vandalism, but that is what God made economists for.

First, the estimate that prices have fallen 47 per cent. The reality is that prices can only exist when there is a market, and the market for commercial property and development land has disappeared.

A less futile exercise is to ask how much Nama would have cost at the end of similar credit-fuelled price bubbles. A decade after their peaks, Tokyo land prices had fallen by five-sixths, while Irish farmland, adjusted for inflation, had fallen by three-quarters. Had Brian Lenihan bought €77 billion of either, applying the proposed Nama discount of 30 per cent, he would have lost €35 billion-€40 billion on our behalf, or roughly €20,000 per taxpayer, and that is before adding interest.

At a quarter of national income, Nama would dwarf the cost of previous bank bailouts, which varied from about 3 per cent of GDP in Sweden to 14 per cent in Finland and Japan.

Most baffling of all the Nama numbers is the proposed discount of 30 per cent, implying that the “long-term economic value” of property is at 2004 prices. Not one shred of evidence is offered for this assertion, the keystone of the Government’s strategy.

At first, I thought that this mystical 30 per cent number embodied Fianna Fáil nostalgia for a vanished era of innocent greed; a hope that we would wake up one morning and find ourselves back in 2004 forever, basking in the benevolent gaze of Bertie Ahern and Seán FitzPatrick. The reality turns out to be a lot more mundane. The EU simply forbade Lenihan to pay any more. This is not through any dismay at seeing Irish taxpayers fleeced by their Government, but for fear that they will be stiffed into carrying out an Iceland-style rescue here.

The figure of a 77 per cent loan-to-value ratio is equally fanciful. It will take years for the courts and Fraud Squad to disentangle multiple personal guarantees and imaginary collateral. The situation in Anglo Irish Bank appears particularly grave.

Finally, there is the assumption that the Irish Government can continue to borrow forever at low rates from the European Central Bank. However, the ECB is making no secret of its dismay at being turned into a credit union for feckless Micks, and is anxious to end such emergency lending facilities within the next year.

Once the ECB slams the window on its fingers, the Government will be forced to borrow at market rates of 5 per cent or more. In the next decade, this will add another €25 billion or so to taxpayers’ losses from Nama.

Property speculation was a mania that swept every level of Irish society, from hairdressers buying apartments in Bulgaria to dentists taking out second mortgages to join commercial property syndicates. Business owners were not immune to the lure of effortless wealth, and many borrowed heavily to gamble in property.

As one banker put it: “We are happy to restore their credit line as soon as they repay us the €15 million they borrowed to buy that land bank on the edge of town.” The destruction of the Irish commercial class, who we might have hoped to be an engine of export led recovery as they were in the 1990s, is likely to prove one of the most enduring and costly legacies of the property bubble.

Forcing banks to lend to SMEs will only compound our problems. One condition of the Japanese bank recapitalisation in 1999 was that they lend to small firms, but the effect was to heap a second layer of non-performing loans onto existing property losses.

As well as being expensive, history shows Nama-style bad banks to be profoundly corrupt and corrupting institutions. After the financial crisis in 1931, the US, Germany and Austria all set up bad banks which turned into conduits for directing funds to politically connected enterprises.

Bad banks are the means for governments to choose which oligarchs will survive to emerge even stronger than before. They do not just happen to behave in a corrupt and anti-democratic manner: it is what they are designed to do.

And do not forget that, even after the crushing expense of Nama, Irish banks will still be seriously short of capital. Under the current, deliberately lax, international bank regulations, AIB and Bank of Ireland need capital of around €8.5 billion.

Financial markets, which assume that Nama will go through, value their existing capital at around €3 billion, and adding Government preference shares of €3.5 billion leaves them short about €2 billion each. Once stricter capital requirements are imposed next year (the so-called Basel 3 process), this shortfall will probably rise to €6 billion.

Nama then, will turn out to be expensive, corrupting, and inadequate. While the abject, almost endearing, eagerness of the Greens to please their Fianna Fáil masters means Nama is almost certain to go ahead, it is perhaps worth asking what would happen if it did not.

All that needs to be done is for ownership of Irish banks to be transferred to their bondholders. This process of converting debt into equity occurs sufficiently often in banking to have a name: resolution. Resolution offers a way for Irish banks to be adequately recapitalised at no cost to the taxpayer, and able to manage their business without political interference.

Under existing Irish corporate law, this transfer would be a recipe for centuries of litigation. That is why most other industrialised economies have, or are introducing, special legislation to resolve failing banks with limited judicial review. Particularly impressive is the UK’s Special Resolution Regime introduced last February, which could easily serve as a template for similar legistlation here.

Instead we will get Nama. Brian Lenihan assures us that Fianna Fáil’s monument to a decade of waste, corruption, and ultimate ruin will not be wasteful, corrupt, and ultimately ruinous.

Let us hope that, for once, he is not wrong.

December 2009
The Irish Credit Bubble ... 54227.html
Ghosts of debt and jobs will haunt economy
December 29, 2009

OPINION : By 2015, Iceland will almost certainly be a lot better off than Ireland because it dealt decisively with its banks

WHILE THINGS are hard to predict, the future, especially the situation of the Irish economy, is so stark that even an economist can make some predictions that stand a chance of being right.

Two ghosts of Christmas will haunt Ireland in 2015: jobs and debt.

For 20 years, the Irish economy experienced extraordinary growth. Unfortunately, this growth came from two separate booms that merged imperceptibly into each other. First we had real growth in the 1990s, driven by rising competitiveness and exports. However, after 2000 competitiveness collapsed, and growth came to be driven by a lending bubble without equal in the euro zone.

As Michael Hennigan of Finfacts ( has pointed out, of the half million jobs created in the last decade, only 4,000 were in exporting firms; and fewer people now work in IDA-supported companies than in 2000. The Irish economy has been faking it for a decade.

Now that the property bubble has burst, people hope that exports will once again become the engine of our salvation. The problem is that, back when we were becoming rich by selling houses to each other, we priced ourselves out of world markets. Wages have risen by one-third here compared with Germany since 2000. Restoring competitiveness will be an arduous task where nobody, outside the banks and ESB, will see a pay rise for a decade, and many will take pay cuts.

Whether desirable or otherwise, leaving the euro is not possible for a mundane reason. Changing currencies takes a lot of organisation, as we saw when the euro was introduced. If the Government announced that a New Irish Pound will be introduced in 12 months, everyone would rush out to withdraw their savings in euro and wipe out the banks.

Prolonged mass unemployment is a disaster not only for its victims, but for all society. The great Harvard sociologist William Julius Wilson showed how the disappearance of low-skilled jobs in the US during the 1970s led to the social collapse of black ghettos.

In Ireland for the last 20 years we saw this process working in reverse, as rising employment turned what had been sink estates into decent, if not wonderful, places to live. Finding a job does more for the disadvantaged than a legion of social workers: people’s sense of self-worth is transformed by being able to earn the money to do ordinary things like own a car, buy toys for their kids at Christmas, and take their family on holiday.

While many commentators argue that the benefits of the Celtic Tiger flowed exclusively to the wealthy and connected, this is nonsense. The benefits went overwhelmingly to ordinary people in the form of something that Ireland had never seen before: abundant jobs. By 2015 we will have seen what happens when jobs disappear forever, particularly from less educated men who were able to earn a good living in construction. In effect, Ireland is at the start of an enormous, unplanned social experiment on how rising unemployment affects crime, domestic violence, drug abuse, suicide and a litany of other social pathologies.

We will be forced to discover the consequences when people, who had worked hard to make decent lives for themselves and their children, find themselves reduced to nothing. Less than nothing in fact because, unlike the unemployed in the past, people now losing jobs are weighed down with debt and facing the terrifying prospect of losing their homes.

Debt will be the second ghost of Christmas 2015. Back in 1997, when exports drove real growth, Irish banks lent little by international standards. By 2008, Ireland had twice as much debt for its size as the average industrial economy: banks were lending a third more to property developers alone than they had been lending to everyone in Ireland in 2000.

It was this tidal wave of credit that inflated house prices and launched the construction boom that drove wages and government spending to unsustainable levels.

To fund this suicidal lending, Irish banks borrowed heavily internationally, and now must pay it back fast as the world realises that our recent economic miracle was less in the spirit of Adam Smith than of Bernard Madoff. As Irish bank lending returns to ordinary international levels, property prices will fall by at least two-thirds from their peaks.

However, five years from now, property prices could have been driven far lower than that by a deluge of sales of unsold, foreclosed and abandoned homes.

Mass mortgage defaults caused by unemployment and falling house prices are the next act of the Irish economic tragedy. As well as bankrupting our worthless banks all over again, the human cost of tens of thousands of families losing their homes will be enormous but, because the Government has already exhausted the State’s resources taking care of developers with Nama (National Asset Management Agency), there is very little that can be done to help these people.

Most people, of course, will not lose their jobs and homes. However, even they will be forced painfully to relearn something our parents already knew: beyond a small mortgage, debt swiftly turns into pure poison that will eat away your prosperity and happiness.

One response to large-scale home repossessions that will be attempted is to buy ghost estates for public housing to accommodate evicted home owners, providing ample opportunities for good old fashioned petty corruption.

For grand corruption, though, we will have to look to Nama. By allowing the banks to dictate the terms of their bailout, the bank rescue was turned into the most lucrative and audacious Tiger Kidnapping in the history of the State, with the difference that, like the sheriff in Blazing Saddles , the bankers held themselves hostage.

Bad banks like Nama were tried on a large scale in the early 1930s in the US, Austria and Germany; and proved to be profoundly corrupt and corrupting institutions, whose primary purpose was to funnel money to politically connected businesses. The German bank is best remembered for setting up what we would now call a special purpose vehicle to fund the presidential election campaign of the odious Paul Hindenberg.

Bad banks do not just happen to be corrupt and anti-democratic institutions, it is what they are designed to be. Effectively, bad banks give governments the power to choose which of a country’s most powerful oligarchs will be forced into bankruptcy, and which will be resuscitated to emerge even more powerful than before.

Nama will get to pick which of the fattest hogs of Irish development will be sliced up and fed, at taxpayer expense, to better connected hogs (remember that Nama has been allocated at least €6.5 billion, considerably more than the Government saved by draconian budget cuts, to “lend” to favoured clients).

While Nama may have momentous political consequences, it has already failed economically: the Irish banks are still zombies, reliant on transfusions of European Central Bank funding to survive until losses on mortgages and business loans finally wipe them out. In the next few months we will discover if the State bankrupts itself by nationalising the banks; or if it has the intelligence to free itself from bank losses by turning the foreign creditors of banks into their owners, as Iceland has just done with Kaupthing bank.

It is ironic that by 2015, having devalued its currency and dealt decisively with its banks, Iceland will almost certainly be a lot better off than Ireland.

Whatever happened to Ireland?
17 May 2010
Morgan Kelly

The Celtic Tiger faces severe challenges. This column argues that the Irish government’s commitment to absorb the losses of its banking system may well lead to a Greek-style debt ratio by 2012. It is a test-in-waiting for the EU, but one that could be solved by a debt for equity swap to cover the losses of Irish banks.

From basket case to superstar and back again – or almost. One has to wonder: How did all this happen? How did an economy where employment doubled and real GNP quadrupled during the “Celtic Tiger” era from 1990 to 2007, come to have GNP contract by 17% by late-2009 (with further falls forecast for 2010), the deepest and swiftest contraction suffered by a western economy since the Great Depression? The adjustments faced by the nation are monumental (see Cotter 2009 and Honohan and Lane 2009).

Two booms
The key to understanding what happened to Ireland is to realise that while GNP grew from 5% to 15% every year from 1991 to 2006, this Celtic Tiger growth stemmed from two very different booms. First, the 1990s saw rising employment associated with increased competitiveness and a quadrupling of real exports. As Ireland converged to average levels of western European income around 2000 it might have been expected that growth would fall to normal European levels. Instead growth continued at high rates until 2007 despite falling competitiveness, driven by a second boom in construction. I analyse this second boom, the Irish bubble, in a recent CEPR Discussion Paper (Kelly 2010).

Credit bubble
Ireland went from getting about 5% of its national income from house building in the 1990s – the usual level for a developed economy – to 15% at the peak of the boom in 2006–2007, with another 6% coming from other construction. In effect, the Irish decided that competitiveness no longer mattered, and that the road to riches lay in selling houses to each other.
However, driving the construction boom was another boom, in bank lending. As Figure 1 shows, back in 1997 when Ireland’s economy really was among the world’s best performing, Irish banks lent sparingly by international standards. Lending to the non-financial private sector was only 60% of GNP, compared with 80% in Britain and most Eurozone economies. The international credit boom saw these economies experience a rapid rise in bank lending, with loans increasing to 100% of GDP on average by 2008.
These rises were dwarfed, however, by Ireland, where bank lending grew to 200% of national income by 2008. Irish banks were lending 40% more in real terms to property developers alone in 2008 than they had been lending to everyone in Ireland in 2000, and 75% more to house buyers.
Figure 1. Bank lending to households and non-financial firms as a percentage of GDP (GNP for Ireland), 1997 and 2008.
This tripling of credit relative to GNP distorted the Irish economy profoundly. Its most visible impact was on house prices. In 1995 the average first-time buyer took out a mortgage equal to three years’ average industrial earnings, and the average house cost 4 years’ earnings. By the bubble peak in late 2006, the average first-time buyer mortgage had risen to 8 times average earnings, and the average new house now cost 10 times average earnings, with the average Dublin second-hand house costing 17 times average earnings (see Figures 2 and 3).
As the price of new houses rose faster than the cost of building them, investment in housing rose. By 2007, Ireland was building half as many houses as Britain, which has 14 times its population.
The flow of new mortgages peaked in the third quarter of 2006, and then fell rapidly. By the middle of 2007 the Irish construction industry was in clear trouble, with unsold units beginning to accumulate. More than one-sixth of housing units are now estimated to be vacant.
Figure 2. Irish house prices relative to average industrial earnings, 1980 – 2009
Figure 3. Irish new house prices and first time buyer mortgages relative to average industrial earnings, 1990 – 2009

Banking collapse
This property slowdown was bad news for an Irish banking system which had lent, usually without collateral, an amount equal to two-thirds of GNP to property developers to finance building projects and make speculative land purchases. Share prices of Irish banks fell steadily from March 2007, with the crisis coming to a head in late September 2008 with a run in wholesale markets on the joint-second largest Irish bank, Anglo Irish. After aggressive denials that the banking system faced any difficulties, the Irish government has been forced to improvise a series of increasingly desperate and expensive responses.
As well as guaranteeing the deposits and most bonds of Irish banks, the Irish government has currently spent, or committed itself to spend, around €40 billion on a National Asset Management Agency to buy non-performing development loans from banks, and to invest around €30 billion in Irish banks. Despite this large injection (equivalent to half of GNP), Irish banks remain moribund.
While the Irish government bailout deals with bank losses on loans to property developers, it does nothing about their two other problems: a heavy reliance on wholesale funding; and the prospect of further large losses on mortgages and business loans.
Half of Irish bank funding comes from international wholesale markets. Without continued government guarantees of their borrowing and, more problematically, continued access to ECB emergency funding, the operations of the Irish banks do not appear viable. Borrowing in bond markets at 6% to fund mortgages yielding 3% is not a sustainable activity, and Irish banks face no choice but to shrink their balance sheets. Should Irish bank lending return to normal international levels, our results indicate that property prices will return to an equilibrium two thirds below peak levels, with larger falls possible in the medium term as the flow of new lending is curtailed sharply.
The third problem facing Irish banks is their mortgages. With house prices down by around 40%, renewed emigration, and unemployment tripled to above 13%, Irish banks face substantial mortgage defaults. For comparison, in Florida and Arizona, whose investor fuelled housing bubbles closely resembled the Irish one, 25% of mortgages are non-performing.
On top of the continued disintegration of its banking system, Ireland faces two other problems: unemployment and government deficits. Private sector employment has fallen by 16%, while the number of males aged 20-24 in work has halved. The collapse in Irish competitiveness (wages have risen over 40% relative to its main trading partners since 2000) which cannot be solved by a devaluation, will frustrate efforts to reverse this decline.

Debt crisis
Fifteen fat years allowed the Irish government to cut income taxes, increase spending and still run a budget surplus. Between 2007 and 2009 however, tax revenue fell by 20%, while expenditure rose by 9%, moving the state from a balanced budget to a deficit of 12% of GDP. In contrast to its inept handling of the banking crisis, the Irish government has moved decisively to reduce expenditure and increase tax rates, and appears on target to reduce its deficit to 3% of GDP by 2012.
Ireland’s government debt is still moderate. At the end of 2009 gross debt was 65% of GDP and, after subtracting the state pension reserve and pre-funded borrowing, net debt was 40% of GDP. Assuming that deficit targets are not missed too badly, gross debt should still be under 85% of GDP by the end of 2012.

This debt would probably be manageable, had the Irish government not casually committed itself to absorb all the gambling losses of its banking system. If we assume – optimistically, I believe – that Irish banks eventually lose one third of what they lent to property developers, and one tenth of business loans and mortgages, the net cost to the Irish taxpayer will be nearly one third of GDP.
Adding these bank losses to its national debt will leave Ireland in 2012 with a debt-GDP ratio of 115%. But if we look at the ratio in terms of GNP, which gives a more realistic picture of the Ireland’s discretionary tax base, this is a debt-GNP ratio of 140% – above the ratio that is currently sinking Greece. Even if bank losses are only half as large as we expect, Ireland is still facing a debt-GNP ratio of 125%.
Ireland is like a patient bleeding from two gunshot wounds. The Irish government has moved quickly to stanch the smaller, fiscal hole, while insisting that the litres of blood pouring unchecked through the banking hole are “manageable”. Capital markets may not continue to agree for long, triggering a borrowing crisis which will start, most probably, with a run on Irish banks in inter-bank markets.
Ireland may therefore present an early test of the EU bailout fund. However, in contrast to Greece, Ireland’s woes stem almost entirely from its banking system, and could be swiftly and permanently cured by a resolution which shares the losses of Irish banks with the holders of their €115 billion of bonds through a partial debt for equity swap. ... 88132.html
Burden of Irish debt could yet eclipse that of Greece
May 22, 2010

OPINION: What will sink us, unfortunately but inevitably, are the huge costs of the September 2008 bank bailout, writes MORGAN KELLY

IT IS no longer a question of whether Ireland will go bust, but when. Unlike Greece, our woes do not stem from government debt, but instead from the government’s open-ended guarantee to cover the losses of the banking system out of its citizens’ wallets.

Even under the most optimistic assumptions about government spending cuts and bank losses, by 2012 Ireland will have a worse ratio of debt to national income than the one that is sinking Greece.

On the face of it, Ireland’s debt position does not appear catastrophic. At the start of the year, Ireland’s government debt was two- thirds of GDP: only half the Greek level. (The State also has financial assets equal to a quarter of GDP, but so do most governments, so we will focus on the total debt.)

Because of the economic collapse here, the Government is adding to this debt quite quickly. However, in contrast to its inept handling of the banking crisis, the Government has taken reasonable steps to bring the deficit under control. If all goes to plan we should be looking at a debt of 85 to 90 per cent of GDP by the end of 2012.

This is quite large for a small economy, but it is manageable. Just about. What will sink us, unfortunately but inevitably, are the huge costs of the bank bailout.

We can gain a sobering perspective on the impossible disproportion between the bailout and our economic resources by looking at the US. The government there set aside $700 billion (€557 billion) to buy troubled bank assets, and the final cost to the American taxpayer is about $150 billion. These sound like, and are, astronomical numbers.

But when you translate from the leviathan that is America to the minnow that is Ireland, it would be equivalent to the Irish Government spending €7 billion on Nama, and eventually losing €1.5 billion in the process. Pocket change by our standards.

Instead, our Government has already committed itself to spend €70 billion (€40 billion on the National Asset Management Agency – Nama – and €30 billion on recapitalising banks), or half of the national income. That is 10 times per head of population the amount the US spent to rescue itself from its worst banking crisis since the Great Depression.

Having received such a staggering transfusion of taxpayer funds, you might expect that the Irish banks would now be as fit as fleas. Instead, they are still in intensive care, and will require even larger transfusions before they can fend for themselves again.

It is hard to think of any institution since the League of Nations that has become so irrelevant so fast as Nama. Instead of the resurrection of the Irish banking system we were promised, we now have one semi-State body (Nama) buying assets from other semi-states (Anglo) and soon-to-be semi-States (AIB and Bank of Ireland), while funnelling €60 million a year in fees to lawyers, valuers and associated parasites.

What ultimately matters for national solvency, however, is not how much the State invests in its banks, but how much it is likely to lose. It is alright to invest €70 billion, or even €100 billion, to rescue your banking system if you can reasonably expect to get back most of what you spent. So how much are the banks and, thanks to the bank guarantee, you the taxpayer, likely to lose?

Let’s start with the €100 billion of property development loans. We’ll be optimistic and say the loss here will be one-third. Remember, Anglo has already owned up to losing about €25 billion of its €75 billion portfolio, so we have almost reached that third without looking at AIB and Bank of Ireland. I think the final loss will be more than half, but we’ll keep with the third to err on the side of optimism.

Next there are €35 billion of business loans. Over €10 billion of these loans are to hotels and pubs and will likely not be seen again this side of Judgment Day. Meanwhile, one-third of loans to small and medium enterprises are reported already to be in arrears. So, a figure of a 20 per cent loss again seems optimistic.

Finally, we have mortgages of €140 billion, and other personal lending of €20 billion. Current mortgage default figures here are meaningless because, once you agree a reduction of mortgage payments to a level you can afford, Irish banks can still pretend that your loan is performing.

Banks in the US typically get back half of what they loaned when they foreclose, but losses here could be greater because banks, fortunately, find it hard to take away your family home. So Irish banks could easily be looking at mortgage losses of 10 per cent but, to be conservative, we will say five.

So between developers, businesses, and personal loans, Irish banks are on track to lose nearly €50 billion if we are optimistic (and more likely closer to €70 billion), which translates into a bill for the taxpayer of over 30 per cent of GDP. The bank guarantee may have looked like “the cheapest bailout in the world, so far” in September 2008, but it is not looking that way now.

Adding these bank losses on to the national debt means we are facing a debt by late 2012 of 115 per cent of GDP. If we are lucky.

There is more. The ability of a government to service its debts depends on its tax base. In Ireland the proper measure of tax base, at least when it comes to increasing taxes, is not GDP (including profits of multinational firms, who will walk if we raise their taxes) but GNP (which is limited to Irish people, who are mostly stuck here). While for most countries the two measures are the same, in Ireland GDP is a quarter larger than GNP. This means our optimistic debt to GDP forecast of 115 per cent translates into a debt to GNP ratio of 140 per cent, worse than where Greece is now.

And even this catastrophic number assumes that our economy does not contract further. For the last two years the Irish economy has not been shrinking, so much as vaporising. Real GNP and private sector employment have already fallen by one-sixth – the deepest and swiftest falls in a western economy since the Great Depression.

The contraction is far from over, to judge from the two economic indicators I pay most attention to. Redundancies have been steady at 6,000 per month for the last nine months. Insolvencies are 25 per cent higher than this time last year, and are rippling outwards from construction into the rest of the economy.

The Irish economy is like a patient bleeding from two gunshot wounds. The Government has moved competently to stanch the smaller, budgetary hole, while continuing to insist that the litres of blood pouring unchecked from the banking hole are “manageable”.

Capital markets are unlikely to agree for much longer, triggering a borrowing crisis for Ireland. The first torpedo, most probably, will be a run on Irish banks in inter-bank markets, of the sort that sank Anglo in 2008. Already, Irish banks are struggling to find lenders to leave money on deposit for more than a week.

Ireland is setting itself up to present an early test of the shaky EU commitment to bail out its more spendthrift members. Probably we will end up with a deal where the European Central Bank buys Irish debt and provides continued emergency funding to Irish banks, in return for our agreeing a schedule of reparations of 5-6 per cent of national income over the next few decades.

To repay these reparations will take swingeing cuts in spending and social welfare, and unprecedented tax rises. A central part of our “rescue” package is certain to be the requirement that we raise our corporate taxes to European levels, sabotaging any prospect of recovery as multinationals are driven out.

The issue of national sovereignty has for so long been the monopoly of republican headbangers that it is hard to know whether ordinary, sane Irish people still care about it. Either way, we will not be having it around much longer.

We have long since left the realm of easy alternatives, and will soon face a choice between national bankruptcy and admitting the bank guarantee was a mistake. Either we cut the banks loose, or we sink ourselves.

While most countries facing bankruptcy sit passively in denial until they sink – just as we are doing – there is one shining exception: Uruguay. When markets panicked after Argentina defaulted in 2002, Uruguay knew it could no longer service its large external debt. Instead of waiting for a borrowing crisis, the Uruguayans approached their creditors and pointed out they faced a choice.

Either they could play tough and force Uruguay into bankruptcy, in which case they would get almost nothing back, or they could agree to reduce Uruguay’s debt to a manageable level, and get back most of what they lent. Realising Uruguay’s problems were largely not of its own making, and that it had never stiffed its creditors in the past, the lenders agreed to a debt restructuring, and Uruguay was able to return to debt markets within a few months.

In one way, our position is a lot easier than Uruguay’s, because our problem is bank debt rather than government debt. Our crisis stems entirely from the Government’s gratuitous decision on September 29th, 2008, to transform the IOUs of Seán FitzPatrick, Dermot Gleeson and their peers into quasi-sovereign instruments of the Irish state.

Our borrowing crisis could be solved before it even happens by passing the same sort of Special Resolution legislation that the Bank of England enacted after the Northern Rock crisis. The more than €65 billion in bonds that will be outstanding by the end of September when the guarantee expires could then be turned into shares in the banks: a debt for equity swap.

We need to explain that the Irish State has always honoured its debts in the past, and will continue to do so. However, the State is a distinct entity from its banks and, having learned the extent of the banks’ recklessness, we now have no choice but to allow the bank guarantee to lapse and to share the banks’ losses with their bondholders. It must be remembered that when these bonds were issued they had no government guarantee, and the institutions that bought them did so in full knowledge that they could default, and charged an appropriate rate of interest to compensate themselves for this risk.

Freed of the impossible bank debt, the Irish State could concentrate on the other daunting problems left by its decade-long credit binge: unemployment, lack of competitiveness and indebted households. The banks would be soundly capitalised and able to manage themselves free of political interference.

There are two common objections to sharing the banks’ losses with their bondholders, both of them specious. The first is that nobody would lend to Irish banks afterwards. However, given that soon nobody will be lending to Irish banks anyway, this is not an issue. Either way, the Irish State and banks are facing a period of relying on emergency funding. After a debt-for-equity swap, Irish banks, which were highly profitable before they fell into the clutches of their current “management”, will be carrying little debt, making them attractive credit risks.

The second objection is that Ireland would be sued in every court in Europe. Again wrong. Under the EU’s winding-up directive, the government that issues a bank’s licence has full power to resolve the bank under its own laws.

Of course, expecting politicians to sort out the Irish banks is pure fantasy. Like their British and American counterparts, Irish politicians have spent too long believing that banks were the root of national prosperity to understand that their interests are frequently inimical to those of the rest of the economy.

The architect of Uruguay’s salvation was not one of its politicians, but a technocrat called Carlos Steneri. The one positive development in Ireland in recent months is that control of the banking system has passed from the Government to similar technocrats.

This transfer did not take place without a struggle – one that was entirely missed by the media. When Anglo announced they wanted to take over Quinn Insurance despite the objections of the Financial Regulator, journalists seemed to view this as just another case of Anglo being Anglo. They should have remembered that Anglo cannot now turn on a radiator unless the Department of Finance says so, and what was going on instead was a direct power struggle between the Financial Regulator and the Minister for Finance.

Having been forced to appoint a credible Financial Regulator and Central Bank governor – first-rate ones, in fact – the Government must do what they say. Were either Elderfield or Honohan to resign, Irish bonds would straight away turn to junk.

Now you understand the extraordinary shift in power that lay behind the seeming non-headline in this newspaper last month: “Lenihan expresses confidence in regulator”.

The great macroeconomist Rudiger Dornbusch observed that crises always take a lot longer to happen than you expect but, once started, they move with frightening rapidity. Or, as Hemingway put it, bankruptcy happens “Slowly. Then all at once.” We can only hope that the Central Bank is using whatever time remains to us as an independent State to devise an intelligent Plan B – or is it Plan C? ... 65400.html
If you thought the bank bailout was bad, wait until the mortgage defaults hit home
November 8, 2010

THE BIG PICTURE: Ireland is effectively insolvent – the next crisis will be mass home mortgage default, writes MORGAN KELLY

SAD NEWS just in from Our Lady of the Eurozone Hospital: After a sudden worsening in her condition, the Irish Patient, formerly known as the Irish Republic, has been moved into intensive care and put on artificial ventilation. While a hospital spokesman, Jean-Claude Trichet, tried to sound upbeat, there is no prospect that the Patient will recover.

It will be remembered that, after a lengthy period of poverty following her acrimonious divorce from her English partner, in the 1990s Ireland succeeded in turning her life around, educating herself, and holding down a steady job. Although her increasingly riotous lifestyle over the last decade had raised some concerns, the Irish Patient’s fate was sealed by a botched emergency intervention on September 29th, 2008 followed by repeated misdiagnoses of the ensuing complications.

With the Irish Patient now clinically dead, her grieving European relatives face the melancholy task of deciding when to remove her from life support, and how to deal with the extraordinary debts she ran up in the last months of her life . . .

WHEN I wrote in The Irish Times last May showing how the bank guarantee would lead to national insolvency, I did not expect the financial collapse to be anywhere near as swift or as deep as has now occurred. During September, the Irish Republic quietly ceased to exist as an autonomous fiscal entity, and became a ward of the European Central Bank.

It is a testament to the cool and resolute handling of the crisis over the last six months by the Government and Central Bank that markets now put Irish sovereign debt in the same risk group as Ukraine and Pakistan, two notches above the junk level of Argentina, Greece and Venezuela.

September marked Ireland’s point of no return in the banking crisis. During that month, €55 billion of bank bonds (held mainly by UK, German, and French banks) matured and were repaid, mostly by borrowing from the European Central Bank.

Until September, Ireland had the legal option of terminating the bank guarantee on the grounds that three of the guaranteed banks had withheld material information about their solvency, in direct breach of the 1971 Central Bank Act. The way would then have been open to pass legislation along the lines of the UK’s Bank Resolution Regime, to turn the roughly €75 billion of outstanding bank debt into shares in those banks, and so end the banking crisis at a stroke.

With the €55 billion repaid, the possibility of resolving the bank crisis by sharing costs with the bondholders is now water under the bridge. Instead of the unpleasant showdown with the European Central Bank that a bank resolution would have entailed, everyone is a winner. Or everyone who matters, at least.

The German and French banks whose solvency is the overriding concern of the ECB get their money back. Senior Irish policymakers get to roll over and have their tummies tickled by their European overlords and be told what good sports they have been. And best of all, apart from some token departures of executives too old and rich to care less, the senior management of the banks that caused this crisis continue to enjoy their richly earned rewards. The only difficulty is that the Government’s open-ended commitment to cover the bank losses far exceeds the fiscal capacity of the Irish State.

The Government has admitted that Anglo is going to cost the taxpayer €29 to €34 billion. It has also invested €16 billion in the other banks, but expects to get some or all of that investment back eventually.

So, the taxpayer cost of the bailout is about €30 billion for Anglo and some fraction of €16 billion for the rest. Unfortunately, these numbers are not consistent with each other, and it only takes a second to see why.

Between them, AIB and Bank of Ireland had the same exposure to developers as Anglo and, to the extent that they were scrambling to catch up with Anglo, probably lent to even worse turkeys than it did. AIB and Bank of Ireland did start with more capital to absorb losses than Anglo, but also face substantial mortgage losses, which it does not. It follows that AIB and Bank of Ireland together will cost the taxpayer at least as much as Anglo.

Once we accept, as the Government does, that Anglo will cost the taxpayer about €30 billion, we must accept that AIB and Bank of Ireland will cost at least €30 billion extra.

In my article of last May, when I published my optimistic estimate of a €50 billion bailout bill, I posted a spreadsheet on the website, giving my realistic estimates of taxpayer losses. My realistic estimate for Anglo was €34 billion, the same as the Government’s current estimate.

When you apply the same assumptions about lending losses to the other banks, you end up with a likely taxpayer bill of €16 billion for Bank of Ireland (deducting the €3 billion they have since received from investors) and €26 billion for AIB: nearly as bad as Anglo.

Indeed, the true scandal in Irish banking is not what happened at Anglo and Nationwide (which, as specialised development lenders, would have suffered horrific losses even had they not been run by crooks or morons) but the breakdown of governance at AIB that allowed it to pursue the same suicidal path.

Once again we are having to sit through the same dreary and mendacious charade with AIB that we endured with Anglo: “AIB only needs €3.5 billion, sorry we meant to say €6.5 billion, sorry . . .” and so on until it is fully nationalised next year, and the true extent of its folly revealed.

This €70 billion bill for the banks dwarfs the €15 billion in spending cuts now agonised over, and reduces the necessary cuts in Government spending to an exercise in futility. What is the point of rearranging the spending deckchairs, when the iceberg of bank losses is going to sink us anyway?

What is driving our bond yields to record levels is not the Government deficit, but the bank bailout. Without the banks, our national debt could be stabilised in four years at a level not much worse than where France, with its triple A rating in the bond markets, is now.

As a taxpayer, what does a bailout bill of €70 billion mean? It means that every cent of income tax that you pay for the next two to three years will go to repay Anglo’s losses, every cent for the following two years will go on AIB, and every cent for the next year and a half on the others. In other words, the Irish State is insolvent: its liabilities far exceed any realistic means of repaying them.

For a country or company, insolvency is the equivalent of death for a person, and is usually swiftly followed by the legal process of bankruptcy, the equivalent of a funeral.

Two things have delayed Ireland’s funeral. First, in anticipation of being booted out of bond markets, the Government built up a large pile of cash a few months ago, so that it can keep going until the New Year before it runs out of money. Although insolvent, Ireland is still liquid, for now.

Secondly, not wanting another Greek-style mess, the ECB has intervened to fund the Irish banks. Not only have Irish banks had to repay their maturing bonds, but they have been haemorrhaging funds in the inter-bank market, and the ECB has quietly stepped in with emergency funding to keep them going until it can make up its mind what to do.

Since September, a permanent team of ECB “observers” has taken up residence in the Department of Finance. Although of many nationalities, they are known there, dismayingly but inevitably, as “The Germans”.

So, thanks to the discreet intervention of the ECB, the first stage of the crisis has closed with a whimper rather than a bang. Developer loans sank the banks which, thanks to the bank guarantee, sank the Irish State, leaving it as a ward of the ECB.

The next act of the crisis will rehearse the same themes of bad loans and foreign debt, only this time as tragedy rather than farce. This time the bad loans will be mortgages, and the foreign creditor who cannot be repaid is the ECB. In consequence, the second act promises to be a good deal more traumatic than the first.

Where the first round of the banking crisis centred on a few dozen large developers, the next round will involve hundreds of thousands of families with mortgages. Between negotiated repayment reductions and defaults, at least 100,000 mortgages (one in eight) are already under water, and things have barely started.

Banks have been relying on two dams to block the torrent of defaults – house prices and social stigma – but both have started to crumble alarmingly.

People are going to extraordinary lengths – not paying other bills and borrowing heavily from their parents – to meet mortgage repayments, both out of fear of losing their homes and to avoid the stigma of admitting that they are broke. In a society like ours, where a person’s moral worth is judged – by themselves as much as by others – by the car they drive and the house they own, the idea of admitting that you cannot afford your mortgage is unspeakably shameful.

That will change. The perception growing among borrowers is that while they played by the rules, the banks certainly did not, cynically persuading them into mortgages that they had no hope of affording. Facing a choice between obligations to the banks and to their families – mortgage or food – growing numbers are choosing the latter.

In the last year, America has seen a rising number of “strategic defaults”. People choose to stop repaying their mortgages, realising they can live rent-free in their house for several years before eviction, and then rent a better house for less than the interest on their current mortgage. The prospect of being sued by banks is not credible – the State of Florida allows banks full recourse to the assets of delinquent borrowers just like here, but it has the highest default rate in the US – because there is no point pursuing someone who has no assets.

If one family defaults on its mortgage, they are pariahs: if 200,000 default they are a powerful political constituency. There is no shame in admitting that you too were mauled by the Celtic Tiger after being conned into taking out an unaffordable mortgage, when everyone around you is admitting the same.

The gathering mortgage crisis puts Ireland on the cusp of a social conflict on the scale of the Land War, but with one crucial difference. Whereas the Land War faced tenant farmers against a relative handful of mostly foreign landlords, the looming Mortgage War will pit recent house buyers against the majority of families who feel they worked hard and made sacrifices to pay off their mortgages, or else decided not to buy during the bubble, and who think those with mortgages should be made to pay them off. Any relief to struggling mortgage-holders will come not out of bank profits – there is no longer any such thing – but from the pockets of other taxpayers.

The other crumbling dam against mass mortgage default is house prices. House prices are driven by the size of mortgages that banks give out. That is why, even though Irish banks face long-run funding costs of at least 8 per cent (if they could find anyone to lend to them), they are still giving out mortgages at 5 per cent, to maintain an artificial floor on house prices. Without this trickle of new mortgages, prices would collapse and mass defaults ensue.

However, once Irish banks pass under direct ECB control next year, they will be forced to stop lending in order to shrink their balance sheets back to a level that can be funded from customer deposits. With no new mortgage lending, the housing market will be driven by cash transactions, and prices will collapse accordingly.

While the current priority of Irish banks is to conceal their mortgage losses, which requires them to go easy on borrowers, their new priority will be to get the ECB’s money back by whatever means necessary. The resulting wave of foreclosures will cause prices to collapse further.

Along with mass mortgage defaults, sorting out our bill with the ECB will define the second stage of the banking crisis. For now it is easier for the ECB to drip feed funding to the Irish State and banks rather than admit publicly that we are bankrupt, and trigger a crisis that could engulf other euro-zone states. Our economy is tiny, and it is easiest, for now, to kick the can up the road and see how things work out.

By next year Ireland will have run out of cash, and the terms of a formal bailout will have to be agreed. Our bill will be totted up and presented to us, along with terms for repayment. On these terms hangs our future as a nation. We can only hope that, in return for being such good sports about the whole bondholder business and repaying European banks whose idea of a sound investment was lending billions to Gleeson, Fitzpatrick and Fingleton, the Government can negotiate a low rate of interest.

With a sufficiently low interest rate on what we owe to Europe, a combination of economic growth and inflation will eventually erode away the debt, just as it did in the 1980s: we get to survive.

How low is sufficiently low? Economists have a simple rule to calculate this. If the interest rate on a country’s debt is lower than the sum of its growth rate and inflation rate, the ratio of debt to national income will shrink through time. After a massive credit bubble and with a shaky international economy, our growth prospects for the next decade are poor, and prices are likely to be static or falling. An interest rate beyond 2 per cent is likely to sink us.

This means that if we are forced to repay the ECB at the 5 per cent interest rate imposed on Greece, our debt will rise faster than our means of servicing it, and we will inevitably face a State bankruptcy that will destroy what few shreds of our international reputation still remain.

Why would the ECB impose such a punitive interest rate on us? The answer is that we are too small to matter: the ECB’s real concerns lie with Spain and Italy. Making an example of Ireland is an easy way to show that bailouts are not a soft option, and so frighten them into keeping their deficits under control.

Given the risk of national bankruptcy it entailed, what led the Government into this abject and unconditional surrender to the bank bondholders? I have been told that the Government’s reasoning runs as follows: “Europe will bail us out, just like they bailed out the Greeks. And does anyone expect the Greeks to repay?”

The fallacy of this reasoning is obvious. Despite a decade of Anglo-Fáil rule, with its mantra that there are no such things as duties, only entitlements, few Irish institutions have collapsed to the third-world levels of their Greek counterparts, least of all our tax system.

And unlike the Greeks, we lacked the tact and common sense to keep our grubby dealing to ourselves. Europeans had to endure a decade of Irish politicians strutting around and telling them how they needed to emulate our crony capitalism if they wanted to be as rich as we are. As far as other Europeans are concerned, the Irish Government is aiming to add injury to insult by getting their taxpayers to help the “Richest Nation in Europe” continue to enjoy its lavish lifestyle.

My stating the simple fact that the Government has driven Ireland over the brink of insolvency should not be taken as a tacit endorsement of the Opposition. The stark lesson of the last 30 years is that, while Fianna Fáil’s record of economic management has been decidedly mixed, that of the various Fine Gael coalitions has been uniformly dismal.

As ordinary people start to realise that this thing is not only happening, it is happening to them, we can see anxiety giving way to the first upwellings of an inchoate rage and despair that will transform Irish politics along the lines of the Tea Party in America. Within five years, both Civil War parties are likely to have been brushed aside by a hard right, anti-Europe, anti-Traveller party that, inconceivable as it now seems, will leave us nostalgic for the, usually, harmless buffoonery of Biffo, Inda, and their chums.

You have read enough articles by economists by now to know that it is customary at this stage for me to propose, in 30 words or fewer, a simple policy that will solve all our problems. Unfortunately, this is where I have to hold up my hands and confess that I have no solutions, simple or otherwise.

Ireland faced a painful choice between imposing a resolution on banks that were too big to save or becoming insolvent, and, for whatever reason, chose the latter. Sovereign nations get to make policy choices, and we are no longer a sovereign nation in any meaningful sense of that term.

From here on, for better or worse, we can only rely on the kindness of strangers.

2011 ... 72123.html
Ireland's future depends on breaking free from bailout
Saturday, May 7, 2011

OPINION: Ireland is heading for bankruptcy, which would be catastrophic for a country that trades on its reputation as a safe place to do business, writes MORGAN KELLY

WITH THE Irish Government on track to owe a quarter of a trillion euro by 2014, a prolonged and chaotic national bankruptcy is becoming inevitable. By the time the dust settles, Ireland’s last remaining asset, its reputation as a safe place from which to conduct business, will have been destroyed.

Ireland is facing economic ruin.

While most people would trace our ruin to to the bank guarantee of September 2008, the real error was in sticking with the guarantee long after it had become clear that the bank losses were insupportable. Brian Lenihan’s original decision to guarantee most of the bonds of Irish banks was a mistake, but a mistake so obvious and so ridiculous that it could easily have been reversed. The ideal time to have reversed the bank guarantee was a few months later when Patrick Honohan was appointed governor of the Central Bank and assumed de facto control of Irish economic policy.

As a respected academic expert on banking crises, Honohan commanded the international authority to have announced that the guarantee had been made in haste and with poor information, and would be replaced by a restructuring where bonds in the banks would be swapped for shares.

Instead, Honohan seemed unperturbed by the possible scale of bank losses, repeatedly insisting that they were “manageable”. Like most Irish economists of his generation, he appeared to believe that Ireland was still the export-driven powerhouse of the 1990s, rather than the credit-fuelled Ponzi scheme it had become since 2000; and the banking crisis no worse than the, largely manufactured, government budget crisis of the late 1980s.

Rising dismay at Honohan’s judgment crystallised into outright scepticism after an extraordinary interview with Bloomberg business news on May 28th last year. Having overseen the Central Bank’s “quite aggressive” stress tests of the Irish banks, he assured them that he would have “the two big banks, fixed by the end of the year. I think it’s quite good news The banks are floating away from dependence on the State and will be free standing”.

Honohan’s miscalculation of the bank losses has turned out to be the costliest mistake ever made by an Irish person. Armed with Honohan’s assurances that the bank losses were manageable, the Irish government confidently rode into the Little Bighorn and repaid the bank bondholders, even those who had not been guaranteed under the original scheme. This suicidal policy culminated in the repayment of most of the outstanding bonds last September.

Disaster followed within weeks. Nobody would lend to Irish banks, so that the maturing bonds were repaid largely by emergency borrowing from the European Central Bank: by November the Irish banks already owed more than €60 billion. Despite aggressive cuts in government spending, the certainty that bank losses would far exceed Honohan’s estimates led financial markets to stop lending to Ireland.

On November 16th, European finance ministers urged Lenihan to accept a bailout to stop the panic spreading to Spain and Portugal, but he refused, arguing that the Irish government was funded until the following summer. Although attacked by the Irish media for this seemingly delusional behaviour, Lenihan, for once, was doing precisely the right thing. Behind Lenihan’s refusal lay the thinly veiled threat that, unless given suitably generous terms, Ireland could hold happily its breath for long enough that Spain and Portugal, who needed to borrow every month, would drown.

At this stage, with Lenihan looking set to exploit his strong negotiating position to seek a bailout of the banks only, Honohan intervened. As well as being Ireland’s chief economic adviser, he also plays for the opposing team as a member of the council of the European Central Bank, whose decisions he is bound to carry out. In Frankfurt for the monthly meeting of the ECB on November 18th, Honohan announced on RTÉ Radio 1’s Morning Ireland that Ireland would need a bailout of “tens of billions”.

Rarely has a finance minister been so deftly sliced off at the ankles by his central bank governor. And so the Honohan Doctrine that bank losses could and should be repaid by Irish taxpayers ran its predictable course with the financial collapse and international bailout of the Irish State.

Ireland’s Last Stand began less shambolically than you might expect. The IMF, which believes that lenders should pay for their stupidity before it has to reach into its pocket, presented the Irish with a plan to haircut €30 billion of unguaranteed bonds by two-thirds on average. Lenihan was overjoyed, according to a source who was there, telling the IMF team: “You are Ireland’s salvation.”

The deal was torpedoed from an unexpected direction. At a conference call with the G7 finance ministers, the haircut was vetoed by US treasury secretary Timothy Geithner who, as his payment of $13 billion from government-owned AIG to Goldman Sachs showed, believes that bankers take priority over taxpayers. The only one to speak up for the Irish was UK chancellor George Osborne, but Geithner, as always, got his way. An instructive, if painful, lesson in the extent of US soft power, and in who our friends really are.

The negotiations went downhill from there. On one side was the European Central Bank, unabashedly representing Ireland’s creditors and insisting on full repayment of bank bonds. On the other was the IMF, arguing that Irish taxpayers would be doing well to balance their government’s books, let alone repay the losses of private banks. And the Irish? On the side of the ECB, naturally.

In the circumstances, the ECB walked away with everything it wanted. The IMF were scathing of the Irish performance, with one staffer describing the eagerness of some Irish negotiators to side with the ECB as displaying strong elements of Stockholm Syndrome.

The bailout represents almost as much of a scandal for the IMF as it does for Ireland. The IMF found itself outmanoeuvred by ECB negotiators, their low opinion of whom they are not at pains to conceal. More importantly, the IMF was forced by the obduracy of Geithner and the spinelessness, or worse, of the Irish to lend their imprimatur, and €30 billion of their capital, to a deal that its negotiators privately admit will end in Irish bankruptcy. Lending to an insolvent state, which has no hope of reducing its debt enough to borrow in markets again, breaches the most fundamental rule of the IMF, and a heated debate continues there over the legality of the Irish deal.

Six months on, and with Irish government debt rated one notch above junk and the run on Irish banks starting to spread to household deposits, it might appear that the Irish bailout of last November has already ended in abject failure. On the contrary, as far as its ECB architects are concerned, the bailout has turned out to be an unqualified success.

The one thing you need to understand about the Irish bailout is that it had nothing to do with repairing Ireland’s finances enough to allow the Irish Government to start borrowing again in the bond markets at reasonable rates: what people ordinarily think of a bailout as doing.

The finances of the Irish Government are like a bucket with a large hole in the form of the banking system. While any half-serious rescue would have focused on plugging this hole, the agreed bailout ostentatiously ignored the banks, except for reiterating the ECB-Honohan view that their losses would be borne by Irish taxpayers. Try to imagine the Bank of England’s insisting that Northern Rock be rescued by Newcastle City Council and you have some idea of how seriously the ECB expects the Irish bailout to work.

Instead, the sole purpose of the Irish bailout was to frighten the Spanish into line with a vivid demonstration that EU rescues are not for the faint-hearted. And the ECB plan, so far anyway, has worked. Given a choice between being strung up like Ireland – an object of international ridicule, paying exorbitant rates on bailout funds, its government ministers answerable to a Hungarian university lecturer – or mending their ways, the Spanish have understandably chosen the latter.

But why was it necessary, or at least expedient, for the EU to force an economic collapse on Ireland to frighten Spain? The answer goes back to a fundamental, and potentially fatal, flaw in the design of the euro zone: the lack of any means of dealing with large, insolvent banks.

Back when the euro was being planned in the mid-1990s, it never occurred to anyone that cautious, stodgy banks like AIB and Bank of Ireland, run by faintly dim former rugby players, could ever borrow tens of billions overseas, and lose it all on dodgy property loans. Had the collapse been limited to Irish banks, some sort of rescue deal might have been cobbled together; but a suspicion lingers that many Spanish banks – which inflated a property bubble almost as exuberant as Ireland’s, but in the world’s ninth largest economy – are hiding losses as large as those that sank their Irish counterparts.

Uniquely in the world, the European Central Bank has no central government standing behind it that can levy taxes. To rescue a banking system as large as Spain’s would require a massive commitment of resources by European countries to a European Monetary Fund: something so politically complex and financially costly that it will only be considered in extremis, to avert the collapse of the euro zone. It is easiest for now for the ECB to keep its fingers crossed that Spain pulls through by itself, encouraged by the example made of the Irish.

Irish insolvency is now less a matter of economics than of arithmetic. If everything goes according to plan, as it always does, Ireland’s government debt will top €190 billion by 2014, with another €45 billion in Nama and €35 billion in bank recapitalisation, for a total of €270 billion, plus whatever losses the Irish Central Bank has made on its emergency lending. Subtracting off the likely value of the banks and Nama assets, Namawinelake (by far the best source on the Irish economy) reckons our final debt will be about €220 billion, and I think it will be closer to €250 billion, but these differences are immaterial: either way we are talking of a Government debt that is more than €120,000 per worker, or 60 per cent larger than GNP.

Economists have a rule of thumb that once its national debt exceeds its national income, a small economy is in danger of default (large economies, like Japan, can go considerably higher). Ireland is so far into the red zone that marginal changes in the bailout terms can make no difference: we are going to be in the Hudson.

The ECB applauded and lent Ireland the money to ensure that the banks that lent to Anglo and Nationwide be repaid, and now finds itself in the situation where, as a consequence, the banks that lent to the Irish Government are at risk of losing most of what they lent. In other words, the Irish banking crisis has become part of the larger European sovereign debt crisis.

Given the political paralysis in the EU, and a European Central Bank that sees its main task as placating the editors of German tabloids, the most likely outcome of the European debt crisis is that, after two years or so to allow French and German banks to build up loss reserves, the insolvent economies will be forced into some sort of bankruptcy.

Make no mistake: while government defaults are almost the normal state of affairs in places like Greece and Argentina, for a country like Ireland that trades on its reputation as a safe place to do business, a bankruptcy would be catastrophic. Sovereign bankruptcies drag on for years as creditors hold out for better terms, or sell to so-called vulture funds that engage in endless litigation overseas to have national assets such as aircraft impounded in the hope that they can make a sufficient nuisance of themselves to be bought off.

Worse still, a bankruptcy can do nothing to repair Ireland’s finances. Given the other commitments of the Irish State (to the banks, Nama, EU, ECB and IMF), for a bankruptcy to return government debt to a sustainable level, the holders of regular government bonds will have to be more or less wiped out. Unfortunately, most Irish government bonds are held by Irish banks and insurance companies.

In other words, we have embarked on a futile game of passing the parcel of insolvency: first from the banks to the Irish State, and next from the State back to the banks and insurance companies. The eventual outcome will likely see Ireland as some sort of EU protectorate, Europe’s answer to Puerto Rico.

Suppose that we did not want to follow our current path towards an ECB-directed bankruptcy and spiralling national ruin, is there anything we could do? While Prof Honohan sportingly threw away our best cards last September, there still is a way out that, while not painless, is considerably less painful than what Europe has in mind for us.

National survival requires that Ireland walk away from the bailout. This in turn requires the Government to do two things: disengage from the banks, and bring its budget into balance immediately.

First the banks. While the ECB does not want to rescue the Irish banks, it cannot let them collapse either and start a wave of panic that sweeps across Europe. So, every time one of you expresses your approval of the Irish banks by moving your savings to a foreign-owned bank, the Irish bank goes and replaces your money with emergency borrowing from the ECB or the Irish Central Bank. Their current borrowings are €160 billion.

The original bailout plan was that the loan portfolios of Irish banks would be sold off to repay these borrowings. However, foreign banks know that many of these loans, mortgages especially, will eventually default, and were not interested. As a result, the ECB finds itself with the Irish banks wedged uncomfortably far up its fundament, and no way of dislodging them.

This allows Ireland to walk away from the banking system by returning the Nama assets to the banks, and withdrawing its promissory notes in the banks. The ECB can then learn the basic economic truth that if you lend €160 billion to insolvent banks backed by an insolvent state, you are no longer a creditor: you are the owner. At some stage the ECB can take out an eraser and, where “Emergency Loan” is written in the accounts of Irish banks, write “Capital” instead. When it chooses to do so is its problem, not ours.

At a stroke, the Irish Government can halve its debt to a survivable €110 billion. The ECB can do nothing to the Irish banks in retaliation without triggering a catastrophic panic in Spain and across the rest of Europe. The only way Europe can respond is by cutting off funding to the Irish Government.

So the second strand of national survival is to bring the Government budget immediately into balance. The reason for governments to run deficits in recessions is to smooth out temporary dips in economic activity. However, our current slump is not temporary: Ireland bet everything that house prices would rise forever, and lost. To borrow so that senior civil servants like me can continue to enjoy salaries twice as much as our European counterparts makes no sense, macroeconomic or otherwise.

Cutting Government borrowing to zero immediately is not painless but it is the only way of disentangling ourselves from the loan sharks who are intent on making an example of us. In contrast, the new Government’s current policy of lying on the ground with a begging bowl and hoping that someone takes pity on us does not make for a particularly strong negotiating position. By bringing our budget immediately into balance, we focus attention on the fact that Ireland’s problems stem almost entirely from the activities of six privately owned banks, while freeing ourselves to walk away from these poisonous institutions. Just as importantly, it sends a signal to the rest of the world that Ireland – which 20 years ago showed how a small country could drag itself out of poverty through the energy and hard work of its inhabitants, but has since fallen among thieves and their political fixers – is back and means business.

Of course, we all know that this will never happen. Irish politicians are too used to being rewarded by Brussels to start fighting against it, even if it is a matter of national survival. It is easier to be led along blindfold until the noose is slipped around our necks and we are kicked through the trapdoor into bankruptcy.

The destruction wrought by the bankruptcy will not just be economic but political. Just as the Lenihan bailout destroyed Fianna Fáil, so the Noonan bankruptcy will destroy Fine Gael and Labour, leaving them as reviled and mistrusted as their predecessors. And that will leave Ireland in the interesting situation where the economic crisis has chewed up and spat out all of the State’s constitutional parties. The last election was reassuringly dull and predictable but the next, after the trauma and chaos of the bankruptcy, will be anything but.

August 6, 2011
The Hubert Butler Annual Lecture

August 25, 2011
A Note on the Size Distribution of Irish Mortgages - PDF

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