We may all pay a very high price for banks’ throwaway lending policies

By Matt Cooper

Friday, September 21, 2007

BANKS get blamed for lots of things, but often not for what they do worst. What is considered excessive profiteering is attributed often to the fees and charges they demand for providing services, but where some banks — particularly smaller ones — are really culpable of damaging the economy and the lives of individuals is in their lending practices.

This could become a very big issue over the next couple of years because of what some banks have done to their customers over the last five. Ireland is threatened with a sharp and damaging economic slowdown largely because of the way in which some banks have lent recklessly.

Many individuals may now suffer the consequences of receiving loans much bigger than they could really afford, especially as inflated asset valuations subside. The flip-side is that having lent excessively, some of these banks may now rein in their lending excessively, exacerbating the slowdown by denying credit to those who need it (and who could repay it).

Irish people are the most heavily borrowed in Europe. Whereas once it was the national debt held by the State on our behalf that was a millstone, loans that we hold ourselves are now the problem. Per head of population, the amount of borrowing Irish people have taken out is the highest in the EU. A decade ago we would have been nearer the bottom of such league tables.

The banks have thrown money at people. Just over a year ago the amount of lending being completed by banks was increasing at an extraordinary rate of 30% per annum. Things have slowed down somewhat to a recent rate of just 19% per annum, especially after the financial regulator belatedly insisted in April last year that the banks increase the amount of capital they put aside as security to the loans they were giving to customers. But the absolute amount of borrowing — heading for €300 billion — is extraordinary in a country of just over four million people and the pace of increase in extra borrowing has been far too fast.

Excessively cheap money has been the main problem. Membership of the euro has given us very low interest rates by historical standards.

The European Central Bank (ECB) sets interest rates and the banks took advantage of this by lending large sums. This fuelled an investment surge, particularly in property. The blame for the excessive valuations attributed to property in recent years lies primarily with the decisions of individuals who chose to purchase houses and apartments, either to live in or as investments, at inflated prices. Nobody forced them to make these decisions; it was their own free will at work. Now people can argue that they need homes, and they do, but that doesn’t mean they should have overpaid for them, especially when renting is an option.

However, the role of some of the banks, especially smaller ones looking for market share as they competed with the traditional big players in the market, in facilitating and encouraging all of this is highly significant. Whereas once borrowers would have to get down on bended knees and stay there for months before getting a mortgage (if indeed they got one), some of the banks have been throwing around loans like snuff at a wake for years and with potentially very damaging consequences.

The stories of excess have been told many times. We’ve heard of single people getting loans six to eight times the size of their annual salary (on the basis that they could let a room to a friend to help reduce the monthly repayments). The duration of loans has been extended from 20 to 25 to 30 and 40 years, so that people could afford monthly repayments, even at lower interest rates. You could borrow 100% of the value of the property (although, honourably, maligned banks such as AIB refused to go beyond 92%).

Young people bought into all of this on the basis that the market would continue to go up indefinitely and that if they didn’t buy now they wouldn’t be able to afford to do so at a later date. How unfortunate for them.

Middle-aged and older people, who had bought their homes many years ago, and who have property valued at a multiple of whatever existing mortgage they may still have, have become obsessive about buying property as an investment. The banks eagerly sought them out for business. People with homes were allowed to borrow on an ‘interest only’ basis to buy other new houses or apartments that they would rent to other people. The idea of ‘interest only’ was that they would cover their monthly interest repayments with the rental income and repay the principal at a later date when they sold the house (presumably at a profit).

What some people did with much of this borrowed money has been mad. They have raced to buy seemingly cheap overseas properties without making any connection between the price and the rental yield available. If they ever want to sell many of them, the only buyers are likely to be Irish, not locals.

In Ireland they have purchased properties to which the Government ludicrously attached tax incentives and left them empty, apparently thinking that the costs of vacancy would be covered easily by the profits on the eventual sale. It is no surprise then to find from the latest Central Bank figures (to the end of June) that property-related lending amounts to 62.4% of all lending in this country, its highest level ever. Or that four-fifths of personal credit in this country is secured on property, compared to an average of two-thirds in the EU.

THIS could not continue indefinitely. There is no doubt that trade in the second-hand market in residential properties has slowed dramatically and that asking prices are down by more than 10% from their peak. New units are no longer selling quickly, notwithstanding the stamp duty changes made by the Government, which means many of the 90,000 that have or will be completed this year will have to be sold at lower prices than previously anticipated. Many builders are finding it tough financially as a result. There will be less than 50,000 new units built next year.

This means construction jobs will be lost and that the ongoing fall in Government tax revenues associated with property will accelerate. It implies that other sectors of the economy will have to provide jobs and tax revenues. It is by no means certain that they will take up the slack, especially if interest rates rise, making loans more expensive, and the banks suddenly tighten up dramatically on their lending criteria, especially towards business ventures.

Now we face an international financial crisis caused by irresponsible bank lending to unsuitable loan candidates in the US. Banks such as Northern Rock underwrote the risk and now they are suffering accordingly. Banks are afraid to lend to each other, making the cost of credit more expensive. The Federal Reserve in the US eased the crisis this week by reducing the price of money but there is no guarantee the ECB will follow suit.

Consumer confidence in Ireland is eroding steadily on the back of the property slump, more expensive money, fears about job security and possible tax hikes in the next budget as the Government struggles to meet its bills in a tougher economy. The IIB/ESRI survey of consumer confidence in April 2006 record a level of 98.8. It was down to 72.0 in August and is falling. Blame the banks.

This appeared in the printed version of the Irish Examiner Friday, September 21, 2007