We need banks to write down mortgage debt

We need banks to write down mortgage debt

In the years before the financial crash, it was considered essential to have a selection of bank shares in a portfolio, even though banks were expensive, writes Eugene McErlean.

UK banks, for example, which once traded at a price- to-book value of around two, now trade at half that value despite the significant upturn in stock markets.

The average price-to-book ratio for the sector can mask a significant divergence between banks; investors have rewarded healthy banks with a 1.3 price-to-book ratio while those exhibiting causes for concern are as low as 0.3.

Fortunately, there is a well-established model for improving a bank’s standing and moving up the value chain: Resolving troubled loans and reducing the level of non-performing loans on the balance sheet appears to be a common trait of banks that give a good return to investors.

That’s because leaving non-performing assets on the balance sheet uses up capital every month and narrows the bandwidth for management to implement a successful strategy.

It was no doubt for these underlying reasons that the Government decided to create Nama and free up the banks from the burden of managing non-performing loans.

The trade-off had to be that in return for the State spending a significant proportion of its resources on banking, it would get a normal functioning banking system.

However, what appears to have been misunderstood is that the trade only works when the balance sheets are actually cleaned up and returned to something approaching normal levels of non-performing loans.

Nama only did part of the job and could never deliver a healthy banking system when half the bad loans were still left on the table. That raises the question: What was the rescue plan all about? For what reason did citizens spend all that money and pledge the name of the sovereign to bail out banks?

The recently published S&P Global Ratings report into the Irish banks confirms that we are still a very long way from collecting for delivering on our side of the bargain. The report notes that despite four years of improvement in asset quality, Irish banks’ elevated stock of non-performing loans remains a continuing cause of concern.

The report notes that Irish loan books are heavily weighted toward residential mortgages. In normal circumstances, that would be a positive factor but in Ireland, residential mortgages remain a weak asset class representing almost two thirds of domestic non-performing loans.

S&P notes that 10.6% of Irish mortgage accounts are more than 90 days past due, compared with less than 1% in our nearest neighbour, the UK.

S&P expects the Irish mortgage books to remain a drag on banks’ creditworthiness for several years.

The important issue is not the quarterly headline reduction in the level of non-performing loans as reported by the Central Bank, but the fact that arrears of more than 720 days appears intractable.

Short-term cosmetic solutions are not going to work for this category of borrowers.

Experience shows these types of arrears are unlikely to resolve themselves and that the best course of action is to have a comprehensive plan of arrears resolution with a defined timeframe, inevitably involving writedowns in the value of these loans.

What is clear is the various government schemes and Central Bank initiatives have not worked. With the ending of quantitative easing and a return to rising interest rates, we are at a seminal point for banks.

Normally, when rates rise so do bank stocks. However, that trend isn’t being uniformly followed. Many bank shares are still in the doldrums.

It would be prudent not to assume the benign conditions of the last few years are likely to continue and to build some capacity. The level of non-performing loans in Irish banking does not leave much headroom.

Uniquely in Europe, we are all invested in the fortune of Irish banks, from the State’s ownership to paying the costliest loans in Europe.

Resolving long-term arrears and restoring Irish banks to somewhere closer to the top tier of European performers will mean we get paid back.

Eugene McErlean is a corporate governance and banking analyst.

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