In the past, the relationship between interest rate movements and property bubbles was pretty straightforward: Central banks lowered rates to stoke economic activity.
A low interest-rate environment encouraged borrowing and spurred investment, usually in the property sector. When asset prices got a bit too frothy, central banks hiked rates in an effort to cool the markets. Since the collapse of the financial system in 2008, that relationship has changed, which has huge implications for Ireland.
The implosion of the banking system in this country means the monetary policy transmission mechanism is broken. The main players in the market — Bank of Ireland, AIB, Permanent TSB, and Ulster Bank — are still trying to repair their balance sheets. Before the Oireachtas Finance Committee on Thursday, Ulster Bank chief executive Jim Brown said he is targeting a net interest margin (NIM) of 2.5% to ensure the bank can generate profits and be capital accretive. Ulster Bank’s current NIM is 2.32%, AIB’s NIM is 1.64%, and Bank of Ireland’s is 2.08%. Permanent TSB is considerably lower.
The net interest margin is a key indicator of profitability as it is the difference between what a bank earns on interest bearing assets and what it pays for its deposits.
The problem with the Irish banks is that they are still struggling with huge tracker mortgage books and other troubled assets. Between the three domestic banks, they have €50bn of tracker mortgages on their balance sheets.
Over 60% of Permanent TSB’s entire mortgage book are trackers. These products are loss-making because they are priced directly off the main ECB rate, which is at a historically low 0.15%. The average cost of funding for the banks is 1.15%-1.5%.
It is unlikely that Mr Brown, Bank of Ireland’s Richie Boucher, or Permanent TSB chief executive Jeremy Masding were too happy with AIB’s decision to cut its standard variable rate by 0.25% two weeks ago.
The problem is particularly acute for Permanent TSB. The recent stress tests showed up an €854m capital shortfall. Excluding the €400m in contingent convertible bonds and the sales of loanbooks, the actual shortfall is €125m.
But as part of the EU banking union, the banks will have to undergo stress tests on an annual basis. That is why Permanent TSB needs to raise a multiple of €125m if it is to get through the stress tests over the next few years.
The problem is that it is still not profitable so is not generating capital. If it was to introduce a rate cut to its mortgages, it would be welcome news for its hard-pressed customers, but it would make the bank even less profitable. Since it is State-owned, that would be bad news for the taxpayer.
There is also a second order effect arising from low interest rates. There is a global glut of capital looking for a home. Ireland has been a hotspot over the past couple of years as investors take the view the economy is recovering.
These private equity firms are able to borrow money at ultra-low rates, which has enabled them to hoover up property assets offloaded by Nama, Ulster Bank, and Lloyd’s, among others.
And while there were bargain basement prices on offer through most of 2011, 2012, and the start of last year, this is no longer the case.
The private equity firms typically operate on a three-year cycle with a target internal rate of return of roughly 15%. This means that in three years, there will potentially be a lot of property coming on the market, or at least a lot of deals that need to be refinanced.
It is highly unlikely that the Irish banks will be in a position to supply the funding needed for refinancing. The most likely outcome is that these private equity firms will not achieve their target internal rate of return and the property market will experience a sudden jolt.
The consequences will be nowhere near as devastating as 2008. But with interest rates set to remain low for the foreseeable future, this current bubble forming will be the first of many.
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