ANALYSIS:THE COMPLEX issue of how to deal with unsustainable mortgages in out-of-court debt settlements may be concluded in three months' time – but the operation of the new system could prove as difficult as its construction.

As part of the latest quarterly review of the bailout programme, the Government last week said it was deferring publication of the personal insolvency legislation until the end of April.

The delay of several weeks was due to the “very difficult” technical nature of the legislation, Minister for Finance Michael Noonan said last week.

The growing number of Irish individuals travelling to declare bankruptcy in the UK – where bankrupts can walk free of debt after a year – makes the need to reform Irish personal insolvency all the more urgent.

Last year the Government reduced the term for the discharge of a bankrupt from 12 years to five years in certain circumstances. This may again be reduced to three under the new legislation.

Under the proposed changes, the Government aims to introduce non-judicial debt settlements, allowing people an alternative to the costly and protracted court system of resolving debts.

But the changes are fraught with difficulties. If the reforms make debt settlement too lenient and include mortgage debt write-offs, it could encourage borrowers who can afford their mortgages to plead an inability to pay in an effort to secure the deals that will be on offer to the “can’t pay” category.

That could see the capital hit to the banks increase the bank bailouts beyond the €62 billion cost of recapitalisations so far.

If bankruptcy remains too onerous and the new out-of-court settlement system does not go far enough, the overhang of personal debt will remain a major drag on economic recovery.

Government officials are said to want to limit write-offs in out-of-court debt settlements to unsecured debt such as car loans, credit card debt and personal overdrafts, and to ensure mortgage debt is only restructured by pushing out the term of the loans.

Such a plan would involve reduced mortgage payments or a mortgage holiday over a period to allow some write-off of unsecured debt during that period. But mortgage debt would not be written off – it would merely be repaid at a later date.

The Irish Banking Federation said last week that lenders wanted the personal insolvency regime limited to unsecured debt.

The representative group said it would lobby the Government to ensure that, if secured debt is included, it will be “done in a way which will minimise the capital impact on balance sheets”.

While the Government hammers out the legislative changes, the banks are not sitting back. AIB recently agreed a deal with Certus – the firm that is managing the run-down of the former Bank of Scotland (Ireland) loan book for the part-nationalised UK bank Lloyds – to help the State-controlled Irish bank devise ways to deal with distressed borrowers.

Certus is managing about €8.5 billion of former Halifax mortgages written in the Irish market.

The company has devised alternative approaches to the limited twin-track options available to lenders – forbearance or foreclosure. The latter option is rarely used relative to the number of mortgages in default, as the cost to the banks is prohibitive given how far property prices have fallen.

About 13 per cent of residential mortgages are in arrears of 90 days or more, or have been restructured to ease the burden on borrowers. This figure is rising.

The number of possession orders on properties granted by the High Court to lenders actually declined in 2011, according to figures obtained by The Irish Times(This does not include repossessions in the Circuit Court).

From the perspective of the banks, it is more commercially viable to keep a distressed borrower in their home and repaying at least some debt than repossessing a house that cannot be sold and costs money to maintain.

“Banks are rarely the best people to sell houses – they typically incur a 30 per cent discount relative to the price index,” said Certus chief executive Joe Higgins, who was previously in charge of Bank of Scotland (Ireland).

“In many cases customers are in the right house, but have the wrong mortgage. They can afford the house they’re in at today’s rental values, but they can’t afford the mortgage they took out to buy it in the boom. In these circumstances, repossession is the wrong answer for both the customer and the bank.”

Higgins and his team at Certus have crunched the forecast numbers underlying the Central Bank’s stress tests figures last year and have charted different routes to avoid the road to repossession.

Seizing control of property means selling houses into the bottom of the housing market. Based on the unemployment estimates for the coming years in the tests, Certus estimates that of the people out of work today more than 50 per cent are likely to be back in work within five years.

The company believes that, for customers in distress, banks should be setting mortgages at an affordable level based on the likely future earnings of a borrower.

Where the bank establishes that the customer is likely to have more than enough income to be able to repay their mortgage from future earnings over time, the borrower should be shown forbearance.

This would involve reduced monthly repayments by extending the term of the mortgage.

If the mortgage that the borrower can afford – again based on likely future earnings – is higher than the potential disposal value of the property, but lower than the existing mortgage, the bank should leave the customer in the property and forgive part of the mortgage down to the level they can afford.

Certus believes that, in these circumstances, the bank is better off accepting reduced mortgage repayments than repossessing.

If the mortgage the borrower can afford is lower than the potential disposal value of the property, then the bank must foreclose – either by repossessing the property or encouraging the borrower to move to a smaller home using a mortgage they can afford.

This three-track approach of forbear, forgive or foreclose is based on the current rental value of the properties.

If a borrower can afford to lease their home based on the property’s rental value and the person’s likely future earnings, they are in the right house but have the wrong mortgage, says Certus. The firm believes adopting this approach could save the banks capital.

The Central Bank’s stress tests, which were verified by consultants BlackRock, estimated that Bank of Ireland, AIB, Permanent TSB and EBS faced expected losses of €5.8 billion over the lifetime of their residential mortgages.

Applying its more advanced forbearance solutions, Certus believes that it can reduce this to €2.9 billion, as the stress tests were based only on foreclosures.

The firm’s approach will only work if the borrowers agree to co-operate through the forbearance period and if the banks can independently verify income through the receipt of tax returns.

The proposed new credit register, which will give lenders a full up-to-date picture of a borrower’s total debts across all credit institutions, will help to assess what mortgage a borrower can afford.

The new personal insolvency regime will also need to prevent “gaming” by borrowers, or moral hazard – where risky behaviour is rewarded.

Such disclosure is required as borrowers could conceal income in an attempt to force the banks to agree to forgive some of the debt.

This will give lenders a stick to force borrowers into out-of-court settlements that will limit their access to credit should agreed debt forbearance and forgiveness arrangements start to fall apart.

Certus says the proposed measures would only be open to banks to apply to customers, and not for borrowers themselves to choose. For this reason, the banks could not advertise the proposals or discuss them openly – again to prevent “gaming” by customers. They must be applied case-by-case.

This is the track recommended by the Government’s expert group led by accountant Declan Keane, which sought to find a solution to growing mortgage arrears.

It found that people have been entering forbearance arrangements with lenders or “sheltering” behind the moratorium on legal action or the slow legal process when, in reality, they will never be able to afford their mortgages.

Introducing alternatives beyond forbearance, or the less-frequently used foreclosure, will allow banks break the logjam of problem mortgages for which no long-term or viable solution has been agreed.

The move by Certus to help manage loans at a second bank means the company’s proposed options could eventually be made available to distressed borrowers within a book of €26 billion mortgages at AIB and a further €15 billion at its subsidiary, EBS.

“Banks will need to think more creatively in Ireland’s unprecedented circumstances,” said Joe Higgins of Certus.

“Long-term forbearance tools and debt forgiveness will be more important remedies than the traditional repossession route.”

THE THREE Fs: BANK SCENARIOS FOR TROUBLED MORTGAGES

1 FORBEAR

Where the borrower can ultimately afford the mortgage from their likely future earnings

PLAN:bear with the borrower and reduce the payments for a short time by extending the term of the loan

2 FORGIVE

Where the borrower can afford only some of the mortgage based on their likely future earnings and the mortgage is higher than the potential disposal value of the property

PLAN:reduce the mortgage by forgiving part of it and leave the borrower in possession of the property

3 FORECLOSE

Where the borrower will never be able to afford the mortgage and the mortgage is lower than the disposal value of the property

PLAN:borrower must agree to sell the property and move to a smaller house – or the lender will repossess the property