So we have arrived at the day when the State has to deal with the consequences of the housing binge on the balance sheet of the ordinary person. A few years ago, people who warned this day would come were dismissed as doom-mongers. Now we see what was clear all along: the real merchants of doom were those who harassed a generation of people into debt, condemning them to negative equity and unpayable mortgages. This problem has to be fixed because the economy, burdened with such huge levels of debt, cannot grow.

It’s a simple equation. If people are paying back debt, they are not spending on other things. The economy runs on the basis that, in the aggregate, my spending is your income and your spending is my income.

Therefore, if people are not spending because they are paying back debt, everyone’s income eventually falls.
This fall in income becomes self-reinforcing. In turn, it leads to a situation where because of – not despite – your best efforts to pay off debt, your income actually falls faster than the rate at which you can pay off your debts. This leads to the strange and sometimes counterintuitive upshot whereby the person who tries to pay down debt fastest actually quickly ends up the most indebted relative to his income.


This contradiction is one of the crucial things to appreciate about macroeconomics. Macroeconomics is counterintuitive rather than intuitive. At its core is the “paradox of aggregation” which means what is good for the individual is not always good for the collective.

So for example, if I cut back on spending to pay back my mortgage, it – in isolation – is good for my balance sheet. But if everyone cuts back at the same time and copies me, who ends up spending? And, if no one is spending, who has any income?

In the end, the economy contracts and the level of debt – as a percentage of income – actually begins to rise rather than fall.

Seems illogical, doesn’t it? Well it is counterintuitive but that’s how it works.

PDH Mortgage accounts arrears 90  days Central bank

Look at the chart; you can see what is happening in Ireland. Arrears have continually risen over the past few years and at the same time, more and more people’s incomes have fallen – a direct result of more and more people trying to pay the debts off. Debt repayment was meant to be the solution, but it is becoming the nub of the problem.

This almost upside down way of looking at things explains why the government is in such a bind. Today the State has to deal with two specific types of debtors. The first is the ordinary mortgage holder and the second is the buy-to-let investor.

Let’s look at the ordinary mortgage holder first. The heroine of my recent book “The Good Room”, Olivia Vickers, is a typical mortgage holder. She is a teacher on a temporary contract. She is still working, but faces lower income due to higher income tax and property tax as well as the arrival of a second child. Olivia’s story is typical and is replicated all over the country.

Politically, the government has to do a deal with people like Olivia – a deal that does not threaten eviction. If it were to preside over mass evictions, it is political suicide.

One way to help the hundreds of thousands of ordinary neighbours, sisters and brother, sons and daughters who are in trouble is via a ‘debt for equity swap’ with the banks. This would involve the banks taking ownership of, say, half the house. The mortgage holder would pay half the mortgage. In, let’s say, fifteen years’ time, when the house is sold, the bank would recoup some of the equity and the seller wouldn’t see all of the capital upside. This is fair and just.

It would give the person breathing space. In such a deal, the banks would have to have the extra capital to cover the loss they would have to carry today and only recoup in the future. Given that the banks have already set aside €17billion capital for mortgage arrears, there is already money in the kitty to cover losses. The question is whether this figure is enough?

If it is not enough, what then? This is where the ECB comes in.

Clearly the ECB is the last line of defense here. It can’t afford another shock in the Irish banking system and it has shown itself, under Draghi, to be very adept at playing the debt juggling game. The ECB might be persuaded to hold bank equity and extend loans to the banks so that the capital base is sufficient to execute the debt for equity swap with the citizens. In this case, the ECB is simply using its role as lender of last resort to facilitate a debt for equity swap in Ireland. This piece of financial engineering would ensure a fair and sustained deal for our people who are in trouble and, in turn, by loosening their purse strings, would underpin demand in the economy. Such an outcome is precisely the outcome that we need for the strapped homeowner.

If we turn to the buy-to-let investor, there is no political reason why they should be bailed out or offered deals. However, there may be a sound financial reason not to take possession of houses now and sell them all.
This reason is called the “paradox of deleveraging”. This works in the same way as the paradox of aggregation. When the buy-to-let investor is well underwater and in arrears, the natural impulse for the bank is to tell the individual investor to sell, in order to fix his balance sheet. This makes sense and sounds prudent. But this is only the case if, when the individual investor sells, no one else is doing the same thing at the same time. What if the banks move on all the buy-to-let investors at the same time? There would be a deluge of selling, leading to falling prices. But remember, while the prices of the properties fall, the debts don’t. So we get into a situation where the debt relative to the value of the property rises rather than falls as a direct result of trying to pay the debt back!

This is the paradox of deleveraging and it is the dilemma faced by the government this morning. The best way to deal with this is to stagger selling the buy-to-lets and underpin the residential mortgages. Let’s see what Merrion Street decides.

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