BUSINESS OPINION:Ongoing forbearance with mortgage holders is making it hard to evaluate scale of issue, writes JOHN McMANUS

ONE OF the more alarming questions raised by the deal hammered out with the EU and the International Monetary Fund is what they actually think is left to go wrong in Irish banking that would burn up another €35 billion?

Paradoxically, the answer appears to be nothing. The Central Bank is sticking to its guns on the banks’ actual capital needs based on the Prudential Capital Assessment Review carried out in March, with some tweaking for more severe haircuts on assets going into the National Asset Management Agency.

Nothing has changed since March to make the bank change its mind, apparently. Mortgage defaults – one of the key variables it looked at – are still below 5 per cent. But in order to convince the wider world that the Irish banks are credit worthy, the decision has been taken to increase target capital levels from €8 for every €100 lent to €12. The read-through from this is that the extra money is not going in to meet losses, but simply to sit on the balance sheet of the banks and earn a return.

Given that the taxpayer owns the banks, there is, in theory, a benefit to offset the cost of “overcapitalisation” which will be about €8 billion. Another €2 billion is set aside to underwrite asset sales and will only be called on if various loan books being sold off by the banks incur unexpected losses. Again, if things are as the Central Bank thinks, then this money will not actually be spent.

The remaining €25 billion is probably not needed either, according to the Central Bank, but again is to give investors assurance that the Irish Government has the fire-power to deal with unexpected losses. Lots of unexpected losses clearly!

If the comments of the Central Bank governor Patrick Honohan are taken at face value, the bank really does think the measures required by the EU-IMF are over the top. He is on record saying he would have preferred some sort of insurance scheme to reassure the market rather than another round of capital injections.

It’s clear that a divergence of views between the bank and the EU-IMF team over the level of mortgage defaults and also buy-to-let mortgage defaults are the nub of the issue. The scenario behind the €25 billion contingency fund sees losses on buy-to-let property loans rising to 10 per cent – double the level projected by the Central Bank under previous stress tests last March – and residential mortgage losses rising from 5 per cent to 6.5 per cent.

Even then, meeting these losses would only require another €15 billion, leaving €10 billion of the fund unused.

Conveniently – if that is the right word – Moody’s rating agency published a report last week on what it believes are the drivers of mortgage default in the Irish market. They put defaults at 5.1 per cent but are pretty pessimistic, arguing that once the current property cycle has run its course and housing market activity picks up, people with large amounts of negative equity may choose to cut their losses, sell the property and default.

Likewise, the inevitable rise in interest rates will push other borrowers over the edge.

Balanced against this is the forbearance being shown by the banks, albeit at the insistence of the Government. In a separate report also released last week, Moody’s cites the Central Bank’s own estimate that 5 per cent of mortgages are only classed as current because of bank forbearance.

It would appear then that the true figure for mortgage defaults is 10 per cent, but the exceptional support being provided to borrowers at the behest of the Government is keeping the headline figure at 5 per cent.

There is, of course, a powerful incentive for the banks to co-operate as the lower they can keep technical default levels, the lower their losses and the less capital they require to meet them. It’s not quite a virtuous circle but it amounts to the sort of debt forgiveness that many believe is vital if the economy is to ever get moving again.

This Irish solution to an Irish problem is exasperating the rating agencies and clearly does not sit well with the EU-IMF. This is because forbearance – while welcome in a wider context – must involve losses for the banks if it is to be meaningful.

At some point a figure will have to be put on all this forbearance and then the €25 billion might not look so contingent.

But if it keeps people in their homes and families together it might be considered better spent than the billions that preceded it.