The Dutch “mortgage mountain” and the risk of creating ‘Copperfieldian illusions’ with the mortgage portfolios on the banks' balance sheets: my reaction to the Op-Ed of retired Professor and ABN Amro executive Dolf van den Brink and independent financial advisor Peter van den Berg

Last weekend, the paper edition of Het Financieele Dagblad (www.fd.nl) featured an Op-Ed article by retired professor and former ABN Amro executive, Dolf van den Brink, and an independent advisor, Peter van den Berg. 

Dolf van den Brink - retired Professor of the
University of Amsterdam and former ABN Amro executive
Picture copyright of: Ernst Labruyère
Click to enlarge 

Subject of the article was roughly stated: 'how to mitigate the paralyzing effects of the ‘Dutch mortgage mountain’ upon the ability of the large Dutch banks to grant credits to SME companies'. 

Although it was a very good article by itself, as it pointed out the drawbacks and dangers of the enormous Dutch mortgage debt mountain for the financial health of the Dutch banks, it found all the wrong solutions for this conundrum.

Unfortunately, this FD article is not available in an online version, so I just print the pertinent snips here, accompanied by my comments:

DvdB / PvdB: […] The Netherlands has a mortgage mountain, as large as the Dutch Gross Domestic Product (GDP). The sheer size and the poor quality of this mountain set us apart globally. Due to the dropping housing prices, the coverage ratio (the actual value of the pledge vs the actual mortgage debt) of this mortgage mountain has further deteriorated, causing the Dutch banks to get in serious difficulties.

Ernst: Although this statement is somewhat hyperbolical in nature, I agree with the general intention of it. 

I do know from particularly ING Bank, that it is closely regarding its problem loans and mortgages-in-arrears and it is maintaining a conservative valuation with respect to such loans.

Nevertheless, every mortgage loan which is currently underwater in The Netherlands – no less than 1.4 million (!) in March 2014– poses a serious risk for a bank, as the owner of such a house can be stuck with a substantial and basically uncovered residual debt, when he is forced to sell his house in case of unemployment or divorce.

The private debt of this mortgage mountain and the collective wealth of the Dutch pension mountain don’t compensate one another. The pension premiums coming from the Dutch labour force are invested abroad for 90%, while our banks have too little capital themselves to meet the domestic capital demand from SME companies, as well as the private sector.

Ernst: Apart from the statement – heavily disputed by some of my Twitter friends – that 90% of the collective pension funds is invested abroad, the second part of this statement is incorrect too, according to the Chief Risk Officer of ING, Wilfred Nagel in an earlier article:

Nagel: Many factors determine the customers that a bank lends to within the scope of its balance sheet, including the nature and duration of the relationship with the customer, the risk profile of the proposed loan, the price the bank receives for taking on risk, the extent to which the loan contributes to the creation of concentration risk on the balance sheet and the requirements of the sustainability policy being pursued. The importance of proceeding carefully in this respect, is underlined by recent experiences with lending to SMEs. Dutch SMEs made up 5% of ING’s total credit portfolio in 2013 but contributed 22% of the total addition to the reserve for loan losses.

Against this background, the question is what actual public interest is served by loosening credit standards applied to SMEs?

On top of this, a further strengthening of the capital positions of large Dutch banks will not lead to more lending to SME’s as this only works if both the bank and potential providers of capital are convinced that the investment will be used for profitable economic activity. In other words, granting capital to creditworthy parties at a reasonable return. Gathering capital only to jeopardise it by lending to parties that do not meet the minimum requirements is not a very productive strategy.

Those calling for a relaxation of bank lending to SMEs are, therefore, promulgating a sort of industrial policy at the cost of banks’ savers and providers of capital. This is not appropriate to a market economy and is particularly unwise given the need to increase not debt but equity of SME’s.”

Ernst: Nagel is totally right with these paragraphs. It is useless for banks to increase the unweighed capital ratio, if they use it to squander money, by lending it to not creditworthy (SME) companies.

Politicians, the employer’s associations and the general public can of course say as often as they want, that the banks should borrow more money to SME companies; these people are all entitled to their opinions. Nevertheless, as long as the banks run a much more than average risk of not getting this lended money back in the end, they should not lend it at all.

Ernst: The fatal flaw in the thinking process of Van den Brink and Van den Berg is, that better capitalized banks would start lending more money to SME companies. 

This probably won’t happen for two reasons:

• The demand for loans and credit lines from financially sound and sensible SME companies will not really increase, as long as the Dutch consumers keep their hands on their wallets. Rapid expansion of one’s business in times of economic stagnation is asking for trouble, as already many companies have expanded themselves to death in the past. Surviving is still the name of the game.

• SME lending is not a profitable business at this moment. It just isn’t. The (in)direct expenses coming from losses, caused by defaulting companies, still overcompensate the profits from successful loans and credit lines; even in spite of the substantial interest margin. When an investment costs a certain party more money than it yields, no sensible investor will make this investment.

DvdB / PvdB: Further, a healthy economy requires banks, which can effortlessly meet their capital demands. Especially due to the leverage ratio, stricter capital demands will be enforced upon this mortgage mountain. 

This requires primarily capital of the highest grade (CET1 aka Common Equity Tier1 capital); for the current Dutch mortgage mountain, this means an increase to €24 billion from €4 billion.

Ernst: I truly cannot judge upon this number of €24 billion in equity, but with 1.4 million mortgages being underwater, it sounds to be even at the lower range of ‘plausible’.

DvdB / PvdB: Even with the current high interest margin, this is not achievable in reality. For this reason, a substantial part of the mortgage mountain should be removed from the bank's balance sheets. By doing so, the banks can meet their core task in a responsible manner: supply loans and credit lines to the SME companies and the private sector.

Ernst: Right, right and wrong:

• Yes, €24 billion in additional equity will be very hard, if not impossible, to gather for the banks;
• Yes, when possible, these excessive mortgage portfolios should indeed be removed from the bank balance sheets;
• But no, I don’t think that banks, with healthier balance sheets, will lead to increased lending to SME companies and the Dutch private sector.

As a matter of fact, the yet unprofitable character of these loans itself and – I’m sorry to say this – the current sorry state of many SME entrepreneurs, is the main reason that credit supply to Dutch SME companies is in a state of hibernation, in my humble opinion. Not a lack of investment capital at the banks.

Personally, I don’t think that a rejuvenation of Ronald Reagan’s supply-side economics – spurring increased consumption by removing boundaries for companies to increase their production, which eventually leads to more and cheaper goods and products, that consumers will subsequently buy – would be a huge success in The Netherlands currently. In this case, I  consider the – presumed – undercapitalization of SME companies as one of the aforementioned boundaries.

DvdB / PvdB: This would be possible, when banks could sell their sound mortgages (mortgages on which no more than 60% of the pledge value has been financed) to a Special Purpose Vehicle (SPV) for the remainder of the interest fixation period. These purchases would be financed by the deployment of securities (i.e. NHP or Dutch Mortgage Paper). To further increase the quality of this paper, credit insurances will be made.

In the ideal case, this basically risk-free paper would be reinsured at the Dutch "Guarantee Fund for Owner-Occupied Housing" foundation (i.e. WEW), at a marked-to-market premium, in order to get a de facto state guarantee on these NHP securities. 

This would minimalize the interest for the NHP, as well as for the underlying mortgages. The state earns money on the reinsurance premium and on the resulting reduction of the payments, made as a consequence of the Mortgage Interest Deductability regulation. 

The banks can reduce their mortgage volume by approximately €250 billion, which releases up to €10 billion in capital reservations. 

On top of that, the interest margin that would be earned until the end of the interest fixation period (i.e. the maturity date of the mortgage arrangement), can be cashed and added to the equity of the banks.

Ernst: This whole arrangement looks, feels and smells as the infamous  and dangerous "Win-Win situation": everybody is a winner in this situation, as nobody loses and there is no risk at all. 

In reality, Win-Win situations do seldomly occur...

First: Everybody thinks – myself included – that a mortgage, with a maximum of only 60% of pledge value, is normally "as sound as the ‘Federal Reserve’ itself". Nevertheless, who would have predicted in 2007 that the Dutch housing prices would drop with 20% - 30% in the six years since 2008;  yet, it happened! 

This means that even such a rock-solid mortgage could become underwater eventually. Who will foot the bill for the additional risk, when such a rare, but non excludable event occurs?

Besides that, when the houseowner defaults anyway, someone will have to perform the salvation operation in order to reclaim the mortgage amount for – in this case – the SPV; this means that the house, as pledge for the mortgage, must be privately sold or auctioned. 

Who will perform this operation? Will this be the bank, as issuer of the mortgage loan and sponsor for the SPV? Or will this be the responsibility of the SPV management itself?

Second: I don’t fully comprehend the last red and bold sentence of this paragraph: 

• Either, the mortgage is sold by the bank for a fixed price; in that case, the only profit for the bank is the difference between the sales yield of the mortgage [for this particular period] and the cashed funding costs for the same period. However, I cannot imagine that the SPV would be willing to pay the full, cashed interest margin for the whole maturization period – without a substantial discount – as the SPV would not earn any profit on the transaction itself. 

• Or, the bank receives the mortgage payments from the mortgage-holder and forwards these to the SPV (minus a certain percentage of profit), but then – in my humble opinion – it would not be an off balance mortgage, as the full collection administration still lies with the bank [Dear readers, please correct me if I’m wrong, in this respect – EL]. 

I wonder if both these options would really lead to substantial additions to the equity of the banks after all.

Third: when such mortgages are ‘sold’ to a Special Purpose Vehicle, they disappear from everybody’s radar, as this is an off-balance transaction.

However, in contrary to the mortgage itself, the risk is not necessarily transfered in full to this SPV. Particularly Enron and Citigroup (the latter almost defaulted under the financial pressure of €1.2 trillion in off-balance SPV’s) have proven this beyond a reasonable doubt in the past.

The following snippet comes from the New York-based CPA (Certified Public Accountant) Journal in a 2004 issue upon Special Purpose Vehicles / Entities:

[Of course, these particular statements concern the American FSAB regulations and not European regulations – EL]

As the Enron crisis brought attention to the use of SPEs, FASB responded by issuing a proposed interpretation of existing accounting principles aimed at putting many off–balance-sheet entities back onto the balance sheet of the companies that created them.

The current accounting standards require an enterprise to include in its consolidated financial statements subsidiaries in which it has a controlling financial interest. The existing common definition of “control” is met when a parent company has more than 50% of the voting stock in a subsidiary. Over the years, however, companies have found ways to obtain economic control of other entities without owning 50% of the voting stock, thereby avoiding consolidation of these entities.

And Wilmington Trust, an US financial service supplier, states the following about the same subject:

Under some circumstances, it may be desirable to remove assets and their corresponding liabilities from the balance sheet of the company, and a sale of the assets to an SPV will accomplish this. However, the sale has to be properly structured to actually transfer both the substantial risks and the rewards of ownership. So, for example, if the sale is coupled with guarantees from the seller concerning performance of the financial assets being transferred, the risks are not really being transferred. In such a case, it could be misleading to shareholders not to disclose the risk retained on the balance sheet.

Similarly, a third-party equity investor must control the SPV's activities and bear the risk of the investment in order for the sale to constitute an arm's length transfer. If the SPV truly assumes the risk and controls the assets transferred, its activities are not controlled by or on behalf of the company that sold the assets to the SPV, then off-balance sheet treatment, rather than consolidation on the balance sheet of the company, usually will be appropriate. The issue, then, is not whether SPVs can be used for asset securitizations, but whether the securitization has been structured and accounted for according to the rules applicable to such structured financial transactions.

I wonder whether the implications of these statements have been elaborated in the ideas of Van den Brink and Van den Berg?! 

Would the SPV from their Op-Ed really reside on ‘an arm’s length’ of the banks issuing the mortgages? And does the SPV really get the full rewards of the ownership? 

I have serious doubts about that and – consequently – about the fact, whether this financial construct by Van den Brink and Van den Berg would a. be tolerated under the prudential supervision of De Nederlandsche Bank (Dutch national bank) and b. would really be considered as an off balance SPV.

DvdB / PvdB: At the maturity date – which is at the end of the interest fixation period – the mortgage is bought back by the bank. […]. For this off balance buy-back obligation, there ought not to be any capital demands. [After a new interest fixation period has been negotiated with the customer] the mortgage can be sold back again at the SPV, eventually.

In the process, banks can remove a substantial part of their assets from their balance sheet, for a period which the individual bank itself deems necessary. This could create new room for credit supply.

Ernst: This red and bold statement seems blatant nonsense to me. When there is an obligation for the bank to buy back these sold mortgages somewhere in the future – hence, a future obligation – then a facility must be created to meet this obligation, based on the cash value of these future obligations. 

This situation is totally akin to the future pension obligations of pension funds, which must be met today, based on their cash value. Besides that, this obligation facility must be funded with a certain amount of equity capital, in my humble opinion, in order to prevent these future mortgage purchases from being hugely leveraged.

This whole paragraph reminds me of a David Copperfield illusion; for instance, when this hero-magician lets the Statue of Liberty disappear. You see and think that the Statue of Liberty is not there anymore, due to the magic of David Copperfield, but you know by heart that it did not move one centimeter.

In case of these mortgages, which are temporarily sold to the SPV, it is exactly the same: these mortgages are optically removed from the balance sheets of the banks, which creates some optical leeway for lending.  

However, in reality those mortgages are still a (future) liability for the bank and – as a consequence – so are the capital requirements of these mortgages. It is nothing more than a financial illusion, that the bank has been performing for you...

The remainder of the article contains a paragraph, which advices to finance residual debt, coming from an underwater mortgage after a (forced) house sale, by using the individual pension savings of the homeowner. 

For reasons of article length, I will not discuss this subject in this particular article anymore. However, also this idea spreads a strong odour of mumbo-jumbo and financial wizardry with uncertain side-effects for the future.

I will conclude with the following statement:

"One can admire David Copperfield for his illusions, but people should beware of a bank, which tries to create such optical illusions with the mortgages on its balance sheet!"