Warden Barrowclough: I’m here at the request of one of my senior colleagues. Well, I think you know that I know that you know what I know
Norman Stanley Fletcher: Oh do I?
Barrowclough: The word on the grapevine is that you can put your hand on what he hasn’t got.
Fletcher: Well if he hasn’t got it, I don’t see how I can put my hand on it, sir. And if he has, I’m not sure that I want to, you know what I mean?
Barrowclough: Don’t be obtuse Fletcher. We both know what I am on about. And I want you to know that I heartily disapprove of this.
Fletcher: Oh so do I sir, so do I, but we are just the go-betweens, ain’t we eh? We are merely here to maintain the status quo. And if we don’t come to some little arrangement they go in the auction Sunday.
Barrowclough: Ah, arrangement yes. My function is to ensure that the item in question is restored to its rightful place
Fletcher: To wit, his mouth.
Barrowclough: I think we see eye to eye
Fletcher: Oh yes, well you know what they say sir, an eye for an eye and a tooth for a mouth.
Barrowclough: I’ve been authorised to go up to a fiver
Fletcher: Then the quicker you go up to it the better, sir.
Barrowclough: Well hang it all Fletcher! I would like to make some token gesture towards bargaining.
Fletcher: Oh I’m sorry sir, sorry you go ahead, bargain away sir
Fletcher: A fiver
Fletcher: You certainly have been
Scene from Porridge (the movie, 1979) where the warden Mr Barrowclough is trying to retrieve his colleague’s dentures stolen by prisoner Fletcher
The information released by the Central Bank of Ireland on Wednesday which set out the macroeconomic parameters for the ongoing bank stress tests, was truly shocking for a number of reasons. The information was released a few hours after the Central Statistics Office made a major revision to the unemployment rate and lifted the February 2011 unemployment rate from 13.5% to 14.6%. And the CBI parameters didn’t even take account of this major revision which might make some of the other parameters look even worse. Of particular interest on here were the parameters in respect of Irish commercial and residential property, and this entry looks at what the parameters mean for residential property.
But before examining the parameters, it is worth looking at what these parameters represent. The CBI has produced what it calls “baseline” and “adverse” parameters and its press release says (my emphasis) “stress testing is used by banking supervisors to determine whether a bank is adequately capitalised to withstand adverse macro-economic events or unanticipated ‘shocks’. It is not an economic forecast: it employs hypothetical scenarios.” Whilst it is understandable that the adverse scenario is not a forecast, I would have expected the baseline scenario to indeed be a forecast. The press release from the CBI is woefully brief but if we go back to the now-discredited Committee of European Banking Supervisors (CEBS) stress tests last summer, we see that what they referred to as the benchmark scenario was indeed a forecast lifted from the “EU Commission Autumn 2009 forecast and the European Commission Interim Forecast in February 2010, with several adaptations to reflect recent macro-economic developments in a number of countries.” The adverse scenario was internally generated by the CEBS. So contrary to what the CBI says, it does indeed appear that the baseline scenario in the present tests is a forecast. I stand to be corrected on this and have asked the CBI for clarification.
And that being the case, what should a “baseline” forecast decline in residential property prices of 13.4% in 2011 and 14.4% in 2012 mean for buyer behaviour in today’s market? Firstly it depends on how credible you think the CBI is. Certainly its governor, Patrick Honohan enjoys above-average trust and a reputation for plain-speaking – he was after all, the man who revealed that we were seeking a bailout last November 2010 when the national mood was that politicians were taking us for idiots with their denials. He is the first governor of the CBI not to be an appointee from the Department of Finance and was chosen from a wide field on merit. Research for a previous entry on Governor Honohan revealed him to enjoy the trust of wide-ranging interests and the reputation of being capable. Of course he hasn’t looked too bright with his constantly-increasing estimates of the bailout costs of the banks – for example, INBS’s estimated bailout went from €2.7bn in March 2010 to €3.2bn in August 2010 to €5.4bn at the end of September 2010 but the Governor might say that was because of new information uncovered by NAMA. So how good will the forecast of residential property prices now be? Difficult to say, but in terms of the source, it must be one of the most credible forecasts we are likely to get.
What does a decline in prices of 13.4% in residential property prices in 2011 and 14.4% in 2012 actually mean? It means that a property “worth” €200,000 at the end of December 2010 will be worth €173,000 at the end of this year and €148,000 at the end of 2012. The average price nationally at the end of December, 2010 was €191,776 according to the Permanent TSB house price series. So with the purchase of an average-priced house you will lose close to €50,000 net in the next two years. You could rent an average house nationally here for about €1,000 per month. A typical interest rate on mortgages is 4%. So if you buy today with a 100% mortgage, over the next two years you will spend some €8,000 on interest and lose €50,000. Compare that with paying just €24,000 in rent. And given the anemic economic outlook (GDP increasing 0.9% this year and 1.9% next year) with relatively high unemployment (13.4% this year and 12.7% next year and remember this was before the CSO dropped their bombshell on Wednesday), there will be worry that you might not be able to meet your mortgage commitments. Oh, and of course there is a property tax and a proposal for water charges in the pipeline. Wouldn’t you need to be a complete idiot or be able to find a property significantly below its “worth” to actually buy today?
So coming back to our opening scene above from Porridge – if you are a buyer and you believe that prices will drop by 13.4% in 2011 and 14.4% in 2012 and your seller also believes that to be the case, then like Norman Stanley Fletcher you might go through the motions of having a negotiation but the terminal price is going to be a price which reflects the drop in prices over the next two years. And if there is no such bargain, the market will freeze and there will be practically no transactions whilst we all wait for the bottom, and if we do have that type of distorting behaviour – waiting for two years for prices to hit the bottom – there is the risk that prices might drop even further if there is a supply glut during a short period. So it probably is the case that Governor Honohan has given buyers a green light to demand a 30% discount on current values and if you’re not getting a 30% discount, then as a buyer you are being done. It’s worth remembering that there is an adverse scenario which projects a 32% decline in the next two years.
UPDATE: 15th March, 2011. The CBI has responded to a request for further information on the baseline scenario and whether or not it is a forecast and has provided a 2-page briefing which includes “the Central Bank is applying a scenario that both commercial and residential property prices continue to decline in the base and the stress case. It is important to note, that these are not forecasts of outcomes but represent two possible paths from a large range of future outcomes regarding property prices. In this regard, there is a significant degree of uncertainty surrounding the range of possible future outcomes for the domestic property market. These are related to borrower and bank behaviour, measurement problems determining the of extent of property price declines due to the lack of a significant amount of transactions, and the continued unavailability of national residential and commercial property price indices, and future demand for residential and commercial property.” I must say that I find this unconvincing because of my understanding that the adverse scenario is supposed to be the worst realistic outcome and the baseline the most likely outcome. The baseline and adverse scenarios are not some random scenarios chosen by rolling a dice, they are deliberately selected (and other scenarios are deliberately excluded) because of what they represent and if the baseline does not represent the CBI’s forecast of the most realistic outcome for the future, what does it represent and why is included in the stress tests. In an entry later today, the CBI’s approach will be contrasted with the UK Financial Services Authority approach to the stress testing of UK banks which was published yesterday.