McWilliams cautions Lenihan

David McWilliams is an economist, whose articles I usually enjoy reading. In this morning's Sunday Business Post, he again doesn't fail to deliver. 'Time to face up to reality' details what he feels the next steps in our banking crisis should be. The main points of the piece are:

• Caution needs to be exercised by Lenihan in putting money into recapitalising the banks now. While now might seem to be the perfect time to do so with their shares so low, the problem is that we still don't know what we are putting money into. The banks' bad debts are going to be far worse than they're admitting now. To demonstate this, the above graph shows how the US banks tried unsuccessfully to deal with their bad debts over the past year. It shows that banks are invariably always wrong when it comes to bad loans, because they underestimate the difficulties in their loan books. The difference between the banks’ forecasts and reality was enormous.
  

• Massive defaults on mortgages will occur over the coming 2-3 years due to the rising unemployment rate. We cannot tolerate thousands of young people (in many cases, young families) defaulting on their mortgages and being kicked out of their houses. Neither can we entertain the prospects of those people languishing in negative equity for a decade. McWilliams advocates that we reset the principal of these mortgages down to 50%, of their peak value. The banks’ shareholders would take on the lion’s share of this pain, with the state taking a proportion. As people move houses over their lifetimes and tend to trade up, the capital gain when the mortgage holder sells on the starter home to the next generation goes to the state. Therefore, the state is protected, the system is preserved, the banks take the hit and the mortgage holder keeps his house today at the price of significantly lower capital gain tomorrow. It is a bitter pill for the banks to swallow, but so be it. Better to have someone paying some interest on a smaller amount of principal than paying nothing on a big loan.

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