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Irish debt disaster a lesson missed

By Charlie Fell, financial market analyst and commentator
  • Cheap loans led to excessive borrowing which fueled a surge in house prices
  • Country emerged from stagnation in 1990s, but boom from 2002 was unsustainable
  • Mid-decade homes in Dublin were selling for ten times average earnings
  • Number of approved mortgages peaked in 2006, one year before Lehmans collapse

Editor's Note: A regular columnist for the Irish Times, Charlie Fell is a financial analyst who also lectures on finance and investment. After gaining experience in the financial markets working for a leading fund manager, he set up his own investment advisory firm, Sequoia Markets, in 2009.

Dublin, Ireland (CNN) -- The Irish nation stands on the precipice. The former tiger-economy has endured a deep recession following the deflation of a massive and ultimately unsustainable credit-fueled property bubble.

A plentiful supply of funds saw the Irish get busy building houses to house people who were building houses. They partied hard and no-one seemed willing to take away the punch bowl. The hangover is now plain to see as jobs have since disappeared, vast swathes of residential land lie empty, and the eventual cost of cleaning up the banking system is expected to amount to more than 30 percent of GDP.

How did it go so horribly wrong? The truth of the matter is that the Irish engaged in a classic credit-fueled property bubble that contained all the hallmarks of speculative manias from the past. Charles Kindleberger provided a comprehensive history of financial crises in 'Manias, Panics and Crashes,' and identified five distinct stages that trace a bubble's rational origins to its irrational peak and ultimate demise. Each stage was apparent during Ireland's unsustainable boom.

The first stage -- displacement -- occurs when there is an exogenous shock to the macroeconomic system that transforms the profit opportunities in at least one important sector of the economy and 'crowds out' opportunities in other sectors.

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Displacement occurred in an Irish context during the mid-90s, as housing demand increased in response to the solid income gains fueled by an emerging export-driven 'Celtic Tiger', and the lower interest rates attributable to prospective EMU membership. The economic boom from 1994 to 2000 was built on sound fundamentals and the house price rises justified, as the country emerged from a prolonged period of economic stagnation.

The boom from 2002 onwards however, became increasingly unsustainable as the nation's fiscal position, labor market gains and the overall level of economic output became increasingly dependent on property-related activity that 'crowded out' the tradable sector and led to a serious erosion of competitiveness.

The second stage -- credit expansion, is required for a speculative bubble to form. The credit expansion is fueled not only by existing banks, but also by the entry of new banks, the development of new credit instruments, the expansion of personal credit outside the banking system, and the inflows of foreign capital seeking high potential returns.

The emergence of new players can be traced to the arrival of Bank of Scotland in September 1999, and the introduction of its variable rate mortgage with the promise that it would not charge a differential of more than 150 basis points above the ECB official rate. More and more new players entered the market and at the height of the bubble, there were 18 providers of residential mortgages; the excessive competition resulted in a reduction in already low borrowing costs.

Competitive pressures intensified due to the reckless expansion of both Anglo Irish Bank and Irish Nationwide, but the leading banks sought to protect market share and were able to do so through the increased use of short-term foreign capital as a source of funds. Financing requirements were easily satisfied following Euro membership, as international banks searched for yield in a low-return world, but the deluge of foreign capital unleashed a lending boom that inevitably brought the country to its knees.

The net external liabilities of the banking system soared by an amount equivalent to 50 percent of annual GDP during the bubble years, and lending to the non-financial private sector reached 200 percent of GDP, roughly twice the European average.

The Irish engaged in a classic credit-fueled property bubble that contained all the hallmarks of speculative manias from the past
--Charlie Fell, financial commentator
  • Ireland
  • European Union

The third stage -- euphoria -- is where irrational exuberance takes hold and speculation gains momentum. The stage is set for a nasty surprise.

Euphoria was evident across the economy mid-decade. New homes in Dublin were selling for ten times average earnings and second-hand prices reached a multiple of 17 times. Lenders dismissed traditional valuation yardsticks and introduced mortgages with high loan-to-value (LTV) ratios and extended maturities to accommodate the higher 'new era' prices. The percentage of mortgages with an LTV of 100 percent or more increased from five to 12 percent between 2003 and 2007, while the percentage of loans with maturities of more than 30 years jumped from 10 to 35 percent over the same period.

Meanwhile, members of the political elite dismissed claims that the boom lacked sound fundamentals. Indeed, the government pursued a pro-cyclical fiscal policy that added fuel to the fire, and the reduction in personal income taxes during the period meant that increases in spending were increasingly funded with windfall property taxes. The fragility of the underlying fiscal position was simply masked by the property bubble.

The penultimate stage -- financial distress -- occurs when some event precipitates a change in the market's overly exuberant psychology. The trigger can simply be the realization that prices are unlikely to continue higher and this seems to have been the case in the Irish context, as the number and average size of mortgages approved peaked in the third quarter of 2006, one year before the collapse of U.S. investment bank, Lehman Bros. triggered the final stage -- revulsion -- where panic grips the financial system.

The lessons of history reveal that Ireland's credit-fueled property boom resembled speculative manias of times passed -- the fearful nineties were followed by the greedy noughties, but despair has descended once again. The message is clear -- the bigger the party, the greater the hangover.

The opinions expressed in this commentary are solely those of Charlie Fell.