The global financial crisis of 2008 was precipitated, in part, by a worldwide wave of mortgage holders who either defaulted or went into arrears. But different nations responded to the emergency in different ways. Can enduring lessons be found in the varied approaches?

That’s the question researchers asked in a paper released by the Federal Reserve Bank of Boston, “Delivering Debt Relief Through the Banking Sector: Lessons from the Irish Mortgage Market.”

The paper focuses on the response in Ireland, where the central bank’s regulatory approach gave private banks more freedom than in the U.S. on how to modify troubled loans.

The paper finds that this flexibility, combined with three other factors in place at the time, created an “environment that allowed for modifications on a remarkable scale.” Those other factors included:

• The threat of home repossession was remote, due in part to a socio-political environment that supported home ownership, and banks operated in a system that explicitly favored modifications.
• Borrowers signaled their willingness to modify their loans by filling out a financial statement that supplied banks with “close to perfect” information on their financial health.
• The banks were incentivized by their regulator, the Central Bank of Ireland, to issue modifications to a majority of their distressed mortgages within a fixed time period.

The paper also advises fiscal policymakers to be ready to step in where banks won’t or can’t, such as when a borrower’s financial circumstances are so damaged they are unlikely to repay even a generously modified mortgage.

“Private entities are unlikely to, and cannot be expected to, have the same set of goals as a social policy maker,” the paper’s authors write. “With this in mind, ancillary programs or links to other elements of the social safety net may be important in achieving wider social welfare goals.”

Banks given two years to change loans

The paper was co-authored by Claire Labonne of the Boston Fed and Fergal McCann and Terry O’Malley at the Central Bank of Ireland. It focuses on the Mortgage Arrears Resolution Targets program, or MART, that the Central Bank of Ireland launched in 2013.

The paper says the program was established after years of largely unsuccessful, short-term forbearance practices (e.g., temporarily allowing borrowers to pause or lower payments). Between 2008 and 2013, the mortgage arrears rate in Ireland rose to nearly 20%.

Under MART, banks were given two years to implement long-term and sustainable modifications of more than 80% of distressed mortgages or face regulatory consequences. But, unlike in the U.S., where the voluntary Home Affordable Modification Program (or HAMP) was implemented as a fiscal incentive, Irish banks were also given broad discretion on how to do it. The Irish central bank issued no guidance on the type or depth of the modifications.

“What's interesting about the Irish case is that, sure, there was significant policy intervention,” Labonne said, “But actually, what they did was they set up the stage for the banks to make all the decisions.”

Paper: Discretion given banks was critical

According to the paper, the banks were closely monitored under the program, but the discretion they were given was critical. The paper said that under the program, in which borrowers agreed to fill out a comprehensive Standard Financial Statement, “banks were armed with close to perfect information on borrower financial health when making modification decisions,” which led to better decisions. Certain patterns emerged, including some that helped advance MART’s goal of widespread and lasting relief:

• Banks tended to make more generous repayment cuts as a borrower’s repayment capacity weakened, as long as those borrowers had some surplus income available to service debt.
• Banks emphasized the liquidity of borrowers above their equity or how much they owed. In other words, a borrower’s access to cash was viewed as the strongest indicator of ability to repay.
• There was a “non-linear relationship” between the borrowers’ financial health and the likelihood that banks would grant permanent modifications (e.g., extension of the term of the loan): “Those with very strong or very weak repayment capacity are less likely to receive a modification than those with an intermediate level.”

Labonne said allowing banks to make decisions they believed were best for their businesses, while also holding them accountable on the proportion of their loan book that was modified, helped lead to more sustainable solutions.

“The alternative is a technocrat like me coming in and saying, ‘I think this should be this.’ But I just don't know,” Labonne said. “Credit allocation is their job. So, by construction, they may be making better decisions than anybody else.”

The paper acknowledges that in a “non-interventionist” program like MART, where banks are given wide discretion in how they modify loans, borrowers in the “deepest financial difficult(y)” may not get the mortgage modifications they need.

“Overarching policy responses to financial crises may need to allow for these trends, with complementary social policies required to ensure access to housing among borrowers not receiving private modification,” the authors write.

Find the paper here.