A new Irish personal insolvency bill has long term credit positives for covered bonds, according to Moody’s, but could increase arrears and losses on existing mortgage loans and therefore have negative credit implications in the short to medium term.

Under the bill, which is expected to come into force in 2013, borrowers with unsustainable mortgage debt can be eligible to enter into a Personal Insolvency Arrangement (PIA) with their creditors and have the value of their mortgage reduced to the relevant property’s current market value, with the borrower continuing to live in the property.

“Moody’s expects debt forgiveness – rather than repossession – to become the preferred option for lenders dealing with borrowers that have unsustainable mortgage debt, once all other alternatives have been deemed inappropriate or unsuitable,” it said.

Under current Irish law, borrowers remain liable for their full outstanding debts for at least 12 years after defaulting on a mortgage loan as well as losing their home. Moody’s therefore believes that the change in law could reduce borrowers’ incentive to repay and this will lead to the increase in arrears and losses in the short to medium term. The rating agency said that these will be “most acute” for RMBS pools since they “will not experience the long term benefits available to banks and their covered bonds”.

Moody’s nevertheless said that in the long term, the legislation will provide an efficient mechanism to deal with the mortgage arrears and equity issue facing Irish banks, thereby quickening a recovery and strengthening of Irish banks’ balance sheets.

“All of the rated Irish banks have been recipients of substantial capital support from either the Irish government or, in the case of foreign owned banks, their parents,” said the rating agency. “Moody’s therefore considers that the banks will be able to cope with substantial losses from their mortgage books.”

Moody’s said that the mechanics of the Irish Asset Covered Securities (ACS) Act and standard practice by issuers imply that investors should be insulated from any rise in arrears until the point of a potential issuer default.

“The ACS act does not permit mortgage loans that are more than three consecutive payment dates in arrears to be included in the cover pool,” said Moody’s. “In practice, the issuers have so far not added to the cover pools any loans in arrears and have actually removed mortgage loans that have become delinquent.”