Tuesday, May 4, 2010

Economics 04/05/2010: Why Anglo case is irreparable

A funny way of arguing financial returns that some of our senior 'bankers' have has been highlighted in the latest comments of the Politician-turns-Banker Mr Alan Dukes reported in today's Irish Times (comments and emphasis are mine):

“The [EU] commission came back with a whole series of questions [concerning Anglo's 'business plan' - whether a zombie can have a business plan is a matter for another debate] and we are now rejigging the restructuring plan to deal with the issues the commission has raised. One of the things we are looking at is what would be the situation if we liquidated the bank immediately? Total disaster. A total non-runner. [ Am I the only person concerned with the fact that apparently the 'new plan' will be a re-jigging of the old version or that Mr Dukes has already decided that, while the bank is still looking into liquidation option, he is sure that it will be a total disaster and a non-runner?]

“...The best prospect of getting some value out of it and reducing the total cost to the taxpayer is keeping the good bank of it, because eventually it could be sold on to the benefit of the taxpayer. If you just do a wind-down, it is losses all the way. Whereas if you can make a good bank of it, which should be a quarter of the size of the whole bank, at least you have got something viable and that can be sold off to the private sector in the fullness of time.”

Our senior banker is clearly confusing gross return with net return here. Let me illustrate:

Suppose Anglo separation into two banks - bad and good -
  • Yields the value of the 'Good' Anglo at €A at the time of disposal t-years from now
  • Winding down 'Bad' Anglo costs €B by the time of disposal t-years from now
  • In the mean time (between now and disposal) the cost of running 'Good' Anglo will be €C
  • While the current value of the 'Good' Anglo, without a workout (a fire sale, if you may prefer to call it, or a shorter winding up over 5 years as I would prefer to label it) implies the value of it of €D today.
  • Also suppose that if we wind down Anglo today (or in the near future), the cost of winding down is €E.
  • Assume that present value adjustment (bringing the value of the bank and the level of costs incurred back to today from the date of disposal) is PVadj<1. pvadj="F(Interest">

Mr Dukes says that: since €A>0 then taxpayers win from the option of splitting the bank into 2 parts.

I say that:
  • if (€A-€C-€B)*PVAadj>€D-€E then taxpayer loses from the rapid winding down and gains from the breaking up of the bank (Mr Dukes preferred solution)
  • otherwise, taxpayers gain from the opposite action of completely winding down the bank as soon as possible
Mr Dukes' vision of 'positive return' is also severely skewed by his failure to consider risks (interest rate risk, asset valuation risk, liquidity risk etc) in his assessment. A rather worrying problem since mis-pricing of risks is what got Anglo into trouble in the first place.

In other words, Mr Dukes should really have read up on
  1. PDV methodology of computing real returns; and
  2. Net Present Value framework for carrying out comparative valuations.
These are really basic building blocks of finance... really!
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