Wednesday, May 6, 2009

Economics 07/05/09: Banks: over-exuberant markets?

Forgive me if I am stating the plain obvious, but Ireland Inc is now insolvent. Full stop. And this means I cannot understand how on earth do the markets think BofI and AIB are a good buy at over €1.00. These prices reflect a peer-pricing comparatives, not the specific banks' fundamentals.

Fundamentals of any regional bank must be tied into two things:
  1. regional growth prospects relative to the bank's market share; and
  2. bank's ability to open new markets.
Both, BofI and AIB are Ireland-only institutions, with some seriously toxic exposures in the UK (both banks hold loads of buy-to-rent mortgages and commercial property deals of recent vintage, many of which are intitiated by the same Irish developers who got their loans in Ireland as well and much of it probably cross-collateralized). AIB also has exposure to Poland and the US, but in the US it has a minor stake in a minor play, while Poland is seriously suffering. Both stakes have no real upside for the bank and are illiquid at this time.

So it is back to Ireland for both banks and thus to points (1) and (2) above.

On point (1), regional economy - Ireland Inc - has no real prospect for growth. If you are in a business of lending you are in for a shock in this country with Ireland's:
  • rising (and already high) insolvency rates for businesses (see here);
  • contracting domestic demand (down 20% already) that, once stabilized, will remain low until households deleverage, which in the case of Irish households means shedding about 50% of their current mortgages and consumer debts to get themselves in line with, say, the US households (in Ireland, household debt per capita stands at about €2 per each Euro of GNP; in the US the figure is about $0.98 per each Dollar of GDP) - do tell me how can this be done if taxes are climbing up while wages are falling down?
  • falling external demand and FX shocks - with Irish exporting sector still performing reasonably well, there will be more bad news on the horizon. Even when the global trade turns the corner, Irish banks are hardly significant players in the MNCs game, having no clout, knowledge and global presence of international banks, so exports-led recovery will do little to improve AIB and BofI balancesheets;
  • new business start-ups - this area has low potential for growth becasue we are in a big time slowdown, but it also has very high risk attached to it and, again, BofI and AIB simply have no experieince of normal (non-collateralized) business lending;
  • housing loans - mortgages lending is going to continue contracting for now and will remain extremely low in years to come because of several factors, including lower incomes, higher income uncertainty, higher taxes (think of us having to actually pay off that NAMA loss over 5-7 years horizon); decimated pension funds, lower disposable savings (just think of people starting to set aside savings for kids college fees and you get the picture), lower cost of housing purchases (smaller transactions volume) and higher costs of house ownership (think of our Greens imposing more and more costs on homeowners while Mr Lenihan & Co are raiding households for more indirect taxation and charges), property tax introduction, etc. etc. etc.;
  • competition from other banks - intensifying competition from the foreign-owned banks present here, entering traditionally AIB and BofI territory of personal banking and consumer lending, small business lending and property loans - can BofI and AIB really compete against Barclays, HSBC, or even Rabo, should these banks pursue aggresive growth strategy?
So where, tell me, will the growth come from to bring Irish banks into profitability to sustain their current valuations?

Ah, but they do have some value left in them, I hear you say. Ok, sure, they do. Run two scenarios:

Scenario 1: NAMA takes a bite and swallows them in chunks. Equity dilution means existent shareholders will be stuck with, say 10% of the post-NAMA equity pool. In effect, if you are buying these shares now, you will have 1/9th of the value of these claims against current assets post-NAMA. Now, put differently, if you bought today at, say, €1.20 AIB and €1.17 BofI, you actually bought a claim that is worth €0.12 on AIB and €0.117 on BofI in post-NAMA equity. Does this make any sense? I'll get to it in a second.

The only way the above trades make sense is if you expect the Government to nationalize both banks at a spot price on the day of nationalization. In other words - you are in aconfidence game, which can be less-flateringly described as a game of chicken. You run at the Government at an increasing pace, hoping that you can make Cowen and Lenihan blink and pay up on your gamble. That is a hell of a lot of hope. But it is worth entertaining:

Scenario 2: Government nationalizes both banks paying spot price on the close of the day before nationalization. You wake up one day and your shares are just worth what they were last evening at the closing bell, except the state is giving you an IOU for them and the IOU might even bear a discount on the closing price.

This has to be priced as a gamble, or an option. You can get some eggheads in your pricing department to do the maths, but here is a sketch:

You in effect are paying €1.2 today on a put option giving you a right to sel to the Irish Government a share of AIB at some excercise price X to be paid at maturity T, when AIB stock will be worth S(T).

  • T is uncertain and can be dependent on the S(t) - if Government were to time its nationalization to cheaper price setting;
  • S(T) is uncertain, since we do not know T and because the Government can apply a purchase discount d at the day of nationalization, paying you S(T)(1-d) for your shares.
  • Discount d can be indepednent of S(T), or it can be increasing in S(T) should the Government decide to extract 'value' out of nationalizing what it might perceive as an overpriced bank.
At this point your eggheads would tell you that there is too much uncertainty to price this deal, stay with me for now.

You expected profit on this put is given by the following:
If you are a sensible investor you have a required rate of return, say r, which in turn determines a strike price required for you option to yield such a return, call it X*:
Of course, your price P is just what you pay today for AIB shares.

The above is still unsolvable and your eggheads are now heading for the windows of their high-rise, high-spec office block. So to save them, lets make another reasonable assumption, namely that when you bought AIB shares at €1.20 you expected them to go up by some factor k which might or might not relate to your required rate of return r. Just for fun, assume that k=r - in other words you were adding AIB to your portoflio on a neutral expectation (we can try it to be aggresive, so k>r, but clearly, no sane person would try to price AIB as a defensive play, unless you've been managing Zimbabwe Soverieign Wealth Fund).

Now, we have required strike price of
Parameterising this for r={5%}, d={0,10%}, we have: X*>{2.5, 2.93}. In other words, for you to make money on this deal, you need the Government to commit to a strike price above €2.5-2.93 per share of AIB range.

And we have not dealt with all layers of uncertainty at all...

Put alternatively - as a bet on nationalization, your purchase of AIB does not really add up. Now, if the price of shares was €0.12 for AIB at the time you bought, then ok, you might have been making a rational bet on nationalization. But not now.

Finally, back to the Option 1: so what does NAMA imply about the fundamentally-justifiable share price for AIB?

Post NAMA, Mr Lenihan will own lions share of AIB. Suppose it will be 90%. Impairment on remaining loans is not going to go away, but it will decline on average. Suppose to 5%, while AIB's book will have shrunk by ca 50%. You are now holding a share covering just 10% of the old total, which means that underlying asset base for you shares is now only 5% of the old share. With 5% impairment, there is no significant asset upside anytime soon, so you are stuck with 5%. Suppose that in the next 5 years you expect AIB to get their act together and rise to the levels of valuation that are 75% of the peak of the 52-weeks range, i.e. old pre-NAMA shares trading at €10.69. In post-NAMA terms, you have a claim to just 5% of this, or €0.53 per share.

Your loss on today's closing price is €1.20-0.53/[(1+i)^5]=€0.72 in today's Euros.

Table below shows some valuation scenarios, assuming 1.5% average annual inflation between now and 2014:
In red - is your bet when buying AIB at €1.20 range: you assume that
  • post-Nama Irish Government will hold no more than 75% of equity in the banks, and
  • by 2014 - 5 years from now, AIB will be trading at the 75% of its past 52-weeks peak valuation - that is very brisk business conditions indeed, roughly consistent with Ireland's GDP growing at 6-7% pa to get you to such valuations;
In blue is the scenario I find more plausible, but which implies today's share price on AIB of €0.43:
  • post-Nama Irish Government will hold no more than 90% of equity in the banks, and
  • by 2014 - 5 years from now, AIB will be trading at 65% of its past 52-weeks peak valuation;
Now, that 65% past price valuation I find a bit optimistic (as I assumed that only 90% not 95% will be owned by Mr Lenihan, and my assumption on shares valuation implies a rather robust 3-4% growth in Irish GDP), but hey, let's not split hair. AIB's shares shouldn't be anywhere near the current price range...

1 comment:

Paul MacDonnell said...

Dr. G. This is excellent. However I think that David Bloch in yesterday's Irish Times 'Ireland’s GDP per capita (our economic output by population) is 135 against the European Union average of 100. Germany’s is 117, the UK’s 114, Japan’s 107.' is a decisive argument against your pessimistic view. What with Viagra and putting the Irish language at the heart of government we are well placed to recover. Now where did I put my pills?