Tuesday, May 20, 2014

20/5/2014: Irish Credit Supply to Non-Financial, Non-Property Sectors

We keep hearing about banks lending to enterprises and the recovery in the banking sector in general. And we keep watching credit supply in the economy shrinking and shrinking and shrinking. The reality, of course, is simple: our banking system continues to deleverage and alongside, our companies continue to deleverage. This means that legacy debts relating to property investments and development are being washed off the books. Which, of course, accounts for property-related credit. But…

Take a look at this chart, plotting credit advanced to Irish private sector enterprises.

The property deleveraging story is in solid orange. And not surprisingly, it is still heading down. With all the fabled foreign and domestic property buyers reportedly killing each other on their hunts for bricks and mortar assets in Ireland, there is less and less and less credit available for the sector. In part, some of this decline is now being replaced by foreign funding (lending and equity, including private equity). But the credit story is still the same: property related lending is down 6% y/y in Q4 2013 (latest for which we have data).

Deleveraging in financial sector is also there - the sector credit lines have shrunk 15% y/y in Q4 2013.

But what on earth is happening in the 'healthy' (allegedly) sectors of the economy - those ex-Property and ex-Financial Intermediation? Here, total credit is down 4% y/y in Q4 2013.

In fact, from Q2 2009 onward, Irish financial system registered not a single quarter of y/y increases in credit supply to non-financial and non-property enterprises in Ireland. That's right: credit did not go up even in a single quarter. Worse, between Q4 2011 and Q4 2013, average annual rate of decline in credit to real economy was -4.0% which is exactly the same as in Q4 2013. In other words, even in terms of growth rates, there is no improvement. 


Brian O' Hanlon said...


Tom Dunne at Bolton Street real estate school, did mention something when interviewed on RTE radio the other evening, I think, about a need to involve pension money in some way in the finance of residential or other development properties in cities in Ireland.

I would have to say, that it was a useful point to make. It gets back to the point I always make about short-term, high-yield construction lending, which is distinct from long term financing of property assets in Ireland.

(And this is all separate again, from financing of buying/selling of strategic land assets, in Irish cities)

Typically in property, the lenders in these different areas, taken on different kinds of risks. I.e. It would be rare to shop for land purchase finance, complete 100% construction finance and long term financing of completed built assets, all at the one lender.

But I fear, that is something that did go on in Ireland.

Basically, it results in compounding of 'property-related' risks, one on top of another.

And of course, we know that Irish banks also operated in residential mortgages, where property was disposed of in units, and that put Irish banks on the other end of the transaction too. There was almost zero risk diversification.

But this is not the most important point, and it relates back to what Tom Dunne was talking about. That because our commercial property investors in Ireland (backed by Irish or foreign lenders), spent a lot of money buying and selling 'fresh air' in places like south Dublin city - what happens was, that much of the finance available got chewed up in the bubble - to the tune of billions upon billions, . . . basically doing shadow-boxing and fore-play, . . . without delivering any tangible product.

This is the point I make always about having a better financial supply line, for delivering property assets to the market.

What we had, for a huge amount of credit extended by our credit supply system, without finishing anything. We got past stage one, of three or four important stages, and got no further.

That is indeed, the worst of all worlds. The assets are still written on the books, in the credit supply system. You have all of these insolvent borrowers 'stuck in the middle', who have no money to proceed anywhere. You have no money going to buyers either at the fourth stage. The whole thing collapses in a huge heap, like the 'solid orange line'.

I've always made this point (and I don't think that the phenomenon was restricted to Ireland), that a banking inquiry should examine this - the amount of 'wheel spinning' and 'hand brake turns' that we managed to do - all over Irish cities, without delivering anything tangible.

I don't know, whether or not, this was the point that Tom Dunne referred to, when he mentioned pension funds and involvement in property finance. But the main story behind the whole financial collapse in Ireland, was a failure to construct any kind of 'supply chain' in financial terms, that could identify projects that needed to be funded, and needed to be delivered, and execute with some efficiency.

Brian O' Hanlon said...

We were in fact very unlucky in Ireland, in our so-called bubble.

I have had a chance to leaf through some of the 2010 Honohan report, the recent PAC report, the Regling-Watson, Nyberg reports, of late.

The story that keeps emerging was that issuing of 'debt securities', in order to compensate for lack of deposits, in order to fund the bank's lending in the property sector.

But I fear, that having made that effort, the Irish banks then had succeeded in doing little more than driving up the prices per acre of development land in Irish cities. But when it got to the stage of doing anything with those assets, and converting them into realized assets, that might produce an income, we just didn't get that far.

The trouble was, that we expanded the size of our banking system, just in order to get that far, and the collapse happened, before anything tangible could be achieved.

The plain fact is, that in Ireland, we would have achieved much more in terms of needed development and construction, . . . had we not got access to the 'debt securities', which were used to replace deposit funding in our banks. We would have been better off with a construction industry, where money was tight, than a construction industry, where money got too readable available 'on the street', too quickly.

And this was backed up too, I recall, by a lot of anecdotal evidence I gathered at the time, from practitioners and players in the commercial property development industry, who actually preferred it, when things had been a lot tighter with finance available in Ireland in the 1980's and the early 1990's, . . . than at the height of the boom in the mid 2000's. Because it became very hard to close deals and generally get anything done at the height of the boom, when there was too much money.

Like, you would have schemes designed, planned, permission-ed and ready to go. But at the last moment, a developer would simply put up the land for sale, because the profit that the developer could make by just turning over the land, to borrowers who were released straight out of the bank, flush with money, . . . . on to the streets, and the first thing they did was pay top dollar, for sites with permissions.

We got away from a time, in Ireland, where we had actual builders, and moved to a time where we simply had gentlemen builders, who went on holidays and bought development land. When we look at that 'hump' of the solid orange line on the graph, and you work your way through it, an awful lot of it was made up of borrowers who were somehow related to construction, . . . who used credit to invest in land assets, and didn't get much further along than that.

The questions for society in Ireland now, is how can we spend so much, and achieve so little?

Brian O' Hanlon said...

The other thing that did stand out to me, from the recent 2012 PAC report on the banking crisis in Ireland (I think it was in that report), was one graph. It was a graph, that showed a line of the lending extended into the Irish market, by foreign lenders.

We always complain about foreign lenders, during the boom in Ireland, and how they introduced 100% mortgage products, 110% mortgage products and so on.

But of course, what happened during the 'credit crunch' around 2007/08 in Ireland (before we had began to admit to the extent of our own problems, in our own banking system), was that the foreign lenders such as BOSI and UB, Rabo, Danske etc, . . . just turned off the taps of lending to residential mortgage applicants and so on.

This relates to the point about having a 'supply chain', in credit supply.

Development land asset purchases have to be financed.
Short term construction lending needs to be financed.
Long term asset management and lending has to come from somewhere.
Consumers of the product, residential mortgage recipients, SME's who rent office space etc, have to be financed.

What happened in Ireland, I believe, when the banks flooded the market with credit, is that it all 'sat' in stage one above.

But what happened then, for the few builders and developers left who were trying to work through stages one, two and three (actually making product and selling/leasing it), . . was that the credit crunch happened. So even where you had product to sell, you had a tightening of consumption.

It became impossible to sign leases for the smallest units, such as restaurants etc. That was one cash flow, which disappeared 'in a puff' for developers who were seriously trading in the market. The next thing that happened was that the foreign lenders supplying mortgages and so on, turned off the taps.

Overnight, the buyers at apartment and house lettings in Dublin city, I remember, just disapppeared. Where we had had queues around the block, up until 2006,... as we went into 2007, with the 'credit crunch', Saturday after Saturday, I would watch was we opened completely residential schemes all over Dublin city, and week after week, we couldn't sell a thing.

I spotted that graph in the PAC report on the banking crisis, which showed the time at which the foreign lenders in the Irish market turned the tap off - and it reminded me of that time in Dublin city - in 2007, when we were still busy completing units, and still even starting construction on a few sites, . . . but we knew there was no market at the other end. We were able to rent these units, however. We set up residential renting companies to manage these properties. But of course, when the collapse in the banking system happened, and all of the largest borrowers did their best to limp as far as the 'gates of NAMA', and were lucky if they weren't made bankrupt in the meantime.

The executives in domestic banks who had lent multiples of hundreds of millions, and even billions to some of these traders, had to sit back and simply watch the horror show of what was happening to their borrowers on the ground.

Brian O' Hanlon said...

I am not absolutely sure about this, but I think that we did manage to set up the basics of a 'supply chain' for property development in Ireland (where some borrowers were successful enough to be able to trade their way through stages one, two and three), . . and then, on the other end, the foreign banks in Ireland, took care of stage four in the supply chain.

But that fell apart in 2007, and it was that, which led directly to the cash flow pinch that it put on property developers who were still actively building in Dublin at the time. I.e. If we could have found some way to turnover those properties in 2007, we might have some builders and developers still actually trading in Ireland now. What some of the developers in 2007 did do, was take out some borrowings with foreign lenders in the region of ten's of millions, to bridge the gap in their cash flow. And that in the end, turned out to be fatal, as it was the foreign lenders making a rapid exit from commercial lending in Ireland in 2009 and 2010, who pulled the plug on many of these borrowers as they went.

And bear in mind, that the plug that they pulled, was on a lot of building and development companies, who had actually delivered hundreds of thousands of square feet of completed construction in Ireland. And now, we're struggling to build anything, and banks are completely terrified of getting back in.

This is why a banking inquiry is needed, in order to explain to the Irish banks themselves, exactly what did occur.

Brian O' Hanlon said...

I don't know if this is written down in the rule books of finance anywhere. But I know that it is particularly important, in a country such as Ireland, where we don't have a large GDP, or financial system. When something goes wrong in one stage of the financial and credit supply line, it tends to affect traders who are trying to operate across all of the four stages that I described.

Generally, in order to 'show up' to the party at all, and qualify for a 70% short term, high yield construction loan,... a trader will be expected to be carrying with them, something of their own into the deal. That is a necessary risk mitigation measure. It ensures that the borrower is committed to the entirety of the project (and generally lenders will insist that the project developer, burns through their own 30% of finance first, before getting access to the other 70%).

In addition to fronting the percentage of the deal as I described, in property development, the acquisition of land also has to be financed, and that is usually done with a different lender.

So that construction loan in the middle, is really maintained very clear and un-contaminated as a deal. Everyone is putting in a part, which they have at risk.

The deals which developers do at the other end, to fund the project after completion (when the assets begins to generate its own income, or until that happens), is another area of expertise again. It generally has its own rules, and puts the developer at a lot greater risk than any other part of the project. Because if the developer cannot bring the facility on-line, with tenants who are able to operate from the location, it eats into the margin that they might have bargained with their funder(s).

This is all separate again, to the finance that is agreed between the consumer of the property space, and their lenders. The consumer of the space, as delivered by the developer, may have to organize their own finance to do very expensive fit outs and so on.

There is a vasts amount of ways in which this can all go wrong. What tends to happen, I think, in Ireland is that these different stages of the pipeline are inter-connected with each other. And something that goes wrong in one stage, can affect all other stages. I could not be absolutely clear about this, but I think that the removal of fourth stage, 'retail' lenders (foreign banks), in 2007, was the first thing in a chain of events that destroy the entire supply chain for credit in Ireland.

(One could argue maybe, that Ireland had made itself much too vulnerable, in its capital structure and way of conducting business, to those foreign lenders deciding to pull out of the market so suddenly as they did)

On its own, it wasn't enough to bring the whole system down. But happening in the way that it did, at the time that it did, was critical. When we talk in Ireland about restoring a banking system, restoring credit to the economy, my point is (and I think, this was a point missed too, by people like former minister Brian Lenehan), that it isn't one thing. It is a series of things, that interlock and has to function as a whole.

Brian O' Hanlon said...

Even at 'peak credit' here in Ireland, what we had was a problem with the credit supply system, for property anyway. There was an under-usage already of the middle stages two and three (especially stage three, the long term funding stage, but also even with stage two, the short term commercial lending). Because when the banks sold all of those 'debt securities' and created so many of these property related assets, it just all got sunk into buying up development land.

It's like what Paul Krugman describes about the 'Fallacy of Savings'.

Everyone imagined, that to raise finance to buy development land was a shrewd thing to do. In other words, not to negotiate one's way through the other stages of getting short term lending for construction, or making the deals with the funder's and putting one's own developer's margin 'at risk', in the same deals.

It was like, everyone decided they had more than enough finance to be able to buy development land, and they would all stay there at stage one only and not go any further.

This is like what Krugman talks about, everyone deciding to save all at once (and in effect, in contributes to everyones' position disintegrating).

What happened too, as I mentioned, was that some developers who had projects approved to go all the ways through to completion, through stages two and three (decided heck, it's not even worth the risk,... it's much easier to flip over this land, to the guys who are coming out of banks all flush). You see?

So that was already happening - and much of that problem started to develop from 2004, 2005 on wards.

And then, bang, in 2007, the credit crunch.

Those in Dublin city at least, who had gone 'all the ways' with some projects, were wondering where the market had gone all of a sudden. I remember sitting down with financial controllers for Christmas dinner's in December 2007 (the accountants of various traders in the property and development industry), and they could all see the writing on the wall, a full year out from the 'crash' of late 2008.

Because Ireland, in terms of its financial system is brittle (we don't have huge volumes of demand, at any time), it is important I think that the whole credit supply system to an economy, is made up of different parts, that need to work together. I'm fairly sure that if we could have done something in 2007, in terms of de-leveraging and also replacing some of the credit supply that was lost, at the 'retail' end of the scale,... the entire crash in Ireland might not have been so bad.

But the lending of so much money to what were not risk-taking traders at all, in 2004, 2005 and 2006, was where damage was really done. It's sort of like, when in Japan in the 1990's, when their central bank put all of the money into the banking system, and it just sat their as Paul Krugman described so well.

In 2004, 2005 and 2006 in Ireland, a lot of money was put into the Irish economy, and it sat there too, in a big heap (and these are the assets that even NAMA, to this day, are 'leaving until last'). This is the 'Irish stuff', that NAMA have always left, in the hopes that a recovery would come about in Ireland (as NAMA got on with selling off foreign assets, in Britain and north America in the mean time).

But it's important to understand, how all of those assets were created, and why it all just sat there. A lot of it was given out to borrowers who really had no idea how to develop assets, and take it to any stage further than stage one. And as I mentioned, a lot of the real traders got wise too, and just decided to scrap the projects that they were developing and sell it back to those borrowers who were 'too flush', for their own good.

Like I said, some times, you can see a heck of a lot more economic activity in general, when credit is a lot more tight, than being a lot more loose. All the best, B.