Economics 12/05/2009: housekeeping & AIB

For those impatient to see analysis of the AIB Interim Results H1 2009 - scroll down to the last entry.


We are launching Ireland Russia Business Association tomorrow - the official D-day. Invitation is here. The website is next and we are currently getting this built, alongside a separate blog for IRBA. Of course, from next week on I will be in Moscow (with our trade mission) and later in St Petersburg in June for St Petersburg Economic Forum. I will be blogging from there - occasionally - so stay tuned...

And upon my return back to Dublin, I will be hosting a round table discussion on Sustainable Finance: Academic-Practitioner Interface at the Infinity Conference in TCD, June 8. The round table will be dealing with issues of facilitating a research interface between industry and academia in the area of sustainable (IIIrd generation sustainability concept) finance.


Here is an excellent article on how Schengen Visa Regime is turning Eastern European border into a new 'Velvet' Curtain. Of course, one can also add that in Ireland's case, lack of Schengen harmonization is resulting a ridiculous situation whereby people from non-EU states working in this country cannot travel on business to the rest of EU or the UK without having to spend days applying and queuing for visas and paying for these. Hours and days of work are being lost, businesses are paying for this and workers are wasting health and time doing needless pages upon pages of applications and documents collecting...


And here is another interesting thingy - for the upcoming European elections, you can actually see the records and votes, and attendance, and days worked, and more... for all our MEPs - here: http://www.votewatch.eu/.

I am not going to do detailed analysis, but Proinsias De Rossa ranks second in the entire Parliament in terms of Parliamentary Questions tabled and 43rd in terms of speeches delivered. I might not agree with most of what the man has to say, but at least he deserves a credit for asking questions.

Eoin Ryan ranked 35th in terms of Motions for Resolutions. Ryan was ranked 456th in terms of Reports Amended by him, above De Rossa - ranked 492nd. In terms of reports drafted, De Rossa ranked 101st, Ryan 170th. In terms of opinions issued, De Rossa ranked 208th, but Ryan ranked 25th. Attendance to plenary meetings: De Rossa scored 499th (97.85% loyalty to political group in voting, 73.21% loyalty to the member state, 85.23% attendance record); Ryan's stats were slightly poorer (82.26% - making him more independent than De Rossa, 87.95% - making him more focused on Ireland's votes, with attendance of 83.22%) giving him a ranking of 553. Mary Lou MacDonald failed to register on the radar at all, although her specific record is there as well: here.


AIB Interim Management Statement (available in full: here) my analysis in blue, IMS original text in black.

Operating Profit: Profit before bad debt provisions has been good in the year to date and up on the corresponding period in 2008. However, this outcome benefited from base period effects, most notably higher costs in the early part of 2008.

Read: the cost base has been trimmed and there isn’t much else we can do from here on. Of course, AIB won’t admit it, but it basically has the same number of employees on its books as at the peak of the growth cycle. In exchange for taxpayers’ money, the three banks have not laid any staff, so it is the taxpayer who is paying wages for over-bloated staff ranks in the Big 3 Irish banks.

The outcome reflects the very strong performance of Capital Markets and Global Treasury in particular, driven by interest rate management activities. Performance in our other operating divisions is in line with our expectations ...down relative to the same period last year.

It does appear that AIB is lending out to other banks and is borrowing from ECB – this is the rates wedge that can be exploited by the Treasury via ‘interest rate management activities’.

Costs are being very actively managed and are down by a higher percentage rate than income at this point. Downward pressure on income is expected as the year progresses due to a continuation of poor economic conditions and dislocated funding markets.

One would presume this is due to management efforts to extract value out of operations?.. Ah, nope, it is more likely due to the positive impact of the following factors:

• Lower ECB rates spilling over into lower financing costs;
• Declining spreads due to taxpayers’ guarantee and capital injection;
• Lower financing rates on property and other operating credit lines;
• Lower cost of physical capital and capacity;
• Lower bonuses.
  

All of this has very little to do with banking.

Loan and deposit volumes: ...loan balances remain broadly in line with the end of last year in each division [so no pay down of loans?]. In our Republic of Ireland business there has been a recent pick up in home mortgage applications but no material increase as yet in drawdowns. This increased activity reflects an attractive customer offering and very weak competitor presence in the market. [So why no drawdowns then, if AIB’s offer is so strong? may be because AIB is not originating any mortgages, despite giving pre-approvals? See their statement on the direction of loan to deposit ratio below...]

Customer deposits have stabilised in recent weeks following some outflows earlier in the year [How much in outflow?]. In the current recessionary conditions balances in current (money transmission) accounts have reduced. Customer resources, which include deposit and current accounts, are down by around 10% in the first four months of this year. This mainly reflects seasonal factors and outflows from our foreign institutional deposit base earlier in the year and a reduction from what was a very strong position at the end of 2008. Customer resources were up c. 9% year on year at the end of the first quarter.

I wonder if any of this is Irish wealth fleeing the Land of Brian (see here). I like, in particular the reference to a 'very strong position at the end of 2008'. Per 9% increase in y-o-y terms in customer resources in Q4 2008, how much of this is due to redundancy payments lodgements? How much is due to precautionary savings? and How much of it is due to a flight from other - weaker - Irish institutions, e.g Nation-vile and Anglo?

Margins: In highly competitive markets and a low interest rate environment, customer deposit margins continue to contract. The elevated price of wholesale market funding is also having an adverse effect on the net interest margin. Though negative effects are being partly offset by better margins on our lending, overall the net interest margin is expected to reduce this year.

Margins contraction is not surprising, given they are forced to pay higher rates to customers to retain deposits. What is surprising, however, is that lending margins are up. This could mean three things:

1. Elevated charges on new loans - AIB doing their 'patriotic duty to lend' bit for the economy;
   
2. Increased roll-over of debt at higher rates; and
3. They are lending out cash to other banks - see the Treasury operations results above - and loving it.

Asset Quality: At our 2008 results announcement on 2nd March we outlined a base case and a stress scenario. The bad debt charge in the first quarter of 2009 of close to n800m was a little ahead of the upper end of that base case. Conditions across our markets have worsened and there will be further pressure on the bad debt provision charge for full year 2009.

Read this as: S***t is hitting the fan and we are in a 'stress' scenario now. For a bank whose chief executive just 9 months ago was raising dividends, this is really an admission that takes courage.

...our key macro assumptions for Ireland are now more negative than in the stress scenario presented at our results announcement. The pace of change is increasing loan impairment and bad debt charges. This continuing factor means that the previous stress scenario charge is likely to be exceeded and we now expect our bad debt charge for 2009 to be around n4.3 bn, c. 325 basis points of average loans.

This is still a denial case scenario. AIB's book is heavily geared toward property-related loans and its business lending is also heavily tied into Irish economy. With companies going bust at a rate rising some 400% since 2007 and accelerating, with house prices hurling toward -50% contraction on 2007 levels, land values heading for -70% and commercial propety values falling toward -50% mark, and with unemployment threatening to reach more than 3 times 2007 level, does anyone believe an impairment charge of 3.25%? In my view, they will face impairments of at least 6% across the entire book, or 3.5% on post-NAMA book.

Group criticised loans (watch, vulnerable and impaired) have increased in the first quarter to c. n24.3 bn, an increase of close to n9 bn [or a whooping 37%]. Republic of Ireland division represents over 70% of the increase and c. 75% of the group bad debt charge. Increases continue to be heavily influenced by downgrades in the property, building and construction sector [so, looking ahead, expect construction sector to flatten out in late 2009, but other sectors pick up the slack in exerting downward force on loans performance: households, personal & motor loans, business investment loans etc].

Informed by the deteriorating environment and evidenced by the increase in criticised loans, we are aggressively recognising impairment as it arises.

It will be important to see how aggressively they do this. Remember - the more they write down today, the heavier will be the total discount that they will face post-NAMA. How? Suppose you have a loan valued on your books at €100 today. Scenario 1: write down the loan value on the books by, say 10% - remaining face value is €90. Here comes NAMAsaurus - with an offer at 25% discount - you get €67.5 on the loan that originally stood at €100. Scenario 2: pretend nothing is wrong with the loan. NAMAsaurus takes a bite at the same discount (they'll have to, simply because they are short talent or staff numbers or both to examine every loan) - you have €75 on your hands. So tell me if you can spot a rational reason for AIB to take 'aggressively' to 'recognizing impairment'?

Increases in the levels of criticised loans in other sectors are now more evident in the Republic of Ireland. Mortgage arrears stand at c. 2.0% of total mortgages at the end of March up from c. 1.5% in December 2008 and impaired loans have increased to n234m [that is a 33% increase in mortgage arrears and this is just the beginning as it takes time for these to build up due to redundancy payments cushion and savings cushion - both of which have to be exhausted before mortgage payments stop. Now, average tenure on the job in Ireland is ca 5 years. This means average statutory redundancy is 10 weeks pay. Add to this consolation 'bonuses' some lucky souls are getting - say we are at 12 weeks pay. Take tax out and spread over existent balances - you are getting closer to that 9% increase in y-o-y terms in Q4 2008 customer resources mentioned above. So we have: potentially, redundancy payments have been inflowing into customers accounts. These are sufficient to cover mortgages with a cushion of, say, x1.5 times the pay length covered - i.e. 18 weeks or 4 months, roughly. That spike in unemployment in January-February 2009 will be felt in mortgage default terms only around May-June! So expect the numbers to nose dive rapidly in months to come. Even more revealing in the light of this is the subsequent fall of 10% in January-April 2009 in customer deposits - this, given inflow of redundancy payments can mean that some (those who can?) are shifting money out of AIB... and they might be doing this by B&B-ing cash abroad... away from Genghis Brian Khan...]

Capital: Our capital remains well in excess of regulatory requirements. Our core tier one capital ratio was c. 5.5% at the end of March and will be strengthened in the event that the n3.5 bn Government recapitalisation proposal is approved at the Extraordinary General Meeting on 13th May. We have previously announced our aim to further increase our core tier one capital by n1.5 bn and will advise progress on this initiative as it takes place. [With recapitalization in place AIB should have just around 10% T1 - 2-4 percentage points shy of the international industry standard. And this is before fresh writedowns... In absence of that €1.5bn capital injection, I fear AIB will not be able to retain 8% core ratio post Y2009 writedowns - let alone post-NAMA. Although this is my suspicion at this time as we await for more detailed statement at EGM].

Funding: ...Market conditions improved during April and we successfully increased our existing Government guaranteed issue maturing in September 2010 by n1 bn to n3 bn. There was good demand for the issue and overseas investors subscribed for 78% of the additional amount. We have also recently seen very good demand for private placements. [I wonder how much of this latest issue is contingent on the markets expectation that the Government guarantees will have to be extended beyond 2010. In fact, AIB, by piling on the debt that it will have to roll over comes September 2010 - for it won't have funds to simply repay it -is, willingly or not, you judge, creating the emergency conditions for the Government to extend the guarantee scheme... Oh, and by the way - do they mean the ECB discount window when they are talking about 'private placements'?]

Over time, we continue to target a reducing loan to deposit ratio although the already referred to reduction in customer resources since the end of 2008 has subsequently increased that ratio.

So, as deposits are down, loans/deposit ratio can fall only if... loans fall even more than deposits. How can this be achieved with a AIB offering "attractive customer offering and very weak competitor presence in the market" for mortgages? Ah, you say - by aggressively attracting new deposits. Indeed, that would be the case, except then, of course, you are offering higher rates than your competitors, e.g the Anglo, which in turn shrinks your margins... which you have just promised to protect (above)...

And the conclusion to all of this is - AIB's statement to the economy: "We love you, man, but we've got numero uno problem of getting these pesky loans to deposits ratios down... so bugger off, you would-be-borrower!"

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).

Now,

• 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...

Daily Economics 21/04/09: AIB and getting reality right

AIB is getting reality, courtesy of the Government...

You'd think it was a joke (here), but the Government that can't balance its own books and that prices risk as my two-and-a-half year old prices candies is now pushing an unwilling, reluctant, downright denial-bound AIB into re-considering its capital adequacy. What a fitting beginning of an end to the sorry saga of Irish banking.

CBFSAI or rather the more competent PWC hired to assist them, carried out a stress testing exercise on AIB and then the bank 'concluded' that €1.5bn more capital will be needed to keep the bank capitalized. And not just any capital - Tier 1 stuff, the caviar of the capital world.

The key word here is 'concluded' for it shows that, most likely, some back and forth bargaining between the bank and the Minister for Finance have taken place before arriving at the final figure. Which, of course, leaves me wonder - was the original stress test capital shortfall even bigger than that? We won't know unless PWC report is leaked.

AIB had core equity of €7.7bn (5.8%) and core Tier 1 of €9.9bn (7.4%) in January 2009 before getting €3.5bn in your and my money. Then, government preference shares hiked capital T1 to €13.4bn (10%) while equity remained intact at 5.8%.

Another transfer of wealth from us... to them
To plug the existent hole, AIB is hoping to sell its stakes in the US-based M&T and BZWBK (Poland). The book-value of these assets is questionable, with estimates of €2.2bn being on the higher end (Credit Suisse estimate) with €1.9bn estimated by AIB. But it is largely irrelevant, as sale of M&T will require a goodwill write-back yielding about €480mln in net T1 addition. Sale of BZWBK will require an RWA reduction, implying a net gain of €320mln. From €2.2bn of assets sold, AIB will get 75bps on Tier 1 - €800mln. Should the sale reduce the value of both assets by a modest 20%, you get €640mln boost to tier 1 (+60bps). In other words, someone (you and me) will have to cough up the remaining €700-860bn-odd cash injection for the bank.

There are reports of other accounting acrobatics - e.g repurchasing of various termed debts (tier 2) into perpetual paper (tier 1), but at the very least, the Government will end up putting enough cash into AIB coffers to own 30-50% of the bank outright. Another transfer of wealth will be in the works. From you and me to... ultimately - the public sector. Why? Because even if the Exchequer gets 10cents on a Euro, the Government will never rebate the money back to us. The Government will waste this cash on paying off the unionized public sector workers for 'industrial peace' achieved.

In the long run, the sale of both or either of the assets is going to be also a problem for the bank shareholders. Why? Because apart from having exposure to the US market (first to recover and to benefit from stronger trend growth in years ahead) and Poland (likely to show much stronger rebound than Ireland in years to come), AIB has no strategy as to how it will be making money into the future.

So to summarize: the recapitalization-Redux will be a raw deal for the taxpayers and shareholders, a sweetheart deal for the bank management and a modest payoff to the public sector unions and employees in the longer term.

Exposing NAMA scam
And it is back to NAMA. Recall the €80-90bn in loans that Lenihan is keen on shifting off the banks and into our taxpayer-financed vehicle? Remember the haircut to the loans value that the Davy etc were calling for? 15% that is, or a hit on the taxpayer of €68-76.5bn. Well, this is now getting bigger. If AIB needs €1.5bn in capital, before NAMAzation of its book, the two main banks will be going into NAMA with €22.4bn estimated core equity base and will inevitably lead to the Government as the majority shareholder in both banks even under a minor discount.

Now, consider the signals indicating the state of the loan books that the AIB stress-test conclusions suggest.

We do not have an exact split on LTVs for loans held by the banks. Bank of Ireland in November 2008 was reporting low-50% range for probably the most toxic of all loans - development land, but high-70% range for its overall property investment book. AIB reported in summer 2008 residential development book at 77% LTV (65% allocated to undeveloped land), total development book was evaluated at LTV in excess 70%.

So it is safe to assume that LTV on entire 2-banks loans book is averaging around 72-75%, while for development land - at ca 50%. The total development book to be bought up by NAMA will likely reflect a similar split to 35-65% in AIB, which out of €90bn can be ca €60bn (Davy, for example, have a similar number under their assumption). Since last reports, LTVs have gone up, as values dropped faster than loans write-downs reduced the 'L' part of the ratio, so these assumptions are relatively conservative.

For land, 55% LTV is likely to rise even further, as land markets all but ceased to function. How dangerous is this stuff?

Well, take BofI: land loans of €5.4bn, non-land development loans of €7.9bn. If LTV was 55% in November for land, the bank holds loans on the land with initial value of €5.4bn/0.55=€9.82bn. By many accounts, land is now largely valued at agricultural prices, plus a mark-up of say 50% for better locations. This would imply a 'Value' part fall-off of ca 70% for land. Let's be generous and allow for a 65% fall-off, reducing the BofI's land bank valuation to €9.82bn*0.35=€3.44bn. Under this scenario, assuming BofI takes an impressively honest impairment charge on land of 10%, the LTV has risen from 55% to €5.4*0.9/€3.44bn=141%. BofI will have to cover €1.96bn in lost value before NAMA discounts.

AIB's land bank valuation is €7bn*0.35/0.55=€4.45bn on currently-held €7bn in loans, with effective current LTV up from 55% to €7bn*0.9/€4.45bn=142%. AIB will have to cover €2.55bn in lost value before NAMA discounts. Assuming that this loss is taken at 40% knock-back on RWA, with 10% Tier 1 provision against RWA, we have a capital base hit of an odd €425mln due to land banks out of €1.5bn stress-test implied capital requirement.

But wait, this was just land.

Outside land, there is some roughly €48bn in other development stuff to be picked up by NAMA, with current LTVs at over 70% and values falling by over 40% by the time this recession will be over, implying book value adjusted for risk of €25.6bn - a shortfall of €22bn, approximately, which with 30% RWA impact and Tier 1 ratio of 10% assumptions will require €2.8bn in fresh capitalization.

So combined land and ordinary development stuff on the AIB book is roughly adding up to 1/2 of €2.8bn (non-land), plus ca €425mln (land) = €1.8bn in capital... Pretty close to the €1.5bn figure we got from the PWC's stress-testing after AIB 'agreed' with Mr Lenihan...

And the conclusions are:
Now get into the entire development books that NAMA is aiming to buy: at, say, 70% LTV, the €60bn in loans that NAMA will buy originally underwrote €86bn in 'value'. This will be down ca 45-50% by the end of the crisis (a relatively conservative assumption on housing and commercial development values declines), and assuming write-downs on loans at 5%, we have an implied bottom-of-crisis LTV ratios of €60*0.95/(€86*0.55)=121%.

Applying 15% cut on these loans, as Davy suggests, the taxpayers will be paying €51bn on risk-adjusted assets valued at €47bn, financing the purchase at, optimistically, 5.1-5.5% pa. That is equivalent to taking 121% mortgage on a house that has a closing cost of ca 8.5% upfront and is financed at an interest rate that is more than 2.5 times the rate of my current ordinary mortgage. This Government will turn us all into subprime borrowers.

So now we suspect two things:

1. Just on land alone, the pre-NAMA liability for two banks is ca €4.5bn - this the cash they will need to find before we level the NAMAzing discount of 15% (Davy), 25% (Merrrion) and so on.
2. The latest PWC/CBFSAI stress-test was most likely not stressful enough, as it barely covers the expected land & development loans-related capital losses alone.

And we know one thing: NAMA simply cannot work for the taxpayers!

Daily Economics Update 21/03/2009

Weekly analysis: Irish shares

The volume of shares traded on the New York Stock Exchange has topped the 50-day moving average on six of the seven days that the stock market has been up since March 6 (the day on which the S&P 500 touched its most recent low). The broad benchmark index has gained 15% since that low, sparking hopes of a recovery. The significant issue here is in the volume figure, not in the actual rise in the index, as stronger volumes on a rising trend tend to support more risk-taking and signal investors' support for the trend.

Interestingly, the same, but less pronounced, process has been starting on Friday in the Irish markets.
Chart above shows last week's movements in ISE Total Price Index (IETP), Irish Financials Index (IFIN), AIB, BofI and IL&P shares. Strong upward trajectories here, with significant volatility. But all underpinned by good (well above the average) volumes, as per chart below.This is less pronounced when we normalize daily volumes by historical average, as done in the chart below.
Less extraordinary change is underway above, because we are using moving averages as normalizing variable, implying that we actually capture the inherently rising volatility in volumes traded here. So the above chart actually suggests that while Friday up-tick in share prices (and pretty much the last three day's rally) was reasonably well underpinned, it will take some time to see if market establishes a solid floor under the share prices.

Monthly results so far remain weak. Only BofI was able, so far, to recover all monthly losses and post some gains. AIB is just hitting the point of return to late February valuations. Given that at the point of sale - at the end of February, beginning of March - the volumes traded were 5-7 times those of the current week's peak, it is hard to see the present recovery as being driven by pure psychology and the spillover from the broader global markets (US' momentary lapse of optimism).

Two more charts: recall that in mid February I argued that downgrades in all three financials will come to an end by February's expiration and all three will settle into a nice slow bear rally, running at virtually parallel rates of growth. Chart below shows that this is happening, indeed.Once we normalize prices and account for volumes traded, there is nothing surprising in the share prices movements since the beginning of March. And this is exactly where, as I argued before, the markets should be: awaiting news catalysts...

Buffet's Lesson from Ireland

Buffett Can't Find Green in Ireland, says Barron's (here)

"IT'S RARE FOR WARREN BUFFETT to suffer a near-total loss on an investment, but he did so with the purchase of shares of two Irish banks last year.

As he admitted in his annual shareholder letter, Buffett, the CEO of Berkshire Hathaway, invested $244 million in shares of two unnamed Irish banks. "At year-end, we wrote these holdings down to market: $27 million, for an 89% loss. Since then the stocks have declined even further. The tennis crowd would call my mistakes "unforced errors."

What were those two Irish bank stocks? We suspect that one of them is Allied Irish Banks (AIB), whose U.S.-listed shares are down to just $1 from a high of $45 last April...

What might have attracted Buffett to Allied Irish? Assuming he bought the stock, we suspect that he was motivated by the same reasoning that attracted Michael Price, a former mutual-fund star who runs MFP Investments.

At the Ira Sohn investment conference last May, Price recommended Allied Irish Banks, then trading around $41. Price said the stock looked cheap because it held a valuable stake in Buffalo-based M&T Bank (MTB). Excluding the M&T stake and another investment, Allied Irish was trading for just five times annual profits, Price asserted.

One reason we think that Buffett bought Allied Irish Banks is that Berkshire is the second-largest holder of M&T Bank at 6.7 million shares, behind Allied Irish Banks at 26.7 million shares. Buffett may have known about the Allied Irish holding in M&T, a bank that Buffett has praised in the past..."

Buffett's losses were small for Berkshire, but they are material for Ireland Inc.

Berkshire's mistake in buying into AIB had nothing to do with M&T share, which fell by only a third, as opposed to a 90%+ loss on AIB and BofI ("The other Irish bank whose shares were purchased by Berkshire could have been Bank of Ireland" says Barron's).

The real mistake was to buy into the banks run by the likes of Eugene Sheehy - a man who just last summer had a nerve to raise AIB's dividend in a clear case of mad macho bravado. And of course, his mistake was to buy into Ireland Inc regulatory circus - ran by a gang of financially inept political appointees of a regime that itself had one economic policy for all problems: throw more money at its cronies.

Now that Mr Buffett has learned his lesson, he will share it with the rest of the investment world. Who would bother putting any institutional money into this economy ever again? And who would bother buying Irish Government bonds backed by a claim on economy that is built on AIB-BofI-Anglo-IL&P-Nationwide & Co sand and issues bonds to keep this sand from liquefying under our feet?

The price of uncertainty

Here is something that we have been discussing in my Investment Theory course in Trinity’s MSc in Finance: the role of LTCM bailout in creating a self-perpetuating culture of “We are too big to fail” amongst the US, UK and even Irish institutions.

“Today, … that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed,” says Tyler Cowen.

How true this rings in the context of AIB and Bank of Ireland today! Indeed, their bizarre wobbling between “We don’t need capital injections” and “We’ll take some public money, please” speaks louder than Anglo’s surrender to the Exchequer. The message to the Government is clear – “Rescue us, but hold passing the costs – we are too big for you to let us fail”.

Tyler Cowen, however, puts this type of bluffing into perspective when he concludes that:
“John Maynard Keynes famously proclaimed that ‘in the long run we are all dead.’ …We’re not quite dead, but we are seriously ailing. ...we may be tempted again to put off the hard choices. But perhaps the next ‘long run,’ too, is no more than 10 years away. If we take the Keynesian maxim too seriously, and focus only on the short run, our prospects will be grim indeed.”

How? Well, those of you who were in my class last Fall would remember its core message: “Uncertainty and risk are all that matters in the financial markets”. In Tyler Cowen’s words:
“It has become increasingly apparent that the market doesn’t know what to expect and that many financial institutions are sitting on the sidelines, waiting to see what regulators will do next. Regulatory uncertainty is stifling the ability of financial markets to engineer at least a partial recovery.”

If there is a need for any proof of this – watch Anglo’s ADRs melting away in the US while the Irish market and the Government remain shut for the holidays: $0.12 on December 26.

Or here is the evidence in two charts and on a slightly more macro scale, plotting ISE Financials index performance against main policy shift dates and ISE Financials relative to S&P Banks index (both normalized to 100 at June 3, 2008). The trend is clear – every new round of Irish Government policy announcements has been greeted by the markets as a sign of a rising risk premium on Irish shares. This macro-trend has been about as clear as the fact that a long put on Irish banks on any date just prior to a new Government policy announcement would be in the money.

And this poor record has far less to do with the Anglo's or AIB's or BofI's fundamentals than with the short-termist and unconvincing policy performance by the Government. For all would-be-Keynesians out there, the gap between December 20th price (Anglo’s de facto nationalization announcement) and current price – a loss of 76% or $-0.38 per ADR – is, in effect, the latest revealed price of regulatory & policy uncertainty in Ireland. Steep!