17/6/2013: Deutsche, AIB and Cypriot Banks: 3 links

Back in 2011, I wrote about the extreme leverage ratios in some of Europe's top banks: http://trueeconomics.blogspot.ie/2011/09/13092011-german-and-french-banks.html. Deutsche Bank was at the top of the list. Now, 19 moths later it seems others are catching up: http://www.reuters.com/article/2013/06/14/financial-regulation-deutsche-idUSL2N0EO1D220130614.

And while on topic of banks, let's check this one for the record: http://www.independent.ie/business/irish/aib-will-not-repay-35bn-cash-it-owes-to-the-state-29337833.html. I wrote about this in Sunday Times last weekend, in passim, but this is more comprehensive article.

Another link of worth on the topic of banks is Cyprus banks fiasco history from ZeroHedge: http://www.zerohedge.com/news/2013-06-17/guest-post-real-story-cyprus-debt-crisis-part-1

6/6/2013: Domestic Economy v MNCs: Sunday Times 26/5/2013

This is an unedited version of my Sunday Times column from May 26, 2013



Over recent months, one side of the Irish economy – the side of aggressive tax optimization and avoidance by the Ireland-based multinational corporations – has provided a steady news-flow across the global and even domestic media. While important in its own right, the debate as to whether Ireland is a corporate tax haven de facto or de jure is missing a major point. That point is the complete and total disconnection between Ireland’s two economies: economy we all inhabit in our daily lives and economy that exists on paper, servers and in the IT clouds. The latter has a mostly intangible connection to our everyday reality, but is a key driver of Ireland’s macroeconomic performance and the Government PR machine.

Take a look at two simple sets of facts.

According to our national accounts, Ireland’s economy, measured in terms of GDP per capita, has been growing for two consecutive years expressed in both nominal terms and inflation-adjusted terms. Real GDP per capita in Ireland grew over 2010-2012 period by a cumulative 2.38% according to the IMF. Accounting for differences across the countries in price levels and exchange rates (using what economists refer to as purchasing power parity adjustment), Ireland’s GDP per capita has risen 5.7% over the two years through the end of 2012. Over the same period of time, Ireland’s GNP per capita, controlling for exchange rates and prices differentials, has grown by 3.3%.

Sounds like the party is rolling back into town? Not so fast. The aggregate figures above provide only a partial view of what is happening at the households’ level in the Irish economy. Stripping out most of the transfer pricing activity by the multinationals, domestic economy in Ireland is down, not up, by 5.2% between 2010 and 2012, once we adjust for inflation and it is down 2.7% when we take nominal values. With net emigration claiming around six percent of our population, per capita private domestic economic activity has fallen 4.2% over the last two years.

All in, Irish domestic economy is the second worst performer in the group of all peripheral euro area states, plus Iceland. Sixth year into the crisis, we are now in worse shape than Argentina was at the same junction of its 1998-2004 crisis.


What the above numbers indicate is that the Irish domestic economy, taken at the household level, has been experiencing two simultaneous pressures.

While aggregate inflation across the economy has been relatively benign, stripping out the effects of the interest rates reduction on the cost of housing, Irish households are facing significant price pressures in a number of sectors, reducing their real household incomes just at the time when the Government is increasing direct and indirect tax burdens. At the same time, rampant unemployment and underemployment have been responsible for lifting precautionary savings amongst the households with any surplus disposable income. By broader unemployment metrics that include unemployed, officially underemployed, and state-training programmes participants, Irish unemployment is currently running at 28% of the potential labour force. Adding in those who emigrated from Ireland since 2008 pushes the above broad measure of unemployment to close to 33%.

Lastly, the households are facing tremendous pressures to deleverage out of debt, pressures exacerbated by the Government-supported efforts of the banks to increase rates of recovery on stressed mortgages.

In this environment, real disposable incomes of households net of tax and housing costs are continuing to fall despite the increases recorded in GDP and GNP. The Irish Government, so keen on promoting our improved cost competitiveness when it comes to the foreign investors is presiding over the ever-escalating costs of living at home.

In 2012 consumer prices excluding mortgages interest costs stood the highest level in history and 1.2% ahead of pre-crisis peak of inflation recorded in 2008. Much of this is accounted for by the heavily taxed and regulated energy prices.

Sectoral data reveals the story of rampant annual inflation in state-controlled parts of the economy. Of ten broader categories of goods and services, ex-housing, reported by CSO, all but one private sectors posted virtually no inflation over 2012 compared to the average levels of prices in 2006-2008 period. Food and non-alcoholic beverages prices declined 1.4%, clothing and footware prices are now a quarter lower, costs of furnishings, household equipment and routine household maintenance are down 13%, and recreation and culture services charges are down more than 2.7%. Restaurants and hotels costs are statistically-speaking flat with price increases of just 0.4% on 2006-2008 average. The only private sector that did post statistically significant levels of inflation was communications where prices rose 3.5% by the end of 2012 compared to pre-crisis average. But even here postal services charges lead overall inflationary pressures.

In contrast, every state-controlled and heavily taxed sub-sector is posting rampant inflation. Alcoholic beverages and tobacco prices are up 12.3%, health up 13.4%, transport up 11.4%, and education costs are up 30.4%. Energy costs are up 32.5% and utilities and local charges are up 14.9%. While energy costs rose virtually in line with increases in global energy price indices, the state still reaped a windfall gain from this inflation via higher tax revenues, and higher returns to state-owned dominant energy market companies: ESB, Bord Gais and Bord na Mona.

The state extraction of funds through controlled charges and taxation linked to these charges is rampant. Over 2009-2012 period, indirect taxes, state revenues from sales of services and investment income – all linked to the cost base in the underlying economy rose from EUR 24.8 billion in 2009 (44.3% of total state revenues) to EUR 25.2 billion in 2012 (44.5% of total state revenues). This was despite significant declines in imports and consumption of goods in the domestic economy and declines in government own consumption of goods from EUR 10.4 billion in 2009 to EUR 8.56 billion in 2012. For those who think this extraction is nearly over now, let me remind you that IMF forecast increases in Government revenues for Ireland over 2014-2018 are set to exceed revenues increases passed in all budgets since 2008.


The price and tax hikes on Irish households leave them exposed to the risk of future increases in mortgages costs. Government controlled prices are sticky to the downside, which means that the once prices are raised, the state regulators and policymakers are unwilling to adjust prices downward in the future, no matter how bad households budgets can get. The reason for this is that semi-state companies reliant on regulated charges have significant market and political powers, especially as they act as prime vehicles for big bang ‘jobs creation’ and ‘investment’ announcements that fuel Irish political fortunes. At the same time, the state uses revenues obtained directly via dividends payouts and indirectly via taxes on goods and services supplied by the semi-state companies as substitutes for direct taxation. Absent deflation in state-controlled sectors, there is very little room left in the private sectors to compensate households for any potential future hikes in mortgages by reducing costs of goods and services elsewhere.

And mortgages costs are bound to rise over time. In 2008, new mortgages interest rates averaged around 5.2% against the ECB repo rate average of 3.85%, implying a lending margin of around 135 basis points. Since January 2013, ECB rates have averaged 0.7% while Irish mortgages rates averaged around 3.4%, implying a margin of 270 basis points. At this stage, we can expect ECB rates to revert to their historical average of around 3.1% in the medium-term future. At the same time, according to the Troika, Government and Central Bank’s plans, Irish banks will have to increase their lending margins. Put simply, current average new mortgages rates of 3.4% can pretty quickly double. Ditto for existent mortgages rates.

Based on CSO data, end of 2012 mortgages interest costs stood at the levels some 14.5% below those in 2007-2009 period and 29.6% below pre-crisis peak levels.  Reversion of the mortgages interest rates to historical averages and adjusting for increased lending margins over ECB rate would mean that mortgages interest costs can rise to well above their 2008 levels, with inflation in mortgages interest payments hitting 50%-plus over the next few years.


The dual structure of the Irish economy, splitting the country into an MNCs-dominated competitiveness haven and domestic overpriced and overtaxed nightmare, is going to hit Ireland hard in years to come. The only solution to the incoming crisis of rampant state-fuelled inflation in the cost of living compounding the households insolvency already present on the foot of the debt crisis is to reform our domestic economy. However, the necessary reforms must be concentrated in the areas dominated by the state-owned enterprises and quangos. These reforms will also threaten the state revenue extraction racket that is milking Irish consumers for every last penny they got. With this in mind, it is hardly surprising that to-date, six years into the crisis, Irish governments have done nothing to transform state-sponsored unproductive sectors of the domestic economy into consumers-serving competitively priced ones.

Chart with Argentina: GDP per capita adjusted for PPP differences (prices and exchange rates)

Box-out: 

Remember Ireland’s ‘exports-led recovery’ fairytale? The premise that an economy can grow out of its banking, debt and growth crises by expanding its exports has been firmly debunked by years of rapid growth in exports of goods and services, widening current account surpluses and lack of real growth in the underlying economy. Recent data, however, shows that the thesis of ‘exports-led recovery’ for the euro area is as dodgy as it is for Ireland. In 2010-2012, gross exports out of the euro area expanded by a massive 21.4%. Over the same period GDP grew by only 2.8%. Stripping out positive contributions from the private economy side (Government and household consumption, plus domestic investment), net exports growth effectively had no impact on shallow GDP expansion recorded in 2010 and 2011. The latest euro area economy forecasts for 2013 across 21 major research and financial services firms and five international economic and monetary policy organizations show a 100% consensus that while exports out of the euro area will continue to post positive growth this year, the euro area recession will continue on foot of contracting private domestic consumption and investment. Median consensus forecast is now for the euro area GDP to fall 0.4% in 2013 on foot of 2.1% drop in investment, 0.8% contraction in private consumption and a relatively benign 0.3% decline in Government consumption. The same picture – of near zero effect of exports on expected growth – is replayed in 2014 forecasts, with expectations for investment followed by private consumption expansion being the core drivers for the euro area return to positive GDP growth of ca 1.0%. Sadly, no one in Europe’s corridors of power seem to have any idea on how to move from fairytale policies pronouncements to real pro-growth ideas.

06/09/2011: Recapitalization of Irish Banks 2011

On August 31, 2011 Irish Government committed €17.3 billion of our - taxpayers - money to underwrite banks recapitalization following the PCAR 2011 exercise carried out by the CBofI. Three "banks" - BofI, AIB and IL&P received the funds. Here is the official summary of how these funds were distributed. No comment to follow.

10/08/2011: Bank of Ireland Interim Results H1 2011

Bank of Ireland interim results are out today, confirming, broadly speaking several assertions I've made before. You can skip to the end of the note to read my conclusions, unless you want to see specifics.

The numbers and some comments:

• Operating profit before impairments down from €479mln to €163mln. Profits before tax rose to €556mln compared to €116mln a year ago. Please remember that PCAR tests assumed strong operating profit performance for the bank through 2013. BofI net loss was €507mln reduced by the one-off gains of €143mln. While it is impossible to say from these short-run results if PCAR numbers are impacted, if deterioration in underlying profit takes place, ceteris paribus, recapitalization numbers will change.
• Impairment charges fell from €1,082mln to €842mln - which is good news. The decline is 22.2% - significant, but on a smaller base of assets and contrasted with 72% drop off in operating profit.
• Residential mortgages impairments shot straight up from €142mln to €159mln against a relatively healthier mortgages book that BofI holds. This 11% rise overall conceals a massive 30% increase in Irish residential mortgages impairments in 12 months. Again - predicted by some analysts before, but not factored fully into either PCAR tests or banking policies at large. Despite claims by Richie Boucher that these are in line with bank expectations, the bank expects mortgages arrears to peak in mid-2012. This is unlikely in my view, as even PCAR tests do not expect the peak to happen until 2016-2017. In addition, the bank view ignores the risk of amplified defaults should the Government bring in robust personal bankruptcy reform. The PCAR indirectly accounted for this, but in a very ad hoc way.
  
• So mortgages arrears in Ireland are now running at 4.55% for owner-occupiers and 7.84% for buy-to-let mortgages, with 3,900 mortgage 'modified' in the period and 5,000 more in process of 'modifications'.
• Past-due loans stood at €5.743 billion in H1 2011 down from €5.892 billion in H2 2010. However, impaired loans rose from €10.982 billion in H2 2010 to €12.311 billion in H1 2011. So overall, past-due and impaired loans accounted for 16% of the loan book (at €18,054 million) in H1 2011 against 14% of the book (€16,874 million) in H2 2010. (see table below)

• Total volumes of mortgages held by the bank is now €58 billion down from €60 billion in H1 2010. However residential mortgages held in Ireland remain static at €28 billion, so there appears to be no deleveraging amongst Irish households despite some writedowns of mortgages in the year to date.
• SME and corporate loans volumes dropped from €31 billion a year ago to €28 billion in H1 2011.
• Property and construction loans declined €1 billion to €23 billion of which €19 billion is investment loans (down €1 billion) and the balance (unchanged yoy) is land.
• So far, as the result of deleveraging, bank assets book became more geared toward residential mortgages (52% as opposed to 51% a year ago), less geared toward SME and corporate sector (25% today as opposed to 26% a year ago) and unchanged across Property and Construction (20%), but slightly down on consumer loans (3%). In other words, the bank is now 72% vested into property markets against 71% in H1 2010.
  
• With only 1/2 Bank of Ireland's assets sourced in Ireland, impairments were reduced by 22% by its operations abroad, which contributed to almost 50% reduction in its underlying pretax loss. This suggests that as the bank continues to sell overseas assets, its longer term exposure to Ireland will expand, implying that the positive impact of the disposed assets on the bottom line will be reduced as.
• Table below breaks down impaired loans and provisions, showing - as the core result that overall impaired loans as % of all loans assets is are now at 11%, against 9.2% at the end of December 2010.
• Coverage ratios are generally determined by the nature of the loan assets and the extent and quality of underlying collateral held against the loan. Across the bank, impairment provisions as a percentage of impaired loans declined from 45% in H2 2010 to 44% at H1 2011. The coverage ratio on Residential mortgages increased from 67% to 72% over the period. However, Residential mortgages that are ‘90 days past due’, where no loss is expected to be incurred, are not included in ‘impaired loans’ in the table below. This represents added risk due to potential inaccuracies in valuations on underlying collateral and/or value of the assets. If all Residential mortgages that are ‘90 days past due’ were included in ‘impaired loans’, the coverage ratio for Residential mortgages would be 29% at
  30 June 2011, unchanged from 31 December 2010. Which, means that risk offset cushion carried by the bank would not have increased since December 2010. In H1 2011, the Non-property SME and corporate loans coverage ratio has increased to 42% from 40% on H2 2010. The coverage ratio on the Property and construction loans was 38% at 30 June 2011 down from 42% at 31 December 2010 primarily due to an increase in Investment property loans which are ‘90 days past due’ that are "currently being renegotiated but where a loss is not anticipated".
  
  

• Per bank own statement: ‘Challenged’ loans include ‘impaired loans’, together with elements of ‘past due but not impaired’, ‘lower quality but not past due nor impaired’ and loans at the lower end of ‘acceptable quality’ which are subject to increased credit scrutiny.
• Table below highlights the volumes of challenged loans.
• Pre-impairment total volume of loans stood at €111.902bn of which €24.464bn were challenged - a rate of 21.9%. In H2 2010 the same numbers were €119.432bn, €23.787bn or 19.9%. In other words, they really do know how to lend in BofI, don't they? Every euro in five is now under stress according to their own metrics.
  

• Per bank statement, deposits remain largely unchanged at the bank at €65 billion (through end of June), same as at the end of December 2010.
  
• This is offset by the fact that parts of its UK deposits book has grown over this period of time, implying contraction in deposits in Ireland. The bank statement shows Irish customer deposits at €34 billion in H1 2011, down from €35 billion in H1 2010. The UK deposits overall remained static at €21 billion (due to stronger Euro against sterling, with sterling deposits up from 18bn to 19bn year on year).
• With ECB/CBofI funding BofI to the tune of €29 billion, the above figures imply that the bank in effect depends on monetary authorities for more funds than its entire Irish customers deposits base, which really means that it is hardly a fully functional retail bank, but rather a sort of a hybrid dependent on the good will of Euro area subsidy.
  
• Loans to deposits ratio fell to 164% - massively shy of 122.5% the Regulator identified as the target for 2011-2013 adjustments. Which means that the scale of disposals will have to be large. This in turn implies higher downside risk from disposal of performing assets (selection bias working against the bank balance sheet in the future). The bank needs to sell some €10 billion worth of loans and work off €20 billion more by the end of 2013 to comply with PCAR target to reduce its dependence on ECB funding.
  
• Reliance on the Central Bank funding is down €1 billion to €29 billion - and that is in the period when the Irish Government put €3 billion of deposits into BofI.
  
• The Gov (NTMA) deposits amount to €3 billion and were counted as ordinary deposits on the Capital markets book, in which case, of course, the outflow of the real Irish deposits from the bank was pretty big. BofI provides an explanation for these numbers on page 2o of its report, stating: "Capital Markets deposits amounted to €9.7 billion at 30 June 2011 as compared with €9.2 billion at 31 December 2010. The net increase of €0.5 billion reflects the receipt of €3 billion deposits from the National Treasury Management Agency (which were repaid following the 2011 Capital Raise in late July 2011) partly offset by loss of deposits as a result of the disposal of BOISS whose customers had placed deposits of €1 billion with the Group at 31 December 2010 and an outflow of other Capital Markets deposits of €1.5 billion during the six months ended 30 June 2011."
  
• Hence, excluding Government deposits, the bank deposit book stood at €62 billion. Factoring out Gov (NTMA) deposits into the loans/deposits ratio implies the ratio rising to 172% from 164%.
  
• Wholesale funding declined €9 billion to €61 billion with some improved maturity (€3 billion of decline came from funding >1 year to maturity, against €6 billion of decline in funding with <1 year in maturity). The bank raised €2.9 billion in term loans in 2 months through July 2011 - a stark contrast to the rest of the IRL6 zombies.

• Net interest margin - the difference between average lending rates and funding costs - fell from 1.41% in H1 2010 to 1.33% in H1 2011 as funding costs rose internationally and as Irish households' ability to pay deteriorated further. Net interest income was down 14% as costs of deposits rose.
  
• In addition, the cost of the government guarantee of Bank of Ireland's liabilities rose 58% from H1 2010 to €239mln in H1 2011.
  
• By division, underlying operating profit before impairment charges fell in all divisions.
• Cost income ratio shot up from 61% a year ago to 83% in H1 2011.
• It's worth noting the costs base at the bank: Operating expenses were €431mln for H1 2011, a decrease of €36mln compared to H1 2010. Average staff numbers (full time equivalents) = 5,519 for H1 2011 were 101 lower on H1 2010. The staff numbers, therefore, are really out of line with decreasing business levels

• Bank Core tier 1, and total capital ratios were 9.5% and 11.0% respectively, against 31 December 2010 Core tier 1, and total capital ratios of 9.7%, and 11.0%. Were €3.8 billion (net) equity capital raising completed at 30 June 2011, the Group’s Core tier 1 ratio would have been 14.8%. Note that, much unreported: "A Contingent capital note with a nominal value of €1.0 billion and which qualifies as Tier 2 capital was issued to the State in July 2011." This comes with maturity of 5 years. The note has a coupon of 10%, which can be increased to 18% if the State wish to sell the note. If the Core tier 1 capital of the Group’s falls below 8.25%, the note automatically converts to ordinary stock at the conversion price of the volume-weighted average price of the ordinary stock over the 30 days prior to conversion, subject to a minimum conversion price of €0.05 per unit.

Summary:

• Overall, BofI confirmed with today's results that it is the only bank that we can feasibly rescue out of the entire IRL6 institutions, as impairments in BofI decline is contrasted with ca 30% rise in impairments at the AIB over the same H1 2011.
• However, severe headwinds remain on mortgages side and provisioning, funding and costs.
• The figures for impairments and 'challenged' loans show that the bank faces elevated risks on at least 22% of its loans.
• The figures on funding side show that the bank is still far from being a functional self-funding entity.
• The figures on deposits side show that it continues to lose business despite shrinking its margins to attract depositors.
• The figures on staffing and costs side show that the bank management has no executable strategy to bring under control its operating costs.
• The figures on lending side show the the bank is amplifying its exposure to property rather than reducing it, in effect becoming less diversified and higher risk.
• The figures on deleveraging side show that the bank risk profile can be severely adversely impacted by the CBofI-mandated disposals of assets.
  

And that's folks, is the best bank we've got of all IRL6!

17/06/2011: Who's Confidence is it, folks?

Here are few charts to illustrate the fact that some 3 years into the 'Restoring Confidence' strategy of the successive Irish Governments... and things are not exactly working out.

First straight up, the markets 'voting' on Irish banks:
Looks like investors are not really in tune with Irish Government plans for 'repairing' our banking system despite unprecedented guarantees from the Sovereign which have:

• Explicitly underwritten virtually all deposits and most of the bonds held or issued by the IRL6;
• Implicitly underwritten virtually any extent of losses in the IRL6;
• Explicitly purchased some of the worst 'assets' held by the IRL6; and
• Explicitly underwritten all of the IRL6 funding through ECB and CBofI lending facilities

And what about the entire system of domestic financial institutions? Well, the story is pretty much the same:Recall, thus that at the present (and the picture remains stable in this context since around late 2008):

• Financial investors have no confidence in IRL6 (as these charts illustrate)
  
• Fellow peer banks around the world have no confidence in IRL6 (as clearly indicated by the fact that other banks are not willing to lend to IRL6)
• Bond markets have no confidence in IRL6 (since none of IRL6 can issue any debt paper)
• The ECB has no confidence in IRL6 as it desperately tries to shed their borrowings off its balance sheet (including by shifting it onto CBofI balancesheet)
• Private sector have no confidence in IRL6 as they have taken out some €24 billion worth of funds from IRL6 (per April 2011 data from CBofI) or 23% relative to peak
  

So the only ones still showing confidence in IRL6 is... Irish Government itself, with the Sovereing - itself severely strapped for cash - putting some €18.566 billion worth of taxpayers money into Irish banks deposits since April 2010. That's a whooping ca 8-fold increase in Confidence, then.

02/06/2011: Latest shenanigans at the banks

Two junior bondholders in Allied Irish Banks - Aurelius Capital Management and Abadi Co – are taking the Irish government to court today over the AIB plans to impose burden-sharing on some bondholders in failed banks. Aurelius is a distressed debt investment vehicle which also holds debt of Dubai World so it should be well familiar with the case of haircuts.

These are not investors who bought Irish banks bonds at their full value, but those who pick up distressed debt at a significant discount. However, it is their right to maximize their returns on such investments.

Let us recall that AIB is the sickest of the 4 banks reviewed under the original PCARs back on March 31 this year. Under the stress tests, AIB is expected to lose €3.07bn on Residential Mortgages (all figures refer to stress scenario, 3-year time frame), €972mln on Corporate loans, €2.67bn on SMEs loans, €4.49bn on Commercial Real Estate loans and €1.4bn on Non-mortgage Consumer loans and Other loans. The grand total expected 2011-2013 losses under stressed scenario is €12.6bn or almost ½ of the total expected stress scenario losses across IRL-4 banks of €27.72bn.

Of the €24bn capital buffer for IRL-4 required by the Central Bank PCAR exercise, full €13.3bn is accounted for by AIB.

Which implies that AIB – accounting for just €93.7bn of the €273.94bn of loans held by the IRL-4 at the time of PCARs (just over 34.2% of the total loans of IRL-4) is responsible for over 55.4% of overall capital demands. It is, by a mile, the worst performing bank of IRL-4... Really, folks, 'Be with AIB' as their old commercials would say.

So in the case of AIB, Finance Minister Michael Noonan – the majority shareholder in AIB – is now attempting to impose losses of between 75 and 90 percent on €2.6bn of the bank’s subordinated debt. This means that the bond-holders are expected to contribute just 15-16% of the total cost of the latest bank recapitalization programme. This, of course, is a drop in a sea of pain already levied against Irish taxpayers.

The problem in Ireland is that the so-called subordinated liabilities orders (SLO), which the government is using to force a deal on bondholders is untested in law. Bondholders can claim priority over shareholders in the event of insolvency. But the banks are now existing solely on government life-support. Although they are complete zombies, they are not technically insolvent. This in turn means their equity retains some – if only tiny – value. The Irish Government in the case of AIB driving bondholders’ haircuts can be seen as the means for improving that value to the shareholder at the expense of bondholders, since equity will benefit from lower debt and changes in the capital structure.

In the case of AIB this means two possible things:

• If the court finds in favour of Aurelius and Abadi, the deal is off the table or will be more expensive to execute (lower haircuts), which will in turn imply greater demand on taxpayers to step in. Of course, this also means the Gov in effect destroying a large portion of its own shares value.
• If the court rules in favour of the Gov, the deal is on and we have a precedent for aggressive burden sharing. This, however, will only benefit the majority state-owned banks, i.e. Anglo, INBS, EBS and AIB, and only with respect to savings on subordinated debt.
  

The problem is in the timing of this burden sharing – the previous Gov insistence on paying on bonds in full means that we, the taxpayers, are now on the hook for losses on our shares in the banks via dilution. You don’t have to go far to see what happens here. Just look at Bank of Ireland (below).

Normal process of banks workout should have been:

• Step 1 – Impose losses on shareholders, while preserving depositors by ring-fencing them via specific legislation to remove equivalent status between senior bondholders and depositors. Such legislation can be enacted on the grounds that depositors are not lenders to the activities of the banks, but are clients of the banks for the purpose of safe-keeping of their money. It is also justified from the point of view of finance, as depositors are being paid much lower rates of return on their money, implying lower risk premium
• Step 2 – Impose losses on bondholders via a combination of robust haircuts and debt-for-equity swaps, but only after depositors are protected
• Step 3 – For any amounts of capital still outstanding per writedowns requirements, the Government can then take equity positions in the banks.

This sequence of actions would have prevented depositors runs and repeated taxpayer equity dilutions. It would also have given the Government a mandate to take over and reform failed banks.

By doing everything backwards, we are now in a veritable mess. This mess was not caused by the current Government – it is the toxic legacy of the previous Government which made gross errors in managing the whole banking crisis. This mess is extremely hard to unwind and my sympathies go here to Minister Noonan who is at the very least trying to do something right after years of spoofing and wasting taxpayers money by his predecessor.

Note: The Government is aiming to cut around €5bn from the total bill for bailing out Irish-6 banks. Imposing losses of up to 90 percent on junior bonds in AIB, Bank of Ireland, Irish Life & Permanent and EBS Building Society is on the cards:

• IL&P said it would offer 20cents on the euro for €840m of debt
• EBS wants to pay 10c to 20c on the euro for around €260m of subordinated bonds
• Bank of Ireland is pushing up to 90% discount on €2.6 billion worth of subordinated debt. Bank of Ireland said it would offer holders of Tier 1 securities just 10 percent of the face value of their original investment, and holders of Tier 2 securities 20 percent.

It is revealing, perhaps, of the state of our nation’s policy making that over a year ago myself, Brian Lucey, Peter Mathews, David McWilliams and a small number of other commentators suggested 80-90% haircuts for subordinated bondholders. We were, of course, promptly attacked as ‘reckless’, ‘irresponsible’ and ‘naïve’. Yet, doing this back then would have netted taxpayers savings of more than double the amount hoped for today.

And this is before the savings that could have been generated from avoiding painful dilution of equity holdings acquired by the Government in Irish banks. How painful? Look no further than the unfolding Bank of Ireland saga.

Bank of Ireland's lower Tier 2 paper is trading at 37-40 cents on the euro post-announcement of the after the announcement that T2 will be offered an 80 percent discount alongside with a ‘more attractive’ debt-for-equity swap. Tier 1 paper holders are offered 10 cents on the euro cash ex-accrued interest. Shares swap will factor in accrued interest to sweeten the deal. The debt-equity swap is so powerful of a promise that BofI shares have all but collapsed over the last few days losing over 62% of their already minuscule value. Of course, with Government holding 39% of equity pre-swap, the taxpayers have suffered the same loss as the ordinary shareholders, all courtesy of perverse timing of equity injections by the previous Government.

And there’s more. Even if successful in applying haircuts and swaps to junior bondholders, Bank of Ireland will still need to raise additional €1.6bn from either new investors or existent shareholders (including the Government). Which means even more dilution is to come.

Economics 6/11/10: Two charts - IRL & Spain

Two interesting charts on 5 year bonds for Ireland and Spain, courtesy of CMA:
What's clear from these charts is the extent of inter-links between banks and sovereign credit default swaps. In Spain at least three core banks - La Caixa, BBVA and Banco Santander act as relative diversifiers away from the sovereign risk since late October. In Ireland - all of the banks carry higher risk than sovereign. Another interesting feature is a significant counter-move in the Anglo CDS since late September. This, undoubtedly underpinned by the large-scale bonds redemption undertaken by Anglo at the end of September. Thirdly, an interesting feature of the Irish data is that CDS contracts on Anglo, IL&P and AIB are now trading at virtually identical implied probability of default.

Lastly, Irish sovereign debt is now trading at probability of default higher than that of the Spanish banks!

Economics 19/9/10: Irish banks - Government intervention still has no effect

Returning to my old theme - let's take a fresh look at the Government and its policy cheerleaders success rate with repairing our banking sector. Here is a quick snapshot of history and numbers as told through the lens of Irish Financials index.
So clearly, we have some really powerful analysts out there and keen commentariat (actually one and the same in this case) on the future prognosis for our banks.

But what about recent moves in the index itself?
Take a look at the chart above, which maps the Financials Index for two subperiods:
Period 1: from Guarantee to March announcement of the 'final' recapitalization of our banks,
Period 2: from Guarantee to today.
Now notice the difference between two equations. That's right, things are not getting any better, they are getting worse.

Next, let's put some historical markers on the map:
Surely, our financials are getting better, the Government will say, by... err... not getting much, much worse. The reality, of course is, any index has a natural lower bound of zero. In the case of Irish Financials Index, this bound is above zero, as the index contains companies that are not banks. As far as the banks go, there is a natural lower limit for their share values of zero. Our IFIN index is now at 80% loss relative not to its peak, but to its value on the day of Guarantee!

Having pledged banks supports to the tune of 1/3 of our GDP already, the Government policy still has not achieved any appreciable improvement in the index.

Forget longer term stuff - even relative to Q4 2009, Government policies cannot correct the strategic switchback away from Irish banks shares that took hold:
A picture, is worth a 1000 words. Unless you belong to the upbeat cheerleaders group of the very same analysts who missed the largest market collapse in history, that is.

Economics 13/07/10: AIB needs your cash

The dogs are barking across Dublin’s RDS. Touring the USofA, our Taoiseach has told the nation that AIB may (oh, just ‘may’?) need further state support to meet new capital targets. That admission, of course, comes after the solemn statement by Minister Lenihan back in March that the announced measures to provide capital to AIB and BofI were final. And on the heels of numerous assertions by our banks’ cheerleaders squad in Dublin’s stockbrokerage houses that AIB will be able to raise capital on its own accord, once the taxpayers pay through the nose for ordinary shares in the bank in round 3 of recapitalisations.

Well, taxpayers did pay through the nose. And AIB still needs more than €7 billion – based on status quo scenario concerning loans quality. Should it see continued deterioration in loans going forward from Q1 2010, the bank will need more than that. How much more? Anybody’s guess. But that open ended nature of AIB’s liabilities won’t hold back our nation’s leader. Last night, Brian Cowen pledged an open ended support to AIB saying that AIB “may need some help, but we will provide that”. How much will Brian be ready to ‘provide’? Not a single word. There is no stop-loss rule operating for this Government. Then again, we know as much from the Government treatment of the Anglo.


And while on the matters of Taoiseach tour of the US, unable to sell the idea that Ireland has turned economic ’corner’ on the recession, our leader is meeting some pretty important people. NYSE CEO Duncan Niederauer and NYC mayor Michael Bloomberg are on the list of those who need to be wooed into ‘Green Jersey’ club. Presumably, they’d love to send some of their companies (listings and HQs) down to the Emerald Isle, but need Taoiseach to convince them.

Messrs Bloomberg and Niederauer will have to be satisfied with playing the second fiddle in Mr Cowen’s sonorous opus ‘Turning Over, Again’. Per Taoiseach: "The first objective will be to give a clear message to key media outlets, business figures and opinion formers that Ireland has turned the corner…"

In other words, accustomed to his own PR hype, economic management is all in the media reporting for Mr Cowen. That, plus what’s being said at business lunches and social dinners in Manhattan. In other words, if the foreigners – especially the important ones – can be made believe things are good back in Auld Dublin, then surely they must be good.

No? Who says so? Oh, those pesky 450,000 unemployed and underemployed back in Ireland? Well, we’ll have jobs for them in no time, once Micheal O'Blumberg and Duncan MacNiedehan send their NYC 'investitors' over to Upper Merrion Street to buy some of those banks shares. After all, Bertie Ahearn thinks they should be a bargain at €5 each, while with Brian Cowen's latest unconditional pledge to plug AIB's capital hole no matter what, Bertie might just be right...

But just in case you think it’s all about Brian Cowen telling the Americans how to properly read our economic stats and banks balance sheets to discern the ‘turnaround’, think twice. Per Reuters report: “Mr Cowen said he will also ask for advice from business and political leaders on how Ireland can continue its fight against the recession and create jobs.”

Oh, wait – what recession? Didn’t we turn that corner?

Does anyone find this a little bit strange? We have an elected leader of the nation whose job description is to govern the state going over to the US to 'ask business leaders for an advice' on how to do his job?

Then again, our Taoiseach can boast of his policies getting us out of the recession. So why would he ask foreigners to provide him with their own ‘get out of recession’ ideas? May be, its because he really hasn’t a policy himself or he might need external validation for his policy of having no policy, or may be it is both. You tell me. But it does seem a bit uncomfortable, in aesthetic terms, to see our head of state travelling to the US to ‘consult’ foreign business leaders on how to solve our problems. I can’t imagine Angela Merkel or Nicolas Sarkozy doing the same. At least, not in front of the media…

Economics 25/05/2010: Looking at the Financial sector

As of now, both BofI and AIB are trading below 52-weeks lows. The financials are continuing to experience pressures. But a look back at the overall sector is warranted. Here are some stats:
Let's start from a far: dramatic or not, but the current market conditions are in line with the long term time trend in Irish financials. If anything, per almost 11 years of data, we are currently above the long run trend line. Guess there's more room for downward pressures, should long run dynamics matter.

Zooming in:
Note the chart above - this shows the totality of value destruction since the beginning of the credit crunch back in July/August 2007.

To see some more dynamics, consider the snapshot from the peak to today:
The chart above shows the entire extent of the crisis, with the medium term (through crisis) trend pointing to consistent positioning of the current market valuations. In other words, per trend, nothing dramatic is happening in the markets right now. I also posted some key dates that mark our policy and opinion makers' ability to track markets and predict the future.

Lastly, chart above shows the dynamics in Irish financials over the span of the 'rebirth of optimism' - the last 12 months during which various Government officials and politicians have made a score of statements to the effect that:

• Ireland has turned the corner on recession
• Irish banks are now in a stronger position than before
• Irish Government has made right decisions and these are now evident in the markets' approval, etc.
  

Revealing, isn't it?

Economics 22/02/2010: Leading indicators of an Irish recovery

For those of you who missed my Sunday Times article yesterday, here is the unedited version (note: this is the last article of mine in the Sunday Times for the time being as Damien Kiberd will be back with his usual excellent column from next week on):


The latest Exchequer results alongside the Live Register figures clearly point to the fact that despite all the recent talk about Ireland turning the corner, the recession continues to ravage our economy. And despite all the recent gains in consumer confidence retail spending posted yet another lackluster month in December 2009. Predictably, credit demand remains extremely weak, with the IBF/PwC Mortgage Market Profile released earlier this week showing that the volume of new mortgages issued in Ireland has fallen 18% in Q4 2009.

Even industrial production and manufacturing, having shown tentative improvement in Q3 2009 have trended down in the last quarter.

As disappointing as these results are, they were ultimately predictable. Economic turnarounds do not happen because Government ‘experts’ decide to cheer up consumers.

Instead, there is an ironclad timing to various indicators that time the recessions and recoveries: some lead the cycle, others are contemporaneous to it, or even lag changes in economy.

In a research paper published in 2007, UCLA’s Edward E. Leamer shows that in ten recessions experienced in the US since the end of World War II, eight were precluded by housing markets declines (first in terms of volumes of sales and later price changes). The two exceptions were the Dot Com bust of 2001 and the end of the massive military spending due to the Korean Armistice of 1953. Residential investment also led the recovery cycle.

Despite being exports-dependent, Irish economy shares one important trait with the US. Housing investments constitute a major proportion of our households’ investment. In fact, the weight of housing in our investment portfolios is around 65-70%. It is around 50% in the US. As such, house markets determine our wealth and savings, and have a pronounced effect on our decisions as consumers.

Consider the timing of events. Going into the crisis, Irish house sales volumes turned downward in the first half of 2007. House prices declines followed by Q1 2008, alongside changes in manufacturing and services sectors PMI. A quarter later, the whole economy was in a recession.

House price declines for January 2010 indicate that roughly €200 billion worth of wealth was wiped out from the Irish households’ balancesheets since the end of 2007. With this safety net gone, the first reaction is to cut borrowing and ramp up savings, to the detriment of immediate consumption and new investment.

So, if housing markets are the lead indicator of future economic activity, just where exactly (relative to the proverbial corner) are we on the road to recovery? Not in a good place, I am afraid.

Per latest data from the Central Bank, private sector credit continues to contract in Ireland, with December 2009 recording a drop of 6% on December 2008. Residential mortgage lending has also fallen from €114.3 billion in December 2008 to €109.9 billion a year later. This suggests that at least some households are deleveraging out of debt – a good sign. Of course, the decline is also driven by the mortgages writedowns due to insolvencies.

Worse, as Central Bank data shows, the process of retail interest rates increases is already underway. In November 2009 retail interest rates for mortgages have increased for all loans maturities and types. Irish banks, spurred on by the prospect of massive losses due to Nama, are hiking up the rates they charge on existent and new borrowers.

And more is to come. Based on the current dynamic of the interest rates and existent lending margins for largest Irish banks compared to euro area aggregates, I would estimate that average interest rates charged on mortgages will rise from 2.67% recorded back at the end of November 2009 to around 3.3-3.5 % by the end of this year, before the ECB increases its base rate. This would imply that those on adjustable mortgages could see their cost of house financing rise by around 125 basis points, while new mortgage applicants will be facing rates hike of well over 150-160 basis points.

On the house prices front, absent any real-time data, all that we do know is that residential rents remain subdued. Removing seasonality out of Daft.ie most recent data, released this week, shows that downward trend in rents is likely to continue. Commercial rents are also sliding and overall occupancy rates are rising, with some premium retail locations, such as CHQ building in IFSC, are reporting over 50% vacancy rates.

Does anyone still think we have turned a corner?

The problem, of course, is that the structure of the Irish economy prevents an orderly and speedy restart to residential investment.

First, there are simply too many properties either for sale or held back from the market by the owners who know they have no chance of shifting these any time soon. We have zoned so much land – most of it in locations where few would ever want to live – that we can met our expected demand 70 years into the future. We also have 350-400,000 vacant finished and unfinished homes, majority of which will never be sold at any price proximate to the cost of their completion. To address these problems, the Government can use Nama to demolish surplus properties and de-zone unsuitable land. But that would be excruciatingly costly, unless we fully nationalize the banks first. And it would cut against Nama’s mandate to deliver long-term economic value.

Second, there is a problem of price discovery. Before the crisis we had ESRI/ptsb sample of selling prices. Based on ptsb own mortgages, it was a poor measure. But now, with ptsb having pushed its loans to deposits ratio to 300%, matching Northern Rock’s achievement, there is not a snowball’s chance in hell it will remain a dominant player in mortgages in Ireland. Thus, we no longer have any indication as to the actual levels of property prices, and absent these, no rational investor will brave the market. The Government can rectify the problem by requiring sellers to publish exact data on prices and property characteristics.

Third, the Government can aid the process of households deleveraging from the debts accumulated during the Celtic Tiger era. In particular, to help struggling mortgage payers, the Government can extend 100% interest relief for a fixed period of time, say 5 years, to all households. On the one hand such relief will provide a positive cushion against rising interest rates. On the other hand, it will allow older households with less substantial mortgage outlays to begin the process of rebuilding their retirement savings devastated by the twin collapse in property and equity markets. Instead of doing this, the Government is desperately searching for new and more punitive ways to tax savings. Finance Bill 2010 with its tax on unit-linked single premium insurance products is the case in point.

Fourth, the Government can get serious about reducing the burden of our grotesquely overweight public sector. To do so, the Exchequer should commit to no increases in income tax in the next 5 years. All deficit adjustments from here on will have to take a form of expenditure cuts. Nama must be altered into a leaner undertaking responsible for repairing banks balancesheets, not for providing them with soft taxpayers’ cash in exchange for junk assets.

Until all four reforms take place, there is little hope of us getting close to the proverbial corner for residential investment, and with it, for economy at large.


Box-out:

Back in January 2009, unnoticed by many observers, a small change took place in the Central Bank reporting of the credit flows in the retail lending in Ireland. Per Central Bank note, from that month on, credit unions authorized in Ireland were classified as credit institutions and their deposits and loans were included in other monetary financial institutions. This minute change implies that since January 2009, Irish deposits and loans volumes have been inflated by the deposits and loans from the credit unions. Thus, a search through the Central Bank archive shows that between November 2008 and February 2009, the total deposits base relating to resident credit institutions and other MFIs rose from €166 billion to €183 billion, despite the fact that the country banking system was in the grip of a severe crisis. Adjusting for seasonal effects normally present in the data, it appears that some €14-15 billion worth of ‘new’ deposits were delivered to the Irish economy though this new accounting procedure. Of course, deposits on the banks liability side are exactly offset by their assets side, which means that over the same period of time more than €16 billion of ‘new’ credit was registering on the Central Bank radar. Now, this figure is also collaborated by the credit unions annual reports which show roughly €14 billion worth of loans issued by the end of 2007 – the latest for which data is available. This suggests that the credit contraction in the Irish economy during 2009 is understated by the official figures to the tune of €14-15 billion. Not a chop change.

Economics 02/02/2010: NTMA and the banks

Per RTE Business (here which so far cannot be confirmed by any official material published on the NTMA website):

The NTMA "will now hold talks on capital needs with the institutions covered by the NAMA legislation. Among the other responsibilities it is assuming, the NTMA will also hold discussions with financial institutions on their realignment or restructuring within the banking sector. It will manage the Minister for Finance's shareholding in the banks, advise on banking matters, and crisis prevention, management and resolution."

Here are the interesting aspects of this change that raise a multitude of questions:

1. How will NTMA manage the conflict of interest between its own objectives per above and Nama objectives?
2. How will the potential conflicts of interest be disclosed to the markets?
3. What does it mean that NTMA will hold discussions with financial institutions? Will these discussions be subject to usual market disclosure rules or will they risk constituting a price fixing behavior?
   
4. How can NTMA's direct interference with the banks be compatible with the rights of other shareholders?
5. How will NTMA advising on banking matters etc play out vis-a-vis the roles of the Financial Regulator and the Central Bank?
6. What does 'crisis prevention, management and resolution' refer to? Systemic banking crises? Specific institutions crisis? Will it also include industrial relations crises? How will this process be carried out while respecting the general rules of disclosure and non-collusion with the market?
7. With massive firepower and own objectives, how NTMA will assure that the rights and interests of minority shareholders in the banks are protected?

In effect - even the mere raising of these questions implies that there is a risk that NTMA will be engaged in interfering with the markets for shares and debt in Irish banks in markets-distorting fashion. Amazingly we have no details as to how the Government and NTMA/Nama plan to avoid these problems.


There is another issue at hand here. If, at least in theory, DofF is a publicly accountable institution, NTMA by its statues is a secret entity (with extremely secretive culture to boot). What transparency can we, banks customers, have and what assurance can we hold that NTMA will not act to undermine or violate our rights, the safety of our deposits or our ability to access these?


Lastly, I am rather surprised at the timing of this change. In my view, this statement coming before Nama begins transfers of loans suggests that the Government is preparing for taking up a majority stake in the banks - a majority stake that will require full state control of these institutions management and activities.

So is this statement a precursor to full nationalization of the banks?

Economics 26/01/2010: S&P Note on Irish Banks

Standard & Poor's has finally thrown in the towel and after having to “periodically increase” their “credit loss assumptions over the course of the current economic cycle” concluded “that Irish banks' asset quality and earnings will, in general, likely remain under significant pressure over the medium term”.

Anyone surprised so far?

“We have considered the implications for each rated Irish bank and lowered the ratings on some of them.” But even after that action, “the ratings on all Irish banks are currently uplifted because of our view of high systemic importance to Ireland and related government support, or their relationship with a higher-rated parent.”

We never would have guessed that if not for the State guarantee plus 11 billion worth of public capital, plus Nama’s countless billions of pledged support, the banks bonds would be junk. Wait, some of them actually would be ‘high risk junk’ as one Russian fund manager once described to me his own bonds (I ran away as fast as I could).

How junk? Take a load of honesty from S&P (with my emphasis added):

“We have lowered the ratings on Allied Irish Banks PLC (A-/Negative/A-2) by a notch. This reflects our view that the environment will remain challenging over the medium term, leading to high credit losses, and a weakened revenue base. We consider AIB to be of high systemic importance and the Irish government to have made a strong statement of support, as a result of which we have incorporated five notches of support into the ratings. The negative outlook reflects our view that AIB's anticipated recapitalization may not fully occur in 2010, and may be of an insufficient size to support an 'A-' rating, as well downside risk to our earnings expectations arising from the weak environment.”

Absent state support, AIB should be BB/Negative/C+. Errr, that is squarely in the junk bonds category.

“We have also lowered the ratings on Bank of Ireland (A-/Stable/A-2) by a notch. This reflects our view that the environment will remain challenging over the medium term and BOI's financial profile will be weaker than we had previously expected, with capital expected to be only adequate by our measures and BOI continuing to make losses through 2011. We consider BOI to be of high systemic importance and the Irish government to have made a strong statement of support, as a result of which we have incorporated four notches of support into the ratings. The stable outlook reflects our expectation that the government will remain highly supportive of BOI, BOI's core Irish banking franchise will remain materially intact, and it will raise significant equity capital in 2010, from the market or the government or both.”

So absent support, BofI would be at BB+/Negative/BB-. Junk status as well.

“The ratings on Irish Life & Permanent PLC (ILP; BBB+/Stable/A-2) are unchanged. In our view, ILP faces continuing uncertainty around its strategic direction and desired business profile, in addition to the near-term pressure on the banking operations from weak earnings prospects and difficult wholesale funding conditions. Nevertheless, the ratings continue to benefit from the relative strength of the ILP group's life assurance operations. They also incorporate two notches of government support, reflecting our view of ILP's high systemic importance and our expectation that the Irish government would provide further support if required. The expectation of government support also underpins the stable outlook."

Absent state aid IL&P would be, then, at BBB-/Negative/B. Barely above water line.

Please, be mindful – S&P expects (and prices in) that the Irish state will be likely to buy equity in the banks. So we all can become investors in junk bonds-issuing institutions.


Very good, although bland, outlook statement:

“We consider the current operating conditions for the Irish banking industry to be weak, and expect that any recovery in earnings prospects will prove to be sluggish. In the coming year, we anticipate that many of the Irish banks may undergo operational and financial restructuring, which will likely lead to consolidation in the sector. Our overall assessment of the sector incorporates our opinions reflected in the following key points:

• The recovery in Irish economic performance appears likely to be gradual, with growth only consistently established in late 2010 at the earliest;
• Loan losses will likely be elevated between 2009-2011 and will likely peak in 2010; Wholesale funding conditions appear likely to remain pressurized, with strong competition for retail deposits...

"Under our base case, we expect loan losses on bank lending to the Irish private sector to peak at about 4.6% or EUR16 billion in 2010, and to total about 10.7% or EUR37 billion over the period from 2009 to 2011."

In country rankings analysis, S&P highlights that they expect the need for significant deleveraging by the banks in the future, reflective, presumably, of the lack thereof so far in the crisis – a risk I warned about consistently over time.

“The impact of the continuing challenging economic environment, which we view as weakening asset quality and earnings prospects” – presumably the S&P is on the same note as the rest of sane analysts: poor economy will drag banks down. Which means that Government logic – restore banks and see economy recover – is out of the window.


Next – a gem: “We have additionally revised our assessment of Gross Problematic Assets (GPAs) in the system to 15%-30% from 10%-20%. GPAs are our estimation of a country's potential problem loans to the private sector and nonfinancial public enterprises in a severe economic downturn, such as that being experienced in Ireland, and includes restructured and foreclosed assets, as well as overdue loans, and nonperforming loans sold to special-purpose vehicles.”

Oh yes – up to 30% GPA means that we can expect 45-50% of the loans to be stressed one way or the other at some point in time – some defaulting, some skipping couple of payments, some restructuring with various haircuts. That is, potentially, up to €200 billion in loans in various forms of distress for the 6 guaranteed banks alone.


With this sort of an outlook, not surprisingly, AIB's CDSs are now at around 650bps, BofI's at 250bps and virtually no action is taking place in bonds. Which, of course, does hint at the market reading Irish banks' bonds as being in effect a purely speculative bet on one probability - that of survival...

The share prices are yet to follow the same path of logic.

Economics 19/01/2010: Irish banks - a rational model of risky strategies

I just came across a very interesting paper, written back in November 2007 and published by the Bank for International Settlements as a Working Paper No 238. Authored by Ryan Stever and titled “Bank size, credit and the sources of bank market risk” the paper “…examines bank risk by investigating the equity and loan portfolio characteristics of publicly-traded bank holding companies.” The study is based on the US banks, with sample being a panel of ‘at least 339 publicly trades BHCs at each point in time” for the period of 1986-2003. “These range in size from American Bancorporation at $31 million in book assets (200 employees) to Citigroup at $1.26 trillion (over 280,000 employees).”

“Unlike the pattern for non-financial firms, equity betas of large banks are two to five times greater than those of small banks. In explaining this, we note that regulation imposes an effective cap on banks’ equity volatility. Because the portfolios of small banks are less diversified, this cap has a greater effect on small banks than large banks.”

In other words, there is plenty of evidence that even when effective, regulators can induce some unintended consequences onto the banking system and that these consequences, if unaddressed can lead to systemic failures.

Here is how it works:

• Regulators (and/or shareholders through exercise of their voting rights) place a limit on the total volatility of each bank’s assets regardless of size, which tends to minimize bank risk; however
• Small banks have more idiosyncratic risk inherent in their loan portfolio “because they cannot diversify away idiosyncratic volatility as well as large bank” (practically – smaller banks are more specialized, making their loans books more exposed to idiosyncratic strategy risk).
• Smaller banks inability to diversify comes about in “a number of different ways – for example; less total loans held, less diversity in borrower type (they do not have access to large borrowers) and geographic restrictions (small banks tend to be more localized);

 Because their total equity volatility is limited by regulation smaller banks must then find a way to eliminate their idiosyncratic volatility that is in excess of larger banks’ idiosyncratic volatility. To do this, small banks do not necessarily pursue higher levels of equity capitalization or lending to different sectors in the economy – in other words, they do not strive to become like larger banks, but instead they either:

•  make loans with less credit risk than large banks (Swiss private banks, for example). This has the effect of reducing idiosyncratic volatility (as desired) and also reducing the beta of each loan (and thus the equity beta of small banks); or
• demand more collateral (e.g. Irish banks).
  

Of course, the problem with selecting the latter path (beefing up collateral) as opposed to the penultimate pathway (more conservative, risk-sensitive lending) – as Irish banks should have learned from the current crisis – leads to additional problem, not highlighted in the study. This problem is manifested in the selection bias induced onto collateral – smaller banks opting for higher collateral requirements will take on less diversified collateral that is more likely to be positively correlated with their own (risk-skewed) loans books. Thus collateral risk becomes positively correlated with loans risk.

Just think of what type of collateral Liam Carroll was supplying for his property development loans? You’ve guessed it – property-based collateral.

In fact, the study does find that small banks did not lower their equity volatility through lower leverage. Instead, “the reduced ability of small banks to diversify forces them to either pick borrowers whose assets have relatively low credit risk or make loans that are backed by relatively more collateral.”

Economics: 15/01/2010: Bank levies

Per FT report today, the US administration is likely to impose a levy on the banking sector to recover. Per President Obama, "every dime" owed by the banks to TARP. The levy will aim to raise $90 billion from the 50 largest institutions in the US, including those with foreign operations in the country (a point that raises the issue of unfavourable treatment of the foreign banks which had no access to TARP and yet are expected to pay for it). 60% of the fee is expected to be generated from the top 10 institutions – another strange feature of the plan that skews the burden of the proposal toward larger banks despite the fact that there is no evidence they benefited disproportionately more from TARP funding. The levy – envisioned for 10 years period – is being set at 15 bps of all insured debt other than deposits and will apply to all institutions with assets over $50 billion. Of course the net effect of the levy will be a higher cost of banking for the end customer.

One can rationally expect the EU to follow the US suit and slap more charges on already stretched taxpayers/consumers.

Bashing the banks is a happy past-time for our commentators, politicos and regulators who have been calling for higher levies on the banks. But anyone with economic stability and growth on their mind should really think as to where the money for such levies will be coming at the end.

Irish banks are in no position to pay the Exchequer for any support out of earnings, so it is us – common banks customers and, co-incidentally the taxpayers – who will be tasked with paying DofF the going costs of banks guarantee scheme, Nama and any other levies the Government might impose on the banks.

As one cannot escape this charge on his/her account, it will be an involuntary transfer from the private economy to the state. Care to call it a new tax, then?

Economics 02/01/2010: Comparing banking systems

Based on the latest available data from ECB (through 2008, unfortunately), the following three tables provide relative performance analysis of Irish banking system against its main peers.

In all three sets of comparisons I have:

• included only countries with some proximity (trade / investment / market structure) to Ireland;
• computed some additional (combined) variables using ECB data (group averages and categories totals etc);
• ranked all countries on subsets of criteria shown in each table, so that increasing scores in each case reflect worsening of the rank position; and
• identified in shaded cells the instances where other countries (and/or group average) show poorer performance than Ireland in specific category.

The first table above shows indicators for profitability & efficiency. Here performance rank is computed by assigning the best performing country the score of 1 and the worst performing one the score of 10. There 11 scoring categories in line with the main parameters.

Irish banking system overall comes out as the fourth worst performing in the sample of countries, with significant gap to the group average in terms of sources of income (less stable in the case of Ireland) and total income as a share of assets. Note a very poor performance in net interest income and net fees / commissions - both of these indicators of income will have to be increased in the near future, leading to higher interest charges and fees for retail and corporate clients.

On expenditure side, Irish banks performed above the average, clearly showing that even in the end of 2008 there was virtually no room for improving the margins through further spending cuts. (One caveat - the expenditure side is measured relative to the assets base, so further writedowns on assets in 2009 would have pushed the expenditure performance metric deeper into negative territory). Apart from some layoffs and wages cuts, the sector in Ireland has no choice but to go after income side of the profit margin equation in order to rebuild margins.

On profitability side, provisions & impairments figure is below the average reflecting a clear lack of realism on behalf of the banks. This, in turn, translated into artificially inflated profits, that fell insignificantly short of the group average. However, the relative underperformance of the Irish banking sector was clearly visible in the distribution of returns on equity with most of our banks performing in the lower tier of the group.

The next table shows balancesheets comparatives:Using the same approach as before, I computed rank scores for the countries (note, I omitted countries with no data observations from the sample). Once again, Irish banks come out as below average performers in the group, ranked fourth from the bottom.

Other interesting features of the data:

• On liabilities side - deposits from CBs - or can we call it dependency on CBs liquidity to prop up deposit base is hefty?
  
• Total equity as share of asset base is low.
• Issued capital was low, while reserves are seemingly ok. Issued capital and reserves combined are below average. Ditto for tangible equity.
• On liquidity side, low dependency on interbank market in 2008 really shows the extent to which Irish banks were not being able to access private liquidity pools. So funding base stability was weak.
  

Last table deals with capital adequacy. Once again, Irish banking sector posted a lackluster performance.

Mid-range solvency ratio and Tier 1 ratio in the environment of artificially depressed / unrealistic writedowns and over-inflated assets base is worrisome as are total own funds. Securitization weighted heavily under standardized approach, but this was not captured under the internal approach. Average risk-weight for credit risk were high and total capital requirements for operational risks were the lowest in the group.

Little insight can be gained from operational exposures, as these are obscured by the non-Irish IFSC operations, but corporate exposure and retail exposures combined to a hefty 105% for risk-weighted assets, compared to 91% for the group average. The last two lines - overall solvency ratios are telling. Group average is 12.36%. For Ireland: 91% of all assets were held by the institutions with less than 12% in terms of solvency ratio.

The main conclusions from the tables are:

• Irish banks were too slow to recognise impairments;
• Irish banks profitability is below par, while efficiency is relative robust (with the risk to the downside due to inflated value of assets);
  
• Risk reserves and equity are poor in comparison to other countries, although this does not appear to be a function of regulatory-set reserves; and
• Margins rebuilding on the banks side will have to take place at the expense of retail and corporate clients.
  

Given the lags in the data and in our banks' willingness to face reality of the risks carried on their books, it will probably take well into 2010 (waiting for Nama to become fully operational) for the banks to start in earnest rebuilding their capital and margins positions. Which means that we will not know the true state of our banking sector fundamentals until mid 2011, when the data will be available to cover 2010.

The risk, of course, is that before then, the banks will squeeze all domestic liquidity out of the Irish economy, while the ECB begins to restrict inflow of external liquidity to the system. If that happens, Nama losses and budget deficits will take the second seat to the wave of insolvencies that will hit our country.

Of course, as usual, we have no road map for addressing such risks. Remember - even despite all banking heads insisting publicly that post-Nama there will be no increase in credit flows to SMEs / corporates / households, our Government continues to claim that Nama will be a 'liquidity event' restoring flow of credit to economy.


I will leave you with the following quote:

"Most of this lending is policy-directed with an implicit government guarantee. Despite ...closed factories in *** resulting from the global financial crisis, and hundreds of empty office buildings, retail centres and hotels that are not meeting their debt service payments, banks are still not foreclosing on these properties nor calling the loans due.

The banks prefer to rollover or extend the loans to avoid having to report an increase in non-performing loans. It is not uncommon for *** banks to extend a loan for as much as one year without interest payments if the lender “believes” the ultimate recovery value of the assets will be greater than the outstanding principal and interest. However, it is nearly impossible for a bank to value an empty office building, in a market with a reported vacancy rate nearing 40 per cent ...and declining rents."

The article goes on to argue that for *** this scenario of banks unwilling to recognize losses is risking a derailment of the country progression to the top of the world economic order. The *** is, of course, China. And the article was published here.

But it might have been written about Ireland, where the banks' belief in the ultimate recovery value is nothing more than a punt on selling the distressed rubbish assets to Nama for the price that even at a 30% haircut will reflect an overpayment on their true value of up to 30-40%.

What will Nama do to these assets and how willing it might be to shut down insolvent operations? More willing than the completely reluctant Irish banks? I doubt it.

So where does this leave us at in the beginning of 2010? A Japanese-styled zombie economy scenario for 2010-2025? I hope I am wrong!