Economics 11/8/10: Anglo saga continues

For about 24 hours I have resisted commenting on the Anglo latest twist in the capital hole - the EU approval yesterday of additional funding for the dead bank. But given the lack of straight forward and insightful analysis in the media, I thought I should throw int couple of direct comments on the affair.

First, consider the EU statement (available here):
"Anglo Irish Bank needs a third emergency recapitalisation to meet its obligations. ...there is no doubt that Anglo Irish Bank has to restructure profoundly in a way that effectively tackles the weaknesses of the past business model and ensures a sustainable future without continued State support."

Sadly, no Irish commentator noticed the irony that the EU is calling for a profound restructuring of the Anglo after 3 episodes of approvals of extraordinary funding for the bank by the taxpayers. Surely, if the Commission were to do its job and properly police national decisions relating to financial institutions stability, after the second call for capital from Anglo, Mr Almunia should have said something along the following lines: "Don't come back for any additional funds approval until you first provide a clear map as to how you are planning to shut down this insolvent institution."

Second, consider the timing of the approval. For some days before the approval, Irish 'analysts' and policy officials have been massaging public opinion. Various leaks and speculative statements that the bank will need more cash were floated around. Some of the Irish brokerages suggested that Anglo will need €2-4bn more in funding. Of course, while this circus was ongoing, the Government has been quietly labouring away at the submission to the EU Commission. The approval was issued on Tuesday, suggesting that the request for emergency funding extension was filed at the very latest - on Friday. This request was not subject to any parliamentary debate or other procedures that should have been deployed to ensure democratic participation in disbursing of the public money was adhered to.

Third consider Irish media and 'analysts' response to the Anglo call for cash. Of all stockbrokers, only NCB managed to comment on the Anglo call, despite the fact that Anglo's capital demands are indicative of the sector-wide problems. NCB guys actually did a good job in their morning note, saying that:

• "We had added €23bn to our General Government Debt to GDP ratio as a result of Anglo to leave it at 98.1% at year end 2011. This additional €1.4bn now needs to be added and will add approximately 0.7% to our debt to GDP figure at year end 2011." Yeps, with Anglo latest request for funding, Ireland Inc sovereign debt is set to be 99% by the end of 2011.
  
• The NCB guys are also aware, unlike, it appears Davy and Goodies, that Anglo can end up costing us (taxpayers) of sovereign bonds side as well: "The NTMA announced that its next auction on Tuesday August 17th it will tap the 4.0% 15 January 2014 bond and the 5.0% 18 October 2020 bond. The NTMA will be hoping that the Anglo issue is cleared up sooner rather than later and that clarity is given on the final requirement by the State. The uncertainty surrounding the exact amount of the transfer into Anglo is weighing on the Irish sovereign. The Irish 10 year is currently at 5.16% which is 274bps over the equivalent German bond and wider than the benchmark Portuguese 10 year which is yielding 5.079%."

Of course, most of the media have missed the two points of Anglo contagion to the broader markets:

1. Sovereign risk rising due to Anglo uncertainty, and
2. Corporate risk is also rising due to spillover from sovereign uncertainty to corporate assets valuations.

Finally, the whole circus around Anglo's 'news' missed the core point - Anglo started into the present mess with €71bn of 'assets' (aka loans). The total amount earmarked to date for the bank amounts to €24.354bn.

If Nama were to be believed in its LTEV estimates, Anglo's book is roughly 55% under water. This means that its post-Nama book is somewhere closer to being:

• 1/7 of the total book (€10bn) under water to Nama or better than Nama levels - say impairment of 30% due;
• 35% (or €25bn destined for the 'Bad' bank) is under water more than Nama haircuts - say 60-70% impairment due.

Translated to the full pre-crisis book, this implies the average recovery rate on Anglo loans of ca 43-47% across the whole book.

Let me explain the above numbers: €10bn recoverable at 70% and 25bn recoverable at 30-40% implies 14.5bn recovery on 35bn of assets left post-Nama, adding to it Nama haircuts implies recovery rate of 43-47%, ex-costs). This, in turn, implies across the book impairments of €37.6-40.5bn. Take the lower number - total through restructuring cost of Anglo can be expected to reach ca €37bn in the end or higher. Take 10% off for risk-weighting and restructurings of funding etc to boost regulatory capital.

End of the Anglo affair cost comes to roughly speaking €33bn. That's the amount we can expect to pay in the end. The latest €24.4bn count is, therefore, only less than 3/4 of the saga. So here's my forecast - by end 2011 Anglo will ask for ca €10bn more in our cash and by the end of 2012 - for up to €13bn more than the amounts already advanced. The only way these figures can be made smaller is if Nama grossly overpays Anglo for Tranche 2 and 3 loans.

Anyone noticed that? Not really. Just as no one noticed that Anglo is going to, in the end, cost every working person in this country something of the order of €19,600 - a hefty bill for rescuing Anglo's bondholders for every household of two trying to pay a (negative equity) mortgage and get kids through school.

Instead, our media keeps on asking Minister Lenihan rhetorical questions along the lines 'How much more?' and lamenting 'unexpected Anglo demands for more cash'. Per all publicly available information on this site, Peter Mathews' site and Irish Economy site, all I can say: "Expect more of the 'unexpected', folks".

Economics 6/8/10: Anglo's plans & systemic risks

Updated

Here are some interesting questions (note - just questions for now, on the foot of comments made by Prof Brian Lucey earlier today) regarding the 'Good' v 'Bad' Anglo plans.

Take it from the top: we started with a bank with €71bn on the books valued at valuations of the peak markets. This is now allegedly going to:

• €25bn of the face value of loans pre-writedowns - to the 'Bad' bank, implying that these loans are so poor in quality, even Nama, with an average 50%+ (LTEV-inclusive) haircut is not touching it. This implies that even in the long run, these loans are not going to generate more than, say, 30% recovery rate (a generous 30% that is, but let's take it as such. Note: that is across the entire loan book of the 'Bad' bank);
• €10bn of the face value of loans pre-writedowns - to the 'Good' bank, implying that these loans are better than Nama average, so the LTEV on these loans is above 50%. Assume that the LTEV on them is 60% (which makes them better than Ulster Bank's Irish book, per today's results for Ulster - again a generous allowance, but let's entertain it);
• the remainder is going to Nama.

Now, another little factoid: Central Bank of Ireland has lent Anglo €11.5bn under a MLRA repo agreement secured against the non-Nama loans.

Per Anglo last published results: "Sale and repurchase agreements with central banks include €12.2bn (30 September 2008: €7.6bn) borrowed under open market operations from central banks and €11.5bn (30 September 2008: €nil) borrowed under a Master Loan Repurchase Agreement (’MLRA’) with the Central Bank and Financial Services Authority of Ireland."

Let's do some simple math.

Value (recall - I am factoring referencing to Long Term Economic Value, not the current mark-to-market value, which is even lower):

• €10bn in 'Good' Anglo can be (optimistically) expected to yield €6bn valuation using LTEV;
• €25bn in 'Bad' Anglo can be (again, optimistically) expected to yield €7.5bn valuation using LTEV.
• Allow for 1.5% margin of costs on both sides, to €525mln pa, or over 5 years - i.e. much shorter than Nama horizon - €2.6bn (note: current bank cost structure, which one can expect to be preserved as both banks go about conducting impaired assets recovery - a higher cost activity)
  
• Total non-Nama book value is, inclusive of LTEV net of expected management costs, therefore could be already around €10.9bn.

Against this value of €10.9-13.5bn, CB of Ireland holds €11.5bn worth of loans to the Anglo.

Now to the question: Does this mean that CB might be facing a potentially significant loss on the repos?

This possibility raises two issues:

1. If the repos are spread across 'Good' and 'Bad' bank, then the 'Good' bank is hardly a feasible undertaking, as repos alone already exceed the value of the 'Good' bank even absent impairment charges, while 'Bad' bank has clearly no ability to repay any fraction of these;
2. If the repos are inherited by the 'Bad' bank, then, either CB has to declare a loss (and I am not sure how it can do this), or the taxpayer is on the hook for the repos by having to pay them down through the 'Bad' Anglo.
   

Now, alternatively, let's ask the following question: to recover CBs repos from non-Nama assets, we need to have a combined 'Good' & 'Bad' banks recovery rate of 33% (not covering the costs of operating both banks, funding, bond holders etc). And this, once again, refers to the valuations done on the face value of the loans before any recent impairments - before the bubble burst. To recover all other CBs' funds, plus our own - we need a recovery rate of ca 68% (again ex all costs etc). That's really highly unlikely, folks.


Quite a dilemma, then, especially since ECB (see here) didn't approved the repos in the first place... and since Anglo also owes the other Eurozone Central Banks some €12.2bn more.

What could Mr Trichet say about Anglo's priorities in repaying the loans? Would he be (a) so kind as allow CB of Ireland to recoup its repos, which ECB thought were dodgy enough to refuse to take them itself? or (b) insist that other CBs be repaid first before our own repos are covered? If (a) - I'd say Mrs Merkel would have a few kind words to say to Mr Trichet, given her electorate's feelings about having to bailout Greece. If (b) - the above potential negative valuation of the repos will have to be multiples larger...

Just asking some questions for now... Wonder if there are any answers out there...

Economics 10/01/2010: A desperate state of economic analysis

This week has been marked by some remarkable statements on the prospects for Irish economy in 2010 that simply cannot be ignored.

Firstly, yesterday, Irish Times (here) decided to devote substantial space to the musing of one of the stock brokerage houses. Bloxham's chief came out to tell us that things are going to be brilliant in 2010: 10% growth in house prices and commercial real estate valuation, and ca 100% increase in banks shares prices to €3 per share for BofI and AIB. So:

1. Pramit Ghose thinks that there is little to Irish economy other than demand for property and banks shares. The implication of this is that the only way that prosperity and growth will be achieved once again in Ireland is through another construction and lending boom. Have our stockbrokers learned anything new from the crisis? Doesn't look like it.
   
2. Mr Ghose also seem to have little time for the fundamentals of Irish consumers and domestic economy. Massively heavy debts loaded onto Ireland Inc don't matter for growth to him. Neither are sky-high marginal taxation and the prospect for more tax hikes in Budget 2011, nor even high unemployment mar his optimism.
   

Banks shares will rise, you see, because investors will become optimistic. Optimistic about what, Mr Ghose? Low profitability of our zombie banks? Their over-stretched customers who cannot be squeezed for higher margins without triggering massive defaults? High default rates on already stressed loans and high proportion of negative equity mortgages on the books? Exporting sectors suffering from the lack of credit and overvalued currency? The reversion of the interest rate curve upward due to expected ECB policy changes and margins rebuilding efforts by the banks? Double-digit deficits on the Exchequer side?

All in, Mr Ghose thinks that the banks shares might reach €3 per share sometime in 2010. He might be wrong, he might be right. I have no prediction on a specific price target. But here is a thought:

The two banks need some €5-6 billion in capital post Nama. At €3 per share two banks market cap will be around €4.5 billion. So with recapitalization - whether by the state or by the international dupes (oh, sorry - investors) - the market value of the two banks will be €9.5-10.5 billion or close to their 2006-2007 valuations. What sort of expectations curve does Mr Ghose have to get there?

A glimpse into his thinking can be provided by his July 22, 2008 note reproduced below:
You judge the merits of this prediction for yourself, but here are the facts
85-142% wrong?

Oh, and do note that in his July 2008 note, Mr Ghose doesn't do any better in historical analysis either. He completely failed to take into the account real (as in inflation-adjusted) returns to equities. If that little inconvenient fact is considered, the '2/3rds of the 1996 price offer' paid on Mr Ghose's family house 8 years after the crisis would represent just 33-40% of the 1996 offer real price. Markets did come back for Thailand, but once inflation (see IMF) is factored in, Mr Ghose's analysis yields a real loss on the 1996 offer of 50%! Ouch...

Mr Ghose's Chief Economist seems to have little time for Mr Ghose's optimism for 2010. Writing an intro to Daft Report this week he states (here): "in overall terms, I would expect house prices to drop another 10-15% on average this year, with Dublin again seeing the biggest decline [now, Mr Ghose thinks prime real estate will lead in growth, which means Dublin]. ...Looking further ahead, I expect house prices to be higher on average in 2011 than in 2010, and should rise on a five-year view as the labour market returns to normal. That said, the level of any increase in house prices over the next few years is likely to be only in single digits, with three factors - the banks' adoption of a more cautious stance to lending than in the 'Celtic Tiger' era, the return of interest rates to 'normal' and the possible introduction of a property tax for 'principal' homes of residence - all weighing negatively on the market."


The second comment, courtesy of today's Sunday Tribune (page 1, Business), comes from Prof John Fitzgerald of ESRI. After largely staying off the topic of Nama and banks recapitalization for the entire duration of the public debate, Prof Fitzgerald decided to offer an opinion on Ireland's 'financial rescue'.

Now that the stakes in the game are low, credit must be claimed for the future 'I too was critical' position, should things go spectacularly wrong on the Nama side.

Prof Fitzgerald thinks that state-injected funds into INBS and Anglo are totally worthless and will be lost. Who could have thought such a radical thingy!?

Some 4 months ago I provided my estimates showing the demand for recapitalization post-Nama totaling €9.7-12.4 billion (here and here). Having spent the entire 2009-long debate on Nama on the sidelines, Ireland's ESRI macroeconomics chief is now telling us that €10-12 billion will be required to complete recapitalization of the banks. This, according to the Tribune is news!

I am delighted to know that Prof Fitzgerald belatedly decided to agree with myself, Brian Lucey, Karl Whelan, Peter Mathews and Ronan Lyons. One only wishes that next time a matter of economic urgency, like Nama, comes up for a public discussion, he joins the debate when it matters - not four months after the fact.

IL&P: next in line? Update

And so the papers today follow our lead...

Tribune (here) starting to smell a rat:
"Irish Life & Permanent (IL&P) and Anglo Irish Bank could be facing fines of €5m each if the Financial Regulator determines the two banks engaged in market abuse by executing €8.2bn in circular transactions to make Anglo's customer deposit base appear more robust. ...which it has called 'completely unacceptable'."
It might be not a smoking gun for IL&P's 'new' sins, but it should keep markets on its trail.

That said, the article has a hint on balance sheet questions for IL&P (and others):
"...banks will either have to demand significant equity from developers or renegotiate loan terms. Most loans were given on the basis of a loan to value ratio, meaning that if the sites are revalued downwards the developer has to come up with the difference. This is viewed as unrealistic. As a result, banks have again moved to avoid formal valuations and there are claims some are setting up special vehicles to move loans off their balance sheet so they can amortise them over time, rather than writing them down."
Well put, boys, revaluing on the balance sheet

• land banks that are virtually worthless
  
• sites that are nearly worthless and
  
• buildings that saw their value decline by 30-50%
  

is 'unrealistic' indeed. I have shown the Anglo Irish Bank's annual results as being clearly indicative of some of this engineering going on (see here). And, since the beginning of 2008, virtually every developer plc has 'renegotiated' its loans covenants. Does anyone seriously believe that the rest of the banks posse is somehow above this Anglo practice?

Ireland is inching closer and closer to the 'Bad Bank' solution that should have been enacted some months ago. At the very least, to repair the repairable - household loans and mortgages - thus providing more room for addressing the developers loans.

The difference today is that we are out of cash to get such a bank going, thanks to a rushed re-capitalization and the Government's unwillingness to extract real value out of public sector waste. And private money is already smelling the roses (here): €10bn outflows out of Ireland in one week - some 5.6% of our GDP or 3.2% of all main banks deposits gone in smoke. What is the downside to the Exchequer on this? Should the outflow continue unabated, within a week or two we will be facing the need for a new round of banks recapitalization, this time around - ca €10bn... and the money will come from?..

The minute the markets recognize this reality - Mr Lenihan with an empty policy gun and the bear still charging undeterred - things are going to get rough.

The Oligarch of the Upper Merrion Street

Flip-Flop-Flip Brian
On October 23, 2008, just two and a half months ago, Minister for Finance has gone out of his way to explain that the State investment in the banks was the 'very final option' he was willing to take. On that date, Anglo’s shares were trading at €1.80 or almost 90% down on their historic high. Flip! Brian's jacket of being 'conservative with taxpayers' money' came undone!

Fast forward 2 months ahead – on December 15, 2008, announcing the rescue plan for Irish banks, Mr Lenihan has flopped the ‘very final option’ into an actual policy. By that date, Anglo’s shares moved to €0.36 or 80% below their October 23 level, yet still the ‘very final option’ was to involve no more than a 3/4 stake in Anglo with no voting rights for the Exchequer. The fig leaf of decorum of being only 1/4 true to his October statement was all that was left of a respectable Exchequer.

Today, Brian ‘The Flipper’ Lenihan has completely reneged on his October-December claims. The state is now poised to take the entire Anglo – toxic and healthy assets, workforce and physical capital alike. Flip! The fig leaf is sailing across the Upper Mount Street - its new Bank-owning Oligarch is now fully exposed as Minister whose words must be read between the lines.

Details? Go straight to the consequences!
Whatever the deal price might be the main point of this performance by the Government has been totally lost in the media to date. The nationalization of the Anglo Irish Bank is simply wrong. Full stop.

Let me focus on this point:

Irish Exchequer has no business taking money from the working families at this time of need (or at any time indeed) to rescue a handful of large development deals and bail out a party of investors. No financial stability emergency, no amount of bad loans on the books, no balance sheet analysis can ever justify the Exchequer using ordinary peoples' cash to buy assets into its own ownership.

If the Anglo needed capital, the Exchequer should have placed money with the institution, collect the shares in return to the current value of the money deposited and then immediately disburse the shares to those who are paying for them – the people.

And I do not mean some collective People – aka the public sector who will reap most of the benefit of any future recovery in Anglo’s fortunes, but the people whose cash 'The Flipper' has so princely pledged to Anglo’s creditors.

To be morally justifiable, the nationalization of the Anglo Irish Bank should:
(1) involve a rigorous investment case analysis carried out by an international assessor with NO connection to Ireland, the Anglo Irish Bank or any other party to the transaction before any announcement of the takeover was made; and
(2) if allowed to proceed, be carried out as a voucher nationalization scheme, with all new Anglo Irish Bank’s shares (underlying the State liquidity injection) being distributed uniformly amongst all households in Ireland.

We've paid for them, Mr Lenihan, in case you've failed to notice!

The price of uncertainty II: Anglo-Irish Bank shares

To continue with my last post's theme:

According to the latest annual results, Anglo-Irish Bank’s loan book carries construction and property sectors exposure of roughly 87% (details in Table 1 below). Given this, the bank is, in effect, a property investment play in the Irish, UK and US markets.
This implies that in the longer-term Anglo’s shares should follow market expectations concerning the ongoing property contraction in Ireland, US & UK. In other words, Anglo’s shares performance should reflect (with a possible lag to account for the differences in timing across the three markets) the fate of the specialty US real estate investors, e.g REITs.

The question is – does it?

Taking weekly closing data for the period of 2006-present for 6 REITs indices:
• SPDR DJ Wilshire REI,
• I-share DJ R EST INX,
• I-share FTSE NRT Residential ID,
• I-share FTSE NRT Industrial/office IDX,
• FTSE UK Industrial REIT and
• MSCI US REIT Index,
normalized at 100% for January 1, 2008, I obtain time-series for changes in weekly prices of these indices and the Anglo’s shares. I then construct Blend 1 & Blend 2 synthetic portfolia with specialty REITs weights in each portfolio reflective of the relative share of these types of properties in the Anglo’s portfolio: 18.4% Residential REIT indices, 77% Commercial REIT Indices and 4.6% I-Wilshire Index (Blend 1) and 4.6% I-Share Index (Blend 2).

Figure 1 compares changes in the valuations of these synthetic portoflia and Anglo-Irish Bank shares.
As shown above, US & UK REITs indices, blended to reflect actual Anglo-Irish Bank’s portfolio allocations of loans across various types of property have significantly outperformed Anglo’s shares since January 2008. While year-to-date decline in Anglo-Irish shares has been a dramatic 98.55%, the same period decline in US and UK REITs with exactly the same property markets and types exposure as Anglo’s was only 44.68%. Even at their lowest point (-63.9%), REITs performance was 54% better than that of the Anglo-Irish shares.

Using synthetic portfolio approach, REITs-based analysis predicts that the Anglo-Irish share prices should trade between €3.21 and €5.66 per share. Synthetic portfolio prices Anglo's shares at €3.75 at their global minimum in the first half of October, rising to €5.70 today.

However, the above does not account for the potential upward bias in Anglo-Irish Bank’s shares valuation prior to January 2008. In other words, we must address the argument that deep discounting in Bank’s shares reflects the fact that its peak valuations were more optimistic than the market average. To do this, I computed blended portfolia discounts from peak to January 1, 2008. Controlling for these, Figure 2 reconstructs the synthetic price share performance for Anglo-Irish Bank based on property markets fundamentals and accounting for the differences in timing in real estate contraction between the UK, US and Ireland.Thus, as shown in Figure 2, Anglo-Irish Bank shares have traded at a sector discount between late June and mid October 2008 and since the beginning of December 2008. Using full-sample simulation, Anglo-Irish shares are fundamentally valued at around €1.09 per share in the current market conditions as opposed to the actual share price of €0.15 today. Note the accuracy of the synthetic portfolio in tracking Anglo's shares since, roughly May 2008.

While the above exercise is not 100% accurate, it does suggest that the markets are currently discounting Anglo’s shares at a rate much greater (ca +13.7%) than warranted by the bank’s exposure to property markets.

There are two possible explanations for this excessive risk premium:
(1) the unexplained risk premium reflects lower quality lending by the bank than the average for REITs; and
(2) the unexplained risk premium accounts for the terms and conditions of re-capitalization scheme announced by the Irish Government.

While the first argument is impossible to assess, given the lack of data on Anglo-Irish Bank’s loans time structure, the second argument can be partially ‘priced’. The re-capitalization scheme will imply a dilution of existent shareholders’ equity to ca 20%. This suggests that the actual price target for the Anglo-Irish Bank shares should be around €0.22-0.25 per share. The associated regulatory risk-premium on the Anglo’s shares is, therefore, in the neighborhood of 69% of the share price.

No coincidence this estimate is so close to the 76% regulatory risk premium for the entire Irish Financials sector estimated in the preceding post…

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!