Economics 11/8/10: Bank of Ireland H1 results

Bof I results for the H1 2010 did represent a significantly different picture from those reported by AIB, with one notable exception – both AIB and BofI are yet to catch up with reality curve on expected future impairments.

BofI profit before provisions was €553mln against €811mln in H1 2009. This, however, doesn’t mean much, as a score of one-off measures were included in H1 2010 figure:

• Losses on sales of loans to NAMA’s were factored in at €466mln
• Debt exchange added a positive of €699mln
• Pension deal brought in a positive contribution of €676mln.
• Net positive of the one-off measures was, therefore around €909mln implying that BofI really was running a loss €356mln before provisions and after one-offs are factored in.
  

Underlying loss before tax, net of charges, was €1.246bn or almost double the €668mln loss last year. The impairment charges amounted to €1.8bn in H1 2010, inclusive of €893mln non NAMA provisions. The impairment charge therefore almost doubled on €926mln in H1 2009.

Big ‘news’ today was that BofI continues to guide for €4.7bn in impairments charges for March 2009-2011. Given that the bank has taken €3.9bn of these provisions to date, it will have to deliver an €1.2bn gain on H1 2010 (roughly 1% of its loan book value) before March 2011 to stick with the impairments estimate. How much can BofI squeeze out of its customers remains uncertain, but to get to its target figures, the bank needs either a helping hand of Nama (on valuations for Tranche 3) or a dramatic reduction in cost of funding (unlikely) or a 30%+ increase in what it charges on loans (without any subsequent deterioration in their quality).

These are unlikely for the following reasons.

Impaired loans are up by a significant €2.1bn reaching 7.1% of the total loan book (these were 5.5% at the end-December 2009). Risk weighted assets stood at €93bn down on €98bn in December. And asset quality is still declining: impaired loans were €15.8bn of which €8.86bn were on non-NAMA book. This compares to €13.35bn in December of which €6.79bn related to non-NAMA book. Provisions were €6.64bn in June of which €3.725bn non-NAMA, implying 42% cover, down from 43% in December when provisions amounted to €5.8bn in total, with €3.0bn non-NAMA.

BofI maintains that bad debts peaked in H2 2009, showing a charge of 1.4% on gross loans in H1, compared with a charge of 2.9% in Q4 of last year.

This looks optimistic. BofI business side continues to suffer from income declines and costs overruns. Total income was down 8% yoy at €1.76bn. Cost cutting this year will have to come at a premium as BofI prepares to shed some 750 more jobs. Total staff numbers are down by 805 or 5% yoy so far in 2010.

BofI H1 2010 net interest margin was 130 bps down 40bps relative to H1 last year. Causes: higher deposit and funding costs, lower capital earnings and Government guarantee. Assets repricing helped by adding 19bps to the margin. Cost to income ratio increased to 61% relative to 54% a year ago, despite costs falling by 3% to €916mln. This means income is seriously under pressure. Impaired loans on residential lending book have increased by 58.5%.

One improved side – capital ratios came in at Core Equity Tier 1 of 8.2% up on 5.3% in December and ahead of 7% regulatory target, but still low relative to European and US peers. Tier 1 ratio was 9.9% virtually unchanged on 9.8% in December.


BofI might be right in some of its rosy projections. You see, Nama has been rolling over for the bank so far. BofI originally guided Nama discount of €4.8bn on €12.2bn it planned to transfer to Nama, or 39% haircut. Nama obliged so far by shaving off 36% on the €1.9bn of loans transferred in Tranche 1 in April and then 35% on Tranche 2 transfer of €1.5bn in July. This was done despite the fact that impaired loans proportion continues to rise in the sub-portfolio of BofI loans destined for Nama.

And this rise is a serious one. At the end of June, 69% of the loans remaining in the Nama-bound portfolio were impaired, up on 54% in the overall Nama portfolio set aside in December 2009. So Tranche 1 transfer picked out better loans or the loans have deteriorated dramatically since Tranche 1 transfer or both. Either way, lower discount on Tranche 2 loans suggests a blatant subsidy from Nama.


Funding side remains under threat, though BofI put a brave face in stating that it raised €4.6bn in term funding so far (mostly in the beginning of the year before the proverbial sovereign debt sh***t hit the fan). The bank still has to raise €9.5bn more before the end of the year 2010. The balancesheet numbers as well as market conditions suggest that this might be tight.

Total loans held grew by €3bn in H1 2010 to €125bn driven by sterling appreciation. Meanwhile, deposits were down €1bn to €84bn, so bank’s loan-to-deposit ratio, ex-NAMA, rose to 143% from 141% in December 2009. Deposits decline was driven by ratings downgrade for S&P in January 2010 which shaved €3bn worth of value from the ratings-sensitive deposits.

This doesn't make BofI any more attractive to the lenders.

But the bank has done coupple of things right. BofI is gradually improving its funding outlook by extending funding maturity – up to 41% of wholesale funding being in excess of 12 months in H1 compared to 32% back in December 2009. And BofI has been reducing its reliance on wholesale funding – down €3bn in H1 to €58bn total. BofI still holds €41bn worth of contingent liquidity collateral, theoretically eligible for ECB borrowings.

The bank also has €8bn exposure to ECB – same as at the end of 2009. You can either read this as the brokers do, meaning that BofI still has massive reserve it can tap if it needs to go to ECB. Alternatively you can say that in the last 6 months, the bank did nothing to work itself off the reliance on ECB funding.

Finally, virtually all analysis (with exception of one brokerage – if I recall correctly it was NCB) overlooked the data released on the deposits breakdown. Per note, “deposits with a balance greater than €100,000 amounted to €50bn at end-June. …As it stands, the ELG guarantee will no longer cover corporate deposits greater than €100,000 with a maturity of less than three months — presumably a significant proportion of these balances — after September, with the ELG set to go completely at year-end. It seems certain to us that the ELG will have to be extended to shore up confidence and facilitate the as yet unfinished wholesale terming effort.”

Economics 27/03/2010: Breaking News: AIB and FF/Government

Major news breaking in the media rooms:
AIB (the first story below)
RedC Poll (the second story below)


Story 1:

The first story is about the leaks reported by Newstalk (see here) that AIB will announce before opening of trading on Monday that the state will be taking a 65% stake in the bank.

Per senior source in the Dail (hat tip to B) - the reason for AIB guiding 65% ownership now is that in addition to Nama haircuts, they are, allegedly, seeing significant deterioration in the sub-€5mln loans (the loans below Nama-eligible threshold).

This is hardly surprising. Since May 2009 I have consistently supplied estimates as to the eventual state ownership in both AIB and BofI. Depending on various scenarios:

• assumed Nama haircuts,
  
• the actual current risk weighting on the loans being transferred,
  
• share price at the time of announcement and
  
• the willingness of the banks and the Government to recognize future expected losses on the loans not transferred to Nama

RVF approach to valuing AIB and BofI balancesheets suggests that at the end of the current crisis, the state will outright own around 85-90% of equity in AIB and 50-60% in BofI. This eventual outcome, for political reasons, will come in two stages:

• post-Nama injection of capital (with AIB placing around 60-70% of its equity with the State and BofI placing around 40-45%), plus
• second stage recapitalization to correct for continued deterioration in the books over 2010-2011 (adding another 20-30% of equity for AIB and 10-15% for BofI)

The problem with this two stage recapitalization is that the taxpayer will end up paying three times for the same equity:

• Having injected €7 bn into two banks at the time when they were worth less than €2.5 bn for the entire lot,
  
• we are now be left on the hook for some €20 bn worth of largely worthless loans - to be purchased at ca 30-40% discounts (against the real market discount of 65-90%),
  
• plus €7-8 bn in fresh capital post-Nama
• plus the margin of ca 10-15% for further deterioration in non-Nama loan books (requiring another €7-9 bn of fresh capital).

Thus the Irish state is now likely to use up to €20 bn to buy up equity and loans from a bank that is currently worth around €1.5 bn... In the world of finance, even the most reckless bankers never managed such margins.

Alternative: force banks to acknowledge the full extent of their expected losses (as Swedes did in the 1990s), then force them to take the bondholders and equity holders to the cleaners (as Swedes did in the 1990s), and only then take equity - or in effect, take full equity in the banks. The cost for AIB would be around €10-12 bn, depending on how deep of a haircut on senior bondholders the banks can impose.

Story 2:

Tomorrow's RedC poll

Here is a preview - as was supplied to me by my sources (a disclaimer is due here: these are as provided by the source, so check tomorrow's papers for actually confirmed figures). Parties support:
The poll was conducted on Monday-Tuesday, so it does not reflect change of opinion in the wake of Cabinet reshuffling and the dissident TDs comments. Both factors can be expected to contribute to further decline in FF ratings, speculatively pushing core FF support post-Thursday to 21-22%.

Some specific questions:
“Brian Cowen understands people like me” - 31% agree
“Brian Cowen is a good Taoiseach” - 27% agree
“Brian Cowen is a safe pair of hands” - 31% agree
“Brian Cowen is the man to lead us out of recession” - 29% agree

Hat tip to NN.

I wonder what the same punters would say about our leaders now, after the reshuffle debacle and the open dissent amongst the back-benchers.

Economics 15/02/2010: Bank of Ireland ethical dilemma

So here we are folks, the state has run into a bit of a trouble.

Remember those dividends that our (taxpayer-bought) preference shares in the BofI and AIB were supposed to generate? Ok, there is a problem here.

On February 22, BofI is supposed to pay out some €240 million to us (the taxpayers, in case if you wondering) in dividends on these shares. Alas, if you recall, the EU has imposed severe restrictions on the banks dividends. This means that we are now in a no-man's land when it comes to getting paid on that €3.5 billion we put into BofI. The Government has an option to circumvent the EU rules and ask for shares to be paid in instead of cash, but this surely will open claims from the bondholders who are not being paid their coupons. And, of course, if shares are issued in the way of payment, there will be dilution. At current price, €240 million worht of BofI shares will be, ahem, 24% of the expected €1,000 million rights issue or 19.1% of the market capi of the bank. Some serious dilution, unless the EU grants an exemption to the State.

But an exemption for the Government is an ethically dubious move for several reasons:

• In all other bank support schemes, the EU did not lift restrictions on dividends/interest/coupon payments for sovereigns. Should it do so for Ireland, what's next?
• Payments to other bondholders who have identical rights to the state (on paper) will not be made, opening up the entire process to legal challenges.
  

And we (the taxpayers) were told by the Government and its stockbrokers that we've made a sound investment in the BofI preference shares... Ouch...

Economics 06/02/2010: Nama stalling at the EU doorsteps

For those of you who missed my Thursday musings on Nama in the Irish Daily Mail, here is an unedited version of that article:

Two friends from the distant land of global finance have caught up with me the other day. ‘What’s going on with your Nama?’ they demanded to know.

Their concerns were about the latest hiatus created around our Bank Rescue scheme.

Yesterday’s news that NTMA is to take over management of the Exchequer affairs relating to bank shares bought with taxpayers’ cash is the case in point. Apparently, NTMA – the parent institution to Nama – will hold talks on capital needs with the banks as well as engage in their realignment or restructuring. It will also advise on banking matters, and crisis prevention, management and resolution. Just exactly can this task be achieved without creating a severe conflict of interest between NTMA and Nama, or without stepping on the heels of the Central Bank and Financial Regulator is anybody’s guess. But the bigger problem here is whether such a role for NTMA will constitute an undue interference in the financial markets for banks shares.

This activist approach to managing Nama news is not new, however. Following the quiet publication of the last piece of legislative jigsaw, Nama (Designation of Eligible Bank Assets) Regulations 2009, on the day before Christmas Eve, our Government has gone into an overdrive, trying to spin Nama as a panacea for all economic ills of the country.

Nama was painted as a socially responsible undertaking that will be reporting to the Government ministers on the issues of ‘social dividend’. It will provide housing for the poor and will take off the market vast surpluses of unwanted properties. Nama will also deliver a healthy dividend by charging local authorities for this ‘service’. But the local authorities will still somehow come on top by saving money.

Perhaps mindful of having produced too much gibberish of the above variety, our public representatives have started talking up the discounts that Nama will apply on loans it buys from the banks. Just 6 months or so ago Nama enthusiasts were saying that a 12-20 percent average discount will reflect the ‘true long term economic value’ of the loans? Now we are into 30-35 percent haircuts and rising.

The iron logic of finance tells us that the greater the discount Nama imposes the greater proportion of the original loan will have to be written down by the banks as a loss. This will require fresh capital, of which the taxpayers are the only source for no investor will be willing to buy new shares in Irish banks voluntarily.

By my estimates from some 9 months ago, the Irish banks will require Euro 10-13 billion of fresh capital the minute Nama goes through their books. After months of ignoring this prediction, the Government now admits as much.

But wait, as the discounts estimates increase, so are the concerns in Brussels and Frankfurt about Irish Government’s plan. First, the ECB is now seriously worried about the quality of Irish banks collateral deposited in its vaults. Second, the EU Commission is more concerned that approving Nama will produce poor optics internationally, as Nama will be openly buying trash with taxpayers cash and Europe’s approval.

As if these two issues were not enough, we now have two official versions of financial theory – the Frank Fahey’s Proposition and an Alan Ahearne’s Theorem.

The former claims that ECB is giving us a free lunch – a deeply discomforting statement from ECB’s point of view as it undermines the bank’s credibility.

The latter states that the banks, repaired by Nama, will “stimulate demand” for consumer loans. So our economic policy is being shaped by people who think that the banks can drive up demand for credit in the economy stuck in negative equity, with consumers facing higher taxes and falling incomes. And, of course, there is an added concern about the ordinary homeowners and their bad debts. As the Government is preparing to create another massively risky scheme for ‘helping’ defaulting mortgage holders, the Commission is starting to think – was Nama a limited undertaking, or will Irish banking crisis spill over into a general economic crisis as well.

Then there is an ongoing saga with loans. Back in the days before Nama Bill was passed, we were told that the Government has an excellent idea as to what security they can get on Nama-bound loans. It turns out they hadn’t a clue. As Namacrats are discovering, the loans held by the Irish banks often have a secondary claim to the underlying assets. And, they are finding that the poorer the loan the lower, usually, is the underlying security.

Suppose the bank has a loan for Euro 10 million secured against the property worth Euro 5 million. Suppose Nama buys the loan for the face value of the underlying property, implying a haircut of 50%. But if loan seniority is secondary in seniority, given the recent cases of our top builders going through the insolvency courts, the post-default value of the asset is somewhere between half a million and nil. Subtract the legal costs of fighting the borrower and better-secured lenders in the courts. The state will be lucky to get a euro from the deal.

This arithmetic is not escaping the ECB. Since December, we are painfully aware of Frankfurt’s intentions to close the discount window through which Irish banks have already pumped some Euro 98 billion worth of junk-rated assets in exchange for cash. By all Euro area standards, Ireland – a minnow accounting for roughly 1.8 percent of the entire common currency economy – has swallowed about 19% of all cash released by the ECB since the beginning of the crisis. More than any other country in absolute terms. Add to that the prospect of Euro 59 billion worth of Nama bonds, plus another Euro 10-12 billion for banks recapitalization, Irish banking system bailout can cost ECB up to Euro 170 billion in loans secured against, you’ve guessed it – unfinished estates in the middle of nowhere.

So understandably, the ECB folks are worried. By May they will start reversing junk securities they loaned against out of their vaults and back into the banks. Should they succeed, Irish taxpayers will be stuck for more cash to plug the new hole in banks balancesheets.

Which in turn will drive the quality of our collateral even lower. Mortgage rates will climb by 100-150 basis points for those of us who are still paying them down. Cost of credit for businesses will rise well into double-digit figures. Credit cards, car loans, consumer loans – all will become as rare in Ireland as polar bears in Sahara. Taxes and charges will increase – by 15-20 percent on average over 2011-2013. Instead of banks stimulating demand for credit, as Alan Ahearne suggests, Ireland Inc will be back on the slippery slope toward deeper recession.

Ultimately, it is the prospect of Ireland sliding back to rival Greece as the drag on the Euro that has been bothering my friends, as well as the ECB and the EU Commission. Sadly, their concerns are our last line of defense against Nama.

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 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.

Economics 07/01/2010: NTMA's end of year results

Here is an interesting one: NTMA published their End Year review. Per statement (page 3 top): “The National Pensions Reserve Fund Discretionary Investment Portfolio (the Fund excluding the preference shares in Bank of Ireland and Allied Irish Banks held on the direction of the Minister for Finance) earned a return of 20.9 per cent in 2009. Since the Fund’s inception in 2001, the Investment Portfolio has delivered an annualised return of 2.6 per cent per annum. Including the bank preference shares and related warrants, which are held at cost and zero respectively, the Fund recorded a return of 11.6 per cent in 2009. At 31 December 2009 the total Fund’s value stood at €22.3 billion.”

If the state were to invest €7 billion it gave AIB and BofI for their preference shares in the Discretionary Fund, the returns on these investments would have been roughly €1.463 billion in 2009. Instead, we got zilch in risk-adjusted returns.


Ok, one would say that ‘investing’ in AIB and BofI is a sensible undertaking as the banks are market-determining entities for ISE. Nope, wrong. Page 4 of release states: “As a result, the Investment Portfolio had an elevated level of quoted equity investment of 80 per cent following completion of the recapitalisation in May compared with 57 per cent before the preference share investments were made. The Fund took advantage of the strong equity market rally to reduce its absolute risk and exposure to the equity markets through phased equity sales of €2.7 billion through the remainder of the year. The Investment Portfolio’s exposure to the quoted equity markets had been reduced to 63 per cent by year end.”

So as the result of AIB & BofI ‘investments’, NPRF is now more heavily geared toward equities as a class. Full stop. Now, give this a thought. We have a Pension fund with 63% exposure to equities that has been forced to sell equity on the basis of the need to re-gear toward banks shares in the economy where banks are the weakest point… Aggressive high risk investment strategy. What’s next? A highly geared derivative undertaking with taxpayers money? Ooops – we already got one, called NAMA SPV.

Back to page 3 stuff: “During 2009 the Minister for Finance directed the Fund to invest €7 billion in preference shares issued by Bank of Ireland and Allied Irish Banks for the purposes of recapitalising these institutions. The terms of the deal, which was negotiated by the NTMA, include a non-cumulative fixed dividend of 8 per cent on the preference shares and warrants which give an option to purchase up to 25 per cent of the enlarged ordinary share capital of each bank following exercise of the warrants. The dividends payable on the preference shares are not recognised or accrued by the Fund until declaration by the bank concerned. These investments were funded by €4 billion from the Fund’s own resources and by €3 billion from a frontloading of the Exchequer contributions to the Fund for 2009 and 2010.”

Two points here:

1. 2009 thus saw a direct transfer of €3 billion to NPRF from the economy that has contracted by 10.5% (GNP). Since NPRF is a de facto piggy bank for public sector pensions only, this type of fiscal management, of course, has no precedent. It is equivalent to taking from the strained middle classes (taxpayers) to award future pay for public employees.
2. This reminds us as to just how outrageously overpriced the preference shares we bought were. AIB and BofI preference shares yielding 8%? Remember – these two banks have balancesheets weaker than those of the main UK banks. Yet, at the same time we were signing off on 8% return, the UK banks bonds were yielding 12-15%. What’s the opportunity cost of such a sweetheart deal for the banks from taxpayers’ perspective? 7% yield foregone, or in 2009 terms - €490 million.
   

Add the two bolded numbers: €1.953 billion is the opportunity cost to the taxpayers of the AIB and BofI capital injection in foregone earnings. This is more than double the amount of savings generated by the Exchequer through public sector wage ‘cuts’ in 2010 Budget.


Another interesting thingy – page 4: “NAMA will acquire loans with a nominal value of approximately €80 billion”. Hold on, folks – was it €77 billion or €80 billion? Or should we take it from the NTMA that +/-€3 billion in taxpayers funds exposure is simply pittance that can be rounded off? What’s next? February 2010 numbers rising to €85 billion, then to €90 billion by March? Why not just state ‘we’ll buy anything they throw at us’ and close off this Cossack Dance with the numbers?


Pages 5 (end) and 6 provide a small, but interesting insight into operational efficiencies of the State Claims Agency: “There has been a substantial decline in employer and public liability claim volumes associated with incidents that have occurred since the SCA was established. Since 2002 the number of employer liability claims has fallen by 71 per cent and the number of public liability claims has fallen by 19 per cent. The total number of active employer and public liability claims has fallen by 35 per cent in 2009 compared with 2008.”

Sounds like good news? All claims are down since 2002 and in particular between 2008 and 2009. Happy times? Not really: “During 2009 the SCA paid out a total of €64 million against all classes of claims. This compares with a total of €53 million in 2008.” So let me run this by you – cases numbers are down 35%, but payouts are up 20.8%! I guess the gravity of injuries in the public sector rose dramatically during the year.


Lastly, Appendix 1 lists bond issues for 2009. This is a nice summary of the fine work being done by the NTMA in placing our debt (although most of it has gone to the banks to be rolled into ECB). But the worrying thing is the time profile of these bonds. €14.53 billion of the bonds issued this year will mature (and will be rolled over) during or before 2014 - the deadline for our compliance with the Stability & Growth Pact ceilings on deficit and debt. Such a large amount, coming already on top of the billions in short/medium-term debt issued in 2008 doesn't do much to support markets confidence in Ireland actually delivering on 2014 commitment...

Economics 21/12/2009: Nama - perpetuum mobile of ethics and objectives

For those of you who missed my Sunday Times article yesterday - here is the unedited version of the text.

But before we begin on Nama - here is a superb article on the prospects of potential sovereign defaults in Europe (read: Baltics, Greece and Ireland) from the FT today.

And here is a fantastic compendium of Brussels-imposed costs to the UK economy as estimated by the UK Government own assessments studies. One wonders if Irish Government bothered to do the same exercise and what its outcome might be. In the UK, the cumulative present value cost of these measures is ca £184 billion through 2020. If the same apply to Ireland, proportional to the overall size of the Irish economy, the combined cost of these Brussels directives could be around €18.6 billion - more than 77% of our annual deficit.



In the real world economics there is one Newtonian-level certainty: what can’t go on, doesn’t. We should have learned this some years ago, following the 1980s economic debacle and the 2001 collapse of the tech bubble. We had another opportunity to understand it last year. But in Ireland, real economics is reduced to the domain of an eccentric hobby. The real business of the nation leadership is preservation of the status quo – first at the state level, then political, and now – in banking.

Nama is a focus of all three. Through it, even in the midst of the current historic crisis, our political and executive elites continue to inhabit a parallel universe where responsibility and accountability are for the commoners, and transparency and governance are decorations for EU summits.

Aptly, in its current form, Nama reigns supreme as the most non-transparent financial institution in the developed world. Its ‘independent’ directors are being selected behind the closed doors by those who presided over the systemic failures of our regulatory and supervisory regimes. Its risk, audit and strategy functions will be fully contained within the secretive and unaccountable structure of the organization itself.

Nama will not publish a register of properties against which it will hold the right of seizure. This, we are being told, is done to protect privacy of the developers involved. But a register does not have to declare the names of the borrowers – property location, purchase price, vintage, LTV ratio and valuation by Nama would do just fine.

Nama accounting and audit functions will not comply with the requirements imposed by our regulators on public companies. Its directors, management and consultants will enjoy a blanket indemnity that is unparalleled by the standards of any public office or company law. Their remuneration will not face even the farcical constraints that senior banks executives face.

Nama owner – the SPV – is a bogus shell entity with ghost investors and a minority shareholder (the state) in charge. That this scheme has been concocted not in a distant off-shore location, but by our own state in our name and with our money adds insult to the injury.

As if the existent shortfalls of the legislation establishing Nama were not enough, even after the entity approval by the Dail, the goalposts for its operational performance continue to shift. Just weeks after the TDs voted to approve it Nama is now a different beast altogether.

Take the issue of discounts. Throughout the approval process, the Government doggedly refused to accept the need for realistic writedowns on the loans. Hence, all official estimates for Nama were incorporating an extremely optimistic 20-23% average discount. A handful of independent analysts, including myself, Professors Karl Whelan (UCD) and Brian Lucey (TCD), and an independent banking expert Peter Mathews, kept on showing analytically and factually that the final discount must be closer to 35-40% if Nama were to become anything but the skinning of the taxpayer.

The latest revelations from the banks and our stockbrokers, who insisted earlier this year that a 12-15% discount would be just fine, put an average Nama discount at over 30%. Nama cheerleaders now admit that applying a low discount is simply bonkers. This week, international agencies – Fitch and Moody – also waded back to the shores of reality. Both highlighted the fact that going forward Irish banks will remain in their current insolvent state. Nama won’t repair their balancesheets and it will not change their ability to raise capital privately.

With this change in direction, Nama became an exercise in racing to the top of recapitalization heap, as banks scrambled to issue new estimates of their expected demand for additional capital.

Two months ago I estimated in a public note that Bank of Ireland will require up to €2.6bn in capital after Nama loans are transferred, AIB will demand close to €3.5bn, Anglo €5.7bn and the rest of the pack will need approximately €1.2bn. The total demand for recapitalization costs post-Nama – none of which is factored into that work of fiction known as Nama Business Plan – will be €10-13 billion.

All of these figures could have been glimpsed from the banks balancesheets, but the Department of Finance, NTMA, and an army of advisers have opted for creative accountancy in place of realistic estimates.

Over the recent months, virtually every vested analyst in the country has confirmed the above figures for the banks. In one case – that of INBS – the analysts actually exceeded my worst case scenario projections. The result of this delayed admission is the current bear run on Irish banks stocks.

Now, recall that consensus estimates prepared by the independent analysts show that in the end of its operations, the ‘bad bank’ is likely to yield net losses to the taxpayers of between €11 billion and €17 billion. Not a single estimate, short of the fictionalized official Nama accounts, shows the entity breaking even on the loans.

Do the maths: expected losses of €11-17 billion, plus recapitalization costs to date of €11 billion, plus expected post-Nama recapitalization costs of €10-13 billion (only partially reflected in the expected losses estimates). The total bill for this bogus ‘rescuing’ of the Irish banking system is likely to be in the neighbourhood of €29-40 billion.

And, judging by the public pronouncements from the top bankers of AIB, Bank of Ireland, Anglo, permanent TSB and EBS – there is not a snowballs’ chance in hell Nama will repair lending to Irish companies or households. Instead, as the US experience with TARP shows – a liquidity trap is awaiting our economy. Put in simple terms, no rational banker would forego an opportunity of borrowing from the ECB and lending at ca 5% to the state instead of providing capital to SMEs and households.

Contrary to the hopes of restarting the lending cycle, what we have to look forward to in 2010 is the strengthening of the margins by the banks. A combination of the ‘risk sharing’ scheme built into Nama legislation, costlier interbank funding markets (courtesy of reduced liquidity supply from the ECB), falling corporate deposits base and the deterioration in the capital reserves of the banks will mean that the cost of existent loans and future borrowing will rise. And it will rise dramatically.

The first taste of this was the implementation by permanent TSB of a rate hike on adjustable rate mortgages. ESB preannounced the same move some months ago. Bank of Ireland, AIB and the rest of the pack will follow. When this happens, even absent ECB rates hikes (anticipated by the market in mid-to-late 2010), the retail lending rates will rise, triggering a wave of defaults by households on credit cards debt, consumer loans, car loans and ultimately home loans.

Short term lending facilities for businesses and export supports will also come under pressure as banks address the twin problems created by Nama – the deficit of capital and the uncertain nature of risk sharing scheme. The lack of exports supports either in the form of state-backed export credit insurance for indigenous exporters or the currency risk offset scheme in the Budget 2010 will further exacerbate the problem.

All of this is fuelling the current run on the banks shares. Even with their wings clipped, stock markets investors are indirectly ‘shorting’ Irish banks by withdrawing their cash from the AIB, Bank of Ireland and Irish Life & Permanent valuations. The markets are shouting: ‘We are not buying your story that Nama will work for Irish economy!’ The Government is not listening.

Box out:
A study based on the Standard & Poor’s data released this week shows that over the last 5 years, active funds managers have managed to under-perform broader market indices in four out of four asset categories. Thus, only 37% of active funds managers with large cap strategy orientation beat S&P500 large cap index to July 1, 2009. Only 32% of funds specializing on small cap equities outperformed S&P Small Cap 600 index, and abysmal 13% of funds with international (as opposed to US) orientation have managed higher returns than S&P700 index of global equities. Just 20% of bonds funds beat Barclays Intermediate Government/Credit index. And that is before we factor in cost differentials between actively managed funds and plain vanilla index-linked ETFs. Ouch…

Economics 01/12/2009: Irish Banks - something stirring in the dark

An interesting, but at this stage purely theoretical conjecture that can play out in the next couple of days.

I will posit it after I go over the facts that led me to this conjecture:

1. Today's reporting on BofI and the banks in general has been focusing on the possible conversion of preference shares into ordinary shares to plug in capital holes. Considering that (a) such a conversion will de facto spell near nationalization of the banks; (b) it will destroy Government's case (supported by the stockbrokers and the banks) that preference shares represent significant cash flow positive back to the taxpayers in exchange for recapitalizations to date; and (c) such a conversion will amount to a swap of a guaranteed asset (preference share dividend) in exchange for of a falling asset (as ordinary shares are tanking and are bound to continue to tank if conversion takes place), the statement is alarming. In fact, the statement is extraordinary in nature, similar to the Banks Guarantee Scheme announcement back in September 2008;
   
2. The RTE has completely failed to explore the very core idea of what effect the conversion will have on both capital reserves at the banks and the value of taxpayers' shareholdings in the banks. This might suggest that the story was potentially heavily 'managed' as a staged release as RTE business editors and correspondents should have been aware of such consequences;
3. The extent of demand for capital post-Nama has been approximately estimable from the sheer size of impairments faced by the banks against banks balancesheets (loans to deposits ratios) and did not come as surprise for, say Anglo earlier this month. Why such a hype then all of a sudden? Did Nama haircut change dramatically? Not, Bloxham note today in the morning explicitly worked its estimates from the assumed Nama-signalled haircut of 30%. No change spotted here, then.
4. Core tier 1 capital already includes preference shares, so conversion will only aid the banks balancesheets if and only if it will allow the banks to keep the preference shares dividend. This means that taxpayers get nothing from these shares. And it also means that things are getting so desperate in the banks that they are having trouble (potentially?) repaying these dividends to the state. What can the impetus for such deterioration be, given both banks already guided recently on expected impairments? Why did RTE reporters never bothered to ask about this issue.
5. The whole mess of demand for post-Nama recapitalizations was predicted by some, and publicly aired in the media. In fact, my estimates from one month ago (here) accurately predicted the numbers involved. While some 'experts' from stock brokerages interviewed today by RTE's flagship News at Nine programme might have been unaware of such estimates back then, their arriving at the same numbers one month later is not really that much of a market-making news. So, again, why the hype today?
   
6. RTE stated tonight that the markets anticipated 20% haircut (here). This is simply not true:

• Per today's Davy note: "This has been reviewed by NAMA and the Department of Finance and on the basis of interaction with both and the minister's estimate of €16bn of eligible bank assets, 'the directors believe that the average discount on disposal applicable to these assets should not be greater than the estimated average discount for all participating institutions of 30%'."
• Bloxham are working off 30% assumption.
  
• Goodbody's note was a bit more volatile on assumptions: "As per BOI’s recent interim results and a November’s IMS from AIB, both banks highlight that a number of uncertainties exist as to the specific quantum and timing of loans which may transfer, the price, the fees due and the “fair value” of the consideration. In its statement, AIB refers to the previously highlighted industry average discount of 30% to the gross value of the loans and indicates - as it did at the time of its IMS - that the board’s view is that “there is no reason to believe that the average discount applicable to AIB’s NAMA assets will fall significantly outside of this guidance”. When we wrote on this at the IMS stage, we highlighted that the language here was more vague than previous utterances and note our haircut applied is 28%. Similarly, in the case of BOI, the references in the release today are all based off the generic 30% industry figure referred to be the Minister, though that the discount will vary by institution, with the Court believing this industry figure to be the “maximum loss likely to be incurred on the sale of loans to NAMA”. We are of the view though that BOI’s haircut will be closer to 18%." I'll explain in human language: AIB itself believed that average Nama discount (30%) or something close will apply, while Goody believed 28% will do. For BofI, the management believed before that 30% will apply. But Goody's believed 18% will do (why, beats me). So no evidence on 20% market consensus anywhere here, then.
  
• NCB applied 30% model to both BofI and AIB in today's note. And so on.
  
• Taken over all brokers and banks themselves, AIB assumed discount averages at 29.5%, not 20%, BofI assumed discount averages at 27%. Now, forgive me, but where is RTE taking its 20% market expectation from?
  

So now, let us summarise the evidence:

• Banks announcement today was out of line with ordinary business;
• Banks announcement was never probed or challenged by the official media;
• Banks announcements were not queried by the the brokers to the full extent of conversion implications to the balance sheets;
• Three components can have a dramatic fast impact on bank core tier 1 capital - equity collapse (not the case - banks shares are down by less than 5% today, plus the statements were released in the morning before market prices were revealed); loans collapse on a massive scale (unlikely, given that both banks guided very recently on new impairments and also unlikely given that both banks appear to be impacted simultaneously); or deposits falling off dramatically (there is no way of confirming this unless banks publish their data, but do recall September-December 2008 when deposits flight exposed Anglo to nationalization).
  

So something really strange is happening around the BofI and AIB in the last few days. I do not know what this might be, but some fast moving deterioration in hitting banks balancesheets.

Watch tomorrow's ticker.

Economics 30/11/2009: Nama estimates confirmed

Scroll for a couple of interesting topics (other than Nama) below...

Per Bloxham’s note today (emphasis is mine):

“Bank of Ireland this morning officially announced its intention to participate in the National Asset Management Agency ... The bank sees the first assets as moving from January 20th 2010, and on a phased basis from there on until mid 2010. The group does not know the discount to be applied to the assets on transfer to NAMA. However, the bank expects to receive €11.2 billion for the assets currently shown with a worth of €16 billion in the balance sheet, based on the 30% discount guided by NAMA. Total provisions set aside on the assets to move to NAMA are €1.4 billion resulting in a €3.4 billion loss. The Risk Weighted Assets will be adjusted down by €15.2 billion as a results of the transfer. The bank shows a loan book of €116.7 billion (down from €131.3 billion pre NAMA) after the movement in assets, while Risk Weighed Assets fall from €100.7 billion to €85.5 billion. Core Equity will fall to €3.5 billion from €6.6 billion. Therefore, the reduction in Core Equity Tier 1 would be from 6.65% in September 30th to 4.2% as a result of the transfer to NAMA, and subsequent write down.”

So to restore the bank balancesheet to internationally acceptable risk-core equity balance of over 6% will require some €2.55bn in capital injection post-Nama, not accounting for any additional deterioration in the remaining book. In a note published exactly a month ago (here) I predicted that BofI will need €2.0-2.6bn in fresh capital – bang on with today’s statement.

This is the second estimate fully confirmed by the Nama-participating banks that is in line with my projections of October 30, with earlier this month media reports putting Anglo’s demand for fresh post-Nama capital at €5.7bn.

Further per Bloxham:

“Loss on disposal of assets will be tax deductible as we understood previously. Bank of Ireland also highlights that after 10 years, in the event NAMA discloses a loss the Minister of Finance may bring forward legislation to impose a special tax on participating institutions. The bank goes on to confirm that the interest rate Bank of Ireland will receive from the bonds which replace the transferred assets, is still not know. Therefore the impact on income is still not known.”

Oh and per Davy's morning note: using average 30% haircut implies a loss of €3.4bn on top of the €1.4bn impairment already estimated at September 30, 2009. This implies - per Davy's model - €960mln pre-tax hit which, "combined with some other adjustments to RWAs and sub-debt... would increase the capital required to keep core equity at the trough of 5% from €1.3bn to €2.3bn."

Now, Davy's model, therefore suggests demand for €2.8bn in capital to 6% ratio. Both Davy estimates are therefore comfortably within my range of expected capital demand by BofI. And good luck to those who have a hope that BofI can raise new funding with 5% core equity ratio at anything close to reasonable costs.

Anyone who at this stage in the game still holds illusions that Nama will allow for a restart of lending in this economy has to be simply bonkers.

Oh, and on a funny side of things: today's CSO data release is for:

"Census of Industrial Production 2008 - Early estimates". One question begs asking: When will the later estimates arive? December 20, 2011?

Oh, and do see this on Ireland v Dubai - here. The worrying thing is that it is talking about partial default scenario for Ireland and the ECB rescue ahead of Greece! which, of course, goes nicely with my article in The Sunday Times yesterday - which I will post later tonight.