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 22/7/10: Banks downgraded - expect more fireworks

After hammering Irish sovereign ratings, Moody’s rightly took the shine off the six guaranteed banks’ bonds. Not surprising, really, and goes to show just how meaningless the term ‘stable outlook’ can be. Now, few facts:

• Moody’s has downgraded the long-term ratings for EBS Building Society and Irish Life & Permanent from A2 to A3, stable outlook didn’t help much here.
• Moody’s also downgraded the government-guaranteed debt of all six guaranteed institutions: AIB, Bank of Ireland, EBS, Anglo, IL&P and Irish Nationwide.
• Prior to the latest downgrade, AIB and BofI both had stable outlook, and this has been maintained.
• The reason for the downgrades was the reduction in the government’s ability to support the banks stemming from the sovereign debt downgrade announced Monday.
  

What’s next, you might ask? Barring any news on loans impairments etc, the growth prospects for banks will have to be the key. And here, folks, there isn’t any good news. No matter how you can spin the thing.

BofI and AIB are disposing of their performing assets – divisions and businesses in the US, UK and elsewhere – in order to plug the vast holes in their balance sheets caused by their non-performing assets.

And it’s a fire sale: Polish BZWBK – 70.5%-owned by AIB – is the only growth hopeful in the entire AIB stable. Yesterday, some reports in Poland suggested that PKO Bank Polski, Banco Santander, BNP Paribas and Intesa San Paolo are the only ones remaining in the bidding. Neither one can be expected to pay a serious premium.

Take a look at M&T in which AIB holds a 22.5%. Not a growth engine, but a solid contributor to the balance sheet. The US bank Q2 profit quadrupled as it is facing the market with structural aversion to banks shares. So M&T is losing value in the market as it is gaining value on AIB’s balance sheet. But hey, let’s sell that, the gurus from Ballsbridge say, and pay off those fantastic development deals we’ve done in Meath and Dundalk.

Likewise, BofI are selling tons of proprietary assets, including proprietary wholesale services platforms, which are performing well.

Will the money raised go to provide a basis for growth in revenue in 2010-2012? Not really. BofI needs new capital. Not as badly as AIB, but still - €2.9bn capital injection in June is not going to be enough to cover future losses. It is just a temporary stop-gap measure to cover already expected losses plus new regulatory capital floors. Future losses will require future capital.

AIB is desperate. €7.4bn is a serious amount of dosh and there are indicators they’ll need more. Of course, in order to properly repair its balance sheet, AIB will need closer to €10bn this side of Christmas (as estimated by Peter Mathews - see here).

However, the bank won’t make any noise about that for political reasons.

Even after getting no serious opposition to their banks recovery plans for some two years already, the Government is starting to get concerned about continuous and never diminishing demand for capital from our banks. This concern is not motivated by the suddenly acquired desire to be prudent with taxpayers’ cash. Instead it is motivated by the optical impressions Irish banks appetite for Exchequer funding is creating around the world. Sovereign ratings are now directly being impacted by banks weaknesses and some investors are starting to ask uncomfortable questions about viability of AIB outside state control. There’s an added sticky issue of Irish Government deficit potentially reaching 20% of GDP this year should our banks come for more cash.

And they will... not in 2010, possibly, but in 2011, once Nama last tranche closes in February (or thereabouts - remember, it has blown through few deadlines already and can strategically move past February 2011 with closing off its purchases, to allow more time for banks to play the 'Head in the Sand' game).

If you want to see what is really happening in our sovereign bonds markets, check out the next post on this blog, which will be covering this.

Economics 20/7/10: Is Zombie Nama propping up Mummified Irish Banks?

As the independents – Brian Lucey, Karl Whelan, Peter Mathews and myself – have warned (actively denied by the Government and its backyard ‘experts’), Nama Tranche II turned out to be yet another unmitigated disaster.

Nama paid €2.7bn for loans that its experts valued at €5.2bn. Of course, these ‘experts’ include many who were responsible for some of the most disastrous valuations of the Celtic Tiger era and are now ‘entrusted’ as being ‘experienced’ with re-valuing their own errors, while collecting a handsome pay packet courtesy of the Irish taxpayers. The implied average discount these folks put on the loans this time around is 48%. Anglo failed to transfer its loans – some €7-8bn worth – due to delays caused, per what I am hearing, by a rather shoddy documentation quality.

Per RTE: “The biggest discount on the second batch of loans was for those from Irish Nationwide. NAMA paid the society just €163m for loans of €591m, a discount of 72% [an increase of 14% on Tranche 1]. The figures for AIB and EBS were 48.5% [on €2.73bn marking a 6.5% increase on Tranche 1], and 46.5% [on €35.9mln and an increase of 9% on Tranche 1] respectively, while the Bank of Ireland discount was 37.8% [on €1.82bn - an increase of 2.8% on T1].” Overall, Nama now has in its vaults €20.5bn worth of loans (or rather largely worthless paper few years ago labeled as loans) for which it paid at a discount of 50.7%.

The loans are concentrated - related to just 23 property developers who are deemed to be 'second tier' aka less flamboyant than those in Tranche 1 and most likely, less experienced too.

It makes me laugh when I recall how our stock brokerage 'analysts' were chirping a year ago that a 20-25% haircut would be warranted by market valuations of these loans.

However, the real problem with all of these numbers is that while the discounts might sound impressive, they are not reflective of any reality. Instead, they are now fully bootstrapped to the capital commitments issued to the banks by Brian Lenihan. You see, as we warned from the start – and this too was vigorously denied by the Government – the heavier the haircut, the greater will be banks’ demand for capital, the greater will be the share of bank equity owned by the taxpayers. Mindful not to take too much stake in BofI – for that would produce poor optics internationally – Brian Lenihan is content to oversee a 38% discount on its loans. Having pumped capital up to 50% of risk-weighted assets transfers to Nama for AIB, the Minister is equally happy not to impose heavier haircuts on AIB Tranche 2 transfers than 50%. Hence the ‘magic’ 48.5% figure. Ditto for EBS. Sounds precise – not 49%, nor 48%. But in the end – the number is most likely utterly bogus.

To put some fluff in the air about ‘Nama is a tough player with the banks’, Tranche 2 hammered INBS and most likely will hammer Anglo. Unless, that is, Anglo fatigue has finally reached Upper Merrion Street buildings. In this case, a discount can be less than that for INBS. Not because Anglo loans have miraculously become sterling in quality, but because the DofF might be just slightly concerned that the bank will come with a fresh capital demand.

So instead of pricing the loans to market, Nama now appears to be pricing them to keep required post-Nama recapitalizations at the levels consistent with earlier Government capital commitments.

In the end, however, a 48% average discount is still a gross overpayment on these loans. Let’s do a back of the envelope calculation here.

25% of Nama loans are ‘cash generative’ – i.e. paying some sort of an interest repayment on interest due. Suppose – just for the sake of making an assumption – that 50% of those cash generative loans are paying full interest due and 50% are paying ½ interest due. Assuming average interest rate on the loan of 8% (a generous assumption, given that banks were lending at lower rates than that) and cost of refinancing banks funds at 3% (well below current yields on banks bonds, even way lower than the latest Exchequer yields of 5.25%, but let’s be generous), if the cost of managing loans at 1% (consistent with Irish banks’ margins), then:

• 75% of Nama loans are losing have a negative yield of 12% (annual loss on interest alone);
• 12.5% of Nama loans are losing 2% pa in net costs, plus 8% rolled up interest, implying their negative yield of 10% pa;
• 12.5% of Nama loans are losing net 8% pa.
  

Expected average annual loss on Nama overall portfolio is therefore 11.25% pa. Value this at x3 revenue flow. Nama portoflia of loans would have a negative, yes, negative, - 34% break-even valuation in the market. Just on the back of interest and costs alone, the value of Nama purchased portfolio of loans should be no more than 66 cents on the euro of face value.

Next, subtract the percentage of loans that are unsecured – while allowing for the expected recovery, subject to the risk. Suppose that 20% of loans taken on by Nama are unsecured (again, likely to be conservative assumption). Suppose these are distributed across the same 12.5%, 12.5% and 75% sub-portoflia following a uniform distribution (again, this is a generous assumption as lower quality loans are more likely to be less secured in the real world). The value of the entire package of loans is now worth only 59 cents on the euro.

Secured loans are also subject to a recovery risk. In general, risk of recovery implies that over 70% for loans in arrears will be non-recoverable, ca 50% for loans under stress (e.g. failing to pay principal when it is due) and 20-25% for loans that are fully performing (e.g. those that are repaying principal and interest to the full amount). These are numbers consistent with the 1990s experiences in Sweden and UK. Translating these into our valuation, adjusted for risk of recovery implies the value of Nama-bound loans around 30-32 cents on the euro.

Other risks can be priced as well, but let us stop here.

Even with relatively rosy assumptions, the value of the loans being purchased by Nama should be at maximum 32 cents on the euro.

Allowing for assets appreciation of 10% over 3 years would imply a valuation of no more than 37 cents on the euro without applying a PDV adjustment.

We are told that Nama is being a tough buyer, paying 52 cents on the euro. Who’s fooling who here?

Incidentally, 30 cents on the euro is what independent banking expert Peter Mathews has estimated as recoverable for all development and property loans held by the banks. It is also the number that myself and Brian Lucey have arrived at in our previous estimates of required haircuts, which were based on analysis of underlying property markets.

What is now clear is that 24 months since the crisis fully exploded in our faces and 15 months after the independent analysts started telling the Government that it is committing a grave error in pushing forward the solution that, under the original name TARP was rejected in the US two weeks after it was put in place, the Irish Government remains hell-bent on pursuing this wrong approach to banks recovery. More egregiously, with Tranche II loans in, there is a strong enough reason to suspect that Nama has turned into nothing more than a façade for delaying even more capital demands from the banks until the end of 2010. The reason for this, one might speculate, is to keep our 2010 public deficit from exploding to beyond 20% of GDP.

A zombie institution (Nama) now is fully in charge of our mummified banking system. What can they do next to make things even more dynamic than that?

Economics 12/04/2010: Nama's economic distorionism

An interesting quote from the just-published paper (Claessens, Stijn, Dell’Ariccia, Giovanni, Igan, Deniz and Laeven, Luc A., Cross-Country Experiences and Policy Implications from the Global Financial Crisis. Economic Policy, Vol. 25, Issue 62, pp. 267-293, April 2010). I reported on this paper last year at length, when it was still an IMF Working Paper.

“An example of distortions between financial institutions and the fiscal conditions is the extension of guarantees in the case of Ireland to the largest banks. Prior to the extension of guarantees, the CDS-spreads for the large Irish commercial banks were very high. Post guarantees, bank CDS-spreads declined sharply, while the sovereign spread increased. Measures like these, now numerous in many advanced countries today, distort asset prices and financial flows.”

This goes hand-in-hand with the EU assessment of Nama as a market distorting mechanism, which, as reported last week by Irish Independent, was concealed from the public when our Minister for Finance issued a press release claiming that Nama was fully supported by the EU Commission.

Further per Claessens et al: “Guarantees on deposits and other liabilities issued by individual countries have led to beggar thy neighbor effects as, starting with Ireland, they forced other countries to follow with similar measures.”

This statement in effect condemns Irish Government claim that our Guarantee was a success because it was copied by other countries. Instead, as Claessens et al confirm, the Guarantee forced risk from Ireland onto our trade and investment partners. Not exactly a high moral ground.

“The rapid spread of guarantees led to further financial turmoil in other markets. Many emerging markets not able to match guarantees suffered from capital outflows as depositors and other creditors sought the safe havens. Distribution of risks sharply changed over time and across circumstances."

More importantly, both – the revealed note from the EU and the above academic assessment – provide a significant warning in terms of the future of the banking and property sectors in Ireland. Given the systemic nature of distortions, subsequent exits and scaling back of foreign banks presence in the country, the lack of transparency and fairness in the property markets, it is now virtually assured that post-crisis interventions Irish banks and property markets will remain in their zombie state. Japan-styled recession is a looming threat for Ireland Inc.


Of course, you wouldn’t notice this, if you were listening to some of our heroic stock brokers – especially those folks like Bloxham who back in mid 2008 ‘forecast’ that ‘markets do come back’. In their latest strategy statement, issued last Friday, the Bloxham’s boys have managed to outperform themselves in terms of Green-jerseying (emphasis is mine):

“Ireland is undergoing some of the heaviest self imposed penalties for the fiscal over exuberance of the 2000s of any EU economy since the global credit crisis began in 2008. From budgetary austerity measures to public sector wage cuts, from crushing additional taxes both personal and indirect, to a mega-costing banking recovery plan; all in the name of stabalisation and repositioning as a viable economy. As Ireland passes through the next major set of hurdles (the transfer of assets to NAMA and the recap of the banking system), the market reaction so far has been favourable.”

Any evidence of this?

“10-year sovereign Irish bonds are still trading at 146 basis points above German bonds, compared with 280 basis points at the worst point for the Irish system in March 2009. Compared with Portugal at 126 bps over Germany, Irish spreads still have strong progress to make.”

The more the things improve in the wake of all the measures passed by the Government, the more the spreads stay the same? Indeed: “Irish sovereign debt costs have remained static in the past week, while Greek debt costs balloon by 100 bps. In relative terms, Ireland sovereign performance has been exceptionally good since the “Super Tuesday” announcements from the National Asset Management Agency (NAMA), the Financial Regulator and the Minister for Finance.”

But hold on to your seats for a wild ride into the land of bizarre logic: “A falling Irish debt cost is largely unappreciated domestically but is a very hansom reward for the pain taken in Ireland thus far.”

I am now thoroughly confused, folks – if the spreads stayed the same, what falling Irish debt costs do the Bloxham folks have in mind? Am I missing something in their vernacular? Or are they missing in the faculty of trivial maths – falling costs mean declining spreads, yet the spreads ‘remained static’ and debt costs did the same.


A real pearl of the note is in its conclusions: “We would expect that the wider Irish stock market will also benefit strongly over the next 6 months, as re-cap plans proceed and the export sector resilience is maintained. Ireland could be finally coming back on the international investor map.”

Indeed it might. Or it might not. I wouldn’t venture a prediction here, but Bloxham guys – having been so right on so many occasions in the past (including that brilliant note from them back in July 2008 (see the note here) surely would know better. Except, hmmm, what does Ireland’s exporting performance have to do with Irish stock prices? Not much – more than 80% of our goods exports and over 90% of our services exports are accounted for by the MNCs – none of which are listed on Irish Stock Exchange. So unless Bloxham guys know something about Fortune 500 companies plans to relocate their listings to Dublin…

Economics 31/03/2010: Nama funding scheme - Maddoffian Risk Pyramid

The saga of Nama continues, folks. Ah, and no, I do not mean the dumping of €8.3 billion to the Anglo which miraculously declared losses of €12bn = €4bn injected by taxpayer in 2009 + €8.3bn injected today. Had the Exchequer given Anglo €15bn last night, the bank would have declared losses of €19bn. And not even the admission on the public airways, by our illustrious 'public interest' director soon-to-be-chief of Anglo, Alan Dukes, that Anglo will most likely need more than additional €10bn promised to it by overly-generous-with-other-people-money Mr Lenihan.

Oh no - the really worrying thing is contained in the notes from March 26th issued by Nama (available here) that detail the financing arrangements that Nama will undertake to cover the purchases of the loans from Irish banks.

Some time ago it was rumored that the Government was setting on the following scheme:

• Nama will issue 12 month bonds
• With interest rate rest at Euribor-Libor plus a margin every 6 months
• Which are to be fully unconditionally and irrevocably guaranteed by the state as ranking pari passu with the Nama other unsecured and unsubordinated debts.

At the time, myself and other analysts said that such a scheme would be a disaster. Now, per latest documentation from Nama - this is exactly the scheme chosen to finance Nama acquisitions.

Let me remind you what the problem with this scheme is.

Nama is buying long-term loans with work-out period stretched over 10-15 years. It will use short term financing to get these through. Problem 1: borrowing short to lend long is what got out banks into this mess in the first place. Now, Nama will have exactly the same risk-loaded funding structure as the worst of our banks. For example, at the peak of risk-loading, Anglo carried about 50% of its funding in short-term inter-banks loans. Nama will do the same for 100% of its funding requirement. Scared yet?

Nama will be loading up with short term debt as the yield curve for Libor and Euribor is pointing up. In other words, every progressive reset (6 months) and roll-over of the debt (12 months) will be more expensive to the State. My third year UCD undergrads last Fall knew that this is a bad risk. Nama, having paid millions to advisers and 'experienced' staff couldn't get it right! Trembling yet?

Nama will be rolling over bonds on an annual basis. This means annual transactions costs (making the entire borrowing much more expensive) and reliance on the ECB to re-collateralize the bonds (putting Frank Fahey's 'free lunch' funding out to new tender annually). Is anyone actually thinking about any of these risks out in the Treasury Building on Grand Canal Street?

Adding insult to injury - despite being issued by the agent different than the Sovereign, Nama bonds will be tax-exempt. In other words, issued at Euribor of, say 2.75%, the notes will effectively be priced at around 3.44%. Worse, the Guarantee statement obliges the Irish state to cover incidental and other expenses of the bond holders and exempts them from all and any taxes relating to the Guarantee. In other words, should the bond holders resell their Nama bonds at a profit (in part determined by the Guarantee), there will be no tax on such a resale.

In short, it appears that neither Nama, nor an army of its excruciatingly expensive advisers, nor DofF, nor the Government have any knowledge that normal interest yield curves are upward sloping - cost of borrowing, normally rises in time. Or may be they simply do not care. After all, its our money they are gambling with.