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.