Economics 21/12/10: Derivatives hole?

Updated (end of post)

The following post is attempting to put some numbers behind a highly uncertain, opaque and completely under-reported side of the Irish banks operations - the side relating to securitisations and derivatives exposures. My numbers below are pure estimates and their objective is to at least start raising the questions as to the depth of our (taxpayers) exposure to this murky world of banks' securitised assets.

Before we begin, I must also relay my thanks to Brian Lucey and 3 anonymous experts for providing advice and comments on the earlier draft and to LorcanRK who was involved in trying to scope the problem earlier.


Years ago, before our sick puppies (banks) became sick, in the golden days when the Anglopup, AIBickey, permo, INBiSquit, EBSsie and BofIpooch were still wagging their happy tails around the streets of Dublin, securitisation was all the rage.

The basic idea behind this transaction runs innocuously enough as follows: a bank holds a bunch of loans, say mortgages. These yield an annual revenue stream, but hold up capital, restricting new lending. To help unlock this capital, a bank can package these loans together and sell them to an SPV which will issue a paper security against these loans that entitles the owner to a share of the total package of loans as they yield returns over time. An SPV, of course, doesn’t manage the mortgages but leaves them in the custody of the bank which acts as a manager/custodian, responsible for collecting the moneys due and paying out to the SPV.

Now, for a bit relevant to us: an agreement between the SPV and the custodian has two key covenants:

1. loans are held by the custodian in trust, so that the custodian is obliged, upon either the termination of the management contract or should other covenants be breached, to deliver the actual loans/mortgages to the SPV owner;
2. ability of the custodian/manager to hold on to the loans is subject to a minimum credit rating, usually - investment grade.
   

The first point means that should an SPV ask an Irish bank for its loans (due to a breach in its covenants), the banks must deliver these loans.

The second point means that if the covenants are breached, by, say for the sake of argument, Irish banks rating sinking to junk, the banks can be found in a breach of covenants and face:

• a margin call – according to my sources, of up to a whooping 20% face value of the securitized loans in some cases; and/or
• a call on the actual loans to be transferred to a different manager/custodian nominated by the SPV

Every securitized contract runs alongside it a derivative security designed to protect against the risk exposures relating to the loans.

These derivatives can be

• symmetric – covering both sides of the potential exposure – e.g. interest rates swaps going both ways or
  
• asymmetric or uni-directional, covering only one side of the risk exposure (e.g. an interest rate swap insuring against a future rise in the interest rates).
  

The derivatives can be written by an independent entity or by the bank, but for the reasons of good risk management (maturity mismatch risk and direct exposure to underwriter risk) these derivatives should really be underwritten by the third parties, not the custodians.

Now, let’s go back to the history. Earlier this year, I wrote about our ‘national derivatives accounts’:

• AIB held the total derivative exposure to the notional value of €261bn in 2008 which fell to €197bn in 2009 (here)
• BOI held €360.5bn (here) in 2009
• Anglo held some €268.3bn worth of notional value derivatives in 2008 (here), falling to €184.5bn in 2010 (here)
  

The above is very close to the gross notional exposure amounts of €640 billion (for two banks ex-Anglo) reported in 2008 by the employee of the Financial Regulator - Grellan O'Kelly (here).

So now, suppose that the notional value reflects symmetric hedges, and even there, let's assume that directionality is such that benign risk is weighted by twice the weight assigned to maximum loss-linked risk, so that the underlying value of these derivatives is around 1/3rd of the €742.3 billion of notional value, or €245 billion.

Here is the beefy problem. Since these derivatives are written against real loans contracts, what happens if the covenants of the SPVs behind them are breached?

Let’s talk some hypotheticals (since we have no actual clarity on these):

• Scenario 1: Irish Government debt sinks to junk, which automatically means banks debt sinks to junk (while I was writing this, the latest Moody’s downgrade pushed it even deeper...). There’s a margin call on derivatives of say ½ of 20% mentioned above, or 10%. Oops – Irish banks are in a hole for up to 24.5bn off the starting line (10% of the 245bn above)
• Scenario 2: Instead of a call on the derivatives, SPV breaks management agreement with an Irish bank and asks for its loans to be moved out of the bank. Wouldn't be a problem, unless: what if the bank, in the mean time, has leveraged the same loans it held in custody for the SPV at the ECB (or CBofI or both) discount window? Well, should the SPVs insist, the Irish banks will be forced to buy their collateral out of ECB and CB of Ireland to the amount that the banks borrowed against such collateral.

Things are starting to smell rotten… But do not be afraid, those in charge who still have some brains left spotted the dodgy stuff. To our chagrin, however, the smart ones are in Frankfurt, not in Dublin. Back in August 2008, the ECB has pulled the plug on taking Irish banks-securitised loans as collateral. Miraculously, in the end of 2008, CBofI lent Anglo €10.5bn against some mysterious collateral that, several of my sources argued, was previously rejected by the ECB.

Why would the ECB decline to take securitised packages as collateral, while taking the loans? Surely this signals something is amiss with the vehicle of securitisation as carried out by the Irish banks?

Two things can be dodgy with the securitized packages in general:

1. Underlying derivatives, and/or
2. Security over the loans/assets that are securitized.
   

I am not going to speculate what it is – time will tell. Instead, let’s run through some scenarios on potential losses due to the above positions.

Assumptions:

• Assume that the above gross notional amounts of derivatives are 2/3 covering one side of exposure (e.g. expected increases in interest rates, for interest rate swaps) and 1/3 covering less expected opposite direction risk. This means that of the total values of derivatives written by the 3 banks, these derivatives were covering a collateralised pool of loans/assets equal to 1/3 of the gross notional derivatives.
• Now, some of collateralised assets were held by the banks themselves, but we do not know how much. So let’s assume that 25% and 50% are reasonable amounts for these shares, implying that banks sold on some 50% to 75% of the securitised assets
• Next suppose that the banks have written down these securitised assets by 20% (a gross overestimate, but let’s allow it to be conservative) and that the ECB has applied the usual 15% haircut in lending against the above writedowns
• Table below shows the estimates of potential losses

So the downside from the derivatives exposure and securitization can range between €12.25bn and €50.8bn.

Pretty wide.

Let’s take a look at the underlying assumptions. Running through the ‘What if covenants are breached?’ scenarios, one has to remember that many of the securitized loans borrowed against are related to more stable, longer-term mortgages. Since default rates across mortgages are lower it is highly unlikely that SPVs wouldn’t want to claim them out of the hands of the insolvent banks. This means that the 10% margin call on all loans scenario is highly unlikely to materialize. More likely – either the margin calls will be larger, or full call backs will be triggered. Which suggests that the range above more realistically should be expected around €17.15bn and €25.7bn.

Also, recall that Irish banks weren’t really at the races in speculating on financial instruments, preferring instead to speculate on property. This means that my assumption of 50% unidirectional net derivatives relating to property securitization is pretty conservative.

And remember that none of this has been factored by either the IMF or anyone else into the expected losses across the Irish banks. It hasn’t been incorporated into my earlier estimates of

• €67-70 billion total losses on NAMA, recognized losses and post-2010 commercial and investment books’ losses, and
• €9-11 billion total losses on mortgages post-2010, plus
• the lower €17bn figure as an estimate for the derivatives and securitization-related losses.
  

The total expected loss across the entire banking sector, net of recoveries might be as high as €93-98 billion. Or it might go as high as €107bn. And at this point, folks, even an old hawk like myself starts to feel scared.


Note: these are potential estimates. Given that we have been given no clarity as to the depth of securitisations, or the derivative instruments underlying it, nor do we have any idea as to what the banks have been doing with custodial-managed loans that relate to securitised products, one can only guesstimate - or speculate - as to the true extent of losses. I tried my best to be very, very conservative in the above, with my upper limit of factored estimate of €25.7bn in losses being below the average of the most benign scenario (€12.25bn) and the worst case scenario (€50.8bn). I was also very conservative in my assumptions. Note also that in the end, €17-25bn range of losses used in final estimate of the total cost of banks bailouts corresponds to just 2.29-3.37% of the notional value of all derivatives held in 2009 by the three banks.


Update: things are hardly trivial when it comes to potential securitisation-linked derivatives exposure. Back in 2007, the IMF has warned Irish regulators that:

“BoI has transferred the bulk of its domestic residential mortgage assets to a designated mortgage credit institution, which has a banking license to issue mortgage covered securities.—these are used both for hedging interest risk and for generating additional funding. Almost 60 percent of these securities were held by other Euro Area members, while 25 percent was held in USD by other countries. (IMF WP/07/44: External Linkages and Contagion Risk in Irish Banks, by Elena Duggar and Srobona Mitra - here)

Did IMF say 'the bulk'? So as of 2006-2007, the bulk of mortgages were out to securitisation in a 'conservatively' run BofI?

Economics 18/01/2010: Sunday Times 03/01/2010

A friend just highlighted to me that I have not posted my articles for Sunday Times since late 2009. In the next few post, I will correct for this omission.

First, unedited version of January 3, 2010. Note the box-out - covering very interesting development on Nama.

Over the last few weeks, a new consensus has emerged on the direction for Ireland in the New Year. Caught in the headlights of the Government PR blitz post-Budget 2010, the media and our quasi-governmental economic commentariate (Quagec) have firmly forgotten the simple fact that the bottom of the economic canyon we find ourselves in will require much more than a wishful New year’s resolution on behalf of the Exchequer. It requires a miracle of decoupling from our Euro zone’s sick twin – Greece – in real economic terms to restore full confidence in this economy.

Throughout 2009, our policymakers grumbled that Ireland was unfairly treated by international markets. As our CDS and bonds spreads were moving in tandem with those of Greece, the sop story from our Quagec was: “Ireland has a better starting position in terms of lower debt burden and it has taken the necessary pain. We are much closer to Berlin than to Athens.”

This, of course, was nothing more than economic gibberish dressed up to sound impressive. Past performance is no guarantee of future returns. It is the prospect of the future that is driving our risk valuations instead.

So what are the New Year’s prospects for our fundamentals?

The Greek Government is aiming for a 2010 deficit of 8.7% of GDP, although Greek parliament has approved budgetary estimate of 9.7%.

Ireland’s Exchequer deficit in 2010 is likely to reach 11.6% of GDP or nearly 15% of GNP, given the prospect for another year of a widening GDP/GNP gap. These stratospherically high numbers do not account for the cost of recapitalising the banks and for Nama. Should even a half of the estimated banks recapitalization costs hit the Exchequer in 2010, our public deficit is likely to exceed that of Greece by 3.7 percentage points in terms of GDP and up to 7 percentage points in terms of GNP.

Behind these headline figures there are other multiple reasons for the deterioration in our fiscal position in 2010.

Rising unemployment will persist through the first half of 2010, imposing new burdens on our already mammoth social welfare bill. These costs will be multiplied by the ongoing and accelerating process of unemployment benefits claimants transitioning onto full social welfare benefits as their supplementary savings and redundancy payments are exhausted.

Irish Exchequer, unlike its Greek counterpart, will be facing a multi-billion euro claim in terms of recapitalizing the banks. This bill is expected to reach above €10 billion for the six guaranteed institutions on top of the costs of Nama.

In 2009 Ireland-based multinational companies have booked massive transfer pricing profits through their Irish operations. 2010 might this activity collapsing. Over 2010, the US and Asia-Pacific region are expected to re-enter the economic growth cycle. Traditionally, this involves a restart of investment cycle. This, in turn, means that the firms will place much lower importance on maximising tax efficiencies via their off-shore operations. The risks for Ireland Inc here are slower inward investment and lower tax revenues, with many of the jobs pre-announced by the IDA in its recent report potentially delayed.

Looking forward, 2013-2014 will see Irish deficits still exceeding those in Greece, even if the New Year’s resolutions by Minister Lenihan are delivered on target. The latter, of course, is doubtful.

Firstly, all Budget 2010 measures announced by the Exchequer are gross, not net, implying that no more than roughly 80% of these can be achieved in real terms once second order effects and automatic stabilizers are counted in. Secondly, Government public sector pay reductions are now coming into doubt with Irish public servants facing a real pay cut of no more than 3-4% for top grade officials.

Getting back to the real economy. For 2010 our officials are forecasting a 1.3% decline in GDP and a 1.7% fall in GNP. The risk here is to further downside. Should Ireland-based MNCs divert their activities to investing in rebuilding their productive capacity in world’s faster growing economies, the GDP might fall by another 0.1-0.2 percentage points. Should housing prices decline another 8-10% as my estimates suggest, the wealth effect alone will shave off 0.1% from our annual output. Unless consumer spending improves substantially, we might be looking at 2010 producing a fall in GDP to the tune of 1.5-1.7% and a decline in GNP of around 1.8-2%.

But what can be the driver of consumer spending increases in 2010? Sky-high taxes and a promise of more taxation rises in 2011 delivered by Minister Lenihan on the Budget Day? Or a hope for continued historically low cost of borrowing?

Don’t hold your breath for the latter. Starting with the first month of Nama operations – which might come as early as February – Irish banks will be increasing the cost of adjustable rate mortgages. The unfortunate souls who hold these loans will end up paying 50-75 basis points more over the course of 2010, regardless of what the ECB might do.

With the ECB widely expected to raise rates in the second half of the year, we might be heading for 2010 ending with mortgage rates priced at around 100 basis points higher than they are today. A new wave of mortgage defaults will be in the making.

Once again, the Greeks are hardly at the races when compared to Ireland’s house prices collapse, or to our stock market crisis to date, or even to our expected mortgage defaults yet to hit the banks in 2010-2011.

The real indicator of stability of our economy compared to that of Greece is the extent of non-financial sectors debts. In Ireland, this figure currently stands at over €1.16 trillion (roughly $570 billion ex-IFSC). Comparable figure for the Greek economy is $35.4 billion – 16 times lower than for Ireland. Irish total gross debt (inclusive of IFSC) was $2,387 billion in Q2 2009 – some 430% the size of the Greek.

All of this goes to prove two things. Firstly, throughout 2009, rational investors operating in fully functioning bond markets were correct in discounting Ireland alongside Greece as the two weakest economies in the Euro area. Secondly, no matter what you might hear in weeks to come from our Quangec, we far from having passed our hardest tests in the current crisis.



Box-Out:

On Christmas eve, while the national news outlets were unrolling their festive medley of jolly carols and light entertainment, the Department of Finance has published a 2-page document, titled Nama (Designation of Eligible Bank Assets) Regulations 2009. The document’s objective was to define the assets eligible for transfer to Nama. Article 2 (a)-(d) state that Nama will be allowed to purchase at our, taxpayers, expense virtually any type of assets (short of credit card debts, but not personal loans or car loans) that are secured against some sort of development land asset. This covers pretty much every credit instrument known to man – from a plain vanilla loan to a structured credit agreement, all the way to a complex derivative contract. Even loans secured against equity shares in the undertaking to develop land, regardless of whether such an undertaking was primarily involved in property development or engaged in this activity as a side-show, will be eligible for taxpayers’ purchase. Undertakings that are eligible for such a treatment include not only plcs and established private businesses, but also opaque private partnerships and ‘over-night’ syndicates.

Take for example the infamous Glass Bottle site in Ringsend. The new edict means that the loans extended to developers and the investors engaged in a partnership, plus all the loans secured against the shares in the partnership and other concerned undertakings linked to the partnership, all and any other loans extended to anyone else who pledged as security any asset related to the site or its developers or investors are all eligible for the transfer.

In other words, the latest legal installment to Nama operational statues makes the state-financed bad bank a target for unceremonious dumping of all forms of toxic risky instruments from the banks balance sheet, regardless of claims seniority. And that, in turn, implies that Nama might end up holding conflicting security seniorities against itself. Good luck untangling that.