IL&P: next in line? Update II

Per Irish Life & Permanent post last week - the predictions of the market downgrades for IL&P have materialised and by now are starting to be exhausted (barring any adverse news). IL&P is now likely to slide toward a general downgrade trend that has plagued the rest of the Irish banking sector.

Here are the updated charts reflecting the call I've made on IL&P last week.

Chart below shows that IL&P is still being pulled away from the rest of the banks, with the share price collapse being much more pronounced. The support for this momentum should be exhausted sooner rather than later, given a hefty sell volume hitting the market.
Chart above shows volumes relative to historic average, with current standing for IL&P sell-off at the local maximum. Again, in my view, this suggests some easing in volumes in days to come.

Chart below shows pure closing price (unadjusted for volume traded), with IL&P's nosedive being steeper than that for other banks. There is some room to travel down the price trend, but the downgrade over the last 3 trading days appears to me deep enough, so that, barring more adverse news, we should see settling of the share price into a gentler downward trend with wavering volume supports.
Finally, the chart below shows volume-adjusted sell-off of IL&P shares in line with the above charts.

Brian Lucey of TCD B-school was last night stressing the issues of the IL&P's uncertain balance sheet and the overall position of the bank in the greater scheme of financial services in Ireland (see Vincent Brown's program recording), although, sadly, this issue was not picked up by either Vincent or other panelists. It is time we put Anglo's saga behind us and start looking at the rest of the sector.

I am also starting to gradually shift into the unpopular view that while Anglo's own share support scheme (that €450mln loan-for-shares deal for the 'Golden Circle' investors) was wrong, ethically unsound and manipulative of the market, the 10 investors themselves (assuming the transaction was cleared by the Financial Regulator and other authorities) should not be scape-goated for their (stupid and financially ruinous) actions.

Instead of disclosing their names, we should demand the disclosure of the names of all incompetent (or negligent - take your pick) employees of CBFSAI who were engaged in clearing the Anglo deal. To date, the blame for the entire affair has been placed solely on the shoulders of private investors who took losses under their own commitments (reportedly covering 30% of the loans total). Instead, it should rest on the shoulders of the Irish regulatory authorities and those in the Department of Finance who knew of the deal and approved it. They are the truly rotten part of the system!

Eastern European Currencies & Soros

Per Financial Times report (here): CBs of Eastern Europe are issuing coordinated statements calling recent currency weakness unjustified and raising the possibility of intervention on foreign exchange markets. Take this, in line with George Soros' weekend cry to arms for state-led socialism to replace liberal financial markets regulation (as if such really does exist in any developed country today). Recall the classic lesson taught by Soros in the case of British experience with ERM: Central Banks interventions in Forex markets impoverish taxpayers and enrich George Soros.

So what should the strategy be for anyone with a position in Poland’s zloty, Hungary’s forint, the Czech koruna and the Romania’s leu? These currencies rallied after the statement. Three scenarios are thus possible:
Scenario 1: CBs mount a spirited defense driving currency valuations up for ca 1 month before all currencies come down again on the back of excessive fiscal deficits, private economy contractions and implosions of housing bubbles (in some countries), with private banking continuous deterioration (in other). Foreign banks and domestic banks use the opportunity to aggressively expatriate capital at higher currency valuations, driving down demand for domestic paper. Shorting now is a 'win' proposition.
Scenario 2: CBs do not mount a serious/credible defense and instead preside over further devaluation to bring currencies down to longer term recessionary equilibrium levels. Foreign banks, suffering their own crisis at home continue to expatriate capital, further contributing to devaluation pressures. Shorting now is a 'win' proposition.
Scenario 3: George Soros gets his wish and EU-styled over-regulation reigns supreme over the Forex markets in which case we get stiffening of the ERM mechanism and a coordinated effort on behalf of the EU to drive down the Euro over a period of time. No Eastern European country would enter an ERM band at a peril to its exporters, so Poland (and potentially at a later date - Hungary, Romania and Czech) will devalue their currencies before the ERM accession to boost the chances of economic recovery. Shorting now is a 'win' proposition.

As with the 1990s ERM crisis, this is a one-way bet assuming you have a stomach for being open in the Eastern European currencies in the first place. (All usual caveats apply of course, plus a disclosure: I hold no open position in the above currencies.)

Germany to the Rescue! - Update I

Now a peak at the CDS spreads again (hat tip to BL). To my earlier post (here) see the chart below: Gheez - we have Irish CDS reaching toward Philippines around mid February...
Of course, per Davy (here) there is no need to panic. “The risk of Ireland not being able to meet ongoing debt payments over the next few years is very low.”

Low? Hmmm.

Ireland government bond CDS at 3.4% and a recovery rate of 40-50% is equivalent to a risk-neutral (frictionless markets etc) default probability of CDS/(1-RR)=3.4%/0.6 = 5.67 pa or (1- (1-0.0567)^5)=25.3% cumulative default probability over 5 years. For 50% recovery rate, the latter figure is 29.7%.

Now, investors are risk averse, not risk neutral, and the Irish bond market is not exactly frictionless which can push the above probabilities down, although we do not know by how much.

What is, however, not accounted for here is the potential downside to the recovery rate - the amount that can be expected to be recovered should a sovereign actually default. For now, the markets price in a 40% recovery, implying that in the case of a default investors can expect to get 40c on each Euro back. But how realistic is this?

One recent experience with sovereign default shows that in the case of Argentina in 2000-2002 (see Andritsky, J (2005) Default and Recovery Rates of Sovereign Bonds, The Journal of Fixed Income, September 2005)
" Uncertainty about the expected recovery value is a main caveat when pricing credit-contingent claims in reduced-form models...The resulting recovery value estimated from Argentine global bonds starts out above 50% and falls to 25% after default."
So back-track from the above to today's Ireland Inc scenario and, suppose the recovery rate of 60% today implies a recovery rate of 30-40% at default and the current probability of default over 5 years of (1-[100-CDS/(1-RR)/100]^5)=36%... Nothing to worry about, folks, then - in plain English the above means that if Ireland Inc is any better than Argentina (the country that routinely and with frightening regularity takes foreign investors to the cleaners), our CDS levels today might be consistent with an equilibrium cumulative default odds of over 1 chance in 3.

But hold on, if the CDS rates are not a decent measure of implied default probability and a purely speculative tool instead (as our Nobel-prize contesting gurus from Davy, the DofF and CB keep telling us), why should the CDS data track closely the yield spreads? Maybe because they 'kinda feel so, man!' or maybe because the speculators in both markets are all in some global conspiracy club (wearing Venitian Canvivale masks and speaking in secret signs), or maybe, just maybe, both markets are really not buying the DofF-led and Davy-repeated story of 'no risk of default for Ireland Inc'.

Either both, the markets for CDS and Irish bonds are wrong, or Davy and the Government are. Take your pick.

IL&P: next in line? Update

And so the papers today follow our lead...

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

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

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

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

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

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

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

IL&P: next in line?

All this week, while the politicians were preoccupied with Anglo's saga, I've been watching what appears to be the next downgrade target: IL&P. Intimately linked to the Anglo Irish Bank's shenanigans, IL&P has had a rough ride alongside its other free-standing (for now) peers: the AIB and BofI. Towards the end of this week, it seems, this term - 'alongside' - has become far less descriptive of IL&P's share price behavior.

Are markets on to something we are yet to discover? I don't know, but here is how strange the things got in the course of last week.
Chart above shows correlation between the daily volumes for IL&P shares and the average daily volumes of AIB and BofI shares since December 2008 through February 20 close. Clearly, things gotten a bit out of pattern ever since the local low -0.5 correlation was approached on February 16. More importantly, Friday the 20th of February saw a reversion of correlation down to below 0.25.

As illustrated in the following chart, this is not surprising, given that both AIB and BofI volumes declines on Friday have been countered by a significant volume uptick in IL&P.Of course the volumes changes - especially pattern reversals over historical averages - are significant as they signal (in this case) a rising support to the general direction of share price movement. At this moment, the market appears rather committed to downgrading IL&P, while treating AIB and BofI much lighter.

Of course, the chart above lends some support to my last hypothesis: while both AIB and BofI are seeing moderating decreases in prices alongside falling volumes, IL&P is seeing increasing downward pressure on price alongside increasing volumes (note the chart above plots the product of price to historic average ratio and volume to historic average ratio). But don't take my word for this: chart below illustrates by referring directly to prices.

And the weekly moving average of correlations between closing prices for AIB and BofI with IL&P are starting to show strain as well.On the net, out of the four main parameters I usually use to gauge the possible shifts in market attitude toward a specific stock:

• divergent price moves relative to historic average and peers;
• volume changes to signal increasing support for one share relative to its peers;
• moving price correlations relative to peers diverging away from strong positive values; and
• moving volume correlations diverging from strong positive values

all four are currently signaling some potentially new concerns about IL&P emerging in the market. Can it be the aftermath of the Anglo affair? Possible. But how likely is such a scenario given extensive downgrades to IL&P on the back Anglo's news in the past and given that by now the company has been devalued as if it were a pure banking sector play, effectively discounting the insurance side of business to nil (chart below).

Can it be that the markets are becoming aware of some new set of skeletons in IL&P's closets? Also, possible. And, given the scandals surrounding Anglo, Irish Nationwide and other players, somewhat probable as well.

Of course, time will tell for sure, but I would watch IL&P very closely on Monday...

PS: Oh, yes and intraday volatility for IL&P is also moving against the peers:

Anglo Irish Bank Annual Report

http://www.rns-pdf.londonstockexchange.com/rns/6782N_-2009-2-20.pdf

The link to the most wanted publication - the Anglo's annual report for 2008.

Let anyone reading this while posessing knowledge in corporate finance and balance sheet analysis (I have none) comment on this and any other findings relating to the report.

So... guess what? The report is a hog wash, containing no real information on

• the impairments outlook,
  
• the reclassification of the loans,
  
• loans under 'watch'
• roll-overs of loans, and so on.

The IL&P loan/deposit scheme is there for all to see, but what it implies is not. It implies that short of IL&P intervention, Anglo had a negative core capital reserves at the time of the announced guarantee scheme. Do the math: Core Tier 1 Capital for 2008: €5,068mln. Per page 4 of report: "At 30 September 2008 the Group’s balance sheet includes €7.5 billion of short term interbank placements with Irish Life & Permanent plc and €7.3 billion of non-retail customer deposits with Irish Life Assurance plc". Oh, my...

Other notables:

• page 6: Ireland lending up from €37bn in 2007 to €42.8bn in 2008. Given lack of demand for new loans and tight credit finance, is a part of this growth due to the rollover of non-performing loans with interest charges absorbed into 'new' loans? The report says: "In keeping with the Bank’s relationship based banking model, lending activity during the year was targeted solely towards the Bank’s longstanding customer base." Should we read this as 'the long-term developers reclassifying and rolling over loans'?
  
• page 7: Impairment charge on the loan book went from 0.5% in 2007 to 1.31% in 2008. Again, no guidance on future impairment charges, but should we agree with my/analysts numbers produced in December (here), we are looking at 4-5.3% impairment on property-linked loans or 3.5-4.6% on loan book. Some distance to travel yet.
• page 70 §12: total provisions for impairment were up from €149mln in 2007 to €879mln in 2008. Again, applying this dynamic to the 2008 figures and projecting into 2009, expected impairment charge for 2009 should be around 5%. Even assuming away the counterparty risk under the investment securities impairment (which might be unlikely to remain as high in 2009 as in 2008), we have a consolidated projected loan impairment charge for 2009 of 5.1% - higher than my 4.6% moderate risk scenario forecast.
• page 74 §20: serious fall off in financial assets held, with a rise in unlisted financial assets - is this again showing some financial engineering on the existent loans side? Unlisted assets against customers' liabilities up over 10% y-o-y, listed - down by ca 60%... losing the 'house' while accumulating the 'rubble'?
• page 81 §22: serious deterioration in the quality of loans and advances to banks. AAA/AA rateds down by more than 1/2, A rateds up by a factor of 3+. And this is to September 30, 2008, since when things went even further South globally. Ouch...
• page 82 §24: assets available for sale securities are ramped up in 2007 and unwound in 2008, potentially depleting the assets risk cushion? Per table below, one has to have a laugh at the AAA/AA classification of a lion's share of Mortgage Securities and ABS. Take

1. the financial institutions downgrades across Ireland (assume 10% moves to BBB and 20% to A),
   
2. the mortgage securities at 15% negative equity (corresponding to the estimated 120,000 households) to BBB level and
   
3. ABS at 25% (US-level) downgrade to Sub-investment Grade and further 25% downgrade to BBB and

you get: AAA/AA total drops to €5,751mln from €6,742mln in 2008, while BBB and lower rises from €197mln to €579mln. All sub-AA classed available-for-sale assets fall from €1,993mln in 2007 to €1,410mln per Report (despite the fact that the quality of may underlying asset classes has been deteriorating during 2008 worldwide, although, apparently not on Anglo's books), but rises to €2,212mln in 2008 terms under my assumptions. What is more plausible, folks?

• page 84 §25: total loans and advances to customers per Bank itself were up €12.5bn in 2008;
• page 86 §25: Lower quality, but not past due nor impaired loans: up from €363mln in 2007 to €2,736mln in 2008, past due but not impaired: up from €1,621 in 2007 to €1,782mln in 2008, impaired up from €335mln in 2007 to €957mln. In the mean time, satisfactory quality loans amounts moved from €322ml in 2007 to €6,302mln in 2008. So in common parlance terms, Anglo's 'slury' loans creek has swell from ca €2,641mln in 2007 to €11,777mln in 2008, an increase of 359% - all in the year when impairement charge officially went up by only 162%. Now, taking 2008 impairment ratio at this rate of deterioration in the quality of loans implies 2009 impairment charge of 4.5% across the entire book (see the second bullet point above)... Hmmmm, someone is foolin here?
• pages 148-149 show loans to Directors and related parties. No new skeletons here - Sean Fitzpatrick is the only name on the list, with the rest of Directors names missing next to loans amounts. Anglo issued loans against its own shares as underlying collateral guarantee funds, and held no impairment provisions for Directors loans.
• page 150: a small goodie: "During 2008 close family members of Sean FitzPatrick received rental income from the Group of €31,500 (2007: €35,500) in respect of a UK property that, rather than hotels, is actively used to accommodate Group employees working in the UK on a temporary basis. Total future minimum payments under the tenancy agreement are €7,600 (2007: €8,600)." So buy-to-let UK markets are alive and kicking then...
  

Ah, I might as well stop at this point. Let anyone reading this while posessing knowledge in corporate finance and balance sheet analysis (I have none) comment on this and any other findings relating to the report.

I am staying off Anglo case for now, having done more than our wonderous Minister for Finance, who could not be bothered to read the entire PWC report on banks he was generously recapitalizing with the taxpayers' money.