August 3, 2005
Have you ever heard the expression ‘Irish pricing’? It is a new term used in banking circles to describe the fact that Irish banks are offering large corporate borrowers money on much better terms than the British or continental banks.
Irish banks are giving away money.
They are undercutting other banks and slashing margins aggressively to get business. So, in big deals of â‚¬50 million or more, the Irish banks are offering lower interest rates, longer repayment terms and less onerous covenant demands. This is ï¿½Irish pricing’. It is great news for the lender and for the bank that gets the business; it looks good on the balance sheet initially as it boosts the bank’s assets, its projected revenues and its market share.
But it also means that Irish banks are taking more risks than others. To generate the same return, they now have to do bigger deals and lend more money.
So to gain market share, they have to gamble a bit more than they did last year. They are running to stand still and, in the process, the quality of their loan book deteriorates. But when credit is ample, no-one bats an eyelid.
This type of thinking dominated corporate analysis during the tech bubble. Back then, the only thing that mattered was the growth in revenues, rather than the quality, sustainability or, in cases where dodgy accounts were later uncovered, whether the so-called ï¿½business’ existed at all. In the late 1990s, nobody really examined what would happen if trading conditions changed.
We are seeing similar carry-on in Irish banking circles, and it is happening across the board. Irish pricing is not limited to the big guys; the little guys are getting in on the act as well.
On Friday, the Bank of Ireland introduced a 100 per cent 35-year mortgage for first-time buyers – the littlest of the little guys. This move follows the First Active 100 per cent mortgage that was announced two weeks ago.
The bank says that this is necessary, and that most little guys will be able to service the higher borrowings. It has put some fairly cosmetic restrictions on who can qualify, but in reality it is throwing money at anyone who comes through the door.
Rather than making houses more affordable, this type of product simply pushes the price of Irish houses up further, forcing the banks to lend even more cash against the same asset this time next year. Friday’s central bank figures showed more than ï¿½2 billion was extended in mortgage credit in June, the highest ever monthly total.
Let’s examine how the credit system works, how loose credit reinforces the upward pressure on house prices and how the banks ultimately become the slaves, rather than the masters, of the housing monster. It might also be helpful to entertain what could happen and who might pick up the tab when things go pear shaped.
The key to the system is collateral, and this is also where the systemic fault lies. When it comes to collateral, the Irish banks have always had faith in the housing market. In recent years, this faith has intensified to blind faith, and now, with a 100 per cent mortgage culture, we are observing new levels of Moonie-style devotion.
Moonie economics is quite straightforward and it works as follows. Take an average person, doing what thousands of Irish people have done in the past few years – buying an investment property.
The latest figures suggests that as much as 40 per cent of houses sold in Ireland in the past 12 months were either second homes or investment properties, so this is a fairly hefty chunk of the market, and by extension, of the banking business in Ireland.
So in this example, a house worth ï¿½400,000 is used as collateral to borrow ï¿½370,000 to buy another apartment for investment. The extra ï¿½370,000 goes into the system. The golden rule of monetary economics is that the more money in the system, the greater the upward price pressures on all other things.
Thus, the extra cash sloshing around in the system puts upward price pressure on houses, because there is too much money chasing too few houses.
This makes the original collateral now increase in ï¿½value’ to ï¿½400,000. The bank extends another loan on the same collateral, failing to distinguish the chicken from the egg. This is the blurred hazy world of Moonie economics.
It is a state of mind characterised by financial back-slapping and corporate high-fiving, where each new loan begets another and the banks and the borrowers waltz blindly up a financial cul-de-sac.
Back in the real world, the only fundamental reason for house prices to rise is if the income from rent is rising. This is not the case in Ireland.
Rents have been falling, according to the Central Statistics Office for over 18 months now. If the income from the asset is falling relative to the value of the asset, then we have a problem. But because of the enormous amount of credit in the system and the way in which the system reinforces the original loan with another one, real world economics is suspended and moony economics takes over.
Moonie economics is the financial equivalent of a confidence trick. When things are going up, Moonie economics accelerates the upswing. When that confidence is punctured, banks pull in their loans, shut up shop and the opposite of Irish pricing occurs – a credit binge is replaced by a credit crunch.
It was interesting last year to hear one of our most senior bankers musing aloud at a conference about the need for Irish banks to remain under Irish management. He made the distinction between ownership and management – which struck me as highly instructive.
He went on to explain why. He suggested that in the event of a property crash we would need a national plan to prevent a credit crunch. It would be the banking equivalent of the countrywide reaction to foot-and-mouth, where everyone would pull together.
In these circumstances, it would be critical that the government could sit down with the country’s main bankers and cut a deal. In the past, countries like New Zealand that allowed its banking system to be taken over by foreigners found that in its property crash of the early 1990s, the foreign owners simply cut lending limits, which had the effect of exacerbating the original downturn.
In the case where the management is Irish, there would be a much greater sense of the impending disaster, because all of us are tied up in the property game in one way or another, whether it is ourselves, our children or our close friends. Laudable and all as these sentiments are, how would such a plan work?
Think about it. In the event of a crash, Irish banks would see their loan books decimated. This would affect their ratings, their share prices, and ultimately their ability to raise new funds.
We, the public, would be in negative equity territory, so would be both unwilling and unable to borrow.
Traditionally, in such cases, the central bank of the afflicted country would slash interest rates dramatically to kick start borrowing. But we could not do this, as our interest rates are set in Frankfurt and might actually be rising.
Do you think the ECB would cut rates to bail out Ireland -1 per cent of the EU’s population? No, I don’t think so either!
The only thing that we could do is let the state borrow enormously by issuing Irish banking bonds to international investors. This cash could then be given to the crippled banks in the form of a 30-year swap, on the condition that the increased liquidity be squeezed into the system, preventing a credit crunch from taking hold.
But who would pay for this? Well, we would, because a special tax would have to be levied initially to pay the repayments of the bonds until the banks’ balance sheets recovered. It is a scary prospect and one that the 100 per cent 35-year mortgage brokers or the guys involved in ï¿½Irish pricing’ dare not contemplate.
Awhile back I heard one of our most successful bankers musing about national plans, financial war cabinets and credit crunches. And if you know he is worried about the ramifications of Moonie economics, you should be too.