March 23, 2008

We must learn costly lessons of America’s sub-prime debacle

Posted in Banks · 22 comments ·
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Could one of the Irish banks meet the same inglorious fate as Bear Stearns? It’s unlikely, but not out of the question.

Am I the only person to have missed the left turn to Galway north on the M50? With typical disregard for locals, let alone foreigners, the NRA(or whoever is responsible for signage) puts a tiny sign signalling one of the country’s main transport arteries, not 100 metres, not 50 metres, not 10 metres but two metres from the turnoff.

The result is that in all the chaos, muck, trucks and traffic cones, many of us only register the turnoff when we are past it. When I furiously drove on to the toll bridge expecting now to have to pay two tolls in order to get back to theN4,the gentleman in the booth immediately gave me a receipt for the price of the toll, as if this happens all the time.

We must learn costly lessons of America’s sub-prime debacle
23 March 2008 By David McWilliams
Could one of the Irish banks meet the same inglorious fate as Bear Stearns? It’s unlikely, but not out of the question.

Am I the only person to have missed the left turn to Galway north on the M50? With typical disregard for locals, let alone foreigners, the NRA(or whoever is responsible for signage) puts a tiny sign signalling one of the country’s main transport arteries, not 100 metres, not 50 metres, not 10 metres but two metres from the turnoff.

The result is that in all the chaos, muck, trucks and traffic cones, many of us only register the turnoff when we are past it. When I furiously drove on to the toll bridge expecting now to have to pay two tolls in order to get back to theN4,the gentleman in the booth immediately gave me a receipt for the price of the toll, as if this happens all the time.

Why can we not appreciate in this country that the purpose of road signage is to forewarn motorists? Signs are to give us time to react, change lanes and without hassle, arrive at our destination. The better the signage, the easier the drive and every developed road network is furnished with a comprehensive system of such warnings.

However, if drivers chose to ignore these signs, even the best systems can’t help. Now try to think of the financial markets as a similarly sophisticated road network, with millions of people buzzing around, tailgating, swerving, taking shortcuts, but ultimately moving in similar directions with the aim of getting there in time without crashing.

The financial network is full of signs which aim to forewarn and alert investors. There’s a mountain of information, tons of research and limitless opinions. There are websites, newspapers and, of course, television shows which devour financial information and assess what it all means for the market and the investor.

Last week, I was in New York on a book tour, and appeared on a number of business programmes, from CNN to NBC to Bloomberg. The weirdest outing was on the Fox News channel. The vamp presenter – part Ashley Alexandra Dupre, part Abby Joseph Cohen – flirted outrageously with the camera as Bear Stearns went up in flames.

Fox News, being the right-winger’s favourite channel, took the line that the takeover of Bear Stearnsby JP Morgan was unpatriotic because taxpayers’ money had been used to guarantee some of the toxic sub-prime waste on Bear Stearns’ balance sheet. The move, described elsewhere as ‘‘socialism for rich people’’, was seen by Fox as the little people being forced to stump up for the wealthy.

Whether you agree with this assessment or not, the point of these programmes is to give investors other opinions, to analyse, editorialise and, most of all, interpret. These programmes are, yet again, part of the system of signposts which form the roadmap of the financial markets.

Given all these warning systems, no one in their right mind can say that they were taken by surprise by the trauma of the financial markets last week or, indeed, this year. The signs have been everywhere for ages.

In Ireland, we have seen rampant inflation, a current account deficit and a money supply growing at a rate that would make Eva Peron blush. Of course the Irish banks, like their British counterparts, were going to be hammered in such an environment.

Some British banks, which have been positively frugal when compared to their Irish counterparts, may have a right to feel aggrieved at their share price collapse. But our own banking system, which fuelled a credit bubble of monumental proportions, has had this coming for a long time.

We are in the midst of a credit crisis, based on over-lending in a boom that, in our case, was almost totally driven by property. Now that property prices are falling, the underlying banking model is being questioned. When the market re-adjusts, banks – the clear winners on the way up – will be the losers on the way down.

We heard last week that our regulator is investigating the source of rumours which the regulator believes drove down the share price of Irish banks. Well, rumours drive markets. Ever heard the market expression ‘‘buy the rumour, sell the fact’’?

Probably not! Of course there are going to be rumours, particularly when some foreign banks have been so economical with the truth. Just last week, the boss of Bear Stearns was denying that there was any problem when the investment bank was technically bankrupt and couldn’t meet its obligations.

Could one of the Irish banks go the way of Bear Stearns? It looks unlikely, but it is not inconceivable to imagine a scenario where this could be possible. If, for example, the assets on a balance sheet are not liquid and the market is worried about a bank’s deposit base, banks can experience a crisis of confidence. If a bank has not invested in extending its deposit base at the same rate as it has expanded its lending, it will have to plug that gap between deposits and loans by borrowing. As its share price falls, the collateral that it can give for this borrowing falls in value too, making borrowing more expensive.

Now think about what constituted much Irish borrowing during the boom. Banks held property as collateral against original loans. So, instead of cash on its balance sheet, many banks held property. This was fine when property was going up – but now, when it is falling in value and no one wants to touch it, the bank has a financing problem.

When the governor of the Central Bank, John Hurley, came out and said ten days ago that the Irish banking system had no sub-prime debts, he was half-right. Yes, the sub-prime market in Ireland was only taking off last year (when it was bizarrely entitled the ‘‘non-conforming market’’). In a gushing report last year, at the height of the boom and a time when sceptics were being treated as heretics, Davy Stockbrokers suggested that this lending could become a €4 billion market by 2010.This will not happen now. However, it doesn’t mean that banks are off the hook, or that their shares have been dramatically oversold.

The Irish banks probably face a bigger headache than many of their American counterparts. Because the bad debts of the Irish banking system are on the balance sheet, as opposed to repackaged crude off the balance sheet, it will take a much longer period for the banks to work these debts out.

The banks now more resemble the continental or Japanese banks of the early 1990s which were straddled with bad property loans for years.

Whereas the US banks are taking a short sharp shock, where some sub-prime style portfolios which used to be regarded as ‘‘assets’’ are being valued at zero overnight, the Irish banks are in a ‘‘death by a thousand cuts’’ scenario, because the value of their former ‘‘assets is being marked down gradually.

The problem for the Irish banks is that they are being sold as if they had US-style ruptured balance sheets. This normally means the bank’s value collapses but recovers reasonably quickly as lending resumes and the banks take a one-off profit hit. So we can be reasonably confident that their share prices will rebound swiftly. In the Irish case, because it will take years to work through bad property debts, the share prices might not recover robustly for some time.

For the long-term investor, this might not be such a bad thing, as prices are low and things will recover. However, it could be a lengthier adjustment period than even the pessimists considered likely. One thing is certain: this banking crisis should have taken nobody by surprise. Unlike the Galway Road on the M50, the warning signs for a banking calamity were in our faces for years.


  1. John Q. Public

    It all depends at which point the fall in property values settle at.Propping up the market somehow might restore confidence all-round.

  2. Rob

    Propping up the property market is a waste of time and if the Government accedes to this request it will only mean that exchequer funds from the public purse are used in effect to shore up the wealth of the property developers, who have in the last ten years made handsome profits. A very bad and unfair idea. Let the market fall where it will. The developers were bold enough to shout ‘don’t interfere’ when it was on the way up. They can now take the pain of falling prices. And anyway this will be healthy for the economy in the long run.Property prices return to reasonable levels and people particularly first-time buyers will return to the market. Today on a radio discussion one contributor suggested that there was evidence that some property prices have fallen by 20 per cent.

  3. The 1st three paragraphs are repeated, looks like ye goofed on the copy’n'paste? As always a good article. The regulators hands are tied by the politicians who only act when they must, and not when they should.

  4. VincentH

    In many states, traffic signs are at best advisory, their clarity and quality may hold only the vaguest acquaintance to the driving standard, Rome esp’ springs to mind, while Paris, I remember before the auto-routes on the east connected. In Ireland, we put in place an instruction to the Counties sometime between ’39-45, which has yet to be rescinded. You should think yourself lucky that there was a sign and that your trip in the direction to Galway was not via St Oliver’s’ head.
    The sub-prime issue is named in the way that the financial markets handles terms. Somewhat like your sign. First time buyers is what we call it.

  5. Dan Hayes

    People (financial speculators as well as motorists) ignoring signs – fast backwards to early 17th century Holland and its Tulip Mania. Does it ring a bell? It should!

    How come the human lemmings never learn? Chalk it up to the Human Condition!

  6. David, mention of you in the Boston Hearld.

  7. Damn! Your comment box, didn’t like me trying to create a link, Here’s the URI:
    http://www.bostonherald.com/business/general/view.bg?articleid=1082406

    Goddamnit! I am not a Bono Boomer!
    http://www.davidmcwilliams.ie/the-quiz

    :)

  8. Dan Hayes

    The signs were also all there in the early 17th Century in Holland’s Tulip Mania. But who pays attention to signs when herd mentality reigns!

    Then as now the human lemmings went over the cliff. Chalk it up to the Human Condition!

  9. Bob

    You omit to say that the US Banks are going through their own “death by a thousand cuts”, except in their case its death by 3 or 4 cuts, and the markets aren’t sure which is the last (or the deepest, Cat Stevens/Sheryl Crow, where are you now…)

  10. Nick

    Can anyone point me in the web direction of general housing supply / demand and vacancy rates for the greater Dublin area?

    Reason I ask is that I am constantly being told by Irish people that there is huge demand and scarcity of supply of housing in Ireland and Dublin. Is this the case? Facts pls !

  11. Nick

    Anyone got any comments or thoughts on what is happening in Iceland? Just curious.

  12. Rob

    Nick,

    there is presently about 10,000 units unsold in Ireland, this is according to a recent report that the media got their hands on from estate agents that was discussed on radio at the weekend. I’m sorry I can’t be more specific but maybe someone out has a link to it? There is a demand for housing all right BUT at the right price. Banks are being more careful with their cash and buyers are wary so the market is a currently stalled/barely moving. It is reckoned that another drop down maybe another 10 per cent will see the market move again. In addition the available units are not necessarily in the rights areas or involve a long commuting distance (no thanks!). A recent dev of swanky apts in clontarf sold v quickly proving the old adage of location etc. right again.
    We were building 80,000 plus units a year and apparently this has halved. This level of activity was unsustainable….

  13. Garry

    Nick, I dont think there are rock solid sources, If you are looking for data, have a look at thepropertypin.com, theres data there but sentiment is negative though, as with everything you’ll need to draw your own conclusions…

    Iceland? small country appearing in the financhial press, never a good sign.

  14. Nostromartus

    Irish banks may not go under but they will certainly be a lot more nervous about who they make loans to. American small businesses are already feeling the pinch finding it difficult to get loans to expand, if we are about a year behind America shouldn’t we start looking at ways to incubate new Irish businesses to protect them from the effects of the credit crunch. A lot of larger developments are going to start to grind to a halt and speculators who bought city centre properties for future development or resale will now sit on these investments until the market picks up again which could be five years from now, these derelict sites and empty premises could exacerbate the severity of the downtown. With little or no investment financially or creatively in irish small businesses mainly because property investment soaked up all the investment capital as David has pointed out there is nothing going on here outside of the multinationals. New powers to mayors may be too little too late what we really need is legislation to reduce the time it takes for compulsory purchase orders to seize these properties and recirculate them back into the market as quickly as possible. At the moment it takes about three years for a compulsory purchase order to go through, I think this should be reduced to six months and in some cases they should have immediate effect. Instead of nationalising the banks or giving the developers more tax concessions the government should take a “use it or lose it attitude” purchasing the properties below market value from the banks or developers that find themselves crunched by the credit crunch. The second stage of building a real economy would be rent or allow small businesses use these premises free of charge to protect them from crippling start-up costs, with some provisoes like the business owners have to live in the flats above the premises to reduce traffic into the city and for insurance reasons. It doesn’t matter if it’s a hippie selling pottery as long as they make some income out of the enterprise. Preferably it would be software developers competing with their former employers but the new focus should be on adapting to the new environment, broadband and other services only exist in the cities, banishing start-ups to industrial estates, hubs or villages that might get connected to broadband in 2020 is handicapping them before they have a chance to compete. I believe these compulsory puchase orders are a necessary tool as pragmatism has deserted the market in favour of an almost religious belief that the property market will be resurrected ,despite seeing the slow crucifiction of property owners in the U.S. leading to a relatively swift stoning of Bear Stearns every Irish property owner believes their house key is the key to the pearly gates and the kingdom of heaven.

    I had the opportunity in 2003 to show some practical skills to post-grads in university, it was then I knew the Irish economy was doomed, despite what we may want to believe there was a complete lack of initiative among the students whose attitude was that they had to have detailed instructions to do anything. They were mature students most of whom were rotating back through the university after a short span working in a multinational, their only interest was in being a cog in a multinational machine, the concept of starting their own business was madness in their eyes as they simply had never know anything other than well paid secure employment in a large company. If entrepreneurship isn’t made more attractive to this generation and more importantly their redundancy money from the fleeing american companies we are going to end up with a generation of perpetual students waiting for the return of “good jobs”, the reason degrees are less valuable is because largely the universities have become creches who advertise education as a lifestyle choice. I’m not suggesting education isn’t the path to a better career, but that experience has value and so does common sense, just like the glut of IT professionals who couldn’t get employed in 2003 we will now have a glut of trainee solicitors and estate agents for whom I have no sympathy, who will rotate back into university looking for new careers. In the current world economic environment this isn’t a gamble it’s the path to certain failure and a waste of resources they could use to have a one in ten chance as a small business, they won’t have anything like the lifestyle they’ve become accustomed to but with a world economic slowdown they can’t emigrate without losing money on property and are unlikely to find better paid jobs abroad. I’m sure there are quite a few Irish people who relocated to spain and elsewhere who will tell tales of nightmares rather than living the dream on their return to Ireland.

    For those living in Dublin apartments suffering from rent hikes I do have sympathy, but from what I hear from the decentralised they have no intention of selling, they now rent to relatives or friends who are effectively nightwatchmen who pay whatever they can towards the mortgage. The majority of those decentralised bought so long ago they would still make a profit selling 20-30% below 2006 prices but they now see that as a loss and want to keep a foothold in Dublin where their social life is based.

    In the past few years I used to walk through new estates with friends to try to figure out which houses were not selling and therefore which ones were motivated sellers, that’s pretty pointless now as many developers and
    owners take houses that arn’t selling off the market and leave them empty, instead I’ve been checking out various pubs in the suburbs and hotels to try to find out how the people in these new estates are surviving, these pubs many of which are modeled on super pubs are slick expensive looking and completely empty. I had assumed in the past that these pubs were the reason for the donut effect emptying city centre pubs but they don’t seem to be doing any better, pubs may seem like a stereotypical barometer of the irish economy but even taking the off-license rebellion into account spending seems to have stopped dead at least in this area. People will always gravitate to pubs with lots of other people, so they’ll walk in and out of empty pubs until they find one with a bit of life but that leaves all the others empty. My weapon of choice as the barometer of the Irish economy is a four star hotel in the centre of a major city I recently visited that could have doubled as the set for a remake of “the shining”. In the bar itself there were a couple of people having a drink, but when I ventured looking for a bathroom getting lost along the way I found the lounge area completely empty and realised I hadn’t seen anyone on my travels. Weeks before we had visited the bar of another four star hotel where a handfull of loud Americans complained not only couldn’t they find their way around or find public transport but they couldn’t find any Irish people in the city. This is how the government propped up the construction industry the last time with tax incentives to build empty generic hotels in which your pension is probably invested. Tourists will find more Irish people in a generic hotel in Dubai than Ireland and pay a fraction of the price of a trip to Ireland for the privilege. Apart from maybe Dublin after 6pm Irish cities empty becoming ghost towns and lifeless, If you want to see real waste visit any of the white elephants built with tax incentives and ask yourself could a start-up company do much worse. I voted labour in the last election to try and prevent what Cowen did with stamp duty, I believe they will continue with this mindset with some wasteful mortgage relief that will drag out a downturn.The link below is visual aid.
    http://www.youtube.com/watch?v=sMZwZiU0kKs

  15. Paul

    “I had the opportunity in 2003 to show some practical skills to post-grads in university, it was then I knew the Irish economy was doomed, despite what we may want to believe there was a complete lack of initiative among the students whose attitude was that they had to have detailed instructions to do anything.”

    I was speaking with a teacher about this same topic recently, she was showing me how teenagers are walked through the leaving cert, and are giving all the help possible, in order to pass, so they are not only mollycoddled at home, they are now pampered when they goto school in the morning.

  16. AndrewGMooney

    Excellent article linking The Financial Markets to Irish Road Signage- given the newspapers reports on Irish driving standards I read whilst in Dublin!

    http://www.independent.ie/national-news/no-fear-factor-as-87pc-of-truckers-break-speed-limits-1321172.html

    Substitute crazy truckers for property investors and you have a useful way of understanding Ireland’s economic situation. It doesn’t matter what ‘safety’ or ‘direction’ signs the road planners or ‘financial regulators’ provide if the driver/investor ignores them. At some stage there will be an almighty smash/crash with a tail-back/log-jam lasting for however long it takes to get the wounded to hospital and give the dead a decent burial. It doesn’t matter if it’s driving like Patrick Kielty or managing consumer credit like the Irish Banks: Sometimes people just have to ‘go through the pain barrier’ and come to a complete stop. Deceleration causes as many problems as acceleration. Inflation/Deflation/Stagnation. Let’s wait and see.

  17. Steve

    Nice little summary:

    Bubbles occur when speculators drive asset prices
    far above their intrinsic value. The collapse of a
    bubble is frequently accompanied by an economic crisis.
    Who gets the blame for this crisis? Not the bulls, who
    were responsible for the bubble and the various frauds
    and manipulations perpetrated to keep shares high, while
    cashing in their profits.

    No, it is invariably the bears who are blamed for the
    post-bubble crises and are the main objects of anti-
    speculative legislation. Yet during the bubble periods
    it is the bears who are generally the lone voice of
    reason, warning people of the folly of investing in
    overpriced markets. In the aftermath of a bubble, they
    continue their forensic work of exposing unsound
    securities and bringing prices back in line with
    intrinsic values, a point which must be reached before
    the recovery can start.

    from http://www.dailyreckoning.com/Issues/2001/110201.html
    (quoted on marketwatch.com)

  18. Nostromartus

    Luckily I wrote my insane rant before seeing this
    http://www.rte.ie/news/2008/0327/collison.html
    It always seems smaller when I’m furiously typing it out.

  19. RB

    Many friends of mine who have bought houses and aquired hefty mortgages over the past five or six years have had to illegally inflate their wages so that they would qualify …
    One close friend of mine got a mortgage only because she was mates with a bank manager.. Can she afford her mortgage ? No.. But with a bit of fiddling here and there, on paper it looked like she could… She has a little house now, but she lives on beans on toast and eats through her credit card too..
    My sister is buying this year, I tried to tell her she is mad to buy now, but she doesn’t want to listen..She has also had to fiddle with her true wage, and through a broker she managed to get a mortgage for a 2 bed apartment off the plans .. she will have to come up with 1200 euro a month.. Can she afford it ? .. No…
    I sometimes wonder how prevalent this type of thing is?..

    If it’s as common as it seems to be , there is going to be a lot of people in negative equity over the next few years..

  20. coldblow

    Nostramartus, your feedback about decentralizers hanging on to their houses in Dublin is interesting. I wonder will many of them now get cold feet and pull out of decentralization altogether? I remember David talking about a 40% fall over a few years in real terms – with inflation factored in that means you still sell at the same nominal price and you can kid yourself you haven’t lost out. I suppose the best option for anyone who has to move is to take it on the chin, stump up the stamp duty and “get over it”. (Or is it?)

    I regret the way the whole housing “market” has evolved. I can still clearly remember the evening my friends started talking about “property”. And the day I was told that it was the only way “people like us” would ever make any money. Those tv programmes my wife watches don’t help either. I wonder is the breeze blocks and mortar thing a result of the insecurity of tenure of the bad old days. If I wasn’t fortunate to own my own modest place I’d certainly have more than a vague feeling that I could be out on my ear – Naipaul’s “A House for Mr Biswas” still resonates with many.

  21. Nostramartus

    Coldblow,
    David covers this better than me in his latest article

    As far as the property market goes the decentralized are a drop in the ocean but it was interesting for me to see a guy adamant decentralization was unworkable ending up moving and unable or unwilling to sell an apartment in the centre of Dublin. In 2006 I argued the benefits of decentralization to him , his brother and their friends all employed in the public service and all convinced only rinky-dink admin jobs and departments would be moved out of the capital. In 2007 he wouldn’t move to a village in the middle of nowhere but in 2008 he got a job in another city in his paygrade, but as we all know the property market has moved on. The value of his apartment has doubled since he bought it, but that’s a double edged sword because the owner occupiers in his building moved up the property ladder into houses in the suburbs, they kept these apartments as cash cows. Three apartments out of eighty spent 2007 up for sale, one dropped his price a dramatic 30% and still received few viewings,as chairman of the tenants association (meaningless title in Ireland) my friend’s noticed a sharp drop in interest in meetings mainly because all the apartments are now rented, trying to resolve any issue is impossible since the owners now living in the suburbs are only interested in maximum rents to pay their inflating mortgages, broken hall lights and intercoms are all things that can be fixed in 2009. According to the hype peddlers 2009 is when the economy will grow again lifting property values, David used the psychology of the school disco in the past to describe the housing market, but in this building it was clear once the first three sellers who had to sell were rejected no one else was willing to take the walk of shame, they instead would take the pain for a couple of years to realize the profit they could have made in 2006 because now they needed it to negate the negative equity on their houses in the suburbs. Both public and private workers are playing a waiting game because they believe Dublin properties will hold their value and even if they have to move for work now to different parts of the country they may in the future end up back in Dublin. They are willing to drop rents for friends and relatives because it effectively remains a foothold for them in Dublin and even I don’t believe property prices for a flat in the centre of Dublin will drop 50%, but his collegues in the public service aren’t as lucky, they moved down the country testing the water renting, keeping their houses in Dublin in case as they believe that’s where the good jobs would stay and they’d be transferred back within a few years. The decentralized in particular should take a “FALL OF SAIGON” attitude as they are the only ones with salaries their helicopters to get out while they still can.

    I think it’s all about location and at which point in the boom you bought, my friend can afford to take the chance and as soon as he can I think he should sell, his friends with houses are screwed. Right now amazingly people are still getting sucked in with flashy sales techniques and show houses, their properties define them as people, older stock won’t sell at any price for cosmetic reasons. I know a girl who worked in Human resources for a multi-national who’s job it was to organise college courses for employees, the company paid for the course if necessary and were flexible about time off, when they pulled out of Ireland many of the qualifications were worthless as they were specific to computer manufacturing. She now works for a retail company where one of her first duties was to tell staff the company would no longer pay for tea bags and they’d have to bring their own, she commutes all around the country but her husband is based in Dublin and so is their property portfolio, she still hopes and needs to get a job in Dublin at the salary only a large multinational would pay to maintain their multiple mortgages,as far as I know all their properties have tenants but even cutting back their spending, wages stagnate while inflation increases and they slowly slide in to large debts on everything. The decentralized lose out in property or break even but keep the salary they need to pay a new mortgage, this is their parachute and soft landing out of the capital, construction and multinational employees end up if lucky in relatively poorly paid retail jobs which means they lose their homes and investments ending up in negative equity they’ll struggle to repay , they can’t sell one property now to relieve the pressure as new buyers are being sucked up by new developments.

    The attitude of most people is follow the crowd , their mantra is see no evil, hear no evil , speak no evil, it’s only when you ask them direct questions you realize they’ve been keeping up appearances. With so much to lose they still believe it’s only those with 100% mortgages that are in trouble and since everyone they know is in the same position the bank can’t repossess everyone’s house, the government will simply have to step in with the stamp duty money they originally paid to bail them all out. When guys who got 560 points in their leaving are all parroting the same thing I have to wonder is this possible, with fianna fail in government anything is possible but putting such a large bet on the line makes it collective madness

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