June 4, 2008

Vultures will be circling over our banking disaster

Posted in Banks · 24 comments ·

The idea that yesterday’s collapse in Irish banking shares comes as a shock to the markets is nonsense. Anyone with a basic knowledge of how economies work should understand that banks get hammered when housing markets go into reverse.

The banks, by lending recklessly in the boom, will now bear the brunt of the slump. Whether their shares fall further might depend on international sentiment. However, it is clear that the financial market thinks the aggregate balance sheet of the Irish banking sector is in tatters.

During the boom, anyone who questioned the logic of betting the nation’s cash on the housing market was dismissed as a crank.

Now it is becoming apparent that the banks in Ireland ceased being banks some year ago and transformed themselves into leveraged gamblers on property.

The Irish banks morphed into hedge funds that bet one way on property. Today, when their darling asset is no longer rising but falling, we realise that the top managers of our banks were nothing more than bull market traders.

So, rather than being the guardians of prudence, the Irish banks became the agents of profligacy.

As long as house prices were going up, the balance sheet of the bank played tricks on the bankers.

Because banks use a ‘loan-to- value approach to assessing whether a loan is risky, the banks got caught in a situation where their balance sheets were deceiving them.

The central problem with the loan-to-value approach is that the loan actually drives the value, not vice versa, as the theory would suggest.

Let’s think about a bank lending €300,000 to a punter to buy a house that is “worth” €350,000. As long as the value on the bank’s books of the asset is greater than amount lent, the loan looked prudent. But if everyone is lending, the price of all houses will go up and the value side of the ‘loan-to-value’ will rise too. So that ultimately the loans are causing the value to go up.

This means that the collateral that the banks are basing their lending on is progressively becoming debased.

This process ultimately turns into a Ponzi scheme, where the entire system is based on getting more and more people to borrow money so that the valuations can be sustained.

Now that this has been exposed, the banks are in serious trouble. They are calling in loans all over the place and have dramatically changed their lending practices.

As many banks have stopped lending to each other, they have to go to the market to borrow. So in the UK, Bradford and Bingley — one of the champions of the buy to let Ponzi scheme — has had to issue shares, hoping to raise money to make sure that its balance sheet is credible. However, the news from the UK in the past 24 hours was that the bank could not raise the cash easily as investors were worried.

Many market watchers believe that the Irish banks — that have been playing the same games as Bradford and Bingley — are probably in a similar position.

So their shares have been sold off. If things are as bad as the market thinks, what is the likely upshot?

Here is where the EU, the Lisbon Treaty and, more particularly EMU, come in. Traditionally in a credit crunch of this type, the national central bank bails out the commercial banks by making loans to them.

The central bank takes IOUs from the commercial banks, prints money in exchange for the IOUs and the banks begin to rebuild their balance sheets.

In addition, in order to entice people to lend, the central bank also cuts interest rates. Gradually, people begin to borrow a bit more, banks begin to lend a bit more and the objective is to prevent making “a drama out of a crisis”.

We in Ireland are now in the unfortunate position of not being able to do this. Because of EMU, we can’t change our interest rates and nor can our central bank give preferential treatment to our banks. We are in effect an economy with no economic tools at our disposal.

This dilemma is made worse by newspaper headlines that the IMF is advising the ECB not to cut interest rates but to raise them in the face of higher European and global inflation pressure.

So instead of getting lower interest rates — which is exactly what our banks need — we might actually get higher rates.

If this occurs, the downturn in Ireland will get considerably worse, not because the actual effect such an interest rates hike would have, but because of the psychological effect it would have on people.

Only then would people realise the extent of the financial cul de sac we have waltzed ourselves up.

Given that this appears to be the type of scenario that the financial markets are betting on, what is the likely endgame for the Irish banks and the Irish credit market in general?

It is clear that with the evaporation of credit, house prices will fall further — there is simply nothing there to keep them up.

This will make things worse as the banks’ balance sheets will be even weaker. At this stage, the banks will need someone to lend them money and lots of it.

However, why would someone lend a bank some money when you can buy the whole thing?

But who would buy an Irish bank? The only people who have money now are the Arabs and the Russians.

The sovereign wealth funds of the Arab oil producers and the Russian Republic are constantly looking around the world for distressed assets.

With all this talk about the EU Treaty, someone has forgotten to tell us that because of exploding oil revenues, the real monetary power has shifted from Brussels to Bahrain and from Paris to St Petersburg.

Forget the rhetoric of the ‘Yes’ and the ‘No’ campaigns, the next big financial and economic development in Ireland is likely to come from much further afield.

Don’t be surprised if one of the upshots of our so-called economic miracle is an oil sheik or a gas oligarch running our banking system.

  1. Dermot

    I heard you yesterday on Matt Cooper discussing this possible scenario, which I’d have to agree is likely. Imagine if Roman Abromovich decided AIB might be more “fun” than Chelsea! I’d be interested in hearing what your thoughts are on the Lisbon Treaty, as no doubt you’ll have a unique take on that too.

    Keep up the good work

  2. VincentH

    Well, they can’t make more of a hash out of it, than the existing lot.

  3. Alex

    I don’t know anything about Saudi sheikhs (but as far as know this type of business is forbidden by Islam) — but I know very well what Russians are going to do.
    Putin has declared few times that main targets in Europe must be gas pipes and gas distributors (Gazprom will be here soon). From other type business – Russia can be interested in few strategic companies such as Airbus or oil industry equipment manufacturers. Bit nothing else — it is regularly published in Russian newspapers. And future EU-Russia talks will be only about this.

    EU want to have access to Russian oil, but ready to give instead only visa-free travel, Russia wants to have access to gas infrastructure without giving full control to EU.

    I simply don’t see any reason to buy banks, which at current situation are only capable to generate loss. To get money for investments — oil is more reliable source. To get respect and popularity (as Abramovich did from Chelsea deal) — I don’t think that AIB has a strong team of supporter, which know name of top-management.

    But the rest of article is brilliant and I fully agree with David explanation situation with banks.


  4. B

    Well at least we can adjust…no, wait, we got rid of that. Or maybe we could…no thats gone too.

    Someone else is driving the Irish bus now and all we can do is watch.

    For all the talk of nationalism and nationhood we gave away the controls very easily and pretty much as soon as someone asked. We got rid of our currency and our economic controls. Why not ditch the pesky democracy we have and the dump our sovreignty. And then we can all go back to buying apartments in Bulgaria “with HUUUUGE rental potential”.

    We have a population of over extended borrowers who have no knowledge or fear of borrowing money. Ah sure its only four hundred grand. Like they would find it in a rummage behind the sofa.

    AIB was bailed out by the taxpayer before when they got indigestion after eating Insurance Coropration of Ireland. This time I hope they go down in flames and are not bailed out by us yet again.

  5. Paul

    Sure the Irish banks have lost billions betting on the UK property market alone, so they are easy pickings for anyone who wants to “be the bank”.

  6. Garry

    Does it really matter if banks which were Irish are foreign owned? Personally, I don’t care if its some f***er in Ballsbridge. Siberia or Dubai who is running AIB or BOI.

    What difference will it make to Ireland Inc or even to the man in the street who owes them money? Surely with the EU, if we don’t like the new owners we’ll be able to move our business elsewhere.

    I am much more concerned at our dependence on the Arabs and Russians for our energy needs. Right now they cant force me to take out a loan and become a debt slave. But they can up the price of diesel and we can do shag all about it. And as you have admitted in your article, thats the real source of their power.

    But should I care about our banks and if so why?

  7. Have I read the irish news right today.?
    Bank of Ireland have sold 23% of the company to an american distressed asset investor for 55 cents per share!!
    They are still on the market around 7.50 Euros as I write. Is it bail out time again for AIB and BofI-or has empty coffers Cowan already turned them down.
    Incredibly they have been busy, as David says, operating the same Ponzi con in England.!
    They deserve a favor from Fianna Fail, as they helped their backers/developers grow obscenely wealthy during the past decade.
    “When the rich wage war,it´s the poor who die” (Jean Paul Sartre)
    (When the great housing rip off is over, ditto.)

  8. Malcolm McClure

    Bertie proved yet again that he is the most cunning of them all by resigning when he did. Perhaps we should pressgang him to head up the B of I to clear up this mess.
    Best advice in the meantime is to hold currencies such as the Singapore dollar, Taiwanese dollar and Hong Kong dollar, invite Chinese and Indian banks to open branches in Ireland and shift our accounts to those foreign banks whose home currencies are still appreciating against the dollar.

  9. Somebody I know has just agreed to buy a small (pre-owned) house that was on the market (in Dublin)for 360,000 euros but deals fell through a number of times in the last two years for one reason or another.
    Apparently the owner is now anxious to sell.
    The new sale agreed price is 285,000 Euros!
    A sign of the times?

  10. walnut

    I believe what we are seeing now is payback for the all the greed, incompentence, hubris and inefficiency of the Irish (not just builders or bankers) over the past decade: this payback is entirely justified, wherever the downturn may take us. A sense of entitlement has permeated deep into the consciousness of us all and needs to be purged out!

  11. Alex

    John mcDermott said,

    >A sign of the times?

    Yes, market is in PANIC stage, when everybody is looking only for negative information and all positive signs are ignored. It is normal for this type of crisis and it is nothing unusual that at this stage psychology is driving market, rather then economic.

  12. michael cummins

    Trying to kick start the economy after a recession is going to take several years.Consumers’ are indebted like never before and Ireland has lost control of it’s monetary policy.Just think what would have happened in 1992 if Ireland and Britain were unable to allow their currencies’ depreciate and cut interest rates simultaneously.The euro will prove to be a disaster and has caused enough damage already.

  13. Philip

    The psychological damage is the big worry. The issues of who owns what banks or who gets their comeuppance is actually beside the point. Indeed, the issue of the Lisbon treaty or the likely inflexibility it may impose upon us is also irrelevant. Constraints and Opportunities go hand in hand.

    The last thing needed is decision making in a panic. A big NO vote coming down the line for a lot of crackpot reasons is scary particulary when you see the ones promoting the NOs. Its good old carmelites in one hand and votes in the other. Do we need to see that nonsense ever again?

    The “told you so” aspect of these excellent articles needs to change tack. Focus on opportunities. Bertie and his gambling habit plus this nonsense needs to be put in the proper context. i.e. a positive learning exercise for this nation.

    Now let’s move on.

  14. b

    I understand the desire to “move on”.

    Can the exact way this can happen please be explained to me with the most productive part of the economy shackled to 30-35 year mortgages and thus unable to move towards economic opportunity?

  15. SpinstaSista

    Carmelites or armalites? Militant monks aside the pen is mightier than the sword, and a long-dead family neighbour who had been around for two world wars used to say “Europe will go to war again, not with guns and bombs but with the pen!”

  16. shtove

    David, are you arguing for the losses on bad loans to be covered by the taxpayer? For a public bail-out of bank shareholders and reckless debtors?

    Are you arguing for the debasement of the currency in the face of price inflation? For systematic theft from those who work for a living and save for the future?

    Let them fail – banks and borrowers. Otherwise, you might as well argue for a communist manifesto: central planning for the central few.

  17. Philip

    The credit crunch is doing serious damage to FDI. Local indigenous stuff will not be able to take up the slack. And we have the indebtedness of many of the 20-30 and possibly 40 year olds. And I see Citycorp have issued a sell recommendation on BoI and Anglo Irish. And Interest rates and energy costs are ramping. So we are in doo doo.

    Moving on for me means: less blaming and more “OK…Now what are we going to do about it”. Because really, from a comparative point of view, we are living better than 10 or 20 years ago. I would like to see a stronger community backbone and better social partnership arising from this and a more imformed view of how to manage the EU and future FDI.

    The game has changed abruptly – globally. This is a time of opportunity. I just need someone to turn on the lights a bit more in this time of panic.

  18. b

    The credit crunch was called at least a year back. Actually I think it was fairly obvious that contrary to popular belief that boom-bust ecomonics had not ended and in the words of any pilot what goes up must do the most natural thing to it.

    I work in the private sector and am writing this on a broadband connection that took 5 years to turn up. We can now expand. We pleaded with the powers that be to get this connection and now that it is in we may be able to double the workforce. The business is there but we were not able to serve it. We work in a major bit of regional infrastructure that politicians would be very fast to come down and cut the ribbon on at the drop of a hat. For big things. But for small things and small developments they give us the two fingers.

    We need to get away from the crack pipe that is FDI and have more faith and support for local entrepreneurship. We invest more in America than they do in us. We need to get rid of the begging bowl and betting on the same lame old horse.

    Unless you are taoiseach that doesn’t prove any benefit to us.

  19. b

    I may be a crank but I am in my 30s. I do not own a home. I do not have any debt. Whatever goes on the card goes off at the end of the month.

    I have small interests in a few businesses and I don’t get a whole lot out now from these but I hope that by enabling employment I can in the future gain some benefit from this.

    It is a concious decision and I am OK with the risk and I know it is not for everyone but if enough people take the risk they can employ the people that don’t want the risk.

    Credit crunch or no credit crunch we have to move on.

  20. Philip

    Well B, yours is the profile we need more of. I think in times like this, more will start to get going just like you. It’ll take time.

  21. Ed

    b, hang in there, you won’t regret it – if only more would follow your example, we’d have a great country.

  22. aidan

    I think job losses in banks and financial services are next on the cards, the smug consensus that construction and manufacturing will bear the brunt of this will be proved wrong, i think the banks have held off on this so far as they believe the bad publicity of job losses would outweigh the benefits, however the more the share prices drop the more the need to improve efficiency takes precedence the same as in any struggling industry

  23. Frank in NYC

    Mortgages were priced at interest rates very close to “the risk free rate” while having some characteristics that make them equity-like. This makes the reported “bad debt” by the banks look much more benign than they are.

    Consider this from the Irish Independent:

    “Banks insist increase in bad debt is just marginal
    Tuesday June 10 2008

    THE level of bad debt in Ireland is on the rise in the current economic downturn, but leading banks insist the increase is only marginal and from historically low levels.”


    While mortgage costs have been creeping up, house repossessions by financial institutions and mortgage arrears remain very low.

    The Financial Regulator has said that, under its statutory Consumer Protection Code, lenders must assist a borrower in difficulty with repayments and help them manage their debts, and only turn to the courts to repossess a property as a final option.”

    So in other words, don’t exercise the usual lender rights when the loan defaults.

    This is similar to what is happening in the corporate debt market. The covenant light “cov-lite” loans the investment banks are holding basically gave the private equity controlled corporate borrowers all the power and the lenders none!

    The market has finally seen through this insanity via a pummeling of bank shares.

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