June 22, 2008
The Central Bank must move, as the Fed did in the US, to prop up Irish banks before a major catastrophe.
Ireland is now going into the early stages of a classic bad debt cycle. While many are still talking about the credit crunch, the crunch is only a mild forerunner of the greater challenge.
When one bad debt begets another, the financial system falls victim to a contagious spread of bad or unpaid debts. This is a bad debt cycle.
As people stop paying back, trust disappears and the collateral demanded to cover the risk of any new loans rises. This tightening causes liquidity to dry up, making bad debts worse. Because the financial system is based on people paying back the cash they owe, if a sufficient amount of people begin to default, the system seizes up.
The banks – as the lubricants of this engine – are the first ones to suffer. In the past few months. we have seen the unsustainable. situation where the maniacally overstretched Irish banks, have been compelled to borrow money at higher interest rates than they can lend it. If they raise commercial rates, whatever limp demand there is out there will be snuffed out.
The effect of this financial brace is to send bank shares plummeting. It is now becoming clear that Irish banks are run by bull market traders, who took enormous risks with shareholders’ capital in recent years.
When the dust settles there needs to be widespread culling of the top brass in the Irish financial industry as they have been exposed as reckless, even predatory lenders.
In this they were aided and abetted by scores of middlemen at our mortgage brokers and estate agents. They should count themselves lucky if they just face losing their jobs. In the US the FBI has been rounding up bankers and estate agents who are now due to face criminal charges over sharp practice in the property boom.
In Ireland, as we have suggested many times, the positive contagion of the past few years has naturally given way to negative contagion. Now everyone is scrambling for cash only to realise that the trough is dry. So while our banks’ quarterly results might suggest that they made good money in the past months – that was yesterday before today’s reality dawned.
It is quite clear that the Irish banks will need to raise substantial amounts of cash in the next few months. The reason is simple: no matter how the banks’ management try to spin things, construction and property apart, there was precious else going on in the Irish financial sector.
Last year, 83 cent in every one euro borrowed was going into either property or property related investments. In addition, in summer 2007 close to half all money being lent by the Irish banks was being borrowed by the banks abroad and injected into our bloated bubble. Our banks turned themselves into little more than leveraged, out-of-control hedge funds that speculated on property.
Now this strategy — which was based much more on raising their share prices than building a proper banking business – is unravelling and the bad debt cycle is taking over.
We can feel it everywhere. As credit in our economy dries up, the stories of payment defaults and bounced cheques are getting more and more commonplace.
The other day a businessman friend, who is owed a substantial amount of money from a well-known developer, was told he’d be paid ‘‘in apartments’’. When he suggested he didn’t particularly want to own apartments as he had to pay his debts in cash and wanted cash not half-constructed shells, he was told ‘‘you’ll get apartments or you’ll get fuck all!
Similarly a banker told me this week that the greed of the past five years is now putting huge stress on the system. During the boom, people didn’t want to sell anything to finance new purchases and nor did the banks care because they, too, believed the hype. Rather than selling assets to buy more stuff, people simply borrowed against the value of their existing holdings.
This financial extravagance is creating a massive dilemma, because as prices start to fall, the banks are looking for more interest rate cover on the ‘margin’ needed to cover their loans. The situation was well summed up by a prominent liquidator recently who observed that ‘‘the quality and reputation of our clients is improving by the day’’. You’re getting a better class of bankrupt these days.
The bad debt cycle leads progressively towards a countrywide, fire sale, where sellers have to sell at prices way below their original purchase price. We are talking negative equity on a monumental scale.
This the next phase of the bad debt cycle is termed the ‘‘distressed phase. In this stage, asset prices fall precipitously and banks need to make huge write-offs against these bad loans.
Rather smugly and with typical self-delusion, the Irish banking sector has looked across the Atlantic and claimed: ‘‘Well, we don’t have sub-prime mortgages, so things won’t get that bad here. Unlike the US mortgage banks, the Irish banks have not re-packaged their mortgages and sold them on to snake oil salesmen in Prada.”
But this actually makes the situation worse. An on-balance sheet bad debt cycle will take longer there to unravel. When your debts are off balance sheet – as they were in the US – you take one large big hit, but as these debts were off balance sheet, your ability to lend is unimpaired.
On the other hand, if like the Irish banks, the debts are on the balance sheet, it takes much longer to work them through. In the early 1990s, the Swiss banking system went through something similar following a housing bust in Switzerland and it took the mighty Swiss banks five years to recover.
Now let’s look at our financial options. We can sit back and take this, allow the bad debt cycle to lead to distressed selling and facilitate global vulture funds to pick off the corpse of the Irish property boom. This is what happens in the US when individual states have property crises.
However, Ireland is, as we were reminded last week, a vibrant, independent democracy with its own agenda. Whatever the economics of monetary union might conclude, politically, we are not a client state of the United States of Europe, not yet anyway. So we need an inventive central bank that has the vision to realise that Dame Street has the solution to Ireland’s bad debt crisis.
We can’t change our interest rates. However, the Central Bank can inject huge amounts of cash without changing the interest rate – if it is prepared to take a risk on commercial banks’ shares. It is now time for the Central Bank to organises a massive sale and repurchase arrangement with Ireland top five banks.
The Central Bank would lease the shares of the Irish banks for a rolling three-month period, in exchange for euro. This would give the banks the cash they need, it would put a floor on where bank shares could fall and it would allow the balance sheet of the country to be rebuilt.
This is what the Federal Reserve has been doing since last January. Not only that but the Fed has organised the bailing out of Bear Sterns, brokering a deal with JP Morgan and giving JP $30 billion to do the deal. When leadership was demanded the Fed gave that leadership.
Can Dame Street offer the same example? Is it brave enough? Or will it wait until one of our banks has a real funding crisis, leading to a panic?
Ireland is facing a crisis and we need all our state agencies to act decisively. The central bank has a responsibility to all of us not to let the bankers mistakes of the past cripple the people’s prospects of the future. A bad debt cycle could ruin this country for a number or years, but the solution is simple.
Let’s hope cowardice and indecision does not prevail. ‘‘Cometh the hour, cometh the plan.”