November 9, 2008
Considering they had neither the financial nous to foresee the global downturn, nor the courage to release accurate figures on the state of their institutions, how can the inept leaders of our banks now expect our trust?
In 1853, an economic crisis in New York spawned a vehemently anti-Irish, anti-Catholic political group called the ‘Know Nothings’.
The Know Nothings emerged from a secret society called the Order of the Star Spangled Banner. It is thought that they took their name from the fact that, initially, whenever their candidates were asked whether they were a political party or a secret society, they answered: ‘‘We know nothing.”
The Know Nothings spread through lodges all over New York, because the local Protestant workers feared the deluge of Irish Catholic workers — who were arriving in New York at a rate of 1,000 a day.
The Know Nothings erupted on to the political scene. In 1854, only a year after the first Know Nothing candidate stood, the party garnered more than one-third of all the votes in the election for New York’s governor. The poor Irish immigrants lived in fear of the Know Nothings, whose central policy was a 21-year naturalisation period whereby Catholics could be ‘‘decontaminated’’ to become – to borrow a label used by Sarah Palin – ‘‘real Americans’’.
The sectarian Know Nothings faded as quickly as they emerged (possibly because Irish emigration to the US fell off in the recession of the mid-1850s), but their ideas remained in the Republican Party for many years.
All crises spawn new interest groups, and our present financial and economic crisis has created our own Know Nothings. These are financial Know Nothings. Every country has them after a crisis – they are the ones who never saw the crisis coming but yet are now dispensing wisdom and making pronouncements as if nothing had happened.
A decade ago, just after the Russian financial crisis, a savvy investor friend of mine was asked what lessons he drew from the event and the behaviour of the financial markets. He replied that the rule of thumb on the economy and the markets was that ‘‘you should not listen to anyone who did not foresee this crisis happening, because these people know nothing. They knew nothing then and they know nothing now’’.
The same logic applies to Ireland. If you want to preserve your capital and think your way out of this downturn, the last people you should listen to when it comes to objective advice are the people who did not foresee this crisis. This group includes every single board member and senior management figure in the Irish banking world. Let us remind ourselves that not one of these individuals predicted this calamity. Worse still, they profited by contributing to it. So why should we believe anything they say now about it?
Last Wednesday, AIB issued an update to the markets on the state of trading. Given that every statement from its management over the past year has underestimated the problems, a sceptical market dismissed the pronouncement and sold the shares down by about 15 per cent. The management of Irish banks is so far behind the markets that it is now becoming risible. How can you take a bank that was promising a chunky dividend in the summer seriously when its share price halved in four months and it couldn’t raise money?
Like Lehman Brothers, Bear Sterns and Merrill Lynch earlier this year, every time AIB’s management has said it has ‘‘come clean’’ to the market over the past 12 months, the reality has turned out to be much worse. Obviously, the stock market figured this out months ago and has dumped the stock.
The problem is simple: if the bank admitted that the problems were as bad as they were, the management and board would have to resign because they would need new capital. New investors would not trust the same people who got the banks into this mess in the first place. So we are experiencing a game of cat-and-mouse between the market and management and, all the while, share prices keep falling.
For the sake of clarity, let’s cut to the chase and do some little calculations. The reason Irish banks are in difficulty is because they are stuffed with Irish – and, to a lesser extent, British – property that nobody wants to buy. AIB has development loans in Ireland of just over â‚¬18 billion, as well as â‚¬5 billion of development loans in Britain.
In all property crashes, development land falls further in value than house prices. Let’s take a conservative view: that house prices will fall by just 25 per cent (it is likely to be far greater, but let’s be positive). This means that the development loan book of AIB will have bad debts of at least 30 per cent and, given a total development loan book of â‚¬23 billion, that means bad debts of about â‚¬7.5 billion. To date, AIB has provided for â‚¬1 billion of bad debts. So it is hardly surprising that the share price has fallen again.
Think about it another way. The bad debt cycle in property busts normally takes four years. If we look at the British property recession of the early 1990s, the average bad debt provision was 1.5 per cent of total loans in year one, followed by 2 per cent in years two and three as the recession really bit, and, finally, another 1 per cent in year four as the situation improved.
AIB’s management has already said that 2009 and 2010 will be horrendous, so it appears this analysis is at least shared by them, if not explicitly outlined.
AIB’s total loan book is â‚¬128 billion. Taking Britain in the early 1990s as a template, it is likely that a total of 6.5 per cent of AIB’s loan book will never be paid back. This means that lenders will default on approximately â‚¬8.3 billion of loans, which the banks will simply have to write off.
The figure isn’t far above the losses on the development loan book. The extra â‚¬1.3 billion is accounted for in general defaults, such as mortgage defaults and defaults on credit cards, home improvement loans and car finance.
These basic calculations give us a much more accurate picture of reality. And there is no sign that any of our other banks will take a more realistic approach. But why, after such a horrendous year, when investors’ expectations are at such a low ebb, is the management of our banks refusing to come clean?
Well, there’s one simple answer. As always, let’s apply the cui bono test. Who benefits from a lack of clarity? Think about it.
Our bankers are petrified of the following scenario. If they admit how bad things are and make proper provisions, their tier one capital ratio will fall. The reason for this is that the more bad loans there are on the books, the more these eat into capital adequacy ratios.
If their capital adequacy ratios fall to, say, 5 per cent, when similar British banks have a ratio of 9 per cent, the game is over for the management. This means the banks will be downgraded by the rating agencies.
Some of the banks will have to look for state help to recapitalise and the positions of the management, chairman and board will be called into question.
So it’s simple: all this prevarication is about self-preservation. The banks are hoping to spoof now and recover their tier one capital ratios by reducing lending.
This is what we do not need, because our economy will seize up without credit and we may face the Japanese long recession scenario, which is precisely what the guarantee was designed to avoid.
Ireland’s financial Know Nothings – the lads who blithely brought us to the abyss – are trying to save their own skins and, in the process, are risking the future of the economy. This is the worst of all worlds.