December 17, 2008
The bank bailout just announced is simply not enough to right the wrongs in our financial system. And yet it is all we have.
The saddest thing about the silly boom is that it has enfeebled us to such an extent that, even if we could be honest about the extent of the banking problem, we now do not have the financial firepower to help ourselves. This should make each and every one of us angry because monumental economic mismanagement and national hubris brought Ireland to the brink.
However, the crisis presents an opportunity: now that we are looking into the abyss, it is a brilliant opportunity to change. As Rahm Emmanuel, Barack Obama’s Rottweiler, commented: “A crisis is too good an opportunity to miss”.
Our country has to take the hardest decisions we have taken in two generations, not because we want to but because we have to. We have the chance to re-invent the country, but only if we do the little things right.
One of the first things we need to get right is to acknowledge the extent of our difficulties. The epicentre of our crisis is the banking system and the legacy of the huge property bubble, which has burst. Apart from this, we have a robust economy with good people and a reasonable chance of getting our act together. However, the banks are contaminating us and need to be quarantined.
There are two quite different problems facing the banks and, make no mistake about it, these problems — which threaten to overwhelm the rest of us — are entirely the responsibility of appalling management.
We need to understand that our banking system is bankrupt. Yes, bankrupt. Without the Government guarantee, Irish banks would run out of money in 90 days. The second thing we need to understand is that no-one wants them, because professional investors and others expect much greater bad loans to emerge in Ireland than anything we have come close to admitting. The rest of the world expects the Irish Bear Sterns to be announced any day where a bank is sold for practically nothing to stave off collapse. But who would buy such a thing?
The crux is that the Irish banking system faces two disasters and one problem is driving the other.
The first disaster is a funding disaster where the average loan to deposit ratio of Irish banks is between 150 and 160pc. For the likes of Irish Life & Permanent it is a ludicrously reckless 260pc! This ratio means that for every â‚¬160 the Irish banks lent out, they only had â‚¬100 in deposits. So they borrowed â‚¬60 from the wholesale money markets — which are now shut.
As long as the money markets are shut, the banks are being kept on a life-support machine by the State’s guarantee. The strategy to borrow for growth was implemented by the managements of our banks who — amazingly — are still drawing hefty salaries. Without the State guarantee, the banks, which have been consistently downgraded to close to “junk status”, would have to pay so much for funding that they would go under gradually.
Even with the guarantee, the banks will have to get the loans to deposits ratios down to somewhere around 80-100pc. This is a process called “deleveraging” and can only be achieved by increasing deposits and reducing lending. This contraction of credit will have a monumental knock-on effect on the second big problem for the banks: bad loans.
At the moment, Irish banks are telling half-truths about their bad loans, and given that the management of Ireland’s banks have got nothing right in the past two years, there is no point believing them now.
To get a better idea of what is likely here, we can examine the experience of other countries. Switzerland and Sweden both suffered a banking crisis following a property bust in the early 1990s. In both cases the banks had to write off close to 8pc of their loan book. This was traumatic and the banks lost fortunes, but they recovered.
Given that the Irish loan book is over â‚¬400bn, a similar writedown would reveal a black hole in the Irish banks of about â‚¬33bn. This figure dwarfs the â‚¬10bn recapitalisation fund and deleveraging guarantees enormous falls in asset prices and concomitant rises in bad debts.
So, no-one wants our banks because they are full of bad loans. Banks and investors are afraid to buy because of what they might find.
How do we solve this conundrum? One idea is to divide our banks into good and bad banks. We could set up one or two bad banks, which would be “financial skips” into which we throw all our bad loans. These could then be restructured and traded by the State, using specialist, restructuring experts. The huge land banks, sites and commercial developments that are now worthless could be traded at, let’s say, 20 cent in the euro.
As the economy recovers, these discounted prices would rise. (Many years ago I traded defaulted Brady Bonds of emerging countries on the same basis and the market worked.)
This would have two positive effects. First, it would get all the crud off the balance sheets of the good banks, allowing them to borrow and restart lending to small and medium-sized enterprises. The second positive is that it would allow some liquidity to return to the market for land, not for speculation but to end the uncertainty, which will otherwise cripple the Irish economy for years.
The idea of “bad” banks has the added positive of allowing those who have the skills to restructure debts to do their job, while those with the skills to lend and get the system going can do their job.
Next year is not going to be pretty but we have to think around corners to see things straight.