February 12, 2009
What have Brian Lenihan and Donald Rumsfeld got in common? Why “unknown, unknowns” obviously! The security dilemma outlined infamously by Rumsfeld in February 2002 sums up our minister’s dilemma perfectly. What most people fail to realise about the recapitalisation is that it is an exercise in reassuring the rest of the investing world that it is safe again to invest in Irish banks and, by extension, Ireland.
To achieve this, the recapitalisation needs to satisfy sceptical investors that the share prices of Irish banks constitute a “once in a generation” bargain.
Certainly on a historic basis or in terms of the banks’ assets, the share prices look unbelievably cheap. A successful recapitalisation leads to a rapid increase in the banks’ share price and ultimately bond investors flock back to the “clean” bank. This way, the share price rises and the Government can sell its stake — now worth considerably more than when it bought the stuff last night — at a significant profit. This is why the Government says it has no interest in owning the banks. The State believes that it will be able to profit from the deal.
But the assumption that â‚¬7bn will be enough runs straight up against the Rumsfeldian conundrum of “unknown, unknowns” which is why Mr Lenihan and Mr Rumsfeld are unusual, but desperate, bedfellows.
In 2003, Donald Rumsfeld won the Plain English Society’s “foot in mouth award for garbled speech” for his immortal “known, unknowns” speech. At the time he was ridiculed but when you cut through all the cheap jibes, you realise that he was on to something.
Rumsfeld articulated the investors’ conundrum perfectly and in his words of wisdom lies the fate of last night’s bank recapitalisation.
Let’s recap what Rummy actually said.
“As we know, there are known knowns. There are things we know that we know. We also know that there are known unknowns, that is to say that there are some things we know we don’t know. But there are also unknown, unknowns, the ones we don’t know we don’t know”.
In the Irish bank recapitalisation, the unknown unknowns are the extent of the bad debts. No-one has any idea how big they are and this is why the whole recapitalisation programme is a leap in the dark. The reason they are unknown is that no-one has any idea what other bad news will emerge from the upper echelons of the Irish banking system, its pathetic regulation and its craven cheerleaders in the golden circle.
In many ways, the banks are acting like the Catholic Church when the child abuse allegations arose. The first reaction was to quash the rumours and draw a line in the sand. This was the regulator’s, the Central Bank’s and the Government’s reaction in September. Back then, I remember going on a radio programme with Mr Lenihan and predicting that an Irish bank would be bust by Christmas. The minister warned that such talk was dangerous and irresponsible. The Central Bank declared that the banks were well-capitalised and the regulator stated that its “stress testing” proved that the banks were fine.
This was the same as the Church saying that child abuse was a rare, random isolated incident. Then there were more and more and more revelations.
Efforts to restore the credibility of the Church were irreparably damaged by the unknown unknowns. In the uncertainty, the institution was badly tarnished. Few bishops were trusted and even the good ones were regarded as suspect — or, at best, patsies defending a dreadful institution.
Think of the banks in the same light. The investors in this case are like sceptical but ultimately believing Catholics who want to believe that the system has rooted out the bad eggs but are not prepared to bet on it.
Investors are afraid of the unknown unknowns, which have not even been thought about, let alone quantified in the Irish banking system.
How many more ILP “bed and breakfasting” deposits in Anglo which were exposed on Tuesday, will emerge? How many more ludicrous examples of banking malfeasance will there be, and, more significantly, just how big will the bad debts be?
No Irish citizen has any interest in Lenihan’s great gamble failing, but the unknown, unknowns make the chances of failure extremely high. If we don’t know how much the bad debts will be how can we, with any certainty, say that the â‚¬7bn figure will be enough?
We do know that in 2002 both the Bank of Ireland and AIB senior management were furious that Anglo were hoovering up all the best commercial land deals, and that they vowed to “out-Anglo” Anglo.
Both banks ramped up their loan book, lending to every two-bit eejit who thought he or she was Donald Trump. As JP Morgan once said, “nothing so undermines your financial judgment as the sight of your neighbour getting rich”.
Bank of Ireland and AIB financed the economics of envy in the commercial property and development land game and it follows that their loans books are likely to be worse than Anglo’s. The extent of their bad debts will be horrendous.
Think about it: they doubled their loan books in the final four years of the boom. This means that their bad debts will be considerably more than the 10pc which is common in boom/bust scenarios. Even looking at the past four years, both banks lent close to â‚¬120bn each; 10pc of this means bad debts of â‚¬12bn.
This means that Lenihan’s â‚¬7bn will be swamped by bad debts. So why would any investor come in until this cash was gone? If they did so, they would risk losing their investment and equity capital in a deluge of yesterday’s bad debts.
The unknown, unknowns …