BANKS' PROPERTY LOSSES - NEXT YEAR "SO LAST YEAR"

With banks looking dirt cheap in the collapsed bull market, what to do with a £100m investment sum for investing in their cheap as chips shares? Well I could buy 0.5% of the new Lloyds Banking Group (LBG). Not enough for a seat at the top table, but more substantial than one thousandth of HSBC, which might leverage something like an office supply contract if I had an office supplies company to hand? I might be better picking up 0.4% of RBS and look for a premium when, if ever sometime soon, it's maybe taken over? The Irish banks, however, appear to offer surprisingly good opportunities just now, not least with a rising Euro/£ rate. The three big Irish banks together are only worth two thirds of HBOS or a seventh of LBG or an eighth of RBS. [Though, by comparison, the UK's global local bank HSBC is king of all it surveys; HSBC could buy any number of banks that not long ago were considered substantial, even predatory, not Christmas bargain sales!] Just look at Anglo-irish bank's shares. I could buy 40% and not have to be passed by the regulator or offer to stump up a lot of funding so long as I don't try to run the bank and am happy to have my share diluted by the next round of capital raising. The bank's got revenues of €5.6bn and net revenue of over €600m, two and a half times its share price! Sure, it's massively exposed to property, but the bank says the credit worthiness of its nborrowers and the loan conditions are above reproach? Something must be wrong though, but what? It may be the 120% ratio of debt to capital, but its cash flow performance looks comfortable? trouble is there is an oily brylcream smell about property lenders, and anyway they have ample deposits from me already that I'm sufficiently concerned about despite the Government guarantee - what if they have a rogue element or an operational risk event? How about Bank of Ireland? Growing revenues of €12.6bn and net revenue of €1.7bn, 75% above the share value; can't lose, got to be a great winner in my portfolio? The stock market is crackpot stupid! Then too there is Allied Irish Bank. Revenue is up in 2008 from €9bn to €11bn and net revenue of nearly €2bn, also more than the share price. What has happened to the Irish miracle economy's banks? They are profitable, in fact returning 50% to over 100% return on equity! Yet, their share values are totally floored. I suppose there is money to be repaid to Government and share issues, but still how cheap has a bank got to be to attract savvy investors? Can shares fall any more than Allied Irish Bank €1.74bn (down 88% this year), Bank of Ireland €1bn (down 91%, and Anglo-Irish Bank €273m (down 97%). If I did invest I'd have to consider the rights issues that might dilute dividends per share (and possible dividend blocking conditions) and then share values diluted by over half, but still very substantial ratios would be left. I cannot see why they are so cheap. Defaults are 1-1.5%, similar, very low given the anxieties about property exposure, slightly below 1.5% at HBOS. I suppose defaults will rise sharply, but they would have to be stratospheric before I'd worry about my stake. 100% of deposits and bondholders are government guaranteed. Some worry whether Government could afford to bail out a major bank collapse? Maybe the problem is the scale of Irish bank lending to the size of the economy? But the banks have adequate reserves, fully in line with the EU's CRD regulatory recommendations, loan-books performing well at this stage of the recession, and a Government about to pump €10bn into the Irish big three plus no.4, Irish Life & Permanent. Are the banks just the victims of short-selling or can anyone seriously have reason to fear any of the banks collapsing absolutely or, in that shock event, the Government unable to pick up the pieces? Maybe the answer lies in Belgium. If the Rubicon is being crossed from banking as usual to complete restructuring it is surely there, and in massive political and economic crisis if BNP Paribas do buy Fortis Belgium and also if it does not buy Fortis Belgium? Fortis, once briefly the biggest bank in Benelux, now dismembered and sicker than a dead parrot. €1bn was lost to Madoff, the bank's in purgatory, and the Belgian parts and some subsidiaries agreed to be bought by France's biggest bank BNP Paribas. Fortis shareholders rejected the appointment of a new chairman on Tuesday during a stormy meeting, at which they lined up to harangue the board after its partial nationalisation. 5,000 investors voted against installing – and loudly booed – Etienne Davignon, the Belgian businessman and former diplomat, as chairman. They rejected re-appointment of two other board members and kept the present board in place for now. There's activism, unlike the supine well managed votes at Lloyds TSB and HBOS recently. Its banking and insurance businesses in the Netherlands are nationalised and the Belgian parts agreed to be sold to BNPP, along with rights to the Fortis name and logo. Jan-Michiel Hessels, vice-chair, argued Fortis had been unlucky in the timing of the ABN Amro deal not mistaken. “The world changed fundamentally in the last 18 months,” he said as shareholders booed, jeered and shouted. “What has not changed is our conviction that the acquisition of ABN Amro was, strategically, a good choice, even with what we know today.” The meeting in Brussels was more emotional than one in Utrecht for Dutch shareholders the day before. Both meetings voted against re-appointing Mr Hessels and Philippe Bodson. For comparison of where its share value is compared to its peers, see how low a €104bn revenue (2007 revenue) bank has sunk. The revenues shown are 2007, share capital is current and employment (in thousands) is 2007. If the sale to BNPP proceeds the remnant will consist of of the group’s international insurance and majority stake in an ABS vehicle holding €10.4bn of structured credits (before a 57% writedown). Trading in shares at €2.15bn was suspended by the Belgian regulator for lack of sufficient details of its new structure, plus problems with its legacy risk accounting. It will get €14.4bn in cash from sale and nationalisation of assets, a net cash position of €10.5bn after funding the securitisations (that it owns 66% of, government 24% and BNPP 10%), exceeding its €9.4bn of debt obligations i.e. not bankrupt. The securitised assets (much of it US subprime) will be funded with €7.4bn in debt and €3bn in equity. The €10.4bn investment will be marked down 57% of face value. In this case, unlike HBOS, court action has however resulted in a delay to the BNPP takeover by 65 days over objections to BNPP taking the bank's reserves even though what these are currently worth is guesswork. Fortis has big question marks over its financial and risk accounting and needs severe auditing. Rarely can a bank's logo have looked so appropriate. The Government is doing all it can to unlock the legal obstacle to proceeding with selling the bank and itself then becoming the biggest single shareholder in BNPP. But, BNPP itself is suddenly not a happy ship, and not just because of €500m lost with Madoff. €800m losses in securities investment trading and 800 sackings plus doubts surfacing about the operational risks and costs of taking over and integrating Fortis, combined with falling assets and deserting customers the longer the Fortis takeover is delayed, are all worrying factors. Fortis is not over-exposed to property, but does have exposures to other sectors that are currently retrenching just a smuch or more. If BNPP back out of the deal, the Belgian Government has a major headache to recover the bank and see it not just solvent but operationally sound? One of the ironies of property exposures (including US subprime assets with about 10% defaults though paying 8-12% coupon) is that a more sober analysis should see the longer term upside. This is the redemption of the Irish banks, despite over 30% property price falls and 60%+ property exposures, plus the cash-flow problems of property (residential especially) may prove to be relatively stronger loan-quality through the downturn compared to other business segments like corporate debt (if much of it also property-related, developers and construction, and many insolvencies!) Bank shares have fallen steepest for property-exposed banks like the Irish or in the UK HBOS. But, next year, even if there is another 10% property price fall, that perception as corporate defaults take centre stage, may appear outdated, just "so last year"! But that is just the brave view. I shall refer to Irish pundit David Williams for a description of the problem, a similar if lesser problem that is considered to best HBOS and why it needed Lloyds TSB takeover and could not have been saved if in an independent Scotland - though I continue to doubt this prognosis, it seems genuinely a severe anxiety in the Republic of Ireland. McWilliams says of the Irish 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. 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... without the Government guarantee, Irish banks would run out of money in 90 days. The second thing ... no-one (share investors) 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 ... first disaster is a funding disaster where the average loan to deposit ratio of Irish banks is between 150 and 160pc (implying large dependency on wholesale interbank funding). For the likes of Irish Life & Permanent it is a ludicrously reckless 260pc! This ratio means that for every €160 the Irish banks lent out, they only had €100 in deposits. So they borrowed €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". In fact Ireland has the benefit of experiencing recession early compared to the rest of the Euro zone. It gets pulled down and up again by the US and UK while able to also rely on EU fiscal and monetary stimuli if there are any of sufficient strength. The Irish economy went into recession six months after the USA (normal irish response) and time will show this coincided with UK recession also. The irish picture is this one. Gradually sounds not to bad for me if in the interim the economy recovers? Also, I'm mindful that some EU countries are in as bad or worse straits e.g. Greece. McWilliams continues more starkly, however, "Even with the guarantee, the banks will have to get the loans to deposits ratios down to somewhere around 80-100pc... “deleveraging” ...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 ... 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... Irish loan book is over €400bn, a similar writedown (means)... about €33bn. This figure dwarfs the €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." This is more or less what has been done in the case of Fortis, but the result is the break-up of the bank and some national loss of a commanding height of the Belgian economy. The irish Government is keen not to lose either of its two main banks to foreign ownership. The persisting crisis is one of interbank funding. But, it is not only a problem for Ireland. McWilliams in his prognosis does not address what might be organised at the EU-level. But he is right to emphasise that more funding is required than more reserve capital buffer. He emphasises future losses to cover what might be 8% loan loss. That is the level I also expect, but a level that will be typical across Europe and the USA (half of which should be recoverable medium term). The more immediate problem is liquidity. Bank of Ireland alone needs to roll-over about €30bn in the next year. Banks may be reluctant to lend new money but should be pressed to renew existing facilities for each other. All depends too on not just how well US, UK and EU actions to jump-start interbank lending succeeds, but how quickly. The Irish Government may not have the €70bn or so resources to provide new funding to the banks itself. But, it has borrowing capacity sufficient (and in conjuncion with the ECB which envisages providing more of a central intermediating role in interbank money markets) to guarantee or provide long term loan guarantee to cover the high LIBOR spread that Irish banks would otherwise have to pay and find uneconomic to do so in the short term. There are however some competition rules governing this that require Commission approval. It may be no coincidence that at this uncertain time for the Irish economy and its awareness of resource constraints that the Government is also being pressed to re-run the Lisbon Treaty vote on whatever basis would gain a yes-vote, even if this requires unique concessions that othetr countries might envy?There is more potentially at stake than just the cash-flow solvency of the banks, and the immediate crisis of the Irish economy. Commission policy wonks clearly believe this is a psychological moment to re-invite the Irish voters express a communitaire majority and overturn two previous no votes, even for a treaty little changed from what was rejected by the Irish twice before.
Analysts also suspect the ECB will outline new plans to kick-start interbank lending by pushing banks out of hoarding cash at its own overnight deposit facility. But banks' borrowing requirements are not overnight but 3-month money. One of the options is cutting the interest rate that banks get from the ECB when they deposit with it. "Re-widening the standing facility band has been openly discussed by some ECB Council members," (analysts at Dresdner Kleinwort). "Such an approach could force banks to start lending excess reserves to other market players again. But, this is a severely unbalanced market between lenders and borrowers and hence it is a dubious belief that the lending margins would significantly contract. The Irish banks are merely a few of many in a long queue, and not the first choice among lenders. The question is whether the time is right at the moment to push the banks?" (euro zone economist Rainer Guntermann). Policy makers are split on timing. There are a host of short term measures in train to provide European substance to the G20 statement of November including a wide range of measures to improve financial stability. There is also a €200bn counter-cyclical spending boost envisaged and €30bn Commission expenditure brought forward, but unlikely to have much immediate impact.
ECB Governing Council member Ewald Nowotny backed the idea of lower ECB deposit rates in a recent interview with Reuters. But Bundesbank chief Axel Weber said on Wednesday that it could also create problems. Aurelio Maccario at UniCredit said there was a good chance the ECB would announce the change although it may also wait until its first meeting of 2009 - January 15. Back in October the ECB made a string of changes to its lending operations in an attempt to restore confidence after the collapse of Lehman Brothers. The last two quarters of 2008 are expected to be negative growth for the Euro Zone, though I suspect 2009 will actually prove to be positive growth.
The October moves included guaranteeing banks as much money as they wanted at a fixed flat rate. At the time the ECB said the changes would stay in place until Jan. 20 at least, but also stressed that they were only supposed to be a temporary measure. There was some resentment at the time about the amount of claim that irish banks immediately made on this liquidity boost. "The next (central) rate setting meeting is Jan 15th... but why not give banks a bit more visibility and say either these are definitely temporary measures, or on the other hand that they will stay in place until some later date?" (Guntermann).
Money market problems remain at the heart of the current financial crisis and policymakers say that they are blunting the effectiveness of cuts in official interest rates. Others say that monetary measures alone are ineffective. ECB President Jean-Claude Trichet has been hammering home the importance of the bank's recent 175 basis points worth of rate cuts feeding through to money market rates so that banks, businesses and consumers feel the benefit. Policymakers also appear to be warming to the idea of an ECB-guaranteed clearing house as one way of getting banks to lend between themselves again. Though it cn only be a vague hope without firm direction. ECB Vice President Lucas Papademos said on Monday it was an idea worth studying but analysts think it unlikely the ECB will come up with any firm plans fast? "If you listen to the comments and speeches we have had over the past couple of days, further action (to restart money markets) at some point will happen, but we have no indication that anything will happen tomorrow" (Dirk Schumacher, economist, Goldman Sachs). Guntermann also ruled out that the bank would announce plans to follow the U.S. Federal Reserve with proposals for quantitative easing measures. "I'm not excited about any announcement about buying other assets like government bonds or commercial paper although they could clarify in theory what they could do."