“Deleveraging” – what does it mean, and what does it really mean.

Having returned to Ireland after more than a decade abroad, I was struck at how our language had changed. In particular how suspicious people had become – we suspect everything. Before I left we would have “thought” or “believed” or “predicted” but now we seem to generally just “suspect”. And more often than not we “somewhat” suspect. When did that adverb gain such strong currency? It used to be “a bit” or “slightly” but now it’s “somewhat”. Mind you I seem to have picked up my own habits abroad, “while” became “whilst” and the past perfect seems to have overtaken the simple past tense so “I got” becomes “I’d gotten”. But regardless of the differences, I have been picking up new words and phrases along with everyone else – bondholders, “we are where we are”, tranches, “there is no alternative”. But there’s a new one which I think will be on everyone’s lips this time next year – deleveraging.

Before discussing what it is, let me remind you that with respect to the IMF/EU bailout, €10bn is pencilled in for the banks, a further €25bn is more lightly pencilled in as a contingency for the banks and €50bn is for our day-to-day spending (y’know the spending for which we are fully funded to the middle of next year and if you factor in the National Pension Reserve Fund and flogging off State-assets then we would get to 2013 by which time our deficit should be running at 5%). And of the €10bn pencilled in for the banks, €8bn is for recapitalisation which is to be completed for most of the banks by the end of February 2011 (Irish Life and Permanent has until May 2011 and the betting is that its €200m-odd recapitalisation will not be funded by the State). The remaining €2bn for the banks is required immediately and it is for “deleveraging”.

Let’s imagine for a moment that you decide to establish a new bank tomorrow – why not, could you be any worse than the present operators? You have €100k which you mostly use to set yourself up with a license and a premises and brand so people don’t think you’re just going to steal their deposits. You offer depositors 3% if they entrust their cash with you and on the other side you lend out at an average of 5%. You hope that you will lend out what is deposited and that the difference in interest rates will cover your ongoing costs of the operation and hopefully a profit. Now at the start you might only be able to lend out a proportion of your deposits whilst you’re building business though you might deposit the remainder with other banks so it is earning some money for you. But as time goes on you get up to lending nearly 100% of your deposits because you know it makes most financial sense if you can be lending as much as possible of the money that is costing you 3%. This is phase one and after a couple of years you have a nice little business running – let’s say that you have €100m in deposits on which you pay €3m a year in interest and you lend it all out and get €5m from your borrowers. Nice. Your loans to deposit ratio is plainly 1:1 or 100%.

You then decide to embark on phase two and in addition to taking deposits, you decide to issue bonds (formal IOUs) to the “market”. And you might pay a bit more than the depositors are getting, say 4%, but still you expect to turn a profit. So at the end of phase two you have €100m in deposits, €100m in bonds and you have lent it all out at 5% so you receive €10m in interest and on the other hand you pay out €7m in interest to your depositors (€3m) and bondholders (€4m). Nice also. Though your loans to deposit ratio has gone to 2:1 or 200%.

So deleveraging means using your assets/income to pay down your debts. As a householder who might have a mortgage and credit card debt, you might deleverage by taking cash from a deposit account and paying down the credit card debt. You might also trade down your car and use the profit to pay down your debt. You might change jobs or take on more jobs to increase your income and use that to pay down debt. You might ask for handouts from family or friends. You might ask your lenders to take a “haircut” on their loans but I wouldn’t bank on the response you’d get. With the banks “deleveraging” really means paying back the bondholders – remember that, when the term comes up again and it will a lot during the next year. I suspect.

But think about how the bank above can deleverage. It can call in loans and it can stop new lending. It could sell on loans to another institution. It could sell the lease on its premises and move to a cheaper premises and use the “profit” to pay off bondholders.  We might cut operating costs and use the increased profit to pay off the bondholders. The above example of a new bank is simple. After a few years the bank might have gone to phase three and perhaps bought another bank or started a specialist subsidiary dealing with sub-prime mortgages or specialist equipment leasing, for example. Deleveraging could also involve selling these operations and repaying the creditors who lent you the money to start these businesses.

Coming back to our present, real-world travails we are to use €2bn of the IMF/EU bailout immediately to deleverage the banks (more correctly I think it will be coming from the “internal” bailout funds at the National Pension Reserve Fund or the National Treasury Management Agency cash on hand). What banks will be the recipients of the €2bn? We don’t know. Which is concerning but not as concerning as the commitment that the Irish Times reported during the week to reduce the loans:deposit ratio% from 165% to 100-120% – “The banks have an average loans-to-deposits ratio of 165 per cent – a measure of reliance on external borrowing. This means that for every €100 on deposit, they have €165 out on loan. Under the EU-IMF plan to reduce the size of the banking sector, the banks must reduce this to 100-120 per cent by selling off loans and “non-core” businesses.”

Take a look at the latest reported lending and deposit positions of the six State-guaranteed banks (you will find links to all of the annual and interim reports here). The latest loans are €285bn and the latest deposits are €156bn. Remember this is based on the financial institutions’ latest reporting which is for the half year to June 2010 for all except INBS which is for the year to December 2009. And remember that our banks still seem to be haemorrhaging deposits – €10bn in October 2010 alone, and remember that Bank of Ireland and ILP reported significant deposit outflows in August and September 2010.

So how do you think these six State-guaranteed financial institutions will deleverage?

(a) Calling in loans – not particularly feasible in an economy which is in distress.
(b) Stop new lending – definitely but what impact will this have on the economy?
(c) Sell loans to a third party – possibly but the demand for Irish loans is not likely to be high unless the loans are sold at a considerable discount. A case in point is the sale of €0-20m exposures at AIB and BoI to NAMA – it will get €16bn off their loans but it will crystallise large losses (and incidententally if BoI sees a final NAMA haircut of 42% then I will be very, very surprised)
(d) Selling off non-core operations – definitely but isn’t this what the banks have been doing and how much non-core value is left to dispose of?
(e) Cutting overheads – definitely staff numbers, opening times and branches can be cut, premises can be downsized or moved to less expensive locations. Difficult because of union/worker resistance.
(f) Increasing revenue – by increasing the difference between the interest rate charged on loans and the rate paid on deposits – increase loan rates or reduce deposit rates or both. Difficult because non State-guaranteed competitors might steal your market share.
(g) More capital injections – new cash can be injected (by the State presumably but third party participation is a theoretical possibility).
(h) “Restructuring” the banks – effectively selling them off but who will buy them?
(i) Burden-sharing with bondholders – in terms of junior bondholders owed some €13bn this process has already started. The €113bn of “senior bondholders” (in reality a mix of bondholders and holders of other credit instruments eg medium term notes, commercial paper, certificates of deposit) seem bullet proof for the time being (but with each day God know how much of their lending is being redeemed)

My guess would be that there will be combination of all of the above but probably the most immediately effective and easiest to execute will be cutting new lending and to provide further State injections of capital. Which means less mortgages, business lending, consumer credit which will impact the economy and house prices which will tempt the State to use that €25bn contingency. A concerning outlook. Somewhat.

(with thanks to Ciaran Tannam for inspiring the above entry)