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Archive for March 7th, 2011

I thought yesterday’s joint Labour/Fine Gael Programme for Government used an interesting form of words to describe the dynamic which would decide the recapitalisation/default debate:

“We will attach the utmost priority to avoiding further down-grades to our sovereign credit rating by setting further capital spend by the State on bank re-capitalisation at a level that is consistent with national debt sustainability.”

I would like to continue “in other words –” to explain what the above meant, but it is not exactly clear. This entry examines the recent history of our credit rating and what the above commitment might mean to the imminent bank recapitalizations (and is by reference to Moody’s rating scheme but that is broadly in line with Standard and Poor’s and Fitch).

2nd July, 2009 – Downgrade from AAA (the highest possible) to Aa1 with a negative outlook and Moody’s citing the widening deficit

19th July, 2010 – Downgrade from Aa1 to Aa2 with a stable outlook citing banking liabilities, weak growth prospects and a substantial increase in the debt to GDP ratio. Moody’s says that Ireland has “turned the corner”

17th December, 2010 – Downgrade five notches from Aa2 to Baa1 with negative outlook citing Budget 2011 and the risk of a debt restructuring

This is the Moody’s ratings scale

Aaa highest quality with the smallest degree of risk
Aa (Aa1, Aa2, Aa3) high quality with very low credit risk
A (A1, A2, A3) upper-medium grade subject to low credit risk
Baa1, Baa2, Baa3 moderate credit risk
Ba1, Ba2, Ba3 Junk: questionable credit quality
B1, B2, B3 Junk: subject to high credit risk
Caa1, Caa2, Caa3 Junk: poor standing and are subject to very high credit risk and may be in default
Ca Junk: highly speculative usually in default
C Junk: the lowest rated class of bonds and are typically in default

So we are presently rated Baa1 and would need fall three notches to have junk status. The Irish Times is today reporting that Moody’s do not see a further downgrade in our rating as imminent. Spare a thought for our fellow PIGS in Greece today who are reported to have been angered by Moody’s decision to downgrade their rating three notches from Ba1 to B1 – Greece is now firmly in junk territory. Meanwhile Spain is on a comparatively healthy Aa1 rating (on review) and Portugal is just behind on A1 (also on review). (UPDATE: 10th March, 2011. Moody’s has downgraded Spain one notch to Aa2 with a negative outlook)

Against the standard of our present rating of Baa1, Labour and Fine Gael are seemingly going to judge the recapitalisation of the banks as suggested by the results of the stress tests at the end of March 2011. Our Baa1 rating was determined by Moody’s in mid-December 2010 after the IMF bailout which earmarked €10bn immediately for the banks and €25bn as a contingency in reserve. Both the government and Central Bank of Ireland governor Patrick Honohan at the time suggested that €10bn would be adequate. Although Governor Honohan has since suggested the results of the stress tests might be worse than expected, he has poured cold water on suggestions by Anglo’s chairman, Alan Dukes that not only will the €10bn plus €25bn contingency be needed but an additional €15bn will be needed on top.

So what happens if the stress tests suggest we need recapitalise the banks by more than €10bn? Will that prompt Moodys to downgrade our rating because the cost has increased compared with official expectations in December 2010 or had Moody’s already anticipated in December 2010 an increase in the costs of the bailout? And if the government decides that it will not recapitalise the banks because the cost is seen as unsustainable, will that mean that there is some measure of default which would force Moody’s to downgrade debt even further? It seems to me that the government is tacitly stating that it will recapitalise the banks by €10bn plus some more as might have been expected by Moody’s in December 2010. And it is the government’s hope that the stress tests do not indicate substantial additional capital requirements. But if there are substantial additional requirements then it seems to me that the government will be caught between Scylla and Charybdis, representing a ratings downgrade through taking on additional unplanned debt and a downgrade by defaulting on debt.

Last week the government-in-waiting received briefings from the Central Bank governor and it is presumably the hope at this point that the stress tests will not uncover substantial new losses and that the recapitalisation can continue as agreed with the IMF/EU without prompting a downgrade from the ratings agencies. However given the uncertain nature of remaining bank losses as well as the fallible caprices of ratings agencies (their “corned turned” opinion last summer was pretty wide of the mark) and their independence from government, there is much to scupper the commitment by the government to “attach the utmost priority to avoiding further down-grades to our sovereign credit rating”

UPDATE: 16th March, 2011. A week is a long time in the sovereign ratings business and reflecting Moody’s downgrade of Portugal this morning citing “weaker growth outlook, risks to the government’s deficit- reduction plans and a possible need to recapitalise its banks”. After the downgrade this is the state of play of the PIGS.

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(The commitment given to the IMF in respect of NAMA 2 – Click to Enlarge)

To date, NAMA has acquired €71bn of loans for which it has paid €30bn. Up to last week, there were some €17bn of additional loans to acquire from the banks. That changed yesterday.

The €17bn of loans remaining to be absorbed by NAMA comprised two elements:  sub-€20m exposures at Bank of Ireland and AIB which were estimated to be worth a total of €12bn at nominal value and secondly €5bn of loans in respect of Paddy McKillen and other NAMA objectors. The €12bn of smaller loans at AIB and BoI are commonly referred to as “NAMA 2”, the €5bn of objectors’ loans would be regarded as part of the original “NAMA 1”. NAMA 3 was the codename for dealing with problem non-NAMA loans at the banks and certain categories of lending such as tracker-mortgages and non-NAMA commercial property lending were cited as examples of what might be included in NAMA 3.

Yesterday, the Labour/Fine Gael Programme for Government cements the commitment made by both parties in their respective manifestos. The document says “we will end further asset transfers to NAMA, which are unlikely to improve market confidence in either the banks or the State”. And last night on RTE’s “This Week in Politics” the following exchange took place:

Sean O‘Rourke (RTE presenter): You say that you will end further asset transfers to NAMA, which are unlikely to improve market confidence in either the banks or the State , in other words nothing else is to be moved to NAMA. Is that the idea?
Pat Rabbitte (Labour party negotiator) Neither the transfers envisaged under NAMA 2 or NAMA 3 will happen. Because that’s not helpful in the overall crisis situation that we’re in.

This interview took place after the exhausting FG/Labour negotiations and Pat Rabbitte was a senior negotiator in those talks and he was emphatic in his response above  so this would all seem to hammer the nails into the coffin of NAMA 2. And a further implication is that the €5bn of outstanding loans in NAMA 1 will also remain with the banks as these loans, which include Paddy McKillen’s reported €2.1bn of loans as well as others, are understood to be “cherry assets”. Absorbing “cherry assets” and making an even bigger hole in the banks’ balance sheets is hardly going “to improve confidence in the banks”.

So what now for NAMA 2 and NAMA 3? It seems that the smaller land and development loans that would have been in NAMA 2 are every bit as toxic as the larger loans already absorbed by NAMA which have attracted average haircuts for AIB and Bank of Ireland combined of over 50%. If NAMA 2 is not to happen how will AIB and BoI instil confidence that the value of these sub-€20m land and development loans are adequately provisioned? What I believe is likely, is that the banks themselves will set up internal transfers which will seek to value and ring-fence these supposedly toxic loans. And that too would appear to be the solution to NAMA 3, an internal good bank/bad bank split where the valuation and management of troubled assets takes place internally in the banks themselves. From this distance it is difficult to see how such an internal transfer and split into good bank/bad bank is very different to NAMA valuing the loans and then managing those loans. It may prevent the crystallisation of losses at the banks today but the markets will still suspect the toxicity of these retained loans. So we end up with a bit of a dog’s breakfast with an expensively-run NAMA plus we have good/bad bank splits plus suspicion about the values of loans retained by the banks.

I wonder if the apparent change in policy towards NAMA 2 and NAMA 3 is akin to the FG commitment on quangos – merge certain quangos to reduce the headline number but overall they still employ the same people and cost roughly the same – and is just juggling the same loans but avoiding the optics of the unpopular NAMA expanding its remit? I also wonder what the EU/IMF will think of the policy as it is a term of the bailout agreement that the sub-€20m exposures be valued and moved off the banks’ balance sheets. Our lenders have already advanced €15bn and can’t be very happy at this and other recent developments such as the uncertainty of the commitment of the government to recapitalise the banks.

UPDATE: 7th March, 2011. The Irish Times reports that one of Fine Gael’s lead negotiators last week, Alan Shatter has backed up his new coalition colleague, Pat Rabbitte in emphatically declaring that there would not be further transfers to NAMA. There are also concerns about professional fees and the sapping effect that NAMA is having on the property market.

UPDATE: 10th March, 2011. As if we needed any further confirmation that NAMA 2 was dead, we had the new Taoiseach Enda Kenny’s maiden speech yesterday together with opening debate of the new Dail in which Enda made it clear that NAMA 2 was indeed dead: “Through NewERA we will revitalise our national infrastructure networks of water, energy and broadband to create thousands of new jobs and increase our competitiveness. We will stop any further transfer of assets to NAMA. We will set up a strategic investment bank and new mechanisms to deliver credit to small businesses.”

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