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Archive for March 15th, 2011

Olli Rehn, the EU Commissioner for Economic and Financial Affairs is a great man for traditional proverbs from his native Finland. Who can forget his “better not paint the devil to the wall unless you can wash it off from there” (meaning hyping up problems can make a situation worse than it actually is) and “salmon is such a noble fish that it is worth fishing even if you don’t finally catch one” (meaning the journey is as important as the destination). Mind you, we have our own rich stock of proverbs here in Ireland and there is one that might become quite apt in the coming days – “you might as well be hanged for stealing a sheep as a lamb” which means if you are going to face consequences for some transgression and the consequences are fixed (being executed by being hanged, for example), then you might as well maximise the value of the transgression (taking a meaty sheep rather than a puny lamb, for example)

In the context of any future bank recapitalisation the proverb could be interpreted to mean “if we are going to default, then we might as well default without putting any more money into the banks, rather than putting in another €10bn and then defaulting”

On a day when, shockingly, it has been announced by the Central Statistics Office that the unemployment rate was 14.7% at the end of December 2010 compared to 13.7% at the end of September 2010, it is perhaps equally shocking that unemployment was not addressed by a single party leader in the inaugural Leader’s Questions in the new Dail, this despite Fine Gael’s election motto “Let’s get Ireland working” The questions focussed instead on last week’s EU summit and the perception that Ireland failed to get a reduction in the interest rate charged on bailout funds because we refused to make concessions to our 12.5% corporate tax rate or to the basis on which the tax is levied. And it was during these exchanges that FG party leader and newly-inaugurated Taoiseach, Enda Kenny did say on several occasions that his government would not put any more money into the banks until the stress test results were known and considered, “beyond those funds already committed”. And he was careful to use those words “beyond those funds already committed” and he used them almost as a fixed suffix to his bold declaration that Ireland would not be putting another cent into the banks.

It is not exactly clear what An Taoiseach actually means by “beyond those funds already committed”. The deal with the EU/IMF anticipated €10bn being injected into the banks by the end of February 2011 unless (hee-hee) the banks were able to raise the funds themselves privately. Beyond that, the bailout deal makes up to €35bn available for recapitalising the banks including the €10bn that was to have been injected in February, 2011. And in fact that €10bn wasn’t injected in February 2011 because Minister Lenihan decided that he didn’t have a mandate with the impending general election and the putative Opposition parties said they wanted to see the results of the stress tests in March 2011 before making any commitments.

So what is going to happen if BlackRock’s stress tests show there to be an additional capital requirement in the four financial institutions – Allied Irish Banks (AIB), Bank of Ireland, the Educational Building Society (EBS) and Irish Life and Permanent – in the €25-35bn zone. The common view of a capital requirement in this zone is that it is unsustainable and would demand some degree of burden-sharing (that is, partial default on bank debts). But coming back to our sheep/lamb, why would we put anything further into the banks if the stress tests do show such elevated losses as now seem widely anticipated? Why would we even put €10bn into the banks without imposing some losses on bank creditors (commonly, bondholders).

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A row of handbag-wielding proportions has broken out between Anglo and NAMA as the Anglo CEO, Mike Aynsley has given an interview to the Australian Financial Review (subscription required) which is briefly critical of the execution of NAMA. The article is reported domestically by the Irish Times and the Irish Independent. NAMA has responded to the criticism by (yet again) wheeling out a cannon to deal with a fly – indeed NAMA seems to have outdone itself for the bitchiness of its response (see here and here for previous examples).

Having read the full article covering the interview with Mike Aynsley I can report that there is a single reference in it to NAMA which reads “He was particularly scathing of the previous Irish government’s handling of the the state “bad bank”, or National Asset Management Agency. While he described NAMA as “a good dea”, he claimed it had been poorly executed” So it is those five words, “it had been poorly executed” that have caused the brouhaha. NAMA’s response is not available from its website but the Irish Times carries some detail from “a NAMA spokesman” which includes describing the Anglo CEO’s comments as “misguided” and “banks like Anglo played a major role in creating the problems that Nama is now working to resolve and the criticisms of the chief executive of Anglo have to be seen in that context” and “unlike Anglo, with over 1,000 exiting staff, Nama – as a start-up organisation which had to recruit its staff from the market – has had a remarkable first year.”

So let’s examine the handbag-wielding contenders:

In the blue corner, you have Mike Aynsley, Anglo’s 53-year old Australian CEO who took up the poisonous role in September 2009 after 30 years in the banking industry. Given what has emerged at Anglo, he could never realistically have been expected to emerge from that car-crash of an institution smelling of roses. But having said that, his tenure at the helm of Anglo has not been marked by any great successes and he has had more of his share of failings

(1) In March 2010, Mike told the Irish Times “detailed financial examination by the bank and its advisers had (sic) shown it would cost between €6 billion and €9 billion – in addition to the €4 billion already invested in the bank – to restructure the lender and run the bank as a going concern”. A few weeks later, Minister Lenihan shocked us with the estimate of €23bn which then went up to €29-34bn in September 2010. So you would have to ask what grasp Mike had of the reality of Anglo’s situation in March 2010, six months after he took over the reins.

(2) According to my count we are at v5.0 of the Anglo restructuring plan. The first was submitted to the European Commission in November 2009, two months after Mike took over at Anglo. In returning the plan to Anglo in March 2010 requiring a re-submission in May 2010, the Commission described Mike’s plan as lacking detail and prompting doubt in its credibility and wrote off as overly optimistic the claim that the Anglo Newbank could be generating €1.2bn per annum in profits by 2014. There was another plan in May 2010 which was effectively rejected and another at the start of September which was eventually put down on paper in October, it was unclear if there was another one in November but we do know that a new plan did go to the Commission on 31st January, 2011. The reception towards the previous plans does not portray Mike  in a good light, to put it mildly.

(3) Anglo’s handling of the David Drumm issue seems cack-handed in the extreme. It seems that an offer to settle claims by David Drumm which included bringing his vast pension pot and his family home into the mix was rejected by Anglo and then David stuck two fingers up to them and initiated his own bankruptcy proceedings in Massachusetts. Having followed the saga closely since last October, it seems that Anglo has been wrong-footed at practically every turn and I would love to see the bills for the legal costs being run up by our 100% State-owned Anglo in pursuing a €8.5m loan which was apparently going to be repaid in full

(4) Just over a year after he joined the bank, Mike has lost what must have been his right-hand man in this crisis, Anglo’s Chief Financial Office, Maarten Van Edens.

(5) And for all of this, Mike’s is paid a salary of €500,000 and reportedly some handsome allowances and expenses on top for which he receives criticism. And to cap it all, the hapless Mike was burgled last November 2010.

In the red corner, you have the asset management heavyweight, NAMA which might reflect on the following aspects of its execution

(1) Its loss of €35m reported to date is dwarfed by the ~€2bn decline in value of its loans reflecting the fact that the agency is valuing loans acquired using a valuation date of 30th November, 2009, after which, NAMA’s primary market, Ireland, has continued to tank.

(2) Although NAMA had taken over €71bn of loans at par value by December, 2010, it seems that all but €27bn was acquired using estimated valuations. It is true that the EU has approved the valuation of the first two tranches. NAMA apparently missed the EU deadline of acquiring all of its loans by February 2011.

(3) In the Paddy McKillen case, NAMA has wasted God knows how many millions in defending an action which it eventually lost, the Supreme Court having determined that NAMA did not make a valid decision to acquire Paddy’s loans in December 2009.

(4) NAMA’s business plans (the draft and the June 2010 versions) are laughable, for their lack of detail which might give their audiences confidence in the projections

(5) Speaking of projections, NAMA believed that the discount to be applied, on average, to loans it was acquiring from the banks would be 30% in September 2009 but the present estimate is 58%. NAMA blames the banks for dud information but seemingly seeks to deny any ownership or responsibility for the original figures which in other organisations would have been validated.

(6) Some ten months after NAMA took over the first tranche of loans it seems that there is not one agreed business plan where both NAMA and the developer (and apparently the developer’s wife) have signed each of the three documents, memorandum of understanding, heads of terms and final agreement. NAMA has been spoofing about there being 12 (or 14) memoranda which have been “or are close to” being signed for the last three months.

NAMA is entitled to defend itself against criticism even if that criticism is published in one of a few financial newspapers on the other side of the world and even if the criticism is confined to five words. But again, the tone of NAMA’s defence is just ugly – “you’ve lost 1,000 employees in the last year, Nah Nah Na Na Naah”. Seriously, has NAMA got an adolescent with low self-esteem and identity issues running its PR.

Despite some failings the agency has taken on a huge volume of loans, employed 100 people directly and has started the process of managing those loans – the numbers involved are enormous and NAMA has at times struggled to cope. But instead of a robust and honest defence of its work we continue to see NAMA lower itself to the level of – let’s face it – not the most credible of critics. In Mike Aysley’s case those five words  – “it had been poorly executed” – deserved at most a brief paragraph outlining achievements and the enormity of the challenge.

And lastly, if you are a NAMA spokesman is it too much to ask that you be literate enough to know that plural nouns take plural verbs as not in “this is hardly the hallmarks of poor execution”? Or maybe that too is a criticism for which handbags are appropriate.

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It will be Thursday the 31st of March, 2011 when we are expecting to hear the detailed results of the ongoing stress tests, though apparently at the end of this week there is to be a briefing on the methodology used and perhaps even a steer as to the final bill (remembering that the “final” bill has already ballooned from the “cheapest bank rescue in the world” to €4bn to €11bn to €33bn to €46-51bn to €56-61bn already). The stress testing is being carried out by BlackRock Solutions projected managed by the Boston Consulting Group with banking expertise provided by Barclays Capital. BlackRock is famed for developing models to assess values of assets and I must say that I find myself smiling as I try to think how they will model the probability of mortgage default by an unemployed young construction worker with a young family and variable rate 40-year mortgage on a practically unsellable semi-detached house on a half-complete ghost estate in Leitrim with 35 years of the mortgage still to go when the local town is decimated by emigration to London, New York, Canada, New Zealand and Australia.

This entry examines six areas where BlackRock’s modelling may well fall down.

(1) Forthcoming personal bankruptcy legislation. There was an entry on here last year which compared the housing market here with Nevada’s, a US state which has suffered a property bubble collapse not dissimilar to our own and a state where mortgages are recourse like our own but where there are over 100,000 foreclosures annually in a state with just over 1m dwellings, compared to some 500 repossessions here in a country with nearly 2m dwellings. What makes Ireland so different to Nevada? There are a number of differences but I would say that the US bankruptcy process is the key difference. In Ireland bankruptcy presently involves a very difficult procedure which can last 12 years typically, whereas in other jurisdictions 1-3 years is more the norm. The Northern Ireland bankruptcy rate is 350 times that of the Republic’s. The IMF Memorandum of Understanding requires us to overhaul our Victorian bankruptcy laws by December 2012 “legislation to reform the bankruptcy regime to be presented to the Houses of the Oireachtas” and the new Programme for Government promises “we will fast-track the substantial reforms needed for our bankruptcy legislation to bring us into line with best international standards, focusing on a flexible personal bankruptcy system that reduces discharge time for honest bankrupts.” If our bankruptcy rate rose to the same level as our neighbours in Northern Ireland we would see 3,500 bankruptcies per year up from the present 10. But could we see 35,000 bankruptcies as people adjust to the reality of negative equity, high interest rates, unemployment and depleted savings?

(2) Psychological shift in Irish society. This economic crisis has seen the denuding of former institutions of authority – the banks and politics. It happened to coincide with a further erosion of confidence in the Church with hard-hitting reports on child sex abuse and the media has been seen to have been asleep as the housing and credit bubble expanded to dangerous proportions. The crisis has also accentuated the perception that some people have retained wealth whilst the ordinary citizen has footed the bill of bailing out the banks, bankers, politicians and developers – even the legal bill payable by the Church for its role in child abuse was capped leaving the citizen to make up the shortfall. My personal (and subjective) assessment of the Irish psyche is that it is slow to abandon responsibility for debts, your name counts in a country where we still know each other. There’s a reason for the Revenue publishing lists of tax defaulters in this country – it’s because we’re still decent enough to be embarrassed and feel shame. But I wonder will the events of the last three years shift that psyche? Certainly when there is such widespread economic hardship, there is less concern these days that the neighbours will find out you have a judgment against you. Everyone’s property has fallen in value, unemployment has afflicted every community and section of society, taxes and levies have been applied to even the very modestly remunerated. And against all that, we have substantially lost confidence in the banks and politicians – worse, we have lost the fear. Throw a little xenophobia into the mix (“the EU is gouging us”, “the IMF has taken our sovereignty”, “we working to pay back gambling banks in France and Germany”) and you have enough to tip the psyche into one which looks at debt, default and court judgments through a dispassionate lens and where a personal sense of accountability has been decimated.

(3) Default. The ECB and EU and the official government position might be that there will be no default in Ireland but the markets don’t believe that. Not for Greece, Ireland or Portugal at least. Will BlackRock adopt the official position or will it at least acknowledge the market’s assessment for our prospects? Default will peripherally damage the banks that hold Greek, Portugese and Irish bonds which will fall in value. But what will happen at Irish banks if, for example, senior bondholders are forced to accept haircuts? Could recovery action lead to fire sales of assets? Will banks continue to be able to access funds from the ECB and Central Bank of Ireland at relatively cheap rates or again, will fire sales be forced upon the banks to access liquidity?

(4) ECB interest rate rises. Even in Ireland where domestic demand is still muted and it is not clear if a recovery is underway, our latest inflation figures show that prices are up 2.2% in the past year. Even if the ECB were to leave rates at 1%, we are still expecting to see increases in mortgage rates as beleaguered banks try to recoup the elevated rates they are paying to access funds.  We have some 790,000 mortgages in this country with 113,000 fixed (14%), 271,000 standard variable rate (34%) and 406,000 tracker (52%) so only 14% of our existing stock of mortgages might suffer with domestic increases but if the ECB were to increase rates then changes to tracker mortgages, which account for over half of our existing stock of mortgages, may start pushing substantial numbers of households to default. How high might the ECB go to tackle rising energy costs or shortages resulting from Japan’s catastrophic earthquake? With economic recoveries underway in Germany and France, will peripheral needs for lower interest rates be ignored in preference to the wishes of other economies? Predictions here in Ireland are that rates may increase 1% this year in four 0.25% increments starting in April 2011. What happens if rates increase by 3% instead?

(5) The future direction of property prices. This being Ireland, the press is already reporting that the stress tests will examine “further drops in property prices of up to 20%” (10% for residential, 20% for commercial according to Laura Noonan at the Independent). It is not clear if that is a 20% drop from present levels or from peak. If it’s present levels then using the Permanent TSB (PTSB) index as representative of current values, then a “further drop of up to 20%” would mean €128,976 if the 20% was from peak or €153,240 if the drop was from current levels (national peak was in Feb 2007 when the average national price was €313,998 and the price at the end of Q4, 2010 was €191,776 nationally). The problem is that the PTSB index is now based on such shallow data that it might effectively be useless. The PTSB index presently says that we are 39% off peak nationally, but estate agents say we are 50-60% off peak and some are saying that we are not yet at the bottom – that’s significant because a common criticism aimed at estate agents is that they exaggerate declines because they want to tempt buyers into the market. Our own Dr O’Doom (to differentiate him from the American Dr Doom, Nouriel Rubini) Professor Morgan Kelly was originally predicting falls of up to 80% from peak. He was dismissed as a crank at the time, his stock has risen considerably since. The absence of a House Price Register and accurate data on housing (including vacant housing) in the country may well come back to bite us on the bum here because it is difficult to assess  present price levels and a key part of demand:supply economics.

Residential property is one aspect of residual non-NAMA lending but there is some €70bn of commercial property lending not going to NAMA, so commercial values are also relevant to the stress tests. And the outlook here is distinctly negative despite the property agencies putting the bravest face on it. It is a fact that we have uncertainty today over upward-only rents – it’s debatable whether or not the new government will deliver its pledge, and if so in what format but meantime the uncertainty will stymie transactions and depress prices further. Commercial rents have been falling in each of the last four quarters by an annualized rate of 20%+. With prices in prime Dublin still almost twice the level of prime Belfast and with an anemic economic outlook, I would have said that there are further falls in prospect from the present position which is already 60% off peak. Even without the review of upward-only leases, I would have said that another 30% drop from current levels was in prospect and indeed evidenced presently in some transactions.

(6) Deposits. Last year the term “bank run” was taboo in the media but then the term “deposit flight” crept into common usage instead. A “bank run” put us in mind of Jimmy Stewart in “It’s a wonderful life” persuading panicked depositors to keep their money in his Savings and Loan because after all, the money was in Bill’s house and Jim’s house or it put us in mind of queues outside Northern Rock in 2007. We seem more detached from the term “deposit flight”. Regardless of what it is called, it seems that the removal of deposits from the six State-guaranteed institutions which was at an elevated level last year has continued into 2011. The IMF and Bank of Ireland might say that deposit flight has moderated but no figures produced so far show deposit flight to have stopped. The headline dependency on ECB and Central Bank of Ireland funding was at a record €187bn in February 2011, up from €183bn in November 2010 and €97bn last February 2010 – you simply can’t disguise the fact that there is a serious problem of confidence in our banks which of course have also suffered ratings downgrades which automatically deter some depositors. Former Minister Lenihan might have famously claimed we are an island which would prevent deposit flight but it seems that we are more than capable of moving household and business deposits to local branches of foreign banks like Nationwide UK, KBC, Rabo and National Irish Bank. If deposits continue to flee then banks will need do a lot more deleveraging which might crystallize loses in fire sales or might push banks to source more expensive funding. Might the stress tested banks simply wither as confidence and deposits are transferred to other banks in the State? How will stress tests account for this?

(7) The stress tests will exclude Anglo Irish Bank and Irish Nationwide Building Society, both of which submitted their latest restructuring plans to EC Competition  Commissioner, Joaquin Almunia on 31st January, 2011. But even after transferring out the NAMA loans and deposits from these two financial institutions there will be the best part of €40bn of loans remaining. Without an estimate for additional losses on these loans, how credible will the stress tests be?

Some might argue that derivative exposures might also skew the stress tests but it is to be hoped that BlackRock can at least assess those exposures.

So it will be with interest that the methodology underpinning the stress tests will be received, as much perhaps as the quantification of the capital requirements themselves. Already there are rumblings that additional capital requirements will be more than the €10bn previously earmarked (which would have meant the bank bailouts had cost €56-61bn). It is not clear how much more of the €25bn contingency earmarked in the EU/IMF bailout will be needed – if it is all needed then the bailout cost will rise to €81-86bn. The Anglo chairman Alan Dukes said last month he believed we might need another €15bn on top of that again – which would bring the total to €96-101bn – his views were dismissed at the time. Unfortunately recent history has shown the pessimists and naysayers to have been more realistic.

UPDATE: 15th March, 2011. Central Bank of Ireland governor, Patrick Honohan has delivered a speech to the International Centre for Monetary and Banking Studies (ICMBS) in Geneva where alludes to the ongoing stress tests. A few points of interest – in respect of point (1) above which deals with the low rate of foreclosures/repossessions in Ireland compared to the UK/US Patrick says “We will seek to largely free the tests of any excessive expectations from Irish exceptionalism in loan-loss recoveries (over the years very few Irish residential mortgages have been foreclosed in downturns by comparison with the experience in the UK and US, for example: with the help of external consultants we are referencing experience in those countries – though not slavishly so – in the analysis that will lead us to choose new tougher capital levels for the banks sufficient to convince the markets. And less reliance will be made on extrapolation from recent experience.” The headline in Ireland will relate to any new estimate of the cost of the bailout about which Patrick says “to be sure the somewhat weaker economic growth projections now available would imply some increase in expected losses, but it is the stress scenario that is the focus of the present exercise. ” Elsewhere Patrick proposes a bailout mechanism which uses the reputation of good creditors to leverage bad banks and Patrick says he would welcome foreign investors in Irish banks as long as they have “credible business plans”

UPDATE: 16th March, 2011. The CBI has issued the macroeconomic parameters used in its ongoing stress tests. They follow the same format as the discredited CEBS stress tests last July which famously gave AIB a tick. Here are the baseline parameter %s.

Here are the adverse %s.

The residential baseline projects a 55% fall from peak (accepting that we were 39% off peak at the end of Q4, 2010 according to the PTSB series) and the adverse projects a 60% drop from peak. These projections are worse than the current projections from the ratings agencies which are in the ~45% area. The EU baseline stress test last summer was 42% and the adverse 46%. On the other hand Morgan Kelly was projecting a 80% drop in January 2009.

The commercial baseline projects a 61% fall from peak (accepting that were 60% off peak at the end of Q4, 2010 according to the JLL series) and the adverse projects a 69% drop from peak. The property companies haven’t really issued predictions for commercial property. The prediction on here for 2011 was that there would be a further drop of 10% but that was before the revision of rents in upward only leases became an election pledge which would on average reduce prices by 20% according to the Society of Chartered Surveyors. So the adverse scenario looks like it should be a base scenario.

 

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