These days, a week is a long time in European economics and given it is now over three months since the announcement of the Irish bank stress tests, is it time to re-evaluate the results in light of what appears to be very changed circumstances? This entry examines what has changed since March and concludes that a review might be justified before the planned recapitalisation of the banks by the end of July 2011.
Cast your mind back to the wet and windy days of late March 2011, share trading in AIB, Bank of Ireland and Irish Life and Permanent had been suspended in advance of the much-anticipated stress tests on 31st March. At a cost of €30m, with oversight from the EU, ECB and IMF, with two previous failed domestic stress tests under our belts, much of the NAMA valuation process concluded, with a totally discredited EU stress test in July 2010 and with a far better knowledge of the extent of losses in our banks, it fell to the governor of the Central Bank of Ireland, Patrick Honohan, to give us the bill of €24bn. But was it the final bill? Of course you could never say “final” with certainty in such matters but the estimate was as near as damnit to final. To quote the Governor in his interview with Vincent Browne on the night of the announcements, “we have put in so many buffers”, “we’ve pushed the boat out this time”, “we’ve calibrated it to a sceptical market”, our IMF and EU partners finally conceded “it was a tough approach” and one of my favourite Honohanism’s “if you’re flying in an aircraft and you’re not sure if you’re exactly on target, you aim above the target (and then turn left)” Truth be told, the estimate of additional capital needed by the banks is not, as the Governor said previously “an exact science”. But the Governor certainly gave the impression that these stress tests were pretty definitive.
And the stress tests were politically important. You’ll recall that under the IMF/EU bailout agreement, the Memorandum of Understanding,Irelandwas required to recapitalise its banks by the end of February 2011. You might then recall the spanner thrown into the general election campaign in February when then-Minister, the late Brian Lenihan decided not to recapitalise the banks on the basis of not having a mandate. And the two likely contenders for power, Fine Gael and Labour, were both boldly stating that the recapitalisation would not take place until the end of March or indeed until the stress tests revealed how much exactly would additionally be required by the banks. And when Minister for Finance, Michael Noonan got his answer on 31st March, 2011, the reaction was not to promptly write a cheque for €24bn to the banks. No, he seemingly agreed with the IMF and EU that he would defer the recapitalisation until the end of July 2011. The reason for the deferral is murky but the programme of buying back subordinated bonds at a steep discount might have been to the fore. In any event, the commitment seems to be to recapitalise the banks, which will need €20bn, given the apparent success of the bond buyback programme, by the end of July – that is within the next three weeks. That’s the political context.
So are the stress test results in March 2011 still valid? Standard and Poor’s said yesterday that the €24bn was “only adequate”, hardly the ringing endorsement of an exercise that was supposed to over-capitalise the banks to the extent that market confidence would return and the banks would be able to switch from funding dependence on the ECB.
But is €24bn even “adequate”? The view on here is that no, it’s not. It would be nice to have a spreadsheet from the CBI where updated factors could be inserted and to get a new recapitalisation figure popping out, but alas the CBI has not given us anything like that level of information on the March stress tests. So the following don’t have quantified effects.
(1) Back in March, our 10-year sovereign bond traded at an all-time-high of 10.32% on 31st March. This morning our 10-year bond has traded at 13.68%. Now Irish banks may only hold €11-12bn of sovereign bonds but plainly, the adverse projection of haircuts look out of line with present circumstances. The position of AIB, which has the largest exposure to Irish banks, is shown below:
(2) Removal of non-standard liquidity. The ECB has signalled an end to its provision of its non-standard liquidity programme in October 2011. The programme has been in existence since the financial crisis first blew up in 2008, and has been extended a number of times beyond previously announced end dates. The ECB has ruled out a medium term programme for funding Irish banks. That being the case, doesn’t the adverse case see Irish banks seeking funding on the open market, with consequent funding shortages and elevated interest charges.
(3) Commercial Real Estate (CRE) – Ireland’s commercial property is already down 60% from peak. The adverse assumption in the March 2011 stress tests was that CRE would fall a further 22% in the full year 2011 before increasing by 1.5% in 2012. In Q1, 2011 according to the Jones Lang Lasalle index, prices dropped just 1.5% but the adverse 22% presumably was based on the possibility of changes to Ireland’s Upward Only Rent Review leases, which would lead to a 20% average reduction in CRE prices. It now seems almost certain that UORR leases will be changed. Property Week reported that after several months of consideration of the matter byIreland’s Attorney General, a “heads of bill” was discussed by the cabinet on Friday last and that a Bill will be brought before the Oireachtas in October 2011. That being the case, the 22% seems like the base case, not the adverse case. But would an adverse case see declines even greater than 22%? There is still a general overhang of vacant CRE, credit is tight without any domestic sign of improvement, the Irish economy is just about stabilising but events in Europe continue to be unfavourable, the bond markets are convinced thatIreland will default on its sovereign debt. The adverse case in March was for a 70% peak to trough fall before a modest recovery next year. With what seems a certainty of legislation to deal with UORRs, that no longer looks realistic.
(4) Reisdential property – the adverse scenario in the stress tests was for what appeared to be a 60% decline overall from peak to trough, assuming the Bank used the premier house price index at the time in Ireland, the ESRI/Permanent TSB. That should be a safe assumption as the other indices are either asking price, non-hedonic or in Sherry FitzGerald’s case not overseen. Since March 2011 we have had two giant (by Irish standards) auctions conducted by Allsop/Space which have given widespread price discovery across the country. Because of successive political failure, Ireland does not have any public record of house sales prices, but we do have asking price histories and are able to see from last week’s auction that prices are down some 68% from late 2007 asking prices. Indeed there are instances of prices being down over 80%, which is consistent with Professor Morgan Kelly’s projections in 2009.
So before Minister Noonan writes the cheque to Irish banks in the next three weeks, shouldn’t he at least check that the stress test results are still valid? Better still, perhaps the Oireachtas Committee on Finance, Public Expenditure and Reform should quiz Governor Honohan on the subject. Given that there is an ECB commitment to continue its non-standard liquidity operation to October 2011, perhaps there should now be a further deferral of the recapitalisation byIreland in order to fully consider current developments and the apparent fact that matters have deteriorated since March 2011. After all, what’s the hurry to recapitalise in July or August or September?
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