The Credit Crunch Banks

Overview The outline of the story is well known. –Banks in several countries may too many loans to the property market –These loans have now gone bad as the bubble has burst –The banks are now in financial trouble and have to be rescued by governments To see how exactly this happened we to see how banks work

Banks Business Model Bank takes in money –Depositors –Selling securities on financial markets (Borrowing on financial markets) Bank lends it out –Formal loans –Buy securities on financial markets Bank profits largely determined by differential between interest rate on deposits and interest rate charged on loans. –The old “ ” rule –However, must allow for bad debts as any business

Liquidity vs Solvency Liquidity is having enough cash on hand –Banking suffers from an inherent liquidity problem –Banks assets and liabilities are of different maturities –Liquidity problems can be solved by borrowing from CB or market providing have assets for collateral Insolvency is assets<liabilities and capital cannot cover the difference –Capital is the cushion that absorbs bad debts –too small in the Irish case Solvency is the more important issue –Solvent: have enough assets –Liquid: have enough cash

Balance Sheet Easiest way to see how this all works is the bank’s balance sheet Liabilities is source of bank funds –Deposits (traditional) –Financial markets (new): “Bond Holders” Assets: –Cash and govt securities (cushion) –Loans (traditional) –Financial markets (new) Imagine what would happen if bank liquidated –Owners of bank would end up with Assets-Liabilities –“Equity” or “Capital” or “Share-holders funds” or “Reserves”

Bank Balance Sheet Assets Liabilities Cash Loans Banks Companies Individuals Deposits from the Public Equity (Capital)  Leddin and Walsh Macroeconomy of the Eurozone, 2003 Bond holders

Mortgage lenders Aug 07 Assets Liabilities Cashetc22 Loans482 Deposits384 Equity34  Leddin and Walsh Macroeconomy of the Eurozone, 2003 Total 526 Debt108 Others22

Role of Equity Crucial to the way bank operates The idea is that if banks suffers losses they are absorbed by the shareholders not the depositors or bond holders Therefore equity has to be large enough to absorb expected losses This is the money you have to put down in order to own a bank Common sense and regulation require a certain level –“reserve ratios”; “Capital requirements”; “Tier 1”

Banks want the ratio as low as possible as it means can lend out more Think of two examples –Ratio of 10% –Ratio of 5% The lower ratio allows bank to take in twice the deposits for the same level of commitment from shareholders Profits higher Risk higher because cushion lower –Smaller bad debts would bankrupt the bank

Bank Balance Sheet Assets Liabilities Cash15 Loans95 Deposits100 Equity10  Leddin and Walsh Macroeconomy of the Eurozone, 2003 Total 110

Bank Balance Sheet Assets Liabilities Cash15 Loans195 Deposits200 Equity10  Leddin and Walsh Macroeconomy of the Eurozone, 2003 Total 210

Key Issue: Solvency One of the key issues in the banking crisis was that the cushion was too low –Banks like small cushion because higher profits –But higher risk also This was a failure of regulator and banks own risk management –Should have realised property lending risky because of bubble Regulator require higher cushion –Reduces profits so lending to property slows down –Canadian approach

Another Key Issue: Liquidity Capital ratio so low that banks couldn’t find enough deposits to finance all the lending they required Borrowed on the international markets –Reflected in BOP: cap inflows “Hot money” –Often 24 duration –Run at first sign of trouble Makes liquidity problem worse

Example: AIB Lets look at a particular bank just before the crash –Annual report for 2007 –Total loans of €137bn Lots of foreign borrowing –In the deposits section Capital 8% –Sounds good but not enough as we will see Key facts –Property a growing share of loans –Much of this in “development”

% of Group loan portfolio

Property & construction %ROI*GB/NICMGroup Commercial Investment Residential Investment71579 Commercial Development Residential Development Contractors3613 Total Balances €m27,80410,0546,696 46,410 *An element of management estimation has been applied in this sub-categorisation

The problem Huge reliance on property and on development in particular Bubble bursting creates huge potential for losses –Particularly so in development loans –What NAMA is now concentrating on AIB aware of this potential & try to assuage investors fears –Say LTV is 65%

Solvency LTV is important –Indicates how much the bank could get back if borrower defaults –One of the key assumptions of NAMA Suppose 65% is true Suppose 50% of development loans default (50*36*29) –Represents 5% of total loans defaulting –€7bn (AIB had total of around €137)

If LTV was 65%, this €7bn in loans was secured on assets originally worth €11bn Key issue is “originally” How much are they worth now? As long as they have declined by no more than 35% bank will get its money back Bubble graph suggests that prices were twice fundamentals –expect decline of 50% –Bank gets back €5.5bn –Maybe less as overshoot

Assessment Bank can handle €1.5bn loss But very optimistic assumptions LTV of 65% seems unrealistic –some say 100% –The other 35% in form of property not cash Why expect only 50% of loans to default? –Why not all? Why only development? –Why not investment, mortgages etc

Banking System We can do the same sort of analysis for the main banks Approx numbers – but give the sense What happens when loans go bad? –Small losses: handle as “bad debts” –Medium losses: Zombie bank –Large Losses: bankrupt

Zombie Bank Losses wipe out lots (but not all) of capital Bank remains solvent but cannot operate effectively For illustrative purposes suppose €20bn goes bad –If it were any other business the bank will be liquidated or some sort receivership –Assets sold off to pay the creditors –Owners get the remainder €14bn

Mortgage lenders with €20bn bad debts Assets Liabilities Cashetc22 Loans462 Deposits384 Equity14  Leddin and Walsh Macroeconomy of the Eurozone, 2003 Total 506 Debt108 Others22

Bank will probably continue in existence –But limited lending –Remember the role of equity – has to cut back on lending –Zombie bank: not dead but not alive either Solution: Get more capital from markets or government –Dilute shareholders wealth –So shareholders may prefer zombie Japan during 1990s

Bankrupt Now suppose even Bigger Losses –e.g, €80bn This is more than the shareholders funds can absorb Bank bankrupt: cannot continue in operation Any other business all creditors take a hit in proportion or priority –Get 90c for every €1 This means that depositors would loose 10% of savings To avoid this the government usually steps in some way Rational for NAMA-like arrangements

Bad Debts of €80bn Assets Liabilities Cashetc22 Loans402 Deposits384? Equity0  Leddin and Walsh Macroeconomy of the Eurozone, 2003 Total 446 Debt108? Others22

NAMA Don’t want banks bankrupted for two reasons –To avoid depositors taking a hit –Banks central to economy so formal bankruptcy (even temporary) is very disruptive So government needs to deal with hole in the banks Need to decide three related Q –How big is the hole? –who pays? –What is done with the banks afterwards?

Who Pays? Someone has to 4 possibilities –Depositors: want to avoid at all costs –Shareholders: “rules of capitalism” –Bond holders: rules also 4 th possibility Tax payers –Make up gap if share and bond holders not enough –It looks like NAMA has taxpayers take on some of the losses even without share and bond holders funds being exhausted –We will look at whether this is necessary

What happens to Banks? After the losses are dealt with banks will need sufficient capital to work with –Avoid zombification –After NAMA: AIB, BOI <4% (JP Morgan) –10% now standard internationally Certain that they will not have enough on their own –Shareholders will absorb some losses –International practice now requires more capital “Recapitalisation” can happen –Via market: rights issue BofA –Via government share holder: RBS 80% owned by UK –Overpayment: NAMA pays €54bn for €47

How Big is the Hole? How much are the bad debts of the banks? IMF estimated them at €35bn Probably a low estimate Government is more optimistic –Assume LTV 77% –Assume prices reached bottom and will rise 10% –Lead to a conclusion that NAMA will make a profit

NAMA’s Valuation Govt.’s view on size of the hole See Ronan Lyons Blog Loans of €68bn backed by assets originally worth €88bn –Implies LTV of 77% Add to that €9bn in unpaid interest NAMA to take loans of face value of €77bn Govt. estimates market fallen by 47% so collateral worth €47bn (=53% of €88bn) Govt will deliberately overpay for loans by giving banks €54bn –Expect prices to rise 10% from current levels

Three Key Assumptions LTV=77 –Anecdotal evidence of 100% –Use other property as collateral for the loan –If 100% then the original value of the collateral was €68bn 47% decline –Large decline –Maybe €21bn in land where decline has been 95% –34% of loans outside Ireland –If decline is (or will be) 60% then current value is €27bn (=0.4*68)

LTEV will be €54bn –Rationale for overpayment –Based on assumption that prices rise by 10% from current level –10% reasonable –is the current level the bottom? Probably not! Even bigger loss

A Comment Any prediction difficult Govt seems optimistic but possible Real issue is not the numbers but how it is structured and who takes the risk –Why over-pay? –Why not take shares in the banks? –Why not have bond-holders pay the price? Under NAMA tax payer bears risk of asset values –There is a notion of future levy

Consequences for Banks See balance sheet –Ok to use 07 Loans decline by €77bn Banks paid €54bn in bonds that may be exchanged for cash at ECB Losses of absorbed by shareholders Capital ratio below 4% Need capital injection of €30bn –Market or government

Mortgage lenders Aug 07 after NAMA Assets Liabilities Cashetc78 Loans405 Deposits384 Equity13  Leddin and Walsh Macroeconomy of the Eurozone, 2003 Total 505 Debt108 Others22

Mortgage lenders Sept 09 After NAMA Assets Liabilities Cashetc76 Loans556 Deposits571 Equity21  Leddin and Walsh Macroeconomy of the Eurozone, 2003 Total 692 Debt110 Others60

Consequence for the Taxpayer Govt already spent €7bn on capital injection to banks in return for preference shares that pay 8% Overpayment is a form of recapitalisation –Without pref shares and overpayment equity would be only €7bn –No ordinary shares in return State guarantees all liabilities of banks –Taxpayers bears all the risks of business –Get very little return In the end taxpayer will provide almost all the capital of the bank but will (likely) have less than 100% shares

Alternatives What are the alternatives? Any sensible alternative is going to look at lot like NAMA –Segregate bad assets from good –Some government involvement The big differences among the alternatives is who pays what and who bears the risk

Alternative 1: Nationalise the Banks Wipe out the equity holders Admit that total losses are likely to be more than the current shareholders funds Risk to taxpayer reduced as we now have assets as well as liabilities Consequences –Overpayment no longer matters –Total losses to be absorbed by the state will be less by the amount of the equity –Taypayer will get the value of the future business of the bank to offset losses

Arguments Against Unfair to shareholders –Maybe if losses actually less than equity –Unlikely –Retrospective compensation possible Too expensive because share price is too high –Lenihan made this argument –Clearly nonsense –Price is only above zero because of NAMA

Nationalised banks become politicised –True –Re-privatise early –Very expensive way of avoiding corruption Foreigners will not deal with nationalised banks –Maybe true for some but not generally true –In any case will not deal with any bank without state guarantee so seem unlikely to object to state ownership Doesn’t get rid of the losses so is irrelevant –True that losses remain –But get share (or all) of future profitable business to offset losses –Eg €7bn overpayment or for shares

Nationalisation hurts reputation –Banana republic –Other countries have done it UK –Partial possible Nationalisation will lead to higher risk premium on corporate and national debt –Anglo cited as evidence –Premium already up because of extent of bad debts –Idea is that nationalisation would increase it further –No evidence that ever happened before

Alternative 2: Bond-holders In addition to wiping out equity holders we could force bond-holders to take some of losses Could even force them to take all the losses (after equity) –Mirrors normal bankruptcy –Joseph Stiglitz & Morgan Kelly –“Debt-equity swap”: INM Minimises cost and risk to taxpayer

Arguments Against Bank financing premium in future –Maybe true –Cost to banks –Pass on to society in short run –In long run foreign Competition will mean no cost to society Pension funds loose out –Mainly foreigners –deal with pension funds directly

Sovereign Risk –Defaulting on the bank debt will be seen as equivalent as defaulting on national debt –Big issue: risk premium of national debt will increase: huge cost –Plain wrong: no evidence of it internationally –Makes no sense: sovereign risk premium rose when we took on the bank liabilities (guarantee) and bad assets (NAMA) –Why would the risk increase if we hand-back those liabilities.