After yesterday’s news on economic growth which might have put a mild smile on UK faces came an announcement from the Irish government which has significant implications which will also echo across the Irish Sea. Before I Leave the subject of our growth figures I would like to remind everyone that recessions are often quite substantially revised (down) as time passes. For example the recession of the early 1990s was in the original estimates thought to involve a fall in Gross Domestic Product (GDP) of 4.2% which was in time revised down to a fall of half that or 2.1%. So we will see further falls in the depth of the recession of 2008/09 as time goes by if it follows the usual pattern, and if this happens we can expect our authorities to try to give the credit to their Quantitative Easing(QE) Project. As I am sure you are aware there was no QE in the early 1990s recession, please remember that.
Before the credit crunch hit Ireland was essentially boom town and much of the boom came from the property sector, particularly commercial property. Here there are some similarities to Greece as Euro zone membership appeared to be almost an elixir. Her banking sector also grew domestically but also grew abroad for example Bank of Ireland bought the Bristol and West building society and became the supplier of savings products to the UK Post Office.
Then came the credit crunch and over-exposure to the property and bank sectors left Ireland’s economic strategy in tatters and Euro zone membership was suddenly no longer an elixir. Furthermore the crisis that is Iceland had similarities to Ireland’s position in terms of an over-exposure to banking (rather curiously this may well have been best expressed by the Scottish National Party’s talk of “an arc of prosperity”). So the Irish government had to provide support for her banks and also had to announce quite a severe austerity budget (total reduction of around 6% of GDP) in an attempt to re-gain control over a rapidly escalating fiscal deficit. It was a sign I felt of desperation when Ireland guaranteed all banking deposits for two years which ends on the 28th September 2010. However to their credit they have attempted to address their problems and they have had some success. But yesterday showed the depth of the problems still ahead.
1. An under-capitalised banking sector
2. Commercial Property loans made by the banking sector where the property used as an asset against the loan has fallen in price often substantially.
Of course these two factors combine. The situation meant that Anglo-Irish Bank was in such a mess nationalisation looked likely and Allied Irish Bank and Bank of Ireland were going to either have to make substantial asset sales or raise more capital or both. Just to look at one bank the Irish Times estimated that Bank of Ireland needs 2.5 billion Euros of capital. Having dealt with them in the past I see this as a sad development. There was talk that there would have to be a haircut on all property assets in the region of 30-40%.
Ireland has created what elsewhere has been called a “bad bank” to take over the underperforming loans and it has called it National Asset Management Agency (NAMA). However before it takes them over it will apply a “haircut” to them which means it will take them over at what it thinks they are worth not what they are in the various banks books. The initial haircut on the first 16 billion Euros of loans will be at an average of 47% with the Irish National Building Society looking the most reckless lender. Put another way this is a write-down for Irish banks of 7.52 billion Euros. In total it will eventually takeover around 81 billion Euros of loans.
The geographical breakdown is important to us in the UK as 21% or 17 billion Euros is here and it would appear Northern Ireland has another 6% (this way of counting is I would imagine a legacy of the obvious territorial issues). Ireland is 67%.
The banks have a massive capital shortfall from this and just to add to it new capital requirements were brought in of 8% tier one capital by the end of this year. So Bank of Ireland turned out to need 2.7 billion Euros and Anglo-Irish Bank needed nationalising as there was no hope of her raising over 7 billion Euros. The state will provide the necessary capital for Anglo-Irish Bank and will also nationalise EBS building society and the Irish Nationwide building society. Bank of Ireland has announced new capital raising plans this morning. All in all the Irish banking sector will soak up 20 billion Eurosinitially and more like 30 billion eventually much of which the taxpayer will have to provide.
Ireland deserves credit for the way she has tackled the financial crisis. She has responded decisively and in a timely fashion. Unfortunately the scale of the mistakes made in property lending were very large when compared with the size of her economy. If NAMA ends up taking over the 81 billion Euros of bad loans that is expected this is equivalent to half of one years economic output for Ireland. In the words of her Finance Minister this is “truly shocking” and “Our worst fears have been surpassed.”
In the short-term I feel that markets will review these moves favourably for the reasons I have described above. But as time goes by she is now very vulnerable to any adverse shocks as the Irish taxpayer is in credit card terminology pretty much maxed to the limit in my view. There is a clear danger of a “vicious circle” of bad news developing as time goes by.
Implications for the UK
There are clear implications for us as the scale of the lending by Irish banks in the UK was high. If we take our definition of the UK then NAMA will own around nearly 22 billion Euros of UK property assets. Sooner or later it will want to sell them.
Added to this is a report from DTZ which has estimated a possible debt finance shortfall in Europe over the next two years. You may not be surprised to read that the majority of this is in the UK and Spain. It estimates that the UK has a prospective shortfall of 42 billion Euros. Now these calculations depend on quite a few things but when added to the fact that the previous paragraph tell us there is at least one sizeable seller around…..
In terms of property exposure it is estimated that Lloyds Banking Group has £67 billion of commercial property loans on its books with RBS having some £43 billion, our other main banks have been more conservative with only £25 billion between them according to NCB Stockbrokers. There have been some small sales of these assets but in essence we have a situation like the residential property market where prices have recovered but volume is low. Many wise investors regard low volume as a warning signal. Another warning signal is that money has again flowed into commercial property investment funds (sadly as a group the retail investor is usually a reverse indicator).
Although they do not admit it our banks would like to sell much of their commercial property holdings. In the case of Lloyds and RBS it would get the taxpayer off their back. But with NAMA such a prospective large property seller in the UK before we even get to them then an enormous amount of property buying will be required. There are large dangers ahead for our two part-nationalised banks and our commercial property sector and I feel that any attempted sale of our holdings should be delayed. It is plain by the way that UKFI (the company which holds our bank stakes) is in effect misrepresenting the taxpayers purchase price that someone in authority is putting plans in place for a future sale. I think a sale can only be made in the near future by also misrepresenting the state of our commercial property market. In short more political fudge of which we have had plenty recently.