Valuing the Anglo 10 Loans

I’m afraid I must disagree with my distinguished colleague Eamonn Walsh’s arguments in today’s Irish Times about the Anglo 10 loans.   Walsh argues that “to state in the Dáil or elsewhere that the Anglo 10 “were given” €450 million is patently incorrect” and that “The most likely outcome is a wealth transfer that was somewhat less than €40 million.”

Let’s recall the details here. In July 2008, the ten investors borrowed €451 million from Anglo and used it to buy shares in the bank.  The Anglo reports describes the terms of loans as “As well as the shares being held as security for the loans, there is additional recourse to the individuals’ personal assets equivalent to 25% of their borrowings.”

Walsh argues that this was equivalent to Anglo selling a standard “put option” to these investors.  He argues that such options “can be easily valued” and puts the estimate of the value of such an option at a maximum of €40 million.  In fact, valuing put options is a tricky business unless one makes pretty strong assumptions about the time series process underlying the value of the share.  The “easy valuation” method that Walsh refers to is most likely the Black-Scholes formula, which relies on the assumption that the share price follows a geometric Brownian motion, i.e. that it is just as likely to go up as it is to go down.  Walsh indeed explicitly characterizes the Anglo “put option” as such:

Consider an investment opportunity. I offer you the chance to invest €50 in a financial product that tracks share prices. If the share price falls by 25 per cent, you lose €50. If the shares appreciate by 25 per cent, you gain €50. Would you invest? Would you describe this investment opportunity as “heads I win, tails you lose”? I would imagine that many readers would be unwilling to engage in risky financial bets of this nature. In essence, this was the nature of the deal that was offered to the Anglo 10.

Walsh then argues that if the interest rate on this loan was higher than interbank rates, then “Anglo Irish Bank may have effectively earned a profit from the sale of its insurance policy.”   However, I think the key word here is “may” since I don’t believe there is any evidence that Anglo did indeed charge its investors for this insurance.

So, why do I disagree with Walsh’s assessment?

1. Anglo’s shares in July 2008 could not fairly be characterized as being an each-way bet to go either up or down.  Indeed, while it has hard to know for sure, there is a strong suggestion that the purpose of the deal was to support a share that was threatening to go into freefall.
2. Ex post, with Anglo’s shares having collapsed (an outcome that can hardly have been too surprising to these investors) this “put option” has now been cashed in.  Anglo’s report tells us “The total amount loaned to ten longstanding clients of the Bank to buy shares from the CFD providers was €451 million of which €83 million has been repaid. As well as the shares being held as security for the loans, there is additional recourse to the individuals’ personal assets equivalent to 25% of their borrowings … The Bank will seek repayment under the borrowers’ recourse obligations as necessary.”  In other words, with the shares worthless, the government-owned bank is willing to go as far as to attempt to recover another €50 million from the Anglo 10, at which point €113 million (or quarter of the original loans) will have been recovered, leaving the taxpayer with the bill for the remaining €338 million.  So perhaps Walsh is partially right.  The Anglo 10 stand to lose up to €113 million and their deal was only responsible for costing the state €338 million, not €451 million. Heroes indeed!

Finally, I have some sympathy with Walsh’s suggestion that the campaign to name the 10 individuals is a witch hunt.  There are no good grounds for any bank to publicly release information on who it has lent to.  However, Colm Keena’s arguments that the equity holdings of the Anglo 10 should have been reported to the Stock Exchange seem pretty convincing to me.

12 replies on “Valuing the Anglo 10 Loans”

Donalsays:

“Ex post, with Anglo’s shares having collapsed (an outcome that can hardly have been too surprising to these investors) this “put option” has now been cashed in. ”

Why would these investors have entered into this transaction of they knew they would loose approximately 100 million Euros? Walsh’s analysis makes sense to me.

Donal raises a good point. One potential answer: If an investor knew that the €X million that they could lose on this loan just meant that they’d eventually be paying back €X million less on their other loans to the bank (when the endgame had come around and they had to admit they were bankrupt) then they’d be no worse off in the end. And as for how they benefited from the transaction? Well, I suppose it’s stating the obvious to say that these guys seemed to have some reason to want to keep Anglo afloat.

Jacksays:

Is there not the possibility that they in fact believed that the shares would ultimately go up in value and that in essence they were capping their potential loss at 25% while the potential upside was limitless?

antoinsays:

It is not clear to me that they stood to lose anything. It was a non-recourse loan from what I understand. Maybe I am missing some information.

Some of the 10 apparently had an interest in maintaining the status quo in the management of the bank. This is a critical consideration.

I do not know the facts in detail and it may be that no one has done anything wrong. But on the face of it there seems to be something not quite right about using the company’s own money to buy shares in the company. Of leaves the parties open to the question of whether the share price might have been buoyed as a result.

It also seems not quite right to effectively act as a conduit to make depositors’ funds appear as first tier equity on the balance sheet. This was the effect of the transaction. It might even appear that the insurance on the deal was an ibcentive for being part of the deal.

It is of course rubbish to say these guys robbed hundreds of millions from the State which is the impression some people have. But I think aomerhing deeply
dubious happened.

Equally it has to be said that a lot of the people in and around Anglo were treated like heroes until a few months ago by some people. Now they are outcasts. It’s a bit pathetic.

Gregory Connorsays:

@Antoin: It was a partial-recourse loan with 25% recourse against borrower’s other assets. Also each of them knew (unlike other shareholders) that there was a big chunk of Anglo shares in the hands of a circle of nine of the investors like themselves, anxious to dump the shares at the first opportunity, and that the share price was being inflated (or prevented from falling) by a secret circle. Besides this, each was being persuaded to a take a large undiversified position in Anglo shares (not sure of course how large their total investment portfolios might be). Individual shares carry substantially more risk when held in large proportions versus in a diversified portfolio.

So they have 25% downside protection courtesy of Anglo management, balanced against holding a large position in a share with dubious long-term prospects. On a net basis it is difficult to assign this deal a positive or negative present value ex ante.

The only thing one can state confidently is that it was very underhanded as business/financial practice and violates several basic principles of security market regulation. The most shocking and horrifying aspect is the nod-and-wink attitude of the Financial Regulator.

Hang on! They had 75 percent downside protection, not 25 percent!

You just can’t get protection like that. This is an extraordinary deal.

In fairness though, the idea that Anglo shares would drop in value by three quarters (which is what would have to happen before they would have had to pay out anything) was completely unthinkable at the time they got involved. They would have assumed that an international player would have bought out Anglo before that would happen.

Why would they believe this? The same reason loads of people thought that everything would keep going up. They had a rose-tinted view of the Anglo loan book, the same as almost everybody else. They had the same happy view of the economy that the politicians had in July 2008. They thought everything was ok, they thought the price would go up again and that they would be able to sell at a profit, pay off their loans, and make out like, ahem, successful businessmen.

However, even if your bank manager is a hopeless optimist, getting the opportunity to invest and take only the bottom quarter of the downside is an extraordinary bargain, especially if the small amount of risk you are taking is contributing to your own liquidity by keeping the bank open.

A very odd transaction indeed. I bet a million Anglo shares that the full story of this transaction will have several more wrinkles that we have not yet been shown.

At any rate, it seems from reading Walsh’s piece that his major error is in thinking that the 10 were at risk for 75 per cent of the loan. That’s how he gets his €40 million Black-Scholes price and the €120 maximum figure.

If he had noticed that the 10 were at risk for only 25% of the loan, perhaps he wouldn’t have written the article.

Gregory Connorsays:

@Antoin — whoops you are correct it is 75% downside protection since there is only recourse to 25% of loan value from other assets. Very sneaky and unethical behaviour by both Anglo and the borrowers — with some “green shirt agenda” nods and winks from the Financial Regulator is my impression (although the whole story has not emerged yet). A very sorry episode which should have ended in jail terms rather than anonymity.

Daire O'Criodainsays:

Does anybody know whether the shares were senior security, pari passu with the other personal assets or junior to the other assets. That would affect the value of the transaction for the borrowers?

Philip Lanesays:

The responses on the web site seem to miss the key error of the article which is that non-recourse loans on share purchases are equivalent to a call rather than a put option. The value of such an option under Black-Scholes depends on the assumption on volatility, which has been very high for the banks, and expected time to exercise (which here also effects the exercise price through an increasing discount rate, in addition to its standard effects). The level of recourse is a negative against this value, which a put option (or a combination of put options with different strike prices) would value.

Gregory Connorsays:

@Philip: I disagree somewhat with the email you received. Since shares + put = cash account + call one can value it either way.

Suppose that the Anglo share price is 1.00 at the inception of the deal and that the borrowing/lending rates are equal and equal to zero.

The payoff is a 0.25 cash account plus an in-the-money call option with strike price equal to 0.25.

or

The payoff is a unit position in the share at current price 1, plus an out-of-the-money put option with strike price equal to .25.

So the analysis is identical whether you want to call it a cash + call or put + share.

The key error that is missed in the article, in my opinion, is that this secretive activity was extremely underhanded and deceitful and violates core principles of well-functioning security markets.

Eamonn Walshsays:

I recently became aware of this discussion.

My article was based on the observation that the ex ante valuation of a 25% recourse provision is a natural candidate for contingent claims analysis. If the recourse provision had economic substance, then the ex ante wealth transfer is significantly less than €450M.

Using a volatility estimate of 30% from Anglo’s Annual Report, I calculated the value of the options received by the Anglo 10 at €40Mln. To allow for alternate assumptions, I also stated in my article ‘Even the most extreme assumptions for this valuation could not make such a figure more than €120 million’. Prof. Connor completed a similar analysis using a 60% volatility assumption and arrived at a valuation of €68M (<a href = “http://www.irisheconomy.ie/index.php/2009/03/07/valuation-of-anglo-irish-golden-circle-deal/” See here).

I trust that it is now clear that there was neither a ‘key error’ (Prof. Lane’s correspondent) nor a ‘major error’ (Prof. Honohan) in my analysis.