Not Too Late for a Different Approach to the Banking Crisis

As I write this, the government is continuing to mull over its NAMA proposal. The proposal has been around so long that it is easy to forget that we are actually still at an early stage with this process, with the legislation yet to be published even in draft form and no vote due for a couple of months. For these reasons, it is still worth discussing why alternative approaches may be worth taking.

I’d like to set out one such approach. But before doing so, let me explain why I think things have moved on since the NAMA proposal was introduced.

Earlier this year, a number of analyst reports were released which suggested that the major Irish banks could be sitting on property-related losses that could wipe out their equity capital and render them insolvent. I think that from today’s perspective the evidence that the losses are likely to be on this scale (particularly for AIB) has strengthened considerably. I’d cite three pieces of evidence here:

  1. The continuing rapid fall in house prices.
  2. Anglo Irish Bank’s assessment of the losses it is facing on its development loan book based on its position that development land is already down 70 percent from peak.
  3. The evidence emerging from the High Court of the full extent of developer indebtedness, in particular the fact Liam Carroll’s Zoe Group are only in a position to pay back quarter of their debts.

NAMA is a plan for dealing with a banking system that has some bad debts but is not insolvent. I think events have now moved beyond that point. It may be embarrassing for the government to admit this, but I believe Mr. Keynes has provided the appropriate response to those who would wish to accuse them of a lack of consistency (“When the facts change ….”)

Here’s a suggestion for an alternative approach to NAMA.

  1. Introduce a Banking Resolution Act along the lines of the UK Special Resolution Regime. This would give the government wide-ranging powers to intervene to deal with banks that are insolvent or close to it.
  2. Where banks are deemed to be clearly insolvent without state help, nationalise them.
  3. Set up a mechanism for compensating shareholders of nationalised banks. One possibility would be to offer to pay the market value on the day after the introduction of a Resolution Act has been announced.
  4. Deal in a systematic manner with subordinated bondholders of nationalised banks.
    1. Those with stronger claims but with debt expiring outside the guarantee period can be offered a cents-on-the-dollar deal in return for the issuance of new guaranteed debt.
    2. Any remaining unguaranteed subordinated debt holders can be offered a debt-for-equity swap to become partial owners of this new bank. It has been known for some time that these are distressed instruments which are unlikely to deliver par value. I suspect that, by and large, they are no longer held by those who originally purchased them with the current owners more likely being experts in distressed assets. These guys may be more happy to play ball and take an equity stake than might be thought.
  5. Write down bad loans by a realistic amount and re-capitalise the banks. Whether the write-downs are done as part of a process of transferring loans to an Asset Management Company is less important than one might think based on the recent NAMA-centric debate. However, if an AMC approach is to be taken, the bad loans should be management by experts in property development, rather than sent back into the original lending banks. It may still be possible as part of shareholder compensation to set up a risk-sharing mechanism (along the lines of Patrick Honohan’s NAMA 2.0 suggestion) so that if losses on property assets turn out to be less than the original value of shareholder equity then the shareholders receive compensating payments in the future.
  6. Open negotiations with major international private equity firms. In exchange for advice on bank restructuring and decisions on senior management, the government could open negotiations with interested private equity firms regarding them quickly taking an ownership share in any nationalised banks. These negotiations could include the government offering to extend the guarantee to these banks for a number of years.

I believe that a systematic approach along these lines will cost the taxpayer far less than the current approach and also has far better potential to quickly resolve our banking problems than the NAMA plan, which is likely to get bogged down in controversies over asset valuation, legal disputes and endless suspicions of crony capitalism.

35 thoughts on “Not Too Late for a Different Approach to the Banking Crisis”

  1. Karl, I agree very much with most of what you say. The hard reality is that the Irish banking system is structurally insolvent. While the focus of public discussion has been on loans to developers, large banks losses on mortgage loans must be looming if house prices are already down by circa 30-50% while unemployment is heading up towards 15%. If Irish house prices returned to their pre-EMU trendline, they would have to fall by two thirds from their peak levels. See the chart here http://www.derekbrawn.com/DoEHLG.html

    Given the scale of our problems, house prices are unlikely to revert to trend. They are more likely to fall through trend and to overshoot on the downside. If that happens, and I believe it will, I cannot see any Irish bank remaining solvent.

    But I have two significant points of disagreement regarding your suggested course of action:

    (i) if the banks are insolvent, why must shareholders be compensated at all? We have already seen bond-holders accept large write-offs on their investments in bonds issued by Irish banks. The implication of that is that the equity in those banks is already worthless. (Although current equity prices of Irish banks clearly contradict that conclusion).

    (ii) I wouldn’t bring private equity (PE) into the equation. Their perspective is too profit-oriented. Our main focus should not be profit maximisation at banks but managing our economy as best we can. Also, I’m not sure that any large PE companies actually have much experience in bank management. Anyway, there has been a bubble in PE investment over the last decade. The PE business model, dependent as it on the ready availability of cheap finance, is itself badly broken.

  2. Karl,

    We’ll see the Bill next week, or at the latest, the following week. The Minister has repeatedly asserted that he will welcome suggestions for amendments, though I doubt that extends to scrapping the draft legislation entirely and starting all over again. Still, Bills have been scrapped before, but the Minister appears convinced that this is the best way forward. Right now he has to convince his government colleagues of that and then the rest of us.

    So I look forward to your views on the framework outlined in the Bill. Incidentally, the credibility on this issue of those who are most vociferous on accusations of ‘crony capitalism’ is already shot to pieces. Crony capitalism is about all they have left to cling to.

  3. @Cormac
    “if the banks are insolvent, why must shareholders be compensated at all?”

    Despite owning shares in banks and having been stung by Anglo, I agree with you. That’s the risk you take in investing in shares.

    My only proviso is the people who misled shareholders as to the value of the investment should be brought to book. It happens in the US, it does not happen here. Not only that you get the impression that one of the biggest culprits will walk away with millions.

    This is probably not the place for it but we need legislation that gives investors confidence that when there is wrongdoing on the part of directors of plcs they will be punished. Otherwise my future investing will be outside Ireland only. Once bitten….

  4. I also believe that an alternative approach is needed, however, I do not understand why ordinary shareholders and unguaranteed subordinated debt holders should receive anything. Nationalisation SHOULD take place to stabilise the country’s financial system. Nevertheless, considering that the banks would collapse if they were not to receive a bailout using public funds, nationalisation is simply an alternative to the bankruptcy of these insolvent businesses – and the same conditions should apply.

    The contrary would lead to moral hazard in the future, with bankers and their shareholders and bondholders continuing to seek short term profits and relying on the taxpayer to guarantee (at least a portion of) their risky investments should things go sour. Denying shareholders and bondholders compensation would encourage them to be more selective in providing capital to banks in the future – at least we would have SOMEONE monitoring the financial sector in place of the pathetic, incompetent and IMHO negligent Financial Regulator. The objective of all this is to maintain the system’s stability and improve liquidity and availability of credit (for viable investments) now, and to build a sustainable financial system for the future.

  5. The government guarantee has bought the time for them to mull over options like NAMA, but at what price? With 20/20 hindsight it is such a shame the govt guaranteed the liabilities as well as the deposits of the Irish banks. At the time, the market only “needed” the deposits guaranteed. Alas, the banks liabilities are linked to the state and that is the biggest problem facing us currently, not the sideshow that is the “NAMA haircut” discussion.

    The government seem to be trying to find a solution to suit the bondholder, the shareholder and the taxpayer (alphabetical order, order of importance is another forums work). There isn’t one, all will take a hit. I agree with Cormac, the shareholders should be taken out of the equation, caveat emptor I’m afraid, their equity has been or will be soon, totally wiped out. That leaves the taxpayer and the bondholder. Without the guarantee it would have been easier to take the bondholder out of the equation, caveat emptor again. With the guarantee, the only way I can see us negotiating our way out of the guarantee whilst keeping the oh so necessary confidence of the international debt markets is with a new government.

    A new government would have the time, the legitimacy and hopefully the nous to rewrite (tear up) the guarantee and start afresh. Then we could look at NAMA as a way to protect the interest of the taxpayer as much as possible. I guess there is no chance of the turkeys voting for Christmas though.

  6. We do need a new approach. However, as the banks are clearly insolvent (inability to meet debts as they fall due without State help) we should nationalise them and then clean them up.

    Citi got 99% acceptance of debt for equity swap last week. (Bloomberg) The US gov. agreed to swap some of their prefs as part of the deal. The reluctance of our Government to frighten the bondholders seems misplaced. As Karl pointed out the current owners probably represent toxic debt funds or suchlike.

    I would by wary of the private equity suggestion as I seem to remember one of these entities has yet to repay the full loan advanced by the |Japanese Government to a Japanese bank they acquired in a similar deal a decade ago.

    Valuing assets at other than their true value is a recipe for prolonging the pain- better a sharp shock than a lost decade.

  7. When receiving bad news, the way people receive that news usually goes through different stages beginning with shock and denial, followed by anger, acceptance and adjustment.

    I fear with our accidental Taoiseach that he is still stuck in the first stage. People react differently in crises as evidence in recent studies that studied why some people survive and some people die in crisis situations. (See http://www.time.com/time/magazine/article/0,9171,1810315,00.html )

    In summary the people who have best chance of survival are those who react and respond appropriately while those who carry on as normal choosing to blank out the peril that is upon them are naturally more likely to be doomed.

    Evidence the delay in implementing necessary cuts in public spending – this is being done in the hope that things may not be so bad in 6 months time – but ironically the delay will prove worse in the long term for both private and public sector tax payers.

    Instead of facing the music and getting on with it, the airwaves are instead filled with woolly words from trade union leaders and well-meaning but naïve comments from Fintan O’Toole and Vincent Brown.

    Regarding NAMA, this has been championed by Brian Lenihan (at least give him credit for doing something significant)– but for this route to be altered would require our Taoiseach to force an alternate course…is there anything in his background to indicate that Brian Cowen would take such action?

    Do we go back to being dependent on Europe for handouts (there are many more mouths to feed this time) – was it all a dream or have we learnt anything?

  8. I wonder if perhaps it is too late for a different approach because the Department of Finance does not have the personnel to carry out the analysis and deliver the complex legislation we need as quickly as we need it.

  9. @CM
    “Alas, the banks liabilities are linked to the state and that is the biggest problem facing us currently, not the sideshow that is the “NAMA haircut” discussion.”

    Well, i dont think the haircut is a sideshow. In fact, its the center of the three rings of the NAMA circus, complet with monkeys and clowns and probably lions and tigers and bears, oh my.
    The situation is really very simple ; if we as taxpayers pay anything like the market value, or even any logical longterm value, the losses will bankrupt the banks. BUT the ringmasters have dictated that the banks will not be nationalised, so the above wont happen. That can only arise if the haircut is small.
    So we overpay by 30b or so – hardly a sideshow

  10. I agree that compensation of shareholders in an inslovent company is not particularly sensible or desirable.

    One nasty little side effect of nationalising banks is the politic pressure that brings as people seem to expect them to be (think they can be) run as some sort of national ATM. Witness all and varied calls recently to:

    Prevent interest rate changes
    Force waiver of penalties for withdrawal from fixed rate contracts
    Waivers for parental guarrantees on mortgages.

    Could you imagine the mess?

  11. Couldn’t agree with you more Karl but this all reminds me of work and the sensible guy telling the director that such and such a project can’t be done unless he changes /resources/delivery date/etc. parameters.

    Director then ignores sensible guy and listens to guys who say ‘yes’; director then initiates project and promotes ‘yes’ men; six months later director and ‘yes’ men are looking for scapegoat because it has all gone down the pan; sensible guy gets scapegoated. Watch out for the FF spin machine in a years time Karl. They’ll be looking for someone to blame and they know where you live (probably)!

  12. @Brian
    That’s why we need to change the ringmasters and nationalise the banks. By sideshow I mean the price we pay will bear no relevance to the real value of the “assets” it seems. Probably too light a word for a €30bn mistake alright.

  13. I don’t understand enough of the details but it looks like a sensible approach…not sure about point 3, shareholders are making a punt, let them profit or lose, its not like the crisis has crept up on us or people aren’t aware of the risks involved.

    NAMA is trying to pull a stroke, same as the guarantee…. Strokes work in politics, in the financial world shorts will beat strokes.

    as we learned from the bond pricing within the eurozone

  14. @Karl Whelan
    You have stated the subordinated debt holders should be offered a debt for equity swap. I agree with this 100% but I would like to know why you think this shouldn’t be done with the senior bond holders when the guarantee expires.

    Surely all providers of RISK capital should share some of the losses.
    Shareholders have taken significant losses, subordinated bond holders have taken some losses while the rest is going to fall back on the state on the taxpayer.

    While I agree that there would be some negative consequences of forcing them to accept a debt for equity swap.
    I think these consequences need to be throughly explained and quantified. This will allow the public to decide if saving them 100% is a good use of taxpayers money.

  15. To all those who wish nationalise the banks and save the financial system and implement a debt equity swap can I point out a few realities.

    Nationalisation would not neccessarily stabilise the system. As the flight of deposits from Anglo shows, national entities might find it difficult to retain deposits precisely because the depositors would be rightly concerned that the banks would be run on a “political basis”. Look at the demands to “do something” when the Permo/TSB raied the mortgage rate.

    Also, I should point out that senior bonds in our system rank “parri passu” with deposits and are not part of the capital structure. They are not “risk capital”.

  16. I think something that is missing from the debate on NAMA is the revelations that happened since the guarantee and how that should be shaping policy…

    Basically within a couple of months of the state unconditionally guaranteeing banks debt up to 460Billion, it emerged that

    1/ One bank was engaged in ‘balance sheet manipulation’ to the tune of billions of euros which was facilitated by other banks.
    2/ One bank’s chairman had massive loans which had been hidden from auditors.
    3/ The Financial Regulator was at best woefully incompetent,

    This was just some of the dealings which emerged when it was ‘too late’ to reverse the guarantee… Clearly, with the benefit of hindsight, a few conditions on the guarantee would have been good.

    So we can be sure similar revelations will emerge post NAMA…. Now before NAMA is set up, and when the banksters and other fraudsters are in a position of weakness, it is imperative the state put measures in place to ensure hiding of assets, fraudulent behaviour, insider tranding and plain corruption are dealt with.

    And that NAMA cannot be obstructed by failed developers or bankers.

    This may mean all debts going in to NAMA should be accompanied by consent forms, waivers of privacy or other rights, indeminification forms etc….. Now is the time to impose conditions that will assist NAMA in its efforts in establishing ownership of assets, debts etc.

    If they wont agree to such conditions, well its a free country, they can pay their debts by raising finance elsewhere.

  17. One compelling reason the Minister should review the planned approach is that evidence has emerged that similar bank bailouts in the UK and US have failed to deliver the lending necessary for the economies to grow.
    The Times of London reports today that the Chancellor has threatened the banks with the Competition Authority in a bid to get them to resume lending and the Wall Street Journal reports “The total amount of loans held by 15 large U.S. banks shrank by 2.8% in the second quarter, and more than half of the loan volume in April and May came from refinancing mortgages and renewing credit to businesses”
    Is there any reason to believe that our banks will behave any differently to their peers in the UK and USA if left to their own devices.

  18. @ podubhlain : while the minister et al may say the point of NAMA is to allow banks to lend, the talk by P Honohan at McGill, plus much other comment, suggests that that is a horse of a different colour. NAMA is not about that. Its about…other things

  19. I wonder, reading many of the comments above, whether the commentators actually understand how the debts are to be paid back. They are so large that it is not possible – I repeat, not possible.

    So, we either have to place the existing financials in receivership – and face the unpleasantness this causes, or bankrupt our state – as the citizen taxpayer will not have the necessary future income to pay all their bills – and bail-out taxes. OK, they will if there is a significant inflation in the money supply, but not otherwise.

    One interesting stat from KW’s post was the probable future value of residential property. When this ensures – what will the level of neg equity be? I understand that Irish mortgages are recourse loans – correct? If this is so, then its curtains!

    Growth. Now several of you have mentioned this. I would like KW and any other senior economists/finance experts who contribute to this blog to carefully explain the difference between a Production/Construction economy, which generates a real surplus after paying its bills, and the current FIRE* economy which uses credit as an input, and produces debt. Debt grows by the way – like exponentially! Ireland is principally a FIRE (consumer) economy, not a P/C economy. So, growth in this context means MORE DEBT! Is this rational?

    A P/C economy mandates a significant input of various forms of energy in order to ‘grow’. There is an emerging real problem with world liquid fossil fuel production (declining) and the internal, domestic consumption of liquid fossil fuels by the producing states (increasing). The nett, available for export is declining, on the double!. Less energy, less growth!

    Someone has some difficult explaining to do.

    *FIRE: Finance, Insurance, Real Estate.

    Brian P

    ps: Throw our banks to the market wolves. Establish new ones with clean balance sheets. At least the taxpayer will not be toasted for years. The longer the debt is held, the worse it will be.

    bpw

  20. I get the impression that the government don’t understand the amounts involved. These numbers are way beyond the normal stroke pulling. It’s one thing wastefully throwing cash at a problem (bertieistas), it’s a lot more serious wastefully throwing debt at a problem (cowenistas).

    The government must give serious consideration to alternative plans. They should bear in mind that these are already in the public domain. The probable NAMA losses being passed to the citizens, will be seen as the ultimate act of cronyism.

  21. I had assumed that it was the government (behind the scenes) that is encouraging the banks to raise their interest rates pre having to re-capitalise them when NAMA is implemented in the hope the figure might look a little better – in conjunction with a small haircut. Put the problem back until later. The next administration can deal with it.

    @Brian Lucey
    “NAMA is not about that. Its about…other things”.
    Brian could you please spell out for me what you think those ‘other things’ are. Serious request – I’m not great at understanding governments’ Machiavellian dealings.

  22. @ Brian P Woods

    I agree wholeheartedly!

    What is a liquidation process for? Oh yes, the little people! It works for the benefit of the economy as a whole. For you and for me. Just because big banks like to employ people who have degrees in wconomics gives them no more right to survive and stink out the economy than any other deadbeat! If all this land is locked up for years, where are the construction jobs to come from? The banks are going to absorb all the money given to them and will still not lend into a deflating economy!

    To reverse the deflation we need to liquidate. Every economist knows this. Recovery starts thereafter. Every commentor on this site, bar our two Brians perhaps, is ignoring this option. Why?

    Set up good banks. And keep them that way.

  23. Other things aside (we can speculate till the cows come home) Brian Cowen is reported today describing the Nama bill as a “strategic priority to get the economy moving”.
    We know similar bailouts are not working in the US and UK and today in the Times a report on an ECB survey contains similar findings – “Euro zone banks tightened credit standards again in the second quarter of the year and expect to do so further in coming months, but at a slower pace, the European Central Bank said today.
    In its latest bank lending survey, the ECB said the ongoing economic troubles were the main driver behind a clampdown on credit to both households and firms”.
    So we are set to spend thirty thousand million euro on a strategy that is doomed.
    The only ray of hope is that Richard Bruton appears to be finally getting to grips with the problem – “Panic today and misplaced optimism that tomorrow will look after itself should not guide this massive step.”
    “By all accounts, the European Central Bank (ECB) has agreed to supply an unlimited amount of funding to the Irish banks on the security of paper issued to them by NAMA,” he said. “In one bound the banks’ liquidity problems are solved.”
    We might yet get some real opposition to NAMA in its current form.
    In any event the game could be up on Friday and a rethink will be required.

  24. NAMA is favoured by the government because
    (1) they think it will come with no immediate costs and
    (2) it is advocated by those of their friends in the finance/stockbroking industries who want their clients to be protected.

    That is all they are interested in – in fact the level of cognitive ability among this zombie administration means they cannot comprehend the problem and their role in creating it. The numbers are beyond comprehension and the implications for our collective future would be enough to dishearten an Obama figure if we had one If they did, they would have taken the Bertie option and commited ritual suicide.

    Only a change of government can alleviate some of the catastrophe.
    The government is full of people who feel sorry for themselves and think this is a terrible time to be in politics – no sweeties to be handed out.

    Without being too political, I know from personal contact that FG is full of front bench spokespeople who are realistic about the catastrophe but alse see this as a great time to be in politics – decisions now will have enormous implications for the next twenty or more years.

    Is there any hope this zombie government will collapse before NAMA is passed?

  25. In relation to the debate on the approach in Ireland to the banking crisis, I thought that people might be interested in the transcript of the appearance of Bo Lundgren at the Joint Committee on Finance and the Public Service as he has been mentioned before in several posts. It is quite interesting, in particular his views on the treatment of bondholders (he cites Morgan Kelly’s article) and the determination of whether or not a bank is systemic. His preference for nationalisation of insolvent banks is well known, of course.

    http://debates.oireachtas.ie/DDebate.aspx?F=FIJ20090707.xml&Node=H2#H2

  26. Normally Ordinary shareholders are liquidated first followed by Preferred shareholders and then the Bond holders. All the precise details are in the public offering documentation for each class. In a gov’t takeover the valuations of each class prior to the takeover is what the gov’t would pay. If ordinaries were Euro 0.92 Preferred Euro 2.78 and Bonds ranging from 30% to 50% of their nominal value then those are the prices the gov’t would pay. If the companies were worth less than nothing then the gov’t could assume the liabilities depositors owed etc. and pay nothing to Share/bond holders. Or the gov’t could let them go bankrupt and let nature take its course.

  27. @M.O’L.

    The Government is hardly going to collapse pre-NAMA when Enda Kenny tabled a no-confidence motion after the local elections specifically to ensure that FF would have to deliver the next budget. FG’s courage knows great bounds.

  28. @Zhou

    You think the EK is that devious, that he would table a no confidence motion to ensure that provided it didn’t pass, the government would continue for another 6 months and so ensure that Richard Bruton would not present the next budget.

    Well you should examine the rules about votes of no confidence.
    The Ceann Comhairle can decide to allow a vote of no confidence within the six month period.

    When I wrote that FG people want to be in office because there are hard decisions to be made I wasn’t trying to do an impersonation of JFK with a Castlebar accent. The point was made to me by an FG front bench spokesperson – a serious person who is not perhaps a media star because (s)he actiually pauses to think before replying.

    This is an economics forum.
    But sometimes you have to say.
    It’s politics, stupid.

    And we have seen what happens when dumb and dumber get to run the country.

    So for once leave cynicism aside.
    The most momentous decisions since at least WWII when we decided to watch are being made.
    Do you honestly believe that we want to see this zombie government sign away the future of at least one generation?

  29. @ Joseph
    Read some of my earlier posts for suggestions as to waht NaMa is about. Most of them are libellous …. Brian still has to live in Ireland!

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