Money Pit Post author By Philip Lane Post date August 19, 2010 This week’s edition of The Economist reports on the lrish banking crisis: you can read it here. Categories In Banking Crisis Tags Irish banking crisis 39 Comments on Money Pit ← Alternative Stress Tests from OECD and Citi → Bike paths to somewhere 39 replies on “Money Pit” From the article: The prime culprit is Anglo Irish, a specialist-property-lender-turned-black-hole that now seems likely to have to write off almost half of every euro it loaned. This isn’t too far from the truth. But if someone could explain this to me, in a way I could understand. Even the dumbest lending institution of all, could not be wrong all of the time. I know Anglo was excessively leveraged. I get that, it is dangerous. I know that Anglo was excessively focussed on the property game. I get that too. But it still doesn’t explain how one institution can have as much bad luck as this one did. Except, if you take the moral hazard theory to its extreme altogether – and argue that Anglo never had any long term strategy for its loan book – only to saddle it onto Paddy the Irishman. And somehow that doesn’t seem totally plausible either. Are we any where near to a better handle on the theory – that unless the crash of 2008 had occured – that institutions such as Anglo, BOSI, INWBS etc would have struggled on for another decade to create an even larger mess? I have heard that theory suggested from time to time on the airwaves, and I was wondering how people feel about that now, as we approach the second anniversary of the Irish bank guarantee. BOH. @ All, I hate to pester the good folk here at the Irish Economy blog, but if I may be so bold. I scribbled a quick blog entry I called Toxic Waste, a year ago. Folk accused me of using incorrect terminology to describe what was unfolding in the summer of 2009. Folks commented that I had no understanding of what was happening. I should stick to construction, and what I knew best. I agreed with them, and still do. The really strange thing from my perspective is, 12 months later, I am reading this in The Economist magazine. NAMA, which is designed to mop up the most toxic loans on the balance-sheets of Irish banks, said that only about a quarter of these loans were producing any income. That is far lower than the 40% it had been told to expect by the banks that are shovelling loans into it. I will continue to stick to what I know – and that certainly isn’t finance. I don’t wish to draw attention to any prescience of mine, but to the fact that attitude can evolve considerably over the course of 12 months. I criticised BOSI aggressively a year ago also. The last serious piece of construction I worked on, was the foundation structure for a new BOSI headquarters at Cherrywood (on land later re-possessed to DLR Coco). Those were the days. Everything can come full circle and in Ireland, it sure has in spectacular fashion. BOH. http://designcomment.blogspot.com/2009/08/toxic-waste.html I will ask this question again as I failed to get a answer from this den of economists. How much yearly interest payments is being extracted from the Irish juristication to pay external bank paper ? It is a simple question. figures from 2007 2008 or 2009 would be sufficient. @ Keith Cunneen, What makes you so sure it is being extracted from the ‘Irish jurisdiction’ at all? We simply don’t know – and my best stab at the matter is, the Irish state itself is wrapped in as a creditor somehow to our own banks (perhaps not intentionally, but through some instrument or mechanism). It is the only theory that makes it all fit, from where I am looking. Ahura Mazda offered another slant in his comment at the link below. He is also correct, in my opinion, but should turn his logic upside down, to see how things fit. BOH. http://www.irisheconomy.ie/index.php/2010/08/18/alternative-stress-tests-from-oecd-and-citi/#comment-66119 Is not the byzantine nature of these accounts a damning indictment of the Guarantee – maybe Dublin castle itself does not know where these glorified chain letters lead ! What a complete and utter mess. I blame Yes Minister for gutting the very idea of competent civil servants and outsourcing core state functions to non-state actors and expecting them to be more capable and lawful. @ Keith Cunneen, If you can get our head around the creditor status of the Irish state to Irish lenders – then Ahura Mazda’s final sentence looks interesting. I’d expect future stess tests will treat NAMA bounds as Irish debt. I will have to take a good run at this. But basically, the stress test will have to figure out the implication, of Irish state bonds deposited on the books of Irish lenders, to which the Irish state is perceived as a major creditor. The implications of that in terms of valuation of anything are just mind boggling. I don’t think we have the mathematics or the machinery to crunch through it. The fact is, the international markets have analysed the deep inter-connectivity with everything in Ireland. It is not so much crony capitalism, to use a phrase that Fine Gael are so fond of. But it speaks of a genuine failure of human beings to understand the presentation of information, and how it is intended to be processed by others. I have always believed in my mind, that a balanced education is a great asset. And certainly, those who work with the arts have to deal with the issue of presentation and perceptions all of the time. It is important that the numbers oriented members of our young population, do not suffer from a full, broad education in arts as well as numbers. It will save us all a lot of heart break, in the longer run. Just my opinion. BOH. Correction: do not suffer from a lack of a full, broad education in arts as well as numbers. BoH, your 1st comment. This paper strongly worth a look — there are circumstances in which the moral hazard gets magnified to where bad luck is not a bug, it’s a feature. The transnational nature of banks is mind blowing in its complexity – even in the states each bank was restricted in its liabilities to its own state until this era of madness. There appears no clear chain of command within western polti- economic structures anymore. I used to think that the Central banks(FED,ECB) had a handle on this but maybe the Friedmanites have created a uncontrollable monster that even they can’t hold down. Where is the centre of power in this circus ? While this article does point out the massive cost and burden which is Anglo Irish and is rightfully concerned about the difficult position we find ourselves in, the article is reassuring here, “Ireland is paying for its decision to set up a toxic-loan repository that forces banks to clean up their balance-sheets vigorously, rather than put off dealing with problems (as Germany has done) or insure dodgy loans and just hope they improve (as Britain has). In the long run Ireland’s response is the better one, but in the short term it puts pressure on borrowing because the government has to keep injecting capital into broken banks. ” As much as many people here oppose NAMA, it’s good to see it getting international recognition as the right approach. @ Cathal Right approach in the long run! If we even get to the long run!!! The Economist is still missing the story, but they are a lot better than the old days when the press claimed “only Ireland was doing everything right”. The trend in the international press is clear. Gradually there is recognition that (i) our fiscal situation remains dire, i.e. those early cuts by the government were not nearly enough (the Ecoonmist lauds the governemnts deficit reduction program but mises that the government prays for growth, rather than having a real plan, to achieve these) and (ii) our tax base (which is best measured by declining GNP, not rising GDP) is still falling, and (iii) that the banking solution through adding NAMA debt and more public sector debt is highly risky in this environment and so means spreads on Irish bonds must be very high (far higher than today probably). They still discuss Ireland in light of the past austerity, which has made people feel comfortable buying our debt. As this past “Irish glow” turns to more realistic pessimism, markets can get very ugly. At some point people will start recognizing that Ireland is on a slow path to default under reasonable assumptions. Even if the annual odds of default are just 5%, our bond yields must go up a lot more. Then, we, this time as a second mover after Greece, go to the IMF. What did the IMF recommend? 1. Much more budget cuts than planned. 2. Immediate action on a bank resolution regime (i.e. make creditors pay, although they naturally did not write this). That’s when we will see the true austerity we are in for…. Paul says: That’s when we will see the true austerity we are in for…. Politics is a strange thing, and a talented politician will develop keen observational skills of the electorate that s/he is working for. I have noticed myself (not claiming any personal mastery over this) amongst the ordinary people in Ireland a switch away from being angry at the banks. In summer 2010, being angry at the banks is so two years ago. The ordinary people in Ireland at this stage, are no surrounded by the effects of the financial collapse, in the form of friends, relatives and neighbours who are all either fired, busted or ruined. I have been listening to commentary in Ireland, and the blame has shifted amazingly away from the banks – and now people are simply occupied in blaming one another. I frequently listen to comments in everyday conversations today, where people quip, the Irish can’t work. The young people have no work ethos. We became too comfortable etc. I.e. If a young man isn’t bringing home a pay packet, and he blames the banks for his plight, he will receive an immediate clip across the ear from his elders. A keen politician in a party such as Fianna Fail will be aware of this, and will take the temperature of the native population over this summer recess. Amazingly, the banks are no longer the targets of peoples’ emotional distress. It makes sense too, as few everyday folk have time to wonder what a subordinated bond is. Despite the best of efforts by RTE’s PrimeTime to explain the same. If Paul’s prediction of the austerity that awaits us, does come about, it will be interesting to know how ordinary people respond at that point. Will they turn increasingly against one another? Is that how the everyday Irish will deal with the emotional distress? Or will the focus of their attention turn back towards the state or towards lending institutions? I strongly suspect the former, instead of the latter. The reason I think, is the informational assymetry. People tend to worry about what they know best – which is family, friends and neighbours. They worry less about stuff, which doesn’t feature in their immediate lives, such as bond auctions and spreads. The other factor, is that in Ireland if someone or some institution can get away with it, people hold a kind of unspoken private respect for that. Which is more than likely, why our banks were allowed to progress as far in their affairs as they did. My best gues-timate is – unless the financial crisis of 2008 happened, and forced it all to grind to halt – the Irish themselves were so passive, they could never have intervened themselves. This brings us back to the point about bond markets and spreads over German bonds. This brings us back to the point often repeated at the Irish Economy blog. That foreign intervention in Ireland’s affairs is not always a bad thing. In fact, without that pressure from bond markets – would the Irish be like the Sims family, who sit on their couch and starve, because someone turned their free will setting down to zero? BOH. Paul agree with you on the IMF Basle seems to be moving towards a resolution regime involving senior debts. The outcome of this though will be an upward repricing of senior debt and possibly a reduction in supply. Ergo, this leads to smaller more deposit funded balance sheets or in simple terms a credit crunch. From the moral hazard paper on the savings and loan crisis linked above, many thrifts were allowed to continue in operation after their true net worth was substantially negative. According to regulatory account- ing principles, an artificial increment to net worth was created to remove the legal obligation that regulators would otherwise have had to close such a thrift. The existence of thrifts in the US market is a bit different to what we have in Ireland, but I assume they are similar to building societies. What is suggested by the Akerlof and Romer paper of 1993, sounds very like Irish Nationwide Building Society. We had the discussion until quite recently too, of INBS becoming merged into a third banking force. Which sounds a lot like the U.S. instance of the thrifts being offered ‘goodwill’ to increase their net worth. BOH. @Cathal The Economist thinks that recognizing your problems now is better than putting things off until later. That’s not the same as saying that NAMA is the right way to do it, or that the pricing mechanisms in NAMA are correct, or that how NAMA will manage the assets will be correct. There’s a big difference between agreeing with a principle of “sooner rather than later” and agreeing with the details of NAMA’s operations. I suspect that many people on here share the Economist’s opinion that dealing with things sooner is better than later….much like going to the dentist. I also suspect that many people on here still have suspicions about the details of NAMAs plans – particularly as they were originally set out before people like the EU commission got involved and before articulate opposition from some of the leading contributors on this board both caused changes. @tull “Basle seems to be moving towards a resolution regime involving senior debts. The outcome of this though will be an upward repricing of senior debt and possibly a reduction in supply. Ergo, this leads to smaller more deposit funded balance sheets or in simple terms a credit crunch.” Yup: http://ftalphaville.ft.com/blog/2010/08/20/321516/flipping-the-capital-structure-erutcurts-latipac-eht-gnippilf/ The question is, I suppose, whether there an alternative? hoganmahew says: The question is, I suppose, whether there an alternative? The alternative is that we stop pretending to ourselves, that Irelands problems are only explain-able in the economic dimensions – the cost of bailouts and fiscal deficit figures. The markets aren’t even interested in those. But because we are the patient lying on the sick bed, it is more comfortable to discuss matters such as that, than admit to the real causes. The fact that our credibility is shot, and we don’t want to go about fixing it. BOH. http://www.irisheconomy.ie/index.php/2010/08/20/the-political-impact-of-the-great-recession/#comment-66332 @Tull & Hoganmahew I wouldn’t get too excited. As far as I know, the proposal only deals with capital instruments. Senior debt is not a capital instrument so they are not suggesting that senior debt holders being forced to take writedowns or do a debt/equity swap. Poorly reported by the FT @ tull Yes you are right. I am mistaken. The proposal does only relate to capital instruments. However, on page 20 “Parallel efforts are ongoing to ensure that all banks that fail are capable of being effectively resolved and losses allocated to both senior and subordinated instruments. The proposal in this document should not be viewed as an alternative to effective resolution schemes, but rather a complement.” This seems to me to refer to the possibility of losses being imposed on seniors in a bank that was being wound up ( Anglo?) but not on a bank that was being recapped to be fit for purpose. In any event, it still seems a long way from the famous D4E swap so beloved of many on this site. It seems like the choices are limited to taking the losses on the chin and fiscal austerity possibly involving some form of IMF package if bond markets get uppity. @Gavin S, post intended for you. In this instance, I am not talking to myself. @ Tull Yeah I agree. I don’t think they would ever try and impose losses on senior bonds in anything but a liquidation situation and in accordance with whatever bank resolution scheme is in place. (if we ever get one of course!) @Gavin S Right, but it refers to both senior and junior capital instruments (I presume meaning dated and undatd?). In addition, the last bit of the BIS proposal document: “Could the proposal reinforce moral hazard in relation to senior debt? The proposal set out in this document aims to solve one very specific problem, which is that there is no internationally consistent mechanism by which all capital instruments at all internationally active banks can be made to suffer a loss in the event that a failed or failing institution is rescued through a public sector capital injection. Parallel efforts are ongoing to ensure that all banks that fail are capable of being effectively resolved and losses allocated to both senior and subordinated instruments. The proposal in this document should not be viewed as an alternative to effective resolution schemes, but rather a complement.” So BIS proposals are not limited to capital instruments alone; they may act to make all forms of capital more expensive? edit: crossed with tull… @Hog Yeah, all capital instruments will be affected. I don’t think Basle will go near senior debt. I think what they are saying is that Countries need to come up with bank resolution schemes to deal with senior debt and how losses are allocated. They won’t start putting loss absorption features into senior debt. All forms of capital will become more expensive. There is no getting away from that. @ Gavin Not only more expensive but also scarecer. IF some forms of capital becomse more absorbing and more equity like in character, then the available volume of fuunds may fall. Some bond funds were dabbling in subbies and have found out to their cost that they are not going to get their money back. @Tull Agreed. Unfortunately I know all about dabbling in subbies and either getting burnt or finding out that pricing to call date because these bonds were always called wasn’t the cleverest! Won’t be doing that again!! Will be interesting to see how the markets develop. Will you have equity investors start looking at sub debt because the yields are so high? If each Country introduces it’s own Bank Resolution Scheme, will senior debt holders in some Countries be better off than in others? These new instruments will have some kind of convertible features. That means niether plain vanilla bond or equity funds will own them. They will become a nightmare. The cost of capital and liquidity is going up for banks which means more expensive funding for business and consumer. I suspect the supply of funding is going down. So in this country, we face a deleveraging banking system & a deleveraging govt. @Gavin S I think Basle will head towards a model for a resolution scheme. It only really makes sense to resolve global banks on a uniform basis, or at least within operating markets. Given that there will be, if you like, equal risk (as all markets will be resolved in the same manner), and investors will want to hold a proportion of bank debt (because everyone else does and it fits nicely into the portfolio), does this not hint at no likely shortage of senior debt appetite? (While the price may be adjusted for risk, the volume will remain). @Hog It would be extremely difficult for Basle to have a model for a resolution scheme because of National laws. You would never get agreement. Look how long it takes to argue over bank capital! @Gavin S Well, yes, it would be difficult if they were to impose it. On the other hand, if they could agree a model amongst the big blocks (US, EU, Japan, maybe?), the financial regulation in those blocks could then restrict entry to those banks that are not resolvable under the BIS model. Something like that anyway. It’s pretty much the way international standards get implemented! Frank Galton says, there are circumstances in which the moral hazard gets magnified to where bad luck is not a bug, it’s a feature. I reviewed a blog entry I compiled recently, on the idea of things becoming magnified during a boom period. Many things with regard to cycles of boom and bust, are counter intuitive, I have noticed. It seems as if financial engineering has similarities with civil engineering. A professor at school once asked which size particles fall to the bottom of a load of aggregate – the large rocks or the little ones? It is actually the large rocks. They work their way down to the bottom over a period of time. But most people think it is the small rocks that go to the bottom, and the large ones stay on top. I was the only kid in class you knew the answer. I knew the answer because I once threw large rocks into a trench after back-filling with gravel once. I had to re-open the trench, because the pipe had failed and I discovered the large rocks squashing the pipe, having worked their way down through the smaller gravel particles. How is that on the scale of useless information? BOH. http://designcomment.blogspot.com/2010/08/house-of-cards.html Confident guy this he not only thinks the Irish responce is better than Britain’s and Germany’s. Interesting artical on the BBC from Robert Preston – he thinks the British Govt will make a profit on the RBS insurance scheme. http://www.bbc.co.uk/blogs/thereporters/robertpeston/2010/08/taxpayer_to_profit_from_insuri.html Sorry first sentence above should read – Confident guy this he not only thinks the Irish responce is better than Britain’s and Germany’s he knows its better. @niall, was looking at some numbers today. The big development book in the Irish banks wil have been written down to 40bn from 70bn. RBS, HBOS, Danske have all followed suit. The Spanish development books have all be written down by less than 10%. Irish banks capital positons will reflect this by year end. More pain to come elsewhere. Our problem is now turning from a banking balance sheet crisis to a public sector balance sheet crisis. @Frank Galton A very interesting paper Frank – I have stored this paper on my computer. Also check out the old Swedish banking model which were 100% reserve banks. Its maybe no coincidence that the Swedish property crisis happened after their 100% reserve saving banks came under severe attack in the 80s. The Bankers then had power to create a bubble. Keith Cunneen says, A very interesting paper Frank – I have stored this paper on my computer. Agreed, it is a paper I am very excited to come across. I have seen it referenced in various places before. I think it was another Irish economist who refers to it in some document I read. I will certainly make the time to read through it – and I don’t make quite as much time as I used, to read these kinds of things. I read Alan Greenspan’s take on the S&L saga in his autobiographical book, so I am very interested to know what Akerlof and Romer have to say. Bill Black was interviewed by Bill Moyers a few times on PBS, and those interviewed discussed the S&L era too. The video interviews are easy to access on the web. BOH. http://www.pbs.org/moyers/journal/04032009/profile.html Tull says, Our problem is now turning from a banking balance sheet crisis to a public sector balance sheet crisis. That is very true, and it is times like this, I always welcome Zhou Enlai’s contributions to the Irish Economy blog, in terms of how to work out how the entire system my respond or behave. When the fiscal crisis reaches its peak, the IMF will become involved in our affairs. At that point we will find that two crisises will converge together. The one that has been submerged underneath the surface at the moment – the personal debt problem – will be pushed over the edge, by the ‘solution’ that is adopted to ‘fix’ the fiscal problem. That as assuming that the banking and property crisis all goes away. If you add it all together though, and these things all strike around the same time, it really is curtains down. I believe that is one of the few advantages of NAMA, if there is anything about NAMA that can be remotely described as advantageous. From a timeline and debt management point of view, it enables us to slide around a couple of ‘events’, so that we can arrange our battles in the best possible sequence, for Ireland to confront them. This is markedly different from having no control over the order in which things advance towards you. I agree that the property industry and associated banking crisis will recede in importance as the fiscal debt looms ever larger. But by the same token, the convergence of the banking crisis with the fiscal debt crisis would spell complete disaster. I haven’t got time to grab a clever quotation from The Art of War, but I think you get the bones of what I am saying. When we talk about market approval of NAMA, or of government austerity measures – it doesn’t pre-suppose the IMF will not arrive on our doorstep at some stage in the future. What the markets are really approving about, is the fact that Ireland is able to kick some cans sufficiently far down the road, to enable the markets also to deal with the issues in a favourable sequence. Rather than all at once, in complete chaos. BOH. @all Shimrod’s comment on this is in tune with me mood ………. http://www.economist.com/user/Shimrod/comments Comments are closed.