Author: Gregory Connor

Valuation of Anglo Irish Golden Circle Deal

There has been some discussion on this blog site about the value of the secret deal provided by Anglo Irish management to a circle of ten wealthy Anglo clients.  The deal was done last summer, in order to prop up the Anglo Irish share price.  Each of the clients was lent Euro 45,100,000 by Anglo Irish with the requirement that all the loaned funds be spent on Anglo shares. Clients were only responsible for repaying one-quarter of the loaned amount (Euro 11,275,000) in cash; they were permitted to repay the remainder of the loan by returning the shares.

At the time of the deal, the Anglo share price was approximately Euro 6.01 per share.  The share price has since collapsed to zero.  Each of the wealthy clients in the secret circle has lost Euro 11,275,000 (unless they now avoid repaying through bankruptcy or restructuring).  Meanwhile, the “shareholders” of Anglo have lost the remainder of the loaned cash (Euro 33,825,000 for each of the ten circle members).  Everyone has lost on this deal ex post.  It is particularly vexing since the Irish taxpayer now serves as the Anglo Irish “shareholder” and suffers a loss of Euro 338,250,00 on this secret deal. 

It is worthwhile to analyse, under reasonable assumptions, the ex ante value of the deal, both to the clients and to the Anglo management acting on behalf of shareholders (as if).  An accurate valuation is not possible with the information available to me, but a reasonable approximation can be made, and also a reasonable analytical framework provided for anyone who wishes to substitute other parameter values.

Last July Anglo had total shares outstanding of 749,585,405 and a share price in the range 4 – 7 Euros (quite volatile during the month), see the data here.  If we use a share price of Euro 6.01 then this gives a total cost of Euro 451,000,000 to purchase 10% of shares outstanding, which corresponds to the stated amount in later government reports.  Hence I assume that this is the share price at the time of the deal.  The one-year LIBOR interest rate last July was 3.2796% so I use a slighly higher interest rate of 3.75% as the two-year borrowing/lending rate.

Suppose that the clients have no insider information telling them that Anglo Irish shares are over-valued.  Also suppose that they are not liquidity-constrained.  In this simple case, the loan-plus-share-purchase is window-dressing designed to hide the real value of the deal. The client takes a loan of Euro 45,100,000 from the bank, and puts the proceeds in an interest-bearing account which exactly pays off the loan.  The client also purchases Euro 45,100,00 worth of Anglo Irish shares with true value of Euro 45,100,000.  Neither of these transactions adds or subtracts any value for the client.  The real value of the deal comes in the free put option which Anglo management has provided to the client.  If the client’s Anglo shares fall in value, the client can pay Anglo only ¼ of initial loan value, plus hand over the shares, in full restitution of the loan.  This put option constitutes the only source of value in the deal (admittedly under these strict assumptions).

The put option can be valued reasonably well using the Black-Scholes option pricing model; see here for details.  These estimates of value are conservative since empirically the Black-Scholes model tends to undervalue out-of-the-money put options.  I assume that the loan is for a two-year period and that the Anglo Irish shares have annualised volatility of 60% per annum.   The put option has an exercise price of (1-.25)(Euro 6.01) = Euro 4.512.  Using normdist and exp in excel it is easy to compute that the value of the put option for each client was Euro 6,757,469.  The put option is given to the client for free, in exchange for acting as a go-between to allow Anglo Irish management to secretly use bank-deposited funds to purchase their own shares.

The client is earning excess return of Euro 6757469 on risk capital of Euro 11,275,000 which is 59.93% or 29.97% abnormal return per year.   So even allowing for some liquidity-constraints or client nervousness about Anglo Irish share values, it seems a good deal.  Admittedly, it turned out disastrously for the clients, but this was due to a worldwide bank share meltdown plus the emerging scandals (notably this one) at Anglo Irish.

Perhaps Anglo Irish management raised the borrowing rate on the loans to account for the free put option.  This seems unlikely.  Again using the case of 2 years and 60% volatility, in order to recoup an option value of Euro 6757469.675 on a loan with principle value of Euro 45,100,000 they would need to add roughly (1/2)( 6757469.675/45,100,000) = 7.49% to their  base interest rate.  So if the base rate is 3.75% they would need to use a loan rate of 11.24%.

Bob Dylan has a song “The Lonesome Death of Hattie Carrol” about a shameful incident in the early twentieth century when a wealthy, well-connected young man bludgeoned to death a poor, African-American female servant, and escaped with virtually no punishment.  In his lyrics, Dylan makes the point that the truly horrifying aspect of this event was not the murder (there will always be violent individuals) but the reaction of the judicial establishment in ignoring it.  Analogously, in the Anglo Irish scandal, it is not the presence of greedy, underhanded individuals in Irish financial services (such people exist around the world in all countries and all industries) but the horrifying approach of the Financial Regulator, condoning and even encouraging such behaviour.  To quote from Dylan’s song:

In the courtroom of honor, the judge pounded his gavel

To show that all’s equal and that the courts are on the level

And that the strings in the books ain’t pulled and persuaded

And that even the nobles get properly handled

Once the cops have chased after and caught ‘em

And that the ladder of justice has no top and no bottom,

Stared at the person who killed for no reason

Who just happened to be feelin’ that way without warnin’

And he spoke through his cloak, most deep and distinguished

And handed out strongly, for penalty and repentance

William Zanzinger, with a six-month sentence.

Oh, but you who philosophize disgrace and criticize all fears,

Bury the rag deep in your face

For now’s the time for your tears.

 

Reinhart and Rogoff, and Ireland

Reinhart and Rogoff have a series of working papers (here) analysing the key features of financial crises, using data over many centuries and from around the world. In their papers 2008a and 2008b (here and here) they highlight  two common characteristics of banking crises: 1. they are usually followed by severe government deficits, but the relationship is not caused by bank bailout costs; the direct costs of bank bailouts are swamped by recession-related tax shortfalls and expenditure increases, 2. banking crises are sometimes followed by sovereign defaults, but again it is not due to direct costs of bank failures including bailout costs, since these are not typically a substantial part of the government budget crisis.  

In another one of this series of papers, 2007 (here) they demonstrate the prevalence and wide ubiquity of sovereign debt crises. They stress that sovereign debt crises are not confined to less developed countries.  The small number of sovereign debt crises in developed Western countries since WWII is a typical trough in the cycle, which by historical patterns is due to end soon. 

Looking around the world and acknowledging the historical patterns shown in their paper, a hidden message of the paper (in my own subjective reading) is that the Euro zone is due for at least one sovereign debt default in the next decade.  Will it be Ireland, and what can be done to prevent such a disaster? 

Rossa White of Davy Stockbrokers argues (here) that quote “the risk of Ireland not being able to meet ongoing debt payments over the next few years is very low.”  The credit default swap market seems to disagree.  The most recent Ireland government bond CDS rate is 3.41% meaning that institutional investor are paying 3.41% to receive the shortfall on par value when and if Irish government bonds default.  If the payment shortfall on default is 50% (a typical disastrous sovereign default) this is equivalent to a risk-neutral per-year default probability of 3.41%/.5 = 6.82%.  Over five years this aggregates to a cumulative default probability of (1- (1-.0682)^5)=28.09%.  Of course investors are not risk neutral so there is a substantial risk premium in the CDS rate, but still this indicates a non-negligible true probability of default reflected in market rates. 

Ireland must make policy changes to set the probability of sovereign default close to zero.  There is an over-emphasis on dealing with the problems in the banking industry as a solution to the current economic crisis.  Going forward, dealing with public finances is at least as important, probably much more important. 

The relative ordering of policy priorities is relevant since there is a finite supply of political capital to address the current crisis.  If all of the political capital is spent on the least important problems, the most important ones will go unsolved.  That increases the medium-term risk of a true disaster: a sovereign debt default.  An article in the Irish Times by Stephen Collins, “The Real Danger is in Political Stalemate as the Roof Falls In,” is disquieting reading (here).

The two crucial intermediate policy goals are broadening and deepening the net tax take from households, and lowering the cost of public services.  The proposed 10% levy on public service pensions is an admirable first start on the second of these goals.  The recent political weakening of the government, in the face of continuing revelations about banking industry shenanigans, has endangered this important first step.   Does the present government have enough political capital to face up to raising taxes on middle earners? 

Another policy goal is to decrease economic policy uncertainty, so that businesses and households can plan and invest.  Mervyn King stresses the importance of economic policy predictability and stability (wittily stated here).  He quips that one of his policy goals as head of the Bank of England is to be extremely boring.  Presumably this comes easy to him as a well-trained economist.  There is also a wealth of evidence that the reason inflation lowers growth is that it creates planning uncertainty for businesses and consumers, see for example Huizinga 1993 (here).  Irish businesses and households are not facing price turbulence but rather government policy turbulence, which can be even worse.  The Irish government needs to make hard policy choices, state clearly that it intends to enact them fully, and then do so reliably.

 

A Contrary View

Some media personalities and political pundits have over-stated the case for placing the blame for Ireland’s current economic mess on the government’s recent policy decisions.  The two big recent decisions of the Irish government (insured deposits and new bank capital) appear to me quite defensible.  If I may bring some controversy to the blog, here are three statements making the media rounds that I think are false:

1.  The primary cause of the Irish economic crisis was bad decisions by Irish policymakers and banks.

The statement above is false since the primary cause of the Irish economic crisis is the US-generated global credit crisis. This credit crisis in turn was caused by disastrously bad decisions by US policymakers (Congress, the quasi-state agency Fannie Mae, the SEC and Federal Reserve) and the U.S. finance industry (mortgage originators, ratings agencies, investment and commercial banks).  The too-weak oversight by the Irish central bank and financial regulator left the Irish bank sector very vulnerable to an external shock, as did the Irish government through its tax-and-spend policies, but these are both secondary not primary causes of the economic crisis.  It is a counterfactual and impossible to scientifically test, but I speculate that in the absence of the U.S. credit crisis, the Irish economy would have experience a somewhat bumpy “soft landing” from its 2002-2005 excesses. Without the US-generated crash, the 2009 situation would have been nothing like what we are in.

2.  The government decision on September 30th to insure all bank deposits was obviously foolhardy and inconsistent with careful economic analysis.

This statement is false since it might possibly have been foolhardy but that is not obvious. As Brunnermeier notes in his recent JEP article, the 2007-8 credit crisis brought a new type of bank run, what he calls an “investment bank run.”  This is a bank run between institutions, where banks lose trust in one another and the relatively strong banks attempt to cut all credit ties to the weaker ones. As the Lehmann Brothers disaster shows, this can be a very destructive type of bank run due to the complex interlocking relationships between large banks.  Going back to the classic Diamond-Dybvig model, a bank run can be stopped by the monetary authority providing or promising monetized liquidity to all depositors.  As soon as the depositors realize that this monetized liquidity is available, the bank run ends.  There is a long-term moral hazard problem of course, but bank runs can be stopped in this way, and it usually works in practice.  So the government’s action was consistent with reasonable economic analysis of the situation.  Unfortunately Diamond and Dybvig wrote their paper before the advent of the Euro, so they do not explain what happens when the national government does not control monetary reserves.  Still, it seems a defensible policy move under the circumstances.

3. The capital injection into the two big banks is wasted and/or inadequate since they are obviously worthless on a net-value basis.  The current share prices are just the speculative value of an out-of-the-money call option.   

The second sentence of this statement might be true (Patrick Honohan made this point earlier on the blog) but the first sentence seems false.   Relatively big banks in small economies probably have considerable economic value even when their market value is near zero or effectively negative on a net basis.  The two big banks will pull through their current “negative value state” and eventually return to being profit-making institutions, with appropriate government support during the current crisis.  Banks are almost always insolvent on the basis of current liquidation value.  The fundamental nature of a bank is that it is a device for changing liquid deposits into illiquid loans.   Government capital support for the banks at this stage seems defensible.  The alternative of full nationalization of all the banks (not just the rogue bank Anglo Irish) carries too many risks for the economy.