Why do bank share prices fall when government buys preference shares?

The two main Irish bank shares fell back again today following the announcement of the details of the recapitalization — down 16 and 14 per cent respectively. There could be lots of reasons. To begin with there was the extraneous factor of the back-to-back deposits between Anglo and ILP mentioned in a previous post. ILP fell back 15 per cent as well.

Then there is the possibility that shareholders expected a more lenient deal? But how lenient could that have been? The interest rate on the preference shares is stiff enough, but not out of line with prevailing practice in other countries and anyway was well-flagged.

To all intents and purposes, however, the share prices are close to zero — down over 95 per cent on their peak.

My purpose in writing, though, is to point out that even though the preference shares are senior to equity, an injection sufficient to assure solvency going forward could nevertheless have been expected to lift ordinary share prices.

I suspect this is not a well-known effect. Permit me to present a very simple model.

Thus, suppose that there are just three periods. For convenience, assume our bank begins with zero capital.

In period 1, the government decides the amount S it will inject through purchase of preference shares.

In period 2 we discover the true state of the world, i.e. the size of the loan losses (H high in the bad state, L low in the good state). If the losses exceed the funds the government injected, then the bank is liquidated and the shareholders get nothing; If the losses are equal to or less than injection, then the bank continues in operation.

In period 3 the bank, if still in operation, earns franchise profits Z on the rest of its business. It is then wound up; the government receives its injection back if possible. Any surplus goes to the shareholders.

Clearly, if the values H and L are known and if the government injects any amount equal to or less than L, the market value of the shares at the end of period 1 is zero. (Of course, the analysis assumes rational market expectations.)

If the government injects more than that, the market value of the shares at the end of period 1 is p*max{0, (Z-L)}, where p is the probability of the good state. A longer expression gives the share value if the injection S is higher than H.

The point is that even an injection S that is only sufficient to ensure the bank’s survival in the good state will, when announced, increase the market value of the shares.

The Irish Government injection of yesterday was insufficient to do that.

Government buys some bank preference shares

Details of the much discussed recapitalization plan for the two main banks have finally been announced as approved by the Government.

In terms of financial restructuring the plan is modest enough. There is only modest dilution of shareholders; the government’s reluctance to take ownership is evident. And there is nothing yet on removing bad assets to be managed separately (though the government statement expresses interest in pursuing this line in light of international developments).

The bank’s books now imply that between them they will now have close to €20 billion in core Tier 1 capital. Out of the money options embedded in the scheme suggest that at least one side of the deal is anticipating a vigorous rebound in the banks’ ability to raise private capital.

Meanwhile Bank of Ireland have taken the opportunity to revise their estimates of prospective loan losses over the next two years by up to €2.2 billion — less than the injection of capital. Of course this is far less than the figures being bandied around by the more strident commentators, so we may look forward to seeing in due course who is right.

But negligible share price reactions so far this morning and over the past few days suggest that the market still assumes that the underlying value of the banks’ equity shareholders claims may not have moved out of the negative range.

An interesting feature is the way in which the Government is sourcing the funds. They could have just issued some new bonds and placed them in the banks’ portfolio, but they have gone for drawing on the NPRF. However, there’s a wrinkle: “€4 billion will come from the Fund’s current resources while €3 billion will be provided by means of a frontloading of the Exchequer contributions for 2009 and 2010.” I’m still trying to figure out what difference this wrinkle makes to the different measures of Government deficit/borrowing in 2009 and 2010.

Lenihan on Insurance and Bad Bank Proposals

Here are the latest comments from the Minister for Finance on the “bad bank” idea.  (And just to be clear, commenters, the bad bank proposal as currently understood in policy circles means governments overpaying for bad assets – a bad idea – and not the process of maximizing the sales value of these assets after banks have been nationalized – a good idea if nationalisation is indeed required.)

The headline “Lenihan says Government will consider setting up ‘bad bank’” confirms what anyone who watches RTE will already know (and what anyone who reads this blog will know I’m not very happy about).  However, the piece starts out promisingly.    “We can’t be jump-led by markets and market expectations into solutions that suit the banks rather than the people,” said Minister for finance Brian Lenihan last night, who noted banks were using the media to try to force politicians to adopt these types of state rescue plans.   Well said Minister!  Couldn’t have put it better myself.

And then some more good stuff: “Some of the proposals that have been advanced today such as risk insurance seem to involve a payment of a definite premium to the taxpayer in return for the assumption of an indefinite risk. And that is not something that any government could commit itself to,” said Mr Lenihan.   That’s the spirit!

But then things get a bit murky:  He said one of the difficulties with creating a scheme to deal with toxic assets was that it would add to the exposure of the state in relation to its sovereign debt. But he said it could be argued that if the Government had enough information on toxic assets – and Ireland was a small enough country to do this – and it could eliminate the risk then it would improve the risk posed by the existing Government bank guarantee scheme.  “We are at a great advantage that many of the larger (European) states have very extensive loan books and it is very difficult for them to do the type of comprehensive trawl through their banking system that we have been able to do,” said Mr Lenihan, who noted that a lot of the toxic assets held by European banks related to commercial paper, which was much harder to value than the property-based debts held by Irish banks.

This sounds a bit like grasping defeat from the jaws of victory, the minister bending over backwards to figure out why the current-vintage bad bank proposal — while generally a bad idea — might actually be a good idea here.  

I’m not exactly sure what the Minister is driving at here.  But I will point out that the most coherent argument put forward in comments yesterday in favour of bad banks rather than just re-capitalisation (from Mick Costigan) involved the Knightian uncertainty provoked by toxic assets.  Because people don’t know the distribution of losses, even a big re-capitalisation could still leave uncertainty about the potential for even bigger losses and thus doesn’t deliver confidence in the banking system. 

This is an interesting argument though I don’t think it’s relevant to the Irish case.   Firstly, there has to some figure for a large enough re-capitalisation (for instance, the full value of the bad assets) that gets rid of any Knightian uncertainty concerns.  Secondly, our toxic assets aren’t rocket science CDO-squareds built by physicists which can’t be valued because nobody understands them.  They’re bad loans to builders and we can go about making a reasonable guess at what they’re worth today.   Indeed, the minister seems to be making exactly this point.  So, as far as I can see, the Minister’s arguments seem to further point against the need for a bad bank scheme.

Toxic Assets and Recapitalisation

Last night’s RTE news was full of breathless commentary from Brussels and Montrose to the effect that governments needed to do more than just re-capitalise the banks.  From Brussels, Sean Whelan excitedly talked about “toxic assets” and how it was going to be necessary to “buy the toxic assets at a steep discount, leaving the banks to continue with the viable parts of their business.  Simply re-capitalising the banks isn’t seen as enough.”  Back in Montrose, David Murphy authoritatively informed us that “In terms of doing something else in addition to re-capitalisation, they have an option of setting up a bad bank or, for instance, insuring the banks against the some of the bad loans that are coming down the track.  But it’s pretty clear that the re-capitalisation on its own won’t be enough.   And if they do something that isn’t enough, the markets won’t like it one little bit and Ireland will be punished for that.”

Despite the confident tones in which this expert analysis was delivered, as far as I can see it doesn’t make any sense. 

There is no logical distinction between the issue of undercapitalisation and the problems created by so-called toxic assets.    Banks could get rid of all their toxic assets in an instant if they just wrote them down to zero.  But then they would be undercapitalised—and that’s the problem with toxic assets.  What appears to be going on is that the various re-capitalisation programs around the world have not managed to offset the likely losses from bad loans.  However, this is a problem with the size of the re-capitalisation programs, not their nature.  There is no logical argument for now augmenting these programs with a scheme to systematically overpay for impaired assets.  (Sean Whelan may think the proposal is for buying assets “at a steep discount” but that discount is relative to what they were originally worth, not what they are worth now.)

What appears to be going on is that neither banks or governments want to inject more government equity capital because going any further than we are now requires effectively admitting that the banks need to be nationalised.  Government concerns about nationalising banks are well-founded but it seems that, in many cases, we are well beyond that point.  If the banks can’t find private equity to re-capitalise them and government is willing to do so, then that’s where we should end up.

As a final point, it’s worth noting that despite the constant commentary about toxic assets and all the problems created by the evils of structured finance (CDO-squared and all that), this stuff is essentially irrelevant to the Irish banks.  Their toxic assets are largely plain old loans to bankrupt developers and rocket science isn’t required to come up with a guess at the size of the loan losses.  As Colm McCarthy has joked “We didn’t import any toxic assets, we grew our own.”

As usual, I have the sneaking feeling that I’m missing something.  Perhaps our team of commenting pundits can explain to me what I’ve got wrong.

Foir Teoranta Nua?

A report in this morning’s Sunday Independent flies the kite for a new State Agency to invest equity in private companies. Inevitably, this will remind some of Foir Teoranta, a state agency which was officieally described as a lender-of-last-resort to private companies in the 1970s and 1980s.

Founded in 1972, Foir Teoranta’s stated objective was “to provide reconstruction finance for potentially viable industrial concerns which are unable to raise capital from the normal commercial sources.”

I’m not aware of a systematic analysis of Foir Teo’s effectiveness in that period. Maybe readers can remember more. But my impression is that, on its dissolution in 1991, it was not widely regarded as having been a brilliant success.

So what would make a new company of this type successful? The Indo’s article confirms that it would be well-managed, so that’s all right. But what else? The intended emphasis is said to be on equity, rather than debt (which was Foir’s main instrument). But is that a strength or a weakness in the current climate? How would it complement the European Investment Bank’s EIF, which seems to be in the same territory?

Would it be better to think in terms of a partial credit guarantee scheme instead? After all, if the banks are to receive huge injections of government capital, should one not be thinking of them as a natural source of finance to keep viable firms going? Partial credit guarantee schemes have been the policy instrument of choice for governments wishing to expand credit to small and medium enterprises, and there is an astonishing number of such schemes around the world. However here too there are severe risks; my recent review of these schemes emphasizes the drawbacks and the need for careful scheme design, if damage is to be avoided.