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The Credit Crunch Banks Overview • The outline of the story is well known. – Banks in several countries may too many loans to the property market – These loans have now gone bad as the bubble has burst – The banks are now in financial trouble and have to be rescued by governments • To see how exactly this happened we to see how banks work Banks Business Model • Bank takes in money – Depositors – Selling securities on financial markets (Borrowing on financial markets) • Bank lends it out – Formal loans – Buy securities on financial markets • Bank profits largely determined by differential between interest rate on deposits and interest rate charged on loans. – The old “3 -6 -3” rule – However, must allow for bad debts as any business Liquidity vs Solvency • Liquidity is having enough cash on hand – Banking suffers from an inherent liquidity problem – Banks assets and liabilities are of different maturities – Liquidity problems can be solved by borrowing from CB or market providing have assets for collateral • Insolvency is assets<liabilities and capital cannot cover the difference – Capital is the cushion that absorbs bad debts – too small in the Irish case • Solvency is the more important issue – Solvent: have enough assets – Liquid: have enough cash Balance Sheet • Easiest way to see how this all works is the bank’s balance sheet • Liabilities is source of bank funds – Deposits (traditional) – Financial markets (new): “Bond Holders” • Assets: – Cash and govt securities (cushion) – Loans (traditional) – Financial markets (new) • Imagine what would happen if bank liquidated – Owners of bank would end up with Assets-Liabilities – “Equity” or “Capital” or “Share-holders funds” or “Reserves” Bank Balance Sheet Assets Liabilities Cash Deposits from Loans the Public Banks Bond holders Companies Individuals Equity (Capital) Leddin and Walsh Macroeconomy of the Eurozone, 2003 Mortgage lenders Aug 07 Assets Liabilities Cash etc 22 Deposits 384 Loans 482 Equity 34 Others 22 Debt 108 Total 526 Total 526 Leddin and Walsh Macroeconomy of the Eurozone, 2003 Role of Equity • Crucial to the way bank operates • The idea is that if banks suffers losses they are absorbed by the shareholders not the depositors or bond holders • Therefore equity has to be large enough to absorb expected losses • This is the money you have to put down in order to own a bank • Common sense and regulation require a certain level – “reserve ratios”; “Capital requirements”; “Tier 1” • Banks want the ratio as low as possible as it means can lend out more • Think of two examples – Ratio of 10% – Ratio of 5% • The lower ratio allows bank to take in twice the deposits for the same level of commitment from shareholders • Profits higher • Risk higher because cushion lower – Smaller bad debts would bankrupt the bank Bank Balance Sheet Assets Liabilities Cash 15 Deposits 100 Loans 95 Equity 10 Total 110 Total 110 Leddin and Walsh Macroeconomy of the Eurozone, 2003 Bank Balance Sheet Assets Liabilities Cash 15 Deposits 200 Loans 195 Equity 10 Total 210 Total 210 Leddin and Walsh Macroeconomy of the Eurozone, 2003 Key Issue: Solvency • One of the key issues in the banking crisis was that the cushion was too low – Banks like small cushion because higher profits – But higher risk also • This was a failure of regulator and banks own risk management – Should have realised property lending risky because of bubble • Regulator require higher cushion – Reduces profits so lending to property slows down – Canadian approach Another Key Issue: Liquidity • Capital ratio so low that banks couldn’t find enough deposits to finance all the lending they required • Borrowed on the international markets – Reflected in BOP: cap inflows • “Hot money” – Often 24 duration – Run at first sign of trouble • Makes liquidity problem worse Foreign Liabilities of Deposit Money Banks 400 350 300 250 % 200 150 100 50 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Year Example: AIB • Lets look at a particular bank just before the crash – Annual report for 2007 – Total loans of €137bn • Lots of foreign borrowing – In the deposits section • Capital 8% – Sounds good but not enough as we will see • Key facts – Property a growing share of loans – Much of this in “development” % of Group loan portfolio Dec-06 Dec-07 25% 23% 12% 12% 12% 11% 8% 8% 5% 5% 3% 3% 2% 2% Agriculture Construction & Residential Manufacturing Personal Services Transport & Other Property Mortgages Distribution Property & construction % ROI *GB/NI CM Group Commercial Investment 34 33 78 41 Residential Investment 7 15 7 9 Commercial Development 22 14 8 18 Residential Development 34 32 6 29 Contractors 3 6 1 3 Total 100 100 100 100 Balances €m 27,804 10,054 6,696 46,410 *An element of management estimation has been applied in this sub-categorisation The problem • Huge reliance on property and on development in particular • Bubble bursting creates huge potential for losses – Particularly so in development loans – What NAMA is now concentrating on • AIB aware of this potential & try to assuage investors fears – Say LTV is 65% Solvency • LTV is important – Indicates how much the bank could get back if borrower defaults – One of the key assumptions of NAMA • Suppose 65% is true • Suppose 50% of development loans default (50*36*29) – Represents 5% of total loans defaulting – €7bn (AIB had total of around €137) • If LTV was 65%, this €7bn in loans was secured on assets originally worth €11bn • Key issue is “originally” • How much are they worth now? • As long as they have declined by no more than 35% bank will get its money back • Bubble graph suggests that prices were twice fundamentals – expect decline of 50% – Bank gets back €5.5bn – Maybe less as overshoot Assessment • Bank can handle €1.5bn loss • But very optimistic assumptions • LTV of 65% seems unrealistic – some say 100% – The other 35% in form of property not cash • Why expect only 50% of loans to default? – Why not all? • Why only development? – Why not investment, mortgages etc Banking System • We can do the same sort of analysis for the main banks • Approx numbers – but give the sense • What happens when loans go bad? – Small losses: handle as “bad debts” – Medium losses: Zombie bank – Large Losses: bankrupt Zombie Bank • Losses wipe out lots (but not all) of capital • Bank remains solvent but cannot operate effectively • For illustrative purposes suppose €20bn goes bad – If it were any other business the bank will be liquidated or some sort receivership – Assets sold off to pay the creditors – Owners get the remainder €14bn Mortgage lenders with €20bn bad debts Assets Liabilities Cash etc 22 Deposits 384 Loans 462 Equity 14 Others 22 Debt 108 Total 506 Total 506 Leddin and Walsh Macroeconomy of the Eurozone, 2003 • Bank will probably continue in existence – But limited lending – Remember the role of equity – has to cut back on lending – Zombie bank: not dead but not alive either • Solution: Get more capital from markets or government – Dilute shareholders wealth – So shareholders may prefer zombie • Japan during 1990s Bankrupt • Now suppose even Bigger Losses – e.g, €80bn • This is more than the shareholders funds can absorb • Bank bankrupt: cannot continue in operation • Any other business all creditors take a hit in proportion or priority – Get 90c for every €1 • This means that depositors would loose 10% of savings • To avoid this the government usually steps in some way • Rational for NAMA-like arrangements Bad Debts of €80bn Assets Liabilities Cash etc 22 Deposits 384? Loans 402 Equity 0 Others 22 Debt 108? Total 446 Total 446 Leddin and Walsh Macroeconomy of the Eurozone, 2003 NAMA • Don’t want banks bankrupted for two reasons – To avoid depositors taking a hit – Banks central to economy so formal bankruptcy (even temporary) is very disruptive • So government needs to deal with hole in the banks • Need to decide three related Q – How big is the hole? – who pays? – What is done with the banks afterwards? Who Pays? • Someone has to • 4 possibilities – Depositors: want to avoid at all costs – Shareholders: “rules of capitalism” – Bond holders: rules also • 4th possibility Tax payers – Make up gap if share and bond holders not enough – It looks like NAMA has taxpayers take on some of the losses even without share and bond holders funds being exhausted – We will look at whether this is necessary What happens to Banks? • After the losses are dealt with banks will need sufficient capital to work with – Avoid zombification – After NAMA: AIB, BOI <4% (JP Morgan) – 10% now standard internationally • Certain that they will not have enough on their own – Shareholders will absorb some losses – International practice now requires more capital • “Recapitalisation” can happen – Via market: rights issue BofA – Via government share holder: RBS 80% owned by UK – Overpayment: NAMA pays €54bn for €47 How Big is the Hole? • How much are the bad debts of the banks? • IMF estimated them at €35bn • Probably a low estimate • Government is more optimistic – Assume LTV 77% – Assume prices reached bottom and will rise 10% – Lead to a conclusion that NAMA will make a profit NAMA’s Valuation • Govt.’s view on size of the hole • See Ronan Lyons Blog • Loans of €68bn backed by assets originally worth €88bn – Implies LTV of 77% • Add to that €9bn in unpaid interest • NAMA to take loans of face value of €77bn • Govt. estimates market fallen by 47% so collateral worth €47bn (=53% of €88bn) • Govt will deliberately overpay for loans by giving banks €54bn – Expect prices to rise 10% from current levels Three Key Assumptions • LTV=77 – Anecdotal evidence of 100% – Use other property as collateral for the loan – If 100% then the original value of the collateral was €68bn • 47% decline – Large decline – Maybe €21bn in land where decline has been 95% – 34% of loans outside Ireland – If decline is (or will be) 60% then current value is €27bn (=0.4*68) • LTEV will be €54bn – Rationale for overpayment – Based on assumption that prices rise by 10% from current level – 10% reasonable – is the current level the bottom? • Probably not! • Even bigger loss A Comment • Any prediction difficult • Govt seems optimistic but possible • Real issue is not the numbers but how it is structured and who takes the risk – Why over-pay? – Why not take shares in the banks? – Why not have bond-holders pay the price? • Under NAMA tax payer bears risk of asset values – There is a notion of future levy Consequences for Banks • See balance sheet – Ok to use 07 • Loans decline by €77bn • Banks paid €54bn in bonds that may be exchanged for cash at ECB • Losses of 77-54 absorbed by shareholders • Capital ratio below 4% • Need capital injection of €30bn – Market or government Mortgage lenders Aug 07 after NAMA Assets Liabilities Cash etc 78 Deposits 384 Loans 405 Equity 13 Others 22 Debt 108 Total 505 Total 505 Leddin and Walsh Macroeconomy of the Eurozone, 2003 Mortgage lenders Sept 09 After NAMA Assets Liabilities Cash etc 76 Deposits 571 Loans 556 Equity 21 Others 60 Debt 110 Total 692 Total 692 Leddin and Walsh Macroeconomy of the Eurozone, 2003 Consequence for the Taxpayer • Govt already spent €7bn on capital injection to banks in return for preference shares that pay 8% • Overpayment is a form of recapitalisation – Without pref shares and overpayment equity would be only €7bn – No ordinary shares in return • State guarantees all liabilities of banks – Taxpayers bears all the risks of business – Get very little return • In the end taxpayer will provide almost all the capital of the bank but will (likely) have less than 100% shares Alternatives • What are the alternatives? • Any sensible alternative is going to look at lot like NAMA – Segregate bad assets from good – Some government involvement • The big differences among the alternatives is who pays what and who bears the risk Alternative 1: Nationalise the Banks • Wipe out the equity holders • Admit that total losses are likely to be more than the current shareholders funds • Risk to taxpayer reduced as we now have assets as well as liabilities • Consequences – Overpayment no longer matters – Total losses to be absorbed by the state will be less by the amount of the equity – Taypayer will get the value of the future business of the bank to offset losses Arguments Against • Unfair to shareholders – Maybe if losses actually less than equity – Unlikely – Retrospective compensation possible • Too expensive because share price is too high – Lenihan made this argument – Clearly nonsense – Price is only above zero because of NAMA • Nationalised banks become politicised – True – Re-privatise early – Very expensive way of avoiding corruption • Foreigners will not deal with nationalised banks – Maybe true for some but not generally true – In any case will not deal with any bank without state guarantee so seem unlikely to object to state ownership • Doesn’t get rid of the losses so is irrelevant – True that losses remain – But get share (or all) of future profitable business to offset losses – Eg €7bn overpayment or for shares • Nationalisation hurts reputation – Banana republic – Other countries have done it UK – Partial possible • Nationalisation will lead to higher risk premium on corporate and national debt – Anglo cited as evidence – Premium already up because of extent of bad debts – Idea is that nationalisation would increase it further – No evidence that ever happened before Alternative 2: Bond-holders • In addition to wiping out equity holders we could force bond-holders to take some of losses • Could even force them to take all the losses (after equity) – Mirrors normal bankruptcy – Joseph Stiglitz & Morgan Kelly – “Debt-equity swap”: INM • Minimises cost and risk to taxpayer Arguments Against • Bank financing premium in future – Maybe true – Cost to banks – Pass on to society in short run – In long run foreign Competition will mean no cost to society • Pension funds loose out – Mainly foreigners – deal with pension funds directly • Sovereign Risk – Defaulting on the bank debt will be seen as equivalent as defaulting on national debt – Big issue: risk premium of national debt will increase: huge cost – Plain wrong: no evidence of it internationally – Makes no sense: sovereign risk premium rose when we took on the bank liabilities (guarantee) and bad assets (NAMA) – Why would the risk increase if we hand-back those liabilities.
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