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The Credit Crunch


									The Credit Crunch

•   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
•   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
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
  – “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









          1999   2000   2001   2002           2003             2004         2005   2006   2007   2008
                 Example: AIB
• Lets look at a particular bank just before the
   – 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


                                                                         12% 12%     12%
                                                              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
  – 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%
• 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
• 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
• 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
  – Dilute shareholders wealth
  – So shareholders may prefer zombie
• Japan during 1990s
• 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
   – 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
• 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
• 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
  – 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
• IMF estimated them at €35bn
• Probably a low estimate
• Government is more optimistic
  – Assume LTV 77%
  – Assume prices reached bottom and will rise
  – Lead to a conclusion that NAMA will make a
           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
• 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
  – 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
• 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
• 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
  – 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
  – Idea is that nationalisation would increase it
  – 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
• 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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