Transcript The Credit Crunch

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
Cash
Loans
Banks
Companies
Individuals
Liabilities
Deposits from
the Public
Bond holders
Equity (Capital)
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Mortgage lenders Aug 07
Assets
Liabilities
Cash etc
22
Deposits 384
Loans
482
Others
Total
22
526
Equity
Debt
34
108
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
Year
2005
2006
2007
2008
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 &
Property
Residential
Mortgages
Manufacturing
Personal
Services
Transport &
Distribution
Other
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
3
6
1
3
100
100
100
100
27,804
10,054
6,696
Contractors
Total
Balances €m
*An element of management estimation has been applied in this sub-categorisation
46,410
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
Others
Total
22
506
Equity
Debt
14
108
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
Others
Total
22
446
Equity
Debt
0
108?
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
Others
Total
22
505
Equity
Debt
13
108
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
Others
Total
60
692
Equity
Debt
21
110
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.