The Credit Crunch

1
The Credit Crunch

• Banks

2
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

3
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

4
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 assetsltliabilities 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

5
Balance Sheet

• Easiest way to see how this all works is the
  banks 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

6
Bank Balance Sheet
Assets
Liabilities
Cash
Deposits from the Public
Loans Banks Companies Individuals
Bond holders
Equity (Capital)
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
7
Mortgage lenders Aug 07
Assets
Liabilities
Cash etc 22
Deposits 384
Equity 34
Loans 482
Debt 108
Others 22
Total 526
Total 526
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
8
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

9

• 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

10
Bank Balance Sheet
Assets
Liabilities
Cash 15
Deposits 100
Equity 10
Loans 95
Total 110
Total 110
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
11
Bank Balance Sheet
Assets
Liabilities
Cash 15
Deposits 200
Equity 10
Loans 195
Total 210
Total 210
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
12
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

13
Another Key Issue Liquidity

• Capital ratio so low that banks couldnt 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

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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

16
of Group loan portfolio
17
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
18
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

19
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
  (503629)
• Represents 5 of total loans defaulting
• 7bn (AIB had total of around 137)

20

• 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

21
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

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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

24
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

25
Mortgage lenders with 20bn bad debts
Assets
Liabilities
Cash etc 22
Deposits 384
Equity 14
Loans 462
Debt 108
Others 22
Total 506
Total 506
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
26

• 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

27
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

28
Bad Debts of 80bn
Assets
Liabilities
Cash etc 22
Deposits 384?
Equity 0
Loans 402
Debt 108?
Others 22
Total 446
Total 446
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
29
NAMA

• Dont 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?

30
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

31
What happens to Banks?

• After the losses are dealt with banks will need
  sufficient capital to work with
• Avoid zombification
• After NAMA AIB, BOI lt4 (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

32
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

33
NAMAs 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

34
Three Key Assumptions

• LTV77
• 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 (0.468)

35

• 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

36
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

37
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

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Mortgage lenders Aug 07 after NAMA
Assets
Liabilities
Cash etc 78
Deposits 384
Equity 13
Loans 405
Debt 108
Others 22
Total 505
Total 505
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
39
Mortgage lenders Sept 09 After NAMA
Assets
Liabilities
Cash etc 76
Deposits 571
Equity 21
Loans 556
Debt 110
Others 60
Total 692
Total 692
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
40
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

41
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

42
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

43
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

44

• 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
• Doesnt 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

45

• 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

46
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

47
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

48

• 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.