Banking on the Irish Banks

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Ireland Calling with John Spain

Banking on the Irish Banks

September 18, 2008

Ireland Calling by John Spain

IS it any wonder that customers of the Irish banks are becoming increasingly nervous? If it can happen in Britain and the U.S., it can happen in Ireland.

First the Northern Rock bank in Britain had to be rescued by the British government. Then a similar rescue had to be mounted for Bear Stearns in the U.S.

Now we have the Freddie and Fannie bailout a couple of weeks back. And last weekend the beleaguered Lehman Brothers bank, the fourth biggest investment bank in the world, ran out of road and into bankruptcy.

The 158-year-old Wall Street institution, a global investment player with thousands of employees around the world, is the latest and by far the biggest casualty of the credit crisis. Its collapse is sending shockwaves across the financial world, and the effects were immediately felt in Ireland where tough questions are already being asked about the health of our own banking system.

In fact many people are saying that a bank collapse is even more likely to happen in Ireland, given the dependence of Irish banks on the property sector which has crashed here just as much as elsewhere.

Last week, the fear about the Irish banks was palpable in Dublin, and rumors were flying about the possibility of one or two Irish banks heading into serious trouble to the point where the government would have to step in to prevent a collapse at some point in the future.

The banks are saying this is nonsense. Their executives say the situation is completely different here. Not only are they not going to get into trouble, they say, they don’t even need to raise extra capital.

The Minister for Finance Brian Lenihan has already branded negative talk about the Irish banks as dangerous and irresponsible. But such reassurances are unlikely to stop the deepening concern among ordinary people here, both bank share investors and account holders.

The fact is that the property market collapse is putting the Irish banks under real pressure. So far there isn’t a problem, but that could change if the slump in property gets even worse.

The Irish banks rode the property boom here over the past decade like cowboys at a rodeo, showering money on sometimes dubious developers and lashing out 100% loans to borrowers who they knew would be stretched to make mortgage repayments in the event of a downturn.

Given the profits to be made when the boom was at its height, the banks vied with each other to get the business. They were the ones who kept throwing fuel on the flames, even when it was clear the fire was getting out of control. The old fashioned rules for prudent lending were ignored in the dash for market share and higher profits.

The result is that several of the Irish banks have loan books that are 50% or more dependent on the construction sector. And that is why the Irish banks have seen their shares collapse in line with the property market.

There was a slight lift in bank shares here in the wake of the U.S. government becoming more socialist than Putin and effectively nationalizing Fannie and Freddie, thereby exposing the American taxpayer to a trillion dollars of bad debt.

But that respite was temporary and Irish bank shares had already slipped back again to embarrassingly low levels even before the Lehman collapse.

Earlier this year Bank of Ireland was over *11 a share and at lunchtime on Monday that was down to *4.63 a share. It was the same story with AIB, Ireland’s biggest bank; its shares have fallen from over *16 earlier this year to *7.12 at lunch time on Monday.

If you compare share prices now with the middle of last year, the fall is even more dramatic. Investors in bank shares here have seen the value of their shares fall by between half and two thirds in the past year.

Tens of thousands of ordinary people here are small time investors in bank shares, and many more have pension funds that are heavily dependent on these shares. These investors — so far — are gritting their teeth and saying they will just have to wait until their shares recover their value.

But that could change if things get worse and confidence collapses. As far as depositors and account holders with the bank are concerned, there is also a growing concern and watchfulness.

There are differences between what is happening in America and here, of course. We don’t have the ludicrous sub prime situation here that you have in the U.S., where loans were given to so many people who had no chance of keeping up with mortgage payments.

The boundaries were pushed here as well, but at least the employment records, earnings, etc. of borrowers were checked, and even if they were being stretched to repayment levels around half of their earnings, some linkage was being made.

That was not the situation in the U.S. And on that score I found it pretty sickening listening to the former chairman of the Fed Alan Greenspan last weekend warning that other major financial firms could fail.

“We shouldn’t try to protect every single institution,” Greenspan said. “The ordinary course of financial change has winners and losers.”

Yes, Alan, and there would be far fewer losers if you had done your job. The fact is that this whole sub-prime mess and the bundling and onward sale of mortgage debt all happened on Greenspan’s watch and he did nothing about it. So it’s hard to listen to him now doing his financial guru act.

There are differences between the situations here and in the U.S. But that does not mean that the situation in banking here does not also have major difficulties ahead.

We don’t have a sub-prime problem. But the property price boom in Ireland was even more crazy than the one in the U.S., and an awful lot of people here bought houses at the top of the market and their homes are now worth 30% or 40% less than the prices they paid for them.

So if they lose their job or get ill or can’t pay the mortgage for other reasons, they are caught. If this happens to enough people, the bank has a problem.

The bank has an even bigger problem with developers who borrowed vast amounts of money to buy overpriced building land, then spent way too much building the apartments or houses or office blocks and now find they can’t sell them at high enough prices even to break even.

That is precisely what is happening here now. It’s a middle market problem rather than a sub prime problem. And as my old economics teacher taught me, it does not take too many bad apples for the banking barrel to start stinking, given the way the banks work.

Everyone thinks that banks are highly complicated and bankers must be highly intelligent. Don’t believe a word of it. Banks work in a very simple way.

The Celtic Tiger economist David McWilliams gives the following explanation — typically, for every *1 million in capital the banks have, they lend out *10 million, he says. The profit is the difference between the cost of their capital (or the money they borrow to lend) and the interest rate they charge.

If a bank is paying 4% for your money and charging 8%, it is making 4% times 10 million — a gross profit of 400,000. That is a whopping 40% return on invested capital.

But if a 500,000 loan the bank made goes bad, that eats up all their profits and also takes 100,000 of their capital. Now they only have 900,000 in capital. That means the bank can now only make 9 million in loans.

And on it goes as more loans go bad. Either the bank has to raise more capital from investors or else reduce its loan portfolio, in addition to writing off the bad loans.

If this continues and the bank has lots of bad loans, then it’s easy to see how even a strong bank can rapidly turn into a vulnerable one. To keep lending, the bank has to go back and ask its investors for more money.

But with share prices falling at the rate they have been recently, investors are not too keen on giving any more of their money to the banks. And it’s all made worse as the economy contracts, with house prices falling further and unemployment rising.

Banking, as McWilliams explains it, is like so many aspects of finance — it’s essentially a confidence trick. If confidence evaporates, the banks have a major problem.

That’s what has happened in the U.S. and it’s happening here as well. Hold on to your hats.

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