He likes a trade on FX and indices, but is a little scared of those volatile commodities. That doesn’t stop a dabble now and again, but he certainly keeps the deeds to the house in the back pocket when Brent Crude is involved.
But he can’t decide whether he prefers fundamental or technical analysis, so often makes “technically fundamental” trades. As long as both sides are saying to go the same way, lump on and hope for the best!
What’s Next For The Irish Banks?
Right, hand’s up who’s been trading the Irish banks and been able to resist trying to call the bottom? No, I didn’t think there’d be many of us. But that’s the past and there no point in crying into your tea forever. Could the turning point be soon, and if so what could signal it? Let’s have a look.
If interested, I’ve also published a blog on the World Banking Crisis recently.
What’s Happened To The Share Prices In The Past 18 Months
First let’s have a look at the painful downward trend. The ‘Big 4’, AIB, Bank of Ireland (BoI), Anglo Irish Bank and Irish Life & Permanent (IL&P), reached their peak between February and June of 2007. How good would we have all felt if we had managed to close our long bets then? Instead we let our myopia get in the way and assumed that banks share prices, like house prices, could only go up. It took the big hedge funds to teach us a valuable lesson: nothing goes up forever. Their short trades brought share prices down to more realistic levels, from where the crumbling Irish and world economy did the rest. The chart shows that €100 invested in the Big 4 on the 21st of February 2007 would be worth just €7.53 now. Ryanair is now worth more than the four banks put together!
Reasons To Be Bullish On The Irish Banks
Irish banks have gotten this far without failing, which is an achievement in itself. Bullish arguments are:
- Still Profitable. Irish banks are not just making a profit but a healthy profit. Anglo announced pre-tax profits of €784m on Wednesday morning. The reason their price/earnings ratio is so low is because of very negative forecasts… but we all know how inaccurate forecasts can be.
- Bad Debts Expectations Are Too Large. Share prices are now pricing in bad debts (loans that won’t repaid) to increase to up to 1500 basis points (bps) or 15% of the banks’ outstanding loan books. But it’s still feasible they may get away with bad debts in the 200 – 250 bps range (which would still be a historically huge number). Market expectations may have overshot the mark on this one.
- Government Intervention Is Priced In. The market expects a large government intervention in the Irish banks. That intervention is likely to dilute existing shareholders shares, but that wouldn’t necessarily cause the share price to fall. A generous (or even fair) investment package could be looked upon very favourably by the market with a short term bounce on relief.
- Reduced Liquidity Problems. Because of the thawing of the credit markets and the Government Guarantee Scheme, Irish banks are not facing the same liquidity problems that other banks were facing a couple of months ago. For the next two years, they literally get to go to the credit markets as sovereign entities.
- Value In The Current Share Price. This is a difficult argument to make because traders have been saying that there’s value in Irish banks for a long time now. But a new indicator is that a lot of Private Equity (PE) companies are now lurking around, looking to invest, especially in Bank of Ireland. If PE is around, there must be some value.
Reasons To Be Bearish On The Irish Banks
Before you all rush to paddypowertrader to put on a huge long bet on the recovery of the banks, let’s have a look at the other side of the coin.
- Continued Uncertainty. Other small European countries such as Belgium and the Netherlands took decisive action over their banking industries a couple of months ago. But in Ireland traders are still unsure of how the endgame will play out. Traders despise uncertainly and will continue to shoot first and ask questions later if they don’t get conclusive answers.
- Banks Need To Be Recapitalised. Irish banks were relatively well capitalised. But that capital base was meant to deal with a rainy day, not the biblical flood they now face. Their core Tier 1 capital ratio (measure of financial strength) needs beefing up to contend with more bad debt write-downs. But they have struggled to get the big investment that they need and the longer this goes on the worse the terms of the investment will be.
- Government Doesn’t Have The Money To Be Too Generous. Undoubtedly the government wants to invest in its banks and help them on the road to recovery. But it simply doesn’t have the finances available for the type of bailout we’ve seen in other countries. The latest Exchequer figures have shown an €8B shortfall so far this year. Tough decisions have to be made: medical cards for OAPs or save the reckless bankers?
- Nationalisation Is Still Possible. The government has too many problems already to want to take on the extra bank debts. But their hand may be forced by the need to support the economy. Finance Minister Brian Lenihan did threaten the “N” word if banks didn’t start lending again. The Irish Congress of Trade Unions is also pushing for this. Nationalisation would leave shareholders with nothing and traders with long positions in a very tough spot!
- Other Banks Haven’t Recovered. So far no bank has suffered share price falls as steep as those of the Irish banks and been able to recover. Anglo Irish Bank has lost over 90% of its value in 2008 alone. Usually when a stock loses that much of its value, plenty of market players believe that it will go bust. And usually it does.
What Else Could Happen In The Next Few Months?
Almost nobody thinks the banks will be able to get through this crisis in their current state. The government played their trump card early with the Guarantee Scheme, but this hasn’t been sufficient. Further action is needed. So how will this play out?
(1) Consolidation
The most obvious action is a consolidation in the sector, whether friendly or forced. It’s becoming clear that IL&P, EBS and Irish Nationwide Building Society (the latter two are private building societies) are too small and vulnerable to survive on their own. Anglo is larger but the question is still whether they are large enough to ride out this crisis independently.
The government’s ideal scenario (although they deny it) is to have two big banks, based around AIB and BoI. The smaller players are pushing for a favourable deal but are running out of negotiating time.
Market reaction to consolidation would depend on the terms of the deal. My hunch though is that the bigger bank would benefit more than the smaller partner from any deal.
(2) Private Equity (PE) Takeover / Investment
Private Equity (PE) companies are in the business of buying large, profitable, cash-rich corporations that are poorly managed. Arguably, Irish banks tick those boxes. They then restructure and chop up the companies before leaving with a handy profit. Letting these ‘vultures’ into a crucial sector of the Irish economy would be one of the last option entertained by the government.
PE has been sniffing around every banking corpse in Europe. It has been reported that JC Flowers, Carlyle, TPG, KKR and Apax have all held talks with BoI about a possible investment. But their interests have been cooled for now with the restrictions that the Irish government is looking to put in place.
A banking deal with PE would probably initially turn the share price south as the bank’s shares would most likely be heavily diluted. But if a deal went through, a long position could be a good bet after any share price fall. PE companies are deadly at extracting every last bit of value from a company. The market always rewards that sort of attitude.
(3) Sovereign Wealth Funds
A Sovereign Wealth Fund (SWF) investment would be a dream for the banks and the government at this stage, especially as they traditionally have a passive attitude. Bank shares would probably rise on any such investment.
But there’s little chance of SWF investment anymore. They have already been burned on other financial investments and with oil below $50, they have more pressing issues back home.
(4) Investment Through The National Pension Reserve Fund (NPRF)
Finance Minister Brian Lenihan has said that the government may invest in the banks through the NPRF, who have cash on hand of about €1.5B, and €1B in their bond portfolios. And that’s not even mentioning their equity portfolio. So the money is there, but raiding the NPRF would need Dail legislation, where there would likely be substantial opposition.
The market has priced in a large amount of government intervention at this stage. If it’s done through the NPRF, this would probably lead to less dilution than a PE deal. A short term relief bounce would have to be expected as traders stop pricing in the chance of bankruptcy. After any initial hullabaloos though, I wouldn’t have the banks as an automatic long. I know that I wouldn’t invest in our Civil Service.
(5) Nationalisation
This is the last resort, something the government neither wants nor may feel it can afford. But, as I mentioned earlier, their hand could eventually be forced. Banks are a fundamental cornerstone of any developed economy. They couldn’t be allowed to fail.
There is another option for the Irish banks which I have outlined in a separate blog called “A “Bad Bank” Solution For The Irish Banks“.
Are All Banks The Same?
So far I’ve looked at the banking sector as a whole. As can be seen in the graph at the top of this blog, their fortunes are strongly correlated. You can differentiate between them on issues such as commercial and residential development exposures, undiversified operations, bad debts provisions, reliance on wholesale credit markets, future revenue and profit forecasts, core Tier 1 ratios and estimated recapitalisation needed.
However I don’t think that it’s too important to differentiate between the Irish banks; one look at the graph near the top should convince you their fortunes are strongly correlated. For me it’s far more important to make a correct call on the industry. I feel that if I can make a call on the industry I can easily split my trade between two or three of the banks.
If you do think that one Irish bank is looking in significantly better shape than another, this blog on Pairs Trading shows you one way you could place that bet.
Conclusion
At this late stage, a committed government intervention would be the best outcome for the economy, society and the banks themselves. But the government is really wary about getting further involved. Ultimately what I think will happen is massive consolidation in the sector with external private funds boosting the new bigger banks.
When/If this happens, I definitely think that there will be a short term rally in share prices. This consolidation is the entry point long signal that I think a lot of traders are waiting for. Into the medium term, the terms of any deal will decide whether the banks share prices will recover more. By then short selling should be back and the market can operate efficiently again.
At the moment placing short bets on the four Irish banks mentioned in this article is banned. For more information, see paddypowertraders Ban on Short Selling webpage. This ban is due to rescinded on the 31st of January 2009.
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December 8th, 2008 at 9:55 am
Great article.
How can we tell that the share prices are now pricing in bad debts (loans that won’t repaid) to increase to up to 1500 basis points (bps) or 15% of the banks’ outstanding loan books. ???
Ireland as an ecomony to me is looking shaky. The property bubble is defating. the government became over exposed to property based tax revenue and ireland had become a building site with a tricolor in the middle of it. €1 in €4 tax coffers was coming from propoerty in 2006/2007. Now thats not healthy.
The two largest employment sectors in the country are the public service and construction sector..
build a house, take the tax revenue and inflate the public service, build a house, take the tax revenue and inflate the public service, build a house……… etc..
The property game is over for the next several years at least. I cant think what the new business model will be for the banks, so I cant think where future profit is going to come from.
Its capital and current defificts are rising and Ireland is now borrowing 10% of the cost of every public sector salary. rejecting the lisbon treaty didnt help either. Tough budgets ahead of the next several years.
If you were a big hedge fund with a big bag of money. You would look at the world like an international beauty contest acting as a judge and see where to invest your dosh…
The country has become uncompeditive and losing its agility to complete on a global scale and remain attractive. Its no longer a low cost place to do business and the management teams economic and fiscal policies which have been followed leave a lot to be desired…
Economics 101 – if you make a pile of cash, save some for a rainy day so you’ll be able to whether the storm…. !!
Would Ireland and the irish banking sector feature high on your list of potential rapidly profitiable reconvery candidates when the credit crisis passes ? Thats the question I bet the hedge funds and SWFs are asking…..
December 8th, 2008 at 11:17 am
Great analysis and I agree with you. The way that the Irish economy was set up was completely unsustainable. I think that the government had a decent plan to make the most out of the property boom and the taxes that it brought, but that plan was never properly implemented. Forfás released a lot of papers over the past 10 years or so on how to turn Ireland into a “knowledge economy”, which is the next necessary step for the economy. But it looks like not nearly enough money and direction was given to the necessary agencies to make it happen. The fault lies squarely at the foot of the government on this one. The easiest thing to do was pad the public sector and concentrate on the current too much. It’s strange that so many people in power thought that the Celtic Tiger would last forever without any concentrated effort to extend it. In theory there was a plan, but in practice, nothing really meaningful or innovative was implemented. Without innovation or something to differentiate us, why exactly did we expect the above average economic growth to continue?
And I agree, once this credit crises passes, we are falling way down the list for potential international investment. We are unfortunately becoming more uncompetitive by the year. If I was managing a SWF, I would be looking towards Eastern Europe or the BRIC countries; Ireland just isn’t differentiating itself anymore. We needed to build up specific infant industries in the good times when they could have been sheltered. We didn’t do this and are thus still very reliant on multinationals. I think that that was a major opportunity lost.
In answer to your question on bad debts, there is no way to tell from a share price how much traders are pricing in for bad debts. The way I came up with up to 1500bps was looking through research papers from the major stockbrokers and talking to people. After Anglo’s earnings report last Wednesday, NCB said that they think Anglo’s bad debts may actually be double what the company claim. NCB officially increased their impairment assumptions for Anglo to 234bps for 2009 and 240bps for 2010. While this is a long way away from 1500bps, remember that research reports have to be taken with a pinch of salt. They have normally a buy-side bias, so those figures from NCB may seriously underestimate what they are actually thinking.
I’m working on another blog today on a potential “Swedish Scheme” that the government could try to help solve this banking crisis. It would require decisive action, but I think that it’s the best thing that the government could do right now for not just the banks, but society and the economy in general. We’ll see if they have the balls or the will to try it. Check back later and I’ll hopefully have the piece published.
December 8th, 2008 at 3:23 pm
Can you tell me more about these capital tier 1 capital ratios. i am not 100% clear what actually they are made up of.
Ok so they have some bad debts coming down the road. Sure nobody knows how much they are going to be but its likely there will be a bun fight between the developers and the banks earlier next year. but saying all that how come a recapitalisation is required..
Can you give me an example with somone numbers… I cant see how the bank can run short of cash that easily without seeing an example.
I’d guess the following, its basically a confidence trick. of which I could perhaps see a bank coming under pressure.
Bank starts with capital €1 million > The lend out €10m based on a 10% reserve ratio 10:1. They Borrow at 4% in the money markets and lend out at 8% to the consumer market. So we generate €800k of customer interest less 400k borrowing cost. This leaves us with a healthy profit of €400k. This is a Return on invested capital of 40%. This all looks very impressive.
Assume only 5% of the market loans of €10 million go bad. That’s a write down of €500k. Now all profit is wiped out and we have eaten into invested capital and we’re down to 900k capital. We can now only lsupposedly lend out €9m into the market place. Effectively we are suddenly over leveraged as we still have €9.5m in loans still in the market
The Bank now has two choices
• Either they raise more capital from investors or recapitalisation.
• Reduce our loan portfolio.
It is easy to see how a strong bank can become a bad bank with bad loans and defaults rising. Here’s the crux of the matter – Remember the bank only has €1 million in cash and if it looses this then the bank is technically bankrupt. This would actually happen if 15% of the loans in the case went bankrupt…
With unemployment rising and house prices falling bank defaults can increase exponentially. Bank share prices have fallen 90% this year so money market and inter-banks investors are hesitant to lend to the bank in the first place. The alternative is lending has to be tightened.
December 8th, 2008 at 4:04 pm
Basically, you’ve hit the nail on the head with your example. It points out the way banks work and the reasons why they have gotten into trouble.
The general formula for the core Tier 1 ratio = (Tier 1 capital / Risk-adjusted assets).
Tier 1 capital is mostly shareholder’s equity, but there are slight variants around the world. Risk-adjusted assets measure the relative risk of the loan book. Basically the dodgier the debt, the higher the risk-adjusted assets. But in real life, it’s much more complicated than that, which has helped cause a lot of the problems. Banks are very good at hiding their riskier loans!
Anyway, a bank with a core Tier 1 ratio of 6% or over was traditionally seen as “well-capitalized”. This would have been good enough a year ago, but now the market is demanding a Tier 1 ratio up over 10%. The market simply doesn’t trust what the banks are saying. They are punishing banks share prices that have a lower ratio.
As more and more loans go bad, the ratio goes lower. As you’ve pointed out, the numerator (capital) needs to be increased or the denominator (risky assets) needs to be decreased to improve the ratio.
As banks are finding it impossible to shift their risky assets, this basically means that they need to get more capital i.e. recapitalisation. At the current state of play, Anglo’s Tier 1 ratio is likely to fall to 5.7% in 2009, which is far too low in this current market. They need substantial investment from somewhere.
Also Anglo needs to quit messing about with increasing their loans to developers. As mentioned in the Weekly Wrap, their exposure to developers rose from €10.4B at the end of March to €16.9B at the end of September. That’s a highly imprudent thing to be doing and their share price has taken a pounding in the past week, partly because of that.
December 8th, 2008 at 4:28 pm
Thanks, how come customer deposits aren’t cosidered as tier-1 capital or money the banks have borrowed on inter-bank markets either? This is still capital right. Whats considered as share holder equity; the money just invested by shareholders orginally?
Can you also give me a numbes example as to how that 6% would be calculated.
thanks
December 8th, 2008 at 5:43 pm
The tier 1 capital ratio is only one measurement of financial strength of a bank. At the moment, it just happens to be the most popular ratio going. The phrase “tier 1 capital” appears to have becomes a bit of a buzz word in this current crisis. But as you have pointed out, it’s not perfect as it doesn’t incorporate everything.
Anyway, here’s an example of how the ratio is worked out:
http://www.fdic.gov/regulations/safety/manual/section17-1_capcalc.html
The tier 1 capital ratio = (5,680 / 76,353) = 7.4%
Here’s another example:
http://en.wikipedia.org/wiki/Capital_requirement
Here the tier 1 capital ratio = (66,871 / 750,293) = 8.9%
December 8th, 2008 at 8:03 pm
This is intersting,
So if I am a bank and I get a ton of cash in on deposits say €1Billion from deposits and in parallell issue a bond for say €2Billion.
I have still raised 3 Billion here and can lend probably a further 30Billion into the economy.
Does that mean my tier-1 capital still doesnt increase??
December 9th, 2008 at 10:48 am
You have got to remember that the tier 1 capital ratio, albeit important, is merely one ratio that analysts use to evaluate banks. As it’s merely one ratio, it can’t be expected to take into account everything that a bank does. Banks are so large and complex these days in their operations that analysts use many new tools to determine a banks performance and fair share value.
But back to your question and firstly a bit of fundamental accountancy. The basic accountancy equation is Equity / Capital (E) = Assets (A) – Liabilities (L).
The tier 1 capital ratio is really an Equity figure divided by an Asset figure. But cash deposits and issued bonds are liabilities on the bank and thus, don’t come into the tier 1 capital ratio directly.
But they do have an indirect impact. Once the bank gets its new money in the door, it has to decide what to do with it. Let’s say the bank is conservative and buys short term US Treasury bonds. These bonds are seen as completely safe and thus carry a risk adjusted weighting of 0%. This will increase banks tier 1 capital ratio as the denominator should fall and the numerator rise. This plan wouldn’t lead to great profits, but it’s what banks should be doing these days to lower their risk.
On the other hand, an aggressive bank, like what Anglo Irish have been doing, could continue to use their new funds to give new loans to developers. Obviously these loans carry a much higher risk adjusted weighting. This weighting can be anywhere from 50% – 100% and would increase the denominator, the risk-adjusted assets, substantially. All else equal, this move would lower the bank’s tier 1 capital ratio.
This mini-analysis has been relatively simplified as the process can be a lot more complicated, but I ‘m sure you’ll get the gist of it.
December 9th, 2008 at 11:24 am
Good stuff I understand what you are saying.
- Equity is what the bank own (retained earnings and cash the shareholders invested). This is there’s
- Libabilites is money owed (Deposits and bond cash raised) It can be used for lending but the bank still own this back to customers and investors.
- Loans are assets to a bank.
One thing though. if bonds and depostis aren’t counted as part of the tier 1 capital how come they affect the denominator in the tier 1 equation.
Or are you saying they only effect the denominator once the are used to purchase something like a treasury bond OR multipled up with leverage and lend out to a customer as a development etc..
December 9th, 2008 at 11:35 am
Actually is there a ratio to measure your total capital available v’s loans.
Assume banks have equity of €10m, bond loans of €11m and deposits of €12m availabile
They have in this case €33m capital available. I pesume they could leverage this at say 10:1 and generate €330m of loans.
So there a ratio of total capital available / loans outstanding which in this case would be 10:1
December 10th, 2008 at 5:05 pm
When I have been lending wholesale funds to independently owned leasing co’s (who have at least some evidence of tangible security to support their exposures), the rule of thumb has always been that 6 x leverage is about as high as it should go. In the early 1990’s it was the 10 x and greater institutions that suffered and fell over.
If the same principles are applied across all levels of commercial and corporate banking (and there is an argument that suggests they should be), then the availability of credit in the corporate space should be severely restricted going forwards. Maybe that’s the new conservative paradigm that will harness our enthusiasm for reckless expansion of the balance sheet?