Banking sector still falling some way short of doing the right thing

BUSINESS OPINION:Investors are inclined to run shy of Irish banks until the full extent of losses becomes clear, writes JOHN McMANUS

A couple of significant milestones on the long and painful road towards restructuring the Irish banking system were passed last week.

The two worst offenders, Anglo Irish Bank and Irish Nationwide, were put out of their misery and merged into a new entity – the Irish Bank Resolution Trust. AIB took over the EBS and conceded that it will be 99.8 per cent state-owned by the time its recapitalisation is complete at the end of this month.

A huge amount has been accomplished, much of it in what looks to have been the hardest and most expensive way possible. It might seem churlish not to allow those involved their few minutes in the sun, but the truth is that the Irish banks remain locked out of the money markets and deposits continue to dissipate, albeit at a low rate. Figures released on Friday show that €752 million worth of household deposits left the Irish banking system.

The reason that banks have not regained the confidence if their peers – despite €70 billion of fresh capital – is multifaceted. The macro economic background and the ever present spectre of an Irish default is a big issue.

The other, and not unrelated factor, is that putting capital into a bank is only one half of the story. Prospective investors and lenders need to have some visibility about future losses in order to have a real picture of a bank’s strength.

The Central Bank, it appears, is now moving to address this issue: the lack of clarity over the likely losses at the banks over the next few years.

One of the obstacles are accounting rules which mean that banks can only record a loss on a loan once the borrower starts to default. Even if a bank knows that a loan will almost certainly go bad in the near term, it cannot reflect the loss in its accounts until the repayments are missed.

As a consequence, the balance sheets of Irish banks at the end of the month will be misleading. They will appear to be massively overcapitalised as the last of the Government money goes in. But it could take years before their actual financial health is clear. Any prudent investor or lender will hang back to wait and see what happens.

Nothing illustrates the problem better than buy-to-let mortgages. The Central Bank last week also published an aggregate figure for the bank’s exposure to the sector for the first time.

Almost one in every four mortgages is for a buy-to-let property and two-thirds of them are of the tracker variety. It is pretty much accepted now that tracker mortgages are inherently unprofitable for Irish banks and in theory they should just write them off. But presumably they can’t – or perhaps just will not – if the borrower is meeting the repayments.

Equally, a significant but unknown portion of these mortgages are on interest-only terms. Borrowers took on these interest-only loans believing that rents and prices could only increase and they would be able to refinance or sell out at a profit once the interest-only terms expired.

Paying back the principal when the interest-only period expired was never part of the plan and is an impossibility now for many investors with rents and prices still falling.

Again, the banks should write off these loans. But again they cannot, or will not, as long as the terms are being met.

The third factor at play with buy-to-let mortgages is that a significant number of them are, in effect, subsidised by the taxpayer. The subsidies take two main forms, the first is housing benefit. No figure seems to be available for the number of buy-to-let properties which are let to tenants in receipt of housing benefit. But given the size of the buy-to-let sector and the numbers in receipt of housing benefit, it must be significant.

The second subsidy is in the form of the tax relief which is available to buy-to-let owners. Seventy per cent of the interest on the mortgage on the property can be offset against rental income.

The withdrawal of one or both of these subsidies would presumably have dramatic consequences for many buy-to-let investors whose interest-only mortgages are just being covered by the rent.

The likelihood that either of these subsidies would be withdrawn in the short term is very low given the catastrophic impact it would have on the finances of the member of the so called “squeezed middle”.

When you consider that these subsidies are in effect going to service mortgages at state-owned banks it starts to make your head hurt. But the key issue is that the banks should be taking very big write-offs on their buy-to-let books but they cannot or will not. If they don’t and investors know they haven’t, then the benefits of the €70 billion of taxpayers cash pumped into the banks will be slow in bearing fruit as issues such as buy-to-let mortgages will take years to play out if left to their own devices.

What we don’t know is the extent to which the banks don’t want to recognise their losses and are using accounting rules as a convenient excuse.

The Central Bank seems to be relying on a certain amount of moral persuasion to get the banks, and more significantly their auditors, to recognise the losses

But if the last three years have shown anything, waiting around for the banks to do the right thing on their own initiative is pretty pointless.