Bad dreams become reality


FOR THE Irish banks, 2008 was a year of plummeting property values, rising bad debts, worst-case scenarios becoming reality, collapsing share prices, panicked depositors frantically withdrawing their money and bank-saving measures involving an unprecedented Government guarantee and bail-out.

It was quite a year. The country's bankers who had only recently enjoyed record profits during the years of extraordinary economic growth and a boom in lending endured the most traumatic 12 months of their careers.

The year started where the last ended - share prices continued to slide as fears that the international crisis would violently shake all banks, while concerns mounted about the impact of a property crash at home. The value of the Irish banks continued to fall, down from their record highs last year.

The banks stressed in the first half of the year - as they unveiled still solid levels of profit for 2007 - that the financial crisis was largely international and that they had no direct exposure to the US subprime
mortgage meltdown that had sparked the turmoil last year - or the toxic investments related to it.

It hardly mattered as the foundations on which all banks were built began to crumble amid the growing financial earthquakes and after-shocks. Put simply, the crisis grew because all banks were carrying too much debt - they had become too highly leveraged, lending much more to customers than they had
taken in deposits.

The international wholesale money markets, where the banks sourced the shortfall in deposits for their loans, froze as investors grew nervous about whether their own loans to banks could be repaid.

The Irish banks were particularly badly hit as they had grown their loans books far faster than deposits in an attempt to feed the insatiable demand for credit during the frenzied property boom that peaked in 2006.

They grew their loan books so rapidly that they had some of the highest loans-to-deposits ratios in Europe following the decade-long property bubble. This mean they were forced - more so than banks in many other countries - to rely heavily on the very financial markets that began to unravel as the year progressed.

The failure of the fourth largest US investment bank, the 158-year-old Lehman Brothers in September, paralysed the wholesale funding markets, which meant banks around the world could not meet their day-to-day outgoings. The crisis quickly spread from Wall Street to the mainstream US banking system
and to Europe.

Unwilling to bail out individual Irish banks - or at least initially reluctant to write a large cheque - Minister for Finance Brian Lenihan came up with a novel solution at the end of September when faced with the looming collapse of the weakest Irish bank, Anglo Irish Bank, and possibly more later. He chose to guarantee €440 billion of deposits and debts at the six Irish-owned banks and building societies.

As the first country to provide such an industry-wide guarantee, Ireland started a wave of State-sponsored guarantees around the world, though others went further injecting cash into specific banks.

After more than two months of procrastination, the Government eventually followed other countries which had copied Mr Lenihan - in early December it offered to invest up to €10 billion in the six guaranteed financial institutions with taxpayers' money and funds from private investors, and later specifically invested €5.5 billion in the three main banks - AIB, Bank of Ireland and Anglo Irish - with the promise of further money, if required.

The road to the bail-out of the banks - how the year unfolded…

January to March

The year began relatively quietly, as the focus remained on the financial difficulties emerging in the US. At home, up to 11 Irish lenders progressed their cases against rogue solicitor Michael Lynn in a bid to recover more than €80 million in loans provided for his property deals. One of his properties, his new family home in Howth, Co Dublin, was sold in January for €4.9 million, though at least lenders were owed €12 million on the property.

In February AIB hinted at the trouble ahead on deteriorating loans to developers when the State's largest bank said it was closely monitoring €700 million of risky loans to builders. The bank's chief executive Eugene Sheehy said that each day some global investment "came out with a howler" - a much
larger multi-billion dollar subprime exposure - and said that the banks had "destroyed their credibility."

The following month, Anglo Irish Bank, which has the largest property exposure of any of the Irish banks, was subjected to a frenetic one-day sell-off on St Patrick's Day in the aftermath of the 11th hour rescue of US investment bank Bear Stearns. Anglo lost 15 per cent or almost €1 billion of
its value in one day as rumours about its potential exposure to bad debts circulated.

In the following days, the Financial Regulator started investigating whether short sellers, investors who profit on share prices falling, spread false rumours about Anglo while trading in the stock. The regulator never published any report into the findings of its investigation, probably because the rumours turned out to be accurate.

April to June

The credit crunch really began to be felt at home, as the stubbornly high cost of bank funding forced lenders to pass on substantial costs to customers, particularly to new borrowers. They tightened lending rules and demanded large deposits. The injection of tens of billions in central bank money failed to stimulate the wholesale markets.

Banks started curbing their new loans sharply as a result. The increased cost of funding driven up by the international credit crunch started to squeeze the banks' margins, making the banks' loans less profitable.

In April Bank of Scotland (Ireland) became the last bank to scrap 100 per cent mortgages, while the largest mortgage lender, Permanent TSB, priced new tracker rate mortgages out of the market as the European Central Bank (ECB) rate, on which the loans are based, bore no relation to the cost the
bank was paying for its money. In other words, the crisis meant the bank was struggling to make money on these loans.

The once attractive mortgages to buy-to-let investors were withdrawn as the banks recalibrated the risk facing them. The changes in the mortgage market fed through to the property market, as falling prices deterred new buyers. This put increased pressure on the banks' developer clients who were stuck
with unsold houses.

The credit crunch finally scuppered a trade sale of Irish Nationwide as the building society's chief executive Michael Fingleton told his annual meeting at the end of April that it would be two years before there would be a sale because the value of financial companies had affected badly by the global
market turmoil.

As inflation rose in Europe, the ECB signalled in early June that it would raise its base benchmark rate. This killed off any potential hope of a recovery in the property market, putting developers and their bankers in crisis mode.

This was confirmed by Brian Lenihan in one of his first public statements as Minister for Finance when he said in June that the booming housing market had come to a "shuddering halt." By the end of the first half of the year, the four public Irish banks had lost €39 billion of their value since they peaked at more than €50 million in early 2007.

July to September

As the speed of the economic downturn picked up pace, investors starting selling down their interests in the Irish banks. Stocks tumbled. Bank valuations were 60 to 75 per cent lower over the year to early July. As euro-zone inflation surged to a record high of 4 per cent in July, the ECB raised interest rates to a seven-year high of 4.25 per cent and sucked any lingering life that was left in the Irish property market.

As Ireland move towards recession, fears were growing that banks would be badly hurt, particularly from losses on loans to the property and construction sectors, to which €110 billion was outstanding in the country.

"It's time for hard hats, I'm afraid," Richard Burrows, governor of the Bank of Ireland's board, told shareholders in early July, as the bank issued a profit warning.

The fears were confirmed at the end of July when AIB, at its half-year results presentation, said that a fifth of the bank's €10.4 billion loans to Irish property developers was "on watch". The bank coined a new euphemism for high-risk loans, saying it had €10.2 billion in "criticised" loans, but added that it was supporting developers by not foreclosing on them and granting them company-saving holidays on their interest payments.

Realising the dramatic economic decline, the bank said losses on loans would peak at just over €1 billion, or 0.8 per cent of loans, in 2009, but set a worst-case scenario where it would lose up to €1.3 billion every year from 2009 to 2011. Despite painting this dark picture of its potential future,
AIB raised its dividend in what was meant as a show of confidence but which was interpreted as a reckless move. Later, Irish Life & Permanent - even though it expected much lower losses on its home loan-dominated business - took a more realistic view, freezing dividends.

In July, Sean Quinn, reputed to be Ireland's richest man, confirmed what the market had been speculating on for several months - he revealed that he and his family converted their interests in Anglo Irish Bank from highly-leveraged (and highly risky) Contracts for Difference (CFDs) to actual shares, taking a stake of almost 15 per cent in the State's third largest public bank. He is estimated to have lost up to €1 billion on the bank at this stage.

The following month, Anglo Irish appeared to have its head in the sand, saying that loan losses would top just €130 million in the year to September 30th - just 0.18 per cent of the bank's overall loan book - far lower than its peers.

But everything changed utterly in September and the unthinkable started becoming the inevitable.

In the middle of the month, Lehman Brothers failed. Most thought Lehman was one long-standing bank that was just too big to fail, given that the US government had stepped in to protect its rival Bear Stearns just six months earlier. The US later stepped in to bail out mortgage giants Freddie Mac and
Fannie Mae, and protect AIG, one of the world's biggest insurers. Lehman was not so lucky; it was allowed to crumble, with devastating consequences.

Across the financial world, investors fled banks and customers moved cash to safe havens such as gold, fearing for the deposits in their banks. Just three days after the collapse of Lehman, Bank of Ireland's shares recorded their biggest drop in 19 years as the State's second largest bank said it expected bad debts to increase fivefold over the next 18 months. The bank halved its dividend to shore up extra capital to prepare for the bad times on the horizon.

Concerns about the security of the Irish banking system persisted and banks' liquidity came under huge pressure as customers withdrew deposits. The Financial Regulator, the banking watchdog, tried unsuccessfully to reassure customers and repeated the same mantra the regulator and Central Bank had
been saying for months - the banks were robust, well-capitalised and could withstand the risks to their financial stability. The regulator encouraged customers to continue doing business with their banks. Many didn't believe him or acted on his advice.

The Government was forced to take action on Saturday, September 20th. Mr Lenihan increased the deposit protection limit to €100,000 from €20,000. This eased the concerns of everyday savers and depositors but the large corporate depositors remained anxious about the security of their multi-million euro sums in the Irish banks.

Matters reached a head on Monday, September 29th. The fallout from the collapse of Lehman sparked a wave of bank rescues in Europe and the United States. Irish bank shares recorded their sharpest falls in more than a quarter of a century, with Anglo Irish particularly badly hit, dropping 46
per cent.

As AIB and Bank of Ireland joined the Government , the regulator and the Central Bank for crisis talks through that night to develop an emergency plan, Anglo Irish chairman Sean FitzPatrick was at home in bed, sleeping easy.

At dawn, Mr Lenihan announced that the Government was guaranteeing all deposits, including money owing to corporate and inter-bank customers, at the six Irish-owned banks and building societies. The extraordinary State insurance policy protected €440 billion in bank liabilities for a two-year

The figure amounted to almost ten times the national debt and more than twice the value of the economy, but Mr Lenihan said the guarantee was necessary to keep the lifeblood of the banking system flowing. "We have to have faith in ourselves as a nation and a people that we are capable of
having a viable banking system." He knew it was economic nationalism but that without Europe-wide protection, the Government had to plough its own furrow.

October to December

A week after the guarantee, the Minister was apoplectic when he discovered that the son of Michael Fingleton, Irish Nationwide's chief executive, had sent out an email in the UK touting for deposits using the lure of the State bank guarantee, contrary to an order from Government when the scheme was not
to be abused by the banks.

He referred the email to the regulator who fined the building society €50,000. Incredibly, this was the first time a bank or building society had been fined by the regulator in its five-year history. The regulator came under intense pressure and a deluge of criticism over his softly, softly policing of the Irish banking sector and not warning - or appearing to understand fully - the growing risks facing the banks from the raging international financial storm.

* *

Irish bank shares rallied after the guarantee as it provided some short-term protection that was drastically needed. While Ireland was the first to move to protect its banks, other countries followed, but went much further by not only guaranteeing but injecting cash into their banks to protect against
rising loan losses.

The UK government injected £37 billion into its three main banks, bringing their key capital ratios above 8 per cent in what was described as "a shock-and-awe recapitalisation". However, Mr Lenihan and the banks held a line that they had sufficient levels of capital to absorb rising losses on loans and that the Irish banks did not need to follow the UK and others. Mr Lenihan praised the Irish guarantee as "the cheapest bail-out in the world so far." Once again, investors were disbelieving.

The banks fought the demands for extra capital from investors and commentators, saying their capital ratios were sufficient. AIB's chief executive Eugene Sheehy even rather alarmingly declared to investors that the bank would "raise die than raise equity." But the market believed the banks needed more cash. In October Irish bank shares recorded their worst ever monthly decline, falling 35 per cent and bringing the year-to-date falls to 75 per cent.

At the end of October, the regulator slapped a fine of €3.25 million on Sean Quinn's insurance company and fined him €200,000 personally for failing to notify a loan of €288 million to a related company. The loan was made to fill the hole left by Anglo Irish's collapsing share price. Mr Quinn's company also revealed the full extent of his losses in Anglo and other stocks. The company had written off up to €959 million this year and last on its investments, most of which was lost on Anglo in what must rank was one
of the worst investments in Irish corporate history. It was an extraordinary sum, even for a man who was supposedly the country's wealthiest man.

In November, as the property market experienced near-collapse, AIB and Bank of Ireland revealed massive increases in bad debt expectations, mostly to the beleaguered property developers and builders.

The worst-case scenarios that the banks had thought unlikely just months earlier started becoming actual forecasts. AIB said it would be writing off 7.8 per cent of its €10.7 billion in loans to Irish property developers over two years, while Bank of Ireland said it would write off 12.5 per cent of its book over three years. The bank said it would write off a total of €3.8 billion over the next three years. Investors were certain it would be higher.

The banks scrapped their dividends, as expected now that they were covered by the State guarantee. They also curbed new lending in a dramatic attempt to grow the banks' capital ratios to the levels set by the UK banks to appease markets and to make sure they had enough in reserve to absorb the
massive likely losses on their loans.

This led to charges from business lobby groups and opposition parties that the State-guaranteed banks were starving Irish companies of credit at a time when they needed it most to survive the recession.

In December, Anglo Irish finally swallowed its reality pill, setting aside a €724 million to cover bad debts, primarily on loans to developers. This almost ninefold increase in likely loan losses - a dramatic increase since August - led to a 37 per cent drop in profits. The bank said that it could have to write off up to €2.76 billion over the coming the years, mostly on development loans.

At the same time, the market was shocked when the bank revealed an additional €6.5 billion in loans to developers as this part of the bank's loan book rose from 15 per cent to 23 per cent in just six months. The bank's chief executive David Drumm said there would be "no daylight until 2011." Life would get even darker for Anglo.

Investors absorbed the dramatic surge in expected bad debts and the bank's share price fell 29 per cent. By mid-December, the four public banks had lost about €50 billion of their value since their peaks last year. Anglo Irish share price losses extended to almost 97 per cent and the Government was forced to step in again.

Amid the growing interest from private equity investors and existing shareholders in the banks, the Government said it would set aside €10 billion to recapitalise the Irish banking sector using cash from the State and private investors. The Government would raid the €18.7 billion National Pension Reserve Fund to make the investment.

Industry-changing mergers between some of the country's banks were tentatively suggested as a means of strengthening the system, but this idea has fallen off the Government's agenda, for the time being at least.

It was too little, too late. Investors continued to sell out of the banks, with Anglo being targeted in particular by incredulous investors. Some of the bank's largest shareholders started sold some long-held stock and Anglo's share price collapsed to just 28 cent, valuing the bank at just over €200 million, down from a high of €13.3 billion in the middle of 2007. Another bombshell landed that led to the evaporation of any remaining confidence in Anglo.

It emerged that Anglo's chairman and one-time chief executive Sean FitzPatrick had been hiding loans at the bank over an eight-year period. The loans totalled €87 million. He had been moving loans off the bank's books before its year-end every September to conceal the from the banks' auditors and moving them back after the year-end.

Incredibly, the regulator had discovered this 11 months earlier during a routine inspection of not Anglo, but Irish Nationwide, to which Mr FitzPatrick had transferred the loans. FitzPatrick resigned on
December 18thsaying what he had done was "inappropriate" Within 15 hours the bank's chief
executive David Drumm had also stepped down. The bank's share price came under further pressure and the Government had to step in, again.

Within three days, the Government had injected €5.5 billion into AIB (€2 billion), Bank of Ireland (€2 billion) and Anglo (€1.5), effectively taking control of Anglo. Mr Lenihan also offered to underwrite the raising of up to €1 billion more at each of AIB and Bank of Ireland by buying any new shares issued that private investors do not buy.

Bank of Ireland jumped at the offer, despite saying a month earlier that capital raising from shareholders was "not on its agenda." Contrary to earlier protestations that it would not need to turn to existing
shareholders to raise capital, AIB "indicated an interest" in raising capital from existing shareholders. The about-turns by both banks will increase the pressure on the positions of the bank's chief executives - Mr
Sheehy and Brian Goggin.

Anglo Irish Bank, whose brash style of banking epitomized the entrepreneurial and risk-adverse nature of the Celtic Tiger, had been so gravely weakened that it had to crawl under the wing of the State. Anglo had in a period of just 18 months become Ireland's greatest rags-to-riches-to-rags story, knocking an estimated €1.5 billion off the fortune of the State's richest man, Sean Quinn and leaving two of the country's best-known bankers as casualties.

Fears linger that the State's injection of €5.5 billion into the three main banks - with a further €2 billion in public money and possibly more promised - will not be enough to cover up to €20 billion - and maybe even as high as €30 billion - in bad debts that the Irish banks will have to write off over
the coming years.

The Government could end up playing a much more significant role on the Irish banking stage than it has reluctantly agreed to by the end of 2008. Any further meltdown in the banking sector in 2009 could be catastrophic for the Government at a time when the public coffers are dwindling. A lot gone, more to go.