Foreign investors believe the economic downturn and property slump will hit Irish banks hard, writes Simon Carswell,Finance Correspondent

THE CREDIT crunch created a perfect storm in the global financial markets, or so the well-worn cliché goes. One year on, the crisis has shown there has been nothing perfect about this storm.

For Ireland, the crisis has been further exacerbated by the economy's growing over-reliance on the property sector in recent years.

This has created much stronger headwinds for the Irish economy.

The inertia in the global bank funding markets means that loans are more expensive and harder to come by, which is delaying any immediate prospect of a resurgence in the property market.

One senior banker went as far as to suggest that the crisis has proven the global banking model to be hugely flawed.

Banks can no longer rely on securitisation and debt markets in which to sell their mortgages on, to generate more money to lend to new borrowers. They are only lending to each other at premium rates and the Irish banks are being forced to pay even more for their money, due to international doubts about the Irish economy.

The senior banker argues that the system has to correct itself, returning it to the cornerstone of the banking model - only lend what you take in on deposit.

Sebastian Orsi, analyst at stockbroking firm Merrion Capital, said this will be the most significant change of the credit crunch.

He said Irish banks were only providing new loans to match new deposits, removing their reliance on the costly wholesale markets dislocated by the credit crisis.

Irish banks have some way to go to match their loans to deposits. The ratio of retail Irish deposits to loans has fallen from 93 per cent in 1997 to 60 per cent in 2007, as Irish banks turned to the wholesale markets to find an alternative source to fund the property boom and the massive surge in lending.

"This is why we are going through a bigger hiccup than other countries," said Mr Orsi.

Housebuilding accounted for 6 per cent of economic activity in 1998. By the peak of the boom in 2006, this had reached 13 per cent of GNP. Residential mortgages rose to €124 billion last March, more than doubling in four years.

In 2002, Irish lenders were lending Irish residents €1.30 for every €1 they had on deposit. By 2007, the loans had reached roughly €2 for every €1 on deposit.

AIB's loan-to-deposit ratio was 1 to 1 in 2002, but rose to 1.5 to 1 by the end of 2007. The bank said last week that in the first half of the year, loan growth more than matched growth in deposits - for every €1 loaned in the six months, it had taken in deposits of €1.50.

Alan McQuaid, chief economist at Bloxham Stockbrokers, said: "Banks are not going to be as generous as during the Celtic Tiger years and that is going to lead to more difficult times."

Tomorrow marks the one-year anniversary of the credit crisis.

On August 9th, 2007, French bank BNP Paribas suspended three investment funds worth €2 billion, blaming the US subprime mortgage collapse. Credit markets froze, forcing the world's major central banks to pump billions into the global banking system. It had little effect as banks and investors grew suspicious, fearing some exposure to high-risk mortgage debt. The global money wheel stopped turning.

The crisis has raged ever since and total on losses linked to the US subprime sector and credit write-downs are approaching a staggering $500 billion (€326.4 billion). The IMF says losses could reach a staggering $1 trillion.

At home, the biggest loss has been the massive drop in the value of the four Irish-listed quoted banks. AIB, Bank of Ireland, Anglo Irish Bank and Irish Life Permanent have shed two thirds of their value since their share prices peaked 18 months ago.

Their market values have fallen from €57 billion to €20 billion.

While the banks have continued to report strong profits, international investors believe the Irish economic downturn and property slump will hit them hard, pushing up bad debts and knocking billions off their future profits.

The depressed share prices reflect the international disbelief in the Irish banking sector and the economy, as investors believe the situation will be far worse than Irish bankers themselves expect.

Property, and particularly the highly vulnerable housebuilding sector, remains the problem, as the number of new houses built more than halves from 78,000 last year to 25,000-35,000 next year. As property sales slide, the market will need a frenetic level of buying if the oversupply is to be reduced.

The signs are not good. Mortgage borrowing and property buying plummeted in May and June due to a combination of tightening on lending rules and loans, and a drop-off in borrower demand. House prices fell 9.5 per cent in the year to May, according to the Permanent TSB/ESRI house price index, and the expectation is that property values will fall 25-45 per cent from their peak.

The credit crunch is preventing a much-needed recovery in the property market. While banks say their lending departments are still open for business, they only want to lend to lower-risk borrowers - customers with low loan-to-value ratios and a well-established track record of repaying loans.

Mortgages to most first-time buyers have been capped at 92 per cent of the property's value.

No-deposit mortgages are rare, leaving prospective buyers having to raise up to 8 per cent of the property's value in cash - about €22,000 on the average house. This could add years to a buyer's plan as they save for a deposit.

The attractive tracker rates of recent years have also been withdrawn because the banks' own borrowing costs (inter-bank rates) have far outstripped those of the customers' (the European Central Bank rate plus the lending margin) due to the rising cost of money.

Banks are paying roughly 16 per cent more now than a year ago on their money costs due to the crisis.

As a result, lenders have had to raise tracker rates by up to 1.5 percentage points over the past year, pricing them out of the market and forcing buyers onto lower standard variable or fixed rates.

Unlike trackers, variable rates can be increased by banks for their existing mortgage customers. Some variable rates have risen by up to 0.63 of a percentage point.

Higher borrowing costs and stricter lending rules make a recovery in the struggling building sector unlikely in the short-term.

The banks have said they will remain supportive of developer customers, rolling up interest for some clients until they start selling properties again and can pay it.

AIB chief executive Eugene Sheehy last week ruled out any need for Government support for the property or banking market.

"The best way for this to cure itself is for the market disciplines to be maintained. If property prices come down further, affordability improves. That is the key change that needs to occur in the next couple of years," he said.

Alan McQuaid said he could see no improvement in the property market unless there was some "adjustment" in the banking sector to remove the logjam.

"Nobody would have foreseen that it would last as long as it has but it looks like it has another 12 months and possibly longer to go."