Bank plan offers hope after a year of carnage

It took the involvement of the EU, ECB and IMF to draw what may be the final line under the country’s banking crisis.

THIS WAS the year that the full scale of the carnage caused by the Irish banks became clearer, although it took three attempts to try to get a handle on the extent of the problems.

The damage caused was so great that, reluctantly, the Government accepted towards the end of the year that the State could no longer afford to fix the banks by itself. This confirmed that government action over the previous two years had been far too slow and had not gone far enough.

The European Union, European Central Bank and the International Monetary Fund arrived in November to hatch a plan for the Government and the banks – tied inextricably since the 2008 guarantee – to draw what may be the final line under the crisis and set an accurate estimate on the cost of the banks.

However, the Government and the new banking regulator initially had two attempts. In the first three months of the year, all eyes were on the new head of financial regulation at the Central Bank, Matthew Elderfield, who started in the job in early January, and on Patrick Honohan, the bank’s governor, as privately they peered into holes in the banks to assess how much capital they required.

Getting a handle on the scale of future losses was the problem. It was all well and good saying the banks would have to reach a core tier one capital ratio of 8 per cent by the end of the year – broadly putting €8 in reserve for every €100 on loan – but without knowing the scale of future losses, it would be hard to know how much more each bank would need to absorb mounting bad debts.

What was obvious but unsaid for most of the second half of 2009 and the early part of 2010 was that the capital pumped into the banks had not been enough.

Allied Irish Banks and Bank of Ireland had received €3.5 billion each from the Government, while Anglo had taken €4 billion. However the National Asset Management Agency, set up to remove the most toxic loans from the banks (estimated at €80 million in early 2010), would determine some losses.

Nama was busy in the background casting a careful eye over the loans of the 10 most heavily indebted borrowers to set the price it would pay the banks for the first tranche of transfers. The names of the top 10, which were never confirmed by Nama, include some of the biggest property developers in the country – Treasury Holdings, Bernard McNamara, Liam Carroll and Gerry Gannon, Seán Mulryan and Derek Quinlan.

The set-piece day for the first shock-and- awe bailout came on March 30th – it was a co-ordinated effort by the Government, the Central Bank and Nama, each making an announcement. Minister for Finance Brian Lenihan set the significance of the day, saying that it would draw a line under the crisis “once and for all”.

Nama said that it was acquiring about €15 billion worth of loans linked to the top 10 borrowers at an average discount of 50 per cent. This involved wiping some €7.6 billion off the value of the loans, forcing massive losses on to the banks. Different discounts, or haircuts, applied to each institution – the bigger the discount, the worse the institution. Bank of Ireland fared best with 35 per cent shaved off its €2 billion in loans; Anglo Irish Bank and Irish Nationwide Building Society fared worst, with 55 per cent and 58 per cent respectively.

Reflecting Anglo’s status as the bank of choice for the big developers, the bank transferred most money – and the majority of the loans – in the first tranche, some €9.25 billion.

To reassure markets – where the Irish banks source about half of the funding – Elderfield said that the banks would have to raise further capital to cover the losses and meet the higher capital target of 8 per cent by year-end.

AIB would require €7.4 billion but the Government said that it would allow the bank time to raise this on its own, first by selling assets – namely its banks in Poland and the UK, and a shareholding in the regional US bank MT. Bank of Ireland stared into a much smaller capital hole: it required €2.7 billion and again, the bank was given time to raise it by its own means. Irish Nationwide and EBS required €2.7 billion and €875 million respectively to cover their Nama-related losses and to replenish their capital.

The horror story was nationalised Anglo – the bank’s capital bill soared to €12.3 billion with the possibility of €10 billion more. Days later, the bank released its long-awaited 15- month results to the end of 2009, which showed losses of €12.7 billion, the worst ever reported in Ireland by a company.

The bank’s management team, led by chief executive Mike Aynsley, was intent on proceeding with its plan to split Anglo into a good bank and bad bank. The bank submitted its revised restructuring plan – with the blessing of the Department of Finance – to the EU in May, clarifying queries around its plan for the bank.

Where AIB had fought with the Government and dragged its heels when managing director Colm Doherty was informed of its large capital target, Bank of Ireland wasted no time raising the required €2.7 billion.

In June, the bank generated more than enough capital selling new shares to its investors, converting some of the State’s €3.5 billion preference shares and swapping debt for shares with bondholders. The bank boosted its capital by €2.9 billion – in excess of the regulator’s target – and paid off warrants limiting State ownership of the bank to 36 per cent.

Irish Nationwide and EBS were not so lucky: both were taken into State control once they received capital by a rather novel means.

The Government issued them with IOUs or promissory notes. This counted as capital and allowed the Government to spread the cost out over a long period.

In June, two reports into the causes of the banking crisis were published. Honohan wrote one, international experts Max Watson and Klaus Regling the other, and together they formed the basis for the Commission of Investigation established by the Government.

Both reports criticised misguided government policies, flimsy bank regulation and poor bank lending. Both said domestic factors were to blame. Watson and Regling refused to be drawn on how much of the crisis was home-grown. Honohan had no such qualms: domestic factors were mostly to blame, he said.

Honohan’s report filled in many gaps in the understanding of the Government’s decision to guarantee the banks in September 2008. He said that an extensive guarantee was necessary but he was critical of the extent of the one chosen, as it limited subsequent options and increased potential losses for the State.

In July, AIB and Bank of Ireland passed an EU-wide stress test of 91 banks to calm the international markets about the amount of sovereign debt, particularly Greek government debt, that they held. The test missed the growing crisis at the Irish banks, however, and there was a slow run on deposits.

Seán FitzPatrick, the former chairman of Anglo Irish Bank, who was arrested in March by Garda Bureau of Fraud Investigation detectives investigating Anglo and released without charge, was declared bankrupt in July. Management at his former bank refused to agree a settlement and, given that it was owed €110 million of total debts of almost €150 million, the bank held all the cards. His assets, mostly property investments and shares in Anglo and other banks, were worth €50 million, leaving him in a deep hole.

His former chief executive at Anglo, David Drumm, also applied for bankruptcy in the US, filing in Boston in October. By doing so, he avoided a legal action with the bank in Dublin over loans of €8.5 million used mostly to buy shares in Anglo.

In August, the bank’s cost rose to almost €25 billion. Losses on the second tranche of Nama loans, about €12 billion, linked to the next 22 most indebted borrowers, were assessed and what the agency discovered wasn’t pretty. The average discount climbed to 55.6 per cent – increasing to 72 per cent and 62 per cent respectively for Irish Nationwide and Anglo, the two worst banks in the sector.

Anglo set another record in late August as the bank’s half-year losses reached new heights, climbing to €8.2 billion. International markets were getting nervous that the cost of the banks was running away on the Government when it had its own problems trying to fix the public finances and narrow a €19 billion deficit. Credit ratings agency Standard and Poors said Anglo could cost €35 billion.

As State borrowing costs rose, the Government decided it had to make a final decision about Anglo. Brussels had not yet ruled formally on Anglo’s management’s good bank- bad bank plan, but the Government threw this out and said it would split Anglo into an asset recovery bank and funding bank. The asset recovery bank would be run down over time and the other bank would be established to retain about €50 million of funding and deposits at the bank.

However, the Government’s efforts were undermined by its inability to put a final cost on the bank – what the markets craved.

Matters went from bad to worse in September. Nama’s slow process of valuing toxic assets loan by loan meant that the quality of loans to less-indebted developers was worse than the first two tranches. This led to another bank bailout announcement and another attempt to draw a line under the crisis.

On September 30th, the Government pushed the bank bailout bill to €50 billion in a worst-case scenario – Anglo’s cost rose to €29.3 billion and possibly €34.3 billion if the property market didn’t recover for 10 years; AIB’s bill rose to €10.4 billion and the cost of Irish Nationwide doubled to €5.4 billion.

The spiralling cost of Anglo was the biggest shock, amounting to a mind-boggling 21 per cent of GDP. Lenihan said that the Government had to stand behind Anglo as the bank’s failure would collapse the State.

AIB’s bill meant that the bank could not survive without another Government injection of capital. This led to the departure of executive chairman Dan O’Connor and managing director Colm Doherty, who were still struggling to meet the previous €7.4 billion target from selling assets and tapping shareholders in a rights issue. An outside candidate, David Hodgkinson, a former senior executive at HSBC, was installed as executive chairman.

The sale of the bank’s Polish subsidiary Bank Zachodni WBK and the stake in MT is raising about €4 billion, but the new capital target meant AIB could not avoid nationalisation.

Despite yet another bank bailout, investors were still spooked. The cost of bailing out the banks would push the Government’s debt to 32 per cent of GDP for 2010 when it was already struggling to correct the public finances so it could borrow at sustainable interest rates. This forced the Government to seek budgetary savings of €15 billion over four years, including €6 billion in the first year, but Government borrowing costs on the markets continue to rise to record levels.

While the banks had capital problems, it was further liquidity problems that threatened their survival. Some €25 billion of debt raised by the banks under the September 2008 two-year Government guarantee came due for repayment to bondholders and the sovereign debt crisis in the euro zone meant that the bond markets were for the most part closed to the Irish banks. They had nowhere else to turn but to the discount loan counter at the European Central Bank.

ECB borrowings by the banks, including international lenders based in Ireland, soared to €130 billion at the end of October from €95 billion two months earlier. However, what concerned the Frankfurt-based bank most of all was that the Irish banks were borrowing heavily from the Irish Central Bank’s emergency lending facility, using as collateral assets that the ECB would not accept. It rose from €14 billion to €34 billion in the same period. Frankfurt shouted stop.

The ECB applied pressure on the Government to seek external assistance to save the banking system and ultimately the country. After initially denying the existence of talks on a bailout by the EU and IMF, the Government reluctantly applied and a €85 billion bailout fund was agreed, with the State providing €17.5 billion, including €10 billion from the National Pension Reserve Fund.

Some €35 billion of this would go to the banks in what amounted to a third banking bailout in the year and the fourth since the crisis struck 27 months ago.

A fund of €10 billion would be provided up front to recapitalise the banks again – or “overcapitalise” them to new international levels. The plan aimed for a radical restructuring of the banking system through the sale of some of the banks’ businesses and loan books in order to get their loans closer to deposits, so that they would not have to borrow as heavily from the ECB and, over time, from the market.

Yet another capital target set for the banks meant AIB would require another €5.3 billion, Bank of Ireland €2.2 billion, EBS €438 million and Irish Life and Permanent €98 million. Bank of Ireland was given yet more time to raise capital by its own means and to avoid Government control of the bank. Irish Life and Permanent plans to raise its own target and is still intent on buying EBS, although the private equity consortium led by Dublin firm Cardinal is still in the race.

Under the EU-IMF plan, Anglo and Irish Nationwide will be merged and, to deal with these failed lenders, fast-tracked proposals will be put in place to wind both down after moving their deposits to help other banks.

Passing these massive cost on to senior bondholders – previously regarded as sacrosanct by the Government – was suddenly back on the table under discussions. It was ruled out in the Government’s programme with the EU and the IMF, however, because of fears that a dangerous ripple effect across Europe would force lenders to flee EU banks.

Forcing so-called “burden-sharing” with subordinated bondholders was very much on the table, however. While voluntary deals to seek losses with them – similar to the 20-cent-in-the euro debt swap offered by Anglo – the Government’s Credit Institutions (Stabilisation) Bill includes measures to force losses on subordinated bondholders.

This legislation, enacted on December 21st, bestows exceptional powers on the Minister for Finance to inflict swingeing changes on the banks to restructure the financial system.

Lenihan used the law for the first time on December 23rd - first, to exclude two Irish Times journalists from a private court application to pump more money into AIB, over-ruling the rights of shareholders, and second, to sanction this second bailout of the bank.

The court ruling allows Lenihan to inject a further €3.7 billion into the bank. This second bailout, on top of the €3.5 billion injected last year, will tip AIB into State hands, as the Government’s stake will rise to 49.9 per cent initially to allow the sale of AIB’s Polish bank and to 92.8 per cent early next year. This brought the fourth of the sixth Irish banks - most of the Irish banking sector - under Government control and pushed the cost of the bank bailouts to €46.275 billion, with more to come in 2011.

This year started out with huge uncertainty around the true extent of the problems at the banks and how they would be fixed.

It ends with something of a plan of action to repair the banking sector once and for all.