Loans to builders big threat to banks
Credit default swaps underwrite banks' risks when they borrow money. As this cost rises, institutions are left vulnerable, writes MORGAN KELLY
WHILE THE recent roller-coaster ride of Irish bank stocks has been grabbing attention, more important and potentially more worrying developments have been taking place in a market of which few people have heard: the market for credit default swaps (CDSs).
Just as people buy insurance against default when they take out mortgages, so do banks when they borrow in the wholesale market from other banks. The rate of insurance they pay is determined in the CDS market.
Last summer, it was costing banks less than 30 cent to insure every € 100 they borrowed. Now insurance is costing Irish-owned banks between €2 and €3.20. Given a base borrowing rate in wholesale markets of just more than 4 per cent, Irish banks are having to pay from 6 per cent to more than 7 per cent to get funds.
This steep rise in insurance rates reflects two things: the growing nervousness in financial markets about the bad lending of US banks; and concerns about the exposure of some Irish banks to loans to builders and developers.
Lending to developers is risky. As property markets slow, banks quickly go from having hardly any impairments on these loans to suffering very large losses indeed. In the last, and far from apocalyptic, downturn in the US in 1991, banks lost 12 per cent of what they had lent to developers.
To operate profitably, banks hold little capital compared with the loans they make, usually about 7 per cent. This means that relatively small losses on loans are enough to seriously impair their functioning, and so banks usually lend cautiously to developers.
Irish banks, however, have given nearly 30 per cent of their loans, some €105 billion, to builders and developers. A loss of 12 per cent on these loans would halve their effective capital, leaving them in need of heavy recapitalisation.
Exposure to developers, moreover, varies widely across banks, from zero to more than 90 per cent. There is a risk that difficulties in one heavily exposed institution might set off a domino effect of depositor panic (current levels of deposit insurance are wholly inadequate) and forced asset sales across the entire system.
It is not inevitable that banks will suffer such heavy losses. Bankers are paid to manage risk, and we must hope that they have done so competently. However, two things will prove particularly testing for banks in the coming year: loans to house builders and the narrowness of the Irish market for commercial property.
During the housing boom of 2000 to 2006, banks lent freely to builders, and loans rose in step with housing starts. Now, although housing starts have fallen sharply, loans to builders have continued to rise, to €25 billion. This could suggest that some builders with unsold houses are having difficulty repaying loans.
Despite some of the highest commercial rents in Europe, rental returns in Dublin, at below 4 per cent, have long been below interest rates, and the market came to be a classic bubble driven by expectations of capital gains. These capital gains were generated in turn by bank lending: with a more or less fixed number of properties coming on the market each year, by increasing their lending annually by 20 per cent, a handful of banks could effectively drive up prices by 20 per cent.
In its heyday then, the market worked like this: developers would buy a property and pay the difference between rent and interest for two to three years as the price rose ("adding value"). Then they would sell on to other developers (often syndicates of affluent amateurs capitalised by second mortgages) or a property fund.
The first signs things were going wrong appeared earlier this year when property funds, which had been the main final buyer in the market, were forced to freeze withdrawals. With the potential of large sales by property funds, rising vacancy rates, a large supply of new properties, and the difficulties of some large lenders in the market in raising funds; there is a real prospect of sharp falls in commercial property prices.
Should we suffer a recession, high rents will drive many firms out of business. This will leave some developers who now have adequate rental income unable to service their borrowings.
Does it matter that Irish banks are finding wholesale funding more expensive? Can they not just borrow from the Irish public? Certainly they are trying - some institutions are offering higher rates of interest on deposits than others are charging for mortgages.
However, the Republic has for several years been running a current account deficit which means that we are net borrowers from the rest of the world, with banks acting as the conduit.
At a time of increased anxiety, it is vital regulators introduce measures to handle impaired loans to builders; overhaul our inadequate system of deposit insurance; and monitor the real solvency of those banks that lent aggressively for speculative land purchases and building, and may now be finding themselves dangerously out of their depth.
Morgan Kelly is professor of economics at University College Dublin.