Better to incinerate €1.5bn than squander it on Anglo Irish Bank

For this Government, the bailout follows a compelling political logic: Anglo Irish funds developers, and developers fund Fianna…

For this Government, the bailout follows a compelling political logic: Anglo Irish funds developers, and developers fund Fianna Fáil, writes Morgan Kelly

FOR THE current Government, a month without a catastrophic policy error has come to seem like a month wasted. After the bank liability guarantee in September and the medical card fiasco in October, the Government had a quiet November but has now come roaring back to form with the bailout of Anglo Irish Bank. Attempting to recapitalise Anglo Irish is not only expensive and economically pointless, but futile.

Some simple arithmetic shows the hopelessness of what the Government is trying to do. In the typical property bust over the last 30 years, US banks have lost on average about 20 per cent of what they lent to developers.

Let us suppose that Anglo Irish is no more incompetent or dishonest than the average bank and will also lose up to 20 per cent of what is has lent.

Then, given lending of about €80 billion to developers, it follows that Anglo Irish is facing losses on the order of €15 billion. The true figure could easily turn out to be twice as large.

With likely losses of this magnitude, the Government's proposed investment of €1.5 billion will vaporise in months, forcing it either to continue pouring good money after bad, or to repudiate Anglo Irish's liabilities. For all it will achieve, the money might as well be piled up in St Stephen's Green and incinerated.

Anglo Irish epitomised the Irish bubble economy. Its rise began a decade ago as the boom created a demand for houses and commercial property. As prices started to rise, banks made a miraculous discovery: the more they lent, the more prices rose; and the more prices rose, the more people wanted loans to get into the booming market. And the more loans that bankers made, the bigger the bonuses they could award themselves.

It was brilliant while it lasted. One of Bank of Ireland's stable of developers would buy an office block for €100 million, and sell it on a year later to one of Anglo's for €120 million, and so on: a process known to bankers as adding value.

Everyone was a genius and nobody could lose.

As a senior executive of Anglo Irish once assured me, there was no risk involved. All of the loans were guaranteed by the enormous property portfolios of the borrowers.

What concerned me at the time was not that he was spouting transparent nonsense - that, after all, was what he was paid to do - but that he clearly believed it himself.

Sadly, like any pyramid scheme, it contained the seeds of its own destruction.

Once banks stopped lending, as they were forced to do earlier this year, the market collapsed. Developers were left holding properties whose rental incomes were a ruinously small fraction of their interest payments, and banks discovered that their collateral was worthless.

All Irish banks have been injured by the collapsing property pyramid, some fatally so. Unfortunately, as international experience shows, banks that have been overwhelmed by bad property loans do not simply fade away. Their final act typically has three scenes.

First, the bank starts to admit that a certain fraction of its loans are receiving active management, it increases its bad loan provision but by an unrealistically low amount, and its share price collapses.

In the second scene, evidence of malfeasance starts to appear, as senior bankers are found to have had difficulties in distinguishing the bank's assets from their own, and to have been acting as poachers as well as gamekeepers in their dealings with developers.

It is to be hoped that any Irish bankers in this situation have heeded the cardinal rule of Irish finance and kept their more imaginative dealings within the jurisdiction. As Patrick Gallagher discovered, the British judicial system takes a less indulgent view of lapses of fiduciary responsibility than does our own, and seems to harbour a particular antipathy towards charming Irish rogues.

In the final stage, as the bank slides over the brink of collapse, senior managers loot its assets. Looting a bank involves nothing so unsubtle or easily traceable as driving away with carloads of cash.

Instead, each bank has a filing cabinet with personal guarantees written by borrowers and deeds to property pledged as collateral (large property deals involve surprisingly little paperwork); and these documents have a tendency to find their way into the briefcases of departing executives who can later negotiate their return to their original owners.

So much for the future. Right now, in the "nothing in the last six months has really happened" world of the Government, the bailout of Anglo Irish follows a compelling political logic. Anglo Irish funds developers, and developers fund Fianna Fáil.

By any other criterion, a bailout of Anglo Irish is senseless. Institutions such as AIB and Bank of Ireland fulfil an economically vital role of clearing payments and lending to households and businesses; Anglo Irish and Irish Nationwide were purely conduits for property speculation.

They fulfil no role in the Irish economy and their absence would not be noticed.

By using taxpayers' money to acquire Anglo Irish's portfolio of dingy shopping centres and derelict development sites, the Government is squandering scarce resources that are needed elsewhere. Just as the State is putting too much money into Anglo Irish, it is putting in too little to recapitalise AIB and Bank of Ireland on which, whether you like it or not, large sectors of the Irish economy depend.

Governments tend to forget whose interests they are supposed to serve. Our Government was not elected to look after the managers, shareholders and bondholders of recklessly mismanaged banks.

Its sole duty is to Irish taxpayers: to ensure that banks that serve a useful economic purpose continue to operate, while those that serve none are swiftly closed down.

Morgan Kelly is professor of economics at University College Dublin