The coming crisis?

It is early February 2010 and it is time again to look at our banking system. If you thought all of the problems had been sorted, then think again. There are really big problems coming down the road, and very few people seem to be talking about them. So let’s look a little closer at the potential fiscal problems Ireland, and our banks, face.

A number of issues have come to the fore in recent weeks, and over the coming weeks and months things could become somewhat – strained.

Yesterday the Minister for Finance Brian Lenihan decided to devolve more functions from the Department of Finance to the National Treasury Management Agency. The Opposition are critical of the move, arguing that Lenihan doesn’t trust his own staff enough. I’m not entirely sure this is the case. One thing that stands out like a sore thumb is the fact that unlike the Department of Finance, the NTMA is not subject to the Freedom of Information Act.

Indeed the Department have said to me several times over the past few months that my requests for information were being delayed because the Department was so busy with NAMA, and with other FOIs. Now, it seems, much of the decision making will be made in secret anyway. And the NTMA is secretive. They are a public body, but we don’t know what the pay levels are.

In the current fiscal crisis we are in, the NTMA is arguably one of the most important public bodies, yet we cannot FOI them. They are the body that issues our bonds, bonds that are keeping this country afloat. The Financial Regulator and Central Bank are also not subject to FOI. The Department of Finance is one of the few bodies in this area we actually can FOI – moving powers to the NTMA will only lead to less accountability for the public.

David McWilliams recently argued that we are facing a debt-fueled crisis, and I agree. There is something going on with our banking system that no one appears to be talking about and things could get very hairy indeed over the coming months.

Let’s take a closer look at the what might be happening in the Irish banking system.

If you’ve read Morgan Kelly’s excellent analysis of the Irish credit bubble you will be aware of the Irish banking system’s over reliance on international money markets for funding. When the financial crisis hit in September 2008, these money markets froze and Irish banks struggled to get day to day funding. This is what ultimately led to the bank guarantee, and to the opening of what’s called the ECB discount window.

Banks all over Europe were struggling with funding, so the ECB essentially enacted emergency measures to help fund the banks. Irish banks were one of the biggest beneficiaries of the discount (the interest rate charged by the ECB is sometimes called the discount or repo rate). Ireland’s banks have effectively been kept on life support by the ECB since 2008, as McWilliams also noted last year. Essentially Irish banks were buying NTMA-issued sovereign bonds with short-term lending, presenting that as collateral to the ECB and then borrowing cheaply from the ECB. Summed up here – 25% of our deficit in most of 2009 was indirectly funded by the ECB.

But these emergency measures will not last forever. And it appears NAMA was part of this methodology. It is entirely possible that in order for banks to be able to fund themselves once the ECB shuts the discount window, and get funding from commercial markets again, the plan is to transfer the crap to the Irish taxpayer in advance. This makes it more likely that banks will be able to fund themselves without the help of the ECB.

In November the ECB announced it would begin the process of winding down the emergency funding. In December the last 12-month repos were sold. We are now approaching the next phase. Next month, the ECB will close the 6-month window. The 3-month and 1-month repos will close after that. McWilliams put it well last week:

We don’t seem to realise that we are now in a phony war situation where our sense of stability is based on the European Central Bank (ECB) injecting soft loans into the banking system. This massive monetary injection was carried out all over Europe to make sure the European banking system survived last year.

The ECB is now unwinding this credit. Let’s just recap on the way the banking system works. If the banks stop lending to each other (as happened in September 2008), the Central Bank, acting as the ‘lender of last resort’, steps in. It says to the banks: ‘‘Give us what you call ‘assets’ on your balance sheets and in return we will give you money so that you don’t run out of money and go bust.”

In Ireland, the assets on the banks’ balance sheets are our mortgages and all sorts of loans to property. So the banks package all these mortgages into what is called an asset-backed security (ABS).

This product, which could be thousands of performing mortgages, is rated by the rating agencies and then given to the Central Bank in return for cash.

This cash goes into our ATMs and we spend it. The ECB did this all over Europe from September 2008, because every banking system was experiencing problems.

The pathetic spin put out by the government and believed by many is that Ireland has some sort of sweetheart deal with the ECB, whereby the Europeans looked favourably on Ireland.

This is not true. The ECB treated the Irish banks the same as any other banks in Europe. In fact, it could not have legally treated us any differently to any other country. It loosened its rules on what did and did not constitute ‘security’. So banks in Europe that couldn’t get money anywhere else went to the ECB and exchanged ‘assets’ for cash.

In normal times, the ECB will only accept assets with an AAA rating as collateral. In the past two years, it has loosened this and accepted any old trash in return for cash to protect the system. Look at the chart for Europe as a whole, and we see that the ECB provided over €500 billion in this type of financing across the eurozone.

In July, it intends to pull €442 billion out of the system, as it reverts to taking only AAA assets and signals to the rest of Europe that the banking crisis is over. But it’s not over in Ireland.

In the crisis, different countries needed differing amounts of cash, depending on how delinquent the country’s bankers and regulators were during the boom. It will come as no surprise that Ireland is the most badly affected. Today, Irish banks are getting €98 billion from the ECB in this type of ‘cash for trash’ funding. That is 17 per cent of our banking system’s assets, which are about €520 billion.

Nearly as fragile are the Greeks, who are getting €42 billion or 8.8 per cent of total assets. For Italian and French banks, only 0.8 per cent and 1.8 per cent respectively of their total requirement comes from the ECB. In other words, when the ECB changes its rules, it will have no effect in Italy and France, a nasty impact in Greece and a catastrophic impact on the amount of money in ATMs here.

The major problem for Ireland is that the ECB will accept only AAA assets from March, but we don’t have any AAA assets.

Our government debt, the least risky (apparently) asset in Ireland is not even AAA any more. The ABS packages of our mortgages are clearly nowhere near AAA and will be further downgraded as mortgage defaults rise.

So where are we going to get €92 billion and how much will our banks have to pay over and above ECB interest rates? Someone will lend to us – but at a huge premium and probably a rationed amount of cash.

The rating issue is important. Our banks were downgraded by S&P last week, which will make it more difficult to sell their own bonds. The assets they hold will also not be sufficient to take advantage of the last of the 6-month repos this month, since the ECB require that the assets they present as collateral for the issues need to be AAA rated by two credit ratings institutions. This is highly unlikely for any of the collateral our banks have – the collateral is essentially junk.

Everyone is talking about Greece right now, but to me Ireland is no different. It is probably worse. So with these deadlines looming, what is happening? Over the past number of weeks you might have noticed various headlines to do with NAMA delays. Why is this important? Could it be that unless the banks can transfer these junk ‘assets’ from their books, they could face funding difficulties on non-ECB markets?

I could well be wrong, or even cynical, but my feeling is that banks are desperate to get this stuff off their books, in order to be better able to fund themselves after the ECB shuts the discount window. If they don’t get them off their books, and onto the backs of the taxpayer, the banks could simply end up going to the wall, or simply being nationalised.

There is another angle to this story that is not getting much coverage. And that’s Anglo’s role in all of this. A number of questions arise and remember Anglo is a public body:

How much exposure does Anglo have to CDOs squared?
65% of Anglo’s loan book is ‘investment lending’, what is this composed of? (Atlas I report)
Who are Anglo’s bondholders, and why were they protected?
How did the S&P downgrade of Irish banking affect Anglo last week?
How much exactly did Sean Quinn own of the bank, and how much did he borrow from the bank? How much of Sean Quinn’s loans were backed using his group of companies, and what other collateral was used for his borrowings?

A number of issues arise. In June, Anglo received a €3.5bn recapitalisation from the State. At the time it said it might need a further €3.5bn. This is money to rebuild the bank’s capital base due to bad loans.

However, these figures are likely much higher. Anglo will likely need up to three times that figure. Combine that with AIB, INBS and Bank of Ireland’s funding needs, and the taxpayer will likely be handing over more than €22bn to our banks over 2010.

When you combine the shutting of the discount window, with the delays in NAMA transfers and ultimately our own State borrowing (indeed we have already borrowed €6.5bn so far this year – 33% of our bond issuance for this year was done in January) and with the likely writedowns of not 30% but 50% on the loanbooks, we are facing a serious crisis. And of course the other factor is the ECB raising interest rates at a time we need them to stay low.

My questions is this: how are we going to pay for all of this?