by Mike Soden
While macro-economic factors were at play globally in 2007 and the first half of 2008, Ireland was feeling comfortable and the six banking institutions were still aggressive in their lending. No one believed that there was a liquidity problem in the Irish banks and, furthermore, there was an unquenchable thirst for credit. Developers who had been successful in Ireland over the previous ten to fifteen years found the market at home less attractive than places far away. Many wealthy Irish developers engaged in international diversification, setting themselves up as property experts in places as far-flung and diverse as Dubai, Abu Dhabi, Hong Kong, Chicago and many other locations, the names of which were unfamiliar and difficult to pronounce. Developers became like Christopher Columbus looking for a New World for their ever-increasing wealth. Was this a signal for them to recognise that the Irish market had peaked and, with the assistance of bankers, they could venture abroad? Developers may not have been aware of what they were embarking on, but they were fast becoming diversified risk managers.
On 28 September 2008 the Government of Ireland was faced with this very critical problem: major corporate wholesale deposits were being withdrawn from Anglo Irish Bank and it was clear that they could not be replaced as quickly as they were being withdrawn. The contagion effect of this was the likelihood of other banks failing and, in turn, the country being put at risk. The decision and speed of putting in place a guarantee for the debts was appropriate at that time and preserved the country from a fate worse than the alternative, which was a potential collapse of the market. Only those who were involved will ever fully understand the various forces at work and the perceived risk to the country when the decision to issue the guarantee was made.
To understand how this situation could have developed for Ireland, one has to go back to the simple activity of getting a loan from your local bank manager. Traditionally, a borrower went with trepidation to his bank manager and would pose the question, ‘How do I stand for an overdraft?’ And the response was often, ‘You don’t stand, you kneel.’ Getting money out of a bank was akin to getting blood out of a stone. However, over time, the culture and thinking of banks changed with regard to the extension of credit. The eternal battle between the credit department and the sales force came to an abrupt halt with decisions on lending being excessively influenced by the need for growth.
In the good old days of the 1970s and 1980s, if you required money for a mortgage, personal loan, car or even a holiday, you would put forward a business case on the lines of how much you owed, what your income was, what other liabilities existed and whether you owned other assets. After an in-depth analysis of the request, a response, negative or positive, was forthcoming within a month. Fundamentally, a bank would take into consideration your total financial picture before they would entertain evaluating the risk attached to the repayment. The ability and willingness of a borrower to repay had always to be determined. It was not complex but sometimes it was burdensome and bureaucratic. However, when the approval came through, the customer felt satisfied. The amounts in question here were between £1,000 and £50,000.
During the 1990s, economic growth, inflation and soaring prices meant there was greater demand for liquidity and credit. An opportunity was apparent in the Irish banking system – lack of competition. Slowly but surely, branches of UK and Australian banks, including Ulster Bank, Bank of Scotland (Ireland), National Irish Bank and others, including Barclays and KBC, that did not have branch networks but were active either directly or indirectly in major developmental or investment property transactions, appeared in the Republic. So the multiplier effect in lending was felt. Prosperity led to demands for larger loans in the mortgage and property areas. The traditional methods of evaluating risk by the two large banks, AIB and Bank of Ireland, were maintained as they had been tried and tested and the losses that had been incurred on any single transaction were small, very small by today’s standards. When I left Bank of Ireland in May 2004, the single largest loan loss experienced in the group’s 221-year history was €25 million. How credit standards would become diluted and people’s judgment would become impaired!
During the period 1991–2007 banks found themselves satisfying the growing demands of their customers for credit. For most of this period, the two major banks employed credit systems that required requests for larger loans to go to their credit committees for approval. This process continued even though it was slow relative to the increasing demands of the customer base. The need for good credit analysis was observed.
All banks, under the guidance of the Regulator, have risk management committees. The risk management committee has experts in three principal areas: credit risk, market risk and operational risk. In addition to this, a bank has what is called the asset and liability committee (ALCO), the principal responsibility of which is to preserve and protect the balance sheet of the bank. This protection is with respect to capital and liquidity in the event of any strains, unexpected or otherwise, that might impair the bank’s ability to perform.
It should have been a comfort to the shareholders, employees and customers to know that a strong defence in the form of robust and vigilant risk management and ALCO committees were ever present in the banks. While markets around the world became more and more complex with the introduction of sophisticated products such as derivatives, credit default swaps, collateralized debt obligations and structured investment vehicles, these instruments had little direct effect on the performance of the Irish banks and on their balance sheets.
In the early part of the twenty-first century, one bank in the marketplace had developed a very simple process for evaluating risk. Business plans and individual projects could be evaluated and credit approvals granted in the shortest turnaround time for an approval in the marketplace – twenty-four hours. This organisation was Anglo Irish Bank.
It was not lost on Anglo Irish Bank that the speed of a bank’s decision making often influenced the borrower’s choice of bank. The principle behind Anglo’s method was that the lender knew their customers, the customers were trustworthy and they understood their business better than the bank (while the bank presumably understood banking better than its customers). Each individual project was considered on a stand-alone basis. A new project in Dublin 4 was not deemed to have any relevance to a project that the same borrower might have started some twelve months earlier in Galway or Cork. If the borrower provided a personal guarantee then there would be no need for cross guarantees from other companies within the borrower’s portfolio. The concept of the customer knowing his business better than the lender has been quickly dispelled by recent experiences. In many ways this was equivalent to self-certification.
This process of credit analysis was not adopted by the two big banks in the late 1990s and early 2000s. Based on the assumption that all banks carried out the same analysis on any given property loan, debates raged within credit committees as to how Anglo could turn around a decision within twenty-four hours while the two big banks with all guns firing were taking anything from ten days to a month. In around 2004, the big banks changed their attitude and moved towards a more lax analysis and decision-making culture. The pressure to close the gap between the EPS (earnings per share) annual growth rate of the two big banks and that of Anglo Irish Bank was a major influencing factor in the growth of the commercial and developmental loan portfolios. In Figure 1 (see Appendix) one can see the accelerated growth from 2004 to 2009 of lending to the private sector by the Irish banks as a percentage of GNP. The growth in this period was over 100 per cent.
The first ever US billion dollar loan in the euromarkets was syndicated in February 1982 for the Kingdom of Denmark. I was fortunate to have won the mandate for Citigroup in London as vice-president responsible for arranging the transaction. I can recall clearly how many of my international colleagues hailed this transaction as a milestone in the European markets. This debt raising concluded in New York with 113 participants in a syndicate where contributions ranged from US$5 million to US
$50 million each. The deal was an unqualified success but it had its challenges. Mr Erling Christensen, permanent secretary for the Danish Ministry of Finance, joined me on an investor tour of the US to present the economic background and outlook for Denmark. Many small banks in the US had never before considered lending money to European sovereigns. Caution prevailed in all the banks, as evidenced by the number of participants; seventy to eighty of the banks lent only $5 to $10 million each. Groups of interested banks attended presentations in New York, Chicago, San Francisco, Atlanta and Charlotte, North Carolina. What we managed to do for the Kingdom of Denmark was to open up a totally new market of investors for sovereign debt.
What was deemed to be a milestone in borrowing for a major European state, some twenty-five years later became normal practice in Ireland for property developers. In most other countries commercial property loans would not be made without full disclosure of the borrower’s financial position, including contingent liabilities. It should be made clear that in the 1980s, whether a sovereign or corporate borrower went to the markets to raise debt, full disclosure of their total borrowings, methods of repayment and the purpose of the borrowings were spelt out. Nothing was done until the documentation was in place. The size of the loans grew with the volume of liquidity in the marketplace around the world during the 1980s and 1990s, but not as freely or as loosely as it would do in Ireland in the noughties. It would appear that our level of sophisticated lending in Ireland during the heady days of the Celtic Tiger was relegated to a handshake, a promise of repayment and what now appears to have been very weak documentation.
Over the past two years I have been approached by several developers who contributed enormously to GDP growth in Ireland over the past twenty or so years. They had been caught by the leverage trap and the liquidity crisis of the banks. No two were in exactly the same predicament but they all appeared to have what I can describe today as phantom equity – equity that was deemed to be real during the halcyon days of the property market and had now disappeared through deleveraging.
Leverage was at the heart of the problem in the Irish banking system. Leverage is best described as the amount of times you can borrow a multiple of your capital, allowing you to complete bigger and bigger transactions and pay even larger prices for property. Capital has always been a prerequisite to a loan transaction to ensure that there is sufficient support to absorb all the losses in the event of a failure to repay. Leverage has the inbuilt capacity to reduce the level of capital available to cover potential losses on any given transaction. Of course, if you live in a world where there are no losses anticipated then you need less capital to protect the lenders against losses. This applies equally to banks as well as any corporate borrowers.
Too much money was being borrowed by the banks’ customers who in turn had little real capital to support their activities. In turn, the banks’ own balance sheets were being swollen with increasing dependency on international wholesale borrowings from the international marketplace and not with retail deposits. There have always been safeguards in place in the running of banks’ balance sheets, but one of the key ratios that was eventually overlooked, and should not have been, was the loan-to-deposit ratio. In effect, this ratio should never exceed 130:100. In other words, you can lend €130 worth of loans for every €100 deposit you have as the €30 difference can be borrowed in the professional international wholesale market. The rationale for this is that depositors’ money is sticky and, in times of market instability, the wholesale funds may depart more quickly but the core deposits will stay with the bank. In the event of a run in the markets there should be standby facilities to protect the bank’s balance sheets, like an overdraft, in order to replace the fleeing wholesale funds and ensure that the bank does not become illiquid. Confidence is essential in the financial markets, and loss of this creates panic.
The market in Ireland has four principal segments in property lending: developers, construction companies, residential mortgages and investment properties. There are subsets to each of these but for the purpose of this observation it is best to leave it at these four. Leverage was not the preserve of the major developers, construction companies, private investors or hedge funds. It indeed proved to be the killer disease that attacked new residential homeowners. Anyone who has been faced with a demand from a bank for a loan that has fallen into arrears for an amount of less than €1 million will know to what lengths the bank will go to get repaid. Add another three zeros to this amount and imagine the respect the borrower receives when he owes the bank €1 billion or more. This borrower has the ability to hurt the bank if they are unable or unwilling to repay. As the saying goes, if you owe the bank €1 million it is your problem; if you owe them €1 billion it is their problem.
Thanks to competition and the professed need by all quarters for it, new products were being created every week, and variations on interest rates, fixed, floating or even deferred, together with mortgages that ranged from 90 per cent to 100 per cent, spurred things on. The 100 per cent mortgage was not a homespun invention, but was a concept imported into the heated residential market in 2004 by First Active, a subsidiary of Ulster Bank. We were not slow to follow and most banks allocated a percentage of their mortgage lending to this product area. It is easy after the fact to rebuke those institutions that participated in 100 per cent mortgages as there is no surer way of creating a negative equity trap for home buyers in the event of an economic downturn. Where was the Regulator at this time? Why was no action taken to curb this trend?
If a deal sounds too good to be true, it usually is. No young person or couple deserves to be trapped for an indefinite period with the fear of being unable to repay their mortgage. We now must find a way out of this dilemma, not only for those who may be trapped now but for the next generation. Homeownership is high on the Irish social agenda and, with the pains of negative equity evident in our society, the pros and cons of renting versus homeownership will have to be played out again. Finding a way out of negative equity for those who are trapped will likely benefit the whole residential market as it will remove the fear of a massive overhang in the market for first-time buyers.
Could the lenders have avoided the situation and protected the borrowers? The old adage ‘know your customer’ was never more applicable. The judgment of the banks was thrown out the window and unfortunately everyone – families, bankers and shareholders – have paid the price. Leverage in property must be controlled in a way that both borrowers and lenders understand the consequences of a downturn and the financial responsibility of each party in this event. Banks should be forced to recalculate what a borrower owes after a downturn. In other words, no bank should lend more than 85 per cent of the value of a property; if it does, it should be held responsible for everything in excess of the 85 per cent should the borrower be unable to repay. This would automatically transfer the burden to the banks and, in turn, would protect the customer. Banks should have strict ratios to guide them on individual mortgages and if they exceed these limits then they should absorb any future losses that might occur due to the excess provided. This would put the responsibility back on to the shoulders of the lenders and within a framework that would facilitate homeownership but would not encourage multiple unit ownership.
The effects of reckless lending on the individual might be best illustrated by the case of Caroline McCann. Mother-of-two Caroline McCann, a resident of Mullaghmatt, Co. Monaghan with its 300 mainly social housing units and a self-confessed alcoholic, failed to repay €18,063.09 to Monaghan Credit Union. Over ten years had elapsed from the time of the first credit advance by the credit union to June 2009 when Judge Laffoy made her landmark ruling. The money was long gone and McCann’s memory was void of any benefit received. The fear that this mother would be separated from her children was all that remained. How any person in McCann’s position could have ever raised such a large sum from a credit union begs the questions: How much was the principal? How much interest accrued? And what
penalty charges were involved?
While the sanction of prison was aimed at debtors who would not pay, it also struck at those who could not. The judge found it inexplicable how the state could countenance the continuance of such a defective scheme of debt enforcement. In response, the Government moved quickly to produce a new Enforcement of Court Order, a bill which contained most of what was judged to be lacking in the previous regime.
Major borrowers now incapable of repaying their debts in full, debts which collectively run into tens of billions, are likely to be discussing their unfortunate circumstances (loss of fortune, loss of security, loss of helicopters, loss of mansions in the South of France, and so on). However, we have to thank the judiciary for their astute analysis, comprehension and swift decision making to change the system to protect the more vulnerable.
CHAPTER 3
The Culture of Silent Dissent
One of the main causes, or at least incubators, of the banking crisis was, I believe, the culture of silent dissent in our corporations and Government. Most people who have served on a board in any corporation or organisation in Ireland will be familiar with this disease. Perhaps it is also this culture that will prove to be a barrier to Ireland’s financial recovery.
In the world of banking the shareholders’ principal representatives are the non-executive directors on the boards of the main banks. The boards, whose principal responsibility is that of governance of the institution, are particularly charged with agreeing the strategy of the entity and ensuring that the executive management does not stray off the agreed path. Regular board meetings facilitate the reporting of performance from the executive directors together with confirmation of the entity’s direction. In addition to the board meetings, there are a series of subcommittees that deal with risk, audit and compensation, and meet several times a quarter.
