by Mike Soden
We struggle between restitution and retribution. It is natural to feel that we have all been let down by regulators, auditors, bankers, developers, Government, brokers, and so the list goes on. However, leaving the construction industry underfunded must be the equivalent of shooting ourselves in the foot. This sector needs to be managed from a funding and investment perspective in a disciplined manner. By ring fencing those potentially good assets and providing the owners with an opportunity to complete or begin and finish project partnerships with NAMA and the banks, we have a chance of rekindling the property market and the economy. If the major developers walk away and leave a mass of unfinished projects, the consequences for the country are unimaginable.
We are now at a point in time when the only innocent participants in the crisis appear to be the board and executive of NAMA, in whose hands the recovery of the country has been fundamentally laid. We have many more moving parts in the recovery equation but none of these will have the influence and capacity to aid a speedy recovery in a sectoral context as easily as the construction sector. The relationship between this sector and NAMA or the banks might be viewed as very similar to the medieval arrangement between landlord and serf: unlikely to foster a strong working relationship between the parties to achieve the end goal of recovery. The pressure on NAMA to ensure that no favours are done or appear to be done for the developers will unfortunately widen the rift that already exists between the three parties. The Government’s ambition of infusing liquidity into the banking system, which will lead to recovery in the economy, will not occur unless civil discussions are held between NAMA, the banks and the developers with the aim of getting the construction industry off its knees. Has NAMA, in its wisdom, considered the consequences should the top ten or twenty developers emigrate? Will the Government be calling them back as it did beef baron Larry Goodman in the 1980s to save the Irish meat industry? Cool heads need to be at work in order to get the best result for the country.
Let us remember that there is an outcry by various quarters in Ireland to have the Government default on the subordinated bonds that were raised by the banks. These bonds could be bought back at substantial discounts in the marketplace today by the Government. So what is good for the goose might well be good for the developers if attractive deals can be negotiated between them and NAMA. It is naïve to believe that the major developers and construction companies will not play a principal role in the revival of the property market. The sooner the contingent risks associated with the Government’s funding of banks’ balance sheets can be reduced or erased, the sooner our sovereign credit rating will improve.
Are the developers’ coffers empty or is there hidden treasure somewhere? Aside from excessive prices paid for some wasteland in parts of Dublin, are there not substantial assets that would benefit enormously from a recovery in the economy? To re-establish confidence and trust in the asset of property must be one of the primary objectives of NAMA. Doing this without creating another bubble is essential to the stabilisation of the finances of the country. Remembering the lesson of the Parable of the Talents, we need to invest wisely and not sit on our capital.
A veritable ‘piggy in the middle’, NAMA sits between the developers and the bankers. It would be folly for NAMA to make a real pig of itself by pricing the loans at a very low rate and gobbling them up. A lesson from the Swedish experience should be taken here (see Chapter 7). Being able to price the assets being taken over from the banks gives NAMA a preferential starting place. It must determine a realistic value for the loans to be acquired. The systematic creation of a portfolio of inexpensively priced assets to exaggerate the performance of NAMA will put the property industry at risk by destroying an active marketplace. Perhaps if a small selection of loans were auctioned to the public, this would in turn establish a market price. If NAMA fails to create an active market it will do a major disservice to the country.
CHAPTER 7
Looking Abroad
Within the Irish market it is important that we consider the alternatives to ‘too big to fail’ and ‘too small to save’. The actions being taken by our Government in ensuring we have a strongly capitalised banking system are not going to be much good without a clear vision of what success looks like from the perspective of all the constituents being served. Weaker institutions in any field will become the targets of acquisition by foreign entities in the future. This may not be the preferred outcome for institutions that have histories that extend over hundreds of years. Yet, it may be the price the country, the shareholders and the community will have to eventually pay to get us out from under the horrendous financial burden that we are now carrying. In terms of our approach to tackling the crisis, it is worth looking at similar situations in other countries – namely, Iceland, New Zealand and Sweden – and how these were dealt with.
THE ALL-IMPORTANT ENQUIRY – ICELAND
A more recent example of a financial bubble and one located close to our own shores was that of Iceland. The old adage ‘misery loves company’ might well be used in this case. The joke that did the rounds when comparing Iceland to Ireland in terms of the financial crisis was that there was only one letter and six months difference between them. Humorous as this may have sounded, it is clear after examination that the magnitude of the crisis in Iceland is in fact far greater than that in Ireland. The Special Investigation Commission (SIC) was charged with the responsibility of determining why Iceland’s banking system collapsed. The SIC’s review32 covered many key reasons, which included but was not limited to the following: the growth of the banks, the weakness of the regulatory system, easy access to credit in the banks by its own shareholders, weak equity and poor liability management.
From the review undertaken in Iceland there are some interesting discoveries that those examining the Irish crisis might do well to consider. The main cause of financial failure in Iceland is attributed to the rapid growth of the banks and their size at the time of collapse. The banks’ balance sheets more than quadrupled over the four years before the bubble burst. This growth was associated with both extremely poor credit management and poor credit record keeping. The policies and procedures in key administrative areas were left behind in the response to the rapid growth targets. In addition to poor credit management, the management of the balance sheets of the major banks was in a shambles. Once the liquidity crisis started in 2007, foreign deposits and short-term securitised deposits became the main sources of funding. This short-term funding was sensitive to market conditions in both availability and pricing terms. At the time of the collapse the repayment schedules for the bonds and collateralized loans were contracting to very short time frames.
The SIC concluded that the major shareholders in the largest banks had abnormally easy access to loans in these banks, apparently in their capacity as owners. On reflection, this raised the questions of whether the loans were done on an arm’s length basis and whether the banks were being run in the interests of a handful of elite customers at the expense of all the shareholders and depositors. This has a great similarity with the problems behind the downfall of Anglo Irish Bank.
With regard to the capital of the banks in Iceland, the investigating commission determined that the banks’ risk exposures due to funding of all shares were excessive. There were two principal culprits in the weakness of the equity: direct loans to shareholders with collateral given in the banks’ own shares and forward contracts in the banks’ own shares. The banks’ capital ratios did not therefore reflect the real ability of the banks or of the financial system as a whole to withstand losses. Again, note the similarity with Anglo Irish Bank’s activities. The SIC concluded that loans exclusively secured with collateral in an institution’s own shares should be subtracted from the equity of the institution.
Finally, the Icelandic review outlined the write-downs of the loans of the banks (the haircuts). The collective value of the assets in the three big banks was reduced on average by 62 per cent. Investigations have revealed that t
he quality of the loan portfolios had started to erode some twelve months before the collapse of the banks and continued to erode until the collapse, even though this was not reported in the banks’ financial statements. The value of the assets was adjusted downwards in November 2008 while the balance sheets of the banks at year-end 2007 and half-year 2008 reflected highly overvalued and exaggerated values. It appears that a culture of denial in the face of large losses was universal.
Putting this haircut on the value of the assets into a national context, the GDP of Iceland in 2008 was approximately IKR1,476 billion, meaning that the write-down of the assets of the financial institutions corresponded to five years’ GDP. The write-down of Ireland’s assets equates to about a quarter-year’s GDP so I suppose we might take comfort that at least things are not as bad here as in Iceland.
In Ireland, the suggestion by the Governor of the Central Bank to have a public enquiry into the Irish financial crisis was greeted initially with partial alarm by Government. However, since then, the Government has established an enquiry. The first stage of the enquiry is the production of two reports: the first to be produced by the Governor of the Central Bank on the performance of the bank and the Financial Regulator in the context of the crisis, and the second report to be produced by Messrs Regling and Watson, economists and independent advisors. The latter have conducted a preliminary investigation into the recent crisis in our banking system and have made recommendations as to the future management and regulation of the sector. The second stage of the enquiry is the establishment of a Statutory Commission of Investigation. Peter Nyberg, a former Finnish civil servant with an excellent pedigree in management of financial crises, has been appointed as chairman of the Commission by Minister for Finance Brian Lenihan. Nyberg’s role in managing Finland’s banking crisis of the early 1990s was among the reasons why he was chosen. The Minister for Finance has said that the terms of reference for the Commission will be directed by the conclusions of the two preliminary reports.
The Commission is to examine and report on systemic failures in relation to corporate strategy, governance and risk management in the Irish banking sector. There will be many broad themes examined, including the performance of individual banks and bank directors whose wrongdoings and lax practices contributed to the crisis. The performance and structure of the banking system, together with the regulatory and Central Bank systems, will be examined in detail. This will be undertaken together with an examination of the response of the relevant government departments and agencies, including the linkage between the banking crisis and overall economic management. The report from the Commission should be available by the end of 2010.
In anticipation of the outcome of the enquiry, we should look forward to revelations about our banking system covering the following and a lot more:
• The culture of compensation for executives and the consistency of this with the long-term aspirations of the institutions must be examined. The policy framework that financial institutions operate under, which includes credit management, liquidity management, capital management, and audit and compensation committees, is well documented. The question that must be answered is how well the executive management and staff observed the policy framework. The investor relations website of each of the major banks has extremely wellarticulated policies and procedures that provide enormous comfort to all existing and potential shareholders. Were executives suppressed by a culture of silent dissent when it came to the difficult questions and answers on audit committees?
• The depth of market awareness within the senior ranks of the organisations dealing with debt and equity products must be revealed. What has to be tested is the experience and knowledge of the regulators in these same areas. There has been a serious void in market knowledge among the executive management of institutions and the investigating regulators.
• We should learn about the optimal structure of banks’ balance sheets and how they relate to global best practice. Are all commonly used ratios adhered to? Do regulators observe anomalies in balance sheets from one year to the next?
• The nature of authority and leadership in the banks and among regulators is another key issue. Do the penalties match the crime if specific rules are not observed in practice and do the associated penalties exceed the gains in cash terms made through the breach? Do the banks’ boards listen to the guidance of the Central Bank and the Regulator?
• Is stress testing undertaken and evaluated in all portfolios of assets, whether by sector, region or borrower?
• In the strategy reviews, are the fundamental business models examined closely by the boards to ensure the executives adhere to them in practice, and do the regulators comment if the banks have strayed from their declared strategies?
• Within each of the operational divisions of the banks were there clearly delegated authorities so that executives would act either independently or with referral to one or more senior people? Were these authorities monitored and were they reviewed periodically in the context of how and when they were used?
• Is there a strong ethos of governance in the banks in practice and not just in word?
• Is risk management – which covers credit, market and operational risks – well structured, with regular reports going to the CEO and the board in a bank with regard to all irregularities?
• Are the boards manned with the levels of skills and experience in the respective areas of banking and insurance that will enable them to understand if there is something amiss?
• Who is equipped to judge the competencies and performance of the regulators?
People with authority must be assessed on their ability to exercise judgment in the context of their positions. This assessment is best made initially by people close to the scene, be they internal auditors or senior executives but, in the end, regulators must be equipped to make a judgment on the competency of any individual performing under delegated authorities.
If we look at the list of constituents who were a party, directly or indirectly, to the crisis, one can only assume that the men in grey behind the above reports will be stressed beyond the norm to meet the tight schedule. The Government, ministers, regulators, civil servants, bankers, brokers, solicitors, the Law Society, investment managers, developers, borrowers, the CIF, shareholders, employees and many, many more need to be interviewed and crossexamined. The response is likely to be mixed in the context of the availability of key people to attend meetings. Getting full comprehensive feedback from the list of constituents, especially in a culture of silent dissent, will be a massive exercise in itself.
Is the real purpose of the Commission to discover the weaknesses in the system and take measures to ensure there is never a recurrence of a crisis like this one? While many have sought a full public enquiry, the Government insists that this process will be much shorter and less costly than a tribunal. Provided the truth is forthcoming and transparency on all aspects of the enquiry is of the highest standard, we should be satisfied. That said, we will be fortunate if we enter 2011 with a satisfactory understanding of what was at the heart of the crisis, the steps we must take to avoid a recurrence and the guilty parties named.
IN FOREIGN HANDS – NEW ZEALAND
A country that has similar demographics to Ireland and, some might say, similar harebrained ambitions, New Zealand should be examined for the similarities between the national crisis in that country in the 1980s and our own current predicament. The crisis that affected the financial markets and the banking system in New Zealand began in 1988 as a result of reckless lending in the commercial property sector through a handful of investment holding companies. The majority of the loans were highly leveraged and many of the eight major borrowers simply had cross shareholdings in a variety of companies that had little substance and possibly even smaller cash flows. The cross ownership through subsidiary investment vehicles reflected the real economic value of these companies. Initially, through active trading in the shares, the market capita
lisation of the traded companies grew quickly and the perception was that real value had been created. On the contrary, there was no real value created and the consequences of this reckless lending and trading led to the collapse of the New Zealand banking system. There were other peripheral activities attached, most of which had a trading element, that simply compounded the financial crisis.
The following commercial property transaction highlights the similarities between New Zealand’s crisis and Ireland’s. At the peak of the market a bank syndicate put a loan together for the acquisition of a premier property in the heart of Wellington for NZ$100 million. With the collapse in the market, this property was foreclosed and taken over by the syndicate. The market for commercial property had collapsed, there was no liquidity and there were very few, if any, potential acquirers with cash in existence. The property subsequently sold for NZ$29 million. That property, some twenty years later, is purported to have a value of NZ$250 million.33
Former Chief Executive of Bank of New Zealand Peter Thodey explained that it was important for the recovery in New Zealand for the banks to have taken a 71 per cent haircut in the property sector in order to re-establish a realistic pricing structure in the marketplace – a salutary lesson for all of us. This laid the foundations for confidence slowly but surely being brought back into the market.
It is worth noting that the New Zealand experience was a consequence of irrational lending and equity trading activities, which contributed to the demise of the domestic banking system. During the crisis, the Government was forced to hand over control of the four major New Zealand banks to Lloyds Bank (UK), National Australia Bank, ANZ Bank (Australia and New Zealand) and Westpac Bank (Australia). The losses associated with property lending and trading destabilised not just the banking industry but also the country. The price of survival was the loss of financial independence and the creation of a foreign bank infrastructure that replaced the domestic shareholders overnight.
