Sunday, April 3, 2011

Disclose or Not to Disclose, That is the Question

The Irish Independent ran an article on BlackRock and the role it played in the Irish bank loan portfolio review and related stress tests.
All eyes this week were on the results of the stress tests on the Irish banks' loan books.
Unless the EU/IMF had control over the results of the loan review and stress test, the Irish government and its regulators faced a choice heading into these stress tests and the fifth bailout of its banking system:
  • It could repeat the strategy of "reviewing" the loan portfolios of the banks and announcing how much capital was necessary; or 
  • It could also disclose current loan-level data to the market and let the market determine how much capital was necessary.  The reason disclosing the data under the FDR Framework is important is because without this data, investors have nothing to independently analyze and as a result there is no logical stopping point in the devaluation of the troubled loans other than zero.  
The Irish government and its regulators were aware of this choice.  Prior to the announcement of the stress tests in November 2010, Irish Central Bank Governor Patrick Honohan, as reported by GFSNews,
[L]aunched an incendiary attack today on credit analysts who he said 'assume the worst' about the country's banking sector.
Governor Patrick Honohan, in an address to a conference of chartered accountants in Dublin, argued that credit analysts do not have enough information about the health of the Irish banking sector and should undergo 'euthanasia'.
Honohan said: 'If there is no information, the credit analyst tends to assume the worst. They think, 'if the actual situation were good, would the bank not have been at pains to disclose it. Since it is not disclosed, it must be bad'.
....  He said that banks should try to boost confidence by disclosing more information to the market, such as on the ageing and migration of loans and status of residential mortgage books....
'Communicating more information to the market would not only enlist the expertise of market credit analysts in a way helpful to all, but could lower the cost of term borrowing as investors regain confidence.
According to the Irish Independent, Mr. Honohan observed
[T]he banks might do well to call in the leading credit analysts and find out what information would be of greatest use to them in identifying tail risks. And then provide it.
The Irish government and its regulators were fully aware of the need to disclose information to the credit market analysts and that they should ask the credit analysts what information would be of greatest use to them.

Still, the choice was made to try to find a half-way house between disclosing all the useful, relevant information in an appropriate, timely manner and the government maintaining its information monopoly on the current asset and liability-level data of its banking system.

According to the Irish Independent article on BlackRock,
The strategy used by the Irish government to review the loan portfolios was to hire a number of high priced consultants, headed up by BlackRock. tests were carried out on behalf of the Central Bank by US investment and consulting firm BlackRock
As an investment and consulting firm, BlackRock of course has many built in conflicts of interest.  Since the market operates under the principle of buyer beware, investors a) recognize that BlackRock has these conflicts of interest, b) understand that there is no way to tell how these conflicts of interest will influence the results of BlackRock's analysis and c) do not rely on BlackRock's findings.
Unlike last July's stress tests, which were carried out by European Committee of Bank Supervisors and gave both AIB and Bank of Ireland a clean bill of health, BlackRock didn't pull its punches.
Given its conflicts of interest that at a minimum include the fact that it would like to be hired by other governments as a consultant, how does the Irish Independent know that BlackRock didn't pull its punches?

The Irish government would like to have market participants believe this is true, but where is the data market participants can use to independently verify the accuracy of this statement?
It carried out a root-and-branch review of the Irish banks' loan books, which included processing the details of millions of individual loans through its powerful computer systems. 
This type of review is exactly what many market participants would do if they had access to the loan-level data.  The type of market participants who would do this type of review include competitors of BlackRock like Pimco and Federated, both American and European banking competitors of the Irish Banks like JP Morgan and Deutsche, rating services like Moody's and S&P, private equity investors like JC Flowers and WL Ross, and loan valuation services to name just a few.

Had the Irish government disclosed this loan-level data to the market, rather than have an opinion on the value of the loans tainted by a conflict of interest, it would have the market's consensus opinion on the value of the loans.

Instead, borrowing from Professor Honohan's observation above, the credit analysts, under the principle of trust, but verify, have to wonder why was the loan-level data not disclosed.
  • If the loan-level data would confirm BlackRock's analysis, then releasing it would help to restore confidence in the banking system.  
  • By not releasing it, should the credit analysts assume that the loan-level data would indicate that BlackRock's analysis presents a rosy picture?
The Irish Independent article continues,
BlackRock's findings don't make for pleasant reading. It calculates that the Irish banks are looking at total losses of up to €40bn on their current loan books. Throw in the near-€60bn which the Irish banks, including Anglo and the Irish Nationwide, have already written off on bad loans and that brings the total to at least €100bn, almost a quarter of their peak end-2007 loan book of just over €400bn.  
Just how unpalatable BlackRock's loan-loss projections, which cover the entire life of the loans, were was evidenced by the fact that the Central Bank also published its own, much lower, loan-loss projections for the period 2011 to 2013. 
While BlackRock expects the Irish banks' loan losses to range from €27.5bn under its base scenario to €40bn under its stress scenario, the Central Bank is pencilling loan losses ranging from €20bn under its base scenario to €27.7bn under its stress scenario for the period to the three years to the end of 2013. 
However, even after putting the best possible gloss on the numbers, the Central Bank has determined that the Irish banks will require an additional €24bn of fresh capital, with the original six banks shrinking to just two. 
This will bring the total cost to the taxpayer of bailing out the Irish banks to €70bn, making this country's banking collapse by far the most expensive in recorded financial history when measured as a proportion of our economic output. 
To put the findings of BlackRock and the Central Bank in perspective, Alan Dukes, who had access to loan-level data due to his position as chairman of Anglo Irish Bank, according to a February 2011 Irish Independent report placed the amount of capital needed to clean up the banks at a much higher level.
Ireland will have to go to the IMF/EU for another €15bn -- on top of the €35bn already earmarked -- to save the banking system, the government-appointed chairman of Anglo Irish Bank warned last night. 
In a bombshell revelation, Alan Dukes said we will need 40pc more, or €50bn, to properly clean up the banks. 
The former finance minister also sensationally suggested €75bn would be needed to fund the existing NAMA operation and a so-called 'NAMA 2' to take more bad loans from the banks. 
His claims sparked a furious rejection from the Department of Finance who said that Central Bank Governor Dr Patrick Honohan had pinpointed a much lower figure. 
Without releasing the loan-level data, market participants still have no way of knowing if Mr. Dukes or BlackRock and the Central Bank are right.

The Irish Independent article on BlackRock continues,
The bad news from BlackRock didn't come cheap. While Central Bank governor Patrick Honohan refused to say how much the firm had been paid for its trawl through the entrails of the Irish banks' loan books, he did concede that the bill came to "tens of millions" of euro. 
Had the Irish government chosen to disclose the loan-level data to the market, it could have had not only BlackRock analyzing the loans, but the many other market participants discussed above who are equally qualified analyzing the loans for free too.

The cost to the Irish taxpayer of providing loan-level disclosure to all market participants on a one-time basis would have been substantially less than hiring BlackRock et al as valuation experts.  As a practical matter, all the work needed to disclose loan-level data to the market had to be done in order for BlackRock to get the data so that it could analyze the loans itself.
While paying a fortune for bad news is never a pleasant experience, the truth is that we didn't have any choice. After last July's fiasco, when the rapidly worsening problems of the Irish banks forced the Government to seek an EU/IMF bailout just four months later, the market was in no mood for another whitewash. Coming clean, no matter how awful the facts, was the only option.
Actually, there was another choice.

Under the FDR Framework, the obvious choice would have been to disclose the loan-level data to the market.  It was also the least expensive choice and the only choice that involved coming clean, no matter how awful the facts!

When compared to what Alan Dukes thought was needed to clean up the bankings system, the choice made by the Irish government and its regulators in fact looks like another whitewash.  Without disclosing loan-level data, there is no way to know that it is not.
When it comes to analysing the loan books of distressed banks no one has more experience than BlackRock....
Actually, there are many market participants with as much if not more experience analyzing the loan books of distressed banks.  For example, every global commercial bank has more experience as they not only have information systems that are comparable to BlackRock's, but they have a far larger army of loan officers who understand how to interpret loan files.
...  By using BlackRock's services, the Irish Government has bought itself time to sort out the Irish banks. However, with the eurozone financial crisis showing no signs of easing, don't be surprised to see other single-currency countries employing BlackRock's expertise as they seek to reassure nervous investors.
As reported in a Bloomberg article discussing whether the stress tests would be successful in buying time,
Ireland is trying to convince investors at home and abroad that it’s finally plugged all the holes in the banking system... 
Our initial impression is that the question of whether this is enough will continue to linger,” said Marchel Alexandrovich, an economist at Jefferies International in London. “The figure is credible enough for now and buys time to see how economic growth unfolds over the next year.” 
... “People may stop worrying about banks and senior haircuts,” Ivan Zubo, a banking analyst at BNP Paribas in London, said in an interview. “But they may start worrying about the sustainability of the sovereign.”

So, what did the Irish taxpayer get for either the Irish or EU/IMF regulators' choice of not disclosing the loan-level information to the market and instead buying time to sort out the Irish banks and sovereign debt issues?
  • A very large bill, measured in the "tens of millions", to pay for all of the firms that the regulators engaged to help them with reviewing the loans.  This bill vastly exceeded what it would have taken to actually disclose all the loan-level data to the market.  Disclosure is low cost, hiring consultants like BlackRock, Boston Consulting and the accounting firms is high cost.
  • Ongoing financial instability as investors and other market participants are still unable to verify that the results of the stress tests are correct.  While investors and other market participants would like to trust that the results are correct, without the loan-level data they cannot verify this for themselves.  
Verification is extremely important.  Ireland has a history of regulators relying on high priced consultants and saying that the size of the hole in the banking system is X and several months later the hole turns out to be much bigger.
Market analysts will continue to ask the question of did 24 billion euros really draw a line under the capital needs of the banking system.   Any data that suggests that this is not enough will generate significant financial instability.
  • A long slog to restore credibility in the banking system.  
If the market could verify the results of the stress tests today, it would dramatically speed up the restoration of confidence in the Irish banking system.  
    With confidence restored, investors would be willing to deposit money in the surviving banks - the ECB could be repaid.  With confidence restored, banks would be more willing to make loans - hard to lend money when economy is contracting and collateral value is uncertain.
    Instead, as reported in a Reuter's article,
    "Ireland may have constructed a road to recovery for its banks, but the prospect of funding problems and massive loan sales in a weak economic environment mean there could still be potholes ahead. 
    ... But the prospect of investing in the banks still makes some investors wary and funding remains a big concern. 
    'There are still many points outstanding which make valuing the existing equity in the banks near impossible... (we) would advise investors to await the capital raise details before deciding on whether or not to get involved,' said Eamonn Hughes, analyst at Goodbody Stockbrokers." 
      • A chance at maximizing the cost of the banking crisis.  Since the loan-level data has not been shared with the market, it was not possible for the market to determine the fair value of the loans.  Without this fair valuation, how does anyone know that the opaque auction process required to shed some of the loans will yield fair value. 
      • The Irish regulators testing the idea that investors will buy equity in one of the two remaining banks without disclosing all the useful, relevant information in an appropriate, timely manner to them.  
      The experience of Spain shows that ultimately the investors are going to want to see the loan-level data before they are willing to invest.  As reported in a Bloomberg article on Spain's efforts to recapitalize its savings banks,
        "The unravelling of the merger of four Spanish savings banks may deter potential investors in similar tie-ups because of concern over hidden real-estate losses.... 
        'It shows there are still uncertainties around the issue of asset-quality risk and how big the losses are going to be,' said Daragh Quinn, an analyst at Nomura International in Madrid. 'It would confirm for some would-be investors that there will have to be absolute clarity on what they are buying.'"

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