The Looting of the Irish reaches new heights

As predicted on this blog, the Irish government is maximizing the taxpayer losses by not disclosing the current asset and liability-level data for its banking system.

Without this disclosure, the markets cannot value the assets in the banking system and the individual banks.  Without this independent valuation, no one, including the Irish government, knows that it received remotely close to market value for the assets or the equity in the banks that it has sold.

For investment bankers, opacity is their friend as it prevents an independent assessment of value.

This blog described in detail how investment bankers would use opacity to screw the Irish taxpayers.  Incredibly, it has come to pass almost exactly as predicted.

The mechanism your humble blogger described Wall Street as using was an auction.  Information on the bank's assets and liabilities would be shared with a small group of investors.  These investors, all of whom have approximately the same rate of return hurdle, would then "bid" against each other.  Note that this auction guarantees no independent valuation by the market.  It also guarantees a hefty discount on the assets and equity.

What is critically important is that information that was not available to all market participants was shared.

Fast forward to last week.  The Irish government announced the investment by a group of these investors in one of the two banks the Irish government has publicly announced it would keep open.  This came after the government discovered that it was difficult to sell shares in a public offering for these banks where there was no transparency into their current asset level data.

Naturally, the investors, who had the extra information from their prior involvement, were in a position where they could assess an investment.  After that, it was just a question of the degree of looting.

As described in an Irish Times column,

THE LOGIC of the Government’s decision to let private equity into the Bank of Ireland party at this late stage in the game is not entirely obvious. 

Depending on how you calculate these things the taxpayer has put between €2.2 billion and €3.5 billion into Bank of Ireland, most of it when nobody else would have contemplated investing in the bank. 

The State’s investment came after it had taken the bank – along with its four peers – under the protective wing of the the exchequer and bankrupted the Republic in the process. 

Bank of Ireland to this day still continues to rely on State support for its survival. Any emergency borrowing it may have from the Irish Central Bank in order to meet liquidity demands are explicitly guaranteed by the Irish exchequer. Its vital borrowings from the European Central Bank are on the back of the Government guarantee bonds issued to it by the National Asset Management Agency in exchange for its toxic property and development loans. Nama has yet to turn a profit. 

The notion that the Bank of Ireland is not an ongoing burden on taxpayers is thus misleading. Until the bank can stand on its own two feet and attract sufficient deposits in its own right to repay its borrowings from the Central Bank and the ECB, the taxpayer remains firmly on the hook. 

For this reason alone the decision to sell 34.9 per cent of it to a group of private equity investors is questionable. 

The decision to sell it to them for €1.1 billion with no strings attached seems to verge on the foolish. 

The Government is keen to point out that the new investors are long-term value holders. That may well be the case, but what they are not is banks and arguably what Bank of Ireland needs right now is another bank.  

The best and simplest route back to viability for Bank of Ireland is to merge its badly damaged balance sheet with the balance sheet of a stronger bank. This has the potential to solve the liquidity problem overnight. 

Fairfax and its fellow north American investors do not have the facility or the inclination to lend balance sheet support to the bank. 

The best that Bank of Ireland can hope for in this regard is that the vote of confidence implied in the private equity investment will help it attract deposits. 

However, it is still likely that the bank will have to be sold to a larger one sooner rather than later and the big winners will be Fairfax and its co-investors. 

So, if the decision to sell down its stake in Bank of Ireland does not solve the underlying problem and represents bad value for the taxpayer, why did the Government do it? 

Could the advice from investment bankers who stood to make a substantial fee have played any role in the decision?

Well, it saves the Government €1.1 billion. Or to be precise, the Government will have to borrow €1.1 billion less this year. It’s a significant sum but will not in itself turn around the national finances. 

The Bank of Ireland deal is best understood in the context of a wider strategy for the sector. 

This in turn stands or falls on international acceptance that following the stress tests carried out earlier this year Irish banks are adequately capitalised. 

The Government believes a significant investment by an overseas institution in Bank of Ireland is the strongest possible endorsement of those stress tests. 

This blog has already documented how and why the stress test and subsequent banking industry reorganization carried out by the Irish government did not restore investor confidence.

Selling equity to distressed investors does not restore investor confidence.  Distressed investors are masters at maximizing their upside while minimizing their downside.  For example, it turns out that the distressed investors are getting approximately a 4% discount on their stock purchase.  This was not announced at the time the deal with the government was announced.

Who knows what else these investors have negotiated or what other investment positions they have that minimize their risk.

It has put particular emphasis on the fact that there is no risk sharing element to the deal and it was reported over the weekend that the Government rejected an approach from Texas Pacific to buy 15 per cent of Bank of Ireland because they wanted the Government to share any future losses at the bank.

The Irish government is going to absorb any future losses above the Bank of Ireland's capitalization.  The investors are not required to put in money to cover additional losses.

The only question is if there are future losses in excess of the Bank of Ireland's capitalization, will the investors' investment be wiped out first or will the investors be bailed out.

The price of the non-risk sharing approach appears to have been the attractive terms given to Fairfax and its partners who have ended up with 35 per cent. 

Would the Irish taxpayer have been better off with risk sharing had the same investment dollars been used to cover the next losses realized by Bank of Ireland and retaining 20 percent of the equity?

Hard to imagine that the Irish taxpayer would not have been better off as they essentially accepted the same deal only without retaining 20 percent of the equity.

You can argue of course that from this point of view the generous terms of the Fairfax deal are as damaging for the credibility of the stress tests as risk sharing. 

But the Government believes it’s a price worth paying because it eases the task of sorting out AIB and Irish Life Permanent in several ways. 

If Bank of Ireland needs to be taken over, the other two really need to be taken over. In theory the way is now cleared to find trade buyers for those two institutions and, realistically, there is only a limited number of them interested in Ireland. Although this assumes that any international bank looking at Ireland will no longer have a preference for Bank of Ireland, which seems naive. 

There are other “wins” from the State’s perspective in deciding to bring in private equity on generous terms at this stage. Not least that it could be 12 months, or never, before a trade buyer could be found for Bank of Ireland and one thing the Republic does not have is time when it comes to sorting out the banking system. 

Actually, the irish government had and still has plenty of time to provide current asset level disclosure.  Had it done so, it would have been easier and much less costly to the Irish taxpayer to sort out the banking system.

Moreover, there is also the argument that when you are selling your entire banking system, it makes sense to try and have a least one of the pillar institutions in diversified ownership. 

The arguments are quite finely balanced. But the good news is that while the State may once again have made a mistake – and will really only know if it has in a few years – it does appear to have its eyes open this time.