Wednesday 22 November 2017

Stress tests must force banks to come clean

THE publication later this week of the latest stress-test results is likely to reveal that the Irish banks need even more capital than was previously predicted.

With their mortgage books in much worse condition than they have admitted up to now, the banks are likely to require a multiple of the €10bn of fresh capital for which the previous Government had provided.

Stress tests have had a bad name, and justifiably so, ever since the publication of the results of the last set of tests in July 2010. The last stress tests purported to examine the loan books of 91 major eurozone banks, including AIB and Bank of Ireland, to determine if they had sufficient capital to deal with further loan losses.

Amazingly, both of the Irish banks received a clean bill of health last July, with only seven of the banks being stress tested -- five small Spanish banks, German property bank Hypo and a Greek bank -- being told that they needed to raise fresh capital, a total of €3.5bn between them.

Within four months the rapidly worsening condition of the Irish banks, with nervous depositors withdrawing tens of billions of their cash, had forced the Government to seek an EU/ IMF bailout.

Given the speed which it was overtaken by events, it is difficult to resist at least the suspicion that the July 2010 stress-test results started with the desired result, that most of the eurozone's major banks were solvent, and worked backwards from there.

Why should it be any different this time? Having got it so spectacularly wrong last time, why should we attach the least bit of credibility to this week's stress-test results? Will economic and financial reality yield to political considerations once again?

Maybe, maybe not. However, mindful of last July's whitewash, the markets will be watching this week's results like hawks. If the results are seen to be excessively lenient, they will be immediately rubbished.

The latest stress tests are being conducted on behalf of the European Banking Authority, which came into existence only in January. An excessively "soft" set of results risks inflicting severe damage on the reputation of the fledgling regulator.

So what are the results of the latest stress tests likely to tell us about the true state of the Irish banks? All eyes will be on what the stress tests have to say about mortgages. Between them, the Irish-owned banks account for just under €100bn of the almost €135bn of residential mortgages outstanding to Irish residents.

Residential mortgages, once regarded as the safest form of bank lending, have been hit by a "perfect storm" over the past four years. House prices have fallen by at least 50 per cent since their early-2007 peak with the prospect of a further 50 per cent fall from current levels -- a total fall of 75 per cent. At least 40 per cent of the country's 790,000 mortgages are now in negative equity, and the proportion is continuing to rise. At the same time a tenth of all mortgages are either in arrears or have been restructured.

On their own, such clear signs of such acute financial stress would be bad enough. Unfortunately that is only part of the emerging mortgage horror story. While there are no precise numbers, an estimated 55 to 60 per cent of Irish residential mortgages are trackers, where the rate is capped at a fixed margin over official ECB rates.

Unfortunately for the Irish banks, as fears have mounted about their solvency, they have been forced to pay ever-higher rates to depositors and other banks in order to attract funds, sometimes as high as 7 per cent. By comparison they are typically receiving an interest rate of just 2 per cent from homeowners with tracker mortgages. This means that the banks, both Irish and foreign-owned, are losing a fortune even on tracker loans that are fully compliant.

Regardless of how much they will eventually have to write off on mortgages which have either defaulted or are in arrears, it is clear that the Irish banks will also have to take a major hit on their loss-making tracker mortgages. How much of a hit? An acquaintance of mine with a €450,000 tracker mortgage with one of the foreign-owned banks was recently offered €100,000 to switch to a standard variable-rate mortgage, the equivalent of a 22 per cent writedown.

On the basis that the Irish-owned banks have about €55bn of trackers on their books, that translates into losses of €12bn.

By the time that those mortgages that have gone bad are added to the total, it's difficult to see how the Irish-owned banks can escape without writing down their mortgage loans by at least 35 to 40 per cent, that is, €35bn to €40bn.

A €40bn writedown would equal the losses suffered by the Irish banks on the bad loans to builders and property developers that they have off-loaded on to Nama.

Appalling as these figures are, it is important to bear in mind that residential mortgages and lending to builders and property developers accounted for less than half of the Irish banks' combined peak loan book of over €400bn.

With the latest figures from the Irish Credit Bureau showing that a tenth of all Irish loans are now in arrears, it is clear that the banks will also have to take major writedowns on their other lending, overdrafts, personal loans, credit cards, business loans etc.

Even on a good day it's difficult to see how the Irish banks can hope to escape with total loan losses of less than €100bn. In practice, with the Irish economy continuing to shrink, the actual figure could be much higher. There is no way that the Irish taxpayer can shoulder losses of this magnitude alone.

Will the stress-test results reflect this grim reality or will we get another politically-convenient fudge? While continuing to sweep the full extent of the Irish banks' problems under the carpet might find favour in some quarters, it's not a solution.

Only by being completely up-front about the extent of the Irish banks' losses can we begin to emerge from the current crisis. If the stress tests force the Irish banks to come clean then they will have done their job. If they don't then they will have been an expensive waste of time.

Sunday Indo Business

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