Could one of the Irish banks meet the same inglorious fate as Bear Stearns? It’s unlikely, but not out of the question.

Am I the only person to have missed the left turn to Galway north on the M50? With typical disregard for locals, let alone foreigners, the NRA(or whoever is responsible for signage) puts a tiny sign signalling one of the country’s main transport arteries, not 100 metres, not 50 metres, not 10 metres but two metres from the turnoff.

The result is that in all the chaos, muck, trucks and traffic cones, many of us only register the turnoff when we are past it. When I furiously drove on to the toll bridge expecting now to have to pay two tolls in order to get back to theN4,the gentleman in the booth immediately gave me a receipt for the price of the toll, as if this happens all the time.

We must learn costly lessons of America’s sub-prime debacle
23 March 2008 By David McWilliams
Could one of the Irish banks meet the same inglorious fate as Bear Stearns? It’s unlikely, but not out of the question.

Am I the only person to have missed the left turn to Galway north on the M50? With typical disregard for locals, let alone foreigners, the NRA(or whoever is responsible for signage) puts a tiny sign signalling one of the country’s main transport arteries, not 100 metres, not 50 metres, not 10 metres but two metres from the turnoff.

The result is that in all the chaos, muck, trucks and traffic cones, many of us only register the turnoff when we are past it. When I furiously drove on to the toll bridge expecting now to have to pay two tolls in order to get back to theN4,the gentleman in the booth immediately gave me a receipt for the price of the toll, as if this happens all the time.

Why can we not appreciate in this country that the purpose of road signage is to forewarn motorists? Signs are to give us time to react, change lanes and without hassle, arrive at our destination. The better the signage, the easier the drive and every developed road network is furnished with a comprehensive system of such warnings.

However, if drivers chose to ignore these signs, even the best systems can’t help. Now try to think of the financial markets as a similarly sophisticated road network, with millions of people buzzing around, tailgating, swerving, taking shortcuts, but ultimately moving in similar directions with the aim of getting there in time without crashing.

The financial network is full of signs which aim to forewarn and alert investors. There’s a mountain of information, tons of research and limitless opinions. There are websites, newspapers and, of course, television shows which devour financial information and assess what it all means for the market and the investor.

Last week, I was in New York on a book tour, and appeared on a number of business programmes, from CNN to NBC to Bloomberg. The weirdest outing was on the Fox News channel. The vamp presenter – part Ashley Alexandra Dupre, part Abby Joseph Cohen – flirted outrageously with the camera as Bear Stearns went up in flames.

Fox News, being the right-winger’s favourite channel, took the line that the takeover of Bear Stearnsby JP Morgan was unpatriotic because taxpayers’ money had been used to guarantee some of the toxic sub-prime waste on Bear Stearns’ balance sheet. The move, described elsewhere as ‘‘socialism for rich people’’, was seen by Fox as the little people being forced to stump up for the wealthy.

Whether you agree with this assessment or not, the point of these programmes is to give investors other opinions, to analyse, editorialise and, most of all, interpret. These programmes are, yet again, part of the system of signposts which form the roadmap of the financial markets.

Given all these warning systems, no one in their right mind can say that they were taken by surprise by the trauma of the financial markets last week or, indeed, this year. The signs have been everywhere for ages.

In Ireland, we have seen rampant inflation, a current account deficit and a money supply growing at a rate that would make Eva Peron blush. Of course the Irish banks, like their British counterparts, were going to be hammered in such an environment.

Some British banks, which have been positively frugal when compared to their Irish counterparts, may have a right to feel aggrieved at their share price collapse. But our own banking system, which fuelled a credit bubble of monumental proportions, has had this coming for a long time.

We are in the midst of a credit crisis, based on over-lending in a boom that, in our case, was almost totally driven by property. Now that property prices are falling, the underlying banking model is being questioned. When the market re-adjusts, banks – the clear winners on the way up – will be the losers on the way down.

We heard last week that our regulator is investigating the source of rumours which the regulator believes drove down the share price of Irish banks. Well, rumours drive markets. Ever heard the market expression ‘‘buy the rumour, sell the fact’’?

Probably not! Of course there are going to be rumours, particularly when some foreign banks have been so economical with the truth. Just last week, the boss of Bear Stearns was denying that there was any problem when the investment bank was technically bankrupt and couldn’t meet its obligations.

Could one of the Irish banks go the way of Bear Stearns? It looks unlikely, but it is not inconceivable to imagine a scenario where this could be possible. If, for example, the assets on a balance sheet are not liquid and the market is worried about a bank’s deposit base, banks can experience a crisis of confidence. If a bank has not invested in extending its deposit base at the same rate as it has expanded its lending, it will have to plug that gap between deposits and loans by borrowing. As its share price falls, the collateral that it can give for this borrowing falls in value too, making borrowing more expensive.

Now think about what constituted much Irish borrowing during the boom. Banks held property as collateral against original loans. So, instead of cash on its balance sheet, many banks held property. This was fine when property was going up – but now, when it is falling in value and no one wants to touch it, the bank has a financing problem.

When the governor of the Central Bank, John Hurley, came out and said ten days ago that the Irish banking system had no sub-prime debts, he was half-right. Yes, the sub-prime market in Ireland was only taking off last year (when it was bizarrely entitled the ‘‘non-conforming market’’). In a gushing report last year, at the height of the boom and a time when sceptics were being treated as heretics, Davy Stockbrokers suggested that this lending could become a €4 billion market by 2010.This will not happen now. However, it doesn’t mean that banks are off the hook, or that their shares have been dramatically oversold.

The Irish banks probably face a bigger headache than many of their American counterparts. Because the bad debts of the Irish banking system are on the balance sheet, as opposed to repackaged crude off the balance sheet, it will take a much longer period for the banks to work these debts out.

The banks now more resemble the continental or Japanese banks of the early 1990s which were straddled with bad property loans for years.

Whereas the US banks are taking a short sharp shock, where some sub-prime style portfolios which used to be regarded as ‘‘assets’’ are being valued at zero overnight, the Irish banks are in a ‘‘death by a thousand cuts’’ scenario, because the value of their former ‘‘assets is being marked down gradually.

The problem for the Irish banks is that they are being sold as if they had US-style ruptured balance sheets. This normally means the bank’s value collapses but recovers reasonably quickly as lending resumes and the banks take a one-off profit hit. So we can be reasonably confident that their share prices will rebound swiftly. In the Irish case, because it will take years to work through bad property debts, the share prices might not recover robustly for some time.

For the long-term investor, this might not be such a bad thing, as prices are low and things will recover. However, it could be a lengthier adjustment period than even the pessimists considered likely. One thing is certain: this banking crisis should have taken nobody by surprise. Unlike the Galway Road on the M50, the warning signs for a banking calamity were in our faces for years.

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