Moral hazard of nationalising Anglo Irish Bank

The response of many prominent Fianna Fáil politicians to the result of the elections last Friday was to plead for more effective communication of Government actions. The saga of Anglo Irish Bank must provide a specimen illustration of ineffective communication.

It was nationalised on January 15^th, less than a month after the abrupt resignation of former Chairman, Seán FitzPatrick, fellow director, Lar Bradshaw who has been the Government appointed director of the Dublin Docklands Development Authority, David Drumm former Group Chief Executive, William McAteer, Group Financial Director and Chief Risk Officer, to mention but a few. McAteer is a former partner of PricewaterhouseCoopers. The current chairman of the nationalised bank was managing partner of that firm for a number of years. But the Government has failed to educate and convince the public that maintaining Anglo is in the national interest.

John McManus, has written a very compelling article in today’s edition of The Irish Times that argues the time has come to shut Anglo Irish Bank for good and the argument that it is too costly to close it is false.

No State money was invested since nationalisation but the begging bowl is out now. When the 6-month report to 31 March was issued on 29 May there was an immediate demand for €4 billion of additional capital. It was also signalled that further losses of €3.5 billion are anticipated. Anglo had assets of €101 million when it was nationalised. But the results at 31 Mar have diminished to €88.5 billion in a matter of 75 days since nationalisation.

The nation's capacity to bail out zombie banks is not infinite, nor is there much faith in their capacity to redeem themselves without extensive changes at the top. The National Pension Reserve Fund was valued at €15.5 billion on 31 March, having lost 30.4% of its value in the previous year. €7 billion of this has been invested in AIB and Bank of Ireland and if €4 billion is to be immediately committed to Anglo and a further demand for €3.5 billion is lurking in the shadows, the nation's sovereign wealth will amount to a mere €500 million.

The incidence of moral hazard is never far away when a fairy grandmother emerges to bail out an errant entity, and the former discipline of the stock market no longer prevails. It has emerged that Anglo made loans of €175 million to 10 directors and that €31 million of these are impaired. Would this impairment arise if the State was not involved and the stock market had to be impressed by the prowess of the business?

Apart from FitzPatrick who owes €106 million, Bradshaw, Drumm and McAteer the former directors were Tom Browne, Fintan Drury, Noel Harwerth, Anne Heraty, Michael Jacob, Gary McGann, Ned Sullivan, Declan Quilligan and Pat Whelan.  The former board received emoluments of €11.5 million in 2008, a slight reduction on the €12.9 million doled out in 2007.  But these far-sighted people decided that, had they remained, fees for non-executive directors would have been reduced by 20%!

This success of nationalisation is predicated on maximising the collection of outstanding liabilities. What signal is conveyed by a high incidence of impairment in the directors' loan account? There should be no directors loans whatsoever outstanding in a nationalised company.

The immediate call on State support of €4 billion immediately, is apparently to be made before the investigation of the Garda Fraud Squad and Office of the Director of Corporate Enforcement is completed. Impaired loans amount to €10.7 billion and a further €12.9 billion are deemed, at this stage, to be 'past due, but not impaired'. But they could be against this background. Loans of over €300 million, provide by Anglo to its own customers to buy Anglo shares, are now impaired and await the pleasure of the Irish taxpayer.

The cost of running Anglo Irish Bank, now a State enterprise is exorbitant. The average salary for the 1,753 employees for six months was €48,488 (equivalent to €96,976 per annum). A comparison with those public entities that engage with Anglo reveals that the average salary at the Department of Finance in 2009 will be €58,601, while the average salary of staff in the Office of the Director of Public Prosecutions is anticipated to be €64,946.

The Minister for Finance advised that nationalisation would mean "drawing a line under past activities". As the Minister is the only shareholder, why was it even necessary to engage a public relations firm in connection with the publication of the first interim statement since nationalisation? If the intention is to signal the drawing of a boundary with life under the ancient regime, why would the new board of directors and not be bold enough to 'go for change' rather than choose Drury Communications, a public relations firm established by Fintan Drury?  Drury was a former director of Anglo Irish Bank until June 27 2008. He was paid €85,000 in 2008 as a retainer to attend 4 board meetings and 6 meetings of the Anglo Risk and Compliance Committee and 2 meetings of the Nomination and Succession Committee.  Surely there is some due out of a staff of 1,753 that could coherently articulate what is happening, or have all those with these qualities already resigned?

The Government has not done enough to convince the public of the systemic importance of either Anglo Irish Bank or Irish Nationwide Building Society. The McManus article suggests that since it is most unlikely to redeem its reputation. Customer funding has dropped from €47.8 billion on 30 September to €34.1 billion on 31 March – driven by “a market wide aversion to risk”. But is also reflects the decrease of €7.3 billion of customer deposits received from Bowler’s Irish Life Assurance Company that was designed to hoodwink stakeholder at the end of the last financial year – 30 September 2008. 

Customer lending, to existing customers, increased fractionally from €71 million to €72.3 million and €700 million of this concerned capitalised interest and the roll-up of other interest outstanding.  Basically it is a matter of endemic stagnation combined with a ruined reputation and an open-ended drain on public funds.

Ireland’s credit rating was reduced on June 8th to AA negative by Standard & Poor’s on account of the fiscal cost of weakening bank sector asset quality.

Overcharging at AIB - 'my personal experience'

Mr Eugene McErlean, former Group Internal Auditor of AIB Plc, from 1997 to 2002 presented to the Oireachtas Joint Committee on Economic Regulatory Affairs yesterday, March 24th. He told the Committee that the Financial Regulator knew about the overcharging of customers in AIB in 2001 and conducted an investigation in this in 2002 but failed to protect customers. He described how €65 million was liable to be paid as restitution to AIB customers who had been overcharged. He also related how a branch manager charged a customer for playing golf for 3 hours’ management time and how the overcharging regime never involved large individual sums so customers were never really in a position to argue. That is until they overcharged me!

When it comes to bank overcharging my antennae is particularly sharp when the subject is AIB Bank. My own experience predates the inauguration of the Irish Financial Regulator. I started a £14,000 20-year mortgage with AIB in 1978 that was fully discharged on schedule and with no missed payments. I recall one February day in 1999 looking at my AIB current account bank statement on the internet and being horrified to discover a debit for a £50 ‘Mortgage Closure Fee’. I instantly called the account officer at the Bankcentre branch in Ballsbridge where my account was maintained. I told this person outright that I was not paying this charge. She advised me that “everybody pays this charge” to which I again responded that “I am not”.

The branch manager then came on the line. I had never met him and I had the impression that he was busily scanning my account history on a computer before he began to converse with me. When he did so I said “you know why I’m on the line. I am not paying this charge”. He responded that I had “operated a very disciplined account” which was the case and still is, to which I replied “yes, so disciplined that the bank never has to spend as much as 32 pence on a stamp to recover a mortgage instalment over the previous 20 years, a period when interest rates were so high that the Government had to subsidise them. You have had this account for 25 years and you can have it for a further 25 seconds while you’re making up your mind about this charge”. He immediately took the only course open to him and dropped the charge.

This incident coincided with the attendance of former Taoiseach, Charles Haughey, at The Moriarty Tribunal and an examination of his relationship with AIB. He owed AIB over £1 million in 1979 when he was elected to the office of Taoiseach.. Haughey had received £750,000 from an unidentified source to help defray this debt and he apparently offered to arrange a £10 million deposit from a source in the Middle East in exchange for offsetting the balance of the debt. But Haughey never repaid a sum of £110,000, on which there was to have been no interest charged, as an element of an overall settlement. Mr Justice Moriarty found that AIB had settled a £500,000 overdraft owing by Haughey shortly after he became Taoiseach on favourable terms and that AIB had shown extraordinary deference to Charles Haughey in their dealings with him. Haughey, it appeared warranted special treatment because he was, as AIB would see it, a KBI (key business influencer). It also coincided with the announcement by AIB of record profits of £800 million+ for 1998.

My fingers were dancing with rage and I decided to write to the Chief Executive of AIB, Tom Mulcahy. The gist of what I said to him was that I was not a KBI but I would consider myself an LLP (loyal little peasant). I stated that this charge was immoral and that I would welcome a debate with him on one of the talk shows on RTE Radio 1; that if he had any balls he would have sent me a case of wine to thank me for my trouble-free business over 25 years rather than imposing this awful immoral charge. Three days later a 6-bottle case of wine arrived at my home from Mitchells Wine Shop, then located under the old railway arches in Harcourt Street!

The upshot is that:

• The charge was instantly removed from my account
  
• The charge, as then defined, was eliminated from AIB’s charge tariff
  
• The charge was one of those rogue charges similar to those described by Mr McErlean in his evidence on 24 March 2009, ten years later.

What Would Warren Buffett Make of Anglo Irish Bank?

Warren E. Buffett is a greatly admired icon of the American business world. He was born in August 1930 in Omaha, Nebraska. He is ranked 2nd on The 2009 Billionaire List published by Forbes with a net worth of $37 billion, having been the richest billionaire in 2008, when his wealth amounted to $62 billion. He founded Berkshire Hathaway Inc in 1964. He has not increased his annual salary at Berkshire Hathaway beyond $100,000 (€78,000) in 28 years. Apart from salary, his overall compensation amounts to $491,000 (€384,000) but he will not be paid a bonus this year. He has also lived in his present home for over 50 years. He is still the Chairman of the Board and around 31,000 shareholders are expected to attend the company’s annual general meeting on Saturday, 2nd May in Omaha, an event that extends over a weekend and offers those attending the opportunity of an extensive discounted shopping spree at a wide range of Berkshire Hathaway consumer businesses!

Berkshire Hathaway investment interests are far reaching. They include the utility sector, insurance, manufacturing and retailing, finance and financial products and a wide range of investments in companies such as Coca Cola, American Express Company, Johnson and Johnson, Proctor & Gamble, sanofi-aventis, Swiss Re, Wal-Mart, The Washington Post and Tesco.

Buffet’s has very focused priorities:

• He ensures that they maintain substantial liquid resources, commits to modest short-term obligations and has diverse sources of earnings and cash



• He strives to ensure that each business has a robust basis (‘moats’) of competitive advantage



• He develops operating managers who deliver exceptional results
  

Despite his accomplishments, not everything he was invested in has been rewarding. The past year has seen his wealth drop by 40% as a consequence of the fall in value of the companies he has invested in. Most of the Berkshire businesses were adversely affected by the economic developments last year but between 1965 and 2008 they achieved a compound annual increase of 20.3%, or an overall gain of 362,319% since 1964.

He invested $244 million on shares in two Irish banks in 2008 as they appeared cheap to him. But by the end of 2008 he had incurred an 89% loss on these, a development he describes as an ‘unforced error’ on his part.

Anglo Irish Bank was nationalised by the Irish Government on 21 January last on account of its systemic importance to the Irish financial system. Its former chairman and founder, Mr. Sean FitzPatrick, resigned on 18 December 2008 when it was disclosed that loans amounting to €87 million were not reflected in the accounts of Anglo Irish Bank and were hidden from stakeholder scrutiny at Irish Nationwide Building Society. While FitzPatrick maintains that this was a legal, if not transparent series of transactions, they would be unlike to pass muster with Buffett. Furthermore, the €1 million bonus and the 12% salary increase for 2008 paid to Michael Fingleton, the chief executive of Irish Nationwide Building Society is likely to be as much of an affront to Buffett as it is to Irish citizens.

The latest balance sheet of Anglo Irish Banks (at 30 Sep 2008), reflects €2,233,000,000 (€2.23 billion) invested in derivative financial instruments. Derivatives are financial contracts whose value is determined by an underlying value such as that of an asset, a commodity, a mortgage or even the movement of an index, such as an interest rate or the FX rate attaching to a particular currency. They are supposed to mitigate the risk of a change in the value of the underlying assets and that activity is hedging. The notional value of a derivative, based on the nominal value of the various assets underlying it, is not recorded on the balance sheet of the business owning it - but the market value is.

Buffett is scathing about structured derivative and describes them as ‘dangerous’ because they have dramatically increased the leverage and, therefore, the risks inherent in the financial system. It is almost impossible for investors to understand and analyze large businesses with substantial amounts of derivatives. He is likely to have similarly sceptical about securitized assets and leveraged funds.

An ordinary share can be bought or sold within days with one party obtaining cash and the other the corresponding security. There is no enduring counterparty risk which means that problems cannot fester. Rapid settlement is the vital to the integrity of the stock market.

But structured derivative contracts often go unsettled for years, or even decades and counterparties can build huge claims against each other. Paper assets and liabilities are hard to completely accurately assess; yet, in the case of Anglo Irish Banks, they are an important element of it financial profile.

A complex web of mutual dependence has developed amongst financial institutions with receivables and payables becoming concentrated among a small number of dealers who maybe excessively leveraged in other ways too. Buffett says that such participants “seeking to dodge trouble face the same problem as someone seeking to avoid venereal disease. It is not whom you sleep with, but also who they sleep with” that is the issue. The current financial crisis has demonstrated that only companies that can ‘infect’ a neighbourhood are attracting US government support and intervention.

Buffet believes that the chief executives of many large businesses were incapable of managing them because of the complexity of the derivatives those businesses are involved with. He doesn’t believe that any mechanism can provide sufficient transparency to describe or regulate derivatives or for auditors to audit them. He cites the collapse of Fannie Mae, Freddie Mac and Bear Sterns to support his opinion.

Buffett might also be curious to know if there is a connection between the Anglo Golden 10 that were provided with loans by Anglo Irish Bank to buy its shares outside normal market structures last year and those borrowers who owe the Bank more than €500 million. He might ask if this is the case were any covenants and obligations attaching to these loans broken at any time. If so what impact could this have had in persuading them to become involved in this Anglo loans for shares episode?

Liam O'Reilly the first Irish Financial Regulator is a busy man

The first chief executive of the Ireland's Financial Regulator, Liam O'Reilly, is a busy man these days at the age of 61.

He has been a board member of Irish Life & Permanent Plc (IL & P) since early September 2008. His appointment was inspired by his "long experience in financial services, public administration and economic and monetary policy in Ireland and at EU level", according to Chairman Gillian Bowler in welcoming O'Reilly.

However, O'Reilly arrived at IL & P just in time for the transaction described as the €7.9 billion in 'exceptional support' to Anglo Irish Bank was executed. The source of these funds is being investigated by the Irish authorities including the Financial Regulator, the Director of Corporate Enforcement and the Garda Fraud Squad.

Bowler, admitted on March 4th this transaction was wrong; that her board knew nothing about it, that if they had, they would not have approved it. But they have not fallen on their swords, despite great unease among the staff and society-at-large - yet.

Mr O'Reilly became the first Chairman of the Chartered Accountants Regulatory Board (CARB) in April 2007. This Board supervises the "to regulate its members, in accordance with the provisions of the Institute's bye-laws, independently, openly and in the public interest".

This CARB appointed the former Irish Comptroller & Auditor General, John Purcell, on 19 February to undertake an investigation into the issue of dirctors loans at Anglo Irish Bank.

Loans to the former Chairman of Anglo Irish Bank, Sean FitzPatrick, for an 8-year period resulted in FitzPatrick's resignation from this position on December 19th as well as his resignation from the boards of Aer Lingus and Smurfit Kappa. The loans outstanding amounted to €83 million in 2008 and €122 million in 2007. These are the very loans which the staff of the Financial Regulator discovered when conducting sn examination of the books of Irish Nationwide Building Society in early 2008 but neglected to tell their boss, the last Financial Regulator, Pat Neary, in sufficient time for him to protect his position. Neary resigned from as Financial Regulator on January 9th.

If that was not enough to keep a man busy Liam O'Reilly is also a director of Merrill Lynch International Bank based at the IFSC. It was disclosed on 6th March that the Financial Regulator is investigating a possible rogue trader case involving an employee at the London branch office of this bank since February 18 relating to the 'mis-pricing of trades'. The NY Times reported that a FX trader may have lost more than $120 million and tha several hundred million dollars could have been lost on derivative trading - MLIB earned pre-tax profits of $860 million on reveues of $2.6 billion in 2007 before the financial tide turned for its parent.

Bank of America acquired Merrill Lynch on 15 September 15th 2008 for a €50 billion all-stock transaction that was "intended to create an entity that would become the leading financial institution in the world based on a great global franchise"

However, just a mere 4 months later, on 21st January 2009, the former boss of Merrill Lynch, John Thain, resigned following a fourth quarter loss in 2008 of $15.3 billion, - $553 million more than Bank of America expected it to lose when it acquired Merill.

Thain was a man with extravagant tastes and spent $87,000 and $68,000 on a sideboard when refurbishing his office last year at an overall cost of $1.2 million. Thain had suggested to his fellow directors the previous month that he be paid a $10 million bonus for the period since he became CEO of Merill in December 2007. He had already received a $15 million bonus in cash when he joined Merrill and a salary package anticipated to yield from $50 million to $120 million over several years.

The US Government has provided $45 billion in bailout money to Bank of America. Apart from selling 3 corporate jets, it is also selling a Merrill Lynch helicopter and has confirmed that no bonuses will be paid to Bank of America executives last year and the remuneration of its chief executive has been slashed by 60% to $10 million.