No evidence of any mid-year green shoots of recovery

Today is the first day of the second half of 2009 and the latest data to assess our economic wellbeing does not provide grounds for reassurance, optimism or encouragement.

Employment and Unemployment

One of the great consequences of our EU membership and the economic growth that it enabled was the expansion in employment numbers and in the population of the country. Approximately one million people had a job in Ireland around 1990, a period when all the economic indicators and the level of government debt and the interest liability on it was punitive. Our labour force in March of last year comprised 2.23 million persons. A year later, 1.965 million persons had a full or part-time job in Ireland, a fall of 7.5%. The number unemployed at the end of March was 222,800 - an unemployment rate of 10.2% that has subsequently exceeded 11%. The most worrying aspect is that the long-term unemployment rate has increased from 1.7% last October to 2.2% last March.

There were over 418,000 persons listed on the Live Register at the end of June, an increase of over 197,000 in twelve months. This number includes persons unemployed , part-timers and seasonal workers.

 

Gross Domestic Product

Personal consumer spending, in volume terms, was 9.1% lower in the first quarter of 2009. Capital investment declined by 34.1 per cent in the first quarter of 2009 compared to the first quarter of 2008. This has resulted in a record GDP contraction of 8.5% in Q1 2009.

Anglo Irish Bank

The first Interim Report, since nationalisation, for the 6-month period to 31 March 2009 indicated that the capital base of this wretched bank has been effectively wiped out. There was an instant demand for a €4 billion capital investment by the Government with the high probability that a further €7 billion will be necessary.  The Government parted with €3 billion this week and God alone knows what the owners of that money will ever obtain for it.

This Bank built its business almost exclusively on property development and speculation. The hypothesis upon which it functioned was predicated on its customers achieving a 30-60% cash return on the sites they developed. The ensuing burden eventually mortally crushed the financial spine of struggling house buyers and the taxpaying public are now expected to bridge the enormous and unascertainable gap.

But the taxpaying public have not been introduced to the interplanetary world of bling-incarnate and the faces and the circumstances behind these impaired loans.

The public have been told about a proposed business plan that is intended to:

• Rebuild trust and confidence in the Bank
• Maximise the recoverability of loans, and
• Reduce the cost base

Rebuilding trust and confidence

A fundamental component of trust and confidence is candour, honesty and openness. The conclusion of the protracted but ongoing investigation by the Garda Fraud Squad and the Office of the Director of Corporate Enforcement is an absolute prerequisite.  Bernie Madoff needs some shamrock-wearing, shillellagh-shaking companions from the universe of moral hazard!

Ireland’s contemporary introduction to the concept of ‘systemic importance’ was in 2007 when the palaver was put about which suggested that the massive high-density developments proposed for Ballsbridge, Dublin with projected construction costs north of €1 billion, would ‘have to win planning approval’ because the big property developers were ‘too big to fail’. No consideration was given to the economic sustainability of this development at a consumer level by Anglo and other finance providers. The developer who described economic commentators then as ‘laughing hyenas – harbingers’ of doom and gloom’ has proven to be myopic and certainly not infallible.

Anglo is now a State owned business with a single shareholder. It is no longer a business with 17,111 shareholders’ who owned 89.2% of the equity; - who were fed a bill of fare by your predecessor about “the excellent performance…of a relationship based business … grounded in the Group’s disciplined and focused business model … prudent risk appetite and very limited exposure to areas affected by the current credit market issues”.

 

Maximising the Recoverability of Loans

The most devastating information in the Interim Report is that Anglo Irish Bank, the State-owned bank lent €175 million to 10 directors and 2 managers and that €31 million of this is impaired, against corresponding deposits of only €20 million - €8 million less than a year earlier. This is not merely a debt but it is the stripping away of national self-respect. What other State system of corporate governance would tolerate incumbent directors of major public companies being a party to impaired directors’ loans raised in a bank of which they were directors and appointees to the Risk and Compliance Committee?

The impaired loans of directors and managers of Anglo align Ireland more closely with Harare than with London, Frankfurt, New York or Geneva. What is the difference between the Zimbabwean taxpayers’ picking up the tab for the extravagant shopping trips to Hong Kong and Paris by Mrs Robert Mugabe while their citizens die from cholera? The difference with Ireland is one of scale and disease type. Our liabilities are much greater and our people will die of cervical cancer rather than cholera because resources committed to Anglo are not available for cervical screening.

Secondly, will this incidence of directors’ loans impairment not set a very low ceiling on the prospects of debt recoverability, causing further exposure to moral hazard? Developers will be thrilled and their legal advocates will argue that their client’s obligations should not be dealt with differently, or more urgently, than those of the directors’ and mangers’ who recommended and approved their loans, possibly completed on-site reviews at least twice a year and stress tested the impact of potential adverse consequences.

Religious congregations on whose sites half-finished properties exist will wonder will they ever reap the agreed selling price that was to have been paid on project completion.

Reducing the cost base of the Bank

The bonus culture meant that average salaries at Anglo Irish Bank almost equate in extravagance to the salary and pension combination of politicians. The average salary reported in the Interim Report is equivalent to €96,976 for staff numbers reduced from 1,922 to 1,753. This is a reduction of the corresponding annual figure of over €137,000 in 2006 and 2007.

The average salary estimated to be paid in 2009 in the Department of Finance is €58,600. The average salary estimated to paid, in 2009, in the Office of the Director of Public Prosecutions, who will hopefully be directly involved with former executives of the Bank, is €68,635. The average at Bank of Ireland, a business like that of Anglo, with activities in Ireland, Britain and the US, is €74,426.

When this is considered in the context of there being no value added at the Bank since September beyond dealing with existing customers the overhead seems exorbitant.

Credit Crunch

It is not surprising that as personal consumption collapses through lack of confidence that that demand for credit is also lower. Outstanding private sector credit amounted to €389.6 billion at the end of May.  This declined by €981 million, €185 million of which is attributable to lower personal credit in May. But the overall amount outstanding is equivalent to over  twice the annual level of total personal consumption on goods and services – in other words, a lot of lolly.  That explosion of private sector credit mirrors what occurred in Iceland.

There were 2,203,000 credit cards in issue to individuals in Ireland at the end of May, a number broadly comparable to a year earlier. New monthly spending on these personal cards has moderated from over €1 billion in June 2008 to €801 million at the end of May. The growth in the level of indebtedness of them at the end of May has moderated to 0.1% compared to 4.4% last January and 19.6% in March 2007. Residential mortgages fell by over €100 million in April and by a further €18 million in May, a trend that is not surprising when the number of planning permission sought in Q1 2009 was 23.7% lower than a year earlier.

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.

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?