€6 billion more and counting

ANY BANKING SYSTEM that posts combined losses of €6 billion for a year is far from out of the woods, particularly when the road back to profitability is not straightforward, or even assured for some.

The State-owned banks have all reported results for 2011, and it is clear the lenders, even plugged with €63.7 billion of State capital (including the €1.3 billion to go into Permanent TSB from the sale of Irish Life) still require further help to return to full health.

Permanent TSB was the last of the domestic banks to report results, on Monday, following AIB and Irish Bank Resolution Corporation (IBRC), which is winding down Anglo Irish Bank and Irish Nationwide, last week and Bank of Ireland in February.

Adding the losses at foreign-owned subsidiaries – RBS subsidiary Ulster Bank, Danske-owned NIB, KBC Bank and the implied losses at the former Bank of Scotland (Ireland), which doesn’t report performance – pushes total losses in Irish banking for 2011 well over the €8 billion mark.

As for the four State-supported banks, the big questions the 2011 results raise is whether last year’s bank stress tests by the Central Bank, verified by a group of costly outside consultants, stand up or whether the banks require further capital.

There were further heavy provisions taken to cover loan losses – almost €13 billion at Bank of Ireland, AIB, Permanent TSB and IBRC – but Bank of Ireland and AIB said 2011 marked the peak of those provisions. It’s unlikely to be end of the story at Permanent TSB, while the biggest hits at Anglo were taken in 2010.

It is hardly surprising that the heaviest impairments are at the banks in wind-down mode. IBRC said that 61 per cent of its loans are impaired and a whopping 66 per cent of the €29 billion loan book at the former Bank of Scotland (Ireland), which is being wound down by UK bank Lloyds, has been classified as impaired.

While the losses at the domestic banks have already hit the base case losses expected in the Central Bank stress tests in March 2011, the banks have enjoyed more success on the “deleveraging” of their businesses as they attempt to shrink in size and get off the drip of cheap funding.

In the case of AIB and Bank of Ireland, the European Central Bank had loaned €31 billion and €22 billion respectively at the end of last year, while both the ECB and the Irish Central Bank had provided combined regular and emergency loans of €42 billion (€40 billion of which are emergency loans) and €14 billion (€2 billion emergency) respectively to IBRC and Permanent TSB at the end of last year.

Both AIB and Bank of Ireland managed to get off emergency funding from the Central Bank during the year, using the proceeds from their deleveraging.

IBRC’s heavy drawings from the emergency lending window in Dame Street, is one of the reasons why the troika and Government are seeking a cheaper way of paying for Anglo and Irish Nationwide over a long period of time, in addition to reducing the annual costs.

On the issue of deleveraging, the lenders have so far picked the low-hanging fruit, selling assets overseas where there were buyers rather than dumping Irish loan assets for which there are few buyers and only at loss-making firesale prices at that.

IBRC chief executive Mike Aynsley said at the bank’s results last week that the bank was unlikely to follow up the chunky sale of €5.8 billion in US loans where the bank benefited from “fortuitous circumstances”.

The debt crisis makes the sale of a large Irish or British book unlikely, he said. Instead, it’s about putting in the “hard yards”, recovering loans one by one and being ready to sell a portfolio should market conditions improve.

Bank of Ireland offloaded 86 per cent of the €10 billion in assets that it must shed by the end of 2013 and managed to take a hit of just €600 million – a 7 per cent discount in the process.

AIB’s €12.7 billion deleveraging in 2011 was €3.3 billion ahead of target at an average discount of 4 per cent, again within targets. AIB, however, did not have quite the same success as its “pillar bank” rival – the bank has completed 62 per cent of the total deleveraging target.

In its results, IBRC rowed in with a wider view of the problems facing the Irish banking system, Some 26 per cent of the total Irish loan market is in wind-down, the bank said. Across the sector, €131 billion of net loans are non-core and are earmarked for deleveraging, of which €64 billion is Irish.

Against the backdrop of between €1.5 trillion and €2.5 trillion of European bank assets being disposed of during the next two years (coinciding with the final two of three years of Irish deleveraging), the system will require “constructive and imaginative thinking” to recover, IBRC said.

The Central Bank said in last year’s stress tests that €13 billion of the additional €24 billion capital bill set in that exercise was to cover losses on deleveraging. The banks are still holding most of this on their books in anticipation of further pain to come, particularly when they shed Irish assets.

At the back of the class on deleveraging is Permanent TSB. Apart from €1.8 billion of loans that were repaid during 2011, the bank has executed no significant deleveraging to speak of and still has to get rid of almost €16 billion in loans.

AIB and IBRC both acknowledged during their respective results presentations that discussions were taking place on the future of residential mortgages across the banks. This was a reference to plans to shift the tracker mortgage books out of AIB (€18 billion) and Permanent TSB (€16 billion) to IBRC or another vehicle to run them down. The removal of the tracker books forms part of the technical discussions around the next restructuring of the banks, tied in with a replacement of the promissory notes funding the bailout of Anglo and Irish Nationwide.

Taking the tracker mortgages out of AIB and Permanent TSB not only purges them of loss-making loans that are a drag on a return to profitability, but may also encourage investors to take out some of the State’s shareholding in these financial institutions.

“The removal of tracker mortgages from banks’ balance sheets would significantly improve net interest margin and enhance the prospect of attracting fresh equity investment to the pillar banks,” said IBRC in its results presentation. Reading between the lines, it would appear that IBRC would welcome the trackers with open arms.

It won’t be known until the end of this month what the future holds for Permanent TSB or, indeed, whether it has a future as a independent institution. A solution on the tracker book would have a major bearing on whether the bank can stand alone.

“There is no guarantee that the tracker mortgage solution would fully remove the threat to future operating profitability, but it would clearly be a step in the right direction,” said Michael Cummins, a director at the Dublin-based bond market specialists Glas Securities.

Tracker mortgages reflect a more structural problem and the dysfunctional nature of Irish banking – banks are paying far more for funding than they are charging to lend it out.

The debt markets remain closed to them, at least at any kind of meaningful rate at which they can repair their business models.

Cummins said removing the trackers would immediately create a deleveraging effect which would reduce the pressure to sell other more profitable assets and provide more flexible to increase new lending at current prices.

They are also having to deal with the perverse situation of having to pay much more for the use of the Government guarantee for covering fewer liabilities than before.

Changes to the guarantee scheme mean the banks no longer have to apply it automatically to any funding raised so as to avoid the nasty cost attached to it.

Paul Stanley, AIB chief financial officer, said the bank can take unguaranteed deposits but there is little appetite among big-ticket depositors due to international concerns about the euro zone. But he said he didn’t believe it would be long before the bank would start accepting unguaranteed deposits as the interest was there.

However, weaning the banks fully off the guarantee will not happen soon.

Until then, solid profitability will remain elusive, despite AIB’s aim to return to the black by 2014 and Bank of Ireland’s plan to get its net interest margin over the 2 per mark in the coming years.

In the meantime, the deteriorating situation regarding the mortgage crisis means arrears will continue to increase.

While the high level of loan losses is a concern given that they have not reached the stress test base-case levels, the banks have not used up as much of the capital set aside to cover the deleveraging as was expected, said Stephen Lyons, analyst at stockbrokers Davy.

This has created a contingency fund in addition to the €5.3 billion existing contingency buffer factored into last year’s additional €24 billion bank recapitalisations.

But, as Michael Cummins says, the stress tests failed to resolve the issue of future operating profitability at the banks, despite the banks being recapitalised based on loan loss projections over three years and assuming a return to profitability after the three years.

“At present, that assumption is beginning to look at risk,” he said.

Another unknown is the effect of the new personal insolvency regime and whether it will encourage more “strategic arrears” on mortgages, thereby increasing losses, and opening the floodgates to large-scale writedowns through a proposed out-of-court arrangements on unaffordable mortgage debt for individual who cannot pay their debts as they fall due.

Rating agency Moody’s has warned that 25 per cent of Irish mortgages could be written down under the proposals, based around the peak-to-trough falls in house prices and how this will push more homes into negative equity.

The effect of the personal insolvency changes won’t really be felt until writedowns are put in practice, and this is unlikely to happen until well into next year.

“The banks still look highly capitalised. Obviously there are risks of further losses with the changes to personal insolvency, but this could be offset by the capital set aside for deleveraging and also from concessions to help deleveraging,” said Stephen Lyons.

Until more light is shed on the next restructuring of the banks, their future is far from bright.