Open Dissent (6 page)

For the sake of brevity I attach my own conclusions on a single sheet to this letter as to the principal causes of the current state of instability in the marketplace. I would be more than pleased to discuss at length or briefly my suggestions as to the solutions that should be adopted to prevent a recurrence of this situation with your colleagues or anyone else who you may feel appropriate.

Yours sincerely,

____________________________

Michael D. Soden

The contents of the attached sheet were:

I stand by my recommendations in the above document.

The crisis that started in the US financial system in August 2007 was going to have far greater impact on the rest of the world than most would have imagined and forecasted. It would appear that, while we listen to forecasts and commentaries on all areas of the international markets, the tendency is to only hear that which suits our own domestic outlook. We had decided that we were in for a soft landing, because anything else would be politically unpalatable and unpatriotic.

It is true that the Central Bank would have given warnings to the Irish banks as regards the overheating of the commercial and residential property sectors. It seems that the six Irish banks – Bank of Ireland, Anglo Irish Bank, AIB, Irish Life and Permanent, EBS Building Society and Irish Nationwide – did not fully listen to the advice of the Central Bank. It is likely that they only heard what they wanted to hear, that we were in for a soft landing. The lack of action taken by the banks was not out of disrespect for the Central Bank but more likely because of the demands for increased profits from their shareholders.

While macro-economic factors were at play globally in 2007 and the first half of 2008, Ireland was feeling comfortable and the six banking institutions were still aggressive in their lending. No one believed that there was a liquidity problem in the Irish banks and, furthermore, there was an unquenchable thirst for credit. Developers who had been successful in Ireland over the previous ten to fifteen years found the market at home less attractive than places far away. Many wealthy Irish developers engaged in international
diversification, setting themselves up as property experts in places as far-flung and diverse as Dubai, Abu Dhabi, Hong Kong, Chicago and many other locations, the names of which were unfamiliar and difficult to pronounce. Developers became like Christopher Columbus looking for a New World for their ever-increasing wealth. Was this a signal for them to recognise that the Irish market had peaked and, with the assistance of bankers, they could venture abroad? Developers may not have been aware of what they were embarking on, but they were fast becoming diversified risk managers.

On 28 September 2008 the Government of Ireland was faced with this very critical problem: major corporate wholesale deposits were being withdrawn from Anglo Irish Bank and it was clear that they could not be replaced as quickly as they were being withdrawn. The contagion effect of this was the likelihood of other banks failing and, in turn, the country being put at risk. The decision and speed of putting in place a guarantee for the debts was appropriate at that time and preserved the country from a fate worse than the alternative, which was a potential collapse of the market. Only those who were involved will ever fully understand the various forces at work and the perceived risk to the country when the decision to issue the guarantee was made.

To understand how this situation could have developed for Ireland, one has to go back to the simple activity of getting a loan from your local bank manager. Traditionally, a borrower went with trepidation to his bank manager and
would pose the question, ‘How do I stand for an overdraft?' And the response was often, ‘You don't stand, you kneel.' Getting money out of a bank was akin to getting blood out of a stone. However, over time, the culture and thinking of banks changed with regard to the extension of credit. The eternal battle between the credit department and the sales force came to an abrupt halt with decisions on lending being excessively influenced by the need for growth.

In the good old days of the 1970s and 1980s, if you required money for a mortgage, personal loan, car or even a holiday, you would put forward a business case on the lines of how much you owed, what your income was, what other liabilities existed and whether you owned other assets. After an in-depth analysis of the request, a response, negative or positive, was forthcoming within a month. Fundamentally, a bank would take into consideration your total financial picture before they would entertain evaluating the risk attached to the repayment. The ability and willingness of a borrower to repay had always to be determined. It was not complex but sometimes it was burdensome and bureaucratic. However, when the approval came through, the customer felt satisfied. The amounts in question here were between £1,000 and £50,000.

During the 1990s, economic growth, inflation and soaring prices meant there was greater demand for liquidity and credit. An opportunity was apparent in the Irish banking system – lack of competition. Slowly but surely, branches of UK and Australian banks, including Ulster
Bank, Bank of Scotland (Ireland), National Irish Bank and others, including Barclays and KBC, that did not have branch networks but were active either directly or indirectly in major developmental or investment property transactions, appeared in the Republic. So the multiplier effect in lending was felt. Prosperity led to demands for larger loans in the mortgage and property areas. The traditional methods of evaluating risk by the two large banks, AIB and Bank of Ireland, were maintained as they had been tried and tested and the losses that had been incurred on any single transaction were small, very small by today's standards. When I left Bank of Ireland in May 2004, the single largest loan loss experienced in the group's 221-year history was €25 million. How credit standards would become diluted and people's judgment would become impaired!

During the period 1991–2007 banks found themselves satisfying the growing demands of their customers for credit. For most of this period, the two major banks employed credit systems that required requests for larger loans to go to their credit committees for approval. This process continued even though it was slow relative to the increasing demands of the customer base. The need for good credit analysis was observed.

All banks, under the guidance of the Regulator, have risk management committees. The risk management committee has experts in three principal areas: credit risk, market risk and operational risk. In addition to this, a bank has what is called the asset and liability committee (ALCO), the
principal responsibility of which is to preserve and protect the balance sheet of the bank. This protection is with respect to capital and liquidity in the event of any strains, unexpected or otherwise, that might impair the bank's ability to perform.

It should have been a comfort to the shareholders, employees and customers to know that a strong defence in the form of robust and vigilant risk management and ALCO committees were ever present in the banks. While markets around the world became more and more complex with the introduction of sophisticated products such as derivatives, credit default swaps, collateralized debt obligations and structured investment vehicles, these instruments had little direct effect on the performance of the Irish banks and on their balance sheets.

In the early part of the twenty-first century, one bank in the marketplace had developed a very simple process for evaluating risk. Business plans and individual projects could be evaluated and credit approvals granted in the shortest turnaround time for an approval in the marketplace – twenty-four hours. This organisation was Anglo Irish Bank.

It was not lost on Anglo Irish Bank that the speed of a bank's decision making often influenced the borrower's choice of bank. The principle behind Anglo's method was that the lender knew their customers, the customers were trustworthy and they understood their business better than the bank (while the bank presumably understood banking better than its customers). Each individual project was
considered on a stand-alone basis. A new project in Dublin 4 was not deemed to have any relevance to a project that the same borrower might have started some twelve months earlier in Galway or Cork. If the borrower provided a personal guarantee then there would be no need for cross guarantees from other companies within the borrower's portfolio. The concept of the customer knowing his business better than the lender has been quickly dispelled by recent experiences. In many ways this was equivalent to self-certification.

This process of credit analysis was not adopted by the two big banks in the late 1990s and early 2000s. Based on the assumption that all banks carried out the same analysis on any given property loan, debates raged within credit committees as to how Anglo could turn around a decision within twenty-four hours while the two big banks with all guns firing were taking anything from ten days to a month. In around 2004, the big banks changed their attitude and moved towards a more lax analysis and decision-making culture. The pressure to close the gap between the EPS (earnings per share) annual growth rate of the two big banks and that of Anglo Irish Bank was a major influencing factor in the growth of the commercial and developmental loan portfolios. In
Figure 1
(see
Appendix
) one can see the accelerated growth from 2004 to 2009 of lending to the private sector by the Irish banks as a percentage of GNP. The growth in this period was over 100 per cent.

The first ever US billion dollar loan in the euromarkets was syndicated in February 1982 for the Kingdom of
Denmark. I was fortunate to have won the mandate for Citigroup in London as vice-president responsible for arranging the transaction. I can recall clearly how many of my international colleagues hailed this transaction as a milestone in the European markets. This debt raising concluded in New York with 113 participants in a syndicate where contributions ranged from US$5 million to US$50 million each. The deal was an unqualified success but it had its challenges. Mr Erling Christensen, permanent secretary for the Danish Ministry of Finance, joined me on an investor tour of the US to present the economic background and outlook for Denmark. Many small banks in the US had never before considered lending money to European sovereigns. Caution prevailed in all the banks, as evidenced by the number of participants; seventy to eighty of the banks lent only $5 to $10 million each. Groups of interested banks attended presentations in New York, Chicago, San Francisco, Atlanta and Charlotte, North Carolina. What we managed to do for the Kingdom of Denmark was to open up a totally new market of investors for sovereign debt.

What was deemed to be a milestone in borrowing for a major European state, some twenty-five years later became normal practice in Ireland for property developers. In most other countries commercial property loans would not be made without full disclosure of the borrower's financial position, including contingent liabilities. It should be made clear that in the 1980s, whether a sovereign or corporate borrower went to the markets to raise debt, full disclosure of their total borrowings, methods of repayment and the
purpose of the borrowings were spelt out. Nothing was done until the documentation was in place. The size of the loans grew with the volume of liquidity in the marketplace around the world during the 1980s and 1990s, but not as freely or as loosely as it would do in Ireland in the noughties. It would appear that our level of sophisticated lending in Ireland during the heady days of the Celtic Tiger was relegated to a handshake, a promise of repayment and what now appears to have been very weak documentation.

Over the past two years I have been approached by several developers who contributed enormously to GDP growth in Ireland over the past twenty or so years. They had been caught by the leverage trap and the liquidity crisis of the banks. No two were in exactly the same predicament but they all appeared to have what I can describe today as phantom equity – equity that was deemed to be real during the halcyon days of the property market and had now disappeared through deleveraging.

Leverage was at the heart of the problem in the Irish banking system. Leverage is best described as the amount of times you can borrow a multiple of your capital, allowing you to complete bigger and bigger transactions and pay even larger prices for property. Capital has always been a prerequisite to a loan transaction to ensure that there is sufficient support to absorb all the losses in the event of a failure to repay. Leverage has the inbuilt capacity to reduce the level of capital available to cover potential losses on any given transaction. Of course, if you live in a world
where there are no losses anticipated then you need less capital to protect the lenders against losses. This applies equally to banks as well as any corporate borrowers.