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Property loans loom over banks
Sunday, October 12, 2008 By Richard Curran
The government guarantee has alleviated the bad debts issue, but exposure to property loans could be a long-term problem.

As the share prices of Irish banks continued to take a pounding last week, the issue of the extent of their potential bad debts is taking centre stage. Question marks over possible bad debts could exercise the minds of the banks’ auditors as they ask whether property revaluations will be needed before signing off the accounts.

With the government guarantee in place, the Irish banks are not in imminent danger of going under. However, long-term issues are arising about how much of the billions of euro loaned to property developers and for other property loans will ever be paid back.

Particular sectors are expected to throw up a lot of bad debts over the next two years. Hotels, office buildings, housing developments and loans for landbank purchases are expected to create difficulties for the banks.

In order to prepare for loans that become stressed as the customer struggles to meet repayments, and also for all-out defaults, banks usually make provisions on their balance sheets for such eventualities.

Right now, there is a fundamental disagreement between the banks themselves and the wider investment community - mainly outside Ireland - about just what kind of charges or financial hits the banks will have to take to provide for bad debts.

The banks are indicating that, while bad debt provisions will have to increase, they see them as taking up between 0.5 and 1 per cent of their total loan books.

Brokers like Citi and JP Morgan see the banks taking impairment charges on their bad debts of between 2.8 per and 6 per cent of their loan books. Davy Stockbrokers last week ticked up its estimates for Anglo Irish Bank in particular to 1.05 per cent for 2010. Anglo itself has pencilled in 0.6 to 0.8 per cent.

The gap between what the banks say it will be and what the investors believe it will be is helping to drag down the share prices of Irish banks. So who is right?

The sharp falls in commercial and residential property prices are an important factor. The deterioration in the wider economy will also play a key role. Citi estimates that, between 1990 and 1992,when retail property prices fell by 15 per cent, office property fell by 18 per cent, industrial property fell by 10 per cent and residential property rose by 7 per cent, AIB and Bank of Ireland took charges that peaked at 1.6 per cent of their loan books. For Anglo Irish,1994 was the highest year with a charge of 1.4 per cent.

In the period between 2007 and 2008, retail property prices are down 10 per cent, office property is down 10 per cent, industrial is down 3 per cent and residential is down 13 per cent.

Overall, this points to amore serious situation. Coupled with this is the fact that the most recent property bubble has been fuelled by a global glut of credit which placed practically infinite amounts of cash with the banks to lend out. The multiples of income that applied in this bubble may make the bad debt problem more pronounced.

Also, the wider international recession should see the problems spill over into the real economy, thereby affecting consumption, disposable income, retailing and other sectors. For example, last week retail sales figures were the worst for 23 years.

This is relevant when we ask just how much money the banks have lent out for property. Anglo Irish has 80 per cent of its €73 billion book in British and Irish property. Price falls of between 20 per cent and 30 per cent are expected here. But just how would that affect Anglo Irish’s bad debts?

AIB has 52 per cent of its loan book out to British and Irish property, while Bank of Ireland has 71 per cent.

Last weekend, Sean FitzPatrick, chairman of Anglo Irish, said this 80 per cent figure was wrong and that its exposure to property was closer to 20 per cent, which equates to the percentage of its loans that were given out for landbank purchases and development purposes.

He emphasised that where €10 million or €20 million is lent out for a customer to buy a commercial property, which in turn is rented out to a fast food chain and a jewellery shop, falling property prices are not the issue.

Once the customer keeps meeting the repayments, the value of the property is not a problem, even if it falls. The difficulty with this version of reality is that the wider economy is also affected by the downturn. A slowdown in the real economy will affect rents.

In the event that the customer defaults on the loan, and the bank has to seize the property, its security is worth perhaps a half or two thirds of what the bank is owed. The banks have to prepare for such scenarios.

Auditors will have a key role in deciding whether property valuations need to be done by the banks before they sign off their accounts. According to one accountant, who has also sat on the boards of two banks in the past, the auditors will take a look at sample accounts and how they are performing.

‘‘They will look at examples of stressed loans and whether a new valuation of the property needs to be done to assess the level of security,” he said.

However, there is massive scope for the banks to classify loans in different ways. ‘‘For example, if a customer is meeting the repayments on a loan, but is only managing to do it by selling off other assets, is that a stressed loan or not?” the accountant said.

Accountancy sources say the banks are not taking on property valuations this year and are not in any hurry to do them. However, the auditors will have to decide whether property valuations would in fact show the banks’ exposure to clients and the need for write-downs.

One bank source said that some loans were structured in a way that was formally based on a loan-to-value ratio.

‘‘If the auditors insisted that a property valuation be done, then the loan would be too high relative to the value of the security and they would have to insist that the customer pay up more cash,” the banker said.

‘‘If they don’t have it, then it would trigger a whole series of events.”

Such a move would create huge difficulties for the banks and could lead to a domino effect in property write-downs. Anglo Irish, whose chief executive is David Drumm, is audited by Ernst & Young. Bank of Ireland, whose chief executive is Brian Goggin, has PWC as its auditor. Both AIB, headed by Eugene Sheehy, and Irish Life & Permanent, led by Denis Casey, are audited by KPMG.

Bank of Ireland was the first bank to come out with a very clear up-to-date statement about the performance of its loan book. Last month, the bank said it expected its annualised impairment charge to hit 0.3 per cent this year, equal to around €440 million.

It suggested that it could go to 0.9 per cent by 2010, equal to around €1.3 billion. It added that arrears in its mortgage book in August 2008 were 0.81 per cent, equal to around €530 million. Arrears do not always lead to bad debts, but they are a warning sign.

NIB last week indicated that it would make a loan loss provision on its commercial book of about €80 million in the third quarter, which equates to an annualised impairment provision of about 3.18 per cent on its €10 billion loan book.

Assuming the other banks, which have been in that business longer, did not hit the same level of problems, a reasonable figure might be 2 per cent. A 2 per cent charge on Bank of Ireland’s total loan book would be €2.8 billion in its peak year. For Anglo Irish it would be €1.5 billion and for AIB it would be €2.8 billion.

If JPM organ is right and bad debt charges have to be made to cover around 5 per cent of their loans, the Irish banks would need to raise €7.6 billion in new capital.

Citi estimates that a peak year charge of 3.5 per cent would cost AIB €4.6 billion in that year. It has done stress testing on charges of 2.8 per cent for Bank of Ireland, which would cost €2.4 billion, and even 6 per cent for Anglo Irish, which would cost it €3.9 billion.

There is an enormous difference between Anglo’s estimated of 0.8 per cent impairment charge and a Citi estimate of up to 6 per cent.

Last week, NCB Stockbrokers estimated that bad debt charges of over 1.5 per cent across the banks would leave them with deficits in their capital. A 3.5 per cent bad debt charge would see a capital deficit across Bank of Ireland, AIB, Anglo Irish and Irish Life &Permanent totalling €14.5 billion.

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