How Minister Lenihan is getting it wrong

Economics 16/9/10: Analysis of global banks rescue packages disputes Irish policy case Posted by Dr. Constantin Gurdgiev

A very interesting paper that a year ago should have alerted this Government to the fallacy of its preferred path to interventions in the banking crisis. Alas, it did not.

Michael King Time to buy or just buying time? The market reaction to bank rescue packages, BIS Working Paper Number 288, September 2009 (linked here).

The paper suggests and tests the following three hypotheses concerning banks rescue packages put in place at the beginning of the crisis (January

* H1: The announcement of government rescue packages will be associated with a narrowing of bank CDS spreads relative to the market.
* H2: Capital injections will be associated with a rise in bank stock prices relative to the market if the benefits of lower leverage and a lower probability of financial distress outweigh the potential dilution of existing shareholders or restrictions on payment of common dividends.
* H3: Asset purchases and asset insurance will be associated with a narrowing of bank CDS spreads and a rise in the stock price relative to the market.

What the study found is that rescue packages confirm H2. But there was significant difference in the effectiveness of interventions.

* In the US, “bank stock prices outperformed reflecting the decline in the probability of financial distress and the favourable terms of the capital injections. The risk of US bank failures was high following the failure of Lehman Brothers and IndyMac, and the government take-over of AIG, Fannie Mae, and Freddie Mac. While the US Treasury’s preferred shares included warrants with the potential to dilute shareholders, the favourable terms of the capital allowed the average US bank share to outperform the market following the announcement of government support.”
* In contrast in Europe, “the risks of financial distress were also high as seen in the capital injections for Fortis and Dexia and the nationalisation of Bradford & Bingley. While banks were recapitalised, the cost and conditions of European rescue plans were punitive for existing common shareholders leading to an underperformance of bank stocks in most countries.” In other words, Europeans, predictably soaked equity holders but didn’t touch bondholders.
* “The UK package appears to have been the most costly for existing shareholders, which explains the fall in stock prices when the terms were disclosed. Given that only three out of six banks accepted the capital, the fall for banks receiving capital was offset by the positive response of banks that did not.”
* “Swiss banks were the exception as the average Swiss bank was relatively unaffected.”

Turning to the cases of asset purchases or asset insurance schemes, “market reaction provides only partial support for the third hypothesis (H3) that creditors took comfort from the reduction in potential losses and the decline in risk-weighted assets”. Oops, I’d say for the Leni/Nama plans.
And this was known as of September 2009, despite which our Government has charged ahead with Nama.

“Overall, globally, asset purchases or insurance were used in only four cases with mixed results.”

Bingo – only in 4 cases: “the Dutch, Swiss, and US governments supported specific financial institutions by purchasing impaired assets or providing insurance against losses on specific portfolios. In an asset purchase, the government buys impaired securities or loans from the bank, reducing the bank’s risk-weighted assets and lowering the amount of capital it must hold against potential losses. While the government bears the risk of losses, it also retains the profits if the assets recover. While the US and Germany announced asset purchase plans, only the Swiss had taken action by the end of January 2009, buying $39.1 billion of illiquid assets from UBS on 16 October. The assets were removed from UBS’s balance sheet and placed in a special purpose vehicle, significantly reducing UBS’s risk.”

So in the end in the duration of 2008, no country has undertaken a significant Nama-like operation with exception of Switzerland in relation to UBS alone. Clearly the claim that Minister Lenihan was acting consistently with other countries in setting up a Nama vehicle is not true.

Here’s an interesting bit: see if you can spot where Mr Lenihan has gone the path differing from everyone else back in 2008. “Under asset insurance, the government assumes a share of the potential losses on a specified portfolio after a first loss amount (or deductible) is absorbed by the bank. In return, the bank pays the government an insurance premium based on the riskiness of the portfolio. By limiting the bank’s potential losses, asset insurance also reduces a bank’s risk-weighted assets and lowers the capital it must hold. The government, however, is left with a large potential liability if the assets fall substantially in value. The US and the Netherlands offered asset insurance to three banks. The US provided protection to Citigroup and Bank of America against the possibility of unusually large losses on asset pools of $301 billion and $118 billion, respectively. In both cases, the US government bears 80% of the losses after the deduction of a first loss tranche paid by the bank but does not share in any profits. The Dutch authorities created an illiquid asset backup facility to insure most of the risk from $35.1 billion of Alt-A securities owned by ING. The Dutch government shares in 80% of the downside and the upside. Asset purchases or asset insurance should be positive for both the stock price and the CDS spread, as both interventions lower the potential losses faced by common shareholders and reduce the risk of default. As a result, the share price should rise and CDS spreads should narrow. In three out of four cases the government’s actions coincided with the injection of capital.”

To conclude: “the October [2008] rescue packages provided governments with time to assess the situation and formulate their policy responses. At the same time, these policy interventions did not represent a buying opportunity as seen in the underperformance of bank stocks in most countries studied.”

Predictably, our stockbrokerages analysts, Nama, Department of Finance, Government and the usual crowd of suspects claimed that:

* Nama will lead to significant improvement in the banking sector health;
* Irish Government interventions were value additive for shareholders – all stockbrokers in Dublin and majority of them outside had ‘Buy’
recommendations on banks based on Government rescue package;
* Banks guarantee scheme is structurally important to the resolution of the crisis (not a delay, but a resolution),
* The rest of the world was doing the same.

International evidence on the matter suggests that banks supports are only as good as the measures to reform banks taken after the supports enactment.
Of course, in the case of Irish banks, no such reforms took place since September 2008.

All I need to add here is that this paper was available to Minister Lenihan’s advisers, to Nama and to DofF and Central Bank handlers. The latter, alongside their Financial Regulator counterparts are linked to BIS.