Banks kept alive by the state can now send viable firms to the wall

LAST Monday the Fianna Fáil TD Frank Fahey joined the small band of interviewees who have offered me a bet live on radio to emphasise his certainty of the point he was making.

Explaining why the Government should be happy to take a 15.7% shareholding in Bank of Ireland (BoI) instead of the €250m in cash that it was due, Fahey declared he was “certain” this would prove a good investment by the state and that the shares would be worth more in the future than they are now.

That’s where the bet came in: he wanted to wager that if we spoke again after 12 months the price of BoI shares would be higher than they were on Monday. Not being one to make rash bets, especially live on national radio, I declined, upon which he offered to limit the bet to a pint.

Fahey may be proven right. Differences of opinion as to what a share is worth is one of the main reasons why shares trade between buyers and sellers.

The owner of a large property portfolio as well as being a full-time politician, Fahey is clearly an optimist by nature when it comes to investing money. It may well be he will put his money where his mouth is and buy shares in BoI himself.

If he did so last Friday he would have lost money. Last Thursday evening the shares were traded at €1.30c. On Friday news began to spread that the bank might not be allowed by the European Commission (EC) to make the dividend payment due on the state’s investment in €3.5bn worth of preference shares it had purchased last year. Confirmation came after the markets shut on Friday. The shares fell 11c to €1.18c on the day Fahey spoke to me. By Wednesday they were down to €1.08c. The value of the Government’s new shares is falling fast already. This put a value on Bank of Ireland of just €75 million higher than €1 billion.

Finance Minister Brian Lenihan put a brave face on things, as is his wont. He admitted that taking the cash had been the preferred option but insisted that getting the shares would provide value for the state. He emphasised the reason this happened was not that BoI did not have ready cash available but that the EC had not completed its deliberations over NAMA, to which BoI will transfer €16bn of its loans. He is confident that when approval is given, which is taken as a given, further dividend payments can be made out of cash instead of in shares.

You would have to hope so because by the time the next payment is due the state is likely to have even more shares in BoI, a majority in fact. The transfer of those loans to NAMA is going to be in exchange for bonds worth at least 30% less (and possibly much less). The losses on the transaction will wipe out the remaining capital at the bank. It will seek to sell assets to raise cash, although as a distressed seller it cannot expect to get very good prices. It will seek to raise capital by issuing new shares on the markets but again the chances of finding buyers must be slim. The belief, up until last weekend, was that BoI was about to do this, but it is likely to be far more difficult after the creation of 180 million new shares to give to the state (diluting the value of existing shares while doing this).

Instead, the Government is going to have to pump billions of euro worth of new capital into the bank. But how will it get value for its shares while not taking full ownership of the bank?

The Government is determined not to take full ownership of the banks. One reason is that the EC and European Central Bank (ECB) have told it not to do so. What those institutions say goes: they are unlikely financially to support the issue of the NAMA bonds in those circumstances.

The EC and ECB do not believe banks work well out of the glare of public transparency (although most didn’t do well enough either when owned by private enterprise). Nor does the state want its balance sheet to become responsible for the debts of the banks, as would happen in full ownership. That would make the cost of borrowing to the state higher.

It also didn’t want to wipe out the investments of existing shareholders, big and small, in the banks, as happened at Anglo Irish Bank when it was nationalised. This left them with something, even if very small, rather than nothing, a small consolation to pensioners or pension funds, for example. This, however, was a form of subsidy by the state. In a normal capitalist system all shareholders should have been wiped out.

We now have the bizarre situation whereby the banks which should have gone bust are being kept alive by the generosity of the state but they now have the power to put good businesses out of action. Banks are behaving outrageously in their efforts to protect what they have: they are not making fresh loans to customers with good records and are squeezing overdraft facilities on the basis that they are not sure about the repayment capabilities of customers. This becomes a self-fulfilling prophecy. Good customers are finding they are having to pay more for existing loans even when they have never missed a repayment.

Take, for example, a company that borrowed money for a property purchase. It may have used a lot of cash and borrowed just 40% of what was the value of the property. However, the property falls in value and the sum borrowed now equals 80% of the new value. The bank requires the borrower – who has never missed a repayment – to pay a higher rate of interest because it is in the small print of the loan agreement. The monthly repayments now attract an interest rate 2% higher. If the company is really unlucky it will be required to make a cash payment to bring the debt-to-equity ratio back to the old level of 40%. But where is the company going to get the money? It could have the loan called in. The company – which has done nothing wrong – is in danger of losing its investment because the bank – which got all its other actions wrong – needs to squeeze it for cash.

It gets worse. AIB this week said it is no longer accommodating “switchers”, domestic home-owners who want to move mortgages to secure a better interest rate. AIB is not interested in the business because it doesn’t have the money to finance the loans. It is only offering loans to first-time buyers who may be few and far between. This implies that competition between the banks is going to stagnate, which is not good news for all kinds of customers.

THESE are the banks we should own. Leaving the valuations involved in NAMA aside for another day – although they create legitimate fears that the state is going to overpay massively for the loans NAMA is buying – we should be questioning what value for money the citizens of the state have received for their beneficence towards BoI and AIB.

Both have received €3.5bn from us, without which they may well have gone bust. The Government, via our National Pension Reserve Fund, invested in preference shares instead of ordinary ones. Such shares are supposed to guarantee an annual return, ahead of anything for other shareholders. To all intents and purposes preference shares are fixed rate loans because they have no voting powers and because they have a guaranteed annual interest rate attached, in this case 8%. It is only in exceptional circumstances that they should be converted to ordinary shares.

If the state had invested €3.5bn in the ordinary shares of both banks it would have taken immediate ownership. It would also have overpaid but that would have been regarded as necessary because without the extra capital the banks would collapse. There is a good argument that the state should have taken full ownership on day one. Instead, we are told NAMA will make an eventual profit – what are the long odds here? – and that the new shares in Bank of Ireland will make a profit too.

The Last Word with Matt Cooper is broadcast on 100-102 Today FM, Monday to Friday, 4.30pm to 7pm.