Bank of Ireland BKIR LN
January 20, 2012 - 5:35pm EST by
lvampa1070
2012 2013
Price: 0.09 EPS NM -$0.04
Shares Out. (in M): 30,120 P/E 0.0x 0.0x
Market Cap (in M): 2,900 P/FCF 0.0x 0.0x
Net Debt (in M): 126,000 EBIT 0 0
TEV: 0 TEV/EBIT 0.0x 0.0x

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  • Ireland
  • Banks
 

Description

INTRODUCTION

Bank of Ireland is a systemically important and regionally dominant bank. The common stock has a present fair value in the range of €0.05 to €0.23, or -45% and +175% compared with today’s price of €0.085. Perhaps this qualifies as an intelligent speculation, rather than a “value” investment. The share price has recently fluctuated between €0.075 and €0.10; at the low end the investment is particularly compelling because of the €0.05 per share price of €1 billion of contingent capital.

The upside case has three main assumptions.  First is deleveraging.  BoI reduces its assets from €155 billion (Jun-11) to €125 billion.  Second is loan losses.  BoI does not need to increase the share count any further.  Third is profitability.  BoI recovers to 80bps return on assets (ROA).  The timing is 2015.  EPS are €0.033 and tangible book value per share €0.30.

The downside case outcomes follow.  First, BoI shrinks to €100 billion.  Second, losses force the €1 billion of debt held by the Irish government to convert into 20 billion shares, increasing shares outstanding from 30 billion to 50 billion.  Third, profitability recovers to 50bps ROA.  EPS are €0.010 and tangible book value per share €0.12.

For background on the Irish banking industry and the Irish credit bubble, refer to the papers at the end of this post.

HOW BANK OF IRELAND IS UNIQUE

The point is that BoI -- the assets and infrastructure -- is not going away and some day may be an attractive franchise again. Of course, the current equity holders could be wiped out while the enterprise carries on.  But that risk is addressed in the credit discussion later.

1) Leading market share in a consolidated market. Last year the Irish government designated Bank of Ireland (BoI) and Allied Irish Bank (AIB) as Ireland’s two “Pillar banks.” They are receiving government support, while the other four major domestic banks have been placed in run-off or absorbed.

Government support will have a direct impact on BoI’s per share value under an adverse scenario.  In Jul-11, the State purchased €1 billion of Bank of Ireland debt that will convert to common equity at a price of not less than €0.05 per share if BoI becomes capital deficienct (e.g. Core Tier 1 falls below 8.25%). In other words, if BoI needs more common equity, the next €1 billion has already been arranged at a cost of no less than €0.05 per share (higher of €0.05 or the prior 30-day average). In the event that BoI required even more equity capital, the investor group that contributed €1 billion of equity in July-11 at €0.10 per share is a likely supplier (Capital Group, Fairfax, Fidelity, and WL Ross).    

One in three Irish consumers (and businesses) deposits money with BoI, which opened in 1784 and operates 248 branches of approximately 825 in Ireland.  AIB holds a similar market share.  New entrants in Irish banking are unlikely, and many foreign banks are retreating, so customers are stuck with BoI and AIB.  While BoI’s total deposits fell sharply as multinationals fled following the downgrade in the financial strength rating of the Irish sovereign in 2010, retail deposits in both Ireland and the UK have remained stable.

2) Superior credit culture.  Numerous factors indicate that BoI’s credit culture is better than other Irish banks. These are a few to consider (see the end of this post for supporting data):

  • lowest loan growth during the credit bubble; 
  • lowest accumulation of construction loans; 
  • smallest haircut on loans transferred to Ireland’s “bad bank,” the National Asset Management Agency (NAMA), on a small volume transferred;
  • arrears on residential mortgage are significantly below the total in Ireland;
  • fewest citations in Phil Ingram’s survey of commercial property valuation firms queried about “Aggressive UK commercial property lending,” and;
  • lowest lifetime credit losses projected by BlackRock in Prudential Capital Assessment Review (PCAR). 

2) Joint venture with UK Post Office.  Since 2007, BoI has been increasing its UK retail deposits by £280 million per month. In the second half of 2011, the rate was £500 million per month.  The Bank has over 2.3 million customers which transact through a joint venture with the UK Post Office and its 11,500 branches.  The JV has operated since 2004.

About half of BoI’s total loans are not in Ireland, with most in the UK (a total of around £39 billion at year end), consisting mostly of residential mortgages. Historically, these loans were funded with wholesale borrowings. Since that funding is no longer available, BoI has placed £17 billion of the portfolio into run-off.  So right now in the UK, each month BoI’s loans decline by £280 million, while deposits increase by £500 million. The loan-to-deposit ratio for the UK retail bank will fall below 100% during the second half of 2012 if the current pace continues.

FUNDING APPEARS SAFE FOR NOW

Background of BoI’s funding crisis. The Irish banks, led by Anglo Irish, began to experience funding trouble in 2008, which culminated in an expansive government guaranty on September 29.  Bouyed by this guarantee, BoI continued to issue unsecured term funding intermittently until the Irish government bailout in November 2010, but required liquidity assistance from the ECB as early as 2009. 

Currently, BoI is relying on liquidity facilities provided by the European Central Bank and the Central Bank of Ireland until certain non-core loans mature.  In addition to direct funding assistance, BoI is “benefiting” from Eligible Lliability Guarantees (ELG) from the Irish state on term debt up to five years, excluding subordinated debt and covered bonds, as well as deposits in excess of €100,000.  The ELG cost BoI €239 million in the first half of 2011 and the balance of covered liabilities was €43 billion at Jun-11. 

Wholesale funding provided by the ECB and the Central Bank of Ireland equaled €23 billion and €7 billion on June 30, 2011, out of total wholesale funding of €61 billion.  By the end of 2011, BoI will have repaid the Central Bank and replaced much of its ECB borrowings with the ECB’s three year Long Term Refinancing Operation (LTRO). 

Emergency funding will subside as non-core loans mature and are not renewed.  With €115 billion in loans and €65 billion in deposits at the end of 2010, BoI had a €50 billion funding gap.  There are three main variables for BoI to close this cap and to eliminate reliance on ECB funding: (1) loan maturities, (2) loan disposals, and (3) deposit growth. 

1) Loan maturities = €14+ billion.  Persuant to orders from the Central Bank, BoI split its loan portfolio at Dec-10 into core (€82 billion) and non-core (€33 billion).  In aggregate, €51 billion of loans will mature between 2010 and 2015, roughly €10 billion each year.  The Central Bank expects BOI to renew the core loans, which are primarily to Irish customers.  Likewise, the Central Bank expects the non-core loans to be run-off (€14 billion) or sold (€10 billion).         

Loan run-off proceeded as expected during 2011.  Since the non-core portfolio consists primarily of UK residential mortgages (€9 billion) and UK commercial mortgages (€3 billion), the likelihood of repayment or is greater than if the borrowers were Irish customers with poorer access to credit.   

2) Loan disposals = €10+ billion.  BoI has already completed disposals of €8.6 billion in loans. (For details see http://www.bankofireland.com/fs/doc/wysiwyg/Sale%20of%20Burdale%20and%20Deleveraging%20Update.pdf.) Management is likely to explore disposals beyond the €10 billion initially targeted given that haircuts so far have been well below budget.   

3) Deposit growth = €10-15 billion.  A deposit war is underway in Ireland as banks endeavor to meet loan-to-deposit targets set by the government and ECB/EU/IMF.  BoI has been able to increase deposits in Ireland slightly, but growth in the UK has been well ahead of expectations.  Accordingly, deposits increased from €65 billion at 12/10 to €67 billion at 9/10, keeping BoI just behind targeted growth of ~€3 billion per year.
 
Wholesale funding (€, bn) 2012 2013 2014 2015
Opening balance           51.0           44.1           38.5           31.5
ECB           20.0           18.0           18.6           15.1
Other           31.0           26.1           19.9           16.4
Cash inflows        
Loan redemptions             3.5             3.5             3.5             3.5
Loan sales             1.4               -                 -                 -  
Deposit growth             2.0             2.0             3.0             4.0
Repayments from NAMA               -               0.1             0.5             0.5
Cash outflow for LT debt maturities          (4.9)          (6.2)          (3.5)          (5.0)
Net available to reduce ECB borrowing             2.0          (0.6)             3.5             3.0
Closing balance           44.1           38.5           31.5           23.5
ECB           18.0           18.6           15.1           12.1
Other           26.1           19.9           16.4           11.4
 
 
Debt maturities look manageable.  Per debt distributions reported by Bloomberg, BoI’s maturities are spread fairly evenly over the next four years.  There are a few peaks, with €2.4 billion due in the first quarter of 2012, and similar amounts in the second and third quarters of 2013.  But generally, expected loan maturities and deposit growth should cover debt maturities, while leaving some excess to repay the ECB.  In addition, BoI holds €19 billion of available for sale securities, including UK T-bills and covered bonds that could be sold if necessary.
 
Funding profile (€, bn) 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13
LT debt maturities -2.4 -0.8 -0.9 -0.8 -0.5 -2.6 -2.1 -1.0
Loan redemptions 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9
Loan sales 1.4 0 0 0 0 0 0 0
Deposit growth 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5
Net cash to repay ECB 0.3 0.6 0.5 0.6 0.9 -1.2 -0.8 0.4
 
RECAPITALIZED TO MAINTAIN A CORE TIER 1 RATIO OF 12%+ BASED ON BLACKROCK LOSS ESTIMATE

Two outside parties performed lifetime loss forecasts on BoI’s loan portfolio during 2011.  BlackRock Solutions was indendent, hired by the Central Bank of Ireland.  Oliver Wyman was quasi-independent, since BoI hired them.  The Central Bank desired Irish banks maintain a core tier 1 capital ratio of more than 10.5%, so the BlackRock loss forecasts was used to determine how much capital the banks were forced to raise (with a backstop provided by the Irish government).      

BlackRock estimated lifetime losses of €7.4 billion and €10.1 billion for €126 billion of BoI loans.  Focusing on the stress case, BlackRock’s key assumptions for 2012 and 2013 were as follows (recall that 50% of the BoI loans evaluated were in the UK): 

  • Irish GDP growth of 0.3% and 1.4%,
  • Irish unemployment of 15.8% and 15.6%,
  • UK unemployment of 10.5% and 10.3%
  • house price depreciation in Ireland of  59% from peak-to-trough,
  • house price depreciation in the UK of 25% from peak-to-trough,
  • commercial property price depreciation in Ireland of  70% from peak-to-trough, and 
  • commercial price depreciation in the UK of 41% from peak-to-trough.

The 59% peak-to-trough decline in Irish home prices is a reasonable one, but seems light.  For example, secondhand homes peaked at 12x income in 2006.  To return to the historical ratio of 4x requires a 67% decline from peak.  The current ratio is estimated at 5.5x.   

Oliver Wyman estimated lifetime losses of €6 billion and €7.9 billion.  The difference between the two forecasts centers on commercial mortgages.  BlackRock assumed immediate default for all borrowers with a LTV over 120% regardless of debt-service-coverage, and assumed immediate default for all borrowers with a property debt-service-coverage below 1.0x regardless of other sources of repayment. Furthermore, BlackRock assumed liquidation without workout.      

Another difference is that BlackRock spent several months on the analysis in 2011 and reviewed 75% of all commercial mortgages over €50 million.  Oliver Wyman conducted a loan loss forecast for BoI management in 2009, 2010, and 2011 with full access to all BoI’s loan files. 

BoI’s share count has increased from 1.5 billion before the financial crisis to 30 billion today.  Credit losses are difficult to predict, and I don’t have confidence in any one. Instead, I prefer to consider various scenarios. For the sake of brevity, only one scenario is presented below.  It approximates the BlackRock “stress” loss case.

The TCE ratio remains around 4.0% or higher with €10 billion of loan losses (excluding €865 million of losses related to loans sold to NAMA) while pre-tax pre-provision earnings remain below 1.00% of assets for most of the forecast period. Tangible book value per share bottoms at €0.16 in 2013 when the Bank reaches breakeven.    

     
Period end Gross loans Loan loss reserve Provision Cum. Provision since Sep-07 Cum Loss rate Tangible equity Tangible assets TCE ratio Pre-tax pre-provision earnings
Sep-06        114,753                397                  48 XX XX            5,030        176,747 2.8%                852
Mar-07        125,476                428                  55 XX XX            5,456        187,870 2.9%                848
Sep-07        133,560                482                  79 XX XX            6,391        199,012 3.2%                951
Mar-08        136,334                596                148                    148 0.1%            5,732        196,571 2.9%                843
Sep-08        145,130                841                267                    415 0.3%            5,609        203,395 2.8%                650
Mar-09        135,521            1,781            1,168                1,583 1.2%            2,990        193,605 1.5%            1,237
Sep-09        134,790            3,475            1,787                3,370 2.5%            3,831        183,794 2.1%                808
Dec-09        134,671            5,775            2,268                5,638 4.2%            2,332        180,599 1.3%                242
Jun-10        124,879            6,638            1,825                7,463 5.6%            5,390        179,953 3.0%                479
Dec-10        119,432            5,050            2,532                9,995 7.5%            4,976        167,021 3.0%                538
Jun-11        111,902            5,427                885              10,880 8.1%            8,409        155,051 5.4%                163
Dec-11        104,500            5,500            1,522              12,402 9.3%            7,256        143,613 5.1%                125
Jun-12        100,000            5,000            1,000              13,402 10.0%            6,613        139,113 4.8%                220
Dec-12          96,650            4,250            1,100              14,502 10.9%            5,974        135,763 4.4%                325
Jun-13          92,800            3,500            1,100              15,602 11.7%            5,429        131,913 4.1%                440
Dec-13          88,650            2,750                900              16,502 12.4%            5,128        115,263 4.4%                535
Jun-14          84,800            2,000                600              17,102 12.8%            5,156        111,413 4.6%                635
Dec-14          81,300            1,500                500              17,602 13.2%            5,267        107,913 4.9%                635
Jun-15          78,075            1,200                425              18,027 13.5%            5,457        104,688 5.2%                655
Dec-15          74,950            1,000                425              18,452 13.8%            5,646        101,563 5.6%                655
 
http://www.bankofireland.com/about-boi-group/press-room/press-releases/item/251/statement-on-the-2011-prudential-capital-assessment-review-and-capital-requirement/
 
RETURN TO 1980s PROFITABILITY SEEMS REASONABLE AND WOULD PRODUCE 10-20% EARNINGS YIELDS

BoI should achieve annual returns on assets (ROAs) of 0.50%-0.80%.  The table below illustrates that since 1995, the trailing 10-year ROA has averaged between 0.42% and 1.18%.   

Year ROA 10yr Avg   Year ROA 10yr Avg   Year ROA 10yr Avg
1986 0.62% NA   1996 1.08% 0.72%   2006 0.90% 1.11%
1987 0.63% NA   1997 1.31% 0.79%   2007 0.94% 1.07%
1988 0.70% NA   1998 1.25% 0.85%   2008 0.88% 1.04%
1989 0.80% NA   1999 1.52% 0.92%   2009 -0.91% 0.79%
1990 0.81% NA   2000 1.17% 0.95%   2010 -0.34% 0.64%
1991 0.19% NA   2001 1.02% 1.04%   2011e -1.17% 0.42%
1992 0.19% NA   2002 1.10% 1.13%        
1993 0.48% NA   2003 0.94% 1.18%        
1994 1.11% NA   2004 0.96% 1.16%        
1995 1.25% 0.68%   2005 0.93% 1.13%        

Three key drivers for a return to profitability are: (1) a reduction in credit losses, (2) elimination in fees for the government’s eligible liabilities guaranty, and (3) partial normalization in deposit rates.  These three factors boost the ROA by nearly 150bps. 

  • A return to historical norms in the provision for loan losses would case a reduction from €1,500-€2,000 million currently to more like €600 million. (This more normal provision is equal to 60-80bps of gross loans.) 
  • Second, BoI paid €434 million for the ELG during the past 12 months. The ELG has been extended into 2012, but certainly will not be renewed perpetually, cutting the expense to zero. 
  • Finally, BoI's deposit costs are abnormally high given the funding crisis.  The Bank is paying 120bps more for deposits in Ireland than the ECB rate compared with 50bps less during 2004-06.  A reduction in the charge of this spread halfway back to historic levels adds another €375 million annually to profits.
The run-rate of profit before tax is around a loss of €1,200 million. Making the three adjustments described above would boost the figure to €700-800 million, all else equal.  After tax that equals €575-660 million, or €0.019-0.022 per share, and 40-45bps of current assets and 55-65bps of projected 2015 assets.
 
A review of ROAs for banks in the US during the last century suggests that ROAs of 50-80bps are reasonable.  The average of 77 years (1934-2010) of FDIC reported annual US bank ROAs is 0.75% with a standard deviation of 0.35%. The lowest 10 year average was 0.45% for the period 1934-43. The highest was 1.27% for the period 1997-06.
 
While the Irish regulators have taken a completely different approach relative to the Japanese, which makes the comparison less relevant, the large banks in Japan have returned 20-50bps on assets in good times during the past two decades.
 
Discussing banking profitability among various nations, a report for the Department of Finance stated: "One study has found that where banks play a larger role in the economy and concentration is lower, margins and profits tend to be lower.  This study also found that foreign banks tend to have lower margins than domestic banks in developed countries. In the Irish case, there is a relatively high level of concentration in the domestic banking market and a large role for banks in the economy.  These factors are associated with a relatively high level of profitability." 
 
Considerable deleveraging is planned on the path to normalization of earnings.  A common mistake made by investors estimating normal earnings for banks these days, in my view, is to apply too high of an ROA to too high of an asset base.  The world just got crazy with leverage.  Ireland was perhaps the worst.  In the 1980s, the ratio of loans at BoI to GDP in Ireland was consistently around 30-35%.  This makes sense because BoI has about 30% market share.  The acquisition of a UK bank in 1998 expanded BoI's addressable market and reset the ratio to 50%, a level at which it remained until 2005, after which it increased sharply to peak at 88%. 
 
Because construction activity contributed one fifth of Irish national income at the peak of the bubble in 2007, it makes sense that GDP will be below peak. It seems reasonable that GDP recovers a bit from today, perhaps to 90% of peak by 2015, or €175 billion.  A ratio loans/GDP of 30-40% suggests that BoI's loan portfolio in Ireland would be €50-70 billion.  Today, BoI has about €50 billion of loans in Ireland and €50 billion outside Ireland.  Interestingly, the plan outlined by the Central Bank and BoI management calls for a reduction in loans to €70-90 billion. The Irish portion is 30-40% of Irish GDP, and the total is 40-50% of Irish GDP. 
    
A WIDE RANGE OF PLAUSIBLE VALUES, BUT EXPECTATIONS APPEAR UNDEMANDING
 
The tables below illustrate a range of fair values.  For example, should BoI require the €1 billion of debt to convert to equity, which will reduce the share count by 20 billion, trough book value per share is still higher than the current share price, and earning power looks like €0.01-0.02 per share, or 10-20% of the current share price. 
 
Upside scenario   Middling scenario   Adverse scenario   Alternative scenario
Loans  €     91,200   Loans  €          70,000   Loans  €          70,000   Loans  €          91,200
Equity  €       8,900   Equity  €             4,800   Equity  €             5,800   Equity  €             8,900
Assets  €   125,600   Assets  €        102,000   Assets  €        102,000   Assets  €        125,600
Net  €       1,005   Net  €                510   Net  €                510   Net  €             1,005
E/A 7.1%   E/A 4.7%   E/A 5.7%   E/A 7.1%
ROA 0.80%   ROA 0.50%   ROA 0.50%   ROA 0.80%
Shares         30,000   Shares               30,000   Shares               50,000   Shares               50,000
EPS  €       0.033   EPS  €             0.017   EPS  €             0.010   EPS  €             0.020
P/E 12x   P/E 10x   P/E 8x   P/E 12x
Target 1/2016  €       0.402   Target 1/2016  €             0.170   Target 1/2016  €             0.082   Target 1/2016  €             0.241
Discount rate 15%   Discount rate 15%   Discount rate 15%   Discount rate 15%
2015  €       0.349   2015  €             0.148   2015  €             0.071   2015  €             0.210
2014  €       0.304   2014  €             0.129   2014  €             0.062   2014  €             0.182
2013  €       0.264   2013  €             0.112   2013  €             0.054   2013  €             0.159
Jan-2012  €       0.230   Jan-2012  €             0.097   Jan-2012  €             0.047   Jan-2012  €             0.138
Current price  €       0.090   Current price  €             0.090   Current price  €             0.090   Current price  €             0.090
Change  €       0.140   Change  €             0.007   Change  €          (0.043)   Change  €             0.048
Change 155%   Change 8%   Change -48%   Change 53%

Consider the ratio of market-value-to-assets and capital ratios for the largest bank in the PIIGS and several additional countries. 

Country Bank Name  Market Cap   Assets  Cap/Assets TCE Ratio CT1 Ratio
Portugal Banco Espirito Santo 1,566                82,767 1.9% 6.5% 9.3%
Ireland Bank of Ireland 2,711              155,438 1.7% 5.8% 15.4%
Italy UniCredit S.p.A. 12,216              950,296 1.3% 3.9% 8.3%
Greece National Bank of Greece S.A. 1,396              115,499 1.2% 5.5% 3.2%
Spain Banco Santander S.A. 51,872          1,250,476 4.1% 3.6% 8.9%
             
US Bank of America  $       63,543  $      2,219,628 2.9% 6.2% 8.9%
UK Royal Bank of Scotland Group Plc  £       12,518  £      1,607,728 0.8% 3.6% 10.9%
Germany Commerzbank AG 6,888              738,240 0.9% 2.5% 8.8%
France Societe Generale S.A. 13,167          1,247,000 1.1% 3.8% 8.2%
 
 
DATA SUPPORTING BOI'S SUPERIOR UNDERWRITING
 
LOWEST LOAN GROWTH DURING THE CREDIT BUBBLE  
  Loans Loans 2003-06  
Bank name 2003 2006 CAGR  
Bank of Ireland          75,700        132,700 21%  
Allied Irish Banks          53,300        120,000 31%  
Anglo Irish          18,100          50,200 40%  
Irish Life & Permanent          19,900          42,200 28%  
EBS Building Society            8,500          14,600 20%  
         
Source: Annual reports & "Preliminary Report on the Sources of Ireland's Banking Crisis," Regling

 

 
LOWEST ACCUMULATION OF CONSTRUCTION & PROPERTY LOANS  
Bank name Ratio of construction & property loans to capital  
Bank of Ireland 3.0  
Allied Irish Banks 3.5  
Anglo Irish 12.5  
Irish Nationwide Building Society 7.4  
     
Source: "Preliminary Report on the Sources of Ireland's Banking Crisis," Regling, p. 32
 
SMALLEST HAIRCUT ON LOANS TRANSFERRED TO NAMA    
Bank name Loans (€, bn) 
transferred
Discount Total Loans Transferred/Total
Bank of Ireland 9 42%               125 7%
Allied Irish Banks 19 55%               128 15%
Anglo Irish 34 62%                 75 45%
Irish Nationwide Building Society 9 64%                 12 73%
EBS Building Society 1 61%                 16 6%
Total 63 58%               231 27%
         
Source: National Treasury Management Agency, Ireland on Path to Recovery, Oct-11
 
LOWEST 90+ DAY ARREARS ON IRISH RESIDENTIAL MORTGAGES    
Bank name Dec-09 Jun-10 Dec-10 Jun-11 Sep-11
Bank of Ireland 2.76% 3.49% 4.17% 5.18% N/A
Allied Irish Banks 1.96% 3.21% 4.80% 7.82% N/A
EBS Building Society 5.20% N/A 8.40% N/A N/A
Irish Life & Permanent 3.90% 5.20% 6.80% 8.80% N/A
Ireland - total owner occupied 3.61% 4.61% 5.66% 7.20% 8.10%
           
Source: Central Bank of Ireland, company reports.        
 
LEAST AGGRESSIVE UK COMMERCIAL MORTGAGE LENDER IN SURVEY  
Bank name Number of Citations by appraisers for "Aggressive UK Commercial property lending"  
Anglo Irish 5  
Allied Irish Banks 5  
Royal Bank of Scotland 5  
Barclays 5  
Deutsche Bank 5  
Goldman Sachs 2  
Bank of Ireland 1  
Irish Nationwide Building Society 1  
     
Source: Reuters story citing Phil Ingram's research report at Merrill which is now quite difficult to locate
 
PAPERS ON IRISH CREDIT BUBBLE
http://www.ucd.ie/t4cms/wp09.32.pdf
http://bankinginquiry.gov.ie/Preliminary%20Report%20into%20Ireland's%20Banking%20Crisis%2031%20May%202010.pdf

http://www.vanityfair.com/business/features/2011/03/michael-lewis-ireland-201103

Catalyst

Need losses to materialize without additional share issuance. Will take time.
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    Description

    INTRODUCTION

    Bank of Ireland is a systemically important and regionally dominant bank. The common stock has a present fair value in the range of €0.05 to €0.23, or -45% and +175% compared with today’s price of €0.085. Perhaps this qualifies as an intelligent speculation, rather than a “value” investment. The share price has recently fluctuated between €0.075 and €0.10; at the low end the investment is particularly compelling because of the €0.05 per share price of €1 billion of contingent capital.

    The upside case has three main assumptions.  First is deleveraging.  BoI reduces its assets from €155 billion (Jun-11) to €125 billion.  Second is loan losses.  BoI does not need to increase the share count any further.  Third is profitability.  BoI recovers to 80bps return on assets (ROA).  The timing is 2015.  EPS are €0.033 and tangible book value per share €0.30.

    The downside case outcomes follow.  First, BoI shrinks to €100 billion.  Second, losses force the €1 billion of debt held by the Irish government to convert into 20 billion shares, increasing shares outstanding from 30 billion to 50 billion.  Third, profitability recovers to 50bps ROA.  EPS are €0.010 and tangible book value per share €0.12.

    For background on the Irish banking industry and the Irish credit bubble, refer to the papers at the end of this post.

    HOW BANK OF IRELAND IS UNIQUE

    The point is that BoI -- the assets and infrastructure -- is not going away and some day may be an attractive franchise again. Of course, the current equity holders could be wiped out while the enterprise carries on.  But that risk is addressed in the credit discussion later.

    1) Leading market share in a consolidated market. Last year the Irish government designated Bank of Ireland (BoI) and Allied Irish Bank (AIB) as Ireland’s two “Pillar banks.” They are receiving government support, while the other four major domestic banks have been placed in run-off or absorbed.

    Government support will have a direct impact on BoI’s per share value under an adverse scenario.  In Jul-11, the State purchased €1 billion of Bank of Ireland debt that will convert to common equity at a price of not less than €0.05 per share if BoI becomes capital deficienct (e.g. Core Tier 1 falls below 8.25%). In other words, if BoI needs more common equity, the next €1 billion has already been arranged at a cost of no less than €0.05 per share (higher of €0.05 or the prior 30-day average). In the event that BoI required even more equity capital, the investor group that contributed €1 billion of equity in July-11 at €0.10 per share is a likely supplier (Capital Group, Fairfax, Fidelity, and WL Ross).    

    One in three Irish consumers (and businesses) deposits money with BoI, which opened in 1784 and operates 248 branches of approximately 825 in Ireland.  AIB holds a similar market share.  New entrants in Irish banking are unlikely, and many foreign banks are retreating, so customers are stuck with BoI and AIB.  While BoI’s total deposits fell sharply as multinationals fled following the downgrade in the financial strength rating of the Irish sovereign in 2010, retail deposits in both Ireland and the UK have remained stable.

    2) Superior credit culture.  Numerous factors indicate that BoI’s credit culture is better than other Irish banks. These are a few to consider (see the end of this post for supporting data):

    2) Joint venture with UK Post Office.  Since 2007, BoI has been increasing its UK retail deposits by £280 million per month. In the second half of 2011, the rate was £500 million per month.  The Bank has over 2.3 million customers which transact through a joint venture with the UK Post Office and its 11,500 branches.  The JV has operated since 2004.

    About half of BoI’s total loans are not in Ireland, with most in the UK (a total of around £39 billion at year end), consisting mostly of residential mortgages. Historically, these loans were funded with wholesale borrowings. Since that funding is no longer available, BoI has placed £17 billion of the portfolio into run-off.  So right now in the UK, each month BoI’s loans decline by £280 million, while deposits increase by £500 million. The loan-to-deposit ratio for the UK retail bank will fall below 100% during the second half of 2012 if the current pace continues.

    FUNDING APPEARS SAFE FOR NOW

    Background of BoI’s funding crisis. The Irish banks, led by Anglo Irish, began to experience funding trouble in 2008, which culminated in an expansive government guaranty on September 29.  Bouyed by this guarantee, BoI continued to issue unsecured term funding intermittently until the Irish government bailout in November 2010, but required liquidity assistance from the ECB as early as 2009. 

    Currently, BoI is relying on liquidity facilities provided by the European Central Bank and the Central Bank of Ireland until certain non-core loans mature.  In addition to direct funding assistance, BoI is “benefiting” from Eligible Lliability Guarantees (ELG) from the Irish state on term debt up to five years, excluding subordinated debt and covered bonds, as well as deposits in excess of €100,000.  The ELG cost BoI €239 million in the first half of 2011 and the balance of covered liabilities was €43 billion at Jun-11. 

    Wholesale funding provided by the ECB and the Central Bank of Ireland equaled €23 billion and €7 billion on June 30, 2011, out of total wholesale funding of €61 billion.  By the end of 2011, BoI will have repaid the Central Bank and replaced much of its ECB borrowings with the ECB’s three year Long Term Refinancing Operation (LTRO). 

    Emergency funding will subside as non-core loans mature and are not renewed.  With €115 billion in loans and €65 billion in deposits at the end of 2010, BoI had a €50 billion funding gap.  There are three main variables for BoI to close this cap and to eliminate reliance on ECB funding: (1) loan maturities, (2) loan disposals, and (3) deposit growth. 

    1) Loan maturities = €14+ billion.  Persuant to orders from the Central Bank, BoI split its loan portfolio at Dec-10 into core (€82 billion) and non-core (€33 billion).  In aggregate, €51 billion of loans will mature between 2010 and 2015, roughly €10 billion each year.  The Central Bank expects BOI to renew the core loans, which are primarily to Irish customers.  Likewise, the Central Bank expects the non-core loans to be run-off (€14 billion) or sold (€10 billion).         

    Loan run-off proceeded as expected during 2011.  Since the non-core portfolio consists primarily of UK residential mortgages (€9 billion) and UK commercial mortgages (€3 billion), the likelihood of repayment or is greater than if the borrowers were Irish customers with poorer access to credit.   

    2) Loan disposals = €10+ billion.  BoI has already completed disposals of €8.6 billion in loans. (For details see http://www.bankofireland.com/fs/doc/wysiwyg/Sale%20of%20Burdale%20and%20Deleveraging%20Update.pdf.) Management is likely to explore disposals beyond the €10 billion initially targeted given that haircuts so far have been well below budget.   

    3) Deposit growth = €10-15 billion.  A deposit war is underway in Ireland as banks endeavor to meet loan-to-deposit targets set by the government and ECB/EU/IMF.  BoI has been able to increase deposits in Ireland slightly, but growth in the UK has been well ahead of expectations.  Accordingly, deposits increased from €65 billion at 12/10 to €67 billion at 9/10, keeping BoI just behind targeted growth of ~€3 billion per year.
     
    Wholesale funding (€, bn) 2012 2013 2014 2015
    Opening balance           51.0           44.1           38.5           31.5
    ECB           20.0           18.0           18.6           15.1
    Other           31.0           26.1           19.9           16.4
    Cash inflows        
    Loan redemptions             3.5             3.5             3.5             3.5
    Loan sales             1.4               -                 -                 -  
    Deposit growth             2.0             2.0             3.0             4.0
    Repayments from NAMA               -               0.1             0.5             0.5
    Cash outflow for LT debt maturities          (4.9)          (6.2)          (3.5)          (5.0)
    Net available to reduce ECB borrowing             2.0          (0.6)             3.5             3.0
    Closing balance           44.1           38.5           31.5           23.5
    ECB           18.0           18.6           15.1           12.1
    Other           26.1           19.9           16.4           11.4
     
     
    Debt maturities look manageable.  Per debt distributions reported by Bloomberg, BoI’s maturities are spread fairly evenly over the next four years.  There are a few peaks, with €2.4 billion due in the first quarter of 2012, and similar amounts in the second and third quarters of 2013.  But generally, expected loan maturities and deposit growth should cover debt maturities, while leaving some excess to repay the ECB.  In addition, BoI holds €19 billion of available for sale securities, including UK T-bills and covered bonds that could be sold if necessary.
     
    Funding profile (€, bn) 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13
    LT debt maturities -2.4 -0.8 -0.9 -0.8 -0.5 -2.6 -2.1 -1.0
    Loan redemptions 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9
    Loan sales 1.4 0 0 0 0 0 0 0
    Deposit growth 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5
    Net cash to repay ECB 0.3 0.6 0.5 0.6 0.9 -1.2 -0.8 0.4
     
    RECAPITALIZED TO MAINTAIN A CORE TIER 1 RATIO OF 12%+ BASED ON BLACKROCK LOSS ESTIMATE

    Two outside parties performed lifetime loss forecasts on BoI’s loan portfolio during 2011.  BlackRock Solutions was indendent, hired by the Central Bank of Ireland.  Oliver Wyman was quasi-independent, since BoI hired them.  The Central Bank desired Irish banks maintain a core tier 1 capital ratio of more than 10.5%, so the BlackRock loss forecasts was used to determine how much capital the banks were forced to raise (with a backstop provided by the Irish government).      

    BlackRock estimated lifetime losses of €7.4 billion and €10.1 billion for €126 billion of BoI loans.  Focusing on the stress case, BlackRock’s key assumptions for 2012 and 2013 were as follows (recall that 50% of the BoI loans evaluated were in the UK): 

    The 59% peak-to-trough decline in Irish home prices is a reasonable one, but seems light.  For example, secondhand homes peaked at 12x income in 2006.  To return to the historical ratio of 4x requires a 67% decline from peak.  The current ratio is estimated at 5.5x.   

    Oliver Wyman estimated lifetime losses of €6 billion and €7.9 billion.  The difference between the two forecasts centers on commercial mortgages.  BlackRock assumed immediate default for all borrowers with a LTV over 120% regardless of debt-service-coverage, and assumed immediate default for all borrowers with a property debt-service-coverage below 1.0x regardless of other sources of repayment. Furthermore, BlackRock assumed liquidation without workout.      

    Another difference is that BlackRock spent several months on the analysis in 2011 and reviewed 75% of all commercial mortgages over €50 million.  Oliver Wyman conducted a loan loss forecast for BoI management in 2009, 2010, and 2011 with full access to all BoI’s loan files. 

    BoI’s share count has increased from 1.5 billion before the financial crisis to 30 billion today.  Credit losses are difficult to predict, and I don’t have confidence in any one. Instead, I prefer to consider various scenarios. For the sake of brevity, only one scenario is presented below.  It approximates the BlackRock “stress” loss case.

    The TCE ratio remains around 4.0% or higher with €10 billion of loan losses (excluding €865 million of losses related to loans sold to NAMA) while pre-tax pre-provision earnings remain below 1.00% of assets for most of the forecast period. Tangible book value per share bottoms at €0.16 in 2013 when the Bank reaches breakeven.    

         
    Period end Gross loans Loan loss reserve Provision Cum. Provision since Sep-07 Cum Loss rate Tangible equity Tangible assets TCE ratio Pre-tax pre-provision earnings
    Sep-06        114,753                397                  48 XX XX            5,030        176,747 2.8%                852
    Mar-07        125,476                428                  55 XX XX            5,456        187,870 2.9%                848
    Sep-07        133,560                482                  79 XX XX            6,391        199,012 3.2%                951
    Mar-08        136,334                596                148                    148 0.1%            5,732        196,571 2.9%                843
    Sep-08        145,130                841                267                    415 0.3%            5,609        203,395 2.8%                650
    Mar-09        135,521            1,781            1,168                1,583 1.2%            2,990        193,605 1.5%            1,237
    Sep-09        134,790            3,475            1,787                3,370 2.5%            3,831        183,794 2.1%                808
    Dec-09        134,671            5,775            2,268                5,638 4.2%            2,332        180,599 1.3%                242
    Jun-10        124,879            6,638            1,825                7,463 5.6%            5,390        179,953 3.0%                479
    Dec-10        119,432            5,050            2,532                9,995 7.5%            4,976        167,021 3.0%                538
    Jun-11        111,902            5,427                885              10,880 8.1%            8,409        155,051 5.4%                163
    Dec-11        104,500            5,500            1,522              12,402 9.3%            7,256        143,613 5.1%                125
    Jun-12        100,000            5,000            1,000              13,402 10.0%            6,613        139,113 4.8%                220
    Dec-12          96,650            4,250            1,100              14,502 10.9%            5,974        135,763 4.4%                325
    Jun-13          92,800            3,500            1,100              15,602 11.7%            5,429        131,913 4.1%                440
    Dec-13          88,650            2,750                900              16,502 12.4%            5,128        115,263 4.4%                535
    Jun-14          84,800            2,000                600              17,102 12.8%            5,156        111,413 4.6%                635
    Dec-14          81,300            1,500                500              17,602 13.2%            5,267        107,913 4.9%                635
    Jun-15          78,075            1,200                425              18,027 13.5%            5,457        104,688 5.2%                655
    Dec-15          74,950            1,000                425              18,452 13.8%            5,646        101,563 5.6%                655
     
    http://www.bankofireland.com/about-boi-group/press-room/press-releases/item/251/statement-on-the-2011-prudential-capital-assessment-review-and-capital-requirement/
     
    RETURN TO 1980s PROFITABILITY SEEMS REASONABLE AND WOULD PRODUCE 10-20% EARNINGS YIELDS

    BoI should achieve annual returns on assets (ROAs) of 0.50%-0.80%.  The table below illustrates that since 1995, the trailing 10-year ROA has averaged between 0.42% and 1.18%.   

    Year ROA 10yr Avg   Year ROA 10yr Avg   Year ROA 10yr Avg
    1986 0.62% NA   1996 1.08% 0.72%   2006 0.90% 1.11%
    1987 0.63% NA   1997 1.31% 0.79%   2007 0.94% 1.07%
    1988 0.70% NA   1998 1.25% 0.85%   2008 0.88% 1.04%
    1989 0.80% NA   1999 1.52% 0.92%   2009 -0.91% 0.79%
    1990 0.81% NA   2000 1.17% 0.95%   2010 -0.34% 0.64%
    1991 0.19% NA   2001 1.02% 1.04%   2011e -1.17% 0.42%
    1992 0.19% NA   2002 1.10% 1.13%        
    1993 0.48% NA   2003 0.94% 1.18%        
    1994 1.11% NA   2004 0.96% 1.16%        
    1995 1.25% 0.68%   2005 0.93% 1.13%        

    Three key drivers for a return to profitability are: (1) a reduction in credit losses, (2) elimination in fees for the government’s eligible liabilities guaranty, and (3) partial normalization in deposit rates.  These three factors boost the ROA by nearly 150bps. 

    The run-rate of profit before tax is around a loss of €1,200 million. Making the three adjustments described above would boost the figure to €700-800 million, all else equal.  After tax that equals €575-660 million, or €0.019-0.022 per share, and 40-45bps of current assets and 55-65bps of projected 2015 assets.
     
    A review of ROAs for banks in the US during the last century suggests that ROAs of 50-80bps are reasonable.  The average of 77 years (1934-2010) of FDIC reported annual US bank ROAs is 0.75% with a standard deviation of 0.35%. The lowest 10 year average was 0.45% for the period 1934-43. The highest was 1.27% for the period 1997-06.
     
    While the Irish regulators have taken a completely different approach relative to the Japanese, which makes the comparison less relevant, the large banks in Japan have returned 20-50bps on assets in good times during the past two decades.
     
    Discussing banking profitability among various nations, a report for the Department of Finance stated: "One study has found that where banks play a larger role in the economy and concentration is lower, margins and profits tend to be lower.  This study also found that foreign banks tend to have lower margins than domestic banks in developed countries. In the Irish case, there is a relatively high level of concentration in the domestic banking market and a large role for banks in the economy.  These factors are associated with a relatively high level of profitability." 
     
    Considerable deleveraging is planned on the path to normalization of earnings.  A common mistake made by investors estimating normal earnings for banks these days, in my view, is to apply too high of an ROA to too high of an asset base.  The world just got crazy with leverage.  Ireland was perhaps the worst.  In the 1980s, the ratio of loans at BoI to GDP in Ireland was consistently around 30-35%.  This makes sense because BoI has about 30% market share.  The acquisition of a UK bank in 1998 expanded BoI's addressable market and reset the ratio to 50%, a level at which it remained until 2005, after which it increased sharply to peak at 88%. 
     
    Because construction activity contributed one fifth of Irish national income at the peak of the bubble in 2007, it makes sense that GDP will be below peak. It seems reasonable that GDP recovers a bit from today, perhaps to 90% of peak by 2015, or €175 billion.  A ratio loans/GDP of 30-40% suggests that BoI's loan portfolio in Ireland would be €50-70 billion.  Today, BoI has about €50 billion of loans in Ireland and €50 billion outside Ireland.  Interestingly, the plan outlined by the Central Bank and BoI management calls for a reduction in loans to €70-90 billion. The Irish portion is 30-40% of Irish GDP, and the total is 40-50% of Irish GDP. 
        
    A WIDE RANGE OF PLAUSIBLE VALUES, BUT EXPECTATIONS APPEAR UNDEMANDING
     
    The tables below illustrate a range of fair values.  For example, should BoI require the €1 billion of debt to convert to equity, which will reduce the share count by 20 billion, trough book value per share is still higher than the current share price, and earning power looks like €0.01-0.02 per share, or 10-20% of the current share price. 
     
    Upside scenario   Middling scenario   Adverse scenario   Alternative scenario
    Loans  €     91,200   Loans  €          70,000   Loans  €          70,000   Loans  €          91,200
    Equity  €       8,900   Equity  €             4,800   Equity  €             5,800   Equity  €             8,900
    Assets  €   125,600   Assets  €        102,000   Assets  €        102,000   Assets  €        125,600
    Net  €       1,005   Net  €                510   Net  €                510   Net  €             1,005
    E/A 7.1%   E/A 4.7%   E/A 5.7%   E/A 7.1%
    ROA 0.80%   ROA 0.50%   ROA 0.50%   ROA 0.80%
    Shares         30,000   Shares               30,000   Shares               50,000   Shares               50,000
    EPS  €       0.033   EPS  €             0.017   EPS  €             0.010   EPS  €             0.020
    P/E 12x   P/E 10x   P/E 8x   P/E 12x
    Target 1/2016  €       0.402   Target 1/2016  €             0.170   Target 1/2016  €             0.082   Target 1/2016  €             0.241
    Discount rate 15%   Discount rate 15%   Discount rate 15%   Discount rate 15%
    2015  €       0.349   2015  €             0.148   2015  €             0.071   2015  €             0.210
    2014  €       0.304   2014  €             0.129   2014  €             0.062   2014  €             0.182
    2013  €       0.264   2013  €             0.112   2013  €             0.054   2013  €             0.159
    Jan-2012  €       0.230   Jan-2012  €             0.097   Jan-2012  €             0.047   Jan-2012  €             0.138
    Current price  €       0.090   Current price  €             0.090   Current price  €             0.090   Current price  €             0.090
    Change  €       0.140   Change  €             0.007   Change  €          (0.043)   Change  €             0.048
    Change 155%   Change 8%   Change -48%   Change 53%

    Consider the ratio of market-value-to-assets and capital ratios for the largest bank in the PIIGS and several additional countries. 

    Country Bank Name  Market Cap   Assets  Cap/Assets TCE Ratio CT1 Ratio
    Portugal Banco Espirito Santo 1,566                82,767 1.9% 6.5% 9.3%
    Ireland Bank of Ireland 2,711              155,438 1.7% 5.8% 15.4%
    Italy UniCredit S.p.A. 12,216              950,296 1.3% 3.9% 8.3%
    Greece National Bank of Greece S.A. 1,396              115,499 1.2% 5.5% 3.2%
    Spain Banco Santander S.A. 51,872          1,250,476 4.1% 3.6% 8.9%
                 
    US Bank of America  $       63,543  $      2,219,628 2.9% 6.2% 8.9%
    UK Royal Bank of Scotland Group Plc  £       12,518  £      1,607,728 0.8% 3.6% 10.9%
    Germany Commerzbank AG 6,888              738,240 0.9% 2.5% 8.8%
    France Societe Generale S.A. 13,167          1,247,000 1.1% 3.8% 8.2%
     
     
    DATA SUPPORTING BOI'S SUPERIOR UNDERWRITING
     
    LOWEST LOAN GROWTH DURING THE CREDIT BUBBLE  
      Loans Loans 2003-06  
    Bank name 2003 2006 CAGR  
    Bank of Ireland          75,700        132,700 21%  
    Allied Irish Banks          53,300        120,000 31%  
    Anglo Irish          18,100          50,200 40%  
    Irish Life & Permanent          19,900          42,200 28%  
    EBS Building Society            8,500          14,600 20%  
             
    Source: Annual reports & "Preliminary Report on the Sources of Ireland's Banking Crisis," Regling

     

     
    LOWEST ACCUMULATION OF CONSTRUCTION & PROPERTY LOANS  
    Bank name Ratio of construction & property loans to capital  
    Bank of Ireland 3.0  
    Allied Irish Banks 3.5  
    Anglo Irish 12.5  
    Irish Nationwide Building Society 7.4  
         
    Source: "Preliminary Report on the Sources of Ireland's Banking Crisis," Regling, p. 32
     
    SMALLEST HAIRCUT ON LOANS TRANSFERRED TO NAMA    
    Bank name Loans (€, bn) 
    transferred
    Discount Total Loans Transferred/Total
    Bank of Ireland 9 42%               125 7%
    Allied Irish Banks 19 55%               128 15%
    Anglo Irish 34 62%                 75 45%
    Irish Nationwide Building Society 9 64%                 12 73%
    EBS Building Society 1 61%                 16 6%
    Total 63 58%               231 27%
             
    Source: National Treasury Management Agency, Ireland on Path to Recovery, Oct-11
     
    LOWEST 90+ DAY ARREARS ON IRISH RESIDENTIAL MORTGAGES    
    Bank name Dec-09 Jun-10 Dec-10 Jun-11 Sep-11
    Bank of Ireland 2.76% 3.49% 4.17% 5.18% N/A
    Allied Irish Banks 1.96% 3.21% 4.80% 7.82% N/A
    EBS Building Society 5.20% N/A 8.40% N/A N/A
    Irish Life & Permanent 3.90% 5.20% 6.80% 8.80% N/A
    Ireland - total owner occupied 3.61% 4.61% 5.66% 7.20% 8.10%
               
    Source: Central Bank of Ireland, company reports.        
     
    LEAST AGGRESSIVE UK COMMERCIAL MORTGAGE LENDER IN SURVEY  
    Bank name Number of Citations by appraisers for "Aggressive UK Commercial property lending"  
    Anglo Irish 5  
    Allied Irish Banks 5  
    Royal Bank of Scotland 5  
    Barclays 5  
    Deutsche Bank 5  
    Goldman Sachs 2  
    Bank of Ireland 1  
    Irish Nationwide Building Society 1  
         
    Source: Reuters story citing Phil Ingram's research report at Merrill which is now quite difficult to locate
     
    PAPERS ON IRISH CREDIT BUBBLE
    http://www.ucd.ie/t4cms/wp09.32.pdf
    http://bankinginquiry.gov.ie/Preliminary%20Report%20into%20Ireland's%20Banking%20Crisis%2031%20May%202010.pdf

    http://www.vanityfair.com/business/features/2011/03/michael-lewis-ireland-201103

    Catalyst

    Need losses to materialize without additional share issuance. Will take time.

    Messages


    SubjectIrish bonds
    Entry02/17/2012 11:34 AM
    Memberlvampa1070
    Significant rally in Irish bonds isn't a big deal for BoI's book value, but it helps at the margin.
     
     
     
     
    In the available for sale portfolio at June 30, BoI held 3.9 billion euros of Irish Government bonds par value carried at market value of 82% of par or 3.2 billion euros. In July, BoI received 1.0 billion euros of cash from the Irish Government in exhange for a contingent capital note described above. BoI used the proceeds to buy Irish Government debt at what looks today at an opportune time.  
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