|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|
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.
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.
|Wholesale funding (€, bn)||2012||2013||2014||2015|
|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|
|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|
|Net cash to repay ECB||0.3||0.6||0.5||0.6||0.9||-1.2||-0.8||0.4|
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|
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|
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.
|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|
|EPS||€ 0.033||EPS||€ 0.017||EPS||€ 0.010||EPS||€ 0.020|
|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|
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%|
|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%|
|France||Societe Generale S.A.||13,167||1,247,000||1.1%||3.8%||8.2%|
|LOWEST LOAN GROWTH DURING THE CREDIT BUBBLE|
|Bank of Ireland||75,700||132,700||21%|
|Allied Irish Banks||53,300||120,000||31%|
|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|
|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)
|Bank of Ireland||9||42%||125||7%|
|Allied Irish Banks||19||55%||128||15%|
|Irish Nationwide Building Society||9||64%||12||73%|
|EBS Building Society||1||61%||16||6%|
|Source: National Treasury Management Agency, Ireland on Path to Recovery, Oct-11|
|LOWEST 90+ DAY ARREARS ON IRISH RESIDENTIAL MORTGAGES|
|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"|
|Allied Irish Banks||5|
|Royal Bank of Scotland||5|
|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|
|Entry||02/17/2012 11:34 AM|
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.