Monday, 28 April 2014

How to fleece a government, Irish style

I really can't resist this.

Via Brian Lucey comes this report that Allied Irish Banks (AIB) is having some difficulty servicing its debts.

AIB was bailed out by the Irish government in February 2009 when its share price collapsed due to severe  liquidity problems and loss of market confidence. It was subsequently nationalised when the collapsing Irish property market destroyed its solvency. Currently, the Irish government owns over 99% of its ordinary shares.

But it's not the shares that are the problem. In three weeks' time, AIB is supposed to pay a cash dividend on 3.5bn euros of preference shares held by the National Pensions Reserve Fund Commission (NPRFC). AIB can't afford to pay the interest on them, apparently, despite the fact that it made an operating profit of 445m euros in 2013.

AIB has a creative solution to this. Cash shortfall? No problem. Issue some ordinary shares to pay the interest. Sounds wonderful, doesn't it? But the NPRFC is a government organisation. So the Irish government not only owns 99.8% of the ordinary shares of AIB, it has £3.5bn of subordinated debt, too - the interest on which will be paid in the form of yet more ordinary shares. Maybe I am cynical, but this sounds like a rip-off to me. AIB's net worth in three weeks' time won't be any greater, so the additional shares will simply dilute the government's holding. In effect, the Irish government will be paying interest to itself.

Mind you, this would still be the case evcn if AIB paid cash, really. After all, interest payments on debt reduce dividend payouts and retained earnings. What the Irish government gained in interest payments it would lose in lower dividends and return on equity.

But the real question is - if AIB is already fully nationalised, and it STILL can't afford to service its debts, why is it still open for business? Why isn't it being wound up? After all, the only reason this solution is possible at all is that the debt is owed to the sovereign. If it were owed to private sector lenders, this would be another bailout. AIB can hardly be considered a going concern, whatever its management might say. It's the worst type of zombie bank - draining resources from the sovereign to keep it alive, while adding little value to the economy it is supposed to serve. Wouldn't Ireland be better off without it?

Mind you, the AQR and stress tests might finish it off. I live in hope.




17 comments:

  1. I think this is laying it on a bit thick really; all that's happened here is that AIB has taken five years rather than four to get back to a state where its profit from operations is greater than the writeoffs it's making on old loans. When you take into consideration the fact that the 2014 provisions line is likely to include a significant amount of clean-up ahead of the ECB's Asset Quality Review, I think there's not so strong a case for shutting the whole bank down.

    Also these are preference shares, not debts. It's always been written into the terms that the coupon can be paid in shares rather than cash, and it was understood when NPRFC got into the deal that their investment was going to be economically more like equity.

    ReplyDelete
  2. I'd hazard a guess that the real reason for paying this interest in shares rather than cash is the forthcoming stress testing. AIB needs the liquidity. Also, I didn't put this in the post but they are considering converting the pref shares to ordinary shares, which would increase their Tier1 capital. The AQR might have something to do with that, don't you think?

    ReplyDelete
  3. "draining resources from the sovereign to keep it alive"

    This is just a book-keeping exercise, where the capital of the bank has been increased by 290m Euro, the value of the dividend payment. No resources have been drained from the Irish pension fund, or is there evidence that Irish pensions were in any way effected by that 290m payment?



    Compare and contrast with a real zombie Bank, Barclays, where close to £6bn were injected by shareholders last year to pay bonus payments of more than £2 bn to its investment bankers.

    ReplyDelete
    Replies
    1. Er no. It is a real loss to the Irish pension fund. As I said, there is no increase in AIB's net worth. Therefore the government's shareholding has in fact been diluted.

      I'm aware of the Barclays' problem - indeed I wrote about it in my previous post. But I would not describe Barclays as a zombie. AIB however is entirely dependent on the sovereign and apparently still in need of bailouts. That is a classic zombie bank.

      Delete
  4. I don't understand why AIB's net worth won't have risen. If it has paid off the interest due, reducing its liabilities by that amount, surely the net worth will rise by the same amount?

    ReplyDelete
    Replies
    1. No.....think about it. It makes NO DIFFERENCE to its net worth.

      Delete
  5. I did think about it. It reduced its liabilities, but didn't reduce its assets (since the debts were paid with equity, which isn't an asset). What am I missing?

    Put another way, suppose that they had sold X amount of equity to some third party (size of equity increases by X), and paid the interest with the cash (assets and liabilities cancel out, no effect on equity). Surely the net worth would have increased by the amount of cash they received? But the effect on the balance sheet would be exactly the same as what did happen!

    ReplyDelete
    Replies
    1. Equity sits on the liability side of the balance sheet. All they have done is swapped one liability for another. The net worth of the bank has not changed.

      Delete
    2. Equity might be on the same side of the balance sheet as liabilities, but it is not a liability.

      Unless we are speaking a completely different language, the net worth of the bank is the value of its equity.

      Delete
    3. To clarify. If NPFRC waived its cash dividend, it would take a real loss and the net worth of the bank would increase by the amount of the interest foregone by NPFRC. But NPFRC is not waiving its dividend. In effect it is being paid the dividend then investing that payment in newly-issued shares of the company that paid it. This is therefore a simple debt for equity swap by an existing creditor. There is no change in the bank's asset base, only in the liability composition.

      Delete
  6. Yes, except that equity is not a liability.

    ReplyDelete
    Replies
    1. But you are talking about the balance sheet position AFTER the debt/equity swap, whereas the point I was making in the post is that there will be no change in AIB's net worth between now and the time of the debt/equity swap - therefore the new shares simply dilute the government's shareholding. I don't dispute that the effect of the swap itself is to increase AIB's net worth, but that is because this is actually yet another recapitalisation of AIB by the Irish sovereign.

      Delete
  7. "I don't dispute that the effect of the swap itself is to increase AIB's net worth, ..."

    Right, and if the net worth has increased, then the additional shares reflect that. So there is no dilution of shareholding.

    In fact, there cannot be any question of the government of Ireland being fleeced at all.

    Ireland owns a bank which either pays out its dividend, (in which case its worth is 290m less), but Ireland get 290m worth of dividends.

    Or the Bank keeps its dividend (in which case its worth 290m more), and the additional shares reflect the more valuable bank.

    Ireland is not better or worse off, either way!

    ReplyDelete
    Replies
    1. "Ireland is not better or worse off, either way".

      That is exactly what I said in the post.

      Shareholding dilution: yes, I should re-word that. To clarify: if AIB issues more shares to its 99.8% shareholder to cover a debt owed to that shareholder, then after the swap that shareholder has neither more nor less than it had before. In effect, it has paid itself the interest on the debt. It is a disguised recapitalisation of the bank - which is what I said.

      Delete
  8. What is interesting is the valuation of AIB equity is close to 6x price to book. Versus 1.4x book at bank of Ireland. That 1% free float values AIB at more than Santander.

    ReplyDelete
  9. It's not even as much as 1%. 0.2% is more like it. I would REALLY like to know how they came up with that valuation. It can't possibly be a real market price on so small a free float.

    ReplyDelete