Central Bank's sweet talk
We can say our banks are well-capitalised, but this does not take into account their exposure to a possible house price fall of 50%
Perception, conjecture, rumour and momentum have replaced fundamental analysis as the key driving force on the markets, said chief executive of the Irish Stock Exchange Deirdre Somers. Somers is starting to sound like the Socialist party's Joe Higgins.
The 55% fall in the Iseq index of the last 14 months has stunned finance industry insiders. If one tots up property developer Liam Carroll's losses, as reported in Sunday papers recently, on Aer Lingus (down 64% from its peak), FDB (down 63%), Greencore (down 74%) and Irish Continental Group (down 33%), he would appear to have lost over 150m Euro. Shares in Anglo-Irish Bank have halved in value since Sean Quinn reportedly spent 1bn Euro buying them. The pattern of losses suffered by the big hitters has been reflected in losses suffered by the smaller investors. Following such heavy losses, all investors are apprehensive and trading activity (and therefore commission income) on the Irish Stock Exchange is well down.
Ireland is being hit by a perfect economic storm. A global downturn is being exacerbated by record energy prices. That downturn is hitting us particularly hard as we have one of the most open economies in the world. The financial crisis is also hitting us particularly hard with out stock market's heavy exposure to bank stocks and with out economy's heavy dependence on largely debt-financed construction sector. Our woes are being compounded by a European Central Bank (ECB) policy error on interest rates which will aggravate a recession already under way. (The Euro area's leading economic indicator is already at its lowest level since 2002). ECB interest rate rises aren't just putting borrowers under pressure. The are also pushing up the Euro against competitors' currencies. The Euro has risen by almost 20% against sterling over the last 12 months, making life for our exporters considerably more difficult.
While many of the factors afflicting Ireland are also afflicting other countries, the scale or our stock market drop is unparalleled. The Iseq has dropped 55% but global stock markets (MSCI World Free Index) have dropped 20% and the FT All Share Index has dropped just 24%. Above all else, it is deflation in the Irish property sector which is causing heartburn for home-owners, property developers, banks and senior politicians alike. It is the banks which are the epicentre of the collapse of the ISEQ index with the Irish financial index (ISEF) down almost 75% from its peak. At this level of losses, we don't have far to go to approach those of the Great Crash of 1929.
The reason why Irish financials have fallen so far is their exposure to the vastly over-priced Irish property sector, If we take the view that, in the long run, there should be no particular advantage to be had from either owning or renting residential property, then rental yields (the cost of renting a property relative to its purchase price) and mortgage rates (the cost of financing the purchase of a property relative to its purchase price) should be roughly equivalent for equilibrium to be achieved. There are other factors to be considered but, in essence, rental yields and mortgage rates are the two key factors.
Mortgage rates are currently about 5% while rental yields are about 3%. All other things being equal, that indicates residential property prices have about 40% to fall. But all things aren't equal. First, rents are likely to fall in the deflationary environment we are now entering. Second, in economic bubbles, asset prices do not revert to equilibrium levels when the bubble ends. The shoot downwards through equilibrium levels as loathing of the asset in question replaces infatuation. Against these factors, we are probably at the peak of the current interest rate tightening phase. From here on, interest rate cuts should more onto the agenda.
All in all, it is my view that property prices will fall at least 50% from their peak levels. Because we lack the economic policy tools to manage our way out of the crisis, I actually expect property prices to fall considerably further than that before they finally find a bottom, maybe in 2012. In this context, the question of a bank failure becomes a real one.
Has the Central Bank carried stress-testing of the banks' positions using a 50% cut in property prices? I doubt it. Has it studied the statistics related to past real estate/credit busts? Listening to the sweet-talk of Central Bank governor John Hurley ("Irish banks are well-capitalised with good asset quality"), I doubt it. Inflation-adjusted house price declines of 49%, 65%, 42% and 26% were experienced by Finland (1992 - 1994), Japan (1991 - 2002), Norway (1987 - 1993) and Sweden (1991) respectively following their housing busts. Those countries each endured eight or nine years of sub-par economic activity thereafter. Bank losses averaged 12% of national income.
Somers may be worried by rumour and conjecture down at the exchange. John Hurley may believe everythings just fine and dandy. They ain't seen nothing yet.
The writer is a former senior Government adviser
