Lending to developers was the rotten core of Irish banking and it ultimately collapsed Anglo and led to the virtual nationalisation of the financial system

COMMENTATORS HAVE tended to interpret the Irish property market bubble as a homogeneous phenomenon. This approach needs to be seriously questioned in order to identify the dominant virus that produced the collapse of the Irish banking system.

After falling significantly in 2001, property prices started to move upwards again from 2002, heralding the arrival of a second phase of the property market boom – a boom that very quickly metamorphosed into a bubble.

The character of this second phase was quite distinct from the first, which prevailed up to 2000. Mortgage loans to finance the residential property market grew again at a fast pace, aided by the new incentives of low interest rates and financial innovations in the form of tracker mortgages, 100 per cent (and higher) loan-to-value mortgages and extensions of the length of loans to 30 years and more.

However, the increase in residential property lending, though significant, was not the most important spoke on the wheel of speculation that characterised the property boom from 2002 onwards.

Indeed, if lending had been solely confined to the residential property market, it would have arguably created a relatively smaller bubble in that market, without the consequences that the larger property market bubble produced – namely the collapse of the banking system.

Something enormously more sinister than residential property mortgages had started to work through the property market in the form of direct lending to property developers of increasingly large sums of money.

This lending amounted to multiples of the amount of money lent into the residential property. More insidiously, it contained the real seeds for the destruction of the banking system.

Hyman Minsky, a distinguished Keynesian scholar, analysed the way in which bubbles emerged by focusing on their financing. He suggested three financing phases: hedge financing, speculative financing and Ponzi financing.

In the hedge financing phase, a bank concentrates on ensuring interest and capital repayments are made on loans. Speculative financing arises when the bank concentrates on interest repayments of loans but neglects capital repayments. Ponzi financing occurs when the bank lends just on the basis of appreciating property prices, and little or no attention is paid to interest and capital repayments.

The Irish banking system moved very quickly away from hedge financing to speculative financing – and even more quickly to Ponzi financing during the period 2002-2008.

My analysis focuses on the three biggest Irish covered banks – AIB, Anglo-Irish and Bank of Ireland – and the focus is on financing, both domestically and internationally, by these institutions for mortgages, property and construction.

It is important to aggregate both the domestic and international property lending of the covered banks because the consequences of such lending directly influenced the liquidity and solvency of the Irish covered banks.

Charles Goodhart, a former member of the Bank of England’s monetary policy committee, astutely encapsulated the consequences of such lending when noting banks are international in life but national in death.

Bad international loans figured just as prominently as bad domestic loans on the balance sheets of the banks, and when they became insolvent, taxpayers were forced to pay for the excesses not only of their domestic lending, but also of their international lending.

AIB and Bank of Ireland increased their mortgage lending from €44.1 billion in 2003 to €91.7 billion in 2008, an overall growth rate of 108 per cent. Contrastingly, lending to the property and construction sector by the three biggest Irish covered banks grew by over 300 per cent (see Table 1, left).

These statistics show the extent to which the property bubble morphed into a predominantly builder/developer Ponzi bubble between 2003 and 2008. By 2003, Anglo Irish Bank, specialising in loans to builders/developers, had captured a sizeable chunk of this apparently profitable and fast-growing market.

The growth in the share price and market valuation of Anglo presented a threat for the more conservative Irish banks, AIB and Bank of Ireland.

Rather than examining the high-risk profile associated with Anglo’s loan book to the property and construction sector, both AIB and Bank of Ireland became obsessed about the growth performance of Anglo.

Thus, while AIB grew its mortgage book by 139 per cent between 2003 and 2008, it expanded its property and construction lending by 332 per cent. Bank of Ireland, despite the widely held opinion it was more conservative in these operations, expanded its property and construction lending by 439 per cent, an even faster pace than AIB, albeit from a lower base. This is a sharp contrast to Bank of Ireland’s increase in mortgage lending of 95 per cent over the same period. Anglo, boosted by its apparent continuing success, increased its lending by 303 per cent during the period.

The yearly rates of growth of property and construction lending by AIB, Bank of Ireland and Anglo showing a race to the bottom are worthy of close scrutiny (see Table 2, above).

The Nyberg report showed residential mortgage lending growth of €56 billion (from €35 billion to €91 billion) and commercial and property lending growth of €64 billion (from €12 billion to €76 billion).

Looking at these statistics, it is easy to conclude the consequences of the property market bubble arose in near equal measures through residential property lending alongside commercial and property lending. However, the aggregated domestic and international statistics for lending to the property and construction sector, compiled from National Asset Management Agency statistics, show this type of lending dwarfed mortgage lending. It was this lending that produced the rotten core of the Irish banking sector that would ultimately cause the collapse of Anglo, the nationalisation of AIB and the semi-nationalisation of Bank of Ireland.

Add to these the activities of Irish Nationwide Building Society, which had increased its property and construction lending from €3 billion in 2003 to €8.2 billion in 2008, and an even broader picture emerges of the Ponzi financing activities of the Irish banks.

Because of the size and pace of growth of lending to the property and construction sector, the banking system had no chance of surviving the property and construction bubble created between 2002 and 2008 – when the banks lost all sight of the need for risk management.

By focusing on the virulent contribution of property and construction lending in creating the Irish banking collapse, it is possible to answer in part the question of why so few people were able to predict the crash of 2008.

Quite simply, statistics were unavailable to distinguish between the activities of the commercial property and construction borrowers and the residential property borrowers.

Aside from the executives and boards of the three main covered banks, their accountants, the Central Bank of Ireland/financial regulator and the National Treasury Management Agency, which had sufficient suspicions at one stage to consider not lending to Anglo, it was extremely difficult to glean from the aggregated banking statistics the extent to which the Irish banking system had abruptly changed direction from hedge-based financing to speculative financing and even more quickly to Ponzi financing.

Antoin E Murphy is a fellow emeritus of Trinity College and is co-authoring The Fall of the Celtic Tiger with Donal Donovan for Oxford University Press