Irish financials have the capacity to absorb a major shock, but that hasn't stopped talk of a new liquidity initiative, writes Arthur Beesley

ANOTHER DAY, another steady stream of downbeat news. Rising inflation and a cut to the Central Bank's growth forecast only add to the gloomy outlook for Irish banks. At the end of a week in which investors in the four main financial institutions endured their nastiest losses for 15 years, it seems there is no end in sight to this bout of exceptional volatility.

Pressure is piling on the banks due to the combined effects of the economic slowdown, a severe deterioration in the property market and the credit crunch in the global financial system; so much so that Bank of Ireland was unable this week to provide a profit forecast for the current fiscal period, except to say that profits continue to weaken. That analysts promptly cut forecasts for rival lenders was hardly a surprise.

Although anecdotal evidence points to dire conditions in the domestic property market, a warning from housebuilder Abbey of much tougher times ahead came as it reported a sharp drop in profits in the year to April.

"In recent weeks, trading conditions have deteriorated noticeably," the company said.

"The rate and depth of the current slowdown in activity is outside our experience. It seems clear that the source of the difficulty is the dramatic contraction of the mortgage market. Unless conditions markedly improve, which seems unlikely in the short term, a wrenching adjustment lies ahead."

One of only two listed house-builders on the Irish public markets, Abbey's woes point to serious pain writ large among privately-owned builders. Further evidence of the steep decline of their business came from builders' merchants Grafton, which said the correction in the volume of housing starts and completions has been "faster and deeper" than expected.

For banks, this greatly increases the risk of bad debts from the army of developers who borrowed billions of euro to buy into a property boom that reached spectacular heights before the slide started last year.

In addition, the lower rate of new mortgage lending reduces scope to increase profits as home-buyers wait for prices to drop. As the unemployment and interest rates creep upwards, so too does the risk of mortgage defaults. Trying times indeed for bank chiefs Eugene Sheehy at AIB, Brian Goggin of Bank of Ireland, David Drumm of Anglo and Denis Casey of Irish Life Permanent.

There is more. In Britain, where the Irish financials have big operations, Halifax Bank of Scotland (HBOS) reported yesterday that an 8.7 per cent reduction in house prices in the year to June represented a bigger fall than at any time during the 1990s crash. "It is fair to say we are now in the worst housing slide for over 50 years," said Michael Saunders, an economist with Citigroup.

Each of the Irish banks are exposed in different ways to the decline of the property markets in Ireland and Britain. Yet while their drooping share prices point to an erosion of investor confidence on a grand scale, Central Bank governor John Hurley was forthright in his judgment yesterday that the Irish banks are well-capitalised with good asset quality.

"In line with the results of previous exercises, the preliminary results of our latest macroeconomic stress tests on the banking sector, which are designed to test the financial position of banks in the face of a serious economic downturn, suggest that the banking sector's shock absorption capacity remains strong. This strength is an essential prerequisite for the more challenging times that have arisen," Mr Hurley said.

Nevertheless, analysts say the market wants clarity from the banks in light of the economic slowdown on the level of loan impairments. Questions also surround asset price stability in three sectors: the British buy-to-let market; the residential market in Ireland and, to a lesser extent, Britain, and the Irish and British commercial property market. "There's no sign of that," said bank analyst Alex Potter of London investment bank Collins Stewart.

The market also awaits a "return to normality" in the inter-bank funding market, struck down since last summer as a result of the international liquidity crisis that flowed from the subprime debacle in the US. In this case also, there is little prospect of any respite on the immediate horizon.

Hence talk in the top echelons of the banking community of an initiative to support liquidity in the mortgage market.

The banks insist they remain open for new business, but the availability of loans has diminished because lenders are conserving liquidity. Quietly under discussion at the moment is an embryonic proposal modelled on the Pfandbriefe system in Germany, where state bodies and state-owned banks are required to subscribe to 60 per cent of the issuance of asset-covered securities backed by residential mortgages. Similar schemes feature in other European markets such as France.

Although Irish law already allows for the issuance of such securities, there is no requirement on State bodies to take them up. In some quarters, the National Pension Reserve Fund has been mooted as a possible investor in such securities. While the fund itself invests in securitised paper issued by banks, including Irish banks, its investment decisions are made independently of the Government.

The extent to which any other arm of the State might invest in such securities even as part of an informal scheme remains unclear. The argument goes that such a scheme would boost the Government's coffers on two levels. First, taxation income would increase through the stimulation of activity in the housing market. Second, there would be an investment return from the security itself.

Even though such securities typically come with solid guarantees, the counter-argument suggests the Government should not expose itself to any risk of any further decline in the property market. Minister for Finance Brian Lenihan did not rule out Government support when saying this week any such proposal would be examined "on its merits". Yet Tom Parlon, head of the Construction Industry Federation, has said the Department of Finance's stance "wasn't very positive" initially. While this is described as an industry initiative by some well-versed financial sources who say no bank would risk broaching the subject on its own, the Irish Banking Federation said it was not involved.

"The Irish Banking Federation is not currently engaged in formulating proposals on possible new funding initiatives and is not formally engaged with Government or other parties regarding such proposals," a spokesman said.

After seeing their combined market capitalisations shed tens of billions of euro this year, a central focus now for Irish banks is to put a floor under the decline in their stock prices. But this will be difficult, as the property market worsens and as the economy skirts on the brink of recession.

Potter acknowledged that Irish financials look cheap on a historic basis, but said that comparable banks in Britain - "you have to point out that the UK banks, specifically looking at banks like HBOS" - are much cheaper.

While banks elsewhere have taken the bitter pill of rights issue to offset losses, he suggested there was a rising risk that some of the Irish institutions might have go down that road "purely on the basis of the relative weakness of their capital ratios".

It's been a long way down for Ireland's banks. It's a long way back up too, and the recovery story hasn't started yet.

Embryonic scheme: Investing in 'jumbo' bonds

UNDER DISCUSSION in the financial sector is an embryonic scheme in which the State would invest in "jumbo" bonds to support liquidity in the mortgage market in an initiative modelled on Germanys Pfandbriefe system.

While Irish law already facilitates the issuance of such asset-covered securities backed by mortgages, the key difference in Germany is that there is some form of requirement on the state in those markets to subscribe to a set proportion of the securities issued.

It still remains to be seen whether current feasibility studies culminate in a formal proposal to Government. Equally unclear is whether the Government would invest in such securities.

Banking sources in Dublin say that the Irish legislation - set out in the Asset Covered Securities Act of 2001 - is regarded in international markets as particularly strong. The key feature of such products, they say, is the enhanced security offered to securities holders.

As was explained when the legislation was introduced, the cover assets must be used first to meet the claims of the holders of the securities in the event of the insolvency of the issuing institution. Thus an institution's ordinary creditors may not make a claim against the assets until the full obligation due to the investors in the securities is discharged. Unlike conventional securitisation, the assets remain the property of the institution issuing the securities and remain on that institution's balance sheet.