Anglo Irish – The Builders’ Bank by Marathon Asset Management, dated May 2004. This is discussed in their new book Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15 we think – anyway read it below.
A pre-crisis look at the Anglo Irish can of worms
“Time is a great story teller.” — Irish proverb
Anyone who thinks Europe is a mature economic region suffering from sclerosis and doomed to perpetually low rates of growth, should have attended a recent Irish equity conference in Dublin. Growth featured heavily on the menu, nowhere more so than in the presentations of Ireland’s leading financial institutions. The main driver of growth is mortgage lending which last year expanded by 26 per cent in Ireland (curiously all of the principal banks reported that their own mortgage lending growth exceeded the national growth rate). Ireland is experiencing a housing boom as low nominal rates of interest – in Ireland’s case negative real rates thanks to the Eurozone’s monetary umbrella – entice individuals to bid up property prices. The arguments for and against the sustainability of this mega-trend, and its implications for banks, are well rehearsed.1 What is perhaps more instructive is to observe the case of an especially successful Irish banking story, namely that of Anglo Irish Bank, and to imagine what lies in store.
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Chart 18: Anglo Irish bank EPS growth and customer advances
(Source: Anglo Irish)
Anglo Irish has grown from a small finance business, with a market capitalization of Eur 8m in 1986 and an asset base of Eur 138m, into a large bank with a market capitalization of Eur 4.3bn and assets of Eur 25.5bn. The bank’s growth has been fueled by lending against property in the booming Irish economy and it has expanded into the UK and Boston markets. Currently 90 per cent of the loan book is secured against property. Rather than individual mortgages, however, Anglo Irish generally lends to small businesses that either wish to expand their property base, acquire premises that had previously been leased, or are borrowing against property to release capital.
The bank’s success has been achieved without a branch network. Although this deprives it of low-cost deposits, not having a branch network also means lower overheads. Anglo Irish boasts an impressive cost-to-income ratio of only 30 per cent. Average loan size is Eur 4.5-5.5m in Ireland (Eur 7-8m in the UK), reflecting the fact that the bank is not significantly involved with residential mortgages. In the UK, which now accounts for Eur 7bn of the total loan book of Eur 17bn, a greater proportion of lending is for investment property where the borrower finances the purchase of a property (often a shop or a warehouse) which is then let to tenants on long-term lease arrangements.
Provisions against non-performing loans are 217 per cent, compared with a European average of 80 per cent. As for valuation, the bank earns a return on equity of 32 per cent, trades at 4.2 times book value and offers a yield of 1.6 per cent. Earnings per share grew at 34 per cent last year, having compounded by 41 per cent annually since 1998.
A central feature of the business model appears to be the relationship between Anglo Irish and its property-owning customers. Chief executive Sean FitzPatrick, who has run the bank since 1986, suggests that its competitive advantage is based on the speed with which they approve loans compared with bureaucratically-challenged peers. At the weekly credit committee meetings, up to 25 loans are approved with an approval rate of 95 per cent. The bank’s publicly professed mission is to “make our customers richer.”
Management presents Anglo rish’s credit risk in terms of current debt-servicing, but this overlooks potential repayment risk. Even though interest payments may be secure in a falling property market – assuming that tenants stay solvent, under such circumstances there must be a large question mark over property developers’ ability to repay the loan principal. To use the terminology of the maverick American economist Hyman Minsky, it appears that Anglo Irish is engaging in “speculative finance” whereby borrowers are only able to cover their interest payments from earnings, as opposed to the more prudent “hedge finance” whereby borrowers can meet all their liabilities, including interest and principal payments, from current cash flows. We are not yet at the point of Minsky’s “Ponzi finance”, which describes the situation when borrowers are unable to fund even interest payments from current cash flow.
The bank’s business model works particularly well in a falling interest rate environment. On the cost side, the bank’s cost of funding in the wholesale loan market declines in line with EURIBOR rates. On the revenue side, lower interest rates have made mortgages more affordable, leading to higher property values, and strong credit growth. As Irish rents have so far moved in step with values, leveraged property developers have more income to meet lower interest payments.
If rates were to increase, however, this virtuous cycle could turn vicious. Without a deposit base, Anglo Irish’s cost of funds would rise quickly. On the revenue side declining property values would make capital repayments on existing loans problematic, raising default risk. In other words, Anglo Irish is a wonderful moneymaking machine when interest rates are declining but not one to invest in under different circumstances. Not many Eur 10m loans would have to turn sour before Anglo Irish’s Eur 1bn equity base was seriously comprised.
It might be argued that management has anticipated these risks and prepared for longer-term contingencies. The trouble is that the equity-based incentives paid to senior executives favour growth in the near-term, while bad debt problems are likely to have a very long tail. The bank has issued stock options for over 6.2m shares (2 per cent of the total share capital) with strike prices of between Eur 1.09 and Eur 6.70 compared with the current market price of Eur 13. Management have responded to the enormous rise in the share price – which fails to discount what a myopic stock market cannot see – by selling vast numbers of shares. Mr FitzPatrick, who is retiring at the tender age of 55, recently sold half of his holding for around Eur 20m and the 46-year old boss of the UK business has disposed of 40 per cent of his holding.
Charles T. Munger is fond of saying that there are “more banks than bankers.” A competitive advantage based on a willingness to make loans in an instant would be anathema to old-fashioned bankers. Of particular concern to us is the extent to which Irish bankers engage in the hard-sell to investors. One of them declared at the conference we recently attended: “I am here unashamedly to sell you X bank!” This rather goes against our preference for bankers as cautious individuals, obsessed with long-term downside risks. As we have seen in many other businesses, an obsession with growth combined with over-promotion is likely to end in tears. As to when this will happen, we must wait for time, Ireland’s proverbial story teller.
1 Capital Cycle footnote: Unlike in the United Kingdom, high Irish property prices provoked a boom in new supply. In 2003, 69,000 homes were built in the Irish Republic which had a population of 4m. This compares with 180,000 new homes in the UK, with a population of around 60m, a housing supply differential of nearly 6 times on a per capita basis. This huge difference in relative housing supply explains why the UK housing market and UK homebuilders weathered the global financial crisis far better than their Irish counterparts.