Commodities

Crude oil for April delivery is currently trading on the New York Mercantile Exchange (Nymex) at $44.12 per barrel down $1.10 from Thursday's close. In London, Brent for March delivery is trading on the International Commodities Exchange at $45.60 down 91 cents.

Gold spot price

Gold is trading at $942.10 down $3.40 from Thursday's spot price close in New York.

Goodbody economist Dermot O'Leary comments: Labour market trends most worrying element of recent months: "With economic events unfolding at a blistering pace, economic data is often considered out-of-date even before it is released. That criticism may indeed be justified for the Irish employment data that are to be released this morning.

The data relate to the period from September-November 2008, although the CSO is adjusting to calendar quarters from Q1 onwards. Following a 0.9% quarter-on-quarter decline over the previous two periods, we anticipate that the fall in Q4 was significantly more. On an annual basis, we are expecting that employment declined by 3.5% in Q4, with the main drag obviously stemming from construction, but marked declines are also likely for retail and wholesale and hotels and restaurant employment.

Unfortunately, judging from the recent Live Register trends, these declines are unlikely to represent the trough in employment growth. As we pointed out in our latest Economic Commentary last week (A Rocky Road Ahead), we expect the number of people employed in the Irish labour market to decline by 13% over the 2008-2010 period. The scale of the increase in unemployment will thus depend on migration trends. There is at least anecdotal evidence of increasing outward flows of migrants, while the number of PPS numbers (a proxy for the inward flow) in the three months to January is c.80% below the peak reached in July 2007. It must be pointed out that the labour market is a lagging indicator of economic activity, but the fall in rapid deterioration in the labour market is still the most worrying development in this economic crisis over the past few months."

Goodbody banking analyst Eammonn Hughes comments on Irish Financials; Lloyds figures a little unexciting:"Lloyds Banking Group has released FY08 numbers this morning. The fact that they haven’t concluded their agreement with the Treasury on the Asset Protection Scheme is likely to diminish the importance somewhat of the figures. Nevertheless, Lloyds is reporting a 35% decline in PTP to £2.46bn and a 39% decline in EPS. On a continuing basis, income is up 2% and costs rose by 5%, though impairments were up 68%. In terms of outlook, Lloyds anticipates that 2009 will be a “challenging year”, so nothing new there then. Within income, the net interest margin appears to be flat as improved product margins offset mix effects (more lower margin lending). In UK Retail, mortgage credit quality remains “good” though arrears are obviously rising with Lloyds looking for a similar decline in house prices this year as last year. Overall, impairments were 113bps at group level, though were 122bps in the UK Retail business. Lloyds is anticipating that retail impairments will “rise significantly in 2009” and corporate impairments are expected “to remain at the high levels seen in 2008”. So no respite there and will be the main driver behind its view that they “expect the enlarged Group to report a loss for 2009”. We would have losses already pencilled in for our own two large banks. On the insurance side, Lloyds highlights the short term volatility in investment markets and widening credit spreads, something we’ll be watching at IL&P next week (FY08 results).

In relation to Ireland, after the RBS figures yesterday (Ulster Bank), we get figures from HBOS Ireland this morning as part of the Lloyds Banking Group. It reported an underlying loss before tax of €250m as loan losses rose from 12bps in 2007 to 187bps in 2008. In euro terms, net interest income increased 9% as the loan book grew 8% to £30.7bn, but the net interest margin eroded 16bps yoy to 1.65% (higher funding costs, slower churn on the loan book, which impacts the timing of fee recognition and changing asset mix with more Retail). In addition, there were €3.1bn of deposit outflows following the introduction of the Irish Government guarantee and due to uncertainty surrounding HBOS (prior to its merger with Lloyds), but in Q4 “deposit capability has been significantly enhanced”. Non interest income fell £59m to give a £28m loss, while costs fell 9% in euro terms on the back of “substantial action” and despite the full year effect of an expanded retail network (cost income 41.4% vs 42.9% for 2007). On credit quality, impaired loans rose to 5.78% of closing advances (1.08% at end 2008), with the extent and pace of economic deterioration in Ireland in recent months leading to rising arrears and falling asset values. The higher impairment loss has been mainly driven by Residential Property Development (9.7% of loans), with a modest rise in impairments on Property Investment loans (21% of portfolio). SME loans and residential mortgages have also seen some deterioration. Presumably, these trends continue to weaken in the year ahead, so the focus now moves to AIB’s results on Monday."

Goodbody analyst Anna Lalor comments on Irish Financials; Further read-through on EU guidance on impaired assets: "We briefly touched on the EU Commission’s guidance on the treatment impaired assets yesterday, but having gone through the report in more detail, we thought it was worthwhile revisiting it. The EU identifies that uncertainty regarding asset valuations has undermined confidence in the banking sector. As a result, asset relief schemes, such as those used in Sweden in the early 1990s, have been gaining greater traction as possible solutions as the credit crisis has persisted. In order for such schemes to work there needs to be “clear identification” of the magnitude of the level of asset related problems and the implied solvency level prior to any support, in the context of the viability of the bank and its systemic importance. In relation to identifying the full extent of losses, the EU recommends valuation by independent experts (on a real economic basis - perhaps with a haircut, rather than on a market value basis), with valuation of each basket of problem loans or assets coordinated/monitored at an EU level to ensure consistency of treatment across countries.

The EU believes that there should be burden-sharing of impaired asset costs among the State, shareholders and creditors. However, for a viable and systemically important bank, where its solvency could fall below minimum levels due to loan losses, it recommends that the bank could contribute to the loss or risk coverage at a later date (claw-back clauses or insurance scheme with a first loss and residual loss sharing). The lower the upfront contribution, the higher the need for shareholder contribution at a later stage, in the form of conversion of losses into bank shares and/or some other compensation. A guarantee from the Government that equity capital would not fall below minimum target levels over a particular period should act in a similar way to a bad bank or insurance scheme (the cost of an insurance scheme would probably need to be at least partially paid for through equity participation as in the case of RBS).

Such a guarantee (with the use of the existing preference shares in a revised form - so with no incremental investment by the Irish Government) could act in a similar way to the mandatory convertible preference shares being used in the US or the B shares being issued by RBS to the UK Government, with benefit to the Government and equity-holders if the credit cycle turns out to be better than expected. Interestingly, the B shares being issued to the UK Government (with an option to issue more in the future) convert into ordinary shares at 50p (double the closing price on Wednesday), limiting the dilutive effect on shareholders and the percentage of the bank that the Government could end up owning.

The budgetary situation of a country is also expected to be taken into account when choosing whether to use an asset relief scheme (purchases, asset insurance, asset swap or some hybrid). Any Government support through an asset relief scheme should not be on a scale that would raise concern over the sustainability of public finances (over-indebtedness and/or financing problems) and the EU suggests that it may be better for countries with scarce budgetary resources to focus on a limited number of systemically important banks, while for some countries, budgetary constraints and/or the size of bank balance sheets relative to GDP may “severely constrain” asset relief options.

The purchase of a assets (leading to immediate recognition of losses) is seen as a potentially more expensive option (presumably as capital would need to be injected into the selling bank immediately) for public finances as it does not allow for pre-provision profits to absorb losses over a number of years. Hybrid schemes, where bad assets are segregated from the bank balance sheet in a separate entity (either within or outside the bank) with a related Government guarantee is thought to limit the immediate impact on Government finances. The Minister for Finance was said yesterday that he is considering some way of “sequestering” or separating impaired assets in a property company that didn’t operate as a bank, but could be capitalised and may become an “attractive investment in due course” (a al Sweden), while he indicated that an insurance scheme for the banks could be a “timebomb” for taxpayers.

The Government has already committed to providing €3.5bn of preference shares each to AIB and BOI and we believe (see our recent note Circularity Squared) that this investment can be converted into higher quality equity capital as required (with the “burden sharing” with equity-holders as guided by the EU). In effect, this acts as a guarantee on a set minimum capital level (which we have at 4%, but may need to be higher if lending is to be encouraged). Our loan losses are based on peak to trough property price declines and incorporate loan losses to a similar level to that experienced in Sweden in the early 1990s."