Monday, July 19, 2010

Ecoinomics 19/7/10: Moody's downgrade Redux

As Brian Cowen has been telling the world that Ireland has turned the corner, the country got some rude awakening.

First, Moody’s – aka the lagging indicator – pushed Irish bond ratings one notch down to aa2. Second - and I will be covering this in a separate blog post - Nama has completed transfer of the second tranche of loans.

With it, Moody’s also downgraded to aa2 that ‘not our problem, says Lenihan’ debt called Nama bonds. Irony has it, for all the SPV accounting tricks deployed by the Government, Nama bonds are rated on par with sovereign bonds and Moody’s statement justified both downgrades as being primarily driven by “the government’s gradual but significant loss of financial strength, as reflected by its deteriorating debt affordability”.

Per Moody’s, the third key factor driving rating cut is “the crystallization of contingent liabilities from the banking system... Overall, the recapitalization measures announced to date could reach almost €25bn …and Moody's expects that Anglo Irish Bank may need further support. … While we do not expect the government -- not even in a moderately stressed scenario -- to incur permanent losses in excess of 25% of the country's 2009 GDP as a result of [Nama] obligations, we believe that the uncertainty surrounding final [Nama] losses would exert additional pressure on the government's financial strength.”

Oh, mighty. So Moody’s believes that Nama will generate final losses. May be not as bad as €41bn (1/4 of GDP), but certainly losses. And notice that losses below 25% of GDP are expected by Moody’s explicitly in the scenarios that are better than or equivalent to their ‘moderately stressed scenario’… Of course, Nama’s Business Plan Redux envisions losses only in the ‘worst case scenario’ and even then, the modest €800mln.

“Moody's notes that the country could experience downward rating pressure in the event of (i) a failure of the economy to rebound in a meaningful way; and/or (ii) a severe deterioration in the country's debt metrics triggered by a further crystallization of bank contingent liabilities beyond Moody's current expectations.”

Err… let me see…

Bank recapitalizations that Moody’s have factored in – at €25bn to date – have already been exceeded, with current running estimate at €32bn committed, plus last week’s open-ended offer to give AIB anything it needs from Brian Cowen. These are likely to rise once again after today’s announcement from Nama on tranche II transfers. So condition (ii) is already satisfied.

Per economy’s likelihood of a rebound – well, give it a thought. Government policy over the last two years was characterized by increased taxes, retained waste, lack of reforms in public sector, lack of reforms in state-controlled private economy, lack of reforms in bankruptcy laws, massive waste of funds on poorly structured banks supports, and laissez fare in relation to banks and semi-state companies ripping off consumers and businesses. None of it is likely to change in 2011-2012. Which part of this litany of economic policies misfires can contribute to an increasing likelihood of a robust economic rebound?

Ireland is clearly not out of the woods when it comes to bonds ratings and this persistent problem of continued deterioration of public debt ratings will be a costly one.

Mark my words – as Ireland’s public finances continue to deteriorate, our debt will become more costly to finance. Should the Government opt for any tax increases in order to raise 2011 revenue, it will face continued fall off in income and transactions taxes collected, as people engage more actively in tax liability minimization. This will trigger widening of our deficits in excess of international forecasts (no one pays attention to our own ‘rosy’ forecasts anymore), leading to further debt downgrades. In particular, I would expect Fitch to move first once again to put two notches between itself, Moody’s and S&P.

One more point before we conclude. Irish banks are heavily dependent for capital and collateral on Irish sovereign and Nama bonds. The latest downgrade must have an adverse longer term impact on the quality of the banks balance sheets. Regardless whether AIB and BofI pass their EU-administered stress tests or not, I would expect the Moody's downgrade to have potentially significant adverse effect on Irish banks ability to tap private markets for funding in the near future. This, of course, might trigger another run on the Exchequer and customers by our leading banks.
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