Friday, December 24, 2010

Economics 24/12/10: Retail Sales for November

Retail sales stats were out this week, prompting the usual 'upbeat' comments from the official analysts.

Here's an example from one bank analyst (emphasis is mine):

"November retail sales figures show a second consecutive monthly increase in sales volumes. The 0.2% rise last month followed a 0.3% monthly gain in October, representing the first back-to-back monthly increases since March/April. This leaves total sales in October/November running some 0.4% above the average level seen in the third quarter."

Oh, Mighty Aphrodite, folks. Time to pull the crackers out and funny hats? Alas, no. The quote above is so full of spin, you get dizzy after the first two sentences and by the end of the second paragraph all systems collapse is virtually inevitable. For reality is nowhere to be seen in the claims made above.

Take a look at the full seasonally adjusted figures for sales:

First, levels of sales - volume and value
Few things are worth noting:
  • November shows that we - consumers in Ireland - are purchasing 23.89% less today than in February 2008 - the peak of our retail sales volumes
  • Same figures show that we are buying 17.45% less value relative to October 2007 - the peak point in the value of sales index
  • We are now consuming some 9.2% less in terms of volume and 4% less in terms of value than in 2005
  • November 2010 index of 90.8 seasonally adjusted volume of sales is below that in November 2009 (91.8) and November 2008 (109.1)
  • November 2010 index of 96 seasonally adjusted value of sales is above that in November 2009 (95.1) but below November 2008 (106.5)

Chart above shows changes in two series mom and yoy. Three things are worth noting there:
  • Mom - both series are pointing down, with alue index going from +0.6% in October to -0.1% in November, while volume index from +0.3% to +0.2%
  • Yoy - value index going from -0.3% in October to -1.1% in November, while volume index moved from +1.9% in October to +0.9% in November
  • Yoy there has not been a positive growth month in terms of value of sales since April 2010
Our friendly economist quoted above went on in his/her note:
"As has been the case for much of the year, the overall picture is being flattered somewhat by rising levels of car sales. This was a pattern that was again evident last month, according to the CSO, as the motor trade category posted a 0.4% monthly rise in sales volumes. While modest by the standards of the stronger increases in car sales earlier in the year, this was still enough to pull total sales higher in November as core sales (which strips out the motor trade) fell by 0.2% on the month. This 0.2% fall in underlying sales followed a flat reading in October to leave core sales running about 0.5% lower than their average level in the September quarter."

Well, notice - there are no yoy references. Shall we take a look?
As above:
  • Relative to the peak (February 2008) value of core retail sales today is down 19.09%
  • Relative to the peak (October 2007) volume of core retail sales today is down 12.90%
  • There are clearly two moments - around Q1-Q2 2010 when the volumes and values of retail sales ex-motors peaked locally - prompting the very same analysts to start trumpeting the recovery in retail sales, alas, all of these 'gains' were exhausted
  • Ex-motor retail sales have reached another record lows in terms of both volume of sales and value in November 2010.

While the picture above confirms that there is little ground for optimistic reading of retail sales let's do justice to the quotes above:
  • While celebrating the first consecutive two months rise in volume of retail sales since April,
  • Keep in mind we also had (1) third consecutive month of declines in the value of core sales - the first time since December 2009, (2) 28th consecutive month of annual declines in the value of core sales, (3) 6th consecutive month of annual declines in the volume of core sales.
Looking at subcategories of sales, 7 out of 12 categories posted declines in volume mom and 8 out of 12 yoy. In value terms these figures were 7/12 and 9/12 respectively. In October 2010 we posted 9th worst performance in retail sales volumes in EU27 and 5th worst in Euro area 16.

Economics 24/12/10: Forecasting 2010 Trade performance

As a follow up for the previous post, here are my forecasts for levels of Exports, Imports and Trade Balance as well as Terms of Trade for Ireland for 2010 - using monthly data:
Overall, Terms of Trade deterioration in October 2010 stood at -5.12% on the best reading for 2007-to date.

Economics 24/12/10: Ireland's Trade Balance

With a slight delay, here is a deeper look into Ireland's trade performance through October.

First - exports and imports in levels:
Notice first that Imports are following steeply down-trending line, while Exports are trending flat and even slightly down over 2007-to-date period. Encouragingly, since May 2010, Exports are managing to stay well above their longer term trend line.

Summarized in the tables below, monthly and annual figures show clearly that significant gains in the trade balance are driven primarily by the continued declines in imports.

Hence, trade balance gains - impressive at +7.46% month on month and 11.95% in year on year terms:

At the same time, strong performance in Trade Balance is coming against the tide of adverse changes in the terms of trade: September marked the 4th consecutive month of deteriorating terms of trade, with a fall of 0.7% on August. Overall, since May 2010 terms of trade
have fallen by a cumulative 5.11% through September 2010. We can now expect this process to continue through October-November and cumulative May-October loss in terms of trade to rise to 5.9-6%.

It is worth taking a closer look at the relationships between trade balance components and terms of trade over the 2007-2010 period.
There is no statistical relationship between the level of exports and the terms of trade over 2007-2010 (through October). The relationship stands at y = 0.0175x + 7257.1, R2 = 1E-08. There is a relativeley weak, but strengthening relationship between trade balance and the terms of trade (as reflected in levels). In 2007-2009 data, terms of trade were able to explain roughly 0.32% of variation in the Trade Balance (y = 14.215x + 1385.2; R2 = 0.0032). Including data through October 2010 provides for much stronger explanatory power of 12.3% (y = 90.668x - 4989.4; R2 = 0.1228).

As chart below shows,
correlation between levels of exports and imports has reversed sign in 10 months through October 2010 (to – 0.1458) compared with the first 10 months of 2009 (+0.3264). In longer terms, 2007-May 2010 data implied relationship between the levels of exports and imports was: y = 0.3266x + 5726.9; with a strong R2 = 0.2171. Adding data through October 2010: y = 0.1953x + 6398.5 and lower R2 = 0.0802.
Looking at the annual data:
Using annual data for 1990-2010 (where 2010 is my forecast values) we have weak relationships between growth rates in imports, exports and trade balance as a function of terms of trade changes. My full year 2010 forecasts are: Imports value €43,506mln, Exports value €85,209mln and Trade Balance of €41,703mln. This represents a forecast of 3.4% drop year on year in imports, 2.02% rise in exports and a jump of 8.4% in trade balance.

All of this data clearly suggests accelerated process of transfer pricing by profit-generative MNCs during the 2010 period. In fact, looking at log-relationships, growth in the trade balance is currently being explained by faster shrinking imports than the changes in exports. Coupled with deteriorating terms of trade, we have strong suggestion that our trade performance is being sustained primarily by the MNCs driving through strong expansion of profit-booking transfer pricing.
Of course, one should remember that whether due to transfer pricing or organic exports growth or - as indeed is the case, both - the improving Trade Balance is about the only positive news we can count on in 2010.

Tuesday, December 21, 2010

Economics 21/12/10: BofI & Irish derivatives warning from the IMF

How wonderful is the world of international banks linkages? And especially, how wonderful it can get when regulators are so soundly asleep at the wheel, a firecracker from the IMF can be shoved in their faces and popped, and the snoring still went on.

A 2007 working paper from the IMF, republished earlier this year in an IMF journal, has warned Irish regulators that (referring to the data through 2005):

“BofI had launched a new venture with a leading Spanish bank, La Caixa to provide extra mortgage options for Irish people buying property in Spain, which included equity release from existing BofI mortgages” (
IMF WP/07/44: External Linkages and Contagion Risk in Irish Banks, by Elena Duggar and Srobona Mitra).

Now, think of those La Caixa/BofI borrowers leveraging levels.
But here’s the bit that relates directly to securitisation threats I hypothesize about in the previous post (here): on page 8 of the report, IMF folks state: “Irish banks could be indirectly exposed to property markets by selling risk protection (buying of covered bonds, credit default swaps, and mortgage backed securities) to other banks which are exposed to foreign property markets. From anecdotal evidence, some small IFSC banks, exposed to international property markets, are selling CDS to other domestic-oriented banks, making the latter indirectly exposed to these property markets even though their loan books are not.”

Of course, the Irish banks were also selling protection to the SPVs they were managing as well. And now, lets jump to IMF’s conclusions:

Some tentative policy lessons could be drawn from the results of this exercise. The Central Bank and Financial Services Authority of Ireland (CBFSAI) may want to stress test specific categories of exposures of Irish banks to both the U.S. and the U.K. Even though linkages with the U.S. do not come out strongly from aggregate consolidated balance sheet exposures, there might be derivatives or other off-balance sheet exposures that the bank supervisors may need to be vigilant of. The Irish authorities may need to collect more information about types and counterparties of derivative positions and risk transfers through structured products of Irish banks, as the use of these is likely to grow rapidly in the future. This would especially be necessary if Irish banks are buying CRT products from foreign banks (that is selling risk protection) that are in turn exposed to property markets or other loan products in the U.S. or the U.K., thus exposing the Irish banks to these markets even though there is no direct loan exposure.”

Sounds like a warning against Irish banks exposures to lending against the US-based property? Oh, no – not at all. In fact recall a basic stylized fact of mortgages finance – in the long run (equilibrium) long term yields on Government debt and long term mortgage rates converge. Which means that if an Irish bank was underwriting an interest rate swap for the US SPV that purchased Irish bank’s securitised loans, then Irish bank was taking a position in providing insurance into the US interest rates environment.

The article – based on 2005 data – couldn’t have imagined what followed in 2007 and 2008.
But, needless to say - judging by their staunch silence on the issue of derivatives and securitisation - our regulators didn't bother with the IMF warnings back then... and still are not bothered by them...

Update: It is worth noting that today the EU Commission approved measures for AIB, Anglo and INBS (details here) that include "a guarantee covering certain off-balance sheet transactions" - a code name for things like securitisations and derivatives...

Economics 21/12/10: Derivatives hole?

Updated (end of post)

The following post is attempting to put some numbers behind a highly uncertain, opaque and completely under-reported side of the Irish banks operations - the side relating to securitisations and derivatives exposures. My numbers below are pure estimates and their objective is to at least start raising the questions as to the depth of our (taxpayers) exposure to this murky world of banks' securitised assets.

Before we begin, I must also relay my thanks to Brian Lucey and 3 anonymous experts for providing advice and comments on the earlier draft and to LorcanRK who was involved in trying to scope the problem earlier.

Years ago, before our sick puppies (banks) became sick, in the golden days when the Anglopup, AIBickey, permo, INBiSquit, EBSsie and BofIpooch were still wagging their happy tails around the streets of Dublin, securitisation was all the rage.

The basic idea behind this transaction runs innocuously enough as follows: a bank holds a bunch of loans, say mortgages. These yield an annual revenue stream, but hold up capital, restricting new lending. To help unlock this capital, a bank can package these loans together and sell them to an SPV which will issue a paper security against these loans that entitles the owner to a share of the total package of loans as they yield returns over time. An SPV, of course, doesn’t manage the mortgages but leaves them in the custody of the bank which acts as a manager/custodian, responsible for collecting the moneys due and paying out to the SPV.

Now, for a bit relevant to us: an agreement between the SPV and the custodian has two key covenants:
  1. loans are held by the custodian in trust, so that the custodian is obliged, upon either the termination of the management contract or should other covenants be breached, to deliver the actual loans/mortgages to the SPV owner;
  2. ability of the custodian/manager to hold on to the loans is subject to a minimum credit rating, usually - investment grade.
The first point means that should an SPV ask an Irish bank for its loans (due to a breach in its covenants), the banks must deliver these loans.

The second point means that if the covenants are breached, by, say for the sake of argument, Irish banks rating sinking to junk, the banks can be found in a breach of covenants and face:
  • a margin call – according to my sources, of up to a whooping 20% face value of the securitized loans in some cases; and/or
  • a call on the actual loans to be transferred to a different manager/custodian nominated by the SPV
Every securitized contract runs alongside it a derivative security designed to protect against the risk exposures relating to the loans.

These derivatives can be
  • symmetric – covering both sides of the potential exposure – e.g. interest rates swaps going both ways or
  • asymmetric or uni-directional, covering only one side of the risk exposure (e.g. an interest rate swap insuring against a future rise in the interest rates).
The derivatives can be written by an independent entity or by the bank, but for the reasons of good risk management (maturity mismatch risk and direct exposure to underwriter risk) these derivatives should really be underwritten by the third parties, not the custodians.

Now, let’s go back to the history. Earlier this year, I wrote about our ‘national derivatives accounts’:
  • AIB held the total derivative exposure to the notional value of €261bn in 2008 which fell to €197bn in 2009 (here)
  • BOI held €360.5bn (here) in 2009
  • Anglo held some €268.3bn worth of notional value derivatives in 2008 (here), falling to €184.5bn in 2010 (here)
The above is very close to the gross notional exposure amounts of €640 billion (for two banks ex-Anglo) reported in 2008 by the employee of the Financial Regulator - Grellan O'Kelly (here).

So now, suppose that the notional value reflects symmetric hedges, and even there, let's assume that directionality is such that benign risk is weighted by twice the weight assigned to maximum loss-linked risk, so that the underlying value of these derivatives is around 1/3rd of the €742.3 billion of notional value, or €245 billion.

Here is the beefy problem. Since these derivatives are written against real loans contracts, what happens if the covenants of the SPVs behind them are breached?

Let’s talk some hypotheticals (since we have no actual clarity on these):
  • Scenario 1: Irish Government debt sinks to junk, which automatically means banks debt sinks to junk (while I was writing this, the latest Moody’s downgrade pushed it even deeper...). There’s a margin call on derivatives of say ½ of 20% mentioned above, or 10%. Oops – Irish banks are in a hole for up to 24.5bn off the starting line (10% of the 245bn above)
  • Scenario 2: Instead of a call on the derivatives, SPV breaks management agreement with an Irish bank and asks for its loans to be moved out of the bank. Wouldn't be a problem, unless: what if the bank, in the mean time, has leveraged the same loans it held in custody for the SPV at the ECB (or CBofI or both) discount window? Well, should the SPVs insist, the Irish banks will be forced to buy their collateral out of ECB and CB of Ireland to the amount that the banks borrowed against such collateral.
Things are starting to smell rotten… But do not be afraid, those in charge who still have some brains left spotted the dodgy stuff. To our chagrin, however, the smart ones are in Frankfurt, not in Dublin. Back in August 2008, the ECB has pulled the plug on taking Irish banks-securitised loans as collateral. Miraculously, in the end of 2008, CBofI lent Anglo €10.5bn against some mysterious collateral that, several of my sources argued, was previously rejected by the ECB.

Why would the ECB decline to take securitised packages as collateral, while taking the loans? Surely this signals something is amiss with the vehicle of securitisation as carried out by the Irish banks?

Two things can be dodgy with the securitized packages in general:
  1. Underlying derivatives, and/or
  2. Security over the loans/assets that are securitized.
I am not going to speculate what it is – time will tell. Instead, let’s run through some scenarios on potential losses due to the above positions.

  • Assume that the above gross notional amounts of derivatives are 2/3 covering one side of exposure (e.g. expected increases in interest rates, for interest rate swaps) and 1/3 covering less expected opposite direction risk. This means that of the total values of derivatives written by the 3 banks, these derivatives were covering a collateralised pool of loans/assets equal to 1/3 of the gross notional derivatives.
  • Now, some of collateralised assets were held by the banks themselves, but we do not know how much. So let’s assume that 25% and 50% are reasonable amounts for these shares, implying that banks sold on some 50% to 75% of the securitised assets
  • Next suppose that the banks have written down these securitised assets by 20% (a gross overestimate, but let’s allow it to be conservative) and that the ECB has applied the usual 15% haircut in lending against the above writedowns
  • Table below shows the estimates of potential losses

So the downside from the derivatives exposure and securitization can range between €12.25bn and €50.8bn.

Pretty wide.

Let’s take a look at the underlying assumptions. Running through the ‘What if covenants are breached?’ scenarios, one has to remember that many of the securitized loans borrowed against are related to more stable, longer-term mortgages. Since default rates across mortgages are lower it is highly unlikely that SPVs wouldn’t want to claim them out of the hands of the insolvent banks. This means that the 10% margin call on all loans scenario is highly unlikely to materialize. More likely – either the margin calls will be larger, or full call backs will be triggered. Which suggests that the range above more realistically should be expected around €17.15bn and €25.7bn.

Also, recall that Irish banks weren’t really at the races in speculating on financial instruments, preferring instead to speculate on property. This means that my assumption of 50% unidirectional net derivatives relating to property securitization is pretty conservative.

And remember that none of this has been factored by either the IMF or anyone else into the expected losses across the Irish banks. It hasn’t been incorporated into my earlier estimates of
  • €67-70 billion total losses on NAMA, recognized losses and post-2010 commercial and investment books’ losses, and
  • €9-11 billion total losses on mortgages post-2010, plus
  • the lower €17bn figure as an estimate for the derivatives and securitization-related losses.
The total expected loss across the entire banking sector, net of recoveries might be as high as €93-98 billion. Or it might go as high as €107bn. And at this point, folks, even an old hawk like myself starts to feel scared.

Note: these are potential estimates. Given that we have been given no clarity as to the depth of securitisations, or the derivative instruments underlying it, nor do we have any idea as to what the banks have been doing with custodial-managed loans that relate to securitised products, one can only guesstimate - or speculate - as to the true extent of losses. I tried my best to be very, very conservative in the above, with my upper limit of factored estimate of €25.7bn in losses being below the average of the most benign scenario (€12.25bn) and the worst case scenario (€50.8bn). I was also very conservative in my assumptions. Note also that in the end, €17-25bn range of losses used in final estimate of the total cost of banks bailouts corresponds to just 2.29-3.37% of the notional value of all derivatives held in 2009 by the three banks.

Update: things are hardly trivial when it comes to potential securitisation-linked derivatives exposure. Back in 2007, the IMF has warned Irish regulators that:

BoI has transferred the bulk of its domestic residential mortgage assets to a designated mortgage credit institution, which has a banking license to issue mortgage covered securities.—these are used both for hedging interest risk and for generating additional funding. Almost 60 percent of these securities were held by other Euro Area members, while 25 percent was held in USD by other countries. (IMF WP/07/44: External Linkages and Contagion Risk in Irish Banks, by Elena Duggar and Srobona Mitra - here)

Did IMF say 'the bulk'? So as of 2006-2007, the bulk of mortgages were out to securitisation in a 'conservatively' run BofI?

Friday, December 17, 2010

Economics 17/12/10: Q3 2010 National Accounts - part 2

This is the second post on the QNA data for Q3 2010.

Let's take a look at three more dynamic sectoral components of GNP.
Services and industry are now pulling in different directions, which means the proverbial glass on growth is really half-full (or half-empty). Amazingly, construction sector continues to shrink. This is even better illustrated as the sector share of domestic economy:
Now, recall that PMIs for construction sector for November showed continued monthly contraction in sector activity, led by civil engineering (as the rest of the sector has already shrunk by well over 80%). 2011 forecast for new homes completion is now around 9,000 units - and in my view that too is rather optimistic. This means we can expect more bad news out of the sector with a continued knock on effect onto auxiliary services and materials sectors.

Taking a look at GDP and GNP in current prices terms:
For the second quarter in a row, the value of Irish exports was in excess of the value of the country GDP (by 2.94% in Q3 - down from 3.03% in Q2, while in Q3 2009 it was 11% below the level of GDP). Undoubtedly, weakening euro helped here.

Again, in current prices, consumers are still striking, while capital investment has gone even deeper into the negative territory, so that the very partial replacement of amortized stocks that gave it a temporary boost in Q2 before has been exhausted. Government spending is not showing much of a decline.
Take a look at quarterly rates of change in the above components:
We are now an economy that consumes its capital stock, not the one that adds to it for future growth.

Thursday, December 16, 2010

Economics 16/12/10: Q3 2010 National Accounts - part 1

This is the first post analysing the latest Quarterly National Accounts data for Q3 2010 released today.

Let's take a big picture view first.
Both the GDP and GNP expanded in Q3, with GNP marking the second quarter of continuous expansion. Real GDP grew +0.5% qoq. Currently, GDP stands at 1.7% higher the lowest point in this recession so far (Q4 2009), but 0.694% below Q3 2009 in current prices. Cumulative Q1-Q3 GDP (seasonally adjusted, constant prices) stands at -1.21% below Q1-Q3 2010 GDP. In other words, year on year we are still in a recession.

Real GNP also rose qoq by 1.1% - a second consecutive quarterly rise following a tiny uplift of 0.1% in Q2. Since GNP measures our actual economy, netting out transfer pricing by the MNCs, it is worth taking a bit of a closer look at the numbers. Net transfers out of this economy, which includes remitted profits, rose 4.573% in Q3 in yoy terms. Over the first three quarters of 2010 this number is up 10.46% relative to 2009. As the result, our GNP was 1.77% below Q3 2009 level and the first three quarters cumulative GNP for 2010 was 3.7% below that of the same period in 2009. By any real metric, this is a raging recession, folks.

The good news from today's figures is that our exports are still growing, and in fact, are still driving economic growth. Total exports grew by 3.6% qoq, though that rate was 7.6% in Q2 2010 and 6.4% in Q1, which implies that Q3 posted a slowdown in exports growth. We now have three consecutive quarters of growth in exports. Which is brilliant news. Year on year, Q3 exports grew by 13.1%, while first three quarters of 2010 posted a rise in exports of 8.9% relative to the same period in 2009.

Irish exporters do deserve some serious praise here. And one other net positive is that we are finally seeing domestic economy benefiting from this exports growth, as evidence by the slight closing of the GDP/GNP gap.

But more on exports later.

As chart above shows, consumer spending and government spending were down, once again.

Consumer spending was down 0.544% qoq - the largest decline in year and a half. In yoy terms, consumer spending was down 1.38% and in Q1-Q3 cumulative terms, personal consumption was down 1.1% on 2009.

Government spending fell 5.053% yoy in Q3 (note that the same yoy decline in Q1 2010 was 6.082%, implying that Government performance on spending side actually worsened during the year), qoq Government spending fell 1.738% in Q3 2010.

Total domestic demand is down 1.7% qoq and 5.1% yoy.

But take a look at the comparatives for the dynamics of private consumption and Government spending since 2005. First, consider both expressed in constant prices:
And next, consider the same expressed in current prices:

In real (inflation-adjusted) terms, Government spending is currently between Q1-Q2 2006, while private consumption is between Q4 2005 and Q1 2006. A close comparison. Once we allow for inflation (in current prices terms), Government spending is currently between Q4 2006 and Q1 2007, while private consumption is between Q4 2005 and Q1 2006. Much less of a match.

Tuesday, December 14, 2010

Economics 14/12/10: ECB/CBofI Ponzi schemes

Last week's ECB figures show that the Irish banks have managed to rake up €136bn worth of borrowing from Frankfurt as of November 26th. This is an increase of €6bn on end-October figures. Mysteriously little? Not really - Irish banks have also borrowed some €45bn from the Central Bank of Ireland - a rise of €10bn on October.

The reason for such a dramatic increase in borrowing from the CBofI instead of ECB is two-fold:
  1. ECB is becoming increasingly reluctant to lend to the Irish banks, and
  2. Irish banks have run out of suitable collateral to pawn at the ECB discount window.
Which, in turn, means 2 things.

Firstly, Irish banks demand for borrowing is not abating despite Nama and other measures undertaken by the Government. Injecting quasi-Governmental paper into banks balancesheets has meant that the banks face immediate loss without any real means for covering it (remember, they can't really count on selling Nama bonds in the market without incurring an extremely steep discount on the value of these notes). Swapping nearly worthless paper for almost totally worthless loans is not doing the job and the entire banking system simply sinks deeper into debt.

Secondly, Irish banks have now uploaded some €45 billion worth of useless paper (that even ECB is unwilling to accept) into the Central Bank of Ireland. How much of this paper is loss-generative and are we, the taxpayers, on the hook for these losses, should the whole pyramid scheme go belly up?

Oh, and in case you wonder - ECB's equity funds are €5.8bn. It's lending side is over €200bn (it was €139bn total - banks lending & sovereign bonds inclusive - as of the end of December 2009), so as a bank, ECB's 2009 leverage was 24 times. Now, it is closer to 35 times. Lehman Bros territory, folks.

Sunday, December 12, 2010

Economics 12/12/10: Europe's crisis won't be solved by the ideas advanced to-date

The most revealing feature of the EU response to the current crisis is the nation states' and Brussels/Frankfurt total denial of the real problem. We are witnessing a debt crisis stemming from unsustainable levels of liabilities piled onto weak economies in order to finance various forms of social welfare state.

This fact is clearly revealed in the 'solutions' being discussed by the EU leaders:
  • Tax and fiscal policies harmonization - Harmonizing PIIGS, German, French and other fiscal systems will not achieve more transparency or discipline than the already existent SGP criteria for deficits and debt allowances delivers on the paper. Nor will it provide for better enforcement of these rules. More importantly, it will not reduce the unsustainable levels of debt accumulated by the citizens and sovereigns of Europe. Instead, the divergence between fiscal objectives of the younger and/or less developed states and those with older population and capital and consumption bases will be amplified.
  • The idea that centralized bond issuing mechanism will solve the current crisis is basically equivalent to believing in self-healing properties of the disease that's killing you. Bond markets are shorting European sovereign debt not because it is issued by decentralized authorities, but because EU sovereigns have borrowed too much already and/or assumed too much of the private banking sector debt. To issue even more debt, underwritten by the very same sovereigns is like combating a hangover by drinking more whiskey in the morning. Common EU bond issuance will be repeating the fallacy of securitization that has resulted in the markets saturated with AAA-rated mortgages packages blending AAA and subprime loans.
  • Increasing EFSF funding will not solve the problem, for it assumes that EU states are facing a cash flow problem, not a structural debt overhang. As I said before in the Irish and Greek cases - issuing more debt to pay down old debt is simply not going to be a long-term solution to our difficulties.
  • Finally, the idea of national currencies or two-tier Euro is even more denialist in its nature than all of the above proposals combined. The argument against it is provided in my article in today's Sunday Independent here.
The core problem is that the EU and the national governments remain blind to the main issue at the center of the current crisis: European social welfare states have accumulated too much debt to sustain status quo. These debts were accumulated via various channels:
  • The sovereign channels operated in Italy, Portugal, Belgium and Greece;
  • The depressed consumption transferred private incomes into public in Germany, Austria, Hungary, Slovenia and the Nordics;
  • Banking debts socialization and obligations transfers from public spending to private liabilities has led to the debt explosion in Ireland
But across the entire Europe, either Governments or private sector or both simply live well beyond their means. The only resolution that can restore health to our economies rests with a two-step structural change:
  1. Restructuring debts to reduce debt burdens on the real economy, followed by
  2. Restructuring economies to make them leaner, fitter and capable of sustaining growth
Both require re-thinking of the European social welfare state system with a view of making it's core principles sustainable in the environment of economic growth we can deliver. Nothing else will do the job.

Monday, December 6, 2010

Economics 6/12/10: IMF stress tests for Irish banks

Here are three things that are worth asking about the latest details of the EU/IMF 'rescue' package released over the weekend. All relate to the issue of banking sector restructuring:

  1. According to reports, some €2 billion will be available to enable the banks to sell €20 billion worth of assets (which, of course, implies sales of performing loans, as all other assets, such as foreign divisions, auxiliary services providers, asset management branches etc have already been flogged or put on the market). As reports issued today specify: the funds may come in the form of a loss protection or as a guarantee for asset purchasers. These €2 billion come on top of the €10 billion set aside for the immediate re-capitalization of the banks, and on top of further €25 billion in contingency funding allocated. So it appears that it either comes from the Exchequer side of the EU/IMF deal, reducing deficit financing available to the Government or, alternatively, on top of the €67 billion in lending extended under the whole deal. In effect, the EU/IMF will now engage Irish taxpayers funds (remember - these €2 billion are loans) to sweeten the bitter pill for buyers of Irish banks assets. A small, but lovely morsel of taxpayers income that will be spent on artificially propping Irish assets for sale.
  2. According to the Irish Times, stress testing scenarios deployed by the IMF in pricing the overall demand for taxpayers funding for the banks involved the following assumptions: losses of 10% on buy to let mortgage books and 6.5% for residential mortgages. These assumptions underwritten the demand for €25 billion in contingency funding, spread as €15 billion in required capital, plus €10 billion additional cushion. This is rather interesting and worrying. Buy-to-let mortgages are most certainly completely under water right now, given collapsed rents and capital values, as well as more recent vintage of these mortgages. If investment and commercial books are facing up to 35-40% losses currently (as consistent with the Government own estimate of €50 billion final cost of banking sector recapitalization), is it safe to assume that buy-to-rent mortgages will tank at 10%? Similar questions arise with respect to 6.5% assumption on mortgages defaults. In fact, we already know that over 100,000 mortgages are either in official distress or under renegotiated repayment holidays or interest rates adjustments. This pushes the effective default and at-risk of default numbers will in excess of 6.5% as of today.
  3. If contingency fund of €10 billion were to be taken as covering any losses in excess of 6.5% defaults on mortgages and 10% default on buy-to-rents, then this amount is expected to cover: (1) Haircuts by Nama on additional €14 billion in loans transfers (cost ca €6-7 billion at past haircuts), plus (2) Losses in excess of assumed rates on mortgages and buy-to-rents, plus (3) any further losses on investment and development books, plus (4) any further losses on derivatives exposures. This is hardly realistic of a cushion. So it appears that the IMF was either not given the full realistic picture of the Irish banks balance sheets, or it is seriously underestimating the demand for future losses cover in the banks.
Either way, the numbers continue to suggest that the €67 billion package of loans will not be enough to provide simultaneously a cover for Exchequer deficits and the funds required to underwrite losses and capital requirements of the banks. Somehow, the Irish Exchequer will have to make up for this shortfall.

Sunday, December 5, 2010

Economics 5/12/10: Debt, debt, debt... for Irish taxpayers

I decided not provide any analysis of the figures below. These figures speak for themselves. To explain their purpose: I have computed the expected burden on current and future taxpayers from the total ex-banks debt carried by Ireland Inc as:
  • Households debts (mortgages, car loans, personal loans, credit cards, etc);
  • Government debt (inclusive of quasi-Governmental debt undertaken under the EU/ECB/IMF loans and Nama).
  • I also incorporate total corporate sector debts, including non-financial corporations debt and debts entered into by non-banking financial corporations. However, the corporate debt DOES NOT form the part of taxpayers liabilities, although at least some of it will have to be repaid out of our (taxpayers) pockets one way or another.
All figures input into calculations were taken from CSO and Central Bank of Ireland databases. All core assumptions are outlined in the second table.

Finally, note - the total figures of debt per taxpayer are for Household Debts and Government (including Nama & ECB/EU/IMF loans) debt. Do not, please, confuse them with the official Government debt alone.

So here are two tables. Interpret them as you wish:

PS: some people accused me of double-counting:
  • banks debts and mortgages/households debts. I am not - banks debts are excluded from the above considerations;
  • Government bonds outstanding and rolled over. I am not - the only net increase between 2010 and 2014 in Government debt due to roller overs of existent (pre-2011) bonds is due to an increase in the interest rate taken on rolled over bonds at 1% (again, conservative, as per ECB/EU/IMF deal we will be paying 1.13% over the current average rate of interest on already issued bonds).

Economics 5/12/10: Reserves requirement ratio

In response to the following tweet:

"A question. You wrote here that the decision of the Chinese government to raise reserve requirement ratio for the commercial Chinese banks in order to cut down on their lending as "monetary tightening".

According to this article by Phillippe Legrain

The Republic of Ireland could have taken similar measures during the past decade to cool down the property bubble but didn't.

I thought after European monetary union, a monetary option wasn't open any more to the Republic of Ireland.

Yet what you described as "monetary tightening" in China was possible in the Republic of Ireland according to Phillippe Legrain."

My view on the topic: Legrain is correct.

As a member of the Euro zone, Ireland retained full control over one of the tools of monetary policy, known as 'reserve requirement ratio' - or capital requirement ratio. Irish regulators (CBFSAI) has a full right to increase requirement on the banks operating in Ireland to hold the proportion of their deposits and/or proportion of their loans in reserves as capital to cover any expected losses.

Such an increase in the ratio would have reduced amount of credit available in the system and would have offset the dramatic increase in lending spurred on by the introduction of higher risk products such as 100% mortgages.

At a dinner event in 2006 I told, at the time, Governor of the Central Bank of Ireland that this is exactly what he needed to do to cool down the market for mortgages lending in the Republic. His reply was along the lines that this was politically impossible to do.

That this lever of policy is still available to Ireland is best illustrated by the two recent decisions by the new Financial Regulator to hike capital requirement ratios for Irish banks to 8% Tier 1 and most recently to 12%. Unfortunately, this decision came too late.

Were Irish banks required by the CBFSAI to hold, say 12% of their risk-weighted assets in form of capital, the taxpayers would have seen their total exposure to the banking crisis significantly reduced. Instead of ca €16.2 billion in capital available to cover writedowns against the total lending of €360 billion across our banking institutions, our banking system would have had ca €34-35 billion in capital cushion against lending of €280-290 billion. (Note: these are back of the envelope calculations, but they still show the impact of raising reserve requirement ratios).

PS: for those of you who missed an excellent PIMCO note on Irish situation and EU's 'solution', here's a link. (Hat tip to Georg)

Economics 5/12/10: Default, debt and 'Rescue of Ireland' deal

Today's Sunday Independent article on inevitability of default, with comprehensive figures on the impact of the IMF/ECB/EU deal for ordinary Irish households and the levels of our indebtedness. Link here.

Saturday, December 4, 2010

Economics 5/12/10: Probability of default

This is an unedited version of my December column with Business & Finance magazine. Note, the copy was filed before the EU/IMF deal was announced for Ireland, so some assumptions have deteriorated since then.

At this point, it is pretty much certain that the events of the last month will have a lasting and profound effect on Ireland’s economy and society at large. So much is clear. What remains uncertain – in these news-saturated times – is the exact nature of the short-term outcome of three processes at play: the Budget 2011, the IMF/EU ‘bailout’ and the end state of Irish financial markets.

Over the last 24 months this column has predicted, with surprising even to myself, accuracy the following events:

  • The complete and total failure of the Irish Government attempts to repair our collapsed banking sector – with even Nama cheerleaders of the past now coming around to recognise that the entire policy has delivered nothing but a powerfull new bureaucracy that put banks and property markets onto a permanent life-support;
  • The true extent of the expected losses in the banks, totalling around €67-70 billion ex-mortgages defaults, in contrast to successive rosy estimates by the public officials, the banks, our stockbrokers and the Government;
  • The inevitability of the banks nationalization and the risk of the Government vastly overpaying for the eventual ownership of the banking system (my estimates suggest that the taxpayers will end up paying some €40 billion more for the banks than necessary, due to the waste built into the system of previous recapitalizations and Nama);
  • The continuation of the economic recession, with a clear and concise prediction of the double dip collapse in GDP and continued contraction in GNP;
  • The inevitability of the IMF/EU taking over the reigns of power at the Department of Finance; and
  • The losses of tens of thousands of Irish and foreign younger and better-educated workers to emigration and unemployment.

Calling it right in these circumstances doesn’t give myself any sense of accomplishment or pride. To put simply, as a taxpayer and a parson calling Ireland home, I would rather have been wrong in my predictions. Unfortunately I, along with a number of other independent analysts, including Peter Mathews, Brian Lucey, and Cormac Lucey, and a number of others, was right.

Even more unfortunate is the fact that the latest events suggest that some of our past predictions are now being overtaken by reality. So let us start with what the future is likely to hold.

First, consider the budgetary arithmetics. The failed spectacle of last week’s release of the multi-annual budgetary framework for 2011-2014 horizon was a clear exercise in Government’s evasion of reality.

Take the headline figures, first.

The Government aims to cut €6 billion from its deficit in 2011. Yet, the very same Government will now require to borrow some €120-130 billion over the next 4 years to finance its day-to-day operations, the redemptions of maturing bonds, write-downs of bad loans, banks recapitalziations and shoring up countless mortgages that are either in a default or heading there. At the rates that ECB and IMF charge Greeks for their emergency funding, this figure can be in excess of €6.1-6.8 billion. At the rates that should apply under the EFSF formula, the interest bill for our new borrowings would add up to roughly €8.6 billion.

In other words, up 58% of the planned 2014 budgetary savings will go up in smoke once the ECB / IMF loans are drawn down.

Add the numbers up. Even if we were successful in driving the deficit to 3% in 2014 as the Government plan – not that there’s a chance in hell that this can be achieved in reality, especially with the new IMF/ECB inetrest charges bills coming, something that the Govenrment has completely failed to even account for in its budgetary framework – Ireland will face continuously increasing debt levels through 2016-2017 due to the cost of new borrowing.

By my estimates, the overall debt levels of the Irish Government will rise to €210-220 billion by the end of 2014, requiring between €12.1 billion and €15.4 billion in annual interest charge against the state. Almost half of 2010 tax receipts will be eaten up by interest charges alone. Put differently, if the Irish Government were to be compared to a household with average income and a mortgage with cost of financing at around 50% of the revenues it bring in, we would be looking at a mean wage earner living in a property with a mortgage that exceeds 11 times its annual pre-tax income. Only a person with absolutely zero understanding of basic finance can think that this type of a scenario can lead to anything other than bankruptcy.

And this is assuming that in the medium term, our collapsed banking sector will be miraculously restored to rude health and the sovereign bond markets will greet Ireland back as a full-fledged issuer of government debt. Both assumptions would stretch the imagination even of the most optimistic forecaster.

Next, take a look at the sub-components of the Budgetary framework.

This Government clearly believes that Ireland’s recession is over. In fact, it believes that we are now on the cusp of a roaring economic growth. Otherwise, how can the Department of Finance hope to raise some €5 billion in new taxes through 2014 and €1.9 billion in 2011 alone? Such a level of tax increases would mean that every working man and woman of this country will be expected to contribute €8,300 annually on top what they already pay the Exchequer

The Government thinks that Ireland’s economy can grow at 2.75% per annum on average through 2014. My own view is that we cannot hope to deliver such rates of growth. My mid-range forecast for average growth in the Irish economy in 2011-2014 is closer to 0.75-1% per annum, with a significant likelihood of further economic contraction in 2011.

Assuming the average rate of growth in the economy of 1% per annum through 2014 – at the top of the range of my estimates – the new taxes will add up to 25% of the projected average earnings in 2014. Again, this is on top of taxes already being collected.

Someone is clearly smoking something funky out in the rarefied atmosphere of the Government buildings.

The Budgetary framework appears to avoid factoring into the deficit calculations the full costs that the Exchequer is likely to face in years ahead. For example, it is difficult to understand how the announced provisions can cover both the need for day-to-day operations of the Government and the forthcoming additional borrowing costs related to the bailout funding, as mentioned above.

The framework also fails to provision for the expected future impact of mortgages defaults. Should, as widely expected now, the Irish households face a rising cost of mortgages finance due to banks shifting more and more burden of capital and operating costs adjustments onto the shoulders of ordinary mortgage holders, we can expect the number of mortgages in official default to reach over 100,000 over the next 2 years. Again, Govenrment’s rummaging through our pockets through higher taxes will accelerate this process. Pushing ca 60,000 new mortgages into default can cost, roughly speaking, €700 million to the annual social welfare and interest relief bills of the Government.

In other words, say whatever you may, but the so-called ‘draconian cuts’ envisioned by the Government are not enough to plug the hole in public finances without a significant reduction in levels and cost of public sector employment and a much more dramatic revision of the social welfare and health spending. We might not like these measures to be put on the agenda, but the reality bites – without shaving off some ¼ of the public sector wages, pensions and employment costs, and without reducing our social welfare and health spending by at least 1/5th each, Ireland is unlikely to begin repaying its vast debt accumulated since 2007 anytime before 2020.

In addition, let us not forget that the entire Government budgetary framework rests on a number of crucial, but economically and politically unjustifiable assumptions. First, there are the assumptions of extremely benign interest and exchange rates environments – the ones that crucially underpin the real cost of borrowing by the state, but also the implicit rate of growth in our exports, the cost of our imports of inputs into exports production and consumption, the rates of mortgages defaults and other economic variables.

Perhaps the only really progressive measure introduced in the programme is the Site Value Tax – a tax levied on the value of land for residential and zoned land, but exempting for the political reasons agricultural land. The idea of the site value tax, advocated by me in these very pages, before is that it should replace transactions taxes on property without penalizing households who invest in improving their homes and properties. The tax can be effectively used to recover the benefits of public investment in schools, infrastructure and other public amenities that currently accrue to the private land owners. Although the Government hopes to raise €530 million from this measure, little detail is provided in the plan as to the specifics of the SVT application.

Government puts much faith into its plans for reinvigorating the economy. These too were outlined in today’s document. The Government that brought us into insolvency through its handling of the crisis over the last 2 and a half years is aiming to “remove potential structural impediments to competitiveness and employment creation” (something that they failed to achieve since 2001) and “encourage exports and a recovery of domestic demand” (with domestic demand clearly identified in the very same document as the sacrificial lamb on the altar of fiscal adjustment).

A net positive, if unfortunately timed to coincide with deep recession, the reduction in minimum wage is hardly the core to the sustained jobs creation in this economy. By Government own admission, even with this measure, Ireland will retain one of the highest minimum wage rates in the EU.

More important are Government plans to strengthen its labour market “activation policies” for the unemployed and “promote rigorous competition in the professions”. Both would be welcomed were we to have any confidence that they can delivered on. The very same Government that promises now liberalization of professional services has presided over a decade-long preservation of non-competitive marketplace in professions. And as far as employment activation policies go, it is patently clear that barring a deep root and branch reshaping of Fas, there is no chance any efficiency can be gained from the existent activation systems.

Which brings us to the point where the evidence of the last few weeks converges to a point which warrants the following prediction. Regardless of the IMF/EU ‘bailout’ loans, Ireland is now firmly on the course toward a restructuring of its debts at some point in the near future. The only choice we have, as a nation, is the path of this restructuring. The options we face are dark. Irish Government can either recognize the gravity of our situation and force an orderly debt for equity swap within the Irish banking sector, simultaneously imposing significant writeoff on the household debts of at least 15-20%. Or we can muddle through more borrowing, more debt, toward a disorderly, market-driven default on the very same banks debt and potentially (depending on the extent of our future borrowings) sovereign debt.

The choices we have, therefore, are unpleasant, painful and unprecedented by the standards of an advanced economy. But their real causes – the failures of the last 2.5 years of crisis management policies – make them virtually unavoidable.

Economics 5/12/10: Links to recent articles on irish economy

Here is the link to my article in Saturday Irish Independent on the topic of FG and Labor 'alternative' Budget 2011 proposals: here.

Here is the link to another article from Saturday, this one from the Irish Examiner on the topic of banks debt default as an option for Ireland: here.

Economics 4/12/10: Exchequer expenditure side

Let's take a look at the dynamics of the Exchequer expenditure, building on the data released for November earlier this week.

First the total expenditure:
On total spending side, November 2010 posted improvement of €1.795 billion year on year or 4.22%, and €2.867 billion on November 2008, or 6.57%. Much of this came out of the capital investment cuts, but even putting this aside it is clear that adjustments on the spending side of Exchequer balance sheet have been too slow to reach the levels required (ca 20-25%).

Next, by separate departments.
A cut of 28.53% on 2009 levels in November.
Chart above shows bizarre reality of our budgetary allocations. Arts, Sport and Tourism gobbled up some 2.2 times more resources than Communications, Energy and Natural Resources in November 2010. This was 2.67 times in 2008, and 2.26x in 2009. No one is to say that Arts, Sport and Tourism are not important, but does anyone feel we've got some priorities screwed up pretty solidly here?
Community, Rural and Gaeltacht Affairs - with a budget 1.97 times (November 2010) greater than that of the Communications, Energy and Natural Resources has also been one of the core laggards in delivering savings. Presumably because it finances such vital economic activities as delivery of Irish language translations of the speeches of our Dear Leaders. Again, anyone seriously thinking that our priorities should be in spending double the amount we spend on communications, energy and natural resources on rural supports schemes and Gaeltacht subsidies?
Education - despite what we might have heard - is one of the least affected spending departments, compared to others. Year on year November 2010 delivered cuts of 4.3%, while 2 year cuts amounted to 3.2%. This does look like at least some priorities might be right. In contrast, ETE saw cuts of 26.9% over 2009-2010 span (November to November) and 26.2% of these came in 2008-2010.

Just in case if you think we were already spending enough on preserving various arts, linguistic and other cultural values, here comes Environment, Heritage and Local Government (of course, I am being slightly sarcastic, as it also provides funding for Local Government):
Environment, Heritage and Local Government delivered the largest cuts of all departments year on year - at 36.3% through November. It also delivered the largest cut on 2008 - 44.1%. In contrast, boffins at Finance are still lagging the average cuts with 2009-2010 reductions of just 4.3% and cumulative 2008-2010 cut of 17.7%.
Foreign Affairs are down 26.7% on 2008 levels and most of this came in in 2009, so 2009-2010 November to November figures are -4.8%. Health - a giant of all departments with a budget of 26.2% of total spending in November 2010 and 27.1% for the full year 2009 and 27.9% in 2008. Notice that as with Education, the priority of inflicting least cuts in Health is also held steady. Overall Health is down 15.3% on 2008 and 11.2% on 2009.
Social Welfare accounted for 22.3% of total departmental spending in the full year 2009 and 19.1% in 2008. These figures rose to 28.65% in 11 months through November 2010. In fact, the department is the only one where the expenditure has risen steadily in 2009 and 2010, for quite apparent reasons. Total rise was 40% over the last 2 years and 21.8% of that came in 12 months since November 2009.

Like Finance, Taoiseach's Group is enjoying shallower cuts than other departments:
So far, Taoiseach's Group lost 17.8% of its 2008 level spending, while Transport lost 30.1%. In part, this reflects differences in the size of capital budgets for two departments, but in part it also represents the skewed priorities of this Government when it comes to cutting current spending, especially within core civil service numbers.

Table below summarizes these results of annual comparisons:

Next, lets plot levels and percentages of reductions in total expenditures, year on year:
Notice the decline in 2009-2010 savings in relative terms over the course of the year. This can be explained in part by the often mentioned, but never confirmed, delays in payments by the Government to suppliers and a lag in capital expenditure.

Chart below summarizes the 2008-2010 changes in spending by quarter (with 4th quarter reflected as to-date figures through November):

Now, for the last bit - the deficit:
Notice that the above is not including banks measures in 2010, but does include bank measures in 2009, which of course, obscures the true extent of our savings. But that is a matter for another post.

Thursday, December 2, 2010

Economics 2/12/10: Exchequer returns - Burden of taxation

Let's take a quick look at the tax burden incidence as per latest Exchequer results.
Proportionally, the burden of taxes paid continues to rise (year on year) for Income Tax, VAT (although VAT burden increases have eased a little bit) and Excise Tax. The burden has been falling for CGT and CAT, Stamps and Customs. It is flat for Corporation Tax.
This goes back to the arguments I made recently - no matter whether it is the Exchequer who assumes new debt, or the banks (under the Guarantee and protection extended to them by the Exchequer), the taxpayers are the ones who will be on the hook to repay it all.

Economics 2/12/10: Exchequer returns - tax receipts

The mixed bag - aka Irish economy - story of the Live Register from yesterday is continuing into today. The Exchequer results for November are being heralded by many 'official' analysts as a sign of significant improvement in the economy.

Are they? Really? Let's update my charts on the matter.

Top level view: tax receipts through end of November totaled €29.489 billion in 2010. This is some €470 million of 1.6% ahead of the DofF projections. Happy times? In 2008 they were €38.86 billion and in the "terrible year" of 2009 they were €30.75 billion. So the good news is that we are still in the worst year of the crisis when it comes to total tax receipts.

I guess I am just not buying the story of 'close to target' being a net positive signal for the economy. It might be a net positive for the DofF - who's forecasts are now accurate (after 3 years worth of trying). But for the rest of this economy, things are worse today - as tax revenues go - than they were a year ago.
Now, November is the month when tax receipts accelerate dramatically. Good news, this year was no worse in the rate of increase than last, even a little better. Bad news, acceleration from October to November has been slower in this year than in 2008. Glass is half full on dynamics.

For 11 months of 2010, all tax heads, except for income tax are on target or ahead of target. Again - good news for DofF forecasters, but not great news for the economy.
You can see how both income tax and VAT are performing poorer in 2010 than in 2009 and 2008. I'll summarize all these differences in a table below. But for now - all other tax heads in charts:
Corporate tax is performing 'spectacularly' better than target +19.1% - sizzling. But year on year it is still 2.2% lower in 2010 than in 2009 and a whooping 26.3% below the levels of 2008. Errr... you see, targets don't really matter, reality does. Ditto for Excise tax: down 0.2% on 2009 and 19.9% on 2008.

Next, then:
Stamps perform better in 2010 than in 2009 so far. This is the one tax head of two that has shown an improvement year on year - plus 7.55% on 2009 and yet still -43.8% on 2008.
CGT... oh, what the hell - you can see, the story is the same as for all other tax heads save for stamps and customs.

Here's a summary table: performance to target (the DofF Delight special):
Charted over the year above.

Now, relative to previous years (the Real McCoy):

Year-on-year rates of change in charts now:

As noted before: with exception for two, by now pretty minor tax heads, accounting for just 2.9% of total tax revenue (Stamps) and 0.7% (Customs) of total tax revenue, everything else is performing worse this year than in 2009. I guess the only good news is that they eprforming not as badly as they could have were the things to completely collapse. Some solace then.