Wednesday, April 8, 2009

Daily Economics 08/04/09: Toxic Fumes from Toxic Bank

First a bit of news
A birdie in front of my window has just chirped (hat tip to the birdie) that the ECB has tentatively signaled to the Irish Government that it will finance (largely? or in full?) the 'bad bank'. Under such an arrangement, the state will issue a sea of bonds - say €30-60bn to cover €50-90bn of impaired loans floating out there - and swap these for freshly printed cash from the ECB. Taxpayers get debt. Government gets pile of assets with default rates of, ughh say 20-25% (?). Banks get cash.

Why would the state go for this? Because if we price this junk at a fair market value, taking it off the banks will still leave us exposed to the need to recapitalize the banks. As they write down their assets after the transfer, the value of an asset will drop - from its current risk-adjusted (if only bogus) valuation of, say €0.90 per €1 in face value, to a fair value of, say €0.50, implying a loss of €0.40 per €1 in face value. This will chip into banks' capital reserves, driving down their core capital.

So the state will pay over the odds for the default-ridden paper to avoid the follow-up recapitalization call. This will sound like a right thing to do, but given that the taxpayers will be holding highly risky debt for which they have overpaid, it is not.

Second source of added liability comes from the nature of assets transferred to the bad bank. Banks have an incentive to transfer impaired consumer loans - the loans on which they have hard time collecting. So the state impaired assets pool will be saddled with near-default mortgages and credit cards debt. This is political dynamite, for no state organization will enforce collection on these voters-sensitive assets.

So the taxpayers will end up banking with the state. The fat cats of the public sector will end up banking with BofI and AIB.

Why would the banks go for this? While getting rid of the troublesome assets, the banks will get capital injections and no equity dilution. The bondholders will be happy too - lower risk base, higher risk cushion imply lower spreads and thus higher prices. The taxpayers will have to get a second round of squeezing as repayment to the state will be required to compensate for losses generated by the overly-generous original pricing scheme. These will take form of 'Guarantee' dividends to the Exchequer which, alongside with existent preference shares, will lead to a widening in lending spreads and banking fees. Customers will have to pay the Government via the banks.

Why would the ECB go for this? Ah, the birdie told me that the ECB, desperate to find some solutions to similar banking problems elsewhere, is keen on using Ireland as a sort of policy lab. Given it's newly acquired mandate to print cash in quantitative easing exercise, this means the price of such Social Laboratory Ireland is low enough for them to deal on Irish 'bad' bank.

All happy, save the soon-to-be-stuffed-again taxpayers...

A follow up on the Budget
Following the Budget last night, Irish media has gone into an overdrive. The simplistic terminology and naive analysis dominate the space between print, radio and TV with commentators heralding the Budget as:
  • 'tough' - nothing tough about slicing off an odd €3bn off a deficit that is so vast. We will have to borrow half of our annual spending requirement this year - primarily, to pay welfare rates and public sector wages. In family economics, such budgeting is known as 'reckless' or 'subprime'. In Lenihanomics it is known as 'making hard choices' (at the expense of others);
  • 'fair' - there is nothing fair about the budget that has taken the pain of adjustments required by the serial failure of this Government (in its various past incarnations) to reign in its own cronies' spending and dumping it all onto the population at large. Nothing can be further away from being fair than an idea that you soak the private sector to insulate and even gold-plate more the lives of the true Irish elite - the public sector dons;
  • 'timely' - there is nothing timely about the Budget that delivers in April 2009 the corrections promissed in July 2008;
  • 'far-reaching' - aside from 'deep-reaching' into yours and my pockets, the Budget failed to deal with the most pressing issues at hand. The actual deficit problem remains unaddressed. Reform of public sector - unaddressed. Economic stimulus - unaddressed. Banks financing - unaddressed. You name the topic.
For anyone who still needs a more down-to-earth explanation of the budget, here is an illustration
The media reaction to the Budget is hardly surprising.

Irish intellectual milieu is based on a vicious pursuit of any independent analysis and thought with a goal of eliminating any possibility of serious dissent. Anyone with a point of view departing from the consensus is left jobless and/or branded as a hack or a generally diseased mind.

How many dissenters are ever asked to advise or brief the policymakers? None. How many non-consensus economists work for the Government? None. In our Universities? A handful and then only on junior posts. How many differing opinions does the Irish Times feature in its main pages? Virtually none, unless they can be comfortably pigeonholed into some agenda slot.

Hence today's reaction. But also the continuous drift of consensus opinion to the La-La land of pseudo intellectualism of some of our left-of-centre pontificates. This is not reflective of any public opinion in the streets, but it is reflective of the incestuous nature of our public policy discourse.

At least in the Soviet Union they respected dissidents enough to physically hunt them. Here, we are simply growing immune to independent thinking.

And the best non-economist analysis of the state of our affairs

The piers are pummelled by the waves;
In a lonely field the rain
Lashes an abandoned train;
Outlaws fill the mountain caves.

Fantastic grow the evening gowns;
Agents of the Fisc pursue
Absconding tax-defaulters through
The sewers of provincial towns.

Private rites of magic send
The temple prostitutes to sleep;
All the literati keep
An imaginary friend.

Cerebrotonic Cato may
Extol the Ancient Disciplines,
But the muscle-bound Marines
Mutiny for food and pay.

Caesar's double-bed is warm
As an unimportant clerk
On a pink official form.

Unendowed with wealth or pity,
Little birds with scarlet legs,
Sitting on their speckled eggs,
Eye each flu-infected city.

Altogether elsewhere, vast
Herds of reindeer move across
Miles and miles of golden moss,
Silently and very fast.

W.H. Auden 'The Fall of Rome'


TrueEconomics said...

Joannah, many thanks for the comment - do come back to read as regularly as time allows and do comment on the posts. Constantin

Anonymous said...

Hi Constantin. I've enjoyed reading your blog over the past few months. Regarding NAMA, it seems to me that the one big advantage to this scheme is that it means someone will lend us enough money to cover the bank's bad debts, via the sleight of hand of issuing government bonds to the banks and then them redeeming this in hard cash from the ecb. I strongly suspect the Irish government would be hard pressed to borrow this kind of money from anywhere else. What I don't understand is why we don't first just nationalize the banks. The question of proper pricing then becomes less of an issue. We'd be just moving money between different arms of the state. One thing I've wondered about: can this device for swapping government bonds for euros only be done by a commercial entity? If we first nationalized the banks would such a move then be precluded? If so, maybe the government do secretly intend to largely nationalize them at a later stage after the cash has already been received from the ecb. I do hope there's some technical reason like this for not first nationalizing the banks, that the reasons are not purely political, because I've no confidence that the taxpayers will end up paying a fair price for these assets.