Friday, May 29, 2009

Economics 29/05/2009: NAMA debate: Part 2

Full text of Oireachtas debate on NAMA is available here. But for some commentary-worthy passages, consider the following:

Deputy Brian Lenihan:The bad bank solution means that the person with the impaired asset takes a very substantial loss, and a substantial loss is also taken by the bank. Looking at it in terms of this particular approach, the first 35% is the equity value of the developer or the owner of the land, and if he or she is not in a position to pay off the loan, then clearly that is wiped out in this exercise. The key question in valuation is not about the wipeout of the initial landowner’s equity, but about how much of the banks’ equity should in turn be wiped out as well, as we are insisting on the banks taking a loss. Therefore, the taxpayer is third in the queue rather than first. There is a risk and the reason we are focusing so much on valuation is to ensure that this risk is minimised as much as possible. In a frozen or illiquid market, it is not possible to place an exact valuation on the loans, but a long-term commercial valuation can be made. That is what we will have to do... It is a long-term economic valuation…

I am not sure I understand the Minister. Take a loan of Euro65 on a bank balance sheet. Suppose the value of the asset underlying the loan at the time of the loan issuance was Euro100, so 35% of the project was the equity accruing to the developer at the time. Assume that the value of the project has fallen 40% since then, so the market value of the project itself is no Euro60. NAMA buys the loan at, say 20% discount on the face value of the loan – it now has Euro52 loan on hands against the project currently valued at Euro60. What will the balance sheet of NAMA look like?

If NAMA can sell the underlying asset today for Euro60, it makes profit of Euro8, but presumably the bank could have done the same without NAMA. But suppose it does go for NAMA. The bank used to have a loan of Euro65 against an asset with Euro60 value, it got back Euro52 from the Government and has new capital demand of ca Euro6. The bank takes the hit and the developer takes a hit. This is a non-flyer for NAMA politically, but in this case NAMA would make a profit of Euro2 on the entire transaction.

If NAMA cannot sell the project, it has to finance the purchase of the loan at say 5.5% pa on a termed bond issue of, say 5-years and face value of Euro52, so total cost of financing is Euro15.96. It has to plug bank’s capital hole – same Euro6, and it has to incur operating cost for the loan – say 0.5% of the loan value pa for 5 years at Euro1.36. Against this, NAMA will receive income stream on average of ca 3-4% pa, or Euro14.37. Assuming the value of the underlying asset remains the same, we have a net loss to NAMA of Euro0.95.

So applying all pain to developer (example of quick fire sale) will yield profit, going NAMA route and soaking the ‘third in line’ taxpayer as Minister Lenihan puts it will make a loss…

However, regardless of how the numbers come out, Minister Lenihan is confusing two things. The developer has already taken a hit, and guess what – I don’t care if he did. Tough luck, mates. But the banks are yet to take a hit. And in part, they have delayed taking a hit because of NAMA promise of rescue. This does not look like NAMA puts taxpayer third in the firing line. It looks more like the taxpayer is next, right after the developers. Except, personal bankruptcy laws protect the developers, but not the taxpayers. Which means that in real world, taxpayer is the first in the firing line and indeed he is the only one in the entire firing line.

Mr. Brendan McDonagh: …about rolled-up interest. I was a member of the due diligence team that worked on Allied Irish Bank and Bank of Ireland. I have also had access to information in terms of reports compiled by the Financial Regulator in regard to the other institutions. What I have seen in the banks’ loan books is that the land and development book generally included a feature that for two years loans had rolled-up interest. Therefore, a loan of €10 million on which the interest was 10% per annum, effectively became a €12 million loan at the end of the two-year period. If at that stage the asset had metamorphosed from land with rezoning to land with planning permission - once a certain element of risk was gone from the loan - it was refinanced or sold on.

So let us revisit the figures provided above… if NAMA cannot sell the project, it has to finance the purchase of the loan at say 5.5% pa on a termed bond issue of, say 5-years and face value of Euro42, so total cost of financing is Euro15.96. It has to plug bank’s capital hole – Euro8, and it has to incur operating cost for the loan – say 0.5% of the loan value pa for 5 years at Euro1.36. It has a capital loss now instead of gain of Euro10. Against this, NAMA will receive income stream on average of ca 3-4% pa, or Euro7.88. Assuming the value of the underlying asset remains the same, we have a net loss to NAMA of Euro27.44. Ouch…

But this, incidentally, does not cover the cost of outsourced functions – and NAMA plans to have loads of outsourcing if it will run a fund requiring 400 staff with 30-40 employees…

Mr. Brendan McDonagh: Bespoke means something has particular features. Usually a loan document with standard terms and conditions is drawn up by an institution when, to give a simple example, it extends a mortgage... It is not a question of quality. It means that if one wants to value these loans which we will be required to do, the terms and conditions of each loan will have to be examined to ensure account is taken of any particular feature... It will not [take years to work these loans out]...

I am puzzled – it will not take years to price individual bespoke loans even with a staff of 30-40 or is Mr McDonagh implying here that the existent banks staff will do pricing?

Senator Feargal Quinn: It is not easy to keep quiet for two and a half hours without asking questions. I was surprised that Mr. McDonagh spoke about a timeframe of ten to 15 years because I had investigated what had happened in the United States in the establishment of the Resolution Trust Corporation in 1989. This corporation only lasted six years but the figures were considerably different. It took in $465 billion and the cost to the taxpayer when the assets were sold was $90 billion. The equivalent cost for us would be €20 billion. Mr. McDonagh spoke about a staff complement of 30 to 40. The aforementioned operation in the United States involved 9,000 people. This scares me because it seems we are not very good at sticking to budgets and timeframes in Ireland.

Note that Senator Quinn’s estimate of NAMA net loss of Euro20bn based on the US RTC experience is exactly the same as my and Brian Lucey’s estimate in last week’s Sunday Times. We arrived at this figure without a reference to RTC, so the fact that the two estimates coincide does suggest that the figure is about right…

Deputy Burton spoke about transparency. Freedom of information provisions will not apply to NAMA, although they were applied in similar contexts in Sweden and Finland. It would be of considerable help if citizens and taxpayers had access to information.

Spot on!

Deputy Brian Lenihan:one of the most difficult tasks relating to NAMA will be drawing the line as to where the agency must or where it should not enforce. A spectrum of borrowers will be hopelessly insolvent; receivers and liquidators should be installed and NAMA will become the property management company for them. That is one side of the spectrum. Clearly, on the other side, because the agency will take performing loans, there will be a category of borrowers who will pay their debts, trade and discharge their obligations as they fall due. In the middle, the agency will have the most difficult commercial decisions to make in terms of the potential viability of the middle category of borrowers.

I am again at a loss as to what NAMA can and cannot do, what enforcement actions it can or cannot take and so on… Does the Minister have a clue himself? Is his own staff and that of NAMA have a clue?

Mr. Brendan McDonagh: Unfortunately, part of the problem is that people have given personal guarantees. If the banks are placing values on personal guarantees as partial security, that is a consequence of what NAMA will be about. If NAMA has to pursue personal guarantees it will do so. I am sure all members are aware that a number of major borrowers, because of the multi-bank nature of their loans, have offered personal guarantees to five or six banks. A personal guarantee can cover only one loan. It cannot cover six. When valuing a loan from a particular institution, we will have to take account of the collateral offered to each institution. One cannot look at this matter in the context of an individual bank or in a vacuum. One must take account of the all the circumstances which can be determined.

Indeed, as I mentioned in the earlier post on this debate, this adds an entirely new and at this stage completely unpriceable risk. NAMA will simply spend the next 5 years tied up in courts with other banks and developers dealing with the issue of who gets which guarantees… Good luck to all involved.

Mr. Brendan McDonagh: With regard to the percentage of foreign assets, …based on the analysis of the loan books of the six institutions which was carried out after the guarantee scheme by PWC for the Financial Regulator, the value of foreign assets of the banks’ portfolios was somewhere in the region of about 35% and most of that would be UK assets... That 35% was of the total loan portfolios of the banks, of the six institutions. I do not have the figures analysed yet as I only received the questionnaires last night.

In other words, we are talking about roughly 35% of the Euro386bn in assets of just BofI and AIB, or Euro135.1bn…

Thursday, May 28, 2009

Economics 29/05/2009: NAMA debate: Part 1

Note: for some reason my Moscow PC does not register any of your comments. If you do post a comment to this site in the next couple of weeks, can you kindly email a copy of it to me as well...

Full text of the Dail debate on NAMA is available here. But for some commentary-worthy passages, consider the following:

Brian Lenihan: [NAMA] will purchase the assets through the issue to the banks of Government bonds which will result in a very significant increase in gross national debt to be offset by the assets taken in. The cost of servicing this debt will be offset, as far as is practicable, from income accruing from the assets of the new agency. The debt will be repaid from funds raised through the realisation of these assets over time.

Thus we have it confirmed - NAMA will rely on ordinary Government bonds, not NAMA-own bonds. Brendan McDonagh confirms as much in his statement as well.

The potential maximum book value of loans that will be transferred to the agency is estimated to be in the region of €80 billion to €90 billion, although the amount paid by the agency will be significantly less than this, to reflect the loss in value of the properties. Initial work on the valuation methodology to be applied is under way and will be elaborated on by the interim managing director.

Hold on, folks, Mr Somers knows nothing of this rather important work, we heard nothing about either the models they plan to deploy or the market valuations they will rely upon, or both, so how can the valuation methodology work be ongoing, unless NAMA is being set up to operate in the climate of complete absence of transparency? And what does 'as far as practicable' mean in the context of off-setting the cost of bonds financing? 'Practicable' from whose perspective - the banks / developers or taxpayers, or NAMA itself?

It is important to note that the State will not assume all of the risk in the acquisition of these assets. The assets will be valued on a basis which is sustainable for the taxpayer. This will entail an assumption of losses by the financial institution whose assets are removed. In the longer term, if the agency were to fall short of recouping all of the costs, the Government intends that a levy should be applied to recoup any shortfall. All borrowers will be required to meet their full legal obligations for repayment. There will be a hardening of the approach to these borrowers as taxpayers’ money is at stake and the agency will be expected to protect it in a commercial way and with an independent remit.

So here we have it - assets will be valued on a 'sustainable basis' from the taxpayers' point of view. Does this mean market-value discounts on loans value? If yes, what recapitalization provisions the state is making and if no, how will the taxpayers value be protected? 'There will be a hardening of the approach to these borrowers' - how, if NAMA were to avoid foreclosures and forcing developers into bankruptcy? Furthermore, if NAMA were to operate in a 'commercial' way, will it be pursuing some sort of risk-adjusted return strategy in pricing the loans, enforcing loan conditions and selling the underlying properties? Once again, how can this be assured if NAMA were to avoid foreclosures, fire-sales of assets and pursuing individual developers for collateral? How will NAMA avoid writing down the underlying assets by at least 30-40% to reflect their fair value?

The establishment of NAMA will, no doubt, give rise to complex practical difficulties and it is important that we undertake the detailed preparatory work necessary before finalising the legislative and operational framework. The preparatory process is being overseen at this initial stage by a steering group made up of representatives of the Department of Finance, the Attorney General and the agency. Mr. McDonagh has been appointed as interim managing director to drive the implementation process forward. He will be assisted by an advisory committee to be appointed shortly which will provide him with a range of expert advice.

So they managed to do all this work already without actually publishing a simple version of a cost-benefit analysis of NAMA. An amazing level of ineptitude in basic management!

Mr. Brendan McDonagh: NAMA will, therefore, acquire both performing and non-performing loans. In return, the institutions will receive Government bonds issued by the NTMA and they may use these bonds as collateral to avail of ECB funding. It is envisaged that the interest payable on the Government bonds will be offset by interest flows and performing loans acquired by NAMA.

This is an interesting statement as far as the 'performing' loans go. Does Mr McDonagh term 'performing' include loans that pay interest only? partial interest only? or rescheduled interest only? This is important, for all such loans will be written against assets that cannot be realised at their loan value and thus, while yielding some interest flows, are distressed assets from the point of view of developers. How will NAMA convert these loans to fully performing (interest plus principal repayment) loans?

And of course, there is an admission that the entire scheme relies on ECB lending window, implying in effect that the issued bonds will have no value to anyone in the market except for the banks and the ECB, and the cost to us, the taxpayers.

We are realistic enough to recognise that there are institutions which will be outside of NAMA but which may also have provided loans for many of the larger borrowers within the NAMA framework. We envisage that NAMA and these institutions will have to work together in many instances to protect our common interests but this will be done at all times in a commercial way to protect the interests of Irish citizens.

This is unclear and undefined. Will NAMA have powers to compel these institutions to interact with its portfolio management of the loans? How? If not, how will the seniority of multi-banked portfolios be managed, given NAMA size and market power? And does Mr McDonagh see any conflict or contradiction in saying that the banks outside NAMA, NAMA, banks inside NAMA, and the developers will be working to 'protect common interests', yet the taxpayers' interest will also be protected? In addition, I wonder if Mr McDonagh actually has in mind the interests of all taxpayers or just the interest of Irish citizens, or whether he actually has a clue as to the difference between the two?

I advise the committee that it is not possible at this stage to determine what that discount will be as it is dependent on such a wide range of factors and also the fact that each loan will have to assessed and valued individually. This is because our current knowledge of the loan books suggests the majority of individual loans are bespoke and have different legal documentation.

Mr McDonagh is clearly a foreigner to finance. Bespoke or not, loans priced individually invite political interference (or perception of such), as well as opens up every set of terms agreed with one developer to a challenge by another. It is non-transparent pricing system and, yet, it underpins the loan value fundamentals. How will NAMA be able to avoid the same problem of valuing the individual loans that the banks have today? Further problem arises due to the absence of market pricing data. Given that there is only a thin volume of sales in the property markets, pricing loans collectively will be onerous enough to yield large deviations from the true expected values of the loans. Pricing them individually will be even less accurate.

In our Sunday Times article with Brian Lucey last week we argued that NAMA is equivalent of a blindfolded person buying an unknown object for an unknown price, while being unsure if he needs this object in the first place. How will Mr McDonagh - a highly paid public servant - ensure that his organization actually acts in the interest of the taxpayer if he cannot even tell us the pricing basics for his organization purchases?

Personally, I do not trust Mr McDonagh, his steering group and the entire state apparatus behind them to deliver value for money on their valuations of these assets. Nothing personal, I just need hard evidence that they are doing their jobs right. The idea that they will be using 'economic' value of property projects to value the loans implies that
  • the uncertainty (risks) relating to the property values
  • will be compounded by the uncertainty (risks) relating to economic forecasts
  • which will be further exacerbated by the uncertainty (risks) of NAMA capabilities to manage investment portfolios
  • which itself be subject to added risk to NAMA cash flows, and so on...
Do tell me that Mr McDonagh is qualified and experienced enough to run this risk pricing model... Would he even get a job of co-managing a Euro10mln property fund in London were he to try? I don't know.

Want the really scarry stuff?

NAMA’s potential powers including, potentially, compulsory purchase orders and powers in relation to borrowing and the investment of equity and working capital in joint ventures. NAMA will have three options in relation to the assets it acquires: it can dispose of them at an early stage; it can hold them with a view to disposing of them when market conditions have improved; or it can develop them to enhance the return. To do so, it is envisaged that NAMA will have the option of entering into joint ventures, partnerships or form special purpose vehicles with other interested parties to enhance the value of some of the acquired assets. The overall objective and foremost in the mind of NAMA will be what will achieve the optimal return and will be in the best interests of the taxpayer.

So NAMA will have a power to act as a co-developer in failing projects?! Dreamy stuff. But:
  1. How will NAMA raise financing for this venturing? By taxing you and me more? or by issuing more bonds? If so, NAMA is an open-ended ticket for the Government/NAMA to clean our pockets and transfer subsidies to the developers;
  2. How will NAMA manage such lending - is it now becoming a fully functional investment bank, well ahead of its original remit? If so, we are in deep trouble, for one has to imagine Mr McDonagh as the CEO of the soft-constrained state-run and state-owned non-transparent, non-compliant and totally secret bank;
  3. How will Mr McDonagh and his successors account for their 'success'? Will he lose his job if NAMA finances a wrong project and generates a loss?
  4. What will happen when a NAMA-co-financed project fails and NAMA goes after its partner in the development? What will happen when NAMA tries to recoup losses on such co-financed project failures from the banks at the end of NAMA lifespan?
  5. What will happen when a developer turned down by NAMA for co-financing goes to court and argues that his project is no worse than the one that NAMA co-financed?
Now, NAMA might not have done cost-benefit analysis yet, but, per Mr McDonagh, the institution that will protect taxpayers value has already met ...with senior members of the Irish Congress of Trade Unions who represent bank staff. Ah, the bearded men of ICTU are briefed, so nothing to worry about, folks.

Brian Lenihan: In respect of such an agency [NAMA], one must understand it is not about the taxpayer assuming the risk, but about ensuring the banks and developers absorb the pain. The taxpayer only enters the equation after this as the sovereign intervener to protect the entire banking system.

Once again, there is a contradiction here between NAMA deriving commercial value, NAMA not forcing developers into bankruptcy and the banks and developers absorbing pain. Furthermore, does this statement imply that Mr Lenihan actually believes that the taxpayers will not bear any pain in the process of NAMA? Does he really believe that NAMA will be self-financing and that he and Mr McDonagh will only borrow from us, the taxpayers some spare cash to get NAMA rolling, repaying us in positive real rates of return? Is this a sign of our Minister for Finance not getting the basics of NAMA right or is it a sign of him being in denial?

And what about the economic model for pricing risks and assets that NAMA will employ? Well, why not pick the most absurd one of the lot: the ESRI's politically palatable drivel predicting 6% medium-term growth for Ireland Inc: Lenihan clearly is impressed...

Still feeling well-protected by NAMA? I don't. Imagine paying a price that assumes that during the lifetime of NAMA, Irish economy will expand at 5-6% pa and then learning the hard way that the actual growth turns out to be 3% pa or even less. How much do you think we, as taxpayers, will overpay for the ESRI's errors?

The reason the full advice [by Bacon] was not published was it contained a great range of sensitive information which would affect the market valuations of financial institutions on the Stock Exchange. Dr. Bacon had access at the NTMA to a wealth of information on the work completed on assessing the exposures in the banking system from an accountancy, evaluation and auctioneering point of view. All of this information was at his disposal in drawing up the report. Placing that information in the public domain would have had an immediate impact on the market prices of individual financial institutions.

Hold on... I thought the entire point of the plcs is that any information pertinent to their pricing must be disclosed to the public. Is Minister Lenihan now finds himself in a position of concealing from the market market-sensitive information? Should you or I do the same, we would not be able to deal in the related companies shares. But Minister Lenihan and NAMA will be dealing in these shares. Who is supposed to uphold the securities law in these cases?

But dancing on the legal borderline is what NAMA and Lenihan will be doing often from now on. Here is a good one, in relation to why banks levy will not be imposed in the NAMA legislation but will have to wait for the Finance Bill:
Mr McDonagh: If there was a clawback within the NAMA legislation affecting the balance sheets of the banks, they would not be able to reduce the assets transferred to NAMA because effectively there would be an unpriced option in terms of what the clawback would be in the future. One cannot do this because it would not be possible to take risk weighted assets off the balance sheets of the banks if the levy was imposed in the NAMA legislation.

Enron's boys would be proud of this one. If NAMA levy is a charge against future losses, as it is, and it is imposed ex post NAMA legislation, would it not be a de facto expropriation of the expected future value of banks earnings? Take your pick then - either you have an option imposed under NAMA putting pressure on banks valuations, or you have a predatory state imposing ad hoc charges on banks post-NAMA... Good choice... markets-assuring.

Deputy Joan Burton's response to McDonagh statement is priceless: That is another critical valuation issue because the Minister has just said he has a guaranteed fail-safe device - a clawback in the event of the assets not realising whatever the taxpayer takes. Mr. McDonagh is actually saying - I accept what he is saying - that in fact that would be almost legally impossible because of the long-term impact on the balance sheets of the banks, assuming they remained quoted companies but the Minister is directly contradicting this. Gotcha!

Mr. McDonagh is saying there will still be a contingent liability which will remain unpriced for a period of at least ten years and that this contingent liability will relate to the €60 billion to €90 billion discounted on values that we do not yet know. How would any financial analyst decide to exclude this for a period of ten years from the liabilities of such a company? Gotcha!

I find it very worrisome that Dr Bacon provides deeply economically flawed rhetoric in arguing the NAMA case:
Dr Bacon:
There is a view expressed that this asset management approach has an inherent flaw, namely, that if one takes a big haircut there is a capital deficit which the banks have to deal with and if one does not do that and overpays, the taxpayer, if the members will pardon me saying so, gets screwed and the shareholder gets away. I do not see any trade-off. The reality we face, with which everybody is trying to grapple as a result, as the Minister said, of bad and disastrous lending, is that there are huge losses facing developers and the banking system and there is only person to pick up the bill, namely, the taxpayer. Regardless of what way the cake is cut, the loss does not change. To use other people’s language about the point of the discount, if the discount and gift shareholders are undercut, the taxpayer suffers because the recovery the Deputy spoke about takes place from a higher base. The taxpayer loses in that respect. If one gets it wrong on the other side and discovers that one has to make up more capital in the banks, who will make it up? In the current environment it is a brute fact that the banks cannot go to capital markets and replenish their equity. I have made the point previously that the loss is the loss. By whom will it be borne? It will be borne by banks and developers, to the extent that there is equity to do so in the case of the banks. One must then replace that equity. Who will replace it? The taxpayer will.

This is simply a case of b***t. Here is a clear trade-off, Dr Bacon: if you overpay for the loans at NAMA point, you do not take equity in the banks and end up with losses on NAMA and no new shares in the banks. If you price assets right, you end up holding lower loss-making NAMA and equity in the banks. Get this? It is that simple. It is, as I have repeated on many occasions, not only about NAMA losses, but about shares held in the banks.

The Deputy has also asked how do we know the taxpayer will not be caught at the end of this process... The first protection of the taxpayer with respect to the work-out is that the assets are being taken on at the bottom of the cycle, either at a mark to market price or at a normalised valuation. The second protection being offered to the taxpayer the potential that NAMA, as an institutional entity ...has the possibility of attracting third party equity. That is a fundamental disadvantage if we do not go this way in terms of maximising the work-out. How does one get the capital and finance to work out semi-completed projects which are fundamentally well designed, be they in Ireland, the UK or elsewhere, without the long-term capital which these entities have not had heretofore?

I find this amazing. In effect Mr Bacon argues here that NAMA will be simultaneously a developer and an investment bank. Did anyone in the Dail notice this remit creep?

Deputy Joan Burton provided an excellent set of questions to follow Dr Bacon's unimpressive discourse: The Minister and his Department ... why is he so confident the fair price NAMA will pay will not wipe out the core equity capital of the banks? Has the decision been taken on what price will be paid? Given the Minister’s confidence that the valuation to be arrived at will not wipe out the bank’s core equity, is it the case that the decision has been made in principle? That brings me to another point.
The Minister cited the case of Sweden. An independent valuation board was established there composed of independent economic experts, including individuals from commercial and academic life who were recognised as independent and acting in the public interest. The Minister has proceeded to appoint all the parties in secret.
Contradictions have emerged in what has been said. The Minister suggests there will be a degree of toughness shown to developers, while Mr. McDonagh suggests NAMA will work with developers and Dr. Bacon suggests it will be essential and may make good business sense to get other investors to come in and co-fund development projects with the taxpayer, whether these developments are in Ireland, the UK or elsewhere. Does the Minister agree that substantial State borrowings will be used to meet the requirements of the NAMA proposal? Is he seriously considering having much more of the country’s borrowing capacity reserved for the working out of the NAMA proposals rather than being invested in infrastructure such as schools, public transport and roads? I find that prospect extremely worrying.

Wednesday, May 27, 2009

Economics 28/05/2009: Two questions, US economy

Some months ago I was telling the readers of this blog and of my column in Business & Finance magazine to keep an eye on US Munis markets. Well, now is the time, especially California Munis... Good hunting...

I have two questions to ask our Brian 'Detouched-from-Reality' Lenihan and his lappy-Lassie Alan 'Tax-em-Brian' Ahearne:

1) If Ireland were to go to the markets with a bond placement of an odd Euro40-50bn, what chances do we have getting such an issue away without direct ECB help?
2) If ECB were to contemplate such a support scheme for Ireland, will it be willing to also underwrite our structural deficit - the deficit that is pure lard for Irish public sector pay and perks?

These are not some esoteric issues, they imply real risks to the systemic stability of Irish finances.

Question 1: in a recent IMF paper (here), the widening of CDS spreads for sovereign debt between Eurozone economies was explained by domestic 'vulnerabilities'. More specifically, the paper asserts that: "The sensitivity of countries to their domestic vulnerabilities appears to be conditioned by their loss of competitiveness over the upswing of the previous economic cycle. The countries with the largest decline in competitiveness display a particularly strong link between the prospects of the financial sector and sovereign spreads... The differentiation of countries by their debt levels is also stronger where the loss of competitiveness has been greater. The inference is that as external competitiveness has weakened, domestic vulnerabilities have acquired greater salience."

And further to the point: "another source of domestic vulnerability: public debt. ...think of loss of competitiveness as a proxy for weaker growth prospects, the question being posed is whether countries within particular competitiveness loss categories are differentiated by their debt ratios. The presumption is that with lower growth potential, a higher debt ratio will prove more onerous. This differentiation should, moreover, increase when the global growth prospects are substantially marked down, as after the fall of Lehman Brothers." And not surprisingly, the paper finds that it does matter - lower growth prospect means less sustainable debt at any given level.

So let us get back to Q1 above. What idiot in the market will be ready to take new Irish debt (Nama-related) with some Euro40-50bn in face value on anything even remotely close to the terms of our current bond offerings?

Which gets us to Q2 next. If no takers emerge, will the ECB cover Nama bonds? This is a question I have no answer to, but several divergent arguments can be made:
  1. ECB might take Nama bonds directly to rescue Ireland, halting altogether or severely restricting acceptance of further Irish bonds as collateral (so Brian Lenihan will be forced to do something about deficits, having been restricted from using banks borrowings from ECB to float his Government). This is the most likely scenario, but it hinges on stable markets for German bund.
  2. If German bund runs into thinner covers, the ECB will only part-finance Nama at the very best, holding its firepower for the potential need to cover some of the German issues. This will also restrict Brian Lenihan's ability to raid the ECB.
Either way, Irish Exchequer will feel some sort of a squeeze on its ability to support further borrowing. Which brings us to the potential response: a new mini-Budget in July. And either way, if you are holding Irish banks shares, give it a thought - do you really believe that ECB is going to print money for Nama on the back of a asset value discounts of 15-20%?

One interesting recent paper worth reading:
The role of the United States in the global economy and its evolution over time
, by Stephane Dees and Arthur Saint-Guilhem, ECB WP 1034/March 2009 (see here). Authors assess the role of the US in the global economy and its evolution over time.

The paper shows first that “the transmission of US cyclical developments to the rest of the world tends to fluctuate over time but remains large overall. Second, although the size of the spillovers might have decreased in the most recent periods, the effects of changes in US economic activity seem to have become more persistent. Actually, the increasing economic integration at the world level [including ‘China effect’] is likely to have fostered second-round and third-market effects, making US cyclical developments more global”. This, of course, simply means that the US is still the engine of global growth, to the chagrin of all those who believe in the decoupling or the European-century hypotheses.

In addition, the study shows that “the slightly decreasing role of the US has been accompanied by an increasing importance of third players. Regional integration might have played a significant role by giving more weights to non-US trade partners in the sensitivity of the various economies to their international environment.” So regional integration did seemingly push some of the economies slightly away from their link with the US, as expected. However, when third-parties (deeper trade cross-links) are accounted for, the regionalization actually deepened these economies link with the US business cycle in the long run.

A 1% increase in the US real GDP tends to be transmitted based on the extent of trade links between the US and other economies. This means that economies with closer ties to the US tend to experience stronger and quicker responses to the shock. For the Euro area, such shock will lead to an increase in real GDP of 0.2% on average (the range is 0.05% to 0.3%) as opposed to 0.4% for Canada and other developed economies. In the UK and Japan the increase in only 0.2%. In all of these economies, the shock is fully absorbed within 5 quarters, as opposed to 3 years for emerging economies. In other words, all the whingeing of EU leaders about the ‘bad Americans’ giving us a deadly flu in this business cycle is a case of a dog that bites the hand which feeds it. Next time you hear Brian Cowen whimpering about the crisis brought onto Ireland and Europe by Americans, remember the figure: every time America grows by 1%, we grow by 0.2%. Converse, of course, is also true.

Tuesday, May 26, 2009

Economics 26/05/2009: US Confidence, NAMA-pack lunacy

I am back from the fabled Russian 'dacha' - the world so close to Moscow, yet so far away that no email can reach you there (assuming you have O2 for your I-phone service provider charging monopoly rip-off rates for data roaming). Sunny last two days and lovely 21 degrees weather. Good fishing. Missing Luca and his Mama, though.

I spotted few stories worth mentioning. First - from the US, then - about NAMA (scroll to the end of the post to read this one)

First, the US Consumer Confidence pick up from 40.8 in April to 54.9 in May - a fourth largest jump in the series in history. Basically, the drivers of expectations rise are business conditions, labour market and personal income, which means the rise is broadly defined. This is good news, as this time around we have a combination of twin factors underpinning the improvement: not only Consumer Confidence rose itself, but the 'Misery Index' components, short of house markets (see Case-Shiller latest data analysis here), are also stabilising. But, should we read to far into the 'resurgent consumer' story or is the US consumer simply catching the same fever as the US (and other countries') politicians who are all too eager to sound the bells of an impeding recovery?

There is a rising sense of denial of the fact that the crisis is far from being over in the US Administration. So much so, that the Tim Geithner managed to simply forget the causes of the current US Housing crisis (see here) in his interview with Washington Post:

Washington Post: "...When you look at the collapse of the housing market, who do you think bears the greatest responsibility? Is it the banks for pushing these loans? Is it the consumer for borrowing over their means? The regulators?"
Geithner: "For something this big and damaging to happen it takes a lot of mistakes over time. ...Interest rate here and around the world were kept too low for too long. Investors ...took a bunch of risks without understanding the risks. ...Rating agencies failed to rate these products adequately. Supervisors failed to underwrite loans with sufficiently conservative standards. So those basic checks and balances failed. And people borrowed too much."

So no regulators faults? No Billy Clinton 'empowering the poor to homeownership' policies fault? No financial services authorities overseeing securities and financial markets (and thus securitization, wholesale lending, etc) fault? Given this state of denial coming from the Treasury top man in office, what can one expect from the poor Fannie & Freddie - late last week, Federal Housing Agency (FHA), the primary tool for Bill Clinton's ill-fated attempt to financialise subprime borrowers has noted that Fannie Mae's HomeSaverAdvance (HSA) programme, launched in February 2008 in an attempt to provide aid to the homeowners who fell behind on their mortgage repayments has produced an increase in re-defaults. FHA director James Lockhart said in a Congressional report last week that “Performance on the February through April [HSA] offerings shows a redefault rate of almost 70%.” Well, I bet. You give bloated mortgages to those who can never repay them, then the proverbial S***T hits the fan and they default. You, thus, give them another unsecured loan to delay the inevitable foreclosure and, guess what, once the dosh runs out, they default again...

Of course, Geithner can take solace that there are plenty of even less enlightened political leaders and regulators out there. I mean Brian 'The Saviour' Cowen (here and here) is simply in such a deep denial, that Geithner's statements read like a sign of lucidity.

And Brian is not alone: NAMA-own Peter 'The Wise' Bacon and Brendan 'The Sleeping-Pill' McDonagh appeared before the Oireachtas Joint Committee on Finance & Public Service (note the irony of putting together Finance and Public Service) today. Per Irish Times and RTE reports:

Mr McDonagh: “We believe the Government is basically interested in keeping banks listed and relies on Nama to trigger a change of market sentiment”.

This clearly indicates that the Government is planning to overpay for the assets transferred to NAMA in order to avoid a much more transparent recapitalization call from the banks post-NAMA. In response, JPMorgan Chase analysts wrote that he sees "sizeable chances of a smaller haircut to avoid further capital needs”. Well, DOUGH, as Homer would reply. The beef here is that the taxpayers are now being set up by the Government to take the fall instead of the banks and developers. Again, all of you know I have nothing against either the banks or the developers, but I am adamantly against my bank account and income being raided by Lenihan to rescue his cronies. And, when the state overpays for assets to avoid future re-capitalisation the taxpayers do not get shares in the banks we re-float.

RTE: "The details of loans furnished to NAMA yesterday from the six covered institutions will show for the first time the exposure of individual developers. Mr McDonagh said a number of borrowers had loans of more than €1bn across all the institutions. Up to a 1,000 borrowers have loans greater than €10mln."

That is a sign of a heavily concentrated market. Which means that foreclosing on some of these 'systemic' borrowers will not be a problem for the country - take a straight hit on assets side and see no ripple effect. But no,

McDonagh said (also per RTE) "NAMA was not in the business of liquidation, but developers who did not comply with NAMA would face the full legal consequences. Finance Minister Brian Lenihan told the committee some liquidations, receiverships and bankruptcies would have to take place."

Now, here are few things to consider:
  1. If NAMA will not be liquidating non-performing assets, how big is the downside it will accept? If downside were to be limited, how can foreclosures, liquidations or receiverships (flr) be avoided?
  2. What 'full legal consequences' does Mr McDonagh have in mind if not flr?
  3. What does Mr McDonagh mean by complying with NAMA?
  4. If NAMA were to have fixed life span, how will NAMA deal with assets that are not performing at the end of such period? Just pretend they do not exist?
  5. What is the difference between NAMA and a Japanese-styled hyper-zombie bank if NAMA cannot liquidate assets?

Mr McDonagh said that claw back levy to address losses from NAMA will not be decided "until the agency completed its work in 10 years' time and the amount realised by assets was clear". Hold on a minute -

  • we now have a date: 10 years. Given that the life-span of NAMA has been cut from 15 years to 10 years, questions 1-5 above just became so much more important as in effect the zombie bank will have to be wound up sooner, rather than later;
  • how does Mr McDonagh see the claw back uncertainty impacting banks operations over the next 10 years? How does he see it impacting risk pricing for NAMA bonds? Does Mr McDonagh actually have a clue what he is talking about? It appears not, for he sees no problem with any of the above issues.

Per RTE: "Finance Minister Brian Lenihan said the levy could not be included in the NAMA legislation for legal reasons but it could be added to a future Finance Act. But he said it would be made clear when NAMA was set up that the levy could be applied in the future."

This is truly amazing. Lenihan also does not understand issues of risk pricing for banks, investors, bond holders, state bond buyers and the Exchequer. Furthermore, I fail to comprehend how will the legal reasons that prevent the Irish Government today from publishing details of the clawback vanish in the future? By some magic FF wand?

Dr Peter Bacon, said (per RTE) "it was important to take all development loans into the agency, including performing loans, in order to give certainty to investors. He said it did not matter whether the loans resided in the banks, overseen by NAMA, or whether they transferred fully to NAMA. The critical point is that NAMA provides the strategic direction, he said".

What 'certainty to investors' does he have in mind? Investors in the banks? Investors in development project? Investors in state bonds? Certainty of return? Certainty in a specific level of return? Certainty that NAMA is not a pure zombie bank? Certainty that the banks will not be saddled with the full NAMA bill in the future?

Perhaps the most astounding feature of the entire reported discourse between Mr Bacon, Mr McDonagh and Brian Lenihan on NAMA is that not a single one of them is concerned with the taxpayers' money significantly enough to discuss the risks of losses to the ordinary people from NAMA operations. Given that, you can't tell me that NAMA is not a pure rescue scheme for the cronies of our political elites...

Friday, May 22, 2009

Economics 23/05/2009: Is Ireland next Finland?

A recent (April 2009) paper by Gorodnichenko, Medoza and Tesar (IZA DP4113) titled “The Finnish Great Depression: From Russia with Love” provides some very interesting analysis of the causes and dynamics of the Finnish economy collapse in 1991-1993 period that contains insights into the current Irish experieince.

During the 1991-93 period, Finland experienced the deepest economic slump in an industrialized country since the 1930s. Between 1990 and 1993 real GDP declined by 11%, real consumption declined by 10% and investment fell to 45%. Unemployment rose from slightly under 4% to a peak of 18.5%, and the stock market fell 60%.

Gorodnichenko, Medoza and Tesar argue that the collapse of trade with the Soviet Union played a major role in causing the 1990s Great Depression in Finland, “since it caused a costly restructuring of the manufacturing sector and a sudden, significant increase in the cost of energy. The barter-type trade arrangements between the USSR and Finland skewed Finnish manufacturing production and investment toward particular industries, and effectively allowed Finland to export non-competitive products in exchange for energy imports at an overvalued exchange rate.” Furthermore, the study also suggests that “downward wage rigidity observed in Finland played a key role in the amplification of the downturn produced by these shocks.”

This is an interesting result. Obviously, trade shock described by Gorodnichenko, Medoza and Tesar does not directly translate to Ireland in current conditions. But some similarities are also evident.

First, just as the Finnish industries exports to the USSR were subsidised by the importing partner via particular pricing mechanisms, so are Irish exporting sectors – especially those dominated by the MNCs are ‘subsidised’ by the presence of the advantageous tax regime and transfer pricing. In other words, if Finnish exporters had to rely on Soviet benevolence in pricing their trade via oil-goods barter arrangements, so are Irish exporting sectors reliant on tax arbitrage. Neither one has a natural (productivity-driven) comparative advantage in trade when compared to other countries.

Second, the same wage rigidity that cost Finland dearly is also present in Ireland. Suffices to say, wage rigidities were also found to be important determinants of the severity and the length of the Finnish crisis by other studies. In particular, labor tax hikes and negative productivity shocks may have been the culprit (Conesa, Kehoe and Ruhl, 2007). Once again, the parallel to Ireland today is striking. By hiking income taxes, Irish Government in effect made it virtually impossible for workers to accept pay cuts, implying that our Government’s reckless policies are amplifying wage rigidity in Ireland. More on this below.

“Finland and the USSR had a series of five-year, highly regulated trade agreements, similar to the agreements between the USSR and its East European allies. These agreements established the volume and composition of trade between the two countries, and by the late 1980s they had evolved into a barter of Finnish manufactures for Soviet crude oil. Roughly 80% of Finnish imports from the USSR in the early 1980s were in the form of mineral fuels and crude materials. More than 90% of imported oil and 100% of imported natural gas came from the USSR.” Sounds familiar? Well, 90% of Irish exports are delivered via tax arbitrage-driven MNCs. Not exactly a ‘Curse of Oil’, but a curse nonetheless.

In a survey of the structural effects of Soviet trade on the Finnish economy, Kajaste (1992, p. 29) concludes that “[Soviet] exports seem to have been exceptionally profitable.” Kajaste (1992) estimated that the prices of exports to the Soviet Union were at least 9.5% higher than those for exports to western markets. Gorodnichenko, Medoza and Tesar found an even larger 36%markup which “suggests that if a Finnish industry redirected its Soviet trade to other countries, its goods would be competitive only if sold at a 10% to 36%discount. Hence, the Finnish economy was subsidized by overvalued prices of Finnish manufactures bartered for Soviet oil so that the effective price of Soviet oil was at least 10% cheaper than its market price.” Well, in Ireland’s case we know that transfer pricing runs ca 15%-18% differential between GDP and GNP. This is, at the very least, a lower bound estimate to the subsidy Irish economy receives from the tax arbitrage-driven exporting activities of our MNCs.

Just as Irish economy decline has been spectacularly fast, Finnish economy collapse was “quick and deep. Imports of oil from the USSR fell from 8.2 million tons in 1989 to 1.3 million tons in 1992. Exports tumbled down by 84% over the same period. …The loss of Soviet exports caused total exports to fall, suggesting that the goods were not redirected to other counties. After the collapse of trade with the USSR in December of 1990, entire industries had to be reorganized throughout the early 1990s.” Hmmm, you would say that Ireland is a different case in so far as we are not facing a possibility of an abrupt collapse in demand for our (MNC’s) exports. True. But we might see a total collapse in supply of exports by MNCs, should our tax arbitrage advantage be eroded by:
1. Higher domestic costs f production;
2. Higher domestic taxes leading to more rigid and inflationary wage processes;
3. Lower cost of production elsewhere;
4. Lower taxes elsewhere; and so on…

Per Gorodnichenko, Medoza and Tesar, “to fully understand the reaction of the Finnish economy to the collapse of the Soviet trade, it is important to examine the Finnish labor market because of its very high degree of unionization. In 1993, approximately 85% of workers belonged to unions and almost 95% of workers were covered by collective agreements (Böckerman and Uusitalo, 2006). Since most employers are organized in federations, the wage bargaining normally starts at the national level. If a federation or union rejects the nation-wide agreement, it can negotiate its own terms. Typically, agreements allow upward wage drift if firms perform well. Although the government does not have a formal role in the bargaining process, the government usually intermediates negotiations.8 Not surprisingly, Finland is often classified as a country with highly centralized wage setting (e.g., Botero et al 2004).

Just as in the case of Ireland’s public sector since 2008, Finnish “unions did not agree to cut nominal wages in 1992-1993, which were the peak years of the depression. Instead, wages were frozen at the 1991 level.” Irony has it, Mr Cowen is doing exactly this, except, unlike Finland, Ireland is currently running deflation, which means that public sector wages are rising in real terms through the downturn. In Finland, “given that inflation was quite moderate in the 1990s, real wages fell only to a limited extent. These findings are consistent with Dickens et al (2007) who cite Finland as the country with one of the greatest downward wage rigidities… Rigid wages amplify the contraction in demand in the short run. As consumers purchase fewer goods, firms demand less labor which entails further contraction of demand and the spiral continues. In summary, a combination of higher costs of producing goods, as well as a fall in demand magnified by rigid wages leads to large short-run multiplicative effects on the initial shocks.”

What is even more interesting is that Gorodnichenko, Medoza and Tesar show that output and economic activity in Finland during the 1990s crisis was, in the short run, sensitive to changes in the elasticity of substitution between capital and labour (loosely speaking a measure of relative labour productivity in the sectors where capital and labour are substitutes). When changing the degree of wage stickiness, the study “found that wage stickiness plays a very important role. In particular, the key parameter governing the response of the macroeconomic variables to the [crisis] is the persistence of real wages”. More specifically, “in the case with fully flexible wages, the recession is short and shallow. For example, output, employment, investment and consumption fall only by 2-5% and there are hardly any dynamics after the first year. Thus, the response of investment, output, consumption and employment is small when compared to the response of these variables in the data.”

Now, “when wages are rigid, the shock reduces the marginal product of labor and firms would like to hire less labor at the current wages or to keep employment fixed but cut wages. If wages are rigid, the adjustment occurs via quantities and the model can capture sizable decreases in output, consumption, investment and labor. The recession is considerably deeper when wages are inflexible.” Guess what: this is exactly what is happening in Ireland today, so next time you see Brian Cowen talking gibberish about his policies delivering for Ireland, remember – per Gorodnichenko, Medoza and Tesar (and per all conventional economics) not cutting public sector wages leads to higher private sector unemployment and deeper recession.

One would expect someone with Alan Ahearne’s grasp of basic economic theory to make an argument against Mr Cowen’s insistence not to reduce public sector wages, but hey – when you are being paid some serious dosh, you might forget economics for a while…

Economics 22/05/2009: Tumbleweed Brain?

Imagine a high desert scene outside Los Angeles - vast expanse of nothingness, sandy patch of a road and a massive, prickly and menacingly fast advancing tumbleweed rolling at you, kicking up dust of sand every time it bumps over a rock or a hillock. Thus, the picture of devastation complete, the sense of stable equilibrium achieved, the landscape is all but a sign of devastation.

Would you call it an image of hope?

Well, Brian Cowen does.

Today reports claim that Mr Cowen told FF gathering that the Government had taken necessary decisions to ensure the Irish economy could bounce back next year. So what can go wrong? Jobless and about to lose your home? Pay-up to the Revenue and shut up, for FF has taken the necessary decisions. We are but the roadkill for Cowen and Co on the road to his recovery.

Mr Cowen also decided that the high cover achieved in the last auction for 5-year bonds was a sign of investors regaining confidence in Ireland Inc.

This blog has long argued that the demand for Irish bonds is similar to a Ponzi pyramid due to Irish banks rolling over Government debt to the ECB and monetizing it. Yesterday's Irish Times editorial finally bowed to the facts and agreed. Last week, Michael Somers of NTMA has "pointed out that 85 per cent of Ireland’s debt is held abroad but that in recent bond sales, Irish banks were significant buyers of Government debt" to be used as collateral to borrow from the ECB. This was not, he said, “a genuine end investor result". How much did the latest bond auction success depend on investment by Irish banks which have already received some €7 billion from the Government to help secure their survival? The NTMA should ease investor concerns and set out the details," said the Irish Times.

I think it is time we ask a hard question about our bond market revolving door to the ECB. Is it true that:
  • as Brian Lenihan takes our taxes, we are hit once; then
  • as Brian Lenihan issues bonds, we are hit again with the debt to be repaid in the future; and
  • as the banks buy these bonds and go to the ECB to borrow against them, we are saddled with the banks-held debt that will have to be repaid to the ECB at some point in time and which is, in the end, our - taxpayers - liability too? so that
  • the entire scheme requires continuous borrowing to sustain itself...
And what is all of this Ponzi pyramid used for? To finance early retirements of the civil servants and to pay their increments? This, indeed, is what Mr Cowen calls 'the necessary decisions'.

Cowen also stated that "we have a way out that is working". Remember the brilliant German movie Downfall about the last days of the Third Reich? (See a reminder/spoof here). Say no more... our unbeloved leader is in a state of delusion that is equivalent to awaiting the arrival of a miracle weapon (which does not exist) as the real enemy tanks are crushing your city.

What plan does Mr Cowen have? Brian Cowen claimed that economic recovery will be based on 4 pillars:
  1. Banking crisis resolution;
  2. Public finances gap closure via revenue increases and spending cuts;
  3. Jobs protection; and
  4. Investing in the unemployed to return them to work.
Brian Cowen has produced not a single policy to address any of the four pillars. Not a single one.

The entire country now is aware that NAMA cannot be made to work. Brian Cowen is in denial of this.

The entire country knows that he has not cut public spending (his own Government Budget shows increasing public current expenditure in every year through 2013). Brian Cowen is in denial of this.

The entire country knows that his Government is drawing blood out of taxpayers to raise revenue and that it is not working. Brian Cowen is in denial of this.

The entire country sees jobs being lost in thousands week, after week, as Brian Cowen and his Government choke enterprises, workers, investors and entrepreneurs with higher and higher taxes and charges. Brian Cowen is in denial of this.

The entire country knows that it was Brian Cowen as Minister for Finance who raised our social welfare rates to such a level that no programme that FAS can run will ever turn former construction workers off the welfare. The entire country knows that FAS should be renamed FARCE because it is one of the most wasteful and least productive Government organizations. Brian Cowen is in denial of this.

It is my sincere hope that his own party colleagues stop listening to the man for two reasons:
  1. Brian Cowen no longer speaks for the people, about the people and with the people; and
  2. No one listens to Brian Cowen anymore.
Brian Cowen is in denial of reality.

Thursday, May 21, 2009

Economics 21/05/2009: Moscow's Greening Pastures?

Russian stock markets are enjoying some recovery - in line with the US and firmer oil prices. Since January, MSCI EM - a broader index of emerging markets shares - rose roughly 25%, while MSCI Russia appreciated 30%. Domestic RTS index was up 48% and MMVB +62%, implying that Russia is now in the top three most profitable markets. JP Morgan note reflected this by lifting their assessment of the Russian market from 'Negative' to 'Neutral'. This, of course, is a lagging indicator, catching up with the rally enjoyed to date.

Although oil prices are much firmer now at $62.04 last night (July delivery) - the highest level since November 10, 2008, the latest price increase was driven by lower inventories, not by rising fundamentals or falling output. Demand for Russian oil and gas remains weak and production and exploration costs are not necessarily falling. If anything, in the long run, these costs are going to rise as new discoveries are being pushed deeper and deeper into Eastern Siberian domain, characterized by much more complex geology and smaller fields.

Likewise, industrial production continues to contract: -16.9% in April 2009 y-o-y, more than double on -8.1% fall in March. Overall Q1 GDP fell 9.2% in y-o-y terms, but there is no deflation in the economy (inflation moderated to around 10% annualized rate). Ruble devaluation expectations fell, but many experts still see some room for the currency to fall in months ahead. At the retail level, even with a span of the last two days Ruble rose from ca 43.30-43.35Rb/Euro to 43.00-43.10Rb/Euro, but majority of the businesses I spoke to expect the retail rates to test 44.00-46.00Rb/Euro before year-end.

JP Morgan note gave some support to the theory that Russian Government response to the crisis has been exemplary to date, but what is really interesting from our, Irish, point of view is the continued pressure from Kremlin to restrict corruption in the public sector.

While our own politicians and bureaucrats enjoy very low transparency over the sources of their incomes, Russian President has signed into law a decree requiring all top Government, political and public sector employees, politicians and even the top management of the public enterprises (commercial and non-commercial) to declare all sources of their own and their family members' income, covering:
  • combined annual income from all sources;
  • all property holdings (including the size of each building, land parcels and the country where the property is located);
  • all cars and other transport owned.
This information will be published on the web and will be accessible to public. Confidential information will also include:
  • addresses of property held; and
  • banking accounts.
These declarations will be subject to audit and false declaration of income will be punishable by immedeiate dismissal from the job and can lead to a criminal conviction.

And in contrast with the Irish Government, Russians are pumping state cash into SMEs - on Tuesday, Russian Government announced a 3-year $23bn fund for SMEs with a new target to increase SMEs employment levels from 14% of the total private sector employment today to 33% in 2012. Funds will be used to improve SMEs access to credit, reduce the cost of credit to the SMEs, some direct subsidies, increasing the share of state purchasing allocated to SMEs and reducing the 'red tape'.

Wednesday, May 20, 2009

Economics 20/05/2009: Moscow, US Green Shoots

Is Alan Ahearne being paid to write Irish Times political infomercials? Today's Irish Times editorial from Alan Ahearne (here) is a marked departure from the long-standing tradition that the civil servants should stay on their main jobs (in Alan's case - that is, apparently to advise Minister Lenihan on matters of Economic policy - not Finance or PR) and not spend public money-financed time on addressing the media. Talking to the electorate is Minister Lenihan's job, as a politician and a member of the Government, not Alan Ahearne's.

That said, Alan's opinion fall flat on a number of other, more substantive points.

These bonds will add to the gross stock of public debt, but so long as the valuation of loans is roughly correct, there will be no change in net public debt. Nama’s assets and liabilities will roughly match," says Alan. Great. We couldn't have imagined this intricacy of accounting without Alan pointing it out to us. But hold on - Alan does not give a figure in his article as to what the expected returns to NAMA can be, or which assumptions he uses to compute such a return. Not a single number! 'Roughly match' may mean a shortfall of Euro 20bn or a gain of Euro20bn, or anything in between, or indeed anything above these numbers. Again, Alain is silent on the matter.

"This approach to fixing banks’ balance sheets has a proven track record. The asset management model has been supported and recommended by banking experts across the globe and used successfully in many countries in the past as part of the work-out process of problem loans. Done properly, investments in the banking system using this approach have eventually been recovered in full," says the article. Ok: which experts? where has NAMA-style model been successful in the past, under what conditions and to what extent? Crucially, how do successful past NAMA-style models compare in terms of underlying fundamentals to Ireland's case? Not a word from Alan on these issues.

Alan Ahearne goes into a lengthy challenge to the German plan for banks rescue. This is irrelevant to his article, as we are not asking our Government officials to provide us with the news stories analysis for Germany. His job and the job of his masters is to deal with NAMA, not with Germany. In this context, it appears that Alan simply uses an argument against the German plan as an argument in favour of NAMA. This, if so, would be fallacious, since Germans making a mistake with their plans does not validate NAMA fundamentals in any way.

In short, I am simply amazed by the political nature of Alan's article, its lack of clarity and rigor, its complete lack of respect for the taxpayers who expect official Government opinion to be grounded in factual evidence. This is hardly an article one can expect from an economist, but rather an article one can expect from a politician. Too bad the Irish Times editorial staff didn't ask Alan to re-write it before accepting for publication...

Moscow is still all sun and cool...
Yesterday was a good and productive day for the mission, meetings between companies and a great dinner in the National Hotel, overlooking the Red Square entrance and the Kremlin. There are some good news on companies front, which I hope to report in the Sunday Times article later, so no preview here. But I was impressed by one Irish company sealing a deal (long time under negotiations) in software area. I was also positively impressed by the Irish delegation head, Billy Kelleher, TD - his first official visit and he has been very good so far. As someone remarked couple of days ago (no names here) - he might be a much better choice of a delegation head. Mike Hogan of EI and the rest of EI team are doing great work on the ground - this is not new as I always known Mike and his team to be really first class point of contact to the Russian market.

Night out on town proved that Moscow is still very much abuzz with life, despite the slowdown. Couple relatively hip places (a Mexican dive with, strangely enough, a very loud rock band playing right in the entrance door, and a can-be-anywhere-else-in-the-world pricey beer joint) all had a calm, but busy, atmosphere. Confidence seems to be unshaken, as far as normal businesses go, but construction is dead and finance people are in hiding.

I was briefing a group of the Moscow Bar Association lawyers yesterday over a friendly coffee on some developments out there in the broader world. The main issue they wanted to know about was the whole mess of the EU/US financial services regulations. Not so much the banks, but the hedge funds etc. Hedgies are in the news in Russia because of the Chrysler story (when they refused an offer of $0.30 on the dollar of the company bonds and got hammered by the Communist-in-Chief in the White House of betting on a taxpayer bailout of the company. Well, there is a point to be made - has there been a single hedge fund in the US which received any bailout money? No. How many US automakers received such funds? All. Spot any difference? Of course, the automakers are all unionized and the unions are the cronies of the Democratic Party. Trace the line to Obama. Aside from politics, my view is that trying to regulate international (as opposed to domestic) financial markets is like squeezing water - should the US/EU try to put any severe measures in place, funds will move off-shore. We will see some measures passed and paraded as a dramatic departure from the status quo, but in the end they will be purely cosmetic. Much more under threat are domestic bankers, who have little choice when it comes to packing suitcases and moving to the Bahamas. In the end, costs will rise for all service providers - hedgies will see the rise much less than domestic bankers, implying that rates of return will fall, but the returns to international financial services will fall less (in the short run) than to domestic financial services. This situation will drive more competition into international finance and will lead to consumer-damaging decline in competition in the domestic sectors. Over a number of years, returns to international finance will fall and returns to domestic banking and finance will rise. As more and more banking clients move off-shore to follow lower cost international finance, EU and US economies will slow down in growth. So all regulatory risk talk is really a cost/return argument in my view. Let's see who is the most daft in regulation - the US Democrats or the EU - in a couple of years time...

US Green shoots just had a massive set back as the US housing starts fell a record low of 458,000 in April. Calculated Risk blog is predicting that we are going to see US house prices falling 40-50% relative to the peak by the end of 2010. Yeah, Davy guys, eat your shorts on US housing market improvements... And of course the inflation story is still out there (here), don't forget.

Monday, May 18, 2009

Economics 18/05/2009: Wealth-destruction, Moscow, Ireland's Green Shoots

Here (hat tip PMD) is a superb article from WSJ on how to destroy thy country's wealth... too bad the US policymakers have not figured the Brian-Brian-Mary solution to the same problem. Possibly, they are not being advised by the wealth loathing, ever-State-loving ESRI?

On a personal note - I am in Moscow: sunny +25 degrees and the city is blooming (chestnut trees, apple trees, cherry trees and lilacs). Construction sites with no workers in sight, but traffic jams are as bad as ever. Ruble is down and prices are up, but on the net, I would not be surprised if there is a real deflation (prices seem to be up about 15%, while ruble is down ca 34%. They are fretting the latests stats from Europe: EU27 gas imports from Russia down 61% in Q1 2009 and exports of gas to CIS down 50%.

Closer to home problems/solutions: LA Times has a very interesting report (here) on solar energy potential. I will it to you to judge the commercial feasibility of what is being discussed (especially given the business-focused bits at the end of the article), but mark my words - within 10-15 years time we will see the end of the fossil fuels era and the start of a new era. It won't be driven by the environmental considerations (although those will form a secondary return on new technologies). Instead it will be driven by two major factors:
  1. Generally prohibitive cost of energy in the long run; and
  2. Higher induced volatility (risk) of energy costs when you factor in the pesky nasty regimes around the world who control most of our oil and gas.
Need an illustration of the latter point - see here.

On Green Shoots theory: here is a good commentary from Martin Feldstein (ex NBER) - he is spot on about Europe's prospects (see my earlier, 2008-dated, comment on WSJblogs exactly to the same point). This, of course, is not as optimistic as Peter Orszag's latest drone about US economy not being in a 'free-fall', but... (here). Then again, recall that Orszag is the director of the President's Office of Management and Budget, so how can things be in a free-fall after Mr Orszag pumped more debt into the US economy within the span of just few months than Alan Greenspan managed to do in years? But care to read more? Here Nouriel Roubini (Dr Doom) and Ken Rogoff (Dr Financial Crises) muse as to why the 'Green Shoots' are a delusion. I don't give any heed to Merkel's comments on German economy (here) - I'd rather trust our bankers than politicians when it comes to reading the tea leafs of global economics.

But here is my own contribution to the debate (for those of you who missed in last Sunday Times issue) - this is an unedited version of the article that appeared in The Sunday Times.

“Despair ruins some, presumption many,” said Benjamin Franklin some 250 years ago.

If despair haunted Ireland’s policy and media circles since last Summer, in recent weeks, much of the economic commentary started focusing on the emergence of the ‘green shoots’ in our economic environment. Even abysmal, by any measure, unemployment and Exchequer data for April are being spun as showing signs of improvement.

Are we seeing the proverbial ‘light at the end of the tunnel’? And if yes, do we know at what rate will the conditions improve in months and years to come? Regrettably, these claims may be erring on the presumption side of Franklin’s quote.

First, there is the alleged stabilization in the rate of decline in the Exchequer revenue. The problem with this assertion is that it ignores the other side of the budgetary equation – the expenditure side. Current spending was up 4.5% in the first four months of the year. Factoring deflation, this is a hefty increase. At this rate the
real difference between economic growth and public sector expansion in 2009 can reach some 16%, before the vast NAMA commitments. In household finances this is equivalent to being insolvent and reckless about it at the same time.

Another issue is the rising cost of servicing public debt (up 21.4% in year on year terms in April). In the longer term, our growing over-reliance on less than 1 year maturity borrowings to finance current expenditure simply means that instead of taking a quick dose of painful medicine today we risk ending up on a drip therapy of minor cost adjustments. This would make the disease of overspending immune to future policies. Should interest rates rise in 2010-2012, as any sane market observer would expect, the Exchequer will be forced to
refinance a mountain of fresh borrowings at an even higher cost to the taxpayers.

Another recent sighting of ‘green shoots’ relates to the unemployment data. While it is true that the pace of increases in the Live Register is abating, the pace of jobs destruction remains furious. And, given the dynamics of rising layoffs in the services sectors, just as the previous wave of unemployment might be subsiding a new one is already heading our way.

Purchasing Manager’s Index (PMI) for April, published by the NCB Stockbrokers, shows employment in services bouncing around the bottom and in manufacturing contracting at a pace only slightly slower than in January – the worst month on record. Layoffs in Business Services accelerated in April, extending the current decline to fourteen consecutive months. Financial Services companies shed jobs at the sharpest pace in history last month.

So things are getting worse, not better on the unemployment front and its now the better quality higher-paying jobs that are being destroyed the fastest. If a loss of an average construction sector job implies a net loss to the economy of some €60,000 per annum, an average Business and Financial services job destroyed takes some €140,000 out of the economy.

At the aggregate unemployment data level, if January-April ‘stabilized’ pace of jobs losses continues to the end of the year, we are looking at 515,000 or more on Live Register by 2010 well above the 384,113 currently. Even more worryingly, this week’s data from CSO, discussed in the box-out below, is showing that the long-term unemployment is rising at an accelerating rate.

Following a marginal improvement in March, April current consumer confidence index fell to 75.1 from 76.2, although the expectations index rose to 27.7 compared to 22.5. Again, as with other ‘stabilizing’ indices this is temporary correction, not a lasting improvement. The so-called consumer ‘misery’ index – a standard measure of forward-looking indicators determining future consumer confidence – went deeper into red in April and is now poised for a further decrease in May based on the data to-date.

When it comes to the PMI data, April business activity in services recorded “an acceleration in the pace of decline”, according to the NCB Stockbrokers. In fact, April figures were so bad, that only February 2009 showed a deeper contraction. The steepest fall-off occurred in the highest value-added sector of the Irish economy – Business Services – down for the eleventh month in a row and falling at the fastest pace since January. Financial Services posted the steepest contraction in its history. And companies are expecting further drops in demand for their services in months ahead.

The story is not that much different in manufacturing. April manufacturing sectors PMI showed a further considerable deterioration of operating conditions. Output in the sector continues to contract at a near-record rate while jobs were cut sharply and new purchasing fell off the cliff. Any ‘green shoots’ in the cycle must involve an increase in planned future purchasing activity by companies and a restart of the investment cycle. This is clearly not on the minds of the majority of Irish managers.

So in the short run, there is no evidence of significant signs of improvement or stabilization in the downward spiral of our real economy.

This does not bode well for our future growth capacity. On Friday, ESRI published an excellent paper titled Recovery Scenarios for Ireland looking at the prospects for our economy through 2015. Under optimistic assumptions, the ESRI forecast is for the Irish income per capita to reach 2007 levels by 2015 implying a round-trip to the peak of 8 years.

Even more significantly, ESRI concluded that “as a consequence of the recession, the potential growth rate of the economy is likely to have fallen from 3.6 % per annum to 3% per annum”.

For all its merits, the paper assumes no changes in the long-run trend for the foreign direct investment inflows into Ireland. This issue is non-trivial. With vast majority of our exports generated by the MNCs, we simply cannot ignore the changing nature of the future international investment cycles on our economy. Looking over the recent years, vast majority of Ireland-based MNCs have chosen not to locate new products and services here. Only a handful elected to put higher value-added R&D and management activities in Ireland. This is a problem, as many MNC-produced goods and services are nearing the end of their life cycle. In time, failure to attract new products and services will spell an irreversible decline of the large share of our trade flows.

My own analysis, based on parameterising a recent IMF model of economies experiencing simultaneous shocks to housing markets, GDP growth and credit creation, predicts that the ongoing contraction in the Irish economy will bottom out at ca 16-18% decline in GDP per capita by the beginning of 2011. My estimates also show that it will take the economy until the middle of 2017 to fully regain, the levels of income per capita enjoyed in 2007.

Over 60% of the recession-related fall-off in our output will be captured by domestic factors: the property markets bust, fiscal policy debacle and rising structural unemployment. Adding to this a possibility that our multinationals-dominated sectors can experience a severe contraction in future investments can reduce our potential GDP growth rate to below 2.5% per annum. In this case, a recovery to 2007 income per capita levels might take us well into 2020.

Saturday, May 16, 2009

Economics 16/05/2009: NAMA Week & Irish Banks

Having been up to my ears in planning for next week’s trip to Moscow, I missed the excitement of the NAMA finally imploding on Thursday and Friday. So here is a recap (for those of you who are in the know already – my analysis is below).

This note is structured as follows: first, I cover Michael Somers' very revealing and honest testimony to the PAC, then I review Friday Davy note on NAMA, lastly, I provide complete estimates of expected losses for NAMA.

Michael Somers - some fresh air on NAMA
On Thursday NTMA ceo Michael Somers told the Public Accounts Committee that putting valuations of the bad loans will present “an enormous dilemma”. Of course in logic, ‘dilemma’ always leads to two undesirable alternatives – in other words, it cannot be resolved within the same logical reasoning chain that leads to it. In layman’s terms, this means that the only way to resolve NAMA problems is to dump the idea alltogether.

So what is this ‘dilemma’ that the country has learned about only this week?

It turns out to that "there will be arguments down the courts if we don’t get it right. The implications of this thing are enormous and the legislation will be very complex,” Mr Somers said. Hmmm… this is hardly new. This blog and many well publicised articles, some written or co-written by me plus a massive wave of media reports that certain big developers are preparing to challenge NAMA - all were well ahead of Mr Somers. But Mr Somers’ testimony is so news worthy now because it is no longer the dirty scoundrels in media and academia who are beating up Lenihan’s dream baby, but one of the Golden Public Circle’s own.

Mr Somers also said that he believed up to 5,000 officials in the main banks “were currently examining bad loans. …At the moment, we really have no feel for how Nama will operate. But my preference would be a core group of between 30-40 people.” Now, wait a second. 5,000 banks officials cannot get the loans right, but 30-40 NTMA/NAMA folks will? This is after Mr Somers admitted that NTMA has not experience in managing distressed assets whatsoever. Of course, Mr Somers was saying 30-40 NAMA officials on top of 5,000 banks officers already in place will manage NAMA, but in such a scecnario, any final cost of NAMA will have to include the cost of those 5,000 bankers as well...

Mr Somers said the NTMA paid its 170 staff a total of €19.4 million in 2008 – “an average of almost €90,000 per person” as Irish Times puts it. Well: 170 staff at €19.4mln is €114,118 per person in pay. Including secretaries and other auxiliary staff, NTMA is now the best paid state entity on the record – ahead of ESB. But hold on, further €8.9 million was paid out in expenses. So total compensation (inclusive of expenses) came to €166,471 per head.

The 30-40 people that Mr Somers would like to have for NAMA is about 20-times smaller than normally is required to run a €90bn fund. Now, given that NAMA will be a distressed assets fund with less active management, say 600-700 people specialising in asset management, portfolio structuring, risk pricing etc would suffice. If the NTMA wage bill were to apply (and there is absolutely no reason as to why it won’t) – we, the taxpayers, are looking at paying something to the tune of €100mln in wages and expenses for these ‘servants’ of the state annually.

Another dilemma, clearly of unresolvable variety, is that NAMA “is expected to pay for the bad loans through the issue of Government bonds to the lenders.” (Quote per Irish Times). Apart from not being new (first disclosed back in April) and being banal (the state has to borrow cash and issue bonds to pay for its day-to-day spending, let alone NAMA), this claim is rather sterile.

In reality, the Government hopes that it will be able to borrow directly and at reasonable terms, but of course, it might run into some tight spots asking the markets to lend money
  • to a half-backed bad bank to be run by 30-40 inexperienced staff;
  • mired up to its chin in the mud of court challenges in our notoriously costly and slow legal system;
  • operating under the umbrella of our Guinness-serving bond issuing authority;
  • in a country whose Government cannot balance its own books;
  • with economy managed so poorly, that we are now presented internationally as the worst case scenario possible; and
  • the Government so grossly clientelist that it can't even manage its own employees without having to run crying to the 'mommy' of the Social Partnership;
  • add to it that NAMA has no popular or political support; and
  • that the same Government is doing everything possible to make certain Irish private economy will not come out of this recession with any strength left
and you really have to ask a question: Are they eating some magic Amsterdam brownies in the land of NTMA/Irish Times/DofF and the rest of the ‘policy’ circle when they claim that this Government/NTMA will be able to borrow cheaply to finance NAMA? (see more on this below).

Irish Times also told us that “Profits from the eventual sale of the loans will be given to the state which may be used to service the €54.2 billion national debt.” Ok, what national debt do they have in mind? €90-110bn or more debt we will have once Mr Lenihan ends his current deficit financing of the public sector employees lifestyles? In fact, the same Irish Times reported as a comment from NTMA chief that he expects Irish debt to top 100% of our GDP in 2010 (see below). So, does anyone in the Times editorial have a calculator at hand?

It's all down to the cost of NAMA
“However if Nama makes a loss, the Government said it will apply a levy on banks to recoup the shortfall.” Ireland’s stockbrokers decidedly focused on this statement much more than on anything else that Mr Somers said. Why? Because this is the real unknown unknown for banks shareholders. This is, of course, ultimately the question of how big the loss will be.

So let’s do some counting of the beans… shall we?

First what the financial markets analysts say: per Davy note assumption, “costs for NAMA will be covered by interest income from the performing loans. Taking a conservative view that only 50% of the €30bn investment loans to be transferred are performing, this could generate initial income of c.€1.2bn as yields are currently at 8%. This would cover the coupon (assumed to be in line with the borrowing rate on ECB liquidity facility) of the bonds issued to the banks in return for their €80-90bn of loans transferred to NAMA. Income will likely be higher because the investment loans to be transferred to NAMA are not bad loans in themselves but are selected due to cross-collateralisation with development loans. An investigation of staff costs as a percentage of properties under management for large real estate trusts suggests that staff costs will be covered, especially given the greater operational leverage due to NAMA's size. Legal costs are less certain as the legality of the agency is one of the greatest obstacles to its performance.”

... And then, the pigs are soaring high in the sky…

Suppose that NTMA goes out to the markets with two suitcases worth of bonds – government bonds and NAMA bonds. Do you think they can price NAMA debt:
  1. at a discount to current public debt issues (a scenario that Davy suggests); or
  2. at a rate that is equivalent to Government bonds, say ca 4.5%; or
  3. at a rate that is higher than Government bonds, say a premium of 20% to Government debt – for 5.4%, while the Government debt remains priced at 4.5%; or
  4. as the markets look at two piles of paper, they tell NTMA: “Ok, we’ll take Government bonds at a premium to previous issues to account for vast number of these things being floated in the market – say 5%, and NAMA bonds at a 20% premium on that – at 6%”?
Reality check – NAMA will not borrow at ECB liquidity facility rates, so (1) is out of the window.
For (2): at 4.5% pa (a very optimistic scenario), buying €90bn worth of loans at 15% discount (as Davy suggest) on their face value will cost us €3.44bn annually in coupon payments. But wait, let’s also look at the downside scenarios: (3) implies €4.13bn price tag, and under scenario (4) the cost of annual NAMA financing alone rises to €4.59bn, or ca 15.3% of the entire Exchequer tax revenue in 2009...

Hmmm... back to that 'country whose Government cannot balance its own books' bullet point above, anyone?

Per debt financing assumptions, Somers said Ireland would be “lucky” to hold on to its sole remaining top AAA credit rating, as its low debt levels could surge to more than 100 per cent of GDP next year, from about 41 per cent in 2008, after the State completed the transfer of the banks’ bad loans. Hmmmm… remember that Irish Times statement that NAMA can be used to pay down €54.2bn debt quoted above? Apparently, NTMA chief expects the debt in excess of €170bn by the end of 2010 - somewhat higher than Irish Times journos do. And, apparently, he does not expect to price any debt (Government or NAMA-issued) at ECB discount facility rates (as Davy assume).

Of course, it is a trite statement to say that NAMA will be able to cover its staff costs, so no dwelling on this, but as far as legal costs uncertainty goes, despite Davy's rather neutered murmurs on this, there is no downside protection for the taxpayers. In other words, once committed to the transfer of a loan, NAMA implicitly assumes that no matter what the legal costs might be, the loan will be moved.

Somers was lethal on this last week: “I see great potential for arguments down in the courts if we don’t get this right,” saying further that he heard “people down in the courts were delighted” about the setting up of NAMA as they were in line for “a bonanza”. He said there would be “eating and drinking” at the committee for decades over the set-up of NAMA. But Davy folks didn't listen, apparently.

Davy goes on to pour more fuel on the NAMA pyre: “…the fear of the unknown has also led developers to call for consultation with the government over NAMA, with many saying that they can be part of the solution. Engagement with developers would arguably help reduce legal challenges and secure buy-in. The NTMA itself has stated that it lacks sufficient skills for setting up NAMA, but many developers will be both skilled and, more importantly, incentivised to work out their projects/loans under NAMA.”

Indeed, NAMA is at a severe risk of getting into bed with developers. Not because developers are ‘evil’ (I certainly do not believe this), but because NAMA should be independent from developers interests and free from their influences. And yet, Davy does not even see the lunacy of its own suggestion that NAMA should engage developers in the management process. This is really worrisome.

Doing the final sums on NAMA cost
Davy’s “simple NAMA model shows that taking our 15% haircut assumption for the sector and assuming no profits on disposal of NAMA assets across a 15-year work-out period implies a present value loss of €4bn. Apportioning this fee on an annual basis over 20 years (similar to Insurance Corporation of Ireland) implies that this fee would be only c.3-4% of normalised profits. However, given the long-term nature of the agency, there is every chance that it can turn a profit similar to that which we have seen in past banking crises such as in Sweden. A more positive outlook, with greater performance from investment assets under NAMA and a 5% profit in aggregate across asset disposals, would result in a present value profit on wind-up of €3bn to the taxpayer from NAMA.”

I do not have Davy’s model at hand to see what assumptions they force into it to get these numbers. Judging by their assumptions on pricing NAMA bonds (above), I have no confidence in any of their numbers. Their concluding scenario in the quote above is so far out there, that the aforementioned Amsterdam brownies come to mind again.

But my own simple model goes as follows (with my assumptions listed transparently for all of you to see and to challenge, unlike Davy):

So, net impact is a loss of €33-68bn.

Remember, Mr Somers said he was “aghast” at the scale of development loans advanced to a small number of borrowers which emerged after the NTMA reviewed the banks’ books. He called the review “a huge eye opener for us”. This is not a statement from a man who expect loans losses to be in 5% category (as my ‘Near Davy’ scenario above assumes).

So turning back to that original concern that investors should have about NAMA - what share of these losses can be recovered through a 3-4% shave on future profits of the banks?