Economics 31/07/09: NAMA Part III

The NAMA Legislation provides some stunningly simplistic and outright primitive economic analysis. This is contained in Part 5 of the Bill (once again, italics are mine):

PART5: VALUATION METHODOLOGY

Determination of acquisition values—valuation methodology.

58.—(1) In this section—
(a) a reference to the current market value of the property comprised in the security for a credit facility that is a bank asset is a reference to the estimated amount that would be paid between a willing buyer and a willing seller...
(b) a reference to the current market value of a bank asset is a reference to the estimated amount that would be paid between a willing buyer and a willing seller in an arm’s-length transaction...

[In other words, the difference between the two values is that the property value is a valuation of the collateral, while the asset value is the valuation of the loan drawn against this collateral as an asset. This difference should capture: counterparty risk, liquidity risk, expected return risk, lien risk and term structure risks. None are specified or explicitly required for pricing in the NAMA legislation.]

(c) a reference to the long-term economic value of the property [bank asset, per point (d) below] comprised in the security for a credit facility that is a bank asset is a reference to the value that the property can reasonably be expected to attain in a stable financial system when current crisis conditions are ameliorated and in which a future price or
yield of the asset is consistent with reasonable expectations having regard to the
long-term historical average...

[So, implicitly, this statement assumes an imposition of some assumptions on:

• What constitutes a stable financial system and how does this system impact the pricing in operative markets - something that is virtually impossible to ascertain as the only functional markets we have a history of relate to the property bubble period? Was our financial system stable when we were lending x10 times income to home buyers? Or was it stable when the likes of AIB were embroiled in a series of massive scandals?
  
• What constitutes an amelioration of the current crisis - with further issues arising as to what crisis is being meant in this context: the crisis in property markets? in banking? in credit supply? in money supply? in financial assets? in the economy at large? in the Exchequer revenue? in the labour markets? in the markets for land sites? or in demographics? or in all the above?
  
• What is the relationship that determines the future (expected?) price of an asset or a yield on the asset and what is the assumed relationship between the yield and the price? What determines the relevant expectations mechanism?
  
• What is the long-term historical average? A 10-year historical average taken from today back 10 years is one thing. A 5 year one is another. Yet a third number can be obtained if the historic average is taken back from some date in the past (say 2007 to 1998) and so on. In reality, there is an infinite number of long-term historic averages that can be taken. Which one will be selected and on what basis is never attempted to be answered in the document.]
  

(2) Subject to subsection (4), the acquisition value of a bank asset is its long-term economic value as determined by NAMA.

[Well, see above on long-term economic valuation, but in effect this is the statement that says it all - there is no price, there is no pricing model, there is not even a hint at the pricing model fundamentals. This is a botched economic analysis that would not warrant a permission to buy a typewriter for the DofF, let alone to 'invest' Euro 90bn into any undertaking. And this problem is compunded by the fact that this Bill seals the hatches on risk and credit committees operating NAMA by requiring that their members be NAMA employees or directors and not establishing any independent presence on these committees. This is like having a reactor heading into a meltdown and shutting down your monitoring systems because they are flashing red.]

(3) NAMA shall determine the long-term economic value of a bank asset by reference to the following:
(a) the current market value of the property comprised in the security for the credit facility that is the bank asset at a date specified by NAMA;
(b) the current market value of the bank asset, at a date specified by NAMA, by reference to market rates and accepted market methodology;
(c) the long-term economic value of the property referred to in paragraph (a) at the date referred to in that paragraph...

[This is incomprehensible gibberish, folks. It has neither any meaning nor economic or financial justification whatsoever. There are no accepted market rates, for there is no market for these securities and/or assets other than at extremely deep discounts that Minister Lenihan has already ruled out. The legislation provides nothing for testing the market - as I suggested in one of the required bullet points below.]

(4) NAMA may, if it considers it appropriate after consultation with the Minister, and subject to any regulations made by the Minister under subsection (5)... determine that the acquisition value to be assigned to particular bank assets or class of bank assets shall be—
(i) their current market value, or
(ii) a greater value (not exceeding their long-term economic value) that NAMA
considers appropriate in the circumstances.
[But not a lesser value, note. And once again, since there is no market value or a mechanism to attempt establishing some market value testing, this means NAMA will pay above market value for all assets. Furthermore, this section explicitly commits NAMA to use taxpayer funds to pay the real price or more for the given loan! Sickened yet? Ok, let me explain in a bit more detail. There is an auction with only one bidder. The bidder has stated up front that he will pay any price at or above the market price. But there is no market price. Where do you think the seller will set the opening bid at? If the implicit market value, known to the seller, but not the bidder is X, the seller will set an opening bid at X+y, where y is a positive premium on the 'stupidity' of the buyer or on the fact that the buyer has committed to buying the asset and is willing to pay above the market value for it. What will be the reservation price set by the seller? X+y+z, where z is a positive premium on 'desperation' of the buyer to acquire the asset. What will be the price paid by the buyer? X+y+z+v, where v is the premium on seller's skills in convincing the buyer to purchase the asset. v is also non-negative. Done. Basic auction theory, folks. Incidentally, adopting the approach advocated by me in the bullet points below removes: y through forcing the banks to take realistic writedowns first prior to NAMA; and removes z by requiring a simulative establishment of the market which can test the actual price of at least of the assets. One can't really remove v, for the smarter bankers will always be able to sell to the careless or incompetent, or both, authorities that can author this document in the first place.]

(6) In determining the acquisition value of a bank asset under subsection (2) or (4), NAMA shall have regard to the following:
(a) any value that the participating institution concerned submits as being, in its opinion, the current market value of the property comprised in the security for the credit facility that is the bank asset [that's X above];
(b) the acquisition value already determined in accordance with the valuation methodology of another similar bank asset [thats y derived from previous sales];
(c) the credit worthiness of the debtor or obligor concerned [that's v above];
(d) the performance history of the debtor or obligor in respect of that asset [that's v above];
(e) any reports furnished to NAMA in relation to the matters specified in subsection (7) whether prepared before or after the commencement of this Act [that's z above].

[So to recap: NAMA paid price for an Asset = X+y+z+v, where X is 'true' value of the asset; and (y+z+v) is a strictly positive premium accruing to the bank from the economic illiteracy written into this legislation!]

I have covered section 59 of the Act already in the previous post.


I will repeat the list of provisions that must be required before NAMA can be allowed to proceed in every post on NAMA from ehre on:

• Provisions for taxpayer protection and provision for a taxpayers' oversight board filled with only independent observers, who are not in the employment of NAMA, NTMA, the State or any other party to NAMA undertaking;
• Complete and comprehensive balance sheet and cost/benefit analysis of the undertaking;
  
• Exact upper and lower limits for banks equity the taxpayers will receive in return for NAMA funds and post-NAMA recapitalization funding;
• The exact procedures for divesting out of the banks shares in 3-5-7 years time with exact legal commitment by the state to disburse any and all surplus funds (over and above the costs) directly to the taxpayers in a form of either banks shares or cash;
  
• The formula for imposing a serious haircut (60%+) on banks bond holders, possibly with some sort of a debt for equity swap and a restriction that NAMA cannot purchase any rolled up interest acrued since the latest 'restructuring' of a loan;
• A recourse to all developers' own assets - applied retroactively to July 2008 when the first noises of a rescue plan started;
• The list of qualifications for any bank to participate in NAMA, including, but not limited to, the caps on executive compensation at the banks and the requirement to set up a truly independent, veto-wielding risk assessment committee at each bank with a mandatory requirement for a position of a taxpayers' representative on the board that cannot be occupied by a civil servant or anyone who has worked in the industry in the last 10 years;
• A requirement that risk and credit committees of NAMA include at least 51% majority of independent experts who cannot be employees of the state, NAMA or any toher parties to this undertaking;
  
• A condition that the banks must undergo loan book evaluation prior to transfer of any loans to NAMA, the results of which will be made public - on the web - instantaneously - and will impose a requirement on the banks to write down their assets, again before NAMA purchases any of them, by the requisite amounts to balance their own books in line with valuations;
• A condition that any loan purchased by NAMA be placed on the open market for the period of 2 weeks and that NAMA will not pay any amount in excess of the bids received (if any), with a prohibition for the participating banks to bid on these loans;
• A condition that every NAMA loan should be publicly disclosed, including its valuations and bids it receives in the auction stage of the process;
  
• A stipulation that all and any regulatory authorities (and their senior level employees) that were involved in regulating the banking and housing sector in this country take a mandatory pension cut of 50% and return any and all lump sum funds they collected upon their retirement;
• A provision for dealing with the speculatively zoned land to be acquired by NAMA, i.e orderly de-zoning of this land and transfer of this land to either public (if no bidders arise) or private use consistent with sustainable agricultural development, environmental improvements, public use or forestry;
  
• The measures to prevent banks from beefing up their profit margins through squeezing their preforming customers;
• The measures to force the banks to reduce their cost bases by laying off surplus workers;
• The measures for accounting (in a transparent and fully publicly accessible fashion) on a quarterly basis for NAMA operations and the performance of the state-supported banks.

If I forget something, please, let me know...

Economics 31/07/2009: NAMA Part II

And now slightly more on theat NAMAster:

Remember the levy that the Government dangled in front of the taxpayers as a sign of loss protection or minimization to be built into NAMA. Well, word 'lvey' does not appear in the entire legislation. Not even in a tocken fashion. Not even as a lip service.

And yet, bad and all as this idea might have been, the levy on the banks was announced by Minister Lenihan, repeatedly, as the only means for recouping losses on NAMA. As a friend and colleague remarked, "even that figleaf of taxpayer saving is gone'.


The document reads:
"In making regulations under subsection (1), the Minister may [my emphasis] have regard—
(a) to the rules in relation to State aid and any relevant guidance issued by the Commission of the European Communities [as if he can avoid this under the EU rules], and

(b) in relation to the determination of the long-term economic value of the property comprised in the credit facility that is a bank asset, to—

(i) the extent to which the price or yield of the asset has deviated from the long-term historical average [the half-wits who wrote this don't even understand that our historical averages are so severely skewed by a lengthy bubble in the property markets, that a return to these averages will take well over a decade],

(ii) supply and demand projections by reference to the type of asset and its location,
(iii) macroeconomic projections for growth in the gross domestic product and for inflation,
(iv) demographic projections,
[Who is going to supply these projections? Our forecasters - the DofF, the CB, let alone completely inadequate Forfas and Fas - are so grossly inaccurate in their usual predictions that you might as well use a crystal ball. One good example is the CB - this institution has been frantically issuing new forecasts on a monthly basis in order to catch up with the published forecasts by the private sector.]

(v) land and planning considerations (including national, regional or local authority development or spatial plans) that may exert an influence on the future value of the asset concerned,
(vi) analyses presented by the Minister of the Environment, Heritage and Local Government on the extent to which existing land zoning and planning permissions granted and in force meet or exceed projected growth requirements, and
(vii) analyses presented by the Dublin Transport Office and the National Transport Authority of existing and future transport planning and the associated supply and demand projections for land use.
[As I told the meeting of the Green Party recently, all of this means only one thing - the fig leaf of decorum awarded to the Green Ministers for their singing on the dotted line will see NAMA as a continuation of the development patterns that were based on utterly mad and unsustainable vision of spatial development in Ireland. In effect, the Green Party has lost all and any moral ground to stand on when it signed up to the development model (under NAMA) that cuts across the entire philosophy of the Greens.]

(c) in relation to the determination of the long term economic value of bank assets, to—
(i) the long-term economic value of the property comprised in the security for a credit facility that is a bank asset,
(ii) the net present value of the anticipated income stream associated with the loan asset,
(iii) in the case of rental property, current and projected vacancy rates,
(iv) loan margins,
(v) an appropriate discount rate to reflect NAMA’s cost of funds plus a margin that represents an adequate remuneration to the State that takes account of the risk in relation to the bank assets acquired by NAMA,
(vi) the mark-to-market value of any derivative contracts associated with the bank asset,
(vii) any ancillary security such as personal guarantees and corporate assets,and
(viii) fees reflecting the costs of loan operation, maintenance and enforcement, and

[This lengthy passage tells me right away that NAMA will operate as a banking sector's out of town office. The primacy of taxpayer protection absent in the legislation and the length afforded to the protection of the banks' bottom line is the destruction of the private sector economy on the vast scale. Incidentally, it is also a sealing of banks into servitude to the Exchequer, implying that from the day of NAMA instituion, Bank of Ireland, AIB, IL&P and other participating banks will be Japanese-styled zombies. A short-term pain relief turns a long term cancer!]


I will repeat the list of provisions that must be required before NAMA can be allowed to proceed in every post on NAMA from ehre on:

• Provisions for taxpayer protection and provision for a taxpayers' oversight board filled with only independent observers, who are not in the employment of NAMA, NTMA, the State or any other party to NAMA undertaking;
• Complete and comprehensive balance sheet and cost/benefit analysis of the undertaking;
  
• Exact upper and lower limits for banks equity the taxpayers will receive in return for NAMA funds and post-NAMA recapitalization funding;
• The exact procedures for divesting out of the banks shares in 3-5-7 years time with exact legal commitment by the state to disburse any and all surplus funds (over and above the costs) directly to the taxpayers in a form of either banks shares or cash;
  
• The formula for imposing a serious haircut (60%+) on banks bond holders, possibly with some sort of a debt for equity swap and a restriction that NAMA cannot purchase any rolled up interest acrued since the latest 'restructuring' of a loan;
• A recourse to all developers' own assets - applied retroactively to July 2008 when the first noises of a rescue plan started;
• The list of qualifications for any bank to participate in NAMA, including, but not limited to, the caps on executive compensation at the banks and the requirement to set up a truly independent, veto-wielding risk assessment committee at each bank with a mandatory requirement for a position of a taxpayers' representative on the board that cannot be occupied by a civil servant or anyone who has worked in the industry in the last 10 years;
• A requirement that risk and credit committees of NAMA include at least 51% majority of independent experts who cannot be employees of the state, NAMA or any toher parties to this undertaking;
  
• A condition that the banks must undergo loan book evaluation prior to transfer of any loans to NAMA, the results of which will be made public - on the web - instantaneously - and will impose a requirement on the banks to write down their assets, again before NAMA purchases any of them, by the requisite amounts to balance their own books in line with valuations;
• A condition that any loan purchased by NAMA be placed on the open market for the period of 2 weeks and that NAMA will not pay any amount in excess of the bids received (if any), with a prohibition for the participating banks to bid on these loans;
• A condition that every NAMA loan should be publicly disclosed, including its valuations and bids it receives in the auction stage of the process;
  
• A stipulation that all and any regulatory authorities (and their senior level employees) that were involved in regulating the banking and housing sector in this country take a mandatory pension cut of 50% and return any and all lump sum funds they collected upon their retirement;
• A provision for dealing with the speculatively zoned land to be acquired by NAMA, i.e orderly de-zoning of this land and transfer of this land to either public (if no bidders arise) or private use consistent with sustainable agricultural development, environmental improvements, public use or forestry;
  
• The measures to prevent banks from beefing up their profit margins through squeezing their preforming customers;
• The measures to force the banks to reduce their cost bases by laying off surplus workers;
• The measures for accounting (in a transparent and fully publicly accessible fashion) on a quarterly basis for NAMA operations and the performance of the state-supported banks.

If I forget something, please, let me know...

Economics 31/07/2009: NAMA legislation Part 1

Over the next few days I will be posting my thoughts on NAMA legislation. But here is a quick first installment:

A search of PDF document reveals that:

1. The word 'taxpayer' appears in the entire legislation only once. Despite the taxpayers being the sole payee for the scheme;
2. Words 'Taxpayers representation' do not appear in the document at all;
3. Words 'Taxpayers interest' do not appear in the document at all;
4. Words 'stop-loss' do not appear in the document at all;
5. Words 'transparency', 'public interest' (outside the scope of court decisions) and 'public information' do not appear at all;
   
6. 'Public disclosure' only applies to restricting such in the cases of expert opinions;
   
7. Word 'loss' appears in the legislation only in the areas of:
   

• Giving NAMA power to issue complex derivative instruments to hedge against "the risk of loss arising from changes in interest rates, currency exchange rates or other factors of a similar nature, to eliminate or reduce the costs of raising funds or borrowing or the cost
  of other transactions carried out in the ordinary course of business, or increasing return on investment. No stop-loss rules on these derivatives are envisioned, as if they are risk free;
• In making sure that "participating institutions to indemnify NAMA. 111.—(1) If NAMA or a NAMA group entity so directs, a participating institution shall indemnify NAMA or the NAMA group entity and its officers against any liability or loss..." In other words, the Government employees and NAMA will be protected from any loss claims, but not the taxpayers. Minister Leniham did his job of shielding his cronies well.

6. "30.—(1) As soon as practicable after the establishment day, the Board shall establish 3 committees, and appoint members to them, as follows: (a) an audit committee; (b) a credit committee; (c) a risk committee." There is no independent committee membership requirements, with all, save two members of each committee appointable by the Board of NAMA, and the remaining two - by the Minister.

Actually, worse that that: "(5) The members of the credit committee and the risk committee shall be members of the Board or officers of NAMA. At least 2 members of each of those committees shall be members of the Board." Thus, there will be no independent oversight over risk and credit decisions by NAMA. Not even in theory.

"31.—(1) The Board may establish such advisory committees as it considers necessary or desirable to advise it in the performance of its functions. ...(4) The Board shall determine the terms of reference and procedures of an advisory committee." There will be no statutory requirement for independent oversight of NAMA - cronies run cronies' loans.

7. "Indemnification of members of Board and officers of NAMA, etc. 32.—(1) This section applies to the following: (a) each member of the Board; (b) each officer of NAMA; (c) a director of a NAMA wholly owned subsidiary; (d) a director of a NAMA group entity; (e) a member of the staff of the NTMA. (2) A person to whom this section applies is indemnified in relation to anything done or omitted in the performance or purported performance or exercise of any of NAMA’s functions or powers under this Act, unless it is proved that the act or omission was in bad faith." So the incompetence can never be penalised - a standard practice for Mr Leniham's pets in the public sector.

And a succinct summary of the legislation (hat tip to Richard W):


More to come, so stay tuned, but this already bad enough...

Economics 29/07/2009: NAMA time horizon

Peter Bacon on today's Morning Ireland has stated that the time horizon for the real estate cycle built into NAMA assumptions is between 5 and 10 years. I have written about this assumption in the previous post (here). Assuming that what is meant by the 'cycle' here is peak-to-peak U-cycle, the most conservative Government estimate, then, is for the growth of 14.86% annually in house prices, if we are now at the bottom of the cycle. Oh, that is realistic, of course, but only if the Government spends the next few months blowing up - physically - so much housing stock in this country that it will create a massive overhang in demand over supply. Good luck!

But there is an added complication that was revealed by Liam Carroll's examinership case. As we all knew, loans to developers, by and large - all developers - to date have not been serviced with interest roll overs becoming a routine at the very latest mid 2008. This means that by the time NAMA purchases a given loan with face value €X, given the reasonably expected average rate of interest on refinanced loans of 8-11%, this loan will be refelective of:

• 12.24-16.95% cumulative rate of rolled interest, plus
• the orignal principal of €0.8305-0.8776 to the Euro of the face value of the loan

Now, suppose NAMA applies a haircut of 25% on the loan, so we buy €1 of the loan at a price of €0.75. What do we get for that €0.75? A loan that had at the time of its origination an underlying asset value of €0.83-0.88. So the real face value discount we are getting is 0.75/0.83 - 0.75/0.88 or 9.64% to 14.77%.

But wait, the actual principal (face value) amount has depreciated by, say, roughly 50% since the time the loan was written, so in reality, the discount NAMA will take will be negative 70-78%! What does it mean? Take a simple analogy. You walk into a shop and see a TV advertised 'For Sale'. The signs reads:
Original Price €100.00
Sale Price €178.00
How fast will you walk away from this 'deal'?

NAMA will overpay for the assets it buys on a vast scale!

Economics 28/07/09: NAMA & Liam Carroll's Case

Of course, the news is in - NAMA got Cabinet approval around 7 pm tonight. This does not change much - we still have a battle to wage to ensure that proper taxpayer protection and risk management, as well as investment strategies and stop-loss rules are put in place, but we are now one step further away from seeing it done.


Per RTE report (here), the High Court has delayed its decision to Friday afternoon on an application by six companies controlled by property developer Liam Carroll to have an examiner appointed to them. There are several significant implications of this for NAMA.

First: it is now clear that any decision will hang over the weekend, providing for increased uncertainty in the banks shares valuations in the days before Monday. Irish banks shares are currently valued as a call option on success of NAMA. If Carroll is not granted an examinership, this will open up a floodgate for the banks to race to force the receivership on other developers in a hope of salvaging whatever value they can under the prospect that NAMA will distort the seniority structure of debts. This, in turn will act to reduce the scope of assets left for NAMA to pick off the banks balancesheets and will force the banks to write down the loans under receivership. The resulting decrease in the future valuation of the big 3 Irish banks will translate in the fall of the value of a call option, thereby reducing the price of the banks shares. Forcing the Carroll decision to Friday afternoon leaves the markets in a serious uncertainty for the next 3 trading days – an uncertainty where anyone staying long in Irish banks shares has a 50:50 chance of not coming out alive, comes the opening bell on Monday.

Second: about that 50:50 chance. Reading into RTE report, one gets a serious sense that examinership might be denied to Carroll. “Senior Counsel Michael Cush said the companies, and the wider Zoe group of which they are a part, had historically been very successful property development businesses. But he said more recently they had experienced difficulty due to credit problems, the downturn in the property market, and problems with investments. In particular, he said difficulties arising from the development of a new headquarters for Anglo Irish Bank at North Wall Quay in Dublin had created significant difficulties. He said Vantive Holdings is now clearly insolvent, as are three other companies related to it. If liquidated, he said, the estimated deficiency of the group as a whole would be over €1 billion.”

This indicates that indeed, aside from historical record, there is no chance for a recovery of the business and that receivership, not examinership should be applied.

Mr Cush also said that “following the drawing up of a business plan in 2008, seven of the companies' eight banks had supported the continuation of the businesses. He said this had required huge forbearance from the banks. Part of the plan, he said, had seen AIB and Bank of Scotland Ireland make available additional finance to pay back third party unsecured creditors, which had since been done. Another feature of the plan saw seven of the banks agree to a moratorium on repayment of the loans and the rolling up of interest. But he said ACCBank, which is owed €136m, or 10% of the six companies' bank debts, had taken a different view, and its intention to have the companies wound up had prompted the application for examinership.”

This is also significant not only because it is showing the scale of banks’ willingness to roll over for large developers – itself hardly a laudable practice – but because it shows clearly that currently insolvent businesses continue to accumulate liabilities (rolled up interest and fresh demands for continuity funding) that are simply cannot be repaid, ever. Again, examinership is not warranted here, since loss minimizations should require an immediate appointment of a receiver to wind down the companies. In fact, this claim invalidates the ‘hardship’ argument about receivership resulting in €1bn loss on current obligations, as it shows that this loss is only going to increase under the case of examinership that will not be able to introduce any chance of reducing the probability of such a loss.

Mr Cush “said that given time, forbearance of the banks (none of which is opposing the examinership application) and the orderly disposal of assets, there has to be a prospect of survival for the companies. He also pointed out that the companies are not envisaging having to write off any of the money they owe the banks, and intend repaying in full.” This is simply impossible under the conditions outlined by Mr Cush in previous paragraphs.


“The court also heard that since the new business plan was put in place [in 2008], the companies had sold 39 residential units, worth €11.7 million.” Which, of course puts these companies cash flow at maximum €23mln pa, with expected loss of €1bn and the combined debt of companies of ca €1.4bn. Now, at 11% yield, the cost of servicing this debt will be around €154mln pa – hardly a sign of ‘survivability’ of the companies.

“Summing up, Mr Cush said it was a most unusual application for examinership as it was not being opposed by any creditors, no debts were being written down, and 90% of creditors were co-operating, all of which must satisfy the requirement for there to be a reasonable prospect of survival.” What Mr Cush neglected to mention is that the lack of opposition by the debtors is simply a jostling for seniority between Irish banks, not a reflection on survivability of the firm.


Carroll’s case shows conclusively that NAMA will transfer liability of the banks and developers onto the taxpayers that is well in excess of the original borrowings. Rolled up interest, operating capital injections and other soft budget constraints for insolvent businesses, like Carroll’s empire were accepted by the banks solely on the anticipation of a state bailout (otherwise these banks actively engaged in destroying their shareholders’ wealth by undertaking knowingly reckless decisions). Once again, the markets have neglected this risk. They might have to reprice that call on Irish banks shares now, or risk being repriced by the more proactive traders comes Monday.

Economics 27/07/2009: NAMA, ILandP rate hike, US home sales and redemptions

So NAMA failed the first day of Cabinet debate. We know this much - even RTE managed to issue a post, although the Montrose boys lacking anything real to report managed to produce a cheerful note on the debacle. Oh, how much they want the State to succeed in soaking the private sector...

But what really hides behind the Cabinet in-decision? Well, it is rumored that not the (allegedly) ethical Greens, but Mr Cowen's own troops are unhappy about NAMA. Some senior ministers, as I hear, are saying 'Hold on, we'll have to face constituency out there one day and you are about to load an average person (25 yo+) in this country with some €20K in fresh debt from the bankers and developers alone'. Good for them. And I certainly hope the Greens also stand up and tell Mr Cowen where to pack that NAMA idea.

Oh, and apparently, the DofF men are saying that the 'long term economic' value under the NAMA formula will be based on, well, more than 5 and less than 9 years. Hmmm... What does this mean? It means that NAMA should be expected to break even (at the very least) were we to price the property assets to be purchased into NAMA on this 'long term' valuation basis. Ok... but...

First there is one majour issue here - in real world of economics, long-term market value usually means a long-term past average or trend. What it means for NAMAphiles is thatwe will be forecasting the values forward over some long-term horizon. Anyone familiar with forecasting knows that this, in reality, means that we will be in a completely arbitrary forecasting territory. In other words, for DofF to say we want to take current discounts based on future values projected 5, 7, or 9 years ahead is like saying 'we'll name the price and then justify it afterward'.

But wait, there is also a problem with the way the DofF is allegedly timing the cycle.

Calculated Risk blog (see below) - the top forecaster for US housing market shows expected time to the bottom in price in the US residential market of 5-7 years. Do you think we gonna get there in this time here in Ireland? No. We have had worse correction in the market to date than Japan, who are 20 years into the downturn in their property markets and still not seeing the light at the end of the tunnel.

And NBER research paper 8966 (BOOM-BUSTS IN ASSET PRICES, ECONOMIC INSTABILITY, AND MONETARY POLICY by Michael D. Bordo and Olivier Jeanne) has a handy set of charts at the end, showing the most recent busts in property markets in the OECD economies. Ratios of boom length to bust duration are (defining as boom - trough to peak prices, bust - peak to trough):

• Australia 1980s: 3 years of boom, 7 years of bust: ratio of 3:7;
• Denmark 1980s: 4 years of boom 7 years of bust: ratio of 4:7;
  
• Finland 1990s: 4 years of boom, 6 years of bust ratio of 2:3;
• Germany 1980s: 4 years of boom, 7 years of bust: ratio of 4:7;
• Ireland 1970s-1980s: 3 years of boom, 7 years of bust: ratio of 3:7;
• Italy 1970s-1980s: 3 years of boom, 6 years of bust: ratio of 1:2;
• Italy 1990s: 4 years of boom, 6 years of bust: ratio of 2:3;
• Japan 1970s: 2 years of boom, 4 years of bust: ratio of 3:4;
• Japan 1985-today: 6 years of boom and 19 years of bust: ratio of 6:19;
  
• Netherlands, 1970s-1980s: 4 years of boom, 8 years of bust: ratio 1:2;
• Norway 1980s-1990s: 4 years of boom, 6 years of bust: ratio 2:3;
• Spain 1970s-1980s: 2 years of boom, 5 years of bust: ratio 2:5;
• Sweden 1970s-1980s: 4 years of boom, 7 years of bust: ratio 4:7;
• Sweden 1980s-1990s: 3 years of boom, 7 years of bust: ratio 3:7;
• UK 1970s: 2 years of boom, 4 years of bust: ratio 1:2;
• UK 1990s: 4 years of boom, 7 years of bust: ratio 4:7

So average ratio is 1.874 years of bust per year of boom... and that means that, given we had 5 years of a boom that the historical data suggests a bust of 9.4 years duration at an average. That is 9.4 years to a trough in Irish property prices! Not to a realization of some miraculous 'long term economic value', but to a trough.

Well, let's take a look at the same data from the point of view of time to full return to pre-crisis property prices, or peak to trough (nominal prices):

• Australia 1980s: 18 years from 1981 through 1998;
• Denmark 1980s-1990s: 8 years (1979-1986) and 13 years (1986-1998);
  
• Finland 1990s: 1989-2004 or 16 years;
• Germany 1970s: 1973- today... oh yeah, right - some 36 years;
• Ireland 1979 to 1995 or 17 years;
• Italy 1981- through today... right, so that's about 29 years;
• Japan: 1973 through 1986: 14 years;
• Japan 1990- today: 20 years;
• Netherlands, 1978 through 1998: 21 years;
• Norway 1987 through 2003: 17 years;
• Spain 1978-1987: 10 years;
• Spain 1991-1998: 8 years;
  
• Sweden 1979-today or 31 years;
• UK 1973-1987: 15 years;
• UK 1989-2000: 12 years.
  

So average peak to trough for 'long term nominal economic value' is 17.8 years. Again, given our peak at 2007 we have to look forward to NAMA recovering peak valuations at around, hmmm... 2026... But wait - not all corrections were steep enough to match ours... so let's isolate those that were:

• Australia 1980s: 18 years;
• Finland 1990s: 16 years;
• Germany 1970s: 36 years;
• Italy 1981: 29 years;
• Japan 1990: 20 years;
• Netherlands, 1978: 21 years;
• Norway 1987: 17 years;
• Sweden 1979: 31 years;
• UK 1973: 15 years

Which yields an average of 22.6 years, pushing our recovery to beyond 2030. By this standard, a break even value for NAMA should be based on something closer to 15-16 years, if we are to take a 20-25% haircut on current book values of the loans.

So DofF is talking about under 9 years then... I see... ah, the poverty of expectations...

The Government has time to get it right - they have the entire month of August to sort the new piece of legislation on NAMA, outlining in details:

• Provisions for taxpayer protection;
• Complete and comprehensive balance sheet and cost/benefit analysis of the undertaking;
  
• Exact amount of equity the taxpayers will receive in return for NAMA funds (hmmm, 100% would be a good starting point);
• The exact procedures for divesting out of the banks shares in 3-5 years time with exact legal obligation to disburse any and all surplus funds (over and above the costs) directly to the taxpayers in a form of either banks shares or cash;
  
• The formula for imposing a serious haircut (60%+) on banks bond holders, possibly with some sort of a debt for equity swap;
• A recourse to all developers' own assets - applied retroactively to July 2008 when the first noises of a rescue plan started;
• The list of qualifications for any bank to participate in NAMA, including, but not limited to, the caps on executive compensation at the banks and the requirement to set up a truly independent, veto-wielding risk assessment committee at each bank with a mandatory requirement for a position of a taxpayers' representative on the board that cannot be occupied by a civil servant or anyone who has worked in the industry in the last 10 years;
• Provision for a taxpayers' board, electable directly by people, to oversee the functioning of NAMA;
• A condition that the banks must undergo loan book evaluation prior to transfer of any loans to NAMA, the results of which will be made public - on the web - instantaneously - and will impose a requirement on the banks to write down their assets, again before NAMA purchases any of them, by the requisite amounts to balance their own books in line with valuations;
• A condition that any loan purchased by NAMA be placed on the open market for the period of 2 weeks and that NAMA will not pay any amount in excess of the bids received (if any), with a prohibition for the participating banks to bid on these loans;
• A condition that every NAMA loan should be publicly disclosed, including its valuations and bids it receives in the auction stage of the process;
  
• A stipulation that all and any regulatory authorities (and their senior level employees) that were involved in regulating the banking and housing sector in this country take a mandatory pension cut of 50% and return any and all lump sum funds they collected upon their retirement;
• A provision for dealing with the speculatively zoned land to be acquired by NAMA, i.e orderly de-zoning of this land and transfer of this land to either public (if no bidders arise) or private use consistent with sustainable agricultural development, environmental improvements, public use or forestry;
  
• The measures to prevent banks from beefing up their profit margins through squeezing their preforming customers;
• The measures to force the banks to reduce their cost bases by laying off surplus workers;
• The measures for accounting (in a transparent and fully publicly accessible fashion) on a quarterly basis for NAMA operations and the performance of the state-supported banks.

If I forget something, please, let me know...


Oh and on the topic of IL&P predatory rate hike for adjustable rate mortgages, here is a brilliant argument as to why Minister Lenihan must intervene to stop the practice of soaking the ordinary consumers to pay for past banks follies. Read it and think - can any government, acting in the interest of the broader economy and taxpayers and voters be so reckless in its attempts to hide behind 'protecting the markets' arguments as to willingly sacrifice its own people on the altar of cronyism. And do remember - I am a free marketeer, and a proud one, yet I see no moral strength in Lenihan's arguments.


US data is now showing more serious signs of an uplift... or does it? Sales of new homes rose 11% in June is a sign that some decided to interpret as a return to growth. I wouldn't be so trigger happy myself - this is the largest rise in new homes sales since... oh you'd think like somewhere in 2006? no - since November 2008. This is volatile series and the seasonally adjusted rate of 384,000 new homes sales in a month is, while impressive, way off the old highs. Thus sales are still down 21.3% on already abysmal levels of 2008 so far this year.

Here is what my favourite US housing guys - http://www.calculatedriskblog.com - had to say about the latest rise: a W-shaped bottoming out is coming. And a superb chart from the source:
Or, in the words of the blog author:"There will probably be two bottoms for Residential Real Estate. The first will be for new home sales, housing starts and residential investment. The second bottom will be for prices. Sometimes these bottoms can happen years apart. I think it is likely that we've seen the bottom for new home sales and single family starts, but not for prices. It is way too early to try to call the bottom in prices. House prices will probably fall for another year or more. My original prediction (a few years ago) was that real house prices would fall for 5 to 7 years (after 2005), and we could start looking for a bottom in the 2010 to 2012 time frame for the bubble areas. That still seems reasonable to me."

And to me too. But what I would caution against is the optimism for the overall property markets. Here are two tidy little reasons:

One: US equitable redemptions are the lags between the property being reported as a non-performing on the loan book of a bank and the time it hits the foreclosure market. Now, these vary by state, with some states having no er provision at all, while others having 9 months plus. The US average is about 4 months. This is what is yet to be reflected in the 'distressed' sales gap - the gap between new home sales and existing homes sales. Chart below illustrates:
Again, the distressed gap is not closing, but both series are pointing up. Now, notice that around November 2008-February 2009, the days of the most fierce destruction of income and wealth worldwide, the number of existent properties on the markets did not rise. Why? The ER lags are kicking in. So take the average of 4 months and get June 2009 to start showing an increase in existent homesales rising - foreclosures are feeding in. This process is likely to continue through months to come.

Two: I would watch the maturity of securitized commercial loans... these are still looming on the horizon for the roll-over (and they are also a problem in Ireland, where most of commercial property lending was securitized)... Comes autumn, expect things to get tough once again... Oh, and then NAMA will coincide with the already tightening credit markets and will take a large chunk of liquidity our of the market... Gotta love that Lenihan/Cowen timing - like two elephants trying to dance polka at a Jewish wedding - loads of broken glass, but not to the delight of the newlyweds...

Economics 25/07/2009: NAMA Presentation

So NAMA... where can it lead us? This is a question I tried to answer for today's very engaging event. I would like to thank all the participants in it for having such tremendous patience to sit through my presentation.

Those of you who attended would remember a comment from the audience that Ireland has a debt overhang on the private economy side and that NAMA is justified as a form of correcting it. This is, in my view, the singular most problematic issue raised for five reasons:

1. Logic commands us to look at a problem to determine whether or not it requires a solution. Once we deem the problem to be grave enough to require a solution, it commands us to devise an appropriate solution. I agree - debt overhang is a severe problem and it requires a solution. However, no logic requires us to undertake a wrong solution to a rightly identified problem.
   
2. Economic efficiency argument tells us that we need to solve the problems relating to the most productive sectors of the economy first so as to rescue our productive capacity. Once that is done, only then can we have a luxury to use limited resources to address problems in less productive sectors. NAMA will concentrate solely on the problem of debt overhang on the developers' side. It will not address debt overhang on consumers' side or on the side of our businesses. Yet, while developers who are in trouble are not a part of the productive sector of our economy (they are, by and large in trouble because of highly speculative re-zoning and building projects they undertook) or at the very least not the most productive part of our economy, households and companies are the productive components of this economy. NAMA will do two things to Irish companies and consumers. It will retain their debts and magnify them by forcing banks to increase their existent loans' profit margins (as we are already seeing with variable rate mortgages and accelerated loans revisions for performing customers on the business lending side). And it will saddle companies and consumers with the debts of developers via NAMA bonds. Which part of this economic policy is economically literate?
3. Financial efficiency requires us to undertake a form of solution that minimises economic and financial costs to the taxpayers. NAMA is the least economically efficient means for doing so, for an alternative - buying out the main banks or forcing a restructuring of their debts (possibly via an debt-for-equity swap) will be cheaper and will offer more control and upside potential to the taxpayers.
4. Any Government policy must apply, without discriminating against or in favour of any particular group of people. And yet, NAMA will create a discriminatory structure whereby the failures in pricing risk by the banks and developers will be dumped unceremoniously onto the shoulders of the ordinary taxpayers. As a taxpayer, I face no chance of doing the same to the banks. In fact, even more egregiously, Minister Lenihan - a lawyer by training has announced recently that he cannot interfere in the 'markets' on behalf of the variable rate mortgage holders who are being fleeced by the banks hiking their rates to push up profit margins. This is the same Minister Lenihan who has no problem interfering with the 'markets' by dumping some €60bn in banks' liabilities on to the taxpayers. This is discriminatory, in so far as both actions are one way streets - the banks cannot be made accountable to the taxpayers, and the taxpayers cannot be allowed to renege on transferring their wealth to the banks.
   
5. Political and ethical legitimacy requires that any solution that uses collective resources must address first the needs of those who provide resources. In the case of NAMA that means the ordinary people. Not of companies (they come second in the tier as employers and creators of added value) and certainly not of the developers (who come in third in the picking order). Which part of NAMA will address the needs of an ordinary family that is going to:

• Pay taxes Messrs Cowen and Lenihan levy on us, while
• Also paying for NAMA, while
• Facing a risk of financial ruin from unemployment and
• Possible home repossession should the default on a mortgage payment because their savings will be wiped out by NAMA debt burden; whilst
• Having the bleak future with no pension provision as
  
• The banks and Messrs Cowen and Lenihan enjoy a nice tidy rescue package paid for by the aforementioned 21st century Irish Government serfs?
  

Hence to argue that we must support NAMA because we have a debt problem in this country fails on five fundamental principals: logic, economic and financial efficiency, non-discriminatory action by the state and political and ethical legitimacy. It is deeply immoral and has not a single rational point in its favour.

So here are the slides...

Economics 24/07/2009: getting deeper into NAMA Wonderland

NAMA is a quagmire that is only getting bigger the longer we are looking at it. The latest reports now claim that the NAMA remit will be extended to cover foreign banks operating here, suggesting that cross-collateralised loans and holdings will be facing embarrassingly lengthy legal challenges otherwise. Of course, it was never the original Government intent to share the spoils of a taxpayer-paid bailout to prop up foreign banks. But hey, if sharing the trough is what it takes to rob the taxpayers, then our Government has no problem with this.

A revealing research note from Davy published today says it all: "From an equity investor’s point of view, an examinership process for a big developer such as Carroll would be preferable to
receivership/liquidation. The banks concerned would still have to take a write-down, but it offers the developer the prospect of survival and provides the banks with an opportunity to get back the remainder of their money. Having said that, it would obviously be preferable if these
actions stopped altogether, allowing NAMA to proceed unobstructed.[Read: the spoils will be richer if the lawyers stayed away from the feeding corale.] It is important to understand that examinerships are likely to occur only where developers are forced into a corner such as we have seen recently with ACC. Voluntary examinership is unlikely given that any successful restructuring of debt does not cancel a developer's personal guarantee to the lender (which many of them have)."

Now, examinerships are also possible, of course, if the developers are insolvent and have cash flow problems. But Davy would not mention that small tid-bit because they are fully aware that majority of the troubled developers are, in collusion with the banks, restructured. Anticipation of NAMA has also made many of them, undoubtedly, transfer all liquid assets to the shelters where no NAMA can touch them. So all of this implies two things:

1. The idea that NAMA will pursue vigorously non-performing developers is bonkers - there will be nothing to pursue comes 18 months since NAMA or the banks rescue (depending on how smart a given developer was) was first rumored. By the time NAMA is operative, there will be nothing left that is held in the name of each one of these developers that has any chance of ever being liquified.
2. The question as to whether this amazing delay in rolling out NAMA was knowingly applied by the Government to allow an escape clause for some loans holders. This is, of course, a speculation, but as any student of undergraduate economics knows, if you want to prevent people from taking preventative actions, any policy change should be unaticipated. Of course, as always, there is an alternative, but equally unpleasant, explanation as to why the Government chose to announce well in advance its desire to set up NAMA - the explanation of a panic response to a perceived crisis.

So do tell me now, how can Minister Lenihan claim that, based on the information he has seen,
it was "not inevitable" that NAMA would result in the state taking majority ownership of AIB and BofI. How? Well, this can be possible if and only if either

1. the haircuts applied to the NAMA purchases are deep enough to compensate for the cost of bonds, plus the impairment rate on loans transferred. Do the math - at 5% over 15 years coupon, applied to a purchase yielding 3% in revenue - 26% (not factoring in any inflation), the latter is anyone's guess, but judging by NIB, ACC, Nationwide etc examples, should be around 20-30%. Do the math, or
2. post-NAMA recapitalization of the banks will be done as a give-away of taxpayers money, while the banks post-default 'liability' on assets that Mr Lenihan was so keen to promote as a 'safeguard' for the taxpayers only few months ago will be nill.

Again, take you pick, but either the Government is aiming to be reckless with our money or deceitful.

Oh, and another thing - the new talk about NAMA liabilities being off the state balance sheet. This is kind of what Messrs Leniham and Cowman assumed will happen with the banks guarantees, until the international observers and analysts got a wind of it. Ditto with NAMA. Last week's decision by Eurostat, titled The statistical recording of public interventions to support financial institutions and financial markets during the financial crisis does allow for the possibility for Minister Leniham to hide NAMA liabilities off the front ledger of his Government. In particular, Eurostat's Section 8: Classification of certain new bodies allows the state to separately account for a funded entity "where ...the identification of an institutional unit in the national accounts requires that the body has "autonomy of decision" in respect of its principle function and either keeps a complete set of accounts or it would be possible and meaningful, from both an economic and legal viewpoint to compile a set of accounts if they were required". Now, if Cowen/Lenihan due can convince the readily convinceable EU Commission that NAMA undertaking has nothing to do with the General Government and has its own life and management. Never mind that the same taxpayers paying for Messr Lenihan and Cowen wages and their spending plans under the General Government expenditure will be underwriting NAMA. The charade of 'low debt Ireland' will then go on unperturbed.

In other words, if Lenihan is successful, some €60bn of bonds might be called something other than the official Irish Government debt. This is pure farce, but hey, may be as the taxpayers we can go on strike and tell Mr Lenihan to pay for NAMA out of its own pocket - afterall, it will be fully autonomous from the Government and therefore from us, the taxpayers?

Economics 22/07/2009: From Economics of Culture to the Culture of Economics

In fear of losing this preciously precise formulation of the Irish State ethos as a proto-nationalist construct (and please do recall the other side of the coin - the proto-corporatist Social Partnership model to complete the circle to matching us to 1930's German model of nationhood), I am posting here below the article written today in the Irish Independent by Kevin Myers. The link to it is here.

Governments must govern -- not try to shape our culture

Kevin Myers Home

Wednesday July 22 2009

In its own twee way, the very name, An Bord Snip Nua, gets to the heart of the issue.

Its utter bogusness echoes so much of what state endeavour has been about: pretending to protect and preserve ancient forms of Irishness, whether it is some precious cultural commodity west of the Shannon, or a peat bog in the Midlands, or the Irish language. Whether the McCarthy report is implemented in part or in whole, it is now on the political agenda: and underlying its proposals is a desire for minimalist government, without any great non-political projects as policy. In other words, an end to the notion of the State as a means of shaping the culture of Ireland, and how its people think.

This would be one of the most revolutionary events since 1916, which in essence was not merely about achieving a Republic, but giving that Republic great cultural projects. Thus Pearse thought that the Congested Districts, the most forlorn and impoverished corners of all of Europe, should be the social models for the new State. Which is the equivalent of making Bord na Mona the cornerstone of a space project. However, the actual founders of the State, after a more than usually stupid civil war, realised that nothing could be done with these human tipheads: they were capable of accumulating no capital, and generating no enterprise.

So they became Indian Reservations, where to stultify was to be Irish, and where backwardness was a form of cultural purity. The people here actually received government grants merely for talking. Everyone over 40 was crippled with rheumatism, and the entire population subsisted on a unique frying-pan diet, which explored the extent to which the human frame could survive without any vitamin C whatever.

There were other places of distinctive national virtue, namely the islands. The idealised role model for young people was thus Peig Sayers, whose senile ramblings were jotted down feverishly by teams of folklore stenographers, and turned into the Holy Scripture of the New Old Ireland. Prophets in other lands have emerged from the deserts. Our native form of revered dementia came from a wind-lashed and uninhabitable island: hence the term, Blasket Case.

Generations of children had their will to live broken on the wheel of Peig Sayers. Did any one of them ask, how come if she is so Gaelic her name is Sayers? The same, of course, for that other cultural icon from the West, Brian Merriman. So the very notion of some pure aboriginal Gaelic island folk offering a model to future generations of free Irish people was based on the words and thoughts of descendants of English settlers -- actually, rather like Pearse himself.

So the Irish language itself became a Government Protected Zone (GPZ). The Gaeltacht naturally became an extended GPZ. The islands became a GPZ. History became a GPZ. Even turf-burning became a GPZ. Moreover, this insanity became a perverse template for all sorts of other state projects. Mail and phone services were already GPZ. In the 1940s, all public transport became a GPZ. Air travel then became a GPZ. Arts became a GPZ -- indeed, the arts were hardly seen to be arts at all unless the State gave them a subsidy.

Even economic development was graded around a GPZ hierarchy.

The plain people of Ireland got the IDA. The semi-pure in the west got the Shannon Development. But the purest of the pure got Udaras, the job-creator for people who spoke Irish in a GPZ, a local shop for local people. In more recent times, Udaras has operated within the very ministerial embodiment of the GPZ, the Department of Community, Rural and Gaeltacht Affairs, which has a budget of €40m, with some 240 civil servants: almost one for every native Irish native speaker left.

Through these GPZs, the State became deeply involved in matters it knew nothing about. To be sure, this pleased politicians, for it increased their power of patronage, and thus accorded neatly with a culture of populist clientelism, as well as satisfying the ambitions of the few political ideological TDs, such as Eamon O Cuiv and Michael D Higgins. These see the primary duty of the State to be the pursuit of Great Cultural Projects, each within its own respective GPZ.

The dreams of such zealots are now dross. Nearly all state cultural projects have failed. The Irish language is effectively dead in its GPZ. The preposterous and Haugheyite confection, Aosdana, has achieved nothing whatever in its GPZ. CIE is a mouldering corpse in its GPZ. Every town now has its own empty GPZ, namely an arts centre, with its deserted craft shop offering (but not selling) environmentally sound raffia condoms, seaweed dental floss, and hand-crafted soaps made from pigfat. Government bribes have resulted in two multi-million pound GPZ stadiums in Dublin -- both of which will be empty, most of the time. And the fortune spent on the GPZ that is Olympian sports has produced just one bronze medal -- in bee-keeping.

The great dream is over. It's finally time for Ireland to be a normal country, one in which governments simply govern. Let the Great McCarthyite era begin.

kmyers@independent.ie

Superb! And full credit to the Irish Independent for bringing Kevin's articles to us.

Economic 20/07/2009: Property Tax

And by request from one of you, an earlier Sunday Times article (July 12, 2009) on property tax:

A specter of a new tax is haunting Ireland. Since last October, the Government has been pre-occupied with finding increasingly less subtle ways to raise revenue out of the shrinking economy. The latest Department of Finance estimates put new ‘committed’ tax measures envisioned for 2010-2011 at €4.6bn – one and a half times more than is planned in expenditure cuts.

Per latest rumours from the Commission for Taxation, the most favoured new scheme being discussed in the corridors of power is a property tax. A source close to the Commission has indicated to me last week that this month’s report will recommend replacing the stamp duty with a levy on residential and commercial properties. Another source – this time from the Upper Merrion Street – voiced a serious concern that the Government is leaning in favour of “a quick and regressive property tax grab”. When civil servants start labelling a new tax prospect as a “regressive” policy”, one has to be concerned.

The problem is that a property tax is an economically inefficient way for addressing our long-term tax reforms objectives. To see this, consider the reasons as to why our existent structure of taxation in Ireland has to be overhauled.


To date, our taxation system has relied excessively on pro-cyclical tax sources: stamp and excise duties, VAT and assets-linked levies. This has contributed (alongside with gross over-expansion of the public sector) to a full-blown crisis of insolvency in this state.

In H1 2009 total returns from capital gains and acquisition taxes (CGT and CAT) were 74% down on their peak in H1 2007. Stamps fell 80%, VAT - 23.5%, while excise duties were off 26%. Of the €5bn shortfall in total tax revenue in the first six months of 2009 relative to the peak year of 2007, €4.7bn was accounted for by the property, capital and consumption taxes.

Assuming the property tax replaces the two-three year average revenue from stamps – in order to compensate the Exchequer at least in part for some revenue declines – the amount of tax to be raised would equal to €2.4-2.9bn against the current revenue of €680-700mln. In other words, property taxes simply cannot resolve the problem of financing the Exchequer deficit until at least there is a dramatic improvement in the economy.

What is more problematic, however, is that our tax system yields are highly volatile and unpredictable. This is linked to stamps and consumption taxes, with the former having by far the largest impact on revenue deviations from the long-term trend. Stamps are transaction taxes that normally act to reduce overall variance of asset prices and thus dampen down market bubbles – the so-called Tobin tax effect. Normally is the operative word here, for when the underlying assets is infrequently traded, like housing, transactions taxes have the exactly opposite effect, contributing to bubble inflation, rampant speculation and producing extreme peak-to-trough deviations in revenue. This makes future changes in tax receipts less predictable and thus hinders expenditure planning.

A property tax will only partially address the issues of predictability and volatility as it will be directly linked to collapsing property prices. And it will not reduce the propensity for speculative investment in real estate, thereby doing nothing to prevent bubbles in property markets. International experience shows this to be the case, as are the simulations for a property tax in Ireland.

Instead, a site value tax can be used more efficiently to smooth real estate price cycles and to introduce a system of revenue falloff warnings, because land values tend to move change slower over time in functional real estate markets than property prices. For example a simple site value tax, along the lines of the one used in Denmark and Hong Kong, can provide up to 10-12 months delay in decline in revenue relative to other tax heads in a recessionary cycle. Such a tax would apply to all land, including residential property, and can be set at rates that would encourage more efficient and environmentally and spatially more sustainable development in the long run.

In the case of Ireland, my simulations show that a land value tax, raising equivalent of the stamp duties revenue at the peak of the growth cycle in 2006-2007, would have reduced Government revenue shortfall by approximately 35-40% until roughly the end of Q4 2008 – delaying the onset of the fiscal crisis by some 9-10 months. The same tax would have fully smoothed out tax revenue volatility in previous two downturns.

In the long run, our reliance on income and consumption-related taxation is starting to adversely impact Ireland’s ability to attract highly educated and young labour force. This imperils our ambitions to develop a knowledge-intensive high value-added trading economy. In H1 2007, income tax and VAT accounted for 64% of all revenue. By 2009 this figure stood at 70%. Property and capital taxes have seen their share of overall tax burden collapse from 14% to 4% over the same period of time. In other words, thanks to our economically illiterate system of taxation, we are now subsidising property speculators while destroying more productive households. Some 83% of all taxes collected since the beginning of the current downturn accounted for by income tax, excise duties and VAT (up from 76% in 2007).

Shifting more tax burden from physical capital stock onto our incomes and consumption – as a property tax would do relative to the site value tax – will lead to two long-term damaging developments. An increased tax burden will disproportionately befall those amongst us who possess greater human capital and destroy the savings and investment capacity of our younger generations.

A property tax, applicable to the value of one’s residence or office will also act to increase the cost of more efficiently used facilities, putting further pressures on income of the more productive segments of our population. A land value tax, in contrast, will raise more funds out of the under-utilized speculative land and property holdings, increasing relative returns to more efficient, sustainable and demand-driven development, thus in the long run improving housing and commercial real estate markets and costs.

A property tax will hinder any realistic chances of us transitioning to a more environmentally and economically sustainable development model, incentivise further sub-urban sprawl and destruction of community social capital. It will also reward, in relative terms, those who let their property fall into disuse or disrepair. For example, for two neighbours residing in otherwise identical residences, higher taxation will apply to the one who adds an extension to her dwelling or improves insulation on the house, thus allowing for a more efficient use of our housing stock resources.

Should the city or a local authority provide new infrastructure to the neighbourhood, thus increasing the value of the land in the area, once again a property tax will hit the hardest those of the neighbours who put most effort into their property, leaving brown sites and underutilised property owners largely unaffected.

A comprehensive research study into the optimal infrastructure-financing tax systems, published this week by the University of Minnesota found conclusively that a land value tax is a unique measure for directly linking private returns to public investment and the Exchequer tax revenue. A property tax, in contrast, will yield higher private gains to less economically and environmentally sustainable forms of development and property ownership, preventing proper payment for the private benefits of public investment by property owners.

In short, introducing a property tax in place of a more progressive land value tax will be an opportunity lost to create a more equitable, economically sustainable and efficient system of taxation in Ireland.



Box-out: In response to my note on June 14 here, a recent editorial in the Irish Times (Friday, July 3) by Cathal O’Loughlin claimed that if the €10 per passenger travel tax passed into Budget in April were to induce some Irish households to stay away from vacationing abroad, there will be net gains for Irish economy.

Mr O’Loughlin’s arguments fail in terms of simple data analysis. Current data shows that in Q1 2009 relative to Q1 2008, Irish economy has lost 148,000 visitors travelling here from abroad for more than one day, it might have gained some share of the 231,000 Irish residents who decided not undertake a trip abroad. Given seasonality in travel demand, the split between business and other travellers, the latter share is likely to be in the range of 30-40%, as at least some of our potential travellers would opt to take discretionary breaks in their second homes or staying with friends and relatives instead of surrendering to the rip-off prices in our hospitality sector. Do the math: 140,000 foreigners gone, about 70-90,000 domestic travellers holidaying at home. Net gains for the travel sector?

Mr O’Loughlin further confuses the effects of imports and exports of services on the domestic economy, when he simplisticly claims that any Euro ‘saved’ from travelling out of Ireland is a Euro spent in Ireland and when he asserts that such a spending turn-about has the identical net economic effect to every Euro in spending by the foreign visitors here.


The sheer economic illiteracy of Mr O’Loughlin’s argument in favour of a tariff protection of an internationally traded domestic sector is stunning and has been refuted by the entire body of international trade literature. Not surprisingly, every developed country in the world has resisted raising such charges on travel in the current downturn, and many have lowered them.

Economics 20/07/2009: Education Plan

For those who missed my Sunday Times article last, here is the unedited version. For more on education premium in Ireland see my Long Run Economics blog here.


Remember the wave of protests hitting the streets over the withdrawal of the automatic entitlement to the senior citizens’ health cards – a benefit worth some €2,500 per annum for a well-to-do family of two? As the Government studies this month’s report on the options for the reintroduction of third-level fees, the prospect of taking out some €5,700-7,300 from the already stretched middle classes has to be an equivalent of a nightmare in our Ministers’ heads. Unlike the elderly, these are the same families hit hard by Minister Lenihan’s tax war on Ireland Inc.

Politics aside, this level of radical pain therapy would be warranted were it to deliver improved quality of education. Alas, the plan is so fundamentally flawed that one must wonder if serious economic impact assessment of its proposals was even attempted.

The Department of Education report suggests, as a clearly preferred option, setting fixed fees of €5,715 for arts and humanities students and €7,272 for nursing and engineering. While these differentials somewhat reflect the variation in capital between the two broad categories of programmes, these are hardly sufficient to establish proper pricing of education. Neither do they recognise the differences in the costs of non-capital inputs, such as faculty salaries.

In other words, the idea of fixed, uniform pricing independent of quality or institution’s ability to attract top internationally competitive students and faculty is about as daft as charging a single price for all cars. Do this, and within years you’ll get an overpriced mediocre labour force.

Two features of the Irish market for education amplify this negative effect of fixed pricing.

The first feature is extreme over-proliferation of third level institutions. In normal circumstances, when price reflects quality differences between competitors, the markets regulate the new entries and the survival of the incumbent colleges, institutes and universities. But absent pricing mechanism and with politically motivated education expenditure allocations you get a competition driven by the race to increase numbers of degrees awarded. A race to excellence is replaced by a race to graduation and grades inflation. Do we, as a nation, want certified mediocrity for the indigenous labour force? If not, we should allow our universities to charge a market rate for their services.

The second feature relates to the market for education. For all our talk about the knowledge economy Irish wages are driven primarily by tenure. Per latest CSO data, released last week, even at the peak of the boom in 2007, Irish workers collected low earnings premia per each additional year of investment in education compared to tenure. Chart illustrates. After-tax real annual earnings gains from moving from post-leaving cert level of education to a 3rd level non-degree education are lower than those from staying in the workforce. This is true for all types of potential students, with exception of mature female students. A picture is better for those planning to invest in a full 3rd level degree or higher, but even here the premium earned falls below the price to be charged under the proposed reform. That was before the latest decimation of jobs, wage rates and bonuses associated with the current recession.

In other words, given the labour market-enshrined system of tenure-driven rewards, education does not really pay in Ireland. Staying in the job does. This is likely to explain why on average more educated EU15 foreign nationals (excluding UK and Ireland) have earned some 9.6% less in hourly wages in 2007 than their Irish counterparts. For males, the same number was a whooping 14%. Per CSO data, not a single sector in Ireland yields an education premium in excess of the upper marginal tax rate other than our knowledge-thirsty public sector. And even there, only females earn such a premium.

This makes it even more crucial for the reform of education financing to be focused on long term objective of creating a functional market pricing of human capital – skills, schooling and aptitude. On a deeper level, such a reform should be linked with a rapid shift away from the system that rewards tenure and taxes heavily educational attainment and resultant skills. In other words, we need more after-tax wage inequality based on skills and educational attainment differentials before we can charge a real price of education. But at the level of education reform itself, we need a system of fees that differentiates between degrees of varying quality, incentivises student effort and merit.

The main mistake of the proposed fees system is that it sets singular pricing for all degrees independent of quality or the variations in the demand for specific degrees in the market place.

For example, if the country is experiencing a reduced supply of engineering and hard science personnel, as FAS and Forfas have asserted on so many occasions, surely we should witness a combination of lower fees (due to smaller demand for admissions from the potential students) and higher wages emerging. Under the latest Department of Education proposal, we will get exactly the opposite.

Similarly, if our two world-class institutions, TCD and UCD, were to offer their degrees at the exact same price as those offered by less internationally recognisable schools, this society will be underpaying for their services and overpaying for lower quality universities and schools. This is hardly a system that can be expected to yield economically and socially efficient outcomes.

Bizarrely, our education mandarins claimed in the report that allowing institutions to vary the price of admission can lead to some charging “excessively high fee rates, perhaps resting more on reputation than service”. This is economically illiterate and smacks of an outright manipulation of the market.

The second grave mistake is not to create a fully diversified and functional system of state-supported lending for tuition fees coverage and merit-based grants. Such a system, for obvious reasons, should be accessible only to the children of Irish citizens and long-term (8-10 years plus) residents. It should be coupled with a University-driven system of own merit grants open to all candidates to attract star applicants from abroad.

It should also work seamlessly with the means-tested system of supports. The much-lauded Australian option (or Option 3a in the report terminology) will simply not work for a small open economy like Ireland that is a temporary migration attractor within a much larger EU. Judging by the fact that the Department of Education expects the cost of running the scheme to be roughly equivalent to only 3-4% of the set up cost, I doubt they counted on the potential education tourism and skills drain to be of any significant magnitude.

And yet, our own Government expects some 150,000 Irish people to leave this country in the current recession alone. How many of these new emigrants will carry with them above average levels of education attainment is an open question. However, were we to have the proposed fees system in place today, the Government migration solution to the crisis could be washing away some €800-1,200mln in educational investment out of the country.

The last error of judgement by the Department of Education is to address the issue of fees separately from the overall financing of academia. Even assuming that our mandarins’ numbers stand up to scrutiny, there is no added certainty as to the future income for the academic institutions in this country. How much of the current funding will the fees replace? How will the fees revenue be distributed across various institutions? Who will be responsible for financing of uncompetitive institutions? All of these and other questions remain unasked. Which suggests that the fees reform will be nothing more than a plaster on a gapping wound that is our system of education.

Box-out: This month’s ECB Bulletin on the Euro area economy included an interesting model for estimating the sovereign bond spreads as a function of public debt to GDP ratio, public deficits, the volumes of bond financing required in the future, past yields and the measure of international financial markets’ willingness to accept investment risk. The original ECB estimation was based on the yields history for 10 Euro area countries, including Ireland. Recalibrated forward to reflect the expected changes in our fiscal position in years to come, this model predicts Irish bonds spreads over the German bund to increase by roughly 40-50% through 2013 assuming NAMA bonds are held off the public balance sheet and have no impact on the market demand for our bonds. Under less favourable conditions, with NAMA bonds entering public balance sheet and demand for Irish bonds falling to the level where the ECB becomes the sole purchaser of bond, market yields spreads can rise by some 200%. Drastic, but feasible.

Economics 19/07/2009: 'Punter's perspective' in my INIA report

A quick reply to a box-out by Liam Fay in the main section of the Sunday Times with a critique of the Irish Nightclubs Industry Association (INIA) report, launched last week, which was prepared by me.

I like Liam's column and was certainly amused by his allegory for my economic career. Not being familiar with Mrs Sophie Ellis-Baxtor's career or personality, I would presume that Liam's reference is a positive one, especially given my suspicion that he is familiar with my established credentials as a champion of competitive and lower cost markets for consumer services and goods and the opponent of the rip-off culture that is a feature of some areas of our economy.

Liam has an acute eye for bulls**t and he spotted something that was missing in my report. "But one of the chief reasons most adults avoid nightclubs is the extortionate prices charged for booze. If Gurdgiev had surveyed the nightlife scene from the punter's perspective, he would've discovered that it's actually the greed of club owners that's killing the groove".

Liam is correct to say that my report was not based on the 'punter's perspective'. I was asked to provide a professional opinion on specific proposals presented by the INIA, not to conduct a general research into what is right or wrong with the industry. Like a lawyer providing a specific client advice, I have my remit and scope of research, and this remit is clearly identified in the title of the report.

But Liam is incorrect to imply that the different approach of my report somehow acts to glance over "the greed of club owners that's killing the groove". If high cost is a deterrent to night clubs attendance, then, as I hope Liam would agree, reducing this cost would help.

Reducing this cost can be done via many alternative ways. Cutting the price of drinks is one, but it is not the policy objective of any of our policymakers, so to deal with high cost of drink, induced by high taxation structure, in a legislative proposal framework would be a waste of time and effort.

Other charges do enter the determination of the cost of entertainment in a nightclub alongside the price of drink. My report clearly shows that these charges can be made more competitive, allowing a punter buying the same drink for the same price to enjoy more entertainment per Euro spent. These are:

• longer hours of access to entertainment,
  
• better quality of music and dancing environments,
  
• more regulated and safer entertainment conditions,
  
• better trained staff etc
  

These benefits are to be delivered as a result of the reforms I was asked to evaluate and these benefits surely provide better value for money to a punter. So, Liam's argument that high cost of drink matters to the decisions made by the punters does not clash with the report findings - it actually supports them.

I do not compare costs of drink in different types of licensed venues, nor do I provide any assessment as to whether a price of drink premium in Irish nightclubs over that of other licensed venues is out of line with other countries. My work did not require this and none of my conclusions depend on any assumptions or inputs relating to these, otherwise very interesting, comparisons.

But even if there are such differentials, to suggest that price of drink is high in the nightclubs (in absolute terms or in relative terms, compared to elsewhere) due to 'greed' of the nightclubs owners is simplistic. My report supplies evidence to show that, at least in part, the cost of drink in the nightclubs is driven by external factors other than 'greed':

1. Table 1.6 on page 9, shows that annual licensing costs to operate nightclubs in Ireland are 8.91% of the total nightclub sector turnover. This is 31 times greater than licensing costs for operating an ordinary on-trade venue and 99 times greater than the off-license licensing cost;
2. nightclubs have to maintain larger physical premises than other on-license venues (e.g at least 20% of the floorspace in the nightclub will be allocated to a dancefloor, which yeilds no drink-related revenue);
   
3. nightclubs operate shorter daily and weekly hours (section 3.7 of the report and Table 3.7);
4. nightclubs face higher rate of amortization of premises (section 3.4);
5. nightclubs maintain higher ratio of staff to clients than oridnary venues (Table 3.7);
6. nightclubs have higher capital cost per each person entertained than other on-license venues (section 3.7 of my report);
7. Table 3.7 in my report clearly states various areas of operations, relating to technology, space utilization and staff requirements, where nightclubs are incurring higher costs than other on-license premises. In fact, of 10 areas related to the subject of my research, 7 show higher cost of operations for the nightclubs;
8. Tables 3.5 and 3.6 show that out of the expected gains in alcohol sales of €122mln pa due to reforms, the Exchequer will receive some €62mln in alcholo-related tax revenues. Roughly 50%, overall value added to the Exchequer will increase by over 2 times tha rate of increase in the value added attributable to labour and 30% more than the value added attributable to physical capital stock. Since roughly 89% of this increase is expected to come from substitution away from home consumption of alcohol, these figures clearly show a vast differences in tax-induced costs of alcohol consumption at home and in the licensed premises.

The bottom line is - over 50% of what we pay in a nightclub for a drink has absolutely nothing to do with the nightclub owner's profit line. The above points - all clearly identified in the report - suggest that the cost of drink to the punter might be driven by the greed and/or other considerations of the Exchequer.

Once again, Liam is correct, this is not a report written from a punter's perspective. As much as I would have loved to work on such an exciting topic of research, limitations of time, resources and brief require that this research be postponed for the future. Economics, like legal profession, is a field of professional inquiry and this means that one works within a given brief.

However, I see no evidence to suggest at this moment in time that the industry I describe in the report is driven by some exceptional greed or short-termist pricing policies that are killing the groove.

If anything, there is evidence in the report to show that the opposite is true. For example, the proposals for nightclub permit set very strict and costly (to the owners) parameters for what constitutes a nightclub. This is not done because there is a pursuit of a groove-killing quick profit, but because the sector participants have recognised the need to explicitly focus on long-term sector development.

The end result of these proposals would be to deliver better value for money for the punters and safer and more responsible entertainment from the social point of view. These are hardly the reforms a 'greedy' profit-stripping business owner would subscribe to.