10/10/2012: Irish Real Economic Debt - Busting Records

Last night I came across the latest data from the IMF on the overall levels of indebtedness and leverage across a number of countries. Here's the original data:

Much can be taken out of the above. For the purpose of discussion below, I define real economic debt as a sum of household, non-financial corporate and government debts, excluding financial firms' debts. This real economic debt is liability of the Irish economy: households, private enterprises and public sector providers of goods and services.

First up, total debt levels:

Ireland's total real economic debt runs at a staggering 524% of our GDP and 650% of our GNP. In fact, I use 24% GDP/GNP gap as a basis for adjustment which is significantly less than the current gap, but is consistent with 2011-2012 (to-date) average. Put into perspective:

• Our economy's overall indebtedness is 1.73 time higher than the euro area levels in GDP terms and if GNP is used as a basis it is 2.14 times higher
• Our real economic debt is 14.4% ahead of that of Japan (second most indebted country on the list) if GDP is used and is 41.9% ahead of Japanese debt if GNP is used.

Our real economic debt can be decomposed into the following three components contributions:

In other words, the above chart clearly shows that Ireland's core debt overhang arises not from the Government finances, but from accumulation of liabilities on the side of the companies. More than that:

• Ireland's Government debt levels are 25.5% ahead of the euro area
• Ireland's Household debt levels are 64.8% above the euro area
• Ireland's corporate debt levels are at 209% of the euro area levels.

Thus, with the Government policy firmly focused on taxing households to save own balancesheet, we have a perverse situation that the economy is dealing with debt overhang in Government debt that is more benign than the debt overhangs in the sectors the Government is obliterating. Households faced with increased taxation to pay for Government debts and deficits implies lower spending on goods and services and lower ability to repay household debt. Thus higher taxes on households (direct and indirect, including aggressive extraction of income via semi-states' charges) imply growing burden of the debt overhang in the private sectors (firms and households).

Adding financial debts to the overall real economic debt in the economy forces Ireland into a truly unprecedented position vis-a-vis other countries in the sample. (Note - adjustment for IFSC is mine).

Using the bounds for debt of 90% (consistent with upper range for Checchetti, Mohanty and Zampolli (2011) and Reinhart, Reinhart & Rogoff (2012)), the levels of cumulated real economy debts that are consistent with reducing future long-term potential growth in the economy are taken to be 270% of GDP. Hence:

and

In the above, the larger the size of the bubble, the greater is the drag on future economic growth from debt. The further to the right on the chart the bubble is located, the greater is the problem associated with Government debt (as opposed to other forms of debt). What the above shows is that Ireland's debt crisis is truly unique in size, but it also shows that the most acute crisis is not in the Government debt, but in private sectors debt.

Now, at 4.5% per annum cost of funding overall debt, irish economy interest rate bill on the above levels of real economic indebtedness runs at ca 29.2% of our GNP. Do the comparative here - interest rate bill equivalent to the total annual output of the Irish Industry (that's right - all of our Industrial output in 2011 amounted to less than 29.3% of our GNP. This is deemed to be 'long-term sustainable'... right...


Note: In my presentation at a private dinner event yesterday I referenced by earlier estimate of the total economic debt in Ireland at 420% of GDP. My 2011 estimate was ca 400% GDP. These figures have been published by me in the Sunday Times and also correspond closely to the 2010 figures cited by Minister Noonan in the Dail and made public here on this blog. They also were confirmed by Peter Mathews TD. My estimates were based on publicly available data which is less complete than data available to the IMF.

30/7/2012: Grazie, Sig Draghi?

So Mr Draghi made some serious sounding pronouncements last week. The markets rallied. Over the weekend, more serious sounding soundbites came out of Mr Juncker. The markets... oh... still rallying? And thanks to both, Italy had a 'Successories'-worthy auction today am:

• Italy 5 year CDS fell 20bps to 478 (lowest since early July) prior to the auction
• 5 year bond sold at yild 5.29 (against 5.84 in previous) with bid/cover of 1.34 (down on 1.54 achieved in previous auction) and maximum allotment of 2.224bn out of 2.250bn aimed
• 10 year 2022 5.5% bond sold at 5.96% yield (previous auction 6.19%) and bid/cover ratio of 1.286 (against previous 1.28) with allotment of 2.484bn out of 2.5bn planned.

Grazie Sig Draghi?

Now, wait a sec. Yes, there's an improvement. But on less than €4.7bn of issuance... and Italy needs are:

(Source: Pictet)

And hold on for a second longer:

• Italy's net debt financing cost was at 4.721% of GDP in 2011 with debt/GDP ratio of 120.11% which implies effective financing rate of 3.931%
• Of course, a single auction does not lift this up in a linear fashion, but... if Italy had troubles with 3.9%, should we not be concerned with 5.29%?
• Let's put it differently: Italy's GDP grew in 2010-2011 by 1.804% and 0.431% respectively. Over the same period of time, Italy's government debt net financing costs went from 4.236% of GDP to 4.721% of GDP. This year they are set to rise to over 5.36% of GDP as economy is likely to contract ca 1.9-2.0%.

So maybe (I know, cheeky) cheering the current yields is a bit premature? Eh?

21/7/2012: Globe & Mail July 2012: Italian dilemma

My article on Italian debt v growth dilemma for Globe & Mail: link.

15/6/2012: Few links worth checking out

Few worthy links accumulated over recent weeks:

What about that jobs creation by MNCs? Well, actually, its a net jobs loss: link here. Note that the net rate of jobs destruction amongst MNCs in the 2008-2011 period is roughly-speaking around 8-9%. Which is below that for the whole economy, but looks to be above that for the economy less construction and retail sectors. Hmmm...

EU Commission issued its guidelines for dealing with 'future' banking crises (assuming we end this one with some banking left for the future crises to challenge): link here.

Quick quote from Lobard Street Research on subordination in the Spanish 'rescue' case - the topic I covered for ages and that I believe is now also related to the ECB reluctance in engaging with secondary markets purchases of peripheral sovereign debt - link here.

Meanwhile, Spanish banks have now surpassed Italian bank in ECB borrowing: here.

Excellent as ever NamaWineLake blog on 18% performing loans ratio at NAMA: here. Stay tuned for my Sunday Times column this weekend where I cover European data on commercial real estate mortgages backed securities that will make Nama look, relatively, not that bad...

BIS blog post on their Q2 2012 quarterly: here. Some nice charts on international debt issuance, showing pick up in debt issuance in the wake of LTROs.

A position paper by Daniel Gros and Dirk Schoenmaker on Spain and Greece backstops: here. With some elements of the solutions that I've been advocating in my Sunday Times articles over the last few weeks - including deposits insurance. I disagree with them on the point that ESM should be used to recapitalize insolvent banks which are to be held in SPVs, presumably until they are 'repaired' to be fit for disposal. This is simply a prescription for de fact protectionism and politically motivated preservation of incumbents. In the end it will lead to European banking becoming fully politicised and ineffective. ESM can be used to cover losses in the banks, but insolvent banks should be shit down and their assets sold off to private investors and other banks to make certain that state-ESM-controlled zombies do not block the banking system.

A thought-provoking presentation on the state of the global economy by Raoul Pal: here.

14/4/2012: An interesting data on Europe's capital flight

Capital flight continues within Europe out of the periphery and into core, according to this article from Bloomberg. If you must see a chart today, see this one

One feature worth considering is the data for Ireland, which appears to conflict with the CBofI data. Although outflows have abated in the chart above, they are certainly pronounced. According to CBofI, deposits are flat and according to the Government, other forms of capital are inflowing into the country like there is no tomorrow (which is disputed by Ireland's own BOP data).

2/4/2012: Banks bailouts and bonds eligibility

Two important documents relating to banks bonds, Sovereign Guarantees and the bondholders' haircuts.

First, the ECB decision of March 21 that was rumored to have been implemented by the Bundesbank last week - allowing the NCBs not to accept as collateral Government-guaranteed bank bonds from the countries currently in the EU-IMF financial assistance programmes (aka Greece, Ireland and Portugal). Here's the link. Key quote (emphasis mine):
"Acceptance of certain government-guaranteed bank bonds: On 21 March 2012 the Governing Council adopted Decision ECB/2012/4 amending Decision ECB/2011/25 on additional temporary measures relating to Eurosystem refinancing operations and eligibility of collateral. According to that Decision, National Central Banks (NCBs) are not obliged to accept as collateral for Eurosystem credit operations eligible bank bonds guaranteed by a Member State under an EU-IMF financial assistance programme, or by a Member State whose credit assessment does not comply with the Eurosystem’s benchmark for establishing its minimum requirement for high credit standards. The Decision is available on the ECB’s website."

Hat tip for the link to @OwenCallan of Danske Markets.

However, the latest information is that Bundesbank clarified that it will continue accepting all EA17 Government bonds. See link here. Confusion continues as to what Bundesbank will and will not accept.

Second, today's release by the EU Commission of the consultation paper on dealing with future banks crises and bailouts. Titled "Discussion paper on the debt write-down tool – bail-in". The paper clearly states (emphasis is mine, again):

"Rather than relying on taxpayers, a mechanism is needed to stop the contagion to other banks

and cut the possible domino effect. It should allow public authorities to spread unmanageable

losses on banks' shareholders and creditors."

The proposals advanced by the EU are not new: "In most countries, bank and non-bank companies

in financial difficulties are subject to "insolvency" proceedings. These proceedings allow either

for the reorganization of the company (which implies a reduction, agreed with the creditors, of its

debt burden) or its liquidation and allocation of the losses to the creditors, or both. In all the

cases creditors and shareholders do not get paid in full."

Per EU: "An effective resolution regime should:

• Achieve, for banks, similar results to those of normal insolvency proceedings, in terms of allocation of losses to shareholders and creditors
• Shield as much as possible any negative effect on financial stability and limit the recourse to taxpayers' money
• Ensure legal certainty, transparency and predictability as to the treatment that shareholders and creditors will receive, so as to provide clarity to investors to enable them to assess the risk associated with their investments and make informed investment decisions prior to insolvency."

There is no point at this stage to explain that in Ireland's case, NONE of the above points were delivered in the crisis resolution measures supported by the EU and actively imposed onto Ireland by the ECB.

It is, however, worth noting that the Option 1 advanced by the EU includes imposing losses on senior bondholders and that the tool kit for doing this includes debt-equity swaps. Readers of this blog would be well familiar with the fact that I supported exactly these measures.

27/3/2012: Two Sovereign Debt Crisis charts

Two interesting charts on the fundamental sources of risks relating to sovereign crises of the 2009-present. No comment needed, really...

20/02/2012: Greece, Europe, Ireland and the crisis: Max Keiser interview

My conversation with Max Keiser last week on Euro, Greece, Ireland etc.
Link here.

12/2/2012: A road map to a cooperative solution for Greek crisis

Papandreou: 'this is a battle between the markets and democracy'.

Greek political discourse - mirroring the received wisdom of the crowds has been reduced to a blatant, and populist lie.

The battles in Greece today are between democracy and European/ECB dogma of preserving the status quo of existent statist system, of which patronage by the State of some markets participants is just an element. Here's why:

1. The markets did not impose ANY conditions on Greece - EU/ECB did. The markets simply refuse to be conned any longer into subsidizing the Greek state through cheap credit. This is the basic right of any participant in the markets - to refuse investing or lending to anyone, just as it is the right of any baker to refuse selling bread to someone with no money and no desire to pay on credit.
2. The markets investors are the injured party - excluding the bottom-fishing hedge funds who bought Greek bonds very recently at hefty discounts. The investors are the only ones who were first deceived by the Greek Governments cooking books and fudging numbers in official statistics. The investors should have known better, but that is not a valid defense of the case against them - they were deceived by fraudulent data reporting by the Greek State (yes, right - politicians, Governments, civil servants). The markets/investors are also the only ones who have to take any writedowns. The ECB and the European Union are taking no writedowns on Greek bonds, and are, in fact, lending Greece 'rescue funds' at a profit. 

I am pointing this not to prevent imposition of losses on Greek bonds investors. They deserve to lose and they should lose more than 70-75% of the face value of their investments in Greek bonds.

I am writing this to point that the battle we are facing in Athens today is between people pushed to a breaking point by the policies of the Governments past, and the EU/ECB.

And there is a way out, folks. Here's what should be done:

1. Impose full losses on Greek bondholders to bring debt/GDP ratio in Greece to 75%. Do same for banks bondholders in Ireland and Spain, and combine these sovereign and banking measures to achieve the same in Portugal and Belgium. Seniority under these arrangements should be as follows: private sector debt holders take the first hit, followed by the public debt holders.
2. All PIIGS bonds held by the ECB are to be transferred into a separate holding fund. This fund is to run between 2012 and 2021. Bonds are to be held in the fund not at face value, but at purchase value to instantaneously reduce debt overhang in these countries. Note: this imposes no loss on ECB until the fund is wound up.
3. The ECB Special Fund (outlined in (2) above) is to monitor the conditions of compliance with real (not the currently identified) reforms aiming to restructure PIIGS economies to put them on the path of private sector-driven growth and fiscal sustainability over 10 years horizon.
4. No coupon payments or principal repayments to be accepted by the ECB on these bonds between 2012 and 2021 to reduce debt overhang drag on the participating economies and improving their fiscal capacity to implement reforms.
5. The bonds held in the ECB fund are to be automatically written down to zero face value in 2021 as long as the participating country meets conditions of implementing the reforms.

The above proposal will eliminate or severely restrict the problem of moral hazard, as countries participating in the programme will be subject to strict reforms programme implementation. The plan will also reduce the burden of repayment of debt on the countries that do stick to the conditions of the reforms. The plan will also bring, gradually, these countries economies to more competitive institutional, fiscal and regulatory environment. In other words, the proposal contains both the sticks (under items (2), (3) and conditionality) and the carrots (items (4) and (5)).

In other words, the fund, as outlined above, would satisfy core objectives of the crisis resolution framework:

• Allow for meaningful change and reforms
• Create an incentive to participate actively in reforms for the countries engaged with the fund
• Reduce moral hazard problem
• Help to establish popular support for reforms by providing real, tangible improvement in the economies ability to sustain reforms

We can't keep fighting battles driven by noble objectives, but based on faulty logic that simply serves the very same elites that have created this crisis. We need to find a cooperative solution to the problems we face.

11/02/2012: Globe & Mail 9/02/2012

Here's the link to my latest article for Economy Lab with Canada's Globe & Mail.

8/2/2012: A more pleasant Sovereign arithmetic

And for a rather more pleasant sovereign arithmetic, here's an interesting table from the Global Macro Monitor (link here) summarizing yoy movements in 5 year CDS:

Frankly speaking, all of this suggest some severe overshooting in CDS and bonds markets on upward yield adjustments over time followed by repricing toward longer term equilibrium. What this doesn't tell us whether we have overshot equilibrium or not... Time will tell.

7/2/2012: An unpleasant risk arithmetic

Here's the guys Irish authorities trust so much on risk assessment, they contracted them to do banks stress tests - PCARs - back in 2010-2011. Note: this is a statement of fact, not an endorsement by me. The Blackrock folks produce quarterly report on sovereign risks and this the summary chart from the latest one - Q1 2012. Negative numbers refer to higher risks:

So Greece leads, Portugal follows, Egypt and Venezuela are in 3rd and 4th place worldwide of the riskiest nations league and then, in the fifth place is Ireland, followed by Italy. And here's the summary of the euro area ratings:

Yes, bond yields have been improving significantly, including due to both fundamentals and banks liquidity steroids, which is a good news. The bad news, yields have been declining for other countries as well and investors' relative sentiment is not improving as much as the absolute levels of yields declines suggest.

Today, one of the Irish Stuffbrokerages claimed in a note that: "The country’s success in meeting its targets under an EU/IMF bailout without social or political unrest and its export-focused economy has enabled it to dodge the recent Eurozone downgrades by S&P and Fitch and distance itself from fellow bailout recipients Greece and Portugal. " Distancing we might be, but the neighborhood we are lumped into is not changing as the result of this distancing. At least not for now.

Please note, the assessments above are consistent with CMA analysis based on CDS spreads, covered here.

3/2/2012: De Kaufman Door 2

Another set of interesting survey results from the Kaufman Econ Bloggers Outlook Q1 2012:

John Cochrane asked: should the eurozone become: 1) a currency union without fiscal union, allowing

sovereign default; 2) a currency union with strong fiscal union; or 3) Broken up

(no euro) into national currencies or smaller units?

So let's set aside the political feasibility of each option, in the first-best economics world:

• Euro as a currency union without fiscal union, allowing sovereign default is an option for 22% of the respondents.
• Euro as a currency union with strong fiscal union is preferred by 27% of respondents
• No euro with national currencies returning or smaller sub-blocks emerging is favored by 51% of respondents

There are, really, only 2 surprises in the above:

1. Relatively large number of economists who believe that sovereign defaults can be sustained in a currency union with no automatic transfers specified (I presume that many could have simply thought that transfer systems can be established either under an EU Commission umbrella or via ECB) and
2. Only 51% of the respondents recognize that there is, under current institutional set up, no real chance of managing an economically effective functional monetary union. And that there is no need to do this either.

16/1/2012: Summary of S&P move and more

In the wake of the S&P action it is a good idea to put side-by-side some ratings on euro area countries. here are S&P ratings before and after downgrade along with CMA ratings and CDS data for Q1 2009 beginning of the crisis) and Q4 2011.

Per S&P: "...the agreement [between euro zone member states in December 2011 attempting to address the crisis] is predicated on only a partial recognition  of the source of the crisis: that the current financial turmoil stems  primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness  between the eurozone's core and the so-called "periphery". As such, we believe  that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers' rising concerns about job security and disposable incomes, eroding national  tax revenues."

In other words, it's growth, stupid. And herein lies the main problem for Europe. While EU might - if forced hard enough - jump onto a more sustainable fiscal spending path (cut deficits and structural deficits) - the EU has absolutely no record of creating pro-growth conditions or environments. In fact, in a bizarre response to the S&P moves:

• France is discussing an increase in VAT as the means for stimulating productivity growth, while
• Austria is planning wealth taxes and increase in retirement age as its response to economic growth challenge.

Now, where do you start in dealing with this lunatic asylum? 

12/1/2012: Q4 2011 Sovereign Bonds Report

CMA released their Quarterly Global Sovereign Risk Report Q4 2011 which makes for an interesting reading. Here are some highlights:

"The Eurozone debt situation continued throughout Q4, with the region widening 9% overall. A bail out of Dexia at the beginning of the quarter was followed by continued concerns on Italy’s debt in November and risk of an S&P downgrade of the entire Eurozone in December.

"Nearly all global CDS prices widened during November’s volatile period, clearly indicating the significance of Western Europe to the global economy and the importance of finding a permanent resolution to the debt crisis.

• Italy’s austerity measures failed to move the market tighter in Q3, and the spread widened to a high of 595bp in-mid November. This prompted the end of the Bersculoni era, a new president [obviously, they mean PM] and a new set of austerity measures aimed at reducing the 2 trillion dollars of debt and 120% debt-to-GDP ratio. Implied FX devaluation from a default in Italy is around 17% according to CMA DatavisionTM Quantos.
• Spain and Belgium’s charts were a mirror image of Italy’s.
• Ireland remained relatively stable throughout the quarter, perhaps indicating a balance between a well capitalised banking sector and IMF concerns about the prospects for growth in exports to Europe."
• Greece was the worst performer worldwide (see tables below charts), while Portugal outperformed Ireland

Charts:

Summary of 10 highest and lowest risk sovereigns:

 

So despite our 'gains' in the bond markets, Ireland moved into 6th highest risk position in Q4 2011 from 7th in Q3 2011. 

And amongst the safest bond issuers there are just 2 euro zone countries: Finland and Germany (an improvement on Q3 2011 where only Finland was there).

Here's the summary of our performance since Q1 2009.

9/1/2012: Week opener: Merkozy continuing to ignore Greek realities

Today's meeting between Sarkozy and Merkel is being framed in the context of continued pressures across the euro area (see report on the meeting here). More ominously - within the context of the euro area leadership duet ignoring the latests warning signs for Greece.

Per Der Spiegel report, IMF has changed its analysis of the Greek rescue package agreed in July 2011 in-line with IMF changes in forecasts for Greek economy in the latest programme review in December 2011. Specifically, IMF lowered its forecast for growth from -3% to -6% GDP.

Der Spiegel cites IMF internal memo in claiming that the Fund is viewing existent Greek programme (including to 50% 'voluntary' haircut on Greek bonds currently under negotiations) as insufficient to stabilize the Greek economy and fiscal situation. The Fund is, reportedly, considering 3 possible options to alleviate the latest set of growth pressures:

• New austerity measures for Athens - a measure that in my view will only exacerbate immediate pressures on Greece and will lead to dangerous destabilization of political situation in the country, leading to even more second order adverse effects on growth (e.g. prolonged strikes and rioting);
• Deeper haircuts on Greek debt held by private institutions - in my opinion this will lead to more contagion from Greece to euro area banks and sovereigns and should be, instead complemented by writedowns of Greek debt held by the ECB, to match existent private sector arrangements;
• Increase in the euro zone bailout funds - in my view, this measure is currently outside the feasibility envelope for Europe and, if attempted, will lead to increased cost of euro area borrowing and have a knock on effect of higher cost of lending to countries currently in the Troika programme. It is also important to note that the EFSF head Klaus Regling is aiming to raise EFSF guarantees to foreign investors to 30%, thus reducing the leverage ratio from 4-5 times to 3 times. This will lower EFSF's theoretical borrowing capacity even further.

The IMF note reports are effectively matched by the statement from the senior Germany Finance Ministry adviser made Saturday, who tole the Greek press that a 50% haircut on Greek debt will not be enough to restore sustainability to Greek fiscal dynamics.

In effect, three of out three IMF 'options' cited will exacerbate the crisis, not resolve it. And there is no Option 4 on the books.

30/12/2011: Taleb's quote

AN excellent quote from Nassim Taleb via @econbrothers :

"If we attempt to systematically extinguish all forest fires, we will eventually experience a big one".

Which, of course, goes to describe concisely and precisely the fallacy of rescuing all banks that Europe has pursued as a principled policy. The old Schumpeterian creative destruction is a required condition for functioning of the private economy, with the latter being the required condition for functioning of the public economy as well. Bankruptcy - as a tool for clearing the hazardously dead forest of private enterprises - must apply to the banks too.

By underwriting the entire private banking system, the EU has created the Mother of All Hazards - a dry forest with numerous pockets of quasi-extinguished fires burning. Now, all we need is wind...

26/12/2011: LTRO will not solve Euro banks' problem

As the annus horribilis concludes for the terminally ill, but refused (by the ECB & EU & the respective Governments) death, Euro area banks, the key note of that Mahlerian (the 5^th symphony-styled) Trauermarsch is the LTRO allocation of cheap 3 year €489 billion worth of ECB credit (at 1%) to the European banks. And, thus, the theme for 2012, the second movement in the opus magnum of the Euro destruction, is the looming recapitalization deadline for the said zombies – the end of June.

Alas, the hope that seems to sweep the markets to boost, albeit moderately, Euro area banks valuations – the hope that having the mother of all carry trades can help these banks recover their margins just in time to use ‘organic’ recapitalization path through mid 2012 – is seemingly out of reach.

Firstly, I put ‘organic’ in the inverted commas, since the margins rebuilding on the back of ECB-created artificial liquidity boost is about as organic as performing a puppet show with a corpse is ‘live-like’.

Secondly, the carry trade I am talking about - for those readers of this blog who are unfamiliar with finance – is the artificial exercise of taking cheap loans in one country/currency and carrying funds into purchase of assets in another country/currency. Of course, with nothing but loss making (or near-loss making) assets in the markets of the Euro zone, any banks who borrowed funds in the LTRO will be either buying Government paper (yielding on average, say, 3.0 percent margin on borrowings gives Euro area banks pre-tax uplift of just €7.3 billion in 6 months time (and no, there are no capital gains realizable, since buying today and selling into mid-2012 will leave this paper, at best, capital gains neutral). Thus, to make even a dent in the capital demand, the banks will be needing assets yielding more than double the junkier Euro area sovereign yields, which means carry trade, and all associated currency and asset risks.

Of course, Euro area banks can try to magnify their returns via ECB-offered leveraged carry trades. But unless ECB offers more LTRO-styled longer term operations, doing so at 3mo or even 11mo liquidity supply windows would be simply mad. 

So, having borrowed through LTRO, Euro area banks will purchase Government bonds which then can be used as a collateral for further ECB borrowing. So let us assume that the banks will be buying liquid debt, e.g. Spanish or Italian. The margin earned by banks is ca 2.6-3.5% per annum after they cover the cost of LTRO borrowing. Note, this carry trade will turn loss-making for the bank if the sovereign bonds yields fall below 1% cost of ECB LTRO funds. In my view, this is highly unlikely.

So the whole operation can provide some €14.6 billion annually to the banks in terms of profits earned. And this is pretty much the unleveraged maximum. Nice one, but through June 2012 hardly enough to support banks recaps. Even if EBA deadline is shifted to December 2012, profits from LTRO are nowhere near the required funds to cover recapitalizations. Recall that under 9% Core Tier 1 scenario, euro area banks require something to the tune of €119 billion in fresh capital.

The downside from this conclusion is that the Euro area banks will require, post LTRO either a warrant to die (the preferred option, assuming the death warrant involves orderly shutdown of the insolvent banks) or a public bailout of immense proportion. Given the EU hit some serious trouble coming up with €200 billion for loans to IMF, good luck with that latter option.

22/12/2011: Europe's policy errors

By now, you have figured it out - I am a big fan of my old UofC professor, John Cochrane. And in this latest article (here) he delivers even more real common sense.

Defaults:

"Conventional wisdom says that sovereign defaults mean the end of the euro: If Greece defaults it has to leave the single currency; German taxpayers have to bail out southern governments to save the union.
This is nonsense. U.S. states and local governments have defaulted on dollar debts, just as companies default."

Cochrane is correct. Orange County, CA - size ca 1/2 Ireland - has defaulted before and so... no end to the State of California or to the Feds and, crucially, no bailout. New York went bust in 1975, Cleveland in 1978. Fitch did a study in 1999, updated in 2003, that shows 2,339 cases of municipal bonds defaults in the US for 1980-2002 totaling USD32.8 billion. And guess what: no bailouts and yet the dollar still exists. Fitch estimated cumulative default rate for 1980-1986 issuance of 1.5%m cumulative default rate for 1987-1994 issuance of 0.63%, average recovery rates were around 63-64%, consistent with standardized CPD pricing practice of 40% haircut. This is not to say that defaults are costless or easy, but there is no ex-ante intrinsic reason for the common currency to implode were a country like Greece - expected by all to default - to restructure its sovereign debts.

Bailouts:
"Bailouts are the real threat to the euro. The ECB has been buying Greek, Italian, Portuguese and Spanish debt. It has been lending money to banks that, in turn, buy the debt. There is strong pressure for the ECB to buy or guarantee more. When the debt finally defaults, either the rest of Europe will have to raise trillions of euros in fresh taxes to replenish the central bank, or the euro will inflate away."

Correct again: latest LTRO allocation of €489bn this week, with €235bn of this being lent in excess of the banks covering shorter-term ECB debt is the case in point. ECB's hope is that the banks - already sick from overloading with low quality sovereign debts on their balance sheets - will use €235bn to buy more sovereign debt. This, of course, will help ECB to cut back its own purchases of Government bonds and to, thus, pretend that 'the market' for sovereign debt in Europe is somehow being repaired. The madness of this 'solution' is that it creates even greater link between ECB, banks and sovereign debt - the very cause of the crisis contagion. You can see an excellent, albeit a bit politically-correct piece on this in the Economist (here).

And to correct for the 'politically correct' bit - here's my view of LTRO: In a nutshell, the ECB will lend the banks unlimited money at 1% so they can buy PIIGS+Belgian+French debt making 2-6% margin as pure profit and benefiting from capital gains in the process. As bonds prices firm up on the back of these purchases, banks collateral deposited with ECB will also improve in value, allowing them to borrow even more. This positive correlation between banks borrowings from ECB and their profits gains will continue until in 3 years from now the entire pyramid collapses - the banks will have to repay ECB funds, prompting massive sales of bonds. And in the mean time, there will be no lending in the real economy, as banks funding will be tied into financing Government spending and banks will continue to deleverage out of real assets. This makes LTRO an equivalent of an RX to a drug addict for unlimited supply of free opiate.

As Cochrane puts it:
"Sovereign default would damage the financial system, however, for the simple reason that Europe has allowed its banks to load up on debt, kept on the books at face value, and treated as riskless and buffered by no capital. Indebted governments have been pressuring banks to buy more debt, not less.

As banks have been increasing capital, they have loaded up even more on “risk-free” sovereign debt, which they can use as collateral for ECB loans. The big ECB “liquidity operation” that took place yesterday will give banks hundreds of billions of euros to increase their sovereign bets. Bank depositors and creditors have figured this out, and are running for the exits.

...By stuffing the banks with sovereign debt, European politicians and regulators are making the inevitable default much more financially dangerous. So much for the faith that regulation will keep banks safe."



Fiscal Union:
"More fiscal union hurts the euro. Think of Poland or Slovakia. ...A common currency without a fiscal union could have universal appeal. A currency union with a bailout-based fiscal union will remain a small affair."

"Europeans leaders think their job is to stop “contagion,” to “calm markets.” They blame “speculation” for their troubles. They keep looking for the Big Announcement that will soothe markets into rolling over another few hundred billion euros of debt. Alas, the problem is reality, not psychology, and governments are poor psychologists. You just can’t fill a trillion-euro hole with psychology."

Conclusion:

"The euro’s fatal flaw then wasn’t to unite areas with differing levels and types of development under one currency. ...Nor was it to deprive governments of the ephemeral pleasures of devaluation. Nor was it to envision a currency union without fiscal union.

Banking misregulation was the euro’s fatal flaw [emphasis is mine]. Sovereign debt, which can always avoid explicit default when countries print money, doesn’t remain risk-free in a currency union. Yet banking regulators and ECB rules continue to pretend otherwise.

So, by artful application of bad ideas, Europe has taken a plain-vanilla sovereign restructuring and turned it into a banking crisis, a currency crisis, a fiscal crisis, and now a political crisis."

And then,
"When the era of wishful thinking ends, Europe will face a stark choice.

1. It can have a monetary union without sovereign defaults. That option means fiscal union, accepting real German control of Greek and Italian (and maybe French) budgets. Nobody wants that, with good reason.
2. Or Europe can have a monetary union without fiscal union. That would work well, but it needs to be based on two central ideas: Sovereigns must be able to default just like companies, and banks, including the central bank, must treat sovereign debt just like company debt.
3. The final option is a breakup, probably after a crisis and inflation. The euro, like the meter, is a great idea. Throwing it away would be a real and needless tragedy."

I agree.

12/12/2011: Are debt repayments to be blamed for growth collapse?

Some of the paper have clearly reached a bizarre level of Keynesian paranoia. Behold one example - The Guardian today (link here) screaming "Debt repayment is driving the EU back to recession".

While I agree with the idea that EU (more like the Euro zone to be accurate - do note that, folks from the Guardian) is heading into another recession, I highly doubt the cause of this is 'debt repayment' (note that the tense suggests that it is currently ongoing repayment) fault. Here's why:

Table above, taken from the IMF WEO September 2011 database clearly shows that not a single euro area member state is currently repaying its debts.

And in fact, as the table below details, NOT A SINGLE euro area state will be repaying any of its debts until the earliest 2014, when Greece is expected to start paydowns on its debts (under very rosy assumptions, of course):

Interestingly, IMF expects that in 2015 and 2016 overall debt levels will continue rising in ALL member states except for Greece.

So, run by me again that headline from the Guardian?