Economics 27/03/2010: Breaking News: AIB and FF/Government

Major news breaking in the media rooms:
AIB (the first story below)
RedC Poll (the second story below)


Story 1:

The first story is about the leaks reported by Newstalk (see here) that AIB will announce before opening of trading on Monday that the state will be taking a 65% stake in the bank.

Per senior source in the Dail (hat tip to B) - the reason for AIB guiding 65% ownership now is that in addition to Nama haircuts, they are, allegedly, seeing significant deterioration in the sub-€5mln loans (the loans below Nama-eligible threshold).

This is hardly surprising. Since May 2009 I have consistently supplied estimates as to the eventual state ownership in both AIB and BofI. Depending on various scenarios:

• assumed Nama haircuts,
  
• the actual current risk weighting on the loans being transferred,
  
• share price at the time of announcement and
  
• the willingness of the banks and the Government to recognize future expected losses on the loans not transferred to Nama

RVF approach to valuing AIB and BofI balancesheets suggests that at the end of the current crisis, the state will outright own around 85-90% of equity in AIB and 50-60% in BofI. This eventual outcome, for political reasons, will come in two stages:

• post-Nama injection of capital (with AIB placing around 60-70% of its equity with the State and BofI placing around 40-45%), plus
• second stage recapitalization to correct for continued deterioration in the books over 2010-2011 (adding another 20-30% of equity for AIB and 10-15% for BofI)

The problem with this two stage recapitalization is that the taxpayer will end up paying three times for the same equity:

• Having injected €7 bn into two banks at the time when they were worth less than €2.5 bn for the entire lot,
  
• we are now be left on the hook for some €20 bn worth of largely worthless loans - to be purchased at ca 30-40% discounts (against the real market discount of 65-90%),
  
• plus €7-8 bn in fresh capital post-Nama
• plus the margin of ca 10-15% for further deterioration in non-Nama loan books (requiring another €7-9 bn of fresh capital).

Thus the Irish state is now likely to use up to €20 bn to buy up equity and loans from a bank that is currently worth around €1.5 bn... In the world of finance, even the most reckless bankers never managed such margins.

Alternative: force banks to acknowledge the full extent of their expected losses (as Swedes did in the 1990s), then force them to take the bondholders and equity holders to the cleaners (as Swedes did in the 1990s), and only then take equity - or in effect, take full equity in the banks. The cost for AIB would be around €10-12 bn, depending on how deep of a haircut on senior bondholders the banks can impose.

Story 2:

Tomorrow's RedC poll

Here is a preview - as was supplied to me by my sources (a disclaimer is due here: these are as provided by the source, so check tomorrow's papers for actually confirmed figures). Parties support:
The poll was conducted on Monday-Tuesday, so it does not reflect change of opinion in the wake of Cabinet reshuffling and the dissident TDs comments. Both factors can be expected to contribute to further decline in FF ratings, speculatively pushing core FF support post-Thursday to 21-22%.

Some specific questions:
“Brian Cowen understands people like me” - 31% agree
“Brian Cowen is a good Taoiseach” - 27% agree
“Brian Cowen is a safe pair of hands” - 31% agree
“Brian Cowen is the man to lead us out of recession” - 29% agree

Hat tip to NN.

I wonder what the same punters would say about our leaders now, after the reshuffle debacle and the open dissent amongst the back-benchers.

Economics 21/10/2009: Ireland = the most leveraged SPV on Earth?

And so we now learn than Nama beast has mutated into a high-risk derivative game with ghost investors, imaginary assets and illusionary payoffs. We are, for all intent and purpose, in the BaNama Republic.

Here is the story: per Annex H of the original statement of intent to establish Nama (April Supplementary Budget 2009 : here), the state will set up a Special Purpose Vehicle (SPV) to issue bonds (Nama bonds) that will be guaranteed by the State. Per Eurostat analysis (here) these bonds will not be counted as Irish Government debt.

First point to be made – we are now the first developed country in history that is about to throw the weight of its entire economy behind a private undertaking of extremely risky financial engineering nature.

€54bn worth of Nama Bonds will be issued by this SPV. SPV will be 51% owned by private equity investors who will supply €51mln worth of capital. Total capital base of SPV will be €100mln. This SPV will be borrowing (by issuing bonds) €54bn – which means that on day 1 of its running, the SPV will be 54,000% leveraged or geared. This will imply that Irish Nama-SPV will be leveraged in excess of LTCM – the infamously riskiest of all major investment propositions that anyone saw in financial history before Nama SPV idea came to being.

Point two: the Irish state will be engaged in the riskiest derivative instrument undertaking of all known to man to date.

To cover up the farcical arrangement (with folks with €51mln buying €77bn worth of risky (but recoverable, by Minister Lenihan’s assertions) assets), maximum 10% of SPV value can be distributed in profits. 10% of what you might ask?

CSO submission to Eurostat states that: “The profits earned by the SPV will be distributed to the shareholders according to the following arrangement, which reflects the fact that the debt issued by the Master SPV will be guaranteed by the Irish Government:

• The equity investors will receive an annual dividend linked to the performance of the Master SPV.
• On winding up of the Master SPV, the equity investors will only be repaid their capital if the Master SPV has the resources; they will receive a further equity bonus of 10% of the capital if the Master SPV makes a profit.
• All other profits and gains of the Master SPV will accrue to NAMA.”

Two possibilities: 10% of expected (by DofF) Nama profits or 10% of Nama assets?

In the unlikely event of 10% of assets, the lucky ‘private equity’ folks can get 10%*€54bn*51% share – or €2.754bn – on the original investment of €51mln. They face no downside other than their initial capital injection less whatever dividends they collect prior to default, as bonds are guaranteed by the State. I assume this is a fantasy land. But one cannot make any rational assumptions about Nama anymore.

In a more likely event, it will be 10% of Nama profits. Ok, per DofF, Present Value of Nama profit is €4.7bn * 10% * 51% = €239.7mln. With principal repayment this means they will collect a cool €291mln on day last of Nama existence if DofF projections stack up.

We know nothing about the dividends, but we do know that the dividends will be paid out over 10 years. For some sort of decorum the Irish Government will have to allow SPV to appear to be legitimate and therefore it will allow it to pay a dividend on assets managed. Suppose the dividend will be around ½ of the standard management fee for assets, or roughly 100bps on revenue generating loans or 2.5% on net cash flow. Per DofF Table 5 of Nama business plan, this will add up to €12bn*1%*51%=€61.2mln using the first method or €61mln computed using the second method. In present value terms. Thus €51mln in initial investment will generate:

Scenario 1 – Nama works out per DofF assumptions = €352mln (inclusive of principal) – a handy return over 10 years of 690% or 21.3% annualized. Not bad for a government guaranteed scheme…

Scenario 2 - Nama loses money and is pronounced insolvent. Investors lose €51ml of original investment, but keep €61mln in dividends. 100% security, 0% risk...

Which brings us to the third point: as Irish taxpayers, we are now in a business of paying handsome returns to private equity folks (more on those below) in exchange for them covering up the true nature of our public finances. A good one, really.

Who owns this SPV? This is an open question. 51% will be held by ‘private investors’. 49% by Nama. 100% of liability will be held by you and me. Is this a Government throwing the entire weight of the sovereign state behind a privately held investment scheme? You bet.

But wait. Who are those ‘private investors’? Can Sean Fitzpatrick be one of them? Why not? Of course he can. Can Ireland’s non-resident non-taxpayers be amongst these? Why not? Of course they can. So as taxpayers we will be issuing a guarantee to tax exiles? Possibly. But wait, it gets even better – can the banks themselves be investors in SPV? Well, of course they can. Wouldn’t that be a farce – banks get to unload toxic waste on taxpayers and then make a tidy profit on doing so…

One way or another – parents struggling to put their kids through schools, elderly people struggling to pay medical care costs, single parents trying to balance work and raising family, young folks studying to better their lives – all of them and all of the rest of us will be bearing 95% responsibility of assuring that some ‘private investors’ will make a nice tidy profit, so Minister Lenihan and Taoiseach Cowen can go around the world claiming that Irish bonds that underpinned Nama were not really Irish bonds!

Which brings us to the fourth point: Why is Eurostat assured by this massive deception scheme to accept it?

Globally, G20 summits one after another have been focusing on how we will have to deal with the risks of the traditional SPVs and other ‘alternative investment’ assets classes that spectacularly imploded during the current crisis. Yet here, in a Eurozone country, a Government is actively setting up the most leveraged, highest risk SPV known to humankind. Surely there is a case to be made that the EU authorities should be actively stopping such reckless financial engineering instead of encouraging it?

The entire SPV trickery works because the Government has managed to convince the Eurostat that SPV will be fully operationally independent of the state. So far so good. But, Nama will sit on the board with a right of veto over SPV managerial and operational decisions: “The NAMA representatives on the Board will maintain a veto over all decisions of the Board that could affect the interests of NAMA or of the Irish Government.” Furthermore, Minister Lenihan and his successors will have veto power over Nama decisions and will be the final arbiters of Nama. Is that arms-length getting to finger-length?

At this point, there is only one institution still standing between the madness of the runaway train of Nama and the crash site of the SPV-high leveraged high finance gables with taxpayers money. That institution is ECB. The ECB will have to be concerned with non-transparent (Enron-like) accounting procedures that are being created by the Irish Government when it comes to accounting for Nama bonds. It has to be concerned if only for the sake of the Eurozone stability and its own reputational capital. Will ECB step in and tell this Government that enough is enough?

Economics 19/10/2009: A proud member of National Mediocrity

Sunday Sunday Business show on Today FM. Minister Lenihan commenting on the anti-NAMA economists (podcast here):

"What I notice about them is that there’s about forty of them. There is about two hundred economists in the state. Most of the rest of them have approached me privately and said that these gentlemen and ladies are wrong. But of course they are not prepared to say so publicly because in Irish academic class, people don’t criticise other people’s books. That’s part of our national mediocrity. ...If you look at the press in the United Kingdom or the United States, you’ll see robust academic criticism of others works but we’re reluctant to do it."

Karl Whelan has his view on this - read it here.

My view is a simple one. Want to have some criticism - compare publications records of Mnister's advisers to that of, ough, say Karl Whelan or Brian Lucey. Want to have some criticism - compare supporters and critics of Nama:
Supporters:

• Stockbrokers and Irish Banks' economists - all with a major conflict of interest implied in their positions as their respective organizations will be the intended beneficiaries of Nama. In my books, this does not invalidate their points and analysis, but it does raise a question or two;
  
• EU Commissioner who actually negotiated with Minister Lenihan Nama solution;
• Ghosts of other - possibly independent - economists who have spoken to the Minister in private?..
  

Critics:

• 4 Nobel Prize winners, several senior faculty members from the top 5 Finance Departments in the world, and one former SEC Board Member;
• 46 academic and practicing economists and finance specialists;
• 4 authors of comprehensive analysis of Nama proposals (myself, Brian Lucey, Ronan Lyons and Karl Whelan - in alphabetic order) that provided more detailed and more accurate costings of Nama and alternatives than the one supplied by Minister's own staff;
• 1 former banker - Peter Mathews - who has extensive experience in managing bad loans within a special division for such loans set up by ICC bank in the 1980s;
• A range of independent economic commentators some with extensive finance experience in the past;
• A number of top class finance entrepreneurs, including Dermot Desmond;
• Hundreds of people from finance, international finance and economics who comment on this blog and the Irish Economy blog;
• One Governor of the Central Bank who proposed significant changes to Nama that were subsequently taken out of context by His Intellectual Excellence's Government colleagues and reshaped into an unrecognizable watered-down versions to suit original Nama.

Not that excellence is measured in numbers (as Gallileo and Copernicus and many others have proven before), but you get the point.

As far as Minister Lenihan has a stomach to talk about mediocrity, I wonder how he feels sitting at the Cabinet table. Or how he feels about the Nama analysis being pushed forward by his staff - analysis that has been time and again proven as:

• coming after the mediocre Irish economists put forward their figures; and
• turning out to be wrong and proven to be wrong by the mediocre Irish economists.

Hmmm...

One real sign of intelligence and excellence is ability to listen, seek truth and change your views/plans in response to overwhelming evidence that disputes one's original proposition. To date, after months of factual analysis by many of us, this Government has been showing complete lack of ability to do either one of the above.

Let us all be judged, then, alongside Minister Lenihan, as to where the real mediocrity in this country resides.

Economics 06/10/2009: A stockbrokerage strategist on Nama

And so it comes to my attention that last week in a local Chamber of Commerce hosted a debate on Nama. Per my contacts, “a number of issues arose that may be of interest”.

These issues are important because they largely outline main arguments about Nama made by the proposal supporters out there.


1) Nama supporter (NS) was keen to distance himself and Nama supporters from ‘theoreticians’ and ‘academics’ who exclusively populate the Nama critics land. It is important to note that many of the people who signed the letter of 46 economists, as well as other members of the critics camp are actually practitioners of the same fine art of finance as NS. Many.

How many? Well, just a quick run through

• myself – former business editor who brought finance coverage to the most respectable Irish business magazine, former director of research at NCB, currently head of research and strategy with an American brokerage.
  
• Greg Connor – former director of research for Barra, Fed employee.
  
• Karl Whelan – former Fed employee.
  
• Other members of 46 run options desks, have been bond traders, worked in central banks and finance ministries... you get the picture.
• Brian Lucey - former employee of the Central Bank;
• Ronan Lyons - former economist wit one multinational company and also chief economist of Daft.ie; and so on.
  

NS might think we in academia are just performing random walks in various universities’ squares, but no, we actually advise governments, international organizations, businesses and have some relevant experience in the real world.


2) NS contended that the main problem with Irish banking sector was that after 2001 we had "over competition" from (guess who?) the foreign banks. One assumes he means Rabo and KBC, for the British banks were here before 2001 and in addition we had our banks in their countries as well, aggressively lending to… yes, you’ve guessed it again – property developers there. So the foreign banks, thus, caused a property boom in Ireland. And the foreign banks forced our banks to issue 110% mortgages. And the foreign banks assured that most of our lending has gone to finance property deals of one variety or the other. Of course, it was the foreign banks that made sure that IL&P and Nationwide made strange dealings with Anglo. Why wouldn’t NS read Noel Whelan’s treatise on the crisis (see my comment here) – he might find out that in addition to the foreign banks, 46 economists also caused the crisis.


3) NS also allegedly claimed that as foreign banks leave Ireland, Irish banks will take a "more prudent, even oligopolistic approach to rebuilding their balance sheets". Oligopolistic? I hope the Competition Authority is reading this, plus the folks at the EU Commission. But for those of you who wonder what this means, let me explain. In the case of oligopolistic competition, banks would earn near monopoly profits by charging their customers (aha, you and me) excessive near-monopoly rents. Happy times, folks. A stockbroker calling for oligopoly? Surely not. Though it might happen if our regulators continue sleeping at the wheel. What’s next? Markets for shares becoming too efficient, so NS will call for regulated trade in equities? Incidentally, courtesy of Anglo, we already have had bans on shortselling - an activity that actually has been proven to aid price discovery in the markets.


(4) Per NS, the main aim of NAMA is to get credit flowing. If this turns out to be a problem in a recessionary economy, the profit motive of the banks will induce them to lend after NAMA. Ahmmm, ok, I have one question – why would they seek profit opportunities in Ireland?

• Because our margins are so high? Nope, they are low, Bloxham, Davy and other Irish stockbrokers said so. Can banks raise these margins? Yes, but only at the expense of already strained households, which will mean that their loans books will suffer more defaults. Surely NS wouldn’t call that an improvement in financial stability?
  
• Will the banks have an incentive to lend post-Nama because our lending bears lower risks? No, we are among the worst performing economies in Europe.
  
• Because the banks will simply have excess of cheap cash after Nama? Oh, no – they will still face some €130bn in interbank loans to repay (pricey stuff) (here).
  
• Maybe because they can’t get better returns anywhere else than in Ireland? Well, they can get higher returns pretty much anywhere else other than in Ireland, given our domestic economy will be contracting through 2010.

So, the banks won’t be rushing to lend here. And, incidentally, there won’t be many borrowers rushing in to borrow either – the households will be scrambling to deleverage in the next two years, not to borrow more. What is most likely is that the banks will use our taxpayers’ cash to repay some of the interbank loans, plus buy some discounted debt of which they had €103.8bn worth of senior bonds and €17.7bn in subordinated bonds as of June 2009.


5) Per NS, Nama provides asymmetric exposure to risk to the benefit of the taxpayer as the subordinated Nama bonds will take 1/3 of the risk. As far as I recall, the actual plan was to issue 5% of the Nama disbursed funds in the form of these bonds. Even if the risk weighting on them truly reflects the risk of Nama generating an end loss, this translates into just 5% of risk being shared. Of course, since we have no exact legally defined and enforceable criteria as to what constitutes ‘success’ or ‘failure’ of Nama, any future Government can ‘fudge’ whatever outcome achieved to be called ‘success’, so effective risk-sharing under subordinated bonds is NIL.


6) Allegedly, NS claimed that current commercial property yields are at 6% nationwide and are heading UPWARDS. These numbers were presented as facts in contrast to the ‘nonsense’ figures being quoted by some economists. (See Ronan Lyons on this one: here).

Of course NS explained that higher yields will come about as economy is now in imminent recovery mode and that we will see a positive q-o-q growth in Q2 2010. Thus, Davy’s Rossa White, for example, is a pessimist compared to NS who was not sure what Rossa White forecasted for Irish economy just a day before this event. Hmmm…

Now, Nama is apparently about Irish economy. Which of course is about GNP – in case NS did not know. In this context, I don’t think anyone really expects the yields to go up to 7% or to even 6% any time soon. And, in addition, I presume NS is unaware of such things as lags – it takes time to work through the surplus properties out there in the market, and it takes time before that to get consumers spending again. So Q2 2010? More like Q2 2011 for consumption to uptick significantly enough for yields to start stabilizing.

Suppose NS is right and the yields are heading for North of 6%, say towards 8%. Does he believe that these yields improvements will be driven by rents increases? In the current economic environment, even if there is some nominal growth in 2010 of say 0.5% in GDP, this an unlikely scenario with vacancy rates in commercial sector of 21% plus, and in residential sector with some 200,000+ properties unoccupied. So the only way yields can hit 8% is by price of property dropping further, and dropping by more than 20%. What does this mean for the ‘haircut’ applied under Nama? It means the haircut is too low. Significantly too low. If the yields were to firm up, per NS’s assertion, property prices will have to drop and Nama will instantaneously be overpaying even more than it already does.

And, folks, there is no arguing against this point for the yield is, by definition, a ratio: rent to price movement ratio. Ratio can rise either if the numerator rises (rents) or denominator drops (prices).


7) The good thing is that NS is at least more committed to some sort of accountability in Nama than the Government is. Per NS, allegedly, we will know if NAMA works within months, perhaps as little as three to six, as the restoration of credit would tell us that. And if not? What would NS do if Nama fails to deliver? Surely all stockbrokers have standard stop-loss rules to prevent reckless or rogue trades? Nama does not – and it always was a major part of my criticism of the current legislation. Surely NS would be familiar, therefore, with the need for a strategic Plan B? He is. And…


8) … of course – Plan B is to buy equity in the banks post-Nama – the Government already admitted this much. Which might lead to nationalizing of the banks or at least nationalizing a large chunk of them. But for NS this won’t work, as he said, allegedly, that people who advocate forcing the banks to face up to the losses are in fact advocating that not only should the equity holders bear the losses but also that the depositors should be expropriated. Of course, no one I know of in the debate on Nama has suggested that, not even unreformed socialists did. Furthermore, as far as I am aware, in every country where the banks were forced to face up to their debts – US, UK, Sweden, Denmark, Spain,... you name it – depositors remained intact.

Two more things come to mind here. Even post-Nama NS, taken at the face value of his argument, won’t stand for nationalization no matter what – in other words, should the banks need more capital he would, I presume agree to simply give it to them once again, with asking nothing in return. And also that post-Nama, when the banks ask for more cash we might be expropriating the depositors?

Is this for real? Is he suggesting that fully guaranteed depositors might face loss of their funds? Personally I think this is completely out of line scaremongering.


9) NS, allegedly, also stated, per my contact who noted it down as the meeting concluded for tea and buns, that NAMA will make a profit as the bonds will be euribor+50bps while the loans (apparently all) will be yielding at euribor+200bps. So the 44% of loans that are performing can easily take the strain of those that are not performing. Well, not so quick.

Assume for a second that NS is right. Banks pay the cost of managing the loans, so euribor+200bps is more like euribor+125bps once cost of managing loans is taken out. State pays the cost of issuing bonds, so euribor+50bps in bonds face value is more like euribor+65bps in gross cost to the state. Now, at 44% weighting, the average loans portfolio yield becomes euribor+55bps, which is below euribor+65bps. Nama makes loss even under NS’s rosy assumption of all performing loans paying euribor+200bps on average.

But here are two additional kickers:

(a) If interest rates increase, and NS should know this, more loans will go into non-performing category, plus, as I explained above. If NS’s assertion of 8% yield in near future is correct, again, more loans will go into non-performing category. Thus 44% of performing loans today, might drop to, ough say 35% or 30% tomorrow. This is what is roughly called interest rate sensitivity – as the cost of loans rises, more loans fail.

(b) NS’s assertion on euribor+200bps and on 44% performing loans rests on the assumption that the due diligence on these loans is straightforward, so Nama won’t make mistakes in buying up ‘performing’ loans. Again, any error, driving either 44% down or euribor+200bps margin down will hammer Nama bottom line figures.

10) NS asserted over some answers to specific questions, that there is a ten year property price cycle, in nominal terms. If he really did say this, this now provides yet another bogus ‘benchmark’ for property markets recovery – first there was a 7 year to 80% correction statement from one property specialist in the Dail, then there were 5 year turnaround time estimates from the Government advisers circles, now it is 10 year nominal recovery number from one of the stockbrokers.

Clearly NS is unaware of the long-term results for property market busts, and he is unaware that combined shocks to property market, plus to broader financial markets yield much deeper contractions than what his statement implies. I did some actual estimates based on OECD and IMF data and found that past busts across the OECD with an average magnitude being lower than that of expected Irish property prices contraction average 18 years in nominal terms. But what is even more surprising is that a stockbroker would care about nominal, not real, returns. Surely that is not what his usual client advices is based on, one hopes.

Economics 21/09/2009: ECB's penalties?

Updated version (00:42am September 22)

On June 23, 2009, ECB opened bidding for its first 12-month refinancing operation.

Back in May 2009, the ECB announced that it would double the maximum length of time it lends money from six months to a year and in June it set the rate for 12-months financing at 1%.

Last time it applied a longer term horizon, ECB placed 348.6 billion euros in December 2007.

So in the nutshell, 1.5% coupon on our bonds bound for ECB and bearing 6 months maturity is a rotten deal.

How rotten? If we were to issue bonds at the ECB own long term financing facility rate with 12 months maturity. The expected cost of total borrowing over 15 years inclusive of the expected costs of roll-overs and reflective of the expected yield curve for ECB rates will be around €15.4bn. In contrast, current structure of 1.5% pa coupon plus 6-months maturity is expected to yield total interest cost of ca €17.5-18.9bn. Then again, what’s €2.1-3.5bn for the Government that burns through €400mln in borrowing on a weekly basis?

What is interesting is why didn't ECB make a similar deal with the Irish Government, allowing it to issue lower coupon bonds or extend maturity of these bonds or both? One can only speculate, for ECB will never tell one way or the other, but I suspect the answer to this lies within the ECB statement that Nama should not overpay for assets it purchases.

Hmmm... Leni took his plan to the ECB men, saying we will buy €77bn worth of stuff, that includes €9bn of rolled up interest, and we will pay €54bn for it. The ECB men pulled out a calculator and extracted: [€54bn/(€77bn-€9bn)-1]*100%=20.6%. The ECB men stared at Leni in disbelief... "Herr Brian, yor ekonomi iz in truble? Djast less fan 21% dropp in yor properti praicez?" 'Oh," replied Brian Lenihan, "but Frank Fahey School of Economics says you'll give us free money!" And here the ECB men smelled a rat...

Otherwise why would the ECB, amidst quantitative easing exercise, impose sanction-level conditions on our bonds? 6-months paper and 1.5% is worse than what ECB gives money to commercial banks at. Much worse, folks.

Now, ECB is no stranger to being taken for a ride. What is telling is that ECB's reaction to 'abuses' in the past is very similar to its reaction to Nama to date.

Most recently, back in July 2008, both the Australian bank, Macquarie Group and the British building society Nationwide have used their Irish subsidiaries to upload hundreds of millions of dodgy ABS packages (in the case of Macquarie, €455mln was borrowed against the most ridiculous collateral –Australian car loans) at the ECB discount window.

On September 4, 2008, ECB’s President, Jean- Claude Trichet stated that he will make it more expensive for banks to borrow from the ECB against most asset-based securities, starting from February 1, 2009. Amidst the crisis gripping European markets at the time, ECB raised `haircut' on the securities it allows to be used as a collateral for 12-months borrowing from 2% to 12%. Additional 4.4% were to apply to paper with no immediate market price.

Note, Irish haircut on bad debts is in effect just below 21% - not that far off the haircuts applied by the ECB (16.4%) on lending backed by much more robust collateral (average European mortgage-securing assets - i.e prperty markets - are down single digits across the entire crisis) than dodgy Irish development projects (down 60-80% and some down 90% in value and falling). When ECB haircut on unsecured banks bonds is added, the total asset discount that ECB could have applied was in excess of 21%. But what is even more significant, the value of the underlying assets accepted by the ECB is supposed to be calculated as the market price less the haircut.

Again, this stands in contrast to Nama which is taking not senior bonds, but ordinary loans, and which is using farcical long-term-economic-value 'pricing', not current market prices. Despite this, Nama haircuts are just 20.6% (once rolled up interest is accounted for) on lower grade assets than the ECB would consider at its window…

No wonder they won’t let Ireland issue bonds with a coupon of 1% or less with 12-months maturity - as would be consistent with a rating on par or better than that for commercial banks. In effect, contrary to the assertions of Brian Lenihan, it is now clear that the 1.5% for 6-months paper deal is far from being endorsed by the ECB. Instead it is a reflection of ECB’s unease with the details of Nama plans. All in, the ECB is now applying nearly as strict terms to the Irish Government Nama bonds as it does to private sector bonds issued by less than thriving European banks.

In July 2008, before changes were announced, the ECB run two-tier pricing system, whereby haircuts of 0.5-5.5% applied to Government paper against the key ECB rate of 4.25%. Mortgage-backed securities – especially Spanish and Irish ones – incurred 18% haircut. Now, do the maths – the spread of 0.5-5.5% haircut on 4.25% lending rate implies the cost of capital of 5-10% for government bonds collateral and up to 24% for MBS. Since July 2008, Irish property markets have fallen by over 12%, so the same collateral rules, that were described by analysts as being loose back in 2008 would require a haircut of ca 27% at the very least, for 1-year long holding period. Again, Nama is implying a haircut of 20.6% on a 15-year holding period.

27% cut held over 1 year was a ‘loose’ condition that had to be drastically revised by the ECB, but 20.6% shave on 15-year holding is deemed by the Irish Government to be reasonable? Who do they think they are foolin?

Another interesting note: following the expression of it dissatisfaction with ‘loose’ borrowing by Spanish and Irish banks, the ECB started quietly talking to the banks urging them to fall in-line. Exactly the same has happened when the ECB issued its thinly veiled directive to Leni – ‘do not overpay for Nama assets’…

Economics 12/09/2009: More NAMA lies exposed

One interesting observation on Nama and a quick follow up to the developing story on ECB alleged unwillingness to deal with nationalized banks.

We, on the critics of Nama side, have expended much gunpowder arguing that there is a natural, legally binding order of rights contained in each asset class held by investors in and lenders to the banks. This order requires that first to take the hit in any balance sheet adjustment will be the shareholders. Then the subordinated debt holders and lastly the secured debt holders. This argument is used by myself and others to show that taxpayer must be last in the firing line - after all of the above take their dose of bitter medicine.

Yet in all of this excitement we forgot the humble contractors. Now, many of the loans Nama will buy into will be written against properties on which some work has been performed in the recent past, or is even ongoing today. The problem is, our heroic developers in many cases have not paid their bills to the contractors providing this work. As far as I can understand, these unpaid contractors are the holders of the priority right on repayment in the case of liquidation of the development firm - ahead of the bank holding lien on the property.

Of course, Nama can go and tell the larger contractors that, look guys, you forget your claims on work done, write it off as a loss on your taxes and we will look after you when time comes to finish the properties. Smaller contractors will be simply told to get lost - suing the state (Nama) is a very expensive business for them. This is dandy in the banana republic we live in. But estimated (rumored) 30% of the properties Nama will claim under loans purchases will be outside this state - in countries like the USA, UK, France, Germany, Bulgaria, Romania. Nama has no sway there and their courts are not going to toe Brian Lenihan's line of National Interest. So in these countries, the unpaid or underpaid contractors can seize the properties ahead of Nama, leaving Nama with loans devoid of collateral.

This should be fun to watch as our legal eagles from Nama fly over to, say,

• Newcastle to fight the UK system that treats people supplying work as real corporate citizens with real rights; or
• Plovdiv to fight Bulgarian courts, where a leather-jacketed Petar would have to explain to them that if you owe money to his cousin, you either should leave now and forget about that unfinished apartment complex 'with amazing views of the local dump' or risk never seeing your own little 4-bed in Howth ever again.

Have our Brian Twins thought of that little pesky complication?

Now to the issue of ECB. Several of us - again from the Nama critics or sceptics - have done some digging on the issue. What my colleagues now firmly claim is that per their sources, there is a mandate on the ECB to actually treat publicly owned banks in exactly the same way as privately held banks so as not privilege the former over the latter.

Here is what I have found:

Per ECB own research paper The European Central Bank: History, Role and Functions written by Hanspeter K Scheller (link to it here) (Second revised edition, 2006), Annex I provides excerpts from the Treaty Establishing the European Community, Part 3 Community Policies, Title VII: Economic and monetary policy, Chapter 1 "Economic Policy":
"Article 101
1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.
2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the ECB as private credit institutions."

Emphasis is mine. This clearly states that the pro-Nama supporters are simply wrong in claiming that the ECB will treat nationalized banks or Trust-owned banks any different from the privately held banks.

Further quoting from the same ECB publication:
"Article 21 Operations with public entities
21.1. In accordance with Article 101 of this Treaty, overdrafts or any other type of credit facility with the ECB or with the national central banks in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.
21.2. The ECB and national central banks may act as fiscal agents for the entities referred to in Article 21.1.
21.3. The provisions of this Article shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the ECB as private credit institutions."

So the same stands. Now, last year, the ECB issued clarification on Article 101 prohibitions of financing (here) which actually stresses that this prohibition (restricting Central Banks from providing ‘overdraft facilities or any other type of credit facilities with the ECB or with the central banks of the Member States … in favour of …public authorities, other bodies governed by public law, or public undertakings' and Article 21.1 of the ECB Statute that mirrors this provision):

• also applies to any financing of the public sector’s obligations vis-à-vis third parties (so technically, either Nama as a state-own undertaking cannot borrow in the future from the ECB via debt issuance of its own - which will imply that Nama own bonds will have to be priced for sale in private markets only, implying horrific cost to the taxpayers of financing Nama work-out, or nationalized banks will have exactly the same access to the ECB lending in the future as Nama will) and
• crucially, that in dealing with publicly owned credit institutions there is no restriction of Article 1 under the ECB statues.
  

In fact, the legal opinion clearly states that Article 1 is designed to restrict National Central Banks' and ECB being used to finance 'public sector' - i.e to raise funds for the Exchequer, not for the credit institution operations.

Here is another interesting factoid. Chart below clearly shows that many European countries operate state owned banks. In Germany, for example the market share of state-owned banks is in excess of 40%.Source: http://ssrn.com/abstract=1360698

Are pro-Nama advocates saying that these banks have no access to ECB's discount window as well? Or will ECB treat them somehow differently from the nationalized Irish banks? If the latter is true, should this be kept hidden from the Lisbon Treaty debate? (Now, personally, I do not believe Irish banks, if nationalized, will have any trouble in raising funding either via ECB or via private markets, so the above question is a rhetorical one).

Now, logic of Article 1 as stated above, actually suggests that the ECB will have harder time allowing Nama - a state-owned non-credit institution explicitly prohibited from obtaining financing from the ECB - to swap its own bonds for ECB's cash than it would allow state-owned bank - a credit institution explicitly allowed to obtain such funding from ECB - to do so. ECB's own paper and legal opinions are confirming, therefore that it is Nama, not the nationalized banks, that would have much harder time getting support from the ECB!

Economics 12/09/2009: ECB, repos and Nama

It has not became customary for the Government and public officials to provide 'expert commentary' on Nama that in effect attempts to deflect substantive criticism by making unarguable, non-falsifiable assertions on Nama that can neither be confirmed, nor rejected, yes sound plausibly informed.

The latest such 'argument' against Nama critics floated in political circles - opposition parties, FF backbenchers etc - is that, per DofF, ECB will not be willing to take repo bond off nationalized banks.

What does this mean? In the lingo of Nama-supporters, this means that if we nationalize banks (either via a direct nationalization or via equity purchases post-Nama), the nationalized banks will not be able to use Nama bonds (or any other repurchase agreements paper) to swap with ECB for cash. The threat then is that the nationalized banks will have no access to a liquidity window at ECB and will not be able to operate.

Is this a serious threat? If true, it is a serious concern, because in our 'confident' economy of Ireland Inc, a combination of severe recession and Brian Cowen's economic (taxation) policies have effectively assured that no deposit-based lending can take place, so our banks are now fully reliant for funding on ECB and interbank markets.

But is it true? This we do not know and we cannot know, for DofF will neither confirm of deny they are saying this. And furthermore, they will never actually show the ECB statement confirming or denying it.

So what can we conclude about this threat?

Two things, really:

1. The latest DofF threat is bogus in its nature, for there are plenty proposals out there for repairing Nama that do not involve nationalization. If ECB is willing to support privately held banks (as opposed to plcs) and since ECB's definition of a 'supported' bank does not have a limit on how large share of public ownership can be as long as the bank remain private to some extent, then my proposal for Nama 3.0 or Nama Trust will work just fine. The alleged DofF 'fear' is misplaced and it is being floated out there simply to deflect public attention away from viable alternatives to Nama.
   
2. The latest claim is also bogus in terms of its logic. Suppose the ECB refuses to swap repos coming through a nationalized bank from Ireland. Since nationalization covers the entire domestic banking sector in Ireland, the ECB then refuses to take any bonds from any of the Irish banks, making the entire system of Irish banking illiquid. Now, Ireland is a Eurozone country. This act by ECB will force at least one Eurozone country into a combined liquidity and solvency meltdown. What do you think will be the expected effect on the Euro? Oh, yes, it will overnight become a twin to the Zimbabwean currency. Will the ECB agree to destroy its own reputation, monetary system and currency only to avoid repurchase operations with a more stable and less risky (post-nationalization) banking system of its member state?

In short, the rumors that DofF is claiming that the ECB will not swap with nationalized banks are so out of line with reality, they either cannot be true, or someone in ECB is flying high as a kite. You judge which one of these two alternatives is a more plausible one.

Economics 11/09/2009: Nama gets some deserved bashing

Brilliant Nama analysis from DKM (available here). Please, do read the whole thing!

Few quotes and comments (emphases are my throughout):

On recovery sources:
“The best that Irish policy makers can do is cheer on the signs of recovery in the Euro area and in the US. Recovery in our main export markets – although far from certain – is likely to be the only source of real green shoots next year.”

And this is not because our banks can’t function without a bailout. It is because our economy has been demolished and demoralized by the public policy that wastes taxpayers cash in tens of billions and taxes Irish workers into consumption growth oblivion. Will Nama solve it or make it better? No. Nama will take tens of billions more out of taxpayers hands and put the money into banks. Banks can do the following with the cash that is surplus on their capital reserves:
1) Lend out to Irish – already heavily leveraged businesses, earning a rate of return on these loans of 3-4%pa at best (they currently earn around 2-3% on their past loans); or
2) Buy European corporate bonds yielding 5-7% pa (blue chips).

Anyone’s guess what they will do with cash? For DKM it is a no-brainer: “Certainly it is hard to see the reconstruction of the banking system through the creation of NAMA contributing much to short-term recovery in the economy. Indeed, it could be argued that there is a very real danger that the operation of NAMA, subject as it is bound to be to the political whims of the moment, could have a prolonged negative impact on construction capital spending in the economy for years to come.”


“It is a racing certainty that the 2010 Budget … will involve substantial cuts in government spending, especially capital spending, and increases in taxes and charges. This reduction in public spending will take place against a background of highly depressed private demand which shows few signs of picking up. ...justified by the need to curtail public borrowing for the sake of future generations (and for the sake of the interest rate margins Ireland has to pay over German borrowing costs). Yet at the same time the Government is proposing to borrow massive amounts – which could be more than all the existing government debt outstanding – in order to become the virtual monopoly developer of land and property in the State for the next decade. It is as if public policy is being determined by the mad offspring of Hugo Chavez and Margaret Thatcher.”

Well, Thatcher reference is overdone - Brian Cowen has shown no ability to deliver any serious cuts in public spending so far. Plus Thatcher actually lowered tax burden. Nonetheless, amazingly, this simple reality of an inherent unresolvable contradiction between two policies pursued by the Government did not occur to that brilliant legal (i.e logic-trained) mind of Brian Lenihan. How?


“Enduring economic hardship now so that the State can become the sole lender to the property sector is a difficult sell.” Yes, folks, ‘Nama will work’ slogan is equivalent to ‘Speculative development and investments will work’ slogan. And we learned a thing or two about the latter one, haven’t we?


“The concept of NAMA was born out of a report by Dr. Peter Bacon, an economist turned property developer.” A pearl!


On Nama effectiveness in terms of credit flow restoration:
“The most likely use of the funds supplied by the NAMA purchases will be to reduce reliance on overseas funding especially funding in the wholesale money markets. In effect the balance sheets of Irish banks will shrink as assets are transferred to NAMA and foreign liabilities repaid. This may lead to a more sustainable banking system but will not lead to an expansion in credit.”

But have they – Leni, Coweee, Ah!Earn & Co – listened to any suggestions for bettering Nama? “The official response to the criticisms of the original NAMA proposals has been ad hoc, indicating that policy is being made on the hoof.”

“The question of the bank valuation of a property related loan versus a “market” value becomes more acute when it is realised that NAMA proposes to acquire performing loans… …It will be difficult for NAMA to pay less than the value of the loan to the bank from which the loan is acquired without substantial risk of litigation. Even if the management of banks is cowed by the scale of the public shareholding in the bank there would be no such constraint on private shareholders especially bondholders who face losses due to the acquisition by NAMA of assets at too low a price.”

Now, Brian Lenihan has absolutely no understanding of either finance or economics. Fine. No one is holding it against him personally. But he is a lawyer! Can he not see this argument coming?

“Defenders of NAMA have pointed out that it is a requirement of the EC that the long run economic value be paid for the loans. … this requirement is designed to prevent national governments from over-paying for loans and so subsidizing domestic banks at the expense of competing banks located in other jurisdictions. In any event it now appears that NAMA will not be paying the long run economic value for loans acquired from the banks.”


“The most recent suggestion is that the banks will receive part of the consideration in the form of a bond whose value will depend on the recovery rate of NAMA. This risk sharing sounds attractive but it begs the question as to how the bonds will be accounted for on the banks’ balance sheets.” This is exactly what I’ve been warning about in my recent blog post (here).


“The more enthusiastic supporters of NAMA have begun to sound like stockbrokers promoting an IPO. [Well, it is an IPO for them, for absent Nama, real value of banks shares is near nil – they are insolvent!] NAMA, it is asserted, will be profitable. On analysis, some part of its profit will arise from arbitraging the yield curve. By borrowing short – through the issue of floating rate bonds to the banks – and by lending long through the acquisition of longer term property debt NAMA can make a profit. [Again, do you think this is a way forward after the current crisis lessons on maturity mismatch risks?]

"It is open to the NTMA to make a similar profit by issuing similar short dated securities and
investing the proceeds in long dated German government securities." [Brilliant! In effect, having Nama is like having a state-run hedge fund. We have truly arrived to Alice in Wonderland.]


“NAMA is also expected to make a profit because when the loans are repaid (or the security underlying the loans realised) the proceeds will exceed the original cost. If one assumes that what is ultimately realised is the long term economic value of the assets then NAMA can only make a profit by paying less than the long term economic value.” [And hence we have another contradiction: pay LTEV and you can’t get profit if your estimation of LTEV was correct. There is no free lunch, folks!]

In fact Nama has to realise the underlying properties or close the loans at

• (price paid today = LTEV) +
  
• (inflation cumulated over the holding period) +
  
• (the cost of borrowing over this horizon) +
  
• (the cost of administering the loans by the banks and Nama) --
  
• (cash flow during the holding period)

This, of course, implies that “most of the NAMA profits, if any, will be at the expense of the banks from which it acquired the asset.” How? You bought at LTEV, you sold at LTEV (remember - Nama will get the price right and it will pay the higher of two: current market price or LTEV). The only way you turn a profit is if your revenue stream during the period of managing the loan was greater than the costs of inflation, financing and administering/managing loans. But the latter are paid by the banks...


"In the case of the windfall tax the distant sounds of belatedly closing stable doors can be heard. And, of course, the best way to depress any recovery in future property values is to impose a high tax on appreciation". [So the Greens’ proposal is like shooting your leg off while running] "The requirement that NAMA responds to social and political demands highlights all too clearly the dangers of creating a state-owned virtual monopoly presence in development land and property.”


“The Government has rightly warned of the dangers – mainly in terms of price discovery – of a wholly nationalized banking sector. It does not appear to have the same concerns about a similar nationalization of property development.” Another brilliant point.


“Our best guess is that a recovery in investment in development related construction will be some distance off and some of the longer term economic growth projections which have not taken account of the radically changed institutional environment caused by NAMA are too optimistic.”

This is correct, and I will be revisiting my longer term forecasts for Irish economy to reflect Nama costs explicitly in days ahead, so stay tuned.


PS: Per earlier reader/follower request:

List of foreign ‘stars’ who criticised Nama:
Mr Bo Lundgren (a man with real experience handling major bank crisis)
ZEW President, Professor Wolfgang Franz
Robert Engel (Nobel Prize, Financial Econometrics)
Paul Krugman (Nobel Prize)
Professor Roberto Rigobon (MIT)
Professor Michael Goldstein (Babson College)

Domestically - at least 46 economists and finance specialists (many are finance specialists)

On pro-Nama academic side: one Alan Ahearne - an economist with no finance experience

Economics 10/09/2009: Greens' 'proposal' might lead to lingering capital problems post-Nama

Oliver Gilvarry of Dolmen - a clear supporter of Nama As Is proposal in today's note: "The tax will be 80% of the profits gained from the increase in land value following a re-zoning decision. The impact of risk sharing in NAMA will be to reduce the liquidity generated by the banks on the sale of loans to NAMA. It could also reduce the capital relief banks will experience from the transfer of loans as a certain amount of capital may have to be put aside for the subordinated NAMA bonds they will receive unlike the other NAMA bonds."

This is exactly the point I made yesterday (here). The Greens' helping hand can just as well cost the taxpayers when the banks come begging to Leni again... post-Nama.

And this bring us to Mr Cowen's performance on today's Prime Time. Hmmm - the Gods gotta be laughing somewhere in ancient Rome's temples. Mr Cowen now wants to bring living standards back to 2007 peak levels by taxing us to death, issuing more debt against our future incomes than was ever issued in this country history before, spending like a drunken sailor, not reforming public sector pay and pensions, running vast deficits and... hold your breath... restoring credit and liquidity flows with a Nama-style undertaking?

You can almost see this working in theory, can't you.

You can't? Well, to be honest neither can I. Here is why, quickly:

Nama is about working out bad loans written against bad assets. It is, therefore, an investment undertaking with a life-span of decades. Liquidity provision is a short-term undertaking aiming to increase money supply in the economy that is free to move across the economy.

Nama bonds will not provide such a 'liquidity event' for three reasons:

1. As an investment undertaking Nama will need credit of its own to work through the loans and underlying assets, so to assume that banks will simply lend-out the €60bn pot of cash they will get from Nama automatically assumes that the cost of working out Nama loans will be financed through some other sources. Is Brian Cowen actually envisioning another issue of debt to finance this undertaking?
2. As an undertaking to repair balance sheets of the banks, Nama will fund capital base, not lending funds on banks books. In other words, for banks with an average 173% loans to deposits ratio, any cash they can get will have to be locked in a vault. Nama funds cannot be disbursed in new loans.
3. The Greens have just shaved off a large chunk of the 'liquidity' pool through their 'risk sharing' gizmo.

Now, Taoiseach has clearly told the nation when he claimed that Nama is based on 'international advice' and 'best advice available'. Given that the side critical of Nama includes virtually all leading Irish economics and finance specialists from academia and a handful of foreign academics, including at least 3 Nobel Prize winners, plus Swedish politicians responsible for their 'bad bank' work-out, I fail to see how can the 'best advice available' actually completely exclude the truly best advice made available to the Government.

Finally, Cowen refused to step in to offer even a momentary protection to ordinary households when he was asked if mortgage defaulters will be protected. Mr Cowen has made it now record-clear that his Government is unconcerned about consumers, taxpayers and ordinary entrepreneurs. It is banks who must be rescued.

The more they (Leni, Ahearne, Cowen - oh, and why not call Mary Coughlan out of her retirement to pedal Nama-cakes too) dig, the deeper is the hole... after all they did dig Brian Cowen out of his hole where he resided for some 5 months post April Budget and back into the RTE studios - twice within the span of 5 days last...