A View From the Musroom Cloud III

As another day of carnage ensues, there are several new and old issues worth giving a thought to:

(1) Recall S&P ratings update (here): now that Irish 10-year spreads, predictably, are pushing beyond 300bps spread on German bund, what service did S&P provide to the bonds buyers who subscribed to the latest Irish issue of 5-year bonds on the back of AAA rating? The yields, as I have predicted (see here and here) on our bonds have moved in above the Greeks' leaving a wave of devastation behind in the balance sheets of those who bought into this paper on the back of S&P's ratings;

(2) Despite Mr Lenihan's assurances to the contrary on last night's Prime Time, the government is appearing to run thin on actual liquidity (in addition to running thin on any ideas). Do the maths. Mr Lenihan (who was, it must be said, trying to do his best in answering tough questions and did solicit some real compassion from this observer for being, evidently, under immense pressure both inside the Cabinet and in the wider world) stated that banks recapitalization requirements were ca €10bn in 2009.

Now, we know this figure was hammered out but the incompetent risk-pricing non-entities in the Department of Finance on the basis of the following assumptions:
(a) BofI and AIB raising some €2-3bn of their own funding,
(b) Anglo's depositors staying put (saying nothing about other banks' depositors),
(c) shares valuations for the three banks at twice above current, and
(d) no skeletons in the closets when it comes to loan books.

All four of these assumptions have now been challenged. So why is Mr Lenihan sticking to this figure? Is it because he has nothing new coming in with the morning briefing papers from our civil service mandarins?

Some commentators estimate the state exposure under recapitalization/guarantee schemes at €30bn. I would put the figure at a more modest €16-18bn. This would leave Mr Lenihan with just €2-4bn reserve to finance, in 2009 alone:

• a 10% deficit (ca €8bn in borrowing in excess of already acquired funds);
• a 'stimulus' package (ca €2bn);
  
• state credit pumping operations (via Anglo) (ca €5bn); and
• €5bn worth of maturing bonds...

In other words, no matter how you spin things, we are in the hole for, in the better case scenario, €16-18bn in 2009. Can the Minister really look straight into the voters eyes (as he did last night) and tell us - 'It's ok, folks, we'll just tap the credit markets for that. We have low sovereign debt'?

(3) David McWilliams brought back the specter of external rescue yesterday (here) with Ireland using a threat to leave the Euro if the ECB/EU Commission to get some funds. I am not sure this is going to be necessary. It is more likely that the Government will tap ECB/EUC for money under the argument that Ireland is yet to have a second Lisbon vote and that denying it emergency aid will be detrimental to the cause of getting us to vote Lisbon in. The funds will arrive in a combination of a straight ECB loan, acceptance of state paper as a collateral for more borrowing, some mixture of the 'knowledge' economy and capital spending investment assistance from the EUC and support for dwindling multinational employment in the likes of Limerick. Saving the face publicly, however, will not fool the debt markets and the yields will go further up.

(4) And while we are on the subject of the Euro - imagine our current Gang of Three running the monetary policy and managing our currency if we were to exit the common currency area? Close your eyes and watch Mary Coughlan trying to compute a three-party FX arbitrage parity, while Brian Cowen discusses a helicopter drop of money with Mr Hurley... Frightening!

(5) More from the bond markets - as our 10-year spreads moved above 300 bps, our short and medium term paper (6-24 months) breached 290bps last night. This suggests a temporary compression in the time structure of the bonds, implying that our 5 year yields will be climbing up and up and up in days to come.

(6) On the positive side, we have the latest comprehensive Government programme for dealing with this crisis (hat tip to Brian, courtesy of the source) in line with our closest competitor for being the worst performing economy in Europe, Latvia (here):

Mushroom Cloud II

No words needed... (Hat tip to an anonymous reader pointing to July 9 event)

Watching a mushroom-shaped cloud rising

Sadly, my quick prediction last night has turned into a reality - bleaker than I could have anticipated. As, at the time of writing, FTSE EUROTOP100 index is trading in the green territory, ISEQ-FINANCIAL is over 34% in the red, with AIB down 41.5%, and BofI and IL&P both down 27%.

We are now safe to assume that the Anglo Irish Bank, taken over by the state last week, was on the verge of becoming a moneyless institution. That despite the tough talk from Mr Lenihan about freezing some deposits, all sizeable corporate deposits have now left the bank's vaults. That the Exchequer downside from the bank 'rescue' is going to be in excess of €10bn, prompting his yesterday's remark that the other banks are now effectively on their own, and in effect admitting that the Exchequer itself may be now out of money, if commitments to date were to be honoured!

All of this has not been lost to international investors, who are currently dumping anything they might still have in the form of Irish banks shares. The surprising thing for now is that Irish bonds yields appear to be holding.

The question, however, is: for how long. If the Black Monday is not reversed, and unless the Government comes out in public with the actually believable statement on its current financial position (including a detailed and credible forecast as to how it plans to manage its exponentially increasing commitments for 2009), Irish yields will rise and prices will fall.

Whatever you do, I would think thrice before switching into Irish bonds... they are far from being a safe harbour...

Irish credit II

Here are the facts in support of Irish credit ratings downgrade (for those impatient to get the actual downgrade forecast, see Table 2 at the bottom of this post) taken directly from the IMF’s latest Global Financial Stability Report published in October 2008.

These facts suggest that:
(a) the problem of Ireland’s high risk of sovereign and economic insolvency is not new –by the end of 2007 Ireland has emerged as the most financially exposed country in the developed world, to the total silence of Irish Government, Regulators and other domestic financial services authorities; and
(b) our sovereign ratings have are failing to reflect this risk, despite the fact that the data was available to all rating agencies for some time.

Our financial health ca January 2008...
Ireland ranks last out of the entire group of countries/ regions covered in the report in terms of its overall capital markets/financial stability (see table below). The countries/regions reported by the IMF include: the EU, Euro area, Canada, US, Japan, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, the UK, a general set of all emerging economies. Report parameters are given in IMF’s Table 3 in absolute terms.

Table 1 below ranks Ireland, and its two European competitors for the title of the worst-off (in terms of financial stability) Italy and Greece, across these same IMF-selected parameters.

Table 1: Ranking for Selected Indicators on the Size of the Capital Markets, 2007, expressed as % of country GDP/GNP
Sources: IMF GFS Report October 2008, and author own calculations.

Figures below plot the data that led to the above table results.

Figure 1: Total Reserves, % of GDP/GNPSources for Figures 1-7: IMF GFS Report October 2008, and author own calculations.

Figure 1 above shows total economies’ reserves (net of gold) as a percentage of GDP (and GNP for Ireland). Technically, ceteris paribus, higher levels of reserves relative to the economy size imply higher levels of solvency. Notice that this data is for 2007 – the year when Ireland was still in a relatively benign economic environment. In 2007 Ireland’s total reserves stood at a level almost 6 times below the EU27 average. Out of all main global financial centers selected by the IMF only Greece and Luxembourg showed weaker reserves base than Ireland.

Of course, we knew this already, as most of our wealth was trapped in the deteriorating housing markets. But the rating agencies failed to see this as a serious threat, preferring to focus disproportionately on the deceptively low public debt levels in this country. The irony that the state has managed to drive down its debt at the expense of economic stability (by taxing businesses and consumers to produce a ‘savings’ piggy bank for the public sector) and by imperiling our financial stability (by re-directing private financial flows and diverting investment into property and other state-incentivised schemes), was totally missed by the likes of S&P and Fitch.

Figure 2: Stock Market Capitalization, % of GDP/GNP
As the above figure shows, our stock market capitalization as the percentage of GDP/GNP ranked the second lowest in the world in 2007. Italy was the only country with a relative weight of the stock markets capitalization in its economy falling below that of Ireland. This parameter reflects, indirectly, the overall mammoth share of debt (as opposed to equity) on our corporate balance sheets and the effects of Irish economy’s dependence on leveraging and housing markets.

Figure 3: Debt securities as % of GDP
Figure 3 above shows how extreme were the levels of Irish debt liabilities in 2007, with the country leading the world in terms of private debt share of GDP. In the figure 4 below, the two sources of debt are combined to show that Ireland (as a share of GNP) has achieved a dubious distinction of becoming world’s most debt-ridden country by the end of 2007 – a point also missed by the rating agencies.

Figure 4: Total Debt Securities Outstanding, as % of GDP/GNP
Figure 5: Bank Assets as % of GDP/GNPWhen it comes to the financial system assets side of the balance sheet, Irish banking assets appeared to be relatively healthy in 2007 (Figure 5), although this does not include any correction for these assets quality. However two factors must be kept in mind:
(1) to date, Ireland has been leading the EU in terms of commercial bankruptcies (up 250% on 2007) and in terms of housing and commercial real estate crises, implying mid-term impairment charges for Irish banking system well in excess of those in other European countries;
(2) as the following two figures show, our assets cushion (non-bank assets as % of the total debt) and reserves cushion (total reserves as % of the total debt) were both thin, despite the fact that we are faced with an unprecedented (by global comparisons) total debt mountain.

Poor protection buffers: still the ‘old’ news

Figure 6: Assets CushionFigure 7: Reserves Cushion
It is worth mentioning that our Assets cushion (Figure 6) is artificially inflated by the still high property valuations of 2007. Correcting for 2008 commercial and residential property contractions, Ireland's non-bank assets to GDP or GNP stand at the lowest level in the entire developed countries sub-sample. Of course, as far as our reserves to GDP ratio goes - the fact is that our banking sector reserves stood at a critically low levels even in 2007 invites two observations:
(1) reserve requirement ratios are the prerogative of Irish Central Bank and Financial Regulator - with domestic regulators having full access to the powerful policy lever of raising these requirements. Both did absolutely nothing;
(2) the IMF figure for reserves includes state own reserves (NPRF), implying that the real problem of the banking sector reserves crisis we are currently experiencing is even worse than the official figures suggest.

Given a precipitous fall in Irish shares, property and economic growth – all registering declines well in excess of other European countries – we are now facing the assets and reserves cushions that are critically low, warranting a significant downgrade on our credit ratings.

Ireland’s comparatives (2008-2009) and ratings forecast
Comparing our financial position to that of the peer countries, Table 2 below shows that our current credit fundamentals are woefully out of line with other AAA rated countries in Europe. In fact, even disregarding the realities of our economic slowdown and fiscal challenges facing the country in 2009, comparative analysis of financial stability fundamentals for Ireland suggest that our true ratings should be below those of Greece or Italy.

Table 2: Assets, Reserves and Ratings
Sources: Fitch, S&P and IMF data, author own forecasts

The above results show that Ireland is well over-due a downgrade on its sovereign debt to bring us in line with our relative peers – Italy, Greece and (correcting for Eurzone membership) Iceland. But Table 2 above (see forecasts for financial stability parameters marked in blue) also shows that taking into account our economic and fiscal prospects for 2009, the downgrade currently overdue can actually be much deeper than the one forecasted herein.

Current environment: even more room for downgrades
One cannot ignore the extent of the economic and fiscal deterioration in Ireland to-date. We are facing an officially projected deficit that is unprecedented in the entire EU27. And the official forecast, as I argued before (here) is by all means an underestimate of the fiscal black hole we are heading for.

Even with An Bord Snip delivering significant – ca 10% - cuts in pubic spending (at least half of which is already factored into the Department of Finance forecasts), and even assuming the Government has the guts to implement such changes, Ireland is likely to find itself in ca 10% deficit in 2009.

This alone should trigger our ratings to be downgraded below AA- and our bonds yields to head closer to 6-6.5% for a 10-year paper. Of course, Ireland cannot at this time issue 10-year paper, implying that our borrowings for the foreseeable future will be short-term. Should the downturn extend through 2013, or alternatively, should the post-downturn growth fail to reach above 3%, Ireland will be in a serious trouble when redemptions on 2008-2009 debt issues come knocking on the door.

But the fiscal challenge is not the only one. Ireland’s economic contraction is likely to reach 4.5-5% (GDP terms) in 2009, implying that we will continue to lead the EU in terms of recessionary pressures. Such a scenario also warrants a downgrade of our ratings to AA-/BBB+.

Last, but not least, the Irish Government has underwritten some €450bn worth of debts and obligations on the domestic banks’ books, plus an open-ended commitment to supply capital to the banks. The nationalization of Anglo alone is likely to add something to the tune of €7-10bn to 2009 liabilities of the Exchequer and some economists estimated last week that this liability can easily reach €15-30bn.

Now, do the math. The Government boasts of holding some €20bn in liquid reserves, including surplus 2008 borrowings. Of these, Anglo commitment will eat through, say €7bn, previous capital commitments alongside the underwriting of the equity placements for AIB and BofI – another €5bn, the Exchequer deficit, assuming An Board Snip delivers real savings, will take up the rest. This leaves Ireland Inc naked for 2009 – no stimulus, no cushion for error, no buffers for any bank or building society default and, even more crucially, no deficit financing for 2010 should the sovereign debt markets get tougher throughout the year.

In these conditions, it is highly likely Ireland will push 10-year yields well beyond 350-400bps spread on German bonds and despite Mr Cowen's protestations to the contrary, find itself begging for funds from external donors. IMF or ECB or both - the acronyms are semantic: either one will part with its money only on extremely strict conditions...

Irish credit I

The prevailing feature of last year’s end is a growing tide of anger at the impotence of our Government to come to grips with the bleak reality of a severe downturn that is facing the rest of us. But the latest developments in global markets are suggesting that our Exchequer will have to deal with more than domestic pressure to reform in 2009.

Three events since the beginning of the New Year show the extent of the deepening global economic crisis with potentially dramatic implications for Ireland.

Sovereign debt financing
First, last week’s German 10-year bund auction, a golden standard of financial security for European markets, turned into an unmitigated disaster. The auction failed to sell 13pct of a relatively modest €6bn issue – second worst result in history that follows on the heels of seven auctions that failed to secure full placements in 2008. The latest US auction of 90-day T-bills – considered to be risk-free by the markets – was subscribed up to 50pct, while the UK’s 10-year bond issue had to be placed at 5pct.

Second, Greece has moved one step closer to a sovereign debt default and a deeper political crisis when banks bailout package triggered a wave of discontent from the crisis-impoverished consumers. To date, this has led to the firing of the Finance Minister in a Government that was, similarly to Ireland’s, elected just 16 months ago. Greek 10-year bonds are now yielding 5.31pct – dangerously close to the junk bond levels. This week’s Irish 5-year bonds being priced at 4.14pct implies that (a) adjusted for their term structure, Irish bonds would be priced to yield around 5.47pct for a 10-year bond – well ahead of Greece, and (b) the global appetite for long-term sovereign debt is in a steep decline. It is doubtful if Ireland will be capable of placing a 10-year note even in theory at anything below 5.6-6pct mark, suggesting that whatever debt we do raise in 2009 might come not only at a high price today, but at an even higher price in the future refinancing markets.

Our borrowing plans
Last, but not least, our Exchequer results for December have shown an unprecedented rate of collapse, with Q4 2008 receipts down a whooping 22pct on Q4 2007. The timeline of deterioration, highlighted in the box-out is frightening. Despite the Department of Finance forecast for 6.5pct General Government Deficit for 2009, it is likely that our GGD will exceed 9pct – three times the Stability and Growth Pact limit for the Eurozone member states by this year end.

The Government has acknowledged that Ireland will have to borrow ca €20bn in 2009 – a level of new bonds issuance that is unprecedented in Europe. And don’t forget that Ireland Inc is also likely to face the need for extra €5bn for the expected cost of banks recapitalization and guarantees and another €5bn in redemption cover for April bond.

Such borrowing, relative to the domestic economy, would imply bonds issuance of ca €450bn for the UK (well above the €160bn debt placement planned by the UK Exchequer) and €470bn for Germany. Put into perspective, the US is planning some $950bn in new bonds issuance, inclusive of some quasi corporate bonds by the likes of Fannie Mae & Freddie Mac, for an unprecedented 2009 economic stimulus. Were the country to use Irish Government fund raising plans it would have to issue over $1.8 trillion in new bonds. And while the rest of the world is using borrowings to finance economic growth, our Government is plugging the Exchequer imbalances.

The cost of digging ourselves out
All three events have one theme in common – they suggests that our economy is now firmly set on track to higher taxes and more pain for the ordinary households. For thousands of Irish businesses toiling under pressure to maintain revenue and employment this is a far more ominous threat than all external shocks combined.

The structure of pricing in the sovereign debt markets is now poised to change, with a renewed buyers’ focus on the underlying economic fundamentals. These include:
• Traditional fundamentals: fiscal deficits, inflation and economic growth prospects; and
• New fundamentals: the quality of macroeconomic management and the reasons for debt placement.
On both, Ireland offers a poor prospect. But it is in the second set that our Government’s failure to deliver leadership will be felt most, both by the NTMA trying to place our bonds and by the ordinary businesses and consumers, trying to cope with the cost of the public sector burden.

For traditional fundamentals, last year’s record unemployment claims growth (up 66pct), EU’s largest economic contraction (-2.5pct of GDP), widening of GDP/GNP gap, above EU-average inflation (especially in the state-controlled sectors), and extreme housing and construction crisis are all set to continue in 2009.

Irish property prices can decline by ca 25pct in real terms in 2009. New construction might replace only 30-40pct of the already low 2008 levels, while our unemployment is likely to climb to 11-12pct. This will be moderated, on the paper, by a rapid outflow of foreign workers and younger Irish employees. But in reality, emigration will take the most productive future employees out of this economy first. Deflation in the private economy will be exacerbated by continued inflation in the public sector as our semi-state companies squeeze Irish consumers in pursuit of increased profits demanded by the Exchequer. Taxes – both on personal income and indirect business and consumer levies – will climb, inducing a rising tide of tax evasion and minimization measures by businesses and sole-traders. All of this will imply that the Exchequer revenue will slide ca 10-12pct in 2009 on the back of a more severe growth contraction (-4.5pct GDP and -5-5.5pct GNP).

At the same time, there is little hope for spending discipline to be imposed on the public sector by this Government. For 2008, despite the extremely modest demand for €440 million in savings issued by the Exchequer in July, overall spending was up 0.7pct or €351 million. In part, this reflected high demand for social welfare benefits due to collapse in employment. In part, however, it reflects the fact that our public sector still managed to award itself the pay increases and pensions hikes set out under the last Social Partnership agreement.

A new set of challenges
New pricing fundamentals in the bond markets support the proposition that the State will find it very difficult to raise funds in international markets and that this will translate into more economic hardship for the private sector.

In 2009, debt markets will favour those sovereign issues that will be placed to provide direct growth stimuli to the economies. In contrast, Irish borrowing will be focusing on maintaining already unsustainable levels of Exchequer expenditure with little stimulus potential.

Can anyone really believe that serious international investors will back our Building Ireland's Smart Economy framework? Or that they will have serious confidence in this Government’s ability to jump-start Ireland’s economy? To date, Irish Government record on taking decisive action is, as the box-out shows, abysmal.

The problem with the current Government’s handling of the economy is that instead of facilitating growth, the State is exacerbating the effects of the global economic slowdown. Majority of Irish businesses are currently operating in the environment of severe shocks to sales, exchange rate valuations, contracting global demand, shortages of credit facilities and rising domestic costs. At the same time, majority of Irish consumers are feeling besieged by the rising risk of unemployment, taxes, debt and falling disposable incomes. None of these players can take on the task of rescuing the Exchequer out of the unsustainable spending increases.


Box Out: A record of errors
Credit ratings agencies reviewing Irish Government creditworthiness in the recent weeks have made sweeping claims that their unwillingness to downgrade Irish ratings from the gold-standard level of AAA are motivated by the speedy and adequate response by the Government to the economic crisis. In reality, our Government has shown zero capacity for leadership and for admitting its own errors. Consider the facts.

Fact: 2007 general elections brought up the need for public sector reforms to the forefront of policy debate. All parties involved made serious hay out of the calls for changing the way this state spends tax revenue on various political white elephants, bogus investments, excessive wages and perks in the public sector and so on. By the end of 2007, the Government has seen the OECD blueprint for change. By the second half this year it had its own assessment of the OECD report. There has been no action by the Government on the issue of public finances.

Fact: in mid 2007, as the credit crisis first manifested itself, a number of commentators, including this column, has told the Government that the spending path it embarked on was out of touch with reality. In late 2007, many analysts, this column included, were predicting a record slowdown in 2008 and a precipitous fall in taxes. The Government ended 2007 in deficit – despite the windfall from SSIAs and buoyant economy. The same leaders are now denying knowing anything about the crisis prior to July 2008.

Fact: The Exchequer registered a 6pct drop in Q1 2008 receipts compared to Q1 2007, 10pct drop in receipts in Q2 2008 relative to Q2 2007, 12pct decline in Q3 2008 and a catastrophic fall of 22pct in Q4, bringing about an unprecedented, by all European benchmarks, deficit of €12.7bn with a span of the year. All of this was happening right in front of this Government’s eyes and with complacent silence of the boffins from our Department of Finance. This Government still insists that it could not have foreseen these events until after the end of Q2 2008 – 7 months after the revenues collapse began.

Fact: Since the beginning of 2008, when the scope of the crisis became apparent first to the independent economist (in January-February 2008), then to the financial services experts (March-April) and later even to the ESRI and other official policy pundits (by April-May 2008), the Government took lengthy vacations and extended tea breaks to evade making any policy decisions that can be considered even remotely effective or decisive. In the year of extraordinary crisis, both the Dail and the Cabinet did not bother to take any significant extra time to deal with the issues.

In the course of 2008, this Government produced four policy documents:
• a banks guarantee scheme which provided no real support to the economy and preciously little support for the banks,
• the Budget 2009 which managed to bludgeon ordinary consumers and small businesses with new taxes and levies but produced not an ounce of reformist thinking,
• the recapitalization scheme for our banks that failed to address the issue of catastrophic household and corporate indebtedness, and
• the farcical Building Ireland's Smart Economy framework, promising more waste and government spending on politically motivated pet projects amidst the trite catch phrases richly sprinkled across 100-plus pages of largely meaningless policy proposals.

Per Hitchhiker’s Guide to the Galaxy, can this Government, please start delivering its future reports and policy papers in a plastic cover with ‘Don’t Panic’ printed on it. At least we will be properly forewarned.


This article appears in the current edition of Business & Finance magazine (January, 16, 2009).