Economics 24/04/2010: Greece and Ireland

The unedited version of my op-ed in today's Irish Independent (link here)

“It’s been a brilliant day,” said a friend of mine who manages a large investment fund, as we sat down for a lunch in a leafy suburb of Dublin. “We’ve been exiting Greece’s credit default swaps all morning long.” Having spent a couple of months strategically buying default insurance on Greek bonds, known as CDS contracts, his fund booked extraordinary profits.

This wasn’t luck. Instead, he took an informed bet against Greece, and won. You see, in finance, as in life, that which can’t go on, usually doesn’t: last morning, around 9 am Greek Government has finally thrown in the towel and called in the IMF.

As a precursor to this extraordinary collapse of one of the eurozone’s members, Greece has spent the last ten years amassing a gargantuan pile of public debt. Ever since 1988, successive Greek governments paid for their domestic investment and spending out of borrowed cash. Just as Ireland, over the last 22 years, Greece has never managed to achieve a single year when its Government structural balance – the long-term measure of public finances sustainability – were in the black.

Finally, having engaged in a series of cover-ups designed to conceal the true extent of the problem, the Greek economy has reached the point of insolvency. As of today, Greece is borrowing some 13.6% of its domestic output to pay for day-to-day running of the state. The country debt levels are now in excess of 115%. Despite the promise from Brussels that the EU will stand by Greece, last night Greek bonds were trading at the levels above those of Kenya and Colombia.

Hence, no one was surprised when on Friday morning the country asked the IMF and the EU to provide it with a loan to the tune of €45 billion. This news is not good for the Irish taxpayers.

Firstly, despite the EU/IMF rescue funds, Greece, and with it the Euro zone, is not out of the woods. The entire package of €45 billion, promised to Greece earlier this month is not enough to alleviate longer term pressures on its Government. Absent a miracle, the country will need at least €80-90 billion in assisted financing in 2010-2012.

The IMF cannot provide more than €15 billion that it already pledged, since IMF funds are restricted by the balances held by Greece with the Fund. The EU is unlikely to underwrite any additional money, as over 70% of German voters are now opposing bailing out Greece in the first instance.

All of which means the financial markets are unlikely to ease their pressure on Greece and its second sickest Euroarea cousin, Portugal. Guess who’s the third one in line?

Ireland’s General Government deficit for 2009, as revised this week by the Eurostat, stands at 14.3% - above that of Greece and well above that of Portugal. More worryingly, Eurostat revision opened the door for the 2010 planned banks recapitalizations to be counted as deficit. If this comes to pass, our official deficit will be over 14% of GDP this year, again.

All of this means we can expect the cost of our borrowing to go up dramatically. Given that the Irish Government is engaging in an extreme degree of deficit financing, Irish taxpayers can end up paying billions more annually in additional interest charges. Adding up the total expected deficits between today and 2014, the taxpayers can end up owing an extra €1.14 billion in higher interest payments on our deficits. Adding the increased costs of Nama bonds pushes this figure to over €2.5 billion. Three years worth of income tax levies imposed by the Government in the Supplementary Budget 2009 will go up in smoke.

Second, the worst case scenario – the collapse of the Eurozone still looms large despite the Greeks request for IMF assistance. In this case, Irish economy is likely to suffer an irreparable damage. Restoration of the Irish punt would see us either wiping out our exports or burying our private economy under an even greater mountain of debt, depending on which currency valuation path we take. Either way, without having control over our exit from the euro, we will find ourselves between the rock and the hard place.

Third, regardless of whatever happens with Greece in the next few months, Irish taxpayers can kiss goodby the €500 million our Government committed to the EU rescue fund for Greece. Forget the insanity of Ireland borrowing these funds at ca 4.6% to lend to Greece at ‘close to 5%’. With bonds issuance fees, the prospect of rising interest rates and the effect this borrowing has on our deficit, the deal signed by Brian Cowen on March 26th was never expected to break even for the taxpayers. In reality, the likelihood of Greece repaying back this cash is virtually nil.

Which brings us back to our own problems. What Greek saga has clearly demonstrated is that no matter how severe the crisis might get, one cannot count on the EU’s Rich Auntie Germany to race to our rescue. We have to get our own house in order. Unions – take notice – more deficit financing risks making Ireland a client of the IMF, because in finance, as in life, what can’t go on, usually doesn’t.

Economics 21/12/2009: Nama - perpetuum mobile of ethics and objectives

For those of you who missed my Sunday Times article yesterday - here is the unedited version of the text.

But before we begin on Nama - here is a superb article on the prospects of potential sovereign defaults in Europe (read: Baltics, Greece and Ireland) from the FT today.

And here is a fantastic compendium of Brussels-imposed costs to the UK economy as estimated by the UK Government own assessments studies. One wonders if Irish Government bothered to do the same exercise and what its outcome might be. In the UK, the cumulative present value cost of these measures is ca £184 billion through 2020. If the same apply to Ireland, proportional to the overall size of the Irish economy, the combined cost of these Brussels directives could be around €18.6 billion - more than 77% of our annual deficit.



In the real world economics there is one Newtonian-level certainty: what can’t go on, doesn’t. We should have learned this some years ago, following the 1980s economic debacle and the 2001 collapse of the tech bubble. We had another opportunity to understand it last year. But in Ireland, real economics is reduced to the domain of an eccentric hobby. The real business of the nation leadership is preservation of the status quo – first at the state level, then political, and now – in banking.

Nama is a focus of all three. Through it, even in the midst of the current historic crisis, our political and executive elites continue to inhabit a parallel universe where responsibility and accountability are for the commoners, and transparency and governance are decorations for EU summits.

Aptly, in its current form, Nama reigns supreme as the most non-transparent financial institution in the developed world. Its ‘independent’ directors are being selected behind the closed doors by those who presided over the systemic failures of our regulatory and supervisory regimes. Its risk, audit and strategy functions will be fully contained within the secretive and unaccountable structure of the organization itself.

Nama will not publish a register of properties against which it will hold the right of seizure. This, we are being told, is done to protect privacy of the developers involved. But a register does not have to declare the names of the borrowers – property location, purchase price, vintage, LTV ratio and valuation by Nama would do just fine.

Nama accounting and audit functions will not comply with the requirements imposed by our regulators on public companies. Its directors, management and consultants will enjoy a blanket indemnity that is unparalleled by the standards of any public office or company law. Their remuneration will not face even the farcical constraints that senior banks executives face.

Nama owner – the SPV – is a bogus shell entity with ghost investors and a minority shareholder (the state) in charge. That this scheme has been concocted not in a distant off-shore location, but by our own state in our name and with our money adds insult to the injury.

As if the existent shortfalls of the legislation establishing Nama were not enough, even after the entity approval by the Dail, the goalposts for its operational performance continue to shift. Just weeks after the TDs voted to approve it Nama is now a different beast altogether.

Take the issue of discounts. Throughout the approval process, the Government doggedly refused to accept the need for realistic writedowns on the loans. Hence, all official estimates for Nama were incorporating an extremely optimistic 20-23% average discount. A handful of independent analysts, including myself, Professors Karl Whelan (UCD) and Brian Lucey (TCD), and an independent banking expert Peter Mathews, kept on showing analytically and factually that the final discount must be closer to 35-40% if Nama were to become anything but the skinning of the taxpayer.

The latest revelations from the banks and our stockbrokers, who insisted earlier this year that a 12-15% discount would be just fine, put an average Nama discount at over 30%. Nama cheerleaders now admit that applying a low discount is simply bonkers. This week, international agencies – Fitch and Moody – also waded back to the shores of reality. Both highlighted the fact that going forward Irish banks will remain in their current insolvent state. Nama won’t repair their balancesheets and it will not change their ability to raise capital privately.

With this change in direction, Nama became an exercise in racing to the top of recapitalization heap, as banks scrambled to issue new estimates of their expected demand for additional capital.

Two months ago I estimated in a public note that Bank of Ireland will require up to €2.6bn in capital after Nama loans are transferred, AIB will demand close to €3.5bn, Anglo €5.7bn and the rest of the pack will need approximately €1.2bn. The total demand for recapitalization costs post-Nama – none of which is factored into that work of fiction known as Nama Business Plan – will be €10-13 billion.

All of these figures could have been glimpsed from the banks balancesheets, but the Department of Finance, NTMA, and an army of advisers have opted for creative accountancy in place of realistic estimates.

Over the recent months, virtually every vested analyst in the country has confirmed the above figures for the banks. In one case – that of INBS – the analysts actually exceeded my worst case scenario projections. The result of this delayed admission is the current bear run on Irish banks stocks.

Now, recall that consensus estimates prepared by the independent analysts show that in the end of its operations, the ‘bad bank’ is likely to yield net losses to the taxpayers of between €11 billion and €17 billion. Not a single estimate, short of the fictionalized official Nama accounts, shows the entity breaking even on the loans.

Do the maths: expected losses of €11-17 billion, plus recapitalization costs to date of €11 billion, plus expected post-Nama recapitalization costs of €10-13 billion (only partially reflected in the expected losses estimates). The total bill for this bogus ‘rescuing’ of the Irish banking system is likely to be in the neighbourhood of €29-40 billion.

And, judging by the public pronouncements from the top bankers of AIB, Bank of Ireland, Anglo, permanent TSB and EBS – there is not a snowballs’ chance in hell Nama will repair lending to Irish companies or households. Instead, as the US experience with TARP shows – a liquidity trap is awaiting our economy. Put in simple terms, no rational banker would forego an opportunity of borrowing from the ECB and lending at ca 5% to the state instead of providing capital to SMEs and households.

Contrary to the hopes of restarting the lending cycle, what we have to look forward to in 2010 is the strengthening of the margins by the banks. A combination of the ‘risk sharing’ scheme built into Nama legislation, costlier interbank funding markets (courtesy of reduced liquidity supply from the ECB), falling corporate deposits base and the deterioration in the capital reserves of the banks will mean that the cost of existent loans and future borrowing will rise. And it will rise dramatically.

The first taste of this was the implementation by permanent TSB of a rate hike on adjustable rate mortgages. ESB preannounced the same move some months ago. Bank of Ireland, AIB and the rest of the pack will follow. When this happens, even absent ECB rates hikes (anticipated by the market in mid-to-late 2010), the retail lending rates will rise, triggering a wave of defaults by households on credit cards debt, consumer loans, car loans and ultimately home loans.

Short term lending facilities for businesses and export supports will also come under pressure as banks address the twin problems created by Nama – the deficit of capital and the uncertain nature of risk sharing scheme. The lack of exports supports either in the form of state-backed export credit insurance for indigenous exporters or the currency risk offset scheme in the Budget 2010 will further exacerbate the problem.

All of this is fuelling the current run on the banks shares. Even with their wings clipped, stock markets investors are indirectly ‘shorting’ Irish banks by withdrawing their cash from the AIB, Bank of Ireland and Irish Life & Permanent valuations. The markets are shouting: ‘We are not buying your story that Nama will work for Irish economy!’ The Government is not listening.

Box out:
A study based on the Standard & Poor’s data released this week shows that over the last 5 years, active funds managers have managed to under-perform broader market indices in four out of four asset categories. Thus, only 37% of active funds managers with large cap strategy orientation beat S&P500 large cap index to July 1, 2009. Only 32% of funds specializing on small cap equities outperformed S&P Small Cap 600 index, and abysmal 13% of funds with international (as opposed to US) orientation have managed higher returns than S&P700 index of global equities. Just 20% of bonds funds beat Barclays Intermediate Government/Credit index. And that is before we factor in cost differentials between actively managed funds and plain vanilla index-linked ETFs. Ouch…

Economics 29/09/2009: Nama Trust Full Costs

Full balance sheet for either a 'nationalization option' or my Nama Trust idea is here, now with bonds figures (courtesy of Peter Mathews):

Economics 23/09/2009: Cost of Nationalization

Today's note from Davy Stockbrokers throws into public domain a challenge and an accusation:

"Regrettably, the public debate on NAMA has been anything but rational and dispassionate. Confusion, misinformation and, at times, rank deception has run riot over the past several months... Tellingly, the brunt of discussion has majored on an anti-NAMA rant, with scant exposition of any credible alternatives."

If Davy is so dismissive of the 'alternatives' - of which there have been several rather involved ones - then Davy should be even more dismissive of the Nama proposal itself, for the Government still has no estimates for costs, returns, time horizons, detailed haircuts, borrowing terms for Nama bonds etc - after 6 months of working on it with an army of civil servants, highly paid consultants and having the likes of Davy on their side!

"Nowhere is this more depressingly obvious than in relation to the nationalisation option, wherein protagonists have tended to confine their treatises to a short paragraph or three, and where the potentially ruinous funding consequences for both the banks and sovereign have been glossed-over..."

Of course, unlike Davy or other stockbrokers, it is the independents: Brian Lucey, myself, Karl Whelan and Ronan Lyons who actually bothered to estimate - to the best of our resources - the expected costs of Nama to the taxpayers. Instead of focusing on the benefits and costs to the taxpayers, Irish stockbrokers focus on benefits to the banks and their shareholders. This is fine, and I will not accuse them of doing anything wrong here - their clients are, after all, not taxpayers, but shareholders. But it is rich of Davy team to throw around accusations of us, independnt analysts, 'glossing over' aspects of Nama - we are not the ones being paid by anyone for doing this work.

The emphasis on 'estimate' and 'expected' is there to address Davy accusations of 'rants' or 'deceptions'. If estimates are rants, Davy-own entire daily research output can be labeled as such.

But Davy folks are correct in one thing - we, the critics of Nama, have not produced an estimate of nationalization option cost. Instead, it was, me thinks, Brian Lenihan who promised to produce such estimates. May be Davy note was addressed to his attention?

Seeing the eagerness with which Davy folks would like to see some numbers on nationalization, below is the summary of estimates of such an undertaking developed by Peter Mathews (you can see his article on this in Sunday Business Post (here) and confirmed and elaborated by myself and Brian Lucey. (Again, note, one can only assume that our Davy folks do not read Sunday Business Post's Markets Section.)

I have argued in my Nama Trust proposal (aka Nama 3.0) (here) that we can avoid nationalization by buying out equity in the banks to support writedowns and then parking this equity in an escrow account jointly owned by all taxpayers. The banks will, then be owned by the Trust, not by the Government. Their shareholders will be Irish taxpayers as individuals, not the Government. The Trust will be there simply to provide a time buffer for orderly dibursal of shares over time.

Now, whether you call it 'nationalization' or 'Trust' or anything else, the problem with the banks in Ireland is that they need to write down something around 40% of the troubled assets values. This can be done by gifting them bonds (as Nama will do), or by buying equity in the banks in exchange for the same bonds, except, as below shows, at much lower cost.

In the first case, you get a promise of repayment from the banks and a pile of heavily defaulting loans. In the latter case, you get shares in the banks.

In the table above, the first set of red figures refers to the amount of equity capital that will be need for repairing banks baance sheets today (it can be issued form of bonds, just as Nama intends to do, which will be convirtible through ECB repo operations at the same 1% over 12 months). The amount we will need to put into banks under 'nationalization' or Nama Trust option is Euro30.88bn.

The bondholders will remain intact (so no additional cost of buying them out).

This upfront cost is over Euro 23bn cheaper than Nama. And it can be further reduced if we get at least subordinated bond holders to take a debt-for-equity swap, which they might agree to as they will be taking equity in much healthier banks.

The second and third red figures refer to the expected recovery on this equity purchase in 5 years time (not 15 as in the case of Nama). And all assumptions used to arrive at these two scenarios are listed. The figures are net of the original Nama cost. In other words, under these two scenarios, we can generate a healthy profit on Nama Trust, which we cannot hope to generate in the case of overpaying under the proposed Nama scheme.

In addition to the table above, I run another third scenario that assumes:

• 5% growth pa in banks shares (as opposed to 15% and 10% growth under scenarios A and B);
• Banks fully covering 1.5% cost of Government bonds (as in scenario B);
• Banks paying a dividend to the Exchequer of 2% on loans (net of bad loans) and charging 0.5% management fee, so net yeild is 1.5% on loans (as in Scenario B).

The bottom line in this scenario was ca €9bn in net return to the Exchequer on 'nationalization' within 5 years of operations.


Back to Davy note: "...the potentially ruinous funding consequences for both the banks and sovereign have been glossed-over..." Well, let me glance it over.

1. Nationalization can be avoided per my Nama Trust proposal, so there goes entire Davy 'argument'.
2. If the banks balance sheets are repaired with a 40% writedown of bad loans under the above costings while Nama would achieve only 30% writedown at a much higher cost, what 'ruinous' consequences do Davy folks envision for the banks? Their balancesheets will be cleaner after the above exercise, than after Nama!
3. If Irish Exchequer were to incur the total new debt of €30bn (per above proposal) and will end up holding real equity/assets against this debt, will Exchequer balancesheet deteriorate as much from such a transaction as it would from an issuance of €54bn in new debt secured against toxic assets such as non-performing loans? Again, it seems to me that a rational market participant (perhaps not the Davy researcher authoring the note) would prefer to lend to a state with smaller debt and real assets against it than to the one with higher debt and dodgy assets in hand.
   

Back to Davy: "...the retention of impaired assets on bank balance sheets ...would continue to cast a deep pall over perceived solvency risks in the Irish banking system, leaving this country still bereft of the necessary refinancing flows from which green shoots might grow."

I would suggest that this statement is itself either a deception (deliberate) or a wild speculation (aka rant). There is absolutely no reason why fully repaired banks (with 40% writedown on the loans under the above costings and as opposed to Brian Lenihan's proposed Nama writedown of much shallower 30%) cannot have access to the same lending markets as banks post-Nama would. However, under the above proposal:

• Irish Government will take much lower (24bn Euro-lower) debt on its books, implying healthier bonds prices for the Government into the future - some savings that won't happen under Nama;
• Banks enjoy much more substantially repaired balance sheets (again, not the case with Nama);
• There is no second round demand for new capital from the banks (not the case with Nama as proposed).

So, again: judge for yourself. When is the insolvency risk for Irish banking system higher:
Case 1: more substantially repaired banks balance sheets and more fiscally sound positioned Exchequer; or
Case 2: lesser writedowns of bad loans and more indebted Exchequer?
If you vote for Option 1 (as any rational agent in the market would do), you vote for the above 'nationalization' exercise.

Lastly, Davy note lands a real woolie: "When all is said and done, NAMA is not a bail-out of developers, or bankers, but of a banking system and its host economy. In that respect, it is a bail-out of ourselves."

Under Nama, developers will be able to delay or avoid insolvency declarations and subsequent claims on their assets. If this is not a bail-out, it is a helping hand of sorts.

As per 'repairing economy' - there is absolutely no evidence to support an assertion that Nama will have any positive economic impact, but given that it will impose much higher cost than alternatives on households, it can have a very significant negative impact on the economy. Perhaps, Davy think that households are simply there to be skinned and that our economy does not depend on them.

Then again, Davy folks thought CFDs and leveraged property deals were gods-sent manna.

Now, let us get to the more rational side of economic impact debate:

1. Under my proposal above, banks get deeper repairs, so they will be healthier and their reputational capital will not be based on a handout rescue, but on actually having equity capital injection. This is a net positive that Nama does not deliver;
2. Under my costings above, the Exchequer and/or households end up being investors with a strong prospect of higher net recovery value over shorter term horizon than in the case of Nama. This is a net positive that Nama does not deliver;
3. Under the above exercise, the banks will not be able to unilaterally take liquidity arising from the injection overseas, so whatever liquidity is generated, will have to stick to our shores, and thus to our economy. They still can use this liquidity to pay down their expensive inter-bank loans, but at least they won't be able to run investment schemes with taxpayers' money abroad. Shareholders might look badly on this one, since the shareholders will be not foreign institutional investors, but domestic taxpayers. This is a net positive that Nama does not deliver;
4. Under the above exercise, we won't have to pay Nama staff and consultants any costs - banks will continue dealing with their bad loans. This is a net saving that Nama does not deliver;
5. Under the above Irish taxpayers won't have to face a massive tax bill of 54bn, but a smaller (though still massive) bill of 30bn. This is a net saving that Nama does not deliver;
6. Under the above proposal Irish banks will be able to access the same ECB window on the same terms as any other bank in the Eurozone. The will also be able to do the same with Nama, so there is no additional cost when it comes to borrowing.
7. Under the proposal above Irish Government debt will be €23bn lower (and adding the second round recapitalisation demand under Nama - €29bn lower) than in the case of Nama, providing potential easing to our cost of borrowing. This is a net benefit that Nama won't deliver.
   

I can go on with these arguments. But I am afraid it will be a bit too much rant for our Davy folks.