Economics 05/06/2009: PMI, Live Register & Why Brian Cowen is simply wrong on economy

So things are getting better, say Comrade ‘Surreal Economist’ Cowen. Translated into human language (any human language short of North Korean) this really means that we have a terrible crisis that is getting worse at a decreasing (for now) rate. What do I mean?

Exchequer returns were bad, but they were not worse than in April. Hmmm – it only took thousands of families drowned in fresh taxes to get us this far. And add to it a ‘slowdown’ in the rate of growth in expenditure. Mr Cowen calls this ‘the right policy that is supported by the majority of economists and the ESRI’. About the only part of this assessment that I would agree with is the one which separates ESRI from economists – being a nearly purely state-paid ‘group-think tank’, ESRI is not about economics, it is about kissing the… you know what.

Back to the ‘greening’ shoots of this week… Irish PMI figures came in with a slowdown in the rate of decline… same as with the Exchequer results… again – things are not getting better, they are getting worse, but worse at a slower pace. Now, services sectors in Ireland, per PMI, shrank for the consecutive 16^th month in May, as NCB’s PMI rose from 32.2 in April to 39.5 in May. If this is a glimmer of hope, it is a smile from the bottom of the ocean. Future expectations are up to 50.8 in May, which is good news, when compared to the reading of 46.6 in April, but what this means exactly, given that we are heading into summer doldrums is highly unclear. One brighter star at the bottom of the barrel was Technology, Media & Telecos (TMT) – most upbeat of all sectors. Apparently, contraction is over in the sector, per May data. I am sceptical here, since this sector just got a boost from political advertising spend, and it has contracted at an extremely fast pace in December 2008-February 2009. Furthermore, most of the spend for the TMT sector for 2009 has already been allocated, so the contraction might have overshot the target before, with a slight bounce to the low flat trend expected about now.

Manufacturing PMI came virtually with the same results as services PMI, delivering a rise to 39.4 in May from 36.1. In other words – still no expansion, or 16 straight months of contraction. Export component of PMI rose, but remains below expansion reading. “With the domestic economy so weak, look for the new export orders component of the PMI to breach the 50 mark before the headline PMI will follow suit”, NCB’s Brian Devine told The Guardian. I agree. So where does this leaves Mr Cowen’s ‘right’ policies? Oh, not far from the proverbial ‘hole’. If Mr Cowen’s policies were right, we should not be expecting our economy to be rescued by exports or in other words, if our policies were to work, they would have positive effect on domestic economy. Instead, Mr Cowen is now positioning himself to claim completely undue credit for any upturn in the global economy… after having spent last 10 months blaming the world for Irish economic troubles.

Going forward, my expectation is for a flat trend for both PMI reports with some volatility in months to come. Autumn 2009 can potentially yield another round of relatively shallow (compared to 2008) contractions, especially in services.

The real issue from now on will be what can we do with an army of unemployed, bankrupt families that is amassing in the country and how can we get out of the hole that Mr Cowen and his predecessor have forced us into.

Today’s Live Register data does not provide much of hope that the task will be easy. In May there was another 13,500 increase in numbers claiming benefits in May. It might have been the lowest monthly rise since September 2008, but we now have 402,100 on the Live Reg and we are still on track for reaching 500,000 before we can toast the New Year.

Dynamics are tough to gauge. May’s monthly rate of increase was 3.5%, down for the fourth consecutive month and the slowest pace of growth since May 2008. But there is no indication that we are not going to see another bout of accelerating growth in unemployment comes June and then September-October. One reason to note – males are still dominating the firing line (65% of all new additions to the LR in May), so at some point in time, there will be new entry by women. How do I know? Simple – since December, layoffs have been moving off the construction sector into other, more ‘gender balanced’ sectors. I many cases, employers there offered voluntary redundancies with rather generous pay-offs. Women were the most likely to take such for a number of reasons:

· Women are more willing to switch into part-time employment;

· Women are more likely to go into continued education than men;

· Women are more likely to undertake family work than men etc

So this means that there a many ‘hidden’ layoffs working their way through redundancy packages that will surface once money becomes extremely tight.

Just in case you still believe in Mr Cowen’s economic assessment, give the following fact a thought. It comes courtesy of the Ulster Bank economics team and I agree with them wholly:

“The Live Register estimate of the unemployment rate increased from 11.4% in April to 11.8% in May, a rate last seen in May 1996. Our unemployment rate forecast of 14% by the end of this year therefore continues to look realistic. While today’s figures were certainly a welcome improvement on preceding months, the numbers signing on will continue to rise in coming months, as job losses in the services sector, most notably in wholesale and retail and hotels and restaurants, in addition to layoffs in construction, are ongoing. We therefore continue to forecast that the unemployment rate will peak at 16% by the end of 2010, before falling back gradually when the economy starts to recover.”

So Brian’s policies are working, then… too bad he can’t even tell us which policies he has in mind…

Economics 04/06/2009: Exchequer returns for May

First order of business today is to say "Happy Birthday, Jen" to my (much) better half - "I miss you here in Moscow!"

Second order of business is the Exchequer release from yesterday. As my access to data and software is somewhat more restricted here, it is a short analysis:

January-May 2009 tax receipts are in and they are down €3.6bn y-o-y – 21%, slightly better than –24% decline in January-April. Uncork that vintage Dom, Brian? Not yet…

Budget expectations are for 15.6% decline in the entire 2009. Not likely at the current rate. So far we have: 5 months receipts accounting for 39% of the total of projected annual intake of €34.4bn. Annual projection from here suggests that we are going to see around €32-33bn assuming all goes as planned.

Good news, in 2007 we also had 39% collected by the end of May. Bad news is – we had a very robust flow of business for SMEs and self-employed – all of whom force tax payments into the end of the year. Now, recall that we are going to see two things around October-November: (1) tax returns reconciled for 2008, (2) tax returns estimates for 2009. On (1) we can assume that estimates made, say in October 2008 did not fully take in the carnage of November-December, so estimated payments back in October 2008 will be erring on higher side, implying that the actual returns filed in autumn 2009 might be much weaker. On (2), given the current tax measures in place, businesses and self-employed will do everything possible to reduce and delay payments, so estimates will be erring on a lower side and tax deductions will be used to the max. I am not sure that a combination of (1) and (2) will not provide for relatively poor showing in autumn returns.

Current moderating is most likely reflective of the fact that the first half of 2008 was relatively buoyant, so the corresponding period in 2009 is going to register steeper declines. This will moderate into the second half of 2009, naturally, but it will mean preciously little, because any decline on the debacle that we witnessed in H2 2009 is going to be a disaster reinforced.

Another issue to keep in mind: current figures include two rounds of tax increases – Budget 2009 and, partially, Supplementary Budget 2009 – some €230mln added in 5 months. So one can expect further push on tax receipts side. The fact that it is not very impressive is telling me that tax measures are not working and tax substitution and minimization are now working their way through the economy.

To see how bad the new tax measures are at raising revenue – consider the fact that tax receipts in April were 1.7% below the tax profile published on April 28. In other words, within days, the receipts have already slowed down 1.7% relative to what DofF expected. May figures were 1.9% ahead of the profile: Corpo Taxes came in €155mln ahead of profile, Excise and Income taxes were ahead by €48mln and €39mln, respectively. VAT was down €139 million on profile in the month. So, ok – we are now bang on the target when it comes to profile.
Note: the source for the above table is Ulster Bank, with minor adjsutments by me.

But Income tax receipts were driven by new taxes, as are Excise duties, and the two will see some new pressure per optimising households and businesses. Corpo tax can surprise on the upside, assuming the US MNCs continue to book profits here – that is the big unknown in my view. CGT is also a candidate for downgrades as investors are shifting out of Ireland, booking losses here. In general, apart from income tax, other revenues were down 27% in May – a moderation of sorts on 32% decline in April, but the flattening out of the tax decreases curve is not anything to cheer about – it is simply the nature of any asymptotic dynamics: the closer you get to absolute zero, the slower the pace.

So back to income tax measures: €48mln monthly gains in May suggest that the income tax measures to date are yielding: 48mln*5/0.39=615mln in revenue, assuming that income tax follows the same path over the year as total tax receipts. A far cry from €1.5-2bn envisioned and very much close to what myself and other observers were expecting back in April.

In the mean time, spending races ahead: current expenditure was up 4.3% (in April it was up 4.5% but the latest ‘moderation’ is still placing current spending at an insolvency levels and the decrease was due to factors other than demand for social welfare and public sector wages). Capital spend continues to fall - down 6.3% year-on-year. Some suggested that there are timing issues delaying capital spending boost, but we are now 5 months into the year and this leaves me wondering – what sort of timing are we talking about?

On the net, therefore, May figures are no real improvement: receipts are flattening at a very slow rate, we might be closer to target here than before, but this only means a difference of €1-2bn on revenue side – a chop-change for our public sector wasters. On expenditure side, we are now 10 months past the July 2008 promises by the Government to introduce real savings, and… zilch, nada, none, nyet, can’t find any no matter how hard I am looking… If a rapidly decaying alcoholic were to be the allegory for the Exchequer balance sheet, we are past the gulp stage and into a burp moment. The hand with a bottle is rising once again, drawing closer and closer to the mouth. How long can this last? Your guess is as good as mine, but a friend today suggested that 6 weeks from now the Government will say, “Whoops, due to international economic conditions (WHICH HAVE NOTHING TO DO WITH THE LAST 12 YEARS OF FIANNA FAIL RULE) our readiness for rebound which was most certainly there when we said so has now disappeared. Not our fault, mate.”

Sounds about right…

Economics 2/06/2009: Innovation debate

My article in the Sunday Times last weekend has triggered some responses. The article is reproduced below.

Here is a link to at least one good reply, from DCU's President, Ferdinand von Prondzynski. In spirit of debate, I decided to address couple of points he raises in the post:

Ferdinand is right that I am arguing 'against' the current approach of promoting, disproportionately, the idea of lab-based innovation. But I think he is wrong in downplaying what I suggest as the way forward.

I am talking about the need to focus more on where the actual returns to innovation are. From business point of view, these returns are in 'soft' innovation - process innovation, managerial improvements, logistics, communications, etc. These have been neglected in academia and SFI has virtually no presence in these areas. Interstingly, Ferdinand actually appears to present these areas as being somewhat below the 'real' innovation, 'understood as investment in high value science and technology'.

I mention a Wal-Mart effect and the value-added accruing to marketing and sales as being more important than producing new patents and scientific papers. I am yet to see an argument that the former yields lower returns to the society and economy than the latter.

Ireland is a small player and holds little promise to deliver hard innovation on global scale. But it does offer a strong potential for delivering high value-added sales, international links etc. It cannot be a unique supplier of a significant number of competitively innovative products on a global scale, but it can be a platform for domiciling innovation of others. For that we have location, links to the EU and the US, and we have talent.

Yet, how many professors of biotech or computer sciences do we have? Dozens. How many professors of finance do we have? A handful. Our system of research and teaching assumes that there is no need for raising investment in innovation or in higher value-added activities because we became fully reliant on the State to provide such financing. We have virtually no indigenous R&D investment, with most of private sector R&D expenditure delivered by the MNCs.

Ferdinand might want to ask the following questions:

1. Can we build a thriving economy without any domestic biotech graduates? To me the answer is yes. Can we train a single biotech graduate without a system of funcitioning finance? To me the answer is no.
2. If you have limited resources to invest in two activities: activity A (lab coats) yielding X% return per annum, activity B (finance) yielding 2X% pa, with everything else being equal, which one would you choose? To me the answer is B. But hold on, B also offers better jobs security for people than A, more diversified markets on which the service can be sold, it is an activity that has remained with us for centuries, so it does not become obsolete. And it can be built in 5-10 years, unlike lab coats that might become outdated by the time we actually have them exiting out Universities.
   

So we have a chain of national economic development that should be going from: build a base for finance and business services first, then indulge in a luxury of producing lab coats. Not the other way around.

I am, of course, exaggerating somewhat, for lab coats are also important. SFI and our Government have made a choice - lab coats and nothing more. I am merely suggesting that we need more!

Are we a country that hosts MNCs and provides them with support labour, or are we a platform from which MNCs actually add value? If we are the former, we need to produce more hard science PhDs. If we are the latter, we need more specialists in marketing, sales, finance, etc. Value-added by the former - not much, once you adjust for the risk of failure and the scale of our R&D sector. Value-added by the latter - well, look at Switzerland, for example, or Luxemburg, or Austria. Hard R&D-intensive IT and Pharma sectors there account for at most 10% of GNP, finance and B2B services account for 30-50%.

Can we be like Switzerland? Yes, if we focus instead on business services, e.g financial services, and import talent for labs-based employment, we will still be able to produce innovative goods and services, but we are no longer running the risk of ending up with the indigenous specialists who are at risk of becoming redundant the minute technology trends shift. Ferdinand might point to the fact that Switzerland trains many hard science PhDs, but hey - they started doing so after centuries of investing in finance and business services.

Finally, there is another argument in favour of abandoning our senile concentration of 'innovation' on ICT and bio: it is a basic 'diversification of your investment' argument... lab-coats simply do not get this.



Sunday Times, May 31, 2009 (un-edited version)

Back in December 2008, Irish Government unveiled its response both to the current crisis and the longer-term growth challenges. The plan, bearing a lofty title Building Ireland's Smart Economy was an amalgamation of tired clichés. But it contained an even less palatable revelation: our Government has not a faintest idea as to where economic growth comes from. This plan – never implemented – would be the old news, if not for the insistence by our leaders that it remains the cornerstone of economic policy.

Economic growth happens when entrepreneurs and investors find new means to extract more value out of existent resources. This is not the same as our Government’s concept of the smart economy.

Instead, Government ideas are closer to Mao Tse Tung’s Great Leap Forward than to the intensive growth models. Mao believed, literally, that shoving more production inputs into economy was growth. Brian Cowen and his Cabinet believe that getting more PhDs and public capital into sciences-dominated sectors generates growth. Net result will be a waste of economic resources for several reasons.

Sustainable growth requires very little in terms of armies of science bureaucrats, people in lab coats and science campuses, and much more of the incentives for business competitiveness and productivity. Over the last 20 years, worldwide improvements in logistics and retailing (known collectively as the Wal-Mart Effect) have yielded several times greater contribution to economic growth than the so-called innovative sectors like bio-tech, nanoscience, clean energy technologies and other lab-based activities combined.

Ireland has missed the Wal-Mart Effect because of the Government’s economic illiteracy that wastes billions protecting inefficient domestic services from competition. Ditto for other crucially important business infrastructure: legal, accountancy, medical, media, energy, utilities and so on. We are languishing at the bottom of the world league in communications services (ranked 23^rd in 2008-2009 Global Information Technology Report) just as the Government policy papers and programmes promising to make Ireland the innovation wonderland by 2013 abound.

Studies in pharmaceutical economics show that the risk-adjusted returns to scientific R&D leading to the development of a blockbuster drug are only half as large as returns to marketing, sales and distribution. When value at risk assessment of pharmaceutical investment accounts for large research pipelines economic returns to companies like Elan (a tiny minnows in the world of global pharma) can be negative.

Our focus on science-based R&D is hopelessly out of synch with international trends. Five years ago, biotech, customiseable software, nanotechnologies, alternative fuels, energy storage and the rest of the fancy scientific stuff were the domain of smaller companies. Today, the big boys of global business – the likes of Pfizer and IBM – are firmly in the field and next to them indigenous Irish enterprises have little chance of succeeding in either attracting capital, or hiring the requisite talent, or capturing markets for their products.

Our real (as opposed to lofty policy-based) metrics reflect this. Last month Science Foundation Ireland claimed that it expects 30 local R&D-based start-ups and 40 revenue generating technology licenses to emerge over the next 5 years. This implies that billions spent on the ‘knowledge’ economy will be adding some 60-100 new jobs or less than half a license per Irish academic institution per annum. In almost 7 years of its existence, SFI supported creation on only 250 patents (1.7 per academic institution annually). Virtually none have any commercial value to date.

All along, our state policies have ignored more productive avenues for growth: international finance, business services and market access platforms. While successful in delivering serious presence of Dublin for international back-office and domiciling operations, to-date we have failed to foster the emergence of Irish front-office activities. Yet, if back-office accounts for roughly 5-10% of the total value added in financial services, front-office (you’ve guessed it: sales, marketing, research and management) account for the rest.

Although employee value-added in Irish internationally traded financial services is some 70% greater than in the IT sector, no innovation policy recognises this. International financial services can be even more R&D and knowledge-intensive than the lab-coat sectors. Strangely, you can get tax breaks for developing new financial software – with a risk-adjusted return of ca10% per annum, but you will be paying exorbitant transactions and income taxes on research- and knowledge-reliant financial management activities.

There are even more bizarre twists in Irish policy. Irish Governments – from time immemorial – have preferred simplistic numerical targets to quality analysis and cost-benefit assessment. Thus, we now have a patently absurd goal of doubling the numbers of PhDs in Ireland by 2013 without any regard to the quality of these researchers. We have no stated goals as to the international rankings we would like to achieve for our numerous third level institutions generously financed by taxpayers. Only four out of our 7 universities and 14 ITs (TCD, UCD, UCC and UCG) have serious chances to either retain their position in the top 200 rankings or reach such position in the foreseeable future. Not a single Government department or public body is expressing any concern about this lack of competitiveness.

[Note: I do recognize (hat tip to Ferdinand von Prondzynski) that by latest rankings, DCU is actually ahead of UCG, so the list should have read TCD, UCD, UCC/UCG and DCU, per my belief that UCG can be competitive if and only if it merges with UCC]

Even more disconcerting is the total lack of foresight as to the employment prospects for our new PhDs. In the US some 50-55% of PhDs are employed by taxpayers. In Europe, the number is even larger – around 70%. In Finland – long regarded to be inspiration for Ireland’s knowledge economy – only 15% of PhDs are employed in the private sector. Majority of Irish PhDs go on to take up post-doctoral grants financed by the Government. They are, in effect, employees of the state with no academic positions and little hope of gaining one in the future. How many will find employment commensurable with their stated qualification once their grants run out in 2-3 years time?

Irish policy structures are simply unsuited to the emergence of entrepreneurial and productivity-enhancing culture necessary to sustain real long-term investment in knowledge-intensive enterprises. Most of our civil service is based on anti-entrepreneurial centrally planned system. Majority of our public service employees lack requisite knowledge of the private sector and the comparable aptitude to understand the present economy, let alone to accurately foresee its future needs. This is reflected in education and research policies, economic analysis documentation and in the structure of taxation.

Instead of providing incentives for business-related innovation, our taxation system penalizes investments in human capital with punitive rates of taxation. Returns to investment in property or physical capital in Ireland imply marginal tax rates of 0-25%. The same investment undertaken in education faces a marginal tax rate in excess of 50%. Chart above shows the relative taxation burdens associated with human capital and property between 1998 and today. As Ireland embarked on the path of building ‘knowledge economy’, tax on human capital as a share of overall tax revenue rose from roughly 63% in 2006 to 80% this year.

High income and consumption taxes are directly linked to the fact that three quarters of the EU nationals who obtain higher degrees in the US never return back. Are we setting ourselves up for the future brain drain from Ireland as well?

In years ahead Ireland stands a chance of either becoming a booming 21^st century economy or a laggard to the increasingly geriatric Eurozone. This choice will be based on our ability to deliver real entrepreneurship and skills infrastructure. More than a breeding programme for PhDs, this will require reforming taxation system to incentivise commercially viable knowledge, risk-taking and skills acquisition. It will also require support of a top-to-bottom reshaping and scaling down of our public sector and focusing the state priorities on delivering real improvements in simple things like communications and early education.

Economics 29/05/2009: NAMA debate: Part 2

Full text of Oireachtas debate on NAMA is available here. But for some commentary-worthy passages, consider the following:

Deputy Brian Lenihan: …The bad bank solution means that the person with the impaired asset takes a very substantial loss, and a substantial loss is also taken by the bank. Looking at it in terms of this particular approach, the first 35% is the equity value of the developer or the owner of the land, and if he or she is not in a position to pay off the loan, then clearly that is wiped out in this exercise. The key question in valuation is not about the wipeout of the initial landowner’s equity, but about how much of the banks’ equity should in turn be wiped out as well, as we are insisting on the banks taking a loss. Therefore, the taxpayer is third in the queue rather than first. There is a risk and the reason we are focusing so much on valuation is to ensure that this risk is minimised as much as possible. In a frozen or illiquid market, it is not possible to place an exact valuation on the loans, but a long-term commercial valuation can be made. That is what we will have to do... It is a long-term economic valuation…

I am not sure I understand the Minister. Take a loan of Euro65 on a bank balance sheet. Suppose the value of the asset underlying the loan at the time of the loan issuance was Euro100, so 35% of the project was the equity accruing to the developer at the time. Assume that the value of the project has fallen 40% since then, so the market value of the project itself is no Euro60. NAMA buys the loan at, say 20% discount on the face value of the loan – it now has Euro52 loan on hands against the project currently valued at Euro60. What will the balance sheet of NAMA look like?

If NAMA can sell the underlying asset today for Euro60, it makes profit of Euro8, but presumably the bank could have done the same without NAMA. But suppose it does go for NAMA. The bank used to have a loan of Euro65 against an asset with Euro60 value, it got back Euro52 from the Government and has new capital demand of ca Euro6. The bank takes the hit and the developer takes a hit. This is a non-flyer for NAMA politically, but in this case NAMA would make a profit of Euro2 on the entire transaction.

If NAMA cannot sell the project, it has to finance the purchase of the loan at say 5.5% pa on a termed bond issue of, say 5-years and face value of Euro52, so total cost of financing is Euro15.96. It has to plug bank’s capital hole – same Euro6, and it has to incur operating cost for the loan – say 0.5% of the loan value pa for 5 years at Euro1.36. Against this, NAMA will receive income stream on average of ca 3-4% pa, or Euro14.37. Assuming the value of the underlying asset remains the same, we have a net loss to NAMA of Euro0.95.

So applying all pain to developer (example of quick fire sale) will yield profit, going NAMA route and soaking the ‘third in line’ taxpayer as Minister Lenihan puts it will make a loss…

However, regardless of how the numbers come out, Minister Lenihan is confusing two things. The developer has already taken a hit, and guess what – I don’t care if he did. Tough luck, mates. But the banks are yet to take a hit. And in part, they have delayed taking a hit because of NAMA promise of rescue. This does not look like NAMA puts taxpayer third in the firing line. It looks more like the taxpayer is next, right after the developers. Except, personal bankruptcy laws protect the developers, but not the taxpayers. Which means that in real world, taxpayer is the first in the firing line and indeed he is the only one in the entire firing line.

Mr. Brendan McDonagh: …about rolled-up interest. I was a member of the due diligence team that worked on Allied Irish Bank and Bank of Ireland. I have also had access to information in terms of reports compiled by the Financial Regulator in regard to the other institutions. What I have seen in the banks’ loan books is that the land and development book generally included a feature that for two years loans had rolled-up interest. Therefore, a loan of €10 million on which the interest was 10% per annum, effectively became a €12 million loan at the end of the two-year period. If at that stage the asset had metamorphosed from land with rezoning to land with planning permission - once a certain element of risk was gone from the loan - it was refinanced or sold on.

So let us revisit the figures provided above… if NAMA cannot sell the project, it has to finance the purchase of the loan at say 5.5% pa on a termed bond issue of, say 5-years and face value of Euro42, so total cost of financing is Euro15.96. It has to plug bank’s capital hole – Euro8, and it has to incur operating cost for the loan – say 0.5% of the loan value pa for 5 years at Euro1.36. It has a capital loss now instead of gain of Euro10. Against this, NAMA will receive income stream on average of ca 3-4% pa, or Euro7.88. Assuming the value of the underlying asset remains the same, we have a net loss to NAMA of Euro27.44. Ouch…

But this, incidentally, does not cover the cost of outsourced functions – and NAMA plans to have loads of outsourcing if it will run a fund requiring 400 staff with 30-40 employees…

Mr. Brendan McDonagh: Bespoke means something has particular features. Usually a loan document with standard terms and conditions is drawn up by an institution when, to give a simple example, it extends a mortgage... It is not a question of quality. It means that if one wants to value these loans which we will be required to do, the terms and conditions of each loan will have to be examined to ensure account is taken of any particular feature... It will not [take years to work these loans out]...

I am puzzled – it will not take years to price individual bespoke loans even with a staff of 30-40 or is Mr McDonagh implying here that the existent banks staff will do pricing?

Senator Feargal Quinn: It is not easy to keep quiet for two and a half hours without asking questions. I was surprised that Mr. McDonagh spoke about a timeframe of ten to 15 years because I had investigated what had happened in the United States in the establishment of the Resolution Trust Corporation in 1989. This corporation only lasted six years but the figures were considerably different. It took in $465 billion and the cost to the taxpayer when the assets were sold was $90 billion. The equivalent cost for us would be €20 billion. Mr. McDonagh spoke about a staff complement of 30 to 40. The aforementioned operation in the United States involved 9,000 people. This scares me because it seems we are not very good at sticking to budgets and timeframes in Ireland.

Note that Senator Quinn’s estimate of NAMA net loss of Euro20bn based on the US RTC experience is exactly the same as my and Brian Lucey’s estimate in last week’s Sunday Times. We arrived at this figure without a reference to RTC, so the fact that the two estimates coincide does suggest that the figure is about right…

Deputy Burton spoke about transparency. Freedom of information provisions will not apply to NAMA, although they were applied in similar contexts in Sweden and Finland. It would be of considerable help if citizens and taxpayers had access to information.

Spot on!

Deputy Brian Lenihan: …one of the most difficult tasks relating to NAMA will be drawing the line as to where the agency must or where it should not enforce. A spectrum of borrowers will be hopelessly insolvent; receivers and liquidators should be installed and NAMA will become the property management company for them. That is one side of the spectrum. Clearly, on the other side, because the agency will take performing loans, there will be a category of borrowers who will pay their debts, trade and discharge their obligations as they fall due. In the middle, the agency will have the most difficult commercial decisions to make in terms of the potential viability of the middle category of borrowers.

I am again at a loss as to what NAMA can and cannot do, what enforcement actions it can or cannot take and so on… Does the Minister have a clue himself? Is his own staff and that of NAMA have a clue?

Mr. Brendan McDonagh: Unfortunately, part of the problem is that people have given personal guarantees. If the banks are placing values on personal guarantees as partial security, that is a consequence of what NAMA will be about. If NAMA has to pursue personal guarantees it will do so. I am sure all members are aware that a number of major borrowers, because of the multi-bank nature of their loans, have offered personal guarantees to five or six banks. A personal guarantee can cover only one loan. It cannot cover six. When valuing a loan from a particular institution, we will have to take account of the collateral offered to each institution. One cannot look at this matter in the context of an individual bank or in a vacuum. One must take account of the all the circumstances which can be determined.

Indeed, as I mentioned in the earlier post on this debate, this adds an entirely new and at this stage completely unpriceable risk. NAMA will simply spend the next 5 years tied up in courts with other banks and developers dealing with the issue of who gets which guarantees… Good luck to all involved.

Mr. Brendan McDonagh: With regard to the percentage of foreign assets, …based on the analysis of the loan books of the six institutions which was carried out after the guarantee scheme by PWC for the Financial Regulator, the value of foreign assets of the banks’ portfolios was somewhere in the region of about 35% and most of that would be UK assets... That 35% was of the total loan portfolios of the banks, of the six institutions. I do not have the figures analysed yet as I only received the questionnaires last night.

In other words, we are talking about roughly 35% of the Euro386bn in assets of just BofI and AIB, or Euro135.1bn…

Economics 29/05/2009: NAMA debate: Part 1

Note: for some reason my Moscow PC does not register any of your comments. If you do post a comment to this site in the next couple of weeks, can you kindly email a copy of it to me as well...


Full text of the Dail debate on NAMA is available here. But for some commentary-worthy passages, consider the following:

Brian Lenihan: [NAMA] will purchase the assets through the issue to the banks of Government bonds which will result in a very significant increase in gross national debt to be offset by the assets taken in. The cost of servicing this debt will be offset, as far as is practicable, from income accruing from the assets of the new agency. The debt will be repaid from funds raised through the realisation of these assets over time.

Thus we have it confirmed - NAMA will rely on ordinary Government bonds, not NAMA-own bonds. Brendan McDonagh confirms as much in his statement as well.

The potential maximum book value of loans that will be transferred to the agency is estimated to be in the region of €80 billion to €90 billion, although the amount paid by the agency will be significantly less than this, to reflect the loss in value of the properties. Initial work on the valuation methodology to be applied is under way and will be elaborated on by the interim managing director.

Hold on, folks, Mr Somers knows nothing of this rather important work, we heard nothing about either the models they plan to deploy or the market valuations they will rely upon, or both, so how can the valuation methodology work be ongoing, unless NAMA is being set up to operate in the climate of complete absence of transparency? And what does 'as far as practicable' mean in the context of off-setting the cost of bonds financing? 'Practicable' from whose perspective - the banks / developers or taxpayers, or NAMA itself?

It is important to note that the State will not assume all of the risk in the acquisition of these assets. The assets will be valued on a basis which is sustainable for the taxpayer. This will entail an assumption of losses by the financial institution whose assets are removed. In the longer term, if the agency were to fall short of recouping all of the costs, the Government intends that a levy should be applied to recoup any shortfall. All borrowers will be required to meet their full legal obligations for repayment. There will be a hardening of the approach to these borrowers as taxpayers’ money is at stake and the agency will be expected to protect it in a commercial way and with an independent remit.

So here we have it - assets will be valued on a 'sustainable basis' from the taxpayers' point of view. Does this mean market-value discounts on loans value? If yes, what recapitalization provisions the state is making and if no, how will the taxpayers value be protected? 'There will be a hardening of the approach to these borrowers' - how, if NAMA were to avoid foreclosures and forcing developers into bankruptcy? Furthermore, if NAMA were to operate in a 'commercial' way, will it be pursuing some sort of risk-adjusted return strategy in pricing the loans, enforcing loan conditions and selling the underlying properties? Once again, how can this be assured if NAMA were to avoid foreclosures, fire-sales of assets and pursuing individual developers for collateral? How will NAMA avoid writing down the underlying assets by at least 30-40% to reflect their fair value?

The establishment of NAMA will, no doubt, give rise to complex practical difficulties and it is important that we undertake the detailed preparatory work necessary before finalising the legislative and operational framework. The preparatory process is being overseen at this initial stage by a steering group made up of representatives of the Department of Finance, the Attorney General and the agency. Mr. McDonagh has been appointed as interim managing director to drive the implementation process forward. He will be assisted by an advisory committee to be appointed shortly which will provide him with a range of expert advice.

So they managed to do all this work already without actually publishing a simple version of a cost-benefit analysis of NAMA. An amazing level of ineptitude in basic management!

Mr. Brendan McDonagh: NAMA will, therefore, acquire both performing and non-performing loans. In return, the institutions will receive Government bonds issued by the NTMA and they may use these bonds as collateral to avail of ECB funding. It is envisaged that the interest payable on the Government bonds will be offset by interest flows and performing loans acquired by NAMA.

This is an interesting statement as far as the 'performing' loans go. Does Mr McDonagh term 'performing' include loans that pay interest only? partial interest only? or rescheduled interest only? This is important, for all such loans will be written against assets that cannot be realised at their loan value and thus, while yielding some interest flows, are distressed assets from the point of view of developers. How will NAMA convert these loans to fully performing (interest plus principal repayment) loans?

And of course, there is an admission that the entire scheme relies on ECB lending window, implying in effect that the issued bonds will have no value to anyone in the market except for the banks and the ECB, and the cost to us, the taxpayers.

We are realistic enough to recognise that there are institutions which will be outside of NAMA but which may also have provided loans for many of the larger borrowers within the NAMA framework. We envisage that NAMA and these institutions will have to work together in many instances to protect our common interests but this will be done at all times in a commercial way to protect the interests of Irish citizens.

This is unclear and undefined. Will NAMA have powers to compel these institutions to interact with its portfolio management of the loans? How? If not, how will the seniority of multi-banked portfolios be managed, given NAMA size and market power? And does Mr McDonagh see any conflict or contradiction in saying that the banks outside NAMA, NAMA, banks inside NAMA, and the developers will be working to 'protect common interests', yet the taxpayers' interest will also be protected? In addition, I wonder if Mr McDonagh actually has in mind the interests of all taxpayers or just the interest of Irish citizens, or whether he actually has a clue as to the difference between the two?

I advise the committee that it is not possible at this stage to determine what that discount will be as it is dependent on such a wide range of factors and also the fact that each loan will have to assessed and valued individually. This is because our current knowledge of the loan books suggests the majority of individual loans are bespoke and have different legal documentation.

Mr McDonagh is clearly a foreigner to finance. Bespoke or not, loans priced individually invite political interference (or perception of such), as well as opens up every set of terms agreed with one developer to a challenge by another. It is non-transparent pricing system and, yet, it underpins the loan value fundamentals. How will NAMA be able to avoid the same problem of valuing the individual loans that the banks have today? Further problem arises due to the absence of market pricing data. Given that there is only a thin volume of sales in the property markets, pricing loans collectively will be onerous enough to yield large deviations from the true expected values of the loans. Pricing them individually will be even less accurate.

In our Sunday Times article with Brian Lucey last week we argued that NAMA is equivalent of a blindfolded person buying an unknown object for an unknown price, while being unsure if he needs this object in the first place. How will Mr McDonagh - a highly paid public servant - ensure that his organization actually acts in the interest of the taxpayer if he cannot even tell us the pricing basics for his organization purchases?

Personally, I do not trust Mr McDonagh, his steering group and the entire state apparatus behind them to deliver value for money on their valuations of these assets. Nothing personal, I just need hard evidence that they are doing their jobs right. The idea that they will be using 'economic' value of property projects to value the loans implies that

• the uncertainty (risks) relating to the property values
• will be compounded by the uncertainty (risks) relating to economic forecasts
• which will be further exacerbated by the uncertainty (risks) of NAMA capabilities to manage investment portfolios
• which itself be subject to added risk to NAMA cash flows, and so on...

Do tell me that Mr McDonagh is qualified and experienced enough to run this risk pricing model... Would he even get a job of co-managing a Euro10mln property fund in London were he to try? I don't know.

Want the really scarry stuff?

NAMA’s potential powers including, potentially, compulsory purchase orders and powers in relation to borrowing and the investment of equity and working capital in joint ventures. NAMA will have three options in relation to the assets it acquires: it can dispose of them at an early stage; it can hold them with a view to disposing of them when market conditions have improved; or it can develop them to enhance the return. To do so, it is envisaged that NAMA will have the option of entering into joint ventures, partnerships or form special purpose vehicles with other interested parties to enhance the value of some of the acquired assets. The overall objective and foremost in the mind of NAMA will be what will achieve the optimal return and will be in the best interests of the taxpayer.

So NAMA will have a power to act as a co-developer in failing projects?! Dreamy stuff. But:

1. How will NAMA raise financing for this venturing? By taxing you and me more? or by issuing more bonds? If so, NAMA is an open-ended ticket for the Government/NAMA to clean our pockets and transfer subsidies to the developers;
2. How will NAMA manage such lending - is it now becoming a fully functional investment bank, well ahead of its original remit? If so, we are in deep trouble, for one has to imagine Mr McDonagh as the CEO of the soft-constrained state-run and state-owned non-transparent, non-compliant and totally secret bank;
3. How will Mr McDonagh and his successors account for their 'success'? Will he lose his job if NAMA finances a wrong project and generates a loss?
   
4. What will happen when a NAMA-co-financed project fails and NAMA goes after its partner in the development? What will happen when NAMA tries to recoup losses on such co-financed project failures from the banks at the end of NAMA lifespan?
5. What will happen when a developer turned down by NAMA for co-financing goes to court and argues that his project is no worse than the one that NAMA co-financed?
   

Now, NAMA might not have done cost-benefit analysis yet, but, per Mr McDonagh, the institution that will protect taxpayers value has already met ...with senior members of the Irish Congress of Trade Unions who represent bank staff. Ah, the bearded men of ICTU are briefed, so nothing to worry about, folks.

Brian Lenihan: In respect of such an agency [NAMA], one must understand it is not about the taxpayer assuming the risk, but about ensuring the banks and developers absorb the pain. The taxpayer only enters the equation after this as the sovereign intervener to protect the entire banking system.

Once again, there is a contradiction here between NAMA deriving commercial value, NAMA not forcing developers into bankruptcy and the banks and developers absorbing pain. Furthermore, does this statement imply that Mr Lenihan actually believes that the taxpayers will not bear any pain in the process of NAMA? Does he really believe that NAMA will be self-financing and that he and Mr McDonagh will only borrow from us, the taxpayers some spare cash to get NAMA rolling, repaying us in positive real rates of return? Is this a sign of our Minister for Finance not getting the basics of NAMA right or is it a sign of him being in denial?

And what about the economic model for pricing risks and assets that NAMA will employ? Well, why not pick the most absurd one of the lot: the ESRI's politically palatable drivel predicting 6% medium-term growth for Ireland Inc: Lenihan clearly is impressed...

Still feeling well-protected by NAMA? I don't. Imagine paying a price that assumes that during the lifetime of NAMA, Irish economy will expand at 5-6% pa and then learning the hard way that the actual growth turns out to be 3% pa or even less. How much do you think we, as taxpayers, will overpay for the ESRI's errors?

The reason the full advice [by Bacon] was not published was it contained a great range of sensitive information which would affect the market valuations of financial institutions on the Stock Exchange. Dr. Bacon had access at the NTMA to a wealth of information on the work completed on assessing the exposures in the banking system from an accountancy, evaluation and auctioneering point of view. All of this information was at his disposal in drawing up the report. Placing that information in the public domain would have had an immediate impact on the market prices of individual financial institutions.

Hold on... I thought the entire point of the plcs is that any information pertinent to their pricing must be disclosed to the public. Is Minister Lenihan now finds himself in a position of concealing from the market market-sensitive information? Should you or I do the same, we would not be able to deal in the related companies shares. But Minister Lenihan and NAMA will be dealing in these shares. Who is supposed to uphold the securities law in these cases?

But dancing on the legal borderline is what NAMA and Lenihan will be doing often from now on. Here is a good one, in relation to why banks levy will not be imposed in the NAMA legislation but will have to wait for the Finance Bill:
Mr McDonagh: If there was a clawback within the NAMA legislation affecting the balance sheets of the banks, they would not be able to reduce the assets transferred to NAMA because effectively there would be an unpriced option in terms of what the clawback would be in the future. One cannot do this because it would not be possible to take risk weighted assets off the balance sheets of the banks if the levy was imposed in the NAMA legislation.

Enron's boys would be proud of this one. If NAMA levy is a charge against future losses, as it is, and it is imposed ex post NAMA legislation, would it not be a de facto expropriation of the expected future value of banks earnings? Take your pick then - either you have an option imposed under NAMA putting pressure on banks valuations, or you have a predatory state imposing ad hoc charges on banks post-NAMA... Good choice... markets-assuring.

Deputy Joan Burton's response to McDonagh statement is priceless: That is another critical valuation issue because the Minister has just said he has a guaranteed fail-safe device - a clawback in the event of the assets not realising whatever the taxpayer takes. Mr. McDonagh is actually saying - I accept what he is saying - that in fact that would be almost legally impossible because of the long-term impact on the balance sheets of the banks, assuming they remained quoted companies but the Minister is directly contradicting this. Gotcha!

Mr. McDonagh is saying there will still be a contingent liability which will remain unpriced for a period of at least ten years and that this contingent liability will relate to the €60 billion to €90 billion discounted on values that we do not yet know. How would any financial analyst decide to exclude this for a period of ten years from the liabilities of such a company? Gotcha!

I find it very worrisome that Dr Bacon provides deeply economically flawed rhetoric in arguing the NAMA case:
Dr Bacon: There is a view expressed that this asset management approach has an inherent flaw, namely, that if one takes a big haircut there is a capital deficit which the banks have to deal with and if one does not do that and overpays, the taxpayer, if the members will pardon me saying so, gets screwed and the shareholder gets away. I do not see any trade-off. The reality we face, with which everybody is trying to grapple as a result, as the Minister said, of bad and disastrous lending, is that there are huge losses facing developers and the banking system and there is only person to pick up the bill, namely, the taxpayer. Regardless of what way the cake is cut, the loss does not change. To use other people’s language about the point of the discount, if the discount and gift shareholders are undercut, the taxpayer suffers because the recovery the Deputy spoke about takes place from a higher base. The taxpayer loses in that respect. If one gets it wrong on the other side and discovers that one has to make up more capital in the banks, who will make it up? In the current environment it is a brute fact that the banks cannot go to capital markets and replenish their equity. I have made the point previously that the loss is the loss. By whom will it be borne? It will be borne by banks and developers, to the extent that there is equity to do so in the case of the banks. One must then replace that equity. Who will replace it? The taxpayer will.

This is simply a case of b***t. Here is a clear trade-off, Dr Bacon: if you overpay for the loans at NAMA point, you do not take equity in the banks and end up with losses on NAMA and no new shares in the banks. If you price assets right, you end up holding lower loss-making NAMA and equity in the banks. Get this? It is that simple. It is, as I have repeated on many occasions, not only about NAMA losses, but about shares held in the banks.

The Deputy has also asked how do we know the taxpayer will not be caught at the end of this process... The first protection of the taxpayer with respect to the work-out is that the assets are being taken on at the bottom of the cycle, either at a mark to market price or at a normalised valuation. The second protection being offered to the taxpayer ...is the potential that NAMA, as an institutional entity ...has the possibility of attracting third party equity. That is a fundamental disadvantage if we do not go this way in terms of maximising the work-out. How does one get the capital and finance to work out semi-completed projects which are fundamentally well designed, be they in Ireland, the UK or elsewhere, without the long-term capital which these entities have not had heretofore?

I find this amazing. In effect Mr Bacon argues here that NAMA will be simultaneously a developer and an investment bank. Did anyone in the Dail notice this remit creep?

Deputy Joan Burton provided an excellent set of questions to follow Dr Bacon's unimpressive discourse: The Minister and his Department ... why is he so confident the fair price NAMA will pay will not wipe out the core equity capital of the banks? Has the decision been taken on what price will be paid? Given the Minister’s confidence that the valuation to be arrived at will not wipe out the bank’s core equity, is it the case that the decision has been made in principle? That brings me to another point.
The Minister cited the case of Sweden. An independent valuation board was established there composed of independent economic experts, including individuals from commercial and academic life who were recognised as independent and acting in the public interest. The Minister has proceeded to appoint all the parties in secret.
Contradictions have emerged in what has been said. The Minister suggests there will be a degree of toughness shown to developers, while Mr. McDonagh suggests NAMA will work with developers and Dr. Bacon suggests it will be essential and may make good business sense to get other investors to come in and co-fund development projects with the taxpayer, whether these developments are in Ireland, the UK or elsewhere. Does the Minister agree that substantial State borrowings will be used to meet the requirements of the NAMA proposal? Is he seriously considering having much more of the country’s borrowing capacity reserved for the working out of the NAMA proposals rather than being invested in infrastructure such as schools, public transport and roads? I find that prospect extremely worrying.

Economics 28/05/2009: Two questions, US economy

Some months ago I was telling the readers of this blog and of my column in Business & Finance magazine to keep an eye on US Munis markets. Well, now is the time, especially California Munis... Good hunting...


I have two questions to ask our Brian 'Detouched-from-Reality' Lenihan and his lappy-Lassie Alan 'Tax-em-Brian' Ahearne:

1) If Ireland were to go to the markets with a bond placement of an odd Euro40-50bn, what chances do we have getting such an issue away without direct ECB help?
and
2) If ECB were to contemplate such a support scheme for Ireland, will it be willing to also underwrite our structural deficit - the deficit that is pure lard for Irish public sector pay and perks?

These are not some esoteric issues, they imply real risks to the systemic stability of Irish finances.

Question 1: in a recent IMF paper (here), the widening of CDS spreads for sovereign debt between Eurozone economies was explained by domestic 'vulnerabilities'. More specifically, the paper asserts that: "The sensitivity of countries to their domestic vulnerabilities appears to be conditioned by their loss of competitiveness over the upswing of the previous economic cycle. The countries with the largest decline in competitiveness display a particularly strong link between the prospects of the financial sector and sovereign spreads... The differentiation of countries by their debt levels is also stronger where the loss of competitiveness has been greater. The inference is that as external competitiveness has weakened, domestic vulnerabilities have acquired greater salience."

And further to the point: "another source of domestic vulnerability: public debt. ...think of loss of competitiveness as a proxy for weaker growth prospects, the question being posed is whether countries within particular competitiveness loss categories are differentiated by their debt ratios. The presumption is that with lower growth potential, a higher debt ratio will prove more onerous. This differentiation should, moreover, increase when the global growth prospects are substantially marked down, as after the fall of Lehman Brothers." And not surprisingly, the paper finds that it does matter - lower growth prospect means less sustainable debt at any given level.

So let us get back to Q1 above. What idiot in the market will be ready to take new Irish debt (Nama-related) with some Euro40-50bn in face value on anything even remotely close to the terms of our current bond offerings?

Which gets us to Q2 next. If no takers emerge, will the ECB cover Nama bonds? This is a question I have no answer to, but several divergent arguments can be made:

1. ECB might take Nama bonds directly to rescue Ireland, halting altogether or severely restricting acceptance of further Irish bonds as collateral (so Brian Lenihan will be forced to do something about deficits, having been restricted from using banks borrowings from ECB to float his Government). This is the most likely scenario, but it hinges on stable markets for German bund.
2. If German bund runs into thinner covers, the ECB will only part-finance Nama at the very best, holding its firepower for the potential need to cover some of the German issues. This will also restrict Brian Lenihan's ability to raid the ECB.

Either way, Irish Exchequer will feel some sort of a squeeze on its ability to support further borrowing. Which brings us to the potential response: a new mini-Budget in July. And either way, if you are holding Irish banks shares, give it a thought - do you really believe that ECB is going to print money for Nama on the back of a asset value discounts of 15-20%?


One interesting recent paper worth reading:
The role of the United States in the global economy and its evolution over time, by Stephane Dees and Arthur Saint-Guilhem, ECB WP 1034/March 2009 (see here). Authors assess the role of the US in the global economy and its evolution over time.

The paper shows first that “the transmission of US cyclical developments to the rest of the world tends to fluctuate over time but remains large overall. Second, although the size of the spillovers might have decreased in the most recent periods, the effects of changes in US economic activity seem to have become more persistent. Actually, the increasing economic integration at the world level [including ‘China effect’] is likely to have fostered second-round and third-market effects, making US cyclical developments more global”. This, of course, simply means that the US is still the engine of global growth, to the chagrin of all those who believe in the decoupling or the European-century hypotheses.

In addition, the study shows that “the slightly decreasing role of the US has been accompanied by an increasing importance of third players. Regional integration might have played a significant role by giving more weights to non-US trade partners in the sensitivity of the various economies to their international environment.” So regional integration did seemingly push some of the economies slightly away from their link with the US, as expected. However, when third-parties (deeper trade cross-links) are accounted for, the regionalization actually deepened these economies link with the US business cycle in the long run.

A 1% increase in the US real GDP tends to be transmitted based on the extent of trade links between the US and other economies. This means that economies with closer ties to the US tend to experience stronger and quicker responses to the shock. For the Euro area, such shock will lead to an increase in real GDP of 0.2% on average (the range is 0.05% to 0.3%) as opposed to 0.4% for Canada and other developed economies. In the UK and Japan the increase in only 0.2%. In all of these economies, the shock is fully absorbed within 5 quarters, as opposed to 3 years for emerging economies. In other words, all the whingeing of EU leaders about the ‘bad Americans’ giving us a deadly flu in this business cycle is a case of a dog that bites the hand which feeds it. Next time you hear Brian Cowen whimpering about the crisis brought onto Ireland and Europe by Americans, remember the figure: every time America grows by 1%, we grow by 0.2%. Converse, of course, is also true.

Economics 26/05/2009: US Confidence, NAMA-pack lunacy

I am back from the fabled Russian 'dacha' - the world so close to Moscow, yet so far away that no email can reach you there (assuming you have O2 for your I-phone service provider charging monopoly rip-off rates for data roaming). Sunny last two days and lovely 21 degrees weather. Good fishing. Missing Luca and his Mama, though.

I spotted few stories worth mentioning. First - from the US, then - about NAMA (scroll to the end of the post to read this one)

First, the US Consumer Confidence pick up from 40.8 in April to 54.9 in May - a fourth largest jump in the series in history. Basically, the drivers of expectations rise are business conditions, labour market and personal income, which means the rise is broadly defined. This is good news, as this time around we have a combination of twin factors underpinning the improvement: not only Consumer Confidence rose itself, but the 'Misery Index' components, short of house markets (see Case-Shiller latest data analysis here), are also stabilising. But, should we read to far into the 'resurgent consumer' story or is the US consumer simply catching the same fever as the US (and other countries') politicians who are all too eager to sound the bells of an impeding recovery?

There is a rising sense of denial of the fact that the crisis is far from being over in the US Administration. So much so, that the Tim Geithner managed to simply forget the causes of the current US Housing crisis (see here) in his interview with Washington Post:

Washington Post: "...When you look at the collapse of the housing market, who do you think bears the greatest responsibility? Is it the banks for pushing these loans? Is it the consumer for borrowing over their means? The regulators?"
Geithner: "For something this big and damaging to happen it takes a lot of mistakes over time. ...Interest rate here and around the world were kept too low for too long. Investors ...took a bunch of risks without understanding the risks. ...Rating agencies failed to rate these products adequately. Supervisors failed to underwrite loans with sufficiently conservative standards. So those basic checks and balances failed. And people borrowed too much."

So no regulators faults? No Billy Clinton 'empowering the poor to homeownership' policies fault? No financial services authorities overseeing securities and financial markets (and thus securitization, wholesale lending, etc) fault? Given this state of denial coming from the Treasury top man in office, what can one expect from the poor Fannie & Freddie - late last week, Federal Housing Agency (FHA), the primary tool for Bill Clinton's ill-fated attempt to financialise subprime borrowers has noted that Fannie Mae's HomeSaverAdvance (HSA) programme, launched in February 2008 in an attempt to provide aid to the homeowners who fell behind on their mortgage repayments has produced an increase in re-defaults. FHA director James Lockhart said in a Congressional report last week that “Performance on the February through April [HSA] offerings shows a redefault rate of almost 70%.” Well, I bet. You give bloated mortgages to those who can never repay them, then the proverbial S***T hits the fan and they default. You, thus, give them another unsecured loan to delay the inevitable foreclosure and, guess what, once the dosh runs out, they default again...

Of course, Geithner can take solace that there are plenty of even less enlightened political leaders and regulators out there. I mean Brian 'The Saviour' Cowen (here and here) is simply in such a deep denial, that Geithner's statements read like a sign of lucidity.

And Brian is not alone: NAMA-own Peter 'The Wise' Bacon and Brendan 'The Sleeping-Pill' McDonagh appeared before the Oireachtas Joint Committee on Finance & Public Service (note the irony of putting together Finance and Public Service) today. Per Irish Times and RTE reports:

Mr McDonagh: “We believe the Government is basically interested in keeping banks listed and relies on Nama to trigger a change of market sentiment”.

This clearly indicates that the Government is planning to overpay for the assets transferred to NAMA in order to avoid a much more transparent recapitalization call from the banks post-NAMA. In response, JPMorgan Chase analysts wrote that he sees "sizeable chances of a smaller haircut to avoid further capital needs”. Well, DOUGH, as Homer would reply. The beef here is that the taxpayers are now being set up by the Government to take the fall instead of the banks and developers. Again, all of you know I have nothing against either the banks or the developers, but I am adamantly against my bank account and income being raided by Lenihan to rescue his cronies. And, when the state overpays for assets to avoid future re-capitalisation the taxpayers do not get shares in the banks we re-float.

RTE: "The details of loans furnished to NAMA yesterday from the six covered institutions will show for the first time the exposure of individual developers. Mr McDonagh said a number of borrowers had loans of more than €1bn across all the institutions. Up to a 1,000 borrowers have loans greater than €10mln."

That is a sign of a heavily concentrated market. Which means that foreclosing on some of these 'systemic' borrowers will not be a problem for the country - take a straight hit on assets side and see no ripple effect. But no,

McDonagh said (also per RTE) "NAMA was not in the business of liquidation, but developers who did not comply with NAMA would face the full legal consequences. Finance Minister Brian Lenihan told the committee some liquidations, receiverships and bankruptcies would have to take place."

Now, here are few things to consider:

1. If NAMA will not be liquidating non-performing assets, how big is the downside it will accept? If downside were to be limited, how can foreclosures, liquidations or receiverships (flr) be avoided?
   
2. What 'full legal consequences' does Mr McDonagh have in mind if not flr?
   
3. What does Mr McDonagh mean by complying with NAMA?
4. If NAMA were to have fixed life span, how will NAMA deal with assets that are not performing at the end of such period? Just pretend they do not exist?
5. What is the difference between NAMA and a Japanese-styled hyper-zombie bank if NAMA cannot liquidate assets?
   

Mr McDonagh said that claw back levy to address losses from NAMA will not be decided "until the agency completed its work in 10 years' time and the amount realised by assets was clear". Hold on a minute -

• we now have a date: 10 years. Given that the life-span of NAMA has been cut from 15 years to 10 years, questions 1-5 above just became so much more important as in effect the zombie bank will have to be wound up sooner, rather than later;
• how does Mr McDonagh see the claw back uncertainty impacting banks operations over the next 10 years? How does he see it impacting risk pricing for NAMA bonds? Does Mr McDonagh actually have a clue what he is talking about? It appears not, for he sees no problem with any of the above issues.
  

Per RTE: "Finance Minister Brian Lenihan said the levy could not be included in the NAMA legislation for legal reasons but it could be added to a future Finance Act. But he said it would be made clear when NAMA was set up that the levy could be applied in the future."

This is truly amazing. Lenihan also does not understand issues of risk pricing for banks, investors, bond holders, state bond buyers and the Exchequer. Furthermore, I fail to comprehend how will the legal reasons that prevent the Irish Government today from publishing details of the clawback vanish in the future? By some magic FF wand?

Dr Peter Bacon, said (per RTE) "it was important to take all development loans into the agency, including performing loans, in order to give certainty to investors. He said it did not matter whether the loans resided in the banks, overseen by NAMA, or whether they transferred fully to NAMA. The critical point is that NAMA provides the strategic direction, he said".

What 'certainty to investors' does he have in mind? Investors in the banks? Investors in development project? Investors in state bonds? Certainty of return? Certainty in a specific level of return? Certainty that NAMA is not a pure zombie bank? Certainty that the banks will not be saddled with the full NAMA bill in the future?

Perhaps the most astounding feature of the entire reported discourse between Mr Bacon, Mr McDonagh and Brian Lenihan on NAMA is that not a single one of them is concerned with the taxpayers' money significantly enough to discuss the risks of losses to the ordinary people from NAMA operations. Given that, you can't tell me that NAMA is not a pure rescue scheme for the cronies of our political elites...

Economics 23/05/2009: Is Ireland next Finland?

A recent (April 2009) paper by Gorodnichenko, Medoza and Tesar (IZA DP4113) titled “The Finnish Great Depression: From Russia with Love” provides some very interesting analysis of the causes and dynamics of the Finnish economy collapse in 1991-1993 period that contains insights into the current Irish experieince.

During the 1991-93 period, Finland experienced the deepest economic slump in an industrialized country since the 1930s. Between 1990 and 1993 real GDP declined by 11%, real consumption declined by 10% and investment fell to 45%. Unemployment rose from slightly under 4% to a peak of 18.5%, and the stock market fell 60%.

Gorodnichenko, Medoza and Tesar argue that the collapse of trade with the Soviet Union played a major role in causing the 1990s Great Depression in Finland, “since it caused a costly restructuring of the manufacturing sector and a sudden, significant increase in the cost of energy. The barter-type trade arrangements between the USSR and Finland skewed Finnish manufacturing production and investment toward particular industries, and effectively allowed Finland to export non-competitive products in exchange for energy imports at an overvalued exchange rate.” Furthermore, the study also suggests that “downward wage rigidity observed in Finland played a key role in the amplification of the downturn produced by these shocks.”

This is an interesting result. Obviously, trade shock described by Gorodnichenko, Medoza and Tesar does not directly translate to Ireland in current conditions. But some similarities are also evident.

First, just as the Finnish industries exports to the USSR were subsidised by the importing partner via particular pricing mechanisms, so are Irish exporting sectors – especially those dominated by the MNCs are ‘subsidised’ by the presence of the advantageous tax regime and transfer pricing. In other words, if Finnish exporters had to rely on Soviet benevolence in pricing their trade via oil-goods barter arrangements, so are Irish exporting sectors reliant on tax arbitrage. Neither one has a natural (productivity-driven) comparative advantage in trade when compared to other countries.

Second, the same wage rigidity that cost Finland dearly is also present in Ireland. Suffices to say, wage rigidities were also found to be important determinants of the severity and the length of the Finnish crisis by other studies. In particular, labor tax hikes and negative productivity shocks may have been the culprit (Conesa, Kehoe and Ruhl, 2007). Once again, the parallel to Ireland today is striking. By hiking income taxes, Irish Government in effect made it virtually impossible for workers to accept pay cuts, implying that our Government’s reckless policies are amplifying wage rigidity in Ireland. More on this below.

“Finland and the USSR had a series of five-year, highly regulated trade agreements, similar to the agreements between the USSR and its East European allies. These agreements established the volume and composition of trade between the two countries, and by the late 1980s they had evolved into a barter of Finnish manufactures for Soviet crude oil. Roughly 80% of Finnish imports from the USSR in the early 1980s were in the form of mineral fuels and crude materials. More than 90% of imported oil and 100% of imported natural gas came from the USSR.” Sounds familiar? Well, 90% of Irish exports are delivered via tax arbitrage-driven MNCs. Not exactly a ‘Curse of Oil’, but a curse nonetheless.

In a survey of the structural effects of Soviet trade on the Finnish economy, Kajaste (1992, p. 29) concludes that “[Soviet] exports seem to have been exceptionally profitable.” Kajaste (1992) estimated that the prices of exports to the Soviet Union were at least 9.5% higher than those for exports to western markets. Gorodnichenko, Medoza and Tesar found an even larger 36%markup which “suggests that if a Finnish industry redirected its Soviet trade to other countries, its goods would be competitive only if sold at a 10% to 36%discount. Hence, the Finnish economy was subsidized by overvalued prices of Finnish manufactures bartered for Soviet oil so that the effective price of Soviet oil was at least 10% cheaper than its market price.” Well, in Ireland’s case we know that transfer pricing runs ca 15%-18% differential between GDP and GNP. This is, at the very least, a lower bound estimate to the subsidy Irish economy receives from the tax arbitrage-driven exporting activities of our MNCs.


Just as Irish economy decline has been spectacularly fast, Finnish economy collapse was “quick and deep. Imports of oil from the USSR fell from 8.2 million tons in 1989 to 1.3 million tons in 1992. Exports tumbled down by 84% over the same period. …The loss of Soviet exports caused total exports to fall, suggesting that the goods were not redirected to other counties. After the collapse of trade with the USSR in December of 1990, entire industries had to be reorganized throughout the early 1990s.” Hmmm, you would say that Ireland is a different case in so far as we are not facing a possibility of an abrupt collapse in demand for our (MNC’s) exports. True. But we might see a total collapse in supply of exports by MNCs, should our tax arbitrage advantage be eroded by:
1. Higher domestic costs f production;
2. Higher domestic taxes leading to more rigid and inflationary wage processes;
3. Lower cost of production elsewhere;
4. Lower taxes elsewhere; and so on…

Per Gorodnichenko, Medoza and Tesar, “to fully understand the reaction of the Finnish economy to the collapse of the Soviet trade, it is important to examine the Finnish labor market because of its very high degree of unionization. In 1993, approximately 85% of workers belonged to unions and almost 95% of workers were covered by collective agreements (Böckerman and Uusitalo, 2006). Since most employers are organized in federations, the wage bargaining normally starts at the national level. If a federation or union rejects the nation-wide agreement, it can negotiate its own terms. Typically, agreements allow upward wage drift if firms perform well. Although the government does not have a formal role in the bargaining process, the government usually intermediates negotiations.8 Not surprisingly, Finland is often classified as a country with highly centralized wage setting (e.g., Botero et al 2004).


Just as in the case of Ireland’s public sector since 2008, Finnish “unions did not agree to cut nominal wages in 1992-1993, which were the peak years of the depression. Instead, wages were frozen at the 1991 level.” Irony has it, Mr Cowen is doing exactly this, except, unlike Finland, Ireland is currently running deflation, which means that public sector wages are rising in real terms through the downturn. In Finland, “given that inflation was quite moderate in the 1990s, real wages fell only to a limited extent. These findings are consistent with Dickens et al (2007) who cite Finland as the country with one of the greatest downward wage rigidities… Rigid wages amplify the contraction in demand in the short run. As consumers purchase fewer goods, firms demand less labor which entails further contraction of demand and the spiral continues. In summary, a combination of higher costs of producing goods, as well as a fall in demand magnified by rigid wages leads to large short-run multiplicative effects on the initial shocks.”

What is even more interesting is that Gorodnichenko, Medoza and Tesar show that output and economic activity in Finland during the 1990s crisis was, in the short run, sensitive to changes in the elasticity of substitution between capital and labour (loosely speaking a measure of relative labour productivity in the sectors where capital and labour are substitutes). When changing the degree of wage stickiness, the study “found that wage stickiness plays a very important role. In particular, the key parameter governing the response of the macroeconomic variables to the [crisis] is the persistence of real wages”. More specifically, “in the case with fully flexible wages, the recession is short and shallow. For example, output, employment, investment and consumption fall only by 2-5% and there are hardly any dynamics after the first year. Thus, the response of investment, output, consumption and employment is small when compared to the response of these variables in the data.”

Now, “when wages are rigid, the shock reduces the marginal product of labor and firms would like to hire less labor at the current wages or to keep employment fixed but cut wages. If wages are rigid, the adjustment occurs via quantities and the model can capture sizable decreases in output, consumption, investment and labor. The recession is considerably deeper when wages are inflexible.” Guess what: this is exactly what is happening in Ireland today, so next time you see Brian Cowen talking gibberish about his policies delivering for Ireland, remember – per Gorodnichenko, Medoza and Tesar (and per all conventional economics) not cutting public sector wages leads to higher private sector unemployment and deeper recession.

One would expect someone with Alan Ahearne’s grasp of basic economic theory to make an argument against Mr Cowen’s insistence not to reduce public sector wages, but hey – when you are being paid some serious dosh, you might forget economics for a while…