Economics 29/08/2009: Nama critics are out of touch academics?

Today’s letter in the Irish Times got me going, along with Noel Whelan’s article on the subject…

“Madam, – The professors’/doctors’ thesis was good (“Nama set to shift wealth to lenders and developers, Opinion, August 26th). To a person who has lost over 70 per cent of their entire pension fund invested over 22 years, it is nice to hear their comment from a secure pension position. It is also nice to read that they now want to confiscate the remaining part of my pension fund.” 

Well, I am sick and tired of this ‘their secure pension / job position’ crap – pardon my use of vernacular here. Here, on the record:

• I have no public pension and have to rely on my own savings to generate one;
• I am in the negative equity, just as many Irish people are;
• I have no tenure in any of academic institution and am paid per each course I teach and each student I supervise, despite having brought more business to TCD than my income from TCD recovers;
• I have no PAYE earnings in Ireland;
• Most of my income comes from pure performance-based pay for private clients in Ireland and abroad;
• I know first-hand what it means to have a two-person unemployed family in this country and yet neither myself nor my spouse have ever drawn on unemployment benefits;
• I know first-hand what it means to have a child when your spouse does not qualify for maternity benefits from an employer;
• I know first hand what it means to pay for my own and my family private health insurance;
• I have no desire whatsoever to see my family income go to support this letter writer’s pension fund – private or public. Full stop!

So message 1 from today to the Irish Times – please stop publishing letters and articles that border on slanderous and inaccurate in their allegations.

Now, let us deal with another piece in today’s Irish Times by Noel Whelan titled “Selling Nama to sceptical public requires political will”.

Whelan simply cannot understand the basic difference between a political reform proposal (Lisbon Treaty) and public expenditure proposal (Nama) and in confusing the two reveals something very interesting about our politicians. As a senior (by tenure, if not by accomplishment) politician, Mr Whelan has no apparent idea that any public spending/ investment undertaking requires cost-benefit analysis. Factual evidence, not ‘selling to the public’ is what such undertakings are based upon. Any hard facts, Noel? Nope.

Instead, Whelan:

• Prefers to dismiss those who provide factual arguments as some sort of ‘out of touch’ academics;
• Blabber on about political selling of Nama to the general public;
• Suggests that arguments of numerous specialists in the area of economics, finance and real estate are nothing more than a “populist card” similar to that played in Lisbon I referendum, and that we – critics of Nama – “scaremonger about its consequences or encourage an “if you don’t know, vote no” stance.”

Well, Mr Whelan, do come out with your facts. Will you? Sadly, he does not. Instead he proceeds to deflect the debate about Nama into an imaginary land of make-believe villains (economists, finance experts, independent observers) combated by the noble knights in shining armor (Mr Whelan including). Don Quixote he is not, but the windmills are aplenty in his article.

“In the past three weeks more time has been allocated to squabbling over issues surrounding the proposal than to shedding light on its contents.” Clearly, Mr Whelan cannot get his a***s of the chair to read this blog, or Irish Economy blog, or anything else but the Irish Times. The debate on Nama has been raging on for months now and in the last three weeks myself and others have comprehensively shredded into pulp the entire Government proposed legislation on Nama. Is there any point of repeating this again in detail in a collective letter? No, Mr Whelan, there is none.

Whelan goes on to repeat, parrot-like the ‘arguments’ against the critics of Nama produced by Mr Ahearne and by the official Government note on how to respond to critics of Nama:

“In all that noise fundamental features of the Nama project have been distorted or misunderstood. These include that Nama will buy loans rather than property, that developers will still be liable for the full amount of their loans and that the success of Nama is contingent on a modest improvement in our economy and property market over the next five to 10 years and not on a return to a bubble.”

These are virtually verbatim taken out of Alan Ahearne’s pitiful ‘letter’ to his ‘colleagues’ which itself was a poorly re-edited rendition of the official unpublished, privately circulated “Nama Q&A” note prepared by the DofF to accompany the release of the Nama legislative proposal.

Whelan has no idea what he is talking about here and is, at the very best, slides into blind repeating of the Government official lines. No serious observer has argued that Nama will buy properties, but that it will acquire properties as a collateral in the process of buying loans. No one is disputing that the developers will be liable, but the extent of liability is highly uncertain and nothing is being done to prevent them from legally shielding their properties from Nama. (Noel, perhaps, really has no clue that this can be done in this country, but hey, I am not about to start running a kindergarten Economic 0.0001 course here for him).

“What is surprising, however, is the limited and broad-brush nature of their contribution. One might have thought that such a group giving the public the benefit of its expertise could have done so in a more substantial manner than merely affixing their names to what is in effect a lengthy letter.”

Oh, Noel, please, get your head out of Biffo’s 'Ideas Bog' and read our separate numerous contributions on the ‘substantive’ aspects of Nama made elsewhere. You can start with my own contributions on this blog or with my article in the Irish Independent yesterday, or Business & Finance archives, or the Sunday Times… You can proceed to read Brian Lucey’s and Karl Whelan’s articles in the Irish Times and elsewhere.

And so, the Irish Times’ message 2 of the day: try to avoid publishing political drivel as a factually-based opinion. Unless, that is, you are doing it in a subversive manner of letting the public know just how detached from the reality can our politicos really get…

Economics 27/08/2009: Rabo and Namaeland

And so the news come out of the depths of Irish banking sector, like an old Soviet sub, with its nuclear reactor still glowing red. Rabo is, as logically expected, on its way out with ACC delivering 20% loans losses and values on underlying assets down 50-60%. Well, there’s more to come according to them and there is no hope a recovery mid-term. This is all happening while the Government is spinning the idea that Nama is going to be just fine because, apparently, it will be taking loans with low LTVs… Hmmm...

Let me see – anyone wonders why Rabo is not buying this story? Simple: a loan written in 2007 with an LTV of, say 50% in the amount €100 had collateral underlying it valued at €200 back then. Table below shows the expected losses on Nama purchasing such a loan under Rabo impairments and stated declines in underlying value.

The above factor in the rolled up interest and a 20% impairment rate on loans. Interest accrues over 2007-2010 and all values are brought into 2009 Euro. 2007-2009 inflation is assumed to be cumulative 2%. 2010 inflation is assumed to be zero. Interest roll ups are taken at 7% in 2007, 9% in 2008 and 11% 2009-2010.

What is clear from the above is that even before we factor in the cost of bonds issuance, the cost of subsequent recapitalization, and the costs of operating Nama, the required gains on 2010 expected values of the underlying properties (assuming 20% are completely bust) required to restore Nama to break-even on its purchases in 2021 will be in the range of 2-5.5% annually in the case of 40% discount paid by Nama on assets and between 4% and 8.3% in the case of 30% discount paid by Nama.

Now, let us factor in  the cost of financing the Nama bonds and the cost of recapitalization post-Nama. Table below shows identical results to the table above, except with the bond financing cost (over inflation – of 3% pa through 2021), plus Nama recapitalization demand at 8% on the value of the loans transferred (a gross underestimate, but hey, let’s give them some slack):

Yes, folks, that is right – to get break even (almost, as we still did not count the cost of Nama operations, plus the cost of redeveloping loans, etc, but we can cancel these out with property yields, just to cut these endless estimates) on Nama, Ireland Inc will need to run annual property markets inflation of 12-15.1% per annum for 10 years after 2011! And this is based on 50%-60% LTVs!

I mean, are you surprised Rabo and the likes are not rushing to buy into our “Low LTVs” Namaeland?

Note of caution: I am just using Rabo numbers here - this is clearly not a complete picture of Nama, but it does give us the latest up-to-date picture of what is going to be happening in Nama.

Economics 26/08/09: Nama debate gone dirty

I have missed today's debate between Alan Ahearne and Brian Lucey, although as far as I understand Dr Ahearne failed to actually face Brian in this debate.

Having heard the 'debate' afterward and having obtained a letter from one of the Green Party parliamentary party members to a senior ranking disillusioned member of the party in which a venerable Green legislator claims, as Alan did today, that academics commenting on Nama with a critical perspective are not fully appreciative of complexities of Nama and are not offering any solutions to the porblems Nama is supposed to tackle, I can say the following:

I stand by my original estimates of losses expected from Nama. Alan Ahearne's quoted figures are based on thin air, as Dr Ahearne has failed to produce any evidence to support his assumptions or estimations, while my (and Brian Lucey's) balancesheet for Nama has been in public domain and under public scrutiny for over two months now,

Points raised by myself, Brian Lucey and Karl Whelan (and some others as well) about the lack of safe guards, stop0loss rules, transparency, accountability and ownership of Nama and its assets are not academic, they are as real as Dr Ahearne's salary in the employment of the Minister. Nay, they are actually more real, because families who will be paying for Nama deserve to be the rightful owners of Nama assets and deserve to have full access to Nama operations,

As far as I know, neither Dr Ahearne, nor his masters have offered any, I repeat, any clarifications as to the amendments they plan to propose for Nama legislation. In contrast, everyone can read my proposal for Nama3.0, Karl Whelan's proposals for changing Nama legislation, Patrick Honohan's ideas on how Nama can be fixed and altered, and so on. None of us have been paid for doing so, unlike Dr Ahearne who, having not failed to accuse us all of being 'academic' has (a) called us 'colleagues' (surely this makes his musings on the subject also 'academic', and (b) has managed to produce no new ideas on Nama beyond what his masters produced in the proposed legislation.

I am having a very hard time understanding how myself and other independent observers of Nama can be labelled 'academic' when the questions we raised about Nama are both immediately relevant to the issue of Nama operations and are countered from the opposing side by the nonsense of unsubstantiated numbers quoting and references to us 'not appreciating the complexities'?

Here are couple of questions sent to me by one senior policy person in Ireland with my quick replies to them:

Q: Apparently, in one of the debates, a pro-Nama person suggested that Banks nationalisation cannot occur before Nama is paid for because, while the ECB will do the swap for Irish government bonds as a reasonable discount, they will not give the same deal for a nationalised bank. Or if they do help us, they will insist on their pound of flesh i.e.they will do an IMF on us and we will lose all economic sovereignty. My questions about that are... a) is that really true...

A: It is true in so far as the ECB lending window is for private banks that are solvent. However, it is a technicality, since the ECB will have to offer lending facility to the governments as well. It simply has not been confronted with such a prospect before, but hey, there is always a first one.

b) if Irish government put their shares in Trust for taxpayers as per Nama3.0 - hey presto no link to government - does that get over ECBproblem?

A: Yes, it does, further, recall that I have argued that (steps 3 and 4) the Government can provide for private ownership diluting its own share holding in the banks, so the banks will be owned by a trust (Nama), plus two large groups of private investors, with the Government nowhere to be seen. We can even go further and include as shareholders in Nama some developers/investors by offering them shares in Nama in return for equity in their development projects written against the loans.

Economics 25/08/2009: Mad Maths at Nama

This might come as no surprise to those of you who have been in Ireland over the last few days, but it still btohers me - a week later. Nama is hiring specialist(s) in derivatives management and pricing to take on complex engineered products that the Banks have on their books.

Now, I know we have serious excellence in the ranks of our public sector and we have promissed ourselves to build on it even further. After all, DofF does excellent job in forecasting receipts and expenditure outlays - year after year, even when the trend is so strong, just adding GNP growth factor to last year's returns and then double that to last year's expenditure would do a better job than the entire DofF 'forecasting' team. And our CBFSAI does an excellent job watching the evolution of major fundamentals affecting the financial stability (it took them until the late 2007 to officially notice that the housing market might be in trouble and that construction sector has actually peaked - despite the fact that construction stocks data actually shows a break point in 2005 - full two years ahead of CBFSAI noticing it). And so on... but

The 'but' part relates of course to the fact that Nama-bound derivatives and complex intruments written against loans and real estate development ventures that are polluting our banks books are soooo toxic, I would compare them to a Chernobyl reactor just after the meltdown. The rest of Nama loans will be medical toxicity-levl stuff, compared to the serious s***t based on securitized underlyings. Nama taking these on will be equivalent to the Soviets sending unprotected troops into Chernobyl reactor to manually remove the fuel rods (they did do that).

This, of course, warrants a revision of our balance sheet totalling expected Nama losses. Once we have a clearer view of these derivative instruments extent, we will have to write them down to 'zero' real value, for I suspect there can be no recovery on secondary lending that was extended on collateral with real current value that has fallen 70-80% in the crisis.

Given speculative reports that Nama will buy into some Euro40bn worth of this stuff, I would say that a clear expected loss on this share of Nama purchases should be in the neighbourhood of
40bn*[Prob(recovery in default)*Prob(default)+(1-Prob(default))*Recovery Rate (No default)*Share (Deriv at recovery)]
Using UK and US data,

• Prob(recovery in default) = 8-11%
• Prob (default)=25-30%
• Recovery rate=40-50%

40bn*[(2%-3.3%)+(28%-35%)]=Euro12-15bn

So total expected recovery on Euro40bn in derivatives to be bought by Nama is around Euro5-7bn, implying the total expected loss on Nama should rise, under the best case scenario, from previous Euro13.4bn to Euro27-30bn over the life time of Nama...

Now, to warn you - these are back of the envelope calculations, and I will re-run full balance sheet to get more exact numbers. But you can already see where this Government is heading - another reckless and completely immoral sell-off of the taxpayers in exchange for a quick fix that has not worked anywhere else before.

Economics 24/08/2009: Alan ''Please read me!!!' Ahearne

The hilarity of a personal Ministerial Adviser sending an article defending his masters' views to a Sunday newspaper was not enough for Alan Ahearne [see that story cover here]. Never mind his article addressed not a single point of criticism levied against NAMA. Alan actually had to send out an e-alert [well, of some 979 words that is] to a list of his "colleagues". The email implored them not to sign up to an article critical of NAMA until they read his own article published in the Sunday B-Post. Given the fact that the said article had no useful information content regarding any potential or alleged NAMA problems, it is hard to imagine why Alan would actually publicise his own "efforts" with Irish academics. Then again, he might be simply keen on publicising his own efforts full stop.

Alan clearly forgot three major things in that email:

1. He failed to include in the email recipients list the names of anyone actually critical of NAMA - surely a majour omission if his intent was to convince us to take another look at NAMA in light of his, then, forthcoming major contribution to the debate;
2. He failed to notice that since he became an employee of the Minister for Finance, he is no longer an academic, so sending an email to academics and saying "Dear colleagues" should really be slightly offensive to the academics, assuming they are really valuing their independence from the political interference (which is, of course, now fully embodied by Alan's position);
3. He failed to provide any real substantive arguments disproving NAMA critics' main positions.

So here we go - two pieces of work by Alan Ahearne, some 1900 words wasted between the two, and not a single coherent point of defense again NAMA critics... Gotta be a record for someone paid to do this kind of work, don't ya think?

Economics 24/08/2009: Oil and Gold – an imperfect hedging tango

In the last bout (right before the collapse of the financial markets in Autumn 2008) much of the inflation was driven by the rapidly rising commodities prices. These prices were in turn linked to the price of oil. Thus, one can naturally think of oil as an inflation hedge. In contrast, the traditional inflation risk management instrument – gold – has hardly kept up with oil prices in the short run back in 2008. So there is a natural question that arises in this context – which is a better inflation hedge? Well, for each month in 2008, in year on year (yoy) changes, oil actually beat gold as a counter-inflationary asset. Only this year have gold and crude exchanged places. But this is optics.

First, both gold and oil prices show some serious medium range inter-annual volatility. This volatility is driven by speculative motives, but also by real demand for oil as a storable commodity that is an input into physical economy. So to abstract away from seasonality and active speculative trading, consider both commodities prices in terms of annual averages. Setting 1968 price index for gold and oil to be equal 100, and adjusting for inflation, chart below shows that both commodities are way off their historic highs and that even in 2008 the two commodities were nowhere near their long term maxima when it comes to a cumulative appreciation since 1968.

Pre 1970, average price of gold ranges around $38-39. It peaked in 1980 at $615 and then got stuck in the flat until 2007 when it breached the 1980s high in nominal terms. The average price of gold was $872 in 2008. Similarly, crude peaked at an average price of $91 a barrel last year. But despite nominal appreciation, oil is still way below its inflation-adjusted highs. Ditto for gold. To do this, gold needs to be at nearly $1,610 and oil at $98-100 per barrel. These are steep, but just how steep? Well, for oil this means roughly an 8% appreciation on 2008 annual average. But for gold this implies a whooping 84% appreciation on same benchmark.

Now, in annual terms, average annual inflation since 1968 was 3.6%. Median annual return to gold exceeded CPI by 1%, while oil did the same by 1.7%. So cumulative gain for oil in real terms since 1968 has been around 96.3%, and for gold it was almost a half of that, or 48.9%. Given that oil took a nose dive in 2009 while gold held its ground, long term comparisons suggest that

• Either oil is oversold today and thus has a mean-reverting potential of ca 45% on current prices to ca $105-110 barrel range (chart below shows WTI, $pb)

• Or gold had been under-bought in the historic past and thus has an oil-inflation trend-reverting potential of ca 50-75% on 2008 average annual price (chart below shows gold price in $ per oz, daily close)

I happen to think that both are likely, though in much more moderate terms, with oil heading for $85pb in 2010 and to $95pb over medium term (5 years), while gold heading for $1,050-1,100 range in 2010 and to $1,300 over the medium term. That would imply annualized gains in oil price of roughly 4.8% and in gold price of ca 6.5% before inflation. Thus, assuming a reasonably well-underpinned by the current money creation worldwide inflation averaging ca 3% pa, this would result in oil beating CPI by 1.8% annually, and gold doing the same by ca 3.5% pa. Why?

For two reasons:

1. Oil demand is going to be imperfectly matched to inflation hedging and short term volatility due to supply/demand for physical commodity will be weighing in oil as a hedge instrument in the current environment where investors are relatively jittery about the markets;
2. Gold simply has to catch up with oil over medium term.

One potential downside to this is continued orderly, but nonetheless pronounced disposal of gold holdings by the Central Banks of the more fiscally strained countries and the IMF. Although China and possibly India are likely to start picking up some of the rising supply through ‘private’ or invisible sales from one CB to another, this unwinding of gold reserves will weigh on the markets.

Per short term oil price volatility a recent example is in order. About two weeks ago, the US crude reserves have been reported to have fallen some 8.4mln barrels, prompting a serious spike in oil to $72.5pb. At the same time, gasoline supplies fell by 2.1 million barrels, distillate stocks declined by 700,000 barrels and refinery utilization reached 84% above analysts’ expectations of ca 83% - in a sign of tighter supply.

In medium term (3-5 years horizon) – watch US Oil Fund (USO) for oil.

On gold side, watch the correlation in gold and stocks, with gold tending to max just ahead of stocks lows (note July/August 2008, October 2008, March 2009 and so on in chart above). In my view, we are set for another local maxima to be tested by gold in months before the end of October 2009.

Economics 24/08/2009: Wealth effects in Ireland and Wholesale Prices

Mountain air and thunderstorms are conducive to light reading, so I was wading through an interesting and sweetly short ECB paper from May 2009, titled “Euro Area Private Consumption: Is There a Role for Housing Wealth Effects”.

The paper looks at a number of Eurozone countries – excluding the wonderland of Ireland (so it provides conservative estimates for the wealth effects) – to find that the marginal propensity to consume out of financial wealth (MPCF) in the Eurozone ranged between 2.4% and 3.6% on the aggregate. The MPC out of nominal housing wealth lies between 0.7 and 0.9%.

Re-parameterizing the model for the case of Ireland,

• financial wealth declines since 2007 peak imply that Irish consumption should have fallen by ca 1.9-2.9%;
• housing wealth declines add another 0.35-0.45% to the consumption losses;
• while negative equity effects (assuming 20% of households in negative equity) subtract further 0.69-1% off our consumption.
• So the cumulative effect of recent wealth losses should be in the area of 1.45-2.1% of consumption expenditure.

The above figure does not account for the fact that in most cases our debt levels used to finance financial and housing wealth acquisitions were not diminished over the last two years. Factoring this in, net decline in consumption expenditure should be around 1.7-2.6% in permanent terms.

This goes some ways to highlight the fact that this economy is not running a tax-shortfall-driven deficit on public accounts – we are now increasing public consumption amidst permanently shrunken private consumption. Given that Ireland’s net current Government expenditure is projected (by the DofF) to rise 17.64% between 2009 and 2013 (from €46.365bn to €54.546bn) while the expected cumulative loss in private consumption is expected to total 8.8-13.7%, the wedge between private and public consumption growth in the crisis years is likely to be around 17.5-22.5% of private consumption. And that is before tax increases and future bonds financing burdens are factored in. In other words, tax us some more and we will withdraw all unnecessary consumption from this economy. If we were a land-locked Luxembourg, I doubt there will be many non-public service workers still living in Ireland after that.

And per the latest wholesale price indices release from CSO, here are few charts.

First, exporting vs home sales prices – a clear return to the previous trend of widening gap. Exporters are still suffering while domestic sectors are running improving pricing conditions. A brief period of convergence in November 2008 – January 2009 has now been firmly replaced by a renewed bout of falling export prices and rising domestic ones. Unfortunately, CSO is not providing actual raw data on these series this time around, so no more analysis is possible for now.

Second chart is dealing with manufacturing prices and growth rates (yoy and mom). Deflation continues here and has accelerated in July relative to June. Month-on-month changes are really telling the story – June improvement is still visible, but is being erased. Note monthly range for July 2008-July 2009 being negatively sloped, as contrasted with July 2007-July 2008. Plotting monthly indices by year shows that seasonality is not as important here and that 2009 is pretty much all about traveling down a steep deflation curve that started in November 2008.

Economics 21/08/2009: Commisions and Taxation

Per Irish Times report today:

"Despite the significant Exchequer deficit the (Commission for Taxation) report does not recommend a rise in income tax rates and says that the combination of taxes and levies mean that anyone earning €75,036 is paying 53 per cent in taxes and levies to the State." You can almost hear the tears dropping from the eyes of the Times staff as higher income tax would be a favourite pet project for the paper.

41 per cent is tax, 4 per cent is PRSI, a further 4 per cent is a health levy and an income levy of 4 per cent. Well, we almost forgot other taxes and rates. All meaning that less than about a 1/3 of Ireland's productive (private sector employed= population supports the entire economy, with some 400,000 overpaid and under-worked public sector employees... Now, Irish Times wouldn't have anything to say about that would it?

A property tax will be introduced which will eventually replace stamp duty and while a new carbon tax on energy has been proposed. Now, what does this mean? We can only speculate, but eventual replacement of stamp duty implies that the two new taxes will coexist. My sources tell me that

• the new property tax will be based on self-assessment, which means it will yield huge rates of tax evasion, will retard even further property resale markets (as under-taxed properties will be held back from the market) and thus will lead to a renewed property crisis over time;
• the new tax will be a double tax with no credit given for recent payments of stamp duty, so in effect, it will be a new additional tax.

You'd wonder if the Irish Times actually cares about these small details.

Well, obviously, another Times pet projects are artists’ exemptions. These should and will be scrapped, so Bono & Co can fully move out of the country. I wonder if that will make them preach less about doing good at the expense opf the ordinary taxpayers. I doubt.

Reliefs on union subscriptions and bin charges will be phased out. Hmmm - wonderful stuff. Union subscriptions relief was an honest admission by the state that it is so deeply in bed with the unions that even a tax amn can't separate the two. Now, let's pretend they no longer are... Does this change the reality of this state doing absolutely everything possible to appease the bearded men of the Liberty Hall? Not a chance.

Another rumoured proposal is a SSIA-type pension for those on lower wages with the State contributing €1 for every €2 saved by employees. Funny thing. Of course it raises two issues:

1. Who will pay for it? You can imagine a family just above the margin threshold for such a subsidy that will have to provide tax payments for this pension scheme and at the same time pay for own pension. Fair?
2. How will we pay for this? Assuming you have to save ca 40% of your income in order to afford a public sector-level of benefits at retirement, how can a country afford paying an additional premium of 40/3=13.3% on lower wages in taxes at the time when we can't afford to cover our current account deficit.
   

This Taxation Commission report is starting to look like a clock made of jello, as PMD like to say...

Economics 21/08/2009: Economic Outlook - Things to Fear

Being in the Dolomites puts me into a long-term thinking mood. So here we are – a post on some of my long run thinking.

In a recent post I wrote about the probability of the L-shaped recovery now standing at and even 1/3 split with the probability of the recovery being V-shaped or W-shaped. I motivated this estimate by the references to some of the US economy fundamentals.

A different world beacons

Think growth dynamics in the long run. Usually, a recovery is led by a small fiscal stimulus and a moderate easing of the monetary conditions. These come after a number of quarters of tighter fiscal and monetary conditions pre-crisis. And both act to moderate fall-offs in household and business investment, plus arise in unemployment in the environments of relatively unchanged long-term savings/investment ratios and a temporary shock to transient consumption.

We are in a different world today from a ‘normal’ recessionary cycle, and this warrants my concern that the recovery dynamics are likely to be highly uncertain.

Fist, think the investment cycle. Investment – both household and corporate – is down and it is down structurally. The structural nature of this downturn is most likely due to the shifting pattern for investment financing into the years ahead. Gone is the leverage and originate model of lending. We are in the new brave world of deposit and originate model, where capital financing will be held back by the need to generate significant deposits.

Even an era of sustained precautionary savings by the households is not going to change this reality. Why? Because in years before the current crisis, leveraging model meant that a deposit of, say, $100 in a bank translated into the lending out of some $960 or more into the economy. With deposit and originate model, the same deposit is going to see first round lending of no more than $90 out into the economy. Once the hovering of excess liquidity into banks capital is done with, we might move to a lending of slightly above the deposit rate, say $100 plus a wedge between the borrowing rate and deposit rate. But this is hardly going to get us above $110 even in most pessimistic inflationary scenario. In the mean time, the banks are going to beef up their capital reserves by skimming retail clients – so returns to savings will quickly turn negative. Never mind the returns, households will still hoard cash as sticky unemployment will breath fear into their hearts – the new era of the hearts of darkness will set in ushered by the elevated risk aversion.

Second, think precautionary savings. If in traditional recession precautionary savings cycle exhausts itself within a span of 2-3 quarters post recession on-set, in the current one, the savings rates are still climbing up, corporates are still hoarding whatever cash they can generate and the late payments gap is widening, not shrinking. This suggests to me that we might see the US savings rate finally moving in the direction the majority of economists in the 1990s wished it would be heading – into possible high single digits or even double digits. The trade wars of the 1930s might be replaced by a slow decay in world trade due to shrinking US (and also European) consumption expenditure. Not as nasty of a proposition as the Depression era ‘beggar thy neighbour’ policies, but a much longer behavioural shift that is more benign in the short run, but is much more damaging in the long term.

Third, think of the place we came from when we entered this recession. That place was Alice in Wonderland mondo bizarro of excessive liquidity sloshing across global boundaries and asset classes and fiscal policies of prolificacy that made even the US Republicans (traditionally pro-balanced budget conservatives) into the spending-happy traditional Democrat-types. In this environment, lack of global inflation was only sustained through a combination of extreme asset bubbles formation (housing, equities, carry trade-financed speculative real estate allocations, excessively optimistic M&As and commodities bubble that rivalled anything we’ve seen since the Dutch Tulip craze. But looking forward, this environment was ‘corrected’ in the recession through another massive injection of liquidity and another substantial hike in public deficits worldwide. It might be a forced measure for Obama Administration to prop up the entire US economy by pumping more steroids of public spending and running printing presses at the Treasury 24:7, but this activism has to go somewhere real, and it will go into real long term inflation and a new asset bubble generation, along with higher taxation.

Ronald Regan inherited from the Democratic Party’s leading historical disaster (Jimmy ‘The Peanut’ Carter) presidency one of the sickest economies in the US history. But one thing he did not inherit was decades-long appreciation of the US deficits. Subsequently, Regan was able to cut taxes while re-channelling fiscal spending into new programmes. Obama’s successor (who is now increasingly looking set to come in 2013) won’t have this luxury. Neither will Angela Merkel’s successor, or Brian Cowen’s or Gordon Brown’s. High tax era is upon us in the developed world and this means we are going to lose in the economic game. This impending tax regime fiasco will be far more damaging to the West’s economic standing in the world than the oil price inflation can ever be.

Fourth, inflation is coming. I wrote about it before and I keep saying this over and over again: if you think double digit yields on US debt are the stuff of science fiction, think again. Someone will have to pay for the orgy of new fiscal debt creation and that someone will have to borrow hard. The new borrowing – the rollovers of the past, plus the interest rates of the future, compounded by the Obamanomics and the Democrats appeasing their traditional constituencies will be exacerbated by the need to rescue the next wave of ‘economic recession victims’ – the states and municipalities. That these are going to be predominantly amongst the Democratic party strongholds (e.g California) will only make matters worse. So what little liquidity will be added over time will be consumed in an orgy of new debt issuance by the Feds and the states and municipalities. The pyramid scheme whereby Feds-created cash will be rolled into Feds-backed Government borrowings will mean investment slowdown will be deeper and more permanent than the point one above suggests.
Inflating and devaluing out of this mess will set the stage for the graduate de-dollarization of the global economy, further undermining the US.

So high inflation, lower growth, lower real rates of return on deposits, lower lending origination and thus lower investment all form the prospects for L-shaped recovery. At the same time, sheer magnitude of liquidity pumping into the global economy via loose monetary policy on top of the previous decade-long monetary easing might, just might, usher a new age of asset bubbles. From oil and gold to banal fertilizers and regulatory-driven forestry – commodities will reign as perceived, if unreal, inflation hedges. Exotics of risk aversion assets might turn out to be even more exotic, more technical and thus less stable than the securitized and repackaged real estate loans of the Mid-Naughties. If they do, a V-shaped recovery is a possibility, as is a W-shaped one. Both will be short-lived, but at least we will get to enjoy one more run of the madness.

About the only silver lining to this long-term Western Winter will be the fact that Europe will be faring even worse than the US with Italian-style slog contaminating the entire EU, inclusive of the Accession states.

So where do we stand?

An L-shaped recovery offers a period of zero (or near zero) real growth post-recession. The V-shaped one represents a robust recovery post-recession. The W-shaped scenario is the one where recession will be followed by a significant bull run, followed by another collapse before the recover set in.

In my view, however, all those who paint the current economic environment in one of these historically known categories miss the majour point — because of the changed relationship between perceived and real risks and our systemic household, banking and corporate responses to these, we are entering a recovery that has elements of all three scenarios. This is risking to be a PQR recovery – a recovery based on Public and Quoted Risks. Now, it is a handy feature of the alphabet that letter PQR are smack in between letters pairs of K and L (denoting traditionally Capital and L-shaped recovery) and V and W shape of recovery descriptors.

PQR is not a simple average of L and V-shapes, some sort of a root sign-shaped recovery. It is a recovery that starts from the top of the previous cycle, heads for depths severe of a recession, rises in a volatile fashion above the floor and flattening out at an equally volatile new floor of suppressed long term growth. It is the stuff that makes superpowers lose their supremacy positions and that led to disintegration of mighty super states of the old.

Historically, recessions follow a V-shaped scenario. The dynamics are as follows:
First businesses cut production through the downturn: capital investment grounds to a halt, layoffs cut less productive workforce and maintenance and capital replacement drop to below amortization;
Second, businesses stop cutting at the point where their capacity still exceeds demand, and they go for correcting the supply overhang by reducing costs and inventories;
Once demand troughs, the depletion of inventory means that any new demand will translate into increased output, sapping the excess capacity;
Capital expenditure rises on the maintenance and amortization side, but no new capital is added, so profits improve and war chests are replenished by the healthier businesses to take on some of their competitors;
Increased corporate profits support strategic drive in increasing capacity to address future demand – employment and investment rise;
High rates of money creation and fiscal stimuli (with priorities going from tax cuts, to public investment in infrastructure upgrading, to Uncle Sam’s shopping for consumption spending, and not the other way around) help the process of orderly de-leveraging and maintenance of excess capacity by businesses.

We, thus, have Public Risk – the risk of permanent deficit financing and the under-saturation of public debt with liquidity (see below). We have Quoted Risk – the risk of higher equity and commodities volatilities as desperately shallow liquidity pools are chasing higher returns in the new era of diminished tolerance for risk amongst retail investors. We have a PQR recession – an alphabet soup of messy noise along a shallower than before and flat growth rate.

A PQR recession dynamics will be as follows:
First businesses cut production below the point where their capacity is less than the expected medium term demand;
The supply overhang will be short-term managed to a supply undercut by reducing costs and inventories much deeper than before;
Once demand troughs, the depletion of inventory means that any new demand will translate into increased inflation, triggering some monetary tightening that will trigger renewed push for precautionary savings and the W-shape will emerge;
Capital expenditure will have to increase on the maintenance and amortization side as even the minimal levels of capital will begin to fall apart at a rate not seen since the collapse of the USSR, but no new capital will be added, so profits will improve;
The improvement in the profits will drive us up the last leg of W, but there will be no build up in corporate war chests as liquidity will remain tight;
Instead, strategic drive in increasing capacity to address future expected demand will mean that employment and investment will rise faster in the BRICs and the rest of the world than in the OECD;
Fiscal stimuli with priorities of Obama administration implying more spending on immediate Uncle Sam consumption of stuff from the Democratic Party cronies, followed by lower public investment creation and not followed by tax cuts, but by tax increases will mean that no productive capacity will be underpinned in the productive US sectors, yielding their competitive positions globally to newcomers from Asia;
The US economy will settle into a permanently lower rate of growth characterized by relatively frenzied swings from Public Capital Formation schemes to Private Risk Premia increases and back to Public Capital.
A PQR paradigm. QED

How do we know this?

We now are wiser than in October-December 2008 and it is now more than apparent that the US fiscal stimulus misconceived (in a rushed atmosphere of a sever crisis) and misdirected (at the least productive sectors of the US economy where mis-aligned long term incentives will prevent any future productivity growth springing the green shoots). Fiscal stimulus in the US did not help significantly to deleverage households, so monetary easing did not restart demand for borrowing. Fiscal stimulus, in the Obama administration conception, did not prop up capacity preservation in productive sectors of the US economy and was wasted instead on the Big 3 Auto-monsters and the larger, less productive financial institutions. Fiscal stimulus did nothing to get the Americans out of negative equity and thus did absolutely nothing to reduce incentives for precautionary savings. This means that consumption growth is simply not going to happen, folks. Not at the rates pre-crisis and not even at the rates of post IT-bubble recession.

Monetary policy is also going to fail in everything but inflation generation. US private sector credit remains in the doldrums a year after the efforts to repair it began and the US wounded and undercapitalized financial system continues to struggle with the ghosts of looming future losses.
The longer-term theme in the US is the emergence of the two polar opposites as demographic drivers of the economy. On the one hand, ageing assets-holding population will have no access to liquidity as home sales will remain subdued by the massive overhang in unoccupied properties still crowding the market and by the banks unwillingness to lend on real estate assets. On the other hand, high savings –geared younger population will be consuming less and repatriating more. Think of the Latin Americanization of the US population with the resultant outflow of financing from the younger second generation US workers to their first generation American parents who will move back to Latin America to get better quality of life in return for their savings.

So future consumption will be depressed by financial system, demographic changes and the overall change in risk aversion across the US population. As an interesting side-bar, in the mid 2008 the number of Google search hits for ‘Paris Hilton’ – an imperfect signifier of the younger generations presence in the economy – has been overshadowed by the number of search hits for that key word of the Wal-Mart generation of greying retirees: ‘coupons’.

The downsizing of American consumption-driven economy has begun. And this is hardly an encouraging sign for the V-shape theorists.

Europe’s moment of sickness

This leaves us at the point for comparing the US with its today’s competitors. The sick state of the nation on the western shores of the Atlantic will be predictably mirrored with an even deeper decay on the eastern shore of the pond. As US continues to improve productivity – albeit at a much slower pace – European society, geriatrically-challenged, hamstrung by the trade unions, obsessed with preserving the status quo of wealth distribution and increasingly anti-immigrant and anti-innovation will suffer even more. Increased consumer demand from China and India, Brazil and possibly Russia will go some way to prop up German manufacturing, but more and more of those fine BMWs and Mercs will be stamped out in the US, assembled in Free-to-work states of the US South, designed in the Free-to-dream states of the US West and financed from the Free-to-invest states of the US Midwest and Northern Atlantic corridor. German manufacturing will sing the same blues as British manufacturing did before it. What will remain will be a museum trinket shop – a place where Ferraris and Bugattis will still be made backed by subsidies from the US- and elsewhere-based ‘German’ production of actually demanded goods.

Investment themes of a PQR recession

There will be new themes for the investment markets in years ahead. These themes will be about more active management of volatility and use of volatility spells to the same purpose as we used the international ‘growth’ stocks in the past – to get ahead of the benchmarks. Another theme will be maintaining sane returns once the risk of dollar devaluation is taken into account. Third theme will be the rise of global volatility. Displacement of the US and EU from the pedestal of global leaders in future growth (the first one still coming, the latter having already taken hold) is not going to take place because some other power will emerge as being better in absolute terms. Unlike almost all other deaths of the superpowers (with exception of the collapse of Rome), this one will not result in an immediate emergence of a heir apparent to the US dominance. China – the sickly giant that will be seen as having toppled the US – will not be able to bear torch for the rest of the world primarily because it has no model of its own, no engaging or charismatic ideology. And this will mean that the world of investment will be jittery, uncertain, fast changing worldwide.

Prepare for some serious volatility management, folks. PQ to QR to PQ across the horizontal axis, US to BRICs to Asia to US to Latina America to the BRICs across the vertical one, and across all asset classes on the Z-axis. Shall I remind you that complexity of PQR recession is by even alphabetic standards much more significant than that of L, V or W?

Economics 17/08/2009: Global Recession is Over - IMF

Per IMF's Chief Economist, Oliver Blanchard, the global recession is now over and a recovery has begun. "The turnaround will not be simple," Blanchard wrote, as "The crisis has left deep scars, which will affect both supply and demand for many years to come." Blanchard expects growth start occurring in 'most countries', but at low rates - not enough to shift unemployment off its highs.More importantly, Blanchard argues that potential global output may have been permanently reduced and that any growth to take place in the short run will still remain highly dependent on government stimulus and accommodating monetary policies. Sustaining growth "will require delicate rebalancing acts, both within and across countries," he said

Now, of course for Ireland, this is not much of a welcome news. Our fiscal stimulus is perverse NAMA sucking cash out households' pockets, plus the widely anticipated and media-supported tax hikes in the next Budget. Our monetary easing is there solely to help the banks, who in turn are now raising mortgage rates.

Per Blanchard, US consumption (ca 70% of the US GDP) and most of global demand will be very slow to return to pre-crisis levels. These long-term declines are driven primarily by wealth effects due to the fall-offs in personal wealth on the back of housing and stock markets collapses. Blanchard, who devoted much of his academic career to the models of nominal and real rigidities remarked that he perceives the crisis legacy as having made Americans more aware of the unlikely events that can yield catastrophic consequences. This is known in the literature as "tail risks". The likely result of this will be a permanently higher rate of savings in the US and elsewhere around the world, leading to lower consumption, but cheaper financial capital.

Interestingly, Blanchard apparently ignored the issue of increased risk aversion that might also accompany the fear of 'tail risks'. If this does materialise, higher risk aversion can shift the burden of financing the latest crisis off the fiscal authorities (through lower yields on bonds) onto the shoulders of already strained corporates (with higher required returns to equity financing). The resultant knock-on effect will be to double the adverse risk of lower consumption by the households, reducing potential rate of growth globally.

Global rebalancing to address this new reality will require, in Blanchard's view :

• "Both higher Chinese import demand and a higher (yuan) will increase U.S. net exports";
• Higher domestic consumption growth in China (effectively replacing the US as the main consumption growth player in global economy);
• Lower current account surpluses in China; and so on

Thus Blanchard's view has not really change that much since the beginning of the crisis and even further back. Even in the late 1990s the IMF kept sounding alarms about the Sino-US imbalances.

Another long-term challenge is decoupling the real economy off its dependence on state spending. This will be painful, as current stimuli around the world spell higher taxation in the future and thus lower future growth. "In nearly all countries, the costs of the crisis have added to the fiscal burden, and higher taxation is inevitable," Blanchard said. "All this means that we may not go back to the old growth path, that potential output may be lower than it was before the crisis," he added.

What's there to say about our country, then - a cost in tens of billions and no stimulus in return... aka NAMA.

Economics 17/08/2009: US markets jitters

US Markets: I've told you to be weary of the return of volatility. Chart below shows today's sudden- 17% jump in VIX volatility index and the coincident fall-off in the main markets (sorry, crumbling Eircom broadband infrastructure means I can't get my hand on better charts right now):

Even more worrisome is the following chart, showing that both near-term VIX and long-term VIX are actually in excess of the current VIX, so markets are now pricing higher volatility for the foreseeable future.
Another telling graph above - notice negative correlation of the last few months turning positive about a week ago and back to negative now - this is a likely holding pattern as in 2007 late Summer and 2008 Summer-Fall.

China was the latest trigger today, but it all goes back to trade flow, as China is a barometer of this and trade flows are a barometer of global growth...

NAMA 3.0 - more weight

My NAMA 3.0 - that includes also some proposals advanced first by Patrick Honohan, Brian Lucey and Karl Whelan - is gaining some speed. Here is a slightly more edited/updated version of it:

Step 1: Require banks to take full mark-to-market writedown on their loan book. This ensures that realistic valuations will be attached to the loans and it is fully consistent with the Swedish Bad Bank model (SBB-consistent);

Step 2: Travel down the capital ranks to draw down shareholder equity, deplete perpetual bond holders, subordinated bond holders and so on to cover the writedowns. This is a natural progression in addressing any insolvency and there is no reason as to why NAMA should be different (SBB-consistent).

Step 3: Force senior bond holders into debt for equity swap (exchanging their bond for shares at a discount), with a possible sweetener on equity conversion formulas relative to the Exchequer valuations (meaning we convert their bonds into shares with a small sweetener or shallower discount than actual valuations will imply). By retaining these guys on board as shareholders, we ensure that the banks will not be 100% state-owned and that potential lenders will have an interest to lend because they will be shareholders in these institutions. This is consistent with GM bunkruptcy proceedings earlier this year;

Step 4: Open enrollment for a share-participation in Irish banks recapitalization to SWFs and private capital. The Government should actively seek such external investors to increase private sector share of overall equity holdings (on top of converted bondholders - point 3 above). This should be done in the period while the banks are drawing down their capital funds to write-off losses to ensure that the banks are not fully nationalized;

Step 5: Cover all the shortfalls in capital base through recapitalization (as in Government's NAMA - or NAMA.G - proposal) after Steps 1-4 are completed and after an independent assessment of the value of the remaining loans is carried out to determine the true extent of banks under-capitalization (SBB-consistent).

To establish independent valuations – set up a Valuations Board of NAMA consisting of 9 individuals: 1 from DofF, 1 from NAMA, 3 valuations experts, 1 finance expert (banks), 1 planning specialist, 2 independents (economist and accountant). There shall be no post-NAMA levy expsoure for the banks as the state will take ordinary shares in those institutions (reducing future uncertainty for banks), thus creating an upside potential to shares (offsetting any losses on NAMA discounts).

Recapitalization, carried out jointly with new shareholders (past bond holders, SWFs, private investors, etc) will see Irish Government taking significant/majority shares in all main banks in Ireland. However, it will not be a nationalization, as the state of Ireland will not own these shares - the shares will be held in the name of Irish taxpayers in an escrow account or holding company called NAMA3.0 (below). Furthermore, significant shareholding in at least 3 banks can be private - through the private placements (step 4 above).

This is constent with SBB, but it is also consistent with the current NAMA-G proposal, as the Government has not explicitly rulled out a possibility of nationalization of the banks in the post-NAMA recapitalization. Furthermore, NAMA3.0 reduces the extent of state ownership of the banks by committing itself to attracting some private sector shareholders - e.g former bond holders and new investors.

Step 6: Hold equity in an escrow account (NAMA3.0) on behalf of the taxpayers, appointing

• The members to the Supervisory Board of every bank recapitalized by the taxpayers money. These should consist of one appointee by the Minister for Finance, 1 independent representative of the taxpayers, who is charged with explicitly guarding the taxpayers' interests, 1 representative of NAMA3.0. Each member (other than those from NAMA3.0 and the bank) will hold a veto power.
• A requirement that risk, audit and credit committees of NAMA3.0 include at 2-3 independent experts who cannot be employees of the state, NAMA3.0 or any other parties to this undertaking
• Set up an independent, bipartisan, NAMA Oversight Oireachtas Committee consisting of non-voting Chair, 1 representative of each Party, 1 independent TD.

Step 7: Accountability:

• no indemnity for negligence and incompetence for any employee or director of NAMA 3.0 organization - no one in the private sector has one (SBB-consistent);
  
• no cross borrowing by the Exchequer from NAMA3.0 is allowed, so Brian Lenihan and his successors cannot raid the nest egg by - at a later date - borrowing funds against NAMA-held assets to spend on other state commitments (current or new). This is SBB-consistent provision;
  
• ownership of shares in the account accrues to the taxpayers, not to the state or the public sector;
  
• NAMA3.0 cannot lend money to continue any of the banks' projects without specific recommendation of the risk committee (unanimous) and an authorization from the special Oversight Committee of Oireachtas;

Step 8: Transparency:

• full disclosure of all recapitalization actions and shares held in NAMA3.0 - on the web, updated live;
  
• full disclosure of all salaries, bonuses etc, CVs of all managers and directors and disclosure of all potential conflicts of interest;
  
• full disclosure and updating of the comprehensive NAMA3.0 balance sheet, cost/benefit analysis of the undertaking and live monthly mark-to-market report on the value of shares held;

Step 9: Operational Efficiencies: NAMA3.0 can, with consent of the Minister for Finance and in orderly (market-respecting) fashion disburse all or a part of its shareholdings so as to maximize the return to the taxpayers. This disbursal should be fully notified to the public immediately post execution, with prices achieved and hedonic characteristics of the properties sold (barring identification information) fully disclosed. NAMA3.0 will then have 60 days to issue every resident of this country - registered at the date of creation of NAMA3.0 as being tax-compliant - his or her share of the sale proceeds net of NAMA3.0 operating costs and a special withholding tax of 40% on Capital Gains, in a form of a cheque;

Step 10: Legal Remit Over Assets: NAMA3.0 in recapitalizing the banks will have a mandate to help the banks collect on outstanding loans by aiding them in seizing requisite collateral. In doing so, NAMA3.0 will have to agree a procedure to address problems of cross-collateralization of specific assets. NAMA3.0 will have a right to seize borrower's property (applicable only to developers) when such property has been legally shielded from authorities or banks at any time after July 2008.

Step 11: Conditions for banks participating in NAMA3.0: banks will be required to adhere to the following rules, including, but not limited to, the caps on executive compensation at the banks set at Euro500,000 maximum with share options not to exceed 75% of the salary, to be taken in long-term options – 5+ years, with the option price to be set as the Moving Average over the last 3 years of Bank’s operations prior to option maturity). Banks must set up fully independent, veto-wielding risk assessment committee with a mandatory requirement for a position of a taxpayers' representative on the board that cannot be occupied by a civil servant or anyone who has worked in the Irish banking or development industry in the last 10 years.

In addition (all below are SBB-consistent):

• the banks must set up independent fully shielded administration offices for managing NAMA-held loans;
• the independent offices must compete against each other in delivering the returns to NAMA loans;
• the annual performance of these offices must be benchmarked also against the annual performance of the banks' own books of loans with the NAMA offices within the banks achieving at least the same average rate of return on its loans as the rest of the bank (adjusted for quality of loans) without any cross-subsidisation of returns to NAMA loans from other loans managed by the banks;
• NAMA offices within each bank must report their results separately from the bank and at the same time for all NAMA offices - quarterly and annually. NAMA3.0 will be responsible for making these reprots public after approval by NAMA board and risk, credit and audit committees.

Step 12: Re-legitimising the public system of regulation in Financial Services: as a part of NAMA3.0, the Government must address the ever-widening crisis of markets, investors' and taxpayers' trust in the Irish system of Financial Services regulation. Many steps must be taken to address this problem, and these can be worked out over time. But in my view, there must be a stipulation that all and any regulatory authorities (and their senior level employees) that were involved in regulating the banking and housing sector in this country until now must be forced to take a mandatory pension cut of 50%, a salary cut to put them at -20% relative to their UK counterparts wages, and return any and all lump sum funds they collected upon their retirement. The Government must impose measures to prevent banks from beefing up their profit margins through squeezing their preforming customers. The measures to force the banks to reduce their cost bases by laying off surplus workers must be enforced. From now on, every regulatory office should be required to publish all minutes of its meetings, disclose all its voting, decisions and rulings to the public, create a public oversight board that must include members of the Dail from non-Governing Parties, a taxpayer representative and independent directors.