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

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

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


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

How many? Well, just a quick run through

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

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


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


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


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

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

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


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


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

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

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

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

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


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


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

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

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


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

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

But here are two additional kickers:

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

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

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

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

Economics 03/10/2009: IMF GFSR: partII

To continue with IMF’s World Outlook (from the earlier post here for GFSR and here for WO Part I):

Remember we left WO Part I on that table estimating expected future contraction in house prices. The table is:
Some interesting estimates of the ‘left to contract’ distance in house prices by countries and by measures of long-term equilibrium pricing, as of Q1 2009, taking into account the contractions achieved to date. As with the analysis of the last table, based on the historical averages Ireland has some room left for downgrades. Loads of room.

As we all know, Ireland is experiencing a perfect storm – a confluence of several simultaneous crises: housing bust, general property bust, general economic recession with global demand contractions, an unprecedented fiscal crisis and a financial sector meltdown. Clearly, these factors warrant much deeper contractions on the long-term adjustment path than what simple averages suggest.
The second chart above shows that indeed, this might be the case – Ireland is distinguished as the country with the greatest remaining room for further downward adjustments in house prices than any other country in the sample. This reflects Ireland’s economic, assets markets and property markets fundamentals comparative to other countries in the sample. So 15% to go still? And that is assuming only property crash has happened…

Chart below actually confirms the above, once we realize that the income measure used by IMF is our GDP. Of course, we are familiar with the following tow facts:

1. GDP in Ireland is currently 18.5% above GNP, and
2. GNP is a closer measure of our income in the country.
   

Thus, adjusting the above figure for GDP/GNP gap implies that instead of roughly 0.2 forward expected adjustment expressed in GDP terms as the income base, we are facing a 0.24 level of adjustment. Furthermore, given that Ireland is currently experiencing deeper income collapse than any of the charted peers, plus, given substantial declines in after-tax income following Budgets 2009 and 2009.II, the real extent of the remaining room to compression for Price-to-Income ratios comparisons is of the magnitude closer to 0.3 – in line with all of our peers. 24-30% still to move down for Irish house prices then?
Lastly, the chart above once again reinforces the conclusions reached by IMF in the second chart above and by my own recalibration of the IMF’s duration-to-amplitude model in the table above. Price to rent ratio still has a room for some contraction of the magnitude of ca 40%. This, of course will be reached through further declines in prices relative to rents and this process is currently being delayed by rents falling off at a faster rate than asking prices in recent months. In rental yield terms, some 40% left to cover for Irish prices. Hmmm… me recalls some stockbrokers recently were saying yields are at 6-8% already and the crisis is nearly over…

Is that really a case? Not per IMF:
So IMF is saying that Irish commercial rents have much further to fall – 30 plus percent more! Say yields also compress – if not by more than that, but at least that much. Ronan Lyons estimated recently that commercial yields in Ireland are around 3% pa. Bringing these to historical average will require prices falling dramatically more from current levels – as chart above implies.

Good prospects for Nama, then, which is overpaying for underlying real assets at today’s prices, let alone at where IMF would expect the prices to be in equilibrium… Will it be -40% from current levels or -30%, or -20% - no one can know for sure. But then again, Nama is a bet on prices actually rising from current levels, not falling.

Economics 03/10/2009: Exchequer receipts - bad news redux

Another month, another set of Exchequer returns and another prediction of mine confirmed: Exchequer revenue is not stabilizing. A second wave of downgrades for Income Tax and VAT, as well as the adverse timing effects on Corpo Tax are now appearing.

This time around, the prediction was not only made on this blog (here), but was also elaborated in my Business & Finance magazine column. A combination of poor forecasting (overestimating the extent of seasonality on tax revenue in August, while underestimating the impact of seasonality on other months revenue) and of a naïve belief that things can’t get much worse from April 2009 Supplementary Budget position are now at play.

In other words, it now appears that summer months’ targets were seasonally adjusted in a simplistic linear fashion. August out-performance by actual returns looks like a DofF failure to see that in a recession more people will be taking forced ‘time-off’ in summer months and that this can boost, temporarily, spending. The DofF also dramatically underestimated the extent of forward payment of corporate taxes, which automatically means that they overestimated corporate revenue expected in the future months.

During the boom, underestimated revenue projections by DofF were routine. Nay, they were annual regularity, so much so that the Government came to depend on these ‘windfall revenues’ as a sweetener to various Social Partnership deals – a little annual bonus for cronies. This time, looking to September, the DofF folks grossly underestimated the extent of the recession impact on income and thus the direction of the income tax. Having stabilized and even improved (very slightly) through July on the back of new levies, Income Tax has since taken a dive again. The implicit assumption that ‘things always improve in September might hold at the times of a boom, when July and August mark mass exodus of consumers from Ireland, while September marks return of the school year and back-to-work spending rises. But it will not hold in a recession, where economic activity remains slow in September or even falls (due to falling tourism and recreational spending).
For some inexplicable reasons, DofF set targets for income tax to rise through September at a constant rate of roughly €1bn per month from May on. Given timing of self-employed filings and seasonalities in their incomes (with many taking unpaid ‘holidays’ during the summer), plus given the fact that the numbers of self-employed are rising due to redundancies and high unemployment, such an assumption of relatively static growth in Income Tax revenues is a bit amateurish.

The same factors have a knock on effect on VAT revenues. As income falls, consumption drops. As people get more leisure time, they tend to shop for cheaper goods and might take two trips up North instead of one. All point to the significant possibility that VAT receipts will be losing ground in summer months. Furthermore, the DofF forecasters also missed the effect of unemployment and falling incomes on parent’s willingness to spend vast fortunes of kids ‘back-to-school’ shopping. More importantly, what DofF clearly had no idea about is the psychology of ‘bundled shoppers’ – parents going to buy kids school-related items. If in Celtic Tiger days such a shopping outing was bound to end in a department store where parents can indulge in some compulsive shopping of their own, this year back-to-school shopping took them more likely to Aldi and Lidl, with only compulsive co-purchases taking place relating to the luxury items of, say, a box of chocolate biscuits. Not exactly an item where 21.5% tax rip off means much.
To be fair to DofF folks, they don’t really have much data to go to get an accurate model working. But to assume that July-September 2009 tax receipts will be directly proportionate (at a virtually constant rate) to those in 2008 is, at very best, naïve. Yet, per chart below, this was simply 'assumed'…
Now, September numbers confirmed more than just a shoddy quality of forecasting by the DofF (with an accumulated error for just 5 months-ahead forecast now standing at 3.91% we really do have a shoddy quality forecast here). Instead they show that all tax heads (apart from artificially inflated by timing changes) tax heads are tanking through 2009 relative to the already crisis-ridden 2008. Chart below and table illustrate:
As far as state solvency goes, there is surprising one off change in our borrowings, which have apparently fallen back by some €5.2bn in September. I have no explanation for this, other than potential maturity of some earlier issued bonds or an error in reporting of the figures. Meanwhile the deficit trend continues to diverge from last years in the direction of further widening in fiscal deficit this year. Chart below illustrates.
Income and expenditure gap is also still widening as the chart above shows. But there is something else that can be glimpsed from the data. Remember that in May 2009 this Government started a campaign to assure the markets and domestic taxpayers that their policies are working, that the worst is almost over and that the economy is in the state of having ‘bottomed out’. Chart below shows that even in the Government’s own back yard such statements were completely unjustified. Suppose that May did mark a month of arrested downward slide in this economy. One would expect at the very least that Government finances will not continue deteriorating at a greater rate than before April Budget. The path of fiscal deficit that is traced out by the black arrows in the chart below corresponds to exactly such an assumption.
It is clear that we are not, currently, anywhere near the state of ‘improvement’ in the economy (as far as the Exchequer figures are concerned), or even the ‘bottoming out’ stage. We are still in a relative free-fall stage.

And this clarity is magnified by the expenditure side of the Exchequer balance sheet. Per Ulster Bank research note, the chart below shows the break down of the excessive spending by two main categories:Minister Lenihan is more than willing to cut into Government's only official stimulus to the economy - capital spending. This is a right way forward as much of our capital 'investment' was, in reality, simply masked-up wasteful current expenditure on soft targets like 'training & education', 'social cohesion' etc. But the chart above shows that current spending cuts to date have been extremely shallow. This is not a policy consistent with the claims of rigorous addressing of the deficit - cyclical or structural.
Table above clearly indicates the following facts about our Exchequer's spending side:

1. Capital spending is down significantly, at -13.1% yoy, but not really enough still - cutting capital spending back by 50% would do a better job;
2. Current spending is still rising +0.7% yoy in September (and no, increased social welfare and unemployment payments are not the only story here);
3. Waste on current spending side is still abundant - table shows those articles of reductions where cuts in spending for each department are the deepest. Predominantly, these cuts are on the capital side and not on the current expenditure side;
4. Increased spending on social welfare is now clearly indicating that early job cuts in 2007 are now translating into people signing off unemployment benefits and onto the dole - a move that is likely to lead to a very long-term dependency on social welfare.
   

The verdict from all of this is a simple one - this Government is not doing enough to correct for structural and cyclical fall off in revenue. Tax increases and levies passed in October 2008 and April 2009 are not working. While cuts promised since July 2008 are not forthcoming. We are still on a path to state insolvency.

Economics 02/10/2009: IMF World Economic Outlook

IMF released its World Economic Outlook for H2 2009 last night. Here are some highlights, more to come later tonight.

Summaries of IMF latest forecasts:

Next, I created an index of overall economic activity that is GDP-weighted. This index is geared in favor of Ireland and other smaller exporting economies by magnifying the effects of GDP growth (as opposed to GNP) and the effects of the current account (reflective of higher share of trade and FDI in Irish economy) and downplaying both price inflation (with larger share of domestic inflation in Ireland imported from abroad) and unemployment (with traditionally smaller both unemployment and labour force participation in Ireland).

Rankings based on the index: Based on the above index of economic activity, ranking countries in order of declining quality of economic environment, shows the extent of our performance deterioration: if in 2007 Ireland ranked 18^th from the top in the developed world, by 2010 we are expected to rank 29^th or fourth from the bottom.
Peer economies comparatives:
Based on the above table, we can compute a relative impact of the crisis 2008-2010 on our competitor economies. Chart below illustrates this, showing that when compared to other economies, only Iceland is expected to show more severe contraction in economic activity than Ireland. More importantly, the gap between Irish performance during the crisis and that of an average economy in our competitor group is 1.5 Standard Deviations away from the mean.
Property markets crisis estimates: based on IMF model of duration and amplitude of property busts, table below reports the relative impacts of the global property slump in the case of Ireland, comparative to the rest of the OECD:
Stay tuned for more...