Economics 04/03/2010: Another grab of taxpayers cash?

Update 1: 04/03/2010: 10:15pm


Yesterday, the Government announced a plan to reform pensions provision system in Ireland by creating a mandatory pension scheme with a limited opt-out clause. The announcement is covered here. While lacking specific details we can only ask questions and await for some answers, here are my top-level views.

Question 1: Will additional contributions required from the taxpayers yield additional cover over the already committed state scheme that supplies 35% of the average earnings in exchange for PRSI contributions?

Question 2: What will determine the return on top-up pension? While the state is quick at setting the cost to the taxpayer (4%) and employers (2%) there is absolutely no reference to the returns to be earned from the scheme. Is the rate of return fixed? Guaranteed? Market-related? Who will underwrite this return?

Question 3: Who will manage the assets? NPRF? NTMA? Private providers? Who will actually write the policy - if any policy will be written at all.

Question 4: The plan exempts those on defined benefit pensions - aka public sector workers. Thus, in effect, the plan opens up two massive problems:

• Defined benefit pensions are the ones that are facing the largest shortfall and they are also being managed by the agent (the State) who will control our top-up pensions. How is this conflict of interest going to be resolved? Will public sector pensions hole be plugged using top-up pension funds?
• Defined benefit pensions are contractually guaranteed, while top-up pensions are not (see below), so in effect the opt-out potentially directly exposes ordinary taxpayers to underwriting the public sector pensions through both their statutory pension (already the risk we are bearing) and through the top up. If so, the top-up element of the proposal is nothing more than a tax on ordinary income earners that can be used to cover public pensions shortfalls.

Question 5: A 4% top-up requirement for 'higher earners' (undefined level of earnings) will create a further erosion of the wage premium for higher educated and higher skilled workers in this country (on top of already punitive levels of personal income taxation). How does this square off with the Government intentions to build a Smart Economy, if Smart workers require higher wage premium?

Question 6: What are the contractual rights of the taxpayers paying top up rates with respect to the pension benefits?

A private sector pension is governed by a clear contract. This contract is fully enforceable in the court of law. State pensions (with exception of those provided to public workers) are not. If you doubt this statement - check numerous legal cases where this has been deemed to be the case.

And look no further than the change in the statutory retirement age that the Government is planning to enact. In effect, forcing retirement age 2-3 years forward means that all of us who have paid PAYE are now entitled to 2-3 years less of the benefits. If this was done by your private pension provider, you would have a legal case against a unilateral change in the terms of the contract. But because it is done by the Government and we have no written legally binding contract with the Government relating to pensions provision, the State simply can cut our benefits, while still requiring us to keep our end of the deal - continuing to pay into the PAYE pot.

So the biggest issue of all is - will the new top-up requirement be legally binding for both sides of the deal or will it remain asymmetric (and therefore subject to the risk of arbitrary changes in the terms and conditions by the Government)?

Question 7: The new pension system would re-enroll people who quit every two years. This begs a question - will this 're-enrollment' be performed with crediting for years lapsed or not. If yes, then the risk of underpayment due to interruptions will be borne by the collective pool of funding. Which means that everyone paying into the system will be at a risk of bearing the cost of higher jobs exits and unemployment. If no, how will the recovery of underpayment take place? Simply requiring people who dropped out to repay the shortfall accumulated over two years of absence will not work, as it will impose huge burden on those with uncertain employment prospects.

Question 8: How will the system manage those in part-time employment, self-employment and those with hybrid income sources (multiple jobs, etc)?

Question 9: Since top-up clause requires private pension plan with employer contribution in excess of 4%, can the new plan be deemed anti-competitive? For example, if a self-employed person obtains no contribution from the employer, does the new pension mandate commit a person to a minimum contribution of 6%, thereby forcing them out of other private pension arrangements they might have, which may include single payment/lump sum contributions?

Question 10: If a person is forced to switch away from a smaller pension plan into the 'top up' Government plan, given that Government plan is not comparable in terms of risk of payout to a private plan, will this not in effect reduce the quality of pension that the employee will obtain? In other words, the Government scheme might result in a reduced quality of pensions for some savers.

Question 11: Will the new top-up arrangement cancel out PRSI contributions, or will it be on-top of the PRSI levies? If the former, who will fund the 35% promisory note of statutory state pensions? If the latter, this constitutes a massive increase in taxation burden in this economy.

Question 12: How will the Government reimburse those of us who might have higher pensions contributions by employers, but whose employers will now opt for a default position and drop their contribution to the effective minimum of 2%?

So far, the proposal is yielding more questions than answers. Which, of course, simply indicates that there is a good chance that the Government has not thought through the whole scheme and might be risking entering into another 'Policy-based evidence' scenario for which we, as a country, are so well known around the world.

On the net, however, given the nature of the top-up arrangement, unsecured contractual status of the proposal and the fact that the State decided to exempt its own employees from the obligation, the whole proposal looks like another tax by the Exchequer.

Economics 03/03/2010: Live Register and Retail Sales

Live register and retail sales are out for today - and:

LR is down in seasonally adjusted terms. A whooping 2,300 down, driving implied unemployment rate from 12.7% in January to 12.6% in February. Sounds like a good deal at last. And, of course, it is, except:

• Actual Liver Register still rose by 20 new signees;
• The rise of 810 in over 25 year olds was offset by a fall of 790 for the under 25 year olds, which makes me wonder - was the former a real increase in unemployment, while the latter a sign of younger kids abandoning the workforce to join training schemes, social welfare (with unemployment benefits for the under-25 year olds being reduced in two budgets) or going off to greener pastures elsewhere (i.e emigrating);
• Whichever way you spin the numbers, 432,400 people on the LR is a sizable number and to me still constitutes a massive crisis. 348,100 of these are over-25 year olds - prime employment age workers (down just 800 on January in seasonally adjusted terms);
• Average net weekly change to the LR in February was a much more modest +5 relative to January's +2,668 - a good sign, if one stretches the term 'good'

Now, do recall - in September 2009 we took off the LR 3,785 people who were placed in various state-sponsored training programmes, so there is still plenty of cushion for LR to show real improvement.

A chart (courtesy of the Ulster Bank economics team) to illustrate:
One clearly needs a microscope to spot the improvements in the overall picture, although the trend in moderating LR growth rate is clearly visible. Another interesting sighting is the dead-cat-bounce in October 2009. Are we in the same pattern now? I don't know, but dynamically, the chart above suggests we are at the flat part of the U-trend. How long will it take before we get through that part? How steep will be the upward part of the U?

The key risk indicator at this moment is QNHS which, I would expect, will show further contraction in employment and more aggressive exits from the labour force.


Meanwhile, retail sales are also bumping up, limp, lifeless, but twitchy. Chart below - courtesy of the Ulster Bank economics team (I will do my analytics later tonight, so stay tuned) illustrates:
The volume of retail sales (i.e. ex effects of price changes) is down 4.8% in January 2010 compared to January 2009 and down a whooping 17.3% in monthly terms. There was a monthly decrease of 17.3%. Ex-motors, volumes are down 4.7% annually and up 0.1% monthly. would the natural (and man-made) disasters of January help here? Quite possibly - electrical goods, furniture, lighting and clothing are up as people had to counter adverse weather and replace those washers and dishwashers frozen in the cold spell.

The value of sales fell 8.4% in January 2010 in annual terms and 15.6% in monthly terms as deflation at retail level continued to bite, primarily at Motor Trade levels: ex-motors, monthly change was +0.6%.

My slight concern here is that the release of retail sales data covers December 27-January 23rd, which means that while it missed a slow-to-go last week on retail sales in January, it also over-states retail sales due to capturing December 27-30 - the busiest sales period in the entire year. And, due to inclement weather, fewer people were able to travel to the North, so more shoppers stayed in the Republic, although many of these stayed at home.

Economics 03/03/2010: IL&P results FY2009

IL&P – the folks who pushed their mortgages lending to 300% of their deposit base – in the style of Northern Rock – have released their FY 2009 results this morning. Overall operating loss of €196 million for 2009 represents a swing of €537 million against the profit of €341m in 2008 reported in 2008. This takes some doing to achieve for a book of loans valued roughly at €39 billion (and that is widely optimistic – the total lending book declined from €40.1bn in 2008 to €38.6bn in 2009 – a decline that is hardly reflective of the peers).

When considered against the Irish Life division operating profit of €102 million (down from €284 million in 2008) the Permanent bit of IL&P is emerging as a seriously weak link. The bank posted a loss of €270 million with operating loss of €280m – a swing of €310 million on €30 million profit in 2008. Bad debt provisions are set at €376 million – assuming relatively static deterioration in 2010 compared to 2009. Total expected provision for 2009-2011 crisis period is standing around €900-950 million. I am not sure this is realistic, given the fact that mortgages are now starting to show increasing stress – with anticipated lag of legal process and for work-through of savings cushions by distressed households. In contrast with all rational expectations, IL&P management commented that home arrears growth was slowing. Good luck to them.

Capital ratios remain flat over 2009 - Total Tier 1 of 9.2% - hefty, healthy, but… one has to remember that IL&P has a much heavier T1 requirement due to life insurance business side. Translated into banks ratios, this implies effective banking side Tier 1 of roughly 6-6.5% - still better than AIB or BofI, but has some room for improvement. Given the overall reluctance of the Permanent side to take realistic writedowns on mortgages, I would suspect there will be renewed pressure on Tier 1 in months to come.

Economics 03/03/2010: IDA's new campaign

IDA have launched their new long-term strategy document that is worth taking a look. Here are my own observations:

“I am delighted to take up the role of chairman of IDA as we launch a new strategy... There are great challenges before us but there are also great opportunities. The sweeping changes in technology and the world economy outlined in this document promotes [sic] an increased sense of urgency as we change the way IDA performs its mission. I have full confidence that the expertise and energy IDA staff bring to the task will ensure we remain one of the world’s most admired agencies for promoting FDI.” [a bit of self-loving here?]

Liam O’Mahony, Chairperson, IDA Ireland

I must confess, I like IDA guys. They and Enterprise Ireland side are the exceptionally rare parts of the public sector that actually work. One can question them from the point of the return on the euro spent (I have no knowledge of the metric, so this is a rhetoric question) but one cannot question their engagement with their work.

Thus, I actually looked forward to today’s release of the IDA strategy 2020 document. And as before, I loved the core theme of their imagery – signifier (perhaps too optimistic) of what Ireland should look like – modern, expressive and smart (not just in terms of technical brains, but in terms of broader, diversified creativity - alas, the signifiers did not match the strategy exactly).

Now, IDA has two very competent, and professionally admired people at the helm – Liam O’Mahony and Barry O’Leary. This should get IDA moving. Maybe not quite into 2020, but certainly into 2010-2011.

So let me not pour too many accolades, and focus on what I usually do – challenges. And there are some in the 2020 strategy document. These are, as I say, challenges. It would have been nice to see them addressed in greater depth in Horizon 2020 document.

Tax policy - absent

Take the first and foremost policy instrument for IDA and for general economic development in Ireland – tax. IDA is keen to recognize the overarching importance of tax policy to attracting MNCs. But it fails to take stock of the more recent changes in tax regime and the ongoing changes in the business development and corporate investment environments.

“We have a young, highly skilled workforce and easy access to the best young talent across Europe. Our tax regime is compelling,” says strategy document.

Really? At 50%+ marginal tax rate on highly skilled and experienced talent? "Compelling" as in second highest in Europe? And adjusted for benefits what do we, the taxpayers, get in exchange for this rate?

Spatial Pipe Dreams

Oh, and there is another little thingy there – the mandate to “support regional development”. Yes – the Spatial Development Plan (or rather our Spatial Development Pipe Dream) is still there, folks. Hasn’t gone away along with all those empty country-side estates that were supposed to be ‘Gateways to Excellence”.

Of course, this is not IDA’s fault - both tax policy and spatial development illusion are domain of policymakers, but still – couldn’t internationally-aware guys like Barry O’Leary and Liam O’Mahony quietly slip this ‘regional development’ schlock into an addendum to an appendix of sorts?

Human capital? Whoa?!

Another interesting omission – also relating to the tax on human capital – is the lack of analysis of the threat to our demographic base from foreign competition for talent.

“With a comparatively younger population, with just 14% of Irish people over 65, Ireland will have a relatively larger proportion of highly skilled and educated workers from which to draw. [Well, that is actually not a foregone conclusion – having younger population does not mean one automatically ends up with a relatively larger proportion of highly skilled and educated workers] Ireland also remains a vibrant and attractive place for younger workers from within the EU, making it easier for multinationals locating here to attract young talent from the whole of the 500 million-strong European Economic Area.”

Really? Are we sure this will be the case? Even when Germany, France, and the rest of ageing EU starts paying higher wages to younger workers to attract them from abroad and to keep their own? Even when other locations worldwide start offering better quality of life and higher wages to younger workers? No, folks, to get that ‘demographic dividend’ we need to work hard to compete for talent globally. And this means putting in place things that IDA strategy does not mention:

• lower tax on higher skilled and better educated workers;
• greater quality of public services for lower price to the taxpayers;
• greater quality of goods and services delivered within domestic economy (competition and market liberalization agendas come to mind here),

and so on.

BRICs: back to the future

I liked IDA’s specific focus on BRICs, but the section on these countries is too thin on details as to how the agency plans to make serious in-roads in these markets. And there are deeper questions here:

• By 2010, BRICs are hardly a new frontier - these are middle income (in case of Russia, officially a developed country) economies with steep competition from other locations for their investment. Shouldn't IDA aspire to broader geographies?
• BRICs are heterogeneous and lumping them into one section is a difficult task - more definition is needed to understand what exactly is the strategy that IDA is planning to pursue here

Regulation - spot on

I liked that IDA is pragmatic – in this age of regulatory hype, this is an achievement – when it comes to recognizing the need for flexible, functional and not-too-burdensome regulation: “Ireland must ensure that it remains at the forefront of creating a regulatory environment that is robust, credible and ‘fit for purpose’ – one that does not place undue burdens on business.”

Creativity mark - C

In a departure with the past, IDA strategy does attempt to deal with the issue of business processes innovation and even strays into business model innovation. This is a fitting change from traditionally 'hard' innovation-driven agency. And it might, just might, sound like a warning shot to domestic sectors - 'Shape up, or lose out'.

But I thought a major weakness of the strategy can be found in the fact that in the entire document, words

• ‘creative’ – as in creative industries/sectors, and as in the business-operative word relating to creative innovation;
• ‘design’ –as in the driver of new products and markets;
• ‘management innovation’ – as in a major driver of systems productivity;
• ‘traded services’ – as in the areas that account for more than 50% of global trade already (note, ‘manufacturing’ is featured in 8 instances in the report),
• 'urban' - as in ca 80% of our economic activity will be by 2015

are not mentioned even once and

• 'high value' - as in high value added sectors

is mentioned only once.

In the age of Twitter, technology is a direct outcome of creativity, not the other way around. In fact, the failure to more comprehensively deal with non-ICT, non-biotech, non-labcoat innovation and sectors puts a massive dent into the entire document. It makes me wonder – does IDA realize that Google, Twitter, Facebook, Apple, IBM, Microsoft – you name a success story in today’s IT & ICT world – are driven more by ‘soft’ innovation and only as a corollary – by technological platforms? I think they don’t – and this mutes that wonderfully designed, creative and aesthetically sophisticated advertising campaign that they feature on the inside cover of their report.

Again, to be fair to IDA - good effort is made to move from previously undefined 'Financial Services' objective toward more specific services-related areas. A bit of an eye-catching is the focus on Financial Analytics - an area where much needs to be done before we can attract into the country leading financial analysis firms. Perhaps, more realistic here would be to develop capabilities by using Ireland as a platform for attracting start-ups and early-stage companies in this area. Bary O'Leary does mention the latter (although not specific to the Fin An sector) in his key note, but again, the document could have had this specified in more detail.

So overall, a slight sense of disappointment, but also some hope that next time (and before 2019) IDA strategy will reflect deeper and more real change in the way the organization is actually starting to see the future. Encouraging signs are present in today’s document.

Economics 02/03/2010: Exchequer (still) Singing Blues

Exchequer returns are in for February (DON'T PANIC sign on the cover) - and things are going just as poorly as was predicted. Well, slightly worse, actually. Few charts to illustrate the trends:

Monthly receipts and expenditures are showing divergent trends. While receipts are showing some improvement relative to 12 months ago, expenditure is showing deterioration. Worse - January 2010 improvement on January 2009 is now gone and February numbers have fallen below long run trend line.

Similar trend on receipts above, but now also adding tax receipts - a relatively hefty deterioration in seasonally adjusted terms (January 2009 to 2010 and February 2009 to 2010 comparatives).

Total expenditure is improving. But exchequer surplus is deteriorating.

What's going on?

At €1.66 billion, receipts in the month were a modest €64 million or 1.3% behind DofF budget forecast. On annualized basis this means something to the tune of €455 million shortfall… small stuff… but.

February income taxes are tanking – down 11.8% on 2009 (-€246 million).

But wait, this was actually the second best performing tax head of all… Table below illustrates

Now, February, seasonally is a low tax revenue month – accounting for around 5% of annual revenue. But this time around, February total tax receipts were down 17.8% on 2009. In two months of the year, the same figure is 17.7% - not much of a change… certainly not enough to say things are improving. Oh, sorry, no – they are actually deteriorating!

How come DofF can be happy about these dismal results? Well, for the first time in over 2 years of this crisis, DofF estimates are sticking! Even if only for two months so far. Budgetary projections assume tax revenue of €31.05bn in 2010 or 6.02% below 2009 figure. So far, seasonally-speaking, we have seen roughly 15% of annual tax revenue coming in at roughly speaking 18% below 2009. So should the trend continue flat from here on, we have lost 2.7% or almost half of the allotted annual deterioration! Slightly better than Nama spending its entire legal costs allowance for the year in two months of work, but still... not a record to be proud of.

And on the spending side things are a bit bleak and bleaker: most of the spending decline to date has been on the capital side. In fact, capital expenditure – remember, Brian Cowen and Brian Lenihan have both claimed in 2008 that capital spending will be our stimulus – is down 25% in February (annual terms). In January, this decline was 21%, so the drying up of the ‘stimulus’ is accelerating.

Of course, it is current expenditure where most of fiscal waste rests and where the entire structural deficit is hidden. So one would assume that here, there should be some sizeable cuts. In January 2010, in order to, presumably, impress ‘international markets’, DofF cut current spending by 12% in year-on-year terms. Happy times? Not really – in February this figure eased back to 8%. Even at a half this rate of a ‘forward retreat’, we will end 2010 with spending well in excess of 2009 total.

But, so far, through February 2010 total savings on current spending side add up to €567mln. Now, our structural deficit is roughly 8-9 percent after the Budget 2010 measures take place. Which means we need to cut roughly €5.5 billion in annual spending. At the rate of current cut-backs we are achieving €3.4 billion, under very optimistic assumptions that the current rate of cutbacks will be sustained.

Economics 02/03/2010: CBFSAI - in search of Art Consultants

As the country is grappling with the risk of banking sector collapse, lack of direction toward new regulatory environment for the financial services, unemployment, fiscal problems, need for reforming (and also lack of direction for such reforms) public sector, and so on, it is comforting to know that at least some of the policy / public management bottlenecks are being addressed...

The Central Bank of Ireland is looking for an Art Consultant - here - seriously (hat tip to Brian)!

There are precious pearls here (comments are mine):

"The CBFSAI maintains and refreshes its visual art collection, not only as an investment, but to enhance and enrich the working environment of its staff and as a means to encourage creativity and cultural diversity amongst employees and the wider community [apparently Central Bankers really need a working environment that encourages their creativity and cultural diversity].

We believe that our particular support for emerging artists, especially those in the early stages of their career, is a valuable conduit of encouragement, not only of individual artists, but of the artistic community in general [and encouraging artistic community is one of the functions of any Central Bank, one would presume]."

One, of course, is wondering if the new Art Consultant role will also be responsible for:

• managing Nama-led acquisition of art accumulated by our poorly performing banks (with some of poor performance likely attributable to poor regulation by, hmmm, ... would that be the Central Bank?)
• giving recognition to the artistic values of Irish banks creativity in the area of financial engineering (with some of the lending deals done at the height of Celtic Tiger clearly bearing resemblance to the post-Abstract Expressionist decompositions of the Barcelona School of Art), or
• providing advice on writing constructive press releases explaining the collapse of our banking system and subsequent taxpayer rescue of the 'art appreciating' financial sector in this country (after all, some of the PR produced on Nama, for example, borders on the best works of Eugene Ionesco and Luigi Pirandello), and
• commissioning and orchestrating the performance of Stockhausenesque compositions to depict the true extent of disorder in our banking balancesheets?

Hmmm... art consultants to the rescue, might be the CBFSAI's next motto...

Oh, and in case you thought our Central Bank is out of tune with the banks it regulates, here are few links: AIB and BofI are also keen on making sure their employees work in a rewarding atmosphere, surrounded by art and that they support arts in this country... sadly - both forgot to support proper risk pricing and responsible lending.

Then again, what is more important to an Irish (Central) Banker? Art appreciation classes or risk pricing?

Economics 02/03/2010: AIB 2009 results

AIB's bad fortunes:

• Pre-tax loss of €2.656bn for 2009;
• €5.35bn in bad loans provisions - 4.05% of customer loans base
• ROI operations losses of €3.5bn
• Total criticised loans up to €38.2bn (24.9% of customer loans base), compared to €15.5bn (11.7%) at the end of 2008
• Criticised loans increase - 23% outside ROI, 77% within ROI
• Mortgages 91+days overdue are at 1.96% (December 2008 0.7%) and this does not account for re-negotiated mortgages
• Post-Nama, expects ROI loans to fall to €58bn (55% of the total loans held), composed of €27bn mortgages, €6bn in personal loans, €12.8bn of property loans, €12.6bn other loans

But the real beefy stuff is on pages 111 and 15 of the report (here). Hold on to your seats, folks - from the realistic folks who brought you a dividend in 2008 (as the Titanic was gliding along the iceberg's first bump):

Page 11: Loans and receivables held for sale to Nama €23.195bn, with Provisions at €4.165bn

implying an 17.96% net discount on loans transferred to Nama (the second table below).

Aha, not 25%, or 30% or 35%, but 18%. And as far as those 'Good Loans' that Minister Lenihan wanted to buy go? That's categories 1-3 loans above, or a whooping total of €21mln. Impressive risk hedging by Nama is expected. Oh, don't take my word for this - here is how the Nama portfolio from AIB will look like:
So wait a second, folks, AIB will dump 63% of their impaired loans into Nama, but will provision for a haircut of 18% on these? Their own debt is now being settled at 50 cents on the Euro with private bondholders, while the Irish taxpayer is expected to settle at 18 cents?!

And have a laugh - page 15: ROI Nama-bound loans provision is 16.6%, UK Nama-bound loans are 5.1% and overall impairment charge due to Nama (remember, this accounts for risk-weighting changes) of 14.54% (Table at the bottom of page 15).

It's a free lunch -Frank Fahey-style - except for the bank!

Economics 01/03/2010: AIB, Nama & tomorrow's numbers

From the Dolmen guys - today's preview of AIB results announcement tomorrow -

"We expect operating income of €2bn for the year, impacted by lack of demand for credit by Irish consumers and lower Net Interest Margins (NIM). Due to a pre-tax loss of €2.7bn, equity tier 1 of the group will move down to 5%. Overall, the market will be looking for guidance on NAMA, capital raise and credit quality in the non-NAMA loan book. It is also likely the group will announce an exchange offer on its Lower Tier 2 debt."

Note the figure of 5% Tier 1. Internationally (e.g. UK) target is for 8%+ Tier 1, for banks with Loan-to-Deposits (LTD) ratios in excess of 100%. AIB's latest accounts I have access to show LTD ratio of over 150%. This means that the AIB will be on the hook for up to Euro 4 billion in order to plug in the Tier 1 capital gap with its international peers. And this is before the expected loans losses of Euro 5-5.3 billion expected in the tomorrow's announcement. So on the net, H1 2010 demand for funding should be around €3.8-4.5 billion before Nama kicks in and before provisions for a new batch of bad loans...

This is more than 3 times the current market capitalization of the bank!

Also note Dolmen's reference to the lack of demand for credit. Spot on - the problem is that no matter how one spins the current credit crunch, consumers and businesses (burdened by massive debt and facing rising tax curve into the foreseable future, along with high risk of unemployment and huge uncertainty about the future performance of the economy) are simply in no position to borrow. This, along with the crippling expected cost of Nama to the real economy means that there is not a snowball's chance in hell the credit bubble can be relaunched in Ireland... at any level of interest rates...

Economics 27/02/2010: How to reform our broken risk pricing system

This is an unedited version of my article in March 2010 edition of Business & Finance magazine:


There are several deeply rooted problems with the current analysis of the ongoing financial crisis. These relate to the sources of the crisis itself and to the solutions proposed for ensuring that a new financial bubble will not emerge out of the ashes of systemic risk under pricing that characterized the period of 2003-2007 around the globe.

So far, the public aspects of the regulatory responses to the crisis have been focused on ‘political’ topics, such as executive compensation. Fine: the incentive for banks executives to structure their own compensation to reflect short term gains is well established.

Political issues are non trivial as well. We all are aware of the fact that politicians – from Bill Clinton to Gordon Brown to Bertie Ahearn and on – have strong incentives to placate voters through fattened Exchequer revenue, expanded public spending and broadened access to credit irrespective of risks. Active encouragement of loose lending standards (especially in the case of the US SGEs: Fannie Mae, Freddie Mac and Ginnie Mae) were enshrined in regulatory and legislative mandates. And look no further than Greece, Portugal, Spain and Ireland as to the troubles this can cause – politicised spending breeding scores of vested interest groups that cannot be disentangled from the feeding trough.

All of these forces, underlying the crisis emergence, are well known. What is less frequently discussed in the media is that wrong incentives alone are not a sufficient condition for markets malfunctioning, since in efficient markets, a contrarian view should be able to price out those players aligned with wrong incentives.

It is a much deeper question as to whether this has happened in the case of the current financial crisis. Anecdotal evidence suggests that this was indeed so. Early in 2007-2008, a number of short positions, including those taken well in advance of the crisis, were generating the payouts consistent exactly with the rapid pricing-out of the malfunctioning lending strategies. Ironically, banning short sales has resulted in the restoration of the mis-aligned incentives in the market. An act by the regulators aimed at restoring order in the financial markets turning out to be nothing more than reinforcing the very causes of the crisis.

This means that we must look back beyond the immediate crisis to find any evidence to either support or dispute the proposition that mispricing of risks by the financial system was systemic (in the sense that existent models of risk pricing could not have allowed for contrarian pricing strategies).

It remains a puzzle that the main villains of the game, sub-prime mortgage packages (the famed ‘Collateralised Debt Obligations’), seem to have been so badly mispriced. This apparent mispricing lay not so much in the slicing of the mortgages but in the failure to price into the packages as a whole the apparent systematic risk due to the general response of property prices to the business cycle.

Suppose that the current view that greed blinded markets participants to the fact that CDOs packages were not properly pricing risks is correct. This explanation requires that not a single market participant was willing to take a contrarian strategy betting against the consensus view. Alas, this is patently untrue.

So ‘collective madness’ explanation does not hold and the crisis roots lie somewhere else – more likely, in the balance of incentives. My suggestion is that on the margin, regulatory and market incentives led to favouring of underpricing risks inherent in CDOs and MBSs. Thus, on the margin, excess returns to unpriced risk for going long on mortgage-backed products were made greater than the expected returns to shorting mortgage-backed products once the price of insuring / shorting these products was taken into account.

In other words, it was a combination of:

• Artificially low perceived cost of long positions;
• Artificially high cost of shorting; and
• Recklessly elevated correlations between product risk (mortgages risk) and insurer risk (AIG)

that drove the bubble formation. The reason why this understanding is important is the following:

If contrarian strategy could have been formulated based on existent risk pricing systems, then short sellers were ‘fundamentally’ justified in their positions and their gains were not ‘speculative’. Furthermore, this would imply that the current crisis is not systemic from the financial point of view, but is driven by incentives and regulatory failures.

If, however, existent risk pricing systems were not sufficient to support the contrarian investment strategy and those short sellers who were betting against the consensus obtained speculative profits, then the markets are not efficient and the crisis is systemic in nature.

So, if we take information about the markets available pre-August 2007, could the crisis been pre-priced? Put differently, were Irish or for that matter UK or US property and credit bubbles predictable on the back of fundamentals or were they random events?

The systemic crisis argument supporters show that since Irish property prices have indeed collapsed on the back of weaker-than-expected ‘fundamentals’ market price risk discounting has failed.

Those opposing the argument point out that the fundamental in the housing market is ultimately driven by income dynamics, which in turn are driven by productivity. In the case of Ireland, productivity growth (income growth) should follow a random walk because innovation is largely unforecastable and in the case of a small open economy it is also subject to global trends. In other words, Irish productivity growth should be following a random walk that is even ‘more random’ than the productivity growth processes in the rest of the world.

Both are wrong. It turns out that close to the crisis – at least from 2003 on – Irish property prices appeared to become a non-stationary process having been largely stationary in the previous decade. Ditto for the US and UK, and even Spanish, Russian and Dutch property prices.

This means that the conditional forecast of the property prices in Ireland was best modelled by a reference to the current prices. More importantly, from the point of view of risk pricing, expected conditional volatility of house prices was a scale factor of the observed current volatility. In other words, the degree of risk 6 quarters from, say February 2003 was simply 6 times greater than very low volatility observed back in February 2003.

The scaling relationship, alas, failed to hold in the real world. As the property boom became, using Bertie Ahern’s terminology, ‘boomier’ through 2003-2006, property prices stopped following non-stationary process and their volatility became largely trend driven. The trend presence means that at least in part, future risk could have been priced into lending decisions by the banks and regulators. Alas, it was not. All evidence on lending suggests that the banks lending margins were heading down during 2003-2008 period, not up. In other words, Irish mortgage lenders, with tacit consent of the regulators, were pricing in decreasing risks into the future during the bubble inflation time. Ditto for all other countries that have experienced the collapse of property markets.

So whilst the financial markets were correct in pricing risks, subject to significant regulatory incentives constraints that skewed their willingness (and later ability) to actually adjust their risk pricing positions, mortgage lenders and regulators were grossly mispricing risks. This realisation leads to two major conclusions.

It shows that globally, financial crisis of 2007-2010 has been driven by the risk mis-pricing that originates in the very institutions whose business is preventing this from happening – the banks and the regulatory bodies.

And it shows where the future reforms attempting to address the issue of financial bubbles formation must lie. And it certainly has nothing to do with bankers compensation packages. The main solution to the problem suggested today is heavy re-regulation of bank risk; moving Basel I and II up to Basel III to include a pro-cyclical risk capital provision.

While a useful idea, greater buffer reserves of risk capital built over the years of credit expansion cycle, are not a panacea to the problem outlined above. The reserves are only sufficient in so far as they reflect actual risk expectations. Missing risk forecast will, in the end, still imply sub-optimally low levels of capital.

Instead, the answer to the problem of how can we prevent future bubble formation similar to the one that has been deflating since August 2007 lies in a more holistic approach to risk pricing reforms. This approach must involve several policy changes along the following directions.

Firstly, a more transparent early warning system must be deployed across the financial markets that would make short trading positions a part of open market pricing mechanisms. Put more simply, short trading must be allowed to operate on unrestricted basis, but all short trading positions must be disclosed and reported in the market in the same way in which we current disclose long positions.

Secondly, property must be treated as investment instrument, with full price and hedonic information disclosure rules mirroring those required for liquid financial instruments under MiFID.

Thirdly, there must be a clear set of strict ‘no pain, no bail out’ rules that will impose severe penalties on the management, bondholders and shareholders in financial institutions seeking public assistance. If countries can change governments within weeks after elections, banks can be weeded of their failed management as a matter of months. Instead of restricting their pay, in the future, we must make bankers accountable for their failures.

Third, regulatory authorities must be beefed up with independent, fully protected risk analysis boards drawn across the broader economy. These boards must be politically unconstrained, free of interest groups influence and must be operated behind a strict Chinese Wall relative to the entire regulatory process. A formal requirement must be imposed that at least 1/3 of the board members should be drawn from outside financial services sector, with the same proportion of members being required to hold a publicly verifiable policy positions that are contrarian to the consensus.

What the current crisis has taught us is that in the environment where politicians and industry drive risk pricing-related policies, failures of the market to cope with distorted incentives and incomplete regulatory oversight will be spectacular. Crises are a natural way for the markets to reassert proper order on inept regulatory and institutional systems.

Economics 27/02/2010: Double dipping

As of recent days, the media has become finally aware of the serious risk of double dip recession - here in Ireland (qualified below) and in the rest of the world. The reason for this awareness is most likely the ongoing crisis in the Euro area debt markets. But the real cause for concern should be the overall markets dynamics.

First, let me qualify what I mean by the double dip recession in Ireland. Officially, to have a double dip you must exist the first recession - which can only happen if Irish economy were to post at least a quarter of positive growth. There is an inherent asymmetry in the way we term the business cycle. While going into a recession requires two consecutive quarters of negative growth, recovery set in after just one quarter of positive growth. The second dip for a recession, however, requires again consecutive two quarters of negative growth.

Which, of course, means that were recoveries distributed following the same probability distribution as recessions, the risk of a double dip recession will be lower than the risk of a single quarter negative adjustment post-recovery. And lower still than a recovery. Statistics bear this out, with double dip recessions being relatively rare.

Of course, for Ireland, a double dip recession in current environment will simply mean that instead of turning first positive, then negative again, our GDP (or as I would prefer to measure it - GNP) growth turns more negative than it currently stands.

Definitions aside, what we do currently know points to a strong probability of a double dip recession in the US. Here is why.

As I pointed out in a recent article in the Sunday Times (here) I argued that residential investment is the leading indicator for both recessions and expansions. What we are now seeing the US and the UK are the first signs of renewed problems in this sector, as stimulus and tax breaks wear out.

• Resales of U.S. homes and condos fell 7.2% in January to the lowest seasonally adjusted levels in seven months. This marks two consecutive months of falls that ended an H2 2009 rise. Sales of existing homes have fallen two consecutive months after rising steadily through the fall on the back of a federal subsidy for first-time home buyers. Inventories of unsold homes fell 0.5% to 3.265 million, or 7.8 months of supply at the current sales pace. And this does not bode well with Irish data, where declines in inventories (see Daft.ie latest reports) were seen as an 'improvement' on the overall trends.
• Sales of new homes in the U.S. fell in January to the lowest level on record. Sales were projected to climb to a 354,000 from an originally reported 342,000 rate in December, according to the median estimate in a Bloomberg survey of 72 economists. The supply of homes at the current sales rate increased to 9.1 months, the highest since May 2009. Purchases of new homes reached an all-time high of 1.39 million in July 2005. January 2010 sales dropped 11.2 percent to a seasonally adjusted annual sales pace of 309,000 units, the lowest level on records going back nearly a half century.
• Foreclosures are continuing to rise and with them - banks failures (see a good post on US banks weaknesses here).

So overall, the US lead indicators are pointing to a double dip.

Ditto for the UK, where home prices are now hitting the reversals of recent gains. Average house prices in the UK fell 1% in February after nine consecutive monthly increases. Although average prices in February were 9.2% higher than in February 2009, according to the Nationwide Building Society, it is the dynamic, not the levels that matter.

And EU economies are now in the reversal as well:

• Confidence among German corporates contracted unexpectedly in February, according to the sentiment index released by the Ifo Institute - winter weather is being blamed, but there is little evidence this is really what is happening on the ground with exports tracing consumer demand downward;
• Italy's state-financed ISAE published a new survey showing that Italian consumer confidence is now in a free fall once again;
• Exactly the same is happening in France, where consumer spending is falling as the state cash-for-clunkers program ended, causing decline in car sales;
• Bank of France data shows that credit to the private sector have slowed down even further in January, while credit to companies was actually falling once again.

Since France and Germany led the Euro area out of recession last summer . That recovery was driven by government stimulus programs and a pickup in global trade. Domestic consumers, meanwhile, were left holding the bag - as usual - in the block which prides itself on selling premium stuff to foreigners and keep its own citizens as savings-generating serfs of the exports-driven economies. Net result? Q4 2009 Germany's GDP growth was flat in quarter-on-quarter terms.

This, of course, is bad news for Ireland. There are three major problems that lay ahead of our recovery and none are being helped by the weakening global economic climate.

First, there is a problem of fiscal deficits financing. Slowdown in the EU and US means that there will be no easing in the glut of new bonds issuances this year. Euro area alone is expected to raise its debt issues to roughly $2 trillion worth of bonds since the beginning of the crisis. A minnow, like Ireland, is bound to see its yields shooting straight up if we are to finance our deficits through open market placements. And there is no hope for placing these bonds elsewhere, as the ECB is hell-bound on clawing back on its quantitative easing programmes of 2009.

The ECB can do so in two ways - hike the rates, or reverse collateral inflows back into the banks. Alas, the former is out of question for now, with economic situation deteriorating. This leaves the latter as the only option. Irish banks - the most dependent on ECB lending throughout the crisis - will suffer heavily through such an exercise.

Second, EU growth reversal spells the end of our exports buoyancy and the hopes for foreign investment boost from the US MNCs aiming for EU presence expansion.

Third, absent growth in the Euro area, the markets will continue scrutinizing closely public finances of the member states. I will post on this issue later today/tomorrow, but the core message here is that Ireland is simply not in a very good position to escape severe downgrades from the markets, given the fact that our policies to-date have been heavy on squeezing all liquidity out of the households.

Economics 26/02/2010: EU Commission decision on Nama

The EU Commission has granted its nod of approval to Nama (here). The Note states that:

"The Commission has found that the establishment of NAMA constitutes state aid to the participating institutions pursuant to Article 107(1) of the TFEU, but that this aid is compatible by virtue of Article 107(3)(b)."

It is therefore clear that Nama is a form of aid. If so, who are the logical recipients of such aid - and there simply has to be someone benefiting from aid. How does this square against the Irish Government repeated statements that Nama is not a rescue plan for either the bankers or the developers.

"The scheme and intended operations of NAMA are in compliance with the guidelines set out in the Commission's Communication on the treatment of impaired assets (see IP/09/322 ) as regards disclosure and ex ante transparency, eligibility of institutions and assets and the alignment of banks' incentives with public policy objectives."

Emphasis above (mine) relates to the following issues:

• Transparency: what transparency does the Commission have in mind, given that Nama is set to report only to the Minister for Finance and will operate under the veil of total secrecy, outside constraints of public scrutiny?
• Alignment of banks' incentives with public policy objectives: does the Commission seriously think that incentives for the banks to repair their balancesheets through increased lending margins and higher costs, or reduced competitiveness in the banking sector due to Nama subsidy to select banks, or the need for recapitalization by the taxpayers post-Nama constitute properly aligned incentives for the banks to act in the interest of the public?

"In particular, the Commission has found that the scheme includes an adequate burden sharing mechanism through the payment of a transfer price which is no greater than the assets' long-term economic value, and the inclusion of an adequate remuneration for the state in the rate used to discount the assets' long term economic cash flows."

Of course, when the Commission is talking about public policy objectives, what they mean is the alignment of the scheme incentives with the principles outlined by the Commission. In other words - by focusing on the erroneous objective of ensuring long-term economic value consistency of valuations, the Commission is confusing public interest (interest of ordinary Irish taxpayers) with its own interest (interest of the Brussels to see compliance with its own regulatory framework, which in itself is a simple deus ex machina for concealing the reality of this state aid).

"Today's approval concerns only the NAMA scheme. The Commission will assess the compatibility (and, in particular, the actual transfer price) of the transferred assets when they are separately notified by the Irish authorities. These individual reviews will include a claw back mechanism in case of excess payments."

This is significant as it introduces a new layer of uncertainty for the banks - post-Nama, the banks will remain exposed to the Commission decision on valuations, which in effect will extend Nama process indefinitely, delaying any potential positive effect of Nama.

"Finally, the Commission relies on a number of commitments from the Irish authorities to ensure that NAMA, whilst it performs its goal of maximising the recovery value of the purchased assets, does not lead to distortions of competition through the use of some of the specific powers, rights and exemptions granted in the NAMA Act."

What are these commitments?

In short, the Commission decision on Nama is as holes-ridden as Swiss cheese and signifies a simple pro-forma sign-off on the scheme.

Finally, in his response to the Commission decision, Minister Lenihan stated that:

"Within the [Nama] valuation methodology a higher remuneration risk margin and higher enforcement costs will be applied. There will however be a reduction in the interest rates used for loan discounting purposes. "

This is significant as well, as a reduction in interest rates implies that the long term economic value valuations will have lower rate of discounting to the present value, thus leading to higher rates of over-payment on the loans. In other words, to keep discounts on assets artificially lower, the Government simply can reduce the cost of capital and increase real return on assets by 'cooking' up lower discount rates.

Of course, one must ask Minister Lenihan why exactly does he (or Nama) envision that the interest rates are going to be lower in the future. I know of not a single forecast out there that envisions the yield curve pointing down in the future.

Economics 26/02/2010: Euro area growth - leading indicators

Eurocoin - leading indicator for growth in the euro area is out today, so it is time to update the forecasts:
Last month, my forecast for Eurocoin indicator was to decline from 0.78 to 0.74 over February-March. The actual outrun was the decline to 0.77. So I stick to my forecast for further deterioration. All signs are pointing in the direction of the recovery being reversed - from exports to industrial production, to consumer confidence. And the global economy is starting to feel the pressures of fiscal unwinding. Ditto for the Euro area countries, where Greece and Spain are now at the forefront of fiscal pressures, while France and Germany are also feeling the heat.

This is consistent with low rates of growth, if not an outright double dip in economic activity. For now, I am still happy to stick to 0.6-0.7% annual growth rate for the Euro area as a whole for 2010.


On a related tone, but different geography, UK house prices are down 1% in February per Nationwide Building Society, reversing 9 consecutive months of growth. The end of stamp duty holiday is to be blamed, as well as poor weather. But in my view, the reversal is a sign that absent stimulus (tax or spending) there is simply no fundamentals-justified demand in the market.