Economics 09/05/2010: What sort of EU leadership?.. Part 1

Prepare to be afraid, ye the financial markets – those always-on-time and forever-effective super leaders of the Eurozone have concocted a Plan. A Plan to deal once and for all with the frightening levels of their own governments’ insolvency. A Plan code-named Bondzkrieg!

The troops of illiquid and insolvent PIIGS will be backed by the armies of the liquid, but pretty much nearly as insolvent the rest of EU. The attack, commencing possibly as early as on Monday next will be a two-pronged strategy: a pincers manoeuvre.

Part 1 will, per latest reports from the EU16 summit, require an issuance of Euro Commission Bonds. These will be backed by the EU16 states’ guarantees and something that is called ‘an implicit ECB guarantee’. Sounds terrifying, folks:

1. What is exactly an ‘implicit ECB guarantee’? A sort of ‘we might print mucho Euro notes, should Brussels default’ stuff? What kind of nonsense is this? The best the ECB can do is promise to monetize the EU Common bond in the same way it monetizes Greek junk bonds. Yet, the latter has not stopped contagion, only accelerated it by undermining the ECB credibility.
2. What will back these Common bonds? The solvency of the EU nations guaranteeing them? But wait – isn’t the problem the EU is facing is precisely the very lack of solvency? How is it going to work then? A severely indebted and deficit ridden pack of nations issues new debt to cover up the old debt problems? Well, that did work for the Russian Government a miracle back in 1998. Without actually resolving the problem of excessive and long-running deficits, and without either restructuring (default) or deflating (devaluation which is a de facto default) the existent pile of debt, the new EU-wide bond issue will simply transfer Greek-style problems of the PIIGS to the rest of EU. Given that we are talking about roughly a €1 trillion worth of junk, the entire pyramid scheme concocted by the EU is going to collapse unless Germany is good for underwriting the entire EU16 with its economic might. Trouble is – Germany can’t. It has little prospect of growth and its’ current economy simply cannot carry the burden of the rest of EU16 obligations.
3. What will be the seniority of these bonds? If the new bond is subordinated to the existent state bonds (as implied by a ‘guarantee’ proviso), these bonds will have no meaning. If it will be senior to existent member states’ debt, then issuing them to pay down sovereign debt will be equal to deflating seniority of sovereign issues already outstanding. Which, in common English, is called defaulting on existent debt.
4. How can these bonds be priced? Normally a bond is priced by a combination of factors. Some are exogenous – such as global liquidity and portfolio driven demand. Some are endogenous – such as analysis of what the sovereign deficit is for the issuer, what debt burden the issuer is paying and what prospects for economic growth (and other components of future default probability) does a sovereign face. Finally, expected Forex positions for sovereign currency in which the bond is denominated are taken into account. Care to guess what any of these endogenous variables might be for the EU16? Right – they are totally meaningless. Will EU bond be written against EU own debt (which is nil) or against guarantors’ debt (sovereigns already overloaded with debt)? Will the Forex rates relate to the ECB rate which the ‘sovereign’ issuing the bonds (the EU Commission) cannot control (due to ECB independence)? Will EU ability to repay these bonds rest on Euroarea economic growth? If so, what does this mean, since the EU Commission collects revenue from EU27, of which 11 member states are not a party to issuance of the bond! Will, for example, UK government assume liability to the Eurozone-issued bonds by committing its own economy to the risk of a call on the bond should, say, Belgium decide to default?

The second prong of the EU attack on the markets is the incessant blabber about the need to set up an EU-own rating agency. Here, the promised might is clearly unmatched by any sort of internal capability:

1. The EU itself cannot certify own annual accounts, despite having only in-house own auditors. Even these are refusing to sign off on EU accounts for over a decade now. How can the same institution produce a credible rating agency that will be entrusted with providing assessment of the EU credit worthiness?
2. Can the EU-imposed metrics be seriously treated as fundamental benchmarks for solvency? Give it a thought – the EU oversees a union of member states bound by own sovereign treaty to uphold the Maastricht Criteria targets. The EU has failed to enforce these in the case of Greeks, Portuguese, Spaniards, French, Italians, Belgians and so on. In other words, the EU cannot enforce its own rules, let alone police economic and fiscal performance parameters required to issue any sort of risk assessments. In fact, this year Euroarea deficit is expected to reach 6.6% of GDP and in 2011 -6.1% - way above the 3% the block set as its own rule. Debt to GDP is heading for double digits, before we add banks supports. Letting the EU run a rating agency is equivalent to letting an alcoholic run a bar!
3. The entire idea of an EU rating agency traces back to Merkel’s and Sarkozy’s desire to shift blame for the Greek (and indeed PIIGS) debacle off the shoulders of the European governments and Brussels and onto the shoulders of ‘speculators’ and the Big-3 rating agencies. Of course, the logical inconsistency of the EU attacks on the Big-3 is painfully obvious. The Big 3 are accused for failing to properly recognize and publicize risks to the systemic solvency of financial institutions in the case of ABS/MBS and so on. Yet, the minute the rating agencies actually do their jobs – as in the case of PIIGS in recent months – they are standing accused of… well… doing the jobs only to well? Can anyone have any trust in a ‘rating agency’ set up by the very people who are simply and evidently incapable of a simple logical argument?

Mrs Merkel have stated this Friday: "Those who created the excesses on the markets will be asked to pay up -- those are in part the banks, those are the hedge funds that must be regulated ... those are the short-sellers and we agreed yesterday to implement this more quickly in Europe." Obviously, over a decade of fiscal recklessness across the PIIGS was never a problem for Mrs Merkel. And she is supposed to be the reasonable one?

All I can say, folks, forget any hope for growth in Europe with this sort of leadership.

Economics 05/05/2010: Third Force's Burn-out Bench

The news stream is getting thicker and thicker with Irish financials and sovereign / fiscal debacles stories. Reuters is reporting (hat tip to Brian) (here) that the Third Force now looks more like a Burn-out Bench and that there is little prospect for growth or profitability for BofI and AIB.

All's fine, as far as the arguments go, except, there is that silly ending to the article putting blame for the crisis on 'too much competition' in the Irish banking sector. I'd say this pure rubbish. Here is an earlier note I wrote on that subject. In simple terms, it does not matter what profit margins could have been were we to have lower competition. Irish banking crisis was caused by excessive willingness to take risks, spurred on by the Government, the Regulator, the Central Bank and ECB. May be there was too much competition amongst the incompetent cooks in that kitchen?


Oh, and Nouriel Roubini puts a clear number on the fear of European contagion: "European banks hold claims of US$193 billion on Greece and more than US$1 trillion of further claims on Portugal, Ireland and Spain. It cannot be ruled out that the ECB will eventually have to resort to more aggressive measures such as buying government bonds in the secondary market in order to stop the contagion."

So the next stage of contagion can cost Germany (and make no mistake - Germany will be paying for this in the end) upwards of 5 times what the Greek bailout will cost.

Economics 04/05/2010: Why Anglo case is irreparable

A funny way of arguing financial returns that some of our senior 'bankers' have has been highlighted in the latest comments of the Politician-turns-Banker Mr Alan Dukes reported in today's Irish Times (comments and emphasis are mine):

“The [EU] commission came back with a whole series of questions [concerning Anglo's 'business plan' - whether a zombie can have a business plan is a matter for another debate] and we are now rejigging the restructuring plan to deal with the issues the commission has raised. One of the things we are looking at is what would be the situation if we liquidated the bank immediately? Total disaster. A total non-runner. [ Am I the only person concerned with the fact that apparently the 'new plan' will be a re-jigging of the old version or that Mr Dukes has already decided that, while the bank is still looking into liquidation option, he is sure that it will be a total disaster and a non-runner?]

“...The best prospect of getting some value out of it and reducing the total cost to the taxpayer is keeping the good bank of it, because eventually it could be sold on to the benefit of the taxpayer. If you just do a wind-down, it is losses all the way. Whereas if you can make a good bank of it, which should be a quarter of the size of the whole bank, at least you have got something viable and that can be sold off to the private sector in the fullness of time.”

Our senior banker is clearly confusing gross return with net return here. Let me illustrate:

Suppose Anglo separation into two banks - bad and good -

• Yields the value of the 'Good' Anglo at €A at the time of disposal t-years from now
  
• Winding down 'Bad' Anglo costs €B by the time of disposal t-years from now
  
• In the mean time (between now and disposal) the cost of running 'Good' Anglo will be €C
• While the current value of the 'Good' Anglo, without a workout (a fire sale, if you may prefer to call it, or a shorter winding up over 5 years as I would prefer to label it) implies the value of it of €D today.
  
• Also suppose that if we wind down Anglo today (or in the near future), the cost of winding down is €E.
• Assume that present value adjustment (bringing the value of the bank and the level of costs incurred back to today from the date of disposal) is PVadj<1. pvadj="F(Interest">

Mr Dukes says that: since €A>0 then taxpayers win from the option of splitting the bank into 2 parts.

I say that:

• if (€A-€C-€B)*PVAadj>€D-€E then taxpayer loses from the rapid winding down and gains from the breaking up of the bank (Mr Dukes preferred solution)
  
• otherwise, taxpayers gain from the opposite action of completely winding down the bank as soon as possible

Mr Dukes' vision of 'positive return' is also severely skewed by his failure to consider risks (interest rate risk, asset valuation risk, liquidity risk etc) in his assessment. A rather worrying problem since mis-pricing of risks is what got Anglo into trouble in the first place.

In other words, Mr Dukes should really have read up on

1. PDV methodology of computing real returns; and
2. Net Present Value framework for carrying out comparative valuations.

These are really basic building blocks of finance... really!

Economics 03/05/2010: World Debt Wish 6

Final part of the series presents two tables, which are largely self-explanatory.

The first table compares Irish Gross External Debt Liabilities to those of other 36 Most Indebted Countries, reporting these countries' GED as % of Irish GED. No adjustments for GDP etc are taken:
You can judge by yourself if Ireland is really economically mightier than Australia, or Argentina, or Brazil and so on...

The second table does two things:
First I reproduce the raw numbers for Ireland and for the group of 36 Most Indebted Countries across three categories of debt, total debt and GDP/GNP. I then compute the relative weight of Ireland in every one of these categories. Column 4 in the top part of the table shows the results as percentages. Thus, Ireland's General Government Debt accounts for 0.96% of the total General Gov Debt incurred by all 36 countries. Ireland's banks' debt accounts for almost 4% of the total banking sector debt for all 36 countries - a hefty weight for the country that has GDP share of the Group of 36 that is only 0.37% or GNP share that is just 0.30%. You can judge for yourselves if the private sector (other than banks) in Ireland is really that healthy to carry us out of the recession, but the figure of 5.88% representing the share of Irish real economy debt as a percentage of the real economy debt for all 36 countries is scary! Especially realizing that this makes our economy leveraged to the tune of 1960% compared to the rest of the world. Imagine having that level of LTV on your house?!

The second part of the table above shows Irish debt levels as percentage of Irish GDP and GNP. Our headline figure here is the level of absolute (not relative to other nations) level of leverage - that of 1,326% or x13.26 times if we are to continue imagining that MNCs-dominated sectors really do carry all activities billed through Ireland here in Ireland (in other words, if we are to use our GDP as income measure). Alas, were we to step down to earth and use our GNP as a metric for income, our level of leverage is reaching a frightening 1,617% or x16.17 times annual income. Compared to that, world's most indebted 36 nations have leverage of just 119%!

Still feel like sending some foreign aid to the Highly Indebted Poor Countries (HIPCs)? Or, for that matter, to Greece?

Economics 03/05/2010: World Debt Wish 5

This is the fifth post in the series covering world debt issues. In the previous posts I provided analysis of the aggregate debt levels for 36 largest debtor nations (here) and for the Government debt (here), the banks debt (here) and the country level data (here). This post puts things into comparative perspective.

Before we begin, however, let me quote from today's Financial Times: "On my estimate, the total size of a liquidity backstop for Greece, Portugal, Spain, Ireland and possibly Italy could add up to somewhere between €500bn ($665bn, £435bn) and €1,000bn. All those countries are facing increases in interest rates at a time when they are either in recession or just limping out of one. The private sector in some of those countries is simply not viable at those higher rates."

Notice the numbers Wolfgang Munchau quotes above, and the countries he includes in the end-game rescue package. Ireland, figures in marginally - the last in line. Yet, what you are about to witness puts a different order on the potential default scenario within the PIIGS.

First the so-called 'good news' - per our Government's repeated boasting, Ireland is a country with sound public sector debt levels. Oh, really?
Chart above shows General Government Debt as percentage of GDP. Note, I decided to play 'fair' with Brian Lenihan here - he seemingly cannot understand the GDP/GNP gap, so let us not challenge him too much in his job and use GDP as a benchmark. Per chart above, as of Q4 2009 we had a 62% ratio of GGD to GDP. This puts us into a 'sound' fifth position in the group of world's most indebted 36 nations, behind such 'sound' public finance countries as

• Greece (93%)
• Belgium (74%)
• Italy (65% - getting dangerously close to Ireland)
• France (63% - virtually indistinguishable to Ireland)

Note, this is GGD nomenclature of the IMF/BIS/World Bank framework, which is slightly different from the Stability & Growth Pact methodology deployed by the EU, but unlike the EU's methodology, this one is comparative across the world.

Nothing to brag about here, folks. Fifth. And rising faster than France's or Italy's or Belgium's...
Chart above puts us into comparison in terms of banks' debt - need any explanation here? Oh, yes, we are the most indebted nation in the world by that metric. Worse than this. Suppose we chop off the IFSC (roughly 60% of the banks & 'other' credit institutions' debt). We end up being - the 3rd most indebted banking system in the world.

Of course, in the end it will be the real economy of Ireland - including our corporates and households - who will be paying for Brian Cowen's policies (GGD) and for the banks (Gross Banks Debt), so perhaps here Ireland is doing well? There has to be hope somewhere?
Oops, not really. In terms of private (non-banks and non-Exchequer) sectors debt Ireland Inc is actually in worse shape than it is in terms of banks and the Exchequer (which of course begs a questions - what are we doing rescuing banks while the real economy sinks?). Notice that we occupied this dubious first place in the world back in the days of 2003 as well, and part of this is IFSC as well - pension funds and investment funds. But the amount of debt we piled on since then is purely spectacular.

And so now, down to the main figure - the combined external debt liability of Ireland relative to other most indebted nations:
I bet the unions who are calling for more borrowing to finance more growth (the irony of ironies is, of course, that they were so loudly opposing 'growth for growth sake' during the Tiger years) want Mister Lenihan to pull out the state cheque book...

Now let me slightly digress from Ireland and focus on the US. Per above data:

• US public sector debt is only a notch above the 36 countries average;
• US Gross bank's debt is by leagues and bound lower than the 36 countries average;
• US private sector debt is just above the average for the 36 most indebted countries, which implies that
• US total economy debt is below the average for the 36 countries.
  

Now, for all Messrs Lenihan and Cowen talk about how the US caused Irish crisis, somehow the real data shows nothing of the sorts... Instead - the real data paints a picture of Ireland deeply sick by all fiscal and financial standards back in Q4 2003. If you go back to those days, really, there were only few economists who warned about some aspects of this problem - myself, Morgan Kelly inclusive. But there was only one economist who consistently argued back then that the entire picture of the Irish economy was wrong. It was David McWilliams. It turns out - he was right!

Economics 03/05/2010: World Debt Wish 4

This is the fourth post in the series covering world debt issues. In the previous post I provided analysis of the aggregate debt levels for 36 largest debtor nations (here) and for the Government debt (here) and the banks debt (here). The current post looks at the country-level data.
Chart above plots the evolution of the Gross External Debt for top 10 debtor nations. The US, predictably leads the way. Remember - these are absolute debt volumes, not relative to GDP. UK comes in second. While the UK Gross External Debt has actually declined in the duration of the crisis, that of the US remained on the rising path, with current GED levels in the US above the 2007 bubble peak. The same is true of the third (France) and fourth (Germany) countries.

Ireland is a remarkable member of this list, coming in ranked 8th largest debtor nation overall in the world in Q4 2009 - up from the 10th in Q4 2003. This clearly shows that in the Irish case, the debt bubble has been forming in the economy well before 2003. My previous research suggests that Irish debt bubble has started forming back in 1998-1999, the last year when our current account registered positive balance, as chart below illustrates:
What's even more interesting is that in 2009 Ireland held 4.1% of the total debt of the 36 most indebted countries, while producing less that 0.37% of the same group of countries' combined GDP. This implies that our economy's dependence on debt is 11 times greater than that of the group of 36 most indebted nations. Put into household finances perspective, we have managed to borrow ourselves into a complete corner, whereby our indebtedness is systemically important to the world, while our economic existence is not. If not for the euro, folks, we would have bailiffs from the IMF calling in.

Having borrowed more than Japan and Belgium, we are also leagues ahead of other, much larger economies in terms of GED:
Think of it: Irish debt is

• x2 times greater than Australia,
  
• x2.5 than Canada,
  
• x3 Hong Kong & Denmark,
  
• x5 Greece
  
• x2 the combined debt of Brazil, India & Russia which have combined 2009 GDP more than x44 times that of Ireland!

And we are the 'rich country' that is contributing to international aid and relief for the HIPCs (Highly Indebted Poor Countries) and whose Presidents (current and former) are jet-setting around the world dispersing piles of taxpayers' cash in aid and preaching economic reforms. Comical or farcical, folks?

Couple of scatter plots showing Q4 2003 position against Q4 2009 one:
Predictably, the US and UK are outliers, so let's zoom on the data ex-US & UK:
Majority of the 36 countries which are world's largest debtors locate above the 1-1 line, implying that between 2003 and 2009 total debt levels have risen in these countries. Countries that are above the regression line have above-average propensity to increase indebtedness between 2003 and 2009. Ireland sticks out like a sore thumb - sporting the largest Gross External Debt increase of all comparators, relative to the starting position in Q4 2003. The overall relationship between the starting debt levels and the current ones is extremely strong - something to the tune of 98% of variation in current debt positions is explained by the starting ones, which simply means that all 36 countries are habitual addicts to debt. Again, Ireland is the leading addict in the club.

A caveat, of course is due here - the figures for Ireland do include IFSC, but hey, why shouldn't they - IFSC is our economic miracle, isn't it? It provides jobs in Ireland. It pays taxes in Ireland. It pays rents to Irish developers...

Of course, do recall that GED includes 3 sectors in it - Banks, Government and the rest of the economy. Banks and Government, as I've shown in the previous post, are linked:
But the link is not particularly strong: correlation between GGD & Banks Debt was +0.49 in 2003 - positive, but not exceptional. It rose to +0.55 in 2009, reflecting the crisis measures transferring taxpayers wealth to the banks. But this too is not dramatic. A relatively modest increase in correlation between 2003 and 2009, plus the fact that we already had a positive correlation back in 2003 highlight pro-cyclicality of fiscal policies worldwide.

Now, let's put the GEDs together, for comparatives:
Ireland is the member of USD1 trillion debt club, despite having a substantially smaller income than any of the countries around it. Even removing IFSC out of this equation still leaves us in the club, pushing our total debt to the 12th position worldwide.

In the next post, I will look at the debt levels relative to countries' GDP, so stay tuned.

Economics 02/05/2010: World Debt Wish 3

Having covered the aggregate debt levels (here) and Government debt (here), now its time to move on to Banks. And some surprising stuff the numbers are throwing:
The UK is clearly an outlier in the entire global series. This is, of course, due to two factors - firstly, the international hub position of London, and secondly - the over-reliance of European and other non-US economies on banks lending (as opposed to the much more significant role played by equities and bonds in the US). Irish reliance on banking sector is also formidable. Also notice that

1. Irish banking deleveraging began in 2008, similar to other countries;
2. Recall from the previous post that Governments ramp up of liabilities in most countries, unlike Ireland, has began with a lag to banks deleveraging.
   

These two facts indicate that Irish banks unable to deleverage outside the state aid support, which, of course simply means that instead of writing down their debts, they re-loaded them onto us, the taxpayers.

Taking out the UK, as an influential outlier:
The remarkable part of the above picture is that virtually no banking sector amongst the top 10 debtor nations has managed to deleverage to anywhere near pre 2006 levels. The crisis, folks, has not gone away - it has been covered up with a thick layer of state-issued liquidity. In other words, printing presses, not structural reforms, what has been working over time to 'resolve' the crisis. And this can only mean two possible outcomes: high inflation or renewed crisis. Since the former relies at least on some recovery in consumer ability to take on new debt, the only way we can avoid a double-dip crisis scenario is if consumers have deleveraged more than the banks did during the last two years. I will be moving on to the real economy sector in my later posts, but for now let me give you an idea of the findings - there was virtually no deleveraging of consumers. Instead, the real economy is now deeply in debt itself.

Back to the banks for now. Chart above shows that the story of banks deleveraging is even worse in the second tier of debtor nations. In fact, with exception of Belgium, no banking system amongst the 11th-20th ranked debtor nations has managed to reduce the levels of debt incurred during the bubble formation.

Chart below once again highlights the nature of the UK banking system
Zooming onto the main group of countries (ex-UK):
All of the banking sectors in top 36 debtor countries are carrying more debt today than they did in Q4 2003. And Ireland once again stands out as the most debt-dependent country in the group when it comes to the rate of growth in banking liabilities since 2003.

So let us summarize the findings so far:

1. Irish Government debt position is by far not the strongest today - in absolute terms, our General Government Debt levels rank 13th highest in the world, up from 19th back in 2003 Q4.
2. Irish Government debt has been rising faster than that of the other 36 most-indebted countries between 2003 and the end of 2009.
   
3. Irish banking sector debt position is 8th highest in the world, up from 10th highest in Q4 2003 - in absolute dollar terms.
4. Irish banks deleveraging has in effect resulted in a swap of private liabilities for public liabilities, with no net reduction in overall economy's debt levels.
   

From the world economy point of view:

1. Global debt levels remain at extremely high levels and deleveraging has not taken place to the extent needed to resolve the crisis.
2. Private (ex-Banks and ex-Government) sectors debt remains at virtually peak level consistent with the bubble.
3. Banks deleveraging also has fallen short of what would be required to bring the debt levels down to more realistic levels.

Next, I will be looking at the data on total debt across 36 economies. Stay tuned.

Economics 02/05/2010: World Debt Wish 2

Continuing with a tour through the world debt numbers, let's take a look at General Government Debt levels:
Chart above shows the dynamics of GGD over the last 7 years. In majority of cases, except for the US, there has been virtually no break in the debt dynamics over the last two years, compared with the past. What does this mean?

1. Firstly, this means that the entire talk about 'massive' Keynesian stimuli around the world is bogus - the governments might have re-directed their spending to new activities in response to the crisis, but the path they chose to expand their spending in the last two years is largely the same they were operating on during the boom.
2. Secondly, this clearly shows that in 9 out of top 10 debtor nations, Governments were operating pro-cyclical fiscal policies during the boom - in other words, to maintain their role in the society, governments required increasingly greater and greater spending - a classic definition of an addiction.
3. Thirdly, the US Republicans were about as eager to burn taxpayers cash as the US Democrats.

The same patterns are not fully present amongst smaller debtors:
In the chart above:

1. With exception of Norway and Turkey, all governments engaged in a much more aggressive ramp up of expenditures during the last two years than before the crisis.
   
2. All governments, with exception of Ireland, that did engage in extensive GGD increases during the crisis did so only starting in 2009.
   
3. Ireland deployed massive increases in GGD back in 2008 - before any other country.
4. Stimulus - in so far as our GGD increases go - in Ireland has been the most dramatic of all other comparator economies.
5. Within a span of 7 years, Irish Government has pushed the country from 19th most indebted in the world in absolute terms to 13th. This is despite the fact that our economy is a minnow compared to the rest of the top 20 debtor nations club.

Ireland's GDP ranked 53rd in the world by the IMF in 2009, 51st by the World Bank and 54th by CIA. Our Government debt ranked 13th... Getting concerned? Or still calling for the Government to borrow more and spend more?
Obviously, it is worth taking a look at the relationship between the starting debt positions and the current levels of government debt. Scatter plot above maps all 36 countries that are the top debtor nations around the world. The US is a significant outlier, so let us zoom closer:
What the chart above illustrates is that Ireland is in the league of its own when it comes to the government reliance on debt financing:

1. Between 2003 and 2009 Irish Government has engaged in the most extreme (relative to peers) debt expansion of all highly indebted nations (compare distance to regression line relative to levels of debt in 2003).
2. While majority of the 36 top debtor nations did run increases in debt levels between 2003 and 2009, Ireland's position is extreme in absolute terms (compare distance to the 1-1 line relative to 2003 debt)
   

In the next post, I will be taking a closer look at the Banks debts, followed by the post analysing total debt levels. The final post of the series will put together debt figures relative to GDP. Stay tuned.

Economics 01/05/2010: World Debt Wish 1

The last two weeks have thrown into the spotlight the reality of the troubled global economy we will be facing for years to come. This reality comes not the courtesy of the reckless banks and excessively greedy speculators. Instead, the 'new normal' is being powered by the same agency that many have come to see as the agent of salvation to the excesses of the private markets - the state.

By all numbers, world's largest governments are now broke. Insolvent and unable, due to political paralysis, to deal with the problem they face. This problem is compounded by the fact that in addition to the governments, the real economies are also broke. Unable to bear the weight of massive debt accumulated during 2003-2007 period, plus the expected burden of the government debts. The banks might have started the process over the period of 2006-2007, but before they did so, world governments were firmly on the path of unsustainable financing. The follies promoted and financed by the public purses in the developed world, which consumed hundreds of billions of taxpayers money, included a wide range of activities - from expansions of the public sector, to vast subsidies on environmental measures (most going to the least verifiable activities aimed at combating climate change instead of basic research, new technology development and investments in quality of life improvements), to pie-in-the-sky global economic development agendas and third world debt workouts. Geopolitical grandstanding, from aspirational 'democratization' to fictional 'unifications' also contributed significantly to the problem.

Now, the very economies that jostled for the positions of global power are suffering from debt overhang. And yet, rhetoric has not changed. Like a shopaholic unable to stop pulling out his credit card at every till in a shopping mall, world's leading economies cannot resist the temptation of vastly expanding public expenditure. In short, the governments around the world are now clearly exhibiting the same pattern of addictive behavior toward debt as a heroin junkie. The world has a debt wish!

Symptoms first. I took 36 countries data from the joint IMF/BIS/World Bank database on external debt positions - these countries represent world's largest debtor nations. Here are the charts (note, I will be publishing these charts over a number of posts in the next couple of days, so do come back for more).
The first chart above shows the overall composition of the total debts held by the world's largest 36 debtor nations. There are several apparent trends shown in this data:

1. Government borrowing did not accelerate dramatically during the current crisis. Instead, the entire government debt was showing clear pro-cyclical pattern during the boom years 2003-2007. In other words, the junkie was out for a fix well before the crisis hit.
2. Only in 2006-2007 did the banks managed to expand significantly their borrowing.
3. Globally, this cumulated banks debt mountain remains largely unaddressed despite a very significant contraction in banks-held debt from the peak. In other words, for all its destructive power, the crisis failed to bring banks debt balances back in line with pre-bubble levels of, say 2003-2004.
4. Global debt now stands dangerously close to the bubble peak.

A closer look at banks and governments
The following facts arise from the above chart:

1. Private sector debt globally falls below banks sector debt (see below for the case of Ireland).
2. Private sector debt deleveraging basically did not take place during the current crisis with non-banks and non-sovereign levels of debt remaining static close to the peak of Q4 2007.
   

Thus, world's largest debtors (and incidentally largest economies) remain exceptionally weak when it comes to their real economic activity reliance on debt financing.

And now on to Ireland:
The country that, according to the Government, has done so many things right in 2009 has... well:

1. Managed to virtually completely avoid any deleveraging in the current crisis, with our debt levels remaining at the peak levels attained (remember - all of the world peaked in debt levels back in Q4 2007) in Q4 2008.
2. There has been a marked increase in the rate of accumulation of government debt in Ireland in 2008-2009, again in departure from the world experience.
3. Irish banks have experienced steady deleveraging since Q4 2007 although this process is still to weak to return them to the healthier levels of 2003-2004.
4. Irish households and the rest of the real economy in Ireland have actually accumulated a debt mountain greater than our banking sector - a position that is different from the rest of the world.
   
5. There has been no deleveraging in the real economy, which continues to increase overall indebtedness.

In short, Irish debt position is deeply sicker than that of the rest of the largest debtor nations.

At this junction, data calls for some comparative analysis of the various debtor nations. This will be the subject of my next post on the topic. Tune in...

Economics 30/04/2010: Minister Lenihan's statements in the Dail

Some interesting points on Nama, coming out of Minister Lenihan's answers to Dail questions this Wednesday, April 28 (emphasis is mine):

"The NAMA SPV structure has a subscribed capital of €100m. As explained to the Dail at the time of the legislation, and subsequently agreed with the EU, 49% of this capital was advanced by NAMA and 51% by private investors.

Three private investors, namely, Irish Life Investment Managers, New Ireland Assurance and a group of clients of Allied Irish Banks Investment Managers, have each invested €17m in the vehicle. It is important to note that in each case the beneficial owners of the investment are pension funds or other clients of these investment companies and not the parent credit institution. [It is equally important to note that in each case the full owner of each one of these entities is an institution directly involved either in Nama or in Banks Guarantee scheme, which, of course, under normal rules of engagement would imply potential conflict of interest]

The SPV has been established in accordance with Eurostat rules. The Board of the SPV is chaired by the CEO of NAMA and has three NAMA nominated directors with the private investors retaining the right to nominate a further three directors. Thus the SPV is structured in such a manner that NAMA representatives will maintain an effective veto over decisions of the SPV Board. [Thus the so-called 'veto' is a de facto, not de jure. Should one of the Nama representatives on the board fall ill, be delayed in travel or be absent on some state-sponsored junket, in absence of the said member, it is quite possible - even if only in theory - that the veto power can pass over to the 'private' owners of SPV.]

Further:

"In line with my statement to the House on 30 March on the banking situation, I subsequently issued Promissory Notes on 31 March to Anglo Irish Bank and Irish Nationwide Building Society. These Notes will ensure that both institutions continue to meet their regulatory capital requirements. The initial principal amount of the Note that issued to Anglo Irish Bank is €8.3bn and to INBS it is €2.6bn. As I indicated in my recent statement, it is likely that Anglo will need further capital in due course but the extent and timing of such further support remains to be determined.

The terms of the Promissory Notes that issued to both institutions on 31 March are substantively the same and, inter alia, provide that 10% of the principal amount will, if demanded by the institution, be paid each year and that the first such payment will fall due for payment from the Central Fund on 31 March 2011. An annual interest coupon, related to Government bond yields, is also payable on the Promissory Notes which the Minister has absolute discretion to pay on the due date or to add to the principal amount. [So, in contradiction to the deeply-informed Dara O'Brien TD, it is the state who will be paying interest to the banks. Not the other way around]

This ensures that the Note meets accounting requirements to be “fair valued” at the principal amount in the annual accounts of each institution, consistent with the regulatory capital requirements. [This sentence is an example of Minister's habitual abuse of financial terminology, in so far as it makes absolutely no rational sense to anyone even vaguely familiar with finance. 'Fair valued' must refer to a benchmark, being a comparative/relative term. 'Fair valued at the principal amount' is gobbledygook as principal amount - the face value of the bond/note can only be valued in relation to the price of the bond or yield on the bond, none of which are referenced in Minister's statement. Furthermore, fair value concept does not refer to the regulator capital requirements. It refers only - I repeat, only - to the market value of the bond/note.]

In the event of a winding-up of either institution, the aggregate of the outstanding principal amount and any unpaid interest that has accrued on the institution’s Note falls due for immediate payment. [So, at least in theory, the Exchequer might face an immediate call for billions of euros in cash... what provisions have been made to ensure we will have this covered? How will Minister Lenihan be able to raise such funding even if the economy is not in crisis? What will be the additional cost of having to raise such funding in a fire-issue of a new state bond? Has the Minister established adequate pricing scheme to charge the banks for the taxpayers assuming such a risk or has he 'gifted' this risk premium away, thereby potentially exposing taxpayers to added hundreds of millions in new costs of such emergency issuance?]

The Deputy may also wish to note that, as indicated in my banking statement of 30 March, the use of Promissory Notes means that the institution’s capital requirements are met in a way which spreads the cash payments over a number of years and thereby reduces the funding burden on the Exchequer that would otherwise arise in the current year. [This statement clearly shows that Minister Lenihan does not understand the basics of interest rate/yield curve relationships. He implicitly assumes that in the future, the state borrowing costs will be lower than they are today. There is absolutely no reason for such an assumption.]

Economics 30/04/2010: Anglo Irish Bank shutdown costs

We are once again swamped with the 'new numbers' from the DofF and Minister Lenihan. This time the latest 'facts' relate to the potential cost of shutting down Anglo. Yesterday, Mary Coughlan stated in the Dail that the cost of an immediate liquidation of the bank had been prohibitive (per Irish times - here). Today, the unquestioning media squad is reporting that the cost of shutting down Anglo will be "more than €100 billion" (The Irish Independent, page 17). This figure has been floated out by the Anglo's paid-public-'experts'-turn-paid-executives, like Mr Dukes, and by the DofF talk-heads.

In reality this number is simply plain wrong, representing, simultaneously, a combination of

• bad arithmetic, and
• poor understanding of finance

Here is why. Take Anglo's balancesheet:

Assets of €72 billion:

• Loans to customers of €65 billion (with €35 billion earmarked for Nama)
• Loans in the interbank markets (loans to other banks) of €7 billion
• Risk-adjusting loans to customers to reflect an impairment charge of 60% implies recoverable loans of €26 billion (without a need to call in Nama at all).

Total recoverable assets of €34 billion.

Liabilities to customers and the ECB of €60 billion

• Customers' deposits of €27 billion
• Banks and ECB deposits of €33 billion

Thus, the real taxpayers' liability is €60bn-€34bn=€26 billion. Not €70 billion, nor €100 billion claimed by the various parties.

You might ask me 2 questions at this junction:

1. "What about bond holders?" Ok, there are €15 billion worth of senior bond holders and €2.3 billion of subordinated bond holders. These bondholders - all institutional - have been begging the State for years to keep banking sector lightly regulated. And I agree with them on this, in principle (omitting details here). As a part of their pleas, we've been repeatedly told that markets are able to price risks better than any regulator can. And I agree with them on this as well. So, as a consequence of their own stated desires and claimed powers, the bond holders should be made to bear the responsibility for their own errors in pricing risks. In other words, the Government should tell them to count their losses. This is what the market is all about and this, not the rescue by taxpayers, is what the real market participants expect from Ireland Inc. Lastly, on this point, there is not a single financial instrument or contract that legally requires the Irish taxpayers to foot the bill for non-sovereign investment undertaking. Full stop. Cut the guarantee on all Anglo bondholders and send them packing. Note: even if we are to cover bondholders in full, Anglo wind down will cost no more than €39 billion. Not €70 billion, nor €100 billion.
   
2. "How can the winding down take place?" Simple - we proceed to gradually, over the next 5 years, to sell assets. Depositors remain guaranteed, so we can rest assured they will not call in their deposits all at the same time. As we realize the value of the assets, we gradually close off the liabilities. To do this, bank staff can be reduced by over 50% and their wages (currently averaging €110,515 per annum per employee) can be cut by the same proportion. This is it, folks - simple.

Now, let me ask you two questions in return:

1. Why are Messrs Dukes, Lenihan etc are claiming that the winding down Anglo will cost €70-100 billion? Is it because (a) they have no idea and are 'inventing' numbers as they go? or (b) they have an ulterior motive to claim improbably high figures to continue dragging out this Anglo saga over 20 years?
2. Why have the Irish taxpayers paid hundreds of thousands of euros to 'consultants' who cannot come up with a simple, straight forward plan for dealing with Anglo to date, despite the fact that people like Peter Mathews (to whom I am obliged for much of the figures quoted above), Brian Lucey, Karl Whelan and myself have provided viable alternatives for dealing with the 'bank' free of charge?

Economics 29/04/2010: House prices peak to peak cycle

Back in October last year I did an estimate, based on the IMF model, of the peak-to-peak duration of the current housing slump. Now's time to do some updating on this matter.

Assumptions:

• Peak to trough correction in real prices of -40-43%;
• Growth rates - resuming in 2011: 2011-2013 +3.6% - in excess of the long-term growth rate estimate for Ireland in the current GFSR (2.6%), slowing to 3% in 2014-2016, then to 2.7% in 2017-2019 and 2.6% thereafter.

Using peak of Q2 2007 to assumed trough in Q3 2010, we have the full cycle duration of between 95 and 87 quarters, taking us back to 2007 peak by either 2029 or 2031.

If bottom hits at -48%, we get return to 2007 peak by 2034, with 107 quarters from peak to peak cycle.

Now, think Nama will run out in 2015? or 2020?

If Nama sets shut-off date in 2015, it is likely to get between 61 and 70 cents on the euro for each value underlying the loan. Assuming loans LTV of 70% and default rate of 30% on loans transferred to Nama (extremely conservative assumptions, but these allow a cushion on some interest collected), the value of Nama realized book will be 26 cents on the euro and 30 cents on the euro, or less than 50% of the post-discounted price paid!

If Nama shuts down in 2020, the above two figures will be 30 cents and 34 cents on the euro paid or just around 50% of the post-discounted price paid!

Now, that's what I would call overpaying for the loans.