Economics 22/8/10: Fundamentals of investing in IRL Inc - I

Few months ago, while speaking as a guest on RTE's Frontline, I confronted two of our 'surrender to Brussels' politicians with a suggestion that a country can do just fine outside the 'Yes, Commissioner' world of European convergence consensus. In return, one politician - from the opposition side of the Dail - rushed to conclude that when advocating greater sovereignty on economic policies I was talking about the UK. My reply was that I had in mind more the path of the country like Switzerland.

In the light of the ongoing sovereign crisis, and with all the talk about bond markets unwillingness to underwrite our economy, I decided to return to the same issue. Here are major comparatives in investment (bonds-related) fundamentals in Ireland vis-a-vis Switzerland and Luxembourg.

I do this in a series of 4 posts. The first one deals with current account dynamics, the second one will deal with Government finances, the third one will show comparatives for GDP, and the fourth one will conclude by making comparisons across other variables, such as inflation, population growth and labour markets.

All data is based on IMF's World Economic Outlook, updates for April and July 2010, which covers period from 1980-2015. Some additional forecasts (beyond 2015) were performed by myself, alongside some additional variables computations.

I chose the two countries for several reasons:

1. Both are core European countries;
2. One of these is outside the EU, another is inside the same tent as Ireland;
3. With a caveat concerning some of aggregate accounting issues with Luxembourg's data, all three have roughly similar economies characterized by: (a) no significant natural resources of their own, (b) small size of population and land mass, (c) heavy reliance on exports, (d) open nature of economies, (e) 'more Boston than Berlin' aspirations in tax policies, (f) being a bit of a thorn in the softer side of Brussels, and so on

So here are few charts and comments. In most cases, I take on the position of a rational investor in sovereign bonds, willing to hold these to maturity. In other words, what matters to me in most of these charts is the answer to the following question: "Given country A fundamentals compared to countries B and C, what is the likelihood that country A can generate sufficient net income to cover its debt obligations?"

Chart 1:
If our expected current account surplus of 2010 were to be used to pay down our debt, how long would it take? The answer to it is 'forever'. Our net surplus from trade and investments from the entire world was negative €4.03bn throughout the 2000s. In the 1990s, our average current account surplus was just €1.108bn, in 2010 our expected surplus in the only year when current account was positive in the 200s - the year 2010 - will be only €849mln. At the same time, our debt currently stands at €86.83bn and rising with interest bill on this well in excess of €4.56bn annually at latest 10 year bond auction yields. In other words, exporting our way out of the recession will not even cover our entire interest bill.

Here's an interesting observation. Irish Government thinks that exports will carry Ireland out of the recession. However, there is an argument to be made that value added in our exports is not really that impressive once the inputs costs are taken out.

Chart 2:If you were an investor thinking about Ireland's fundamentals, you wouldn't have much hope of getting a positive return on your investment, if net exports were your underlying security, except in the period 1992-2000.

This, one can argue, might be true of our manufacturing exports, where we import often expensive inputs and where transfer pricing (on inter-company sales) further contributes to lower net value added. But what about our services trade? Well, the current account data shows that during the last decade, when services trade really started to take off in Ireland, our net external balance was negative. So something is not adding up and I will take a look at this in the forthcoming posts.

But for now, we do have impressive exporters, yet our current account performance has been exceptionally weak, compared to Switzerland and Luxembourg - two countries that are equally as reliant on imported inputs as Ireland.

It is worth noting also that in the case of Switzerland, their exports composition includes significant pharma and high tech manufacturing exports as well. It just appears that they manage to do trade better...

In fact, a bet made on Ireland Inc based on its external economic performance back in 1980 would have been a disastrous one as Chart 3 below illustrates. An investor betting on our external balance would have 48.1 cents on every euro invested. Based on IMF forecasts, by 2015 this loss can be expected to widen to 48.9 cents. At the same time, identical bet on Luxembourg would have netted a gross return of over €5.11 by now, and a projected gain of €9.20 by 2015: a spread in return relative to Ireland of €5.59 by 2010 and €9.69 by 2015.

Chart 3:
The differences are even more dramatic when we look at comparison to Switzerland: a bet of €1.00 on Swiss external balance made in 1980 would have netted investor €8.145 by 2010 and is expected to yield €13.434 by 2015, implying the spread between investment in Ireland and Switzerland of €8.626 in 2010 and €13.923 in 2015.

Obviously, the earlier analysis is sensitive to the time frame for investment chosen (Chart 4).

Chart 4:
Suppose a bet €1.00 was made on Ireland Inc based on its external economic performance back in 1995. An investor betting on our external balance would have grossed 0.393 cents on every euro invested by today and can be expected to gross a loss of 1 cent by 2015. An identical bet on Luxembourg would have netted a gross return of 11.23 cents by now, and a projected gain of 13.305 cents by 2015. The differences are slightly less dramatic when we look at comparison to Switzerland: a bet of €1.00 on Swiss external balance made in 1995 would have netted investor 9.54 cents by 2010 and is expected to yield 11.88 cents by 2015. Oh, and there wouldn't be any risk of getting these returns expropriated by the Government tax policy changes.

(Second post to follow)

Economics 20/8/10: BOSI lessons

Some impressive numbers from BOSI withdrawal from the Irish market are:

• BOSI holds a €32bn loan book in the Irish market (total Irish market is ca €350bn)
• BOSI holds a just over 9% market share of total Irish loans market
  
• BOSI withdrawal of working capital facilities in Ireland will have immediate impact on 12,000 business customers
  
• BOSI also holds €10bn mortgage book, or 7% of all Irish mortgages
  
• BOSI holds 5,000 current accounts
  
• Amazingly, 44% of the bank’s book was impaired as per H1 2010 generating a write-off of €4bn in loans
• Per Bloxham stockbrokers: "the move is likely to have a negative impact in the economy where liquidity is still scarce and the closing off of business lines will force some businesses to wall" (sic).

Now, unless we are willing to assume that Irish banks (with such flagships of prudential lending as AIB, Anglo, INBS etc) are massively more brilliant than BOSI in writing loans, we simply cannot avoid translating BOSI impairment rate to their books as well. Which, of course, makes my estimate of 40% across the books losses for the banking system as a whole, peak to trough, rather safe.

Economics 19/8/10: Irish bonds & our fndamentals

This is an unedited version of my article in the Irish Examiner from August 18, 2010.

The latest Irish bonds auction was perhaps the most eagerly anticipated event in the NTMA’s history. Its outcome was a small victory for NTMA, but a Pyrrhic victory for Ireland.

A quick guide to the results first. Facing svere headwinds from the markets, NTMA managed to sell 4 and 10 year bonds at average yields of 3.627% and 5.386% respectively.

This means that NTMA improved on July auction of 10 year bonds, but is still locked into what amounts to the third highest cost of borrowing over the last three years. A year ago the same bonds were placed at an average yield of 4.55% - which means that borrowing €1 billion today is now €8.4 million costlier than a year ago.

However, the NTMA results are hardly a reason to cheer, from the economy wide perspective.

Three events have triggered the extraordinary global attention to Irish bonds over the last few weeks. Firstly, there was a public relations flop when the ECB had to step in provide support for Irish bonds by directly buying the surplus paper out of the market. Second by Monday this week, Irish bond spreads over the benchmark German bunds rose to a stratospheric 300 basis points. At the same time, our CDS spreads hovering above 310 basis points benchmarks, were
signaling that markets anticipated a significant probability of Irish Government default on its sovereign debt.

All of these developments, especially set against much calmer changes in yields and CDS spreads in other Eurozone economies have indicated that the markets are changing not just in terms of the overall willingness of bond investors to underwrite risk in general, but in their attitudes to Irish debt in particular.

You see, during the first quarter of this year, sovereign debt crisis has engulfed the peripheral economies of Europe, collectively know as PIIGS (Portugal, Greece, Ireland, Italy and Spain). The crisis, of course, was triggered by the markets belated realisation that these countries economies cannot sustain massive debt and deficit financing liabilities they have taken on before and during the current Great Recession. That was the moment when Ireland was lumped together with the rest of the Eurozone’s sickest economies.

This time around, we are on our own. Over recent months, all of the PIIGS countries have unveiled a series of aggressive deficit reduction and austerity programmes aimed at significantly reducing their future borrowing requirements. All, that is, except for Ireland. Instead, Irish Government has spent the last 9 months waiting for the Trade Unions to vote on the Croke Park deal that actually limited our future ability to address deficits. On top of that, we staunchly resisted markets, the IMF and the EU Commission repeated calls for clarity on specific budgetary measures planned for the period of 2011-2014. Currently, the IMF forecasts Irish deficit to remain at over 5% of GDP in 2015.

In May 2010, before factoring in the latest funding allocations to banks, IMF Fiscal Monitor provided an estimate for Ireland’s borrowing requirements for 2010. These figures are strikingly different from the deficit numbers presented by our official framework. IMF forecast that Ireland will need to borrow at least 19.9% of its GDP in order to finance debt roll overs from previous years maturing in 2010, plus the deficit of -12.2% of GDP. In approximate terms, Ireland’s Government borrowing this year would amount to roughly €33bn before Anglo Irish Bank and INBS latest projections for new funding.

Thus, in the last two weeks, the bond markets have finally began to re-price Irish sovereign debt as if the country is no longer the leader in the PIIGS pack in terms of expected future deficit
corrections.

In the end, the markets are right. Ireland is facing a massive debt and deficit overhang that is well in excess of any other advanced economy in the world. And contrary to official statements uttered on the matter this week, this twin problem is not a matter of one-off recapitalization of the Anglo Irish Bank. Instead, it is a long-term structural one.

Take first the banks. The recapitalization and balance sheets repair approach undertaken by the Government so far means that Nama alone can be expected to lose around €12 billion over the next 10 years. These losses will have to be underwritten by the Irish economy.

In addition, total losses by the Irish banks are likely to add up to between €49 and €53 billion over the next three-four years. These can be broken down to €33-36 billion that will be needed in the end for the zombie Anglo, €6bn for equally gravely sick INBS, at least €8 billion for AIB and up to €2 billion for the healthiest of all – Bank of Ireland.

These numbers are based on my own analysis and are confirmed by slightly more pessimistic estimates by the independent banking sector analyst Peter Mathews. Once again, Irish economy – or in other words all of us – can be expected to underwrite these. Thus, total bill for ‘repairing’ Irish banks via Government preferred approach of Nama, plus recapitalizations is likely to be €61-65 billion over the next decade.

Now, consider our current spending. Having slashed capital expenditure down to the bone, the Government has committed itself to preserving public sector pay and employment through 2014. Transfers – including welfare and subsidies – are pretty much a no-go area for serious
savings, given continued rises in unemployment, long term nature of new joblessness and political dynamics in the country. Between them, these two spending headlines account for over 1/3 of the entire deterioration in our public spending from 2008 to-date.

Budget 2010 forecasted that our debt to GDP ratio will peak at around 84% in 2012 and will slowly decline thereafter. This, of course, is clearly an underestimate, but even by that metric, we are looking at a debt mountain of over €152 billion.

All of this means that at the very least, Irish state debt will be well in excess of €210 billion by 2014-2015. Given yesterday’s auction results, the interest bill on this debt alone will total €11.3 billion annually – more than 1/3 of all tax revenue collected in 2009.

Let’s put this into more easily understood perspective. If Ireland were a household and its debt constituted its mortgage taken over 30 years, the ‘family’ will be spending more than half of its total gross income on interest and principal repayments.

Or put differently, the legacy of this crisis and systemically mistaken approach taken to repairing the banking sector will amount to over €111,000 in new debt dumped on the shoulders of every currently employed person in the country. To say, as our policymakers and official analysts do, that this figure doesn’t really matter because it is a ‘one-off measure’ is adding insult to the injury.

Economics 18/8/10: NTMA's foray into bond markets wilderness

As promised - a more in-depth analysis of today's data from NTMA auction.

"The Gruffalo said that no gruffalo should
Ever set foot
In the deep dark wood"

Clearly, bent on saving nation's face, the NTMA could not pass on going to the markets today.

First, let us take a look at the changes in averages from April 2009 first auction through today, against the same averages for the period excluding today's auction.
So today’s auctions have led to:

• a small increase in overall maturity profile of Irish debt (good news)
• a small increase in average coupon paid for all maturities (true future liabilities on debt)
• a modest rise in average cover (potentially due to massive overbidding by ECB, but this is a speculative remark at this moment in time)
• a drop in average price paid and a corresponding rise in the weighted average yield.

These effects were most discernible in the benchmark 10 year bonds issue, where:

• Average coupon rose by ca ½ basis point;
• Average cover dropped
• Weighted average price declined and weighted average yield rose (the latter by almost 0.7%)
• Average allocation amount rose.
  

Even more interesting stats are in the price and yield spreads:
Again, for across all issues averages spreads in prices rose significantly – by 8.3% and spreads in yields rose 7.85%. This is on the back of 10 year paper alone, suggesting the following two things:

1. Whatever was happening in the shorter term paper market (cover and lower yields) appears to be disconnected from what was going on in longer term paper markets (perhaps the rumoured ECB intervention on the shorter side was after all true?);
2. Since the prices and yields reflect bids by market makers – the widening of the spreads between max and min bids might be indicative of the markets inability to tightly price Irish sovereign risk. In other words, this might signal general markets uneasiness about the bonds.
   

Some charts illustrate more general trends.

Short term paper auctions first (5 years and less):
Average yield is still on the rising trend despite a clearly 'extraordinary' move down in today's auction. Even steeper upward trend for November 2009-present is still present. Yield spreads are on the upward move again once more signaling potential rise in overall market skepticism.
Price spread trends up predictably in line with yield spread trend. To see it in absolute terms:
Weighted average price achieved in the auctions:
Again, if ECB speculations play out to be true, the small uptick in price in last auction can be written off completely.

Now to longer maturity (10 years and above).
Average yield down, but still above long term trend. Yield spreads up, quite significantly. As I mentioned in the earlier post, latest auction produced yield spreads of 9.9bps - third highest spread since April 2009.
Price spreads are 75bps - second highest spread since April 2009. Cover down - lowest since February 2009 and is down year on year. Again, to highlight spreads in real terms:
Next, look at the price achieved:
This hardly constitutes any sort of 'success'. May be, just may be - some sort of a stabilization, with mean reversion still incomplete.

Now to the maturity profile of our debt:
We keep on loading the 2014 end of the spectrum - bang on for the year when we are supposed to reach 3% deficit. Of course, with already close to €5 billion in rollovers due in 2014, it's hard to imagine how this is going to help our fiscal position.

Economics 17/8/10: Another 'success' marks NTMA's foray into bond markets wilderness

Wall Street Journal blogs have beat me to the analysis of our NTMA results. Four reasons can explain this blogs tardiness:

1. I was doing Drivetime commentary on the results at 5:15pm today;
2. I was finishing my article on the topic for the Irish Examiner tomorrow;
3. Call of work duty had shifted me firmly for a few hours into a beautiful world of international macro data (oh, the place where there are no Anglos and INBSs... at least not after FDIC gone through their equivalents with a sledge hammer);
4. Last, but not least, my son gave me an even more important task of playing with him Garda and Helicopter rescue of a Big Black Spider.

To atone for this, this post precludes my deeper analysis of today' NTMA results. This post is a verbatim reply to Wall Street Journal blog post (linked here).

"Dear Richard,

I appreciate the short-term analysis span you deployed in your article on the latest Irish bonds auction.

However, several points worth raising in relation to the claimed 'success' of today's
NTMA placement.

1. the auction achieved price bid spreads of 75bps - 2nd highest in the last 2 years, suggesting that 'success' was based on a rather less consensus-driven pricing with market makers (traditionally most stable pricing players in the market) having shown significant differences in their ability to price Irish sovereign risk;
2. the weighted average yield achieved was the 3rd highest over the entire 2009-2010 period of issuance of 10 year bonds; and
3. cover achieved in 10 year paper auction was lower than a year ago (down to 2.4 from 2.7)
   

However, it is the longer term issues, that are certainly worth highlighting.

These involve the fact that even under Government own projections, factoring in expected Nama losses forecast by independent analysts, such as myself, Peter Mathews, Prof Brian Lucey and Prof Karl Whelan, by 2012 Ireland will be carrying over 210 billion worth of state (sovereign and quasi-sovereign) debt on its books. At 5.386% yield, this translates into ca €11.31 billion in interest payments alone or more than 1/3 of the entire tax revenue collected by the Irish Government in 2009.

It is naive to believe that 2010 gargantuan deficit in excess of 20% of GDP is a 'one-off' reflection of banks recapitalizations demand.

Again, based on balance sheet analysis, I expect 6 banks covered by the State Guarantee to incur loans losses of ca €50 billion between 2008 and 2012. Current provisions announced by the Irish Government and the banks cover roughly a half of these. The rest will have to be financed out of taxpayers funds in years to come.

In a taste of things ahead, earlier today Governor of the Central Bank has stated that next stage
recapitalization of Irish Nationwide and EBS building societies will cost taxpayers not €3.5 billion earlier factored in by the Minister for Finance, but €4 billion. €500 mln discrepancy within 5 months is a pittance for the Exchequer burning deficits at 20% of GDP (or roughly a quarter of the real domestic economy), but... Independent estimates put the final figure at €7 billion.

So much for the 'one-off measures'.

Perhaps the most telling sign of what is really happening in the markets NTMA tapped today is the fact that having dropped 20bps, Irish bonds spreads over German 10-year bund have risen once again to within a hair of 300bps.

Some success, then..."

In addition, one can only speculate whether the 'spectacularly' large cover of 5.4 for shorter term 4 year paper is due to the much speculated about, but yet to be confirmed or denied, direct buying by the ECB. If so, then we might have a situation where ECB gross over-bidding in the shorter maturity paper placement drove buyers into longer term paper. this, in turn would imply that neither the 3.627% weighted average yield achieved in 4 year bonds nor the 5.386% average yield priced in 10 year bonds are to be trusted as market benchmarks.


A more detailed analysis of the bonds issuance follows in the next post, so stay tuned.

Economics 12/8/10: Irish July CPI: Deflation is over, for the State sectors

“Consumer Prices in July, as measured by the CPI, remained unchanged in the month,” says CSO. Hurrah, the end of deflation then? “This compares to a decrease of 0.8% recorded in July of last year. As a result, prices on average, as measured by the CPI, were 0.1% lower in July compared with July 2009.”
Sounds like the good news. But… “The EU Harmonised Index of Consumer Prices (HICP) decreased by 0.1% in the month, compared to a decrease of 0.8% recorded in July of last year. As a result, prices on average, as measured by the HICP, were 1.2% lower in July compared with July 2009.”

Err, of course, HICP excludes the cost of housing. And the cost of housing has been going up in Ireland courtesy of the banks. So let me see:

• Deflation is bad, because it signals lower returns for businesses, induces consumers to save excessively and stops investment;
• Inflation is ok, then, as long as it reverses the three ‘bads’ caused by deflation.
  

So our ‘good news’ of the ending of deflation isn’t good at all, then. Why? Because, per CSO: most notable changes in the year were decreases in (see charts below)

• Clothing & Footwear (-8.5%) - competitive sector;
  
• Food & Non-Alcoholic Beverages (-3.8%) - relatively competitive sector; and
  
• Furnishings, Household Equipment & Routine Household Maintenance (-3.4%) - buyers' market.
  

There were increases in

• Education (+9.2%) - state controlled,
  
• Housing, Water, Electricity, Gas & Other Fuels (+5.5%) - state- and banks-controlled, and
  
• Transport (+2.7%) - state-controlled in terms of costs and charges.

Which of course means that prices have risen primarily in state- and banks- controlled sectors. These sectors inflation does not induce businesses to invest (as they are forced to pay higher costs and do not see increased revenue in their core activities), it does not induce people to consume (as they continue to save even more in anticipation of banks coming for their money through mortgages increases) and it does not result in increased returns to productive business activity (as higher costs shrink margins). The CPI excluding mortgage interest showed no change in the month and was down by 1.0% in the year.

Let’s plot that relationship between state-controlled prices and private sector prices, weighted by their respective weights in overall CPI basket:

No further comment needed, I presume.

Economics 11/8/10: Bank of Ireland H1 results

Bof I results for the H1 2010 did represent a significantly different picture from those reported by AIB, with one notable exception – both AIB and BofI are yet to catch up with reality curve on expected future impairments.

BofI profit before provisions was €553mln against €811mln in H1 2009. This, however, doesn’t mean much, as a score of one-off measures were included in H1 2010 figure:

• Losses on sales of loans to NAMA’s were factored in at €466mln
• Debt exchange added a positive of €699mln
• Pension deal brought in a positive contribution of €676mln.
• Net positive of the one-off measures was, therefore around €909mln implying that BofI really was running a loss €356mln before provisions and after one-offs are factored in.
  

Underlying loss before tax, net of charges, was €1.246bn or almost double the €668mln loss last year. The impairment charges amounted to €1.8bn in H1 2010, inclusive of €893mln non NAMA provisions. The impairment charge therefore almost doubled on €926mln in H1 2009.

Big ‘news’ today was that BofI continues to guide for €4.7bn in impairments charges for March 2009-2011. Given that the bank has taken €3.9bn of these provisions to date, it will have to deliver an €1.2bn gain on H1 2010 (roughly 1% of its loan book value) before March 2011 to stick with the impairments estimate. How much can BofI squeeze out of its customers remains uncertain, but to get to its target figures, the bank needs either a helping hand of Nama (on valuations for Tranche 3) or a dramatic reduction in cost of funding (unlikely) or a 30%+ increase in what it charges on loans (without any subsequent deterioration in their quality).

These are unlikely for the following reasons.

Impaired loans are up by a significant €2.1bn reaching 7.1% of the total loan book (these were 5.5% at the end-December 2009). Risk weighted assets stood at €93bn down on €98bn in December. And asset quality is still declining: impaired loans were €15.8bn of which €8.86bn were on non-NAMA book. This compares to €13.35bn in December of which €6.79bn related to non-NAMA book. Provisions were €6.64bn in June of which €3.725bn non-NAMA, implying 42% cover, down from 43% in December when provisions amounted to €5.8bn in total, with €3.0bn non-NAMA.

BofI maintains that bad debts peaked in H2 2009, showing a charge of 1.4% on gross loans in H1, compared with a charge of 2.9% in Q4 of last year.

This looks optimistic. BofI business side continues to suffer from income declines and costs overruns. Total income was down 8% yoy at €1.76bn. Cost cutting this year will have to come at a premium as BofI prepares to shed some 750 more jobs. Total staff numbers are down by 805 or 5% yoy so far in 2010.

BofI H1 2010 net interest margin was 130 bps down 40bps relative to H1 last year. Causes: higher deposit and funding costs, lower capital earnings and Government guarantee. Assets repricing helped by adding 19bps to the margin. Cost to income ratio increased to 61% relative to 54% a year ago, despite costs falling by 3% to €916mln. This means income is seriously under pressure. Impaired loans on residential lending book have increased by 58.5%.

One improved side – capital ratios came in at Core Equity Tier 1 of 8.2% up on 5.3% in December and ahead of 7% regulatory target, but still low relative to European and US peers. Tier 1 ratio was 9.9% virtually unchanged on 9.8% in December.


BofI might be right in some of its rosy projections. You see, Nama has been rolling over for the bank so far. BofI originally guided Nama discount of €4.8bn on €12.2bn it planned to transfer to Nama, or 39% haircut. Nama obliged so far by shaving off 36% on the €1.9bn of loans transferred in Tranche 1 in April and then 35% on Tranche 2 transfer of €1.5bn in July. This was done despite the fact that impaired loans proportion continues to rise in the sub-portfolio of BofI loans destined for Nama.

And this rise is a serious one. At the end of June, 69% of the loans remaining in the Nama-bound portfolio were impaired, up on 54% in the overall Nama portfolio set aside in December 2009. So Tranche 1 transfer picked out better loans or the loans have deteriorated dramatically since Tranche 1 transfer or both. Either way, lower discount on Tranche 2 loans suggests a blatant subsidy from Nama.


Funding side remains under threat, though BofI put a brave face in stating that it raised €4.6bn in term funding so far (mostly in the beginning of the year before the proverbial sovereign debt sh***t hit the fan). The bank still has to raise €9.5bn more before the end of the year 2010. The balancesheet numbers as well as market conditions suggest that this might be tight.

Total loans held grew by €3bn in H1 2010 to €125bn driven by sterling appreciation. Meanwhile, deposits were down €1bn to €84bn, so bank’s loan-to-deposit ratio, ex-NAMA, rose to 143% from 141% in December 2009. Deposits decline was driven by ratings downgrade for S&P in January 2010 which shaved €3bn worth of value from the ratings-sensitive deposits.

This doesn't make BofI any more attractive to the lenders.

But the bank has done coupple of things right. BofI is gradually improving its funding outlook by extending funding maturity – up to 41% of wholesale funding being in excess of 12 months in H1 compared to 32% back in December 2009. And BofI has been reducing its reliance on wholesale funding – down €3bn in H1 to €58bn total. BofI still holds €41bn worth of contingent liquidity collateral, theoretically eligible for ECB borrowings.

The bank also has €8bn exposure to ECB – same as at the end of 2009. You can either read this as the brokers do, meaning that BofI still has massive reserve it can tap if it needs to go to ECB. Alternatively you can say that in the last 6 months, the bank did nothing to work itself off the reliance on ECB funding.

Finally, virtually all analysis (with exception of one brokerage – if I recall correctly it was NCB) overlooked the data released on the deposits breakdown. Per note, “deposits with a balance greater than €100,000 amounted to €50bn at end-June. …As it stands, the ELG guarantee will no longer cover corporate deposits greater than €100,000 with a maturity of less than three months — presumably a significant proportion of these balances — after September, with the ELG set to go completely at year-end. It seems certain to us that the ELG will have to be extended to shore up confidence and facilitate the as yet unfinished wholesale terming effort.”

Economics 11/8/10: Anglo saga continues

For about 24 hours I have resisted commenting on the Anglo latest twist in the capital hole - the EU approval yesterday of additional funding for the dead bank. But given the lack of straight forward and insightful analysis in the media, I thought I should throw int couple of direct comments on the affair.

First, consider the EU statement (available here):
"Anglo Irish Bank needs a third emergency recapitalisation to meet its obligations. ...there is no doubt that Anglo Irish Bank has to restructure profoundly in a way that effectively tackles the weaknesses of the past business model and ensures a sustainable future without continued State support."

Sadly, no Irish commentator noticed the irony that the EU is calling for a profound restructuring of the Anglo after 3 episodes of approvals of extraordinary funding for the bank by the taxpayers. Surely, if the Commission were to do its job and properly police national decisions relating to financial institutions stability, after the second call for capital from Anglo, Mr Almunia should have said something along the following lines: "Don't come back for any additional funds approval until you first provide a clear map as to how you are planning to shut down this insolvent institution."

Second, consider the timing of the approval. For some days before the approval, Irish 'analysts' and policy officials have been massaging public opinion. Various leaks and speculative statements that the bank will need more cash were floated around. Some of the Irish brokerages suggested that Anglo will need €2-4bn more in funding. Of course, while this circus was ongoing, the Government has been quietly labouring away at the submission to the EU Commission. The approval was issued on Tuesday, suggesting that the request for emergency funding extension was filed at the very latest - on Friday. This request was not subject to any parliamentary debate or other procedures that should have been deployed to ensure democratic participation in disbursing of the public money was adhered to.

Third consider Irish media and 'analysts' response to the Anglo call for cash. Of all stockbrokers, only NCB managed to comment on the Anglo call, despite the fact that Anglo's capital demands are indicative of the sector-wide problems. NCB guys actually did a good job in their morning note, saying that:

• "We had added €23bn to our General Government Debt to GDP ratio as a result of Anglo to leave it at 98.1% at year end 2011. This additional €1.4bn now needs to be added and will add approximately 0.7% to our debt to GDP figure at year end 2011." Yeps, with Anglo latest request for funding, Ireland Inc sovereign debt is set to be 99% by the end of 2011.
  
• The NCB guys are also aware, unlike, it appears Davy and Goodies, that Anglo can end up costing us (taxpayers) of sovereign bonds side as well: "The NTMA announced that its next auction on Tuesday August 17th it will tap the 4.0% 15 January 2014 bond and the 5.0% 18 October 2020 bond. The NTMA will be hoping that the Anglo issue is cleared up sooner rather than later and that clarity is given on the final requirement by the State. The uncertainty surrounding the exact amount of the transfer into Anglo is weighing on the Irish sovereign. The Irish 10 year is currently at 5.16% which is 274bps over the equivalent German bond and wider than the benchmark Portuguese 10 year which is yielding 5.079%."

Of course, most of the media have missed the two points of Anglo contagion to the broader markets:

1. Sovereign risk rising due to Anglo uncertainty, and
2. Corporate risk is also rising due to spillover from sovereign uncertainty to corporate assets valuations.

Finally, the whole circus around Anglo's 'news' missed the core point - Anglo started into the present mess with €71bn of 'assets' (aka loans). The total amount earmarked to date for the bank amounts to €24.354bn.

If Nama were to be believed in its LTEV estimates, Anglo's book is roughly 55% under water. This means that its post-Nama book is somewhere closer to being:

• 1/7 of the total book (€10bn) under water to Nama or better than Nama levels - say impairment of 30% due;
• 35% (or €25bn destined for the 'Bad' bank) is under water more than Nama haircuts - say 60-70% impairment due.

Translated to the full pre-crisis book, this implies the average recovery rate on Anglo loans of ca 43-47% across the whole book.

Let me explain the above numbers: €10bn recoverable at 70% and 25bn recoverable at 30-40% implies 14.5bn recovery on 35bn of assets left post-Nama, adding to it Nama haircuts implies recovery rate of 43-47%, ex-costs). This, in turn, implies across the book impairments of €37.6-40.5bn. Take the lower number - total through restructuring cost of Anglo can be expected to reach ca €37bn in the end or higher. Take 10% off for risk-weighting and restructurings of funding etc to boost regulatory capital.

End of the Anglo affair cost comes to roughly speaking €33bn. That's the amount we can expect to pay in the end. The latest €24.4bn count is, therefore, only less than 3/4 of the saga. So here's my forecast - by end 2011 Anglo will ask for ca €10bn more in our cash and by the end of 2012 - for up to €13bn more than the amounts already advanced. The only way these figures can be made smaller is if Nama grossly overpays Anglo for Tranche 2 and 3 loans.

Anyone noticed that? Not really. Just as no one noticed that Anglo is going to, in the end, cost every working person in this country something of the order of €19,600 - a hefty bill for rescuing Anglo's bondholders for every household of two trying to pay a (negative equity) mortgage and get kids through school.

Instead, our media keeps on asking Minister Lenihan rhetorical questions along the lines 'How much more?' and lamenting 'unexpected Anglo demands for more cash'. Per all publicly available information on this site, Peter Mathews' site and Irish Economy site, all I can say: "Expect more of the 'unexpected', folks".

Economics 9/8/10: Ireland's Construction PMIs

This morning brought with it another bunch of wonderfully optimistic statements from the Irish 'experts' on business cycles.

Let's take in the facts:

• Ulster Banks’ Irish Construction PMI data released today showed moderating decline in Irish construction activity in July. PMI increased modestly from 44.9 in June to 45.0 in July which still means a contraction in activity.
  
• However, at 45.0 the 'improvement' in terms of slower rate of decline is within margin of error, at least one based on time series residuals (Ulster Bank won't tell us what the real underlying margin of error in PMI surveys for the sector is).
  
• So on the surface, contraction in activity is now "the slowest in three years". Which of course is only a natural statistical property - after 3 years of destruction raging across the sector, you'd get an asymptotic curve to 'stabilization', aka the bottom. This has absolutely nothing to do with any pending improvements.
  
• Residential sub-sector was the weakest, showing accelerating drop-off to 40.8 in July, from 45.4 in June. So housing continues to fall off the cliff.
  
• Commercial and civil engineering sub-sectors posted an 'improvement' in July - with the rate of collapse slowing from 45.8 to 46.0 (another statistically insignificant change) and to 43.6 form 38.4 respectively (clearly a statistically significant number). Again - the 'good news' here is a slowdown in the rate of the fall off, no real improvement.
  

The real spin stuff was, actually, in the interpretations concerning future expectations: "Future sentiment remained strongly positive in July, and improved slightly since the previous month, as over 40% of respondents expect activity to be higher in twelve months’ time."

You see, should the question have been 'Do ou expect any improvement in activity 10 years from now?' the 'improved' sentiment would have probably been even stronger.

Virtually identical analysis was presented by the Ulster Bank itself (here). Ulster Bank chief economist Simon Barry told the Irish Times that "index showed that conditions in the Irish construction sector remained “very tough”, with firms continuing to cut back sharply on their employment levels... [But] 'Looking forward, the July survey picked up a further improvement in confidence among Irish construction firms,' Mr Barry said. The rise in new business would provide “added encouragement”, he noted... 'As heartening as this development is, the increase is very modest indeed and it is probably more an indication of possible stabilisation in the sector at very weak levels rather than a strong recovery anytime soon.'"

This type of interpretation omits a very simple economic reality: after 38 months of contraction, the firms still remaining standing in for the survey are those that survived so far into the downturn. These same firms might have higher expectation of surviving into the near future as well. In other words, the entire PMI survey component suffers from survivorship bias. This bias may (or may not) be significant for several reasons:

1. Surviving firms might be biased on the optimism side because they expect to pick up a greater share of future public spending on construction due to declined competition. In other words, survivors might be looking forward to having an increased market share of a shrinking economic pie. Surely that wouldn't be indicative of 'stabilization'.
2. Surviving firms might also be collectively biased in their responses to the survey, if they have individual incentives to do so. For example, a number of Irish construction firms are currently under continued pressure from their banks. If each one of those firms were to make a signal to their lenders that 'things are going to improve soon, just wait a little longer', the resulting bias can be significant enough to induce higher optimism readings on the survey side. This is a significant enough effect in other sectors using surveys of expected future conditions to invalidate entire indices. One classical example involves surveys of expectations for future direction in Forex markets.
3. Surviving firms might also be selected on the basis of their actual exposure to the Irish market. For example - two leading surviving firms in the Irish construction sector are Kingspan and CRH. CRH derives only 4% of its revenue from Ireland and Kingspan's share of revenue accruing to Ireland is 7%. If firms are indeed selected into survivors group by their lower exposure to the Irish market, the question is then whether the expectations data they report is purely based on their perception of future trading conditions in Ireland or whether it is 'contaminated' by their reading of other markets.
   

What (1) and (3) above really suggest is that before we engage in interpreting the future expectations we need to rigorously check for a number of classical biases that might be present in the data. Only economists unaware of the hazards of interpreting survey based gauges of expectations would make the basic mistake of taking the number at their face value and interpreting them directly.

Alternatively, for a more crude correction, the survey results should not be interpreted independent of the quantitative data from contemporaneous PMI reading. In other words, one can make a conclusion that 'It is likely that in the near term there will be improvements in trading conditions in the sector' only if there are some contemporaneous signals of improvements and only if these signals are statistically strong enough.

This, of course is hardly the case, given that PMIs contemporaneous reading increased by just 0.1 from 44.9 to 45.0 - an increase that appears to be well within the margin of error.

Economics 8/8/10: Some Tullamore fun

Per report by RTE today (here), our Minister for Agriculture Brendan Smith said that Ireland's agri-food sector "is making a colossal contribution to economic recovery". The Minister was speaking at the Tullamore Show in Co Offaly.

I am impressed. Of course, agri-food sector is a relatively undefined (by CSO core national accounts statistics - it doesn't even exist) sector, so Minister's claims cannot be fully tested. You see, they belong to that great category of assertions that are non-falsifiable.

But we can take a look at Minister's direct sector of charge - Agriculture. Here are few charts based on latest data from the Quarterly National Accounts and National Income and Expenditure Annual Results for 2009.

Let us start with the Agriculture, Forestry & Fishing sector contribution to GDP:
Not exactly spectacular contributions to the national income - AFF sector delivered just 2.38% of national GDP in Q1 2010 - and that was above average performance. All in, the sector output was worth just €995mln. Not a pittance, but when one considers the massive levels of CAP-delivered financial subsidies the sector receives, I wonder what is so 'colossal' in this?

When measured in terms of constant factor costs, AFF sector has hardly performed any better. Its share of our GDP stands at a miserly 2.37% in Q1 2010, which is down on 2.39% achieved in Q1 2009. Back in Q1 2005 the same share was at a height of a 'colossal' 2.77%.

Annual value of the sector output, in constant market prices, never once exceeded €4,000mln since 2005 and has actually declined over the years from the peak of €3,953mln in 2005 to €3,555mln in 2009.

But may be Minister Smith's sector is 'colossal' in terms of its contribution to growth in our economy?
Again, data suggests that, sadly, this is not true either. In 2004-2009 the overall net value added in AFF sector has fallen by 4%. Other sectors experience growth in net value added of 2.5% over the same period. AFF has managed to collect massive load of subsidies over these years. Subsidies to all other sectors have been negligible and actually declined precipitously.

May be the AFF sector provided a relatively stronger shoulder for our floundering economy in 2008-2009? Not really -

• Between 2007 and 2008, Net Value Added in the AFF sector shrunk by 10.4% while NVA in all of the economy declined by 3.9%;
• Between 2008 and 2009, NVA in AFF sector has fallen by 24.4% against a drop of 8.6% in the economy-wide NVA;
• So far in the crisis - between 2008 and 2009, Net Value Added in Agriculture, Forestry & Fishing sector has declined by 32.3% while economy-wide NVA declined by less than 12.2%.

But wait, if AFF sector is not so 'colossal' in terms of growth in income or its contribution to income, may be it is a giant in terms of capital formation (aka wealth storage)?
Look at the national accounts data. The AFF sector is barely registering on the radar as a capital investment sector. True, it does appear to be more stable in the wake of the massive wave of capital values destruction since 2007 that impacted other sectors (e.g. construction, development, finance etc). But...
As you can see from above, sector share of overall capital pie remains miserably low, with exception of the two years when our land markets went nuts - 2007 and 2008 (incorporating lags).

Overall, per latest CSO data (so grossly outdated, we only have figures for 2009 so far):

• Net value added at basic prices in the entire sector was €1,197.5mln in 2007, €840.2mln in 2008 and a dramatic €204.2mln in 2009. In other words, once subsidies and consumption of capital are taken out, Irish Agriculture, Forestry and Fishing managed to post of collapse in the Net Value added of -76% between 2008 and 2009.
  

Sorry, Minister, I don't seem to find much of evidence of anything colossal going on in our AFF sector at all, apart, that is, from the subsidies it receives from the EU (€1,850mln in 2009 net of taxes paid by the sector or well in excess of the sector operating surplus of €1,612mln) and the precipitous rate of collapse in

• Goods output (down 18.1% yoy in 2009) and
  
• Operating surplus (down 30% yoy in 2009).

Of course, as I have mentioned above, the CSO nomenclature does not allow us to test the proposition of 'colossal' potential for our agri-food sector. But as far as Minister Smith's direct charge goes, we are now decades away from the days when Agriculture, Forestry & Fishing last time provided a significant, let alone 'colossal', contribution to economy or economic growth or increases in the country stock of wealth.

Which is really sad, given our natural conditions for excellent agricultural production.

Economics 6/8/10: Anglo's plans & systemic risks

Updated

Here are some interesting questions (note - just questions for now, on the foot of comments made by Prof Brian Lucey earlier today) regarding the 'Good' v 'Bad' Anglo plans.

Take it from the top: we started with a bank with €71bn on the books valued at valuations of the peak markets. This is now allegedly going to:

• €25bn of the face value of loans pre-writedowns - to the 'Bad' bank, implying that these loans are so poor in quality, even Nama, with an average 50%+ (LTEV-inclusive) haircut is not touching it. This implies that even in the long run, these loans are not going to generate more than, say, 30% recovery rate (a generous 30% that is, but let's take it as such. Note: that is across the entire loan book of the 'Bad' bank);
• €10bn of the face value of loans pre-writedowns - to the 'Good' bank, implying that these loans are better than Nama average, so the LTEV on these loans is above 50%. Assume that the LTEV on them is 60% (which makes them better than Ulster Bank's Irish book, per today's results for Ulster - again a generous allowance, but let's entertain it);
• the remainder is going to Nama.

Now, another little factoid: Central Bank of Ireland has lent Anglo €11.5bn under a MLRA repo agreement secured against the non-Nama loans.

Per Anglo last published results: "Sale and repurchase agreements with central banks include €12.2bn (30 September 2008: €7.6bn) borrowed under open market operations from central banks and €11.5bn (30 September 2008: €nil) borrowed under a Master Loan Repurchase Agreement (’MLRA’) with the Central Bank and Financial Services Authority of Ireland."

Let's do some simple math.

Value (recall - I am factoring referencing to Long Term Economic Value, not the current mark-to-market value, which is even lower):

• €10bn in 'Good' Anglo can be (optimistically) expected to yield €6bn valuation using LTEV;
• €25bn in 'Bad' Anglo can be (again, optimistically) expected to yield €7.5bn valuation using LTEV.
• Allow for 1.5% margin of costs on both sides, to €525mln pa, or over 5 years - i.e. much shorter than Nama horizon - €2.6bn (note: current bank cost structure, which one can expect to be preserved as both banks go about conducting impaired assets recovery - a higher cost activity)
  
• Total non-Nama book value is, inclusive of LTEV net of expected management costs, therefore could be already around €10.9bn.

Against this value of €10.9-13.5bn, CB of Ireland holds €11.5bn worth of loans to the Anglo.

Now to the question: Does this mean that CB might be facing a potentially significant loss on the repos?

This possibility raises two issues:

1. If the repos are spread across 'Good' and 'Bad' bank, then the 'Good' bank is hardly a feasible undertaking, as repos alone already exceed the value of the 'Good' bank even absent impairment charges, while 'Bad' bank has clearly no ability to repay any fraction of these;
2. If the repos are inherited by the 'Bad' bank, then, either CB has to declare a loss (and I am not sure how it can do this), or the taxpayer is on the hook for the repos by having to pay them down through the 'Bad' Anglo.
   

Now, alternatively, let's ask the following question: to recover CBs repos from non-Nama assets, we need to have a combined 'Good' & 'Bad' banks recovery rate of 33% (not covering the costs of operating both banks, funding, bond holders etc). And this, once again, refers to the valuations done on the face value of the loans before any recent impairments - before the bubble burst. To recover all other CBs' funds, plus our own - we need a recovery rate of ca 68% (again ex all costs etc). That's really highly unlikely, folks.


Quite a dilemma, then, especially since ECB (see here) didn't approved the repos in the first place... and since Anglo also owes the other Eurozone Central Banks some €12.2bn more.

What could Mr Trichet say about Anglo's priorities in repaying the loans? Would he be (a) so kind as allow CB of Ireland to recoup its repos, which ECB thought were dodgy enough to refuse to take them itself? or (b) insist that other CBs be repaid first before our own repos are covered? If (a) - I'd say Mrs Merkel would have a few kind words to say to Mr Trichet, given her electorate's feelings about having to bailout Greece. If (b) - the above potential negative valuation of the repos will have to be multiples larger...

Just asking some questions for now... Wonder if there are any answers out there...

Economics 5/8/10: Russia and wheat prices

Following the worst drought in 130 years, the unprecedented heat wave and subsequent wild fires, Russia stopped exports of wheat, corn, rye, barley and flower from August 15 through December 31, 2010. Russia is the third largest exporter of wheat in the world. It expects 2010 harvest to come at 65-75mln tonnes, a 25% shortfall on 2009. Prior to the latest disasters, which started in April this year and is expected to continue at least through August, Russia expected to post second record breaking export years in wheat in 2010.

Despite the shortfall, Russian Government does not expect significant shortages of wheat for domestic markets. Government holds estimated 9.5 million tonnes of wheat in reserves and has ordered fixed price deliveries of wheat to regions impacted by the fires and drought.

The implications of the Russian exports ban are multiple:

1. There is a direct impact on wheat prices, with short term futures rallying today 8%, while longer term deliveries contracts being on an exponential uplift curve (see chart below for December deliveries contracts);
2. There is indirect impact on other commodities and food products, such as milk, etc, as wheat and its by-products are used across almost entire production and breeding chain.

Wheat prices on the CBOT were up 42% in July, the biggest monthly gain since at least 1959. Monday prices were up 5%, and are now the highest for 22 months.