15/09/2011: Some observations on NTMA & NAMA statements to the Oireachtas Committee

I was going over the statements issued by NTMA and NAMA to the Oireachtas Committee last week and was struck by some rather interesting bits...

Let's start with the Statement by John Corrigan, Chief Executive NTMA, to the Joint Committee on Finance, Public Expenditure and Reform, 9 September 2011:

"The banking stress tests carried out by the Central Bank in the first quarter of 2011 quantified the additional capital support required by the banking sector at €24 billion. The NTMA Banking Unit has worked very hard to minimise the amount of this additional capital to be provided by the taxpayer. Through initiatives like burden sharing with the junior bondholders and the sourcing of private capital for Bank of Ireland, the net amount of this capital provided by the State is now expected to be around €16.5 billion. The savings generated can be redirected to funding the day-to-day operation of the country."

Can Mr Corrigan explain this: as of August 1, 2011, the State has injected (under PCAR/PLAR allocations) €17.292bn (here) according to DofF note. That €792mln difference is not exactly a pittance...

Oh, and while we are on the issue of being accurate - PCAR/PLAR capital allocations are designed to deliver capital & liquidity cushions for the period 2011-2013. Not a trivial issue, mind you, especially since Mr Corrigan repeatedly relies on PCAR/PLAR recapitalization exercise as a definitive (aka permanent) line in the sand on banking crisis.

Now, as to the "savings can be redirected to funding the day-to-day operation of the country" - that is pure rhetoric, sir, isn't it? Mr Corrigan himself shows that it is (see marked with italics next quote below).

"In order to stabilise our debt/GDP ratio Ireland needs to get back to running a primary budget surplus (the budget balance excluding interest payments) as soon as possible. Indeed in the context of debt sustainability, this metric is far more important than the absolute level of debt per se. Ireland still has the biggest primary deficit of any eurozone country, a fact not lost on investors..."

So, wait a sec, Mr Corrigan. You said "savings [from PCAR/PLAR recaps] can be redirected to funding the day-to-day operation of the country". You also said that we need to run a primary surplus. You can't have your cake, Mr Corrigan, and eat it.

"The objective of the [banks] deleveraging process is to achieve a more prudent loan to deposit ratio for the institutions concerned through a reduction of their balance sheet assets of some €70 billion while avoiding sales at prices which absorb excessive capital."

Was Mr Corrigan trying to say that we need to deleverage the banks while minimizing the calls on the banks' capital for losses incurred in the process of deleveraging? Ok, that would imply selling good - aka performing - assets first. What would that do to the banks balancesheets, Mr Corrigan? It will undermine banks balancesheets, leaving them with poorer quality average assets. Is that Mr Corrigan's idea of restoring banking system to health? And is that covered by PCAR/PLAR definitive line in the sand? You know, Mr Corrigan, that it is not.



There was also Mr McDonagh speaking on the day...

Opening Statement by Mr. Brendan McDonagh, Chief Executive of NAMA, to the Joint Committee on Finance, Public Expenditure and Reform Friday, 9th September 2011"

"We have now recruited over 190 staff with the specialist skills and experience required to manage a portfolio of property loans with balances in excess of €72 billion."

So NAMA chief thinks it is a great achievement of NAMA that it managed to hire 190 people. Boy, Mr McDonagh would do well in public sector where the metrics of spending are more important than those of earning...

But what is this about €72 billion portflio balances? NAMA valued the portoflio it purchased at €30.5bn gross (inclusive of the LTEV uplift). Banks, who sold NAMA that portfolio wrote down the losses realized, implying that NAMA end valuation in their view was a reasonable reflection of the value of portfolio NAMA bought. So is Mr McDonagh deploying Eugene Sheehy's approach to claiming balances on loans to be assets under management and refusing to write down the actual loans values to the publicly disclosed valuations that NAMA itself prepared?

And is Mr McDonagh conveniently forgetting that the book value of these assets has fallen since that LTEV was assessed and assets were valued? May be Mr McDonagh should consult his own annual report to see his organization taking charge against that loss?

Of course, Mr McDonagh is just pumping up NAMA's (aka his own) importance. NAMA, you see, is not managing €30.5 billion-valued undertaking, or an odd €25 billion actual undertaking (once we factor in at least some of the value losses on NAMA's portfolio), but a €72 billion portfolio. In a way, Mr McDonagh is like Montgomery Burns checking his old ticker for the price of his Federated Slaves Holdings plc...

I love Mr McDonagh's next statement:
"There is a third, small group of debtors ... with whom we could work but who are not co-operating adequately with the process and who appear to believe that, after all that has happened, the taxpayer somehow still owes them a living. We have been as fair, reasonable and patient with these people as any court could possibly expect us to be but, in the circumstances, it is likely that we will be left with no option but to instigate additional enforcement actions before the year is out. Above all else, ...the self-indulgent behaviour of a few has no place in resolving the national crisis with which, collectively, we are grappling."

Now, close your eyes, imagine a summer night, chirping of birds in the distance. From an open window dark woods staring into the room. Armchair. The house owner, with mustache, in military tunic, pipe in hand, explaining in deep Georgina accent to two smaller (in evident statue) men the rationale for dealing resolutely with a small group of dissidents who refuse to cooperate, betraying self-indulgent decadent behavior amidst the national crisis... Mr McDonagh's rhetoric is permeated with Joe Stalinesque tonalities, innuendos, juxtaposing reasonable (NAMA) against the decadent and asocial (developers), the 'few' against the 'many'. Himself positioned in a high priest fashion at the head of the judgment table, burdened with the duty of carrying NAMA's burden of justice to the few unwise dissenters. Why not visit Lubyanka Museum in Moscow on your next corporate outing, my dear NAMAnoids?

There's more of the same, pardon me self-indulgent and arrogant stuff in relation to the public allegedly asking politicians uninformed questions and some people (unknown to us) making uninformed statements about NAMA. "The accusation that NAMA is bureaucratic and slow in dealing with these approvals is unfair and unwarranted but, unfortunately, in the current environment, when it comes to NAMA, many seem to feel that they have no obligation to check the facts before making the accusation."

Ok, Mr McDonagh. I would like to make an informed observation. Where do I get the facts? From you? From NAMA? Who can assure me that the facts you &/or NAMA present are full, correct and not mis-represented?

Let's try the 'trust your NAMA' thingy. Here you say: "There has been much interest from the public (over 100,000 downloads) [in relation to NAMA list of properties under receivership] and in particular from younger people who are keen to use the current correction in property prices to purchase their own homes."

How do you know these are young people? I downloaded the list without any registration. Are you tracking my IP address and accessing, unbeknown to me my details? Are you acting legally in doing this? Or are you simply making a claim that cannot be verified? So much for 'trust your NAMA' proposition then.

And now to the conclusion: "It is our intention that NAMA will be a creative and dynamic force in the property market and, more generally, that it will contribute significantly to the economic resurgence of Ireland in the years ahead." Sorry, Mr McDonagh, but you are not getting it. NAMA has a defined - according to your own chairman and legislation establishing NAMA - mandate. That mandate does not envision NAMA becoming either 'creative' or 'dynamic', nor does it envision 'NAMA contributing to the economic resurgence of Ireland'. Your mandate is to:

1. Recover taxpayers' funds, and
2. Close the shop after doing so.

In case you weren't paying attention on September 9th, Mr Frank Daly said in his statement - made alongside your own: "...the objective that has been set for us by the legislature, under Section 10 of the NAMA Act, is to recover, at a minimum, that amount plus whatever additional funds we need to advance as working or development capital for projects." Mr Daly repeats this objective (in slightly different wording) twice in his statement. Mr Daly does refer to NAMA being "creative and flexible", but unlike Mr McDonagh, he limits this to the reference to properties that NAMA is working with, not to the entire property market and not to the economic resurgence of the whole country.

“Ἀπόδοτε οὖν τὰ Καίσαρος Καίσαρι καὶ τὰ τοῦ Θεοῦ τῷ Θεῷ” (Matthew 22:21), Mr McDonagh. And please, extinguish that pipe and change the tunic... Being Uncle Joe is not only uncool, it is also, fortunately, infeasible for you.

14/09/2011: More soft slop from Irish stuff-brokers

You gotta hand it to the Irish stuff-brokers community. They do routinely produce pearls of wisdom that we, the mere mortals can only aspire to. Here's one latest installment from one morning note issued today:

"If Ireland can meet its deficit cutting/growth targets over the next 2 years, then investor demand for Irish bonds should remain firm".

Let's start peeling this profoundly rhetorical onion:

1. The problem with Irish bonds is that there is NO demand for them. This is why we can't sell them and this is why we are reduced to borrowing from EFSF/EFSM/IMF/Bilateral Begging Bowl. So - the law of physics lesson for stuff brokers - that which doesn't exist cannot "remain firm".
2. If we can sustain our "deficit cutting / growth targets" over the next 2 years (i.e., given I see on my calendar "September 14, 2011") we will be in mid-September 2013 - at which point, per IMF/DofF/ESRI and other folks, usually not renown for their pessimistic assessments of our 'targets', Ireland will be at the peak of our substantial sovereign debt pile. If our stuff-brokers think that is a scenario consistent with "firm" investor demand for bonds, I wonder if the FR should suggest they attend some basic courses in finance.
3. What the hell does construction "deficit cutting / growth targets" mean? Usually, "/" implies "or". At the very least - "and / or", though that construction has own logical sign "v" as in "A ∨ B is true if A or B (or both) are true" of course, "A ⊕ B is true when either A or B, but not both, are true, which can also be written as A ⊻ B". So suppose our stuff-brokers think that delivering on our "deficit cutting" or "growth targets" (but not both) will assure "firm demand" for our bonds. We can, therefore, have NTMA going into the market telling the potential investors: "Give Ireland a chance. We have budgetary consolidation (economic growth), but no economic growth (deficits and debt sustainability)". Again, such a proposition suggests that more basic finance & economics courses are in order.

I am not being pedantic, folks. The problem is that this rhetorical exhortation can easily serve as an example of what passes for policy thinking in Ireland's more august quarters (DofF, Government, Dail, etc). It is an exact formula of what the Government / ESRI / IBEC etc have been putting forward as our policy to resolve the crisis. And yet... yet it makes absolutely no sense.

14/09/2011: Ireland & Portugal are allowed to restructure some of their sovereign debts

The EU Commission issued its proposals for altering terms and conditions of loans extended under the EFSM (and same is expected for EFSF). The details of release are here.

The move comes after July 21 EU summit agreement to alter these terms and took surprisingly long to deliver. This has nothing, I repeat - nothing - to do with the claimed efforts by the Irish Government to secure similar reductions over recent months. The reductions come on the foot of the EU-wide deal for Greece.

Per Commission statement: "The Commission proposes to align the EFSM loan terms and conditions to those of the long standing the Balance of Payment Facility. Both countries should pay lending rates equal to the funding costs of the EFSM, i.e. reducing the current margins of 292.5 bps for Ireland and of 215 bps for Portugal to zero. The reduction in margin will apply to all instalments, i.e. both to future and to already disbursed tranches."

Two critically important points here:

• The reductions, especially for Ireland, are significant in magnitude and will improve Ireland's cash flows and net small reduction in debt burden over time. However, much of these are already factored in recent debt and deficit projections.
• The reductions are retrospective, which is a very important point for Ireland.

Further per EU Commission statement: "...The maturity of individual future tranches to these countries will be extended from the current maximum of 15 years to up to 30 years. As a result the average maturity of the loans to these countries from EFSM would go up from the current 7.5 years to up to 12.5 years."

Two more important points follow from the above:

• Extended maturity in combination of lower coupon on borrowings imply significant cuts in NPV of our debt from EFSM, which, in turn, means that under current EU Commission proposal we will undergo a structured credit event (aka - an orderly default). When this course of action was advocated by myself and others calling for the Irish government to force EU hand on providing for structured default, we were treated as pariahs by the very same 'green jersey' establishment that now sings praise to the EU largess.
  
• Second point is that, as I have noted back in July, this restructuring implies longer term maturity period and can result in total net increase in our overall debt repayments, were we to delay implementation of austerity measures. The silver lining, folks, does have a huge cloud hanging over it.

Lastly: "...the new financial terms will bring benefits such as enhanced sustainability and improved liquidity outlooks. Moreover, indirect confidence effects through the enhanced credibility of programme implementation should result in improved borrowing conditions for the sovereign as well as the private sector."

In effect the above implies that absent such reductions and maturity extensions, Ireland and Portugal are unable to remain on a "sustainable" path and/or lack or experience a deficit of "credibility" whne it comes to their adjustment programmes. That, of course, is plainly visible to all involved.

So here we are, folks - we now had:

1. Bank defaulting on some of its liabilities - and cash machines kept on working
2. Government undergoing debt restructuring - and cash machines keep on working.

Not the end of the world, is it?

14/09/2011: Clueless from the world of finance

I had to get this riddle solved, folks: In the pic below, spot 1,000,023 clueless doorknobs


Answer:

Clueless Number 1: Erin Callan
Clueless numbers 2-15: 14 Goldman Sachs analysts who labored hard to produce that recommendation
Clueless number 16-23: 8-strong crew on CNBC who decided to carry this drivel unchallenged
Clueless numbers 24-1,000,023 (or so): all those who rushed out to buy Lehman's shares on GS recommendation

(I obviously made the numbers up, but, hey... in the world full of clueless analysts this gets one paid loads of money, apparently. Just ask GS)

13/09/2011: Latest research on Tax Havens & Safe Havens

A recent CEPR research paper (CEPR Discussion Paper No. 8570, "TAX HAVENS OR SAFE HAVENS" by Patrice Pieretti, Jacques-François Thisse and Skerdilajda Zanaj, from September 2011) attempts to explain -at least in theory - the policy choices of a small open economy (SOE) that wants to be a viable international banking center (IBC).

The basic dilemma faced by such an economy is that to attract IBC activity, the economy needs to choose between either becoming a tax haven, a safety haven or both for investors from large economy. In other words, the SOE is required to establish a competitive advantage relative to a large economy in terms of two possible instruments: taxation and institutional infrastructure.

The problem is that in reality, the same SOE will not be able to provide both - quality institutions and tax haven protection, since the latter contradicts the former. One can argue that in the past some tax havens were institutionally extremely robust, but in the current globalization-altered world, good institutions require compliance across the borders, not just within the country.

What the paper shows is that in such a setting, the tax haven can act as a catalyst to induce institutional reforms despite the fact that it cannot create institutional competitive advantage. The reason is that competition amongst tax havens drives institutional improvements in these IBCs.

As surveyed in the paper, a recent study by Dharmapala and Hines (2009) "investigated 209 countries and territories to determine which jurisdictions become tax havens and why. They found that successful jurisdictions are overwhelmingly small, but that they are especially well governed, with sound legal institutions and low levels of corruption. Poorly run jurisdictions fail to attract or retain foreign capital, and many do not even try. Thus, the quality of governance seems to matter for the existence of tax havens. According to Gonzalez and Schipke (2011), there is some empirical evidence that countries that apply stronger regulation rules have benefited from higher portfolio investments."

The CEPR study largely confirms this. The core conclusions are:

• "...whether the small country becomes a tax haven depends on the integration of financial markets and the intensity of the small country's comparative advantage."
• "The nature of government matters too to the extent that benevolent governments never build a tax haven. They prefer to erect an IBC through the provision of better institutional infrastructure."
• "By contrast, tax havens may emerge under Leviathan governments. This may explain why tax havens are developed in microstates where there is almost no conflict between social welfare and tax revenues because the local population benefits from the taxes which are mainly levied on foreign investors."
• "Our analysis also reveals that the presence of heterogeneous investors matters for the viability of the IBC and the nature of the policy mix."
• "IBCs need not be as bad as claimed in the media because they foster institutional competition which is beneficial to all investors."
• "Our results provide evidence that safe havens have a place in the global financial environment and provide benefits to governments, firms and households."
  

13/09/2011: German and French Banks - "extreme" leverage & elevated risks

So what's the real trouble with German (and French) banks, folks? Errrm... they are kinda seriously bordering the "insolvency" territory.

The sources for this information, in addition to those cited below, include an excellent research note prepared by Peter Mathews (FG), TD for the Dail Finance Committee, the IMF GFSR and IMF WEO databases.

Deutsche Bank

Leveraged 52:1 (16 August 2011) based on a Tangible Common Equity (TCE) to Total Asset measurement.

Tangible Common Equity is a better gauge of solvency than Tier 1 capital, particularly in the midst of a liquidity crisis. Tier 1 gives no sense of a bank's ability to withstand a liquidity crunch as it includes market-sensitive instruments that are subject to liquidity and price declines risks. Tangible Common Equity is also a much better indicator of a bank's ability to raise further funds in the market as it inversely relates to the rate of assets dilution implied in any rights issuance. (1), (2)

As TCE of €36.2bn is written against €1.85 trillion of assets, DB has just 1.96% cover in form of TCE against assets it holds - a writedown of just 2% on the asset values (cross the book) will wipe out the DB TCE cushion, rendering its current equity-holders de facto bust. Even excluding derivatives, MorningStar estimated DB leverage (TCE ratio 2.1%) at 47.6:1.

DE's current leverage levels compare unfavorably against 44:1 TCE leveraging on Lehman Bros books at the time of collapse (ordinary leverage ratio in Lehman's prior to collapse was 31:1) and makes DB the second most-leveraged bank in the euro area after Credit Agricole.

To bring DB closer to sustainable levels of TCE delveraging - 8-10% reading (note this is different from Tier 1 capital) will require it raising €110-150 billion in equity (depending on specifics of risk weighting ratios) or 3-4 times the current valuation of TCE or 3-4 times the current market value of the DB. Implied dilution for current equity holders under such scenario bears the risk of 75%- 80% loss on equity.

Note that 8-10% ratios are rather conservative, considering that in 2006-2009 TCEs for countries with banking sector crisis averaged (across top100 banks) TCEs of 11.5% to 15.3%. (3) Raising TCEs to the crisis-average levels of ca 13.4% will require equity raising of ca 5.7 times current market valuations or implied dilution of current equity by 85%.

To match TCE/Total Asset leverage ratio of the most leveraged US bank, JP Morgan chase (5.58%), DB would require €67 billion of additional equity or equity raising to the tune of 1.8 times current market cap.

DE's current market capitalisation of €37 billion as of 2 September matches relatively closely tangible common equity of €36.2 billion. In previous weeks, DE market cap fell as low as €26 billion or 70% of TCE. A market capitalisation at or below TCE is a warning sign that the bank is in trouble and questions surround its solvency and stability.

Worse than that, per research from Espirito Santo, DB liquid assets as % of the short term (<1 year) funding in 2010 stood at 47%, well below global leaders Credit Suisse (82%), UBS (77%) and Barclays (59%). At the same time 2010 wholesale funding maturity requirement was 49% - in excess of the iquid assets cover. Again, Credit Suisse had 33% funding call against 82% cover.

DB is structurally important to Germany as its assets stand at around €1.85 trillion, close to 75% of Germany's 2010 GDP (€ 2.498 trillion).

DB exposure to Greek assets is €1.6 billion for the core Group components (sovereign debt only), of which €1.34 billion in Deutsche Postbank AG exposures. Under 70% haircut scenario across the entire DB Group, the total implied loss will be around 5% of TCE.

Commerzbank

Current leverage around 35:1 in TCE terms, which is elevated compared to both historical averages and 2008-2009 crisis levels for comparable institutions. Given current assets valuations at ca €700 billion, the implied TCE is 2.92%, which means that a writedown of 3% of the assets will result in a complete wipe-out of TCE.

The core problem with 35:1 TCE leveraging in the current environment of globally impaired liquidity is that any deleveraging of the balance sheet will require substantial equity rising, similar to that in DE as discussed above. Adjusting for derivatives held, TCE ratio in Commerzbank runs at 30:1 - according to MorningStar who called this leverage ratio as consistent with "extreme" risk rating.

Together with DB, Commerzbank account for ca 102% of German GDP. As German debt to GDP ratio currently stands at 83% and heading for 87% , German taxpayers can see significant adverse impact of the DB and Commerzbank recapitalizations should the calls on PIIGS come in.

Commerzbank is the most exposed of all German banks when it comes to Greek sovereign debt, with nominal exposure at of the end of Q2 2011 of €2.9 billion. Applying the market-expected mid-point writedown in the case of default of 70%, bank losses on the Greek sovereign bonds will wipe out around 19% of the bank equity.

Recent data shows deep concentrations of Greek risks exposures in German banking sector, with German commercial banks holding ca €19.3 billion in public sector debt from Greece, €2.9 billion worth of banks debt from Greek banks and €7.4 billion of corporate and private debt, to the total of €29.5 billion (per BIS data). According to Fitch research, only €13.1 billion of that is on the banks balancesheets, the rest tucked away off the books.


French Banks

Credit Agricole is leveraged 70:1 (assets €1.5 trillion), while BNP Paribas is leveraged 36:1 (assets €1.93 trillion, Common Equity Tier 1 ratio of 9.6% well below minimum standard set for SIFIs of 10%). Bank's assets to market value currently stands at 64:1. BNP's exposure to Greek debt is now at ca €4 billion. SocGen is leveraged 34:1 (assets €1.16 trillion) on TCE basis and 28:1 on ordinary basis (again, recall Lehman's numbers at the point of collapse were 44:1 and 31:1) the bank has huge short term funding requirements presently being exposed by the flight out of Europe by US money market funds and Asian investors. SocGen exposure to PIIGS debt is €4.3 billion, referring to banking book only. SocGen is also in trouble on the liquid assets side with 26% ratio of liquid assets to short-term wholesale funding calls in 2010. Worse, wholesale funding that matured within 1 year of 2010 as percent of total wholesale funding was 69% for SocGen. Three French pillar banks have assets coming in at well over 200% of French GDP.

The banks are aggressively moving out of the PIIGS with SocGen in recent note stated that it cut its exposures to the peripheral states by 23% since early June 2011, taking out $1.5 billion and $2 billion in assets from Greek and Italian books. French banks total exposure to Greece is estimated at around $89 billion.

On top of this, French banks are now becoming effectively shut out of the dollar funding markets (4). And liquidity woes do not stop there. US Prime money funds have cut their holdings in certificates of deposits from French banks by about 40% in the three months through August 11. The proportion of the remaining holdings of French banks short term funding notes maturing in less than a month increased to 56% on August 11 from 17% on June 11. (5) The banks, of course, deny this is happening.

Let's run though some grim figures for one of the French "dogs" - BNP: as of June 30, 2011, the bank had €109bn worth of sovereign bonds on its books, amounting to 190% of the bank TCE (that's JUST Government bonds!), of which €31bn (or 54% of TCE) was in PIIGS bonds split as follows: Portugal - €1.7bn, Ireland - €400mln, Italy - €23bn, Greece - €3.8bn, and Spain €2.5bn. 95% of these exposures were held on banking book. So, now, let's do the same exercise as above - apply 50% haircut to Greek bonds, 25% haircuts to Porto bonds, 15% to Spanish, Irish and Italian bonds - all below market rates of implied haircuts, but let's indulge them with this assumption. This adds up to a writedown of €6.21bn or a wipe out of 11% of TCE. Bank becomes insolvent.


Summary

To summarise the above, two of German core banking institutions are currently operating in the extremely risky environment with leverage levels that can be classified as "extreme". The French banking system is even more sick than the German one with leverage ratios close to those attained by Lehman and PIIGS exposures that are well in excess of "manageable", given already strained capital cushions.

In common parlance, if it barks & wags the tail, it's a dog... regardless of what the official stress tests and powerpoint slides say.


Notes

(1) See BASEL III: Long-term impact on economic performance and fluctuations, by P. Angelini, L. Clerc, V. Cúrdia, L. Gambacorta, A. Gerali, A. Locarno, R. Motto, W. Roeger, S. Van den Heuvel, J. Vlc_ek, BIS Working Paper 338, February 2011, http://ssrn.com/abstract=1858724

(2) Note that Tier 1 capital is classified into different Tiers of capital, based broadly on the maturity profile of the capital invested. The most stable capital is Tier 1 capital and consists of items such as paid-up ordinary shares, non-cumulative and non- redeemable preference shares, non-repayable share premiums, disclosed reserves and retained earnings.

(3) Bank Behavior in Response to Basel III: A Cross-Country Analysis, by Thomas F. Cosimano and Dalia S. Hakura1, May 2011, WP/11/119, IMF Working Paper, Table 3.

(4) http://www.forexcrunch.com/bnp-paribas-executive-admits-access-denied-for-dollars/

(5) http://www.businessweek.com/news/2011-09-13/bnp-paribas-socgen-rebound-after-rejecting-funding-concerns.html

13/09/2011: Forthcoming Conference on Economic Sustainability

Forthcoming Feasta conference on, among other things,

• Alternative currencies / parallel currencies
• Site-Value Tax / Land-Value Tax
• Dealing with private debt overhang
• Energy, economic growth and crises, and more
  

Loads of interesting thinkers and usual suspects too. Unorthodox, provocative, and worth attending.

National Strategies for dealing with Ireland's debt crisis: Exploring the options

Link here.

13/09/2011: Global contagion from Greece

In the torrent of newsflow from the euro area, we are forgetting about the wider geography of implications of the Greek default. Here are some of the points in addition to my comment to today's article on the topic in Canada's Globe & Mail (article here).

There are two core pathways through which the Greek default will have an adverse impact on banking and sovereign risk valuations outside the euro zone. Firstly, there is the direct impact via foreign banks exposure to Greek debt. These range from small to medium sized and can be concentrated in a small number of institutions in each country. Secondly, there is a number of inter-linked second order effects, which tend to have much larger implications once propagated across the global financial system.

Direct impacts include:

• Japanese banks hold $432 million in Greek debt
• U.S. banks hold $1.5 billion in Greek debt
• UK banks hold $3.4 billion in Greek debt
• Bulgaria has bank credit exposure of $13.5bn to Greece (banks and sovereign debt)
  
• Serbia's exposure is about $7 billion
• Romania's banking system is tied into $20.2 billion of exposures to Greek banks and sovereign debt
  
• Turkey $30.4 bn exposure
  
• Poland $8.0 bn
• Croatia, Hungary and the Czech Republic combined are exposed to some $460 million.

Indirect impact:

Were Greece to default, core euro area banks - Deutsche Bank (including Deutsche Post) carries ca €2.94 billion exposure, Commerzbank (€2.9 billion), but also SocGen, Credit Agricole, Commerz Bank etc will come under severe pressure to recapitalize. German banks have combined exposure to Greece of ca $22.65 billion, French banks $14.96 billion. Cross positions vis-a-vis Greek banks (with their exposure to Greek sovereign bonds of $62.8 billion) imply strong spill-overs. Thus, Greek default can lead to a severe liquidity crunch and flight to safety of deposits from not only Greek and euro area banks, but from a number of closely inter-connected banking systems, especially those with close trading and investment links to the European Economic Community.

This is bound to induce contagion across the entire euro area and spill overs to euro area banks cross links to Eastern and Central Europe and beyond. In effect, Romanian and Bulgarian banking systems are heavily dependent on Greek banks and their own banks collapse will put huge pressures on Hungary. The ripple effects of this can reach as far as Ukraine and Turkey.

There are other interesting cross-links worth looking at. Greek default can trigger default across Cyprus banking sector which holds ca $28.3bn exposure to Greek banks and sovereign debts (156% of Cypriot GDP). With 30% recovery rate on Greek default, Cyprus is facing with recapitalization bill for its banks to the tune of 10% of GDP. This, irony has it, can put pressure on Russian deposits in Cyprus and capital flows between Cyprus and CIS, which are massive - note that Cyprus is the largest single FDI transfer point for Russia with CB of Russia estimating that in 2007-2010 Cyprus banks channeled some 42bn USD worth of FDI to Russia.

To sum up, Greek default - which will inevitably combine sovereign and banking sectors defaults - will trigger a large-scale revaluation of assets and risk-weightings across a broad range of Eastern and Central European Economies, including Turkey, in effect slamming the breaks on the only growth engine within the European Economic Community and its nearest neighbours.

But there is a global cost to the Greek default as well, which rests with significant dislocations of risk-linked investment markets (equities and corporate debt), insurance and derivative products. The multiplier effects, consistent with 2008-2010 financial markets experience, suggest that magnification of Greek default costs across the global economy can reach 4 times the original volume of default itself. With 50% recovery rate on Greek liabilities, this implies a total expected cost of ca €240 billion, and with 30% recovery rate currently appearing to be more realistic, the propagated effects can sum up to €340 billion.

12/09/2011: CHF and the "soon-to-be-busted" peg

Some weeks ago I have addressed one of the core reasons why the CHF/Euro peg, announced last week by the SNB will not hold for longer than 1-2 months. Here are the previous links to:

1. Small Open Economy argument (link)
   
2. Small Open Economy as safe haven argument (link)

Since then, in last weekend comment to the Sunday Times, I outlined another core reason for the peg to fail - the SNB has been brandishing the war chest of some USD 230 billion of FX funds that it says will be delivered into the battle field to support CHF, should pressures on CHF/Euro cross continue to mount. Now, that number above is roughly 1/2 of the Swiss 2010 end-of-year M1 money supply.

• Imagine the scale of intervention and the resulting interest rates hikes that will be required to extinguish inflationary pressures arising from this?Up by 50-100%?
• Now imagine what will happen with CHF cross with the euro if the interest rates in Switzerland were to, say, rise by 50-100%? Correct - demand for CHF will go through the roof, undoing any CHF/euro supports erected before.
• And alongside this, imagine what the 50-100% increase in interest rates do to capital investment and corporate balancesheets in Switzerland? Again correct - corporates, spared by SNB peg from being destroyed by the exchange rate appreciation will now face the very same FX pressures as before, plus higher cost of capital

And now, folks, for the third weighty reason why SNB will be forced to abandon its peg. Medium-term promise of a devalued CHF coupled with zero interest rates (0-0.25% on 3mo Libor target against Euribor 1.56% comp) implies a huge incentive for carry trades origination in very short term run, while in the medium-term, expected long-term revaluation of the CHF creates an incentive to make carry trades very short-lived. Both are not so much the forces to drive demand up, but the forces to destabilize fundamentals-determined medium-term FX rates.

Good luck betting that CHF peg holds, my friends...

12/09/2011: IMF admits failures in debt risk forecasting frameworks

In the analysis published just minutes ago, the IMF ("Modernizing the Framework for Fiscal Policy and Public Debt Sustainability Analysis" by the Fiscal Affairs Department and the Strategy, Policy, and Review Department, dated for internal use from August 5, 2011) implicitly admits deep errors in the methodology for analyzing public debt dynamics. Given the magnitude of errors reported by the IMF (see table summary below), the entire exercise puts the boot into the EU-led attacks on the Big 3 ratings agencies - it turns out that the wise and uncompromisable IMF was not much good at dealing with fiscal sustainability risks either.

Here are the core conclusions: "Modernizing the framework for fiscal policy and public debt sustainability analysis (DSA) has become necessary... [This paper] proposes to move to a risk-based approach to DSAs for all market-access countries, where the depth and extent of analysis would be commensurate with concerns regarding sustainability..."

DSA could be improved, according to the IMF report, through a greater focus on:

• Realism of baseline assumptions: "Close scrutiny of assumptions underlying the baseline scenario (primary fiscal balance, interest rate, and growth rate) would be expected particularly if a large fiscal adjustment is required to ensure sustainability. This analysis should be based on a combination of country-specific information and cross-country experience." (Note that in Ireland's case such analysis would probably require, in my view, using GNP metrics in place of GDP).
• Level of public debt as one of the triggers for further analysis: "Although a DSA is a multifaceted exercise, the paper emphasizes that not only the trend but also the level of the debt-to-GDP ratio is a key indicator in this framework. [Apparently, before the level of debt didn't matter much, just the rate of growth in debt - the deficit - was deemed to be important] The paper does not find a sound basis for integrating specific sustainability thresholds into the DSA framework. However, based on recent empirical evidence, it suggests that a reference point for public debt of 60 percent of GDP be used flexibly to trigger deeper analysis for market-access countries: the presence of other vulnerabilities (see below) would call for in-depth analysis even for countries where debt is below the reference point." [So, now, folks, no formal debt bounds, but 60% is the point of concern. Of course, by that metric, IMF would have to do country-specific analysis for ALL euro area states]
• Analysis of fiscal risks: "Sensitivity analysis in DSAs should be primarily based on country-specific risks and vulnerabilities. The assessment of the impact of shocks could be improved by developing full-fledged alternative scenarios, allowing for interaction among key variables..." [Another interesting point, apparently the existent frameworks fail to consider interacting risks and second order effects. That is like doing earthquake loss projections without considering possibility of a tsunami.]
• Vulnerabilities associated with the debt profile: IMF proposes "to integrate the assessment of debt structure and liquidity issues into the DSA." [Again, apparently, no liquidity risk other than maturity profile analysis is built into current frameworks]
• Coverage of fiscal balance and public debt: "It should be as broad as possible, with particular attention to entities that present significant fiscal risks, including state owned enterprises, public-private partnerships, and pension and health care programs." [It appears that the IMF is gearing toward more in-depth analysis of the unfunded state liabilities, such as longer-term liabilities relating to pensions and health expenditure, as well as more explicitly focusing on unfunded contractual liabilities, such as specific contractual exposures on state pensions. If that is indeed the case, then there is some hope we will see more light shed on the murky waters of forthcoming sovereign exposures that are currently outside the realm of exposures priced in the market.]

Now, several interesting factoids on sovereign debt forecasts and sustainability as per IMF paper.

Here's the summary of IMF own assessment of its forecasting powers when it comes to Ireland: "The 2007 Article IV staff report included a public DSA, which showed that government net debt (defined as gross debt minus the assets of the National Pensions Reserve Fund and the Social Insurance Fund) was low and declining. In the baseline scenario, net debt was projected to fall from 12 percent of GDP in 2006 to 6 percent of GDP by 2012. The medium-term debt position was judged to be resilient to a variety of shocks. The worst outcome-a rise in net debt to 16 percent of GDP in 2012-occurred in a growth shock scenario. Staff identified age-related spending pressures as the most significant threat to the long-run debt outlook. The report noted that, although banks had large exposures to the property market, stress tests suggested that cushions were adequate to cover a range of shocks. Net debt to GDP subsequently increased nearly fivefold from 2007 to 2010, owing to a sharp GDP contraction and large fiscal deficits linked mainly to bank recapitalization costs."

No comment needed on the above. The IMF has clearly missed all possible macroeconomic risks faced by the Irish economy back in 2007.

On Greece: "In the 2007 Article IV staff report, staff indicated that fiscal consolidation should be sustained over the medium term given a high level of public debt and projected increases in pension and health care costs related to population aging. ...In the baseline scenario, public debt to GDP was projected to fall from 93 percent in 2007 to 72 percent in 2013. All but one bound test showed debt on a declining path over the medium term. In the growth shock scenario, debt was projected to rise to 98 percent of GDP by 2013. Two years later, staff warned that public debt could rise to 115 percent of GDP by 2010-even after factoring in fiscal consolidation measures implemented by the authorities-and recommended further adjustment to place public debt on a declining path."

So another miss, then, for IMF.

Here's the summary table on these and other forecast errors:

Next, take a look at a handy summary of debt sustainability thresholds literature surveyed by the IMF (largely - sourced from IMF own work):
So for the Advanced Economies (AE), debt thresholds range from 80-150 percent of GDP, the range so wide, it make absolutely no sense. Nor does it present any applicable information. By the lower bound, every euro area country is in trouble, by the upper bound, Greece is the only one that is facing the music. Longer term sustainability bound is a bit narrower - from 50% to 75%, with maximum sustainable debt levels of 183-192%.

And, for the last bit, off-balance sheet unfunded liabilities and actual debt levels chart:
Here's an interesting thing. Consider NPV of pension and health spending that Ireland is at - in excess of aging economies of Italy, Japan and close to shrinking in population Germany. One does have to ask the question: why the hell does the younger economy of Ireland spend so much on age-linked services and funds?

Another thing to notice in the above is that there appears to be virtually no identifiable strong statistical relationship between debt levels and pensions & health expenditures. This clearly suggests that the bulk of age-related spending looking forward is yet to be factored into deficits and debt levels. Good luck with getting that financed through the bond markets, I would add.

12/09/2011: Bilateral trade with Russia - latest data

Speaking at today's Croke Park conference "Finding New Markets: Doing Business in Russia, Central & Easter Europe and the Gulf", organized by Enterprise Ireland and Ulster Bank, I realized that in the rush of recent markets and crises, I forgot to update the charts on our bilateral trade with Russia, to reflect the latest data for May 2011 (released a couple of weeks ago).

Not to be a harbinger of only bad news, here's the latest bilateral trade results. And they are even more impressive, folks, than our overall external trade performance (see the latest data covered here).

The chart above shows truly dramatic gains in Irish exports since the beginning of this year. In May 2011, Irish exports to Russia amounted to €63.3 million against our imports from Russia of €9.2 million, implying the monthly trade balance of €54.1 million - the highest on the record. May was the second consecutive month of records-breaking trade surpluses in our bilateral trade with Russia with April surplus standing at €36.5 million.

In annualized terms, these numbers are also impressive. Using data from January through May 2011 and historical trends for monthly series from 2004 through present, my forecast for Irish exports to Russia for 2011 is to reach €569 million (range of €560-575 million) against projected imports of €115.7 million, to deliver a massive trade surplus of €454 million for the year as a whole.
If delivered, this level of trade surpluses will be more than double achieved in 2010 (€213.1 million) and will be 83% above the trade surplus achieved in 2007.

In terms of international comparatives, Russian market importance to Irish exporters is hard to overestimate. Take the first 5 months of 2011. Against bilateral trade surplus of €231.3 million achieved with Russia (an increase of 162% on same period in 2010), we have:

• Bilateral trade surplus of just €33.4 million with Brazil (with trade surplus falling in the first five months of 2011 by 23.7% compared to the same period of 2010)
• Bilateral trade deficit of €130 million with China (with trade deficit in the first five months of 2011 contrasted by the small trade surplus of €74 million achieved in the same period of 2010)
• Bilateral trade deficit of €86.2 million with India (with trade deficit in the first five months of 2011 showing further yoy deterioration on the deficit of €56.2 million achieved in the same period of 2010)
• Bilateral trade surplus with our traditional trading partners: Australia (€262 million down from €291 million yoy), Canada (€89.9 million down from €123.8 million yoy), Japan (€340 million down from €382.7 million yoy), Turkey (€99 million up on €83 million yoy)

11/09/2011: What gold coins sales tell us about the 'bubble'

Here is the extended version of the article published by Globe & Mail on the topic of US Mint sales of gold coins.

Of all asset classes in today's markets, gold is unique. And for a number of reasons(i).

Firstly it acts as a long-term hedge and a short-term flight to safety instrument against virtually all other asset classes.ii Secondly, it supports a wide range of instruments, including physical delivery (bullions, coins and jewellery), gold-linked legal tender, gold-based savings accounts, plain vanilla and synthetic ETFs, derivatives and producers-linked equities and funds. All of these are subject to diverse behavioural drivers of demand. Thirdly, gold is psychologically and analytically divisive, with media coverage oscillating between those who see gold as either a long-term risk management tool, or a speculative investment, a "barbaric relic" prone to "bubble"-formation.

In the latter context, it is interesting to look closer at the less-publicised instrument - gold coins, traditionally held by retail investors as portable units to store wealth. Due to this, plus demand from collectors, gold coins are less liquid and represent more of a pure 'store of value' than a speculative instrument. Lower liquidity of coins is not driven by shallow demand, but by reluctance of owners to sell them when prices change. Gold coins are economically-speaking "sticky" on the downside of prices - when price of gold falls, holders of coins are not usually rush-prone to sell as they perceive their coins holdings to be 'long-term accumulations', rather than speculative (or yield-sensitive) investments. They are also "sticky" on the upside of prices - while demand is impacted by price effects (with generally higher gold prices acting to discourage new accumulation of coins), holders of coins are not quick to sell to realize capital gains, again due to entirely different timing to the holdings motives. Think of a person setting aside few thousand dollars worth in gold coins to save for child's college fund.

In general markets, classical bubbles begin to arise when speculative motives (bets on continued and accelerating price appreciation) exceed fundamentals-driven motives for opening new long positions in the instrument. Bubbles blow up when these tendencies acquire wide-based support amongst retail investors.

In late stages of the bubble, we should, therefore, expect demand for gold coins to falter compared to the demand for financially instrumented gold (ETFs shares and options). In the mid-period of bubble evolution, however, as retail investors just begin to rush into the asset, we can expect demand for coins to rise in line with demand for jewellery and smaller bullion. But we do not expect a flood of gold coins into the secondary market (and hence a collapse in gold coins sales) until literally past the turn of the fundamentals-driven prices toward the stage of mid-cycle "bubble" collapse.

The US Mint data on sales of gold coins suggests that we are not in the last days of the "bubble". But there are warning signs to watch into the future.

August sales by the US Mint were up a whooping 170% year on year in terms of total number of coins sold, while the weight of coins sold is up 194%. On the surface, this gives some support to the theory of gold becoming short-term overbought by retail investors (see chart below), but it also contradicts longer-term view that gold coins sales should fall around bubble peak.

Source: US Mint and author own analysis

In part, monthly comparatives reflect huge degree of volatility in US Mint sales. Looking at the longer term horizon, since January 2008, US Mint sales volumes averaged 97,011 oz with average coin sold carrying 0.82 oz of gold, the standard deviation of these sales was 45,196 oz and 0.19 oz/coin, implying that August results comfortably fit within the statistical bounds of +/- 1/2 STDEV of the mean for the crisis period. Equally importantly, August results fit within +/-1 STDEV band of the historical mean since 1986 through today. In other words, current gold coinage sales do not even represent a 1-sigma event for the entire history of gold coins sales supplied by the US Mint and are within 0.5-sigma risk weighting for the crisis period since January 2008.

Neither is the current monthly increases in demand represent a significant uptick on previous months or years demand. At 112,000 oz of gold coins sold, August 2011 is only the 19th busiest month is sales since January 2008. It ranks as the 34th month in terms of the gold content per coin sold. Again, not dramatic by any possible metrics. Since January 1988 there were 87 months in which average gold content per coin exceeded August 2011 average and on 38 occasions, volumes of gold sold in the form of coins by the US Mint exceeded last month's volume.

Again, not dramatic by any possible metrics, especially once we recognize that in terms of risk-related fundamentals, August was an impressive month with US and EU debt crises boiling up and economic growth slowdown weighing on global equities markets.

Charts below illustrate these points.
Source: US Mint and author own analysis
Source: Author own calculations based on the US Mint data
Source: Author own calculations based on the US Mint data

The data also shows that physical demand for coins is largely independent of the spot price of gold. Historically, since 1986, average 12-months rolling correlation between the spot price of gold and the volumes of gold sold in US Mint coins is negative at -0.09. Since January 2008, the average correlation is -0.2. And over the last 3 years, the trend direction of gold spot price (up) and the volumes of gold sold in coinage (down) have actually diverged (see chart). The latter is, of course, concerning and will require closer tracking in months to come. The correlation between price of gold and volumes of gold sales through US Mint coins is now negative or zero for 13 consecutive months.

Source: Author own calculations based on the US Mint data

Source: Author own calculations based on the US Mint data

The chart above also highlights the fact that the current trend levels of US Mint sales are significantly elevated on previous periods, with exception of 1986-1987 and 1998-1999 demand spikes. Since the global economic crisis began, annual coinage sales rose 7-fold from just under 200,000 oz in 2007 to 1,435,000 oz in 2009, before falling back to 1,220,500 oz in 2010. Using data through August, I expect 2011 sales to remain at around 1,275,000 oz. This implies that the 2008-2011 average annual sales of US Mint coinage gold are likely run at slightly above 2 times the average annual rate of sales of coinage gold in the period 1988-2007.

Given the state of the US and other advanced economies around the world since January 2008, this is hardly a sign of dramatic over-buying of gold by masses of retail investors. Instead, we are witnessing two core divergent trends emerging from the coins markets:

1. Since, roughly-speaking, 2009, the trend in coins sales is moving counter to the trend in spot price for gold, implying that retail investors are not rushing into gold, as one would expect were gold to be a bubble, and
2. The levels of sales of US Mint coins remain elevated, on average, since the crisis began, implying that high demand for coins, relative to historic trends, is most likely being driven by fundamentals-underpinned demand for safety.
   

In short, there is no indication, in the data reviewed, of the bubble beginning to inflate (sharp rises in gold coins demand along the trend with prices) or close to deflating (sharp pull-back in demand for gold coins).

Of course, the evidence above does not imply any definitive conclusions as to whether gold is or is not a "bubble". Instead, it points to one particular aspect of demand for gold - the behaviorally anchored, longer-term demand for gold coins as wealth preservation tool for smaller retail investors. Given the state of the US and other advanced economies around the world since January 2008, US Mint data does not appear to support the view of a dramatic over-buying of gold by the fabled speculatively crazed retail investors that some media commentators are seeing nowdays.


Disclosure: I am long physical gold and hold no long or short positions in other gold instruments.


i These and other facts about gold are summarized in my recent presentation available at http://trueeconomics.blogspot.com/2011/08/20082011-yielding-to-fear-or-managing.html.

ii As shown in the recent research paper by Profs Brian Lucey, Cetin Ciner, and myself, covering the period of 1985-2009: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1679243