24/10/2011: Euro CDS disaster Redux?

A picture (table) worth a 1,000 words...

via CMA.

24/10/2011: Euro area competitiveness indicators update

ECB posted updated Harmonized Competitiveness Indicators data for Q2 2011

Chart above shows that euro area HCI (unit labour cost adjusted) have deteriorated (higher values in the graphs reflect lower competitiveness) from 96.4 in Q1 2011 to 99.2 in Q2 2011. Q2 2011 reading was 2.5% above Q2 2010 reading, but 6% below Q2 2009 reading. Relative to Germany, euro area HCI(ulc) index now stands at 17.4% premium, reflecting relatively much stronger competitiveness of German economy.

Considering the charts above (note that the top chart reflects annualized data, while quarterly data is shown in the second chart above), Ireland retains its relatively uncompetitive position vis-a-vis all 'old' euro area countries. For larger economies:

• Germany's HCI(ulc) rose from 82.6 in Q1 2011 to 84.5 in Q2 2011, marking deterioration in competitiveness qoq. Year on year, index is not 3% higher, and the gains in competitiveness since 2009 have been virtually erased, as Q2 2011 index reading is just 0.3% below Q3 2009 reading. However, Germany remains the most competitive economy in the euro area in terms of HCI(ulc) index with own index reading currently 14.8% below euro area overall index.
• Spain's HCI(ulc) was virtually unchanged, rising from 107.3 in Q1 2011 to 107.4 in Q2 2011. Spain's competitiveness index has fallen (improved) by 2.0% yoy in Q2 2011 and is down 5.0% on same period 2009. Spain remains 8.3% less competitive than the euro area and 27.1% less competitive than Germany.
• France's HCI(ulc) deteriorated from 102.6 in Q1 2011 to 104.2 in Q2 2011, rising (deteriorating competitiveness) 1.8% yoy and 0.1% no Q2 2009. Relative to Germany, France is 23.3% less competitive in terms of HCI(ulc) and 5% less competitive than euro area.
• Italy's HCI deteriorated from 110.1 in Q1 2011 to 111.2 in Q2 2011, rising (deteriorating competitiveness) 1.65% yoy and improving (falling) 1% on Q2 2009. Relative to Germany, Italy's HCI is now at 31.6% premium (poorer competitiveness) and Italy is 12.1% less competitive than euro area average.

Smaller economies are charted above.

For Ireland, HCI(ulc) also posted deterioration in Q2 2011 rising from 113.2 in Q1 2011 to 113.8 in Q2 2011, marking decline in Ireland's competitiveness as measured by HCI. Ireland's competitiveness, however, improved yoy by 1.6% and is up on Q2 2009 level by 12.1%. Despite these gains, Ireland remains the least competitive 'old' euro area economy with Ireland's competitiveness gap of 34.7% compared to Germany and 14.7% compared to euro area.

As I have noted on numerous occasions before, much of the gains in our competitiveness in 2009 can be explained by the wholesale destruction of less competitive sectors: construction and domestic services (retail, security etc). The concern is that our future competitiveness gains will be compressed by the fact that from here on, we will need much harder to attain productivity growth in remaining sectors. So far, some nascent costs inflation in other economies have helped us to continue improving compared to euro area average. But in absolute terms, it is clear that since Q2 2010 we have lost momentum in gains in HCI(ulc) measures.

24/10/2011: New Orders for Industry: August data

Cheerful update today from the Eurostat on New Orders in Industrial Production series:

"In August 2011 compared with July 2011, the  euro area (EA17) industrial new orders index rose by 1.9%. In July the index dropped by 1.6%. In the EU27 new orders increased by 0.4% in August 2011, after a fall of 0.6% in July. Excluding ships, railway & aerospace equipment, for which changes tend to be more volatile, industrial new orders rose by 0.7% in the euro area and by 0.5% in the EU27. In August 2011 compared with August 2010, industrial new orders increased by 6.2% in the  euro area and by 6.5% in the  EU27. Total industry excluding ships, railway & aerospace equipment rose by 5.0% and 5.2% respectively."

Here are the details:

Start at the top: EU17 new orders index is now at 115.11 for August, up on 112.93 in July, down on 115.54 in May. The index is now back into the comfortable expansion territory, where it has been since April 2010. 

2008 average reading was 110.09, 2009 average was 86.99 and 2010 annual average was 102.2. So far - through August - 2011 average is 112.93 - not a bad result. But miracle it is not - reading of 100 is consistent with activity back in H1 2005, so in effect, through August 2011 we have achieved growth of 2.05% annualized in terms of volumes of output. Given that since then we had pretty hefty doses of inputs inflation and moderate gate prices inflation, the margins on the current activity have to be much lower than for pre-crisis years. Which means relatively robust improvements in volumes of industrial new orders are not necessarily implying robust value added growth in the sector.

Meanwhile, German new orders have shrunk in August 2011 from 122.4 in July to 120.9 in August. Month on month German new orders are down 8.04% and year on year activity is down 13.34%. This marks the lowest reading since April 2011.

 Of the big players:

• France posted an increase in new orders index to 102.90 in August from 100.1 in July. France's 2011 average to-date is 100.43, well ahead of 2010 average of 90.93 and 2009 average of 84.31. France's new orders index averaged 100.06 in 2008.
• Spain posted a surprising improvement in August to 96.43 from 93.85 in July and yoy rise of 2.0%. Spain's 2008 average was 102.93, 2009 average of 81.57 and 2010 average of 89.61. For 8 moths through August 2011, Spain's new orders index averaged 94.27.
• Italy;s new orders index hit 117.21 - very robust increase of 6.14% mom from 110.56 in July. Italy's new orders index is now averaging 113.58 for eight months of 2011, up on 2010 annual average of 103.09, 2009 average of 89.75 and 2008 average of 104.59. It's worth noting that Italy exemplifies the fallacy of 'exports-led growth' argument - the country has posted very robust recovery in its significant and highly exports-oriented industrial sector, and yet it also posted virtually no growth over the last 2 years.

Other countries are illustrated below.

 So on the net, industrial production new orders signal some bounce back from the troughs of the slowdown in early summer 2011, but this can be immaterial for the wider Euro area economic growth and a temporary improvement. September and October data will be more crucial, signaling into early 2012.

24/10/2011: Some interesting links

Couple of interesting links on various topics of the crisis:

Fist, my most recent post for The Globe & Mail EconomicsLab: Europe’s (non) bailout plan predictable in its absurdity

Second, a very good graphic from NYTime on debt-default interlinks globally: Chart 1 and an interactive version here.

Third, some interesting points on global yield curves here.

And lastly, a good summary of contagion dynamics from the zerohedge blog which roughly outlines the scenario that I presented on Friday, October 14th, at the American Bar Association meeting in Dublin - that of the inevitable destruction of the euro as we know it (either in composition or in its totality) - here. 

24/10/2011: Budget 2012 - doing the right thing right

This is the unedited version of my article in Sunday Times (October 23, 2011).

As the Troika gives another ‘thumbs up’ to our fiscal policies, the reality check on our medium term fiscal objectives suggests that the real cuts are yet to come.

Staring into the barrel of the next budget, the Irish nation is now slowly, but surely coming around to the realization that the medicines for our twin malaise of unsustainable debt and deficit to-date not only failed to cure the disease, but instead made it virtually incurable.

Now the fourth year into the austerity, per latest figures, Irish budget deficits for H1 2011 remain stuck above 13% of the country GDP. Taken against the more realistic metric, GNP, the shortfall between Exchequer spending and revenue is running at ca 17.6%. Even per Stability Programme Update, current expenditure – stripping out banks measures and capital investment, for 2011 is expected to run ahead of the 2010 levels.

Austerity, to-date, has been visible solely in capital investment cut backs and tax increases on personal incomes of the households. The rest of the ‘savings’ are really a game of shells – shifting expenditure from one side of the balance sheet to the other. In medical terminology, courtesy of the Irish Government choices of policy tools, our economy is now like a body consuming itself from the inside.

Quarterly National Accounts clearly show that Gross Fixed Capital formation in the economy is no longer sufficient to cover amortization and depreciation on private and public capital stocks accumulated between 2004 and 2008.

Meanwhile, in nine month through September this year, income tax alone accounted for 38.4% of the entire Government tax revenues, up from 28.4% for the same period of 2007.

Taking out tax increases, Irish Government austerity has delivered no real, long-term changes to-date. Neither public sector pensions, nor numbers employed, nor public wages paid relative to comparable grades in the private sector have seen much of a change worth talking about.

Adding more injury to the economy, tax increases have been concentrated at the top of earnings distribution, creating in effect the unsustainable environment where by our exports-oriented, higher value-added economy is being starved of the main input into its activity – human capital.

In 2009, Irish residents earning ca €58,000 and above, faced an average income and social security tax burden of 39.9% - ahead of the OECD average of 39.4%. The OECD average tax calculations do not adjust for the fact that whilst in Ireland income tax and social security levies and charges yield no tax-specific benefits, in other countries, social security charges include payments into private pensions and insurance funds. After Budgets 2010 and 2011, and adjusting for private pensions and health insurance contributions, this figure has most likely risen to above 45%.

Lacking competitively priced access to early education, childcare, healthcare and transport services taken for granted in other European member states, Ireland has now lost its competitive edge in attracting, retaining and developing skills needed for successful growth of our core modern sectors: research-intensive pharma, biotech and ICT, and skills-intensive international financial and legal services, business analytics and creative industries.

All of this means two things for the forthcoming Budget 2012 and for the medium term budgetary framework. Firstly, to restore Irish public finances back to health, the next four budgets will require dramatic cuts in the current public spending. Second, there is no room for new tax revenue measures.

Any further increases in taxation even at the lower end of the earnings spectrum will increase effective tax burden on highly skilled workers. This will act to further undermine our economy’s competitiveness in the core growth areas of the skills and knowledge-intensive sectors.

The problem is not a trivial one. Currently, there are between 3,500 and 5,000 vacancies in the ICT sector alone that cannot be filled by indigenous and multinational employers in Ireland. Despite the fact that ICT workers have the highest private sector average earnings of all sub-sectors in Ireland and enjoy average earnings almost 20% above their EU counterparts, companies cannot fill these vacancies. The reason is simple – we are not competitive, compared to our European counterparts, when it comes to the value for money that our after-tax earnings provide.

And this problem is not restricted to ICT sector. In the last two months at least seven internationally competitive researchers previously working in top Irish universities and institutes have packed their bags and moved overseas, leaving highly paid positions to seek better value for money and career opportunities abroad.

The next Budget must, therefore, address the problem of current spending overhang by cutting into the most painful areas of spending: social welfare, education, health and public sector employment bills.

Education-related spending has remained constant over the years of this crisis, accounting for ca 18% of the total budgetary allocations in the nine months through September 2008 and in the same period of 2011. Department of Health share of total expenditure has risen from 27.9% in 2008 to 30% in the nine months through September 2011. Social Protection share rose from 19% in 2008 to over 30% so far this year. Combined, three top spending heads accounted for almost 79% of the total voted expenditure by the State in 2011 to-date. Year on year, for the period of nine months through September 2011, there has been zero change in Education spending, a 10% increase in Health spending and a 4% increase in Social Protection.

Any serious effort at fiscal austerity requires much more dramatic cuts in these three departments.

Combined deficit reduction measures between 2012 and 2015, envisioned by the agreement with the Troika add up to €11.8 billion. Last week, the Fiscal Council has correctly proposed revising this figure up to €15.8 billion, to be delivered with €4.4 billion adjustment in 2012 and €3.7-3.9 billion every year thereafter. In my view, the measures are not front-loaded enough. In my view, Ireland’s economy will require €5.0-5.5 billion adjustment in deficits in 2012 and 2013, followed by €3.5 billion in cuts in 2014 and a €2 billion or less cut in 2015 to the total target for deficits reduction of €16-16.5 billion.

Such frontloading of cuts is required to control for the risk of further economic slowdown in 2012-2015, with 1% reduction in nominal growth rate potentially leading to a debt/GDP ratio deterioration to above 120% and even more dramatic decline in debt sustainability as measured against GNP. Frontloading is also need to provide a buffer against the expected increases in interest rates in post-2013 environment. Current inflation rates and growth dynamics within the euro area imply optimal ECB rates in excess of 2.5%. 2012-2015 period is likely to see significant increases in ECB rates, leading to an uplift in overall debt financing burden for companies and households in Ireland. With Ireland’s private sectors debt well in excess of the majority of our euro area counterparts, imposing more austerity in later period of fiscal adjustment can risk coinciding with the period of reduced private debt affordability and lead to a simultaneous adverse shocks to growth. Lastly, frontloaded cuts will act to rebalance future growth expectations for 2014-2015, helping to restore some investment activity in the economy.

Of the above measures, only about €3.5-3.7 billion can be expected to come from increased tax revenues driven by organic growth in economic activity not new taxes. No more than €1.2-1.5 billion more in savings can be generated by cutting deeper into capital expenditure. This means that the Government must find some €11-12 billion in current spending cuts over the next four years. Spread across current weights of specific top spending heads, this implies cuts of €2 billion in Education, and ca €3.3 billion in Health and Social Protection, each. Much of these cuts will have to come from involuntary redundancies and possibly cuts to indexation awarded previously for existent public sector pensions.

If management is doing things right, and leadership is doing the right things, as Peter Drucker remarked, Ireland’s Government has no choice but exercise both in the forthcoming Budget.

Box out:

The latest European Commission proposals for banning credit ratings changes for euro countries applying for EFSF or IMF rescue funds is the embodiment of the complete detachment of the European leadership from the realities of financial markets. Instead of dealing with the pressing issues of spreading contagion, the EU Commission has largely remained in its usual modus operandi since the beginning of the sovereign debt crisis, seeking new and ever-more elaborate means for raising new taxes, banning markets activities that actually act to increase markets transparency and efficiency, such as short-selling and independent ratings, while issuing vast encycliae on economic growth, invariably based on some new subsidies, state supports and other markets distortions. As with other ‘measures’, the latest proposal can backfire spectacularly. Rating agencies, only recently burned by their own failures to properly assess risks of complex securitized products relating to the US mortgage loans, have been rebuilding their reputations by re-asserting independence and pushing stronger ratings discipline through. In the presence of the ban, off-shored rating functions will be more likely to more severely downgrade euro area sovereigns seeking emergency funding, just to show the markets their own models robustness. Someone should tell the EU Commission that spitting into the hurricane wind might not be such a good idea.

23/10/2011: Economic Freedom of the World 2011

Couple of weeks ago, Ireland's Open Republic Institute and Canada's Fraser Institute published annual Economic Freedom of the World Index - the most comprehensive and academically credible index of institutional quality of economic environments around the world. Unlike other similar indices, EFW uses latest comprable available data for all countries in the index and undertakes detailed assessment of the largest number of criteria in arriving at its final rankings.

The results for Ireland are not good. As well as for Europe overall.

No EU countries in top 5 ranks, only one EU country in top 10 and no Euro area country in top 10. In top 20 ranked countries group, there are only 3 Euro area core EU countries, with 3 more Central and Eastern European states. Ireland ranks only 25th in the world - an extremely poor performance, given that last year we were ranked 11th and in 2009 index we were ranked 9th.

Overall, chart below shows historical trend for Ireland:

We are now ranked back in the position that is consistent with economic environment-determining institutions quality that is worse than the entire 1980s!

Charts below summarize the sources of our underperformance:

The data above refers to performance parameters for 2009. Since then, Irish economic conditions and policies have deteriorated substantially so we can expect further downgrades in the index.

23/10/2011: Ireland-Russia Trade for July 2011

Another data update - for bilateral Russia-Ireland trade flows. It's been some time since I looked at these series (CSO reports the data monthly with 1 month delay on overall trade flows data).

July 2011 exports to Russia rose from €37.3mln in June to €48.8mln. Year on year, exports to Russia are up 53.5%. Imports from Russia in July 2011 stood at €4.4mln, up on €2.5mln in June and down from €6.4mln in July 2010. Imports are now down 31.3% year on year.

Trade balance with Russia rose to €44.4mln in July 2011, up 74.8% yoy.

Annual forecasts for Ireland-Russia trade are looking solid.

For seven months through July 2011, Irish trade balance with Russia was €241.6mln, up on €122mln for the same period in 2010. In contrast, Irish trade balance with Brazil was €54.2mln in 7 months through July 2011, down from €66.5mln in same period 2010. Irish trade balance with China was -€91.5mln in January-July 2011, a major deterioration on €75.3 trade surplus in the first seven months of 2010. Irish trade balance with India posted a deficit of -€89.9mln for the first seven months of 2011, compared to -€80.5mln in the same period of 2010.

Over first seven months of 2011, Ireland's trade surplus with Russia was larger than our trade surplus with Canada (€158.7mln), Malaysia (€140.3mln), Mexico (€178.3mln), Singapore (€145mln - note that Singapore acts as a major entry point for global trade to the broader South-East Asia), South Africa (€99.3mln) and Turkey (€138.8mln). 

Of all BRIC countries, Russia was the only country that delivered improved trade surplus for Ireland.

23/10/2011: Ireland's External Trade data: August 2011

Catching up on some data releases missed last week (lecturing marathon of MSc in TCD, plus UCD MiM - great students, great honor to mentor). First up - trade data.

Seasonally adjusted exports rose 10.24% mom to €7,767mln in August. Annual increase in exports was 2.25% yoy on seasonally adjusted basis. Relative to August 2009, this year exports rose 15.76%. Overall, additional exports yoy were €170.8mln compared to August 2010 and 1,057.5mln on August 2009.

Seasonally adjusted imports were up 6.23% mom to €4,068mln, annual imports rate of growth in August 2011 was 5.71% and relative to August 2009 imports are up 13.45%. Year on year imports are up €219.6mln, which implies that trade surplus is down €48.8mln on 2010.

Trade surplus rose 14.71% mom to €3,698.5mln on seasonally adjusted basis. Trade surplus in August was 1.3% below (-€48.8 mln) August 2010 level and €575.2mln (+18.4%) above August 2009 level.

On an unadjusted basis, trade surplus of €3,251mln in August 2011 was virtually unchanged from the 2010 figure of €3,221mln.

Volume indices of trade - reported with 1 month lag - showed that in July 2011 exporting activity fell to 466.3 against 532.2 in June 2011, and July 2011 reading was below comparable reading for 2010 (494.3) and July 2009 (469.5).

Imports intensity of Irish exports rose to 190.91 in August - up 3.8% on July 2011 and down 3.3% on August 2010. The intensity is up 2.0% on August 2009 and remains well above historical average of 155.3 reflecting the overall increasing share of MNCs in our exports.

Terms of trade have improved in July (also reported with 1 month lag) from 78.2 in June to 76.9 in July 2011. This compares to 86.2 in July 2010 and 86.6 in July 2009, showing overall easing in exchange rates pressures over 2011 compared to 2009 and 2010.

Per CSO, based on final data for seven months through July 2011, Irish exports rose 4% to €54,258mln compared to 2010, driven by:

• Medical and pharmaceutical products +11% or €1,599mln 
• Organic chemicals +8% or €925mln
• Exports of Computer equipment declined by 10% or €261mln and 
• Telecommunications and sound equipment fell by 25% or €124mln

Based on data through August, my forecast for 2011 external trade is:

• Imports up to €49,068mln in 2011 from €45,772mln in 2010
• Exports up to €92,356mln in 2011 from €89,260mln in 2010
• Trade surplus down to €43,271 in 2011 from €43,488mln in 2010.

16/10/2011: Negative Equity and Debt Restructuring

This is unedited version of my article in Irish Mail on Sunday (October 16):

This week, we finally learned the official figure for what it would cost to address one of the biggest problems facing this country.

According to the Keane Report - or the Inter-Departmental Mortgage Arrears Working Group Report - writing off negative equity for all Irish mortgages will cost “in the region of €14 billion”. Doing the same just for mortgages taken out between 2006 and 2008 would require some €10 billion.

These numbers are truly staggering, not because of they are so high, but the opposite: because they contrast the State’s unwillingness to help ordinary Irish families caught in the gravest economic crisis we have ever faced with the relatively low cost it would take to do so.

Let me explain.

Firstly, the figure of €14billion itself is a gross overestimate of the true cost of dealing with negative equity. This is because this figure appears to include not just owner-occupiers but also people with buy-to-let loans in his sums.

Secondly, the real amount required to get rid of negative equity where it matters most – for ordinary first-time buyers - is lower still. For example the scheme could be set up in a sliding scale based on value of house compared to average house prices. This would reduce the final cost of the scheme and help those who need it most - moderate income and younger-age households.

In other words, a realistic and effective debt cancellation scheme can be priced at closer to €6-8 billion instead of the €10-14 billion estimated in the report.

In its simplest form it would work like this: say you bought a house for €300,000, with a mortgage of €250,000, and it is now worth just €150,000. The government, or the bank using the recapitalisation funds they have received, would pay off the €100,000 difference.

By doing this your monthly payments would be less, and you could now sell up to pay off the debt or move house, and in the meantime the extra money you have to spend could go back into the economy.

The scheme could even be set up so that write downs would be smaller on houses with above average values so as to prioritise young and low-earning families. In the above example, if the house was purchased for, say €500,000 and is no worth half that amount, the bank would write-off, say, €200,000, leaving the household with residual negative equity of €50,000. This would still improve affordability, but will also cut the overall cost of the scheme.

So why did the report completely rule this out? It was very clear on this topic: “a blanket debt or negative equity forgiveness scheme would not be an effective use of State resources and would not solve the problem,’ it says.

But it goes further, claiming that “the primary driver of mortgage arrears is affordability, not negative equity. While a write-down of negative equity would help mortgage holders in arrears, in many cases it is unlikely to create an affordable mortgage”.

I believe this rejection betrays the overall lack of understanding by our senior civil service officials of the problems we face.

The Irish economy is suffering primarily from three things. The biggest is excessive household debt.

While this would be bad enough, it is exacerbated by two additional factors. The cost of the government’s policy of bailing out our banks, which is being paid for with higher taxes on ordinary working households. And the rising cost of mortgagesdue to aggressive drive by Irish banks to improve their profit margins at the expense of the most vulnerable mortgage holders - those with adjustable rate mortgages who cannot protest. Both contribute to mortgages defaults.

By saying that cancelling negative equity will not be a magic bullet solution to the problem of the defaulting mortgages, the report is simply referencing the smaller problem of mortgage affordability to evade addressing the effects of the much larger crisis facing us.

Negative equity is the single most egregious and damaging segment of the debt problem faced by Irish families.

It is the most egregious because it was caused not by reckless borrowing, but by reckless lending by the banks - actively supported at the time by the Irish Government.

The problem of negative equity is the result of state policy in the first place, and it is up to the state to rectify it.

And contrary to the assertion of the report and Government claims, we do have the funds to deal with negative equity. Freeing these funds to help ordinary families is just a matter of priorities for the Government and the state-controlled banks.

To-date, the Irish Government has injected €63 billion worth of taxpayers’ funds into Irish banks.

Various other commitments, and the banks’ own state-guaranteed borrowings from the Central Bank bring the total cost of keeping our banking sector working to a gross figure of about €125 billion.

Yet while they have saved the banks, all of these measures have acted to increase, rather than reduce, the level of debt being carried by the households of this country.

In addition to their own household borrowings like credit cards or credit union loans, mortgages-holders are now in effect liable both for banks’ debts and their losses on property development and investment.

In contrast, even at Keane’s upper estimates, the cost of paying off negative equity liabilities for household mortgages would require just one ninth of the funds we have made available to the banks.

Last July the Government injected some €19 billion worth of capital into Irish banks. This capital is provided to cover potential future losses on loans. This included €9.5 billion, which was the estimated worst-case scenario for losses on residential mortgages. It also included another €8.9 billion to cover remaining expected losses on commercial property.

If some of these funds were used instead to restructure negative equity mortgages on family homes it would do two things for the banks.

Firstly, because the banks would now have securities as valuable as the mortgages they have given, a mortgage default would not be such a threat in terms of losses. This then reduces the bank’s need for further capital.

Secondly, the writedown of the mortgages will prevent defaults in the first place, at least for some families.

This implies that prioritising how that money is used to help mortgages rather than losses on commercial property loans, will be a more effective way to improve their balance sheets.

And it’s not like the money is not there. Our banking system currently has surplus capital available. Since August this year, our ‘pillar’ banks, instead of helping the struggling households, have used taxpayers funds to quietly buy high-yield Irish Government bonds.

Some €3 billion worth of Government debt was bought by the banks using our money in order to beef up their own profits. Don’t tell us that the banks cannot afford negative equity restructuring when they clearly can afford buying junk bonds in the markets to book higher profits.

And the farcical nature of Irish government responses to the mortgages and personal debt crises continues.

The Keane report ruled out increasing tax relief on mortgage interest finance for first time buyers during the boom, 2004-2008. Why? Because the estimated cost each year would have been €120 million.

Yet, come November, the very same state will pay in full the unguaranteed and unsecured €737 million debt of the bankrupt zombie Anglo. Between Anglo and INBS, the state has also committed to repaying in full €2.4 billion more of similar bonds in 2012.

Instead of repaying un-guaranteed bondholders, the Government should use the funds available to the banks to cancel commercial property-related losses on banks books, freeing the capital injected for this purpose in July this year to restructure negative equity mortgages.

Earlier this year, I proposed that Irish Government impose an obligatory restructuring of all mortgages to achieve a maximum Loan-to-Value ratio of 110%.

This would reduce the problem of ‘moral hazard’ because households with greater borrowings will still be left with more debt than their more prudent counterparts. But it would also reduce the overall debt burden faced by our families, freeing them to return to active economic and social life, helping to restart the Irish economy. Based on the Keane Report’s own estimates of the cost of such a scheme we have more than enough money to make this choice.

All we need is the will - the will to free hundreds of thousands of Irish families from the negative equity jail that was built by reckless banks which lent the money with explicit approval of the previous Governments.

16/10/2011: Hot air balloon of G20 summits

Having by now grown accustomed to the vacuous and pompous non-statements from European leaders of the crisis, one could not have expected much from the G20 summit other than predictable verbal ping pong of the non-EU nations urging Europe to deal with the crisis and the EU representatives returning boisterous claims that the “solution” being presented are “robust”, “timely”, “resolute”, “breakthrough”-like, “decisive”, and so on. This is exactly what is going on.

This weekend’s G20 summit failed to provide for anything different. Here are just few points from the final comments by the participants. The sources are here (http://www.reuters.com/article/2011/10/16/us-g-idUSTRE79C74G20111016) and here (http://www.reuters.com/article/2011/10/15/us-g20-highlights-idUSTRE79E1DA20111015).

Per French Finance Minister Fracois Baroin, the Euro crisis "…took up a little part of our dinner last night. We presented ... elements of the global and lasting package which heads of state and government will present at the Oct 23 summit. It responds to the Greek issue, the maximization of the EFSF, on the level of core tier 1 with a calendar which will be coordinated by the heads of government for the recapitalization of the banks. It responds, naturally, on the governance of the euro zone... We still have a week to finalize it."

Extraordinary vanity and vacuousness of the statement is self-evident. The idea that the Euro area crisis – pretty much the only reason for G20 gatherings nowdays “took up a little part” is absurdly juxtaposed by the claim that the EU presented “elements of the global… package” for resolution of the crisis. And do note the language: “global package” and “lasting”. To the French, it is rather common to refer to anything that impacts them as “global”, but the stretch of terminology here is obvious – the ‘package’ will have to be about the euro zone. In other words, it is not even pan-European, let alone global!

And then there’s that “lasting” bit. Per report: “The [G20] communique urged the euro zone "to maximize the impact of the EFSF (bailout fund) in order to address contagion". EU officials said the most likely option was to use the 440 billion euro [EFSF] fund to offer partial loss insurance to buyers of stressed member states' bonds in a bid to stabilize the market.” Now, give it a thought. A ‘lasting’ package of ‘solutions’ will use temporary guarantees to buyers of distressed debt?! This begs two questions: (1) How on earth will such use of EFSF address the main problem faced by over-indebted nations, namely the problem of unsustainable debts? Guarantees will not reduce Greek, Portuguese, Irish, Italian and Spanish debts to sustainable levels. (2) If EFSF were to remain a €440bn fund, how can the said amount be sufficient to provide already-committed sovereign financing backstop through 2015-2017, supply funds for banks recapitalizations to cover the shortfalls on sovereign funding, provide additional backstop funds for the sovereign deficits in the future, and underwrite a new tranche of CDS-styled insurance contracts that will have to cover ALL of the debt issuance by the distressed sovereigns? Note: it will require to provide cover for all debt, not just maturities-specific issues in order for it to be meaningful and prevent massive amplification of upward sloping yield curve, leading to potential front-loading of new debt by the distressed states and the resulting dramatic rise in maturity mismatch risks.

Baroin went on to dig himself even deeper into the verbal hole: "I have to tell you in truth that the results of the European Council on October 23 will be decisive… We've made good progress [on Greece] with the German finance minister. There are points of agreement which are emerging rather clearly and we will have an agreement on this point, but it would be premature to say what accord will emerge on Oct 23." In  other words: the summit achieved nothing and we might not even get a resolution ready for October 23^rd summit.

On France position on Greek creditor haircuts: "We will find an answer. [Read: we have no plan] You know the French position which is quite clear: we will refuse any solution that leads to a credit event." So overall, there is no plan and any plan will have to avoid significant write-downs on Greek debt. Or in other words: we have no idea how to solve it, but any solution will be irrelevant, because France wants it to be such.

"Central banks will continue to supply banks with necessary liquidity, we will ensure banks have the necessary capital. This is a very important message central banks are sending." That sounds like ‘do more of the same’ and pray for a different outcome.

"We prepared ambitious decisions for Cannes including a list of systemically important financial institutions." Jeez, what a breakthrough. How about just checking http://graphics.thomsonreuters.com/11/07/BV_STRSTST0711_VF.html list - it’s pretty comprehensive and you don’t need a summit to get it.

My favourite court jester was also out in force with statements. EU Economic Affairs Commissioner Olli Rehn didn’t wait for too long to stick his foot into his mouth:

"The communique of this meeting rightly underlines the urgency and need for decisive action to overcome the sovereign debt crisis and restore confidence in our economies."

Sorry, but does the EU Commissioner still need another communiqué to underline the importance of resolving the greatest crisis his employer faced since foundation of the EU?

"The communique welcomes, since the Washington meeting three weeks ago, that in the EU the reform of the economic governance has been concluded."

What reform, Olli? When and how has it been ‘concluded’? And if the ‘reform has been concluded’, why on earth would you say there’s any ‘urgency to overcome the crisis’?

"It is a very important reform ... It will help us to prevent future crisis"

So that’s it, folks. EU will never have another crisis again. As soon as they can deal with the current one, that is. Which, so far, has taken… oh… like 3 years of wholesale destruction of European economies and wealth.

"Beyond these positive steps, and in order to break the vicious circle, ... we put last week on the table a comprehensive plan, a road map. I am pleased to say that this plan received today a warm welcome from our G20 partners" If so, Olli, why on earth would the G20 continue to urge action?

On the net, the ‘summit’ was just another hot air balloon floating up above the havoc of reality, heading straight into the hurricane. Good luck to all on board.

13/10/2011: CPI for Ireland: September 2011

Consumer prices inflation is now running above 2.5% in Ireland and the usual culprits are to be blamed.

Consumer Prices in September rose +0.3% mom against a decrease of 0.1% recorded in September 2010. As a result, per CSO, "the annual rate of inflation increased to 2.6%, up from 2.2% in August 2011". Annual inflation is now running above 2% target every month since January 2011.

The EU Harmonised Index of Consumer Prices (HICP) for Ireland rose +0.1% in the month, compared to a decrease of 0.2% recorded in September 2011. The annual rate of HICP was 1.3% higher in September compared with September 2010. Annual HICP was running at 1% increases in July and August - the lowest rate of HICP in Europe.

Chart below illustrates:

All Items CPI is now in annual expansion since August 2010. Moderate rates of under 1.7% CPI were exhausted in January 2011 and since then we have entered the period of excessive inflation, especially compared with the overall stagnant domestic demand activity. This means that accelerating price increases are no longer acting to support economic growth, but are compressing already strained household budgets and increasing future pressure on interest rates. It is worth noting that ECB decisions on rates are based on HICP, not CPI, which means that with Euro area HICP at 2.5% in August and July, against HICP rates at or above 2.5% every month since April 2011, the rates direction should be up.

Pert CSO, the most notable changes in the year were:

• Increases in Housing, Water, Electricity, Gas &Other Fuels (+8.9% in September 2011 which comes on top of 8.5% rise in a year to September 2010), Miscellaneous Goods &Services (+6.5%), Transport (+4.2%) and Health (+3.4% - unchanged mom but up yoy in September, against an annual rise of 0.5% in September 2010).
• Decreases in Furnishings, Household Equipment & Routine Household Maintenance (-2.3%) and Education (-1.6%).
• The annual rate of inflation for Services was 3.6% in the year to September, while Goods increased by 1.3%.

The most significant monthly price changes were:

• Increases in Clothing & Footwear (+5.4% - mostly due to seasonal effects) and Housing, Water, Electricity, Gas&Other Fuels (+1.7% - mostly due to mortgages interest costs rising +3.1%mom, liquid fuels (i.e. home heating oil) costs up +1.7%, electricity (+1.6%)).
• Decrease in Transport (-0.7% - primarily due to decreases in airfares which fell 16.9%. Increases were recorded in bus fares (+8.8%), bicycles (+0.4%) and petrol (+0.3%)).

Charts below illustrate:

Charts below detail the rising gap between state-controlled prices and overall CPI as well as the gap between state-controlled prices and private sector prices:

13/10/2011: Mortgages report - offensive & ineffective failure

Inter-Departmental Mortgage Arrears Working Group report, released yesterday is a truly abysmal document that neither delivers meaningful solutions to the problems it sets out to tackle, nor provides any really new solutions that were not already discussed in the Cooney report of 2010.

Let’s consider the ‘solutions’ advanced by the Report. Let us also juxtapose these ‘new’ proposals against the existent means for alleviating stress on households finances arising from the excess debt or lack of debt affordability, which are enumerated in the Report.

An excellent additional analysis of the report is provided by Namawinelake blog (here) and I am broadly in agreement with its author conclusions.

Note that, unlike the Report authors, I view two problems as separate, but related.

The problem of debt overhang is the problem of too much debt carried by the household preventing this household from accumulating pensions and precautionary savings, reducing its ability to provide insurance cover for catastrophic losses of income due to illness or unemployment, restricting reasonable investments in household members’ education and skills (children education, but also adult education – both of which require outlays from the household finances), extending care for incapacitated relatives, saving for potential investment in family business etc.

The problem of debt servicing is the problem whereby debt to income ratios rise to levels whereby debt financing becomes unbearable for the household. This can arise due to any of the following factors or a combination of several factors, such as: loss of income due to unemployment, loss of income due to wage cutbacks or decline in bonuses and commissions, loss of income due to higher taxation burden, loss of income due to illness, increase in expenses due to birth of a new child or arousal of new dependency from, for example, ill close relative, etc.

What solutions does the Report propose?

Solution 1: Forbearance.

This is not a new solution and the Report states that as a part of the “wait and see approach” already adopted by the Government, they are not always appropriate. In other words, one of the solutions presented by the Report is already deemed by the very same Report not to be sufficient. Forbearance is ‘extend and pretend’ type of a ‘solution’ that temporarily reduces the mortgage burden in the hope of short-term return to affordability. It does not deal with the problem of excessive debt carried by the household. Instead it actually exacerbates the problem by accumulating retained interest and extending over time the period of principal repayment, as in the case of forbearance households are mostly excluded from counting their repayments against the principal. It is a very short-term measure (extending the period of forbearance will have a compounded effect of increasing the overall debt level of the household).

As an extension of the Forbearance scheme, the Group notes that Deferred Interest Scheme has already been introduced in the state. The Group fails to provide any meaningful assessment of the scheme claiming that it is too new to allow for such assessment. In reality, deferring interest repayment implies accumulation of higher debt over time through compounding and roll up of interest into the future and has exactly the same shortcomings as the general forbearance scheme discussed above.

Another major issue with both schemes is that they do not alter life-time affordability of the mortgage, which is reflected in their temporary nature. Temporary nature of these schemes, in turn, implies that households entering into these arrangements cannot be expected to meaningfully engage in the economy as savers and consumers. They are suspended in a debt hell limbo for the duration of the scheme and face uncertain future as to their ability to return to normal functioning.

What we need is: conversion of the existent mortgages pool into non-recourse mortgages only for the amount of negative equity. To deliver this, mortgages outstanding should be seen as split between those covering 90% of the current value of the asset (10% cushion provided for future decreases in valuations) and the residual. The 90% current value of the mortgages is recoursed against the value of the home. The excess amount of mortgages outstanding is non-recourse.

Solution 2: Mortgage Interest Supplement.

A measure that provides cash flow support to households that are on public assistance due to unemployment or disability. The Group identifies this scheme as in the need of alteration and suggests that mortgage-to-rent (MTR)schemes (see below) can be used to move long-term recipients of MIS off the temporary measure. This implicitly suggests that the Group sees MTRs as a long-term default option.

Amazingly, the Group provides un-backed and un-specified estimates for writing down the entire pool of negative equity or writing down the most severe negative equity cases (2006-2008 mortgage originations) at €14 billion and €10 billion. The Group states in a blanket fashion that “scheme would not be an effective use of State resources and would not solve the problem”.

Worse than that, the Group has managed to produce not a single meaningful or even token debt relief measures. The Group “examined the proposal to increase mortgage interest relief to 30% for First Time Buyers in 2004-08 but it was considered that this change should not be recommended. The proposal would give increased relief in an indiscriminate manner as it would give benefits to all who took out mortgages in the relevant years, regardless of their economic circumstances. The proposal would cost the Exchequer approximately €120m in a full year and it would not be appropriately targeted at those who need the support.”

This is an extraordinarily bizarre statement. The Group on objective – as stated – included to consider measures “to reduce the drag on the economy from a significant cohort of over-indebted people whose spending is constrained by mortgage debt obligations.” And yet, the Group passed on the only solution they considered to deliver some relief here. Reducing effective cost of mortgages interest financing would have improved significantly many, more stretched, households cash flows, especially for those early into the process of mortgages repayment. In other words, it would have had a compounded effect of reducing interest payments when these payments are the largest proportion of the mortgage itself, potentially improving repayment of capital. The scheme would have had no adverse impact on moral hazard and would have been politically acceptable as a partial compensation for tax increases suffered by the very same households. It is cheap (could be financed for 6 years out of just one unsecured unguaranteed bond repayment by Anglo due this November at €737 million) and effective in reducing the most egregious share of the debt incurred – interest charges. It also could have served as a buffer for future interest rate increases, thus effectively helping more, in the longer term, those on the adjustable rate mortgages who are currently subsidising tracker mortgage holders.

The fact that these considerations were omitted by the Group shows that the Group was not fit for purpose – its members had no sufficient financial insight into the debt issues and mortgages finance to make any reasonable assessment of the situation.

What we need is: extended Interest Tax Relief scheme covering all first-time mortgages for principal residences issued in 2004-2008 with extension for 5 more years at 50% of the total interest paid. The cost of this scheme should be in the neighbourhood of €250 million per annum and it should be financed through writedowns of unsecured bondholders in Irish banks.

Solution 3: Introduce New Bankruptcy Legislation.

This is hardly a new solution and as such the Group was expected to provide more robust guidance as to the terms of reform of existent bankruptcy laws. The Group correctly identifies one major part of the problem with existent legislation as: “Given the full recourse nature of mortgages there is no current insolvency option for many mortgage holders who are in difficult or unsustainable mortgages – they could face permanent bankruptcy”. In other words, the problem is in the full recourse nature of the mortgages and the long-term or permanent nature of the bankruptcy.

The Group comprehensively fails to address both sides of the problem in its recommendations.

With respect to the length of the bankruptcy status and associated claim on the debtor income, the group states:

“The group understands that the automatic bankruptcy discharge period under the judicial process could be set as low as 3 years”. In other words, the Group fails to make any proposal as to the length of bankruptcy period. It simply defaults to 3 years as the only option because it is what it being discussed elsewhere.

What we need is a two-tier approach to the bankruptcy reforms:

Tier 1: Emergency level legislation covering mortgages taken prior to 2009 which will have automatic release after 12 months of compliance with court-ordered repayment schedule and zero recourse thereafter. In the case of non-compliance with repayments, the bankruptcy period can be extended to 3 years and then to 5 years. There should be no recourse on assets outside the mortgage, but access to bankruptcy should be granted only to those unable to pay their mortgages through current income as supplemented by a reasonable drawdown of existent assets. For example, a household savings should not fall below 20% of annual pre-tax income so as not to deplete insurance buffer against household loss of income in the future due to illness or unemployment. The households can be required to sell any other property assets they hold if this releases funds to aid repayment of mortgage. The legislation should apply only to primary residences and can be staggered to reduce its applicability to ‘trophy’ homes, so that only part of the family home mortgage under, say, the threshold of €500,000 can be covered by such process.

Tier 2: Long term legislation covering all mortgages taken since 2009 that will include, 3 year term for automatic release, recourse against other assets and restriction on mortgages issued in the state to non-recourse mortgages only, for all new mortgages going forward.

Instead of robust proposal for reforming the bankruptcy law, the Group report produces extraordinarily woolly wish list of non-judicial process proposals for dealing with defaults.

This includes a non-judicial settlement process that is not backed by any compulsion on behalf of the lender to engage in such a process or to deliver any specific targeted means for reducing overall debt burden of the household. Instead of specifically calling for lenders being required to write down some minimum share of debt, or some debt linked to, say, income and affordability metrics, the proposal simply waffles on about “mortgage lenders will need to make allowance within their mortgage solutions, on a case by case basis, to make some funds available to facilitate unsecured debt settlement”.

And there’s more: “Uncertainty exists as to how the courts will deal with an income earning bankrupt – it could require them to make payments to the creditors beyond the discharge period.” Now, this begs a question: why on earth did we need the Group report if all it can tell us is that the courts will decide? And how can the report make a claim that this entire strand of bankruptcy resolution has any whatsoever validity as a tool for alleviating currently draconian bankruptcy conditions if it is left up to the courts to decide?

Another ‘measure’ proposed by the Group is Debt Relief Order (DRO), which will “allow persons with “no assets – no income” to fully write-off unsecured debt within a short period of time”. How? No information is given. How long is the ‘short period of time’? Unspecified. But the Group refers to the UK DRO equivalent of €17,000. So, let’s summarize this ‘measure’ – under DRO, once you are bled dry, the Government will facilitate (legislatively, presumably) an up to €17,000 writedown of your debt alongside the loss of your home, your assets and your income, while levelling you with the very same bankruptcy burdens as above. The whole mechanism would constitute a reasonable measure only in a lunatic asylum.

Solution 4: Mortgage to Rent Scheme (MTR)

This implies converting existent mortgage to a lease with the mortgage holder losing all future claim on equity in the property.

The problem is that, as the Group states: “The group recommends the introduction of two mortgage to rent (MTR) schemes aimed at those people who would qualify for social housing if they lost their home and where their house is appropriate to social housing”

So explicitly, there is no cover for anyone who does not qualify for social housing. In brief – you are either broke or you are not covered. Which automatically means the scheme does no work to alleviate constraints on future savings and investment, pensions provision, education investment etc.

“The schemes should be subject to an initial review after 12 months and a value for money review after 24 months” In other words, the scheme is non-permanent and cannot be considered a solution to the long term problem. It is simply ‘extend and pretend’ type of a solution with the worst possible outcome – all future uncertainty is loaded onto the mortgage holders.

A person entering the scheme, in effect, surrenders any legal claim on the asset and any leverage for dealing with the default-related loss once he/she signs the papers as the state can simply deny the benefit in 12 months or later.

Worse than that, “There may be a mortgage shortfall that will still need to be dealt with” in other words, the negative equity component of the mortgage remains unaddressed, i.e. it remains the liability of the original borrower. This provision is simply mad, given the Group set out to resolve the problem of defaulting mortgages.

Solution 5: Trade-down Mortgages (TDM)

Trade down mortgages is in itself not a solution to the debt crisis, but an affront to those currently struggling under the weight of debt. It ignores the fact that majority of those heavily indebted (relative to their incomes) are younger families who bought their first homes – small, usually out of town, lower-end-of-the-market dwellings trading down from which is an equivalent to telling them to pitch a tent in a bog and call it a “more modest home”.

Worse, the proposal admits that the scheme would increase, not decrease, the overall debt burden carried by the mortgage holder as LTVs are going to rise and not just by the amount of negative equity carried over, but also by the closing costs which the Group has no grace to advocate forgiveness for. Negative equity is then crystallized into real debt. In medical terms, it is like advocating cutting both limbs for a patient with one gangrened arm!

The Group’s brain-dead - and I cannot call it any other – ‘logic’ is such that they actually state: “While the increased LTV is relevant, so long at the mortgage holder can afford the new mortgage and the ratio is not so high as to be a disincentive to the mortgage holder, it is a secondary factor”. In other words, higher debt is a secondary issue from the Group’s point of view, despite the fact that it clearly contradicts their own objective of reducing the negative debt effects on the economy.

What we need here is an explicit cap on carry over of negative equity under TDM scheme. In other words, cap the amount of negative equity to be carried to new ‘smaller’ dwelling mortgage to not exceed 10-20% of the total new loan, with additional ceiling on combined new mortgage not to exceed 110% of the current value of the new property bought. This will provide both an incentive to engage in trade down for the household and a finite cap on debt limits. It will also reduce future default risk for lenders.

Solution 6: Split Mortgages (SM)

Split mortgages proposal allowing the household to split existent mortgage into ‘affordable’ part to be subject to continued repayment and the ‘unaffordable’ part to be either warehoused until repayment environment (income) improves or until the mortgage holders is forced into other types of arrangements.

This, of course, presents a number of problems. Firstly, it is another extend-and-pretend measure not dealing with debt overhang, as the overall level of debt carried by household remains identical to pre-restructuring. Secondly, it introduces an incentive for the banks to hold mortgagees in constant fear of foreclosure, especially if the property prices rise or if the banks find capital to writedown the foreclosed mortgage. Thirdly, there is no provision for the interest rate relief in the scheme, implying that interest rate will roll up on both sides of the split mortgage. This means, the banks can ‘warehouse the principal’ while forcing households to pay interest on full amount of the mortgage. In other words, effective interest rate payable on mortgages will rise and the present value of the lifetime debt will rise as well.

The Group failed to see any of these possibilities in their report.

What we need here is a New Beginning type of a solution with added caveat that the warehoused part of the loan does not involve roll up of interest for 3 years and that the part of the loan due for continued repayment be structured in such a way as to payments covering at least 50:50 the interest due on overall mortgage and repayment of the principal. In other words, at least every €1 of each €2 of repayment has to be used to reduce principal amount under mortgage. Furthermore, we need protection of borrowers from increases in the interest rates, with warehoused mortgage converted to fixed rate or tracker mortgage at inception.

Overall, therefore, the Keane report utterly and comprehensively fails to deliver any new and/or meaningful measures for dealing with the crisis. The Report is extremely weak on analytical details (using nothing more than publicly available data from the CB of Ireland, without even applying CBofI own model for dynamics of future mortgages distressed available from the PCAR/PLAR exercises). It is a lazy, write-off piece of work by people who appear to have no understanding of the realities of the problems they discuss.

The failure of this report is so comprehensive and represents such a direct affront to the nation burdened with unprecedented debt overhang that the entire report must be binned – publicly and irrevocably – by the Government and a new, independent and broadly authorized commission should be set up to produce real measures aimed at alleviating both problems:

Problem 1 – financial sustainability of currently distressed borrowers, and

Problem 2 – overall debt overhang in the household economy.

Some of the possible measures aiming at dealing with the above problems are already outlined in my comments above. More proposals will follow on this blog in the future. Stay tuned.