7/6/2012: Sunday Times June 3, 2012

This is an unedited version of my Sunday Times article from June 3, 2012.

In early 2008, Brian Cowen described Ireland’s predicament with a catchy phrase ‘We are where we are’. Ever since this became synonymous with gross incompetence, epic failure and outright venality of our elites.

Fast forward to May 2012. In the heat of the EU Referendum campaigns, both Government parties have paraded their up-beat assessments of the economy, their own stewardship and achievements. The factual record of the current Government on economic policies is only slightly ahead of that attained by their predecessors.

Don’t’ take my words for this. Look at just where exactly ‘we’ – Ireland – ‘are’ in the crisis after a year of stewardship by the Coalition.

We are officially in a recession. Both GDP and GNP have shrunk in the last half of 2011 and all indications are, growth is unlikely to have returned in Q1 2012 either. Should Ireland post another quarter of negative growth, we will join the club of Italy, Cyprus, the Netherlands and Portugal. This select group of the euro area countries have managed to record GDP declines in three consecutive quarters since the end of June 2011. For Ireland, this abysmal economic performance comes on foot of the overall 17.6% decline in GDP and 24.2% drop in GNP since 2007 peak through the end of 2011. This didn’t stop this Government from declaring, as its predecessors did, various ‘turnarounds’ and ‘improvements’ in the economy, as a part of their credit, even though so far, the actual record of this Government on growth is negative. Since the Coalition came into power, GDP grew just 0.7% and GNP shrunk 4.1%, investment is down 12.8%, personal consumption fell 1.6%, while expatriation of profits by the MNCs operating here rose 24.6%.

Despite accelerating emigration and ever-rising numbers of unemployed being reclassified as engaged in state-sponsored training programmes, the latest unemployment remains stuck at 14.3% exactly identical to that recorded a year ago. In May 2011, there were 444,400 people on the Live Register and 71,231 in various state training schemes, this month these numbers were 436,700 and 82,331, respectively. Year on year, numbers at risk of underemployment rose 3,131. The Government has claimed that it has helped creating some tens of thousands new jobs, ranging from MNCs-supported ‘smart economy’ workers to hospitality sector. In reality, once training programmes are added, the numbers of those drawing unemployment supports rose 3,400 over the tenure of this Coalition.

Not surprisingly, consumer demand – accounting for 52% of our overall economic activity (in comparison, net external trade in goods and services accounts for less than one half of that figure) – is shrinking. Hammered by the push toward debts deleveraging, higher taxes, losses of income due to shrinking earnings and strong inflation in state-controlled sectors, Irish consumers are running away from the shops. Retail sales, ex-motors, have fallen 2.3% year on year in April 2012 in value terms and 3.8% in volume. This marks the fourth consecutive month of dual declines in volumes and value and the steepest rates of declines since October 2011 for value series and since May 2011 for volume. Things used to be getting worse at a slower rate in retail services sector. Now they are getting worse at a faster rate.

Banks reforms are truly not paying off for the Government. The latest banks lending survey for April 2012 shows that Irish banks have uniformly tightened, not relaxed, lending to enterprises in Q1 2012, compared to no change in lending standards recorded in Q4 2011. Things have not improved in consumer lending either, with mortgages lending running at just 5% of the levels seen during the peak. Meanwhile, costs remained the same in Q1 2012 as in Q4 2011 across all sources of funding. Following the estimates of foreign analysts, mirroring this column’s earlier prediction, the Central Bank now quietly admits that more funds will be required to offset rising mortgages arrears. More capital will be called on to bring Irish banks balancesheets to Basel III standards in years to come.

We are nowhere near the end of the crisis relating to housing markets. In Q1 2012 the overall level of mortgages at risk of default or already in default has reached 15.3% of the overall outstanding mortgages, 19.3% of all mortgages balances. This compares to 11.1% for levels and 13.6% for balances a year ago.

The game of extend-and-pretend drags on, as the Government publicly makes bombastic pronouncements about ‘stabilization’ and ‘reforms’ achieved in the sector, while reluctantly admitting that mortgages books are in a mess. The strategic response to this is the Government’s hope that the EU will be forced to mutualize banks debts, shifting them off the books of the state.

Housing markets continue to contract and commercial real estate values are still declining. The latest Residential Property Price Index for April shows that overall national property prices are already 50% down on the peak. Two consecutive monthly rises in Apartments and Dublin sub-markets can be interpreted as either a nascent stabilization, or one of the already numerous ‘false starts’ soon to be followed by renewed prices contractions. Take your pick, but either way we are way off any real recovery here.

Since about mid-2011, the Government has been committing a twin fallacy of referencing our bond yields moderation as a sign of ‘improved confidence’ in its policies. In reality, after massive LTROs that saw billions of euros pumped by the Irish banks into Government bonds, Irish yields are now back at the levels seen in January 2012. Over the last 18 months, the Troika programme has seen billions of Irish bonds taken off the market. This, alongside with the lack of new issuance, has meant that our bonds yields no longer provide a signal as to the expected cost of Irish Government borrowing. Since April 2011, the volumes of Irish Government bonds held by foreign investors have fallen by some 20% - the third steepest rate of decline in Europe after Greece and Portugal. The rate of foreign investors’ exiting Irish Government bond holdings has accelerated once again in the last 2 months. Year on year, Irish Credit Default Swaps spread over Germany is up almost 8% and this week our CDS reached 720bps.

The fact is, even by the above metrics, the current relative stability of our fiscal, financial and economic conditions is being supported by exceedingly optimistic assessments of our future growth and fiscal potential. Currently, Ireland runs the highest level of Government deficits in the euro area. Even if we stick to the EU-IMF adjustment programme, based on Department of Finance projections, in 2015 Ireland’s structural deficit will be the second highest amongst the old euro area member states. And to get to this unenviable position, we will need to carry out some €8.6 billion worth of new cuts between Budget 2013 and Budget 2015, taking more than €9,500 in additional funds out of working families’ budgets.

We are where we are – in a worse place than we were a year ago. Given the rates of economic destruction experienced since the onset of the crisis in 2008, this is doubly damaging to the claimed Government credit of reforms. Economics of the crises tell us that, on average, the harder the fall, the faster is the rise in the recovery. Ireland seems to be bucking this historical trend with our L-shaped recession to-date.

CHARTS:

7/6/2012: Sunday Times May 27, 2012

This is an unedited version of my Sunday Times article from May 27, 2012.

Slowly, but with punctuality and certainty of a German train system, Irish mortgages crisis continues to roll on.

This week’s comments from the Central Bank of Ireland, the Financial Regulator and the Department of Finance have exposed the reality of the problem. Our banks’ extend-and-pretend ‘solutions’ to dealing with defaulting mortgagees, was only compounded, not ameliorated, by the State prevarication on core crisis resolution measures, such as personal bankruptcy reforms, developing robust measures to compel banks to deal with the owner-occupier loans arrears and putting forward an infrastructure of supports for Irish mortgagees.

Now, pretending that capital injections based on year-old PCAR tests were sufficient to manage ‘the isolated cases’ of defaults no longer works for the Government. As revealed in the Central Bank comments this week, mortgages arrears have now spread like a forest fire, overwhelming the banking system. Per Central Bank admission, almost one quarter of all mortgages in Ireland are now at risk of default or defaulting, with mortgages in arrears 90 days and over accounting for 10.2% of all mortgages outstanding or 13.7% in terms of the amounts of mortgages involved.

Based on the latest available data, 77,630 mortgages across the nation were in arrears over 90 days in Q1 2012. Using the trends in figures to-date, that would imply de-acceleration in the quarterly rate of arrears build-up from 11.5% in Q4 2010 to Q1 2011, to 9.5% in Q1 2012, although in absolute numbers, arrears increased by 6,719 in Q1 2012 on previous quarter, against a rise of 5,101 a year ago.

There are more ominous signs in mortgages data that are likely to be confirmed in the forthcoming Q1 2012 report.

The main one is the rate of deterioration in the quality of already restructured mortgages. In Q4 2010, 59.4% of all restructured mortgages were classified as performing. In Q4 2011, only a year after, that number was 48.5%. This doesn’t even begin to address the bleak reality of previously restructured mortgages that are currently ‘maturing’ out of the temporary interest-only and reduced payment periods.

Courtesy of the Central Bank of Ireland, we do not have any meaningful data for mortgages restructured in 2008-2009, nor do we have any data on what exact vintages and arrangements these restructurings cover. But we do have some information on the matter from the four state-backed banks annual reports. In the case of these, 10.8% of owner-occupied mortgages were in arrears at the end of 2011, while the arrears rate amongst the mortgages that have been previously restructured was running at close to 33%. More significantly, the rate of arrears build up amongst restructured mortgages was running at 77% over 2011, outstripping a 59% rise in overall number of mortgages in arrears.

Now, recall that the entire Government strategy for dealing with mortgages defaults rests on the extend-and-pretend principle of delaying the recognition of the losses. This is done through imposition of forbearance period, introduction on the voluntary basis of a repayments reliefs. Thus, the restructured mortgages are supposed to be cheaper to maintain than ordinary mortgages. Presumably, the restructured mortgages are also closely monitored by the banks, allowing for earlier flagging of growing problems with repayments and potential additional restructuring before the arrears build up.

Yet, as counterintuitive as it might be, the overall strategy is patently not working exactly for those who were supposed to have benefited from it. The menu of solutions developed by our reformed Financial Regulator and the Central Bank and the policy-active Government departments, alongside numerous working groups and task forces is both woefully short of tools and largely ineffective in scope.

The belated realisation of this has now led the Central Bank of Ireland and the Financial Regulator to make repeated calls for the banks to proactively engage in driving up foreclosures and repossessions, appointments of receivers and enforcers. The problem, from the consumer-conscious, yet banks-supporting Dame Street institution is that its estimates for mortgages-related losses produced back in March 2011 are now at a risk of being overrun by the reality. The problem from the economy’s point of view is that these calls come at the time when we have no new tools for dealing with negative equity involved in such foreclosures, thus risking accelerated foreclosure process to become nothing more than an extension of the crisis itself.

Back in March 2011, the Central Bank estimated base-line scenario 2011-2013 banks losses on residential mortgages books of the four core banking institutions to reach €5,838 million. The adverse scenario is for losses of €9,491 million. Taking into the account changes in house prices since the beginning of the crisis, the current running rate of arrears can put losses on mortgages, if the delinquent properties were to be foreclosed, closer to the levels that would wipe out the capital cushion provided for mortgages losses. And this just for the first two years of the three-year programme. Thereafter, either capital for mortgages losses will have to come from other assets cover (such as Commercial Real Estate or SME loans or corporate lending), or fresh capital will have to be injected.

The irony, of course, is that as I suggested in my analysis of the PCAR results a year ago, the Blackrock original adverse case scenario for life-time losses on residential mortgages – put at €16,898 million – was probably closer to what can reasonably be expected to materialize in the current crisis. Incidentally, the difference between Blackrock’s estimates and Central Bank provisions would mean an injection of €2-4 billion of new capital into the banks to deal with worsening mortgages losses over 2013-2014. This is exactly the volume of additional capital required as estimated by the Deutsche Bank analysts in a note published last week.

So the crisis has now crossed or is about to cross the lower bound of PCARs-allowed losses. And the Central Bank is spurring on the banks to more aggressively foreclose on defaulting mortgages. A major issue with such calls is that absent reforms of personal insolvency regime, accelerated foreclosures will mean lower banks losses at the expense of households. Central Bank’s vision for ‘more robustly addressing the crisis’ would put more people into a perpetual serfdom to the banks in order to undercut banks losses.

Instead of forcing banks to foreclose on defaulting and at-risk mortgages, the Central Bank should create a series of structural incentives that will compel banks to share burden of negative equity with households in financial distress.

CB should shed their pro-banks stand and force banks to take on deeper losses on defaulting mortgagees for owner-occupiers. They should re-evaluate banks capital allocations, and ring-fence specific funds, well in excess of those allocated under PCAR to mortgages writedowns only. In the case where mortgages are at risk of default bit not yet defaulting, banks must be forced to restructure these with a haircut on overall debt relative to equity.

One of the vehicles for restructuring can be the model deployed in the 1920s under the land purchase annuities. Funding a combination of interest relief and mortgage maturity extension can be secured via Central Bank underwriting for a ring-fenced distressed mortgages pool. In addition, it is crucial that banks are forced to consider both the current and the expected future taxes and charges increases in computing mortgages affordability.

Mortgage-to-rent scheme and split mortgages are valid tools in some cases, but these are not being deployed fast enough and the banks have no incentive to structure these in favour of the households. Short-term forbearance should be replaced by measures aimed at achieving long-term sustainability.

A functional and robust mechanism must be put in place to independently oversee the on-going restructuring of these debts. Having sided with the banks all the way through the crisis, existent State bodies cannot be trusted to deliver on this. Instead, a transparent and fully independent entity, involving the non-profit sector operating in the areas of assisting people in mortgages difficulties, plus the strengthened Financial Services Ombudsman and the National Consumer Agency, should be put in place to police the resolution process. Legacy institutions, such as Mabs, should be reformed, if not reconstituted top-to-bottom. Alongside the reform, their resources, professional and board-level, should be strengthened.

Simply talking tough at the banks, as our Financial Regulator and the Central Bank are doing, will not resolve the crisis we face.

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Source: Author calculations based on data from the Central Bank of Ireland

Box-out:

A recent World Bank research paper “Performance-Related Pay in the Public Sector: A Review of Theory and Evidence” surveyed the literature on the theoretical and empirical studies of performance-related pay schemes in the public sector spanning the fields of public administration, psychology, economics, education, and health. The authors found that, based on a comprehensive review of 110 studies of public sector and relevant private sector jobs, a majority of studies (some 60%) found a positive effect of performance-related pay, with higher quality empirical studies generally more positive in their findings (68%). However, these studies predominantly covered jobs where the outputs or outcomes are more readily observable, such as teaching, health care, and revenue collection. There is insufficient evidence, positive or negative, of the effect of performance-related pay in organizations characterized by task complexity and the difficulty of measuring outcomes. Several observational studies identify problems “with unintended consequences and gaming of the incentive scheme”. With a number of caveats in place, this evidence strongly suggests that Irish Government approach to ‘reforming’ the public sector within the confines of tenure-based, rather than performance-based salaries and bonuses, as enshrined in the Croke Park agreement, is a false start on achieving meaningful productivity improvements in the sectors where outputs can and should be measured and cross-linked to actual performance.

7/6/2012: Sunday Times May 13, 2012

This is an unedited version of my Sunday Times article from May 13, 2012.

With Greek and French elections results out last week, the European leadership is rapidly shifting gears into neutral when it comes to austerity. Within two weeks surrounding the French elections, the Commission has issued a set of statements pushing forward its ‘growth budget’, and issued new proposals for enhancing European investment bank.

This, of course, is a classic rhetoric of damage limitation, contrasted by the reality of the currency union that is in the final stage of the crisis contagion. Having spread from economic to financial and subsequently to fiscal domains of the euro area, the cancer of Europe’s debt overhang has now metastasised to its political leadership. And the financial pressures are back on. Since the late March, credit default swaps spreads have widened for all but two core euro area states (excluding Greece), with an average rate of increase of 10.6%, implying that the markets-priced cumulative probability of the euro zone country default within the next 5 years is now, on average, close to 24%.

Next stop is a period of extended navel-gazing, with summits and ministerial dinners, contrasted by the European electorate moving further away from the centre of power gravity.

By autumn we will be either in a selective euro unwinding (Greece exiting) or in a desperate policies u-turn into mutualisation of the national and banking debts, supported by a return to high pre-2011 deficits and an acceleration of the debt spiral.

The former is going to be extremely disruptive in the short run. Portugal will be watching the Greeks closely, while Spain and Italy will be sliding into unrest. If properly managed, Greek and, later Portuguese exits will allow euro area to cut losses. With a stronger ESM balancesheet, euro area will buy more time to deal with the markets panic, but it will still require serious structural adjustments to shore up the failing currency union. Mutualisation of debt will remain inevitable, but deficits run up can be avoided in exchange for slower reduction in deficits.

The latter option of starting with mutualising debt, while allowing for new deficit financing of growth stimuli will be a road to either a collapse of the common currency within a decade or a Japan-style stagnation. The central problem is that the current political dynamics are forcing the euro area onto the path of growth stimulation amidst a severe debt overhang. The lack of real catalysts for economic recovery means that a temporary stimulus will have to be replaced by sustained debt accumulation. In other words, the political cure to the crisis a-la Hollande, not the austerity, will spell the end of the euro zone.

There are two sides to this proposition.

Firstly, the villain of the European austerity is a bogey. In 2011-2012, euro area fiscal deficits will average 3.7% of GDP per annum, identical to those recorded in 2010-2014 and deeper than in any five-year period from 1990 through 2009, including the period covering the recession of the early 1990s. The ‘savage austerity’, as planned, is expected to result in historically high five-year average deficits. At over 3.2% of GDP, 2012 forecast deficit for the common currency zone will be 6^th largest since 1990.

Instead of shrinking, euro area governments over-spending will remain relatively static under the current ‘austerity’ path. Per IMF, general government revenues will account for 45.6% of GDP in 2011-2012, well ahead of all five-year period averages since 1990 except for 1995-1999 when the comparable figure was 46% of GDP. The same comparative dynamics apply to the government expenditure as a share of GDP.

In other words, euro area voters are currently revolting against the austerity that, with exception of Greece and Ireland, is hardly visible anywhere.

Secondly, the talk about Europe’s growth stimulus is nothing more than a return to the policies that have led us into this crisis in the first place. In 1990-1994, euro area public debt to GDP ratio averaged 59%. By 2005-2009, the average has steadily risen to 71%. In 2010-2014, the forecast average will stand at 89%, identical to the ratio in 2011-2012. Euro area is now firmly stuck in the policy corner that required accumulation of debt in order to sustain economic activity. Since the mid-1990s, the EU has produced one growth policy platform after another that relied predominantly on subsidies and public investment.

By the mid-2000s, the EU has exhausted creative powers of conceiving new subsidies, just as the ECB was flooding the banking system with cheap liquidity. At the peak of the subsequent sovereign debt crisis, in March 2010, Brussels came up with Europe 2020 document – yet another ‘sustainable growth’ scheme through featuring more subsidies and public investment.

At the member states’ level, private debt-fuelled construction and banking bubbles were superimposed onto public infrastructure investments schemes and elaborate R&D and smart economy bureaucracies as the core drivers for jobs creation. State spending and re-distribution were the creative force driving economic improvements in a number of countries. Amidst all of this, euro area overall growth remained severely constrained. For the entire period between 1992 and 2007, euro area real economic growth averaged less than 2.1% per annum, while government deficits averaged over 2.5%. The only three years when public deficit financing was not the main driver of growth were the peaks of two bubbles: 2000, and 2006-2007.

In brief, Europe had not had a model for sustainable growth since 1992 and it is not about to discover one in the next few months either.

Which brings us to the core problem facing the European leadership – the problem of debt overhang.

As a research paper by Carmen M. Reinhart, Vincent R. Reinhart and Kenneth S. Rogoff published last week clearly shows, “major public debt overhang episodes in the advanced economies since the early 1800s [were] characterized by public debt to GDP levels exceeding 90% for at least five years.” The study found “that public debt overhang episodes are associated with growth over one percent lower than during other periods.” Across all 26 episodes studied, “the average duration …is about 23 years.”

Now, according to the IMF data, the euro area will reach the 90% debt to GDP bound in 2012 and will remain there through 2015. Statistically, the euro area will be running debt levels in excess of 90% through 2017. Between 2010 and 2017, IMF forecasts that seven core euro area states will be facing debt to GDP ratios at or above 90%. Of the four largest euro area economies, Germany is the only one that will remain outside the debt overhang bound. Increasing deficits into such a severe debt scenario would risk extending the crisis.

After two years of half-measures and half-austerity, the euro as a currency system is now less sustainable. The survival of the euro (even after Greek, Portuguese and, possibly other exits) will depend on structural reforms, including change in the ECB mandate, political federalisation and fiscal harmonisation beyond the current Fiscal Compact treaty.

The real problem Europe is facing in the wake of the last week’s elections in Greece and France is that traditional European elites are no longer capable of governing with the tools to which they became accustomed over decades of deficits and debt accumulation, while the European populations are no longer willing to be governed by the detached and conservative elites. Not quite a classical revolutionary situation, yet, but getting dangerously close to one.

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Box-out:

This was supposed to be a boom year for car sales as the threat of getting an unlucky ‘13’ stuck on your shiny new purchase for some years was supposed to spell a resurgence in motor trade fortunes. Alas, the latest stats from the CSO suggest that this hoped-for prediction is unlikely to materialise. In the first four months of 2012, new registrations of all vehicles have fallen 8.5% year on year and 60% on 2007. New private cars registrations have suffered an even deeper annual fall, down 10.2% year on year although since the peak they are down ‘only’ 56%. The news of the motor trade suffering is hardly surprising. Unemployment stuck above 14%, fear of forthcoming tax increases in the Budget 2013, plus the dawning reality that sooner or later interest rates (and with them mortgages costs) will climb sky-high are among the reasons Irish consumers continue to stay away from purchasing large ticket items. Cyclical consumption considerations are also coming into play. Over the last 4 years, Irish households barely replaced their stocks of white goods. Given the life span of necessary household appliances, the households are likely to prioritize replacing ageing dishwasher or a fridge over buying a new vehicle. Families compression with children returning back to parental homes to live and grandparents taking over expensive crèche duties are also likely to depress demand for cars. Lastly, there is a pesky consideration of the on-going deleveraging. Irish households have paid down some €36 billion worth of personal debts and mortgages in recent years. Still, Irish households remain the second most indebted in the Euro area. New cars registrations fall off in 2012 shows that in the end, sanity prevails over vanity and superstition, at the detriment to the car sales industry. 

7/6/2012: Irish Services PMI - May 2012

­­In the previous post (link here) I covered manufacturing PMI, showing a slight lift up in the growth rate from 50.1 in April (stagnant economy reading) to 51.2 in May (sluggish, but growth). More importantly, the 3mo average for March-May 2012 stood at 50.9 (weak expansion) compared to 48.9 average for December 2011-February 2012 (contraction).

Today’s Services PMI paints a weak picture in the other 48% of the private sectors economy in Ireland.

Headline Services PMI fell to 48.9 (contraction) in May from 52.2 in April. This marked the first month of sub-50 reading since January 2012. 12mo MA is at 51.2 and 3mo MA is at 51.1 in line with 12mo MA, slightly below 51.7 average for 2011.

This suggests that 5 months in 2012, growth conditions remain challenging. January-May 2012 average reading is 51.0, which, if sustained through 2012 will imply Services sectors growth of close to, but worse than a 2.15% real contraction in Services in 2011. Not exactly what I would call good news.

Of course, there are loads of various caveats to the above analysis, so don’t take it as some sort of a forecast.

New Business sub-index deteriorated from 52.7 in April to 49.6 in May, posting first usb-50 reading since January 2012. 12mo MA for the sub-index is now at 50.1, in effect implying that new business activity has been stagnant over the last 12 months. 3mo average is at 51.5 and the previous 3mo average was 50.2, some improvement on December-February period is still present. Good news, current 3mo average is ahead of same period averages for 2010 and 2011.

In line with broader indices, employment sub-index has fallen to 49.1 – returning to sub-50 level after March and April departures from the trend. Thus, 12mo MA for employment sub-index is now at 48.0 firmly signaling contraction in jobs in the sector. 3mo MA is at 50.3 owing to 51.9 spike in March, while previous 3mo average is 46.6. Current 3mo average and May level reading are both below the 3mo average for the same periods in 2011. 

Meanwhile, the giddy happiness signalled by the Services sector Confidence indicator bubbled up from 64.1 in April 2012 to 64.3 in May. The indicator runs on a silly scale well off the 50=neutral stance. Give you an example, in 2010, the indicator averaged around 66.7 and in 2011 it averaged 64.8. In both years, Irish Services sectors were, ahem… in a recession.

Output prices continued to fall, with the rate of decline accelerating to 44.4 from 44.9 between April and May. 3mo average through May is now at 45.4 and the previous 3mo average is 45.7. This marks continuation of below-50 readings in output prices since July 2008. Meanwhile, input costs rose at a faster pace (51.4) in May than in April (51.0), with 3mo average through May at 52.5, against previous 3mo average of 54.3.

Predictably, profitability was shot, again. Profitability sub-index fell to 45.8 in May from 47.5 in April.

More on profitability and employment in the following posts as usual.