A recent (April 2009) paper by Gorodnichenko, Medoza and Tesar (IZA DP4113) titled “The Finnish Great Depression: From Russia with Love” provides some very interesting analysis of the causes and dynamics of the Finnish economy collapse in 1991-1993 period that contains insights into the current Irish experieince.
During the 1991-93 period, Finland experienced the deepest economic slump in an industrialized country since the 1930s. Between 1990 and 1993 real GDP declined by 11%, real consumption declined by 10% and investment fell to 45%. Unemployment rose from slightly under 4% to a peak of 18.5%, and the stock market fell 60%.
Gorodnichenko, Medoza and Tesar argue that the collapse of trade with the Soviet Union played a major role in causing the 1990s Great Depression in Finland, “since it caused a costly restructuring of the manufacturing sector and a sudden, significant increase in the cost of energy. The barter-type trade arrangements between the USSR and Finland skewed Finnish manufacturing production and investment toward particular industries, and effectively allowed Finland to export non-competitive products in exchange for energy imports at an overvalued exchange rate.” Furthermore, the study also suggests that “downward wage rigidity observed in Finland played a key role in the amplification of the downturn produced by these shocks.”
This is an interesting result. Obviously, trade shock described by Gorodnichenko, Medoza and Tesar does not directly translate to Ireland in current conditions. But some similarities are also evident.
First, just as the Finnish industries exports to the USSR were subsidised by the importing partner via particular pricing mechanisms, so are Irish exporting sectors – especially those dominated by the MNCs are ‘subsidised’ by the presence of the advantageous tax regime and transfer pricing. In other words, if Finnish exporters had to rely on Soviet benevolence in pricing their trade via oil-goods barter arrangements, so are Irish exporting sectors reliant on tax arbitrage. Neither one has a natural (productivity-driven) comparative advantage in trade when compared to other countries.
Second, the same wage rigidity that cost Finland dearly is also present in Ireland. Suffices to say, wage rigidities were also found to be important determinants of the severity and the length of the Finnish crisis by other studies. In particular, labor tax hikes and negative productivity shocks may have been the culprit (Conesa, Kehoe and Ruhl, 2007). Once again, the parallel to Ireland today is striking. By hiking income taxes, Irish Government in effect made it virtually impossible for workers to accept pay cuts, implying that our Government’s reckless policies are amplifying wage rigidity in Ireland. More on this below.
“Finland and the USSR had a series of five-year, highly regulated trade agreements, similar to the agreements between the USSR and its East European allies. These agreements established the volume and composition of trade between the two countries, and by the late 1980s they had evolved into a barter of Finnish manufactures for Soviet crude oil. Roughly 80% of Finnish imports from the USSR in the early 1980s were in the form of mineral fuels and crude materials. More than 90% of imported oil and 100% of imported natural gas came from the USSR.” Sounds familiar? Well, 90% of Irish exports are delivered via tax arbitrage-driven MNCs. Not exactly a ‘Curse of Oil’, but a curse nonetheless.
In a survey of the structural effects of Soviet trade on the Finnish economy, Kajaste (1992, p. 29) concludes that “[Soviet] exports seem to have been exceptionally profitable.” Kajaste (1992) estimated that the prices of exports to the Soviet Union were at least 9.5% higher than those for exports to western markets. Gorodnichenko, Medoza and Tesar found an even larger 36%markup which “suggests that if a Finnish industry redirected its Soviet trade to other countries, its goods would be competitive only if sold at a 10% to 36%discount. Hence, the Finnish economy was subsidized by overvalued prices of Finnish manufactures bartered for Soviet oil so that the effective price of Soviet oil was at least 10% cheaper than its market price.” Well, in Ireland’s case we know that transfer pricing runs ca 15%-18% differential between GDP and GNP. This is, at the very least, a lower bound estimate to the subsidy Irish economy receives from the tax arbitrage-driven exporting activities of our MNCs.
Just as Irish economy decline has been spectacularly fast, Finnish economy collapse was “quick and deep. Imports of oil from the USSR fell from 8.2 million tons in 1989 to 1.3 million tons in 1992. Exports tumbled down by 84% over the same period. …The loss of Soviet exports caused total exports to fall, suggesting that the goods were not redirected to other counties. After the collapse of trade with the USSR in December of 1990, entire industries had to be reorganized throughout the early 1990s.” Hmmm, you would say that Ireland is a different case in so far as we are not facing a possibility of an abrupt collapse in demand for our (MNC’s) exports. True. But we might see a total collapse in supply of exports by MNCs, should our tax arbitrage advantage be eroded by:
1. Higher domestic costs f production;
2. Higher domestic taxes leading to more rigid and inflationary wage processes;
3. Lower cost of production elsewhere;
4. Lower taxes elsewhere; and so on…
Per Gorodnichenko, Medoza and Tesar, “to fully understand the reaction of the Finnish economy to the collapse of the Soviet trade, it is important to examine the Finnish labor market because of its very high degree of unionization. In 1993, approximately 85% of workers belonged to unions and almost 95% of workers were covered by collective agreements (Böckerman and Uusitalo, 2006). Since most employers are organized in federations, the wage bargaining normally starts at the national level. If a federation or union rejects the nation-wide agreement, it can negotiate its own terms. Typically, agreements allow upward wage drift if firms perform well. Although the government does not have a formal role in the bargaining process, the government usually intermediates negotiations.8 Not surprisingly, Finland is often classified as a country with highly centralized wage setting (e.g., Botero et al 2004).
Just as in the case of Ireland’s public sector since 2008, Finnish “unions did not agree to cut nominal wages in 1992-1993, which were the peak years of the depression. Instead, wages were frozen at the 1991 level.” Irony has it, Mr Cowen is doing exactly this, except, unlike Finland, Ireland is currently running deflation, which means that public sector wages are rising in real terms through the downturn. In Finland, “given that inflation was quite moderate in the 1990s, real wages fell only to a limited extent. These findings are consistent with Dickens et al (2007) who cite Finland as the country with one of the greatest downward wage rigidities… Rigid wages amplify the contraction in demand in the short run. As consumers purchase fewer goods, firms demand less labor which entails further contraction of demand and the spiral continues. In summary, a combination of higher costs of producing goods, as well as a fall in demand magnified by rigid wages leads to large short-run multiplicative effects on the initial shocks.”
What is even more interesting is that Gorodnichenko, Medoza and Tesar show that output and economic activity in Finland during the 1990s crisis was, in the short run, sensitive to changes in the elasticity of substitution between capital and labour (loosely speaking a measure of relative labour productivity in the sectors where capital and labour are substitutes). When changing the degree of wage stickiness, the study “found that wage stickiness plays a very important role. In particular, the key parameter governing the response of the macroeconomic variables to the [crisis] is the persistence of real wages”. More specifically, “in the case with fully flexible wages, the recession is short and shallow. For example, output, employment, investment and consumption fall only by 2-5% and there are hardly any dynamics after the first year. Thus, the response of investment, output, consumption and employment is small when compared to the response of these variables in the data.”
Now, “when wages are rigid, the shock reduces the marginal product of labor and firms would like to hire less labor at the current wages or to keep employment fixed but cut wages. If wages are rigid, the adjustment occurs via quantities and the model can capture sizable decreases in output, consumption, investment and labor. The recession is considerably deeper when wages are inflexible.” Guess what: this is exactly what is happening in Ireland today, so next time you see Brian Cowen talking gibberish about his policies delivering for Ireland, remember – per Gorodnichenko, Medoza and Tesar (and per all conventional economics) not cutting public sector wages leads to higher private sector unemployment and deeper recession.
One would expect someone with Alan Ahearne’s grasp of basic economic theory to make an argument against Mr Cowen’s insistence not to reduce public sector wages, but hey – when you are being paid some serious dosh, you might forget economics for a while…
Friday, May 22, 2009
Economics 22/05/2009: Tumbleweed Brain?
Imagine a high desert scene outside Los Angeles - vast expanse of nothingness, sandy patch of a road and a massive, prickly and menacingly fast advancing tumbleweed rolling at you, kicking up dust of sand every time it bumps over a rock or a hillock. Thus, the picture of devastation complete, the sense of stable equilibrium achieved, the landscape is all but a sign of devastation.
Would you call it an image of hope?
Well, Brian Cowen does.
Today reports claim that Mr Cowen told FF gathering that the Government had taken necessary decisions to ensure the Irish economy could bounce back next year. So what can go wrong? Jobless and about to lose your home? Pay-up to the Revenue and shut up, for FF has taken the necessary decisions. We are but the roadkill for Cowen and Co on the road to his recovery.
Mr Cowen also decided that the high cover achieved in the last auction for 5-year bonds was a sign of investors regaining confidence in Ireland Inc.
This blog has long argued that the demand for Irish bonds is similar to a Ponzi pyramid due to Irish banks rolling over Government debt to the ECB and monetizing it. Yesterday's Irish Times editorial finally bowed to the facts and agreed. Last week, Michael Somers of NTMA has "pointed out that 85 per cent of Ireland’s debt is held abroad but that in recent bond sales, Irish banks were significant buyers of Government debt" to be used as collateral to borrow from the ECB. This was not, he said, “a genuine end investor result". How much did the latest bond auction success depend on investment by Irish banks which have already received some €7 billion from the Government to help secure their survival? The NTMA should ease investor concerns and set out the details," said the Irish Times.
I think it is time we ask a hard question about our bond market revolving door to the ECB. Is it true that:
Cowen also stated that "we have a way out that is working". Remember the brilliant German movie Downfall about the last days of the Third Reich? (See a reminder/spoof here). Say no more... our unbeloved leader is in a state of delusion that is equivalent to awaiting the arrival of a miracle weapon (which does not exist) as the real enemy tanks are crushing your city.
What plan does Mr Cowen have? Brian Cowen claimed that economic recovery will be based on 4 pillars:
The entire country now is aware that NAMA cannot be made to work. Brian Cowen is in denial of this.
The entire country knows that he has not cut public spending (his own Government Budget shows increasing public current expenditure in every year through 2013). Brian Cowen is in denial of this.
The entire country knows that his Government is drawing blood out of taxpayers to raise revenue and that it is not working. Brian Cowen is in denial of this.
The entire country sees jobs being lost in thousands week, after week, as Brian Cowen and his Government choke enterprises, workers, investors and entrepreneurs with higher and higher taxes and charges. Brian Cowen is in denial of this.
The entire country knows that it was Brian Cowen as Minister for Finance who raised our social welfare rates to such a level that no programme that FAS can run will ever turn former construction workers off the welfare. The entire country knows that FAS should be renamed FARCE because it is one of the most wasteful and least productive Government organizations. Brian Cowen is in denial of this.
It is my sincere hope that his own party colleagues stop listening to the man for two reasons:
Would you call it an image of hope?
Well, Brian Cowen does.
Today reports claim that Mr Cowen told FF gathering that the Government had taken necessary decisions to ensure the Irish economy could bounce back next year. So what can go wrong? Jobless and about to lose your home? Pay-up to the Revenue and shut up, for FF has taken the necessary decisions. We are but the roadkill for Cowen and Co on the road to his recovery.
Mr Cowen also decided that the high cover achieved in the last auction for 5-year bonds was a sign of investors regaining confidence in Ireland Inc.
This blog has long argued that the demand for Irish bonds is similar to a Ponzi pyramid due to Irish banks rolling over Government debt to the ECB and monetizing it. Yesterday's Irish Times editorial finally bowed to the facts and agreed. Last week, Michael Somers of NTMA has "pointed out that 85 per cent of Ireland’s debt is held abroad but that in recent bond sales, Irish banks were significant buyers of Government debt" to be used as collateral to borrow from the ECB. This was not, he said, “a genuine end investor result". How much did the latest bond auction success depend on investment by Irish banks which have already received some €7 billion from the Government to help secure their survival? The NTMA should ease investor concerns and set out the details," said the Irish Times.
I think it is time we ask a hard question about our bond market revolving door to the ECB. Is it true that:
- as Brian Lenihan takes our taxes, we are hit once; then
- as Brian Lenihan issues bonds, we are hit again with the debt to be repaid in the future; and
- as the banks buy these bonds and go to the ECB to borrow against them, we are saddled with the banks-held debt that will have to be repaid to the ECB at some point in time and which is, in the end, our - taxpayers - liability too? so that
- the entire scheme requires continuous borrowing to sustain itself...
Cowen also stated that "we have a way out that is working". Remember the brilliant German movie Downfall about the last days of the Third Reich? (See a reminder/spoof here). Say no more... our unbeloved leader is in a state of delusion that is equivalent to awaiting the arrival of a miracle weapon (which does not exist) as the real enemy tanks are crushing your city.
What plan does Mr Cowen have? Brian Cowen claimed that economic recovery will be based on 4 pillars:
- Banking crisis resolution;
- Public finances gap closure via revenue increases and spending cuts;
- Jobs protection; and
- Investing in the unemployed to return them to work.
The entire country now is aware that NAMA cannot be made to work. Brian Cowen is in denial of this.
The entire country knows that he has not cut public spending (his own Government Budget shows increasing public current expenditure in every year through 2013). Brian Cowen is in denial of this.
The entire country knows that his Government is drawing blood out of taxpayers to raise revenue and that it is not working. Brian Cowen is in denial of this.
The entire country sees jobs being lost in thousands week, after week, as Brian Cowen and his Government choke enterprises, workers, investors and entrepreneurs with higher and higher taxes and charges. Brian Cowen is in denial of this.
The entire country knows that it was Brian Cowen as Minister for Finance who raised our social welfare rates to such a level that no programme that FAS can run will ever turn former construction workers off the welfare. The entire country knows that FAS should be renamed FARCE because it is one of the most wasteful and least productive Government organizations. Brian Cowen is in denial of this.
It is my sincere hope that his own party colleagues stop listening to the man for two reasons:
- Brian Cowen no longer speaks for the people, about the people and with the people; and
- No one listens to Brian Cowen anymore.
Thursday, May 21, 2009
Economics 21/05/2009: Moscow's Greening Pastures?
Russian stock markets are enjoying some recovery - in line with the US and firmer oil prices. Since January, MSCI EM - a broader index of emerging markets shares - rose roughly 25%, while MSCI Russia appreciated 30%. Domestic RTS index was up 48% and MMVB +62%, implying that Russia is now in the top three most profitable markets. JP Morgan note reflected this by lifting their assessment of the Russian market from 'Negative' to 'Neutral'. This, of course, is a lagging indicator, catching up with the rally enjoyed to date.
Although oil prices are much firmer now at $62.04 last night (July delivery) - the highest level since November 10, 2008, the latest price increase was driven by lower inventories, not by rising fundamentals or falling output. Demand for Russian oil and gas remains weak and production and exploration costs are not necessarily falling. If anything, in the long run, these costs are going to rise as new discoveries are being pushed deeper and deeper into Eastern Siberian domain, characterized by much more complex geology and smaller fields.
Likewise, industrial production continues to contract: -16.9% in April 2009 y-o-y, more than double on -8.1% fall in March. Overall Q1 GDP fell 9.2% in y-o-y terms, but there is no deflation in the economy (inflation moderated to around 10% annualized rate). Ruble devaluation expectations fell, but many experts still see some room for the currency to fall in months ahead. At the retail level, even with a span of the last two days Ruble rose from ca 43.30-43.35Rb/Euro to 43.00-43.10Rb/Euro, but majority of the businesses I spoke to expect the retail rates to test 44.00-46.00Rb/Euro before year-end.
JP Morgan note gave some support to the theory that Russian Government response to the crisis has been exemplary to date, but what is really interesting from our, Irish, point of view is the continued pressure from Kremlin to restrict corruption in the public sector.
While our own politicians and bureaucrats enjoy very low transparency over the sources of their incomes, Russian President has signed into law a decree requiring all top Government, political and public sector employees, politicians and even the top management of the public enterprises (commercial and non-commercial) to declare all sources of their own and their family members' income, covering:
And in contrast with the Irish Government, Russians are pumping state cash into SMEs - on Tuesday, Russian Government announced a 3-year $23bn fund for SMEs with a new target to increase SMEs employment levels from 14% of the total private sector employment today to 33% in 2012. Funds will be used to improve SMEs access to credit, reduce the cost of credit to the SMEs, some direct subsidies, increasing the share of state purchasing allocated to SMEs and reducing the 'red tape'.
Although oil prices are much firmer now at $62.04 last night (July delivery) - the highest level since November 10, 2008, the latest price increase was driven by lower inventories, not by rising fundamentals or falling output. Demand for Russian oil and gas remains weak and production and exploration costs are not necessarily falling. If anything, in the long run, these costs are going to rise as new discoveries are being pushed deeper and deeper into Eastern Siberian domain, characterized by much more complex geology and smaller fields.
Likewise, industrial production continues to contract: -16.9% in April 2009 y-o-y, more than double on -8.1% fall in March. Overall Q1 GDP fell 9.2% in y-o-y terms, but there is no deflation in the economy (inflation moderated to around 10% annualized rate). Ruble devaluation expectations fell, but many experts still see some room for the currency to fall in months ahead. At the retail level, even with a span of the last two days Ruble rose from ca 43.30-43.35Rb/Euro to 43.00-43.10Rb/Euro, but majority of the businesses I spoke to expect the retail rates to test 44.00-46.00Rb/Euro before year-end.
JP Morgan note gave some support to the theory that Russian Government response to the crisis has been exemplary to date, but what is really interesting from our, Irish, point of view is the continued pressure from Kremlin to restrict corruption in the public sector.
While our own politicians and bureaucrats enjoy very low transparency over the sources of their incomes, Russian President has signed into law a decree requiring all top Government, political and public sector employees, politicians and even the top management of the public enterprises (commercial and non-commercial) to declare all sources of their own and their family members' income, covering:
- combined annual income from all sources;
- all property holdings (including the size of each building, land parcels and the country where the property is located);
- all cars and other transport owned.
- addresses of property held; and
- banking accounts.
And in contrast with the Irish Government, Russians are pumping state cash into SMEs - on Tuesday, Russian Government announced a 3-year $23bn fund for SMEs with a new target to increase SMEs employment levels from 14% of the total private sector employment today to 33% in 2012. Funds will be used to improve SMEs access to credit, reduce the cost of credit to the SMEs, some direct subsidies, increasing the share of state purchasing allocated to SMEs and reducing the 'red tape'.
Wednesday, May 20, 2009
Economics 20/05/2009: Moscow, US Green Shoots
Is Alan Ahearne being paid to write Irish Times political infomercials? Today's Irish Times editorial from Alan Ahearne (here) is a marked departure from the long-standing tradition that the civil servants should stay on their main jobs (in Alan's case - that is, apparently to advise Minister Lenihan on matters of Economic policy - not Finance or PR) and not spend public money-financed time on addressing the media. Talking to the electorate is Minister Lenihan's job, as a politician and a member of the Government, not Alan Ahearne's.
That said, Alan's opinion fall flat on a number of other, more substantive points.
"These bonds will add to the gross stock of public debt, but so long as the valuation of loans is roughly correct, there will be no change in net public debt. Nama’s assets and liabilities will roughly match," says Alan. Great. We couldn't have imagined this intricacy of accounting without Alan pointing it out to us. But hold on - Alan does not give a figure in his article as to what the expected returns to NAMA can be, or which assumptions he uses to compute such a return. Not a single number! 'Roughly match' may mean a shortfall of Euro 20bn or a gain of Euro20bn, or anything in between, or indeed anything above these numbers. Again, Alain is silent on the matter.
"This approach to fixing banks’ balance sheets has a proven track record. The asset management model has been supported and recommended by banking experts across the globe and used successfully in many countries in the past as part of the work-out process of problem loans. Done properly, investments in the banking system using this approach have eventually been recovered in full," says the article. Ok: which experts? where has NAMA-style model been successful in the past, under what conditions and to what extent? Crucially, how do successful past NAMA-style models compare in terms of underlying fundamentals to Ireland's case? Not a word from Alan on these issues.
Alan Ahearne goes into a lengthy challenge to the German plan for banks rescue. This is irrelevant to his article, as we are not asking our Government officials to provide us with the news stories analysis for Germany. His job and the job of his masters is to deal with NAMA, not with Germany. In this context, it appears that Alan simply uses an argument against the German plan as an argument in favour of NAMA. This, if so, would be fallacious, since Germans making a mistake with their plans does not validate NAMA fundamentals in any way.
In short, I am simply amazed by the political nature of Alan's article, its lack of clarity and rigor, its complete lack of respect for the taxpayers who expect official Government opinion to be grounded in factual evidence. This is hardly an article one can expect from an economist, but rather an article one can expect from a politician. Too bad the Irish Times editorial staff didn't ask Alan to re-write it before accepting for publication...
Moscow is still all sun and cool... Yesterday was a good and productive day for the mission, meetings between companies and a great dinner in the National Hotel, overlooking the Red Square entrance and the Kremlin. There are some good news on companies front, which I hope to report in the Sunday Times article later, so no preview here. But I was impressed by one Irish company sealing a deal (long time under negotiations) in software area. I was also positively impressed by the Irish delegation head, Billy Kelleher, TD - his first official visit and he has been very good so far. As someone remarked couple of days ago (no names here) - he might be a much better choice of a delegation head. Mike Hogan of EI and the rest of EI team are doing great work on the ground - this is not new as I always known Mike and his team to be really first class point of contact to the Russian market.
Night out on town proved that Moscow is still very much abuzz with life, despite the slowdown. Couple relatively hip places (a Mexican dive with, strangely enough, a very loud rock band playing right in the entrance door, and a can-be-anywhere-else-in-the-world pricey beer joint) all had a calm, but busy, atmosphere. Confidence seems to be unshaken, as far as normal businesses go, but construction is dead and finance people are in hiding.
I was briefing a group of the Moscow Bar Association lawyers yesterday over a friendly coffee on some developments out there in the broader world. The main issue they wanted to know about was the whole mess of the EU/US financial services regulations. Not so much the banks, but the hedge funds etc. Hedgies are in the news in Russia because of the Chrysler story (when they refused an offer of $0.30 on the dollar of the company bonds and got hammered by the Communist-in-Chief in the White House of betting on a taxpayer bailout of the company. Well, there is a point to be made - has there been a single hedge fund in the US which received any bailout money? No. How many US automakers received such funds? All. Spot any difference? Of course, the automakers are all unionized and the unions are the cronies of the Democratic Party. Trace the line to Obama. Aside from politics, my view is that trying to regulate international (as opposed to domestic) financial markets is like squeezing water - should the US/EU try to put any severe measures in place, funds will move off-shore. We will see some measures passed and paraded as a dramatic departure from the status quo, but in the end they will be purely cosmetic. Much more under threat are domestic bankers, who have little choice when it comes to packing suitcases and moving to the Bahamas. In the end, costs will rise for all service providers - hedgies will see the rise much less than domestic bankers, implying that rates of return will fall, but the returns to international financial services will fall less (in the short run) than to domestic financial services. This situation will drive more competition into international finance and will lead to consumer-damaging decline in competition in the domestic sectors. Over a number of years, returns to international finance will fall and returns to domestic banking and finance will rise. As more and more banking clients move off-shore to follow lower cost international finance, EU and US economies will slow down in growth. So all regulatory risk talk is really a cost/return argument in my view. Let's see who is the most daft in regulation - the US Democrats or the EU - in a couple of years time...
US Green shoots just had a massive set back as the US housing starts fell a record low of 458,000 in April. Calculated Risk blog is predicting that we are going to see US house prices falling 40-50% relative to the peak by the end of 2010. Yeah, Davy guys, eat your shorts on US housing market improvements... And of course the inflation story is still out there (here), don't forget.
That said, Alan's opinion fall flat on a number of other, more substantive points.
"These bonds will add to the gross stock of public debt, but so long as the valuation of loans is roughly correct, there will be no change in net public debt. Nama’s assets and liabilities will roughly match," says Alan. Great. We couldn't have imagined this intricacy of accounting without Alan pointing it out to us. But hold on - Alan does not give a figure in his article as to what the expected returns to NAMA can be, or which assumptions he uses to compute such a return. Not a single number! 'Roughly match' may mean a shortfall of Euro 20bn or a gain of Euro20bn, or anything in between, or indeed anything above these numbers. Again, Alain is silent on the matter.
"This approach to fixing banks’ balance sheets has a proven track record. The asset management model has been supported and recommended by banking experts across the globe and used successfully in many countries in the past as part of the work-out process of problem loans. Done properly, investments in the banking system using this approach have eventually been recovered in full," says the article. Ok: which experts? where has NAMA-style model been successful in the past, under what conditions and to what extent? Crucially, how do successful past NAMA-style models compare in terms of underlying fundamentals to Ireland's case? Not a word from Alan on these issues.
Alan Ahearne goes into a lengthy challenge to the German plan for banks rescue. This is irrelevant to his article, as we are not asking our Government officials to provide us with the news stories analysis for Germany. His job and the job of his masters is to deal with NAMA, not with Germany. In this context, it appears that Alan simply uses an argument against the German plan as an argument in favour of NAMA. This, if so, would be fallacious, since Germans making a mistake with their plans does not validate NAMA fundamentals in any way.
In short, I am simply amazed by the political nature of Alan's article, its lack of clarity and rigor, its complete lack of respect for the taxpayers who expect official Government opinion to be grounded in factual evidence. This is hardly an article one can expect from an economist, but rather an article one can expect from a politician. Too bad the Irish Times editorial staff didn't ask Alan to re-write it before accepting for publication...
Moscow is still all sun and cool... Yesterday was a good and productive day for the mission, meetings between companies and a great dinner in the National Hotel, overlooking the Red Square entrance and the Kremlin. There are some good news on companies front, which I hope to report in the Sunday Times article later, so no preview here. But I was impressed by one Irish company sealing a deal (long time under negotiations) in software area. I was also positively impressed by the Irish delegation head, Billy Kelleher, TD - his first official visit and he has been very good so far. As someone remarked couple of days ago (no names here) - he might be a much better choice of a delegation head. Mike Hogan of EI and the rest of EI team are doing great work on the ground - this is not new as I always known Mike and his team to be really first class point of contact to the Russian market.
Night out on town proved that Moscow is still very much abuzz with life, despite the slowdown. Couple relatively hip places (a Mexican dive with, strangely enough, a very loud rock band playing right in the entrance door, and a can-be-anywhere-else-in-the-world pricey beer joint) all had a calm, but busy, atmosphere. Confidence seems to be unshaken, as far as normal businesses go, but construction is dead and finance people are in hiding.
I was briefing a group of the Moscow Bar Association lawyers yesterday over a friendly coffee on some developments out there in the broader world. The main issue they wanted to know about was the whole mess of the EU/US financial services regulations. Not so much the banks, but the hedge funds etc. Hedgies are in the news in Russia because of the Chrysler story (when they refused an offer of $0.30 on the dollar of the company bonds and got hammered by the Communist-in-Chief in the White House of betting on a taxpayer bailout of the company. Well, there is a point to be made - has there been a single hedge fund in the US which received any bailout money? No. How many US automakers received such funds? All. Spot any difference? Of course, the automakers are all unionized and the unions are the cronies of the Democratic Party. Trace the line to Obama. Aside from politics, my view is that trying to regulate international (as opposed to domestic) financial markets is like squeezing water - should the US/EU try to put any severe measures in place, funds will move off-shore. We will see some measures passed and paraded as a dramatic departure from the status quo, but in the end they will be purely cosmetic. Much more under threat are domestic bankers, who have little choice when it comes to packing suitcases and moving to the Bahamas. In the end, costs will rise for all service providers - hedgies will see the rise much less than domestic bankers, implying that rates of return will fall, but the returns to international financial services will fall less (in the short run) than to domestic financial services. This situation will drive more competition into international finance and will lead to consumer-damaging decline in competition in the domestic sectors. Over a number of years, returns to international finance will fall and returns to domestic banking and finance will rise. As more and more banking clients move off-shore to follow lower cost international finance, EU and US economies will slow down in growth. So all regulatory risk talk is really a cost/return argument in my view. Let's see who is the most daft in regulation - the US Democrats or the EU - in a couple of years time...
US Green shoots just had a massive set back as the US housing starts fell a record low of 458,000 in April. Calculated Risk blog is predicting that we are going to see US house prices falling 40-50% relative to the peak by the end of 2010. Yeah, Davy guys, eat your shorts on US housing market improvements... And of course the inflation story is still out there (here), don't forget.
Monday, May 18, 2009
Economics 18/05/2009: Wealth-destruction, Moscow, Ireland's Green Shoots
Here (hat tip PMD) is a superb article from WSJ on how to destroy thy country's wealth... too bad the US policymakers have not figured the Brian-Brian-Mary solution to the same problem. Possibly, they are not being advised by the wealth loathing, ever-State-loving ESRI?
On a personal note - I am in Moscow: sunny +25 degrees and the city is blooming (chestnut trees, apple trees, cherry trees and lilacs). Construction sites with no workers in sight, but traffic jams are as bad as ever. Ruble is down and prices are up, but on the net, I would not be surprised if there is a real deflation (prices seem to be up about 15%, while ruble is down ca 34%. They are fretting the latests stats from Europe: EU27 gas imports from Russia down 61% in Q1 2009 and exports of gas to CIS down 50%.
Closer to home problems/solutions: LA Times has a very interesting report (here) on solar energy potential. I will it to you to judge the commercial feasibility of what is being discussed (especially given the business-focused bits at the end of the article), but mark my words - within 10-15 years time we will see the end of the fossil fuels era and the start of a new era. It won't be driven by the environmental considerations (although those will form a secondary return on new technologies). Instead it will be driven by two major factors:
On Green Shoots theory: here is a good commentary from Martin Feldstein (ex NBER) - he is spot on about Europe's prospects (see my earlier, 2008-dated, comment on WSJblogs exactly to the same point). This, of course, is not as optimistic as Peter Orszag's latest drone about US economy not being in a 'free-fall', but... (here). Then again, recall that Orszag is the director of the President's Office of Management and Budget, so how can things be in a free-fall after Mr Orszag pumped more debt into the US economy within the span of just few months than Alan Greenspan managed to do in years? But care to read more? Here Nouriel Roubini (Dr Doom) and Ken Rogoff (Dr Financial Crises) muse as to why the 'Green Shoots' are a delusion. I don't give any heed to Merkel's comments on German economy (here) - I'd rather trust our bankers than politicians when it comes to reading the tea leafs of global economics.
But here is my own contribution to the debate (for those of you who missed in last Sunday Times issue) - this is an unedited version of the article that appeared in The Sunday Times.
“Despair ruins some, presumption many,” said Benjamin Franklin some 250 years ago.
If despair haunted Ireland’s policy and media circles since last Summer, in recent weeks, much of the economic commentary started focusing on the emergence of the ‘green shoots’ in our economic environment. Even abysmal, by any measure, unemployment and Exchequer data for April are being spun as showing signs of improvement.
Are we seeing the proverbial ‘light at the end of the tunnel’? And if yes, do we know at what rate will the conditions improve in months and years to come? Regrettably, these claims may be erring on the presumption side of Franklin’s quote.
First, there is the alleged stabilization in the rate of decline in the Exchequer revenue. The problem with this assertion is that it ignores the other side of the budgetary equation – the expenditure side. Current spending was up 4.5% in the first four months of the year. Factoring deflation, this is a hefty increase. At this rate the
real difference between economic growth and public sector expansion in 2009 can reach some 16%, before the vast NAMA commitments. In household finances this is equivalent to being insolvent and reckless about it at the same time.
Another issue is the rising cost of servicing public debt (up 21.4% in year on year terms in April). In the longer term, our growing over-reliance on less than 1 year maturity borrowings to finance current expenditure simply means that instead of taking a quick dose of painful medicine today we risk ending up on a drip therapy of minor cost adjustments. This would make the disease of overspending immune to future policies. Should interest rates rise in 2010-2012, as any sane market observer would expect, the Exchequer will be forced to
refinance a mountain of fresh borrowings at an even higher cost to the taxpayers.
Another recent sighting of ‘green shoots’ relates to the unemployment data. While it is true that the pace of increases in the Live Register is abating, the pace of jobs destruction remains furious. And, given the dynamics of rising layoffs in the services sectors, just as the previous wave of unemployment might be subsiding a new one is already heading our way.
Purchasing Manager’s Index (PMI) for April, published by the NCB Stockbrokers, shows employment in services bouncing around the bottom and in manufacturing contracting at a pace only slightly slower than in January – the worst month on record. Layoffs in Business Services accelerated in April, extending the current decline to fourteen consecutive months. Financial Services companies shed jobs at the sharpest pace in history last month.
So things are getting worse, not better on the unemployment front and its now the better quality higher-paying jobs that are being destroyed the fastest. If a loss of an average construction sector job implies a net loss to the economy of some €60,000 per annum, an average Business and Financial services job destroyed takes some €140,000 out of the economy.
At the aggregate unemployment data level, if January-April ‘stabilized’ pace of jobs losses continues to the end of the year, we are looking at 515,000 or more on Live Register by 2010 well above the 384,113 currently. Even more worryingly, this week’s data from CSO, discussed in the box-out below, is showing that the long-term unemployment is rising at an accelerating rate.
Following a marginal improvement in March, April current consumer confidence index fell to 75.1 from 76.2, although the expectations index rose to 27.7 compared to 22.5. Again, as with other ‘stabilizing’ indices this is temporary correction, not a lasting improvement. The so-called consumer ‘misery’ index – a standard measure of forward-looking indicators determining future consumer confidence – went deeper into red in April and is now poised for a further decrease in May based on the data to-date.
When it comes to the PMI data, April business activity in services recorded “an acceleration in the pace of decline”, according to the NCB Stockbrokers. In fact, April figures were so bad, that only February 2009 showed a deeper contraction. The steepest fall-off occurred in the highest value-added sector of the Irish economy – Business Services – down for the eleventh month in a row and falling at the fastest pace since January. Financial Services posted the steepest contraction in its history. And companies are expecting further drops in demand for their services in months ahead.
The story is not that much different in manufacturing. April manufacturing sectors PMI showed a further considerable deterioration of operating conditions. Output in the sector continues to contract at a near-record rate while jobs were cut sharply and new purchasing fell off the cliff. Any ‘green shoots’ in the cycle must involve an increase in planned future purchasing activity by companies and a restart of the investment cycle. This is clearly not on the minds of the majority of Irish managers.
So in the short run, there is no evidence of significant signs of improvement or stabilization in the downward spiral of our real economy.
This does not bode well for our future growth capacity. On Friday, ESRI published an excellent paper titled Recovery Scenarios for Ireland looking at the prospects for our economy through 2015. Under optimistic assumptions, the ESRI forecast is for the Irish income per capita to reach 2007 levels by 2015 implying a round-trip to the peak of 8 years.
Even more significantly, ESRI concluded that “as a consequence of the recession, the potential growth rate of the economy is likely to have fallen from 3.6 % per annum to 3% per annum”.
For all its merits, the paper assumes no changes in the long-run trend for the foreign direct investment inflows into Ireland. This issue is non-trivial. With vast majority of our exports generated by the MNCs, we simply cannot ignore the changing nature of the future international investment cycles on our economy. Looking over the recent years, vast majority of Ireland-based MNCs have chosen not to locate new products and services here. Only a handful elected to put higher value-added R&D and management activities in Ireland. This is a problem, as many MNC-produced goods and services are nearing the end of their life cycle. In time, failure to attract new products and services will spell an irreversible decline of the large share of our trade flows.
My own analysis, based on parameterising a recent IMF model of economies experiencing simultaneous shocks to housing markets, GDP growth and credit creation, predicts that the ongoing contraction in the Irish economy will bottom out at ca 16-18% decline in GDP per capita by the beginning of 2011. My estimates also show that it will take the economy until the middle of 2017 to fully regain, the levels of income per capita enjoyed in 2007.
Over 60% of the recession-related fall-off in our output will be captured by domestic factors: the property markets bust, fiscal policy debacle and rising structural unemployment. Adding to this a possibility that our multinationals-dominated sectors can experience a severe contraction in future investments can reduce our potential GDP growth rate to below 2.5% per annum. In this case, a recovery to 2007 income per capita levels might take us well into 2020.
On a personal note - I am in Moscow: sunny +25 degrees and the city is blooming (chestnut trees, apple trees, cherry trees and lilacs). Construction sites with no workers in sight, but traffic jams are as bad as ever. Ruble is down and prices are up, but on the net, I would not be surprised if there is a real deflation (prices seem to be up about 15%, while ruble is down ca 34%. They are fretting the latests stats from Europe: EU27 gas imports from Russia down 61% in Q1 2009 and exports of gas to CIS down 50%.
Closer to home problems/solutions: LA Times has a very interesting report (here) on solar energy potential. I will it to you to judge the commercial feasibility of what is being discussed (especially given the business-focused bits at the end of the article), but mark my words - within 10-15 years time we will see the end of the fossil fuels era and the start of a new era. It won't be driven by the environmental considerations (although those will form a secondary return on new technologies). Instead it will be driven by two major factors:
- Generally prohibitive cost of energy in the long run; and
- Higher induced volatility (risk) of energy costs when you factor in the pesky nasty regimes around the world who control most of our oil and gas.
On Green Shoots theory: here is a good commentary from Martin Feldstein (ex NBER) - he is spot on about Europe's prospects (see my earlier, 2008-dated, comment on WSJblogs exactly to the same point). This, of course, is not as optimistic as Peter Orszag's latest drone about US economy not being in a 'free-fall', but... (here). Then again, recall that Orszag is the director of the President's Office of Management and Budget, so how can things be in a free-fall after Mr Orszag pumped more debt into the US economy within the span of just few months than Alan Greenspan managed to do in years? But care to read more? Here Nouriel Roubini (Dr Doom) and Ken Rogoff (Dr Financial Crises) muse as to why the 'Green Shoots' are a delusion. I don't give any heed to Merkel's comments on German economy (here) - I'd rather trust our bankers than politicians when it comes to reading the tea leafs of global economics.
But here is my own contribution to the debate (for those of you who missed in last Sunday Times issue) - this is an unedited version of the article that appeared in The Sunday Times.
“Despair ruins some, presumption many,” said Benjamin Franklin some 250 years ago.
If despair haunted Ireland’s policy and media circles since last Summer, in recent weeks, much of the economic commentary started focusing on the emergence of the ‘green shoots’ in our economic environment. Even abysmal, by any measure, unemployment and Exchequer data for April are being spun as showing signs of improvement.
Are we seeing the proverbial ‘light at the end of the tunnel’? And if yes, do we know at what rate will the conditions improve in months and years to come? Regrettably, these claims may be erring on the presumption side of Franklin’s quote.
First, there is the alleged stabilization in the rate of decline in the Exchequer revenue. The problem with this assertion is that it ignores the other side of the budgetary equation – the expenditure side. Current spending was up 4.5% in the first four months of the year. Factoring deflation, this is a hefty increase. At this rate the
real difference between economic growth and public sector expansion in 2009 can reach some 16%, before the vast NAMA commitments. In household finances this is equivalent to being insolvent and reckless about it at the same time.
Another issue is the rising cost of servicing public debt (up 21.4% in year on year terms in April). In the longer term, our growing over-reliance on less than 1 year maturity borrowings to finance current expenditure simply means that instead of taking a quick dose of painful medicine today we risk ending up on a drip therapy of minor cost adjustments. This would make the disease of overspending immune to future policies. Should interest rates rise in 2010-2012, as any sane market observer would expect, the Exchequer will be forced to
refinance a mountain of fresh borrowings at an even higher cost to the taxpayers.
Another recent sighting of ‘green shoots’ relates to the unemployment data. While it is true that the pace of increases in the Live Register is abating, the pace of jobs destruction remains furious. And, given the dynamics of rising layoffs in the services sectors, just as the previous wave of unemployment might be subsiding a new one is already heading our way.
Purchasing Manager’s Index (PMI) for April, published by the NCB Stockbrokers, shows employment in services bouncing around the bottom and in manufacturing contracting at a pace only slightly slower than in January – the worst month on record. Layoffs in Business Services accelerated in April, extending the current decline to fourteen consecutive months. Financial Services companies shed jobs at the sharpest pace in history last month.
So things are getting worse, not better on the unemployment front and its now the better quality higher-paying jobs that are being destroyed the fastest. If a loss of an average construction sector job implies a net loss to the economy of some €60,000 per annum, an average Business and Financial services job destroyed takes some €140,000 out of the economy.
At the aggregate unemployment data level, if January-April ‘stabilized’ pace of jobs losses continues to the end of the year, we are looking at 515,000 or more on Live Register by 2010 well above the 384,113 currently. Even more worryingly, this week’s data from CSO, discussed in the box-out below, is showing that the long-term unemployment is rising at an accelerating rate.
Following a marginal improvement in March, April current consumer confidence index fell to 75.1 from 76.2, although the expectations index rose to 27.7 compared to 22.5. Again, as with other ‘stabilizing’ indices this is temporary correction, not a lasting improvement. The so-called consumer ‘misery’ index – a standard measure of forward-looking indicators determining future consumer confidence – went deeper into red in April and is now poised for a further decrease in May based on the data to-date.
When it comes to the PMI data, April business activity in services recorded “an acceleration in the pace of decline”, according to the NCB Stockbrokers. In fact, April figures were so bad, that only February 2009 showed a deeper contraction. The steepest fall-off occurred in the highest value-added sector of the Irish economy – Business Services – down for the eleventh month in a row and falling at the fastest pace since January. Financial Services posted the steepest contraction in its history. And companies are expecting further drops in demand for their services in months ahead.
The story is not that much different in manufacturing. April manufacturing sectors PMI showed a further considerable deterioration of operating conditions. Output in the sector continues to contract at a near-record rate while jobs were cut sharply and new purchasing fell off the cliff. Any ‘green shoots’ in the cycle must involve an increase in planned future purchasing activity by companies and a restart of the investment cycle. This is clearly not on the minds of the majority of Irish managers.
So in the short run, there is no evidence of significant signs of improvement or stabilization in the downward spiral of our real economy.
This does not bode well for our future growth capacity. On Friday, ESRI published an excellent paper titled Recovery Scenarios for Ireland looking at the prospects for our economy through 2015. Under optimistic assumptions, the ESRI forecast is for the Irish income per capita to reach 2007 levels by 2015 implying a round-trip to the peak of 8 years.
Even more significantly, ESRI concluded that “as a consequence of the recession, the potential growth rate of the economy is likely to have fallen from 3.6 % per annum to 3% per annum”.
For all its merits, the paper assumes no changes in the long-run trend for the foreign direct investment inflows into Ireland. This issue is non-trivial. With vast majority of our exports generated by the MNCs, we simply cannot ignore the changing nature of the future international investment cycles on our economy. Looking over the recent years, vast majority of Ireland-based MNCs have chosen not to locate new products and services here. Only a handful elected to put higher value-added R&D and management activities in Ireland. This is a problem, as many MNC-produced goods and services are nearing the end of their life cycle. In time, failure to attract new products and services will spell an irreversible decline of the large share of our trade flows.
My own analysis, based on parameterising a recent IMF model of economies experiencing simultaneous shocks to housing markets, GDP growth and credit creation, predicts that the ongoing contraction in the Irish economy will bottom out at ca 16-18% decline in GDP per capita by the beginning of 2011. My estimates also show that it will take the economy until the middle of 2017 to fully regain, the levels of income per capita enjoyed in 2007.
Over 60% of the recession-related fall-off in our output will be captured by domestic factors: the property markets bust, fiscal policy debacle and rising structural unemployment. Adding to this a possibility that our multinationals-dominated sectors can experience a severe contraction in future investments can reduce our potential GDP growth rate to below 2.5% per annum. In this case, a recovery to 2007 income per capita levels might take us well into 2020.
Saturday, May 16, 2009
Economics 16/05/2009: NAMA Week & Irish Banks
Having been up to my ears in planning for next week’s trip to Moscow, I missed the excitement of the NAMA finally imploding on Thursday and Friday. So here is a recap (for those of you who are in the know already – my analysis is below).
This note is structured as follows: first, I cover Michael Somers' very revealing and honest testimony to the PAC, then I review Friday Davy note on NAMA, lastly, I provide complete estimates of expected losses for NAMA.
Michael Somers - some fresh air on NAMA
On Thursday NTMA ceo Michael Somers told the Public Accounts Committee that putting valuations of the bad loans will present “an enormous dilemma”. Of course in logic, ‘dilemma’ always leads to two undesirable alternatives – in other words, it cannot be resolved within the same logical reasoning chain that leads to it. In layman’s terms, this means that the only way to resolve NAMA problems is to dump the idea alltogether.
So what is this ‘dilemma’ that the country has learned about only this week?
It turns out to that "there will be arguments down the courts if we don’t get it right. The implications of this thing are enormous and the legislation will be very complex,” Mr Somers said. Hmmm… this is hardly new. This blog and many well publicised articles, some written or co-written by me plus a massive wave of media reports that certain big developers are preparing to challenge NAMA - all were well ahead of Mr Somers. But Mr Somers’ testimony is so news worthy now because it is no longer the dirty scoundrels in media and academia who are beating up Lenihan’s dream baby, but one of the Golden Public Circle’s own.
Mr Somers also said that he believed up to 5,000 officials in the main banks “were currently examining bad loans. …At the moment, we really have no feel for how Nama will operate. But my preference would be a core group of between 30-40 people.” Now, wait a second. 5,000 banks officials cannot get the loans right, but 30-40 NTMA/NAMA folks will? This is after Mr Somers admitted that NTMA has not experience in managing distressed assets whatsoever. Of course, Mr Somers was saying 30-40 NAMA officials on top of 5,000 banks officers already in place will manage NAMA, but in such a scecnario, any final cost of NAMA will have to include the cost of those 5,000 bankers as well...
Mr Somers said the NTMA paid its 170 staff a total of €19.4 million in 2008 – “an average of almost €90,000 per person” as Irish Times puts it. Well: 170 staff at €19.4mln is €114,118 per person in pay. Including secretaries and other auxiliary staff, NTMA is now the best paid state entity on the record – ahead of ESB. But hold on, further €8.9 million was paid out in expenses. So total compensation (inclusive of expenses) came to €166,471 per head.
The 30-40 people that Mr Somers would like to have for NAMA is about 20-times smaller than normally is required to run a €90bn fund. Now, given that NAMA will be a distressed assets fund with less active management, say 600-700 people specialising in asset management, portfolio structuring, risk pricing etc would suffice. If the NTMA wage bill were to apply (and there is absolutely no reason as to why it won’t) – we, the taxpayers, are looking at paying something to the tune of €100mln in wages and expenses for these ‘servants’ of the state annually.
Another dilemma, clearly of unresolvable variety, is that NAMA “is expected to pay for the bad loans through the issue of Government bonds to the lenders.” (Quote per Irish Times). Apart from not being new (first disclosed back in April) and being banal (the state has to borrow cash and issue bonds to pay for its day-to-day spending, let alone NAMA), this claim is rather sterile.
In reality, the Government hopes that it will be able to borrow directly and at reasonable terms, but of course, it might run into some tight spots asking the markets to lend money
Irish Times also told us that “Profits from the eventual sale of the loans will be given to the state which may be used to service the €54.2 billion national debt.” Ok, what national debt do they have in mind? €90-110bn or more debt we will have once Mr Lenihan ends his current deficit financing of the public sector employees lifestyles? In fact, the same Irish Times reported as a comment from NTMA chief that he expects Irish debt to top 100% of our GDP in 2010 (see below). So, does anyone in the Times editorial have a calculator at hand?
It's all down to the cost of NAMA
“However if Nama makes a loss, the Government said it will apply a levy on banks to recoup the shortfall.” Ireland’s stockbrokers decidedly focused on this statement much more than on anything else that Mr Somers said. Why? Because this is the real unknown unknown for banks shareholders. This is, of course, ultimately the question of how big the loss will be.
So let’s do some counting of the beans… shall we?
First what the financial markets analysts say: per Davy note assumption, “costs for NAMA will be covered by interest income from the performing loans. Taking a conservative view that only 50% of the €30bn investment loans to be transferred are performing, this could generate initial income of c.€1.2bn as yields are currently at 8%. This would cover the coupon (assumed to be in line with the borrowing rate on ECB liquidity facility) of the bonds issued to the banks in return for their €80-90bn of loans transferred to NAMA. Income will likely be higher because the investment loans to be transferred to NAMA are not bad loans in themselves but are selected due to cross-collateralisation with development loans. An investigation of staff costs as a percentage of properties under management for large real estate trusts suggests that staff costs will be covered, especially given the greater operational leverage due to NAMA's size. Legal costs are less certain as the legality of the agency is one of the greatest obstacles to its performance.”
... And then, the pigs are soaring high in the sky…
Suppose that NTMA goes out to the markets with two suitcases worth of bonds – government bonds and NAMA bonds. Do you think they can price NAMA debt:
For (2): at 4.5% pa (a very optimistic scenario), buying €90bn worth of loans at 15% discount (as Davy suggest) on their face value will cost us €3.44bn annually in coupon payments. But wait, let’s also look at the downside scenarios: (3) implies €4.13bn price tag, and under scenario (4) the cost of annual NAMA financing alone rises to €4.59bn, or ca 15.3% of the entire Exchequer tax revenue in 2009...
Hmmm... back to that 'country whose Government cannot balance its own books' bullet point above, anyone?
Per debt financing assumptions, Somers said Ireland would be “lucky” to hold on to its sole remaining top AAA credit rating, as its low debt levels could surge to more than 100 per cent of GDP next year, from about 41 per cent in 2008, after the State completed the transfer of the banks’ bad loans. Hmmmm… remember that Irish Times statement that NAMA can be used to pay down €54.2bn debt quoted above? Apparently, NTMA chief expects the debt in excess of €170bn by the end of 2010 - somewhat higher than Irish Times journos do. And, apparently, he does not expect to price any debt (Government or NAMA-issued) at ECB discount facility rates (as Davy assume).
Of course, it is a trite statement to say that NAMA will be able to cover its staff costs, so no dwelling on this, but as far as legal costs uncertainty goes, despite Davy's rather neutered murmurs on this, there is no downside protection for the taxpayers. In other words, once committed to the transfer of a loan, NAMA implicitly assumes that no matter what the legal costs might be, the loan will be moved.
Somers was lethal on this last week: “I see great potential for arguments down in the courts if we don’t get this right,” saying further that he heard “people down in the courts were delighted” about the setting up of NAMA as they were in line for “a bonanza”. He said there would be “eating and drinking” at the committee for decades over the set-up of NAMA. But Davy folks didn't listen, apparently.
Davy goes on to pour more fuel on the NAMA pyre: “…the fear of the unknown has also led developers to call for consultation with the government over NAMA, with many saying that they can be part of the solution. Engagement with developers would arguably help reduce legal challenges and secure buy-in. The NTMA itself has stated that it lacks sufficient skills for setting up NAMA, but many developers will be both skilled and, more importantly, incentivised to work out their projects/loans under NAMA.”
Indeed, NAMA is at a severe risk of getting into bed with developers. Not because developers are ‘evil’ (I certainly do not believe this), but because NAMA should be independent from developers interests and free from their influences. And yet, Davy does not even see the lunacy of its own suggestion that NAMA should engage developers in the management process. This is really worrisome.
Doing the final sums on NAMA cost
Davy’s “simple NAMA model shows that taking our 15% haircut assumption for the sector and assuming no profits on disposal of NAMA assets across a 15-year work-out period implies a present value loss of €4bn. Apportioning this fee on an annual basis over 20 years (similar to Insurance Corporation of Ireland) implies that this fee would be only c.3-4% of normalised profits. However, given the long-term nature of the agency, there is every chance that it can turn a profit similar to that which we have seen in past banking crises such as in Sweden. A more positive outlook, with greater performance from investment assets under NAMA and a 5% profit in aggregate across asset disposals, would result in a present value profit on wind-up of €3bn to the taxpayer from NAMA.”
I do not have Davy’s model at hand to see what assumptions they force into it to get these numbers. Judging by their assumptions on pricing NAMA bonds (above), I have no confidence in any of their numbers. Their concluding scenario in the quote above is so far out there, that the aforementioned Amsterdam brownies come to mind again.
But my own simple model goes as follows (with my assumptions listed transparently for all of you to see and to challenge, unlike Davy):
So, net impact is a loss of €33-68bn.
Remember, Mr Somers said he was “aghast” at the scale of development loans advanced to a small number of borrowers which emerged after the NTMA reviewed the banks’ books. He called the review “a huge eye opener for us”. This is not a statement from a man who expect loans losses to be in 5% category (as my ‘Near Davy’ scenario above assumes).
So turning back to that original concern that investors should have about NAMA - what share of these losses can be recovered through a 3-4% shave on future profits of the banks?
This note is structured as follows: first, I cover Michael Somers' very revealing and honest testimony to the PAC, then I review Friday Davy note on NAMA, lastly, I provide complete estimates of expected losses for NAMA.
Michael Somers - some fresh air on NAMA
On Thursday NTMA ceo Michael Somers told the Public Accounts Committee that putting valuations of the bad loans will present “an enormous dilemma”. Of course in logic, ‘dilemma’ always leads to two undesirable alternatives – in other words, it cannot be resolved within the same logical reasoning chain that leads to it. In layman’s terms, this means that the only way to resolve NAMA problems is to dump the idea alltogether.
So what is this ‘dilemma’ that the country has learned about only this week?
It turns out to that "there will be arguments down the courts if we don’t get it right. The implications of this thing are enormous and the legislation will be very complex,” Mr Somers said. Hmmm… this is hardly new. This blog and many well publicised articles, some written or co-written by me plus a massive wave of media reports that certain big developers are preparing to challenge NAMA - all were well ahead of Mr Somers. But Mr Somers’ testimony is so news worthy now because it is no longer the dirty scoundrels in media and academia who are beating up Lenihan’s dream baby, but one of the Golden Public Circle’s own.
Mr Somers also said that he believed up to 5,000 officials in the main banks “were currently examining bad loans. …At the moment, we really have no feel for how Nama will operate. But my preference would be a core group of between 30-40 people.” Now, wait a second. 5,000 banks officials cannot get the loans right, but 30-40 NTMA/NAMA folks will? This is after Mr Somers admitted that NTMA has not experience in managing distressed assets whatsoever. Of course, Mr Somers was saying 30-40 NAMA officials on top of 5,000 banks officers already in place will manage NAMA, but in such a scecnario, any final cost of NAMA will have to include the cost of those 5,000 bankers as well...
Mr Somers said the NTMA paid its 170 staff a total of €19.4 million in 2008 – “an average of almost €90,000 per person” as Irish Times puts it. Well: 170 staff at €19.4mln is €114,118 per person in pay. Including secretaries and other auxiliary staff, NTMA is now the best paid state entity on the record – ahead of ESB. But hold on, further €8.9 million was paid out in expenses. So total compensation (inclusive of expenses) came to €166,471 per head.
The 30-40 people that Mr Somers would like to have for NAMA is about 20-times smaller than normally is required to run a €90bn fund. Now, given that NAMA will be a distressed assets fund with less active management, say 600-700 people specialising in asset management, portfolio structuring, risk pricing etc would suffice. If the NTMA wage bill were to apply (and there is absolutely no reason as to why it won’t) – we, the taxpayers, are looking at paying something to the tune of €100mln in wages and expenses for these ‘servants’ of the state annually.
Another dilemma, clearly of unresolvable variety, is that NAMA “is expected to pay for the bad loans through the issue of Government bonds to the lenders.” (Quote per Irish Times). Apart from not being new (first disclosed back in April) and being banal (the state has to borrow cash and issue bonds to pay for its day-to-day spending, let alone NAMA), this claim is rather sterile.
In reality, the Government hopes that it will be able to borrow directly and at reasonable terms, but of course, it might run into some tight spots asking the markets to lend money
- to a half-backed bad bank to be run by 30-40 inexperienced staff;
- mired up to its chin in the mud of court challenges in our notoriously costly and slow legal system;
- operating under the umbrella of our Guinness-serving bond issuing authority;
- in a country whose Government cannot balance its own books;
- with economy managed so poorly, that we are now presented internationally as the worst case scenario possible; and
- the Government so grossly clientelist that it can't even manage its own employees without having to run crying to the 'mommy' of the Social Partnership;
- add to it that NAMA has no popular or political support; and
- that the same Government is doing everything possible to make certain Irish private economy will not come out of this recession with any strength left
Irish Times also told us that “Profits from the eventual sale of the loans will be given to the state which may be used to service the €54.2 billion national debt.” Ok, what national debt do they have in mind? €90-110bn or more debt we will have once Mr Lenihan ends his current deficit financing of the public sector employees lifestyles? In fact, the same Irish Times reported as a comment from NTMA chief that he expects Irish debt to top 100% of our GDP in 2010 (see below). So, does anyone in the Times editorial have a calculator at hand?
It's all down to the cost of NAMA
“However if Nama makes a loss, the Government said it will apply a levy on banks to recoup the shortfall.” Ireland’s stockbrokers decidedly focused on this statement much more than on anything else that Mr Somers said. Why? Because this is the real unknown unknown for banks shareholders. This is, of course, ultimately the question of how big the loss will be.
So let’s do some counting of the beans… shall we?
First what the financial markets analysts say: per Davy note assumption, “costs for NAMA will be covered by interest income from the performing loans. Taking a conservative view that only 50% of the €30bn investment loans to be transferred are performing, this could generate initial income of c.€1.2bn as yields are currently at 8%. This would cover the coupon (assumed to be in line with the borrowing rate on ECB liquidity facility) of the bonds issued to the banks in return for their €80-90bn of loans transferred to NAMA. Income will likely be higher because the investment loans to be transferred to NAMA are not bad loans in themselves but are selected due to cross-collateralisation with development loans. An investigation of staff costs as a percentage of properties under management for large real estate trusts suggests that staff costs will be covered, especially given the greater operational leverage due to NAMA's size. Legal costs are less certain as the legality of the agency is one of the greatest obstacles to its performance.”
... And then, the pigs are soaring high in the sky…
Suppose that NTMA goes out to the markets with two suitcases worth of bonds – government bonds and NAMA bonds. Do you think they can price NAMA debt:
- at a discount to current public debt issues (a scenario that Davy suggests); or
- at a rate that is equivalent to Government bonds, say ca 4.5%; or
- at a rate that is higher than Government bonds, say a premium of 20% to Government debt – for 5.4%, while the Government debt remains priced at 4.5%; or
- as the markets look at two piles of paper, they tell NTMA: “Ok, we’ll take Government bonds at a premium to previous issues to account for vast number of these things being floated in the market – say 5%, and NAMA bonds at a 20% premium on that – at 6%”?
For (2): at 4.5% pa (a very optimistic scenario), buying €90bn worth of loans at 15% discount (as Davy suggest) on their face value will cost us €3.44bn annually in coupon payments. But wait, let’s also look at the downside scenarios: (3) implies €4.13bn price tag, and under scenario (4) the cost of annual NAMA financing alone rises to €4.59bn, or ca 15.3% of the entire Exchequer tax revenue in 2009...
Hmmm... back to that 'country whose Government cannot balance its own books' bullet point above, anyone?
Per debt financing assumptions, Somers said Ireland would be “lucky” to hold on to its sole remaining top AAA credit rating, as its low debt levels could surge to more than 100 per cent of GDP next year, from about 41 per cent in 2008, after the State completed the transfer of the banks’ bad loans. Hmmmm… remember that Irish Times statement that NAMA can be used to pay down €54.2bn debt quoted above? Apparently, NTMA chief expects the debt in excess of €170bn by the end of 2010 - somewhat higher than Irish Times journos do. And, apparently, he does not expect to price any debt (Government or NAMA-issued) at ECB discount facility rates (as Davy assume).
Of course, it is a trite statement to say that NAMA will be able to cover its staff costs, so no dwelling on this, but as far as legal costs uncertainty goes, despite Davy's rather neutered murmurs on this, there is no downside protection for the taxpayers. In other words, once committed to the transfer of a loan, NAMA implicitly assumes that no matter what the legal costs might be, the loan will be moved.
Somers was lethal on this last week: “I see great potential for arguments down in the courts if we don’t get this right,” saying further that he heard “people down in the courts were delighted” about the setting up of NAMA as they were in line for “a bonanza”. He said there would be “eating and drinking” at the committee for decades over the set-up of NAMA. But Davy folks didn't listen, apparently.
Davy goes on to pour more fuel on the NAMA pyre: “…the fear of the unknown has also led developers to call for consultation with the government over NAMA, with many saying that they can be part of the solution. Engagement with developers would arguably help reduce legal challenges and secure buy-in. The NTMA itself has stated that it lacks sufficient skills for setting up NAMA, but many developers will be both skilled and, more importantly, incentivised to work out their projects/loans under NAMA.”
Indeed, NAMA is at a severe risk of getting into bed with developers. Not because developers are ‘evil’ (I certainly do not believe this), but because NAMA should be independent from developers interests and free from their influences. And yet, Davy does not even see the lunacy of its own suggestion that NAMA should engage developers in the management process. This is really worrisome.
Doing the final sums on NAMA cost
Davy’s “simple NAMA model shows that taking our 15% haircut assumption for the sector and assuming no profits on disposal of NAMA assets across a 15-year work-out period implies a present value loss of €4bn. Apportioning this fee on an annual basis over 20 years (similar to Insurance Corporation of Ireland) implies that this fee would be only c.3-4% of normalised profits. However, given the long-term nature of the agency, there is every chance that it can turn a profit similar to that which we have seen in past banking crises such as in Sweden. A more positive outlook, with greater performance from investment assets under NAMA and a 5% profit in aggregate across asset disposals, would result in a present value profit on wind-up of €3bn to the taxpayer from NAMA.”
I do not have Davy’s model at hand to see what assumptions they force into it to get these numbers. Judging by their assumptions on pricing NAMA bonds (above), I have no confidence in any of their numbers. Their concluding scenario in the quote above is so far out there, that the aforementioned Amsterdam brownies come to mind again.
But my own simple model goes as follows (with my assumptions listed transparently for all of you to see and to challenge, unlike Davy):
So, net impact is a loss of €33-68bn.
Remember, Mr Somers said he was “aghast” at the scale of development loans advanced to a small number of borrowers which emerged after the NTMA reviewed the banks’ books. He called the review “a huge eye opener for us”. This is not a statement from a man who expect loans losses to be in 5% category (as my ‘Near Davy’ scenario above assumes).
So turning back to that original concern that investors should have about NAMA - what share of these losses can be recovered through a 3-4% shave on future profits of the banks?
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