Economics 29/08/2009: Nama critics are out of touch academics?

Today’s letter in the Irish Times got me going, along with Noel Whelan’s article on the subject…

“Madam, – The professors’/doctors’ thesis was good (“Nama set to shift wealth to lenders and developers, Opinion, August 26th). To a person who has lost over 70 per cent of their entire pension fund invested over 22 years, it is nice to hear their comment from a secure pension position. It is also nice to read that they now want to confiscate the remaining part of my pension fund.” 

Well, I am sick and tired of this ‘their secure pension / job position’ crap – pardon my use of vernacular here. Here, on the record:

• I have no public pension and have to rely on my own savings to generate one;
• I am in the negative equity, just as many Irish people are;
• I have no tenure in any of academic institution and am paid per each course I teach and each student I supervise, despite having brought more business to TCD than my income from TCD recovers;
• I have no PAYE earnings in Ireland;
• Most of my income comes from pure performance-based pay for private clients in Ireland and abroad;
• I know first-hand what it means to have a two-person unemployed family in this country and yet neither myself nor my spouse have ever drawn on unemployment benefits;
• I know first-hand what it means to have a child when your spouse does not qualify for maternity benefits from an employer;
• I know first hand what it means to pay for my own and my family private health insurance;
• I have no desire whatsoever to see my family income go to support this letter writer’s pension fund – private or public. Full stop!

So message 1 from today to the Irish Times – please stop publishing letters and articles that border on slanderous and inaccurate in their allegations.

Now, let us deal with another piece in today’s Irish Times by Noel Whelan titled “Selling Nama to sceptical public requires political will”.

Whelan simply cannot understand the basic difference between a political reform proposal (Lisbon Treaty) and public expenditure proposal (Nama) and in confusing the two reveals something very interesting about our politicians. As a senior (by tenure, if not by accomplishment) politician, Mr Whelan has no apparent idea that any public spending/ investment undertaking requires cost-benefit analysis. Factual evidence, not ‘selling to the public’ is what such undertakings are based upon. Any hard facts, Noel? Nope.

Instead, Whelan:

• Prefers to dismiss those who provide factual arguments as some sort of ‘out of touch’ academics;
• Blabber on about political selling of Nama to the general public;
• Suggests that arguments of numerous specialists in the area of economics, finance and real estate are nothing more than a “populist card” similar to that played in Lisbon I referendum, and that we – critics of Nama – “scaremonger about its consequences or encourage an “if you don’t know, vote no” stance.”

Well, Mr Whelan, do come out with your facts. Will you? Sadly, he does not. Instead he proceeds to deflect the debate about Nama into an imaginary land of make-believe villains (economists, finance experts, independent observers) combated by the noble knights in shining armor (Mr Whelan including). Don Quixote he is not, but the windmills are aplenty in his article.

“In the past three weeks more time has been allocated to squabbling over issues surrounding the proposal than to shedding light on its contents.” Clearly, Mr Whelan cannot get his a***s of the chair to read this blog, or Irish Economy blog, or anything else but the Irish Times. The debate on Nama has been raging on for months now and in the last three weeks myself and others have comprehensively shredded into pulp the entire Government proposed legislation on Nama. Is there any point of repeating this again in detail in a collective letter? No, Mr Whelan, there is none.

Whelan goes on to repeat, parrot-like the ‘arguments’ against the critics of Nama produced by Mr Ahearne and by the official Government note on how to respond to critics of Nama:

“In all that noise fundamental features of the Nama project have been distorted or misunderstood. These include that Nama will buy loans rather than property, that developers will still be liable for the full amount of their loans and that the success of Nama is contingent on a modest improvement in our economy and property market over the next five to 10 years and not on a return to a bubble.”

These are virtually verbatim taken out of Alan Ahearne’s pitiful ‘letter’ to his ‘colleagues’ which itself was a poorly re-edited rendition of the official unpublished, privately circulated “Nama Q&A” note prepared by the DofF to accompany the release of the Nama legislative proposal.

Whelan has no idea what he is talking about here and is, at the very best, slides into blind repeating of the Government official lines. No serious observer has argued that Nama will buy properties, but that it will acquire properties as a collateral in the process of buying loans. No one is disputing that the developers will be liable, but the extent of liability is highly uncertain and nothing is being done to prevent them from legally shielding their properties from Nama. (Noel, perhaps, really has no clue that this can be done in this country, but hey, I am not about to start running a kindergarten Economic 0.0001 course here for him).

“What is surprising, however, is the limited and broad-brush nature of their contribution. One might have thought that such a group giving the public the benefit of its expertise could have done so in a more substantial manner than merely affixing their names to what is in effect a lengthy letter.”

Oh, Noel, please, get your head out of Biffo’s 'Ideas Bog' and read our separate numerous contributions on the ‘substantive’ aspects of Nama made elsewhere. You can start with my own contributions on this blog or with my article in the Irish Independent yesterday, or Business & Finance archives, or the Sunday Times… You can proceed to read Brian Lucey’s and Karl Whelan’s articles in the Irish Times and elsewhere.

And so, the Irish Times’ message 2 of the day: try to avoid publishing political drivel as a factually-based opinion. Unless, that is, you are doing it in a subversive manner of letting the public know just how detached from the reality can our politicos really get…

Economics 27/08/2009: Rabo and Namaeland

And so the news come out of the depths of Irish banking sector, like an old Soviet sub, with its nuclear reactor still glowing red. Rabo is, as logically expected, on its way out with ACC delivering 20% loans losses and values on underlying assets down 50-60%. Well, there’s more to come according to them and there is no hope a recovery mid-term. This is all happening while the Government is spinning the idea that Nama is going to be just fine because, apparently, it will be taking loans with low LTVs… Hmmm...

Let me see – anyone wonders why Rabo is not buying this story? Simple: a loan written in 2007 with an LTV of, say 50% in the amount €100 had collateral underlying it valued at €200 back then. Table below shows the expected losses on Nama purchasing such a loan under Rabo impairments and stated declines in underlying value.

The above factor in the rolled up interest and a 20% impairment rate on loans. Interest accrues over 2007-2010 and all values are brought into 2009 Euro. 2007-2009 inflation is assumed to be cumulative 2%. 2010 inflation is assumed to be zero. Interest roll ups are taken at 7% in 2007, 9% in 2008 and 11% 2009-2010.

What is clear from the above is that even before we factor in the cost of bonds issuance, the cost of subsequent recapitalization, and the costs of operating Nama, the required gains on 2010 expected values of the underlying properties (assuming 20% are completely bust) required to restore Nama to break-even on its purchases in 2021 will be in the range of 2-5.5% annually in the case of 40% discount paid by Nama on assets and between 4% and 8.3% in the case of 30% discount paid by Nama.

Now, let us factor in  the cost of financing the Nama bonds and the cost of recapitalization post-Nama. Table below shows identical results to the table above, except with the bond financing cost (over inflation – of 3% pa through 2021), plus Nama recapitalization demand at 8% on the value of the loans transferred (a gross underestimate, but hey, let’s give them some slack):

Yes, folks, that is right – to get break even (almost, as we still did not count the cost of Nama operations, plus the cost of redeveloping loans, etc, but we can cancel these out with property yields, just to cut these endless estimates) on Nama, Ireland Inc will need to run annual property markets inflation of 12-15.1% per annum for 10 years after 2011! And this is based on 50%-60% LTVs!

I mean, are you surprised Rabo and the likes are not rushing to buy into our “Low LTVs” Namaeland?

Note of caution: I am just using Rabo numbers here - this is clearly not a complete picture of Nama, but it does give us the latest up-to-date picture of what is going to be happening in Nama.

Economics 26/08/09: Nama debate gone dirty

I have missed today's debate between Alan Ahearne and Brian Lucey, although as far as I understand Dr Ahearne failed to actually face Brian in this debate.

Having heard the 'debate' afterward and having obtained a letter from one of the Green Party parliamentary party members to a senior ranking disillusioned member of the party in which a venerable Green legislator claims, as Alan did today, that academics commenting on Nama with a critical perspective are not fully appreciative of complexities of Nama and are not offering any solutions to the porblems Nama is supposed to tackle, I can say the following:

I stand by my original estimates of losses expected from Nama. Alan Ahearne's quoted figures are based on thin air, as Dr Ahearne has failed to produce any evidence to support his assumptions or estimations, while my (and Brian Lucey's) balancesheet for Nama has been in public domain and under public scrutiny for over two months now,

Points raised by myself, Brian Lucey and Karl Whelan (and some others as well) about the lack of safe guards, stop0loss rules, transparency, accountability and ownership of Nama and its assets are not academic, they are as real as Dr Ahearne's salary in the employment of the Minister. Nay, they are actually more real, because families who will be paying for Nama deserve to be the rightful owners of Nama assets and deserve to have full access to Nama operations,

As far as I know, neither Dr Ahearne, nor his masters have offered any, I repeat, any clarifications as to the amendments they plan to propose for Nama legislation. In contrast, everyone can read my proposal for Nama3.0, Karl Whelan's proposals for changing Nama legislation, Patrick Honohan's ideas on how Nama can be fixed and altered, and so on. None of us have been paid for doing so, unlike Dr Ahearne who, having not failed to accuse us all of being 'academic' has (a) called us 'colleagues' (surely this makes his musings on the subject also 'academic', and (b) has managed to produce no new ideas on Nama beyond what his masters produced in the proposed legislation.

I am having a very hard time understanding how myself and other independent observers of Nama can be labelled 'academic' when the questions we raised about Nama are both immediately relevant to the issue of Nama operations and are countered from the opposing side by the nonsense of unsubstantiated numbers quoting and references to us 'not appreciating the complexities'?

Here are couple of questions sent to me by one senior policy person in Ireland with my quick replies to them:

Q: Apparently, in one of the debates, a pro-Nama person suggested that Banks nationalisation cannot occur before Nama is paid for because, while the ECB will do the swap for Irish government bonds as a reasonable discount, they will not give the same deal for a nationalised bank. Or if they do help us, they will insist on their pound of flesh i.e.they will do an IMF on us and we will lose all economic sovereignty. My questions about that are... a) is that really true...

A: It is true in so far as the ECB lending window is for private banks that are solvent. However, it is a technicality, since the ECB will have to offer lending facility to the governments as well. It simply has not been confronted with such a prospect before, but hey, there is always a first one.

b) if Irish government put their shares in Trust for taxpayers as per Nama3.0 - hey presto no link to government - does that get over ECBproblem?

A: Yes, it does, further, recall that I have argued that (steps 3 and 4) the Government can provide for private ownership diluting its own share holding in the banks, so the banks will be owned by a trust (Nama), plus two large groups of private investors, with the Government nowhere to be seen. We can even go further and include as shareholders in Nama some developers/investors by offering them shares in Nama in return for equity in their development projects written against the loans.

Economics 25/08/2009: Mad Maths at Nama

This might come as no surprise to those of you who have been in Ireland over the last few days, but it still btohers me - a week later. Nama is hiring specialist(s) in derivatives management and pricing to take on complex engineered products that the Banks have on their books.

Now, I know we have serious excellence in the ranks of our public sector and we have promissed ourselves to build on it even further. After all, DofF does excellent job in forecasting receipts and expenditure outlays - year after year, even when the trend is so strong, just adding GNP growth factor to last year's returns and then double that to last year's expenditure would do a better job than the entire DofF 'forecasting' team. And our CBFSAI does an excellent job watching the evolution of major fundamentals affecting the financial stability (it took them until the late 2007 to officially notice that the housing market might be in trouble and that construction sector has actually peaked - despite the fact that construction stocks data actually shows a break point in 2005 - full two years ahead of CBFSAI noticing it). And so on... but

The 'but' part relates of course to the fact that Nama-bound derivatives and complex intruments written against loans and real estate development ventures that are polluting our banks books are soooo toxic, I would compare them to a Chernobyl reactor just after the meltdown. The rest of Nama loans will be medical toxicity-levl stuff, compared to the serious s***t based on securitized underlyings. Nama taking these on will be equivalent to the Soviets sending unprotected troops into Chernobyl reactor to manually remove the fuel rods (they did do that).

This, of course, warrants a revision of our balance sheet totalling expected Nama losses. Once we have a clearer view of these derivative instruments extent, we will have to write them down to 'zero' real value, for I suspect there can be no recovery on secondary lending that was extended on collateral with real current value that has fallen 70-80% in the crisis.

Given speculative reports that Nama will buy into some Euro40bn worth of this stuff, I would say that a clear expected loss on this share of Nama purchases should be in the neighbourhood of
40bn*[Prob(recovery in default)*Prob(default)+(1-Prob(default))*Recovery Rate (No default)*Share (Deriv at recovery)]
Using UK and US data,

• Prob(recovery in default) = 8-11%
• Prob (default)=25-30%
• Recovery rate=40-50%

40bn*[(2%-3.3%)+(28%-35%)]=Euro12-15bn

So total expected recovery on Euro40bn in derivatives to be bought by Nama is around Euro5-7bn, implying the total expected loss on Nama should rise, under the best case scenario, from previous Euro13.4bn to Euro27-30bn over the life time of Nama...

Now, to warn you - these are back of the envelope calculations, and I will re-run full balance sheet to get more exact numbers. But you can already see where this Government is heading - another reckless and completely immoral sell-off of the taxpayers in exchange for a quick fix that has not worked anywhere else before.

Economics 24/08/2009: Alan ''Please read me!!!' Ahearne

The hilarity of a personal Ministerial Adviser sending an article defending his masters' views to a Sunday newspaper was not enough for Alan Ahearne [see that story cover here]. Never mind his article addressed not a single point of criticism levied against NAMA. Alan actually had to send out an e-alert [well, of some 979 words that is] to a list of his "colleagues". The email implored them not to sign up to an article critical of NAMA until they read his own article published in the Sunday B-Post. Given the fact that the said article had no useful information content regarding any potential or alleged NAMA problems, it is hard to imagine why Alan would actually publicise his own "efforts" with Irish academics. Then again, he might be simply keen on publicising his own efforts full stop.

Alan clearly forgot three major things in that email:

1. He failed to include in the email recipients list the names of anyone actually critical of NAMA - surely a majour omission if his intent was to convince us to take another look at NAMA in light of his, then, forthcoming major contribution to the debate;
2. He failed to notice that since he became an employee of the Minister for Finance, he is no longer an academic, so sending an email to academics and saying "Dear colleagues" should really be slightly offensive to the academics, assuming they are really valuing their independence from the political interference (which is, of course, now fully embodied by Alan's position);
3. He failed to provide any real substantive arguments disproving NAMA critics' main positions.

So here we go - two pieces of work by Alan Ahearne, some 1900 words wasted between the two, and not a single coherent point of defense again NAMA critics... Gotta be a record for someone paid to do this kind of work, don't ya think?

Economics 24/08/2009: Oil and Gold – an imperfect hedging tango

In the last bout (right before the collapse of the financial markets in Autumn 2008) much of the inflation was driven by the rapidly rising commodities prices. These prices were in turn linked to the price of oil. Thus, one can naturally think of oil as an inflation hedge. In contrast, the traditional inflation risk management instrument – gold – has hardly kept up with oil prices in the short run back in 2008. So there is a natural question that arises in this context – which is a better inflation hedge? Well, for each month in 2008, in year on year (yoy) changes, oil actually beat gold as a counter-inflationary asset. Only this year have gold and crude exchanged places. But this is optics.

First, both gold and oil prices show some serious medium range inter-annual volatility. This volatility is driven by speculative motives, but also by real demand for oil as a storable commodity that is an input into physical economy. So to abstract away from seasonality and active speculative trading, consider both commodities prices in terms of annual averages. Setting 1968 price index for gold and oil to be equal 100, and adjusting for inflation, chart below shows that both commodities are way off their historic highs and that even in 2008 the two commodities were nowhere near their long term maxima when it comes to a cumulative appreciation since 1968.

Pre 1970, average price of gold ranges around $38-39. It peaked in 1980 at $615 and then got stuck in the flat until 2007 when it breached the 1980s high in nominal terms. The average price of gold was $872 in 2008. Similarly, crude peaked at an average price of $91 a barrel last year. But despite nominal appreciation, oil is still way below its inflation-adjusted highs. Ditto for gold. To do this, gold needs to be at nearly $1,610 and oil at $98-100 per barrel. These are steep, but just how steep? Well, for oil this means roughly an 8% appreciation on 2008 annual average. But for gold this implies a whooping 84% appreciation on same benchmark.

Now, in annual terms, average annual inflation since 1968 was 3.6%. Median annual return to gold exceeded CPI by 1%, while oil did the same by 1.7%. So cumulative gain for oil in real terms since 1968 has been around 96.3%, and for gold it was almost a half of that, or 48.9%. Given that oil took a nose dive in 2009 while gold held its ground, long term comparisons suggest that

• Either oil is oversold today and thus has a mean-reverting potential of ca 45% on current prices to ca $105-110 barrel range (chart below shows WTI, $pb)

• Or gold had been under-bought in the historic past and thus has an oil-inflation trend-reverting potential of ca 50-75% on 2008 average annual price (chart below shows gold price in $ per oz, daily close)

I happen to think that both are likely, though in much more moderate terms, with oil heading for $85pb in 2010 and to $95pb over medium term (5 years), while gold heading for $1,050-1,100 range in 2010 and to $1,300 over the medium term. That would imply annualized gains in oil price of roughly 4.8% and in gold price of ca 6.5% before inflation. Thus, assuming a reasonably well-underpinned by the current money creation worldwide inflation averaging ca 3% pa, this would result in oil beating CPI by 1.8% annually, and gold doing the same by ca 3.5% pa. Why?

For two reasons:

1. Oil demand is going to be imperfectly matched to inflation hedging and short term volatility due to supply/demand for physical commodity will be weighing in oil as a hedge instrument in the current environment where investors are relatively jittery about the markets;
2. Gold simply has to catch up with oil over medium term.

One potential downside to this is continued orderly, but nonetheless pronounced disposal of gold holdings by the Central Banks of the more fiscally strained countries and the IMF. Although China and possibly India are likely to start picking up some of the rising supply through ‘private’ or invisible sales from one CB to another, this unwinding of gold reserves will weigh on the markets.

Per short term oil price volatility a recent example is in order. About two weeks ago, the US crude reserves have been reported to have fallen some 8.4mln barrels, prompting a serious spike in oil to $72.5pb. At the same time, gasoline supplies fell by 2.1 million barrels, distillate stocks declined by 700,000 barrels and refinery utilization reached 84% above analysts’ expectations of ca 83% - in a sign of tighter supply.

In medium term (3-5 years horizon) – watch US Oil Fund (USO) for oil.

On gold side, watch the correlation in gold and stocks, with gold tending to max just ahead of stocks lows (note July/August 2008, October 2008, March 2009 and so on in chart above). In my view, we are set for another local maxima to be tested by gold in months before the end of October 2009.