Economics 22/09/2009: Two further Nama points

Updated below:

Global Finance Magazine on the concept of ‘long-term economic value’ of distressed assets (here) and on effectiveness of bad assets purchasing schemes:

“Meanwhile, the passage of the Troubled Asset Relief Program (TARP) into law in the United States failed to alleviate strains in the financial markets...

The TARP empowers the US Treasury to buy troubled assets at heavily discounted prices, well below their long-term economic value. “No one yet knows what price will be paid for the toxic paper, or what the default rates will be on the underlying mortgages,” said Carl Weinberg, chief economist at High Frequency Economics. “

Over time, people will realize that all the underlying mortgages are not defaulting, and panicky market conditions should abate, according to Weinberg. “We have seen this game before,” he says. “In the 1980s highly indebted economies like Mexico, Brazil, the Philippines and Argentina bought back their own debt from panicked small banks at 20 cents on the dollar.”

20 cents on the Dollar, folks? Nama is buying defaulting developers loans (not sovereign bonds) at 79 cents of the Euro!!! I’d rather have Brazil’s and Argentina’s bonds, thank you very much.


Another interesting bit:

Robert Boyer’s paper “Assessing the impact of fair value upon financial crises” published in the Socio-Economic Review, 2007 deals with the expected effects of LTEV application to accounting standards, but the implications of this are pretty much the same for pricing (as in Nama). Boyer concludes that LTEV “gives at each instant a seemingly relevant liquidation value, but obscures the value creation process by mixing present profit with unrealized capital gains and losses. This discrepancy increases with an increased degree of uncertainty, which is at odds with widely held beliefs about the efficiency of existing financial markets. Fair value introduces an accounting accelerator on top of the already present and typical financial accelerator. …If fair value accounting is applied to banks, an extra volatility may be created...” What is this about? Three things, as far as Nama is concerned:

1. LTEV will simply translate future value (capital gains) on assets underlying Nama-purchased loans into monetisable value as if all future price appreciation expected under LTEV can be captured in full. This, of course is a matter of timing (knowing when to sell) and efficiency of sales (having zero cost of selling and no impact on selling price of the volumes of sales that Nama will have to undertake);
2. LTEV neglects to price in the effect of large asset holdings off the market (Nama holding vast portfolio of property-backed loans off the property market), which is likely to depress property prices over the life-time of Nama itself. The end result here – a gross overestimate of future expected prices.
3. As the two points above coincide in timing, they act to reinforce each other – an accounting accelerator occurs.
   

Who says you overpay only once?

Here is the rate at which the Government can currently borrow on a 6-months basis:
Let me explain:

• we can borrow in the form of ordinary bonds at 0.481% for 6 months period. These are convertible at repo window of ECB at a discount of 12% on face value and 1% interest rate. Total cost of injecting €1 into bank balance sheet is, thus, 15.2 cents; or
• we can issue Nama bonds at 1.5% with 5% in subordinated bonds, with banks taking these to the ECB repo window at 12% and 16% discounts respectively, borrowing at 1% against both. Total cost of injecting €1 into bank balance sheet is, thus, 16.4-18.1 cents depending on how ECB risk-weights subordinated bonds.

Cheap money in the Frank Fahey World of Stupid Economics?

Economics 21/09/2009: ECB's penalties?

Updated version (00:42am September 22)

On June 23, 2009, ECB opened bidding for its first 12-month refinancing operation.

Back in May 2009, the ECB announced that it would double the maximum length of time it lends money from six months to a year and in June it set the rate for 12-months financing at 1%.

Last time it applied a longer term horizon, ECB placed 348.6 billion euros in December 2007.

So in the nutshell, 1.5% coupon on our bonds bound for ECB and bearing 6 months maturity is a rotten deal.

How rotten? If we were to issue bonds at the ECB own long term financing facility rate with 12 months maturity. The expected cost of total borrowing over 15 years inclusive of the expected costs of roll-overs and reflective of the expected yield curve for ECB rates will be around €15.4bn. In contrast, current structure of 1.5% pa coupon plus 6-months maturity is expected to yield total interest cost of ca €17.5-18.9bn. Then again, what’s €2.1-3.5bn for the Government that burns through €400mln in borrowing on a weekly basis?

What is interesting is why didn't ECB make a similar deal with the Irish Government, allowing it to issue lower coupon bonds or extend maturity of these bonds or both? One can only speculate, for ECB will never tell one way or the other, but I suspect the answer to this lies within the ECB statement that Nama should not overpay for assets it purchases.

Hmmm... Leni took his plan to the ECB men, saying we will buy €77bn worth of stuff, that includes €9bn of rolled up interest, and we will pay €54bn for it. The ECB men pulled out a calculator and extracted: [€54bn/(€77bn-€9bn)-1]*100%=20.6%. The ECB men stared at Leni in disbelief... "Herr Brian, yor ekonomi iz in truble? Djast less fan 21% dropp in yor properti praicez?" 'Oh," replied Brian Lenihan, "but Frank Fahey School of Economics says you'll give us free money!" And here the ECB men smelled a rat...

Otherwise why would the ECB, amidst quantitative easing exercise, impose sanction-level conditions on our bonds? 6-months paper and 1.5% is worse than what ECB gives money to commercial banks at. Much worse, folks.

Now, ECB is no stranger to being taken for a ride. What is telling is that ECB's reaction to 'abuses' in the past is very similar to its reaction to Nama to date.

Most recently, back in July 2008, both the Australian bank, Macquarie Group and the British building society Nationwide have used their Irish subsidiaries to upload hundreds of millions of dodgy ABS packages (in the case of Macquarie, €455mln was borrowed against the most ridiculous collateral –Australian car loans) at the ECB discount window.

On September 4, 2008, ECB’s President, Jean- Claude Trichet stated that he will make it more expensive for banks to borrow from the ECB against most asset-based securities, starting from February 1, 2009. Amidst the crisis gripping European markets at the time, ECB raised `haircut' on the securities it allows to be used as a collateral for 12-months borrowing from 2% to 12%. Additional 4.4% were to apply to paper with no immediate market price.

Note, Irish haircut on bad debts is in effect just below 21% - not that far off the haircuts applied by the ECB (16.4%) on lending backed by much more robust collateral (average European mortgage-securing assets - i.e prperty markets - are down single digits across the entire crisis) than dodgy Irish development projects (down 60-80% and some down 90% in value and falling). When ECB haircut on unsecured banks bonds is added, the total asset discount that ECB could have applied was in excess of 21%. But what is even more significant, the value of the underlying assets accepted by the ECB is supposed to be calculated as the market price less the haircut.

Again, this stands in contrast to Nama which is taking not senior bonds, but ordinary loans, and which is using farcical long-term-economic-value 'pricing', not current market prices. Despite this, Nama haircuts are just 20.6% (once rolled up interest is accounted for) on lower grade assets than the ECB would consider at its window…

No wonder they won’t let Ireland issue bonds with a coupon of 1% or less with 12-months maturity - as would be consistent with a rating on par or better than that for commercial banks. In effect, contrary to the assertions of Brian Lenihan, it is now clear that the 1.5% for 6-months paper deal is far from being endorsed by the ECB. Instead it is a reflection of ECB’s unease with the details of Nama plans. All in, the ECB is now applying nearly as strict terms to the Irish Government Nama bonds as it does to private sector bonds issued by less than thriving European banks.

In July 2008, before changes were announced, the ECB run two-tier pricing system, whereby haircuts of 0.5-5.5% applied to Government paper against the key ECB rate of 4.25%. Mortgage-backed securities – especially Spanish and Irish ones – incurred 18% haircut. Now, do the maths – the spread of 0.5-5.5% haircut on 4.25% lending rate implies the cost of capital of 5-10% for government bonds collateral and up to 24% for MBS. Since July 2008, Irish property markets have fallen by over 12%, so the same collateral rules, that were described by analysts as being loose back in 2008 would require a haircut of ca 27% at the very least, for 1-year long holding period. Again, Nama is implying a haircut of 20.6% on a 15-year holding period.

27% cut held over 1 year was a ‘loose’ condition that had to be drastically revised by the ECB, but 20.6% shave on 15-year holding is deemed by the Irish Government to be reasonable? Who do they think they are foolin?

Another interesting note: following the expression of it dissatisfaction with ‘loose’ borrowing by Spanish and Irish banks, the ECB started quietly talking to the banks urging them to fall in-line. Exactly the same has happened when the ECB issued its thinly veiled directive to Leni – ‘do not overpay for Nama assets’…

Economics 19/09/2009: Nama, bondholders and shareholders

Setting aside, for now, the issue of who subsidises who in Nama, a quick note on opportunity cost of the undertaking when it comes to the structure of Irish Financial Services in general.

June 2009 paper from a group of US and Canadian researchers, published for the European Finance Association, 2009 meeting (here) provides an interesting read. The study delivers "...a comprehensive analysis of a new and increasingly important phenomenon: the simultaneous holding of both equity and debt claims of the same company by non-bank institutional investors (“dual holders”). The presence of dual holders offers a unique opportunity to assess the existence and magnitude of shareholder-creditor conflicts. We find that syndicated loans with dual holder participation have loan yield spreads that are 13-20 basis points lower than those without. The difference is even greater after controlling for the selection effect. Further investigation of dual holders’ investment horizons and changes in borrowers’ credit quality lends support to the hypothesis that incentive alignment between shareholders and creditors plays an important role in lowering loan yield spreads."

Without giving too much technical detail, the study effectively says that inducing greater share of bond holders to also hold equity (or vice versa) results in lower cost of credit to the firm.

Now, recall that my Nama3.0 or Nama Trust proposal (here) has, as one of the first conditions for taxpayer bailout, a full or partial conversion of Irish Banks' debt holders into equity holders. This would have achieved two positive outcomes simultaneously:

1. reduce demand for taxpayer funds, while assuring that some private markets trading in banks' equity will remain post-Nama Trust implementation; and
2. per above study, lead to a long term improvement in the cost of liquidity for Irish banks.

Incidentally, the third net positive impact of such conversion would be effective risk-sharing, as bondholders will be given a direct stake in the Nama process, something that is not even attempted in the current 'risk sharing' proposals on the table.

Economics 18/09/2009: An Illustration to the Idiot's Guide to Economics

Per chart below, average monthly bond spreads for Irish Government 10-years paper for the last 8 months.We've read Brian Lenihan's lips and here is what he said:

August 2009 (here): "The proposal to establish a National Asset Management Agency has been widely supported internationally by bodies such as the IMF and the OECD and tellingly since
the announcement of the establishment of Nama in April, bond spreads above the German benchmark for Irish sovereign debt have halved, from almost 3 per cent over 10 year German Bonds to now just 1.5 per cent. Irish 10 year bond yields are now 4.8 per cent."

August 2009 (here): "Indeed, during May I had to undertake a tour of EU financial centres to correct misinformation that existed about Ireland. This tour had a positive impact and there has been a significant reduction in the spreads on the State’s borrowing."

Plenty more to be found in the same vein. So per chart above, we've read your lips, Minister and... they produce gibberish so far. As I have remarked on many occasions, Irish bond spreads decline was

• in line with other countries (and in particular - with APIIGS);
• had more to do with the global change in appetite for risk and little-to-nothing to do with Minister Lenihan's decisions or policies;
• lastly, per chart above, while Minister Lenihan was trying to sell his disastrous policies to the nation on the back of declining bond spreads, Ireland has moved from the already dubiously distinctive position of being the second most screwed up economy in the Eurozone after Greece prior to May 2009 to being the worst economy in the Eurozone in terms of its bonds spreads over German bund since Minister Lenihan (per above quote) undertook his courageous road show to Europe.
  

Per one observer comment on this: "we are now the largest pig in the APIIGS pen" - welcome to Lenihanomics?

And on a funny note (credit here)and courtesy of bocktherobber :

Economics 18/09/2009: hard numbers for our delusional leaders

Retail sales for July gotta be hard read for our delusional leaders (here).

Per CSO release today: "The volume of retail sales (i.e. excluding price effects) decreased by 15.0% in July 2009 compared to July 2008. There was a monthly increase of 0.2%... partially explained by the increase in new motor sales in July 2008 that coincided with the introduction of the new VRT system." Ex Motor Trades retail sales decreased by 6.2% in July 2009 compared to July 2008 and fell -0.7% in monthly terms. Things are getting worse once again, after a short reprieve of June.

A good summary above (from Ulster Bank economics team). Food, Bars and Other Goods improved in monthly series, everything else is tanking. But all three categories of 'improved' goods are about people staying at home instead of leaving for a vacation, so here we go - have a sandwich and a pint instead of a break - Lenihanomics at work.

Few charts below (back to my favorite hobby):

It is worth noting that, of course, changes in our retail sales = changes in our VAT receipts. This said, can you spot where the 'No New Taxes' Lenihan's statement yesterday can be supported here?

Economics 18/09/2009: Idiot's guide to the Galaxy

One of my favorite books in the Universe, The Hitchhiker's Guide to the Galaxy has been surpassed, if only momentarily, by a publisher in Ireland producing this superb Idiots' Guide to Science and Economics. Behold, the front page of today's Indo:
Of course, Mary Coughlan's theory of Relativised Evolution or Evolutionised Relativity and the absolutely unfortunate nature of the venue at which she managed to live up to her well-deserved name 'Calamity Coughlan' are straight out of the chapter 'National Embarrassment Exemplified'. It is a serious public blemish on an otherwise worthy event of IDA launching a serious campaign to attract more FDI into Ireland that I wrote about before (here). No need to detail much here, Indo's article speaks volumes, one can wonder now as to what evolutionary process can lead to the emergence of the species so ignorant of basic knowledge as Mrs Coughlan. One note worth making - the fiasco perfectly exemplifies Kevin Meyers' excellent argument in the same paper today (I might not agree with it myself, but Mrs Coughlan has made his case iron-clad).

But Brian Lenihan's lack of grasp of simple realities of public finances and economics is as breathtaking as Mrs Coughlan's lack of basic erudition. After weeks of being fed drivel of FF backbenchers' and hacks' version of economic ("Nama bonds are not debt", "We will get cheap money from ECB", "ECB supports us" etc), it seems our own Finance Minister got convinced that there is such a thing as a Free Lunch. Per Indo's article here, Lenihan "gave his firmest pledge yet that there would be no tax hikes in the December Budget. And Mr Lenihan challenged anyone who doubted him to "watch my lips"... Mr Lenihan said he was committed to introducing a carbon tax... But he gave his clearest indication yet that the Government would not bring in a property or water tax this year. "I am not aware of any other (new tax hikes)," he said.

Ok, three Indo reporters (including senior ones) failed to actually query the details of this statement the Minister made. But the very fact that Lenihan actually said what he did is a testament to the fact that this Government has no real financial brains in the Cabinet at the time of fiscal and financial crises. None at all.

Per statement itself, Minister Lenihan obviously does not consider introduction of the Carbon tax to be a new tax. Presumably, he lived so long outside the real world, in the world of chauffeur driven Mercs and vast taxpayer-paid perks that he might be under the impression that Carbon tax already exists, so 'introducing' it will not constitute an imposition of a new charge on taxpayers.

The Minister also indicated that he has seen no other tax proposals (other than the Carbon Tax and Property Tax). Has he read his own Commission for Taxation voluminous report? Or has it escaped his field of view as the Lisbon Treaty volume had escaped Brian Cowen's view earlier?

Finally, the Minister has to be living in the surreal world where a €20bn-plus shortfall between tax receipts and liabilities can be covered by something other than taxes. Indo's journos refer to the possibility of €4bn savings on the expenditure side as the means for avoiding new taxes. Have they done a simple sum ever before? Has Minister Lenihan done a simple sum ever before?

Even if the Government does deliver on €4bn in savings, and even if part-year measures announced in April 2009 budget continue through the full year 2010, the entire savings will not be able to cover a quarter of the fiscal spending gap. If the Government commits to fully ending all capital expenditure in 2010 and if the economy grows by 5% in 2010, the expected fiscal gap will still be in excess of €8bn in 2010.

This money will have to be borrowed in the international markets. The roll-over of a vast sea of short-term debt issued in 2008-2009 will have to happen. Is Minister Lenihan really buying the idea that these state liabilities - some €30bn worth already accumulated, plus Nama's €54bn expected plus the ones awaiting NTMA's printing press on the back of long term unemployment increases into foreseeable future can be 'deflated' away at the current rates of spending and taxation without raising new taxes?

Well, only in the world where Einstein authored On the Origin of Species, perhaps?