Economics 13/05/2010: AIB's IMS blues

AIB released its Q1 2010 IMS statement:

• It will issue 198m shares to the Government in lieu of a €280m preference coupon it will not be paying (remember the stockbrokers and the Government argued that this coupon payment will be a handsome return on our ‘investment’ in AIB?).
• AIB, subsequently will be in for an 18.6% Government stake in the bank.
• Some analysts are saying that the lack of dividend is due to AIB being precluded from paying cash dividends on debt instruments while its business case was under review at the EU.
• I would say that this represents a convenient excuse. In reality, AIB simply cannot afford a €280 million pay out, given its funding conditions and given its capital requirements.
  

There is more farcical stuff in the IMS. AIB claims that while trading conditions remain challenging in Ireland, its UK (ex Northern Ireland), Polish and Capital Markets operations are booming. Ooops, the very family silver that AIB is going to sell to cover its bad loans in the Republic is still the only set of assets that have any positive value in AIB.

IMS confirmed that AIB will need €7.4bn in new capital, and that this based on Nama discount expected to average 45%. As AIB is shifting €23bn of the bad and the outright ugly loans to Nama, this discount might change. So no speculation here…

Aside from speculation, if AIB is hoping to get some dosh for its 22% stake in the US M&T, worth estimated $2.3bn. If this target is achieved (a big if, given that large placements like these would probably attract some discount) the sale can deliver new capital of €900mln. The target for capital raising then moves to €6.5bn. Selling Polish holdings will provide maximum of €2.4-2.6bn, assuming euro holds against zloty and assuming a discount of no more of 10% on block sales, inclusive of commissions. Of course, this means that AIB will have to write down its book value on the asset side, so that the net gain is likely to be around €1.2-1.4bn to capital side.

Which leaves us with a hole of €5.1-5.4bn to plug. The UK side of business is a sick puppy, unlikely to yield any net gain on risk-weighted assets side, but let’s be generous and give it €500mln of value. On the other hand, AIB investors are raking the dosh in… well, not really. I would expect the bank to be able to sell something to the tune of €1.2bn worth of equity at the most (its current market cap is €1.22bn as of yesterday close price). Suppose this is the net (although discounts might imply much shallower rate of capital raising). Will the Exchequer be required to pump in another €3.4-3.7bn into AIB?

But wait, this is hardly a final number. Remember, so far AIB has been assuming (in its impairments provisions) that the 2009 performance will continue into 2010. It sounds conservative, until you actually pause and think. There are serious lags on some assets deterioration and on recognition of impairments. These lags are driven by two major factors:

1. On households and corporate loans side, impairments take time to build up. For example, an average unemployed person with job tenure of 6 years would have gotten around 36-42 weeks of redundancy (factoring in tax relief) when they lost their jobs back in the H1 2009. They might have had savings. At an average rate of saving of 5% of annual income over 6 years, that would add up to 30% annual income or another 16 weeks worth of income cushion. Again, net of tax the cushion rises to ca 19 weeks. This means that any serious distress on their mortgages will show up around 55-61 weeks after the layoffs. Guess that pushes the dateline for major stress on mortgages only starting to manifest itself to around May-July 2010.
2. Much of the non-Nama book of commercial and development lending that will remain with AIB has been rolled up, redrawn across covenants and so on. How long will it take for these to come up for another appraisal? I’d say on average 12-24 months. So look back at 2008-2009 loans that were non-performing then and were rolled over for 12-24 months. These will start flashing red once again sometime around 2010-2011.
   

Neither (1) nor (2) is provided for (as far as risk capital goes) under the current €7.4bn new capital requirement. By the time the demand on these hits, AIB will have no assets left to sell. Then what?

How I know that AIB is once again has its head stuck in the sand on future impairments? Well, this morning’s IMS tells me as much. For its non-NAMA loans, AIB is expecting bad debt charges to be matching 2009 rates. IMS says that bank’s €27bn residential loans book is continuing to perform “better” than the sector averages (as if there is any meaningful average here to be had). And significantly it says that residential bad debt charges are currently not significantly different from 2009. The non-NAMA exposure to property in Ireland will be €12bn of which €9 is investment and €3bn land and development. These are still material at this stage, as any further writedowns on this part of the book are going to hit capital base again.

On the macro side of its balancesheet, AIB is still going to be a sick bank with loan to deposit ratio declining from a severely unhealthy 146% to a still unhealthy 124% post-Nama. And this is really rosy, folks. And the cost base and margins are unlikely to improve. Take for example deposits costs – AIB’s IMS highlighted the reality of high cost of attracting new deposits. Wait till Government starts hovering dosh from the punters through the new Post Office bonds. Supply of deposits will drop. And then, wait for the ECB to cut its discount window operations again, should things improve in the euro area funding markets. AIB, alongside BofI, is heavily dependent on being able to roll the collateralized borrowings from ECB. AIB’s term funding as a percentage of wholesale funding is massively up from 30% in December 2009 to 41% by end Q1 2010, reflecting a €6bn of issuance.

So can anyone explain just how on earth can AIB escape a de facto nationalization?

Economics 12/05/2010: How not to do austerity...

How not to do austerity? Well, Ireland is a good example.

For all the tough talk about reforms and changes to spending habits of the public sector, the new employment in civil service document released two weeks ago, drawn up by the Department of Finance envisions that staffing levels will fall from 37,376 estimated for the end of 2010 to 36,594 at the end of 2012. That’s a whooping (or in terms of SIPTU/ICTU savage) drop of 782 workers, or less than 2.1%. The resultant savings, assuming jobs cut will be at the media level of pay for the civil service, will total a massive €39.41 million per annum. Translated into our public sector’s spending habits, that’s about 16 hours and 20 minutes of our deficit financing for the first 4 months of this year. Not counting the banks costs.

The Government has told the nation before that the new public service pay and reform deal negotiated with unions at Croke Park last month will "substantially" reduce the number of State employees over the coming years. Hmm... guess 2.1% is philosophically ‘substantial’, even if not economically substantive.

But wait, these are gross savings, pathetic as they might be. To get to the net figure, we must factor in early retirement incentives doled out to civil servants by Brian Cowen in Supplementary Budget 2009 and golden handshakes for voluntarily leaving staff.

So take a rule of thumb - the cost of laying off civil service workers ranges around 15-20% of their total annual salary per year of service – once the value of pensions and redundancy payments are factored in. This is very, very much conservative, given the one-off payments and other perks accruing to retiring public sector workers and given that their tax liabilities collapse upon the retirement, especially over the first year. Take 15% on the lower end and assume that average tenure of the workers leaving the service is around 15 years (lower-end assumption as those taking early retirement would more likely to be more senior than that).

What do you have? The cost – and not all of this obviously will hit the taxpayers at one single shot, but most will – will be around €133,400 per worker reduced. And that’s at the lower end.

Savings of €50,294 per annum, at a cost of €133,400 means that given our Government’s innate inability to manage its own workforce, the first time we, the taxpayers, will see positive net savings on the deal (assuming opportunity cost of funds at 5% and automatic stabilizers on the salary payments to public sector workers at 30% - income tax, levies, etc - none of which are going to apply under voluntary retirement) September 2015!

I am not kidding you – September 2015! By which time, of course, the Unions would have forced the Government to get a new Benchmarking going…

Folks, we are now truly turning the corner!

Economics 12/05/2010: How to do fiscal austerity... 2

Ireland, Spain and Portugal currently represent a major threat to the credibility of the euro, according to a number of observers, ranging from the FT to RBS. Not because of their public debts, but because of their deficits. Spanish and Portuguese deficits are expected to hit 11.4% and 9.2% respectively this year. Irish - anywhere between 11% and 18%, depending on how much of the banking liabilities will be covered by the Government. These levels are more than double Italy's deficits and almost double those of the Eurozone as a whole.

Moody’s are now talking about downgrading Portugal and Greece to junk status.

If you look at the countries that are really getting it right - Ireland is not at the races. So far we have seen largely cosmetic reductions in the deficit. As of April 2010 results, the deficit is down 4.86% year on year and up 86% still on the same period of 2008. Worse than that - most of this undramatic cut between 2009 and 2010 was achieved by reducing capital spending. Which means the cuts are not structural and we are rapidly running out of room for any future improvements.

I wrote yesterday about Bulgaria (with 1/4 the size of Irish deficit levels) slashing its public spending by 20% and hitting hard pensions and wages in the public sector (here). I forgot to mention Latvia - assisted by the IMF loan back in 2009 (USD10 billion) - cut public sector jobs by 20% and the remaining public servants took a minimum of 25% pay cut.

Replicating these cuts in Ireland, however, would only be a beginning of the process of restoring public purse to health - we need to shave off 39.5% of our ongoing spending (as of April 2010) figures to bring our finances into balance. The cuts will have to add up to 36% in order to get us down to the Growth & Stability Pact level of acceptable deficit.

At this stage, with Croke Park deal done, and with economy unable to pay much more in added taxes, and the banks still begging for money, the Government has simply run out of any options.

Economics 11/05/2010: Exchequer figures - no real relief in sight

You have to feel for some of our desperate cheerleading squad of ‘analysts’ who toil for some of our banks and stock brokers. These folks are clutching at the straws trying to find something to cheer about. Case in point – latest data from the Irish Exchequer, which was heralded as showing ‘stabilisation’ and even ‘improvement’ in ‘funding conditions’ and ‘headline deficit’.

Putting aside the fact that most of these analysts have no real idea what these terms really mean (and in some cases, neither do I, for they mean preciously nothing in the real world of economics), the fault in their logic is an apparent one:

They say: ‘Irish exchequer receipts are finally coming closer to the Budget 2010 projections. Therefore, things are improving or stabilising.’

I say: ‘Statements like this are pure bollocks, folks. Just because DofF has finally caught up (somewhat) in its forecasts with reality, does not mean reality is getting any rosier.’

Here is the evidence that I am correct. Forget the Exchequer forecasts, and look at the actual data.
Chart above shows that:

• Irish Exchequer tax revenue in April came in below the downward linear trend established since January 2008, which means that we are still returning tax receipts at below 2008-present average rates. Long term, things are still sliding down.
• Irish Exchequer total receipts fared better than tax revenue, but that’s because the Exchequer has managed to squeeze more out of the likes of the semistates. Don’t be fooled – the semistates do not create their own money. This is just a hidden tax on us all.
• Total expenditure, despite all the fanfare from the ‘analysts’ is heading up, and is now above the trend line again. Which (the trend line) is upward sloping. This means that long term trend is still rising for our public spending, and that we are on a seasonal upper push in public spending.
• Thus, our Exchequer deficit has gone up in April, and it did so at a rate virtually identical to April 2009. Long term deficit is still upward moving and we are now above the long term trend once again.

Translated into cardiology, the patient now has an accelerating erratic pulse reaching beyond the norm, and continuously falling blood pressure. Just as Good Doctors Brian & Brian are talking about discharging...

To see if things are indeed improving (or stabilizing) as our ‘analysts’ suggest, let’s put back to back receipts and expenditures for the last three years in one chart:
Clearly, our total Exchequer receipts (and recall, these are boosted by abnormally higher non-tax revenue) are now below those for April 2008 and April 2009. Indeed, only once so far in 2010 have receipts rose to above corresponding monthly levels for 2008 and 2009 – back in March, when the Exchequer booked some of the backed receipts on VAT, VRT and Excise.
Chart above shows that the Exchequer did indeed achieve some reduction in spending in April 2010. But,

1. Good ¾ of these savings came from reduced capital investment cuts
2. Cumulative savings for the first 4 months of 2010 are so far €1.346 billion, implying an annualized rate of savings of €4.035 billion. Over the same time, cumulative losses in revenue were €990 million, implying an annualized loss in revenue of €2.969 billion.
3. So we are looking at (omitting timing consideration) net savings on 2009 of €1.1 billion. This would be a reduction of just 4.3% out of an annual deficit for 2009, or related to GDP – a reduction of roughly 0.6% of GDP. In other words, all the ‘right decisions’ taken by this Government are currently looking like being able to reduce or 14.3% 2009 deficit to a massively ‘improved’ 13.7% deficit? And that’s assuming that the Anglo support this year will only impact the deficit by the same €1.5 billion as last year…
   

This miserably low level of achievement in our battle to restore Ireland to solvency is, of course, fully visible in the above chart, once one considers the Exchequer surplus performance.

Economics 11/05/2010: How to do fiscal austerity...

An interesting example for Ireland?

Two weeks ago, Eurostat confirmed that Bulgaria's deficit stood at 3.9% of GDP. A crisis was, therefore, unfolding in the Black Sea nation. The Bulgarian government decided to act and on the 5th of May it acted to drop public sector spending by 20% to reduce its budgetary deficit. The Government adopted an update to its 2010 budget in which spending on the part of State organisations, ministries and other public institutions is to be reduced by 20%. Flat cut across the board, with separate budgetary entities deciding on how the cuts should fall.

Clearly Bulgarians have not heard of the Croke Park 'deal' that, according to the Irish government, will help to stabilize Irish deficit (per my estimates, around 7% of GDP by the end of 2014, should all Croke Park-agreed provisions remain in place).

I will be blogging later today on the latest Exchequer results - which, recall, were received well by the banks' /stock brokerages' economists, cheering the fact that 'Exchequer revenue is now on target', without actually asking themselves the more important question: what is this target implying in terms of our solvency.

Economics 09/05/2010: Abandonning the ship of fiscal reforms

Here is an unedited version of my current article in the latest edition of Business & Finance magazine.


After two years of frantic crisis management by default and piece-meal recapitalizations, last month, the Irish state has fully committed to an outright dumping of public and banks debts onto the shoulders of the ordinary taxpayers. Since the onset of the crisis in 2008 through 2014, based on the latest Budgetary projections and banks recapitalization plans, the Government will consign ca €221 billion liabilities onto Irish workers, businesses and entrepreneurs. This figure, adding to a whooping €234,000 of new debt per average household with two working parents, is the toxic legacy of our crony corporatism.

Consider the banks. Minister Lenihan’s announcement made on Super Tuesday in March means that over the next two years, the Irish taxpayers will foot a bill of some €37 billion in direct capital injections to the banks. The interest on this bankers’ loot will add up to another €12 billion over 10 years. Nama will contribute the net loss of up to €30 billion to our woes. This comprises the costs of loans purchases, bonds financing and Nama management and operations, less the expected recovery of assets and the cash flow from the undertaking. When all is said and done, Irish people will be left with a gargantuan bill of almost €80 billion for rescuing the banks, not counting tens of billions of written-down loans and ruined businesses.

If you doubt this figure, look no further than the numbers released to accompany Tranche 1 transfer of assets from the banks to Nama. These show that having paid €8.5 billion for the first instalment of loans, Nama financial wizards managed to overpay €1.2-3.1 billion compared to the actual value of the loans. On day one of its operations, therefore, Nama has managed to put the taxpayers billions deep into the negative equity. Minister Lenihan’s choice of the cut-off date of November 30, 2009 for Nama valuations implies that Irish taxpayers stand to lose over €1.5 billion on top of all other previously forecast Nama losses. This addition is a pure waste, as there is absolutely no logistical or economic reason for setting such a date in the first place.

In the mean time, taxpayers’ representatives – from our ‘public interest’ banks’ directors to legislators – continue to insist that Nama is a profit-making opportunity for the state. In a recent encounter with myself on a national radio programme, Darragh O’Brien TD who acts as a Vice-Chair of the Public Accounts Committee has gone so far as to claim that under Nama, the state will be borrowing money from the ECB at 1% and lending it to the banks at 3%, thereby earning an instant gain of 2% on the transaction. The fact is according to Nama own documentation it will be the state who will owe the banks an annual coupon payment at the rate of euribor (currently just over 1.2% for a 12 month contract). This rate will be resettable every 6 months, so looking back at historical data, Nama cost of borrowing can easily go to 4.9% - the euribor level back in 2007 or even higher. Since the banks will be holding the bonds they, not the Exchequer, will be collecting the interest payments. The Irish taxpayers, therefore, can potentially be on the hook for an additional €2.6 billion subsidy to the banks in the form of coupon payments on the bonds.

My estimates of the overall debt burden imposed by the banks onto the taxpayers are erring on a conservative side. The latest figures from the Central bank show that the entire Irish banking sector, inclusive of non-Guaranteed institutions, holds a balance of just €226 billion in customers deposits. Assuming that some 10-15% of these deposits are subject to customer demand in any two weeks period, risk-adjusted customer deposit base of Irish banking sector is roughly €192-203 billion. This is offset but loans to customers amounting to €609 billion, plus bonds in the amount of €73 billion, and short-term ECB deposits of €78 billion. Thus, the ratio of debt and short-term obligations relative to customer deposits in the Irish banking sector currently stands at more than 323%. Liquidity risk-adjusted, this figure rises to 400%. In comparison, UK’s Northern Rock had 306% loans to customer deposits ratio at the peak of its solvency crisis in 2008.

So the entire recapitalization fiasco, coupled with the continued stream of disastrous news from the Anglo and the spectacular collapse of the INBS, should have taught us one simple lesson – people who are in charge of the banking crisis management in this country are either unaware of facts or are willingly distorting the reality.


However, for all of its publicity, the banking crisis pales in comparison with the fiscal meltdown we face. As of the time of going to press, Irish workers and small businesses – the lifeline of our economy – are being held hostage by the ‘deal brokering’ between the Trade Unions and the Government. The likeliest outcome of these talks will be a public sector ‘reforms’ package which will see a deferred reversal of Government intentions to cut wasteful spending. Freezing future pay cuts in the public sector, while pushing forward a naïve (if not deceptive) agenda of ‘improved productivity’ means that while in theory we might get more for each euro we spend, in practice, the overall spending bill will remain well out of touch with our tax receipts. The structural deficit simply cannot be corrected by plastering the expenditure gap over with new work practice rules. Only a dramatic cut in overall spend, plus a significant cut in the numbers employed in the public sector will save this country from becoming Greece-sur-Atlantique.

Looking at the Government own projections for future deficits and factoring in the cost of borrowing, Ireland Inc will have to find some €92 billion from now through 2014. Factoring in deficits cumulated between January 1 2008 and December 31 2009 adds another €37.3 billion, plus interest to the above figure. All in, 2008-2014 fiscal deficits are likely to cost Irish taxpayers some €139 billion based on Government own figures. How realistic these Government projections are is a matter for another debate, but the recent revision of our 2009 deficit from the Government-published 11.7% to 14.3% of GDP by the Eurostat shows that the above estimate of the total deficits-related costs can be even higher. Either way, the fiscal crisis we face is clearly much more significant than the banks crisis.

Having invited the Unions back to the bargaining table, the Government has ex ante turned taxpayers into a bargaining chip that it can (and will) use to appease the intransigent interest groups.

Which brings us back to that top line figure of €221 billion in liabilities that Messrs Cowen and Lenihan have decided to offload from the banks and public sector and onto the shoulders of the ordinary taxpayers. Per CSO’s latest data there are 1,887,700 people in employment in Ireland today. Everyone of these workers – no matter whether currently covered by the tax net or not – will be facing an average bill of some €117,000 for the mistakes made by our past Governments’ public expenditure policies, bankers, regulators and developers.

This is, put simply, an unsustainable mountain of public and quasi-public liabilities. Something will have to give.

Back in 2008, Ireland’s top 11,714 earners (those who earned more than €275,000 in a year), paid almost 18% of all income tax. Forget the fact that many of these individuals are now broke. Doubling their tax rates would deliver less than €10 billion in tax revenue over the next 5 years – hardly a drop in the sea of new public debt being created. Quadrupling taxes on Irish median earners – those with income around €25,000 mark – will yield no more than €5 billion in new revenue through 2014. A full one third of all income earners back in 2008 were outside the tax net. These workers, with incomes below €17,000 per annum, are about to be thrown to the wolves by our policies as the Government sets out to plug the twin budget and the banks black holes. Taxed at the standard rate, they will be in for some €0.9 billion tax burden annually. So where will the rest of €205 billion come from?

In reality, the Government simply cannot avoid hiking taxes on businesses. Budget 2010 forecasts corporation tax revenue to reach €3.16 billion. Doubling the rate of tax to 25% can be expected to yield no more than €12-14 billion through 2014. So even this amount will not correct for the public sector and banks’ debts.

Super Tuesday’s announcements by the Minister for Finance signalled the beginning of an end for the dreams for a better future for this and several subsequent generations of Irish people. Remember when Mr Lenihan asked us to be patriotic in his Budget 2009 speech?

Since July 2007, the Government has shown itself incapable of understanding the nature of the crises we face. The banks, we were told, were suffering shortage of liquidity. This means that replacing dead-weight loans on their balancesheets with bankable quasi-Government bonds will do the job of restarting lending. We now know that the real problem the banks face is that of insolvency, with their balancesheets destroyed by worthless loans offset by hefty liabilities. We were told that the collapse in the Exchequer tax revenue not the excessive permanent spending habits of our State were to be blamed for the fiscal crisis. Now we can see the truth – the Irish Exchequer and economy are facing a problem of insolvency, for not even a restoration of tax revenue to its pre-crisis long-term trend will resolve the problem of excessive deficits.


Box-out
Over the recent weeks, the heated debate about Irish banks’ liabilities has shifted its attention to the elusive bond holders. “Who are, these captains of speculation armada? The sharks of the international financial markets?” some demanded to know. Well, we can’t quite tell you who all of them are, but at least for some of the three big banks’ bond holdings we can tell. These arch-capitalists are… you, me, and the Irish Exchequer. That’s right. Per NTMA own figures, our National Pension Reserve Fund – the pot of gold at the end of the public sector employment rainbow – designed to shore up Exchequer pensions deficit has managed to get its snout deep into the Irish banks bonds feeding trough. In the 12 months between December 2007 and December 2008, NPRF has bought itself into a long position in AIB variable rate bonds - €155 million, Bank of Ireland fixed coupon bonds €205 million, Bank of Ireland variable bonds €35.5 million, hiking its overall exposure to Irish banks’ bonds from €89.2 million in 2007 to €461.7 million in 2008. Given that these long positions withstood the wholesale collapse in banks bonds prices in 2008, this was an incredibly risky bet. Then again, adding up NPRF’s balance sheet exposures to low liquidity, higher risk investment classes, such as unquoted property investments, commodities and private equity, corporate debt in Greece, plus almost €74 million worth of Greek Government bonds, etc, NPRF’s higher risk investments accounted for almost 13% of the entire investment portfolio in 2008, up from 11% in 2007 and 6.3% in 2006.