Economics 15/7/10: European bailout fund - set up to fail?

I thought it is worth sharing few thoughts on a superb article by Satyajit Das"Debt shuffling will be a self-defeating exercise" in July 12 Financial Times (sorry - no link) concerning the European bailout fund. All quotes are from the article, with some of my additions/explanations etc.

European Financial Stability Facility (EFSF) “…structure echoes the ill-fated collateralised debt obligations (CDOs) and structured investment vehicles (SIVs). …In order to raise money to lend to finance member countries as needed, the EFSF will seek the highest possible credit rating – triple A. But the EFSF’s structure raises significant doubts about its creditworthiness and funding arrangements…”

The €440bn bailout fund created a SPV, “backed by individual guarantees provided by all 19 member countries. …The guarantees are not joint and several…”

This means that SPV – an insurance fund against sovereign defaults – is in the need of an additional insurance mechanism against the risk that one or more of the funders fail to pay up into the EFSF. This is achieved by “…a surplus ‘cushion’, requiring countries to guarantee an extra 20% above their ECB contributions.”

One point, not mentioned to Das is that this ‘cushion’ fund is itself subject to risk as a call on the ‘cushion’ will require some states near default to supply even more funding to the fund. In other words, to any of the PIIGS participating in supporting one of their fellow member states, the cost of the EFSF bears a 20% premium reflective of the ‘cushion’. Just how this is going to be feasible for severely financially stretched states remains to unknown. Take one example – for Ireland this would mean that our €5bn exposure to the EFSF is, in reality, a €6bn exposure.

Das focuses on the overall risk transfer within the EFSF arrangement, saying that the ‘cushion’ “is similar to the over-collateralisation used in CDOs to protect investors in higher quality triple A rated senior securities.”

Das puts some numbers on this: “If 16.7% of guarantors (20% divided by 120%) are unable to fund the EFSF, lenders to the structure will be exposed to losses. Coincidentally, Greece, Portugal, Spain and Ireland happened to represent around this proportion of the guaranteed amount. If a larger eurozone member, such as Italy, also encountered financial problems, then the viability of the EFSF would be in serious jeopardy.”

There are other problems with the EFSF. Das notes the issue of ratings migration – the situation where if one eurozone member state experiences problems, then the ‘cushion’ will suffer to the proportion of that member state contribution to EFSF, thus reducing overall insurance pool and adversely affecting overall EFSF ratings.

There is an added and much more severe problem here that no one dares to talk about. If one of the PIIGS experiences problems contributing to the EFSF, then other eurozone states with tight borrowing constraints might have an incentive to ‘run on the bank’, attempting to hover up EFSF funds before they are depleted while simultaneously withholding all contributions to IFSF. First mover advantage here will guarantee a payoff, while staying on the sidelines guarantees at least an up to 120% hit on the member state own funding.

As Das correctly points, “any ratings downgrade would result in mark-to-market losses to investors. …Given the precarious position of some guarantors and their negative ratings outlook, at a minimum, the risk of ratings volatility is significant. This means that investors may be cautious about investing in EFSF bonds and, at a minimum, may seek a significant yield premium. The ability of the EFSF to raise funds at the assumed low cost is not assured.”

So the problem then is that from a political standpoint, EFSF might be borrowing in the markets at 3.5-4%, while lending out to PIIGS at 5%. Should interest rates rise, or inflation tick up, or Euro devaluation continues, the net of costs safety band of 75-125bps can be exhausted very quickly. As the safety band is being eroded, the pressure on triple A ratings will rise, triggering the need for further insurance provisioning. Which can, in turn, put pressure on the troubled states to cut provisions for the EFSS. The EFSF will then turn into a loss-making subsidy generator to the PIIGS.

Germans won’t be too happy to see this. The noises from Germany – the main underwriter of the EFSF will put added pressure on the PIIGS to act fast, increasing a probability of a run on EFSF and triggering ratings pressures once again. Notice that to get to this point won’t require an actual run on the fund – a simple rise in the probability of a run will do the damage.

Das’ superb analysis comes at the end of his article (emphasis is mine):

“Major economies have over the last decades transferred debt from companies to consumers and finally onto public balance sheets. A huge amount of securities and risk now is held by central banks and governments, which are not designed for such long-term ownership of these assets. There are now no more balance sheets that can be leveraged to support the current levels of debt.

The effect of the EFSF is that stronger countries’ balance sheets are being contaminated by the bail-out. Like sharing dirty needles, the risk of infection for all has drastically increased.

The reality is that a problem of too much debt is being solved with even more debt.

The EFSF …may be self defeating and unworkable. The resort to discredited financial engineering highlights the inability to learn from history and the paucity of ideas and willingness to deal with the real issues.”

Of course, much of this criticism is pretty close to heart for Nama - an SPV with even lesser transparency, accountability and capability of management. Irony has it, the SPV has no insurance 'cushion' provisions and instead becomes a direct liability of the Irish state as its guarantor. Then again, we already know this much...

Economics 14/7/10: Car sales: Vanity or Incentives?

Using the same data as in the previous post on car registrations (see here), let’s take a look at the underlying demand for cars and see if this year’s increase in new car registrations is really driven by the scrappage scheme or by the ‘vanity’ effects of 2010 license plates. To do this, I separated cars that belong to a luxury segment (priced above €45,000) from other new cars.

Since demand for luxury cars should be less elastic with respect to scrappage scheme, we can treat the number of new vehicles registered in this category of prices as being a control group – the group that would have seen its demand rising pretty much independent of the scrappage scheme.

The >€45,000 vehicles control group is strongly robust as an instrument for overall demand over 2006-present, as shown by correlations in levels and yearly changes, reported in the table below.

As the first chart below shows, this strong correlation became somewhat reduced during the recession, with luxury cars sales suffering more pronounced declines in absolute levels of sales:
and in year on year changes in levels of sales:

However, as the last chart above shows, luxury vehicles have posted a more significant rise in year on year changes in sales over 2010, than their more price elastic (and thus scrappage scheme elastic) counterparts.

So I estimated two structural relationships between levels and yearly changes in car sales, shown in the two charts below:
Notice high coefficients of determination, signalling high explanatory power of the ‘vanity’ effect (sales of luxury vehicles) on overall sales (sales of cheaper vehicles). Given that the demand for cars around January of each year has nothing to do with actual fundamentals-driven demand, tending to follow instead the pinned up demand in realisation of the ‘vanity’ plate effects, these relationships provide an estimate of the ‘vanity’ effects on overall demand for new cars.

A snapshot of the 2010 data here:
Removing this effect from the sales of new cars, table below shows clearly that vanity effects accounted for more cars sold in all months of 2010 so far. In other words, scrappage scheme introduction, alongside all other factors (such as significant depreciation of older vehicles, increases in family sizes, etc during 2008 and 2009 crisis years) have been responsible for lesser number of car sales than the ‘vanity’ effect of having a 2010 license plate.
Of course, this is not a perfect estimate, but the persistency with which the numbers come out to show the power of the completely silly license plates vanity ‘competition with the Joneses’ is frightening. Oh, and it does show that the Government didn’t really ‘save our auto retail industry’, but rather once again helped inflating the artificial demand.

Economics 14/7/10: Car registrations & Emissions policy

I trawled through the CSO database on vehicles registration, trying to find some information concerning the efficiency of our emissions-reducing policies on taxation of vehicles and found some pretty interesting results. Here are the latest charts, for the data ending June 2010.

The first chart above shows all passenger vehicles registered (new and used) on a monthly basis. It clearly highlights the fact that our license plates act as a major vanity point. There are severe peaks in January each year, followed by more demand-driven local peaks in May-July (as families prepare for vacations). It is also interesting to note that despite the scrappage scheme and the psychologically significant change to ‘10’ plates, January 2010 was still posting fewer vehicles registrations than January 2009. Instead, what is significant in 2010 is the return of March local peak – a feature of 2006-2007.

There is a clear and strong dominance of demand for diesel engines, compared with petrol. This trend started in July 2007 – a year ahead of the new taxation system based on emissions was introduced.

And the ‘vanity effect’ is even more evident in new vehicles registrations (chart below):


Chart above clearly shows lack of demand for alternative fuel vehicles. It also shows that prior to 2010, peak demand months for cars was not coincident with peak demand for alternative fuel vehicles, suggesting different structure of the market for normal passenger vehicles when compared to alternative fuel vehicles. However, the data is still thin on alternative vehicles, as their sales prior to the recession are extremely thin. Finally, an interesting feature of this data suggests that during the recession, demand for alternative vehicles has been slightly more robust than for ordinary types of vehicles. This is most likely due to demographic of purchasers – more urban, professional, more secure in their jobs consumers of alternative fuel vehicles are also more likely to weather the recession with greater confidence than the general population. (Note of caution: given the short term horizon of this data, and low levels of alternative vehicles sales, these points are ‘educated guesses’ rather than hard evidence).

Diesel vehicles make up the vast majority of eco-friendlier Band A vehicles in Ireland, while heavily subsidised alternatives are lagging well behind petrol engines in comprising ecologically cleaner segment of Band A vehicles. As a driver of a mid-size diesel with emissions equal to a smaller and less comfortable Toyota Pious (ooops… Prius), I am can testify to the fact that our Government policies currently reward vehicles few of us want to drive, yet which pollute as much as (or as little) as vehicles people actually choose. It does seem to me that should Ireland’s Greens pursue in earnest their objective of cutting emissions, they should provide better incentives to cleaner diesel technologies.

Notice that a greater proportion of the diesel engines registered in 2010 are Band A emissions, compared to all alternative fuels (hybrids etc) combined. In proportional terms, hybrids etc are less emissions-reducing than the average new vehicle registered, while diesels are more emissions abating. This is a new trend since January 2010 and most likely reflects two changes in demand and supply: firstly, there is a new generation of diesel vehicles coming into the market, and second, there demand has shifted in favour of smaller (and cheaper) diesel vehicles (a recession effect?).

Two charts below plot 12 manufacturers that supply the largest share of Band A vehicles relative to their overall cars supply to the market in Ireland. The rankings are dominated by smaller engine diesel suppliers.
Chart below breaks down alternative fuel vehicles (including hybrids) into new vehicles purchased and used vehicles purchased. It clearly shows that for now, sales of alternative fuel vehicles are dominated by new car purchases, which, of course, means that our drivers of these vehicles are years away from realising real net emissions savings. Remember, production of every new car requires serious emissions, so unless a new car is driven significant number of miles, buying a used car in place of the new one is actually contributing less emissions, especially if the used car belongs to the same emissions band category as the new one.

Thus, once again, economic efficiency argument suggests that incentives for purchase of new lower emissions vehicles should be extended to cover used lower emissions vehicles as well.

Chart below shows the demise of the petrol engine and the rise of diesel engine during the current recession. It also shows a relatively flat trend for alternative fuel vehicles. However, the alternative fuel vehicles trend line remains upward sloping through the current economic crisis.

The really amazing figure is the following one. As can be seen from the chart below, even petrol-fuelled vehicles in Band A category are more prevalent than all alternative fuels vehicles, and the trend is so far driving this difference even further. Once again, a more efficient (from economics) perspective means for reducing Irish motors-related emissions is to have incentives for buying lower emissions vehicles. Not those run on alternative fuels, but ones run on diesel and petrol. As long as they fit into Band A…

Economics 13/07/10: AIB needs your cash

The dogs are barking across Dublin’s RDS. Touring the USofA, our Taoiseach has told the nation that AIB may (oh, just ‘may’?) need further state support to meet new capital targets. That admission, of course, comes after the solemn statement by Minister Lenihan back in March that the announced measures to provide capital to AIB and BofI were final. And on the heels of numerous assertions by our banks’ cheerleaders squad in Dublin’s stockbrokerage houses that AIB will be able to raise capital on its own accord, once the taxpayers pay through the nose for ordinary shares in the bank in round 3 of recapitalisations.

Well, taxpayers did pay through the nose. And AIB still needs more than €7 billion – based on status quo scenario concerning loans quality. Should it see continued deterioration in loans going forward from Q1 2010, the bank will need more than that. How much more? Anybody’s guess. But that open ended nature of AIB’s liabilities won’t hold back our nation’s leader. Last night, Brian Cowen pledged an open ended support to AIB saying that AIB “may need some help, but we will provide that”. How much will Brian be ready to ‘provide’? Not a single word. There is no stop-loss rule operating for this Government. Then again, we know as much from the Government treatment of the Anglo.


And while on the matters of Taoiseach tour of the US, unable to sell the idea that Ireland has turned economic ’corner’ on the recession, our leader is meeting some pretty important people. NYSE CEO Duncan Niederauer and NYC mayor Michael Bloomberg are on the list of those who need to be wooed into ‘Green Jersey’ club. Presumably, they’d love to send some of their companies (listings and HQs) down to the Emerald Isle, but need Taoiseach to convince them.

Messrs Bloomberg and Niederauer will have to be satisfied with playing the second fiddle in Mr Cowen’s sonorous opus ‘Turning Over, Again’. Per Taoiseach: "The first objective will be to give a clear message to key media outlets, business figures and opinion formers that Ireland has turned the corner…"

In other words, accustomed to his own PR hype, economic management is all in the media reporting for Mr Cowen. That, plus what’s being said at business lunches and social dinners in Manhattan. In other words, if the foreigners – especially the important ones – can be made believe things are good back in Auld Dublin, then surely they must be good.

No? Who says so? Oh, those pesky 450,000 unemployed and underemployed back in Ireland? Well, we’ll have jobs for them in no time, once Micheal O'Blumberg and Duncan MacNiedehan send their NYC 'investitors' over to Upper Merrion Street to buy some of those banks shares. After all, Bertie Ahearn thinks they should be a bargain at €5 each, while with Brian Cowen's latest unconditional pledge to plug AIB's capital hole no matter what, Bertie might just be right...

But just in case you think it’s all about Brian Cowen telling the Americans how to properly read our economic stats and banks balance sheets to discern the ‘turnaround’, think twice. Per Reuters report: “Mr Cowen said he will also ask for advice from business and political leaders on how Ireland can continue its fight against the recession and create jobs.”

Oh, wait – what recession? Didn’t we turn that corner?

Does anyone find this a little bit strange? We have an elected leader of the nation whose job description is to govern the state going over to the US to 'ask business leaders for an advice' on how to do his job?

Then again, our Taoiseach can boast of his policies getting us out of the recession. So why would he ask foreigners to provide him with their own ‘get out of recession’ ideas? May be, its because he really hasn’t a policy himself or he might need external validation for his policy of having no policy, or may be it is both. You tell me. But it does seem a bit uncomfortable, in aesthetic terms, to see our head of state travelling to the US to ‘consult’ foreign business leaders on how to solve our problems. I can’t imagine Angela Merkel or Nicolas Sarkozy doing the same. At least, not in front of the media…

Economics 12/7/10: Toyota on electric vehicles

An interesting set of revelations from Toyota (hat tip to Seeking alpha post on this) – the most advanced electric and hybrid vehicles producer in the world and one of the largest producers of car batteries (post-acquisition of 80.5% stake in Panasonic EV Energy). See their site (here).

The range of the plug-in electric vehicle motor: Toyota is preparing to test PHV-13 for its delivery to the markets in 2012. PHV-13 will have a 13 miles-range electric drive. Why so little? Toyota explains: "… the smaller the battery in a PHV the better, both from a total lifecycle assessment (carbon footprint) point of view, as well as a cost point of view."

You’d think that electric vehicles are supposed to provide a meaningful replacement for hybrids, according to Irish Government-ESB plans? Think again. Don’t even try to reach Dublin Airport from your Foxrock house in one of these.

Certainty of success in deploying electric plug in vehicles: recall that Toyota already has 2 million hybrid-electric vehicles running around the world. Yet, Toyota, with all its experience, doesn't believe it knows enough about electric vehicles: "The [electric plug in] Prius PHV will come to market in 2012. The PHV demonstration program [starting in 2010] is designed to gather real world driving data and customer feedback on plug-in hybrid technology. In addition, the program will confirm the overall performance of the first-generation lithium-ion battery technology ..." So Toyota wants to make sure it can meet customers’ demands and satisfy their needs. No such caution for the Irish Government that is putting all its faith and a hell of a lot of taxpayers’ cash into electric vehicles and ESB.

extent of plug in vehicles usability: here’s another interesting bit from Toyota – emphasis is mine: “Toyota believes that PHVs can be part of a solution to climate change and for energy security, for certain customers, in certain geographic areas, with certain grid-mixes, with certain drive-cycles, and with access to charging. There will be an important role for PHVs, but it will not be in high volume until there are significant improvements in overall battery performance…and battery cost reduction.”

Err… what was that? But what about Irish Government plans for large-scale switch to electric vehicles in Ireland? Have Toyota heard Minister Ryan speaking on Prime Time about his dreams? May be the Japanese manufacturer can do with a dose of our Green Optimism? Ironically, Richard Tol from the ESRI appearing on the aforementioned programme clearly warned that Minister’s plans for electric car fleets in Dublin will require massive breakthroughs in battery technology.

Cost of technology: Lastly, we are being told that Ireland’s electric vehicles fleets of the future will be powered cheaply (by ESB’s second highest cost electricity in Europe, one presumes). But Toyota guys are not so sure. Again from the Prius PHV site: "During [2009] testimony [at the National Academy of Science in Washington, D.C.] …Toyota said …that the very rough estimate was approximately $1200 per KWH for a complete pack ... Significant reductions in cost will require major technological breakthroughs."

Hmm… so are we going to get cheap and clean electric vehicles in Ireland? According to the world leader in this technology, the 2012 generation of electric vehicles is likely to be about 2-3 times more expensive than running a mid-range Beemer or a Merc. And that’s before we factor in our ESB’s tariffs and the cost of infrastructure to deliver their electricity to the cars’ batteries… dream on, man, of those Green pastures…

Economics 12/7/10: ECB - cooking up the (banks') books?

Something fishy is going on at the ECB. Having all but destroyed its own reputation (for the n-teenth time), the ECB has swung into its usual modus operandi – ‘We are tightening, tightening no matter what!’ First, in the face of clearly sluggish writedowns by the Euro zone banks, the ECB decided to close its longer-maturity lending window. Despite a clear warning from the Bank for International Settlements stating that there is a worldwide rising risk of a severe maturity mismatch on banks balancesheets.

Now, the ECB is signalling that it will cut government bond purchases – just in time for euribor climbing up and sovereign spreads shooting past their pre-Greek crisis highs. Last Friday, Jürgen Stark said that declining scale of the ECB’s bond markets interventions reflects improving market environment for sovereign bonds. In May the ECB was hovering ca €33bn in bonds per month, last week this has fallen back to €16bn in monthly purchase rates. “If the situation improves further, then there is no need to continue [with bonds purchases]”, he told FT.

Funny thing, the IMF has just urged the ECB not to discontinue bond purchases. But, to Mr Stark “The IMF has not caught up with the reality in Europe.” Oh, poor IMF, apparently a quick reprieve in some credit default swap indices last week (e.g. Markit iTraxx Financial, down 25bp, its largest decline in two months) is not exactly convincing for the IMF as far as prognosis of markets confidence in Europe goes. It looks like either the ECB is betting a house on its own forecasting prowess or setting itself up for another ‘Fool’s stumble’ through monetary policy. Expect bond purchases to resume once the summer is over and the markets re-open for business.

Oh, and just in case you might think that the IMF is really not getting the ECB’s “Europe is Great” vision, here’s the note from the WSJ blog (here) which shows that the ECB will be facing not just a steep sovereign bonds purchase curve, but will be getting more of the Euro area dodgy collateral into its vaults very soon. Apparently, the rest of 2010 through 2011, Euro area banks are facing a mind-blowing level of debt refinancing – the whooping €1.65 trillion worth of stuff. Don’t think they’ll be highlighting that in the shambolic stress-testing PR exercises that will be released July 23. I wrote about Euro zone’s banks propensity to stick their heads into sand when it comes to recognizing loans losses. But now, it also looks like they are doing the same with their funding sources – a dangerous game given the direction in which borrowing rates are going (see my earlier post on euribor).

Here is a nice pic I reproduced from the IMF GFSR database showing those dogs. The tail is wagging, noses are wet, barking mad… furry friends of ECB’s discount window.

I know, I know – Stark would say that the WSJ also ‘doesn’t get Europe’s great progress to prosperity’. But the little problem is – if the banks are to refinance these borrowings at current rates, between 2010 and 2015, Europe’s borrowers, consumers and investors will have to come up with a whooping €152-187 billion worth of interest rate cover. Yes, that’s right – while ECB is playing an outright silly game of ‘We are tough and things are great’, European economies will have to deliver almost 2% of their domestic output to plug interest rate hole alone.

But do not worry, the stress tests deployed by Europe are not designed to reckon with reality – they are simply a PR exercise. How else can one see a test that prices Greek default losses at 10% and Spanish at 3%, when the markets are pricing these at 4 times higher. Or how does one really test the banks if there are no scenarios for loans defaults and/or yield curve tests for debt refinancing?

If you need an indication just how shambolic these tests are, look no further than banks actions in refinancing markets over the last week. Clearly fearing that the investors might, just might, come to their senses and label the whole stress testing a farce, Euro banks have gone aggressively into the markets to raise €18.4bn worth of bonds last week, up from €4.8bn a week before. Do you think they are doing this because of cheaper cost of finance? Not really, costs remain high, though they are off their June peaks. So they are doing this only because they anticipate further increases in the cost going forward.

Yet, the ECB is drumming up the beat that the stress tests will reveal Euro area banks to be well-capitalized (haven’t we heard this before in Ireland? Ca 2008 from our own CB?). So the banks do not believe that the stress tests, which they all pretty much have passed already, per ECB assertions, are going to reduce risks perceptions in the markets. Why would that be the case, if the tests were honestly designed to really test their balancesheets? Last week’s survey of money managers by US-based Ried Thunberg ICAP found that 95% of the 22 survey respondents (controlling $1.39 trillion in assets) said most major European banks will receive positive test ratings.

Hmm… that, I would say, is a darn good evidence that the tests might be rigged. In which case, prepare for a rally in the banks that will turn South as soon as serious analysis of the tests assumptions comes through.