Economics 16/9/10: Analysis of global banks rescue packages disputes Irish policy case

A very interesting paper that a year ago should have alerted this Government to the fallacy of its preferred path to interventions in the banking crisis. Alas, it did not.

Michael King Time to buy or just buying time? The market reaction to bank rescue packages, BIS Working Paper Number 288, September 2009 (linked here).

The paper suggests and tests the following three hypotheses concerning banks rescue packages put in place at the beginning of the crisis (January 2008):

• H1: The announcement of government rescue packages will be associated with a narrowing of bank CDS spreads relative to the market.
• H2: Capital injections will be associated with a rise in bank stock prices relative to the market if the benefits of lower leverage and a lower probability of financial distress outweigh the potential dilution of existing shareholders or restrictions on payment of common dividends.
• H3: Asset purchases and asset insurance will be associated with a narrowing of bank CDS spreads and a rise in the stock price relative to the market.

What the study found is that rescue packages confirm H2. But there was significant difference in the effectiveness of interventions.

• In the US, “bank stock prices outperformed reflecting the decline in the probability of financial distress and the favourable terms of the capital injections. The risk of US bank failures was high following the failure of Lehman Brothers and IndyMac, and the government take-over of AIG, Fannie Mae, and Freddie Mac. While the US Treasury’s preferred shares included warrants with the potential to dilute shareholders, the favourable terms of the capital allowed the average US bank share to outperform the market following the announcement of government support.”
• In contrast in Europe, “the risks of financial distress were also high as seen in the capital injections for Fortis and Dexia and the nationalisation of Bradford & Bingley. While banks were recapitalised, the cost and conditions of European rescue plans were punitive for existing common shareholders leading to an underperformance of bank stocks in most countries.” In other words, Europeans, predictably soaked equity holders but didn’t touch bondholders.
• “The UK package appears to have been the most costly for existing shareholders, which explains the fall in stock prices when the terms were disclosed. Given that only three out of six banks accepted the capital, the fall for banks receiving capital was offset by the positive response of banks that did not.”
• “Swiss banks were the exception as the average Swiss bank was relatively unaffected.”

Turning to the cases of asset purchases or asset insurance schemes, “market reaction provides only partial support for the third hypothesis (H3) that creditors took comfort from the reduction in potential losses and the decline in risk-weighted assets”. Oops, I’d say for the Leni/Nama plans. And this was known as of September 2009, despite which our Government has charged ahead with Nama.

“Overall, globally, asset purchases or insurance were used in only four cases with mixed results.”

Bingo – only in 4 cases: “the Dutch, Swiss, and US governments supported specific financial institutions by purchasing impaired assets or providing insurance against losses on specific portfolios. In an asset purchase, the government buys impaired securities or loans from the bank, reducing the bank’s risk-weighted assets and lowering the amount of capital it must hold against potential losses. While the government bears the risk of losses, it also retains the profits if the assets recover. While the US and Germany announced asset purchase plans, only the Swiss had taken action by the end of January 2009, buying $39.1 billion of illiquid assets from UBS on 16 October. The assets were removed from UBS’s balance sheet and placed in a special purpose vehicle, significantly reducing UBS’s risk.”

So in the end in the duration of 2008, no country has undertaken a significant Nama-like operation with exception of Switzerland in relation to UBS alone. Clearly the claim that Minister Lenihan was acting consistently with other countries in setting up a Nama vehicle is not true.

Here’s an interesting bit: see if you can spot where Mr Lenihan has gone the path differing from everyone else back in 2008. “Under asset insurance, the government assumes a share of the potential losses on a specified portfolio after a first loss amount (or deductible) is absorbed by the bank. In return, the bank pays the government an insurance premium based on the riskiness of the portfolio. By limiting the bank’s potential losses, asset insurance also reduces a bank’s risk-weighted assets and lowers the capital it must hold. The government, however, is left with a large potential liability if the assets fall substantially in value. The US and the Netherlands offered asset insurance to three banks. The US provided protection to Citigroup and Bank of America against the possibility of unusually large losses on asset pools of $301 billion and $118 billion, respectively. In both cases, the US government bears 80% of the losses after the deduction of a first loss tranche paid by the bank but does not share in any profits. The Dutch authorities created an illiquid asset backup facility to insure most of the risk from $35.1 billion of Alt-A securities owned by ING. The Dutch government shares in 80% of the downside and the upside. Asset purchases or asset insurance should be positive for both the stock price and the CDS spread, as both interventions lower the potential losses faced by common shareholders and reduce the risk of default. As a result, the share price should rise and CDS spreads should narrow. In three out of four cases the government’s actions coincided with the injection of capital.”

To conclude: “the October [2008] rescue packages provided governments with time to assess the situation and formulate their policy responses. At the same time, these policy interventions did not represent a buying opportunity as seen in the underperformance of bank stocks in most countries studied.”

Predictably, our stockbrokerages analysts, Nama, Department of Finance, Government and the usual crowd of suspects claimed that:

• Nama will lead to significant improvement in the banking sector health;
• Irish Government interventions were value additive for shareholders - all stockbrokers in Dublin and majority of them outside had 'Buy' recommendations on banks based on Government rescue package;
  
• Banks guarantee scheme is structurally important to the resolution of the crisis (not a delay, but a resolution),
• The rest of the world was doing the same.

International evidence on the matter suggests that banks supports are only as good as the measures to reform banks taken after the supports enactment. Of course, in the case of Irish banks, no such reforms took place since September 2008.

All I need to add here is that this paper was available to Minister Lenihan's advisers, to Nama and to DofF and Central Bank handlers. The latter, alongside their Financial Regulator counterparts are linked to BIS.

Economics 16/9/10: Why a rescue package for Ireland might not be a bad idea

This is an edited version of my article in today's edition of the Irish Examiner.

Two weeks into September and the crisis in our sovereign bond markets continues unabated. Ireland Government bonds are trading at above 6% mark and given the perilous state of the Irish banks, plus the path of the future public deficits, as projected by the IMF, Ireland Inc is now facing a distinct possibility of our interest bill on public debt alone reaching in excess of 6% of GDP by 2015. [Note: by now, the magic number is 6.12% as of opening of the markets today].

Sounds like a small number? Here are a couple of perspectives. At the current cost of deficit financing, our Exchequer interest bill in 2009 was 1.7% of GDP or €2.8 billion. Within 5 years the interest bill can be expected to reach over €12 billion, based on the Government own projections for growth. By this estimate, some 30% of our expected 2015 tax receipts will go to pay just the financing costs of the current policies.

It is precisely this arithmetic that prompted the Financial Times this Monday to question not only the solvency of the Irish banking sector, but the solvency of the Irish economy. The very same inescapable logic of numbers prompted me to conjecture in the early days of 2009 that our fiscal and banks consolidation policies will lead to the need for an external rescue package for Ireland.

This external rescue package is now available, fully funded and cheaper (financially-speaking) to access than the direct bond markets. It is called the European Financial Stability Fund (EFSF). More than money alone, it offers this country a chance to finally embark on real reforms needed to restore our economy to some sort of a functional order.

The EFSF was set up to provide medium term financing at a discounted rate of ca 5% per annum for countries that find themselves in a difficulty of borrowing from the international markets. With effective yields on our bonds at 6.05% and rising – we qualify.

The EFSF requires that member states availing of European cash address the structural (in other terms – long term) deficit problems that got them into trouble in the first place. In Ireland’s case this is both salient and welcomed.

It is salient because, despite what we are being told by our policymakers, our problems are structural.

Banks demands for capital from the Exchequer – a big boost to Irish deficit last year and this – are neither temporary, nor dominant causes of our deficits. In the medium term, we face continued demands for cash from the banks. By my estimates, total losses by the Irish banks are likely to add up to €52-55 billion (ex-Nama) over the next three-four years. These can be broken down to €36-39 billion that will be needed in the end for the zombie Anglo, €6bn for equally dead INBS, at least €8 billion for AIB and up to €2 billion for the ‘healthiest’ of all – Bank of Ireland. These demands will come in over the next 24 months and face an upside risk should ECB begin aggressively ramp up interest rates in 2011-2012.

No economy can withstand a contraction in its GDP on this scale. Least of all, the one still running 5-7% of GDP structural deficits over the next 4 years. In 2009, banks demands for Exchequer funds managed to lift our deficit from 11.9% to 14.6%. This year, absent banks bailouts, our deficit will still reach around 11.3%. Only 3.3% of that due to the recessionary or temporary effects. In 2011, IMF estimates our structural deficit alone to be 7% and 5.9% in 2014.

Which brings us to the point that the use of the EFSF funds should also be a welcomed opportunity for Ireland.

A drawdown on EFSF funding will automatically trigger a rigorous review of our fiscal plans through 2015 by the European and, more importantly, IMF analysts. This is long overdue, as our own authorities have time and again proven that they are unable to face the reality of our runaway train of fiscal spending.

Since 2008 in virtually every pre-Budget debate, Minister Lenihan has been promising not to levy new taxes that will threaten jobs and incomes of the ordinary people of Ireland. In every one of his budgets he did exactly the opposite. Under the EFSF, the IMF will do what this Government is unwilling to do – force us to reform our tax system to broaden the tax base, increase the share of taxes contributions by the corporate sector and start shifting the proportional burden of taxation away from ordinary families.

Minister Lenihan has repeatedly promised reforms of spending. In every budget these reforms fell short of what was needed, while the capital investment was made to bear full force of the cuts. Drawing cash from the EFSF will make Mr Lenihan scrap the sweetheart Croke Park deal and start reforming current spending. Politically unacceptable, but realistically unavoidable, deep cuts to social welfare, public sector employment and wages, quangoes, and wasteful subsidies will become a feasible reality.

Starting with December 2009, the Irish Government faced numerous calls from within and outside this state (headed by the EU Commission and the IMF) to provide clarity on its plans to achieve the Stability and Growth Pact criteria of 3% deficit to GDP ratio by 2014-2015. The Government has failed to do this. Drawing funds from the EFSF will help us bring clarity as to the size and scope of fiscal adjustment we will have to take over the next 5 years.

Lastly, the EFSF conditions will include a robust change in the way we are dealing with the banks. Gone will be the unworkable Government strategy of shoving bad loans under the rug via Nama and drip-recapitalizations. These, most likely, will be replaced by haircuts on bond holders and equity purchases by the State.

Contrary to what the Government ‘analysts’ say, drawing down EFSF funds will not shut Ireland from the bond markets. Instead, swift and robust restoration of fiscal responsibility and more a more orderly exit of the exchequer from banks liabilities are likely to provide for a significant improvement in the overall markets perception of Ireland. After all, bond investors need assurances that we will not default on our debt obligations in the future. Only a strong prospect for growth and recovery can provide such an assurance. Ministerial press releases and Nama statements are no longer enough.

Economics 16/9/10: One sick pup lifts one ear

Funny thing the market is, at least if you are an Irish banker.

The rationale for AIB selling its profitable divisions to plug the holes in its collapsed domestic business (notice, more detailed analysis of exactly the same fundamentals argument was supplied by Prof Brian Lucey back in March in his article in the Irish Times - see here). The logic of this AIB's perverse move was:

• sell the stakes in M&T and BZWBK to provide capital to write down bad loans on homegrown turf;
• put the bank assets squarely into the geography where it has proven time and again to be incompetent in lending (aka Ireland);
• reinforce the incompetence of the management of the bank by showing to the rest of the world that over the last 10 years, AIB could manage to make money only in those divisions/investments where it had no managerial say (I mean, really, folks - AIB's competent managers - who need to be paid wages comparable to other bankers around the world, cause, you know they are being actively headhunted by global banking syndicates for their ability to turn funding into bad loans - had nothing to do with only two profitable sides of the bank: M&T and BZWBK)

Ex post the sale of BZWBK, the AIB therefore anticipated markets to rush to their rescue. This clearly is not what's on the minds of the markets. S&P last night held its A-/A-2 credit rating on AIB and the negative outlook, implying a new downgrade might be in the works. Oh, how dare they?

AIB needs not €7.4bn (the minimum regulatory requirement capital top up), but more like €10bn to plug the hole in bad loans. It has managed to under-report (thanks to an accounting rule) losses in H1. The bank is now being stripped of the very few assets it has that actually make sense, leaving it with the legacy of its own actions and choices that is purely toxic. The markets don't buy the management 'plan' (what plan?) nor do they by the management team itself. The only thing that separates AIB from heading the Anglo route is the willingness of the Government to throw taxpayers guarantees and cash at the bank to rescue its shareholders and bondholders. How long will that last is an academic point at this moment in time. The real point is - AIB simply has so far shown no capacity to produce viable banking business short of buying into foreign-run assets.

Economics 16/9/10: Improving competitiveness

Recently, there have been plenty of claims concerning improving Irish competitiveness through the crisis. Most refer to the Irish Central Bank-reported Harmonized Competitiveness Indicators (HCIs). Here are some charts to detail what has been going on in this area:

The first chart below shows historical trends in HCIs.

On the surface, it looks like:

1. The story of dramatic improvements in our competitiveness (at least as measured by the HCIs) has been true - we are now back to competitiveness levels not seen since June 2007 (in Nominal HCIs), February 2003 (when it comes to HCIs deflated by consumer prices) and January 2006 (as measured by HCIs deflated by producer prices)
2. At the same time, the gap between our performance in HCIs deflated by producer prices and consumer prices clearly shows that these gains in competitiveness were not due to producer cost deflation (improved productivity), but due to massive deflation in consumer prices (margins erosion and collapse in domestic demand).

A closer look in the chart below, however, shows that the timing of our competitiveness gains is not as straight forward as the arguments put forward in the public suggest:
Starting with the peak year for our bubble (2007), our gains in competitiveness since the beginning of this recession in Q1 2008 are hardly impressive at all. To summarize these, here is a table of relative changes:

Loss of 1.4% (nominal) in competitiveness, contrasted by gains of just 2.4% in producer prices-termed HCI and 5.6% in consumer prices-termed HCI are hardly a matter of bragging rights for Ireland Inc.

Irish HCI data is strongly suggesting that so far in the recession, Ireland's producers have failed to gain significant inroads into productivity gains. Instead, lower retail prices so far remain the primary drivers of the improved indices reading.

Economics 16/9/10: Migration & natives mobility

In my presentation yesterday at IBM's Extreme Blue event, I mentioned that we know very little about the location decisions of the modern migrants - people with high skills, education, aptitude, creativity and innovation capacity.

An interesting new study from the Bank of Italy (“HOW DOES IMMIGRATION AFFECT NATIVE INTERNAL MOBILITY? NEW EVIDENCE FROM ITALY by Sauro Mocetti and Carmine Porello, Working Paper Number 748 - March 2010) assessed the relationship between “native internal mobility and immigration in Italy”. The study attempts to analyse “the impact of immigration on local labour markets and to gauge the consequences for the socio-demographic composition of the local population”.

Traditionally, immigration into a given geographic region is seen as a driver of outward migration of the natives due to jobs displacement (the argument that by taking lower wages migrants force indigenous workers out of their jobs). This is known as a substitution effect. Alternatively, there is a view out there that migration induces clustering of both migrants and domestic workers.

A set of studies in the 1990s and early 2000s have produced mixed results as to the relationship between inward migration and flows of the native workers:

• Frey (1996) shows “a strong correlation between immigrant inflows and native outflows in US metropolitan areas, and argued that this behaviour was bringing about a ‘demographic balkanization’”. Borjas et al. (1997) report a strong negative correlation between native net migration and immigration from abroad. Hatton and Tani (2005) find a negative displacement effect in the UK. Brűcker et al. (2009) find that “foreign immigration replaces native internal mobility in Italy”. (substitution in levels)
• Wright et al. (1997) disagree by showing that “immigrant inflows are unrelated to native outflows in large metropolitan areas.” Card (2001) confirms this in a broader setting. (independence)
• Card and DiNardo (2000) find that “increases of the immigrant population in specific skill groups lead to small increases in the population of native-born individuals in the same skill group.” (clustering)
• Borjas (2006) finds that “immigration is associated with lower in-migration rates, higher out-migration rates, and a decline in the growth rate of the native workforce.” (substitution at the level of growth rates)

In their study, Mocetti and Porello find that “immigration has a negligible impact on overall native mobility while it does have a significant impact on its skill composition” in Italy. Crucially, immigration leads to

• a displacement of low-educated natives,
• immigrant clusterization in the northern regions has partially substituted South-North mobility flows of less-skilled natives,
• immigration is positively associated with highly-educated native inflows
• the impact is concentrated among the young population and is somewhat stronger in more urbanized areas.

Interestingly, the devil is not in the details, but in interpreting the results: “is not clear how these results may be interpreted. If we consider the arguments in the literature on labour, we should read these findings as evidence of the substitution effect for low-educated natives and of complementarities for highly-educated ones. Task specializations and complementarities between immigrants and highly-educated natives might induce higher demand (and productivity) for natives in areas with a higher share of immigrants; having said this, if low-educated natives and foreign workers compete for the same jobs, then immigration might have a depressive effect on labour demand for natives.”

Labour market story aside, and related to our own study at the Institute for Business Value (here), immigration has skills-specific effects on internal mobility due to what I would term quality-of-life considerations. Inflow of migrants can alter quality of state in the recipient city. Mocetti and Porello refer to this effect as “the impact of immigration on natives’ location choices [that] might also work through other channels such as the housing market and the preferences for ethnic composition of the local context.”

Their study includes “house prices in the regressions to control for the effects through the real estate market; regarding “racial” preferences, they are likely to affect neighbourhood choice within a city rather than displacements across regions. Therefore, we argue that our estimates can be reasonably interpreted as the result of the interaction between immigrants and natives in the labour market.” The authors find that housing costs, associated with higher inward migration, do have a negative effect on the regions’ ability to retain domestic workers of similar skills levels.

So on the net, while the study does not deal specifically with the high quality of human capital group involved in migration, the study does suggest that better skilled/educated workers tend to produce a clustering effect leading to complementarity with the native workers of similar skills and creating a pull factor for inward migration of highly skilled workers to a specific location. The offsetting deterioration in living conditions (due to higher house prices etc) is not sufficient in size to cancel out this positive effect.

Economics 13/9/10: FT's belated recognition of Irish realities

In today's FT (here), Wolfgang Munchau clearly states that (emphasis is mine): "...Irish banking sector is insolvent, and there are questions about the capacity of the Irish state to absorb those losses. ...two years have passed [since the crisis acknowledgement by the state] and nothing has been resolved.

…As we saw last week, this strategy [of shoving bad loans under the rug via Nama and quasi-recapitalizations] came badly unstuck in Ireland. The Irish government massively underestimated the scale of the problem in its banking sector. On my own back-of-the-envelope calculations, the cost of a financial sector bail-out may exceed 30 per cent of Irish gross domestic product, if you make realistic assumptions about bad debt write-offs and apply a conservative trajectory for future economic growth.

[Note: this blog has previously (here), on a number of occasions estimated the overall impact of the net losses realized by the banks to Irish taxpayers will be in the region of €62-75 billion, inclusive of Nama. Based on the Department of Finance own figures, this can be expected to amount to 38.5-46.6% of Ireland’s 2010 GDP or 48-58.1% of our GNP. Either range of numbers is significantly in excess of Munchau’s back-of-the-envelope estimate.

However, even at 30% of annual GDP, the expected hit on this economy from the banking sector debacle is simply insurmountable.

No economy on earth can be expected to withstand a 30% contraction in its GDP over two-three years, while still running a 7-8% of GDP structural deficit in every one of these years. The insolvency of Irish banks recognized by Munchau, therefore, automatically implies the insolvency of our economy, unless the banks are isolated from the rest of our economy by a removal of the blanket guarantee on the bondholders, while retaining a guarantee on depositors.]

Munchau goes on to say that: “We know from economic history that countries enter into longish phases of stagnation after a financial crisis.

[My estimates based on the IMF and OECD models of fiscal and financial crisis imply that Ireland can expect at least another 33 quarters of continued crisis pressures in Exchequer finances, house prices and asset markets, as well as a permanent decline in the potential rate of economic growth to below 1.5%]

Ireland suffered an extreme crisis. In the light of what we know, the safe assumption to make for Ireland – and Greece – is that there will not be much nominal growth in the next five years. If you make that assumption, you realise Greece will almost certainly not be in a position to repay its debts. While Ireland’s situation is marginally better, there are justified doubts about the country’s long-term solvency.”

[The above are not some idle words. They are, as I mentioned early, fully in line with the existent econometric models of crises based on historical experiences in the advanced economies in the past.]

Per Munchau: “….In Ireland, the cure would consist of nationalisation and wiping out the bondholders of Irish banks through bond-to-equity conversions.”

[Needless to say, since April 2008 I am on the record – in the press, media, on this blog, in public meetings and private briefings to the policymakers – these are exactly the first steps that need to be taken in order to begin – note, just to begin – the process of restoring order to our banking system. Irony has it – on a number of occasions, I have written to the Financial Times precisely about these issues, raised by Mr Munchau, with, needless to say, not a peep back from the broadsheet offices].