Economics 6/12/10: IMF stress tests for Irish banks

Here are three things that are worth asking about the latest details of the EU/IMF 'rescue' package released over the weekend. All relate to the issue of banking sector restructuring:

1. According to reports, some €2 billion will be available to enable the banks to sell €20 billion worth of assets (which, of course, implies sales of performing loans, as all other assets, such as foreign divisions, auxiliary services providers, asset management branches etc have already been flogged or put on the market). As reports issued today specify: the funds may come in the form of a loss protection or as a guarantee for asset purchasers. These €2 billion come on top of the €10 billion set aside for the immediate re-capitalization of the banks, and on top of further €25 billion in contingency funding allocated. So it appears that it either comes from the Exchequer side of the EU/IMF deal, reducing deficit financing available to the Government or, alternatively, on top of the €67 billion in lending extended under the whole deal. In effect, the EU/IMF will now engage Irish taxpayers funds (remember - these €2 billion are loans) to sweeten the bitter pill for buyers of Irish banks assets. A small, but lovely morsel of taxpayers income that will be spent on artificially propping Irish assets for sale.
   
2. According to the Irish Times, stress testing scenarios deployed by the IMF in pricing the overall demand for taxpayers funding for the banks involved the following assumptions: losses of 10% on buy to let mortgage books and 6.5% for residential mortgages. These assumptions underwritten the demand for €25 billion in contingency funding, spread as €15 billion in required capital, plus €10 billion additional cushion. This is rather interesting and worrying. Buy-to-let mortgages are most certainly completely under water right now, given collapsed rents and capital values, as well as more recent vintage of these mortgages. If investment and commercial books are facing up to 35-40% losses currently (as consistent with the Government own estimate of €50 billion final cost of banking sector recapitalization), is it safe to assume that buy-to-rent mortgages will tank at 10%? Similar questions arise with respect to 6.5% assumption on mortgages defaults. In fact, we already know that over 100,000 mortgages are either in official distress or under renegotiated repayment holidays or interest rates adjustments. This pushes the effective default and at-risk of default numbers will in excess of 6.5% as of today.
3. If contingency fund of €10 billion were to be taken as covering any losses in excess of 6.5% defaults on mortgages and 10% default on buy-to-rents, then this amount is expected to cover: (1) Haircuts by Nama on additional €14 billion in loans transfers (cost ca €6-7 billion at past haircuts), plus (2) Losses in excess of assumed rates on mortgages and buy-to-rents, plus (3) any further losses on investment and development books, plus (4) any further losses on derivatives exposures. This is hardly realistic of a cushion. So it appears that the IMF was either not given the full realistic picture of the Irish banks balance sheets, or it is seriously underestimating the demand for future losses cover in the banks.
   

Either way, the numbers continue to suggest that the €67 billion package of loans will not be enough to provide simultaneously a cover for Exchequer deficits and the funds required to underwrite losses and capital requirements of the banks. Somehow, the Irish Exchequer will have to make up for this shortfall.

Economics 5/12/10: Debt, debt, debt... for Irish taxpayers

I decided not provide any analysis of the figures below. These figures speak for themselves. To explain their purpose: I have computed the expected burden on current and future taxpayers from the total ex-banks debt carried by Ireland Inc as:

• Households debts (mortgages, car loans, personal loans, credit cards, etc);
• Government debt (inclusive of quasi-Governmental debt undertaken under the EU/ECB/IMF loans and Nama).
  
• I also incorporate total corporate sector debts, including non-financial corporations debt and debts entered into by non-banking financial corporations. However, the corporate debt DOES NOT form the part of taxpayers liabilities, although at least some of it will have to be repaid out of our (taxpayers) pockets one way or another.

All figures input into calculations were taken from CSO and Central Bank of Ireland databases. All core assumptions are outlined in the second table.

Finally, note - the total figures of debt per taxpayer are for Household Debts and Government (including Nama & ECB/EU/IMF loans) debt. Do not, please, confuse them with the official Government debt alone.

So here are two tables. Interpret them as you wish:


PS: some people accused me of double-counting:

• banks debts and mortgages/households debts. I am not - banks debts are excluded from the above considerations;
• Government bonds outstanding and rolled over. I am not - the only net increase between 2010 and 2014 in Government debt due to roller overs of existent (pre-2011) bonds is due to an increase in the interest rate taken on rolled over bonds at 1% (again, conservative, as per ECB/EU/IMF deal we will be paying 1.13% over the current average rate of interest on already issued bonds).
  

Economics 5/12/10: Reserves requirement ratio

In response to the following tweet:

"A question. You wrote here http://j.mp/eL9QWg that the decision of the Chinese government to raise reserve requirement ratio for the commercial Chinese banks in order to cut down on their lending as "monetary tightening".

According to this article by Phillippe Legrain

http://j.mp/hnSF9w

The Republic of Ireland could have taken similar measures during the past decade to cool down the property bubble but didn't.

I thought after European monetary union, a monetary option wasn't open any more to the Republic of Ireland.

Yet what you described as "monetary tightening" in China was possible in the Republic of Ireland according to Phillippe Legrain."

My view on the topic: Legrain is correct.

As a member of the Euro zone, Ireland retained full control over one of the tools of monetary policy, known as 'reserve requirement ratio' - or capital requirement ratio. Irish regulators (CBFSAI) has a full right to increase requirement on the banks operating in Ireland to hold the proportion of their deposits and/or proportion of their loans in reserves as capital to cover any expected losses.

Such an increase in the ratio would have reduced amount of credit available in the system and would have offset the dramatic increase in lending spurred on by the introduction of higher risk products such as 100% mortgages.

At a dinner event in 2006 I told, at the time, Governor of the Central Bank of Ireland that this is exactly what he needed to do to cool down the market for mortgages lending in the Republic. His reply was along the lines that this was politically impossible to do.

That this lever of policy is still available to Ireland is best illustrated by the two recent decisions by the new Financial Regulator to hike capital requirement ratios for Irish banks to 8% Tier 1 and most recently to 12%. Unfortunately, this decision came too late.

Were Irish banks required by the CBFSAI to hold, say 12% of their risk-weighted assets in form of capital, the taxpayers would have seen their total exposure to the banking crisis significantly reduced. Instead of ca €16.2 billion in capital available to cover writedowns against the total lending of €360 billion across our banking institutions, our banking system would have had ca €34-35 billion in capital cushion against lending of €280-290 billion. (Note: these are back of the envelope calculations, but they still show the impact of raising reserve requirement ratios).


PS: for those of you who missed an excellent PIMCO note on Irish situation and EU's 'solution', here's a link. (Hat tip to Georg)

Economics 5/12/10: Default, debt and 'Rescue of Ireland' deal

Today's Sunday Independent article on inevitability of default, with comprehensive figures on the impact of the IMF/ECB/EU deal for ordinary Irish households and the levels of our indebtedness. Link here.

Economics 5/12/10: Probability of default

This is an unedited version of my December column with Business & Finance magazine. Note, the copy was filed before the EU/IMF deal was announced for Ireland, so some assumptions have deteriorated since then.


At this point, it is pretty much certain that the events of the last month will have a lasting and profound effect on Ireland’s economy and society at large. So much is clear. What remains uncertain – in these news-saturated times – is the exact nature of the short-term outcome of three processes at play: the Budget 2011, the IMF/EU ‘bailout’ and the end state of Irish financial markets.

Over the last 24 months this column has predicted, with surprising even to myself, accuracy the following events:

• The complete and total failure of the Irish Government attempts to repair our collapsed banking sector – with even Nama cheerleaders of the past now coming around to recognise that the entire policy has delivered nothing but a powerfull new bureaucracy that put banks and property markets onto a permanent life-support;
• The true extent of the expected losses in the banks, totalling around €67-70 billion ex-mortgages defaults, in contrast to successive rosy estimates by the public officials, the banks, our stockbrokers and the Government;
• The inevitability of the banks nationalization and the risk of the Government vastly overpaying for the eventual ownership of the banking system (my estimates suggest that the taxpayers will end up paying some €40 billion more for the banks than necessary, due to the waste built into the system of previous recapitalizations and Nama);
• The continuation of the economic recession, with a clear and concise prediction of the double dip collapse in GDP and continued contraction in GNP;
• The inevitability of the IMF/EU taking over the reigns of power at the Department of Finance; and
• The losses of tens of thousands of Irish and foreign younger and better-educated workers to emigration and unemployment.
  

Calling it right in these circumstances doesn’t give myself any sense of accomplishment or pride. To put simply, as a taxpayer and a parson calling Ireland home, I would rather have been wrong in my predictions. Unfortunately I, along with a number of other independent analysts, including Peter Mathews, Brian Lucey, and Cormac Lucey, and a number of others, was right.

Even more unfortunate is the fact that the latest events suggest that some of our past predictions are now being overtaken by reality. So let us start with what the future is likely to hold.

First, consider the budgetary arithmetics. The failed spectacle of last week’s release of the multi-annual budgetary framework for 2011-2014 horizon was a clear exercise in Government’s evasion of reality.

Take the headline figures, first.

The Government aims to cut €6 billion from its deficit in 2011. Yet, the very same Government will now require to borrow some €120-130 billion over the next 4 years to finance its day-to-day operations, the redemptions of maturing bonds, write-downs of bad loans, banks recapitalziations and shoring up countless mortgages that are either in a default or heading there. At the rates that ECB and IMF charge Greeks for their emergency funding, this figure can be in excess of €6.1-6.8 billion. At the rates that should apply under the EFSF formula, the interest bill for our new borrowings would add up to roughly €8.6 billion.

In other words, up 58% of the planned 2014 budgetary savings will go up in smoke once the ECB / IMF loans are drawn down.

Add the numbers up. Even if we were successful in driving the deficit to 3% in 2014 as the Government plan – not that there’s a chance in hell that this can be achieved in reality, especially with the new IMF/ECB inetrest charges bills coming, something that the Govenrment has completely failed to even account for in its budgetary framework – Ireland will face continuously increasing debt levels through 2016-2017 due to the cost of new borrowing.

By my estimates, the overall debt levels of the Irish Government will rise to €210-220 billion by the end of 2014, requiring between €12.1 billion and €15.4 billion in annual interest charge against the state. Almost half of 2010 tax receipts will be eaten up by interest charges alone. Put differently, if the Irish Government were to be compared to a household with average income and a mortgage with cost of financing at around 50% of the revenues it bring in, we would be looking at a mean wage earner living in a property with a mortgage that exceeds 11 times its annual pre-tax income. Only a person with absolutely zero understanding of basic finance can think that this type of a scenario can lead to anything other than bankruptcy.

And this is assuming that in the medium term, our collapsed banking sector will be miraculously restored to rude health and the sovereign bond markets will greet Ireland back as a full-fledged issuer of government debt. Both assumptions would stretch the imagination even of the most optimistic forecaster.

Next, take a look at the sub-components of the Budgetary framework.

This Government clearly believes that Ireland’s recession is over. In fact, it believes that we are now on the cusp of a roaring economic growth. Otherwise, how can the Department of Finance hope to raise some €5 billion in new taxes through 2014 and €1.9 billion in 2011 alone? Such a level of tax increases would mean that every working man and woman of this country will be expected to contribute €8,300 annually on top what they already pay the Exchequer.

The Government thinks that Ireland’s economy can grow at 2.75% per annum on average through 2014. My own view is that we cannot hope to deliver such rates of growth. My mid-range forecast for average growth in the Irish economy in 2011-2014 is closer to 0.75-1% per annum, with a significant likelihood of further economic contraction in 2011.

Assuming the average rate of growth in the economy of 1% per annum through 2014 – at the top of the range of my estimates – the new taxes will add up to 25% of the projected average earnings in 2014. Again, this is on top of taxes already being collected.

Someone is clearly smoking something funky out in the rarefied atmosphere of the Government buildings.

The Budgetary framework appears to avoid factoring into the deficit calculations the full costs that the Exchequer is likely to face in years ahead. For example, it is difficult to understand how the announced provisions can cover both the need for day-to-day operations of the Government and the forthcoming additional borrowing costs related to the bailout funding, as mentioned above.

The framework also fails to provision for the expected future impact of mortgages defaults. Should, as widely expected now, the Irish households face a rising cost of mortgages finance due to banks shifting more and more burden of capital and operating costs adjustments onto the shoulders of ordinary mortgage holders, we can expect the number of mortgages in official default to reach over 100,000 over the next 2 years. Again, Govenrment’s rummaging through our pockets through higher taxes will accelerate this process. Pushing ca 60,000 new mortgages into default can cost, roughly speaking, €700 million to the annual social welfare and interest relief bills of the Government.

In other words, say whatever you may, but the so-called ‘draconian cuts’ envisioned by the Government are not enough to plug the hole in public finances without a significant reduction in levels and cost of public sector employment and a much more dramatic revision of the social welfare and health spending. We might not like these measures to be put on the agenda, but the reality bites – without shaving off some ¼ of the public sector wages, pensions and employment costs, and without reducing our social welfare and health spending by at least 1/5th each, Ireland is unlikely to begin repaying its vast debt accumulated since 2007 anytime before 2020.

In addition, let us not forget that the entire Government budgetary framework rests on a number of crucial, but economically and politically unjustifiable assumptions. First, there are the assumptions of extremely benign interest and exchange rates environments – the ones that crucially underpin the real cost of borrowing by the state, but also the implicit rate of growth in our exports, the cost of our imports of inputs into exports production and consumption, the rates of mortgages defaults and other economic variables.

Perhaps the only really progressive measure introduced in the programme is the Site Value Tax – a tax levied on the value of land for residential and zoned land, but exempting for the political reasons agricultural land. The idea of the site value tax, advocated by me in these very pages, before is that it should replace transactions taxes on property without penalizing households who invest in improving their homes and properties. The tax can be effectively used to recover the benefits of public investment in schools, infrastructure and other public amenities that currently accrue to the private land owners. Although the Government hopes to raise €530 million from this measure, little detail is provided in the plan as to the specifics of the SVT application.

Government puts much faith into its plans for reinvigorating the economy. These too were outlined in today’s document. The Government that brought us into insolvency through its handling of the crisis over the last 2 and a half years is aiming to “remove potential structural impediments to competitiveness and employment creation” (something that they failed to achieve since 2001) and “encourage exports and a recovery of domestic demand” (with domestic demand clearly identified in the very same document as the sacrificial lamb on the altar of fiscal adjustment).

A net positive, if unfortunately timed to coincide with deep recession, the reduction in minimum wage is hardly the core to the sustained jobs creation in this economy. By Government own admission, even with this measure, Ireland will retain one of the highest minimum wage rates in the EU.

More important are Government plans to strengthen its labour market “activation policies” for the unemployed and “promote rigorous competition in the professions”. Both would be welcomed were we to have any confidence that they can delivered on. The very same Government that promises now liberalization of professional services has presided over a decade-long preservation of non-competitive marketplace in professions. And as far as employment activation policies go, it is patently clear that barring a deep root and branch reshaping of Fas, there is no chance any efficiency can be gained from the existent activation systems.

Which brings us to the point where the evidence of the last few weeks converges to a point which warrants the following prediction. Regardless of the IMF/EU ‘bailout’ loans, Ireland is now firmly on the course toward a restructuring of its debts at some point in the near future. The only choice we have, as a nation, is the path of this restructuring. The options we face are dark. Irish Government can either recognize the gravity of our situation and force an orderly debt for equity swap within the Irish banking sector, simultaneously imposing significant writeoff on the household debts of at least 15-20%. Or we can muddle through more borrowing, more debt, toward a disorderly, market-driven default on the very same banks debt and potentially (depending on the extent of our future borrowings) sovereign debt.

The choices we have, therefore, are unpleasant, painful and unprecedented by the standards of an advanced economy. But their real causes – the failures of the last 2.5 years of crisis management policies – make them virtually unavoidable.

Economics 5/12/10: Links to recent articles on irish economy

Here is the link to my article in Saturday Irish Independent on the topic of FG and Labor 'alternative' Budget 2011 proposals: here.

Here is the link to another article from Saturday, this one from the Irish Examiner on the topic of banks debt default as an option for Ireland: here.