14/09/2011: More soft slop from Irish stuff-brokers

You gotta hand it to the Irish stuff-brokers community. They do routinely produce pearls of wisdom that we, the mere mortals can only aspire to. Here's one latest installment from one morning note issued today:

"If Ireland can meet its deficit cutting/growth targets over the next 2 years, then investor demand for Irish bonds should remain firm".

Let's start peeling this profoundly rhetorical onion:

1. The problem with Irish bonds is that there is NO demand for them. This is why we can't sell them and this is why we are reduced to borrowing from EFSF/EFSM/IMF/Bilateral Begging Bowl. So - the law of physics lesson for stuff brokers - that which doesn't exist cannot "remain firm".
2. If we can sustain our "deficit cutting / growth targets" over the next 2 years (i.e., given I see on my calendar "September 14, 2011") we will be in mid-September 2013 - at which point, per IMF/DofF/ESRI and other folks, usually not renown for their pessimistic assessments of our 'targets', Ireland will be at the peak of our substantial sovereign debt pile. If our stuff-brokers think that is a scenario consistent with "firm" investor demand for bonds, I wonder if the FR should suggest they attend some basic courses in finance.
3. What the hell does construction "deficit cutting / growth targets" mean? Usually, "/" implies "or". At the very least - "and / or", though that construction has own logical sign "v" as in "A ∨ B is true if A or B (or both) are true" of course, "A ⊕ B is true when either A or B, but not both, are true, which can also be written as A ⊻ B". So suppose our stuff-brokers think that delivering on our "deficit cutting" or "growth targets" (but not both) will assure "firm demand" for our bonds. We can, therefore, have NTMA going into the market telling the potential investors: "Give Ireland a chance. We have budgetary consolidation (economic growth), but no economic growth (deficits and debt sustainability)". Again, such a proposition suggests that more basic finance & economics courses are in order.

I am not being pedantic, folks. The problem is that this rhetorical exhortation can easily serve as an example of what passes for policy thinking in Ireland's more august quarters (DofF, Government, Dail, etc). It is an exact formula of what the Government / ESRI / IBEC etc have been putting forward as our policy to resolve the crisis. And yet... yet it makes absolutely no sense.

14/09/2011: Ireland & Portugal are allowed to restructure some of their sovereign debts

The EU Commission issued its proposals for altering terms and conditions of loans extended under the EFSM (and same is expected for EFSF). The details of release are here.

The move comes after July 21 EU summit agreement to alter these terms and took surprisingly long to deliver. This has nothing, I repeat - nothing - to do with the claimed efforts by the Irish Government to secure similar reductions over recent months. The reductions come on the foot of the EU-wide deal for Greece.

Per Commission statement: "The Commission proposes to align the EFSM loan terms and conditions to those of the long standing the Balance of Payment Facility. Both countries should pay lending rates equal to the funding costs of the EFSM, i.e. reducing the current margins of 292.5 bps for Ireland and of 215 bps for Portugal to zero. The reduction in margin will apply to all instalments, i.e. both to future and to already disbursed tranches."

Two critically important points here:

• The reductions, especially for Ireland, are significant in magnitude and will improve Ireland's cash flows and net small reduction in debt burden over time. However, much of these are already factored in recent debt and deficit projections.
• The reductions are retrospective, which is a very important point for Ireland.

Further per EU Commission statement: "...The maturity of individual future tranches to these countries will be extended from the current maximum of 15 years to up to 30 years. As a result the average maturity of the loans to these countries from EFSM would go up from the current 7.5 years to up to 12.5 years."

Two more important points follow from the above:

• Extended maturity in combination of lower coupon on borrowings imply significant cuts in NPV of our debt from EFSM, which, in turn, means that under current EU Commission proposal we will undergo a structured credit event (aka - an orderly default). When this course of action was advocated by myself and others calling for the Irish government to force EU hand on providing for structured default, we were treated as pariahs by the very same 'green jersey' establishment that now sings praise to the EU largess.
  
• Second point is that, as I have noted back in July, this restructuring implies longer term maturity period and can result in total net increase in our overall debt repayments, were we to delay implementation of austerity measures. The silver lining, folks, does have a huge cloud hanging over it.

Lastly: "...the new financial terms will bring benefits such as enhanced sustainability and improved liquidity outlooks. Moreover, indirect confidence effects through the enhanced credibility of programme implementation should result in improved borrowing conditions for the sovereign as well as the private sector."

In effect the above implies that absent such reductions and maturity extensions, Ireland and Portugal are unable to remain on a "sustainable" path and/or lack or experience a deficit of "credibility" whne it comes to their adjustment programmes. That, of course, is plainly visible to all involved.

So here we are, folks - we now had:

1. Bank defaulting on some of its liabilities - and cash machines kept on working
2. Government undergoing debt restructuring - and cash machines keep on working.

Not the end of the world, is it?

14/09/2011: Clueless from the world of finance

I had to get this riddle solved, folks: In the pic below, spot 1,000,023 clueless doorknobs


Answer:

Clueless Number 1: Erin Callan
Clueless numbers 2-15: 14 Goldman Sachs analysts who labored hard to produce that recommendation
Clueless number 16-23: 8-strong crew on CNBC who decided to carry this drivel unchallenged
Clueless numbers 24-1,000,023 (or so): all those who rushed out to buy Lehman's shares on GS recommendation

(I obviously made the numbers up, but, hey... in the world full of clueless analysts this gets one paid loads of money, apparently. Just ask GS)

13/09/2011: Latest research on Tax Havens & Safe Havens

A recent CEPR research paper (CEPR Discussion Paper No. 8570, "TAX HAVENS OR SAFE HAVENS" by Patrice Pieretti, Jacques-François Thisse and Skerdilajda Zanaj, from September 2011) attempts to explain -at least in theory - the policy choices of a small open economy (SOE) that wants to be a viable international banking center (IBC).

The basic dilemma faced by such an economy is that to attract IBC activity, the economy needs to choose between either becoming a tax haven, a safety haven or both for investors from large economy. In other words, the SOE is required to establish a competitive advantage relative to a large economy in terms of two possible instruments: taxation and institutional infrastructure.

The problem is that in reality, the same SOE will not be able to provide both - quality institutions and tax haven protection, since the latter contradicts the former. One can argue that in the past some tax havens were institutionally extremely robust, but in the current globalization-altered world, good institutions require compliance across the borders, not just within the country.

What the paper shows is that in such a setting, the tax haven can act as a catalyst to induce institutional reforms despite the fact that it cannot create institutional competitive advantage. The reason is that competition amongst tax havens drives institutional improvements in these IBCs.

As surveyed in the paper, a recent study by Dharmapala and Hines (2009) "investigated 209 countries and territories to determine which jurisdictions become tax havens and why. They found that successful jurisdictions are overwhelmingly small, but that they are especially well governed, with sound legal institutions and low levels of corruption. Poorly run jurisdictions fail to attract or retain foreign capital, and many do not even try. Thus, the quality of governance seems to matter for the existence of tax havens. According to Gonzalez and Schipke (2011), there is some empirical evidence that countries that apply stronger regulation rules have benefited from higher portfolio investments."

The CEPR study largely confirms this. The core conclusions are:

• "...whether the small country becomes a tax haven depends on the integration of financial markets and the intensity of the small country's comparative advantage."
• "The nature of government matters too to the extent that benevolent governments never build a tax haven. They prefer to erect an IBC through the provision of better institutional infrastructure."
• "By contrast, tax havens may emerge under Leviathan governments. This may explain why tax havens are developed in microstates where there is almost no conflict between social welfare and tax revenues because the local population benefits from the taxes which are mainly levied on foreign investors."
• "Our analysis also reveals that the presence of heterogeneous investors matters for the viability of the IBC and the nature of the policy mix."
• "IBCs need not be as bad as claimed in the media because they foster institutional competition which is beneficial to all investors."
• "Our results provide evidence that safe havens have a place in the global financial environment and provide benefits to governments, firms and households."
  

13/09/2011: German and French Banks - "extreme" leverage & elevated risks

So what's the real trouble with German (and French) banks, folks? Errrm... they are kinda seriously bordering the "insolvency" territory.

The sources for this information, in addition to those cited below, include an excellent research note prepared by Peter Mathews (FG), TD for the Dail Finance Committee, the IMF GFSR and IMF WEO databases.

Deutsche Bank

Leveraged 52:1 (16 August 2011) based on a Tangible Common Equity (TCE) to Total Asset measurement.

Tangible Common Equity is a better gauge of solvency than Tier 1 capital, particularly in the midst of a liquidity crisis. Tier 1 gives no sense of a bank's ability to withstand a liquidity crunch as it includes market-sensitive instruments that are subject to liquidity and price declines risks. Tangible Common Equity is also a much better indicator of a bank's ability to raise further funds in the market as it inversely relates to the rate of assets dilution implied in any rights issuance. (1), (2)

As TCE of €36.2bn is written against €1.85 trillion of assets, DB has just 1.96% cover in form of TCE against assets it holds - a writedown of just 2% on the asset values (cross the book) will wipe out the DB TCE cushion, rendering its current equity-holders de facto bust. Even excluding derivatives, MorningStar estimated DB leverage (TCE ratio 2.1%) at 47.6:1.

DE's current leverage levels compare unfavorably against 44:1 TCE leveraging on Lehman Bros books at the time of collapse (ordinary leverage ratio in Lehman's prior to collapse was 31:1) and makes DB the second most-leveraged bank in the euro area after Credit Agricole.

To bring DB closer to sustainable levels of TCE delveraging - 8-10% reading (note this is different from Tier 1 capital) will require it raising €110-150 billion in equity (depending on specifics of risk weighting ratios) or 3-4 times the current valuation of TCE or 3-4 times the current market value of the DB. Implied dilution for current equity holders under such scenario bears the risk of 75%- 80% loss on equity.

Note that 8-10% ratios are rather conservative, considering that in 2006-2009 TCEs for countries with banking sector crisis averaged (across top100 banks) TCEs of 11.5% to 15.3%. (3) Raising TCEs to the crisis-average levels of ca 13.4% will require equity raising of ca 5.7 times current market valuations or implied dilution of current equity by 85%.

To match TCE/Total Asset leverage ratio of the most leveraged US bank, JP Morgan chase (5.58%), DB would require €67 billion of additional equity or equity raising to the tune of 1.8 times current market cap.

DE's current market capitalisation of €37 billion as of 2 September matches relatively closely tangible common equity of €36.2 billion. In previous weeks, DE market cap fell as low as €26 billion or 70% of TCE. A market capitalisation at or below TCE is a warning sign that the bank is in trouble and questions surround its solvency and stability.

Worse than that, per research from Espirito Santo, DB liquid assets as % of the short term (<1 year) funding in 2010 stood at 47%, well below global leaders Credit Suisse (82%), UBS (77%) and Barclays (59%). At the same time 2010 wholesale funding maturity requirement was 49% - in excess of the iquid assets cover. Again, Credit Suisse had 33% funding call against 82% cover.

DB is structurally important to Germany as its assets stand at around €1.85 trillion, close to 75% of Germany's 2010 GDP (€ 2.498 trillion).

DB exposure to Greek assets is €1.6 billion for the core Group components (sovereign debt only), of which €1.34 billion in Deutsche Postbank AG exposures. Under 70% haircut scenario across the entire DB Group, the total implied loss will be around 5% of TCE.

Commerzbank

Current leverage around 35:1 in TCE terms, which is elevated compared to both historical averages and 2008-2009 crisis levels for comparable institutions. Given current assets valuations at ca €700 billion, the implied TCE is 2.92%, which means that a writedown of 3% of the assets will result in a complete wipe-out of TCE.

The core problem with 35:1 TCE leveraging in the current environment of globally impaired liquidity is that any deleveraging of the balance sheet will require substantial equity rising, similar to that in DE as discussed above. Adjusting for derivatives held, TCE ratio in Commerzbank runs at 30:1 - according to MorningStar who called this leverage ratio as consistent with "extreme" risk rating.

Together with DB, Commerzbank account for ca 102% of German GDP. As German debt to GDP ratio currently stands at 83% and heading for 87% , German taxpayers can see significant adverse impact of the DB and Commerzbank recapitalizations should the calls on PIIGS come in.

Commerzbank is the most exposed of all German banks when it comes to Greek sovereign debt, with nominal exposure at of the end of Q2 2011 of €2.9 billion. Applying the market-expected mid-point writedown in the case of default of 70%, bank losses on the Greek sovereign bonds will wipe out around 19% of the bank equity.

Recent data shows deep concentrations of Greek risks exposures in German banking sector, with German commercial banks holding ca €19.3 billion in public sector debt from Greece, €2.9 billion worth of banks debt from Greek banks and €7.4 billion of corporate and private debt, to the total of €29.5 billion (per BIS data). According to Fitch research, only €13.1 billion of that is on the banks balancesheets, the rest tucked away off the books.


French Banks

Credit Agricole is leveraged 70:1 (assets €1.5 trillion), while BNP Paribas is leveraged 36:1 (assets €1.93 trillion, Common Equity Tier 1 ratio of 9.6% well below minimum standard set for SIFIs of 10%). Bank's assets to market value currently stands at 64:1. BNP's exposure to Greek debt is now at ca €4 billion. SocGen is leveraged 34:1 (assets €1.16 trillion) on TCE basis and 28:1 on ordinary basis (again, recall Lehman's numbers at the point of collapse were 44:1 and 31:1) the bank has huge short term funding requirements presently being exposed by the flight out of Europe by US money market funds and Asian investors. SocGen exposure to PIIGS debt is €4.3 billion, referring to banking book only. SocGen is also in trouble on the liquid assets side with 26% ratio of liquid assets to short-term wholesale funding calls in 2010. Worse, wholesale funding that matured within 1 year of 2010 as percent of total wholesale funding was 69% for SocGen. Three French pillar banks have assets coming in at well over 200% of French GDP.

The banks are aggressively moving out of the PIIGS with SocGen in recent note stated that it cut its exposures to the peripheral states by 23% since early June 2011, taking out $1.5 billion and $2 billion in assets from Greek and Italian books. French banks total exposure to Greece is estimated at around $89 billion.

On top of this, French banks are now becoming effectively shut out of the dollar funding markets (4). And liquidity woes do not stop there. US Prime money funds have cut their holdings in certificates of deposits from French banks by about 40% in the three months through August 11. The proportion of the remaining holdings of French banks short term funding notes maturing in less than a month increased to 56% on August 11 from 17% on June 11. (5) The banks, of course, deny this is happening.

Let's run though some grim figures for one of the French "dogs" - BNP: as of June 30, 2011, the bank had €109bn worth of sovereign bonds on its books, amounting to 190% of the bank TCE (that's JUST Government bonds!), of which €31bn (or 54% of TCE) was in PIIGS bonds split as follows: Portugal - €1.7bn, Ireland - €400mln, Italy - €23bn, Greece - €3.8bn, and Spain €2.5bn. 95% of these exposures were held on banking book. So, now, let's do the same exercise as above - apply 50% haircut to Greek bonds, 25% haircuts to Porto bonds, 15% to Spanish, Irish and Italian bonds - all below market rates of implied haircuts, but let's indulge them with this assumption. This adds up to a writedown of €6.21bn or a wipe out of 11% of TCE. Bank becomes insolvent.


Summary

To summarise the above, two of German core banking institutions are currently operating in the extremely risky environment with leverage levels that can be classified as "extreme". The French banking system is even more sick than the German one with leverage ratios close to those attained by Lehman and PIIGS exposures that are well in excess of "manageable", given already strained capital cushions.

In common parlance, if it barks & wags the tail, it's a dog... regardless of what the official stress tests and powerpoint slides say.


Notes

(1) See BASEL III: Long-term impact on economic performance and fluctuations, by P. Angelini, L. Clerc, V. Cúrdia, L. Gambacorta, A. Gerali, A. Locarno, R. Motto, W. Roeger, S. Van den Heuvel, J. Vlc_ek, BIS Working Paper 338, February 2011, http://ssrn.com/abstract=1858724

(2) Note that Tier 1 capital is classified into different Tiers of capital, based broadly on the maturity profile of the capital invested. The most stable capital is Tier 1 capital and consists of items such as paid-up ordinary shares, non-cumulative and non- redeemable preference shares, non-repayable share premiums, disclosed reserves and retained earnings.

(3) Bank Behavior in Response to Basel III: A Cross-Country Analysis, by Thomas F. Cosimano and Dalia S. Hakura1, May 2011, WP/11/119, IMF Working Paper, Table 3.

(4) http://www.forexcrunch.com/bnp-paribas-executive-admits-access-denied-for-dollars/

(5) http://www.businessweek.com/news/2011-09-13/bnp-paribas-socgen-rebound-after-rejecting-funding-concerns.html

13/09/2011: Forthcoming Conference on Economic Sustainability

Forthcoming Feasta conference on, among other things,

• Alternative currencies / parallel currencies
• Site-Value Tax / Land-Value Tax
• Dealing with private debt overhang
• Energy, economic growth and crises, and more
  

Loads of interesting thinkers and usual suspects too. Unorthodox, provocative, and worth attending.

National Strategies for dealing with Ireland's debt crisis: Exploring the options

Link here.