Economics 04/08/2009: NAMA, Liam Carroll & Short Termist Bonds

I should make it a habit to direct every NAMA post reader to my proposal for NAMA 3.0 here.


Yeps, Supreme Court came in on the side of the Government, throwing a lifeline to NAMA and forcing taxpayers into deeper losses. My earlier note stand now (see here) with all the gory implications for losses on Mr Carroll's loans now being back in the NAMA court.

But two birdies have chirped to me that there is more brewing up in the land of NAMA-fantasy. Apparently, the rumor has it, the Government plan is to issue short term bonds to cover NAMA liabilities. Given that NAMA will start issuing bonds in 2010 for this undertaking, the short term nature rumored is for a 2011-2012 bonds.

This, if true, makes no sense for several important reasons. Here are some:

(1) Issuing short-term debt with maturity before 2013 is equivalent to a financial suicide. The reason is simple - there is no credible (or for that matter even an incredible one) commitment from the ECB that

• such issuance can be rolled over at the same or lower interest rates to cover maturing bonds; and
• the EU will allow these bonds to remain off the balance sheet of the Government upon the roll over.
  

(2) Issuing short term bonds will be a fiscal suicide, for their maturity, and roll-over date, will fall dead on in the years of heavy Exchequer borrowing and maturity of other - 2008-2009 issued bonds. Given that the market demand for fixed income paper worldwide will be thinner then (due to increased appetite for equities-linked risk), a flood of rolled over bonds can risk derailing the borrowing programmes for Irish sovereign debt. Now, if you are a forward-looking investor, expect Irish yields to run away from the benchmarks once again, then.

(3) Short term maturity does not take into account the main risk to NAMA valuations, namely that by 2011 or for that matter 2013, the assets taken over by NAMA will be priced at any significant upside relative to what NAMA will pay for them, implying that, under short-term issuance, this Government will face the need to

• engage in a massive refinancing operations
  
• at the time when its balance sheet liabilities will be almost at their peak (see Department of Finance projections);
• pay higher expected cost of borrowing than today; and
• potentially, load the NAMA liabilities onto Government own balancesheet, while
• facing market prices and demand for real assets that is well below the valuations applied by NAMA.
  

If you look at the latter point. DofF uses 7 year U-shape cycle as its basic assumption. Peter Bacon last week stated that the cycle is expected to be 5-10 years. My estimations, based on NBER research (here), show that the average duration of the U-shaped cycle in historical data for OECD economies for 1970-2003 episodes of house prices collapse co-measurable with the one we are experiencing today is between 18 and 23 years. This range is dependent on how you time the cycle, but it refers to a nominal price cycle, unadjusted for Forex devaluations that accompanied such cycles in other countries and inflation. Japan (in down cycle since 1989-1990), Germany (since 1972-73), Italy (since 1981) and Sweden (since 1979) have not recovered to date.

Considering rolled up interest charges on impaired loans, banks' restructuring of interest payment schedules on so-called 'performing' stressed loans that in any other country would be classified as having defaulted, NAMA will be purchasing assets from the banks at an extremely shallow effective discount.

For example, a discount of 30% applied to a loan with 1.5 years (since July 2008 through December 2009) rolled up interest at 10%, and a built in re-financing cost of 1% will be equivalent to an effective discount of just 18.1% relative to the original principal of the loan itself. If, in the mean time, the underlying asset value itself has depreciated by, say 40%, then
NAMA will be buying a Euro 60 asset for Euro81.86. Now, in order for NAMA to recoup the original cost of purchase (not counting the cost of financing the purchase and managing the asset etc), the asset value needs to appreciate by a compound 36.4% within the span of the bond
finance. Thus between now and 2011 when the alleged bonds should mature, the annualized rate of appreciation required on the assets for NAMA just to recoup the original loan amount would have to be 16.8% per annum!

If anyone in the Department of Finance thinks this is a sane bet on a market turn-around, God help us.

Short-term financing of long-term obligations, as we should have learned in the current crisis, is equivalent to giving steroids to an unfit athlete and sending him out to run a marathon.

Though to repeat once again - this is just a speculation at this moment in time although two independent sources have tipped me on this one.

NAMA 3.0: A real alternative

I was bemused to learn that a number of my economics colleagues are apparently starting to 'discover' the idea of resolving the banking crisis through the use of a voucher-styled equity acquisition in Irish banks and disbursement of these to the taxpayers. Oh, it makes me glad that potentially some of them - possibly including even those who would not give me a fulltime job in their august departments - are now coming around to accepting some of my original ideas.

So to clearly draw a line in the sand, I espoused the idea of voucher-styled recapitalization of Irish banks on the pages of Business & Finance, with Prof Brian Lucey (the only person who saw, amongst academics, any merit in this idea from the start) in the pages of the Irish Times, in the Sunday Times and in the Irish Independent, as well as, of course, on this blog. But my entire view on how the banking crisis should be handled is summarized here:

Step 1: Require banks to take full mark-to-market writedown on their loan book;
Step 2: Travel down the capital ranks to draw down shareholder equity, deplete perpetual bond holders and so on to cover the writedowns;
Step 3: Force the bond holders into debt for equity swap;
Step 4: Open enrollment for a share-participation in Irish banks recapitalization to SVFs, vulture funds and any other form of private capital;
Step 5: Cover all remaining shortfalls in capital base with Government bonds swapped for equity after Steps 1-4 are completed and after an independent assessment of the value of the remaining loans is carried out to determine the true extent of banks under-capitalization;

Step 6: Hold equity in an escrow account (NAMA3.0) on behalf of the taxpayers, appointing a Supervisory Board to every bank recapitalized by the taxpayers money. The SB should consist of one appointee by the Minister for Finance, 3 direct independent representatives of the taxpayers, who are charged with explicitly guarding the taxpayers' interests, 1 representative of the bank board, 1 representative of NAMA3.0 and 1 independent director. Each member (other than those from NAMA3.0 and the bank) will hold a veto power. A requirement that risk and credit committees of NAMA3.0 include at least 51% majority of independent experts who cannot be employees of the state, NAMA3.0 or any other parties to this undertaking;

Step 7: NAMA3.0 accountability: no indemnity for negligence and incompetence for any employee or director of the escrow organization; no cross borrowing by the Exchequer from NAMA3.0 is allowed, so Brian Lenihan and his successors cannot raid the nest egg; ownership of shares in the account accrues to the taxpayers, not to the state or the public sector; NAMA3.0 cannot lend money to continue any of the banks' projects;

Step 8: NAMA3.0 transparency: full disclosure of all recapitalization acts and shares held in NAMA3.0 - on the web, updated live; full disclosure of all employment contracts, wages, bonuses etc, CVs of all managers and directors and disclosure of all potential conflicts of interest; full disclosure and updating of the comprehensive NAMA3.0 balance sheet, cost/benefit analysis of the undertaking and live weekly mark-to-market report on the value of shares held;

Step 9: NAMA3.0 operational efficiencies: NAMA3.0 can, with consent of the Minister for Finance and in orderly (market-respecting) fashion disburse all or a part of its shareholdings so as to maximize the return to the taxpayers. This disbursal should be fully notified to the public immediately post execution, with price achieved fully disclosed. NAMA3.0 will then have 30 days to issue every resident of this country - registered at the date of creation of NAMA3.0 - his or her share of the sale proceeds net of NAMA3.0 operating costs and a special withholding tax of 25% on CGT, in a form of the cheque;

Step 10: NAMA3.0 legal remit over assets: NAMA3.0 in recapitalizing the banks will have a mandate to help the banks collect on outstanding loans by aiding them in seizing requisite collateral. In doing so, NAMA3.0 will have to agree a procedure to address problems of cross-collateralization of specific assets. NAMA3.0 will have a right to impose seize borrower's property (applicable only to developers) when such property has been legally shielded from authorities or banks at any time after July 2008.

Step 11: Conditions for banks' participation in NAMA3.0 banks wishing to participate in this undertaking will be required to adhere to the following rules, including, but not limited to, the caps on executive compensation at the banks and the requirement to set up fully independent, veto-wielding risk assessment committee at each bank with a mandatory requirement for a position of a taxpayers' representative on the board that cannot be occupied by a civil servant or anyone who has worked in the Irish banking or development industry in the last 10 years;

Step 12: Re-legitimising the public system of regulation in Financial Services: as a part of NAMA3.0, the Government must address the ever-widening crisis of markets, investors' and taxpayers' trust in the Irish system of Financial Services regulation. Many steps must be taken to address this problem, and these can be worked out over time - suggest away. But in my view, there must be a stipulation that all and any regulatory authorities (and their senior level employees) that were involved in regulating the banking and housing sector in this country until now must be forced to take a mandatory pension cut of 50%, a salary cut to put them at -10% relative to their UK counterparts wages, and return any and all lump sum funds they collected upon their retirement. The Government must impose measures to prevent banks from beefing up their profit margins through squeezing their preforming customers. The measures to force the banks to reduce their cost bases by laying off surplus workers must be enforced. From now on, every regulatory office should be required to publish all minutes of its meetings, disclose all its voting, decisions and rulings to the public, create a public oversight board that must include members of the Dail from non-Governing Parties, a taxpayer representative and independent directors.

This is a sketch of NAMA3.0. Please feel free to build a bigger picture with me

Economics: 15/05/09: Ned 'Homer' O'Keeffe & ESRI's latest trip

So we have Ned O'Keeffe as Irish Politics answer to Homer -
except the former's daftness is actually intended as political and economic view points... read here...

"What has Tesco offered us since they came over to Ireland?" said Deputy O'Keeffe. "I think we would be better off if Tesco were to leave Ireland altogether. Their absence from the Irish market would be taken up by other supermarkets who would fill the gap and hopefully it would lead to less exploitation of Irish food suppliers. We’ve already seem the damage that foreign banks have done to Ireland and how the Irish banks were forced to make up for their mistakes. Well the same could happen in the retailing sector with the foreign retailers such as Tesco ruining the Irish supermarket industry and putting thousands of people out of work around the country", Deputy O'Keeffe concluded.

This is either delusional or clinically mad. And it comes from a sitting TD. In fact, the statement is so historically, economically and socially illiterate, Mr O'Keeffe deserves no comment on this blog other than one word: FRIGHTENING!


And in case you are not scared enough by Ned 'The Belching Brain' O'Keeffe, look no further than the latest trip-to-the-light-fantastic from ESRI: Recovery scenario for Ireland in the medium term, calling for 6.5% GDP growth. Yes, you are reading it right - 6.5%!

How did they got so high? Well, they estimated that Irish potential GDP growth post-crisis will be 3.0% (down from their previous estimate of 3.6%). Then, they slapped on top of this an additional 3.5% to account for the severity of the downturn we are currently experiencing. So the logic is - the further you fall in a recession, the steeper will be the climb on the way up. Ah, if only the world evolved according to the ESRI model.

Per IMF earlier studies (including the one I covered in several previous posts and in my column in Business & Finance), current recession, globally and in specific countries, like the US, is likely to lead to a flat-line recovery in output. But don't trust my words - see in the excellent note from NCB's Brian Devine (here):
So ESRI is in effect assuming that Ireland will be unique in the world in experiencing stronger recovery post-crisis than other economies, including those that will drive Irish recovery - i.e. the US and UK.

Alternatively, you can read ESRI's 'forecast' as being driven by the rate of FDI inflows into Ireland outstripping in the rate of growth the US/UK domestic capital investment expansion post recession 2:1.

As Brian put it in his Friday note: "The ESRI have assumed that this catch-up process will cause Irish economic growth to average 6.5% over the period 2011-2015. We would be highly cautious of this growth rate because of: a) The difficulty in measuring potential output especially in light of the current shock to the domestic and global financial system. b) The uncertainty surrounding the pace of global growth, again because of the difficulty in assessing the potential output of our main trading partners arising from the damage to the global financial system. c) The uncertain effects on consumption of further tax hikes. We also believe that consumption will remain subdued because of the rise in the level of real indebtedness."

Well argued, although I would have put it in less polite terms.

Per NCB note, the summary of ESRI 'forecasts' and NCB latest forecast, alongside with my own estimates are shown in the following table:
The difference between NCB's forecast, my estimate and ESRI's absolutely acid-sharp predictions is in assumptions...

As NCB note explains: "The conventional view of economic growth is that business cycle fluctuations in GDP represent temporary deviations from trend. In other words the economy eventually returns to a path determined by the potential of the economy. It is not abundantly clear that the current deviation from trend is transitory in nature. In other words it is quite possible that the problems in the economy are more structural in nature i.e. there has been a permanent loss of output relative to previous potential. The ESRI have acknowledged this and lowered the potential growth rate from 3.6% to 3.0% over the period 2005-2020 (driven by a significant part of the capital stock being rendered obsolete, the increase in taxes, the risk premium on borrowing and the reduction in global output potential). As a result of the current recession the ESRI estimate that there will be a permanent loss of the level of output relative to previous potential of 10%."

Ok, but... is 3.0 a relevant figure for the future? What reasons can ESRI bring about to set our potential growth rate close to the US and well above our main Eurozone competitors? Superior education system? Super-human entrepreneurship drive? Low cost base? Low tax rates? Fit and efficient public sector? Effective and pro-market Government? Workers who are accustomed to giving that extra effort and not expecting to be paid for it on the double? Competitive domestic service providers ensuring low cost of doing business in Ireland? Not likely. Shamrocks planted on a White House garden patch from the last Taoiseach's visit for Paddy's Day? More like it.

But here is more from NCB note: "As the ESRI note “In considering how the Irish economy is likely to exit from the current recession the key lies with the timing and nature of a world recovery.” Most of the world’s economies are forecast to grow at rates close to potential over the period 2011-2015 in the ESRI forecast." So why, again, does the ESRI assume that Irish economy will grow at more than double its potential GDP?

NCB also highlights timing issues in ESRI forecast: "Despite the fact that the pace of the decline in global downturn is likely behind us ...things are only getting less worse not better and the outlook remains highly uncertain, with the possibility of policy error large. The ESRI do take this into account by running an alternative scenario in which global growth does not recover until 2012 – in this case GDP growth in Ireland averages 5.5% over the period 2011-2015." So feel free to wonder - the world will still be in a recession in 2012, but ESRI's Ireland will be looking at a growth of 5.5% pa over 2011-2015? Let's take it apart: suppose 2012 the world is still in a recession, with growth of -1% - for the sake of an assumption. In 2011, obviously, things wouldn't be much better either, so let's say GDP growth is at -1.5% then. Now, to post average growth rate of 5.5% over 2011-2015 as ESRI predicts, Ireland would have to grow at a cumulative compounded rate of 34% between 2013 and 2015, or at an average annual rate of 10.25%! The ESRI use this as their pessimistic scenario...

So why are these unrealistically high numbers? Why now? Why from the ESRI? We can only speculate.

NCB's note says: "We think the greatest domestic risk to economic recovery is that the fiscal consolidation which has begun is not seen through or that taxes bear even more of the adjustment than currently envisaged (ironically the ESRIs document could halt the process of adjustment as unions/ government point to the fact that the economy is forecast to average growth of 6.5% in the future). This would have a major knock effect on consumption, competitiveness and borrowing costs and as such GDP growth."

That is, as far as I can understand it, a hint at something that I completely agree with. ESRI is a quasi-Governmental organization with no real independence in sight. In fact, what passes for 'independent' thinking in the ESRI's usual policy work is a mix of Labour's leftism in social policy department and Garret Fitz FG's legacy in taxation thinking (i.e the inherent inability of the ESRI to actually think rationally about tax burden and the damage it does to our economy). Hence, ESRI saying today that 'look - things are going to be just fine in couple of years' can be interpreted as their masters' signal to the unions and the social partners that the discomfort they might feel to be will be rewarded out of the spoils of the growing economy once again tomorrow. The timing of this rosy forecast - close enough to the elections is also, at the very best, an unfortunate coincidence.

Which brings us back to NAMA - why isn't the Government pre-committing itself to disbursing NAMA proceeds (if any gains occur) in the future to the taxpayers? Why isn't it ringfencing these proceeds? Perhaps, the NAMA upside is being held back to pay off the unions in the future through a compensatory wages increases after the crisis to the public sector workers for the income reductions they have suffered? or perhaps such a commitment has already been made? After all, the Bearded Men of the unions are not exactly fighting against NAMA, are they?..