A View From the Musroom Cloud III

As another day of carnage ensues, there are several new and old issues worth giving a thought to:

(1) Recall S&P ratings update (here): now that Irish 10-year spreads, predictably, are pushing beyond 300bps spread on German bund, what service did S&P provide to the bonds buyers who subscribed to the latest Irish issue of 5-year bonds on the back of AAA rating? The yields, as I have predicted (see here and here) on our bonds have moved in above the Greeks' leaving a wave of devastation behind in the balance sheets of those who bought into this paper on the back of S&P's ratings;

(2) Despite Mr Lenihan's assurances to the contrary on last night's Prime Time, the government is appearing to run thin on actual liquidity (in addition to running thin on any ideas). Do the maths. Mr Lenihan (who was, it must be said, trying to do his best in answering tough questions and did solicit some real compassion from this observer for being, evidently, under immense pressure both inside the Cabinet and in the wider world) stated that banks recapitalization requirements were ca €10bn in 2009.

Now, we know this figure was hammered out but the incompetent risk-pricing non-entities in the Department of Finance on the basis of the following assumptions:
(a) BofI and AIB raising some €2-3bn of their own funding,
(b) Anglo's depositors staying put (saying nothing about other banks' depositors),
(c) shares valuations for the three banks at twice above current, and
(d) no skeletons in the closets when it comes to loan books.

All four of these assumptions have now been challenged. So why is Mr Lenihan sticking to this figure? Is it because he has nothing new coming in with the morning briefing papers from our civil service mandarins?

Some commentators estimate the state exposure under recapitalization/guarantee schemes at €30bn. I would put the figure at a more modest €16-18bn. This would leave Mr Lenihan with just €2-4bn reserve to finance, in 2009 alone:

• a 10% deficit (ca €8bn in borrowing in excess of already acquired funds);
• a 'stimulus' package (ca €2bn);
  
• state credit pumping operations (via Anglo) (ca €5bn); and
• €5bn worth of maturing bonds...

In other words, no matter how you spin things, we are in the hole for, in the better case scenario, €16-18bn in 2009. Can the Minister really look straight into the voters eyes (as he did last night) and tell us - 'It's ok, folks, we'll just tap the credit markets for that. We have low sovereign debt'?

(3) David McWilliams brought back the specter of external rescue yesterday (here) with Ireland using a threat to leave the Euro if the ECB/EU Commission to get some funds. I am not sure this is going to be necessary. It is more likely that the Government will tap ECB/EUC for money under the argument that Ireland is yet to have a second Lisbon vote and that denying it emergency aid will be detrimental to the cause of getting us to vote Lisbon in. The funds will arrive in a combination of a straight ECB loan, acceptance of state paper as a collateral for more borrowing, some mixture of the 'knowledge' economy and capital spending investment assistance from the EUC and support for dwindling multinational employment in the likes of Limerick. Saving the face publicly, however, will not fool the debt markets and the yields will go further up.

(4) And while we are on the subject of the Euro - imagine our current Gang of Three running the monetary policy and managing our currency if we were to exit the common currency area? Close your eyes and watch Mary Coughlan trying to compute a three-party FX arbitrage parity, while Brian Cowen discusses a helicopter drop of money with Mr Hurley... Frightening!

(5) More from the bond markets - as our 10-year spreads moved above 300 bps, our short and medium term paper (6-24 months) breached 290bps last night. This suggests a temporary compression in the time structure of the bonds, implying that our 5 year yields will be climbing up and up and up in days to come.

(6) On the positive side, we have the latest comprehensive Government programme for dealing with this crisis (hat tip to Brian, courtesy of the source) in line with our closest competitor for being the worst performing economy in Europe, Latvia (here):

Talking up our economy

Today, Brian Cowen has issued a Bertiesque warning to commentators 'talking down Irish economy'. I beg to disagree. Firstly, the problem Ireland is facing is not that some commentators want to uncover the truth, but that our Government is failing to listen to anyone, save for a handful of public sector mandarins and political appointees. Secondly, lest anyone accuses myself of scaremongering, I remind our Taoiseach and his Cabinet that I have publicly put forward a constructive proposal for dealing with the current crisis as far back as in August 2008.

Here are few details:

In August 2008 edition of Business&Finance magazine, I predicted that Ireland will continue its downward trajectory in terms of stock market valuations and economic performance unless the Government were to tackle the issue of public sector overspend and consumer debt. In early October, from the same platform, I re-iterated a call for the Government to get serious with the problem of rising household insolvencies and corporate debt burden. At that time, I provided an outline of a basic plan that I hereby reproduce (some of the modifications to the original plan were featured in my article in Business&Finance in November).

Here is a bold, but a realistic proposal for moving the Government beyond its current position of playing catch up with deteriorating fundamentals. The Exchequer should:

• Announce a 10% reduction across the entire budget and an up to 60% cut on the discretionary non-capital spending under the NDP, generating ca €12-15bn in savings. The cut should include a 100% suspension of all overseas assistance until the time the economy returns to its long-term growth path of ca 2.5-3%.
• Cut, permanently, 10% of the public sector employment (effecting back office staff alone), saving ca €1bnpa after the costs of the measure are factored in.
• Freeze pensions indexation in the public sector for 2008-2015 and make mandatory a 50% contribution to all pensions plans written in the public sector, generating ca €1-2bn in savings.
• Stop the unfunded contributions to the NPRF, saving some €1.5bn per annum.
  

Combining all the savings, the Government should be able to :

• Bring 2009-2010 deficits to within the Eurozone limits; and
• Supply temporary tax refunds of ca €5,000pa per household in 2009-2010 ring-fenced for pensions plans and mortgages funding only.
  

The resulting capital injection of ca €7.5bn pa will be able to:

1. de-leverage the households (amounting, by the end of 2010 to a ca 25% reduction in the total households’ debt), improving consumer sentiment and re-starting housing markets;
2. help recapitalize the banks and improve their loans to capital ratios more efficiently than a debt buy-back, a nationalization, a direct injection of capital from the Exchequer or a debt guarantee.
   

It will result in a sizeable (ca 5% of the entire economy) annual stimulus, without triggering inflationary pressures associated with the Santa-like Government subsidies or consumption incentives.

This proposal implies no burden on the future generations, as the entire stimulus will be paid from the existent fiscal overhang and the set-aside public funds, with the public pensions covered by the contributory schemes.

Lastly, to achieve a morally justifiable and economically stimulative recapitalization of the banks, the plan would require Irish institutions receiving any additional public financing to issue call options on ordinary shares with a strike price set at the date of the deposit and maturity of 5 years. These shares should be distributed to all Irish households on the flat-rate basis.

Thus, assuming the need for additional capital injections of €6-9bn in the Irish financial institutions through 2010 (over and above the €7.5bn pa injected through mortgages repayments and pensions re-capitalizations), Irish households will be in the possession of options with a face value of €4,000-6,000 per household, thus increasing their financial reserves. At the time of maturity, assuming options are in the money, the Exchequer will avail of a special 50% rate of CGT on these particular instruments. Assuming that share prices appreciation of 40% between 2009 and 2014, the CGT returns to the Exchequer will yield ca €1.8bn, ex dividend payments.

Mushroom Cloud II

No words needed... (Hat tip to an anonymous reader pointing to July 9 event)

Watching a mushroom-shaped cloud rising

Sadly, my quick prediction last night has turned into a reality - bleaker than I could have anticipated. As, at the time of writing, FTSE EUROTOP100 index is trading in the green territory, ISEQ-FINANCIAL is over 34% in the red, with AIB down 41.5%, and BofI and IL&P both down 27%.

We are now safe to assume that the Anglo Irish Bank, taken over by the state last week, was on the verge of becoming a moneyless institution. That despite the tough talk from Mr Lenihan about freezing some deposits, all sizeable corporate deposits have now left the bank's vaults. That the Exchequer downside from the bank 'rescue' is going to be in excess of €10bn, prompting his yesterday's remark that the other banks are now effectively on their own, and in effect admitting that the Exchequer itself may be now out of money, if commitments to date were to be honoured!

All of this has not been lost to international investors, who are currently dumping anything they might still have in the form of Irish banks shares. The surprising thing for now is that Irish bonds yields appear to be holding.

The question, however, is: for how long. If the Black Monday is not reversed, and unless the Government comes out in public with the actually believable statement on its current financial position (including a detailed and credible forecast as to how it plans to manage its exponentially increasing commitments for 2009), Irish yields will rise and prices will fall.

Whatever you do, I would think thrice before switching into Irish bonds... they are far from being a safe harbour...

Will mayhem begin?

This is an unusual post for this blog - short and an attempt to 'call' the market - but given the comments, reportedly, given on RTE today by Mr Lenihan, I would venture to attempt to predict this week's start of trading (6 hours 30 min from now). With the Government once again faltering at the banks recapitalization policy and talking gibberish (with RTE reporting that "Brian Lenihan said each bank had to take responsibility for its own bad debts"), it is difficult to see how we can avoid another deep meltdown in the markets. I hope I am wrong, but today might be the first Black Monday of 2009... Stay safe, ye all who trade today!

Irish credit II

Here are the facts in support of Irish credit ratings downgrade (for those impatient to get the actual downgrade forecast, see Table 2 at the bottom of this post) taken directly from the IMF’s latest Global Financial Stability Report published in October 2008.

These facts suggest that:
(a) the problem of Ireland’s high risk of sovereign and economic insolvency is not new –by the end of 2007 Ireland has emerged as the most financially exposed country in the developed world, to the total silence of Irish Government, Regulators and other domestic financial services authorities; and
(b) our sovereign ratings have are failing to reflect this risk, despite the fact that the data was available to all rating agencies for some time.

Our financial health ca January 2008...
Ireland ranks last out of the entire group of countries/ regions covered in the report in terms of its overall capital markets/financial stability (see table below). The countries/regions reported by the IMF include: the EU, Euro area, Canada, US, Japan, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, the UK, a general set of all emerging economies. Report parameters are given in IMF’s Table 3 in absolute terms.

Table 1 below ranks Ireland, and its two European competitors for the title of the worst-off (in terms of financial stability) Italy and Greece, across these same IMF-selected parameters.

Table 1: Ranking for Selected Indicators on the Size of the Capital Markets, 2007, expressed as % of country GDP/GNP
Sources: IMF GFS Report October 2008, and author own calculations.

Figures below plot the data that led to the above table results.

Figure 1: Total Reserves, % of GDP/GNPSources for Figures 1-7: IMF GFS Report October 2008, and author own calculations.

Figure 1 above shows total economies’ reserves (net of gold) as a percentage of GDP (and GNP for Ireland). Technically, ceteris paribus, higher levels of reserves relative to the economy size imply higher levels of solvency. Notice that this data is for 2007 – the year when Ireland was still in a relatively benign economic environment. In 2007 Ireland’s total reserves stood at a level almost 6 times below the EU27 average. Out of all main global financial centers selected by the IMF only Greece and Luxembourg showed weaker reserves base than Ireland.

Of course, we knew this already, as most of our wealth was trapped in the deteriorating housing markets. But the rating agencies failed to see this as a serious threat, preferring to focus disproportionately on the deceptively low public debt levels in this country. The irony that the state has managed to drive down its debt at the expense of economic stability (by taxing businesses and consumers to produce a ‘savings’ piggy bank for the public sector) and by imperiling our financial stability (by re-directing private financial flows and diverting investment into property and other state-incentivised schemes), was totally missed by the likes of S&P and Fitch.

Figure 2: Stock Market Capitalization, % of GDP/GNP
As the above figure shows, our stock market capitalization as the percentage of GDP/GNP ranked the second lowest in the world in 2007. Italy was the only country with a relative weight of the stock markets capitalization in its economy falling below that of Ireland. This parameter reflects, indirectly, the overall mammoth share of debt (as opposed to equity) on our corporate balance sheets and the effects of Irish economy’s dependence on leveraging and housing markets.

Figure 3: Debt securities as % of GDP
Figure 3 above shows how extreme were the levels of Irish debt liabilities in 2007, with the country leading the world in terms of private debt share of GDP. In the figure 4 below, the two sources of debt are combined to show that Ireland (as a share of GNP) has achieved a dubious distinction of becoming world’s most debt-ridden country by the end of 2007 – a point also missed by the rating agencies.

Figure 4: Total Debt Securities Outstanding, as % of GDP/GNP
Figure 5: Bank Assets as % of GDP/GNPWhen it comes to the financial system assets side of the balance sheet, Irish banking assets appeared to be relatively healthy in 2007 (Figure 5), although this does not include any correction for these assets quality. However two factors must be kept in mind:
(1) to date, Ireland has been leading the EU in terms of commercial bankruptcies (up 250% on 2007) and in terms of housing and commercial real estate crises, implying mid-term impairment charges for Irish banking system well in excess of those in other European countries;
(2) as the following two figures show, our assets cushion (non-bank assets as % of the total debt) and reserves cushion (total reserves as % of the total debt) were both thin, despite the fact that we are faced with an unprecedented (by global comparisons) total debt mountain.

Poor protection buffers: still the ‘old’ news

Figure 6: Assets CushionFigure 7: Reserves Cushion
It is worth mentioning that our Assets cushion (Figure 6) is artificially inflated by the still high property valuations of 2007. Correcting for 2008 commercial and residential property contractions, Ireland's non-bank assets to GDP or GNP stand at the lowest level in the entire developed countries sub-sample. Of course, as far as our reserves to GDP ratio goes - the fact is that our banking sector reserves stood at a critically low levels even in 2007 invites two observations:
(1) reserve requirement ratios are the prerogative of Irish Central Bank and Financial Regulator - with domestic regulators having full access to the powerful policy lever of raising these requirements. Both did absolutely nothing;
(2) the IMF figure for reserves includes state own reserves (NPRF), implying that the real problem of the banking sector reserves crisis we are currently experiencing is even worse than the official figures suggest.

Given a precipitous fall in Irish shares, property and economic growth – all registering declines well in excess of other European countries – we are now facing the assets and reserves cushions that are critically low, warranting a significant downgrade on our credit ratings.

Ireland’s comparatives (2008-2009) and ratings forecast
Comparing our financial position to that of the peer countries, Table 2 below shows that our current credit fundamentals are woefully out of line with other AAA rated countries in Europe. In fact, even disregarding the realities of our economic slowdown and fiscal challenges facing the country in 2009, comparative analysis of financial stability fundamentals for Ireland suggest that our true ratings should be below those of Greece or Italy.

Table 2: Assets, Reserves and Ratings
Sources: Fitch, S&P and IMF data, author own forecasts

The above results show that Ireland is well over-due a downgrade on its sovereign debt to bring us in line with our relative peers – Italy, Greece and (correcting for Eurzone membership) Iceland. But Table 2 above (see forecasts for financial stability parameters marked in blue) also shows that taking into account our economic and fiscal prospects for 2009, the downgrade currently overdue can actually be much deeper than the one forecasted herein.

Current environment: even more room for downgrades
One cannot ignore the extent of the economic and fiscal deterioration in Ireland to-date. We are facing an officially projected deficit that is unprecedented in the entire EU27. And the official forecast, as I argued before (here) is by all means an underestimate of the fiscal black hole we are heading for.

Even with An Bord Snip delivering significant – ca 10% - cuts in pubic spending (at least half of which is already factored into the Department of Finance forecasts), and even assuming the Government has the guts to implement such changes, Ireland is likely to find itself in ca 10% deficit in 2009.

This alone should trigger our ratings to be downgraded below AA- and our bonds yields to head closer to 6-6.5% for a 10-year paper. Of course, Ireland cannot at this time issue 10-year paper, implying that our borrowings for the foreseeable future will be short-term. Should the downturn extend through 2013, or alternatively, should the post-downturn growth fail to reach above 3%, Ireland will be in a serious trouble when redemptions on 2008-2009 debt issues come knocking on the door.

But the fiscal challenge is not the only one. Ireland’s economic contraction is likely to reach 4.5-5% (GDP terms) in 2009, implying that we will continue to lead the EU in terms of recessionary pressures. Such a scenario also warrants a downgrade of our ratings to AA-/BBB+.

Last, but not least, the Irish Government has underwritten some €450bn worth of debts and obligations on the domestic banks’ books, plus an open-ended commitment to supply capital to the banks. The nationalization of Anglo alone is likely to add something to the tune of €7-10bn to 2009 liabilities of the Exchequer and some economists estimated last week that this liability can easily reach €15-30bn.

Now, do the math. The Government boasts of holding some €20bn in liquid reserves, including surplus 2008 borrowings. Of these, Anglo commitment will eat through, say €7bn, previous capital commitments alongside the underwriting of the equity placements for AIB and BofI – another €5bn, the Exchequer deficit, assuming An Board Snip delivers real savings, will take up the rest. This leaves Ireland Inc naked for 2009 – no stimulus, no cushion for error, no buffers for any bank or building society default and, even more crucially, no deficit financing for 2010 should the sovereign debt markets get tougher throughout the year.

In these conditions, it is highly likely Ireland will push 10-year yields well beyond 350-400bps spread on German bonds and despite Mr Cowen's protestations to the contrary, find itself begging for funds from external donors. IMF or ECB or both - the acronyms are semantic: either one will part with its money only on extremely strict conditions...

Irish credit I

The prevailing feature of last year’s end is a growing tide of anger at the impotence of our Government to come to grips with the bleak reality of a severe downturn that is facing the rest of us. But the latest developments in global markets are suggesting that our Exchequer will have to deal with more than domestic pressure to reform in 2009.

Three events since the beginning of the New Year show the extent of the deepening global economic crisis with potentially dramatic implications for Ireland.

Sovereign debt financing
First, last week’s German 10-year bund auction, a golden standard of financial security for European markets, turned into an unmitigated disaster. The auction failed to sell 13pct of a relatively modest €6bn issue – second worst result in history that follows on the heels of seven auctions that failed to secure full placements in 2008. The latest US auction of 90-day T-bills – considered to be risk-free by the markets – was subscribed up to 50pct, while the UK’s 10-year bond issue had to be placed at 5pct.

Second, Greece has moved one step closer to a sovereign debt default and a deeper political crisis when banks bailout package triggered a wave of discontent from the crisis-impoverished consumers. To date, this has led to the firing of the Finance Minister in a Government that was, similarly to Ireland’s, elected just 16 months ago. Greek 10-year bonds are now yielding 5.31pct – dangerously close to the junk bond levels. This week’s Irish 5-year bonds being priced at 4.14pct implies that (a) adjusted for their term structure, Irish bonds would be priced to yield around 5.47pct for a 10-year bond – well ahead of Greece, and (b) the global appetite for long-term sovereign debt is in a steep decline. It is doubtful if Ireland will be capable of placing a 10-year note even in theory at anything below 5.6-6pct mark, suggesting that whatever debt we do raise in 2009 might come not only at a high price today, but at an even higher price in the future refinancing markets.

Our borrowing plans
Last, but not least, our Exchequer results for December have shown an unprecedented rate of collapse, with Q4 2008 receipts down a whooping 22pct on Q4 2007. The timeline of deterioration, highlighted in the box-out is frightening. Despite the Department of Finance forecast for 6.5pct General Government Deficit for 2009, it is likely that our GGD will exceed 9pct – three times the Stability and Growth Pact limit for the Eurozone member states by this year end.

The Government has acknowledged that Ireland will have to borrow ca €20bn in 2009 – a level of new bonds issuance that is unprecedented in Europe. And don’t forget that Ireland Inc is also likely to face the need for extra €5bn for the expected cost of banks recapitalization and guarantees and another €5bn in redemption cover for April bond.

Such borrowing, relative to the domestic economy, would imply bonds issuance of ca €450bn for the UK (well above the €160bn debt placement planned by the UK Exchequer) and €470bn for Germany. Put into perspective, the US is planning some $950bn in new bonds issuance, inclusive of some quasi corporate bonds by the likes of Fannie Mae & Freddie Mac, for an unprecedented 2009 economic stimulus. Were the country to use Irish Government fund raising plans it would have to issue over $1.8 trillion in new bonds. And while the rest of the world is using borrowings to finance economic growth, our Government is plugging the Exchequer imbalances.

The cost of digging ourselves out
All three events have one theme in common – they suggests that our economy is now firmly set on track to higher taxes and more pain for the ordinary households. For thousands of Irish businesses toiling under pressure to maintain revenue and employment this is a far more ominous threat than all external shocks combined.

The structure of pricing in the sovereign debt markets is now poised to change, with a renewed buyers’ focus on the underlying economic fundamentals. These include:
• Traditional fundamentals: fiscal deficits, inflation and economic growth prospects; and
• New fundamentals: the quality of macroeconomic management and the reasons for debt placement.
On both, Ireland offers a poor prospect. But it is in the second set that our Government’s failure to deliver leadership will be felt most, both by the NTMA trying to place our bonds and by the ordinary businesses and consumers, trying to cope with the cost of the public sector burden.

For traditional fundamentals, last year’s record unemployment claims growth (up 66pct), EU’s largest economic contraction (-2.5pct of GDP), widening of GDP/GNP gap, above EU-average inflation (especially in the state-controlled sectors), and extreme housing and construction crisis are all set to continue in 2009.

Irish property prices can decline by ca 25pct in real terms in 2009. New construction might replace only 30-40pct of the already low 2008 levels, while our unemployment is likely to climb to 11-12pct. This will be moderated, on the paper, by a rapid outflow of foreign workers and younger Irish employees. But in reality, emigration will take the most productive future employees out of this economy first. Deflation in the private economy will be exacerbated by continued inflation in the public sector as our semi-state companies squeeze Irish consumers in pursuit of increased profits demanded by the Exchequer. Taxes – both on personal income and indirect business and consumer levies – will climb, inducing a rising tide of tax evasion and minimization measures by businesses and sole-traders. All of this will imply that the Exchequer revenue will slide ca 10-12pct in 2009 on the back of a more severe growth contraction (-4.5pct GDP and -5-5.5pct GNP).

At the same time, there is little hope for spending discipline to be imposed on the public sector by this Government. For 2008, despite the extremely modest demand for €440 million in savings issued by the Exchequer in July, overall spending was up 0.7pct or €351 million. In part, this reflected high demand for social welfare benefits due to collapse in employment. In part, however, it reflects the fact that our public sector still managed to award itself the pay increases and pensions hikes set out under the last Social Partnership agreement.

A new set of challenges
New pricing fundamentals in the bond markets support the proposition that the State will find it very difficult to raise funds in international markets and that this will translate into more economic hardship for the private sector.

In 2009, debt markets will favour those sovereign issues that will be placed to provide direct growth stimuli to the economies. In contrast, Irish borrowing will be focusing on maintaining already unsustainable levels of Exchequer expenditure with little stimulus potential.

Can anyone really believe that serious international investors will back our Building Ireland's Smart Economy framework? Or that they will have serious confidence in this Government’s ability to jump-start Ireland’s economy? To date, Irish Government record on taking decisive action is, as the box-out shows, abysmal.

The problem with the current Government’s handling of the economy is that instead of facilitating growth, the State is exacerbating the effects of the global economic slowdown. Majority of Irish businesses are currently operating in the environment of severe shocks to sales, exchange rate valuations, contracting global demand, shortages of credit facilities and rising domestic costs. At the same time, majority of Irish consumers are feeling besieged by the rising risk of unemployment, taxes, debt and falling disposable incomes. None of these players can take on the task of rescuing the Exchequer out of the unsustainable spending increases.


Box Out: A record of errors
Credit ratings agencies reviewing Irish Government creditworthiness in the recent weeks have made sweeping claims that their unwillingness to downgrade Irish ratings from the gold-standard level of AAA are motivated by the speedy and adequate response by the Government to the economic crisis. In reality, our Government has shown zero capacity for leadership and for admitting its own errors. Consider the facts.

Fact: 2007 general elections brought up the need for public sector reforms to the forefront of policy debate. All parties involved made serious hay out of the calls for changing the way this state spends tax revenue on various political white elephants, bogus investments, excessive wages and perks in the public sector and so on. By the end of 2007, the Government has seen the OECD blueprint for change. By the second half this year it had its own assessment of the OECD report. There has been no action by the Government on the issue of public finances.

Fact: in mid 2007, as the credit crisis first manifested itself, a number of commentators, including this column, has told the Government that the spending path it embarked on was out of touch with reality. In late 2007, many analysts, this column included, were predicting a record slowdown in 2008 and a precipitous fall in taxes. The Government ended 2007 in deficit – despite the windfall from SSIAs and buoyant economy. The same leaders are now denying knowing anything about the crisis prior to July 2008.

Fact: The Exchequer registered a 6pct drop in Q1 2008 receipts compared to Q1 2007, 10pct drop in receipts in Q2 2008 relative to Q2 2007, 12pct decline in Q3 2008 and a catastrophic fall of 22pct in Q4, bringing about an unprecedented, by all European benchmarks, deficit of €12.7bn with a span of the year. All of this was happening right in front of this Government’s eyes and with complacent silence of the boffins from our Department of Finance. This Government still insists that it could not have foreseen these events until after the end of Q2 2008 – 7 months after the revenues collapse began.

Fact: Since the beginning of 2008, when the scope of the crisis became apparent first to the independent economist (in January-February 2008), then to the financial services experts (March-April) and later even to the ESRI and other official policy pundits (by April-May 2008), the Government took lengthy vacations and extended tea breaks to evade making any policy decisions that can be considered even remotely effective or decisive. In the year of extraordinary crisis, both the Dail and the Cabinet did not bother to take any significant extra time to deal with the issues.

In the course of 2008, this Government produced four policy documents:
• a banks guarantee scheme which provided no real support to the economy and preciously little support for the banks,
• the Budget 2009 which managed to bludgeon ordinary consumers and small businesses with new taxes and levies but produced not an ounce of reformist thinking,
• the recapitalization scheme for our banks that failed to address the issue of catastrophic household and corporate indebtedness, and
• the farcical Building Ireland's Smart Economy framework, promising more waste and government spending on politically motivated pet projects amidst the trite catch phrases richly sprinkled across 100-plus pages of largely meaningless policy proposals.

Per Hitchhiker’s Guide to the Galaxy, can this Government, please start delivering its future reports and policy papers in a plastic cover with ‘Don’t Panic’ printed on it. At least we will be properly forewarned.


This article appears in the current edition of Business & Finance magazine (January, 16, 2009).

Our true credit ratings

The credit ratings agency, Fitch, has downgraded all Irish banks closer to the junk-bond status:
• Allied Irish Bank and Bank of Ireland went down a mile from AA- to A,
• Anglo fell two stories to A-,
• Irish Nationwide, having fallen from BBB+ to BBB-, is now just one inch away from being valued as pure junk,
• IL&P sits pretty (thanks to its insurance arm) at A+, down from AA, while
• EBS is now up for a review of its A- status.

All moves were triggered by Fitch’s (somewhat belated) realization of “the deteriorating economic environment, an abrupt contraction in forecasts for Irish economic growth in 2009, rising unemployment and a worsening outlook for commercial property", that threaten earnings and loan book losses.

Clearly, Fitch's folks have not been listening to
• the increasingly irrational pronouncements from our Taoiseach in Tokyo about the imminent return of the age of prosperity and the bottoming out of the housing market in 2009 (made on the day when RGE Monitor pushed back expected date of the US housing market bottoming out to 2010 (see here), as did the UK);
• the oblivious statements from the Exchequer about the low-debt competitive economy that is Ireland Inc; and
• those voices of the Irish knowledge economy pioneers that RTE’s Wednesday Prime Time programme unearthed (how can one fail to see the bright future for the country covered by fish farms with a perpetuum mobile machines providing zero-cost energy? As we speak, I am quite confident Eamon O'Cuiv is seeking state funding for a Galetacht company to produce tin whistles for export, while SFI is funding the path breaking research in alchemy).

But Fitch did swallow some propaganda junk from our leaders. Chris Pryce from Fitch Ratings told the UK Telegraph that “Ireland had shown great courage by facing up to the full implications of the global crisis earlier than others. "We're very impressed by the vigour of the Irish government," he said.”

What courage? What vigour? A lifeless cabinet limping from one crisis statement to another? What 'facing up'? We have a PM who finds nothing better to do than attack American foreign policy and the UK monetary authorities in between lunches and receptions in Tokyo? A Deputy PM who is incapable of a single meaningful thought on this crisis on an hour long program on the national broadcaster devoted to it?

Next stop for the country? An honest reappraisal of our sovereign debt ratings to reflect the fact that our actual debt ratio to committed obligations under the banks guarantee and recapitalization schemes is about 1:5, yielding a total expcted Exchequer exposure of ca 120-150% of GDP should impairment charges at the banks reach UK's 1990s levels, implying that Ireland’s own bonds cannot be traded at the prices far off the banks bond levels.

Of course, not willing to follow S&P’s delirious review that left Ireland’s sovereign rating at AAAa week ago (here) and Fitch’s yesterday’s failure to mention the execpected impact of their banks downgrade on Irish sovereign debt, the markets have already started the repricing process. Our five-year credit default swaps are being quoted at a 250bps, roughly 66bps above Monday levels.

We are now at par with Greece, while enjoying a much more rapid deterioration in the economy and public finances, implying our debt rating should be at or below their A-/A-2 range.


PS: at the rate our CDS spreads deteriorate, it is worth a mention that our NTMA is about the only properly functioning branch of the State.

The Oligarch of the Upper Merrion Street

Flip-Flop-Flip Brian
On October 23, 2008, just two and a half months ago, Minister for Finance has gone out of his way to explain that the State investment in the banks was the 'very final option' he was willing to take. On that date, Anglo’s shares were trading at €1.80 or almost 90% down on their historic high. Flip! Brian's jacket of being 'conservative with taxpayers' money' came undone!

Fast forward 2 months ahead – on December 15, 2008, announcing the rescue plan for Irish banks, Mr Lenihan has flopped the ‘very final option’ into an actual policy. By that date, Anglo’s shares moved to €0.36 or 80% below their October 23 level, yet still the ‘very final option’ was to involve no more than a 3/4 stake in Anglo with no voting rights for the Exchequer. The fig leaf of decorum of being only 1/4 true to his October statement was all that was left of a respectable Exchequer.

Today, Brian ‘The Flipper’ Lenihan has completely reneged on his October-December claims. The state is now poised to take the entire Anglo – toxic and healthy assets, workforce and physical capital alike. Flip! The fig leaf is sailing across the Upper Mount Street - its new Bank-owning Oligarch is now fully exposed as Minister whose words must be read between the lines.

Details? Go straight to the consequences!
Whatever the deal price might be the main point of this performance by the Government has been totally lost in the media to date. The nationalization of the Anglo Irish Bank is simply wrong. Full stop.

Let me focus on this point:

Irish Exchequer has no business taking money from the working families at this time of need (or at any time indeed) to rescue a handful of large development deals and bail out a party of investors. No financial stability emergency, no amount of bad loans on the books, no balance sheet analysis can ever justify the Exchequer using ordinary peoples' cash to buy assets into its own ownership.

If the Anglo needed capital, the Exchequer should have placed money with the institution, collect the shares in return to the current value of the money deposited and then immediately disburse the shares to those who are paying for them – the people.

And I do not mean some collective People – aka the public sector who will reap most of the benefit of any future recovery in Anglo’s fortunes, but the people whose cash 'The Flipper' has so princely pledged to Anglo’s creditors.

To be morally justifiable, the nationalization of the Anglo Irish Bank should:
(1) involve a rigorous investment case analysis carried out by an international assessor with NO connection to Ireland, the Anglo Irish Bank or any other party to the transaction before any announcement of the takeover was made; and
(2) if allowed to proceed, be carried out as a voucher nationalization scheme, with all new Anglo Irish Bank’s shares (underlying the State liquidity injection) being distributed uniformly amongst all households in Ireland.

We've paid for them, Mr Lenihan, in case you've failed to notice!

Renewing appetite for risk?

“I have some good news, at least for the intermediate term: Investors are slowly regaining their appetite for risk”, wrote Marketwatch’s Mark Hulbert in his today’s column (here)
“This represents a big shift from the situation that prevailed last fall, when investors became so repulsed by any kind of risk that the yields on safe-haven investments like Treasury bills actually went negative.”

But now, says Hulbert, with January effect in full swing, things are looking up – investors are looking for risk once again.

“Of the several straws in the wind that point to at least a partial return of a risk appetite, one of the more compelling is the recent relative strength of risky small-cap stocks over the more conservative large caps. So far this year through Tuesday night, for example, large-cap stocks (as measured by the Standard & Poor's 500 index (SPX: S&P 500 Index) have fallen 3.5%. Small-cap stocks, as measured by the Value Line Arithmetic Index (92040310), have declined by just 1.1%.”

Now, I am not convinced by Hulbert’s main argument.

January effect is a tax-minimization event, driven by heavier sales of shares with lowest capital gains potential to maximize losses in December (blue chips down) and re-balancing portfolio toward higher capital gains potential (small cap) in the new year. In normal years, movements correlate positively with risk, i.e. small cap – higher expected return, higher risk, blue chip - smaller expected returns, lower risk. But is that the case this time around? In other words, the markets might be going into smaller cap because the larger cap is actually relatively riskier (controlling for current valuations), not because they are seeking higher risk-return strategies.

Chart below illustrates Mark Hulbert’s point – at its right-hand margin. Indeed, the short-term performance by the two indices does suggest that the markets are placing more faith in the small-caps. But it shows that this was true for much of the 2008 with exception of the late autumn. In other words, if current divergence vis-à-vis S&P is a sign of new appetite for risk, what did the market have appetite for in July 2008 when small caps went up and S&P stayed relatively flat? Why did the price of risk implicit in the difference in two indices has fallen in April-June and July-early August? Were these the ‘turning’ points in underlying appetite for risk or just traditional bear rallies?
An alternative explanation for the ‘January effect’-like pattern observed is that investors' risk perception might have shifted. Consider the following scenario: You are in a market with four broad asset classes:

• large-cap,
  
• small-cap,
  
• corporate bonds and
  
• Treasuries.

You believe that too much risk-taking has taken place in the second half of December by pursuing a bear rally in S&P500 stocks and the Treasuries. If you move into relative safety, you will move into the two remaining assets. You will have an incentive to prefer the small caps if you believe that they have taken the heaviest beating to date (which they did – see peak to trough moves around September-mid November) and you invoke another powerful anomaly of the ‘Winner’s Curse”. The real question then becomes is what does the analysis of relative position changes in corporate debt and small cap shares tell us. The large cap stocks are irrelevant here.

Hence, what appears to be a renewed appetite for risk can be interpreted as a hedging strategy against rising risk levels and falling expected returns in the so-called traditionally ‘safer’ asset classes.

What Hulbert is right about is that one should not overplay the story too much. Instead, the return of the January effect pattern (or something else resembling it) might mean “that the stock market will gradually resume its normal function of assessing different securities' relative risks and returns, a function it couldn't fulfill when it was indiscriminately punishing virtually everything other than Treasuries.”

Yes, but… even if Hulbert is correct, the return to rationality in the markets will be bound to:
• trigger fresh downgrades in many companies and indices as corporate returns deteriorate throughout H1 2009, as the bath water gets muddier with longer recession; and
• this rationality will remain extremely fragile and prone to collapse every time the elephant in the room – the US Government – moves about.

Hulbert omits the latter issue, but it is non-trivial to his topic. We are in the changing political cycle – and with it – a prospect of a new stimulus that is bound to prop up smaller business. If, as is the case, Uncle Sam’s rescue packages for many blue chips were already priced into these companies valuations in late December, Obama's first 100-day sweetheart package for Congress is yet to be fully priced into stocks valuations. It might be that the ‘January effect’ is simply the reflection of this delay in recognizing that the next Uncle Sam's move will a stimulus for smaller companies?..

Foot-in-Mouth Outbreak update I

From today’s WSJ – hat tip to Paul – see the first comment here:

“So the Fed is again in the position of "pushing on a string" and finding that nothing happens. Some economists describe this as a "liquidity trap." Money creation loses its stimulative power -- vastly overrated even in ordinary times -- because public demand for loans is weak. Americans are too strapped financially, too short on investment opportunities, or too concerned about the future to borrow. They prefer to save instead.”

This makes sense, especially in Ireland – the incessant blabber we are now accustomed of hearing from the Dail – the Government and the Opposition – is that the banks must start lending to the households and the corporates. But, as I pointed out on numerous occasions since last summer (including in the posts here), there is no demand for these loans – Irish households (the most indebted in the EU) and companies (the most indebted in the EU) simply have no demand for new loans. Hence, the main problem faced by the Irish government is de-leveraging of companies and households, not recapitalizing the banks!

According to WSJ:
“Some economists argue that... the new money the Fed has pumped into the economy to replace the financial-sector liquidity wiped out by the collapse of the bubble has to go somewhere, they point out. It has to end up in someone's bank account and banks have to quickly convert deposits (liabilities) into investments or go broke even faster than some have by loading up on polluted, mortgage-backed securities. Maybe "liquidity malfunction" is a better term than "trap."”

The malfunction, according to the WSJ is that the money creation feeds US Government spending, yielding little benefit for the private sector. It is, according to the WSJ article – a Keynesian policy Redux, not a monetary policy paradigm.

I agree with that view. In September this year I authored a research note – which was never published – saying that the US Fed’s monetary operations – ‘helicopter drop of money’ and monetary policy easing can be viewed as a Ponzi game. Ditto for Ireland’s banks guarantee scheme and banks rescue package. I returned, briefly, to this is my Business&Finance column in November 2008.

Effectively, the rescue policies work like an old fire engine pump – the flow of funds from the Treasury to the Fed to the Treasury passing through the markets creates a vacuum of liquidity in the associated securities markets. Think buying bonds, liquifying existent positions at a discount, and then selling new bonds at a premium, thus generating net negative position. These flows sap private and foreign liquidity out of the private sector loans market and into public sector stimulus financing (or assets purchasing, banks propping and Detroit rescues). In effect, this ‘liquidity’ pump is destroying any hope of private credit markets return to some sort of stability, while financing Treasury's operations.

The thing is that, while we do need to prop up some financial institutions, if you push liquidity flows through household balances – by forcing the banks to issue new equity/options and write down loans – you use the liquidity to achieve both – provide a pool of potential loans and deleverage households. Only then will you simultaneously solve the twin problem of:
(1) shortage of loans supply;
(2) shortgae of loans demand.
Not a single politician to date cared to listen.

Yet, this is exactly what the article in the WSJ is saying...

Surprise! Our Brian's new 'foot-in-mouth' outbreak

As stated in the Financial Times today (here):

"Brian Lenihan, the Irish finance minister, accused the UK authorities of, in effect, devaluing the pound by expanding the UK money supply, action that was causing “immense difficulties” in the Irish economy. “It is a question for all of us in the EU as to the extent to which a competitive devaluation can be used as any kind of weapon,” he said."

Oh, dear. Our Brian does not get it - British monetary policy is about British economy. It is not - and should not be - about some abstract idea of European solidarity (which seems to work for our Government only when solidarity means that others do something 'nice' for Ireland) or coordinated responses to the crises (if the UK were to coordinate things with Ireland, they would be rising taxes, squeezing consumers, issuing blanket guarantees and wasting billions on inefficient public sector).

Whether the UK is engaging in a competitive devaluation, or is simply conducting more pro-active monetary policy than 'we-don't-give-a-damn-if-you-are-in-pain' ECB is a moot point. Bank of England has a mandate to manage money supply for the UK. British Exchequer has a mandate to respond to the real needs of the UK economy. It is Brian Lenihan who has a mandate (if only theoretically) to sort out his own Government's response to the crisis in Ireland. Does the fact that the latter does not seem to be up to his job imply that the former two are obliged to help him finance his wobbling decision-making?

Oh, when one hears an ex-lawyer talking about Forex valuations, ...it sounds only half as bad than when one realises that he is in charge of our entire Exchequer!