Monday, 31 August 2009

Why, you're welcome Mr Desmond

You will go a long way to find a much clearer and damning indictment of the way the banking crisis has been handled in Ireland than the reported cases of Dermot Desmond in the Sunday Independent. The articles reports how Mr Desmond divested himself of around 14 millions shares in Bank of Ireland and AIB that he had acquired in January, netting himself a supposed €20 million profit.

Let's just review what has happened here. Over the course of 6 months it has been possible to make a staggering windfall return on, what everybody explicitly accepted at the time of purchase, were two insolvent banks. No extra capital required, just a share of the negative net asset value purchased and then sold for a higher sum.

How is this possible? John Q Taxpayer of course, via the globally patented "bank liability guarantee" and more recently "NAMA". Entirely predictable; the government effectively took financial responsibility for these entities but left ownership (potential upside) to the current shareholders. Desmond, among others, was too shrewd to let Christmas pass buy and did the rational thing.

But the real travesty in this case is that this is unlikely to be the end of the story if the NAMA plan results in a taxpayer funded recapitalisation of the banks (via overpayment for assets, or invocation of the liability guarantee or both - see earlier blog) without a proper equity stake (probably 100%) in return. NAMA might not lead to this. The government might stand strong and insist shareholders and bondholders lose all - but the track record is not encouraging. After nearly a year we are still not yet in a position to ring fence the cost to taxpayers to any meaningful degree - we still might end up recapitalising the Irish banking sector using taxpayers' money, but with equity left in the hands of the current shareholders and also possibly bond holders fully repaid.

NAMA is a bad idea because it leaves this possible outcome open.

That is the long and short of it.

Friday, 28 August 2009

NAMA and "long-term" economic pricing

The basis on which NAMA buys assets from the Irish banks is a key issue, as highlighted below. Something that all should bear in mind when making any sort of forecast for the prospect for returns on Irish property (be it equity or debt exposure) is likely to be remote when there is so much spare capacity:

A survey from the Irish Brokers Association has today found that the number of buildings left vacant in Ireland rose 150pc from 140,000 last year to 350,000 today.

To put that into perspective, there is around 1.5 million household in Ireland. So this represents more than 20% of present demand for housing and is spare capacity. OK, there is likely to be some mismatch in terms of type of accommodation and/or location wanted versus available, but that is a second order concern when you consider the amount of excess supply. And excess supply in economic terms generally means only one thing; lower prices and poor returns (if any).

In this case the "long-term economic value" of these assets could be far, far less than people think.

More NAMA debate

The NAMA debate is going round and round. Some good points are coming from all sides of this argument (I am yet to decide for myself where I am looking at a cube or a dodecahedron).

Something that I think is still creating some cross purpose is the lack of a clear delineation of what I believe are the two primary issues here:
  • Reinstating the Irish banking system with a viable and solvent balance sheet
  • Deciding on the fiscal role of taxpayers in the process
The former is an issue of economic efficiency, the latter one of equity.

Once we state this clearly, I think the viable options become more transparent and we are more likely to get a durable (i.e. politically acceptable) solution. I don't think I have seen any knowledgeable commentator disagree with the first objective. So on that there is essentially unanimous agreement. And this isn't really very complicated. What needs to be done is to write down the assets held on bank balance sheets and having done that recapitalise them. NAMA is certainly one way of doing that and I even the most vociferous opponents of the plan don't seem to disagree either.

So clearly the difference of opinion lies in the latter point. Note that this is about two things:
  1. The potential magnitude of cost ot tax payers
  2. The distributional affect
And these two points are partially linked and I will look at them separately below.

Magnitude of cost to the taxpayer

The single greatest irony of all the present debate, which is focused on the price NAMA will pay for the assets, is that it is too often being posed as a debate about "what is the financial loss?". Of course, there is nothing to debate here. The loss is there, it has already occured and has a value, it is simply that we don't know how to measure it yet.

No, the issue is where will this loss (of unkown size) fall. And we can simplify this down to a choice of falling on those took on these assets (or exposure to these assets) in the first place, or tax payers.

Say we let the banks reconstitute their balance sheet internally, by marking down the assets and defaulting on their liabilities, starting from the top tier down (shareholders, top tier unsecured bond holders etc. etc.) until their assets again equal their liabiilties. Or perhaps more accurately, until the assets are close enough to their liabilities that they would have some economic value that would justify someone buying the whole balance sheet (i.e recapitalising them).

If we simply allow that to happen and that "someone" is a foreign bank or a new group of shareholders then the cost will fall on the banks' current shareholders and bond holders - in my mind, exactly where it should fall.

But if the government decides to buy the worst of the assets of the banks at a premium the tax payer is instantly being forced to bear some of the cost - this is NAMA. At the extreme, if NAMA paid the nominal value for the assets the entire, exact same, cost would fall on tax payers and the banks' shareholders and bond holders would be let off scot free.

If we pay something between the true mark-to-market price for these assets and the nominal value the taxpayers will be stumping up some proportion of the cost.

But it doesn't end there, because even if NAMA managed to buy the asset at their market price we are simply back to where we began - the bank marking down their assets. The implications from there are the same - liabilities have to be marked down and losses taken by shareholders and bond holders. NAMA hasn't changed a thing - the banks are still insolvent and someone needs to take the loss in order to reconstitte the banks' balance sheets. Under the "liability guarranttee", thoughtfully provided by the Irish Government, that means taxpayers have to.

But it doesn't have to be that way. The guarrantee expires next year. The government can effectively renege by threatening to string out affairs until its expiry. This can be used as leverage to force the reconstituion of the banks balance sheets by wiping out current shareholders and doing debt-equity swaps on some bond holders to reestablish the banks.

If the shortfalls are too large the government could then force the banks to be declared insolvent and nationalise them on the basis that they tale only those liabilities they are required to - effectively deposits and secured crditors/bondholders. Then use taxpayers' funds if necessary to restore tier 1 capital. Only that way could you ensure that the burden on the taxpayer is kept to a minimum.

And what is funny about this is that this is absolutely no different to simply making the banks properly revalue their assets in situ and have themselves declared insolvent.

So NAMA is clearly a contrivance that adds nothing but the opportunity for taxpayers to indirectly recapitalise the banks on very poor terms.

So to:

Distributional effects

Well, this can be brief. Form the previous paragraphs it is clear that we are looking at a range of potential outcomes which range from a redistribution of the total cost from taxpayers to bank shareholders and bondholders to one where, if we are lucky, all the losses are bourne by shareholders and bondholders.

I don't see that as a difficult issue to grapple with. Let's simply find agreement on these two points, which I would describe as the necessary and sufficient conditions that need to be met:

Necessary condition - is the proposed solution one which will successfully reconstitute the bank
balance sheets?
Sufficient condition - is the proposed solution one which will (not might, if...) succesfully minimise any redistriubtion from taxpayers to current bank shareolders and bondholders?

I think NAMA meets the necessary condition, but not the sufficient condition - back to the drawing board.

My preference? Should have let everyon bar AIB and BoI go under in the first instance and then temporarily nationalised those two and reconstituted their balance sheets at minimum taxpayer cost (possibly as a merged entity) for continuing operation; be that with immediate pass back into the private sector (e.g. debt-equity swap), or interim public ownership for later IPO or sale.

It still isn't too late.

Tuesday, 25 August 2009


Some things in nature are just amazing. Check this out:

What's the story Morning Glory?

Friday, 7 August 2009

Just another reason why "buy local" is stupid

The US fiscal stimulus package has resulted in this interesting little difficulty:

At stake are the president's efforts to fuel an economic recovery in the US by funneling stimulus funds to communities, including $US6 billion for municipal water projects. Lawmakers mandated that the money be spent on US products, with exceptions to meet international trade obligations.

GE says it assembles high-tech filtration systems for North American markets at its plants in Toronto and Oakville, Ontario, with parts from Hungary and elsewhere.

We improve our welfare when we trade.

The funniest punchline to this story would be the discovery of a supplier that produces the required filters in the US, but is wholly owned by a foreign investor.

US Fed buying up government bond issuance - old news

I have seen via the that there seems to be a little consternation building in the bloggernet about the US Federal Reserve buying up Treasuries (bonds) issued by the US Federal government. See the Dailykos for some sudden realisation.

Well, this is pretty old news. In fact not much news at all. This is what is known as "quantitative easing". Look, the Washingtion post was writing about this in March. I know my broadband is the fastest in the world, but I tend to get my news downloaded the week it is published.

And it is exactly what some of the fearful or outraged bloggers think it is. It is a monetisation of government debt, or printing of money, or whatever equivalent terms you wish to use to describe it. And the potential ramifications are indeed as suggested; much higher inflation, depreciation of US Dollar etc.

It is just that it isn't news. Look here, it is already in the data. Here is a chart of the money base, sometimes known as narrow or high powered money. In simplified terms, currency on issue. This shows the amount of new money being injected into both the UK and US economies as both the Fed and the Bank of England practice "quantitative easing".

What happens next is that "broad money", which includes deposits at banks, rises. Well, it does if the financial system is working properly. Of course it hasn't been, so it isn't just yet (plus there is always some lag). But Fed (and BoE) need to watch for when it does - it will do so because banks will start lending again and households and companies will start borrowing again. At that point interest rates will need to go up - and pretty quickly.

Thursday, 6 August 2009

Cleaning up Irish banks

This is a first post on this issue, so a quick catch up on the story so far:

  • Irish banks lend to all comers on increasingly lax terms for 10 years plus, funding their balance sheet from bond and interbank money markets.
  • Debt financed demand for Irish real assets (property) leads them to become over-valued to a mind boggling extent.
  • Policy tightening from the ECB and subsequent crisis in credit markets (i.e. the global financial crisis) squeeze demand and then supply of credit (mortgages, commercial development loans)
  • The spiral reverses its course and demand for real assets crashes and prices deflate.
Leading to present state:

  1. Large amounts of liabilities on bank balance sheets (borrowing from other banks, institutions)
  2. A large chunk of certain assets (lending, to developers mainly) that will never be repaid in full and hence needs to be marked down in price.

2-1 < 0 =" insolvent

It really is that simply.

Now for the complicated bit. What to do about it?

Firstly, make an observation on the potential answers to the question posed. At the highest level there is in fact two potential answers:

  1. Do something
  2. Do nothing
It is remarkable how few people even realise the existence of the second option. But I will deal with that option some other time and concentrate on the do something route, because that is where policy has taken us.

So, here is the story so far on "what has been done":

  1. Offer enhanced government guarantee on deposits (total guarantee)
  2. Guarantee most of the liabilities of the bank (i.e. just about most people in addition to depositors who have lent money to these banks)
  3. Form a government Special Purpose Vehicle (SPV) to buy large amounts of the assets that have created the insolvency problem.

It is important at this point to understand a little about 3. Earlier I stated that large chunks of bank assets (loans to developers) needed to be marked down, hence making assets less than liabilities and hence making the banks insolvent. However, I left out an important extra fact. The banks have not written down those assets sufficiently to reflect their true worth (what you might expect to get back from the people who borrowed the money) because the size of the deficit would be so large that the government would have had to recapitalise them by nationalising (taking ownership and injecting tax payers' money, or cough up money under the liability guarantee to people who have lent to the banks. So, everyone has been pretending that the banks are technically solvent by only writing down those bad assets a little bit at a time.

You may say this sounds like a pretty puerile fudge that wouldn't fool a 5 year old.

You would be correct.

So we find ourselves now with NAMA. This is the SPV that, when tanked up with bucket loads of money borrowed on bond markets (i.e. deferred tax), will buy the bad loans that the banks are gradually trying to write down to their true worth in order to restore solvency. With the banks free of these loans that everyone knows are worth far less than reported in the banks' financial accounts, the banks can get back to banking instead of playing a three cup game with their balance sheets. That's the theory.

So NAMA buys these assets, but the question is how much to pay? Remember, we they aren't worth what the banks claim they are. So NAMA (i.e. the tax payer) is facing two options.

Pay the true market value that reflects the fact that these loans will never be repaid in full (because the people who borrowed the money effectively just wasted it) and are extremely uncertain. This will mean the banks crystallise their losses in one big hit and declare insolvency - back to nationalisation (taxpayers pouring money into the banks to own them) or deliver on the liability guarantee (effectively pay off a load of the banks creditors).

Pay a more generous price, justifying it on the premise that the loan money wasn't wasted, the developers are just having a few short-term difficulties. Over time these loans will pay back a big proportion of their initial amount (yeah, right). D0 that of course and NAMA is going to be a loss making venture (Ireland has too many houses, built for too much money, on land that was bought by developers for too much money).

So that is it. All government policy has been set up so that which ever way things go, taxpayers are on the hook for the losses.

A lose/lose for tax payers.