A bottled water frenzy

The Grauniad appears to have saved the day again by quickly alerting us hoi polloi to the imminent danger/disaster/apocalypse into which we were plummetting. This final warning on the complete depletion of Adelaide's water supply seems to have done the trick:

http://geckkosworld.blogspot.com/2009/09/rip-quality-journalism.html

You will recall that last month Adelaide had but one week's supply of water left before emergency bottled supplies would need to be shipped in. It seems that the local population has been extra busy, by pouring the emergency bottled supplies directly into the drinking water reservoirs, which have increased from 90% of capacity to 93% capacity.

Apocalypse averted. Keep up the good work guys.

NAMA. "It's about getting liquidity flowing"

I was in Cork yesterday attending the Chamber of Commerce conference there. One phrase that was oft repeated was that we needed to "get the liquidity flowing from banks again". That doesn't really make a lot of sense from an economics point of view. Liquidity in the strict sense of the banking system related to the workings of the money market; being that market for short-term lending (under 30 days by general convention). This is dominated by banks that use it balance their immediate needs for funds - say to fund withdrawals of deposits.

But I think what everyone meant was that they didn't think that banks were lending large enough sum to enough companies - my general impression was that this included any company that wanted/needed it.

A couple of observations on that line of thinking that seems to be too prevalent and, in my opinion, likely to meet a sudden stop against the cold hard facade of reality.

Firstly and briefly, should banks be lending? No. Banks should be managing risk. If a loan, line of credit or overdraft does not make commercial sense from a risk and expected return basis, it should not lend.

Secondly, what is likely to happen when the Irish banks wend their way to the ECB and exchange their NAMA bonds for some freshly minted Euros? As some commentators have already indicated, the likely outcome is that they will pay down some of their liabilities. They will shrink their balance sheets.

Why would they do this? Simple. Because their balance sheets are too large. Don't tell me you have forgotten already how we came to be in this mess? Let me remind you. We (the collective people of Ireland) borrowed until we had put into hock virtually all our future income earning potential. And then we borrowed some more. That, dear readers was the expansion of the balance sheets of Irish banks.

And flowing directly from that, we have our present economic obstacle. Too much debt - synonymously bank balance sheet are too large.

And flowing from that is the unavoidable economic correction that needs to take place. A contraction in the balance sheets of Irish banks.

The following things will cause this to happen:

• Writing off bad debt/defaulting on some liabilities starting from the top and moving down the capital structure (e.g. shareholders' equity, unsecured bond holders etc.).
• Use any excess liquid assets (thank you NAMA/ECB) to retire short-term laibilities

The following things would not allow this to happen:

• Increased growth in lending

And are you curious about how big the balance sheets of Irish financial institutions became of recent years? Here is a handy comparison. The UK is considered one of the more leveraged countries in the world. Total assets held against residents (i.e. outstanding lending to UK residents) reached 1.9 times annual GNP at the end of 2008. The equivalent for Ireland was around 2.5 times annual GNP. For the US the ratio is about 0.6.

People really need to be told. There is too much debt, which means banks will be taking every opportunity to shrink their balance sheets. That means no free money.

Need credit? State owned enterprises to the rescue

An interesting announcement yesterday. Bord Gais, the state owned gas monopoly, have announced that they are moving into the market to provide a wide range of consumer energy related services. Not only will they supply you with gas, but they will sell you all manner of insulation, heating and associated services.

All very good, thinking at the margin and employing their core comparative advantage (direct access to households) to their strategic corporate gain. Let's leave aside concern about market power that one might have (they might easily throw other suppliers out of the market due to their size, brought by their state enshrined monopoly in gas supply, or their very favourable access to capital markets as a state owned monopoly utility). No, what I am thinking about is the way they are going to allow customers to pay for such big-ticket capital expenditures.

It is the intention of the Bord Gais that customers will be able to "pay via their gas bill". That is just another way of saying that Bord Gais will extend credit to allow customers to undertake expenditure. No need to borrow from a bank (that has quite rightly tightened up its lending criteria). Bord Gais will, in the words of their CEO John Mullins at the Cork Chamber of Commerce yesterday, let customers have it "on the never-never".

There seems to be a general clamour for banks to open up the taps to all comers. The Irish government is happy to play along. I find this a curious development in such a context. With credit comes euphoria, if only for a short time until the never-never arrives for payment.

How are the recapitilisation plans going boys?

One thing that gets pushed off the front pages during the NAMA debate is the fundamental question of how and by how much Irish banks will recapitalise themselves.

So far we know:

• The banks were insolvent, regardless of fiction that appeared in company accounts
• The Banks are unloading 77bn of assets on their balance sheet in exchange for 54bn in sovereign paper (and then on to cash via the ECB Refi window).

So how big is the capital hole, how is it going to be filled and by whom? Plans really should be afoot now, but I have not seen so much as a rumour appearing in the press.

Associated loans - what the hell are they?

Yes, NAMA again.

This question has been keeping me awake at night. The Draft Business Plan for NAMA identifies 36% of loans to be bought as being "associated loans", without any clear explanation of what that might mean. The Department of Finance is only marginally more enlightening with this:

Associated loans will be those loans which are not in the land and development category but which are held by individuals/companies that also have land and development exposures or the borrower may be a systemic risk to the financial system. Associated loans will take account of cross collateralisation and other associated loan exposures of borrowers.

which is pretty much what one would have guessed, but gets us little closer to the purpose for which these funds were advanced and to whom.

I have been searching for more detail, but have found nothing. And in the absence of facts the imagination runs riot. Are they unsecured? Do they represent advances to insolvent creditors (like rolled up interest for example)? I don't know, but would sure like to know.

I think we, as taxpayers, have over 27 billion good reasons why we should be told a bit more about this.

NAMA - how much write-down?

One for the greatest unknowns about the NAMA escapade is the proportion of loans that will be recovered by this newly conceived Naughty Bank (increasingly naughty by the day). Under the Plan, the loans to be acquired will have a nominal value of €77bn and will be purchased by John Q Taxpayer for €54bn. The Draft Business Plan for NAMA assumes that €62bn of the €77bn will be reapid - an 80% recovery rate. 62 is greater than 54, brilliant, we're laughin'. Let's just ignore for the moment the matter of interest on this €77bn pile of debt, which is a tidy sum itself, which may or may not be paid.

Now, you may have read in the press that NAMA is going to make us taxpayers a tidy €5.5bn in profits. That of course depends on the ability to recover from the various borrowers 80% of what they borrowed. If we get only 70% paid back, that is €7.7bn lost and there goes the profits and up go the taxes. Not much wriggle room in those assumptions, I think you will agree. I wonder what type of robust analysis has been done to arrive at the 80% recovery assumption. How certain can we be that it will be achieved. Well, here it is:

"Over a five year period in the early 1990s, one UK bank experienced a default rate of less than 10% on its whole book. Given the concentrated nature of the prospective NAMA portfolio and the risk of a prolonged recession, a 20% default rate assumption has been made."

Looks impressive, doesn't it? We have found out via Karl Whelan at irisheconomy.ie that this "one UK Bank" was in fact Barclays. So let's have a little gander at Barclay's accounts.

In the five years between 1990 and 1994 inclusive Barclays recorded realised losses on write-offs of £7.0 bn. At the start of 1990 Barclays had a total loan book of £77.7bn. Now what I am about to do is a massive fudge, as it assumes that all the write downs occurred on loans on the balance sheet at the start of 1990. But I am writing this on the hoof and in the spirit of NAMA I don't think it appropriate to get to pernickety about precision.

Barclays realised default rate was 7/77.7 = 10% near enough for any Naughty Bank.

Excellent. This seem quite robust then. But, just for fun, let's dig a fraction deeper. Let's look at the type of loans NAMA is taking on. This is taken from the Draft Business Plan again and is a broad breakdown by borrower:



















Doesn't look great to me. Lent to people to develop property assets, to buy land to develop property assets and to buy things associated with buying land and developing property assets.

I think we can safely say that there is a comprehensive diversification of exposure right across the property development/construction sector of the Irish economy. It is the contention of the government that this Naughty Bank will recover all but 20% of lending from this portfolio of loans.


Now let's look what Barclays did in 1990:


















Yes. Do you see that pale blue slice around 6 o'clock. That is the amount that Barclay's accounts for 1990 identify as being to customers in "property and construction". The rest is spread all over the place (what were these guys thinking?????).

Do you want to see where the UK economy generated its income around 1990? Here is a breakdown of Gross Value Added by sector. Not directly comparable, but the best I could do on my budget (45 minute lunch break):
















Note that I have taken out the public sector as best I could. Also note, that I have built in a novel "Individual" sector; this doesn't exist of course, but I need some device to compare with Barclays lending. I could have allocated that lending across the Barclays book - and maybe should have, but the affect on what this data is telling us should be the same.

Now look at those two compared. The proportion of Barclays loan book exposed to any sector minus the size of that sector in the economy by income).

It looks like this:

















You can see the affect of my fudge. It assumes that Barclays exposure to individuals was neutral on a sectoral basis (i.e. it wasn't all to people in finance for example). You can also see the overweight and underweight position of Barclays' loan book. A maximum exposure of around 10% to broad sector. Underweight manufacturing and finance and overweight services and property and construction.

That isn't too bad I would suggest, when you compare with NAMA, which is 100% overweight property and construction.

Now, this data isn't particularly robust. But it is certainly more detailed than that revealed in the NAMA draft Business Plan, which is a type of finger in the air exercise. But I think it tends to suggest that if Barclays managed to confine their losses to 10% of their loan book with a good amount of diversification, then NAMA will have one hell of a time trying to confine its losses to 20%. Even 30% seems a bit racy to me.

You can make up you own mind. Then cross your fingers. That is what the architects of this seem to be doing.

Water charges - some political slight of hand

I blogged about water charges a little while back. I don't think they make sense in the form of water metering in Ireland.

Now those Red-Green (does that make purple?) political advocates for around 2% of the electorate are proposing a flat rate household water charge. All my points about water as a scarce resource in Ireland still apply. Little reason to set the marginal price of water above zero.

What I want to highlight here is this bit:

"Charging for water in every house was agreed by the government parties, at the Greens' behest, as a way to reduce waste and fund local government."

Do these people really think the electorate are that stupid that they think they are presently getting water for "free"?

This is ludicrous beyond belief. The overwhelming majority of houses in Ireland have mains water. This makes a flat rate household charge a type of "poll tax" - although levied per household rather than per head.

It is also coming on top of the tax paid that presently funds water catchment, storage, distribution, treatment and maintenance. This is more tax on top of the tax that currently goes towards paying for our mains water.

Is a little bit of honesty too much to ask. Even if you are purple?