Friday, April 29, 2011

Deposits in the Covered Banks continue to fall

Not surprisingly the level of deposits in the six covered banks continues to fall.  We have not got a recent update of the consolidated balance sheets of the banks so some of this may be due to transfers between subsidiaries of the banks but as we will see below this could only be a partial explanation.

Total Deposits by Covered Banks

Since last August there has been a €100 billion drop in the amount of deposits in the covered banks.  As the graph below shows most of this has been for residents outside the eurozone and is probably mainly money based in London.

Total Deposits by Origin in Covered Banks

The Central Bank does not provide a breakdown of the sectors of rest of the world deposits in the covered banks but can be seen from this graph of all banks operating in Ireland that this drop has been in deposits from other financial institutions, i.e. inter-bank lending.

Rest of the World Deposits

Returning to the covered banks, the Central Bank does provide a breakdown of Irish resident deposits in the six banks.  It is pretty evident that Irish private sector deposits are leaking out of the covered banks.

Irish Resident Deposits in Covered Banks

This time last year the Irish private sector had almost €130 billion on deposit in the covered banks.  The most recent figure put this at €106 billion.  More and more private sector deposits are leaving the covered banks. 

We can get some insight into where they are going if we look at Irish resident private sector deposits in the non-covered domestic banks and other banks operating in Ireland.  In the last six months deposits in these banks have risen by more than €6 billion.

Private Sector Depoits in non-Covered Banks

Where did the other €18 billion go?

Whose problem is it?

Here is a pretty startling graph. It shows the liabilities of the six covered banks broken into three groups.

  1. Irish residents
  2. Non-Irish residents
  3. The ECB

Covered Banks Liabilities by Creditor

The patterns are pretty self evident.  The liabilities for the Irish and non-Irish residents are made up of four categories.  The numbers in this table give the change in each liability since the month of the blanket guarantee (September 2008)

Liabilities by Creditor2

Since the guarantee was introduced Irish resident exposure to the covered banks has increased by almost €110 billion.  Most of this has been through the ELA offered by the Central Bank of Ireland.  At the same time non-Irish resident exposure to the banks has fallen by almost €170 billion which huge drops in deposits and bondholdings by non-residents in the bank. 

The other player in all this, the ECB, has seen it exposure increase €14 billion in August 2008 to almost €80 billion now.  The drop in deposits and bonds from non-residents is the reason the banks have needed almost €150 billion of central bank funding.

In the immediate aftermath of the guarantee non-resident lending to Irish banks surged and rose by over €25 billion to €310 billion in November 2008.  This enthusiasm was short-lived and over the next few months non-resident lending to Irish banks dropped around €60 billion by March 2009.  It then remained steady at around €250 billion until August 2010 when the original blanket guarantee expired. 

Since then it has dropped at a remarkable rate and is now down to €117 billion.  The total drop since November 2008 is almost €200 billion.  It does appear that this is being isolated as very much an Irish problem.

Here are graphs for the above liabilities.  Every non-resident apart from the ECB is getting out.

Total Deposits by Origin in Covered Banks2 Holders of Covered Bank Bonds2 Capital and Reserves Other Liabilities

Central Bank Funding Falls (but is still massive!)

The reliance of the six covered banks on funding from central banks fell for the first time in a year in March.  Last April the borrowings of the covered banks from central banks fell from €52 billion to €47 billion.  In March it fell from €153 billion to €144 billion. 

It might have fallen for the first time in a year but it is also €100 billion bigger!  The six banks are borrowing the equivalent of 94% of GDP from central banks.  It will take more than one monthly drop to solve this problem.

Central Bank Funding

The banks’ borrowings from the ECB have fallen for the past two months and are down to €79 billion from the peak of €93 billion in January.  The green line actually represents the “Other Assets” category in the Central Bank of Ireland’s balance sheet.  It is widely accepted that all bar about €2 billion of this is Emergency Liquidity Assistance (ELA) that the is being provided to the banks.

As the assets being provided by the banks were shunned by the ECB the banks turned to the ELA on offer from Dame Street.  This is generally at a rate about 2% above the ECB rate. 

The level of ELA first became noticeable following the nationalisation of Anglo in January 2009.  It then stayed between €10 billion and €12 billion between then the the expiry of the original blanket guarantee in August 2010. 

As soon as the guarantee expired it ballooned as the banks lost huge amounts of deposits (as well as paid off a few bonds) and did not have assets that the ECB would accept.  In just five months it went from around €10 billion to be near €70 billion.  In the light of those increases the falls this month are nothing to be getting excited about.

Slight uptick in Retail Sales

The March Retail Sales Index has been released by the CSO.  Core retail sales are showing a slight improvement on the February levels.  Nothing huge, but both the value and volume series edged upwards.

Ex Motor Trades Index to Mar

As expected the annual changes remain negative as the first quarter 2011 figures are being compared against the short-lived “turning the corner” momentum of early 2010.

Annual Change Ex Motor Trade Index to Mar

The volatility in the monthly changes continues.  The severe weather in December is a major factor in this but we can expect to be able to read more from these over the coming months.

Monthly Change Ex Motor Trade Index to Mar

Friday, April 22, 2011

Evening Echo Article 22/04/2011

Here is the text of an article I wrote after this week’s publication of the Review of State Assets and Liabilities that was carried by Friday’s Evening Echo.

The Review of State Assets and Liability published this week identifies around €5 billion of assets which could be sold. The report was undertaken by a group of three, but it is the group chairman, UCD Economics Lecturer, Colm McCarthy who is associated by name with the report. The other members of the group were Alan Mathews, an Economics Professor in Trinity College and Donal McNally who is the Second Secretary in the Department of Finance.

The report gives a useful insight into the activities and outcomes of 15 commercial state bodies, including the ESB, Bord Gáis, CIE, An Post, RTE and the airport and port authorities. Some commercial bodies were excluded from the report. These were the VHI, NAMA and the now nationalised banks as these are all subject to separate processes.

The report makes some strong recommendations about how these assets should be used, but emphasises that an immediate sale of these assets should not be contemplated. The recommendations of the report are to be considered by government and it is only once their actions are announced that we will know what the outcome of this process will be. The report, though, does give us the information they will be using on which these decisions will be based.

At the end of 2009 the 15 bodies covered by the report had just over 40,000 employees which was identical to the number of employees at the end of 2007. The average annual salary was €54,600, with pension contributions bringing this up to €63,200. As the country experienced economic collapse average salaries increased by 2.6% from 2007 to 2009, and once pension contributions are included the increase was actually around 4%.

In 2009, these companies earned an aggregate operating profit of nearly €400 million. Although the State is the beneficiary of these profits, subsidies to loss making elements, particularly rail travel and rural transport, meant that the State had a negative dividend of €340 million to keep these companies running. There has been no year since 2002 when the aggregate of these companies has produced a positive return for the State.

Since 2002, the ESB has paid over €700 million in dividends to the Exchequer with Bord Gáis contributing over €130 million. These two companies provide over 70% of the total dividends paid to the State from these enterprises, though it must be remembered that these dividends are generated from the prices charged in providing electricity and gas to households up and down the country. All the other companies covered the report are not significant contributors of dividends to the State.

The ESB and Bord Gáis also have the highest salary levels. In 2008, the average annual salary for the ESB’s 8,000 employees was €76,000. Once pension contributions by the company are accounted for the average annual salary rises to nearly €90,000. This is two and a half times the average industrial wage. The average annual salary for the 1,000 employees of Bord Gáis was €67,000 with pension contributions bringing this up to €77,000. Again, these salaries are funded from the revenue collected from households.

These companies have total debts of around €6.5 billion with the bulk of this in ESB, Bord Gáis and the Dublin Airport Authority. CIE does not have a significant level of debt as investment in the transport infrastructure it uses is directly funded by the State. This debt reduces the potential sale value of these enterprises.

Although many of the companies cover the entire country, there are three instances that relate to specific assets in the Cork region. These are Cork Airport, the Port of Cork and SWS Natural Resources, which was acquired by Bord Gáis in December 2010.

The report does not recommend that Cork Airport be sold. The report is, however, critical of the capital expenditure undertaken in the airport and describes the new terminal as “controversial”. The report states that there is “excess terminal capacity” in Cork Airport. This is undoubtedly true but it does mean that using Cork Airport is now a far more enjoyable experience than under its predecessor.

The report then states that it is the customers who are paying for this excess capacity through higher airport charges and suggests that, if the airport were a private enterprise rather than a public one, it would be shareholders rather than customers who would absorb the capital loss.

The report, however, stops short of recommending privatisation of the airport and merely suggests that the regulatory arrangements need to be reviewed. This may see the current situation changed where Cork Airport is actually controlled by the Dublin Airport Authority rather than acting as an independent entity. Cork Airport will remain in public ownership.

The report’s recommendations for the 11 seaports owned by the State are somewhat different. Here the report recommends that the ports be restructured around three “multi-port” companies built around Dublin, Cork and Shannon Foynes. It seems that Cork could become the largest part of an entity that would see it merge with Waterford, New Ross and, possibly, the CIE-controlled Rosslare port. Some of the smaller ports may actually be closed.

Once this amalgamation process has been completed, the report recommends that some or all of the ports should be privatised. Unlike the airport, it is not certain that the Port of Cork will remain in public ownership.

The port currently has 111 employees and in 2009 generated a profit of €1.5 million on sales of €21 million. In 2008 there was a profit of €6 million on sales of €26 million. The report does not indicate how much could be raised by the sale of the port but, if it was to happen, the likely return would be relatively small.

SWS Natural Resources is a wind-generating company based in Bandon that employs 50 people and was bought by Bord Gáis from IAWS for €500 million in December 2009. The report is unambiguous in its recommendation that this, as well as other parts of Bord Gáis excluding the actual network, should be privatised. One final recommendation that has a specific local bearing is the selling by Bord na gCon of its holding in greyhound tracks around the country.

In general the report is largely as expected. Given the current economic environment we are unlikely to see substantial sales of State assets in the medium term. Over a timeline longer than three years the outcome is less clear. Experience from other countries suggests that privatisation brings its own problems and our own experience with eircom should not be forgotten.

The sale of eircom raised over €6 billion for the Exchequer but the company and the infrastructure it should provide have been beset by problems ever since. In total, the sales recommended in this report have a net asset value of €5 billion. In the context of a banking crisis that is set to cost €60 billion and an ongoing budget deficit that will add €100 billion to the National Debt over six years, the figures in this report are quite small.

It is more likely that the sales that could be undertaken in the near term will raise about €2 billion.  This is a once-off gain and €2 billion is a lot of money but it would be far better if policies that generate an annual reduction of €2 billion in the deficit were introduced.  This is an issue that has not got sufficient attention in recent times.

The country faces more pressing concerns than deciding to sell off some of our assets at a time when values are depressed. Some of these companies are substantial profit earners and provide an annual dividend for the State. Maybe in the future we can look more calmly at what can be done with these assets. In the meantime the State should look to reduce the debt levels and labour costs of these companies. The middle of a crisis, with a delinquent banking system and an €18 billion annual budget deficit, is not the time to be rushing into unnecessary firesales.

Bond yields soar

Two weeks ago we looked at the fall in Irish government bond yields that occurred in the week following the announcement of the stress test results.  The stress tests offered some credibility to our attempts to solve the banking crisis, but making AIB a ‘pillar’ bank with annual losses of €12 billion to be covered, bringing to €20 billion the total pumped in by the State may have dampened the optimism somewhat.  Looking at bond yields now, we can see that they’re at new record levels. 

Here’s the 3-month graph from Bloomberg showing the yield on 10-year Irish government bonds. 

Bond Yields 3M to 21-04-11

For further confirmation of this deterioration you can see the yield on two-year bonds here.  These are streaking upwards and at nearly 12% are almost three percentage points higher than they were at the start of the month.  A similar pattern can be seen for five-year Credit Default Swaps (the cost of insuring Irish debt) here.

There has been little in the way of economic data released recently and nothing so negative to explain the surging bond yields.  Those buying or recommending Irish bonds have gone rather quiet.  Talk of the stable outlook from Standard & Poor’s has been replaced by the continued negative outlook from Moody’s.

So what happened?  It could be down to the watery statement from the EU/ECB/IMF team that undertook a review of the support process.  The yield rise had begun by the time the statement was released but it had been leaked by degrees over the previous few days.  The statement includes (emphasis mine):

The teams’ assessment is that the program is on track but challenges remain and steadfast policy implementation will be key.

Ireland is making good progress in overcoming the worst economic crisis in its recent history.

The may as well have said “the plan is working, we’ve turned the corner”!  The yield rise actually began earlier that week after the IMF had cut its 2011 growth forecast for Ireland from 0.9% to 0.5%.  Is this significantly different from zero?

So if we take the IMF’s statements from that week and combine them we get “Ireland is making good progress but things are getting worse”.  Sounds a bit like an Irish solution to an Irish problem.  It seems the IMF have learned that trick from us.  The truth is, though, that we need more than wordplay to navigate our way out of this crisis.  And the yields above indicate that the words aren’t working.

Thursday, April 21, 2011

Net Lending/Borrowing

This graph follows from a discussion to an earlier post on whether the Irish recession can be classified as a “demand-side recession”.  The graph is a replication of a slide in this presentation on the “balance sheet recession” that the Japanese economy experienced in the 1990s.

Here we use the data in the Institutional Sector Non-Financial Accounts to give the net lending/borrowing positions of different elements of the Irish economy since 2002.

Net Lending Borrowing

The changes are fairly evident.  The government has gone from a surplus to a huge deficit.  The household sector has gone from borrowing 10% of GDP per annum to saving 5% of GDP per annum.  The changes in the other sectors are not noteworthy.

Mortgage Debt Forgiveness

The issue of mortgage debt forgiveness has come front and centre again.  The last time we looked at this was when 11 economists proposed a huge debt-forgiveness  scheme back in November.

The Irish Times article is here and the response on this site is here.  I remain opposed to the views in the article.  At one stage it says:

In the case of Ireland, such a formula would most likely lead to an implicit writedown of at least 30 per cent of the more recent mortgage amounts on average, yielding an expected total cost to the entire system of circa €37 billion to €49 billion.

I’m not sure the article is actually in favour of such a widespread scheme (but if not, why was the paragraph included I ask) but this is a huge immediate solution to what is a long run problem.  The article also overstates the size of the problem.

Their arrears of €10 billion would compare to total mortgage debt outstanding in the Republic of €115 billion.

This is wildly overstating the arrears problem.  The most recent recent figures from the Financial Regulator can be seen here.  There are 44,500 mortgages in arrears of three months or more.  The total outstanding balance of these mortgages is €8.6 billion and will likely approach €10 billion in the coming months.   This gives an average outstanding balance of around €190,000 per mortgage in arrears.

However, the balance outstanding and the arrears owing are two different things.  The total amount of arrears on these mortgages is actually around €700 million.  The average arrears per mortgage is around €16,000.  It is difficult to imagine the amount of arrears ever approaching €10 billion.  A solution based on clearing the balance of mortgages in arrears is just too broad when the problem is more focussed.  My initial thoughts can be read in the post linked above.

I still think that any solution should be based on interest relief rather than capital forgiveness.  I think the State should pay the interest on a certain portion of the loan for a certain period.  This is offering something to those in need but avoids shifting the burden of capital repayment around.  So, for some mortgages the State could service up to 50% of the loan for a certain period of time.  If these are tracker-rate mortgages the cost may be somewhat contained.  There will be some cost to the State.

[As an aside it would be great to know where the mortgages in arrears actually are.  What is the breakdown between the covered six, other domestic banks (UB, NIB etc.), banks that have left (BoS) and subprime lenders?]

Anyway once the State takes on the servicing of the mortgage to give these people some breathing space we need some process that sees the responsibility move back to the individual.  As in a debt-forgiveness scheme which would see people position themselves to benefit from it, I think the key is "incentives matter".  I would allow the scheme to extend, to say, 15 years but the individual decides when the mortgage moves back to them.

If they do so after three years they just take it back under the original conditions.  For every year after that the interest rate on the loan increases by some incremental amount (say 0.25%).  This extra interest does not go to the bank, but goes to to the State for providing the scheme.  The longer a person needs support from the scheme the more they will have to pay.  If they wait the full 15 years the extra interest will be 3% per annum.  These numbers are only for illustrative purposes.

A lot can happen over a period of five to eight years (even economic growth, inflation and the like can happen!).  I don't think we need a short-run solution (immediate debt-forgiveness) to what is a long-run problem (repaying a mortgage).

I may update this with further thoughts.

Wednesday, April 20, 2011

A “Demand-Side Recession”

This has been some criticism recently of the revised elements in the Memorandum of Understanding which forms the basis of the EU/IMF deal.  The details can be read from this DoF statement.  One frequent criticism levelled against the programme is that it offers “supply-side” solutions to what is a “demand-side” problem.  This is most visible if we consider the elements included under the heading ‘structural reforms’.

Structural Reforms

Product and Labour Market Reforms

  • We are adopting policies to lower costs in sheltered sectors, thus boosting purchasing power and underpinning further competitiveness gains.
  • The Government is due to consider a potential programme of asset disposals based on the Programme for Government and the Review Group on State Assets and Liabilities. The Government will discuss its plans with the European Commission, the IMF and the ECB when it has finalised its response to the Review.
  • We are committed to create conditions conducive to job creation through the Jobs Initiative, which will be announced in May.
  • The reversal of the cut in the minimum wage will be reversed with the effect on business costs being offset by a reduction in employers' PRSI.
  • The review of the EROs/REAs and other measures to increase competition in sheltered sectors of the economy (these measures are not conditional on each other but are part of a comprehensive package designed to make work pay and improve the competitiveness of the economy).

No other structural reforms are listed.  Here is a thoughtful post on some of these changes from UL’s Stephen Kinsella - Will cutting GP and lawyer fees help Ireland?  I too would have concerns about the effectiveness of this list and would largely agree with the conclusion.

The core issues are not supply-side rigidities such as expensive lawyers and doctors and overpaid low-skilled workers. The core issue is the collapse in domestic demand.

Ireland's problem is demand deficiency caused by a collapse in asset prices, expansion in debt, and a fiscal imbalance caused by improper taxation policies during the boom.

Supply-side measures, while useful, won't solve, or even buttress, the problems of our economy, because they aren't the cause of the problem. We should remember this when listening to prognostications from our well meaning EU colleagues.

Although there is a “demand deficiency” I am not sure that demand-side solutions will necessarily work.  If we look at the contribution of the domestic and traded sectors to overall GDP growth we can see the domestic demand story stacks up.

Contributions to Real GDP Growth1

It is pretty obvious that the domestic economy that has been the source of the collapse with falls in ten of the past 12 quarters.  On the other hand net exports has made a positive contribution to growth in eight of the 12 quarters.

As we have done before we can break the fall in domestic demand into it’s constituent parts of consumption, investment and government expenditure.

Contributions to Real GDP Growth

Although a negative pull of consumption is seen up to Q1 2009 for the past two years two factors have dominated the growth rates.  Net exports has made a positive contribution to growth and investment has made the dominant negative contribution to growth.  Here is the same data presented in a different fashion.

Changes in GDP Components

Private consumption has contributed to the fall in GDP but consumption has been unchanged over the past two years.  In real terms consumption in 2010 was 1.2% lower in 2010 than in was in 2009 (because of price falls the nominal change was –2.5%).  However as a result of the falls that occurred in 2008 and 2009, consumption in 2010 was 9.5% below the level seen in 2007 in real terms (the nominal drop is an eye-watering 12.8%).  There is no doubt that a fall in private consumption has been a key component of the downturn but most of this occurred more than two years ago.

On the other hand investment has been falling continually over the entire period.  Although investment makes up a much smaller proportion of GDP than consumption, it has made a much larger contribution to the collapse of GDP.  Since 2007, consumption in constant prices has fallen from €96 billion to €87 billion.  Over the same time investment in constant prices has fallen from €46 billion to €20 billion.  Consumption has fallen €9 billion.  Investment has fallen €26 billion.

One would expect that the fall in consumption is the result of a fall in income, but as we have seen that is not necessarily the case.

Household Expenditure

In 2009 net household disposable income fell by about 2%.  At the same time, consumption expenditure fell by over four times that rate.  Demand as measured by ability to pay still existed, it was demand as measured by willingness to pay that fell.  We don’t know what happened to disposable income in 2010 but we know that the decline in consumption eased.  The impact of the tax increases in last December’s Budget are likely to further tighten income. 

The above gap was money that was saved and more than likely used to pay down debt.  The savings rate has shot up to near 12%.  It is more probable more accurate to say that we have a “debt problem” rather than a “demand problem”, though the two are obviously related.  Consumption has fallen because the demand has shifted from buying goods and services to paying down debt.  This pattern is likely to continue.

Finally, as we said above, the biggest source of the decline in domestic demand is investment and it is pretty evident that we do not want to go back to the way things were.  Here is what has driven the change in the contribution of investment to GDP growth.

Investment Contributions to Growth

Building houses drove the boom and not building them has driven the recession.  It is likely that investment is undershooting, but the fall in investment from building 90,000 houses a year at the peak is a necessary one.  The fall of this “excess demand” is an adjustment that has to be made.  The task is now to find the replacement.

Tuesday, April 12, 2011

Austerity and Expenditure

Since the middle of 2008 there has been €20.6 billion of budgetary adjustments untaken.  By the end of the current “four-year plan” a further €9.8 billion of adjustments are planned.  These are huge changes.  However, we must not confuse adjustments with cuts or savings.  Adjustments are just changes.  Whether they lead to expenditure reductions or savings depends on the nature of the adjustment and the environment in which they are enacted.

Here we provide an update of government expenditure using the 2011 projections.  First up, here is gross government expenditure. 

Gross Expenditure

Gross government expenditure in 2011 is forecast to be €68.1 billion.  This will be about 44% of GDP.    And this is central government expenditure.  A further €6 billion of local government expenditure would have to be added to get total government expenditure bring government expenditure to around 48% of GDP.

Looking at the graph it can be seen that the reduction seen in 2010 does not seem to be continuing into 2011.  Were the €6 billion of adjustments in last December’s budget just a spook story?  After €20.4 billion of adjustments gross government expenditure is back to 2008 levels.  However, this doesn’t tell the full story.

The first thing we can do is break expenditure into voted and non-voted.  Voted expenditure is the money spent by various government departments providing goods, services and transfer payments.  This must be “voted” through in the Dail.  Non-voted expenditure does not require an annual vote as it is required under existing legislation. 

Voted and Non-Voted Gross Expenditure

We can see that voted expenditure has continued to decline and has been falling since 2009.  Voted expenditure at €57.5 billion is now back to 2007 levels.  Voted expenditure in 2011 will be about 38% of GDP.  In 2007 it was 30% of GDP.

The “levelling-off” of gross expenditure in 2011 is due to changes in non-voted expenditure.  We will return to this shortly.  The next distinction we can make is between current and capital expenditure.

Current and Capital Gross Expenditure

This shows that current expenditure has been largely unchanged over the past few years with the changes in gross expenditure actually caused by capital expenditure, even though it is only a fraction of current expenditure.  However, these totals are again a bit misleading.  It is important to break these totals into voted and non-voted expenditure.  Again voted expenditure represents the provision of goods and services by the government.

Here is the breakdown of current expenditure.  Voted current expenditure is estimated to be €52.8 billion in 2011.  This is just below the level recorded in 2008. 

By departments this expenditure goes on Social Protection (39%), Health (27% ), Education (16% ), and Other Departments (18%).   Although Health and Education make up a large proportion of voted current expenditure most of this actually goes on pay.  Across all voted expenditure pay, pensions and transfers make up 74% of the total.

Voted and Non-Voted Current Expenditure

The reason that current expenditure has not fallen has been because of the increase in non-voted current expenditure.  This is mainly interest on the National Debt which has been increasing for obvious reasons.  Most of the reduction in voted current expenditure has been offset by increases in non-voted current expenditure.

These changes are even more pronounced for capital expenditure.

Voted and Non-Voted Capital Expenditure

The biggest proportion change in expenditure has been in voted capital expenditure through the huge scaling down of the public capital programme.   Voted capital expenditure in 2011 will be almost 50% lower than it was in 2008 and is now back below the level seen in 2001.  A lot of the expenditure adjustments have been on voted capital expenditure but the limits of this are now being reached.

Non-voted capital expenditure has exhibited unusual volatility since 2009.  This is explained by the banking crisis.  In 2009, there was a €4 billion payment to Anglo Irish Bank.  While there was no payment in 2010, in 2011 the first of the promissory note payments occurred with €3.2 billion paid to Anglo and INBS.  Again, a lot of the reductions in voted expenditure are being offset by increases in non-voted expenditure.

The final two graphs just give the voted and non-voted expenditures on the same graph.

Voted Current and Capital Expenditure

When it comes to voted expenditure, the total in 2008 before the current austerity programme began was €62.4 billion.  In 2011, after three years of austerity, it is forecast to be €57.5 billion.  Government expenditure in the economy is forecast to be €4.9 billion lower than it was in 2009.  This is 3.2% of GDP.  Of this reduction, €0.5 billion has been from current voted expenditure and €4.4 billion has been from the voted capital budget.

The final graph gives non-voted expenditure.  The changes in non-voted capital expenditure have been explained.  The increase in interest payments leading to the rise in non-voted current expenditure is evident and this expenditure is now more than double the 2008 total.

Non-Voted Current and Capital Expenditure

Monday, April 11, 2011

A 50% haircut on unguaranteed bondholders

A previous post asked about the possible savings to be made through burden-sharing with senior bondholders in the banks.  Here we try to answer some of those questions.   The starting point is again this table published by the Central Bank a few weeks ago.

Bonds in Covered Banks (Updated)

The following table works through the figures when imposing a 50% haircut on all unguaranteed senior debt.  Click table to enlarge.

Senior Debt Haircuts

The first column gives a breakdown of the €46.3 billion given to the banks so far.  The next column gives the capital requirements from the recent stress tests.  It excludes €2 billion for IL&P as it is assumed that this can be raised by the sale of Irish Life and the use of other assets in the group.  It also excludes the additional capital “buffer” of €5.3 billion that the banks may receive.  The banks, particularly, but maybe only, BOI, might be able to raise some of this €16.7 billion themselves but we will assume that all of it comes from the State.

The third column shows that losses that will be applied to subordinated bonds if a 70% haircut was applied to them.  The next column gives the total losses that are currently being covered by the State.  Adding the capital “buffer” of €5.3 billion brings the State’s contribution to €63.5 billion.

How much of this can be offset if losses are imposed on unguaranteed senior debt?  The next column gives the losses that would be applied to all unguaranteed senior debt (secured and unsecured) if a 50% haircut is applied. (It is not clear if this can be done for secured debt but we will assume it can).  This shows that more than €18 billion of savings are possible.

However, in the case of BOI and EBS the losses imposed on bondholders are greater than the maximum losses to be covered by the State.  We will assume that the State’s contribution gives the upper limit on losses to be forced on senior bondholders in each bank.   This is the figure given in the second last column.  The only changes are for BOI and IL&P as a 50% haircut on senior debt would result in savings greater than the amount of losses covered by the State in the first place.

This means that savings of €13.2 billion are possible if a 50% haircut is applied to all unguaranteed senior debt (this is in addition to the €5 billion from the 70% haircut on subordinated debt already announced).  Although this is only 20% of the total State contribution to the banking disaster, €13.2 billion is a colossal amount of money.  It must be assumed that somebody somewhere has done the sums of a cost-benefit analysis that shows the benefits to the State of taking these losses exceeds the costs.  Alas, no such analysis has been published.

A revised table assuming a 50% haircut for unguaranteed unsecured debt but a 25% haircut for unguaranteed secured debt is provided here.  Again click the image to enlarge.  The same logic as above is used.  This doesn’t change the arithmetic a huge amount and just under €12.0 billion of savings are possible.

Senior Debt Haircuts 2

€13.2 billion (or €12.0 billion) is a huge amount amount of money and it would be interesting to know what benefits from carrying these losses are believed to offset this amount.  This analysis assumes that guaranteed senior debt is paid off in full, but as 52% of this is in BOI and IL&P the scope for savings here with say a 20% haircut would be small (though this is if we start to consider €1 billion ‘small’!).  The above table also shows the savings that are possible if burden sharing is limited to a 50% haircut to the unguaranteed, unsecured senior debt.

In all analysis the greatest potential for savings is in BOI.  If done on a bank-by-bank basis it may be decided that burden sharing should not be applied in the case of BOI.  This is the only bank that has “non-zombie” status and is the bank that has the potential to return to some form of normality the quickest.  It’s ability to raise capital independently may be unduly harmed if burden-sharing is applied here.  That would reduce the potential savings to below €8 billion and down to around €6 billion for the four “viable” banks.  With the 25% haircut on unguaranteed secured debt the figures are €6.6 billion and €4.8 billion.

It is pretty clear that the biggest sinkholes in this mess are Anglo, INBS and AIB.  The former two are being wound down.  AIB (once merged with EBS) has been designated a “pillar” bank.  This looks like an expensive way to establish a pillar bank.

As we said elsewhere it is probable that the State can service the debt from this banking fiasco.  But the question remains, if we are putting up €64 billion for this disaster, why can’t those who had the money in the first place stump up €8 billion?  Burden sharing with senior debt in Anglo and INBS cannot be avoided.  This will raise less than €2 billion. 

The question is whether it is worth avoiding this scenario for AIB, EBS and IL&P.  A 50% haircut across all unguaranteed senior debt would generate savings of €6 billion.  Even with a the reduced haircut for secured senior debt the savings would be €4.8 billion.  These savings are not as large as those who are shouting loudest might have us believe, but they are significant nonetheless.

It would be nice to think that there is €6 billion (plus interest) of benefits to be gained from taking on this debt, but it would be even nicer to know it.  This question was asked to Patrick Honohan in a recent interview but the answer was less than convincing.  A transcript of the relevant portion is included below the fold.

Vincent Browne: Ok who’s going to pay for this?

Patrick Honohan: I’m afraid that the costs are going to be borne by the beneficiaries of Irish public services and the taxpayer.  I don’t just say the taxpayer because this is a squeeze on the government. The government finances are going to absorb this.  Of course, in the early stages the shareholders lost money, the subordinated debt holders lost money. Ah…

VB: €65 billion of the bank losses that you have calculated here. €65 billion are not covered by the State guarantee.  The guarantee.  Why should we be paying them?

PH:  Well, the figures are laid out.  You’re including some things that although not covered by the State guarantee, that’s fine, but they are also collateralised so they’re not going to be paid by the taxpayer, they’re going to be paid out of the collateral in that case.

The unguaranteed element here is as you know considerably smaller, a number in the, in the, hmmm, oh what is it? About 20-something billion. Anyway that’s a well-known number, of which the subordinated debt, I think, will inevitably take very significant losses.

VB: But there’s €35 billion that now covered by the State guarantee. Now why should the State be paying back those people not covered by the State guarantee?

PH: Ah, in the case of the subordinated debt, which is part of this, I would be very surprised if they won’t be subject to…

VB: No, but the senior debt is €35 billion.

PH: OK, moving into the senior debt. It is an argument of expediency and calculation. OK. There, first of all it’s not legally unproblematic to do this. Maybe you can find a legal way. You certainly need legislation.  Let’s just think through it.

VB: Yes, because the problem of forging of preference, but that would be about the case of liquidation.

PH: You could, you could.. lawyers have proposed ways of doing this, but it’s not unproblematic. 

Secondly, however, you have to evaluate the consequences for the State’s finances, and indeed for the banks’ finances, of a government taking aggressive action of that type. Aggressive, legislated action of that type.

There will be consequences. One has to calculate them. The calculation of expediency that one would make is “is the amount recovered, is that going to be offset by higher funding costs and the smaller the amount to be recovered relative to the total amount of debt, the more adverse that calculation becomes”.

VB: But we going to give €35 billion…

PH: So the amounts of debt that are involved here, that are in play here, are small relative to the potential losses.  That is the calculation that has to be made.

Now, there is a third factor, which is very very important, which is at the spill-over, the potential spill-over on other banking markets in Europe and therefore the effect on the rest of Europe and the consequences for our relationships with the rest of Europe.

Those are the three reasons.

VB: There’s a fourth reason.  There’s a fourth factor which you haven’t mentioned and it is the effect of a further €35 billion going out of this country to these senior bondholders not covered by the State guarantee.  The effect in terms of education.  The effect in terms of poverty.  And misery, unemployment and everything else.

PH: No.No. No. What I am doing is a calculation that says the net advantage to the fiscal accounts, to the ability of Ireland to fund all the services you are talking about.  That is the calculation that has to be made and it is not at all clear that without the support of our European partners, this would be positive.  In fact I think it would be negative.

VB: In other words, our European partners are saying that this deal, this bailout deal that we have given you is conditional on you paying back people not covered by the State guarantee. Is that what you are saying?

PH: The... am. No, they didn’t say that. But there would be consequences for our relationship.

VB: And we have to defer then.  Irrespective of the consequences for this society and our citizens we have to pay €35 billion to people not covered by the State guarantee.   On top of all the other disasters.

PH: We have to take account of the consequences.

VB: On top of these other disasters.

PH: We have to take account of the consequences. It is not on top of it. It is part of it.

VB: On top of the other disasters. The €75 billion, or the €65 billion disaster.

PH: It is all included.

VB: Hmmm. Yeah. You were one of the people who negotiated this EU/IMF deal.  Did you take account of the social costs of the deal we entered into?

PH: Absolutely. This is an arrangement which is attempting to recover the finances of the State, and of the banks, of course you’re talking about the banks today, but of the State. The State was in a position where it had lost access to the markets, lost confidence.

We have very little alternative here, than to seek support from official partners. And they want to see a plan that restores the finances.

VB: As far as I’m know there’s nothing in the EU/IMF deal that requires us to pay this €35 billion.

PH: Absolutely not. That’s right, that’s right.

VB: So, we wouldn’t be breaking the deal if we said we’re not paying.  But you’re saying in addition to that…

PH: No, I’m saying that a calculation has to be made as to whether it would be advantageous.

VB: But the deal would stand in any event.  We would still be paying whatever we’re paying, 5.8% or whatever.

PH: Certainly. But, but I think I’ve pointed out, it’s not legally unproblematic. That there would be consequences in terms of the cost of funds and there would be consequences in terms of the impact on our partners and therefore that would feed back to us.  So it is an argument of expediency.

In this exchange, Prof. Honohan used the words ‘calculate’ or ‘calculation’ ten times.  It is clear that he has done this calculation but not once did he offer the figures involved in this analysis.  He never offered the benefits and costs of this calculation. 

How much does he think can be saved through burden sharing with unguaranteed senior bondholders (and he limits it to unsecured bonds)?  Then, on the other hand what cost does he put on the consequences of this decision?  He clearly believes that the costs exceed the benefits but seems unwilling to provide the numbers behind this view.

As we have seen the savings are not as substantial as might be believed, but still run to several billion.  A 50% haircut on all the unguaranteed unsecured senior debt would generate a savings of €6.3 billion in the four ‘viable’ banks (€3.8 billion excluding BOI). 

From the outside we can only guess what the costs of such a decision would be.  From my limited perspective, I would tend to go with Prof. Honohan’s view, but I would like to be able “to put my finger into the holes”, so to speak, to see and believe for myself.

How much can we save from burden-sharing?

This post is more questions than answers!

How much can we save if burden sharing with bank bondholders is undertaken?  What is the appropriate form that this should take?  Is it a problem that more than 40% of the senior debt is in Bank of Ireland?

The CB data from mid-February showed that there €63.4 billion of bonds issued by the covered six.  This has now been updated to €64.3 billion as EBS seemed to forget about €941 million of unguaranteed secured senior bonds in issue.  This is quite the error given that they originally said there were €1,050 million of such bonds in issue.  We do not know what has happened since mid-February but here is the breakdown as it was.

Bonds in Covered Banks (Updated)

Anyway, what can be done with this €64 billion?  And what about the €46 billion we have already put into the banks?  This is now made up of €19 billion in cash and €27 billion of outstanding promissory notes.  Can we get any of this back?

With looked at in the aggregate a total of more than €64 billion of outstanding bonds in the covered six looks promising.  It is likely that the upfront cost to the State of this disaster will be also be around €64 billion.  This is the current €46 billion with maybe another €18 billion from the most recent stress test results.  As we have stated elsewhere this can be done, but “can” and “should” are two very different verbs.

We know that some savings will be made on the subordinated debt.  Micheal Noonan has indicated that he believes this will yield around €5 billion, with an assumed haircut of around 70%.

We have been told that the other €57 billion of senior debt cannot be touched.  Of this, €23.6 billion is in BOI.  This is the strongest of the banks and the only one that has "non-zombie" status.  So far, the State has put in €3.5 billion through the purchase of preference shares by the NPRF. 

The recent stress tests have shown that BOI needs €3.7 billion of additional capital to meet the stress tests with an additional €1.5 billion of a "buffer" also required.  Some of this €5.2 billion will come from the €2.8 billion of subordinated bonds in BOI and it is likely that attempts will be made by the bank to raise further capital themselves in an attempt to stave off State control but a significant portion of the €5.2 billion will have to come from the State. 

Is burden-sharing limited by the amount of losses in a bank itself?  Can we "cross-burden share" between the banks?  Can we get senior bondholders in BOI to pay for the losses in Anglo?

Similarly there is €8.9 billion of senior debt in IL&P.  PTSB needs a total of €4 billion in capital (€3.3 billion for the stress tests and €0.7 billion as a "buffer").  It looks like about €2 billion will come from the sale of Irish Life and the use of other assets in the group.  There is €1.2 billion of subordinated debt which will provide another chunk.  Again the State will have to make up the shortfall but can we impose losses on €8.9 billion of senior debt when we will be putting in less than €2 billion in total.

The numbers are smaller for EBS which needs a total of €1.5 billion in capital and has €3.5 billion of senior debt outstanding.

Among those examined in the stress test, the one exception to all this is AIB which for some reason has been designated as a “pillar” bank.  AIB has already consumed €7.2 billion of the NPRF and needs a further €13.3 billion as a result of the recent stress test.  €20.5 billion is a lot of money to pay for a dysfunctional pillar bank.  There is €14.7 billion in senior bonds in AIB.  Unlike the other banks in the stress tests this is not sufficient to cover the level of additional capital required.

Should we just give AIB to the senior bondholders and let them fight over the carcass?  It would mean abandoning the €7.2 billion we have already put in, but saving whatever portion of the next €13.3 billion is needed.  With Polish and US assets sold off, and no hope of AIB raising any significant capital elsewhere, the State would have to provide the vast majority of this.  It is hard to imagine any scenario where the resale of a cleaned up AIB would allow this contribution to the reclaimed.

For the two banks not included in the recent stress tests, Anglo and INBS, we have been told that burden-sharing with senior bondholders is still “on the table” but no further details are expected until information on their wind-downs is released in May.  But even then the amounts left are dwarfed by the losses that these institutions left behind. 

INBS has been given €5.4 billion of the State’s resources but there is only €0.8 billion of bonds remaining.  Anglo, which for some reason was deemed be systematic, has had €29.4 billion poured into it .  Provision has been made for a total of €34.4 billion but it is unclear if the additional €5 billion will be required.  Regardless €29.4 billion is a colossal waste and the scope to get any of this back is limited to the €6.3 billion of bonds outstanding in Anglo.

Has the strategy followed for the past two and a half years left us in a policy strait-jacket.  In August 2008, the month before the blanket guarantee, there was €82 billion of bonds from the covered six held by non-Irish residents.  The most recent Central Bank data put this at €28 billion – a reduction of €54 billion.

Those who could afford to pay for this fiasco are largely gone and the days of having the option to “burn the bondholders” to any significant degree could well have passed.  With  41% of the outstanding senior debt in BOI, it appears that the 27% in AIB offers the only real scope for significant savings.  Are we willing to give up one of the “pillar” banks?

Thursday, April 7, 2011

Core inflation returns

The CSO have released the March CPI numbers and headline inflation is now running at 3.0%.  Looking at our measure of core inflation, we see that this has moved into positive territory for the first time in almost two years. 

Core Inflation March

Up until now the positive inflation we have had has been driven by energy prices and mortgage interest.  Energy prices are largely determined externally, though the increase in excise duty in last December’s budget are also a factor.   Mortgage interest rates have been driven up as our ailing banks have been pushing up variable and fixed rates for the past 18 months or so.  Here are the inflation rates in these categories for the past three years.

Energy Inflation MarchMortgage Inflation March

Energy inflation is now running at 14.8% with mortgage interest an eye-watering 28.6%.  Both of these are likely to increase in the coming months.

Up to now there was some solace that the positive CPI rate was not determined by the movements of core prices in the Irish economy and were only reflective of substantial changes in particular sectors.  This is now not true and prices are rising (or falling less slowly) across all sectors of the economy. 

We can see this if we compare the current annual inflation rate in the 12 commodity categories provided by the CSO to that from last November.

Inflation Rates

Of course, some sectors still are exhibiting deflation as can see.  The point is that in sectors with inflation prices are now rising faster and in sectors with deflation prices are now falling slower. 

This is not to say that everything is getting more expensive.  It is just indicative of where prices changes are going.  Here are the actual price changes showing that some things are cheaper.

Price Changes

If we compare the price of these commodity groups to last November we can see that for clothing, furnishing, recreation, education and restaurants prices are now lower than they were five months ago.  Over the coming months it is likely that fewer of these comparisons will be negative.

Wednesday, April 6, 2011

Bond yields fall

Since last Thursday’s stress test announcements yields on Irish government 10-year bonds have been falling.  Here is a graph from Bloomberg.

Bond Yields 1W to Apr 05

The peak is Thursday 31st March when the yield closed at 10.22%.  The stress test results were published later that evening and since the open on Friday the yields have been falling (though there has been some intra-day volatility).  The yield fell on Friday, again on Monday and continued on Tuesday when it closed at 9.68%.  In early trades this morning the yield has continued to fall and was at 9.64% as I write this.

The falling yields means there are buyers for Irish government bonds and the perceived probability of default is now lower than it was last Thursday.  However, we are still at the top of the yield mountain and have a very long way to descend before we can consider borrowing additional money from the markets.  The prospects of being able to do that before the end of the EU/IMF deal are improving but still shrouded in doubt. 

Here are the yields over the past 12 months.

Bond Yields 1Y to Apr 05

The recent falls have only brought the yields back to the level recorded around the 23rd March – just two weeks ago.  There is a lot of distance between the current rates and those recorded 12 months ago but we are going in the right direction.

UPDATE: (2pm) They're dropping like a stone.  Down to 9.31% now!

Monday, April 4, 2011

Evening Echo Article 04/04/2011

Here is the text of an article I wrote in the aftermath of last week’s stress test announcements that was carried by Monday’s Evening Echo.

The much anticipated bank stress tests revealed that four of the six banks covered by the guarantee will require an additional €24 billion to cover the losses built up during the property boom.  These banks (AIB, BOI, EBS and IL&P) have already received €11 billion in recapitalisation funds from the State.

The bulk of the money spent by the State in what is now ‘the costliest bank bailout in history’ went to Anglo Irish Bank and Irish Nationwide.  These zombie institutions have already consumed €35 billion of State resources.  None of this money will be returned. 

As these banks are being wound down they were excluded in the current stress test process.  The report gives the belief that no additional capital will be required by Anglo and INBS.  It would be nice to think that this is true.  The previous recapitalisation process for Anglo has made provision for an additional €5 billion of funds to be provided by the State.  We will know more about these two banks when further details of their wind-down process are revealed in May.

Thus far, the State has poured €46 billion into our delinquent banking system.  Of this, €35 billion has been with borrowed money with the remaining €11 billion coming from the destruction of the National Pension Reserve Fund – a €25 billion savings fund the state had built up during the good times.

There has been a lot of talk recently about debt sustainability and the inevitability of default.  Things are not as bad as many would have us believe.  The key to debt sustainability is the amount of debt accumulated and the interest cost of services that debt.  So far the banking crisis has burdened us with €35 billion of debt.

It is likely that there will not be a significant increase in debt as a result of the stress test results.  The banks need an additional €24 billion of capital but it is not necessary that this all come from the State. 

For example, Irish Life and Permanent is actually two companies – the  profitable pensions and insurance business, Irish Life and the loss-carrying banking business, Permanent TSB.  As part of the process to recapitalise Permanent TSB, Irish Life will be sold and other resources of the company will be used.  This will provide €2 billion of the €4 billion required by Permanent TSB.

The Minister for Finance has indicated that subordinated bondholders will continue to carry the cost of this disaster.  So far, subordinated or junior bondholders have had losses of €10 billion applied to their investments.  Nearly €7 billion of subordinated bonds remain in the four banks.   The Minister for Finance has indicated that a ‘haircut’ of around 75% will be applied to these bonds.  These bondholders are only going to get about €2 billion of their money back.  The other €5 billion will not be paid back and this reduction in the banks’ liability will see their capital bases improve by that amount. 

These two elements alone reduce the State’s contribution by €7 billion.  There is still €17 billion to be found to prop up our ailing banks but it may be possible to do this without incurring any additional borrowings.

The Memorandum of Understanding agreed between Ireland and the EU/IMF as part of the rescue deal allowed for a “worse case” scenario of an additional €35 billion to be put into the banks.  Of this money, €10 billion was to come from the remaining funds in the NPRF, €7.5 billion was to come from the remaining cash balances of the State with €17.5 billion borrowed from the EU/IMF as part of the €67.5 deal agreed.  We no longer need all of this money.

The €10 billion contribution from the NPRF was already agreed and was actually postponed by the previous government in the run-up to the election.  This money is waiting and will be used as part of this final-stage recapitalisation.  That leaves €7 billion and we had already committed to providing about that amount from the €15 billion of cash balances the National Treasury Management Agency had built up in the early part of the crisis through bond issues.

It is very possible that the €24 billion could be found for the banks without any recourse to additional borrowings by the State.  Of course, it appears that the State will still have to provide around €17 billion to this process and this is a huge waste of State resources.  We could borrow the final €7 billion required as keeping a large cash buffer would be useful as the country tries to work its way out this economic crisis.

The final cost of this banking disaster could approach €120 billion.  Shareholders in the banks have seen €60 billion of value eroded to close zero.  Shareholders have been almost completely wiped out.  Subordinated debt holders will have been forced to take losses of around €15 billion with 70% haircuts applied to their investments.  We now know that the State is contributing  about €63 billion to clean up this mess.  The remainder of the cost will have come from the sale of assets and other sources within in the banks.

This €63 billion is a colossal waste of money for the State.  However, because we came into the crisis with a €25 billion sovereign wealth fund and €15 billion of available cash balances we will not need to borrow all of it.  Debt sustainability and the probability of default depends on the amount of debt accumulated.  If a family buys a home, sustainability is determined by the repayments on the mortgage rather than the initial purchase price.  If a large deposit had been used it reduces the size of the debt and makes sustainability more likely.

We have already borrowed €35 billion for the banks.  The most that could be added to this as a result of the recent stress tests is around €7 billion.  This gives a banking-related debt burden of €42 billion.  The rest comes from the destruction of savings we had built up during the boom, but just like a household will not have to pay interest on the amount they paid in a deposit, the State will not have to pay interest on the full amount of the bank bailout.

A banking-related debt of €42 billion is sustainable and will not tip a country with a GDP of €154 billion into default.  We can service the interest payments on this debt.  The entire process is a huge waste of money but it will not ruin the country.  Sustainability does not require that we pay off this money, but that we can meet the interest repayments.  The €42 billion debt at an interest rate of 6% would require €2.5 billion of interest payments to be made each year.

It is also important to remember what we are getting for this money.  The consultants who undertook the stress tests estimate that over the next three years the four banks that we now own will generate €4 billion of operating profit.  There are huge losses on the banks’ balance sheets but they also generate substantial profits.  Anybody who has a current account, chequing account, credit card or business account knows of the charges and interests that are levied by the banks. 

These day-to-day charges have not gone away in the current crisis, but have been completely swamped by the huge losses built up as the traditional banks got dizzy chasing the shadows of Anglo Irish Bank around the Irish property market.  In time, the banks’ balance sheets will be cleaned up and it is hoped that three viable business will emerge, the two “pillar” banks of AIB and Bank of Ireland and a smaller, leaner Permanent TSB. 

With substantial annual profits these banks can be sold on.  This money will not come anywhere near allowing the State to recoup all of the money this crisis has wasted, but when evaluating the long-term consequences the benefits as well as the costs must be considered.  Many commentators have focussed almost exclusively on the costs of this crisis.

This process is an extraordinary waste of resources, but it is one that we can survive.  It has seen the destruction of assets and savings built up over the last decade, and the imposition of a significant debt burden on the State.  However, default is still an option rather than a necessity and we can work our way out of this crisis.

Saturday, April 2, 2011

Banking on bank analysis

I have been watching a lot of the analysis on Thursday’s stress test announcements and, to be honest, a lot of it has been cringe inducing.  The banking crisis is catastrophic but it is not terminal.  Last week was actually a relatively good week in the context of the crisis.  Yes, a further €24 billion has to go into the banks but it seems likely we will have to borrow very little of it.  And the ECB has indicated that the emergency funding provided to the banks will continue to be available at the base rate.

This is a bit of an unnecessary rant but here are some contributions discussing the stress test results and my take on them.  This was as much me getting my thoughts on this straight rather than making any contribution.  In some cases it is an issue of facts, in which case the difference is clear. In others it is just a difference of opinion, which can make the distinction a little vague.

The banking crisis is one of the most destructive events ever in the Irish economy.  It is bad and will continue to be bad.  But, the evidence now suggests that we can get through it using the current strategy.  Some people need to realise this and provide alternatives to the strategy rather than simple saying “it can’t work”.

There is a lot to this post so I’ve put it below the fold. 

Contributor One: Unfortunately, when I read through the actual assessment documents themselves, I see that they moved in the right direction with it, but they haven’t arrived there.  If you look for example, in terms of being more conservative on the capital side, he is talking about 10.5% Core Tier One capital for the Irish banking system. 

The Financial Regulator said 12.0%, so there is a gap there which has to be closed there after this so on top of €24 billion the Irish banks will have to go out on the market, apparently, and try to raise additional capital, which is not a snowball’s chance in hell that they can raise any capital on the markets, so that is not really a conservative assumption.

The four banks don’t need any additional capital.  They do not have to go to the markets to raise any additional capital.  It is more likely that there is a “snowball’s chance in hell” than the banks will need any more capital.

In fact to achieve the target of a 10.5% Core Tier One capital the banks “only” need €18.7 billion as this sentence on page 11 of the stress test document reveals.

The table below presents the minimum amount of capital the banks will be required to raise, a total of €18.7bn, in order to meet the new ongoing target of 10.5% Core Tier 1

The Central Bank has decided that the banks require an additional capital ‘buffer’.  They estimate this to be €5.7 billion and this is where the final €24 billion figure comes from.  The stress tests reveal that the banks need an additional €18.7 billion.  The current process will actually see their capital increase by €24 billion.  The banks don’t need “to go out to the market to raise additional capital”.  They are being over-capitalised.

Contributor One: If you look at the tough approach.  If you look at the core figures, and we have no answer on it, the big issue is the Blackrock estimated that there is €40.1 billion in losses total.  The Central Bank of Ireland in its exercise only takes into account €27.7 billion out of those losses.  So in other words, €12 billion odd is somewhere lost miraculously. 

It is true that the total losses estimated by Blackrock are €40.1 billion.  But this is over the entire lifetime of the current loan books on the banks’ balance sheets – probably about 30 years.  The figure of €27.7 billion is “the cumulative 2011-2013 crystallised losses plus losses attributable to 2011-2013 loan defaults that crystallise later”.  These are the losses that will materialise over the next three years.

The Central Bank did not omit “€12 billion odd” of losses.  It is just that they will occur so far in the future they do not form part of the current recapitalisation process.  Why would we put money into the banks now for losses that will come about in 15 years time?  But in a sense we are doing so through the additional capital buffer.  There is also another factor that has not been mentioned very often over the course of this banking crisis – operating profit.  Here is the last paragraph from Box 1 on page 11 discussing the losses that occur after 2013.

Besides, any such losses are spread over a quarter century, allowing a lot of time for provisions to be set aside out of normal profits in what would then be a recovered and downsized banking system operating in a non-stressed situation. The proposed cash buffer together with the deferred contingent buffer amounts are therefore ample to deal with this prospect. The capital injection for the buffer will be met partly through equity and partly through contingent capital instruments.

So ease up about the €40.1 billion of losses.  We’re covering €27.7 billion up front and that’s plenty.  In the three year period 2011-2013 BlackRock estimate that the four banks will generate €3.9 billion of operating profit on their day-to-day operations.  There might be €12.4 billion of losses to come over the 30 years after 2013 but the banks will be able to absorb these themselves with need to require additional capital.

Also this total of €40.1 billion is the “stress” of worst-case scenario.  Under the “base” scenario the total lifetime losses are estimated to be €27.5 billion (see Table 10 on page 27).  I’m glad they’ve chosen the stress scenario to work with but it does show that the figures are used are the worst estimates of the possible losses in the banks.  The Central Bank say that the “stress” losses are  “not considered likely to materialise; they are merely an input designed to ensure the associated capital requirements are fully convincing to the market as being sufficient to cover extreme and improbable losses”. 

Finally, on the losses it is important to note that the BlackRock estimates are over and above the loan loss provisions the banks have already made on their balance sheets.  The banks had already allowed for €9.9 billion of losses.  This figure is included and the loss estimates of Blackrock are in addition to that.  So the total lifetime losses are actually €50 billion.

The €24 billion recapitalisation also covers an additional estimated loss of €13.2 billion of losses the banks will incur due to the forced sale of non-core loans over the next three years.  These are large, and in some ways, unnecessary losses for the banks to incur. 

Huge potential losses have been incorporated into the stress tests.  What will the final cost of this bailout be?  Back to contributor one.

Contributor One: In my estimate the final cost of the banking bailout, net of all recovery of assets will be around €105 billion.  We are heading there right now.  They are more or less on track except that they are not recognising the additional €15 billion that Anglo has said that they will require and they are not recognising the additional €3 to €4 billion that will be required in terms of the funding for the INBS.

This €105 billion is made up of four elements:

  1. Money used on recapitalisation to date (€46 billion)
  2. Money now to be used on recapitalisation (€24 billion)
  3. Projected outcome of the NAMA process (unknown)
  4. Further recapitalisation for the four "live” banks and the two “zombie banks” (unknown)

Number 1 is correct.  Number 2 is the figure released on Thursday but we know that the State will not have to provide all of it.  €2 billion will come from the assets in Irish Life and €5 billion from haircuts to subordinated debt holders.  Thus the known cost of the bank bailout to the State is €63 billion.  Can we find another €42 billion?

The final outcome of the NAMA process is unknown.  From this report we know that “as of today [2nd March], the Agency has acquired €71.2 billion of loans for a consideration of €30.2 billion – a discount of 58%”.  If all the assets turn out to be worthless then NAMA would lose €30.2 billion plus its operating expenses.  The loans already have an average loss of 58% built into them.  The final outcome could be lower and could be higher.

The “central scenario” of the NAMA business plan envisages a €1 billion euro profit.  I cannot vouch for these figures but given the buying discount and the composition of the loans purchased it is not unreasonable to expect the NAMA process to break even.  Why we moved rubbish loans from one set of State-owned entities (the banks) to another State-owned entity (NAMA) is another question. 

For the sake of argument, let’s just say that the NAMA process is a complete disaster and the loans have to be written down to an average of 75% of their original value.  Note that on the 30th of September last, one quarter of the loans by value in NAMA were deemed to be “performing”.  For the 75% write-down to hold in this scenario the other three quarters of the loans on NAMA’s books would have to be worth zero – no repayment, zilch and the assets backing those loans would have to be worth zero, nada.  This is unlikely.  Anyway this implausible 75% write-down would see NAMA make a loss of €13.4 billion plus operating expenses.

Adding this unlikely outcome to the known €63 billion brings to the total to about €78 billion.

We now know that the four “live” banks are unlikely to need additional capital and are being over-capitalised.  There still are the two “zombie” banks, Anglo and INBS.  These are covered in Appendix One (pp. 80-81) of the stress test document.  Here is a short extract.

Capital requirements of new entity
The capital requirements of Anglo and INBS were assessed by the Central Bank in September 2010. As a result of this assessment, new capital of €6.42m for Anglo and €2.7m for INBS was injected by the Government in December 2010, bringing the total amount of State capital the two institutions have received since 2009 to €29.3bn and €5.4bn respectively. Anglo and INBS were not included in the stress testing exercise carried out in Q1 2011 as the institutions are in the process of implementing the restructuring plan.

Once merged, it is forecasted that group will have a Total capital ratio of 14.1% and a Core Tier 1 ratio of 12.5%. This will consist primarily of equity already injected by the State. The remaining regulatory capital will consist of the small amounts of preference shares and subordinated debt remaining after recent liability management exercises. The plan submitted to the Commission in January forecasts that this capital level will be sufficient to maintain a Total Capital Ratio above 8% until the loan management exercise is completed, given the planned reduction in the new entity’s required capital as its assets are worked out, and the existing levels of provisions on the Anglo and INBS balance sheets.

Future loan losses at Anglo Irish Bank
The Anglo loan book has been subject to a number of third-party reviews over the last year, detailed in Box 4. Based on these reviews, the Central Bank estimates that the current capital levels held by the Bank are adequate to cover future loan losses, in a base scenario.

It is noteworthy that the capital levels only cover losses in the “base” scenario.  It would be better if the capital covered the losses in the “stress” scenario as is the case for the other four.  But we are subsequently told that

Significantly, the riskier elements of Anglo book relating to development loans have already been transferred to NAMA. The remaining loans are in relatively less risky categories relating to investment, office and retail, with over 50% in the United Kingdom and the United States.

In addition, 2010 outcomes at Anglo corresponded more closely to the stress test base case scenario, rather than the adverse scenario.

So it seems we are fairly well covered on Anglo.  We have allowed for another €5 billion to go to Anglo.  When the €29 billion bill for Anglo was announced by Brian Lenihan last September he said it could be as high as €34 billion, and provision has been made for an additional €5 billion of promissory notes to be provided, though the Central Bank thinks that Anglo will not need this funding.  There are no suggestions that Anglo will need an additional €15 billion.  Now turning to INBS in the stress test document.

Provisions at Irish Nationwide Building Society
INBS’s loan portfolios were also reviewed in late 2010 as part of a full assessment of the Bank’s capital requirements.

In March 2011, the Central Bank benchmarked the loss rates assumed for INBS in the 2010 review against an even more conservative stress case lifetime losses for other banks forecast by BlackRock in Q1 2011. This benchmarking exercise showed that, unlike for Anglo, the loan losses assumed for INBS portfolios were slightly lower than the stress lifetime loss of the worst of the four stress test banks.

However, even if loss rates comparable to those of the BlackRock stress case worst bank were realised on all portfolios, the resulting increase in provisions would be relatively small (estimated at up to €195m). Significantly, a large portion of the losses on mortgage portfolios would likely not be realised until after 2015.

Here, there may be some additional loses if the stress scenario comes to pass.  These are estimated to be €195 million (It’s nice to get to use the word million in all of this!).  But the Central Bank says that once Anglo and INBS are merged that this can be absorbed by the new entity.

The Central Bank estimates that by this time, the surplus capital of the new merged entity (in excess of the requirement of an 8% Total capital ratio) would be more than adequate to absorb such additional losses.

Anyway, we will know more about Anglo and INBS when details of the wind-down process are published in May.  When discussing this week’s announcements, Minister for Finance, Michael Noonan, did say that the government would be looking for burden-sharing with senior bondholders in Anglo and INBS as these are non-viable institutions.  There currently is above €7 billion of bonds outstanding in these institutions.

Anyway, at a pure guess let’s say the worst that can happen is that this wind-down needs an additional €10 billion (say €7.5 billion for Anglo and €2.5 billion for INBS).  The State may not have to pick up the full tab on this bill and even if we add of this amount to our running total we come up with a total cost of the bank bailout of €88 billion, and this is only based on extremely negative assumptions of a €15 billion loss for NAMA and an extra €10 billion for the Anglo-INBS wind-down.  The total cost of €63 billion seems entirely more plausible.

Of course, the total cost of the banking crisis has been far more than €63 billion.  There are four groups who have suffered losses in the crisis.

  1. The State
  2. Bondholders
  3. Shareholders
  4. The Banks themselves.

The State will have contributed €63 billion (plus or minus the final outcome on NAMA).  Junior bondholders have so far taken haircuts totalling €10 billion, with a further €5 billion announced this week. 

Shareholders in the banks have taken ferociously losses but these are hard to quantity.  The banks had a total market capitalisation of about €55 billion at the peak but you would have to know the initial purchase price of each shareholder to know the actual losses.  Regardless, these holdings have been almost entirely wiped out.

The banks themselves have had to come up with some of the money to cover their losses.  AIB has sold its stake in Polish and US banks for around €4 billion, and Irish Life will be broken off from PTSB generated around €2 billion to cover some of the losses there.  As with the shareholders it is difficult to know how much the bank is actually losing by selling off these assets to cover losses.

Still, it would not be a huge stretch to suggest the following contributions of each group to the bailout:

  1. The State - €63 billion (actual)
  2. Bondholders  - €15 billion (actual)
  3. Shareholders - €20 billion (guess)
  4. The Banks - €5 billion (guess)

This comes to €103 billion which is a huge sum for a banking crisis in such a small country.  The only group that can see any return on these contributions is the State.  The State will be the owner of the four “live” banks which are estimated to generate €3.9 billion of operating profits between now and 2013.  If their balance sheets can be cleaned up, the potential to sell on these banks will emerge and the final cost to the State of this fiasco that be reduced from the current €63 billion.  And back to our contributor.

Contributor One: They are also not recognising any of the funding costs for the bank in itself which over 3 years will be about €6.1 billion in itself.  There is no way without a financial solution we can get back on track on growth.

I’m not quite sure what this is.  My best guess is that it is interest the Central Bank will have to be pay on the money it is using to provide Emergency Liquidity Assistance (ELA) to the banks.  All we need to note here is that the Central Bank is not giving away this money for free and the interest it charges for the money will cover the funding costs of getting the money.  If this is the case, then there is nothing to see here.  Move along, folks. Nothing to see here.

Next we move briefly to a second contributor to Thursday’s discussion:

Contributor Two: Well, unfortunately it’s a very depressing day.  I’m mean, this is what I most feared.  We are shoving money into a black hole, €24 billion this time.  We have got no explicit commitments from the ECB.  It is a really, really bad day.  The reason being is, they keep talking about getting confidence back into the marketplace.  I work in that marketplace and the market place will have no confidence tomorrow and the reason being is – just think of it logically. Is there more of a chance of a sovereign default in 2012 for Ireland or less chance? And the answer is unequivocal there is more chance of a sovereign default in the second half of 2012 now than there was yesterday.  So the markets will take that on board and that will be it.

How did the “market” respond to Thursday evening’s announcement?  Here is the yield on 10-year Irish government bonds for the week.  Taken from Bloomberg.

10 years yields

At the close of Thursday the yield on Irish government 10-year bonds was 10.223%.  The markets took that evening’s announcement “on board” and at the close on Friday the yield was 9.978%.  The yield had dropped!  We better edit the second last sentence above, “there is” less “chance of a sovereign default in the second half of 2012 now than there was yesterday.”

Of course, the rates are still in the stratosphere and in relative terms Thursday’s announcements have hardly moved them.   This is because Thursday’s announcement has more to with the banks and less to do with the borrowings of the State.  Potentially, we may not have to borrow any of the €24 billion as we said here.

How did the rest of the world react the to stress tests? They gave them the thumbs up!  Here is the rationale for the S&P downgrade and their reasons for removing the negative outlook on Irish government debt.  Read it all.  Read it slowly. Look for the negativity of Ireland.

The downgrade reflects our view of the concluding statement of the European Council (EC) meeting of March 24-25, 2011, that confirms our previously published expectations that (i) sovereign debt restructuring is a possible pre-condition to borrowing from the European Stability Mechanism (ESM), and (ii) senior unsecured government debt will be subordinated to ESM loans. Both features are, in our view, detrimental to the commercial creditors of EU sovereign ESM borrowers.

We have removed the ratings on Ireland from CreditWatch, where they were placed with negative implications on Nov. 23, 2010. The outlook is now stable, reflecting our opinion that the assumptions underlying the stress test (The Financial Measures Programme, comprising Prudential Capital Assessment and Prudential Liquidity Assessment Reviews) conducted by the Central Bank of Ireland--in conjunction with the IMF, European Central Bank (ECB), and European Commission--are robust and that the expected €18-€19 billion (11.5%-12.0% of GDP) net cost to the Irish state of additional recapitalization, plus the contingency buffer for the banking system, is within our range of expectations, albeit at the upper end.

Of this net cost, we understand that €10 billion will be funded by a contribution from the National Pensions Reserve Fund, while the remainder will be financed via €7 billion in cash balances at the Treasury, implying a €1-€2 billion (0.6%-1.0% of GDP) increase in gross debt. This would still leave an estimated €9 billion (5.6% of GDP) in cash balances at the Treasury.
Our understanding is that the anticipated gross cost of the state's further participation in the financial system would be €23.8 billion (15% of GDP) of which €3 billion is a contingency. The outcome of the Prudential Capital Assessment and Prudential Liquidity Assessment Reviews stress tests does not include, however, any discount for tax-loss carryforwards of the Irish banking system, which we anticipate are equivalent to less than 2% of GDP. We consider that tax-loss carryforwards have weak capacity to absorb losses.

Standard & Poor's is of the opinion that the sharp contraction in Ireland's nominal GDP and gross national product since 2008 has reached an end, and that the Irish economy is now set to gradually recover. We believe that the Irish economy has stronger growth prospects than the Portuguese and Greek economies considering its openness (Ireland's exports are forecast at 107% of GDP for 2011 compared with Portugal's 30% of GDP), its flexibility, and its competitiveness. We anticipate that Ireland's current account will post a full-year surplus of more than 2% of GDP during 2011, for the first time since 2003, while net exports will continue to be the major contributor to headline GDP performance.

Standard & Poor's expects that Ireland's emergency liquidity assistance advance of €65 billion will gradually be repaid with proceeds from the disposal of non-core assets of Irish banks as part of the deleveraging process. That said, we also anticipate that the repayment of €88.7 billion in ECB advances to domestic credit institutions will be more difficult to achieve during the lifetime of the EU-IMF Extended Fund Facility Arrangement, which
expires in December 2013. In our view, despite the announced capital injections, the Irish banking system's liquidity position remains weak and we do not expect that its earnings prospects will recover any time soon.

What negativity?  The downgrade was the result of an EU decision.  The view on Ireland is generally positive.  Lads it’s time to change the tune.  You might disagree with the plan but it looks like it can work.

Contributor One:  If you look at the cost of funding our debt right now, and I’m not talking just sovereign debt, €49 billion, more than a quarter of the entire GDP of this country, almost a half of the entire GNP of this country, is flying out in terms of interest payments, on the debt at the current valuations of the government debt itself – and that disaster is going to continue as long as we have the debt not restructured.

I’d love to what this figure is.  €49 billion of what?  That’s nearly as much as the entire banking crisis is costing us. It could be related to our €1.6 trillion of external debt but most of that has little to do with the domestic economy as it is a function of IFSC activities.  If it is an annual interest cost of some sort it is 31.8% of 2010 GDP and 39.3% of 2010 GNP.

In the Balance of Payments there are three income flows that contain interest elements in them (2010 total in brackets).  These are:

  • Direct investment income on debt (€1.9 billion)
  • Portfolio investment income on debt (€16.5 billion)
  • Other investment income  (€15.5 billion)

The Balance of Payments indicates that up to €34 billion of interest income left the country in 2010.  What they also reveal is that under these three categories €40.5 billion of interest income flowed into the country. More interest flows in than out!!

We have a huge and growing debt and it will generate large interest costs.  However the sum of public and private debt is unlikely to rise much above €450 billion.  Unless all of this was borrowed externally and unless the interest rate is above 10% that will never generate an interest cost of around €50 billion.  If this isn’t an annual interest cost, then it’s hard to know why it is being compared to annual national income figures.

When discusses the following day’s newspaper the Irish Examiner headline “€70 billion the total cost of banks to the taxpayer of the bank bailout but ” was covered and one contributor was asked “what is missing from that €70 billion?”  The reply:

Contribution One:  It doesn’t include a helluva lot.  It doesn’t include the €12.4 billion that the Central Bank somehow miraculously lost between the estimate that BlackRock submitted as their worst case scenario and what they accepted as their own scenario.  It also doesn’t include Anglo’s €15 billion additional capital demand, which the Anglo management has flagged already.  It doesn’t include three to four additional billion that INBS will need. It doesn’t include the funding costs for the banks right now.  It’s well over a €100 billion.

We have gone through most of these.  They don’t stack up at all.  The Central Bank didn’t lose €12.4 billion of losses.  They happen over a 30-year period beginning in 2014. 

Here is an important one.  Anglo’s management have not flagged that they will need an additional €15 billion.  This figure probably comes from Anglo chairman, Alan Dukes’ guess that the entire banking system would need €50 billion.  This is €15 billion more than the €35 billion contingency fund set up as part of the EU/IMF deal.  When questioned about the bank he chairs, Dukes said “his bank will not require any further capital beyond the €29-34 billion range as outlined last year by the Central Bank” as reported here. (You can also actually listen to what Alan Dukes said at the same page.)

We now know that Dukes’ €50 billion guess for the entire banking system was too pessimistic by a factor of two.  If his pessimism also holds for Anglo then we probably have poured our last euro in that black hole and throwing figures of €15 billion around is completely disingenuous.

We have no reason to believe that INBS will require additional State funding and I’m not sure what this “funding costs for the banks right now is” but I would be pretty surprised if Governor Honahan, Elderfield and their staff have left it out.

Discussion facilitator:  There is €35 billion of unguaranteed bonds in the banks.  Why should this country pay?

It is true that there is about €35 billion of unguaranteed senior debt in the banks as can be seen from this table we have used a number of times.

Bonds in Covered Banks

It is clear that €26 billion of the unguaranteed bonds are in the main “pillar” banks of AIB and BOI.  These are the banks we want to survive and we need them to be able to raise capital at some unknown future date.  The strongest of the banks is BOI and that has more than €17 billion of the unguaranteed debt.  How can we default on €17 billion of debt in a bank into which we are only putting €5.2 billion per the recent stress test and €8.7 billion in total.  Bondholders in BOI are sure to have a strong case if they are forced to bear losses that occurred in banks that they didn’t even invest in!  That would be like your bookie not paying out on a winning bet because a half-brother of the horse you backed lost in an earlier race.

Another important thing about the €35 billion is the composition of it.  More than half is unguaranteed but secured.  This €19 billion is secured against assets.  If the banks try to renege on paying these bonds, the creditors will be able to claim the assets that have been used as collateral for these bonds.  It will be difficult to effectively burden share with these bondholders as they have rights to assets of the banks.  These are customer loans so that the repayments on these will go to the bondholders rather than the banks.  Defaulting on these bonds will see the banks lose whatever gain they made by not paying the bondholders.

Burden sharing could occur with the €16.4 billion of unguaranteed unsecured senior bondholders.  A 40% haircut on this debt would save €6.5 billion.  This is a huge sum.  But it must be weighed against a number of other considerations.  Firstly, almost €11 billion of this is in AIB and BOI.  Secondly, the reputational cost of the default would lead to higher borrowing costs for all banks in the future.  The future cost of this additional interest must be netted against the immediate savings of €6.5 billion.  With ongoing total funding of about €300 billion required by the banks it would not take long for even a slightly higher interest rate to completely erase the gain made by the immediate restructuring of unsecured unguaranteed debt.

I better stop now.

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