Earlier we focused on the basis for Prof. Morgan Kelly's diagnosis that the country is freefalling into the economic abyss with no hope escape. We are undoubtedly in a very perilous position but it is not as severe as he has suggested. One contrast we have noted is that the public debt will be around €200 billion rather than “closer to €250 billion” as he suggested. In this instance we will look at the proposed prescription.
National survival requires … … the Government to do two things: disengage from the banks, and bring its budget into balance immediately.
This is utter nonsense. Earlier in the piece we had been told that the public debt would be €250 billion. In this instance, it was suggested that the debt “can be halved to €110 billion by cutting loose the banks”. There's something not quiet right with the sums here.
Regardless, there is no way we could save €110 billion of debt by handing the banks over to the ECB. We've committed to spending €66 billion in total on the bank bailout so how can we possibly knock €110 billion off our debt by “disengaging from the banks”. And as around €16 billion will come from the destruction of the money built up in National Pension Reserve Fund during the good times, the amount of debt that we could save is closer to €50 billion. Still significant but not €110 billion.
So how much could we save?
We could save on the €28 billion of Promissory Notes outstanding for the zombies that are Anglo and INBS, and the €20 billion required from the State to recapitalise the four "viable" banks (BOI, AIB, PTSB and EBS) as a result of the recent stress tests. The term viable is used loosely in the context of AIB, but it is clear that we wish to keep this bank open. This would knock €38 billion off our debt and keep another €10 billion in the NPRF.
That's €48 billion of a savings but we would also be giving up any claim on the potential resale value of the banks. It is almost impossible to say what this will be but it will not be zero.
Cutting the six banks loose is a different prescription to what Prof. Kelly suggested in January 2009 when he said:
The worthwhile banks need to be maintained by any means necessary, including nationalisation, while Anglo Irish and Irish Nationwide must be allowed to collapse.
It could be argued that we would also save on the €30 billion of NAMA bonds, but they were used to buy €70 billion of developer loans and still carry some value. If we renege on the bonds we'd have to give back the loans. They could be worth some amount less than €30 billion (they might also be worth more) but the saving wouldn't be anything close to €30 billion. Current estimates from "the best source on the Irish economy" indicate that, given current property prices, the expected loss on NAMA would be around €3.5 billion. Depending on future property prices it could be more but it will not approach anything near €30 billion.
All told, there might be a maximum debt reduction of maybe €60 billion possible if we abandon the banks. Half of this comes from the "zombie" banks of Anglo and INBS where such a course of action could be justified. About a third comes from the four "viable" banks in which cases it is in our interest to hold on to. The remaining savings are dependent on the final outcome of the NAMA process.
If possible, €60 billion would be an impressive saving but we're left whistling in the wind waiting to see what the ECB would actually do with the banks, particularly the four we want to remain open. Prof. Kelly was aware of this in January 2009 but it seems to have slipped his mind since then.
You could also look at the €80 billion in liquidity funding owed to the ECB, but like the NAMA bonds this is backed by the assets of the banks. It's a liability of the banks, but will not become a debt of the State unless there are losses generated on those assets. If we give up the banks we do lose this €80 billion in liabilities but we also lose the €80 billion of assets (in nominal terms) that this money is financing.
The banks also owe around €65 billion to our own Central Bank. This is much like the money owed to the ECB. It will only become a debt of the State if the assets supporting it make losses.
There may be some further losses in the banks but to give credence to the suggestion that there are €110 billion of debt savings possible another €50 billion of losses are necessary, to add to the €60 billion of debt outlined above.
Between the NAMA process and the recent stress tests €85 billion of loan losses have been accounted for the in the covered banks. Losses accounted for elsewhere would bring this even higher and maybe close to €100 billion. These losses have been covered by the money we have already committed to the bank rescue package.
At his most pessimistic Prof. Kelly forecast total losses of €106 billion in the five banks engaged in the NAMA process. Unlike his inconsistent public debt estimates for which no details are provided, we did get an insight into his accurate prediction of losses in the banks in a spreadsheet on this post over on irisheconomy.ie. Add in PTSB to his analysis, which does not have a developer loan book, using the same assumptions he applied to the other banks and the total comes to around €110 billion.
Based on the contribution of equity and reserves to cover the losses he estimated a cost to the Exchequer of around €80 billion. So far the State has committed €66 billion to the banks. Could we have to stump up another €14 billion. Unlikely. So far haircuts to junior bondholders have provided around €10 billion of savings. We know there will be further haircuts to the remaining junior debt for about another €4 billion of savings. The sale of Irish Life will generate a further €1 billion or so.
Prof. Kelly was 100% accurate in his forecasts of the losses in the banks. €110 billion of losses and an €80 billion tab to be picked up after equity takes the first hit. Of this €66 billion will come from the State with junior bondholders carrying the remaining €14 billion of losses. He was so accurate it is uncanny. It truly was a remarkable forecasting performance and huge kudos has accrued to him because of it.
He should have reinforced this and then provided some viable solutions as to how we can work out way out of this mess he has so brilliantly forecast. Instead he ups the doom level even more suggesting the banks will generate €110 billion of debt by 2014. By looking at the money committed so far it is hard to see how anything above €60 billion of debt reduction is possible by abandoning the banks.
Where are the additional €50 billion of losses going to come from that would mean we will be on the hook for one-third the €150 billion the banks are getting from the ECB and the Central Bank of Ireland?
According to the recent data from the Central Bank the six covered banks had €294 billion of customer loans on their books at the end of December 2010. NAMA has taken €72 billion of developer loans from five of them. This gives a total of €366 billion of loans originating from the six banks.
For the numbers used by Prof. Kelly to hold up there would have to a total of about €160 billion of losses on these loans. That is a loss rate of nearly 44% across the entire loan book. This is a staggering loss rate. Also remember that many of these loans are secured loans so the level of default necessary to generate this level of losses would be larger again.
Obviously in some areas higher losses are possible. Losses of 80% or 90% on some development land loans will occur, but not to the level that can make these numbers feasible in the aggregate.
For those who think that such a 50% default on all Irish loans is possible how do you counter that with the fact that the household savings rate has been at about 12% for the past two years. Households account for about half of the loans in the banks, and households are now spending about seven-eights of their disposable income on consumption. The other eight is been used to build up savings and pay down debt. Obviously, this is at the aggregate level and there are individual households in dire needs. This is a serious problem but not the concern here.
This chart from the Central Bank’s Quarterly Financial Accounts shows that households have been saving an average of €4 billion a quarter up to October of last year. It can be seen that about €3 billion of this (based on the red bar) is going to reduce household liabilities.
Data from the Financial Regulator on Mortgage Arrears show that 92% of residential mortgages are being repaid according to the original terms of the contract.
It must also be realised that the banks hold substantial loans outside of Ireland. For example, nearly one-third of the residential mortgages held by the banks in the stress tests were in the UK. That is €43 billion of the total loans. Here is the table from the recent stress test document.
This table shows €274 billion of loans. The remaining loans to bring this up to near €300 billion are in the carcasses Anglo and INBS.
In the worst case scenario the banks are expected to make a loss of 1% on these €43 billion of UK mortgages. The banks will also have non-Irish loans in the corporate, small and medium enterprise and non-mortgage consumer parts of their loan books where losses comparable to those in Ireland are not expected.
Of the €72 billion of NAMA has taken responsibility for nearly €20 billion are in the UK with small amounts in other international markets. Just taking the mortgage and NAMA loans already reduces the amount of Irish loans to below €300 billion.
With this in mind it is clear that losses well in excess of 50% are needed on the Irish loans in the covered banks for the €160 billion of losses envisaged in this "analysis" to materialise. There are huge problems in the Irish banking system but we gain nothing by treating them in such a ridiculous manner.
There is no way we can halve our debt by cutting loose the banks as Prof. Kelly suggests. The numbers just aren't there to back it up. At the most, we could knock a quarter of the debt off. Prof. Kelly believes that that “Ireland’s problems stem almost entirely from the activities of six privately owned banks”. Our banks have created huge problems but they are responsible for only one-quarter of our public debt.
In 2014, our debt will be around €200 billion. Here is a new note from the NTMA. The evidence to suggest that it will be significantly greater than this is lacking. We brought about a quarter of that into the crisis with us. Another quarter will be due to our calamitous banks. Half of the debt will be due to funding the annual Exchequer deficits from 2008 to 2014. The banks are definitely the single biggest problem in the Irish economy but they are not the biggest source of our public debt.
Prof. Kelly suggests a remedy to that debt generator – immediately bring the budget into balance. We might come back to this at some stage. His first suggestion that we “halve our debt” by disengaging from the banks is populist nonsense.
Undoubtedly, there are debt savings that could be made and the debt legacy from Anglo and INBS is a complete waste. There is no doubt that on a standalone basis the money going into Anglo and INBS is dead money, but as part of an overall strategy to solve our banking crisis it may offer some merits. I don’t know the answer to this.
The situation is not so clear cut with the other four as they do have strategic importance for the State. Any savings from NAMA depend on the final outcome of the process.
The benefits to be made from this suggestion are probably 66% smaller than Prof. Kelly has led people to believe. He does not indicate what he believes the costs to be. All this does is feed into the belief that the banks are dominant cause of all our problems. Get rid of the banks and you get rid of our problems. This is not true.
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