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

Saturday, April 23, 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.

Friday, April 22, 2011

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.

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.

Thursday, April 21, 2011

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.

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!

Tuesday, April 5, 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.

Sunday, April 3, 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.