Grand Theft NAMA

In Endgame: What happens next? I laid out the path Ireland’s battered economy would take through 2009. It is now November so let us review what has happened in recent months.

I predicted that following the nationalization of Anglo Irish Bank late last year, the other Irish banks would soon run out of funding and would have to be nationalized. This would scare funding away from the Irish government’s bond market, and the state would be forced into default. The EU and ECB, I predicted, would quickly swoop in to restore funding and refloat the Irish state.

In point of fact, the ECB acted even faster than I had expected, intervening early to prevent a default in its Eurozone community.
And the Irish government, though it must have briefly contemplated the idea, chose to avoid further nationalization and do all it could to keep the remaining Irish banks in private hands. None of which however, limits the impairment of the banks or the exposure of the Irish taxpayer to that black hole.

While the steps have been rearranged, with intervention coming earlier to avoid nationalization and default, the problems remain in our banking sector. And the shuffling of deckchairs has only prolonged the timeline of the collapse.

The Irish taxpayer remains, as predicted, on the hook for the malinvestments of the country’s financial establishment. And, as predicted, aid, such as it is, is coming from the EU through the ECB. But to what end is all this frantic financial support? The ‘aid’ received from the ECB is not as I had suggested it might be, a gift, but only a further loan. The ECB appears prepared to keep lending money to the Irish government and banks indefinitely so as to indefinitely postpone default. But what good is that to the Irish taxpayer? Such ‘assistance’ keeps the zombie banking system from dying at the expense of the living citizens, who have to service this ever-increasing debt pile.

The Irish government’s current plan is to bundle all the liabilities of our failed developers and bankers into the NAMA agency and pass them, along with our ever-growing national debt onto the country’s taxpayers; Who already have the highest personal indebtedness in the world to shoulder. The ECB is happy to facilitate this transfer of liabilities because it keeps the banks open for business. It is not after all, the European Citizen’s Bureau; It is the European Central Bank and the reputation and viability of the European banking sector is its only concern.

How then do the Irish people avoid being turned into, as David McWilliams puts it, “a large debt-servicing machine”? There is but one way. We must drop the charade and admit that we are in over our heads. We have borrowed far more than we can ever hope to repay. And, as no one is willing to gift us the money we must be allowed to default.

The best and most humane thing that the Irish government, the EU, and the International community can do for the people of Ireland now is to allow them to fail. To concede to our creditors that we cannot repay them; To liquidate our banking system and property assets, retrieving from them for their creditors what little value remains; And to begin anew. With a fresh, new banking system lending unimpaired to new businesses unshackled from the mistakes of their forebears, Ireland can recover. But if it stays on its present course, it can only sink deeper into penury.

State Will Pay For Individuals’ Folly

The marketplace functions by rewarding individual success, and in theory only, by punishing individual failure. In Ireland and elsewhere this year, collective society will pay a high price for the mistakes of some.

Ireland’s problem, as described in earlier posts, is an unmanageable debt burden. While government debt is relatively low for now, private sector debt (mortgages, car loans, credit card debt, etc.) is somewhere north of 180% of GDP. This gives Ireland the highest level of personal indebtedness in the world. In an economy contracting at an alarming pace, we have no chance of being able to pay it all back.

Debt default will visit Ireland in a big way. But the nature of that default will not reflect the current ownership of the debt. Instead of allowing private debtors to individually default as their personal finances wane, the debt will be assumed by the state and repayed/defaulted against collectively. This will happen through state nationalization of the banks, through which all private credit is extended.

Once the state owns the banks, it will be on the hook for the losses on all the private loans, in addition to its own public debt. In this way, the public debt that funded schools and postmen will be merged with loans for BTL apartments and pie-in-the-sky skyscraper developments.

Every taxpayer in Ireland, whether they directly participated in the housing bubble or not, will soon be on the hook for the losses of those who played a fool’s game and lost.

Does Ireland threaten the EU?

Ireland is experiencing an extraordinary economic crisis, but do its ties to the EU and Eurozone threaten even the wider bloc?

Crippled from the fallout of a massive housing bust, Ireland is wobbling towards default. A rocketing soverign deficit and the world’s highest levels of per capita private debt mean Ireland’s ability to service its debt is becoming increasingly precarious. But what implications does this have for the wider economic bloc of which Ireland is a part?

Sovereign default is a traumatic event even for unattached nations like Russia in the 90s or Iceland in 2008. It has dramatic implications for that country’s currency and its future ability to borrow. In most cases the defaulting country will absorb the shock, stumble, but eventually carry on. It will wear the badge of a defaultor for a time and its creditors will be more cautious in their future dealings with it.

Can Ireland be allowed to default like this? Ireland is a member of the Eurozone, the 16 nation EU single currency zone. As such its debt obligations affect the standing of the shared currency. A failed member state, even a small one like Ireland, could badly damage the credibility of the currency. Which begs the question of whether the EU could allow a Eurozone member to default? Larger Eurozone members would have to consider coming to Ireland’s aid to avert damage to their own currency. This is the reason why Ireland’s bailout will come from Europe, with Germany reluctantly cleaning up Ireland’s mess.

Ireland’s economy is only 1/50th of the overall Eurozone’s, and could easily be picked up by other members. But the systemic threat comes from the fact that Ireland is not alone among Eurozone members in courting default. Ireland’s position may be the worst, but Greece, Portugal, Spain and Italy all have problems that place them at higher than normal risk of default. Were Ireland to be rescued, these other states may also demand rescue. And that is a bill that the EU cannot easily shoulder.

Such an event could greatly alter the structure of the EU. Consider the following crisis scenario from FT Deutschland; Substitute if you wish Ireland for Greece in the opening act, who the CDS market now rates a higher risk of defaulting.

But that does not mean that a breakdown of the euro area is inconceivable under all scenarios. Let us start with the hypothetical scenario of a Greek payment default. If the German finance minister, as I would expect, were to insist pedantically to apply the no-bail out clause, the crisis could, within hours, spill over to Portugal, Ireland, Spain and Italy, where bond spreads would be shooting up. Hedge funds will suddenly have discovered a good opportunity to make up for previous losses. Finance instruments such as Credit Default Swaps (CDS) are imminently suited to this type of speculation: If you stock up with Portuguese or Italian CDS during one of the panic runs, you stand to make very large profits. This in turn accelerates the domino effect of the crisis, and market interest rates will go up to double-digit rates all over southern Europe. The EU will hold an emergency summit at which it becomes clear that it is too late for a general bailout. This would have worked in the case of Greece or Ireland. But Italy and Spain are simply too big.

The summit would summon experts who tell the prime ministers that there are only two alternatives. Either the euro-area is dissolved with immediate effect. Or, one creates an imminent fiscal union, starting with single the European issuance of all future debt, and the transformation of all existing debt into a single European bond. The member countries would lose the sovereignty over budgetary politics. The finance ministers would receive their daily marching orders from Brussels. This would, of course, require a whole new EU Treaty, which the prime minister would have to agree on almost in real time.

I am not sure how Germany’s political leadership would jump when confronted with such a stark choice. Jean Quatremer, the Brussels correspondent of the French newspaper “Libération”, asked on his blog on Tuesday whether Germany is still a European country? The political instincts of Angela Merkel and Peer Steinbrück have been clearly anti-European during this entire crisis. They have prevented any real economic coordination with persistent reference to the national interest.

Ireland’s calamity has been so great that it must be recused before it threatens the entire European project. What price the EU will extract for its rescue, and how it will change both Ireland and the EU remain to be seen.

Where have all the new cars gone?

In the New Year a popular game is watching for the first newly registered cars. Who will be first to spot a car registered this year?
In the heady years of the boom cars appeared earlier and earlier. It was common even to spot several new cars on New Years day itself.
Not so in 2009. Car sales have plummeted in Ireland, down 66% overall on January 2008, and 80% in commercial vehicles.
This year I saw my first 2009 registered vehicle on February 4th. It was a Dublin bus.

The Endgame: What happens next?

Developments in the Irish economy are gathering pace, and we are entering the endgame period of this economic cycle. With so much happening in the economy, lets look forward a few months into the future to see how the endgame is going to play out.

Nationalisation of Anglo Irish Bank

A withdrawal of deposits from Anglo Irish Bank threatened its viability last week. This moved the Minister for Finance, Brian Lenihan, to take the bank under full state control. The nationalisation of this bank, whose €80bn balance sheet faces major impairment, is the impetus for all that follows.

Share Price Collapse

Following the nationalisation of Anglo the share prices of the remaining large Irish banks, AIB and BOI, will collapse to near zero levels. This collapse began Monday 19th January, and will continue until the share prices are so low they threaten the viability of the banks, in the same way as happened to Anglo.

Nationalisation of AIB and BOI

The state will be forced to take control of Ireland’s remaining large banks, AIB, BOI and likely PTSB and NIB. The biggest of these banks differ from Anglo in that they are of genuine systemic importance to Ireland’s economy. But they share Anglo’s fate as becoming vessels of the state and in the manner in which they will be nationalized. The market will demonstrate such a loss of confidence in them by collapsing their share prices that they will be unable to rollover their debt. A run on these banks is unlikely to happen from Irish depositors, who have no other Irish banks to run to, but some substantial deposits may be withdrawn by institutional depositors, as happened with Anglo.

Sovereign Default

On assuming the liabilities and bad debts of Ireland’s toxic banks, the Irish state will also inherit the market’s disdain for them. CDS spreads on Irish sovereign debt will explode and ratings agencies will belatedly downgrade Irish debt. Ireland needs to raise huge amounts of new debt on international money markets in 2009, including €20-25bn for a fiscal shortfall, and a potentially near-unlimited amount to meet bank losses, in addition to bank rollovers which will become the duty of the state.
The markets will have no appetite for this debt, whose scale is preposterous in comparison to the country’s fortunes. Ireland will be unable to meet its debt obligations and will default.

EU and IMF Intervention

With no recourse to normal money markets to raise debt, Ireland will have to accept a loan from a lender of last resort. This will be the EU or ECB in the main, with additional funds coming from the IMF. The EU will accept this burden for the sake of its political and monetary union. It cannot allow one of its members to sink without trace, particularly one inside the Eurozone. A complete collapse of the Irish banking system and sovereign could threaten the European currency. That risk is so great that Brussels (and Frankfurt) will loan, or even gift many billions of Euros to Ireland to refloat the state.
This intervention must carry a price. It will certainly include ratification of Lisbon II at a minimum. It may also include greater control over Irish affairs from Brussels, perhaps no bad thing? And the IMF portion of the loan will be used to demand stripping of the public sector and sale of state assets.

If this sounds unthinkable now, alarmist or even dangerous, consider what was believed unthinkable just 6 months or a year ago. The collapse of Irish house prices and the ISEQ, the spiraling budget deficit, the nationalisation of the high-flying Anglo Irish Bank, all these sacred cows were sacrificed to reality. The endgame, appalling though it is, is irreversible. The damage has been done and our course has been set. And though we may for a while lose our prosperity and even some independence, we should welcome any lines that are thrown us, and be thankful that we were not left to drown alone.

Other People’s Money: Explaining the Celtic Tiger Boom and Bust

From the early nineties until 2007, Ireland was known for its economic miracle. The Irish economy was dubbed the Celtic Tiger for its boundless growth. Asset prices and living standards rose year after year. In 2008 that “miracle” derailed and in the years ahead Ireland will come to be known for its spectacular fall from grace. How did it all happen, the dizzying growth and the paralyzing fall?

The answer lies in capital, getting access to it and ensuring the means to repay it.

In the 1980s Ireland had no money and no capital. Without capital it is nearly impossible to launch businesses, where it is needed to pay for buildings, equipment, wages, etc. What little capital was available within the country was rationed by the banks, who demanded a high return on their scare resource and who rarely entertained ambitious business ideas. As a result, economic activity in Ireland was very low at the time.

But Ireland spotted a clever way to get capital, and in the early ’90s cut corporate tax rates to very low levels. This attracted foreign capital, as multinational corporations saw that their capital could achieve better returns in Ireland than elsewhere. The capital influx was just what Ireland needed. It employed our underutilised workforce, whose spending created a domestic consumer market, and whose taxes funded infrastructural projects.

Of course capital demands a return, and the MNCs got it from their productive new Irish workforce. Their capital had purchased a competitive and skilled workforce whose output, often in high-tech and bio-pharma products, easily compensated the use of that capital.

Low corporation taxes worked well and Irish exports continued to rise into the early 2000s. But in the late ’90s, Ireland found another source of capital: the Euro. Membership of the European Union’s single currency would give Ireland access to the vast pool of capital in continental Europe, and at the same rates enjoyed by Germany and other well capitalized economies. This must have been a glorious prospect to the once cash-starved state.

Ireland joined the EMU in 1999, completing the process in 2002. From this point Irish banks could lend to domestic customers from the huge pool of Eurozone capital at interest rates determined by the ECB, much lower than those traditionally known in Ireland. Unlike the capital provided by MNCs, this capital was available to any Irish person who sought it, for whatever purpose. But like the MNCs, it demanded a return; That is, it had to be repayed with interest.

Had the new capital been employed productively, like the MNC capital, repaying it with interest should have been easy. Instead, the capital converged on one particular and non-productive asset class: property. Lending for property exploded from 2002 on and prices, already rising rapidly since 1996, surged higher with it.

This created a problem not immediately obvious, but that would ultimately lead to the economy’s collapse in 2008.

There are limits to the productive returns of property. It provides a service, shelter, but beyond that it does not generate wealth for its owner. It allows the owner to defer paying rent to a landlord, or to charge rent if not living in the property themselves. But to pay more for any property than is achieved by this is an indulgence, not an economy.

The Irish bought property from each other at ever more indulgent prices. Mistaking the self-perpetuating phenomenon of rising prices for a perpetual path to riches, they accumulated a massive debt owed to their Eurozone neighbours.

This debt was being serviced not from income returned by their investment, but by capital gains in that investment, which could only last as long as their own appetite for investing. The Ponzi scheme reached a top in the summer of 2006, after which insufficient investment followed and the scheme toppled. House prices collapsed, down 30% by Jan 2009 and falling, but the enormous debt remained.

That debt is sinking Ireland. With no means to repay even the principal, never mind the interest, Ireland is facing default both at a private and a national level. The legacy of Ireland’s grand malinvestment is a debt burden that could cripple the country for a generation.

Recession Reprices All Assets Lower

Ireland’s inventory of assets is being repriced in the face of collapsing demand and a shrinking money supply. The achievable market price of all assets is moving lower as fewer buyers and less money compete for the same stock.

The fall in the price of Irish houses is well documented. But all other classes are now being affected too. Everything from second hand cars to bathroom furnishings is getting cheaper.

One example is in the second hand car market, where depreciation is happening faster than normal. When I bought a two year old VW Golf in 2006 for €18,650, my research indicated that it would depreciate at a rate of about 10% p.a. That rate of depreciation held until the economic crisis gripped the country in 2008. In mid 2008 I estimated, using a mark to market valuation, the value of my car at approx €15,000. In the six months since then it’s value has fallen to approx €12,000, an annualised fall of around 30%!

The only asset not declining in value today is cash, whose purchasing power is increasing as Ireland enters monetary deflation. All of this is good news for cash ready consumers, but bad news for the “asset rich, cash poor”.

Ireland Stares Into The Abyss

2008 was an annus horribilis for Ireland, but 2009 will be much worse.

The past 12 months have seen a remarkable transformation and deterioration in the Irish economy.  Recession, while predicted well in advance, started officially in summer 2008 on the back of an ever worsening housing crash.

That seems like a long time ago now, and predictions of a benign contraction of <1% of GDP are exposed as so patently untrue now as they were fallacious then. Ireland without its debt-fuelled construction industry is like an athlete without its leg. We are in the process of falling over and losing 20% of our economic mass.

Ireland at the close of 2008 finds itself wedded to its toxic banks. The extraordinary bank guarantee scheme threatens the entire state which, unable to jettison its doomed banks is forced to share their fate. The state has assumed a level of risk in bank guarantees and cost in bank recapitalization programmes that, while cautioned of from some quarters, would have been unthinkable to the majority a year ago.

The economy is deteriorating at its fastest rate in modern times, while the danger to the very existance of the state is greater now than at perhaps any time since the civil war. So what does the coming year hold for us? Might we anticipate an upturn, or should we expect more turmoil?

Ireland in 2009 will experience its first year of debt deflation. This near unprecedented event is uncommon not only in Ireland, but anywhere in the developed world in modern times. Debt-based fiat currencies like ours, you see, simply do not do deflation. They are designed to expand only, and do not accomodate contraction such as we are about to experience. When it does happen the process is painful beyond proportion.

The deflation will result from reduced bank lending. Money will be repayed to credit institutions faster than it is loaned out, leading to a contraction in the amount of money in circulation. There will be a couple of visible effects of this.

The price of goods will decline. Goods in general (not just the CPI) will be nominally cheaper next year. That doesn’t mean they will be easier to acquire, as we’ll have to compete harder for the money to buy them. But for those with cash, goods will be available at less expense.

Debt defaults will rise. When money growth falls below a certain threshold, insufficient funds exist to make debt repayments as they fall due. There simply won’t be enough money in the economy to pay off all the outstanding debt, and some of it will be defaulted on. All forms of debt will be affected, from unsecured credit card debt to home mortgages. But significantly higher levels of home foreclosures will be a noticeable outcome.

Banks will be threatened with insolvency. The debt defaults explained above will greatly exceed banks’ provisions for them, and will threaten the very solvency of the banks themselves. Huge amounts of debt will have to be written off, and banks with insufficient reserves will have to raise funds elsewhere or fold. Even the state’s €10 billion recapitalization programme, intended for exactly this purpose, will be hard-pressed to meet the losses incurred over the next number of years.

Unemployment will continue to rise. This is not directly a result of the coming deflation, but of the banks’ impotence. Our credit institutions will be so bowed by the weight of their property losses that they will be unable to continue effective lending for regular purposes. The broader economy, which relies on credit to exploit business opportunities, will suffer for this. Many otherwise healthy businesses will be forced to close when they cannot secure credit for ongoing business, and starting new business will be next to impossible owing to difficulties in raising venture capital.

2009 will be a very difficult year for Ireland. The economic quagmire of our own creation poses huge challenges, and is likely to deepen as we approach 2010. Relief from our prediciment will not be soon in coming, and this may be the beginning of a 10-15 year long deflationary depression. But painful as it will be, this correction is necessary. It won’t often feel like it in 2009, but the economy is fixing itself in the only painful way it can. We’re returning to competitiveness and proportionality, where a moderate wage can compete with a moderate wage in Europe and purchase a moderate house in Ireland. Fasten your seatbelts and get ready for one hell of a ride.

Further Down We Go

The economy’s descent into hell continues this week, with several unprecedented developments in the U.S. The world’s fourth largest investment bank, Lehman Brothers Corp., has filed for bankruptcy, and another behemoth, Merrill Lynch, has been forced to merge with Bank of America over fears for their solvency.

These are significant events, both in terms of scale and the reactions they brought from the market. These are massive, and once highly sought after banks. That such a prestigious bank as Lehman could fail, let alone fail to attract a buyer, would only a couple of years ago have been unthinkable. Now, the bigger the bank the more polluted it is with debt that no one wants to be holding.

Lehman’s debt must now be unwound, and the markets are in for a couple of jittery days while they try to absorb it. There is the potential there for a panic, but expect the Fed to anaesthetise the market should things start to get out of control.

While the financial markets may now be closer to collapse than at any time in recent history, it has been the Fed’s actions in recent weeks that most drawn my attention. The Federal Reserve has now opened its lending window to almost anyone, and will accept any old junk for cash. As real banks go to the wall, the Fed increasingly steps in to fill the credit void. The Fed is becoming the market. And we can expect this to continue for some time longer, until the Fed and its member banks are the only ones left standing.

Not since the Great Depression has the financial world been in such turmoil. Its painful penance for the excesses of the last decade is a story Dante would have been proud of. And this tale is nowhere near finished yet.

Fair Value and Affordability

A chief concern of property watchers is trying to gauge what a house is worth. What is a fair value for a house? In the case of the Irish property market, this may also mean “what will be the final price of a house after the crash”? And, when is it better to rent than buy?

One yardstick for calculating whether to rent versus buy is the opportunity cost method. Buying a house can be considered equivalent to renting from the bank. The interest paid on a mortgage is economic rent just the same as the rent on a property. In addition to the interest payments (rent) the bank’s tenant additionally pays a little extra each month so that the house will eventually be theirs; This is the principal portion of the mortgage payment.

The only other difference is that the purchase price (the principal sum) is fixed as of the date the mortgage is signed. One could consider signing a mortgage as 'going long' the market, i.e. expecting that house prices will be higher by the time the mortgage matures than they are now. Equally, one who chooses to continue renting is shorting the market and assumes that house prices will be lower in the future.

In signing a mortgage, the rent is not fixed. Economic rent from the bank can rise if interest rates go up, just the same as a landlord can raise one’s rent.
One could argue that in general, inflation dictates that a landlord’s rent would rise faster than the bank’s rent, but this is not true in every case.

Buying the house I live in

The following is an illustration of the opportunity cost method. It also demonstrates why house prices need to fall dramatically in Ireland to be affordable, and why even at dramatically lower prices they will still be out of the reach of many.

I live in a house that rents for €25,000 per annum. To rent the house from the bank for the same price would mean the interest portion of the mortgage would be €25k pa. At prevailing mortgage interest rates of 6% (ECB+2%, is this fair?) gives us the equation:
x ✕ 0.06 = 25000, where x is the purchase price of the house.

Solving for x, this gives us x = 25000/0.06, or x = 416,666. In other words, €416k would represent fair value for this house. Incidentally, €416k is about half the house’s peak valuation.

So we have a fair value, a price that we might expect the house to achieve after the crash in say, 4-5 years. But does that make it affordable?

Suppose I wanted to buy the house that I now rent in 4-5 years at €410k. At that time lending will be so restricted that I will require a deposit of 25-30%, or ~€110k. That’s ~€25k in savings per year! It’s a lot of money to save, but with two incomes and strict Lidl shopping, it might just be possible.

But what about the other 75% of the purchase price? This would of course have to be funded by the bank, so I would require a mortgage of ~€300k. That is more than 6 ✕ my income! While banks may be willing to lend that kind of money today, they certainly won’t be willing to do so 5 years from now. In fact, the most one could expect to get in the future lending environment is 4 ✕ primary income, maybe 5 ✕ dual income.

So even though house prices will tumble, so will the ability to purchase. So affordability, while it will improve, will still be elusive after the crash.