The Irish Economy

Writing in today’s Irish Times, former Fianna Fail candidate Noel Whelan writes about the article signed this week by 46 academic economists.

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The last couple of days have seen several commentators raise fundamental questions about the role and optimal size of the financial sector. Free Exchange very helpfully links to three pieces, including one discussing the extraordinary statements (given their provenance) by Lord Turner, chairman of the British FSA. Turner suggests that a lot of what the City does is socially useless, and that finance has gotten too large.

There are lots of issues to be discussed here, so let me just pick up on one for now. That is the argument that the UK (and arguably other Anglo-Saxon economies) is suffering from a form of Dutch Disease, with an expanding financial sector sucking in too many resources, and depriving other sectors of much-needed inputs.

A standard thing to say about the Dutch Disease is that it isn’t a disease at all. If workers flock into the booming sector (say natural gas) because of higher wages, that is efficient, since those higher wages reflect higher productivity in the booming sector. (The higher productivity is due not just to the physical productivity of the workers in that sector, but to the price of the sector’s output.)

The term ‘Dutch Disease’ is thus a misnomer.

On the other hand, you can clearly argue that high wages and bonuses in the City have reflected bubble conditions, and the relative prices guiding resource allocation have thus been ‘wrong’. There is therefore a much better case for regarding financial services expansion as a ‘disease’, and for government intervention of some sort to reduce the consequent misallocation of resources.

So: can anyone think of a nice alliterative label to replace ‘Dutch Disease’?

From an article by then-ivory-tower economist Alan Ahearne in the Sunday Independent on July 27, 2008:

However, if the borrower is unlikely to repay the loan, the best strategy is often for the bank to sell the loan to a special company created to handle bad debts. This allows the banks to concentrate on what banks do best – making new loans.

In some countries that have had severe property busts, these asset management companies have been state-owned agencies. In this country, one could imagine an agency like the National Treasury Management Agency buying nonperforming loans from the banks and then managing and disposing of the properties that are collateral for these loans. These distressed properties could be disposed of gradually, thereby avoiding fire-sale liquidations.

A key question would be what price the agency should pay the banks for the loans? Buying the assets at inflated prices would amount to a back-door recapitalisation of the banks. Similarly, many of the proposals currently doing the rounds to reignite the housing market using government subsidies to first-time buyers involve disguised bail outs of banks and developers.

Best practice is for the banks to recognise the losses on these loans up front and sell the assets at fair market value. If banks do not have sufficient capital to take the hit, then they should raise new capital to plug the hole. Dealing with impaired assets properly will be critical for our economic recovery.

Discuss.

NAMA is just one policy problem facing the government this Autumn.  I review some issues in the public expenditure debate in this article in today’s Irish Times.

In interpreting the write down on loans that NAMA is intending to announce in mid-September, an important element will be the loan to value ratios. A commonly cited figure has been that original loan-to-value ratios on development loans were about 75%.

For example, this ratio would be consistent with a property purchased for €100 million with a loan of €75 million. If for instance, this property had fallen in value by 50% and the developer had insufficient cash flow to repay the loan, then bank would only recoup €50 billion, for a one-third loss on the original loan. A 70% decline in property value, as Anglo Irish noted for Irish property development land back in March, would imply a 60% loss.

So far, so simple. However, the real world is not so simple. Here are two complications that seem likely to have pushed loan to value ratios above 75%.

First, there is the fact that many (most?) development loans allowed developers to roll up the interest from day one. This then gets incorporated into the principal that they owe. So, to take the example above, three years of rolled-up interest at a six percent rate will have left the developer owing €88.5 million, leaving an LTV of only 88.5%.

Second, it’s my understanding that the average loan-to-value ratios generally quoted include a quite different form of loan to the one outlined in the fictional example above. For instance, a developer may have borrowed 100% of the money for the project. However, in addition, they have put up additional collateral in the form of another property they own. If this additional property was worth one-third of the value of the new property being purchased, then this would count as an LTV of 75%.

For example, the developer may have borrowed €75 million to buy a property worth that value and then pledged €25 million in additional collateral. In this case, not only is the property that the loan financed declining in value but so is the additional collateral (the “equity” component.)  It is also widely reported that the same piece of property may have been put up multiple times as additional collateral in these types of loans.

From my ivory tower, I’m afraid I don’t know how much this stuff affects overall LTV rates but both practices seem to have been pretty prevalent and they both point towards higher ratios than 75%. I would really appreciate if those with more detailed knowledge of these issues could give us some estimates on the magnitudes at hand here.

Beyond that, I think it will be important that the mid-September announcement of NAMA’s intended purchase prices include information on true underlying loan-to-value ratios, including the amount of rolled-up interest and the valuation of additional collateral pledged.

These authors identify low usage of wholesale funding as a key factor: read the VOXEU article here.

Robert Wade has an interesting piece on Iceland in today’s FT: you can read it here.  The main point he makes is that some of the assistance measures adopted last year are due to expire soon: much of the pain of the crisis was delayed rather than eliminated by these measures.  Accordingly, the full impact of the crisis on Icelandic living standards has yet to kick in.

Patrick Cunningham outlines his position in this article in today’s Irish Times.

The Irish Times has an article today by Rory Gillen of Merrion Capital. Gillen takes issue with arguments raised in a recent Irish Times article by Fintan O’Toole and also, to a lesser extent, with arguments in the 46 economist piece.

There is one argument in piece that I think is worth highlighting. It relates to subordinated bond holders. The 46 guys piece makes it clear that “certain classes of bondholders” should take a hit. Gillen presents this proposal as disastrous. He says that the

argument that bond holders should also be scalped is, in my view, a very short-sighted one. The cost of Ireland’s debt would most certainly increase, further hitting the majority of mortgage holders and businesses.

In the eyes of the international community, it would also link us to such bedfellows as Argentina, Russia and Iceland. I, and surely our descendents, would rather not be stuck with that particular stigma.

Raising the spectre of Argentina, Russia and Iceland here is unfair and, funnily enough given the title of Gillen’s article, alarmist. An Irish bank defaulting on its subordinated debt is not the same as our government defaulting on its debt (Argentina, Russia) or our banking system refusing to pay up on huge amounts of foreign liabilities (Iceland).  And as for the cost of “Ireland’s debt”, some highly respected sovereign bond analysts have repeatedly pointed out that a resolution of the banking crisis in a manner that eases the burden on the taxpayer will have a positive effect on market’s assessment of Irish sovereign debt.

There is the question of the guarantee. However, some of the subordinated debt is not guaranteed while the rest is only guaranteed up until September 2010. A signal that the guarantee will not be extended for this class of assets would in no way be similar to a sovereign default.

More generally, subordinated debt is, by definition, at the back of the debt queue in terms of being paid back when a business gets into trouble. Sometimes businesses default on their subordinated debt—that’s sort of the point—and this happens not just in the countries mentioned by Mr. Gillen but also in the US, the UK and every other capitalist country in the world. We will not automatically turn into Iceland if a few subordinated bond holders don’t get their money back.

Perhaps the most contentious issue in NAMA planning is the distinction made between the long-term economic value and the current-market prices of bank assets, particularly developer loans collateralized by Irish property portfolios. 

Optimists see a strong case for a liquidity-related price bounce in these bank assets, that is, low current-market prices recovering to higher “true economic value” prices over coming years, as financial market distress dissipates.  This optimistic view, forecasting a bank asset price bounce, provides a strong justification for setting up NAMA, and also justifies paying the banks more than current-market prices for their bad loan portfolios (but still much less than accounting book value).

Pessimists forecast either flat or declining market prices for these bank assets over coming years.  This pessimistic view implies that NAMA (if it comes into existence) should pay current-market prices or less for bank assets. 

 I think that the optimists might be over-extrapolating from the current US environment.  There are important differences for the case of Irish bank assets.  In my opinion, the market prices of US bank assets will bounce up strongly sometime during the next few years, whereas the prices of Irish bank assets will recover more modestly or not at all. (more…)