Author: Karl Whelan

Toxic Assets and Recapitalisation

Last night’s RTE news was full of breathless commentary from Brussels and Montrose to the effect that governments needed to do more than just re-capitalise the banks.  From Brussels, Sean Whelan excitedly talked about “toxic assets” and how it was going to be necessary to “buy the toxic assets at a steep discount, leaving the banks to continue with the viable parts of their business.  Simply re-capitalising the banks isn’t seen as enough.”  Back in Montrose, David Murphy authoritatively informed us that “In terms of doing something else in addition to re-capitalisation, they have an option of setting up a bad bank or, for instance, insuring the banks against the some of the bad loans that are coming down the track.  But it’s pretty clear that the re-capitalisation on its own won’t be enough.   And if they do something that isn’t enough, the markets won’t like it one little bit and Ireland will be punished for that.”

Despite the confident tones in which this expert analysis was delivered, as far as I can see it doesn’t make any sense. 

There is no logical distinction between the issue of undercapitalisation and the problems created by so-called toxic assets.    Banks could get rid of all their toxic assets in an instant if they just wrote them down to zero.  But then they would be undercapitalised—and that’s the problem with toxic assets.  What appears to be going on is that the various re-capitalisation programs around the world have not managed to offset the likely losses from bad loans.  However, this is a problem with the size of the re-capitalisation programs, not their nature.  There is no logical argument for now augmenting these programs with a scheme to systematically overpay for impaired assets.  (Sean Whelan may think the proposal is for buying assets “at a steep discount” but that discount is relative to what they were originally worth, not what they are worth now.)

What appears to be going on is that neither banks or governments want to inject more government equity capital because going any further than we are now requires effectively admitting that the banks need to be nationalised.  Government concerns about nationalising banks are well-founded but it seems that, in many cases, we are well beyond that point.  If the banks can’t find private equity to re-capitalise them and government is willing to do so, then that’s where we should end up.

As a final point, it’s worth noting that despite the constant commentary about toxic assets and all the problems created by the evils of structured finance (CDO-squared and all that), this stuff is essentially irrelevant to the Irish banks.  Their toxic assets are largely plain old loans to bankrupt developers and rocket science isn’t required to come up with a guess at the size of the loan losses.  As Colm McCarthy has joked “We didn’t import any toxic assets, we grew our own.”

As usual, I have the sneaking feeling that I’m missing something.  Perhaps our team of commenting pundits can explain to me what I’ve got wrong.

Forget Bad Banks, Why Not New Banks?

I’ve written here before about my puzzlement over the widespread international enthusiasm for “bad bank” proposals and I haven’t changed my mind since.

A more attractive proposal, which is getting less attention, is the idea of establishing new banks.  It could be argued that this directly addresses the problems being created by the weak capitalization of the international banking system, without the extreme moral hazard problem associated with TARP-style over-paying for bad assets.  The financial intermediation function performed by banks is crucial to the efficient functioning of the economy and, for a number of reasons, undercapitalized banks do not perform this function well. Understanding this, the approach of govenments everywhere has been to use taxpayers money to prop up undercapitalized banks. But while banks play a crucial role that doesn’t mean that we necessarily need the current set of banks to perform this role.

Kevin already posted a link to Willem Buiter proposing something like this but the idea is now being given wider prominence. Here for instance is a nice clearly-written piece from today’s Wall Street Journal by Stanford’s Paul Romer.  An important benefit of this type of plan, as Romer notes, is that it seems more likely to attract additional private sector equity capital relative to the various plans to attract new investors for existing banks with failed management and murky balance sheets. Indeed, I first read about the idea of new banks in this 2009 predictions piece from celebrity uber-bear bank analyst Meredith Whitney and she was focusing purely on the private sector opportunities. She said:  “I think you’ll see more new banks created. We’ve already seen more applications. And it’s a great idea: You start with a clean balance sheet and make loans today with today’s information. Plus, right now you’ve got a yield curve that’s good for lending.”

Skeptics could point out that these new banks will lack the branch network or knowledge capital of existing banks.  However, branch networks could be purchased pretty cheaply these days and the newly-minted banks could be attractive places for those bankers with good track records to work. Perhaps the best argument against this idea is the time lags involved in getting new banks set up. But the problems in the international banking system seem likely to be with us for some time so useful long-term solutions may be called for.

No doubt I’m being wide-eyed and innocent here.  Perhaps our trusty band of loyal commenters can give me a word to the wise.

Sunday Times Death Spiral Watch

Reading my Sunday newspapers for insights on the economic crisis, I came across the following from Damien Kiberd in the Sunday Times: “Two hundred economists gathered at UCD last week and all we heard from them were suggestions for more taxes: the reintroduction of domestic rates and third-level fees, taxes on child benefit, carbon taxes, taxes on social welfare, sucking the low-paid back into the tax net and higher excise duties. This is exactly what we did in the 1980s, when Ireland nearly went bankrupt.”

What a pity I missed that conference. Now I did attend an event on Monday at the Royal College of Physicians (organised by UCD and the Dublin Economics Workshop) and funnily enough that event had about two hundred people at it also. But there the similarities end. Participants at the conference I went to focused heavily on the need to cut public sector pay and of the range of tax measures mentioned by Kiberd, only one (reintroducing rates) was discussed. It’s rather strange of UCD to organise two different conferences on the same topic in the same week, but then that’s economists for you.

Bad Bank Bafflement

A number of comments on Kevin’s link to Buiter’s discussion of bank nationalisation have brought up the idea of a “bad bank” that can be used to take over non-performing assets.   I think this issue is important enough to hoist out of the comments and onto the front page!   It should be noted that Buiter is discussing this idea in the context of a fully nationalised British banking system.  The “bad bank” idea has an “economies of scale” advantage in that case. so that all bad loans can be grouped together and dealt with by a team specialising in getting the best long-run return for the government from working out bad loans.

Outside the context of full nationalisation, I’m not sure I understand the “bad bank” idea or why it has caught on in the Irish media over the last day or two.   I’ve been puzzling over this the last few days and then found a post by Paul Krugman that expressed my puzzlement far better than I could.  In a post entitled bad bank bafflement (good post title!), Krugman says: “The idea of setting up a “bad bank” or “aggregator bank” to take over the financial system’s troubled assets seems to be gaining steam.  So let me go on record as saying that I don’t understand the proposal.  It comes back to the original questions about the TARP. Financial institutions that want to “get bad assets off their balance sheets” can do that any time they like, by writing those assets down to zero — or by selling them at whatever price they can. If we create a new institution to take over those assets, the $700 billion question is, at what price? And I still haven’t seen anything that explains how the price will be determined.”

In the Irish case, perhaps someone could explain to me how the bad bank proposal gets at this question.  What price would the Irish government pay to struggling banks for their underperforming loan portfolios?  Why should the government pay a price above current market value rather than, for instance, provide additional capital to cover the implicit losses and thus increase the government’s equity share?

As Krugman notes, in the US case, the answer to these questions appears to be that Bernanke believes the market is systematically underpricing a wide range of mortgage-backed securities and that the US government may break even (or perhaps profit) from buying them at above market rates and selling them later or holding to maturity.  Whether Bernanke is right or not is open to question.  But is there any reason to think a similar logic applies to Irish commercial property loans?

Where is Ireland’s Tax Burden Heading?

In my discussion at Monday’s conference (slides here), I raised the question of where Ireland’s tax burden was going to settle down once the public finances have been stabilized. The Addendum to the Stability Report published last week by the Department of Finance shows how the Gross Budget Balance can be brought back to a deficit of 2.5% by 2013 through an adjustment process in which the revenue share of GDP stays roughly stable so that almost all of the adjustment occurs on the Revenue side. The document itself does not comment on the composition of the adjustment described in this table, so perhaps this isn’t an actual plan but instead an illustrative example. Still, it’s worth starting with as a baseline for discussing where we are heading.

I noted on Monday that the plan projects a government revenue share of GDP of 34% in 2013 and that this is well below the equivalent share for EU15 countries, which has been stable at about 45% for a number of years. A number of observers at the conference questioned this calculation on the grounds that the calculation should be done relative to GNP. In particular, since GDP has been about 17% higher than GNP in recent years, one might want to adjust the tax share upwards by this amount. Doing so would give a figure for 2013 of about 41.5%. This is still a reasonable amount lower than the EU15 average but not nearly as much as the figures I quoted

However, I do not view this higher GNP-based figure as a useful one, for two reasons.

First, I believe that GDP rather than GNP should be viewed as the correct tax base when making calculations of this sort. GDP represents all the income generated in this country and, technically, all of it is available to be taxed by the Irish government at whatever rate it chooses. Of course, profit income generated by multinational corporations is likely to move elsewhere if we tax it at a sufficiently high rate but this is an issue faced by all governments, not just our own.

Second, if one is going to exclude the substantial factor income repatriated abroad (€28 billion in 2007) from the tax base it is not consistent to then include the taxes earned on this income in the measure of the tax burden. Assuming that the €28 billion figure represents corporate profits repatriated after paying the 12.5% corporate tax rate, one comes up with a figure of €4.1 billion in taxes paid by multinationals on repatriated profits. Excluding tax payments of this magnitude would give a 2013 (adjusted) tax share of GNP of 39%. So, even if one agreed with the idea of GNP as the tax base, an internally-consistent calculation of the Irish tax burden would still leave it well below the European average.

The broader and more important point here is that we need a wider debate about the shape of future fiscal adjustment than the one currently taking place, which focuses almost without exception on the need to reduce public sector pay.