Colm McCarthy’s presentation to the Green Party conference this weekend is available here.
McCarthy Green Conference March 7th 2009
The lack of exposure to the international banking system had led many to hope that the Developing world would be somewhat sheltered from the fallout of the financial crisis. However it is becoming clear that this will not be the case.
The global economic downturn has already pushed 100 million people back into poverty, and the developing world is likely to experience a growing crisis of external finance over the coming months. Commodities prices (on which most of the developing world’s economies rely) have already begun to fall, and there are predictions of a 20% drop in non-oil commodities over the coming year. Similarly, as access to credit in the developed world contracts, sources of foreign direct investment and commercial lending to the developing world will dry up. So too will remittances which totalled an estimated $24 billion last year, and in Lesotho’s case, one quarter of its GDP. Household donations to NGOs are falling dramatically.
Worst of all, though is the risk that developing governments will begin curtail their foreign aid budgets. For sub-Saharan Africa, foreign assistance accounts for approximately half of all its external financing. Ireland was the first donor to cut its foreign aid budget. If other donors follow suit the developing world will be facing an economic downturn of massive proportions. History shows us that even the most resilient of donors, such as the Nordic Countries, can cut back greatly on Foreign Aid during a banking crisis. In the years after the Nordic Banking Crisis in 1991 we see the Aid budget, in real terms, falling in Sweden, by 17 per cent, in Finland by 62 per cent and Norway by 10 per cent.
Already economists are predicting that the effects will lead to significant human costs, with average life expectancy in Africa dropping by three years, and child mortality rising by up to 700,000 annually. Such volatility of aid supply will causes untold economic and fiscal difficulties for countries in the developing world, at a time when they need financial stability most. All the recent good work of Governments, Private Companies and NGOs will be lost.
It was only a few months ago we saw rising food costs as a real threat to our standards of living. Africa’s potential in agriculture was seen to be part of a global solution. The global problems around water, energy, food security and infectious diseases have not gone away but will get worse and haut us well after the current crisis is over.
Let’s maintain our commitment to Overseas Development Aid. Irish Aid has earned a massive international reputation for its work and the world has a lot of respect for the Irish Taxpayer and her drive to reaching ODA of .7 of GNP by 2012.
Niall Morris and Patrick Paul Walsh,
UCD SPIRe & Geary Institute
The Sunday Independent reports that an important debate is taking place within the Commission on Taxation:
“But its report may also call for a reduction in tax relief for ordinary private sector pension-holders and a “fierce argument” is raging within the commission over the €2.9bn cost of this relief versus the incentives that it gives to provide for the future.”
The idea of limiting tax breaks on pension contributions has received a good deal of attention, with Fintan O’Toole a notably vocal advocate (see here). This focus is understandable given that the better off are the primary beneficiaries of the tax breaks.
The fact remains that many households – even better off ones – are not saving enough to sustain their living standards in retirement. This is compounded by staggering losses in both defined contribution and defined benefit pension plans. (See Brendan Walsh’s post from December on the crisis in occupational pension plans.)
The tax incentive can be viewed as a device to overcome the inertia that keeps people from making adequate pension provision. As such, I would agree that it is not particularly efficient. But it is encouraging to see that at least some on the Commission believe it is important to approach pension reform in a comprehensive manner rather than simply eliminating the existing incentive.
The Green Paper on Pensions looked at the possibility of moving to some sort of mandatory or “soft mandatory” (with default) contributions to retirement savings accounts. Unfortunately, with households being squeezed from so many different directions, it is hard to see from where they would find the money. In a post a few weeks back, I proposed the idea of a Swedish-style system of unfunded – or “notional” – defined contribution accounts that could at least reduce the pressure for other tax increases.
What is most important is that reforms take place in the context of an overall plan for the retirement income system. The complexities and importance of pension reform are such that it should not be driven solely by short-term fiscal considerations.
There has been some discussion on this blog site about the value of the secret deal provided by Anglo Irish management to a circle of ten wealthy Anglo clients. The deal was done last summer, in order to prop up the Anglo Irish share price. Each of the clients was lent Euro 45,100,000 by Anglo Irish with the requirement that all the loaned funds be spent on Anglo shares. Clients were only responsible for repaying one-quarter of the loaned amount (Euro 11,275,000) in cash; they were permitted to repay the remainder of the loan by returning the shares.
At the time of the deal, the Anglo share price was approximately Euro 6.01 per share. The share price has since collapsed to zero. Each of the wealthy clients in the secret circle has lost Euro 11,275,000 (unless they now avoid repaying through bankruptcy or restructuring). Meanwhile, the “shareholders” of Anglo have lost the remainder of the loaned cash (Euro 33,825,000 for each of the ten circle members). Everyone has lost on this deal ex post. It is particularly vexing since the Irish taxpayer now serves as the Anglo Irish “shareholder” and suffers a loss of Euro 338,250,00 on this secret deal.
It is worthwhile to analyse, under reasonable assumptions, the ex ante value of the deal, both to the clients and to the Anglo management acting on behalf of shareholders (as if). An accurate valuation is not possible with the information available to me, but a reasonable approximation can be made, and also a reasonable analytical framework provided for anyone who wishes to substitute other parameter values.
Last July Anglo had total shares outstanding of 749,585,405 and a share price in the range 4 – 7 Euros (quite volatile during the month), see the data here. If we use a share price of Euro 6.01 then this gives a total cost of Euro 451,000,000 to purchase 10% of shares outstanding, which corresponds to the stated amount in later government reports. Hence I assume that this is the share price at the time of the deal. The one-year LIBOR interest rate last July was 3.2796% so I use a slighly higher interest rate of 3.75% as the two-year borrowing/lending rate.
Suppose that the clients have no insider information telling them that Anglo Irish shares are over-valued. Also suppose that they are not liquidity-constrained. In this simple case, the loan-plus-share-purchase is window-dressing designed to hide the real value of the deal. The client takes a loan of Euro 45,100,000 from the bank, and puts the proceeds in an interest-bearing account which exactly pays off the loan. The client also purchases Euro 45,100,00 worth of Anglo Irish shares with true value of Euro 45,100,000. Neither of these transactions adds or subtracts any value for the client. The real value of the deal comes in the free put option which Anglo management has provided to the client. If the client’s Anglo shares fall in value, the client can pay Anglo only ¼ of initial loan value, plus hand over the shares, in full restitution of the loan. This put option constitutes the only source of value in the deal (admittedly under these strict assumptions).
The put option can be valued reasonably well using the Black-Scholes option pricing model; see here for details. These estimates of value are conservative since empirically the Black-Scholes model tends to undervalue out-of-the-money put options. I assume that the loan is for a two-year period and that the Anglo Irish shares have annualised volatility of 60% per annum. The put option has an exercise price of (1-.25)(Euro 6.01) = Euro 4.512. Using normdist and exp in excel it is easy to compute that the value of the put option for each client was Euro 6,757,469. The put option is given to the client for free, in exchange for acting as a go-between to allow Anglo Irish management to secretly use bank-deposited funds to purchase their own shares.
The client is earning excess return of Euro 6757469 on risk capital of Euro 11,275,000 which is 59.93% or 29.97% abnormal return per year. So even allowing for some liquidity-constraints or client nervousness about Anglo Irish share values, it seems a good deal. Admittedly, it turned out disastrously for the clients, but this was due to a worldwide bank share meltdown plus the emerging scandals (notably this one) at Anglo Irish.
Perhaps Anglo Irish management raised the borrowing rate on the loans to account for the free put option. This seems unlikely. Again using the case of 2 years and 60% volatility, in order to recoup an option value of Euro 6757469.675 on a loan with principle value of Euro 45,100,000 they would need to add roughly (1/2)( 6757469.675/45,100,000) = 7.49% to their base interest rate. So if the base rate is 3.75% they would need to use a loan rate of 11.24%.
Bob Dylan has a song “The Lonesome Death of Hattie Carrol” about a shameful incident in the early twentieth century when a wealthy, well-connected young man bludgeoned to death a poor, African-American female servant, and escaped with virtually no punishment. In his lyrics, Dylan makes the point that the truly horrifying aspect of this event was not the murder (there will always be violent individuals) but the reaction of the judicial establishment in ignoring it. Analogously, in the Anglo Irish scandal, it is not the presence of greedy, underhanded individuals in Irish financial services (such people exist around the world in all countries and all industries) but the horrifying approach of the Financial Regulator, condoning and even encouraging such behaviour. To quote from Dylan’s song:
In the courtroom of honor, the judge pounded his gavel
To show that all’s equal and that the courts are on the level
And that the strings in the books ain’t pulled and persuaded
And that even the nobles get properly handled
Once the cops have chased after and caught ‘em
And that the ladder of justice has no top and no bottom,
Stared at the person who killed for no reason
Who just happened to be feelin’ that way without warnin’
And he spoke through his cloak, most deep and distinguished
And handed out strongly, for penalty and repentance
William Zanzinger, with a six-month sentence.
Oh, but you who philosophize disgrace and criticize all fears,
Bury the rag deep in your face
For now’s the time for your tears.
Business World and RTE are reporting on a new research note from JP Morgan that gives Ireland a vote of confidence by telling clients not to bet on the state defaulting on its debt. The note describes Ireland’s financial position as “remarkably strong” despite the banking crisis and economic downturn. On the issue of banks’ bad loans, the analysts at JP Morgan are pencilling in a worst-case scenario of €27bn in write-offs over the coming years. Not trivial, but certainly manageable.