Irish Mortgage Brokers Blog

Nassim Taleb says in this interview that the debt problems of 2010 are worse than those of 2008, he has re-released his now famous book ‘Black Swan’, and his core belief presently is that recession is not the issue, debt is the issue. Fragility is exacerbated by high levels of debt - we can see that from an Irish context on Sovereign Debt/Bank Debt (whether the problem is real or perceived).

One of the most poignant things Taleb talks about is the failure of stimulus, and he rightly points out that Greece is not being asked to ’stimulate’ their way out of their debt issues, they are being asked to look for austerity solutions, perhaps Keynesian beliefs might be shunted once again into history?

The point holds true in our opinion, high levels of debt are a wealth destroyer and inhibitor to prosperity, the drag on economies, in particular our own, will be evident for many years to come.

I used to be in a Chess Club, and one thing it taught me (apart from how to lose using the Kings Gambit) is that you can often see a general result long before you see it exactly, when you are a piece down and can’t control the centre of the board you know you are in trouble, but how and where the checkmate occurs is unknown, game theory can’t tell you precisely and reverse integration from the end game may not bring you to where you started from, but the player knows instinctively that they are up against the wall.

Sometimes appearances can be deceiving, you might think you are fine and you are not (2003-2009), other times you can get caught up about losing a pawn but you are in fact gaining ground (2010), albeit painfully and slowly.

I believe the same can often apply to markets. Today we will look at the reasons for why we believe the banks are going to survive and furthermore, what the results will be of their survival.

The core belief in this firm is that market rules should apply, the banks should have to stand on their own or or shut down or find a buyer, its just that simple, however, we have not allowed that to occur so we now have to find our way through having avoided that option. In chess this is the equivalent of trying to save the Queen instead of Castling - the Queen is just too important, or is she? Depends on who you ask. We think not, but the decision makers made the play.

Our primary belief is that the banks will survive. Sometimes the noise is hard to ignore, but this time last year there were many commentators saying that our banks would be nationalised within a month or two, then the we should leave the Euro, last month the Euro was going to collapse and now we are once again on the road to hell minus the Chris Rea soundtrack, the truth is we’ll muddle through and come out the other side one way or another.

So why will the banks make it? For no other reason than because we have pinned the hopes of this country upon their survival, to the point of no return. In the absence of a ‘Plan B’ the success of ‘Plan A’ becomes highly incentivised. The current big issue that some people are pointing to is that of the bond credit that has to roll over by the end of 2010, the figure was c. €74bn (previous calc’s said €71bn) which is made up of Interbank Lending €16,405m, Senior Debt €57,791m and Subordinated Debt €866m.

We’ll focus on the bond holders as they represent a foundational risk to the system, so… Will the bond holders stay the course and support Ireland? I would imagine the answer to be ‘yes’, but I’ll qualify it.

Reasons:

1. Guarantee
2. What failure would mean
3. ECB support & approach thus far
4. Shareholder support
5. Euro implications
6. Effect on cost

1. Guarantee: We have made a guarantee to world markets, world markets like that kind of thing, the state will ensure that no institution will not be able to come good on their liabilities and it is underwritten by the state guarantee (taxpayers), this kind of ‘can’t lose’ situation is preferable to fixed income markets, it is the reason the USD is a safe haven when you can’t trust much else (bar gold or perhaps Yen). No bondholders have been burned and they are generally satisfied that their capital values are safe, over and above coupon payments, bond buyers want to know that they are going to get their capital back (in full and on time). No bank has yet defaulted nor will they, as a default on a state guaranteed bank is essentially a sovereign default - it ain’t gonna happen.

Some people think a sovereign default might be just the answer, it is hard to disagree in many cases, it sounds like a nice plan to go and shaft those big faceless bond-holders, and many countries do, Greece (for instance) has made a career of it - which is why everybody there is so angry at the concept of actually having to get their house in order. Would it be a good idea for Ireland?

I doubt it - there is not only the implications of default to consider, firstly, the ECB would likely force non-default, taking up the slack and forcing us to pay eventually anyway, secondly, we export a lot of financial services and nobody wants to deal in serious finance services with a country that defaults (except of course those that make a profit from restructuring etc.).

Uruguay is a country that people point to as being evidence of the ‘correct’ way to default, having been to that country six times and studied it extensively I can safely say that we don’t want to go down that path (yet). The guarantee will stand and thus the Irish banks will stand. The one outlier in this is if there is some substantial credit event (either large institution or sovereign).

2. What failure would mean: An inability to refinance would be read internationally as a country being broke, believe it or not Ireland doesn’t matter to the international marketplace as much as we’d like it to. I speak to traders in the US regularly enough and they don’t know the difference between Anglo, BOI or AIB - nor do they really care, something bad happens in Ireland and the whole place is tarnished. Oddly we actually have earned great respect internationally for how we are handling our issues (I’m not talking about the OECD/IMF/WorldBank etc. - I’m talking about the opinion of the people who actually buy our bonds as opposed to those who make economic forecasts/comment), a credit event now would spell disaster, we wouldn’t be even be able to finance our public services.

Strangely, the Public Sector Unions are quite vociferous on how ‘angry’ the are about the ‘bank bailout’, failing to see that if the banks fail that their paymaster won’t be able to borrow to pay them, they didn’t cause the crisis but they are one of the primary beneficiaries and if one domino falls the next will follow, it isn’t different this time. Uruguay is testament to that.

3. ECB Support & approach thus far: Name a bank in Europe that was allowed to go to the wall? … Still thinking? After Lehman the banking bluff was seen for what it is, namely a ‘fairly real threat’, banks are not joking when they say ‘if we fail we can bring down the system’, that type of event may not bring the four horsemen charging out of the sky earth-bound and ready for destruction, but it can cause systematic distress which is far beyond the price of avoiding it.

This may not have been the case if we went for this option originally, but certainly now - as it would involve breaking our sovereign promise -it would ensure a far larger bank run than necessary and likely collapse. Bailouts sicken me, especially when I see competitors bailed out who are then able to unfairly chase the same clients we chase, trust me, nobody is angrier than intermediaries when it comes to life support to banger businesses that should have shut down but are instead artificially supported.

4. Shareholder Support: Bond holders are at the very end of the risk queue - the most senior ranking on par with depositors, shareholders on the other hand are the ones playing with dynamite, and despite this, the BOI rights issue was 93% subscribed with buyers for the remaining 7%. That means that people are more than happy to take the most risky asset available, that is the market speaking loud and clear that they trust in BOI’s ability not only to survive but to prosper, if people and institutions are willing to back the equity you can be damn sure they’ll back the bond debt. While the buyers are often of different mind sets (shares v.s. bonds), the fact is that it means there is a bigger buffer of safety for the bond holders, and a pre-auction phone call from the desk will likely help to assuage any fears ensuring that the debt rolls. Saying otherwise is like thinking a person wouldn’t drive a car when there are people trying to get to the same destination on uni0-cycles, the bonds are safe and will remain as such.

CDS’s are often news makers, hard to think that only a decade ago almost nobody even knew what they were, and a decade and a half ago they didn’t exist. CDS’s are like a secondary thermometer: let me ask you - is 30 degrees hot? Yes if you are in Ireland, yes if you are in the North Pole, but no if you are in Brazil and definitely no if you are trying to cook a turkey, but we often see CDS’ prices reported as if they are the one cooking the goose, it isn’t the case, often issuers realise that higher yields players will happily sacrifice some coupon for a hedge, and almost all the CDS’s are settled materially or manually (the actual asset passes to the issuer) rather than via a direct insurance payment.

The likelihood of a qualifying credit even for the reference entity doesn’t have to occur, it just has to be perceived as ‘a risk’, prices can be a reflection of yield sacrifice for a hedge, CDS’s are a secondary measurement, they are not the reference entity and cannot be seen as such, capital values are a better tool in our opinion than looking at the derivative values or bids where that capital value is the reference entity. If an LT2 bond is paying c. 11% then a CDS of 5% isn’t the end of the world, having said that, you would always wonder what might prompt an 11% payment to begin with! However, the main thrust remains - Shareholders have stepped up and that is like a wave of infantry charging over the top, which makes the bondholders who are still in the trenches feel much safer.

5. Euro Implications: Despite the hullabaloo being caused, the EU and even Germany all want a devalued euro, granted, German savers will be angry, but everybody else wins, low rates, quantitative easing and monetary policy that encourages exports will be of benefit to everybody, Germany gets their exports and output back up, Greece gets their bailout, everybody else gets some inflation which will hopefully feed into new employment faster than wage increases for existing employees and we all muddle on through.

This latest test isn’t testament to the failure of the Euro, it is rather testament to the success that it represents in converging largely disparate nations and economies- the USD does the same thing. While the current issues represent a test, it doesn’t represent a ‘failed test’, if a member leaves it won’t be the end of the world, but don’t bet on it, if you could just kick people out of monetary unions then Louisiana would have been kicked out and California would have seceded long ago, don’t doubt the staying power of EU members.

6. Effect on Costs: Far from seeing the present storm as a sign of imminent collapse, I see it as a signal that we are in for a period of much higher financial costs on any credit or financial transactions, banks are going to have to retrench, build deposits, build assets carefully and find operational gains (fire lots of people). The most likely outcome isn’t that a bank will fall, it is that they will find a way through via operational profits and price increases. Much of the past losses are paid for, NAMA has taken away a huge amount and they are jacking up mortgage rates to cover the lagging residential issues. It’s easy to cry ‘Uncle!’ now, or to believe it is upon us, but the fact is that we made it this far and both Ireland, and its banks are probably going to find a way to stagger through, punch-drunk and beaten, to the other side of this mess, I’m not saying it won’t hurt in the mean time, or that there won’t be further slaps to the head, but we’ll muddle through in spite of it, the markets have already spoken, it’s time to listen.

We were asked to make a presentation to the Department of Finance’s ‘Expert Group on Mortgage Arrears’ which is made up of the main interest groups and representative bodies in finance and housing. This firm has long been an advocate of market oriented solutions (short sales, moving paper etc.). However, in Ireland there are several issues.

Firstly, short-sales are not possible because of the manner in which recourse to the loan exists, it is on the person and not just the asset, this gives no incentive to lenders to accept a short sale except for people who are already financially strong, our debt laws also work against the borrower.

Secondly, as a shareholder in the banks it may not be in the interest of the shareholder (taxpayer) to bail out the individual, personally I don’t want to continue to shoulder costs for anybody, not our banks, borrowers or anybody else, I want taxes to go toward vital services and not much else. Any scheme should be revenue neutral or profitable.

That is where the idea of loans to cover a short sale come in. We posted the concept before back in April and Economist Iain Nash did trojan work to put together a report on the workings of a scheme. We used data from the ESRI, Financial Regulator/Central Bank and tried to create a ‘real life’ costing of a scheme. The fundamental idea is to let people borrow the difference (negative equity) and get out from under the loan, carrying a much smaller debt which is manageable and affects their individual cash flow positively, but there is no free money. The loan is underwritten by tax credits and needs to be paid back eventually.

The changes that may be required (and that are not in the paper as we were working to fairly stiff deadline where time was short) would be some kind of loss sharing mechanism that makes it more reasonable and palatable to all of the constituencies involved, namely, tax-payers, state, borrowers, bank and communities.

We welcome critique, please feel free to comment/cut apart the idea as you see fit! The full paper is here or click on the image to the left.

This is a video by my friend Dan Mitchell from the Cato Institute and the Centre for Freedom and Prosperity.
While it may be primarily about the USA the concepts hold in Ireland. For instance, there are people in the OPW who are given a house on-site as part of their job and yet they still receive a travel allowance! It would be laughable if it wasn’t real. Dan spells out the downsides and you can’t easily dispute the numbers - if we were to do a similar analysis in Ireland would we find similar results?

One person who is a personal hero for me is a guy named Salman Khan, he started a youtube project called the ‘Khan Academy’, when he was working as a hedge fund analyst. He made videos on mathematics for his cousins who lived in a different state.

Now it is the one of the largest internet resources for education, his plain English explanations are exactly the kind of thing that people latch on to and can understand. We’ve been watching his videos for several years having been fortunate enough to find him early on.

The internet, and the world should be grateful for people like Salman Khan. Great work and well done.

This is a fascinating video that clearly points out some of the myths surrounding the housing bubble in the USA, describing the role that Federal Reserve policy played in creating the bubble, they created a set of incentives which were badly aligned with long term aims. We have long felt that the role of monetary policy and regulation have been central to the problems in both the US and Europe, the full video of the conference is below.

Author Nils Gilman argues that black markets may not be a negative from every perspective. “If you like entrepreneurship, if you like innovation,” says Gilman, “then you’ve got to love deviant globalization.” Gilman notes that the narcotics industry in Mexico directly employees 400,000 people - more than finance or oil.

There is some great research being done on the black market, in Ireland Karen Mayor is working on a paper on the topic.

Deviant globalization is a strange thing, on one hand you have tourism, then on the flip side you have sex tourism. Legal drugs are one market, illegal drugs are another and a serious multi-billion industry too. There is military distribution then you have arms dealers, for almost any industry there is an illegal version and this video is looking at these in a manner that doesn’t get into the morality of it but rather the economics of the issue. This is fascinating viewing, the full clip is here

Last night the Eurozone leaders agreed with the IMF on a €750bn emergency funding package to help protect various sovereign bond markets from speculative attacks. The package takes the form of €440bn from Eurozone member states, €60bn from the EU balance of payments facility and €250bn from the IMF, this is over and above the €110 earmarked for Greece already. And although the plan is for Eurozone nations both Sweden and Poland will also be taking part.

The new move is described as being ‘Shock and Awe part II‘. The move came after a 14 hour meeting which was in part prompted when Barack Obama called Angela Merkel & Nicolas Sarkozy to use resolute steps to reign in the contagion that had markets in turmoil last week. The first week in May was marked by a spectacular 1,000 pt drop in the Dow Jones industrial average on Thursday night and of wild volatility on the Sovereign debt and forex markets. Meanwhile, the Dow story remains somewhat of an enigma, some reports blame a ‘fat finger’ trade and others report that it was due to key resistance levels in the Dow and the S&P being broken which triggered automated trades.

The yield drop in US Treasuries is a sure sign that in times of total uncertainty the market players went and hid in the Buck, the US dollar might have some serious problems in a secular market, but short term it is still the first safe haven of consideration and drops in the 10yr note are clear evidence that positions were liquidated and taken up in US paper.

Last week gold also broke a key resistance at $1,214 and it reached new heights not only in USD but also in sterling and euro prices as well.

This intervention is ‘good news’ in the sense that it puts of the day off reckoning, but curing debt with more debt is a dangerous game, and now it will be virtually impossible to resist calls for bailouts or rescue packages - look at the precedent that has been set? Eventually, the euro will have to be able to stand the test of the markets, not because of what we do to support it, but of itself, otherwise there can never be a functional monetary union, sound money comes at a price - one that Europe is not yet willing to pay.

In this clip Michael D. Goldberg talks about the efficient market hypothesis, a talk given at the King’s Institute for the inaugural conference of the Institute for New Economic Thinking (INET), a group financed by legendary investor George Soros.

This video has a behavioural slant to it, and there is a strong focus on irrationality, herding, and other behavioural aspects of the markets.

Personally I’m not convinced that we can turn our back on the efficiency of the markets, nor that we can necessarily undo or limit the inherent weakness in any market, any blockade or regulatory restriction has a tendency to fall victim to circumvention of various sorts. However, there are growing bodies of work that point out the weaknesses of markets, and in this area the behaviourists are streets ahead of the curve in understanding the key points of market movements that are difficult to comprehend because they don’t act the way we think that they would or should.