Will the bank stress tests be tough enough?

UL's Stephen Kinsella puts stress tests under the microscope over on the Guardian's business blog here.

Stephen Kinsella on moral hazard

"Everyone from the Financial Regulator to the staff in RTE to my mother will cry ‘Moral Hazard!’ when talking about bailing out homeowners who signed their names to forms and borrowed money they couldn’t pay back. Moral hazard is a widely misused term." You can read the rest of Stephen Kinsella's thought-provoking post here.

Medicine killing the patient

"The key question is … has the medicine worked? Has what the government said would happen happened in terms of reviving economic growth?The resounding answer is: Absolutely not. This medicine isn't working,it's actually killing the patient." PE bloggers Michael Burke and Stephen Kinsella were among those interviewed recently by the Los Angeles Times for an article which asked: "As Ireland slashes spending, is it model or cautionary tale?" You can read the full article here.

There are smarter ways to economic recovery

Stephen Kinsella: The smart economy is a nice idea, perhaps even a good idea. But like most nice ideas, when exposed to reality, the smart economy just breaks down. The smart economy as a concept takes no notice of the detail: who is looking for what type of job right now, and how long will it take those people to train for new ones? When confronted by the facts, we have to augment our industrial development strategy if we want to protect the real, on-the-ground, economy.


A smart economy is supposed to drive economic growth by bringing in or creating 'high value added' jobs for well-qualified people, who, because these jobs pay really well, make and spend lots of money locally, and pay lots of taxes, thus boosting the local and national economy. The smart economy idea has merit, but if we created the smart economy in full, no-holds-barred, tomorrow, if the smart economy succeeded beyond our policy makers' wildest dreams, it wouldn't help most of the people in the Mid West region who are unemployed for 3-5 years. This is because the idea of the smart economy is at variance with the facts of the type of unemployment in the Mid West right now.

The fact of the matter is that most of those newly unemployed come from construction and services, and will require significant and costly retraining, which may take years, to make them elligible for 'smart economy' jobs, even if those jobs were plentiful. The reserve of labour the Mid-West has right now, to be clear, is best helped by intensive retraining and retooling of a portion of the workforce, while providing state-stimulated projects to help workers and the local economy while retraining. Three infrastructural projects with long-run benefits to the region that are shovel-ready are the Links project, the expansion of Foynes port, and the Regeneration project, not to mention the 20+ recommendations of the Mid West Taskforce. Implementing large capital projects concurrent with up skilling, retraining, and business development programmes takes care of the time lags involved in training workers, boosts the local economy, and does not overly harm the debt: GDP ratio of a country running headlong into +100% debt: GDP territory in any case. The question to answer when thinking of borrowing for these types of projects is: does the long term social benefit exceed the long term social cost? If the benefits are a halt or reduction in the increase in unemployment, the creation of new capital and a reduction in social maladies like poor health and lawlessness, combined with an increase in local consumption and investment, coupled with the retraining of a large portion of the unemployed workforce, then, set against the cost of borrowing a fraction of the cost of NAMA's €54 billion to achieve those ends is, for me, worth it. I'd welcome any costings on such projects--if the long term benefits turn out to be less than the costs, I'll shut up.

You might ask why the MidWest is different, why it should receive special treatment ahead of other regions with similar, if not worse, problems. The answer is historical. The MidWest has underperformed economically relative to the rest of Ireland throughout the boom years. There are many reasons for the region's underperformance, but the fact remains. To focus exclusively on creating high-value added jobs is to disenfranchise tens of thousands of unemployed persons in the Mid West region, because they just won't get those jobs. The smart economy, rather than helping the newly unemployed, has hurt them, by diverting funds which could have helped them to other uses.

I'm not arguing for a return to the days of the construction boom: those days are gone, and good riddance to them. I'm asking that we look squarely at the data first, talk to people on the ground, and ask them what they need. Couple that to local and international expertise, and get something credible, accountable, and practical started inside of 6 weeks. Not 18 months. Not 24 months. Certainly not 3-5 years. Our unemployed can't wait that long.

Municipal bonds can help solve our funding problems

This post has been written by Stephen Kinsella of the University of Limerick and Karl Deeter of Irish Mortgage Brokers

Problem: Cash strapped local authorities, inadequate pension provision within an aging society, and reduced infrastructural development. Solution: Municipal bonds.

Municipal bonds are debt instruments issued by local authorities to finance investment projects. Yesterday’s announcement by government of a Recovery bond is a variant of the municipal bond idea, but on a national level. We have written about municipal bonds before, several times. We are interested in recapitalizing local authorities and regional authorities using these bonds, and we’d like to use this blog post to sound out possible issues with the idea, and compose a plan of action for implementing the idea if people think it is feasible.

Cash-strapped local authorities can use funds generated by municipal bond issues on a yearly basis to reduce their infrastructural deficits in transport, water provision, port equipment, broadband provision, and community initiatives. Ireland’s regions can compete on the quality of our infrastructure, rather than on direct wage competition.

Dealing locally but funded centrally to deal with extremely poor infrastructural provision with broadband, hospitals-both public and private, roads, amenities, playgrounds, local housing, homeless initiatives, and regeneration projects. Individuals can use municipal bonds in order to save and invest, or to fund their pensions, ensuring a guaranteed rate of return on their savings. Local authorities can respond to the needs of citizens directly using these bond issuances.

Ireland's recent flooding has exposed three painful facts. First, increased flooding as a result of climate change is inevitable. This 1 in 800-year event will be probably be seen again inside a decade. It should be remembered the flooding of 2008 broke all previous records in Dublin and Cork. Second, public services were not equipped to stop the flooding from occurring or to deal with the floods once they had occurred. Third, the government cannot pay for the cleanup operation, which may cost a half a billion Euros. In simple terms we need the infrastructure, we cannot go forward with the risk of recurrence unmitigated, and yet we equally can’t afford to pay for the improvements, it is a considerably difficult position to find oneself in nationally.

Municipal bonds can finance important local projects that won’t get funded.
Ireland's local authorities are underfunded, and have been systematically underfunded for decades have been systematically underfunded for decades. The current economic climate means Ireland will reduce its capital spending provision for several years on many crucial projects of long-term national importance, like flood prevention infrastructures, environmental cleanups, broadband provision, roads, port systems, and many more.

According to the Global Competitiveness Report, in the category of 'Quality of Overall Infrastructure' we rank 64th in the world. We will lag further behind as our investment reduces further in the next three to four years. A measure must be found to balance the need for public spending and public saving on a local basis, in order to develop investment strategies that are business-friendly and of long-term economic and social significance.

An aging population requires increased pension provision

By 2050, 1 in four workers will be over 65, 1 in 10 will be over 80. Regardless of the year of retirement of these workers, and the replacement rate of the old by the young, the implications of this demographic shift for our pension and health care system are enormous. Public pension provision may bankrupt the state unless private provision is instituted on a mandatory basis. Private pensions are risky, in particular Defined Benefit schemes, as Waterford Crystal employees found out last year to their dismay.

At present there are 1700 Defined Benefit schemes in Ireland. About 400 schemes are less than 50% funded, a full 1500 are below the 100% threshold, meaning there are only roughly 10% of active and deferred members who have coverage levels of 100% or greater. The scene is set for a social tragedy.

Municipal bonds represent a means to increase private provision of savings and pension entitlements while simultaneously recapitalising local and regional authorities. Authorities can reduce their other minor money-generating schemes such as rates and parking charges, and become more business-friendly, increasing inward investment by private business at the same time as providing world-class infrastructure.

Municipal bonds are working now in the US and Europe.

Municipal bonds are most developed in the US. Build America just increased and re-issued their tax-efficient subsidised debt product to the tune of 56 billion. The bond market in the US is currently thriving.

The State of Oregon is a prime example of municipal bond usage. Municipal bonds are very safe and historically have had a very low default rate. They are appropriate as a pension vehicle and also as a savings and investment vehicle.

How do Municipal Bonds work?

A simple diagram helps to explain how bonds work.

The bonds are issued by the local authority or a regional authority. They are underwritten, in this case, by the government, and rated if there is the ability to obtain a debt insurance (such as AMBAC in the USA) it reduces the cost to the municipality by ensuring they achieve a top rating. A consultant is required at this stage to manage the process. The bonds are issued to the markets at a fixed coupon and end date, usually 20 years, and their sale frees up funds to be used in the construction of large scale public projects.

Examples of projects funded by municipal bonds include: power plants and distribution systems, public markets, hospitals and health care centers, water supply, sewerage and sanitation, flood protection and prevention systems, schools and day care centres, broadband rollout, telephone and communication systems, toll roads, bridges, ports, airports and public transportation facilities, government housing and regeneration developments, development of industrial estates, tourism and green energy investment and research/development.

Broadly there are two types of bond that tend to issue, one is a ‘General Obligation’ which means that the regional authority/city/municipality are responsible for repayment of the debt out of their general revenue stream, the other is a ‘Revenue Bond’ which pays the debt via revenue from a particular project such as toll bridge/tunnel etc.

Advantages of Municipal Bonds

1. More certain payback for future pensioners, decreased volatility of pension funds, in particular if funds were moved into bonds on a dynamic basis whereby there is greater participation as you near retirement (ie: move away from equities as volatility risk due to retirement age approaching becomes a greater issue); easily transferrable title; increased savings provision for all.
2. Increases funding to local authorities for large capital projects: It would also place the full responsibility for timely and within budget projects upon the areas and taxpayers of the region that benefits from same.
3. Transparent and easily governed structure.
4. Government backed and insured.
5. Solves the 2050 pension provision problem if mandatory. Some form of mandatory participation is required, whether it is under the Singaporean Model (state managed) or Australian Model (individual managed) is a matter of process, but the need for mandatory pension provision is becoming increasingly clear.
6. If funds are never used to finance current expenditure, increased capital provision means the economy can develop in line with local voter's preferences.

Next Steps

1. Get buy in from Central government. Local authorities don't have the ability legally to do this. Yet. The current system is referred to as ‘tax and transfer’ and there are sizeable extraction costs before ground is broken on shovel ready projects.
2. Group spending priorities by region and by location first. Small projects ready to go with 3-5 year time horizon only. Essentially bonds could be part of an overall stimulus package, there is sufficient private wealth seeking low risk yield in this country which remains under utilized in terms of being a part of national recovery, there is no reason for investors not to be part of a coalition of the willing in terms of stimulus, but without the very vehicle to allow this to happen we cannot even bring them to the table.

In the example of infrastructure for floods, perhaps insurance companies would be happy to invest in these bonds as it would reduce liability to their insurance book in the future, they have a vested interest in not seeing the area under water, to the same degree residents do. Municipal projects can therefore bring together disparate groups within a common ideal, whereby profit is far from being a dirty thing, it is an honourable element of necessary infrastructural advancement.

3. Fully cost out a Municipal bond issue for the BMW region: population, prospects for issuances, new types of bonds, and new state pensions model.

Cash for Crap Houses: Ireland & NAMA

Stephen Kinsella: Ronan Lyons has the story on the idea that NAMA should become a hands-on property management company. Long story short, it is a very bad idea. But you knew that.

Allow me to be very cynical for a moment and, just as a thought experiment, assume NAMA does become such a property management company, because of political and regulatory capture, say. I'd value everyone's comments on this, simply because I'm worried a version of this idea is in the backs of minds of a set of vested interests.

NAMA will obtain houses in targeted regions all over Ireland, specifically the areas where the boom went last, and then bulldoze them, collapsing supply back to, say, 2002 levels. NAMA can also use some of the newly constructed dwellings for social housing and amenity projects.

NAMA can then offer current homeowners a twenty percent rebate for the building of new homes, or a straight cash for crap houses swop, where we upgrade the housing stock for everyone overnight, so someone in an uninsulated bungalow can get a brand-new house for, literally, nothing. NAMA can bulldoze the old house to further restrict supply.

This would help boost the construction and associated industries, create job growth and allow for legions of people to get back on an artificially constructed 'property ladder'.

Someone please tell me I'm wrong about all this. I'm sure I've missed a step somewhere along the way.

Prudence in the Face of the Unknown is Key

Stephen Kinsella: It is almost never correct to sacrifice a present benefit for a doubtful advantage in the future. Ireland's political classes understand this truism at the genetic level. In a world where less and less seems predictable, Ireland faces multiple uncertainties: we cannot afford to splurge on one by neglecting the other.

The coming budget will unhinge whatever remains of social partnership, and may even bring down the Government. The coming wave of mortgage defaults will ensure our banking system remains under extreme pressure and international scrutiny, no matter how well NAMA does or does not perform in cleaning up the balance sheets of recalcitrant banks. It is uncertain how many indigenous Irish businesses will weather the unprecedented economic storm they find themselves in, and what the resulting level of unemployment may be. The slow, but steady, international recovery may leave many parts of Irish society not directly tied to export industries behind. These are short-term concerns.


The negative social consequences of mass unemployment are starting to be felt. The cost to families and communities of increased domestic violence and criminality is incalculable. The security of every family against unnecessary hardship is an invisible social asset on which our culture is dependent: we don’t see this asset until it is gone. These are longer-term concerns.

In the midst of these uncertainties, the government must display prudence in the face of the unknown. Freeing up resources through increased efficiencies in the public sector will take time. One swipe of a pen can reduce incomes of public sector by thousands. A cut in public sector pay is inevitable. An increase in efficiency in the public sector—doing more with less—is not. Which course of action is more prudent, and which more likely to save taxpayers’ money in the long run?

In attempting to be prudent in some areas— fiscal policy, for one—the government may lose the good will of its citizens. By being extremely imprudent, in the cases of NAMA, the stalled reform of the taxation system, the crawl toward accountability, and most of all in a claw back of frontline public services, the government may damage the long run interests of its citizens.

The government has a duty to provide the highest standard of living for its citizens the nation can afford. That appears to be at 2003 levels of income at the moment. Our spending remains at 2009 levels. Prudence dictates the most likely course of action for the government in the coming budget. Actions are not without consequences, however, and a prudent public will do well to remember the choices made on their behalf come election time.

Will there be a NAMA for personal debt?

Stephen Kinsella: No. The National Asset Management Agency, NAMA, is designed to remove the ‘impaired loans’ generated by excessive lending to the construction industry. NAMA will exchange bonds, backed by the taxpayer, for these impaired loans. The ECB will exchange the bonds for cash, injecting liquidity into the banking system and, so the story goes, getting banks lending again.

I don’t believe that NAMA in its current form will get banks lending again. Even if NAMA’s critics are 100% wrong, and NAMA succeeds brilliantly, bankers know that another set of ‘impaired loans’ are on the way, and so banks won’t lend into the `real’ economy — to businesses and households — at reasonable rates of interest, because they expect that householders will begin to default en masse. NAMA will fail in its primary objective of ‘getting the banks lending again’.

When interest rates go up, as the European economy recovers, many households now barely making their monthly mortgage repayment will find themselves having to restructure their mortgages, or default entirely. What’s going to happen when thousands of homeowners throw their keys back over the bankers’ desks?

Banks, through the courts, have a set of processes for dealing with the painful processes of individual mortgage defaults. There is no process for dealing with hundreds, and perhaps thousands, of mortgage defaults in a short space of time. Banks will be left with large swathes of bad debt, and will come looking for taxpayer assistance again if they can’t raise funds on the interbank market to cover their losses. We will be back to square one, needing a NAMA 2.

Why?

Like banks, individual households are highly leveraged, meaning the ratio of their debt to their equity (for most people, their home) is large. The recent Law Commission report puts the ratio of household debt to disposable income at 176%. Just for this reason alone, the probability of large-scale household default is very high. There are other reasons to be concerned about household debt however.

First, the current level of mortgage repayment is low, because of historically low ECB interest rates. Mortgage repayments must, as I’ve mentioned, rise as the EU economy improves in the coming eighteen months and the ECB increases interest rates.

Second, the Central Bank forecasts unemployment to rise to 14%, and perhaps above 14%, in 2010. More and more households will therefore be unable to meet their mortgage payments.

Third, a recent study by David Duffy of the ESRI puts the number of homes in negative equity at 196,000 homes, implying the pool of potential defaulters is large.

To get a very rough sense of the scale of the problem, multiply the 196,000 homes in negative equity by the average mortgage price of a home today, around €235,260. We have €46,110,960,000 of potential bad debts for banks, just from this pool alone. 46 billion euros. If even 15 or 20% of those homes, and only those homes, default, we have another banking crisis, because banks won’t have the capital to absorb so much bad personal debt at once.

Will there be a NAMA 2 for personal and household debt? Can banks and the government devise a formula to forgive part of the principal for homeowners, and absorb the losses partially through a combination of blanket restructuring, debt-equity swops, swift personal bankruptcy processes, and refinancing? I don’t think the combination of financial and regulatory innovation under political pressure is beyond our leaders, but it does seem like a lot to ask for, considering the NAMA 1 money will be well and truly spent in 18 months’ time, and Ireland’s national debt may be as high as 120% of its national output.

Guest post by Stephen Kinsella: NAMA will not get banks lending again

Stephen Kinsella: The primary objective of the National Asset Management Agency is to increase the flow of credit to the ‘real’ economy — that’s you and me, homes and businesses — by clearing banks’ balance sheets of ‘impaired’ assets. The story goes that these assets reduce the banks’ abilities to borrow on the interbank lending market, choking the banks of the necessary funds to lend out to small and medium businesses. Starved of capital, the businesses fold, and people are made unemployed; economy and society generally suffer.

The ‘impaired’ assets to be bought by NAMA are to be seen as the dam obstructing the flow of capital to these businesses, and their removal will start the process of lending by our retail banks off again.

This logic is flawed.

The cleansed banks will not begin lending once the transfer of loans to NAMA is complete, and NAMA’s bonds are swopped for ECB cash. Even completely cleansed banks are not enough to restore lending to previous levels for several reasons.

First, we are in a completely different business environment. Banks as for-profit going concerns are right not to lend to prospective borrowers whose businesses are too risky: that behaviour would throw away the cash NAMA just gave the banks.

Second, banks debt in relation to their equity—their leverage—is too high, meaning they need to pay down their debts quickly, and cannot do so while lending out more money, which would perforce increase their debt.

Third, despite evidence to the contrary, bankers are smart people. Bankers understand instinctively that the level of uncertainty in the economic system is very high, so they will try to increase their cash balances to compensate for that reduction in certainty. As JM Keynes once wrote: “The possession of actual money lulls our disquietude, and the premium which we require to make us part with money is the measure of the degree of our disquietude”. Our bankers now have a ‘liquidity preference’ for cash, meaning we won’t see increased lending to the real economy at reasonable rates of interest. Banks can always manage to lend at unreasonable rates of interest, but that doesn’t help the real economy.

Fourth, all our bankers understand that even if NAMA succeeds brilliantly, beyond even its greatest supporters’ dreams, their balance sheets contain another ticking time bomb: the coming implosion of the Irish residential mortgage market. The ECB will increase its interest rates in the coming year. When hundreds, and perhaps thousands, of homeowners throw their keys back in the bankers’ faces, and create another slew of bad debt to be mopped up, the bankers know they will need cash waiting to cover these bad debts, in addition to another bailout from the taxpayer.

Banks will not lend to risky propositions in riskier times when their balance sheets (and their fiduciary duty) is to deleverage. The bankers will wisely sit on the cash we will have injected into their balance sheets, and wait until the time is right to call for more.

It is now a foregone conclusion that NAMA will be brought in. NAMA’s basic form is unalloyed by months of intense public debate on the merits and demerits of this ‘bad bank’. Given that NAMA will not meet its objective to increase lending to the real economy, we must urgently consider major modifications to NAMA as it moves through the committee phase toward its eventual implementation.
Dr. Stephen Kinsella is a Lecturer in Economics at the University of Limerick and author of Ireland in 2050: How Will We be Living? (Liberties Press)