The Morgan Kelly Opus - Part IV


The Irish Property Bubble and its Consequences
January 12, 2009 - PDF ... 61333.html
Piling Anglo losses on to national debt risks bankrupting the State
January 20, 2009

ANALYSIS: Anglo Irish is poisoning the banking system and is of no systemic importance. It must not be nationalised; it must be allowed to collapse and with it the developers at the heart of the problem, writes Morgan Kelly

YESTERDAY’S CATASTROPHIC collapse of Irish bank shares stems directly from the Government’s proposal to nationalise Anglo Irish Bank. With the Government’s finances already buckling under the collapse of our bubble economy, financial markets began to fear that with the added burden of Anglo’s debt, the Irish State cannot afford to finance itself, let alone support the remaining national banks.

Facing the imminent collapse of the national financial system, the Government needs to perform a ruthless triage. The worthwhile banks need to be maintained by any means necessary, including nationalisation, while Anglo Irish and Irish Nationwide must be allowed to collapse.

What began as farce has turned swiftly to catastrophe. Last September the Government casually decided to give a small dig-out to some developer pals by guaranteeing the liabilities of Anglo Irish Bank. This spiralled into a proposed nationalisation that would saddle Irish taxpayers with Anglo’s bad debts, which could easily exceed €20,000 per household, and starve the other, worthwhile, banks of the capital they need to survive.

At the original crisis meeting on September 29th, Brian Cowen claimed that the blanket guarantee to all six banks was given “on the basis of the advice from those who are competent to so advise the Government”.

That does not appear to have been the case.

According to a source of mine very familiar with what happened at the meeting, extending the liability guarantee to Anglo Irish and Irish Nationwide was strongly opposed by representatives of the Central Bank and the Department of Finance (who reportedly came into the meeting with a draft Bill to rescue only four institutions). However, I am told they were overruled by the Taoiseach and the Minister for Finance, who were supported by the Financial Regulator and the Governor of the Central Bank on the grounds that a sudden liquidation of Anglo’s assets would not be in the national interest.

It is still worth asking what would have happened if Brian Cowen had listened to the Department of Finance and allowed Anglo Irish to sink? The answer is: very little.

Developers would have gone bust and commercial property would have become more or less worthless, but that is going to happen anyway, with or without Anglo Irish. Depositors of Anglo Irish would have been paid off in full, and the hit would have been taken by the international financial institutions that hold around €22 billion of its bonds.

These bondholders are professional institutional investors who signed up for higher returns on Anglo debt in the knowledge that they were facing higher risks. They are, moreover, insured against their losses through insurance contracts called Credit Default Swaps.

This is the central point about the bailout of Anglo Irish, and one that has not received any attention: the only effect of a bailout is that the Irish taxpayer will make up the losses of Anglo Irish’s bondholders instead of the insurers who had already been paid to underwrite the risk.

Why it is necessary to transfer Anglo’s losses from the writers of Credit Default Swaps to the Irish taxpayer is something that the Government has not thought to justify.

Indeed, what has been disturbing about the entire Anglo affair is that at no stage has the Government felt it necessary to explain why any bailout was needed, beyond inchoate mutterings about the “systemic importance” of Anglo Irish.

The reality is that Anglo has no importance in the Irish financial system. It existed purely as a vehicle for a few politically connected individuals to place reckless bets on the commercial property market. These property speculators may be of systemic importance to the finances of Fianna Fáil, but their significance ends there.

In ordinary times, piling €30 billion of Anglo Irish losses on to the national debt would be painful and pointless but not impossible. These however are not ordinary times. International debt markets are flooded with governments trying to borrow. The other Irish banks are dangerously short of capital. Most importantly, the Irish economy and government finances are collapsing.

Ireland’s growth during the last decade was largely illusory, generated by a property bubble fuelled by reckless bank lending. In 2007 an incredible 20 per cent of our national income and employment came from building houses and commercial property. Next year, the percentage will be approximately zero.

The only industrialised economy that has endured a property and banking crash remotely comparable to what we are beginning to experience was Finland in 1991, where national income fell in total by 15 per cent and unemployment rose by 12 percentage points. As the private sector haemorrhages jobs it is hard to see how Irish national income will fall by less than 20 to 25 per cent in the next few years. Unemployment will easily reach 15 per cent by the end of the summer, and 20 per cent by next year, and will not start to fall until recovery in Britain and elsewhere permits mass emigration to resume. The economy will not begin to grow until real wages fall to competitive international levels, a process that will probably take a decade.

In other words, the Irish economy is facing a decade of stagnation and mass unemployment of the same magnitude as the 1980s, with the difference that the unemployed now have mortgages, car loans and maxed-out credit cards. Faced with an irreversible contraction on this scale, the Government will have grave difficulty borrowing to fund its ordinary expenditure, even after draconian cuts in spending and increases in taxation. In the view of international investors, piling Anglo Irish’s gambling losses on top of a spiralling national debt could easily suffice to sink the Irish State into bankruptcy.

In this national crisis, what should be done? The answer is simple. The State must do everything to rescue AIB, Bank of Ireland and Permanent TSB, and let Anglo Irish and Irish Nationwide sink.

The Government must continue to guarantee all deposits at Anglo Irish while announcing that, in the light of continuing revelations of misconduct in the bank and shortcomings in its auditing procedures, it will enter into negotiations with senior and unsecured bondholders.

The proposed Anglo nationalisation marks a decisive watershed in Irish democracy. With it, an Irish government has coolly looked its citizens in the eye and said: “Sorry, but your priorities are not ours.”

It is to be hoped that the collapse of other bank shares will serve as a warning to deter the Government from this catastrophic course. I would therefore urge any TDs and Senators who still believe that the Irish State exists to act in the interests of its people to vote against the nationalisation of Anglo Irish and do everything to protect the other banks.

Morgan Kelly is professor of economics at University College Dublin.

Corrections & Clarifications - Published January 22nd

In this article, it was stated that the Minister for Finance Brian Lenihan had failed to follow advice received from representatives of the Central Bank and the Department of Finance at a meeting on September 29th 2008 at which the Government decided to guarantee the deposits and certain identified liabilities of six named financial institutions.

It was also stated that a Bill to rescue only four institutions was before the Government on that occasion. In fact, the Bill was the same as that passed by the Oireachtas this week, being a Nationalisation Bill. The Irish Times notes the unequivocal statement by the Minister for Finance in the Dáil on Tuesday confirming the correct factual position and we are happy to set the record straight and withdraw any suggestion of corrupt motives on the part of the Minister. ... 78003.html
Bank guarantee likely to deal a crippling blow to the economy
February 17, 2009

ANALYSIS: Government borrowing is not an immediate problem, but the extent of banks’ bad debts may prove catastrophic, writes MORGAN KELLY

BETWEEN COLLAPSING house prices, bankrupt banks and spiralling unemployment, you might be forgiven for thinking that fate has already dealt Ireland every misfortune in its hand. However, there may be one more unpleasant surprise in store for us, the prospect that international investors unexpectedly stop lending to the Government.

Economists call this a “sudden stop”. The original sudden stop occurred in 1998 when a default by Russia panicked lenders away from Latin America and plunged their economies into prolonged crisis.

The consensus among Irish economists is that government borrowing is not an immediate problem. Ireland has a low level of public debt by international standards, and even a few years of heavy borrowing will still leave it below Greek and Italian levels.

To understand why this view is too complacent, imagine that you are a bank manager and somebody that we will call Brian (not his real name) comes in looking for a loan.

Brian’s income is €30,000 and he would like to borrow €20,000 to cover living expenses. This sounds like a lot in these nervous times but, because Brian is not carrying much debt, you think you might lend to him.

However, Brian then lets it slip that, because his income is falling sharply, he will need to borrow at least as much each year for the foreseeable future. He also admits that, late one night and for what seemed like good reasons at the time, he somehow agreed to insure the gambling losses of some “banks”.

Brian has no idea how large these losses might be, but is starting to fear that they might be substantial. At this stage, you realise that Brian is on a trajectory into bankruptcy and show him the door.

Multiply the numbers in this story by a million and you begin to understand why Ireland makes bond markets nervous. First, the Irish economy is heading into a severe and prolonged slump that will force the Government to borrow heavily at a time when markets are increasingly reluctant to lend heavily.

Secondly, the Government’s delay in revealing how much its bank liability guarantee is likely to cost is making markets suspect that the final bill will be crushing.

After a decade of a credit-fuelled property bubble, the economy is not so much crumbling as vaporising: were we the size of Britain, January’s rise in unemployment would have been over half a million.

As the economy collapses, so does the Government’s tax revenue. This year the Government will have to borrow about €20 billion – everything it spends on wages or on social welfare – or about 15 per cent of a falling national income.

With no chance that the hopelessly uncompetitive economy will recover in the next five years and little sign that the Government has any appetite for serious cuts in spending or increases in taxation, borrowing looks set to continue at around this level for the foreseeable future.

If this borrowing was the limit of the Government’s liabilities, Ireland would probably just about weather the storm in the bond markets. Unfortunately, an elephant is lurking in the corner in the form of the bank liability guarantee, and this looks increasingly certain to sink the economy.

In my view, the Government has made insufficient effort to estimate how much its banks have lost. We have therefore had the bizarre experience of nationalising Anglo Irish Bank and recapitalising Allied Irish Banks and Bank of Ireland without knowing precisely the extent of their bad debts.

The Government has not updated its estimate of losses since Brian Lenihan’s boast that the liability guarantee was “the cheapest bailout in the world so far”, an assurance that already ranks in the annals of supreme political irony alongside Neville Chamberlain’s “peace in our time”.

The ability of the State to continue funding itself ultimately depends on the size of these bad debts. If they are of the order of €10–€20 billion, we will survive. If they are of the order of €50-€60 billion, we are sunk.

Irish banks could easily lose this much. If we suppose that most of the €20 billion lent to builders will not reappear this side of Judgment Day, along with 20 per cent of the €90 billion lent to developers, and 10 per cent of the €120 billion in mortgages, then we are already up to €50 billion.

These are only guesses. However, the continuing stream of revelations from Anglo Irish – which bear out the old investment dictum that there is never just one cockroach in a kitchen – suggest that they could be optimistic guesses.

To see what would happen to Ireland if foreign lenders suddenly pull the plug, we only need to look at what happened in Latvia last December. We would be forced to seek an international bailout, with the International Monetary Fund and European Union playing bad cop and good cop. We could expect cuts of one-quarter to one-third in public sector wages and social welfare benefits, and draconian tax rises to bring the deficit back to around 5 per cent of national income in two years.

There is actually a worse scenario where international bond markets suffer a general panic, like 1998. Not only does Ireland gets torpedoed, but also Portugal, Italy, Greece, Spain and Austria. The IMF and EU simply would not have the resources to bail out so many economies and we would be entirely on our own.

In circumstances where the Government could not even pay public sector salaries, the bank guarantee would immediately become worthless and we would see an uncontrollable run on all the Irish banks.

Watching the ineptitude and complacency of Lenihan’s bank bailout, we can understand increasingly how the people of New Orleans must have felt as they watched George Bush rescue their city: “Brianie: you’re doing a heck of a job.”

Particularly galling are the Government’s efforts to feign surprise and indignation at the behaviour of the banks, when the reality is that this is how we have always done business here. All that the Anglo affair has done is to hold up our grubby brand of crony capitalism for international ridicule.

For increasing numbers of ordinary people, the Irish economic miracle has turned out to be as worthwhile as a share in Bernard L Madoff Investments.

In return for working hard and paying their taxes, the lucky ones who keep their jobs can now look forward to pay cuts, negative equity and savage tax rises; while the unlucky ones face prolonged unemployment and losing their homes, their cars and everything for which they have worked.

If, on top of this, we suffer a sudden stop, people will see their pensions and Government spending slashed to pay off the gambling losses of Seán FitzPatrick and his pals. The Irish social fabric would certainly rip and unprecedented civil disorder ensue.

Bill Clinton’s feared enforcer James Carville once said that he would like to be reincarnated as the bond market, because that way you get to intimidate everyone.

Without decisive and intelligent Government action in the next few weeks, by the end of this year we will understand exactly what he meant. ... 65637.html
Brought to our knees by bankers and developers
July 3, 2009

OPINION: Nama is in effect Fianna Fáil’s shrine to the property bubble for which the party still yearns. Prepare to pay 10 per cent more in income tax for the next 10 years to pay for it all . . . we are headed for national bankruptcy, argues MORGAN KELLY

WRITING HERE two years ago, I pointed out that the exuberant lending of Irish banks to builders and property developers would sink them if the property bubble burst. Since then, the bubble has burst, the banks have sunk, and we are all left wondering how to salvage them.

Two ideas for fixing the banks have been suggested: a bad bank or National Asset Management Agency (Nama) and nationalisation. While these proposals differ in detail, their impact will be identical. Irish taxpayers will be stuck with a large bill, and in return will get an undercapitalised and politically controlled banking system.

A far more efficient and cheaper alternative to Nama is to copy what Barack Obama did with General Motors, and transfer ownership of Irish banks to their bond holders. In this way we can achieve well capitalised banks, run without political interference, at minimal cost to taxpayers.

By converting a portion of Allies Irish Banks’ approximately €40 billion of bonds, and Bank of Ireland’s €50 billion, into shares, each institution can be recapitalised. Transferring ownership to bond holders will not cost the taxpayer a cent and will avoid interminable legal battles over the transfer of assets to Nama.

While the shaky state of Irish banks had been worrying investors since early 2007, when the crisis finally broke in late September the Government was taken completely by surprise and reacted with blind panic. Faced with a run on Anglo Irish Bank by institutional depositors on September 29th, the Government was stampeded into guaranteeing virtually all liabilities, except shares, of the six Irish banks.

This guarantee contained two obvious but fundamental flaws. Everything that has happened since – the proposed recapitalisation of Anglo, the nationalisation of Anglo, the establishment of Nama – can be understood as the Government scrambling to catch up with the consequences of these two errors.

The first mistake was to guarantee not only deposits – which had to be guaranteed – but also most of the existing bonds issued by banks to other financial institutions. Bond holders receive higher returns in the knowledge that they are accepting the risk of losses on their investment. In addition, unlike depositors who can scarper, existing bond holders are effectively stuck.

It made no sense for the Government to insist that taxpayers would take the hit on any bank losses instead of the financial institutions that had already entered legal contracts to do so.

The second mistake was to extend the guarantee to Anglo Irish and Irish Nationwide. As specialised property development lenders with incompetent management, they were at risk of heavy losses as their market collapsed, and fulfilled no role in the wider economy.

In making the guarantee on September 29th, I do not doubt that the Government believed that the difficulties of Irish banks ran no deeper than temporary liquidity problems stemming from the international crisis. However, as it has become apparent that Anglo was a mismanaged wreck, with AIB and Bank of Ireland scarcely better, the Government has stuck with the mantra that all banks are equally important and equally worth saving at any cost to the taxpayer.

Brian Lenihan and Brian Cowen are happier to dice with national bankruptcy than lose face by admitting that they were misled about the state of Irish banks last September.

Nama, then, is the latest twist in the Government’s increasingly bizarre efforts to save the Irish banking system while claiming that it does not really need to be saved.

Underlying Nama is the delusion that the collapse of our property bubble is a temporary downturn. In a few years time when the global economy recovers we will be back building houses like it was 2006. All the ghost estates, empty office blocks, guest-less hotels and weed choked fields that Nama has bought on our behalf will once again be worth a fortune.

The reality is that, because of our surfeit of empty housing, there will be almost no construction activity for the next decade. Empty apartment blocks in Dublin will eventually be rented, albeit at rates so low that many will decay into slums. However, most of the unfinished estates that litter rural Ireland – where the only economic activity was building houses – will never be occupied.

Nama is a variant on the “Cash for Trash” scheme briefly floated in the United States last year where the government would recapitalise banks by overpaying for their bad loans. Our Government is proposing to buy €90 billion of loans and will reportedly pay €75 billion for them.

The International Monetary Fund (IMF) guesses that Nama will cost us €35 billion, and this is probably optimistic. The narrowness of the Irish property market meant that banks effectively operated a pyramid scheme, bidding up prices against each other. Now that banks cannot lend, development assets are effectively worthless.

The taxpayer is likely to lose well over €25 billion on Anglo alone. Among its “assets” are €4 billion lent for Irish hotels, and almost €20 billion for empty fields and building sites. In fact, I suspect that the €20 billion already repaid to the casino that was Anglo represents winners cashing in their chips, while the outstanding €70 billion of loans will turn out to be worthless. And it is well to remember, as the architects of Nama have not, that although the problems of Irish banks begin with developers, they do not end there.

The same recklessness that impelled banks to lend hundreds of millions to builders to whom most of us would hesitate to lend a bucket; also led them to fling tens of billions in mortgages, car loans, and credit cards at people with little ability to repay. Even without the bad debts of developers, the losses on these household loans over the next few years will probably be sufficient to drain most of the capital out of AIB and Bank of Ireland.

Brian Lenihan’s largesse to bond holders could cost you and me €50 to €70 billion. What do numbers like these mean?

The easiest way to put numbers of this magnitude into perspective is to remember that in 2008 the Government generated €13 billion in income tax. Every time you hear €10 billion, then, think of paying 10 per cent more income tax annually for the next decade.

In other words, the fiscal capacity of a state with only two million taxpayers, and falling fast, is frighteningly thin. Ten billion here, and ten billion there and, before you know it, you are talking national bankrutcy. Even without bankrupty, Nama will ensure a crushing tax burden for everyone in Ireland for decades.

The tragedy is that, were it not for the Government’s botched efforts to save financiers from the predictable consequences of their own greed, the Irish economy would have recovered far more quickly than most people, including the IMF, expect.

Recovery for the Irish economy will not be easy – there is no painless way for an economy to move from getting about 20 per cent of its national income from construction to getting about zero – but the flexibility of the Irish labour market would have ensured that our incomes and share of global trade would have rapidly recovered. Now, however, any fruits of recovery will be squandered on Nama.

Aside from the fact that Nama will spend huge sums to achieve little, its governance is problematic. Here, the fog of secrecy that has quietly settled over Anglo Irish since nationalisation sets an unsettling precedent.

After revelations of financial irregularities forced the resignation of three executive directors, Anglo moved decisively to replace them with . . . Anglo insiders. Most astonishing, in the light of the scandal over Irish Nationwide deposits, was the decision to replace Anglo’s disgraced financial director with his immediate subordinate, Anglo’s chief financial officer.

It is hard not to conclude that a deliberate decision has been made at the highest level of Government that what happened in Anglo, stays in Anglo. And we can expect Nama to be run in the same tight manner.

While there has been considerable speculation about dark motives for bailing out developers and banks, I do not believe that the Government’s behaviour has been corrupt: it has been far worse. At least corruption implies a sense that you are doing wrong, and need to be paid in return. Our Government actually thought it was doing the right thing in risking everything to safeguard the interests of developers who had given us an economy that was the envy of Europe.

Instead of recognising bankers and developers as parasites on our national prosperity, the Government came to see them as its source. While everyone else in Ireland has come to see the past decade as an embarrassing episode of collective insanity to be put behind us as soon as possible, the Government still sees it as the high point of our nation’s history. Nama is effectively Fianna Fáil’s shrine to the bubble, and likely to be an expensive and enduring one.

What should be done instead of Nama? First, we need to understand how the idea of Nama follows from a mistaken analogy with the Swedish banking crisis and bad bank of the early 1990s. The Swedish banks differed in one fundamental way from ours: they only had deposits as liabilities. If their government had not taken over their bad debts, ordinary depositors would have suffered. By contrast, Irish banks had borrowed heavily from other financial institutions through bonds, and these bondholders originally agreed to take losses if Irish banks got into difficulties.

By placing the costs of the banking collapse primarily on existing holders of bank bonds, the State can improve its credit rating and pull back from the edge of bankruptcy. Knowing that taxpayers are not liable for the losses of AIB and Bank of Ireland will make capital markets more willing to lend to the Irish State.

Instead, like a corpulent Tooth Fairy gently slipping billions under the pillows of sleeping bond holders, Brian Lenihan has chosen to extend the liability guarantee and further weaken the bargaining position of the State.

The drift into national bankruptcy looks increasingly unstoppable. ... 55311.html
Overpaying for Nama may hit taxpayer for €30bn
September 15, 2009

ANALYSIS: Government estimates of Nama valuations appear implausible, are out of line with other property collapses and may impose massive losses on the taxpayer

WHAT HAS been dismaying about the recent acrimonious exchanges over Nama is that neither side seems to feel it necessary to produce any evidence to support its assertions about its likely cost to the taxpayer. Like most discussions in Irish public life, the Nama debate seems set to generate more heat than light.

If we want to make sensible predictions on the likely course of Irish property prices over the next decade, we need to see what has happened historically in the aftermath of similar booms. In other words, we need to find property booms where sharp increases in bank lending caused real prices to more than double.

In Ireland, between 1995 and the peak of the boom in 2007, the average price of housing and commercial property roughly tripled, adjusting for inflation, while disposable incomes increased by one half.

Two previous booms fit this pattern closely: Japanese urban land in the 1980s, and Irish agricultural land in the late 1970s.

In Japan between 1985 and 1990, the real price of commercial land in major cities tripled, while the price of residential land doubled. What makes the Japanese case particularly relevant to Ireland, as I pointed out here two years ago, is that at the peak of their bubble, Japanese banks had the same extreme exposure to development and construction loans – 30 per cent of their lending – as Irish banks did in 2007.

As Japanese banks buckled under bad property debts, lending fell sharply and prices with it. By 2005 – 15 years after the peak – residential land had fallen back to its pre-bubble level, while commercial land had fallen by nearly 90 per cent. Given that many people are claiming that Irish property prices will recover once the economy starts to grow again, it is interesting to note that Japanese property prices collapsed while the economy continued slowly to expand: real output in Japan rose 20 per cent between 1990 and 2007 and did not fall in any year during this period.

The next case is much closer to home but almost forgotten: the boom and bust in Irish farmland prices in the late 1970s. After joining the EEC in 1973, Irish banks began to lend heavily to farmers. As a result, the inflation adjusted price of agricultural land tripled between 1975 and 1977, reaching a peak equivalent to €14,000 per acre in 2009 prices. Real Irish GNP in 1977 was about one third of its present level, so this price is roughly equivalent to €50,000 per acre in current purchasing power for land with no development potential. For comparison, during the recent boom, when agricultural land prices were driven by demand for potential development, prices peaked in 2006 at an average of €21,000 per acre nationally.

The bubble quickly burst as farmers ran into difficulties servicing loans: between 1977 and 1980 real prices fell by around 75 per cent, and remained at this level, more or less where it had started in 1973, until 1995, 18 years after the peak.

These examples illustrate a general principle: property bubbles are the consequence of abnormal levels of bank lending. Once the bank lending that fuelled the boom returns to its usual levels, prices return roughly to where they started before the boom.

In ordinary times, property prices grow at the same rate as national income: people in industrialised economies spend much the same fraction of their income on housing as they did a century ago.

However, a surge in prosperity, which drives property prices higher and encourages banks to lend more on appreciating assets, can lead to a self-reinforcing cycle of rising prices and rising lending.

Eventually, banks get a fright and return to levels of lending they used to regard as prudent, causing prices to fall back to where they were before the bubble. Just like Irish farmland in the 1970s, and Japanese property in the 1980s, our recent property boom was the product of unsustainable bank lending.

Between 2000 and 2007, while nominal GNP rose by 77 per cent, mortgage lending rose from €24 billion to €115 billion, lending to builders from €2.4 billion to to €25 billion, and to developers from €5 billion to €80 billion. Should the usual post-bubble correction occur in Ireland, it would suggest that real prices of residential and commercial property would return to their levels of the mid-to-late 1990s, two thirds below peak values.

Already the Irish property market has seen unusually sharp falls by international historical standards. The Sherry FitzGerald house price index is down 35 per cent nationally, and 42 per cent for Dublin; while the Society of Chartered Surveyors estimate that commercial property prices have fallen 48.6 per cent from their peak; and Knight Frank estimate that farmland prices, which were driven by their development potential, are down 45 per cent from their peak but are still twice those of comparable UK land.

Despite these large falls, which already exceed the one third haircut on Nama assets rumoured to be proposed by the Government, the property market remains moribund. Property transactions, measured by stamp duty receipts, are two thirds down on this time last year, and 80 per cent lower than two years ago.

In other words, if nobody is buying despite large falls in price, then price needs to fall considerably further to reach its long-run equilibrium.

The impression that Irish property prices are still considerably above long-term value is reinforced by rental yields: the ratio of the rent you get from a property to the price you paid for it. As many of you have discovered to your cost, property is a risky asset that performs particularly badly during economic downturns. To compensate for this fundamental risk, property should earn a long run rental return of at least 8 per cent.

Despite some of the highest rents in the world at the peak of the bubble (according to Lisney, Dublin ranked as the second most expensive location for industrial property and ninth for offices, with Grafton Street coming in as the fifth most expensive retail street on earth), new residential and commercial property was earning a paltry rental yield of 3-4 per cent.

This means that, to restore long-run equilibrium, prices needed to halve from peak levels, or rents to double.

Suppose for a moment that the Government’s assertions are correct, and the long-run value of Irish property is two thirds of its peak value. In order for rental yields to rise from an unsustainable 4 per cent to a long-run equilibrium of 8 per cent, the Government needs rents to rise one third from their already extreme peak values.

In fact, instead of rising, rents have fallen, and nearly as sharply as prices. The Irish Property Watch website estimates that residential rents have fallen by 32 per cent since May 2008; while Lisney estimate that commercial rents have fallen 24 per cent from peak, with office rents down 35 per cent and now lower than they were a decade ago.

Again, these large falls have not been sufficient to restore equilibrium. The number of rental properties listed on has risen from 5,000 at the start of 2007 to nearly 25,000 now, while the average time to rent a property is now 76 days.

For offices, HWBC estimate that lettings are running at one fifth of their rate last year; while Lisney calculates that one fifth of Dublin offices are now empty (something they describe as “startling”) and one third in west Dublin.

The usual post-bubble correction in property prices is likely to be aggravated in Ireland’s case by large falls in national income, and the dislocation in the banking system and Government finances, caused by the collapse of our unusually large construction boom.

The effective ending of new construction activity, collapsing consumption, rising taxes and cuts in Government spending all make the 15 per cent contraction in GNP forecast by the ESRI and others look optimistic. The fall in national competitiveness and likely continuing difficulties in the banking sector make the prospect of a swift national recovery seem problematic.

What we have seen then is that as the abnormal lending that fuelled the property boom returns to its normal level, Irish property prices should fall back to their pre-bubble values, at around one third of their peak values.

In the absence of evidence to support it, the Government’s claim that €90 billion in developer loans are backed by €120 billion in assets appears implausible. While five-year developer loans were the norm, properties were usually flipped on after two years, meaning that existing loans were mostly taken out at peak prices.

In addition, while loans were supposedly 70 per cent of property value, the collateral supplied was usually equity in other property or personal guarantees, both now worthless.

It appears, therefore, that, by paying an average of two thirds of the face value for Nama assets, the Government is likely to impose severe losses on taxpayers of the order of €30 billion, or one fifth of national income.

Morgan Kelly is professor of economics at University College Dublin. During the recent High Court case involving the Zoe group of companies and ACCBank, he gave property valuation estimate evidence on behalf of the bank ... 08947.html
Turning bank debt into equity will save us from Nama ruin
October 13, 2009

History shows Nama-style bad banks are profoundly corrupt and corrupting institutions. If Nama didn’t happen, the alternative would involve minimal cost to the taxpayer and banks would manage their business without political interference

WHILE MOST economists by now simply dismiss Brian Lenihan’s utterances on the economy as “not even wrong”, this is to miss the Minister’s almost eerie ability to predict exactly the opposite of what is going to happen. Merely to contradict Brian Lenihan is virtually to guarantee that you will later be credited with supernatural prescience.

Who else, as Irish bank shares plunged 13 months ago, could conclude: “Our banks uniquely have weathered this storm . . . We are in a zone of financial stability in a very troubled financial world.”? Two weeks later, having been panicked into his catastrophic bank liability guarantee, the Minister assured us that we had “the cheapest bailout in the world so far”, and six weeks later averred that: “It is not the function of the Government to fund or bail out the banks.”

The effortless miscalculations, the assured non sequiturs, the lofty indifference to facts: all reveal Brian Lenihan as a master of what Princeton philosopher Harry Frankfurt defined succinctly in his 1986 paper, On Bullshit .

The Nama legislation, as expected, piles up this material on an Augean scale. Prices have fallen 47 per cent; the long-term economic value of property is 30 per cent below its peak value; the loan-to-value ratio is 77 per cent; prices only need to rise by 10 per cent in 10 years for the State to break even.

To subject these almost poetic flights of ministerial imagination to any sort of rational analysis will seem to many like vandalism, but that is what God made economists for.

First, the estimate that prices have fallen 47 per cent. The reality is that prices can only exist when there is a market, and the market for commercial property and development land has disappeared.

A less futile exercise is to ask how much Nama would have cost at the end of similar credit-fuelled price bubbles. A decade after their peaks, Tokyo land prices had fallen by five-sixths, while Irish farmland, adjusted for inflation, had fallen by three-quarters. Had Brian Lenihan bought €77 billion of either, applying the proposed Nama discount of 30 per cent, he would have lost €35 billion-€40 billion on our behalf, or roughly €20,000 per taxpayer, and that is before adding interest.

At a quarter of national income, Nama would dwarf the cost of previous bank bailouts, which varied from about 3 per cent of GDP in Sweden to 14 per cent in Finland and Japan.

Most baffling of all the Nama numbers is the proposed discount of 30 per cent, implying that the “long-term economic value” of property is at 2004 prices. Not one shred of evidence is offered for this assertion, the keystone of the Government’s strategy.

At first, I thought that this mystical 30 per cent number embodied Fianna Fáil nostalgia for a vanished era of innocent greed; a hope that we would wake up one morning and find ourselves back in 2004 forever, basking in the benevolent gaze of Bertie Ahern and Seán FitzPatrick. The reality turns out to be a lot more mundane. The EU simply forbade Lenihan to pay any more. This is not through any dismay at seeing Irish taxpayers fleeced by their Government, but for fear that they will be stiffed into carrying out an Iceland-style rescue here.

The figure of a 77 per cent loan-to-value ratio is equally fanciful. It will take years for the courts and Fraud Squad to disentangle multiple personal guarantees and imaginary collateral. The situation in Anglo Irish Bank appears particularly grave.

Finally, there is the assumption that the Irish Government can continue to borrow forever at low rates from the European Central Bank. However, the ECB is making no secret of its dismay at being turned into a credit union for feckless Micks, and is anxious to end such emergency lending facilities within the next year.

Once the ECB slams the window on its fingers, the Government will be forced to borrow at market rates of 5 per cent or more. In the next decade, this will add another €25 billion or so to taxpayers’ losses from Nama.

Property speculation was a mania that swept every level of Irish society, from hairdressers buying apartments in Bulgaria to dentists taking out second mortgages to join commercial property syndicates. Business owners were not immune to the lure of effortless wealth, and many borrowed heavily to gamble in property.

As one banker put it: “We are happy to restore their credit line as soon as they repay us the €15 million they borrowed to buy that land bank on the edge of town.” The destruction of the Irish commercial class, who we might have hoped to be an engine of export led recovery as they were in the 1990s, is likely to prove one of the most enduring and costly legacies of the property bubble.

Forcing banks to lend to SMEs will only compound our problems. One condition of the Japanese bank recapitalisation in 1999 was that they lend to small firms, but the effect was to heap a second layer of non-performing loans onto existing property losses.

As well as being expensive, history shows Nama-style bad banks to be profoundly corrupt and corrupting institutions. After the financial crisis in 1931, the US, Germany and Austria all set up bad banks which turned into conduits for directing funds to politically connected enterprises.

Bad banks are the means for governments to choose which oligarchs will survive to emerge even stronger than before. They do not just happen to behave in a corrupt and anti-democratic manner: it is what they are designed to do.

And do not forget that, even after the crushing expense of Nama, Irish banks will still be seriously short of capital. Under the current, deliberately lax, international bank regulations, AIB and Bank of Ireland need capital of around €8.5 billion.

Financial markets, which assume that Nama will go through, value their existing capital at around €3 billion, and adding Government preference shares of €3.5 billion leaves them short about €2 billion each. Once stricter capital requirements are imposed next year (the so-called Basel 3 process), this shortfall will probably rise to €6 billion.

Nama then, will turn out to be expensive, corrupting, and inadequate. While the abject, almost endearing, eagerness of the Greens to please their Fianna Fáil masters means Nama is almost certain to go ahead, it is perhaps worth asking what would happen if it did not.

All that needs to be done is for ownership of Irish banks to be transferred to their bondholders. This process of converting debt into equity occurs sufficiently often in banking to have a name: resolution. Resolution offers a way for Irish banks to be adequately recapitalised at no cost to the taxpayer, and able to manage their business without political interference.

Under existing Irish corporate law, this transfer would be a recipe for centuries of litigation. That is why most other industrialised economies have, or are introducing, special legislation to resolve failing banks with limited judicial review. Particularly impressive is the UK’s Special Resolution Regime introduced last February, which could easily serve as a template for similar legistlation here.

Instead we will get Nama. Brian Lenihan assures us that Fianna Fáil’s monument to a decade of waste, corruption, and ultimate ruin will not be wasteful, corrupt, and ultimately ruinous.

Let us hope that, for once, he is not wrong.

December 2009
The Irish Credit Bubble ... 54227.html
Ghosts of debt and jobs will haunt economy
December 29, 2009

OPINION : By 2015, Iceland will almost certainly be a lot better off than Ireland because it dealt decisively with its banks

WHILE THINGS are hard to predict, the future, especially the situation of the Irish economy, is so stark that even an economist can make some predictions that stand a chance of being right.

Two ghosts of Christmas will haunt Ireland in 2015: jobs and debt.

For 20 years, the Irish economy experienced extraordinary growth. Unfortunately, this growth came from two separate booms that merged imperceptibly into each other. First we had real growth in the 1990s, driven by rising competitiveness and exports. However, after 2000 competitiveness collapsed, and growth came to be driven by a lending bubble without equal in the euro zone.

As Michael Hennigan of Finfacts ( has pointed out, of the half million jobs created in the last decade, only 4,000 were in exporting firms; and fewer people now work in IDA-supported companies than in 2000. The Irish economy has been faking it for a decade.

Now that the property bubble has burst, people hope that exports will once again become the engine of our salvation. The problem is that, back when we were becoming rich by selling houses to each other, we priced ourselves out of world markets. Wages have risen by one-third here compared with Germany since 2000. Restoring competitiveness will be an arduous task where nobody, outside the banks and ESB, will see a pay rise for a decade, and many will take pay cuts.

Whether desirable or otherwise, leaving the euro is not possible for a mundane reason. Changing currencies takes a lot of organisation, as we saw when the euro was introduced. If the Government announced that a New Irish Pound will be introduced in 12 months, everyone would rush out to withdraw their savings in euro and wipe out the banks.

Prolonged mass unemployment is a disaster not only for its victims, but for all society. The great Harvard sociologist William Julius Wilson showed how the disappearance of low-skilled jobs in the US during the 1970s led to the social collapse of black ghettos.

In Ireland for the last 20 years we saw this process working in reverse, as rising employment turned what had been sink estates into decent, if not wonderful, places to live. Finding a job does more for the disadvantaged than a legion of social workers: people’s sense of self-worth is transformed by being able to earn the money to do ordinary things like own a car, buy toys for their kids at Christmas, and take their family on holiday.

While many commentators argue that the benefits of the Celtic Tiger flowed exclusively to the wealthy and connected, this is nonsense. The benefits went overwhelmingly to ordinary people in the form of something that Ireland had never seen before: abundant jobs. By 2015 we will have seen what happens when jobs disappear forever, particularly from less educated men who were able to earn a good living in construction. In effect, Ireland is at the start of an enormous, unplanned social experiment on how rising unemployment affects crime, domestic violence, drug abuse, suicide and a litany of other social pathologies.

We will be forced to discover the consequences when people, who had worked hard to make decent lives for themselves and their children, find themselves reduced to nothing. Less than nothing in fact because, unlike the unemployed in the past, people now losing jobs are weighed down with debt and facing the terrifying prospect of losing their homes.

Debt will be the second ghost of Christmas 2015. Back in 1997, when exports drove real growth, Irish banks lent little by international standards. By 2008, Ireland had twice as much debt for its size as the average industrial economy: banks were lending a third more to property developers alone than they had been lending to everyone in Ireland in 2000.

It was this tidal wave of credit that inflated house prices and launched the construction boom that drove wages and government spending to unsustainable levels.

To fund this suicidal lending, Irish banks borrowed heavily internationally, and now must pay it back fast as the world realises that our recent economic miracle was less in the spirit of Adam Smith than of Bernard Madoff. As Irish bank lending returns to ordinary international levels, property prices will fall by at least two-thirds from their peaks.

However, five years from now, property prices could have been driven far lower than that by a deluge of sales of unsold, foreclosed and abandoned homes.

Mass mortgage defaults caused by unemployment and falling house prices are the next act of the Irish economic tragedy. As well as bankrupting our worthless banks all over again, the human cost of tens of thousands of families losing their homes will be enormous but, because the Government has already exhausted the State’s resources taking care of developers with Nama (National Asset Management Agency), there is very little that can be done to help these people.

Most people, of course, will not lose their jobs and homes. However, even they will be forced painfully to relearn something our parents already knew: beyond a small mortgage, debt swiftly turns into pure poison that will eat away your prosperity and happiness.

One response to large-scale home repossessions that will be attempted is to buy ghost estates for public housing to accommodate evicted home owners, providing ample opportunities for good old fashioned petty corruption.

For grand corruption, though, we will have to look to Nama. By allowing the banks to dictate the terms of their bailout, the bank rescue was turned into the most lucrative and audacious Tiger Kidnapping in the history of the State, with the difference that, like the sheriff in Blazing Saddles , the bankers held themselves hostage.

Bad banks like Nama were tried on a large scale in the early 1930s in the US, Austria and Germany; and proved to be profoundly corrupt and corrupting institutions, whose primary purpose was to funnel money to politically connected businesses. The German bank is best remembered for setting up what we would now call a special purpose vehicle to fund the presidential election campaign of the odious Paul Hindenberg.

Bad banks do not just happen to be corrupt and anti-democratic institutions, it is what they are designed to be. Effectively, bad banks give governments the power to choose which of a country’s most powerful oligarchs will be forced into bankruptcy, and which will be resuscitated to emerge even more powerful than before.

Nama will get to pick which of the fattest hogs of Irish development will be sliced up and fed, at taxpayer expense, to better connected hogs (remember that Nama has been allocated at least €6.5 billion, considerably more than the Government saved by draconian budget cuts, to “lend” to favoured clients).

While Nama may have momentous political consequences, it has already failed economically: the Irish banks are still zombies, reliant on transfusions of European Central Bank funding to survive until losses on mortgages and business loans finally wipe them out. In the next few months we will discover if the State bankrupts itself by nationalising the banks; or if it has the intelligence to free itself from bank losses by turning the foreign creditors of banks into their owners, as Iceland has just done with Kaupthing bank.

It is ironic that by 2015, having devalued its currency and dealt decisively with its banks, Iceland will almost certainly be a lot better off than Ireland.

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