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Archive for July 12th, 2011

Moody’s has this evening downgraded Ireland’s credit status by one notch from Baa3 (moderate credit risk) to Ba1 (Junk: questionable credit quality). Moody’s is maintaining its negative outlook for Ireland which means further downgrades are likely in the next 12 to 18 months. There is unlikely to be an immediate effect on Ireland as we are funded to late 2013 and the ECB has already confirmed in the cases of Greece and Portugal that it will accept sovereign bonds as collateral, even if they are junk-rated.

The NTMA, Ireland’s state agency for managing national debt,  has responded as follows:

“The National Treasury Management Agency (NTMA) notes the decision by Moody’s Investors Service to lower Ireland’s credit rating by one notch from Baa3 to Ba1.

The NTMA notes that Moody’s decision was primarily driven by their concern about the prospect of private investor participation in future financial support programmes in the euro area. Moody’s acknowledges that Ireland has demonstrated a strong commitment to fiscal consolidation and is successfully delivering on its objectives as required under the EU/IMF Programme of Support.

The situation in the euro area is evolving rapidly. In their statement of Monday 11 July, the Eurogroup set out a range of measures to safeguard the euro area’s financial stability.  These include enhancing the flexibility and the scope of the European Financial Stability Facility, lengthening the maturities of the loans and lowering the interest rates. These are positive developments for Ireland.

Ireland has sufficient funding under the EU/IMF Programme of Support to cover all its financing requirements until the end of 2013.

Ireland retains investment-grade status with the other main ratings agencies.”
Moody’s Ratings

Aaa highest quality with the smallest degree of risk
Aa (Aa1, Aa2, Aa3) high quality with very low credit risk
A (A1, A2, A3) upper-medium grade subject to low credit risk
Baa1, Baa2, Baa3 moderate credit risk
Ba1, Ba2, Ba3 Junk: questionable credit quality
B1, B2, B3 Junk: subject to high credit risk
Caa1, Caa2, Caa3 Junk: poor standing and are subject to very high credit risk and may be in default
Ca Junk: highly speculative usually in default
C Junk: the lowest rated class of bonds and are typically in default

For an overview of PIIGS credit ratings and current bond yields, click here.

UPDATE: 13th July, 2011. The Moody’s statement is available here. This sets out the reasons for the downgrade. “The key driver for today’s rating action is the growing possibility that following the end of the current EU/IMF support programme at year-end 2013 Ireland is likely to need further rounds of official financing before it can return to the private market, and the increasing possibility that private sector creditor participation will be required as a precondition for such additional support, in line with recent EU government proposals. “

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Jones Lang Lasalle (JLL) has today published its commercial property series for Ireland for Q2, 2011(free registration required). The JLL series is one of the two Irish commercial indices referenced by NAMA’s Long Term Economic Value Regulations (Schedule 2) and is used to help calculate the performance of NAMA’s “key markets data” shown at the top of this page. The other quarterly Irish price series is published by SCS/IPD and will be available by the end of July 2011; because it is generally published after JLL’s, it is not used here but the index does historically show a close correlation with JLL’s.

The JLL Index shows that capital values are continuing to decline. The Index declined by 5.7% in Q2, 2011 compared with Q1, 2011. Overall since NAMA’s Valuation Date of 30th November, 2009 prices have declined by 18.1%. Commercial prices in Ireland are now 63.1% off their peak in Q3, 2007. On an annual basis prices are down by 11.0%. The NWL index is now at 857 which means that NAMA needs to see a blended increase of 16.6% in property prices across its portfolio to break even at a gross profit level (taking into account the fact that subordinated bonds will not need be honoured if NAMA makes a loss).

Today’s figures from JLL are shocking. The 5.7% decline is the biggest quarterly slump since Q3,2009 (7.1%). JLL are at pains to emphasise that the effect of the proposed change to Upward Only Rent Review (UORR) leases is EXCLUDED from these falls. JLL says “it must be noted that capital values at Q2, 2011 do not allow for the proposed legislation on the abolition of upwards only rent reviews in existing leases. Should a downward rent review be introduced into existing leases, a fall in capital values of an estimated 20% to 30% may occur”

JLL’s index is now down 7.2% for the first six months in 2011. If the expected changes are made to UORRs, then a mid-point 25% reduction from today will see a total decline of more than 30% for 2011. That compares with a Central Bank ofIrelandadverse scenario in its March 2011 stress tests of 22%. Plainly the stress tests are now deeply inadequate in respect of this component.

Also based on a NAMA portfolio acquired for €30bn, NAMA is nursing a loss of over €5bn. That is, if NAMA paid €30bn for the loans, that would comprise €28.5bn NAMA bonds and €1.5bn subordinated bonds which need not be honoured if NAMA makes a loss. The €30bn includes a Long Term Economic Value premium of an average of 10%. So the loans were worth €27.3bn in November 2009 (€30bn / 1.1) and are now worth 14.3% less (index of 857 is 14.3% less than 1000; 857 plus 16.6% = 1000) or €23.4bn. So if the loans have cost NAMA €28.5bn and are only worth €23.7bn today, NAMA is nursing a paper loss of €5.1bn.
Elsewhere the JLL report shows that the fall in capital values is spread across different commercial property categories with Offices down 6.2%, Retail down 4.6% and Industrial down 7.1%. Rents also continue to fall with JLL’s income index down 2.5% in the quarter, and its ERV index down 4.6%, the latter representing the notional fall if properties were vacant and available to rent.

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[The copy of the ESM Treaty signed in July 2011 is available here)

 

Yesterday whilst bond markets were running around like headless chickens in anticipation of a fissure caused by Italy and Spain, the Eurogroup of EuroZone finance ministers, including our own Minister for Finance, Michael Noonan, were signing a new treaty to create – wait for it, and don’t nod off just yet – the European Stability Mechanism (ESM). “Oh no!”, I hear you say, not ANOTHER feckin’ acronym that’s going to cost us money. You might be at least glad to hear that this new acronym will replace two existing funding schemes, the European Financial Stability Fund (EFSF) and the European Financial Stability Mechanism (EFSM).

Here are the highlights of what Minister Noonan committed you and I to, in Brussels, yesterday

(1) The new fund will become operational in July 2013

(2) The new bailout fund will have a maximum of €500bn available, but that is after the “complete run down of the EFSF” and remember the EFSF has a maximum capacity of €440bn. So in total, we might have a bailout fund worth €940bn, it seems though it is not 100% clear from the treaty itself. The initial paid-in shares will total €80bn, though that will be paid in five annual instalments.

(3) The ESM is only for the euro area. So Britain, Sweden and Denmark won’t benefit. Mind you, neither will they be on the hook for bailouts.

(4) The ESM will operate closely with the IMF and countries seeking a bailout are expected to deal with both.

(5) Now this next bit is important, in October 2010 when Angela Merkel and Nicolas Sarkozy met at Deauville in France, their musing on how the ESM might work spooked markets into thinking that from 2013, Ireland’s creditors would be ranked, with the EU bailout funds ranked senior to “the rest”. And as a result of said musings, it is believed Ireland’s cost of borrowing shot up, because “the rest” thought that in a default they’d get little back fromIreland, with the result thatIrelandneeded a bailout. And now, nine months later, the treaty itself tells us that Ireland’s existing debt will be excluded from any new ranking after the ESM comes into being, and existing EU debt in 2013 will rank equally with other creditors  So Ireland’s lenders last October 2010 needn’t have been spooked after all, because the new ESM wasn’t going to affect lending until 2013.

(6) Voting at the ESM will require an 80% majority, so no vetoes. And voting rights go with contribution to the ESM’s capital. And if likeIrelandat present, you can’t pay your contribution to the ESM’s capital, you won’t get a vote at all.

(7) Contributions to the ESM are supposed have the same national proportions as contributions to the capital of the ECB (shown here at ~1.1%), but the treaty itself shows that Ireland’s contribution is to be 1.59%, or €1.27bn for the initial paid-up capital of €80bn. Luckily we can pay in five annual installments from January 2013. But still, €254m in 2013 is going to be a significant outgoing.

(8) And again, another kick in the goolies for Ireland as the treaty says “an adequate and proportionate form of private-sector involvement shall be sought on a case-by-case basis where financial assistance is received by an ESM Member, in line with IMF practice” Remember IMF practice which apparently called for a 2/3rd haircut on senior bondholders in November 2010, only to be told “nein/non” by the European bailout partners.

(9) A lot of commenters on here have previously asked whether we should be buying our own bonds given the elevated discounts available in the market. Well that suggestion seems to have been taken on board “The Board of Governors may decide, as an exception, to arrange for the purchase of bonds of an ESM Member on the primary market, in accordance with Article 12 and with the objective of maximising the cost efficiency of the financial assistance.”

(10) The ESM loans provided to EuroZone members will be at cost + 2%, but for amounts loaned for longer than 3 years, + 3% on the amount outstanding after 3 years.

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These days, a week is a long time in European economics and given it is now over three months since the announcement of the Irish bank stress tests, is it time to re-evaluate the results in light of what appears to be very changed circumstances? This entry examines what has changed since March and concludes that a review might be justified before the planned recapitalisation of the banks by the end of July 2011.

Cast your mind back to the wet and windy days of late March 2011, share trading in AIB, Bank of Ireland and Irish Life and Permanent had been suspended in advance of the much-anticipated stress tests on 31st March. At a cost of €30m, with oversight from the EU, ECB and IMF, with two previous failed domestic stress tests under our belts, much of the NAMA valuation process concluded, with a totally discredited EU stress test in July 2010 and with a far better knowledge of the extent of losses in our banks, it fell to the governor of the Central Bank of Ireland, Patrick Honohan, to give us the bill of €24bn. But was it the final bill? Of course you could never say “final” with certainty in such matters but the estimate was as near as damnit to final. To quote the Governor in his interview with Vincent Browne on the night of the announcements, “we have put in so many buffers”, “we’ve pushed the boat out this time”, “we’ve calibrated it to a sceptical market”, our IMF and EU partners finally conceded “it was a tough approach” and one of my favourite Honohanism’s “if you’re flying in an aircraft and you’re not sure if you’re exactly on target, you aim above the target (and then turn left)” Truth be told, the estimate of additional capital needed by the banks is not, as the Governor said previously “an exact science”. But the Governor certainly gave the impression that these stress tests were pretty definitive.

And the stress tests were politically important. You’ll recall that under the IMF/EU bailout agreement, the Memorandum of Understanding,Irelandwas required to recapitalise its banks by the end of February 2011. You might then recall the spanner thrown into the general election campaign in February when then-Minister, the late Brian Lenihan decided not to recapitalise the banks on the basis of not having a mandate. And the two likely contenders for power, Fine Gael and Labour, were both boldly stating that the recapitalisation would not take place until the end of March or indeed until the stress tests revealed how much exactly would additionally be required by the banks. And when Minister for Finance, Michael Noonan got his answer on 31st March, 2011, the reaction was not to promptly write a cheque for €24bn to the banks. No, he seemingly agreed with the IMF and EU that he would defer the recapitalisation until the end of July 2011. The reason for the deferral is murky but the programme of buying back  subordinated bonds at a steep discount might have been to the fore. In any event, the commitment seems to be to recapitalise the banks, which will need €20bn, given the apparent success of the bond buyback programme, by the end of July – that is within the next three weeks. That’s the political context.

So are the stress test results in March 2011 still valid? Standard and Poor’s said yesterday that the €24bn was “only adequate”, hardly the ringing endorsement of an exercise that was supposed to over-capitalise the banks to the extent that market confidence would return and the banks would be able to switch from funding dependence on the ECB.

But is €24bn even “adequate”? The view on here is that no, it’s not. It would be nice to have a spreadsheet from the CBI where updated factors could be inserted and to get a new recapitalisation figure popping out, but alas the CBI has not given us anything like that level of information on the March stress tests. So the following don’t have quantified effects.

(1) Back in March, our 10-year sovereign bond traded at an all-time-high of 10.32% on 31st March. This morning our 10-year bond has traded at 13.68%. Now Irish banks may only hold €11-12bn of sovereign bonds but plainly, the adverse projection of haircuts look out of line with present circumstances. The position of AIB, which has the largest exposure to Irish banks, is shown below:

(2) Removal of non-standard liquidity. The ECB has signalled an end to its provision of its non-standard liquidity programme in October 2011. The programme has been in existence since the financial crisis first blew up in 2008, and has been extended a number of times beyond previously announced end dates. The ECB has ruled out a medium term programme for funding Irish banks. That being the case, doesn’t the adverse case see Irish banks seeking funding on the open market, with consequent funding shortages and elevated interest charges.

(3) Commercial Real Estate (CRE) – Ireland’s commercial property is already down 60% from peak. The adverse assumption in the March 2011 stress tests was that CRE would fall a further 22% in the full year 2011 before increasing by 1.5% in 2012. In Q1, 2011 according to the Jones Lang Lasalle index, prices dropped just 1.5% but the adverse 22% presumably was based on the possibility of changes to Ireland’s Upward Only Rent Review leases, which would lead to a 20% average reduction in CRE prices. It now seems almost certain that UORR leases will be changed. Property Week reported that after several months of consideration of the matter byIreland’s Attorney General, a “heads of bill” was discussed by the cabinet on Friday last and that a Bill will be brought before the Oireachtas in October 2011. That being the case, the 22% seems like the base case, not the adverse case. But would an adverse case see declines even greater than 22%? There is still a general overhang of vacant CRE, credit is tight without any domestic sign of improvement, the Irish economy is just about stabilising but events in Europe continue to be unfavourable, the bond markets are convinced thatIreland will default on its sovereign debt. The adverse case in March was for a 70% peak to trough fall before a modest recovery next year. With what seems a certainty of legislation to deal with UORRs, that no longer looks realistic.

(4) Reisdential property – the adverse scenario in the stress tests was for what appeared to be a 60% decline overall from peak to trough, assuming the Bank used the premier house price index at the time in Ireland, the ESRI/Permanent TSB. That should be a safe assumption as the other indices are either asking price, non-hedonic or in Sherry FitzGerald’s case not overseen. Since March 2011 we have had two giant (by Irish standards) auctions conducted by Allsop/Space which have given widespread price discovery across the country. Because of successive political failure, Ireland does not have any public record of house sales prices, but we do have asking price histories and are able to see from last week’s auction that prices are down some 68% from late 2007 asking prices. Indeed there are instances of prices being down over 80%, which is consistent with Professor Morgan Kelly’s projections in 2009.

So before Minister Noonan writes the cheque to Irish banks in the next three weeks, shouldn’t he at least check that the stress test results are still valid? Better still, perhaps the Oireachtas Committee on Finance, Public Expenditure and Reform should quiz Governor Honohan on the subject. Given that there is an ECB commitment to continue its non-standard liquidity operation to October 2011, perhaps there should now be a further deferral of the recapitalisation byIreland in order to fully consider current developments and the apparent fact that matters have deteriorated since March 2011. After all, what’s the hurry to recapitalise in July or August or September?

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