Economic Babelfish

Irish Economics translated

Some thoughts on Morgan Kelly’s latest working paper

Morgan Kelly’s paper can be found here: http://www.ucd.ie/t4cms/wp09.32.pdf

On a personal level:  my daughter was just born 3 days ago so I don’t have sufficient time to give a proper response to his paper but the following is one area that I feel he’s overstated the downside risk. I don’t believe there is no downside risk only that it isn’t as great as he presents it to be.

The issue is with this quote:

“From being almost entirely funded by domestic deposits in 1997, by 2008 over half of Irish bank lending was funded by wholesale borrowers through bonds and inter-bank borrowing. This well of easy credit has now run dry. In the words of Bank of England Governor Mervyn King: “But the age of innocence—when banks lent to each other unsecured for three months or longer at only a slight premium to expected policy rates—will not quickly, or ever, return.”4 As foreign lenders have become nervous of Irish banks, their place has increasingly been taken by borrowing from the European Central Bank and short-term borrowing in the inter-bank market. Payments from NAMA will allow Irish banks to reduce their borrowing by a trivial amount. Without continued government guarantees of their borrowing and, more problematically, continued ECB forbearance, the operations of the Irish banks do not appear viable. Borrowing in wholesale markets at 5.6 per cent5 to fund mortgages yielding 3.5 per cent is not a sustainable activity, and Irish banks face no choice but to shrink their balance sheets by repaying debt and returning to their earlier state of being funded mostly by deposits.

From being almost entirely funded by domestic deposits in 1997, by 2008 over half of Irish bank lending was funded by wholesale borrowers through bonds and inter-bank borrowing. This well of easy credit has now run dry. In the words of Bank of England Governor Mervyn King: “But the age of innocence—when banks lent to each other unsecured for three months or longer at only a slight premium to expected policy rates—will not quickly, or ever, return.”4 As foreign lenders have become nervous of Irish banks, their place has increasingly been taken by borrowing from the European Central Bank and short-term borrowing in the inter-bank market. Payments from NAMA will allow Irish banks to reduce their borrowing by a trivial amount. Without continued government guarantees of their borrowing and, more problematically, continued ECB forbearance, the operations of the Irish banks do not appear viable. Borrowing in wholesale markets at 5.6 per cent5 to fund mortgages yielding 3.5 per cent is nota sustainable activity, and Irish banks face no choice but to shrink their balance sheets by repaying debt and returning to their earlier state of being funded mostly by deposits.”

Essentially, Irish banks will be forced to go back to a deposit only model where their current levels of assets vastly outstrips their current level of liabilities so they’ll have to trim the asset side of their balance sheet. Because much of these assets are long term assets that are difficult to liquidate (if not impossible in some cases), the Irish banks will be forced to cut back on new lending and “rolling over” old lending. Thus very very bad for the Irish economy.

The problems I see with this are:

a) The idea that wholesale funding won’t be made available to Irish banks at attractive rates if there is an obvious availability of good investment opportunities being left go seems to run against basic economic logic. Short term mismatches between available credit and potential demand for credit do occur but is there good evidence to suggest that such short term fluctuations can become long term in a country? The examples of the Latin Debt crises and South-East Asian crises would say no.

b) Mortgage rates aren’t fixed at 3.5%. Most commentary on the residential market that I’ve read indicates that variable rate mortgages are the norm not fixed or tracker mortgages. If wholesale money costs more, mortgage rates will be forced upwards. The issue comes from whether one believes that wholesale money will decrease for Irish banks or not. I’d argue that we’re seeing the high point for the medium term right now with respect to the difference from the ECB rate over the past year and a half not the norm for the next 5 – 10 years. Market confidence is weak, risk aversion is high and so on. This isn’t a new market norm though, we’re simply in a global recession with a nastier national recession, of course wholesale money is going to be expensive for Irish banks right now but that doesn’t mean it will necessarily stay this way over the medium term! Higher mortgage rates bring problems for the banks, but this is inevitable given the abnormally low ECB rate.

c) The problem of the level of mortgage debt versus GDP/GNP is undoubtedly a real and very worrying problem. There are some aspects of it that are less apocalyptic though compared to the problems seen in the US.  First, bankruptcy law is very different here and encourages the debtor to avoid default at all costs in a falling market versus in the US where no-recourse loans make walking away from debt easy. Second, we thankfully only had minimal activity in the sub prime market and minimal “no paperwork” mortgages and similar. While we do have too much mortgage debt, that debt is generally sitting on the laps of people with goodly sized incomes. Yes these incomes are now under threat but we have nothing close to the problem we would have if lending practices had been as loose as they were in the US.  Finally, those that hold the mortgages income streams are far closer to the borrower than in the US with CDOs. This closer banking relationship should allow for a smaller default rate through banks being able to offer easier terms if temporary repayment difficulties are encountered. This isn’t a panacea and Irish banks will have to deal with defaults but we might be spared the meltdown that the US property market saw.

Overall, I agree that the Irish banks will have serious problems to deal with in both the short and medium term. I don’t agree that the downside risk on this side of things (i.e. wholesale market funding especially) is as bad as this paper would have us believe. Then we are dealing with large unknowns here and perhaps I’m being overly optimistic but I think I have history on my side with regard to credit inflows after banking crises and recessions.

December 24, 2009 - Posted by | Irish Banks, Irish Economy | ,

2 Comments »

  1. I note you economic credentials. I maintain that the USA has been in depression since 1999 and that it was foreseeable for a few years before that. The sub-prime was a deliberate way of allowing the greedy to make money off of those who could not afford the housing that was then dangled in front of them. Ireland was blind to these developments and fell into the same trap as fuelled by fiscal stupidity, particularly as the EU interest rate fuelled malinvestment.

    This depression will continue as with Japan over the last twenty years, and has yet to deepen but all the capital created by poorly regulated banks and shadowbanksters has now been destroyed and economies the world over are shrinking back to premania levels.

    Kelly is correct, sadly. It may be possible to influence EU policy on capital creation by government, ie public works programs justifying the printing of more money equal to the multiplier affected value added, but otherwise I foresee more capital contraction. Accordingly, NAMA is precisely the wrong thing to do! It will impoverish Ireland.

    Merry Christmas and enjoy the sleeples nights!

    Comment by Pat Donnelly | December 24, 2009 | Reply

  2. Pat,

    First, ignore my credentials, my arguments either make sense or they don’t!

    With regard to capital inflows, this isn’t something the Irish Government can directly create, at best they can merely try to make Ireland more attractive to investors. The thing to bear in mind is that Ireland’s economy is tiny in international terms and we only need to attract a very small percentage of globally available capital to prop up our banks.

    Regardless, Merry Christmas and a Happy New Year to you.

    Comment by economicbabelfish | December 24, 2009 | Reply


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