Credit jitters - Market Update on Ireland - the game is changing

Big sell-off in late afternoon on Irish Banks senior debt thanks to the comments from the Finance Minister:

"Finance Minister Michael Noonan has said Ireland will go to our European partners with a plan to impose significant losses on the senior bondholders in Anglo Irish Bank and Irish Nationwide Building Society.

He was speaking in Washington after meeting the IMF and the US Treasury Secretary Timothy Geithner.

Mr Noonan said the Government will seek to impose losses on senior bondholders in Anglo Irish Bank. He said that around €3.5 billion in senior unsecured, unguaranteed bonds issued by Anglo Irish Bank and Irish Nationwide Building Society should have losses imposed on them.

Mr Noonan said he had discussed this with the IMF, who supported the strategy.

The Finance Minister said these banks are no longer normal entities and are more like warehouses for bad debts. In that context, he would be going to our European partners to propose significant cuts in the money to be paid to the bondholders.

Mr Noonan also revealed that he had asked Mr Geithner to support Ireland's effort to cut the interest rate paid on the European parts of our bailout programme. He said Mr Geithner agreed to support Ireland's effort and would speak to the French in connection with this."

Senior bonds for both entities got whacked after these comments:

Source: the market...

Anglo Irish has 3.1 billion euros in unsecured senior bonds not covered by a state guarantee.
Irish Nationwide Building Society, (which by the way is being merged with Anglo Irish), has 601 million euros worth in unsecured senior bonds not covered by the state guarantee as well.

Both have already cost 35 billions euros worth of bailout funds courtesy of the Irish taxpayer.

Ireland seeks to go after Anglo's senior bondholders - Reuters
From Reuters:
"No euro zone government has imposed losses on senior bank bonds, which are ranked on a par with depositors, but senior unsecured debt amounting to 320 million euros was subjected to a 41.2 percent haircut when Danish bank Amagerbanken failed in February."

The game is changing.

Meanwhile all is not well at Bank of Ireland either:

Shareholder Anger Erupts At Bank Of Ireland Meeting - WSJ

"The bank, which is already 36% owned by the Irish government after receiving EUR3.5 billion in bailout aid, needs EUR5.2 billion more in capital and new buffer reserves, mainly to make good lending excesses during the boom years."

I wrote in December 2010 in Europe - The end of the Halcyon days that:
"Either bondholders of Irish banks debt agree take a haircut on both the sub and senior debt, or the Irish Goverment will have to cut more spending, which means more austerity for the Irish people."

We have reach that point.

Portugal and Ireland drifting wider still:

Source CMA

French banks as well today have been put under pressure by the rating agencies due to their exposure to Greek debt.
Moody's Investors Service placed the three largest French banks on review for a possible downgrade.
The three banks are:
BNP Paribas, down 2.55%.
Credit Agricole, down 2.49%.
Societe Generale, down 2.48%

French banks CDS wider on Moody's rating threat:

Source CMA


EUR/USD is down 2% today on these news to around 1.4165:

Itraxx 5 Year Financial Senior CDS was wider today by 16 bps at around 178 bps whereas the Itraxx 5 Financial Sub widened by 26 bps, market being around 304-310, 6 bps bid-offer spread...ouch.


"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."
Henry Ford

European issues and the Greek jinx - Macro update, a focus on Iceland and more.

New week, new records on the CDS front, new downgrades...

As I am typing this evening, Greece got whacked to CCC by S&P.

with negative outlook...

Greece 5 year CDS now standing above 1600 bps, at 1612 bps according to Markit, up from 1510 bps from my last post from the 9th. New day, new record.
Spain 5 year Sovereign CDS at 283 bps.
Italy 5 year Sovereign CDS at 178 bps.
Portugal 5 year Sovereign CDS at 763 bps, wider now than Ireland at 736 bps.
SovX western Europe 5 year index at 215 bps, top level was 222 bps on the 10th of January (as I posted previously, Greece's weight in the index is 1/15th of the whole index).

Iceland is now trading tighter than Spain, Ireland, Portugal and Greece at 266 bps as of the 10th of June, cumulated probability of default for Iceland amounts to 21.82% according to CMA. Iceland decided not to bailout its banks and went for massive short term pain. Iceland went back to fishing:
Iceland GDP Growth Rate

"The Gross Domestic Product (GDP) in Iceland contracted 1.5 percent in the fourth quarter of 2010 over the previous quarter. From 1997 until 2010, Iceland's average quarterly GDP Growth was 0.71 percent reaching an historical high of 8.41 percent in March of 2004 and a record low of -5.07 percent in December of 2007."
Source Trading Economics

Deep pain for Iceland but a tamed inflation:

With lower interest rates than before the crisis:

But unemployment rate is still stubbornly high:

Iceland's stock market has been obliterated...

"Iceland's main stock market index, the ICEXI, declined 59 points or 10.53 percent during the last 12 months. From 1992 until 2011 the ICEXI market value averaged 2001.82 points reaching an historical high of 8174.28 points in July of 2007 and a record low of 314.93 points in May of 1993. This page includes: Iceland Stock Market Index chart, historical data and news."
Source Trading Economics

Obliterated back to 1996 levels...

And in the process its currency divided by two versus the USD:

Any similarities with what's happening with Greece's stock market?

"Greece's main stock market index, the ASE, declined 232 points or 15.62 percent during the last 12 months. From 1987 until 2011 the ASE market value averaged 2019.58 points reaching an historical high of 6355.04 points in September of 1999 and a record low of 97.36 points in January of 1987."
Source Trading Economics.

20 Stocks in the ASE Greek index, guess how many banks?
FTSE/ATHEX 20
Alpha Bank
ATE Bank
Bank of Cyprus Group
National Bank of Greece (exposure to Greek Government bonds = 218% of equity)
EFG Eurobank Ergasias SA
Marfin Laiki Banks (exposure to Greek Government bonds = 72% of equity)
Marfin Investment Group
Piraeus Bank

As I stated before, banks are like second derivatives of an economy, if Greece gets downgraded, so will its banks, pushing them even more into difficulties.
You can draw from the above list where the ASE Greek index is heading...

For more on the subject on Greek Banks:
Banks Are Greece's Achilles' Heel - WSJ

And by the way Allied Irish Bank just defaulted. I was expecting it for a long time "Bye Bye Irish Bank Debt".
Junior bond holders are getting a 90% haircut on their holdings. CDS Sub to be triggered. As reminder, last year, sellers of CDS for Anglo Irish Bank paid out around 82%. That was 8% more than for Allied Irish Bank.
Roman Abramovich's family office Millhouse just took a big hit following a stupid gamble. I commented on this very subject last year - "Ireland in the need of a lucky Shamrock..."
This is what I wrote at the time:
"Subordinated bonds pay higher yields than senior debt to reflect the fact that they are more likely to take losses if the issuer gets into difficulties."


There are some greedy people, they are some stupid people, and they are also some stupid greedy people.
There is no free-lunch when you buy risky sub debt...If his team had done a proper risk assesment of their investment (which they are supposedly paid for...), they would have seen that the government guarantee's expiry was running out on the Thursday 30th of September.


There should not be bailout for stupid investors....

In addition to my previous posts where I indicated why I strongly feel it is not time to be buying bank common stocks, you can read some additional very valid points from the excellent David Goldman here - One More Time: Why You’re STILL Not Supposed to Buy Bank Common Stocks.

Or you can disregard my comments and agree with Otto Waser, chief investment officer at R&A Research & Asset Management AG, who made recommendations to buy Wells Fargo and JP Morgan stocks on the 8th of June as reported by Bloomberg.

But Otto, you might want to look at this bloomberg article:

Maiden Lane Sales Trigger Stampede to Dump Risk: Credit Markets

"Default swaps on the six largest U.S. banks have gained an average of 19.4 basis points to 137.2 basis points since May 31, according to data provider CMA".

It is still "Risk-Off"...

"the more it changes, the more it's the same thing" - Review of the ongoing economic issues

"plus ça change, plus c'est la même chose"—"

Jean-Baptiste Alphonse Karr (November 24, 1808 – September 29, 1890)
French critic, journalist, and novelist.

Ireland 10 year bonds are trading now north of 10% for the first time since December 1992.
As I previously posted, we are in a time machine and just made a quick trip to the past:

European Government Bonds - Back to the Future?
"From 1991 until 2010 Ireland's Government Bond Yield for 10 Year Notes averaged 5.72 percent reaching an historical high of 10.47 percent in December of 1992 and a record low of 3.06 percent in September of 2005."

The yield on Ireland’s two-year securities rose 57 basis points to 10.44 percent. The 10-year yield exceeded 10 percent for the first time since the euro was introduced in 1999.

The problems is that the Irish financial sector troubles are just too big now for the Irish Government to cope with.

According to a recent article in Bloomberg by Joe Brennan published on March 18, "Ireland Said to Weigh Allowing Banks to Set Up Asset Warehouse"
Ireland is finally giving in setting up an Irish "Resolution Trust Corporation".
Joe Brennan commented:

"Irish authorities are considering allowing the country’s debt-laden lenders to set up a company to warehouse more than 60 billion euros ($84.8 billion) of loans that would be wound down or sold over time, according to three people familiar with the matter."

The reality behind this move is that the deposit outflows experienced by Irish banks since last year is making them increasingly dependant on funding from the ECB.
From the same article:
"Irish central bank Governor Patrick Honohan said the ECB wanted to accelerate deleveraging, Ireland has “put in the condition of no fire-sale losses because the state cannot afford it,” he said."

On the 31st of March we will get the results from the capital and liquidity stress tests on Irish Banks.

Joe Brennan added:
"So-called viable lenders, including Bank of Ireland Plc, Allied Irish Banks Plc (ALBK), Irish Life & Permanent Plc and EBS Building Society, need to cut their loan-to-deposit ratios to 122.5 percent, “which is acceptable to Europe,” Finance Minister Michael Noonan said March 14. The average loan-to-deposit ratio is currently about 170 percent."

From TBTF (Too Big To Fail) to TBTB (Too Big To Bail)...

Joe Brennan also indicated in Bloomberg news the following sobering fact:
"Irish Credit Bureau Chief Executive Officer Seamus O’Tighearnaigh said that 9.5 percent of loans registered with the company are at least one month in arrears, up from 0.75 percent in 2006, the Sunday Times reported."

The example of Ireland clearly showed the issue, where Ireland's public finances were put in disarray due to the massive bail out need of its financial sector (please see previous posts on that subject: The European Vortex, The Irish Black Hole, Ireland in the need of a lucky Shamrock).

5 years CDS on Portugal stands at 536 bps and Ireland 5 years CDS increased by eight basis points to a seven-week high of 625 bps, according to CMA.

Portugal's government as well is collapsing, given parliament is not willing to bite the bullet and to accept the latest austerity measures proposed by the government. Another EU member bites the dust as I type this latest post. You can expect another bumpy ride in the Eurozone.

The housing hangover issues are still the biggest problems plaguing not only the Irish economy but the US economy as well.

U.S. New-Home Sales fell to the lowest level on record:

Yes indeed, the more it changes, the more it stays the same...

Bank of America CEO Brian T. Moynihan said:
"The problem of delinquent mortgages and falling home values is the most stubborn, entrenched and damaging economic problem our country faces today."
Bank of America's CEO is correct. I touched on the subject of the impact of real estate on the US economy in my post "Extend and Pretend" - Banks bloated balance sheets and the Impact of Real Estate crisis.

January home prices in the U.S. fell 0.3 percent from December, according to the Federal Housing Finance Agency. Prices nationwide fell 3.9 percent in the 12 months ended in January.

So big is the issue that Bank of America had to segregate almost half of its mortgages Into ‘Bad Bank’ according to Bloomberg report from Dawn Kopecki published on the 8th of March:

"The legacy portfolio will hold 6.7 million loans with outstanding principal balance of about $1 trillion."

"Of the 13.9 million loans Bank of America services, about 3.5 million are held by the company on its balance sheet. The rest are owned by other investors."

Reminder:
"Bank of America services 14 million mortgages, or one out of every five in the U.S., and its loan-servicing portfolio exceeds $2.1 trillion in size. Of its mortgages, 10 million came from its 2008 acquisition of troubled California lender Countrywide Financial Corp. More than 80% of its delinquent loans were acquired through Countrywide."

Bank of America is also actively selling its exposure to commercial real estate:
BofA Is a ‘Very Active’ Seller of Commercial Real Estate to Limit Losses
The US Treasury is as well reducing its portfolio of Mortgage Backed Securities, looking at selling 142 billion USD worth of MBS guaranteed by Fannie Mae and Freddie Mac at the tune of 10 billion per month.

As I wrote in "Resolution Trust Corporation II - the unavoidable Sequel", 1 out of 4 US Household is already in negative equity, "Desperate times need decisive action and setting up a new RTC would definitely be the right move in the right direction".

For more on the difficult situation for the US economy and the impact of households in negative equity please look at the following post:

The end of the American Dream, the call for trade barriers and the rise in populism...

So far 25 banks failed in the US in 2011. 157 banks failed in 2010 according to FDIC. Increasing loan losses on commercial real estate are expected to result in hundreds of bank failures in the coming years.
The Unofficial Problem Bank list on the 19th of March stands at 982 institutions with assets of 430.4 billion USD, up from 964 institutions with assets of 420.7 billion USD as per the excellent CalculatedRisk blog.

For Robert Burney, a banking and finance professor at Coastal Carolina University:
"It's a race between deteriorating portfolios and recovering economies,"
Read more: http://www.thesunnews.com/2011/03/20/2047287/undercapitalized-banks-struggling.html#ixzz1HRrvO1fK

The US need more job creation but negative equity weights heavily on job mobility:
Non Farm Payrolls from 1992 onwards.

At the same time inflation in the UK keeps creeping up, no surprise there. It was expected previously on numerous posts on this blog.

UK inflation from January 1989 until March 2011:

Mervyn King at the Bank of England doesn't seem to be able to keep the ink dry, yet another letter to the Chancellor.

The Bank of England purchased around 165 billion GBP of assets by September 2009 and around 175 GBP billion of assets by end of October 2010.

Any coincidence with the rise in inflation in the UK is of course purely fortuitous given QE started in March 2009...

As a reminder of the risk of QE:
"Quantitative easing may cause higher inflation than desired if it is improperly used, and too much money is created. It can fail if banks are still reluctant to lend money to small business and households in order to spur demands. Quantitative easing can effectively ease the process of deleveraging as it lowers yields. But in the context of a global economy, lower interest rates may contribute to asset bubbles in other economies."

Consumer confidence in the UK is still at the lower end:
January 1992 - March 2011

Are we seeing asset bubbles in other economies? China? Brasil? Etc.
Most certainly. QE is exporting inflation first in emerging markets then back to developped countries:

Both the UK economy and the US economy are in "The Hurt Locker".

As a reminder from previous post The Endgame - Fin de partie:

Inflation, Not Deflation, Mr. Bernanke
By Andy Xie 08.16.2010 18:12

http://english.caing.com/2010-08-16/100171139.html
"The globalization reality is that developed economies like Europe, Japan, and the U.S. will suffer slow growth and high unemployment. Stimulus is the wrong medicine for solving problems. Believing this will lead to excessive stimulus, which causes inflation and bubbles in emerging economies first and inflation in developed economies later. The wrong policy prescription pushes the global economy through unnecessary gyrations, stagflation and possibly another major financial crisis in the emerging economies. It's high time for Mr. Bernanke to wake up from his stimulus obsession."

Can we expect QE3?

Bye bye Irish Bank debt...

On the 26th of November:
Irish Banks CDS still getting crushed...

Allied Irish Banks Plc Senior 5 year : 1354 bps, wider by +213 bps, +18.75%.
Allied Irish Banks Plc (SUB)5 year : 5042 bps, wider by a cool 982 bps, +24.19%.
Bank of Ireland Senior 5 year : 989 bps, wider by +167 bps, +20.32%.
Bank of Ireland (SUB) 5 year: 2330 bps, wider by +339 bps, +17.07%.

http://www.cmavision.com/market-data/

The European Vortex

It looks like the European Financial Stability Facility is going to be triggered early to help out Zombie Ireland.

The issue is that, following Ireland, there is Portugal and then Spain to take care of.

There is 440 Billions Euros available (probably less given its similar resemblance to a CDO structure). Clearly not enough to bail out everyone. If the EFSF wants a AAA to issue bonds to fund the oncoming bailouts, it will need to overcollateralize to 120% and maintain a cash buffer. It cannot lend against backing of troubled nations. The more countries in trouble, the smaller the pot available for bailing out countries in trouble, simple as that. Given Austria is witholding already its funding for Greece, the entire unity of the European Union is being tested.

For more explaination about the weakness of the EFSF, you can read the excellent article written by Tracy Alloway in FT Alphaville, published on the 27th of September as well as the post by Dr. Constantin Gurdgiev in the link below:


http://ftalphaville.ft.com/blog/2010/09/27/353176/europes-spv-really-is-not-saving-anything/


http://trueeconomics.blogspot.com/2010/11/economics-131110-efsf-ireland-and.html


The EFSF game is well summarised by Dr. Constantin Gurdgiev:

"Now, any sovereign with an once of sense now will know that a race to tap EFSF is on. The faster you get to it to borrow from it, the more likely you’ll arrive to the borrowing window before the limits are reached. Portugal, Spain and possibly even Italy are in the race.

This is why the markets have never been easy about the entire EFSF – they know that Ireland tapping into EFSF simply does two things:

It delays the inevitable restructuring of the massive debts accumulated on the Irish economy side – either sovereign or banks or households or any two or all three. EFSF does not remove the need for such a restructuring. It simply delays it.
It signifies an exponential increase in the probability of EFSF acting as a conduit for contagion from the PIIGS to the rest of the Euro area."

European politicians are trying all they can to kick the can down the road with the EFSF. The "only" major issue is that they are running out of road. Structural issues have not been addressed.

The problem for Ireland, has I discussed in my last post is that its financial sector is damaged beyond repair and need additional support. Currently Irish banks are heavily depending on the ECB for their funding, they are indeed truly zombie banks. The issue is that it is such a black hole for Ireland's public finances, that some external support is necessary. As for Iceland, the Irish banks where too big to fail for the country, hence an estimated budget deficit of 32% for 2010.

On the 17th of November Allied Irish Banks Plc (SUB)was trading at 2568 bps, +405 bps on the day, a 18.76% widening...

Ireland faces the same issue than Iceland did in relation to its banking sector. It did not kept its banking sector under scrutiny and now the whole banking sector is taking the country with it in its downfall.

Analyze this

Allied Irish CDS Sub, you know the score from the previous post (Source CMA DataVision):



Anglo Irish CDS Sub on the 6th of October, can you spell default? (Source CMA DataVision):



and on the 7th of October, this is how it looks like for Anglo Irish Sub...2743.85 bps on the 5 year CDS...300 bps wider!



Debase this! Check out the evolution of the USD since 1971 against:

Japanese Yen:



Have a look at 1985 on the Graph and the huge rise in the Japanese yen following the 1985 Plaza Agreements which spelt economic disaster for Japan and the crash of the Japanese economy and the Nikkei index at the same time. 1985 to 1990, 240 to 120, bring it!

At around 82 JPY per USD I don't expect the BOJ to stay idle...

Swiss Franc:



and the evolution of the US dollar versus the Euro since 1999:



An interesting view of the evolution of Fed Funds Rate since 1950:



And the evolution of Oil prices since 1940:



Gold is continuing its steady rise:



At the same time we have Secretary of Treasury Timothy F. Geithner still gesticulating around China and the ongoing Debasing game taking place. Pathetic...

http://www.treasury.gov/press/releases/tg894.htm

"The Framework, called the "Framework for Strong, Sustainable and Balanced Growth," was designed to create stronger incentives for rebalancing growth, as the world recovered from the crisis, with higher savings in countries like the United States, complemented by reforms to strengthen domestic demand in surplus countries like China, other emerging economies, Germany, and Japan.

Alongside this "Framework" we agreed to give emerging economies a greater stake in the most important institutions for economic and financial cooperation, to increase the resources available to the international financial institutions, and to make the G-20 the centerpiece of cooperation, replacing the role traditionally played by the G-7."

Dear Tim, I don't think you have a choice in relation "to give emerging economies a greater stake in the most important institutions for economic and financial cooperation." Guess it is a done deal with China, India and Brasil...

"We have moved aggressively to do our part to help bring the world out of crisis. We are working very hard to repair our financial system, to fix what was broken, and to reduce the future risk of financial crises here at home. We have seen a very significant increase in private savings by households. Our external deficit has fallen sharply, and we are financing at home a much larger share of the fiscal deficits we inherited."

Wow!
Who in the first place put us ALL in this mess? Was letting Lehman Brothers going down a wise decision? I don't think so. In relation to reducing the future risk of financial crisis, I disagree, banks are still too big to fail. Fannie Mae and Freddie Mac are a joke and should be gradually winded down. The commercial real estate disaster is still an ongoing concern: 129 banks down this year so far and counting.

Hey Tim, where were you working before taking up the role of Secretary of the Treasury? Weren't you president of the New-York Fed from 2003? Were you not in charge of supervising and regulating financial institutions? Great work!
In May 2007, did you not work on reducing the capital needed to run a bank? Great timing! Was the "excellent" Lawrence Summers your mentor previously? It would explain a lot...

Nice one Tim, just like you tried to talk to the Chinese about how safe it was to invest in the US...
"On June 1, 2009, during a question-and-answer session following a speech at Peking University, Geithner was asked by a student whether Chinese investments in U.S. Treasury debt were safe. His reply that they were "very safe" drew laughter from the audience."



Tim, you can always send your CV to your buddy Hank Paulson, I am sure he can help you land a good job at Goldman Sachs...

Tim also added in the same speech:
"That brings me to the second policy challenge: we believe it is very important to see more progress by the major emerging economies to more flexible, more market-oriented exchange rate systems. This is particularly important for those countries whose currencies are significantly undervalued.

This is a problem because when large economies with undervalued exchange rates act to keep the currency from appreciating, that encourages other countries to do the same.

This sets off a damaging dynamic, described first by my former colleague Ted Truman, as "competitive non appreciation." Over time, more and more countries face stronger pressure to lean against the market forces pushing up the value of their currencies. The collective impact of this behavior risks either causing inflation and asset bubbles in emerging economies, or else depressing consumption growth and intensifying short-term distortions in favor of exports.

This is a multilateral problem. It is unfair to countries that were already running more flexible regimes and let their currencies appreciate. And it requires a cooperative approach to solve, because emerging economies individually will be less likely to move, unless they are confident other countries would move with them.

This problem exposes once again the need for an effective multilateral mechanism to encourage economies running current account surpluses to abandon export-oriented policies, let their currencies appreciate, and strengthen domestic demand."

The message is that the US is concerned that everyone is devaluating at the same time and they would like to be the only one playing this game to restore competitiveness. Tim would also love China to explode like Japan did after the 1985 Plaza Agreement. Unfortunately, dear Tim, Chinese are not stupid and are well aware of the risks. If the US hadn't based 70% of its GDP on Consumption and was actually producing more and exporting more, they would not be in such a difficult situation.

Zombieland 2...The sequel...

Welcome to Zombieland 2, the Sequel !!!

The latest trailer featuring:

Zombie banks, zombie hotels, zombie rates, zombie returns and brainless politicians...



What is a zombie bank:

http://en.wikipedia.org/wiki/Zombie_bank

A zombie bank is a financial institution that has an economic net worth less than zero but continues to operate because its ability to repay its debts is shored up by implicit or explicit government credit support. The term was first used by Edward Kane in 1987 to explain the dangers of tolerating a large number of insolvent savings and loan associations and applied to the emerging Japanese crisis in 1993. Zombie institutions face runs by uninsured depositors and margin calls from counterparties in derivatives transactions

We had zombie banks now we have zombie hotels, like in Ireland for example:

http://noir.bloomberg.com/apps/news?pid=20601109&sid=aOKhxHd4Zk5c&pos=15

"At least 200 hotels opened during Ireland’s decade-long economic boom, leaving a glut of rooms and mountain of debt as the number of visitors dwindles. While some establishments cut their losses and shut, others are lowering prices to stay in business and avoid repaying tax breaks if they were to close.

Irish hotel occupancy slumped to about 54 percent in 2009, the lowest level since the early 1980s, as the economy fell into its worst recession on record, the hotels federation said. In 2007, the height of Ireland’s boom, the figure was 64 percent.

The numbers of trips to Ireland fell 20 percent in the two years through June 2010, the Central Statistics Office said on Aug. 27. Hotels have almost 7 billion euros ($9 billion) in bank borrowings, equivalent to about 111,000 euros per bedroom, according to figures from the industry group.

Sixty percent of hotel loans at Allied Irish Banks Plc, the country’s second-largest lender, are classed as “criticized,” either closely watched or in trouble, Managing Director Colm Doherty said Aug. 4. Britain’s Lloyds Banking Group Plc, among the biggest lenders to Irish hotels, said this month it’s pulling out of Ireland."

Ireland’s National Asset Management Agency, created by the government to purge banks of risky real-estate loans, has taken control of 48 loans secured on hotels. In the latest batch of loans, hotels accounted for 23 percent of the assets bought by the agency.

“The big problem that the industry faces at the moment is that banks are keeping hotels open that would not normally survive,” said Charlie Sheil, manager at Dublin’s four-star Gibson Hotel. “They are being propped up by the banks, which is causing major damage to a lot of the good hotels.”

And this is what happens in a zombie economy suffering from acute deflation.

The Irish banking system is indeed a very big black hole:

http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=axTNh79dJBPk

“Anglo Irish has proved to be an even larger black hole than anyone imagined,” said Bill Blain, joint head of fixed income at Matrix Group in London. “There are worries that the cost of banking recapitalization is now beyond the reach of the government.”

http://www.businessweek.com/news/2010-08-30/irish-bank-recapitalization-may-cost-eu39-9-billion-glas-says.html

"Aug. 30 (Bloomberg) -- Ireland’s bank recapitalization may cost a total of 39.9 billion euros, acccording to fixed-income specialist Glas Securities.

A total cost of 39.9 billion euros is a “reasonable forecast,” Dublin-based Glas said in a research note today. The final net cost to the government will probably be 32.9 billion euros after 7 billion euros invested in Bank of Ireland Plc and Allied Irish Banks Plc is recouped."

Allied Irish Bank this month reported a record loss for the first half, losing 2.03 billions Euros over 6 months largely as a result of continued losses on its lending on Irish real estate...and Anglo Irish a whooping 8.2 billions Euros.

Total support for Anglo Irish amounts to 22.9 billions Euros so far and will cost 25 billions to the Irish taxpayers according to its CEO Mr Aynsley but S&P put the figure at 35 billions Euros.

http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/7973829/Anglo-Irish-set-to-cost-taxpayer-25bn.html

"Yesterday's results also revealed that:

More state cash may be needed, depending on the discount placed on future loans going to NAMA.
About €600m of loans that went into NAMA are worthless as they were secured on nothing more than personal guarantees.
Deposits of €5.5bn have flowed out of the bank in just six months, with the turnover cut in half.
The bank gave €1.1bn of fresh working capital to developers to finish off schemes and developments.
It expects to be forced to take over more struggling businesses, like Arnotts, in Ireland, but also in the US."

Zombie banks often have a large amount of nonperforming assets on their balance sheets which make future earnings very unpredictable...ouch...



This year, Ireland budget deficit will amount to around 29% of GDP...



To conclude, please find below's an extracted comment from Brendan Brown, chief economist at Mitsubishi UFJ Securities International Plc, from a Bloomberg article:

http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aWVk5qjMUYn4

"The biggest danger for European monetary stability is that the ECB pins interest rates near zero for too long. As the world economy rebounds, say, into 2011-12, the ECB will have its eyes on those mega-billions it lent to zombie banks and sovereigns. A significant increase in key money-market rates may be the trigger for an even more threatening round of credit quakes."

AAA, the most endangered rating, regulating the rating agencies and Basel III

This title sounds like a warning issued from the WWF, relating to endangered species. Truth is the coveted AAA rating ranks have been seriously depleted by the past and current credit crisis we have been through. We will look at what happened in the corporate sector and as well in the sovereign space as well as the role of the rating agencies given the recent turmoils and scandals, regulations and Basel III implications.

Given the latest downgrade of Spain from AAA to AA+ is the latest in an increasing list given the current deflationary environment and credit situation in Europe, we can expect many more downgrades to come.

First we will look at the decline of AAA ratings in the corporate world:

The link below refers to an article which was published in 2002.

1969: 61 American Companies were AAA
1982: 21 American Companies were AAA
2002: 9 American Companies were AAA
2009: 4 American Companies were AAA

As of October 2009 only 4 remains rated AAA by S&P:

Automatic Data Processing (NYSE:ADP)
Johnson & Johnson (NYSE:JNJ)
Microsoft (NASDAQ:MSFT)
ExxonMobil (NYSE:XOM)


http://articles.sfgate.com/2002-03-03/business/17537097_1_credit-ratings-major-rating-agencies-moody-cash-flows

In 1979, there were 61 American companies that earned a top-level Aaa credit rating from Moody's. Ten years ago, there were 21. Today, there are only nine.

The decline in triple-A-rated companies is one of the most obvious -- though hardly the most worrisome -- sign of a widespread decline in credit quality.

"Corporate America has become more risky," says James Van Horne, a finance professor at Stanford's Graduate School of Business. "The triple-A decline is a manifestation of the decay of credit ratings in general."

In the same article, Kathleen Pender also review the list of AAA corporate entities in 2002:

The bankruptcies of Enron, Kmart and Global Crossing are refocusing attention on credit ratings and balance sheets.

"We've always focused on the balance sheet. In this environment, we've been even more focused," says Scott Glasser, co-manager of the Smith Barney Appreciation fund.

Glasser's top 10 holdings include five Aaa-rated companies: Berkshire Hathaway, ExxonMobil, General Electric, Pfizer and American International Group.

The other four Aaa-rated companies (excluding government-backed companies such as Fannie Mae) are Bristol-Myers Squibb, Johnson & Johnson, Merck and United Parcel Service.

In 1979, Moody's list of Aaa companies included 12 banks and insurance companies, such as Bank of America, Chase Manhattan, Chemical Bank and Citicorp.

It also included 25 industrial and consumer-oriented companies, such as Minnesota Mining & Manufacturing, General Motors, Ford, IBM, DuPont, Kellogg, Procter & Gamble, Sears Roebuck, Federated Department Stores and the major oil companies.

The remaining 24 companies were telephone and electric and gas utilities.

"The '80s really gutted the list," says Moody's economist Kamalesh Rao.

We all know what happened to the AAA for banks as well as for GM, Ford and we all know the dire situation of Fannie Mae, Freddie Mac and SLM.

From the same article:

"The major reasons cited for the decline in triple-A companies are deregulation, global competition, debt-financed mergers, bad management decisions and a growing tolerance for risk among investors.

Many banks also got hurt by the collapse of real estate in the early 1990s."

You would think the banks would have learnt from the real estate collapse in the early 1990s following the Savings and Loans debacle.

Does that sound familiar? We are talking about the economic environment of 2002...

The article goes on:

"Money managers are not too worried about the long-term decline in Aaa companies, mainly because the difference between a triple-A and a double-A company is slight.

They're far more concerned about a recent, widespread decline in ratings across the credit spectrum.

"You could do a story on the demise of double-A and single-A companies as well," says Putterman."

http://stocks.investopedia.com/stock-analysis/2009/the-aaa-rated-bond-club-gets-smaller-gexommsft0305.aspx

It is true the reputation of the ratings agencies have been seriously tarnished in the last two years given the evident conflict of interest which came with the business of providing AAA rating to dubious structured credit products.

This is what Bill Gross from PIMCO had to say about the rating agencies and discussion around reforms of their model:

http://www.guardian.co.uk/business/2010/jun/02/european-union-credit-agency-watchdog

"Credit rating agencies have fallen out of favour with top investors. Bill Gross, founder of Pimco, the world's biggest bond investor, recently said: "Their quantitative models appeared to have a Mensa-like IQ of at least 160, but their common sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply it."

He added: "I come not to bury the rating services, but to dismiss them. To tell the truth, they can't really die – they serve a necessary and even productive purpose when properly managed and more tightly regulated.""

Truth is all the concerns regarding regulating the ratings agencies were previously discussed and not applied by many authors and Scholars. Below is an example of previous discussions surrounding regulation of rating agencies.


Claire Hill in a paper published in 2004 called Regulating the Rating Agencies

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=452022

"Less promising are suggestions to begin substantive oversight of rating agency business operations, and to increase the ability of investors and others to sue rating agencies. Finally, conflicts of interest may become a significant problem, especially if the market becomes much less concentrated - an annual certification by rating agencies that they are operating in accordance with procedures to guard against conflicts may be desirable."

The only way to restore trust in ratings, is to remove conflicts of interest which means not an annual certification as suggested above but a review in the way rating agencies operate.
There was a similar issue with Equity Research Analysts during the run up to the Technology bust in 2000. Henry Blodget was barred from the securities industry because of fraudulent activity.

The only way to regulate is to impose accountability to the Rating Agencies, ensuring the risks twart the rewards. If ratings agencies face losing the license of conducting business due to high conflict of interests similar to what we have seen during the build up to the credit crisis, they might do a better job and serve their necessary purpose of independent assessment of credit risk.

Although credit ratings can be a good indicator in measuring the risk of a corporate or country, they always lag the market. Credit spreads and Credit Default Swap (CDS)spreads are better at indicating increased perceived credit risk in issuers.

The implication of ratings downgrade are very important in relation to assessing the risk for financial institutions, when taking into account Basel II regulation. This was particularly the case for structured credit positions in Banks.

http://en.wikipedia.org/wiki/Credit_rating_agency

"Basel II agreements meant that CDOs capital requirement rose 'exponentially'. This made CDO portfolios vulnerable to multiple downgrades, essentially precipitating a large margin call. For example under Basel II, a AAA rated securitization requires capital allocation of only 0.6%, a BBB requires 4.8%, a BB requires 34%, whilst a BB(-) securitization requires a 52% allocation."

Because of the need for independent assessment of credit risk, Rating Agencies must be regulated in a way that the ratings which are issued enable investors to trust these ratings and use them as a guidance in their investment.

As well as reviewing the role played by the rating agencies in the financial crisis, it is essential that bank regulation takes place.

Basel III proposed reforms are going in the right direction:

http://en.wikipedia.org/wiki/Basel_III

The introduction of a leverage ratio is essential to avoid the same mistakes which were done. The Canadian banking system had the leverage capped to around 20 times which meant that the Canadian Banks were in a much better situation than their American neighbours when the financial crisis occurred.

The idea of also promoting the build up of capital buffers in good times, is also a very good one.

There is great resistance from the bank to fully implement Basel III as indicated in this article from The Economist:

http://www.economist.com/business-finance/displaystory.cfm?story_id=16231434

If the same idea of capital buffer could be implemented for goverments in relation to public finances, it would be great but given the propensity of our politicians to overspend in good times as well as in bad times, there is a very low probability of seeing it happen effectively.