The Celtic Chimera

(fist published on Benzinga.com)

I’m writing from the scene of the first Kilkenomics Festival, which brings together finance experts and professional comics to try to answer the public’s questions about why the world is suffering recurrent, intensifying financial crises, why Ireland has gone to the heights and crashed spectacularly, and what options does it have that other nations in crisis have used successfully.

David McWilliams, an Irish economist, and Richard Cook the man that started the Kilkenny comedy festival (Cat Laughs) decided to create an economics festival with sessions run by professional comedians questioning the economists. This is an utterly bizarre idea, so I accepted immediately. It turns out that professional Irish comics are every bit as quick and well read as you would have guessed by extrapolating from what you see on Jon Stewart’s Daily Show. (Irish angst and Jewish angst bear a strong resemblance.) There’s a long European tradition of the “fool” being able to mock the pretentious and powerful and bring out the truth. Talking to the comics and answering their questions forces us to speak clearly and bluntly – or be skewered. The public love it (both parts – getting clear answers to their questions or watching the comics skewer us) and the roughly 20 events have been sold out.

Ireland was known as the “Celtic Tiger.” It shot to economic fame. From the poor man of Northern Europe, it was transformed into a nation with a reported per capita GDP equivalent to that of the United States. The old, true, and painful joke: “What’s Ireland leading export?” (Answer: “the Irish”) was reversed as people began to move to Ireland.

Unfortunately, the Celtic Tiger was ultimately revealed to be a Celtic Chimera. Irish bank supervision was so weak and Ireland’s banks so wild and crazy that the New York Times called Ireland the new “Wild West.” Ireland’s largest banks hyper-inflated twin bubbles in commercial and residential real estate. They grew massively. Fortunately, Lehman failed and the Irish banks’ ability to grow collapsed – which meant that the bubbles imploded in late 2008. Had it not done so, the Irish banks would have continued their staggering growth and caused almost incomprehensible losses (relative to the size of the Irish economy) when the (vastly larger) bubbles finally collapsed.

Anglo Irish Bank was merely the worst an awful collection of large Irish banks. The Irish entity disposing of the Irish banks’ bad assets is now estimating 70% losses on Anglo’s (copious) bad assets. That percentage loss estimate is, bizarrely, mandated to be as of a year ago even though property values have fallen significantly since that date and are expected to continue to decline next year. Non-linear increases in losses are common when a bubble hyper-inflates. Therefore, any estimate of the increased losses that would have resulted had the collapse of the Irish bubbles come two years later should assume percentage losses on the new assets of well above 75%. The size of Irish bank losses that the Irish government claims its taxpayers should bear is contested, but has a lower bound of roughly 60 billion Euros. Had Dick Fuld’s avaricious heart not led to Lehman’s collapse, or had Treasury bailed out Lehman and prevented (delayed) its failure, Ireland (and Iceland) would have collapsed as nations. If their banks had continued their growth for even two more years, Ireland and Iceland’s per capita debts would have been so staggering (in the range of $50,000) that they would have sparked massive emigration, which would have pushed the per capita debt even higher. Both nations would now be occupied almost entirely by pensioners and non-nationals.

The economists and finance practitioners that presented at the Kilkenomics Festival came from diverse streams of economic and political views. They, nevertheless, agreed on three points about the Irish crisis: (1) it was insane for the Irish government to provide and extend unlimited financial guarantees of virtually all debts of the failed Irish banks, (2) the Irish government had transformed a private banking crisis into a sovereign debt and budgetary crisis that imperiled Ireland’s recovery from the economic crisis and gravely stressed the EU and the Euro, and (3) that either the EU or IMF would bail out Ireland or Ireland would default.

I’m going to write a series of columns about what I’ve learned by examining the Irish and Icelandic crises. I urge readers to take these two small islands’ experience seriously for at least five reasons. First, one of the key analytical issues has long been which flashpoint would spark the next stage in the ongoing, global financial crises. The leading candidates have been the EU periphery and the collapse of the still-growing Chinese bubbles. (Of course, they may occur simultaneously or the first crisis may quickly trigger the second.) Europe now looks like it will win the “next crisis” race. (I believe that the European Union (EU) is rich enough to paper over the crisis for several years, but European politics could scuttle that effort.)

Second, the EU is set up in a fashion that creates strong, perverse incentives for future financial crises. Third, the EU is set up in a fashion that is periodically strongly criminogenic in particular nations. These criminogenic environments will feed future epidemics of “accounting control fraud” – the leading cause of severe financial crises. Massive amounts of European money will move to fund these frauds, which will cause financial bubbles to hyper-inflate and produce catastrophic banking losses and severe recessions.

Fourth, the EU is set up in a manner that makes it extremely difficult (and expensive) to attempt to respond to the severe recessions and debt crises that these perverse incentives generate. The EU “channels” IMF’s “let’s turn a financial crisis into a crisis of the real economy” strategy.

Fifth, the Irish government’s response to their epidemic of fraudulent lending has been so exquisitely awful that it (A) demonstrates the catastrophic costs of deregulation, desupervision, and deifying finance, and (B) allows one to illustrate why it is essential to combine good analytics, skepticism, courage, and integrity in responding to such epidemics.

One of the independent reports that the Irish government commissioned about the banking crisis was co-authored by Professor Karl Whelan of University College Dublin. That report has received moderate attention and I will discuss it in more detail in future posts. Professor Whelan, however, has provided a far more candid briefing paper for the European Parliament: “The Future for Eurozone Financial Stability Policy” (September 2010). His briefing paper makes clear why there will be an EU bailout of the Irish banks. One of his key conclusions is that sovereign defaults by EU nations are likely and that the EU must prepare now to deal with them. That fundamental candor is matched by his explanation for why the EU created a bailout fund earlier in 2010.

“While the public discussion of this decision has largely focused on the idea that the agreement was aimed at preserving the Euro as the common currency, the truth was more prosaic: The European banking system was already in a fragile state and would not have coped with a series of sovereign defaults. The need to maintain financial stability, specifically banking sector stability, was what prompted the unprecedented announcement of the bailout funds.”

“The health of the European banking system remains in question. The most likely trigger for sovereign defaults in the next few years is a prolonged period of slow growth or perhaps a double-dip recession.”

Whelan is trying to make clear the great underreported fact of the Irish banking crisis – the broader EU banking crisis. (And, while Whelan does not emphasize this point, his discussion inherently means that there was a horrific failure of EU banking regulation.) He explains that the European “stress tests” were farcical because they assumed no sovereign defaults could occur and ignored all market value losses on the banks’ “held for investment” exposures to sovereign risk. He cites the OECD study that discussed these massive loss exposures. The OECD emphasized that the losses were lumpy.

“Large cross-border exposures (defined as an exposure above 5% of Tier 1 capital) to Greece are present for Germany, France, Belgium (all with systemically important banks), Cyprus and Portugal. Large exposures to Portugal are present in Germany and Belgium; to Spain in Germany and Belgium; to Italy in Germany, France, Netherlands, Belgium, Luxembourg, Austria and Portugal; and to Ireland in Germany and Cyprus.”

The alert reader will have noted the nation whose banks have large, unrecognized losses on debt among each of the PIIGS – Germany. German banks acted like drunken “Girls Gone Wild” as soon as they were approached by a foreign borrower. Germany’s Banks Gone Wild were hooked on yield – for a trivial increase in yield, without any meaningful due diligence, they made massive unsecured loans to many of the most fraudulent borrowers throughout Europe. Borrowers engaged in control fraud have two great attractions for bankers gone wild – they typically report extreme profitability (which makes them appear to be creditworthy to the credulous) and they are willing to promise to pay higher interest rates). Their promises, of course, have all the reliability of the producers’ of “Girls Gone Wild” promises that the girls will be able to launch a film career if they shed their clothes.

Where were the German banking regulators? They seem to have believed that “What happens in Vegas (Dublin) stays in Vegas (Dublin).” Instead, their German banks came back from their riotous holidays in the PIIGS with BTDs (bank transmitted diseases). The German banks’ regulators continue to let them hide the embarrassing losses they picked up on holiday, but that cover up will collapse if any of the PIIGS default. The PIIGS will default if the EU does not bail them out, so there will be a bail out even though the German taxpayers hate to fund bailouts.

All of this should put a very different interpretation on Chancellor Merkel’s insistence on unsecured creditors suffering losses when they lend to banks that fail. She has argued that it is essential that they suffer losses so that they will have the proper incentives to provide effective “private market discipline” and that it is fair that they suffer losses given the premium yields they received and their lack of due diligence. German banks would be the primary losers under her proposal, so her position is remarkable. She is apparently disgusted with the German “banks gone wild” that were the largest funders of the accounting control frauds that drove several of the epicenters of the European financial crises and helped push Europe into the Great Recession.