What's that rising in the (Y)east? part II

This is part II of this post, if you have not read part I you can find it here

So we left yesterday’s blog asking

1. What if the status quo takes a turn for the worse?

2. Who will pay for any shortfall in capital?

The first question is something that the Irish government doesn’t want to think about. However we can say with 'some certainty' that the Irish property market has 'probably' hit the bottom - or at least, we can cross or fingers and pray that it has. In Dublin the prices are rising again, and nationally we are very close to rock bottom. The drop from the peak has been 50%, but remember, not all houses were bought at the peak, so the value of the houses with mortgages remaining on them – and taken out pre-crash - are in negative equity to the tune of between 0-50%. We can say with some certainty that writing off 50% of the value of Irish loans is a conservative measure – aka is close to a worst case scenario. Hence, the capital against the Irish loans should be sufficient. Yet, what about the British loans? Remember, everyone is assuming that they will not suffer any significant losses.

At the moment the British loans are performing largely as expected, their rates of default are within normal levels and therefore no extra emergency capital is required for them. In London - where I believe the majority of these loans were made – the value of property has risen above pre-crisis levels, meaning there is a good chunk of equity in place as a cushion. This means that if a borrower in London gets in trouble the bank can foreclose and sell the property, without taking a loss on the transaction. This is definitely a positive.

Much of the UK loan book has been put on the block, or will be put on the block in the coming years. As the loans are performing, the banks should recoup the full or close to the full value of the loan, and will be able to walk away without any major loss. Over time then, the Irish banks can shrink their loan books to circa 150 billion, a more sustainable amount.

The problem is that London is in the midst of a rapidly inflating housing market. To some – and Mark Carney the Governor of the Bank of England is not one of these – this is a property bubble pure and simple. David McWilliams - who predicted the Irish crash – had a piece in the Irish Independent recently, where he made the case for this. Credit has risen 6% in the past year alone in the UK, and central London house prices have risen by 11.5% this year, and are forecasted to rise another 8% next year.

This property bubble is unusual in that some people are convinced that it is a bubble and others - mainly the people who are actually buying the houses, as well as most regulators - are convinced that it’s not, or have not factored this into their thinking. Those who are asked about the housing market, say that they feel buying now is a good investment, as they believe prices will only rise in the future. Further to this, the issue of affordabillity has been debated to a large extent in the media, yet seems to have made no impact on the pysche of the people who are buying the properties. No one ever knows when a bubble will burst so this could have some legs in it yet. It may even be that there is no bubble here, yet history would seem to suggest otherwise.

Let's assume that there is a bubble and at some point it will burst. If at this point, the Irish banks are still sitting on 50 billion of UK loans, we will know all about it very very quickly.  The chalice will turn out to be a poison one and guess who will foot the bill?

Well doesn’t that lead me nicely into question 2….Who will pick up the tab for any further capital needed by our banks?

There are essentially 4 and a bit options here

1. The bank raises the extra capital needed on the capital markets - highly unlikely.

2. If one bank is especially exposed to Britain it could be merged with a 'stronger bank' - also highly unlikely as no Irish bank is in a strong enough position to save another.

3. The government steps in again - More likely although there would be massive resistance from the public, the government would probably fall and we would just end up needing another bailout.

4. The European Stability Mechanism (ESM) directly re capitalises the bank(s) and takes a stake in said bank(s), or it puts the burden on the government in what essentially would be another bailout.

As options 1 and 2 are unlikely I will ignore these and look at 3 and 4.

Option 3 - Enda the White Knight

If we are using the same method as we used for the Irish loans, the capital shortfall for the UK would be somewhere in the region of 25 billion. Our national debt currently stands at 200 billion and rising vs a GDP of circa 160 billion. Factoring in another 25 billion - a whopping 15% of GDP - seems like an event that the markets would not take kindly too. Most commentators would tell you that Ireland is on the edge at the current levels of debt, and an extra 25 billion would almost certainly push us over.

Option 4 - Germany, eh I mean Europe to the rescue

If everyone in Europe can agree - highly unlikely given what has gone before - that Ireland can shoulder no more debt, then the Europe wide ESM would have to kick in. This would be deeply unpopular in countries like Germany and Finland where voters are against any sort of debt mutualisation or write down. They may not have any choice however, Ireland has been the poster boy of Europe and of all the countries that have been bailed out, Ireland looks the most likely to succeed. If Ireland were to falter then the likes of Greece, Italy, Spain, Portugal and Cyprus may decide that the pain is no longer worth it, and could in theory decide to leave the Eurozone.

This if nothing else should spur Germany into action. While German voters may not like the thought of sharing the peripheral countries' debt, the other option of a wide scale default would damage Germany to a far greater extent.

If the Eurozone were to break up, there would be another global recession. The value of the Deutsche Mark (DM) - we must assume that the Euro would cease to exist - would shoot through the roof, as investors looked for a safe haven. German exports would grind to a halt due to the recessions in its trading partners, and the prohibitive cost of its goods caused by the very strong DM. Exports, by the way are the driver of the German economy.

The weaker nations however should in theory thrive - after some initial pain - as they would be able to export very competitively, with their new greatly devalued currencies. This is of course theory and other nations like Argentina, who have defaulted before are still feeling the pain, although this is possibly due to political decisions rather than purely economic factors.

Competitiveness is what the peripherals need more than anything else, they lost their competitiveness during the boom years and the only way back for them is to be able to devalue. Devaluation in a monetary union is a painful process - as we have seen - and there is only so much an electorate will take before they start to look to extremist parties. See the rise of Golden Dawn and Syriza in Greece.

There is another option - call it 4 b - which is still unpopular amongst the Germans, but may be the only answer, and the most palatable to all concerned.

This option is inflation. Inflation can - I stress the word can - be a very useful tool as it makes debt smaller in a real sense. If I owe someone 100 euro and inflation runs at 50% then after one year the amount I owe is only worth 66 euro in today's money. Inflation is a more palatable way to reduce your debt burden, although in theory it is a sort of soft default. Currently Eurozone inflation is running at 0.7% which is considerably lower than the 2% that the ECB is mandated to achieve. Most of the trouble countries are used to high inflation, but the Germans detest it, as it caused them huge issues after WWI during the Weimar Republic. The Germans will have to give ground somewhere though, and this looks like the most likely compromise. An added boon would be that inflation would almost certainly run higher in Germany than the rest of Europe, making Germany less competitive and allowing the peripherals to export more to Germany, rather than the Germans exporting to the peripherals as is the current state of affairs.

I should add that Chris Johns in today's Irish Times argued that while inflation is needed, it will not be allowed to happen. He feels that the peripherals will be forced to continue their painful process of devalutaion. I strongly disagree with this point, while Ireland is starting to look somewhat better, the level of unemployment and especially youth unemployment in Greece and Spain at +25% (general) and +50% (youth) will cause tensions to boil over at some point in the not too distant future. Angela Merkel's CDU party has been voted in for another 5 year term and should have a strong mandate to resolve the Euro crisis once and for all. Germany can push so far but they are running out of room and need to look at new ways of adressing the crisis. 

Inflation is not without it's issues and like everything there are pros and cons, I will discuss this in a future blog, in greater detail.

You have probably noticed that the Germans have the final say in most of European policy decisions. In part III I will look at what the rest of Europe and especially Ireland, should do to stand up to Germany, and make the Euro work for everyone and not just the Germans.