Friday, 26 November 2010 08:47

The BoomBustBlog Contagion Model: How We Predicted 9 Months Ago That The UK and Sweden Would Rush To Bail Out Ireland, and Why

Summary: The BoomBustBlog contagion model easily predicted the actions of the UK and Sweden in aiding Ireland 9 months ago. The model also has some dire predictions for the near future.

Ireland, like several other EMU states, is in a very difficult position. It has built up significant amount of debt on top of a crippled banking system of which it has decided to exchange taxpayer capital for private losses. Like many other EMU nations, it is overbanked, hence is literally dwarfed by both its banking system and the bad assets contained therein (see Erin Gone Broken Bank: The 2nd EMU Nation That Didn’t Need a Bailout Get’s Bailed Out Within Months, Next Up??? November 22nd, 2010).

The ECB, EU, IMF and individual states UK and Sweden (in a bilateral agreement) have agreed to bailout Ireland and its mired banking system. It is interesting to note that there are actually individual countries that have volunteered (out of the goodness of their collective hearts) to assist Ireland outside the collective (UK and Sweden offer over €9bn in bailout loans). The secret of said generosity is in the charts.

As you can see, the UK has little choice but to come to the aid of Ireland, for in reality it is simply coming to its own aid. As a matter of fact, Ireland is so intertwined into the other members of the PIIGS members that its fall (or their fall) literally ignites the contagion effect that we warned is literally a foregone conclusion (Financial Contagion vs. Economic Contagion: Does the Market Underestimate the Effects of the Latter? and Introducing The BoomBustBlog Sovereign Contagion Model).

The European mainstream media sees this obvious motivation on the part of the UK, as this article from the Financial Times demonstrates.

Unlike the UK, Sweden has little direct exposure to Ireland’s crippled financial sector but Mr Borg said it was in the country’s interest to prevent Irish problems spreading to other parts of the eurozone.

“For a country like Sweden, that is so open and dependent on Europe, it is impossible to sit on the sidelines when this kind of risk occurs.”

Mr Borg indicated that Sweden’s contribution to the Irish rescue would be on a similar scale to its participation in earlier bail-outs for Latvia and Iceland – implying a loan of SKr5bn-SKr10bn (€530m-€1.06bn).

Of course, the Swede’s generosity can also be explained by their exposure to their own banking system and that of other countries which Ireland would be forced to destablize, which would be roiled by the activity throughout Europe. If we bring back the original charts from the post Ovebanked, Underfunded, and Overly Optimistic: The New Face of Sovereign Europe

As you can see, Sweden is in the bad assets bank camp as well as Ireland, the UK and Spain. This actually puts them in a rather precarious predicament, but that predicament may not be apparent on its surface (outside of outsized NPAs as a percentage of GDP, of course). This is probably why the European MSM reports such benevolent actions as the FT did, and I repost just for the effect:

Unlike the UK, Sweden has little direct exposure to Ireland’s crippled financial sector but Mr Borg said it was in the country’s interest to prevent Irish problems spreading to other parts of the eurozone.

“For a country like Sweden, that is so open and dependent on Europe, it is impossible to sit on the sidelines when this kind of risk occurs.”

Mr Borg indicated that Sweden’s contribution to the Irish rescue would be on a similar scale to its participation in earlier bail-outs for Latvia and Iceland – implying a loan of SKr5bn-SKr10bn (€530m-€1.06bn).

Well, since it appears that the FT doesn't subscribe to BoomBustBlog (and they really should), let's break it down for them, shall we?

The focus is now on the contagion effect of Ireland, specifically (jumping on a monthly basis from Greece, Portugal, Spain, etc.). We have performed a lot of work in this area in the beginning of the year. Let’s borrow from our foreign claims model (icon Sovereign Contagion Model – Retail (961.43 kB 2010-05-04 12:32:46) and File Icon Sovereign Contagion Model – Pro & Institutional) in order to see who may be effected from the rush to pull capital out of extant positions to fill the leveraged NPA holes left by the banks…

claims_against_uk.jpg

Ireland has the largest claims against the UK as a percentage of the its respective GDP, the largest in the world. In a rush to raise cash by selling assets, expect some fire sales in the UK. For those who may be wondering how this may affect the UK, see our premium subscription report on the UK’s public finances and prospects (recently updated to include the last round of government projections): UK Public Finances March 2010 UK Public Finances March 2010 2010-03-29 06:20:38 615.90 Kb. Of course, this is the reason why the UK rushed to Ireland's aid. This intercrossed aid will be prevalent over the next year with different sets of countries running to each other's side.

ireland_claims_against_piigs.jpg

Ireland can also be expected to pull assets out of the ailing PIIGS group as well, since they are, bar none, the biggest lender to that group as a percentage of GDP. No wonder their banks are having problems. This is the main reason why the ECB has jumped into the fray. Their biggest exposure? Italy! See our premium analysis of Italy’s public finances and prospects: Italy public finances projection Italy public finances projection 2010-03-22 10:47:41 588.19 Kb as well as their other major exposures:Spain public finances projections_033010 Spain public finances projections_0330102010-03-31 04:41:22 705.14 Kb and Greece Public Finances Projections Greece Public Finances Projections 2010-03-15 11:33:27 694.35 Kb.

Of course Spain, Italy and the other members of the PIIGS group are in no condition to rush to the aid of Ireland since they are most assuredly anticipating the need of aid being rushed to them in the near future - all public protestations to the contrary withstanding...

Of particular interest may be the prospects of the various banks caught in this interwoven web (premium subscription material). To date, these analyses have proven to be right on the money:

Of course, none of this goes to explain why Sweden has been so generous with the offer of aid to Ireland. So, let's dig in to some of the innards of the BoomBustBlog foreign contagion model to see how successful it has been in its predictive powers...
ireland_claims_against_cee.png

Ireland also has the second highest claims (as percent of GDP) against the central and eastern European nations, who happen to be in a full blown depression. The withdrawal of assets, banking support and credit will exacerbate both Ireland’s problems and that of these nations - along with those sovereign states who have large claims into said states. Who is the largest claimant. You guessed it, SWEDEN! This also explains the Swedish loans to Latvia. The content from this post and the resultant models was originally published on (and around) Tuesday, March 30th, 2010 at 11:00 pm. Those who subscribed to BoomBustBlog had plenty of time to prepare.

See The Depression is Already Here for Some Members of Europe, and It Just Might Be Contagious! to find that Ireland can exacerbate the problems of Austrian, Swedish and Belgian banks by pulling capital out of the CEE region, and yes, they are truly in a depression:

Austria, Belgium and Sweden, while apparently healthy from a cursory perspective, have between one quarter to one half of their GDPs exposed to central and eastern European countries facing a full blown Depression!

Click to Enlarge…

cee_risk_map.png

These exposed countries are surrounded by much larger (GDP-wise and geo-politically) countries who have severe structural fiscal deficiencies and excessive debt as a proportion to their GDPs, not to mention being highly “OVERBANKED” (a term that I have coined).

So as to quiet those pundits who feel I am being sensationalist, let’s take this step by step.

Depression (Wikipedia): In economics, a depression is a sustained, long-term downturn in economic activity in one or more economies. It is a more severe downturn than a recession, which is seen as part of a normal business cycle.

Considered a rare and extreme form of recession, a depression is characterized by its length, and by abnormal increases in unemployment, falls in the availability of credit, shrinking output and investment, numerous bankruptcies, reduced amounts of trade and commerce, as well as highly volatile relative currency value fluctuations, mostly devaluations. Price deflationfinancial crisis and bank failures are also common elements of a depression.

There is no widely agreed definition for a depression, though some have been proposed. In the United States the National Bureau of Economic Research determines contractions and expansions in the business cycle, but does not declare depressions.[1] Generally, periods labeled depressions are marked by a substantial and sustained shortfall of the ability to purchase goods relative to the amount that could be produced using current resources and technology (potential output).[2] Another proposed definition of depression includes two general rules: 1) a decline in real GDP exceeding 10%, or 2) a recession lasting 2 or more years.[3][4]

Before we go on, let’s graphically what a depression would look like in this modern day and age…

A depression is characterized by its length, and by abnormal increases in unemployment.
image012.png
Price deflationfinancial crisis and bank failures are also common elements of a depression. image011.png

A depression is characterized by … shrinking output and investment … reduced amounts of trade and commerce.

image007.png

In order for the CEE region to improve, it must avoid the shocks associated with financial and economic contagion from far flung regions such as Ireland. The reality of the matter is that it may not be that easy. BoomBustBlog premium subscribers may download the CEE bank exposure analysis to see which banks we feel have the highest exposure to such an incident, or more realistically, string of incidents:
File Icon Banks exposed to Central and Eastern Europe.

ireland_developed_country_claims.png

From an empirical perspective, Ireland is in a prime position to export contagion. Not only does it have the 2nd highest banking NPAs to GDP ratios in the developed world, it has one of the highest foreign claim to GDP rations as well. I have already demonstrated how these foreign claims just happen to be concentrated in today’s problem areas, but Ireland has spread this exposure far and wide as well. It is second only to Switzerland (due to Swiss private banking industry) in claims against developed countries. It is also second only to the Swiss in its total foreign claims as a % of GDP.

ireland_foreign_claims.png

You can see some forced solidarity amongst the brethren. BoomBustBloggers will not be surprised to hear Denmark, Spain and Italy pop up in the news in the next quarter or two. Oh yeah, Spain is already in the news…

Current Affairs in the News Friday, November 26, 2010

The Next Debt Crisis May Start in Washington: FDIC's Bair



The US needs to take urgent action to cut its debt in order to prevent the next financial crisis, which may start in Washington, Sheila Bair, chair of the Federal Deposits Insurance Corp. (FDIC) wrote in an editorial in the Washington Post.

Keep in mind that Greece and Ireland both denied any possibility of a bailout as well. These absolute denials are becoming a tell tale sign of an impending bailout!!! Reference Erin Gone Broken Bank: The 2nd EMU Nation That Didn’t Need a Bailout Get’s Bailed Out Within Months, Next Up??? November 22nd, 2010

Over the weekend, I will attempt to release the Irish Haircut model for professional and institutional subscribers, which I can tell you now is looking uglier and uglier. I have warned of these impending haircuts as Wall Street's sell side assert that they are improbable. The reason why the haircuts are likely is because without them it will be virtually impossible for Ireland to bring its debt level to below 100% of GDP on a sustainable basis without them. Yes, the banking situation is actually that bad! It is really all about the math.

After the Irish haircut release, I will delve deeper into the contagion effect using our proprietary models, which have worked like a (not so Irish) charm thus far.

In the meantime, peruse the entire Pan-European Sovereign Debt Crisis history from the BoomBustBlog perspective. Any who have not followed me in the past can learn more about me here: Who is Reggie Middleton and What is BoomBustBlog?

For those who want to see how I have seen Ireland throughout the year...

Erin Gone Broken Bank: The 2nd EMU Nation That Didn’t Need a Bailout Get’s Bailed Out Within Months, Next Up???

Monday, November 22nd, 2010

If the World Knew What BoomBustBlogger’s Know, Would Ireland Default Today?

Wednesday, November 17th, 2010

As We Have Clearly Anticipated Since Early 2010, Ireland is About to Go

Monday, November 15th, 2010

Did Reggie Middleton, a Blogger at BoomBustBlog, Best Wall Streets Best of the Best?

Friday, October 15th, 2010

How Likely Is Greece to Default? It Would Be a Downright Miracle If They Didn’t! Numbers Don’t Lie, Although Some Sovereign Reporting Agencies Do! Let’s Walk Through the Math…

Thursday, October 7th, 2010

Many Are Still Underestimating the Damage That Can Be Done By Ireland’s Bank Troubles

Wednesday, September 8th, 2010

I Suggest Those That Dislike Hearing “I Told You So” Divest from Western and Southern European Debt, It’ll Get Worse Before It Get’s Better!

Friday, August 27th, 2010

Here’s More Proof of the Sheer Lunacy of the European Bank Stress Tests: Passed Banks are Already Trying to Collect on Defaulted Claims of European Nations

Tuesday, July 27th, 2010

European Bank Stress Test Joke: This Insolvent Euro-Bank and Group of Central Bankers Met at a Bar and…

Friday, July 23rd, 2010

Death by a Thousand Irish Cuts: The Poster Child of Austerity Measure Success Gets Downgraded After Several Devastating Expenditure Reductions That Really, Really Hurt the Irish People!

Monday, July 19th, 2010

Introducing the Not So Stylish Portuguese Haircut Analysis

Wednesday, June 2nd, 2010

With the Euro Disintegrating, You Can Calculate Your Haircuts Here

Monday, May 17th, 2010

BoomBustBlog Irish Research Becomes Reality

Wednesday, May 12th, 2010

Last modified on Friday, 26 November 2010 09:04

5 comments

  • Comment Link bet365 Wednesday, 01 December 2010 09:08 posted by bet365

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  • Comment Link Cplus Friday, 26 November 2010 12:24 posted by Cplus

    The DIW chief in Germany is now suggesting a 1.5 Trillion Euro rescue fund may be needed. IMO, to be conjured up from pixels in cyberspace.

    Latest schedule calls for the the terms of the bailout of Ireland to be agreed and announced before the markets open on Monday. Reminiscent of the frantic Treasury-Fed weekends of 2008 .

    It will be entertaining to see how much support there will be for the European rescues when they recognize that they are bailing out Goldman Sachs again.

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  • Comment Link Reggie Middleton Friday, 26 November 2010 11:35 posted by Reggie Middleton

    You know the answer is yes. Actually, the Spanish housing contagion was analyzed and baked in as far back jan. 2009, with our BBVA analysis.

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  • Comment Link kingjoe Friday, 26 November 2010 11:12 posted by kingjoe

    This is like a dog chasing its own tail or a falling man catching another falling man.

    Bloomberg just released an article yesterday saying foreclosed homes in Spain may "triple" in 2011. If this is true, does it mean that things will really really get worst for EU based on your contagion model?

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  • Comment Link Reggie Middleton Friday, 26 November 2010 10:50 posted by Reggie Middleton

    Things should start to get interesting now that Germany, the ECB and the IMF have made it clear that bank senior bondholders, that most sacrosanct of asset classes, are now in the cross hairs. Be prepared for back stabbing and rushes to the exit, with the lesser of reflex getting stepped on and stomped out, as bond holders tremble world over that they may actually have to pay for the risks they have assumed (or at least some of them) in lieu of passing them on to the international tax payer.

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