Cablegate: Corporate Bonds: Israel's "Subprime Crisis"

DE RUEHTV #2739/01 3431356
R 081356Z DEC 08




E.O. 12958: N/A

REFS: 1) Tel Aviv 2636 2) Tel Aviv 2597 3) Tel Aviv 2548 4) Tel Aviv


1. (SBU) Gil Buffman, the Chief Economist at Bank Leumi, says that
the GOI is only now waking up to the trouble in the Israeli
corporate bond market. The problems were brought on by deregulation
and the import of the global financial criQQQ 1QQQQQavings funds have
been rather mild, he nonetheless supported establishing a safety net
for holders of these funds. He advocated the use of the 2003
U.S.-Israel Loan Guarantee Agreement to raise funds for government
efforts in these and other areas. Eyal Klein, formerly the Debt
Division Chief at the Ministry of Finance (MOF) and now the Chief
Economist at IBI Investments strongly opposed the use of the LGA
funds, saying it would send the wrong message to the markets about
the state of the Israeli economy. (Comment: if the USG ever makes
further deductions from the Loan Guarantee money available to Israel
due to Israel's continued spending on West Bank settlements, the
argument between the two economists may be moot, as there would be
too little of the LGA funds left to matter. End Comment.)

2. (U) Buffman thinks the GOI did not act quickly enough to deal
with the crisis. The Bank of Israel (BOI) is finally on track,
substantially lowering interest rates. He favors increasing
unemployment benefits and keeping the scheduled 2009 income tax cuts
in place. He says that Israel is still in the interim stage and has
not yet been hit full force by the global financial crisis. He
foresees 2009 growth slowing to two percent, the deficit rising to
about 2 - 2.5 percent and inflation near zero. He also thinks that
exports will be flat.
End Summary.

Corporate Bond Market in Trouble

3. (U) At a recent meeting with Dep EconCouns, Gil Buffman, the
Chief Economist at Bank Leumi, one of Israel's two biggest banks,
said that his greatest concern was the situation in Israel's
corporate bond market, which he called "the weakest part of the
economy," characterizing the problem in that market as "Israel's
subprime crisis." Bank Leumi has long been concerned about the
health of that market, but Buffman said that Ministry of Finance and
Bank of Israel officials dismissed these concerns when he raised
them. He said that the financial indicators in that market had been
deteriorating, with the spreads becoming very low. This indicated
that something was "deeply wrong with the pricing of risk in the
market." The interest being paid on the bonds issued by risky
ventures was barely higher than on lower-risk bonds.

Bachar Reforms Deregulated Risk

4. (U) While the Bachar capital market reforms implemented over the
past few years have recently been subjected to withering criticism,
Buffman faulted them mostly in connection with the corporate bond
crisis. As a result of the reforms, pension and long-term savings
plan money management moved from relatively conservative banks to
considerably less conservative institutional investors, who promised
investors high returns in a short period of time. These
institutions were very creative in the way they catered to the
business sector, coming up with various sorts of risky corporate
bond offerings. However, these largely unregulated institutions did
not sufficiently consider risk in any of its manifestations --
market, legal, operational, or credit.

Transfer of Ownership without Responsibility

5. (U) Buffman characterized the shift in money management from the
highly regulated banks to these unregulated institutions as "a
transfer of ownership without a transfer of responsibility." As a
result, the corporate bond sector evolved very quickly and
institutional investors bought bonds with little thought about risk.
Prior to this period, business borrowings were about 80 to 90
percent from banks. With the reform, corporate customers left the
banks and found easy financing elsewhere. Buffman added that the
banks also took advantage of the situation, encouraging their
riskier clients to find their credit solutions elsewhere, which they

TEL AVIV 00002739 002 OF 004


Real Estate Crisis Comes to Israel

6. (U) Regarding some of the "tycoons" in the real estate market
who invested heavily in other countries, Buffman said they got hit
by inflation in various countries and by the high value of the
shekel, which hurt them as they converted their profits from foreign
currency. The increase in commodity prices was also a negative
factor. Their investments, whether in Las Vegas and Arizona, or
Russia and Eastern Europe - all of which are now getting hammered --
were mostly in non-residential construction, including office and
retail space. The global real estate crisis came to Israel via this
drastic decline in the value of their holdings. About one third of
Israel's corporate bonds were issued by companies involved in real
estate, which gives an idea of the dimensions of the problem.
Buffman thought it not unreasonable to assume that some of these
companies would fail. He said that the banks will be increasing
provisions for doubtful debt, and will likely try to continue to
diversify their portfolios by doing more business with households
and smaller businesses. An advantage of bank credit is that it can
be renegotiated when necessary. Bonds lack that flexibility,
another factor which contributes to the likelihood of substantial
default rates. Buffman forecast about a five percent default rate
for corporate bonds in the coming period.

Safety Net OK

7. (U) Buffman noted that holders of corporate bonds and of pension
and long-term savings accounts are exerting enormous pressure for
the government to take action to provide a safety net with a
guaranteed minimum rate of return for their investments. He was
supportive of the concept, saying that a safety net would provide a
greater degree of certainty and end the tendency of the public to
panic in the face of harsh economic news. This would also reduce
the incentive to withdraw funds, engendering further stability.
However, the mechanism for establishing safety nets is complex. One
suggestion Buffman had was for the government to take steps to
increase liquidity for institutions. He cited the example of a
government bonds buyback program in 1995, during which institutional
investors were allowed to sell government bonds prior to maturity
without incurring penalties.

Pension Funds Not That Badly Hit

8. (U) Regarding the breathless newspaper reporting about huge
losses in the value of these funds - which is generating the demands
for a safety net, Buffman said that the funds have declined in the
last year by about 9-15 percent, with the higher risk ones down by
about 20 percent. In the present difficult financial environment,
institutional investors are selling low-risk government bonds to
increase desperately-needed liquidity. While foreigners have been
pulling out of the Israeli markets, Israelis have been bringing a
substantial amount of money back home, resulting in a net inflow of
portfolio investment. Buffman added that foreign investors are
unlikely to return to the Israeli market until after the February
Knesset elections, when the political situation stabilizes.

Support the Corporate Bond Market

9. (U) Buffman said that the government could consider purchasing
corporate bonds. Noting, however, that the USG has backed away from
this concept, he said that this is probably not the best way to
address the root of the problem. The MOF has also stated that it
does not plan to intervene in the corporate market. (Note: Bank of
Israel [BOI] Governor Stanley Fischer said on November 13 that the
government should not intervene in the corporate bond market. He
said that the fact that a company was able to borrow money during
good times does not justify intervention by the government to help
it in less prosperous times. As long as the market is functioning
regularly, as it is currently, intervention is not necessary or
desirable. End Note.)

Use the Loan Guarantees

10. (U) Buffman supports having the government advance credit for

TEL AVIV 00002739 003 OF 004

specific sectors in a sort of matching process with the banks. For
every shekel that the banks would provide, the government would
provide a shekel of earmarked credits. He also suggested that money
remaining in the 2003 the U.S.-Israel Loan Guarantee Agreement (LGA)
be used to raise money abroad to finance directed credit through the
banking system. He said that this would improve the situation in
numerous sectors and also allow for extending credit terms form, for
example, 120 to 180 days. When asked if the use of the LGA money
would have a negative impact on the international perception of
Israel's credit-worthiness, he said that it probably would.
However, he added that it was worth doing regardless, as the
perception would likely become reality if the problem were not
properly addressed.

Another Economist Says Don't Use LGA

11. (SBU) At a separate meeting, when Dep EconCouns asked Eyal
Klein, formerly the Chief of the MOF Debt Division, and now the
Chief Economist at IBI Investment House, about the use of the LGA
money, Klein was adamantly against it. He said that it is known
that Israel views the LGA money as a sort of "rainy day fund," to be
used "only in the case of dire need." Therefore, the extremely
negative message that would be sent about Israel's economic
situation would far outweigh whatever little good would come from
using the money still available under the loan guarantee program.
(Comment: if the USG ever makes further deductions from the Loan
Guarantee money available to Israel due to Israel's continued
spending on West Bank settlements, the argument between the two
economists may be moot, as there would be too little of the LGA
funds left to matter. End Comment.)

GOI Didn't Act Quickly Enough

12. (U) Buffman felt that the GOI should have acted earlier in its
handling of the crisis. He was disappointed with the lack of
contingency planning in both the MOF and the Bank of Israel, saying
that they are six months behind where they should be. Despite
thinking that the Israeli economy was in good shape and not
endangered by the international financial upheaval, Israel's
economic leaders should have taken seriously and addressed public
fears with regard to their savings programs early on.
Buffman said that the senior management of the bank would be
meeting, at the government's request, to formulate its
recommendations on how to deal with the overall economic situation.

Interest Rate Policy Finally on Track

13. (U) On interest rate policy, Buffman said that the BOI is
finally on the right track, after a long period of failing to do the
right thing. The recent surprise cuts in interest rates indicate
that the BOI finally realized that something had to be done. He
thinks that more cuts are in the offing -- perhaps another 100 to
200 basis points. Regardless, he praised BOI Governor Fischer as an
important stabilizing factor in the Israeli economy, who is now
proving himself.

Additional Suggested GOI Actions

14. (U) Buffman dismissed as totally ineffectual a recent MOF plan
to allow fund managers to value three percent of the bond holding
they plan to hold to maturity at their maturity values rather than
having to mark them to market for valuation purposes. While this
would mask some short-term losses, this was simply a palliative,
which did nothing to deal with the problem and, in any case,
affected very little of the money under management. He did,
however, favor increasing unemployment benefits, and/or extending
the benefit period for people continuing to actively seek work. On
the issue of the long-planned income tax reductions scheduled for
2009, he opposed delaying them, for fear of sending a negative
message that the situation is worse than it really is. He also said
that the government was remiss in only providing an implicit
guarantee of the security of bank deposits via public statements by
senior officials that no one would lose money deposited in bank
accounts. He thinks that the guarantee should have been made
explicit as soon as problems arose a few months ago, and that the
banks should participate in bearing the cost through the payment of

TEL AVIV 00002739 004 OF 004

insurance premiums.

--------------------------------------------- --
GOI is the Obstacle to Infrastructure Spending
--------------------------------------------- --

15. (U) Buffman was against the original Ministry of Finance
economic plan. He said it would not be effective, and the Knesset
would not approve it in any case. The plan's call for a NIS 10
billion investment in infrastructure is "wonderful," but will not
have much impact in the coming months. He maintained that finding
financing for infrastructure spending is not a problem, even in
economically difficult times. The problem is the bureaucratic
obstacles the government puts in the way of getting projects
approved and moving. Regardless, such projects cannot stimulate the
economy much in the short-run as they are very time consuming and
take years to get off the ground and pay off.

Israel Still OK but Crisis Coming

16. (U) Israel is now in an interim stage, waiting for the
financial crisis to hit the real economy with full force. However,
he shares the widely-accepted view that the country is doing
relatively well, and is not being affected as much by the crisis as
other developed and emerging economies. This is due to strong
fundamentals, including the responsible economic policy of the last
few years, the current account surplus, and a relatively high rate
of household savings - 12 percent of net income. Only France has a
higher rate, while in the U.S., the savings rate has been close to
zero. The reason for this is that employees make extensive use of
automatic savings plans, and have significant portions of their
salaries automatically deposited into pension funds, long-term
savings (provident) funds, and educational training funds. These
savings instruments also have tax benefits. Buffman contrasted
these mandatory savings plans with the situation in the U.S., where
participation in such plans is not automatic as it is in Israel.

2009 Economic Forecast

17. (U) Buffman forecast two percent growth in 2009, and 3 - 3.5
percent growth in 2010. He thinks there will be a significant
slowdown, but not like the severe recession of 2001-2002, which was
exacerbated by the confluence of numerous events which all hit at
the same time: the Intifada, the hi-tech bust, and September 11,
2001. On exports, Buffman said that there would have been negative
growth in 2009 if not for the new USD 2.5 billion Intel plant that
will soon come on line and begin exporting during the year. He
thinks that the deficit in 2009 will be 2 - 2.5 percent, which is
lower than many other estimates. However, he noted that the
implementation of a pension safety net and directed credit would
raise the deficit. Given lower commodity prices and the economic
slowdown, Buffman foresees no inflation in 2009, and does not rule
out mild deflation.


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