VZCZCXRO0847
RR RUEHROV
DE RUEHTV #2739/01 3431356
ZNR UUUUU ZZH
R 081356Z DEC 08
FM AMEMBASSY TEL AVIV
TO RUEHC/SECSTATE WASHDC 9494
INFO RUEHXK/ARAB ISRAELI COLLECTIVE
RHEHNSC/NSC WASHDC
RUEATRS/DEPT OF TREASURY WASHDC

UNCLAS SECTION 01 OF 04 TEL AVIV 002739 
 
NEA/IPA FOR GOLDBERGER, LENTZ; EEB/IFD FOR SNOW, JACOBY; TREASURY 
FOR BALIN 
 
SIPDIS 
SENSITIVE 
 
 
E.O. 12958: N/A 
TAGS: ECON EFIN PGOV IS
SUBJECT: CORPORATE BONDS: ISRAEL'S "SUBPRIME CRISIS" 
 
REFS: 1) Tel Aviv 2636 2) Tel Aviv 2597 3) Tel Aviv 2548 4) Tel Aviv 
2430 
 
------- 
Summary 
------- 
 
¶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 
 
 
did. 
 
---------------------------------- 
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. 
 
 
SIEVERS