This is a longer version of an opinion piece published in the Irish Examiner, P13, 21/June/2011. It doesnt seem to be online, but examiner210611_crisis is a scan (2mb) of the article.
The opening words of the great Russian novel Anna Karenina ” All happy families resemble one another, each unhappy family is unhappy in its own way “ could serve as a metaphor for the European debt crisis. The countries in the spotlight, Greece center stage, Ireland and Portugal hanging on the edge of the llight, Spain and Italy in the wings, all share very different characteristics as to how they have ended up with the potential to bring down the euro experiment. In the case of Ireland we have a situation where we ran up a catastrophically large sovereign debt, composed however of two very distinctly different elements: the government debt run up by a gap between tax and expenditure and the debts of the banks taken onto the state in 2008. Greece on the other hand is quite different, with gargantuan sovereign debt as a consequence of a combination of poorly performing export economy, very poor tax collection, and an extremely bureaucratic, rigid, and crony-based approach to doing business internally. In many ways the Greek economy now resembles, albeit superficially and with a lot more sun, the Irish economy of the 1980s. Here are links to two interesting papers on the Irish and Greek crises.
The Greek taxpayer and economy cannot, under any feasible set of circumstances which would be acceptable in a modern democratic country, tax and cut its way out of the hole into which it has dug itself, albeit with the tools provided foolishly by German and French banks. The IMF and Greek government forecasts for debt to GDP suggests that it will peak at between 150% and 170% and even at the end of the adjustment program, in 2015, will still be between 140% and 160%.
(source for figure: this excellent blog )
This is well beyond sustainability, and is nearly double that which is suggested by Reinhart and Rogoff as the death zone area. It is very clear that Greece is going to require not more debt but less debt, and in that context the recent EU decision to consider another round for the bailout, as if piling more debt on top of the existing Greek debt would allow them to get out from under the mountain of debt is unwelcome, as is the decision to do all this out of a drip feed basis, kicking the financial can down the road in the hope that the something will turn up. We’ve seen this approach tried in Ireland over government of 2007-2010, with disastrous consequences.
If Greece cannot, as most people believe it cannot, extract itself from its position then we face into a very serious political economy crisis over the summer. The ramifications of Greek default, whether forced from the outside or emergent from the domestic political situation, are complex and I will revisit these later. However a crisis can also be an opportunity. It is very clear that in the negotiations around the bailout in November 2010 the Irish negotiating team was either outgunned or outfoxed. The full story of what happened around that time will take decades to emerge, but the consequence is very clear. These consequences include we have an interest rate on our bailout which is seen by many, including crucially the EC Commission, government and the IMF, as being to high and requiring reduction, as well as a seeming ban on cutting payments to senior bondholders. Indeed this was the second time around for that government to find itself emerging from a negotiation having sold the store, with the new original sin of Irish economic policy, the banking bailout of 2008, been a consequence of the government not being able to negotiate effectively with the bankers. The Irish situation is not nearly as powerless as that of Greece, but it is to a great extent a matter of degree rather than kind. We too, like Greece, are in a financial death zone. We have a better chance than Greece of climbing out of it, but this is by no means certain, and the benign external factors upon which our climbing out is predicated are looking less and less likely to be realised.
That Ireland needs to restructure its domestic government finances is undisputed. That doing so would be much easier, and at the risk of any potential default would be greatly reduced, almost to nil if we were to be able to remove the albatross of the Irish banking debt is undisputed. By undisputed I mean that all players, government, IMF, ECB, European commission, all agree. Where they do not agree is when, how fast and how this should be achieved.
The Irish banking crisis now consists of two elements: there is liquidity and a solvency problem. The liquidity problem for the Irish banks is that they are massively dependent on money from the ECB, as well as money from the Irish Central bank, to keep their day-to-day activities ongoing. The threat, not so subtly implied (see here ,and here ) , from the ECB is at the Irish government were to take any form of unilateral action in terms of dealing with, a.k.a. a imposing glasses/haircuts/burning on the senior bondholders and the ECB would withdraw this funding. This is palpable nonsense, as this funding for the most part consists of well-collateralised assets which the Irish banks are swapping, albeit on a relatively short-term rates, with the ECB. There is no possibility whatsoever that the ECB will withdraw, for Irish assets, this facility. Even were they minded to do so the consequences for the ECB, and for the euro, of deliberately creating an existential liquidity crisis in a Eurozone country would be sufficient to demonstrate the ECB as being unfit to manage the euro, with the consequences we can well imagine.
The solvency issue for the banks, intertwined with that of the government, revolves around the fact that Irish banks hold a number of forms of financial liabilities by which they fund themselves. Banks like any other company finance themselves in a number of ways. A large part of bank financing is the deposit base, the savings of people placed on deposits with the banks, which is then lent out in order to make a return. In general banks lend out more money than they have on deposits. Anybody who seen the Jimmy Stewart movie “it’s a wonderful life” is aware of this. This is why bank runs are so dangerous: there is simply never enough money in the bank for all people to withdraw all savings at once. Banks also finance themselves, like any other company, by borrowing money on the open market from investors. There are two main kinds of this borrowing. The first add the “subordinated” bonds, financial instruments, bonds, issued by banks which pay a higher return. This higher return is an explicit recognition of the fact that these are riskier than other forms of investment in the bank. They are especially riskier than deposits, and the returns on these bonds to the investors are higher than the returns, which would be made by placing funds on deposit. Paying, at least in principle, a higher return again is shares in banks. The whole concept of a limited liability company is that you invest a certain amount of money in order to take partial ownership of a company but you may lose all of this. In between deposits and subordinated bonds, we find other forms of bonds. These are the so-called “senior” bonds. This now is where the action lies in relation to whether or not the Irish government should, could, or must continue to pour money into the Irish banks. The capital structure of banks therefore consists of, in increasing order of likelihood under normal circumstances to be eroded by losses, shares then subordinated debt then senior debt then deposits. It is agreed by all that deposits should be protected, if not in hold them in substantial part. This is where deposit protection, at whatever level set by the government comes into play.
But do we have to pay these bank bonds? It’s clear that Minister Noonan is now intent on pushing the issue, to allow some burning of the bondholders take place. Even if we save a single cent it is worth it, for the moral justification alone of not bailing out investors when we are cutting domestic expenditure is in my view insurmountable. Every penny we save by not paying off foreign investors in failed banks is a penny that can be deployed to more rapidly bringing the Irish government finances into the balance they need to be brought into.
In 2008 the then government either decided on its own, or had decided for it by the European Central bank, that a very large proportion of the bonds in issue would be guaranteed by the state. Only a small part of the subordinated bonds were excluded. This guarantee has subsequently been amended and extended over the years. The arguments about “burning the bondholders” have revolved around whether or not this guarantee, once given, can or should be eliminated and the bondholders exposed to what would be normal convention, that as losses are recognized the capital structure (senior and junior bonds plus the shares of the company) is progressively eroded. The degree to which this guarantee, and subsequent government decisions, backed by the ECB, have subverted the normal rules of finance is evidenced by the fact that we still, in theory, have value in Anglo Irish bank. Not a peep has been heard regarding the assessor whose job it is to determine, as if any determination more than a moments consideration is required, whether or not there is value left in Anglo Irish bank.
Earlier on this spring the central bank, in what it claimed to be a one-off exercise, published details of the outstanding bonds issued by the Irish banks. In addition to guarantees, in this case guarantees given by the Irish state that the taxpayer will make good the losses of this private investors, bonds may also be secured. Anybody who has a mortgage should be familiar with this; the banks loan to you is secured upon your house. If you do not pay your mortgage then your house can be taken sold and the proceeds used to pay off the debt which you owe. Similarly banks issue secured bonds. These bonds are secured on assets. If the bank finds itself unable to pay either the interest or the outstanding amount on these bonds then the people who hold the bonds can take possession of the underlying assets, and either sell them run them as going concerns, in the same way as a bank would take somebody’s home. In other words secured bonds are already secured on assets. The superlative NAMAwinelake blog has updated and analyzed the Irish banking figures, continuing a tradition of deep detailed analysis of the banks which makes it required reading for anyone serious about the Irish situation The table below is taken from there
There are some €20 billion worth of these secured, unguaranteed, senior bonds outstanding, mostly in bank of Ireland and AIB. There is some €20 billion additional of unguaranteed but secured senior debt. There are some €16 billion outstanding of un guaranteed but unsecured bonds, €3.1 billion in Anglo and €600 million in Irish nationwide building society. While one might in principle think that as these are not guaranteed by the state and are not secured on anything then these bankrupt institutions would not repay one would have to think again. A couple of weeks ago Anglo Irish bank paid back in full some €200 million of these unsecured unguaranteed senior bonds. It is likely based on this precedent that the state via the banks would in normal course of events pay off the entirety of the senior debt. The majority of these bonds will be paid back over 2012-2013 period. Finally we still retain in all of the banks nearly €7 billion worth of subordinated bonds. Great trumpeting has been made of the decision to offer to redeem this outstanding subordinated debt at very deep discounts. But one would have to wonder again as the morality of paying 1% or 10% or 20% of the face value of these bonds when in fact under normal rules of capitalism they should be worth precisely 0. Of course the only way in which they could be valued at zero would be for the state to have wiped out the total shareholdings of the banks, and the previous government set its face firmly against the consequences of forcing bank investors to take the losses until it was too late and we ended up in this mess.
There is a deeply immoral action in the state continuing or even contemplating to continue to pay out on these bonds. The banks exist at the moment only under the protective umbrella of the state. They are in fact creatures of the state. The state has no money other than that which takes off the taxpayer. We have an enormous hole in our budget. This will have to be filled. It will only be filled by the state cutting back on its spending and increasing the tax base. Inevitably in cutting back on expenditure there will be painful decisions made. But one would have to think that there is something plain wrong about choosing to first payoff investors in failed institutions, while simultaneously cutting back on services to the most needy. We may well have to cut back on incontinence pads for the elderly or condem our children to remain in leaky prefabs, but this should not be because we have decided to pay private debts first. The Irish taxpayer should not be expected to pay for any secured debts. Let investors who lend the money to Anglo and Irish Nationwide and AIB go and exercise the security which they have been given. The reality is of course that the assets upon which these loans are secured may no longer be the same as the the value of the loans. But that is capitalism. Taking the security for the loans might also have the advantage of assisting in the shrinkage of the irish banks loan books, something that will have to be done anyhow.
There is an argument that senior debt ranks “pari passu” with deposits. This may well be the case, or it may not, but the reality is that there are longer any deposits in Irish Nationwide or in Anglo. Therefore there is absolutely no need to be concerned about the effect upon these deposits of requiring these senior unguaranteed unsecured bondholders to take their place in the queue for orderly liquidation. There may well be a case that this senior guaranteed bondholders have some legitimate expectation of repayment consequent to the decisions made to guarantee. Some form of debt for equity swap might well be worth considering here. 100 days into its hundred days the coalition has an opportunity to take a bold step. This bold step would be to take the Irish taxpayer off the hook for as much money as possible. This is not a sovereign default, nor would it be treated as such. The sooner we can remove the albatross of the Irish banking losses from the states shoulders the sooner the state can get on with the unpleasant but eminently doable task of restoring order to the public finances.In doing this it would show that it places the moral argument front and center, and regain and restore trust in its task.
Michael Noonan represents a constituency which is at the heart of Munster rugby, known for its uncompromising defence. Might we suggest that he now take a leaf out of their book, and use this crisis as an opportunity for the Irish? Eurozone finance ministers have once again decided to kick the can down the road, until mid-July, when they will make a final final final decision as to how to proceed with the Greek situation. Minister Noonan should consider vetoing any final Greek proposal, until three issues are resolved to the satisfaction of the Irish government. The ECB needs to put in place a medium-term strategy for the liquidity needs of the Irish banks, a strategy which it itself has said is required but which has not proceeded. We need a reduction, towards 3%, in the blended interest rate on the Irish bailout. And we need the ECB to accept that the Irish government, acting on behalf of the Irish people, will not put a penny into un-guaranteed senior bonds of any bank, pillar or otherwise, and will convert guaranteed bonds into equity in the banks. Nations, Lord Palmerston told us, do not have friends, only interests. It’s time to look after our own interests. While there is no doubt that this approach would enrage our european partners, it should come as no surprise to them that after subjecting ireland to a regime of threats, and after having forced us to take on board debts whose taking on subverts the basic tenets of capitalism as well as threatening to submerge the state, the Irish governmental worm turned. And, they will get over it. After all, if faced with the prospect of Greece melting down (earlier than it might anyhow) or Ireland being fobbed off, they will have no choice..will they?