Sunday, March 20, 2011

What is sustainable?

The sustainability of Irish debt has come more and more into the spotlight.  Outside of the sphere of political institutions the view that Ireland’s debt are unsustainable is becoming an ever more dominant viewpoint.   The blame for this unsustainability is being directed at the bank debt which is being heaped onto Ireland’s public debt.  A recent Primetime show highlights this view (starts 10:15 in).  The full interviews with the contributors to the show are posted here and are also worth watching, particularly that by Prof. Philip Lane of Trinity College.

So, is the banking-related debt we are assuming sustainable?  On examination it turns out that it might be.

So far, €46,279 million has been poured into the banks.  This is made up of

  • €4,675 million via the Exchequer with 
    • €4,000 million going into Anglo Irish Bank
    • €575 million into EBS and
    • €100 million into INBS;
  • €10,700 million via the NPRF with
    • €3,500 million in AIB preference shares and
    • €3,700 million in AIB ordinary shares
    • €3,500 million in BOI preference shares; and
  • €30,904 million through Promissory Notes with
    • €25,354 million going to Anglo Irish Bank
    • €5,300 million to INBS and
    • €250 million to EBS.

Of this €46.3 billion, €35.6 billion is with borrowed money, with the remainder coming from the savings built up in the National Pension Reserve Fund (though it is possible to argue that the €4.7 billion contributed to the fund since 2008 was also borrowed).

The great unknown is how much more money will needed to prop up these banks.  The EU/IMF deal has a “worse-case” scenario of a further €35 billion needed to complete the cleansing of losses from the viable banks and the wind-down of the zombie banks that Anglo and INBS have become.  This €35 billion comes from three sources:

  • €10 billion of the remaining balance in NPRF, 
  • €17.5 billion borrowed from the EU/IMF package, and
  • €7.5 billion from other State resources (there were c. €12.3 billion of available cash balances as of 31/12/2010.  See third paragraph here.) .

The new Minister for Finance, Michael Noonan has indicated that the further recapitalisations will be greater than the €10 billion to be taken from the NPRF, and we will require some of the EU/IMF contingency fund for the banks.  

To find out how much we will have to wait until the stress test results are published at the end of the month.  We can only hope that these finally paint the full picture and we don’t get the ridiculous situation of last year with AIB passing the stress tests only to need further recapitalisation a few months later.  We need these to tell what the worst possible outcome is to see if continuing with the bank bailout is indeed sustainable.  The fact that finally publishing this is also in the interest of the new government lends some hope.

Let’s assume that the “adverse scenario” of the stress tests matches the “worst case” scenario of the EU/IMF deal.  This means a further €35 billion going to the banks, bringing the total cost of the bank bailout up to €81 billion.  Adding the additional €17.5 billion of borrowings that this requires to the existing €35.6 billion of borrowings used for the banks so far means that we will have a €53 billion millstone of bank-related debt weighing us down (as well as the elimination of €20 billion of sovereign savings and the reduction of €7.5 billion in our cash balances).

This €53 billion of debt is sustainable (with sustainable being defined as the ability to avoid default).  We could carry this debt and service the interest.  It is hard to see how we can actually pay it off but having it is unlikely to tip us into default.  Of course,we have another reason for our soaring borrowings that also needs to be addressed.   Why is this €53 billion of debt sustainable?  If we assume an interest rate of 5.7% this would require €3 billion a year just to pay the interest – about 1/12 of Exchequer tax revenue. 

However, we must consider what we get for this €53 billion of debt – six banks.  All that can be done with Anglo and INBS is a wind down and we can forget about ever seeing any of the huge sums of money that has been swallowed by them.  EBS may have some value but nothing significant.  It is unclear what the State’s holding, if any, in PTSB will be.  The State will own AIB and BOI.

Amazing as it may seem on an operating, or day-to-day basis, these banks are actually profitable.  The banks’ balance sheets are an unholy mess but anyone who has a current account, business account, cheque book, overdraft, or credit card will be fully aware of the level of charges, interest rates and referral fees charged by the banks.  These were the bread and butter of the main banks before they got dizzy chasing the shadows of Anglo around the Irish property-development bubble.  These day-to-day profits still exist but are completely dwarfed by the losses on the banks’ balance sheets.  The most recent figures show that for the first six months of 2010:

  • AIB made a pre-tax operating profit of €976 million (see slide 5)
  • BOI made a pre-tax operating profit of €553 million (see page 4)

These operating profits were eliminated by impairment charges and other balance sheet adjustments.  If considered over a full year these operating profits would total around €3 billion.  As the dominant shareholder the State would be entitled to a significant dividend on these profits (once most of the impairments and loans losses have been washed through).  These profits will NEVER cover the losses the six banks have made but they can be used to offset some (though probably less than half) of the annual interest cost we are incurring from covering these losses.

Indeed, if the €81 billion package manages to make good most of the immediate losses in AIB and BOI, it is likely that the banks can be sold on at a price.  Again, this will only cover a fraction of the money pumped into them.  It might be possible to get €4 billion for reasonably cleaned-up versions of the two main banks.  Using this would bring the debt legacy of this ill-constructed bank bailout down to €45 billion, a figure which is unlikely to push us over the precipice of a sovereign default, though it is also unlikely we will ever pay this debt down.

Of course, just because something is sustainable is not a reason to proceed with it, and could not be used as a justification to reject “burden sharing” with bank bondholders.  An element of burden sharing would further reduce the residual debt left by this banking meltdown but it is important to note who these bondholders actually might be.  And we cannot forget the gains or losses that will result from the NAMA process or the money owed to the ECB that is now keeping the banks open and funding the customer loans they have issued.

Regardless, I think an €81 billion bank bailout package is sustainable – though it is a colossal and, particularly in the case of Anglo and INBS, a needless waste of money.  What will the final cost of this financial disaster be?  We await the answer.  If we can get out the far side for something less than the €35 billion available under the EU/IMF deal then we can survive it without default. 

We must decide if we want to continue along this road and the opportunity to change course grows ever smaller as more and more bonds are paid off (with the money provided the ECB).  This decision, and the decisions required to bring down the fiscal deficit, must be made quickly.  We are still in a position where default is an option rather than a necessity.

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