Tuesday, April 5, 2011

Evening Echo Article 04/04/2011

Here is the text of an article I wrote in the aftermath of last week’s stress test announcements that was carried by Monday’s Evening Echo.

The much anticipated bank stress tests revealed that four of the six banks covered by the guarantee will require an additional €24 billion to cover the losses built up during the property boom.  These banks (AIB, BOI, EBS and IL&P) have already received €11 billion in recapitalisation funds from the State.

The bulk of the money spent by the State in what is now ‘the costliest bank bailout in history’ went to Anglo Irish Bank and Irish Nationwide.  These zombie institutions have already consumed €35 billion of State resources.  None of this money will be returned. 

As these banks are being wound down they were excluded in the current stress test process.  The report gives the belief that no additional capital will be required by Anglo and INBS.  It would be nice to think that this is true.  The previous recapitalisation process for Anglo has made provision for an additional €5 billion of funds to be provided by the State.  We will know more about these two banks when further details of their wind-down process are revealed in May.

Thus far, the State has poured €46 billion into our delinquent banking system.  Of this, €35 billion has been with borrowed money with the remaining €11 billion coming from the destruction of the National Pension Reserve Fund – a €25 billion savings fund the state had built up during the good times.

There has been a lot of talk recently about debt sustainability and the inevitability of default.  Things are not as bad as many would have us believe.  The key to debt sustainability is the amount of debt accumulated and the interest cost of services that debt.  So far the banking crisis has burdened us with €35 billion of debt.

It is likely that there will not be a significant increase in debt as a result of the stress test results.  The banks need an additional €24 billion of capital but it is not necessary that this all come from the State. 

For example, Irish Life and Permanent is actually two companies – the  profitable pensions and insurance business, Irish Life and the loss-carrying banking business, Permanent TSB.  As part of the process to recapitalise Permanent TSB, Irish Life will be sold and other resources of the company will be used.  This will provide €2 billion of the €4 billion required by Permanent TSB.

The Minister for Finance has indicated that subordinated bondholders will continue to carry the cost of this disaster.  So far, subordinated or junior bondholders have had losses of €10 billion applied to their investments.  Nearly €7 billion of subordinated bonds remain in the four banks.   The Minister for Finance has indicated that a ‘haircut’ of around 75% will be applied to these bonds.  These bondholders are only going to get about €2 billion of their money back.  The other €5 billion will not be paid back and this reduction in the banks’ liability will see their capital bases improve by that amount. 

These two elements alone reduce the State’s contribution by €7 billion.  There is still €17 billion to be found to prop up our ailing banks but it may be possible to do this without incurring any additional borrowings.

The Memorandum of Understanding agreed between Ireland and the EU/IMF as part of the rescue deal allowed for a “worse case” scenario of an additional €35 billion to be put into the banks.  Of this money, €10 billion was to come from the remaining funds in the NPRF, €7.5 billion was to come from the remaining cash balances of the State with €17.5 billion borrowed from the EU/IMF as part of the €67.5 deal agreed.  We no longer need all of this money.

The €10 billion contribution from the NPRF was already agreed and was actually postponed by the previous government in the run-up to the election.  This money is waiting and will be used as part of this final-stage recapitalisation.  That leaves €7 billion and we had already committed to providing about that amount from the €15 billion of cash balances the National Treasury Management Agency had built up in the early part of the crisis through bond issues.

It is very possible that the €24 billion could be found for the banks without any recourse to additional borrowings by the State.  Of course, it appears that the State will still have to provide around €17 billion to this process and this is a huge waste of State resources.  We could borrow the final €7 billion required as keeping a large cash buffer would be useful as the country tries to work its way out this economic crisis.

The final cost of this banking disaster could approach €120 billion.  Shareholders in the banks have seen €60 billion of value eroded to close zero.  Shareholders have been almost completely wiped out.  Subordinated debt holders will have been forced to take losses of around €15 billion with 70% haircuts applied to their investments.  We now know that the State is contributing  about €63 billion to clean up this mess.  The remainder of the cost will have come from the sale of assets and other sources within in the banks.

This €63 billion is a colossal waste of money for the State.  However, because we came into the crisis with a €25 billion sovereign wealth fund and €15 billion of available cash balances we will not need to borrow all of it.  Debt sustainability and the probability of default depends on the amount of debt accumulated.  If a family buys a home, sustainability is determined by the repayments on the mortgage rather than the initial purchase price.  If a large deposit had been used it reduces the size of the debt and makes sustainability more likely.

We have already borrowed €35 billion for the banks.  The most that could be added to this as a result of the recent stress tests is around €7 billion.  This gives a banking-related debt burden of €42 billion.  The rest comes from the destruction of savings we had built up during the boom, but just like a household will not have to pay interest on the amount they paid in a deposit, the State will not have to pay interest on the full amount of the bank bailout.

A banking-related debt of €42 billion is sustainable and will not tip a country with a GDP of €154 billion into default.  We can service the interest payments on this debt.  The entire process is a huge waste of money but it will not ruin the country.  Sustainability does not require that we pay off this money, but that we can meet the interest repayments.  The €42 billion debt at an interest rate of 6% would require €2.5 billion of interest payments to be made each year.

It is also important to remember what we are getting for this money.  The consultants who undertook the stress tests estimate that over the next three years the four banks that we now own will generate €4 billion of operating profit.  There are huge losses on the banks’ balance sheets but they also generate substantial profits.  Anybody who has a current account, chequing account, credit card or business account knows of the charges and interests that are levied by the banks. 

These day-to-day charges have not gone away in the current crisis, but have been completely swamped by the huge losses built up as the traditional banks got dizzy chasing the shadows of Anglo Irish Bank around the Irish property market.  In time, the banks’ balance sheets will be cleaned up and it is hoped that three viable business will emerge, the two “pillar” banks of AIB and Bank of Ireland and a smaller, leaner Permanent TSB. 

With substantial annual profits these banks can be sold on.  This money will not come anywhere near allowing the State to recoup all of the money this crisis has wasted, but when evaluating the long-term consequences the benefits as well as the costs must be considered.  Many commentators have focussed almost exclusively on the costs of this crisis.

This process is an extraordinary waste of resources, but it is one that we can survive.  It has seen the destruction of assets and savings built up over the last decade, and the imposition of a significant debt burden on the State.  However, default is still an option rather than a necessity and we can work our way out of this crisis.


  1. Seamus
    I know you are trying to bring some realism into the debate but allow me to make a few points.
    The €42 billion debt you attribute to the banking disaster has been after the use of cash resources and NPRF.
    If those cash resources had been available to the State, then State borrowings would have been much less. Therefore an attempt to segregate the total loss to the State from the bank disaster as distinct from the borrowings resulting to the State can give a false impression of the true cost to the State.

    Another concern I have is the lack of discussion on a levy to recoup the full loss from the fiancial secotr over a long period. In fact I understand from the MoU last November that we are obliged to get the banks back into the market as quickly as possible.

    You are right to point out (in another comment) that it is the deficit that presents the continuing problem. As I write this an offical from the Impact trade union is dodging the issue of up to 40 days annual leave for County managers.
    While a cossetted and overpaid officer corps remains insitu, there is no hope of getting out of this.

  2. Hi Tumbrel,

    Your point about the segregation of the cost is important. I am trying to focus on the additional borrowing as a result of the banking crisis. I think that without this the NPRF would be intact and would not used used to finance the deficit.

    I acknowledge that the cash balances we have have actually being accumulated from borrowed money. The breakdown of the costs to the State so far are:

    Total cost: €63 billion
    NPRF drawdown: €21 billion
    New Borrowing: €43 billion

    Over the medium term the impact on the State will be the servicing of this €43 billion of borrowing. Also, the structure of the promissory notes means the actual effect of some of the debt will be spread over a ten-year period.

    The true cost of this fiasco is €63 billion. Nothing should, or could, hide that. Utter madness, but we are so far into Plan A that no matter how sensible Plan B is it could not generate sufficient benefits to merit changing. Non paying off €54 billion of the €82 billion of non-resident bondholders that existed in August 2008 looks like such a simple thing to do now.

    I too would have doubts about the ability to recoup the losses via a levy. Banks can't pay a levy, only people can. Such a levy could only be paid through a combination of increased charges on customers (on a lot of us), reduced pay to workers (some of us) and lower dividends to shareholders (all of us).

  3. Seamus: re
    "lower dividends to shareholders (all of us). "

    Hardly 'all of us'.It depends on who you define as us. With some exceptions that include pension funds, the us that receive dividends are a different us from those us that will struggle to survive over the next number of years.

  4. Tumbrel,

    The pension funds don't own the banks anymore. We do! With the exception of BOI all the banks are certain to be fully state-controlled. The State will be the only shareholder.

    The levy could either reduce dividends to the State and/or reduce the potential resale value for the State.

  5. Seamus
    I don't want to be pedantic. My point is that pension funds are large holders of bank shares. As such levying profits which in turn would reduce dividends would affect the income of pension funds.
    I am not that bothered about other people whose dividends are reduced,because the middle class many of whom had invested their life saving in banks shares have now lost that money. It will be a long ,long time before any middle class person again takes the view that banks shares are the friends of widows and orphans. Or any other shares for that matter.
    As for the State, the levy would merely be a preferential dividend, so as the principal owner of the bank, it would get the lolly first.

  6. Hi Tumbrel,

    I'm pretty sure we'd only be able to apply the levy to banks that have benefitted directly from the bailout. All bar BOI are now under State control. Pension funds cannot hold a large amount of these shares (the NTMA has them!) and therefore pension funds will not lose because of the levy. If the banks are sold at some future date to pension funds the imposition of the levy will be built into the price.

    I think we are both agreed that such a levy cannot recoup the massive costs of this bailout to the State.