Sunday, June 26, 2011

What can we default on?

Our continued insistence on paying unguaranteed debts in the banks has seen the State pour €46 billion into the six covered banks so far, with a further €18 billion or so to be provided as part of the ongoing recapitalisations.  Of this €64 billion, about €16 billion will have come from money that was built up in the NPRF, so by the end of this year the bank bailout will have created about €48 billion of debt.

There are many who view this as an unsustainable debt for the State to carry and that default is inevitable.  Personally I am still of the view that a sovereign default can be avoided but that does not mean that such a course of action should be discounted.   It is not inevitable but that does not mean it should not be considered as a policy option.

At the end of this year the General Government Debt will be around €170 billion.  In increasing order of importance that will be made up of the following components:

  • Retail Debt: €15 billion
  • Promissory Notes: €28 billion
  • EU/IMF Borrowings: €41 billion
  • Government Bonds: €86 billion

This €170 billion of debt will be about 108% of GDP.  The potential for substantial savings appears to be limited.  The €15 billion of retail debt is Prize Bonds, Post Office Bonds, Savings Certificates/Bonds and the National Solidarity Bonds.  It is very unlikely that there will be a default on these.

At the end of the year there will be €28 billion of Promissory Notes outstanding.  These are used by Anglo, and to a lesser extent, INBS as collateral with the Central Bank of Ireland to obtain Emergency Liquidity Assistance (ELA).   If payment is refused on these Promissory Notes, Anglo will not be a position to repay the ELA it is drawdown from the CBoI.  If that is the case who picks up the tab?  The answer is on page 104 of the CBoI’s 2010 Annual Report:

In addition, the Bank received formal comfort from the Minister for Finance such that any shortfall on the liquidation of collateral is made good.

The €28 billion of Promissory Notes seem an ideal candidate when considering a default as this money will disappear in the zombies that are Anglo and INBS with absolutely zero return for the State.  The problem is that it looks very difficult to escape the liabilities that are being covered by these Promissory Notes.

Default on the EU/IMF borrowings is a non-runner as these institutions have priority status on our list of creditors and are legally guaranteed to get their money back.  It may be possible to reschedule the repayment of these loans.  This repayment is due to begin in 2015.  Such a rescheduling would not be far removed from a default event but it would not reduce the aggregate amount of debt we are carrying.

That means we are down to the outstanding sovereign bonds that were issued prior to our shut-out from markets towards the end of 2008.  A full list of these can be seen here.  At the end of this year there will be €85 billion of these bonds outstanding. 

If a default is going to be worthwhile it would have to reduce our debt/GDP ratio to something around 75% that would mean the aggregate debt would have to be reduced from €170 billion to around €120 billion.

To make these €50 billion of savings it seems the only realistic possibility is to enforce significant haircuts on our outstanding government bonds.  This would have to be of the order of 60% across all government bonds to make the default worthwhile.  If the haircut is less than 60% it is hard to see how the savings to be made could offset the inevitable fallout of a default. 

It is unlikely that such a haircut could be introduced, but if it was it is more than a little incongruous that those who invested in senior bonds from our delinquent banks are getting their money back, while those who invested in the bonds of the country could be forced to carry losses.  Like lots of developments in the response to the crisis, this does not add up.

However, it does not seem that default could generate the required savings to make it a viable policy option.  We are not going to default on out retail debt.  The construction of the Promissory Notes makes it very difficult to escape from the liabilities they cover.  The EU/IMF have preferred creditor status and are virtually guaranteed to get repayment on their loans.  That leaves, our government bonds. 

The yields on these indicate that markets know that this is where the risk lies.  Current market prices have an in-built 40% write-down included in them.  The haircut would need to be half as large again to make it worthwhile.


  1. @Seamus
    "The €28 billion of Promissory Notes seem an ideal candidate when considering a default as this money will disappear in the zombies that are Anglo and INBS with absolutely zero return for the State.  The problem is that it looks very difficult to escape the liabilities that are being covered by these Promissory Notes."

    If we are in the process of defaulting I don't see why the promissory notes and a letter of comfort would be the most difficult to avoid

  2. Hi Dreaded_Estate,

    To be honest I find the Promissory Notes a bit confusing and maybe I am over-stating it but I think the problem is finding a third party to default on. The Promissory Notes have been given to Anglo and INBS, which in turn have given them to the CBoI and taken cash from the CBoI. If we default on these it is the CBoI that takes the hit. We are the CBoI.

    The Promissory Notes have allowed virtually everyone to escape from Anglo and INBS. There are now no deposits and less than €4 billion of bonds in these decaying carcasses.

    How do we work it so that a third party takes the hit if we don't pay the Promissory Notes? There are no depositors and few bondholders left. Can we in some way force the losses onto the ECB? Is that even possible and is it something we would want to do?

  3. But I think the CBI has effectively printed the money they lent to the banks with the promissory notes as collateral.

    It may be possible for the CBI to write off the debt to the bank while at the same time allowing the banks/state to write the value of the promissory note to zero. There would be no net change at the banks but the state would have €30bn less debt and the CBI would be insolvent.

    So if the CBI were to become insolvent who is responsible, the Irish state or the ECB?

  4. That is the key issue. As you say if the Promissory Notes are set to zero the banks get to keep €30 billion of cash, the State gets a €30 billion debt writedown, but somebody has to make good the €30 billion owed to the CBoI.

    Can we in some way pass the liability onto the ECB? I don't know. There are reasons why this money was provided through the Central Bank rather than through the ECB (it is still essentially the ECB's money) but I'm not sure how much distance was created.

    I think the Promissory Notes are a card that we can play but I'm not sure how strong it is. Again it illustrates how difficult it has become for us to pass the losses/debts onto private investors. Nearly half of our liabilities are to international institutions and that proportion is increasing.