Monday 25 September 2017

Emmet Oliver: Junior bondholders knew the risk before buying Irish bank debt

Emmet Oliver

The surprised and indignant reaction from subordinated bondholders in the main Irish banks to the losses being imposed on them this week is itself surprising and mildly perplexing.

The Irish banks have a gross capital requirement of €24bn following the stress tests in March, but this is the gross requirement. Michael Noonan was always going to try and drastically reduce this sum via what are known as liability management exercises, or burning junior bondholders.

Never mind Noonan, the drastic buybacks are an accepted part of the EU/IMF programme.

There was no mystery about how drastic it was going to be once the €24bn figure emerged in March.

Anglo set the standard back in October 2010 when only 20pc of face value was offered to junior debt holders.

If holders of these highly risky, but usually rewarding securities, didn't get the message then, they got a second chance to hear it loud and clear in early May when AIB announced another drastic offer with losses imposed of up to 90pc on junior bondholders.

While there were 18 different types of bonds impacted and some got away with just a 75pc haircut, the message was unambiguous. Losses would be steep and the format would be uncompromising.

It was known at that stage that the Irish government had a target of raising between €5bn and €6bn for the banks from subordinated bondholders.

Also known was that Bank of Ireland would offer to convert the debt into equity if holders were prepared to accept such an offer. But yet this week analysts expressed surprise at this move.

They could have read reports of such a move on their Bloomberg screens last January, but clearly didn't.

For some reason those trading the junior debt in Irish banks didn't seem to realise any of this and this week the bonds were still trading at 50 cent in the euro.

Even yesterday the holders were trying to adjust, working out whether the debt for equity offer was attractive or not (the answer is nobody really knows).

While certain media outlets, most pointedly the Financial Times, said the government here was turning the hierarchy of creditors on its head, this is not really telling the full story in several crucial respects.

Extremely risky

Firstly, the holders of the securities did extremely well from holding these Irish banks assets originally, considering the extremely risky bank balance sheets they were based on.

For example, hard to believe now but Irish Nationwide sold stg£126m of five-year, lower Tier 2 bonds in August 2009, offering an astonishing coupon of 13pc.

One of the buyers was Russian billionaire Roman Abramovich.

Bank of Ireland is no Irish Nationwide of course, but holders of its subordinated debt were also getting a very healthy yield in the final years of the boom.

Also Ireland, despite having the most expensive banking bust in Europe as a percentage of GDP (36.3pc), has actually paid a cash price to every class of subordinated bondholder so far.

Even Irish Nationwide, which did a subordinated bond buyback in early March at an 80pc discount, was still paying holders a premium above the market price, even though the institution was by then all but defunct.

But more than any of this, it is worth remembering that despite bearing the largest banking burden as a percentage of GDP, the current and previous Irish government have not wiped out any subordinated bondholders entirely.

Other European governments have been less generous.

Denmark's Amagerbanken in February wiped out all subordinated debt holders, telling them in a curt sentence "other creditors in Amagerbanken, including lenders of subordinated loan and other subordinated debt, must direct their claim towards the estate in bankruptcy''.

Junior bondholders with investments in Irish banks have reacted with fury in print and in the courts.

In the latter forum they've had virtually no success so far. For some reason the holders of these securities don't seem to realise that burden sharing across Europe is going to be at its most extreme in the country with the largest bank bust and consequently the largest burden to bear.

Honohan turns a profit on secretive bank lending

When this reporter first asked Central Bank governor Patrick Honohan last year about 'special liquidity' he was extending to Anglo Irish Bank in particular, the governor shrugged and described the query as a "matter of little importance".

Unfortunately the scale of the Central Bank's loans to Anglo and other banks has now reached a staggering €49.5bn (an eye watering 30pc of GDP), making it a little harder for Honohan to sound so relaxed.

Clearly the need for such arrangements is unarguable in the current environment, but the lack of transparency about this wall of money and the accompanying risk to Irish taxpayers makes one jittery.

While moving money around in peculiar circumstances is the stock in trade of central banks, the annual report unveiled by Honohan this week does little to dispel the mystery surrounding the arrangements. This is a pity because economists like Willem Buiter of Citi have started to peek a little closer at the arrangements in recent months.

The money is advanced based on "suitable collateral" we are told, but what is the collateral? The collateral is suitable once it meets "criteria defined by the bank", but what are the precise criteria?

We are also told that "appropriate haircuts" have been applied to the collateral to make sure the bank is not exposed, but what is the level of haircut considered appropriate? Have they changed over the last year?

The final piece of camouflage concerns a letter of comfort given to the bank by Michael Noonan, to cover the bank for any loss on the liquidity.

It appears from a brief trawl that this letter of comfort is not accounted for anywhere in the Government's books, at least not to date.

While all of this is most unsatisfactory, the Central Bank mightn't want all the secrecy to end just yet -- it got €510m interest from such lending last year, double that of the previous year. With tax-payers covering it for any losses, it is the easiest money it will ever make.

Varadkar annoys the magic circle of ministers

After four days of rising bond yields and reassuring statements, the Government appears to have finally undone the damage caused by the loose lip of Transport Minister Leo Varadkar.

While Varadkar is right -- at present there is no obvious route back to the bond market before 2013 -- actually giving voice to such thoughts sends out the signal that Ireland isn't even going to bother trying to reach the targets as set down in that agreement.

If a reasonably senior minister believes Ireland will need a second EU/IMF rescue programme, well bond purchasers -- not unreasonably -- start to believe Ireland will need a second EU/IMF rescue programme.

What Ireland will or won't need is unknown at this stage. The December Budget will tell a lot about whether the Government's heart is still in deficit reduction or whether other ways out are on the agenda -- default or another lengthening out of the deficit reduction timetable.

What must also have grated with senior ministers and the Taoiseach is that Varadkar is not part of the magic circle of ministers that are running the current Government or its economic policy.

To be in that magic circle, one needs to be a member of something called the Economic Management Council, which consists of Taoiseach Kenny, Michael Noonan, Brendan Howlin and Eamon Gilmore.

Those with previous experience of finance like Ruairi Quinn and Joan Burton are not invited to its meetings, nor is Varadkar.

This small exclusive club has an "over-arching role'' in just about everything -- from the talks with the IMF/EU/ECB troika, to banking policy to the economic recovery programme.

In fact, so wide is its remit, one wonders why the Government bothers holding meetings of the normal Cabinet at all?

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