The bank guarantee: a mistake we must fix
The markets see a rising risk of default. That is a more powerful argument for renegotiation, writes Colm McCarthy
Irish and European policies have been stuck behind the curve since the onset of the financial crisis in 2008. European banks remain under-capitalised and the stress tests in March come a full three years since the collapse of Bear Stearns signalled the onset of the international crisis.
Not one of the weaknesses in the design of the European Central Bank and the Eurosystem over which it presides has been addressed. The principal weaknesses exposed over these last few years are the absence of centralised bank supervision and resolution, and the reliance on uncoordinated national-level fiscal support when banks fail.
At the end of March, European leaders meet in Brussels to consider Franco-German proposals, the so-called Pact for Competitiveness, which address neither the current and continuing crisis nor the prevention of the next one.
The guarantee of Irish bank liabilities at end-September 2008 was followed by State capital injections, nationalisations, toxic-asset purchases by Nama and finally the IMF/EU deal at end-November 2010. All have failed to resolve the banking crisis, mainly because the scale of bank losses has been under-estimated with steadfast consistency. The intention, on each occasion, was that the action taken would see the banks enabled to finance themselves again. They cannot, nor can the State itself as a result of the dramatic growth in its liabilities and the funding pressures resulting. The most recent action, the IMF/EU deal, is beginning to look incapable of resolving the banking crisis again.
The deal makes it clear that the IMF/EU saw a final resolution of the Irish banking disaster as the key element, along with unavoidable budgetary tightening and some worthwhile measures to restore competitiveness. The immediate priority is the banks. They are bust, have lost their ability to finance themselves in the markets and are bleeding deposits. The budgetary adjustment will take several years and restoring competitiveness even longer. The IMF/EU plan rightly saw the banking mess as the short-term priority.
The Irish banks cannot shrink their balance sheets, and hence their requirement for continuous funding, unless they dispose of assets. They are losing deposits and their guarantor, the Irish State, has itself been forced into a bail-out and can no longer borrow in the market.
The government guarantee burdens the State finances but is now valueless to the banks it was designed to assist, which are reliant on emergency financing from the European Central Bank and its constituent, the Central Bank of Ireland. A banking system reliant on indefinite liquidity support from the monetary authorities is in permanent crisis and the situation cannot be sustained. The side-effects include down-grading of Irish credit-worthiness across the board and sound Irish businesses which enjoyed direct access to international capital markets are suffering collateral damage. Inward investment deals of all sorts are being put on hold.
The IMF/EU bailout plan accordingly placed bank restructuring at the top of the to-do list. It argued that the banks need to shrink through the sale of further loan assets, and need to be given adequate equity capital. They would then be enabled to return to the funding markets under their own steam, and could reduce their reliance on emergency liquidity from the ECB.
The Memorandum of Understanding outlines the steps to be taken: "The plan to overhaul the banking system has several elements. First, banks will be required to run down non-core assets.
"Second, land and development property loans that have not yet been transferred to Nama will also be transferred.
"Third, banks will be required to promptly and fully provide for all non-performing assets as needed.
"Fourth, the banks will be required to securitise and/or sell asset portfolios or divisions with credit enhancement, if needed, once the market normalises."
The plan also provides for wind-up of the hopeless cases, Anglo Irish and Irish Nationwide, and concludes: "To achieve the above goals, banks will be required to submit deleveraging plans to the national authorities by end-February 2011."
The banks have already disposed of non-core businesses including the Polish and American interests of AIB and further disposals, none of which will make a decisive difference, are in train. The key action is the disposal of asset portfolios and the key phrase is 'credit enhancement'.
As has been reported in the media, disposal of €100bn of loans, additional to whatever further distressed debt goes to Nama, is being pursued. But such disposal would need credit enhancement, a nifty technical term which allows for the possibility that these assets are not in fact worth €100bn. Since the banks are more or less bust and need capital, every euro of credit enhancement (read discount on the sale price) will have to be made up by the providers of capital, which means using the funds provided in the IMF/EU plan.
The plan is viable if €100bn of the remaining loan assets can be sold at a small discount to book value. If the €100bn loan books fetch €90-€95bn, the resulting equity gap could possibly be made up within existing provisions. But if the discount is 30 per cent or 40 per cent, the resources are not within the financial resources of the Irish Government.
The guaranteed Irish banks have off-loaded to Nama most of their problem property loans. What remains is dominated by variable-rate and tracker mortgages and the 'credit enhancement' that is required on this €100bn will reflect the willingness of buyers to acquire Irish residential mortgage assets. The banks are increasing their variable rates while post-tax incomes are declining.
Many borrowers are in negative equity since most of the loans were taken out during the house-price bubble, and many borrowers have lost their jobs. Default and non-performance is already at high levels and will rise further.
These are not attractive assets and securitised Irish mortgage books already in existence can be insured against loss only at steep rates. These imply that new bundles of Irish variable-rate mortgages offered in the market will only be shifted at sharp discounts.
The tracker mortgages have been a disaster for the banks. Introduced in 2004 and marketed aggressively until their demise in 2008, these toxic products have done as much damage to some mainstream retail banks as their speculative property lending. Margins were set at a margin over the ECB rate so borrowers are now paying around 2 per cent. When the loans were taken out the tracker rate would have been 4 per cent or 5 per cent and banks could borrow at rates below that level.
Borrowers were stress-tested at these rates and most, if they still have jobs, must be happy, and also able, to keep up their payments. Default rates are low even though many of these mortgages are in severe negative equity. Since the loans are performing (for now) they have not been written down in the books of the banks. But how much would a buyer pay for these loss-making loans? The cost of funds to the banks is well ahead of the interest received and the banks are losing at least €1bn per annum on trackers. If the ECB rate rises in due course, which it will, these mortgages will begin to default.
If the €100bn of assets to be deleveraged can fetch, in an early sale, €90bn or more, the gap may be tolerable. But if the best figure available is €50bn or €60bn, the wheels have already come off and the deal concluded with the IMF/EU cannot be executed.
The focus on the banks' property losses has deflected attention from other unexploded bombs lying around from the bubble. Mortgage borrowers with positive equity and secure incomes are being surcharged through rising variable rates, to cross-subsidise the lucky trackers. These variable-rate borrowers are attractive to UK and other banks with lower cost of funds and will be cherry-picked.
People who can switch to a cheaper mortgage provider are entirely free to do so, leaving the problem borrowers with the distressed Irish banks. Some of the mortgage-backed securities sold by Irish banks in recent years leave risk on the balance sheet, since the selling banks can be required to replace defaulting mortgages in the pool with fresh and better ones from their dwindling stock of performing loans.
For both reasons, the quality of the variable-rate loan books is under a cloud, aside entirely from the problem of distressed borrowers keeping up repayments.
What began in 2008 as a deficit crisis with illiquid banks became successively a debt crisis with insolvent banks and finally a State-plus-banks liquidity crisis with resort to official lenders.
This system-wide liquidity crisis continues three months after the IMF/EU deal was concluded. The gross financial liability of the State, when items such as Nama bonds, promissory notes issued to the banks, and emergency liquidity operations conducted by the Irish Central Bank are added to the gross Exchequer debt, is now heading for levels which could prevent indefinitely a re-entry to the markets.
Bluntly, the markets see a rising risk of default. When the next Finance Minister goes to Brussels to re-negotiate the terms of the IMF/EU deal, there is a more powerful argument than the unfairness of the burden on Irish tax-payers.
The deal, as envisaged in the Memorandum of Understanding, may not be capable of implementation and thus, as a matter of pragmatism, the preservation of order in the eurozone financial system requires that it be modified.
The problem with the bank guarantee is not that it was unfair, although it was. The problem is that it was a mistake, and mistakes, fairness aside, have to be undone as a matter of practical policy.
Colm McCarthy lectures in economics at University College Dublin. He has headed an expert group examining State assets and chaired the Special Group on Public Service Numbers and Expenditure Programmes, aka An Bord Snip Nua