Burn the rhetoric, by all means, but not the bondholders

"Burden sharing" with senior bondholders runs contrary to the national interest, writes DONAL O'MAHONY

LAST FRIDAY, an angry Irish electorate took to the polls, intent on imposing the biggest ever “haircut” on the parliamentary representation of an historically dominant Fianna Fáil party. This was probably inevitable, given the political fallout from Ireland’s seismic economic and financial upheavals. However, it was the deep unpopularity of policy stabilisation efforts, particularly in the banking arena, that ignited the rhetorical wrath of all and sundry during the recent hustings.

“Burn the bondholders” has become the defining refrain of the entire debate, this borne out of a pervasive sense of injustice regarding the dearth of “burden sharing” in the current crisis. The conviction has steadily grown that the State’s contingent banking liabilities are now impossible to bear, such that a certain reneging of these liabilities is a sine qua non for debt sustainability. Initial calls for the imposition of “haircuts” on subordinated bank debt have now given way to more aggressive demands for burden sharing among the senior bondholders.

The incessant vox pop on this issue has been ill-served by a crass misrepresentation of the senior bank debt investor. Far from being the reckless high risk/high reward speculators characterised in various dispatches, senior bondholders are the most risk-averse of species. They are placed alongside rank and file depositors at the very top of the creditor pecking order, where return of capital rather than return on capital is the absolute byword. Senior debt provides term financing for bank credit creation that stretches well beyond the limits of ordinary deposit maturities. Continuous repayment of this debt, alongside that of the pari passu depositor, is the confidence glue which sustains the “maturity transformation” process of modern commercial banking.

Senior bank debt, like deposits, is not risk capital, and does not share in the profits (or losses) of banking operations. Risk capital resides further down the balance sheet in the form of subordinated debt, preference shares and common equity. It bears reminding that such capital has already played a substantial role in the burden sharing of Ireland’s bubble burst. Destruction of shareholder value (and loss of capital reserves) across the banking system amounts to circa €55 billion, while a near €10 billion haircut has already been applied to subordinated bondholdings following numerous liability management exercises.

These numbers need to be placed alongside the cost to Irish taxpayers of the banking stabilisation efforts to date. The €34 billion of promissory note/ cash injections into the failed entities (Anglo/INBS) represent the true dead-weight loss of the banking debacle. Additional injections into the viable institutions (BKIR/AIB/EBS) are financial transactions by the NPRF, with legitimate expectations of longer-term return.

Any taxpayer burden sticks in the craw in current circumstances. However, the moral justification for State burden sharing (over and above financial stability issues) lies in the acute failings of domestic regulators (Central Bank, FR). It is the implicit acceptance of across-the-board regulatory failure during the credit bubble that has now focused the attention of euroland authorities on “bail-in” considerations for future (post-2013) bond contracts only.

Ireland, for its part, remains more focused on the present, and those incessant demands for burning bondholders are being voiced with scant regard for the legal obstacles involved (the current Anglo US investor challenge being a case in point), not to mention the adverse cost/benefits of any such action. Note Moody’s recently junked the senior unsecured debt ratings of the Irish banks, while also placing deposit ratings under review for downgrade. Their decision reflects the understandable perception of reduced systemic support for this particular debt category.

It was a similar perception of systemic support loss for senior subordinated paper in early October that contributed to a vicious contagion of junked credit ratings, surging bond yields, seized-up funding markets and dramatic deposit flight, all of which culminating in the EU/IMF interventions of late-November. Then, as now, the amount of relevant debt outstanding was relatively small, particularly in relation to the two failed entities most at risk of a coercive burden sharing arrangement. Then, as now, the risk/reward associated with such withdrawal of systemic support may have seemed attractive politically; however, it was to prove financially disastrous first time around, and this remains the threat today.

The reality of Ireland’s situation is that, notwithstanding painful efforts to improve the solvency of both sovereign (fiscal consolidation) and banks (over-capitalisation), expected improvements in funding costs have failed to materialise. Irish default risk premia (per market pricing) remain highly elevated, and this increasingly reflects as much investor concern over Ireland’s “willingness” to pay as “ability” to pay. Worse, by continuing to undermine creditor confidence at the very summit of the Irish banks’ capital structure, a much-needed stabilisation of deposit balances is being further imperilled, leaving Ireland susceptible to more prolonged emergency funding assistance than need otherwise be the case.

When the government forms, the rhetoric stops, and negotiations with our European partners will resume. Fine Gael’s election manifesto aspires to extending coercive burden sharing to the senior bank debt of failed institutions “as part of a European wide framework”. But although bank resolution schemes are emerging across Europe, there is no appetite to impose losses on senior creditors on the grounds of contagion risk. Such fears are valid in the context of a still fragile eurosystem, wherein any coercive action against senior bondholders could ripple through to other vulnerable financials in the euroland periphery, threatening renewed deposit outflows and increased funding reliance at the ECB window. With less than €4 billion of senior unsecured debt outstanding at Anglo/INBS, the resolve of our EU paymasters will hardly soften on cost/benefit grounds.

Not that our new government has nothing to negotiate over. Clearly, some concession on the non-IMF portion of Ireland’s bailout interest cost may soon materialise, albeit more likely in the generalised context of an EFSF revamp for the system as a whole. However, a much more important concession may await during the requisite downsizing of the Irish banking system. Any further asset sales at firesale prices will only further imburden the sovereign via stepped-up recapitalisation injections. On the other hand, a second asset transfer scheme, this time conducted at current bank marks, and with attractive long-term funding provided by Europe, could represent a defining moment for Ireland’s financial recuperation.

The optimal path to debt sustainability stems from economically viable funding costs for both sovereign and banks. If the EU/ECB facilitates lower funding costs, a recovering Irish sovereign and banking system can dismiss all talk of default.

Donal O’Mahony is a global strategist with Davy Stockbrokers