Banks and hedge funds may have to pay out on Anglo Irish Bank debt insurance after the government insisted holders of its riskiest bonds share the pain of the bailout.
The cost of credit-default swaps protecting Anglo's subordinated notes has more than doubled since September 1st on speculation of a payout. Minister for Finance Brian Lenihan said last week that holders of the bank's €2.45 billion of junior notes must take on some of the "burden" of the rescue, raising the prospect of the swaps being triggered.
"It's almost guaranteed that there will be an event of default" that will cause the swaps to pay out, said Michael Hampden-Turner, a credit strategist at Citigroup in London. "It's almost inevitable that the junior bondholders won't get paid."
There are 674 credit-default swap contracts insuring Anglo Irish's senior and subordinated debt, according to Depository Trust and Clearing data. It now costs €5.2 million in advance and €500,000 annually to insure €10 million of the bank's junior bonds for five years, implying a more than 82 per cent probability of default, according to data provider CMA.
Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent when a borrower fails to adhere to its debt agreements.
Last month, the Government pledged as much as €11.4 billion to support Anglo, on top of the €22.9 billion it has already pumped in since nationalising the lender in January 2009.
Mr Lenihan said that, while senior bondholders will be paid in full under the bailout, legislation is being prepared to "address the issue" of junior bondholders taking a loss on their investments.
Ireland will retain the option of asking investors to sell their holdings back at a "very deeply discounted" price, according to Michael Torpey, head of banking at the National Treasury Management Agency.
The cost of bailing out Ireland's banking system has also weighed on the nation's credit quality. Moody's Investors Service placed the nation's rating on review for possible downgrade yesterday. Any downgrade to Ireland's Aa2 rating will "most likely" be by a single level, Moody's said in a statement.
Credit-default swaps tied to Irish debt have risen 115 per cent since the beginning of August, climbing to 427 basis points, according to CMA. The extra yield investors demand to hold 10-year Irish government bonds instead of benchmark German securities rose to a record 4.54 percentage points on September 29th, and was at 4.12 percentage points today.
The Anglo Irish rescue package will cost every man, woman and child in Ireland as much as €7,500. The bailout of Germany's Hypo Real Estate Holding AG, in absolute terms Europe's most expensive bank collapse, cost less than 5 per cent of the nation's GDP of €3.4 trillion in guarantees and cash injections, according to data compiled by Bloomberg.
"Anglo Irish is one of the lessons from the crisis," said Simon Adamson, a banking analyst at CreditSights in London. "A bank may not be obviously systemically important, yet because it's a bank that makes it too big to fail."
The price of Anglo Irish's junior debt has fallen in past months on speculation holders would lose money in a rescue. The bank's Tier 2 floating-rate bonds due 2016 have dropped to about 23 cents on the euro, from as high as 42.75 cents in May, according to composite prices compiled by Bloomberg. Tier 2 notes rank above so-called Tier 1 debt in a default.
If the Irish government fails to repay Anglo Irish's junior notes, investors would then need to ask the New York-based International Swaps and Derivatives Association, which administers the credit-swap market, to declare an event of default that would cause the insurance contracts to pay out.
Bloomberg