Bailout inept and potentially dangerous

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OPINION:The Government has acted in haste and the banking bailout will be regretted at leisure, writes Morgan Kelly

THIS IS the wrong solution to the wrong problem. It has put the Irish taxpayer at risk of considerable losses, and does nothing to solve the real problem of Irish banks, which is a shortage of capital.

Irish banks get about one-third of their funds by borrowing from foreign banks. What precipitated the crisis on Monday was that foreign banks stopped lending to them. What we need to understand is what caused foreign banks to stop lending to Irish banks while they kept lending to most other banks in Europe. Once we understand the answer to this question we will understand how inept and potentially dangerous the Government's attempted bailout really is.

The reason that foreign banks started to shun Irish banks is that international investors have gradually become aware of the scale and recklessness of Irish bank lending to builders and property speculators. Irish banks are currently owed €110 billion by builders and developers. Of every €100 that Irish residents have deposited in banks, €60 has been lent for property speculation.

As the property bubble has burst, it is looking increasingly unlikely that banks will get back more than a fraction of this. In particular, very little of the €25 billion lent to builders to construct the ghost estates and vacant apartment blocks that now blight the landscape will ever be seen again. Foreign banks know of these toxic loans - even if Irish banks are still trying to disguise them - and are frightened by them. That is why they stopped lending to our banks, and why the Government was panicked into taking their place.

The difficulty that Irish banks had in raising funds was a symptom of the bad debts that foreign investors know have eaten up most of their capital. By treating the symptom, the Government has ignored the cause which is the shortage of bank capital.

The failure of Government policy can be seen in the share price of banks. On Tuesday evening after the bailout had been announced, the shares of the three retail banks were still slightly lower than they had been on Monday morning before the panic. If all that was wrong was a shortage of liquidity then they should have roared back to their levels of a year ago.

Is this just abstract carping? Surely deposits are again flowing into Irish banks, and all their troubles are behind them. Unfortunately not.

The amount that a bank can lend is proportional to its capital: the amount of money that its owners have invested in it. As banks suffer bad debts, this capital falls and the amount that they can lend contracts.

Effectively the Irish banks are heading in the same direction that the Japanese banks were in the 1990s: zombies that are kept on life support by the Government, but without the capital to provide firms and households with the borrowing that they need. However this cosy Japanese solution to an Irish problem could come unstuck if bank auditors refuse to sign off on the valuations that banks are still putting on their dead assets. This would precipitate a new crisis that would make last Monday seem like a picnic.

The Irish Government should have done what the Swedes did in 1991. The Swedish government stepped in and, in return for banks' admitting the scale of their losses and firing the senior managers that had caused their problems, provided capital in return for a share of ownership.

As the Swedish economy recovered, the government was able to sell off its share in the banks, with the result that the Swedish taxpayer lost nothing on the bailout. In Finland, by contrast, the government denied that there was any problem until their banking system had collapsed and was then forced into a ruinously expensive bailout. The Government should have offered new capital to four of the institutions, and left the others, where the real problems lie, to fend for themselves.

Not only does the Government guarantee of bank borrowing fail to solve the underlying problem of bad loans; it faces the Irish taxpayer with a real risk of enormous losses.

By insuring the borrowing of banks with toxic assets, the Government has taken up where the collapsed American insurer AIG left off. It was by guaranteeing to cover any losses to institutions that lent to client banks, what was called monoline insurance, that the world's largest insurance company went bankrupt. The particular risk that the Government now faces is that Irish banks will package toxic loans as asset-backed securities and sell them off with a Government guarantee, passing on their losses to the Irish taxpayer.

Suppose that you are a bank that has lent €100 million each to 10 developers who are having problems meeting their repayments. What you do is bundle the loans into one asset and sell it, with Brian Lenihan's signature on the bottom, on financial markets for €1 billion. When the borrowers default, the taxpayer will be left taking up the tab.

The following months will see a battle of wits between banks and the Financial Regulator, as banks try to offload bad debts on to the taxpayer and the regulator tries to stop them. As this realisation dawns on investors we can expect bank shares to soar in the coming weeks, and the cost of Government borrowing to rocket.

Irish banks were facing potential losses on their property lending of the order of €10 billion to €20 billion. Thanks to Brian Lenihan's master stroke it looks as if it will be you, rather than bank shareholders, who will be taking the loss.

• Morgan Kelly is professor of economics in UCD

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