OPINION:Instead of burning bondholders, Irish debt may be restructured with European support
HIGH ON the agenda of the incoming Fine Gael-led government will be their promise to seek to “renegotiate” the terms of the EU-IMF bailout. Apart from the interest rate on the EU portion of the loan and the policy content of the memorandum of understanding, some attention will be given to whether the banks’ senior bondholders can or should be required to take a financial hit.
So far the EU has been opposed to this, citing the wider implications for the euro area. But is it in Ireland’s own interest to follow such an approach? And as a related matter, what is the status of the loans from the Central Bank and the European Central Bank that have been used to repay the banks’ guaranteed maturing bonds and deposits over the last few months?
Burning the bondholders has been an emotional issue during the election campaign. In most debt crises, it is normal that aggrieved creditors or, in the case of Ireland, the taxpayers, feel that lenders should be forced to accept some financial responsibility for the loans that they extended without, it is argued, undertaking sufficient due diligence.
On the other hand, senior creditors do not accept they were reckless gamblers, maintaining that they are entitled to repayment on the due date of the amount stipulated in their bond contract. They would further argue that Ireland Inc enjoyed the fruits of the loans it received.
Both sides have significant elements of right on their side, but the question is whether, from the viewpoint of Ireland’s self-interest, the benefits of a restructuring operation outweigh the possible costs?
The main cost could be some reputational loss to Ireland’s overall creditworthiness. Almost by definition, this is difficult to evaluate in advance and there will always be an element of risk. However, we know that Irish banks are heavily dependent on foreign sources to fund new lending activities. The sharp mortgage interest hikes in recent weeks have been attributed partly in some market reports to increased nervousness in the wake of the heightened talk, including in Ireland, of imposing losses on bondholders.
It should also be recalled that in November last year, markets became unsettled by chancellor Angela Merkel’s announcement favouring a possible debt restructuring mechanism beginning in 2013. This had immediate negative repercussions on Ireland’s credit rating and contributed to the financial pressures leading to the eventual arrival of the IMF in Dublin.
Whether well-founded, the fears of investors cannot be ignored in situations where market confidence remains fragile.
It can be argued that the proposed operation would be aimed only at holders of bank bonds and that there is no question of restructuring sovereign debt per se. However, from a lender’s viewpoint, it can be difficult to make a clear distinction between the two, for example, if budgetary funds (financed by the accumulation of sovereign debt) are used to recapitalise banks as a result of funding gaps relating to repayments to bondholders.
MORE GENERALLY,one cannot discount the thought that five years from now, voices could emerge calling for a renegotiation of the EU-IMF debt on the grounds that it was "foisted" on Ireland on unfair terms to repay greedy foreign lenders. If a burning of bondholders took place in the interim, why not go down the same route again? Unfortunately, lenders do have to take such possibilities into account, even if the above scenario might appear unlikely at present.
The benefits of a restructuring of unguaranteed bond debt are in principle more straightforward – the stock of debt is reduced, as are the associated current interest payments. The actual savings would depend on the terms and size of the debt covered. According to recent data from the Central Bank, the stock of such senior unsecured bondholder debt is €16 billion, most of which is owed by AIB and Bank of Ireland.
There is also some €7 billion of subordinated debt which has been, or is being, restructured. These figures do not include senior secured debt of €19 billion, the restructuring of which has not been raised seriously to date. Any move in that direction would likely encounter significant legal obstacles and entail considerably greater reputational costs. It is believed, but not known precisely, that a significant portion of the senior unsecured debt is held by Irish banks, pension funds and credit unions.
THE POINThas been made by some commentators that even if Irish senior bondholders were to end up being captured in a burning operation, they have, or should have, acquired credit default insurance to compensate. However, the cost of credit default insurance on Irish paper has risen sharply in recent months. This represents a real financial burden and one which could increase further for any Irish institutions concerned.
Let us assume that one-third of the €16 billion debt is owned by Irish institutions and that a 35 per cent “haircut” is applied (typically, haircuts are 20 to 50 per cent). The net financial savings to the economy in terms of debt reduction would be around €3 billion. The associated annual interest payment savings could be about €150 million, assuming an interest rate of 5 per cent.
Are the potential savings just described sufficient to outweigh the costs of a restructuring? One cannot say, without further efforts to identify more precisely the possible magnitudes involved. But in my view it is more constructive to focus the debate on these practical aspects rather than on the question of “who is to bear the blame”.
THE AMOUNTof outstanding senior bonds likely to be eligible for restructuring may seem surprisingly modest. The reason, of course, is that over the last two years, many of the banks' maturing bonds were guaranteed and have already been redeemed, using financing from the ECB and the Central Bank, respectively. What is the nature of this debt?
Financing from the ECB (around €100 billion) is provided to banks against collateral (“ECB-eligible assets”), usually involving a substantial haircut. That is, if a bank holds collateral it believes to be of a certain value, the ECB may extend a loan of, say, 70 per cent of that amount, to protect itself against a fall in the asset’s value.
Central Bank funding (about €50 billion) in the form of emergency lending assistance, is typically provided to banks who have exhausted their stock of ECB-eligible assets. It requires prior approval by the ECB and has virtually all been used to repay government guaranteed debt. The collateral includes non-eligible ECB assets, as well as an Irish government guarantee.
The ECB is engaged in discussions as to how and when its outstanding lending to Irish banks can be reduced via the disposal of bank assets. One cannot say at this stage if the outcome will end up being sufficient to cover all the debt owed to the ECB. In the case of the government debt to the Central Bank, the bank could call in the government guarantee provided in respect of emergency lending.
All the institutions involved – the Central Bank, the ECB and the Government – are intertwined. If issues were to arise in respect of the settlement of either Central Bank or ECB lending, the focus of the discussions might shift towards Europe. If other countries were to experience similar difficulties, there could be talk of the need for some kind of a pan-European “public sector solution”, possibly involving taxpayer support.
It may well be that for the reasons outlined earlier, a “burning of the bondholders” option is not in the end pursued by Ireland. However, it cannot be excluded that, via the more circuitous route described above, European taxpayers will have to pay some part of the bill for the Irish bank guarantee.
Donal Donovan is a former deputy director of the IMF. He is adjunct professor at the University of Limerick and a visiting lecturer at Trinity College Dublin.