Looks like Cowen was right about burning bondholders

Ireland’s archaic property rights could hamper a response to any future bank failure

It was largely taken for granted that holders of subordinated debt, also known as “junior bondholders”, were not subject to similar protection and would receive very little of what was owed to them. Photograph: Getty Images

It was largely taken for granted that holders of subordinated debt, also known as “junior bondholders”, were not subject to similar protection and would receive very little of what was owed to them. Photograph: Getty Images

 

Undoubtedly apart from the comprehensive bank guarantee in 2008, the single most controversial aspect of the government’s handling of Ireland’s banking crisis was the subsequent 2010-2011 decision not to “burn” senior bondholders. Although over time the passions involved may have lessened, this issue will likely continue to be argued over for many years to come.

Given this, the latest media reports regarding the treatment of junior bondholders have highlighted an important ( and generally hitherto overlooked) dimension to the earlier debate. What lessons can be drawn?

In 2010, controversy centred largely on the treatment of senior bondholders – those with a preferential ranking among creditors, especially creditors of the two by then “defunct” banks Anglo Irish and Irish Nationwide.

Faced with this implacable opposition, the Irish government yielded and abandoned a proposed burning operation

In contrast, it was largely taken for granted that holders of subordinated debt, also known as “junior bondholders”, were not subject to similar protection and would receive very little of what was owed to them.

This position was reflected in a “take it or leave it” offer of 20 cent on the dollar/euro to junior bondholders by the Irish government, an offer accepted by most creditors. Some, however, decided to “hold out”, including by selling their claims to hedge and distressed debt funds (otherwise known as “vulture funds”).

Fast forward several years and considerable legal activity in the meantime regarding junior debt, including litigation in the UK courts. Most recently, a few days before Christmas the Government let it be known that for legal reasons outstanding holders of junior bonds issued by Anglo Irish would have to be “made whole”, i.e. repaid in full.

Specifically, “the Attorney General’s Office had warned that trying to circumvent these investors would not withstand a likely constitutional challenge”. This far-reaching conclusion clarifies an important aspect of the earlier debate and what may need to be done going forward.

Reputational damage

The contentious discussion in 2010-11 on whether to burn senior bondholders mainly focused on the strongly held view that “irresponsible” lenders should be forced to share some of the burden of the debt debacle.

Against this, the European Central Bank (and some others) were adamantly opposed, citing reputational damage and possible contagion effects throughout the euro zone and elsewhere. Faced with this implacable opposition, the Irish government yielded and abandoned a proposed burning operation.

However, quite apart from these external pressures there was another issue that received relatively little attention at the time.

Former taoiseach Brian Cowen has argued subsequently (in defending the bank guarantee decision) that under Irish law it was not possible to apply discriminatory treatment between senior bondholders and holders of deposits (which no one was urging be touched).

The implication was that such a differentiated approach to these creditor classes would likely be successfully contested in the courts.

Interestingly, Paul Gallagher, attorney general in the Cowen government, later indicated to the Oireachtas Commission on the Banking Crisis that at the time he had “repeatedly confirmed” the opposite, namely that legally senior bondholders only could have been “burned”.

Regrettably, the commission did not pursue the striking contradiction between these views with either Gallagher or Cowen.

Full circle

Now the issue has come full circle. As reported, the advice of the current Attorney General now is that, on legal/constitutional grounds, not even junior bondholders can be burned. Presumably this conclusion would apply (and would have applied in 2010) a fortiori to a burning of better protected senior debt.

If valid it would appear that the Irish legal framework prevents burning of either class of bondholders. It now appears that former taoiseach Cowen may well have been correct after all.

The vulture funds purchased junior debt at very low prices from the original holders. These funds specialise in pursuing legal actions against debtors (such as governments seeking to impose defaults – Argentina is a good example) where individual creditors perceive their chances of success as not worth the costs and trouble involved.

The recent Irish Government decision implies massively high returns (over 500 per cent) on the funds’ investment. By contrast, creditors who disposed of their junior debt several years ago will have lost out.

This is the spirit of the new euro-area wide approach to resolving banks that run into serious financial difficulties

The latest chapter in this long drawn out saga has several important implications.

First, the earlier debate on whether to burn the bondholders was highly partisan, not to say emotional at times, on the part of some leading politicians and media commentators. However, the parties on both sides of the argument should have paid attention to what at the end of the day has turned out to be a key issue – Irish law apparently prohibits such an approach.

Second, while not sympathising on economic or moral grounds with their situation, one wonders whether some of the original junior bondholders may be tempted to consider reopening the issue.

For instance could it be argued that, as suggested in a UK judge’s ruling referred to in the recent reports, they were placed under undue pressure, pressure it turns out that was not necessarily grounded on sound and consistently held legal advice?

The issue could well turn on the nature of the assessment conveyed by the Irish authorities to the bondholders at the time, as well as the degree of “finality” embodied in the agreed settlement.

Pros and cons

Finally, the case for burning creditors (holders of either senior or junior debt) should be determined by economic and financial pros and cons rather than by legal/constitutional constraints.

This is the spirit of the new euro-area wide approach to resolving banks that run into serious financial difficulties. To the extent that current Irish law constrains such a policy, changes should be introduced, including, if necessary, via a constitutional amendment.

Somewhat archaic provisions regarding property rights embedded in the Irish Constitution over 80 years old may not be suited to the world of modern finance that encourages use of a wide range of instruments embodying different rates of return and risks.

Donal Donovan is a former deputy director at the IMF and the joint author with Antoin Murphy of The Fall of the Celtic Tiger: Ireland and the Euro Debt Crisis ( Oxford, 2014)

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