Too late now to burn Anglo's bondholders

 

OPINION:Reneging on this issue would completely shatter all confidence in the commitments given to the other Irish banks, says one bond investor, writes DAMIAN CHUNILAL

THE ANGLO Irish debacle has given rise to the view that bank bondholders should be called upon to share the burden of the Irish taxpayer and absorb losses, particularly in the case of Anglo Irish.

While this view has obvious political attractions, its broad application would be extremely dangerous for Ireland, ignoring the harsh lessons that should have been learned by all after the Lehman failure.

Ireland is an open economy with relatively small domestic capital markets. Under normal market conditions, Ireland and its banks rely on overseas investors for a substantial part of their funding.

It is estimated that less than 20 per cent of Irish sovereign debt is held domestically. Ireland also has a highly concentrated financial system that has been allowed to grow to a very large size when compared to the size of the domestic economy.

Hence, preserving international investor confidence in Ireland’s banks and its financial system is of the utmost importance if Ireland and its banks wish to continue to access the international capital markets in the future.

As we have seen from the Lehman failure, when confidence in a single, systemically important financial institution is lost, such a loss of confidence spreads very rapidly and endangers the whole system.

Permitting a systemically important institution such as Lehman to fail and forcing bondholders to take losses led to a wholly rational fear among financial market participants that no systemically important US financial institution would be protected.

This greatly contributed to the magnitude and extent of the “run on the bank” and the freezing of all credit markets that then ensued. The consequences of allowing Lehman to fail and allowing bondholders to take losses was a much deeper economic downturn than would have been the case had the bondholders not been allowed to “burn”.

In the case of Ireland, allowing a major bank to fail and burning the bondholders would have catastrophic consequences for Ireland’s financial system and for the sovereign state.

That is why Ireland acted so promptly to protect confidence in its financial system after the Lehman failure, and guaranteed the obligations of those institutions that were deemed to be systemically critical. In fact, Ireland’s actions with respect to creditors preceded and were subsequently adopted by the UK and other countries.

Ireland should be commended in acting as quickly as it did to prevent a catastrophic systemic collapse of its financial system which would have made today’s problems, as serious as they are, a shadow of what they otherwise would have been. However, in putting in place the framework of systemic support, Ireland took several decisions based upon what was known at that time that have had major, longer term and possibly unintended consequences.

Importantly, in providing support to its banks, Ireland, rightly or wrongly, deemed all of its major banks to be systemically critical and thus eligible for State support.

Having done this, bondholders of all banks were led to assume they would not be forced to bear losses unless this was contractually permitted by the terms of the instruments they held, and that the legal framework of the time would be respected and upheld. Many investors made subsequent investment decisions based upon these two factors.

Whether Anglo’s bondholders should have been included within this framework is another issue. But the fact is that they were. By including Anglo Irish within the support package upfront and covering bondholders under that support package, rather than attempting to draw the line between Anglo and other banks, or between Anglo’s depositors and its other creditors, the stakes were raised.

It will now be very difficult to attempt to renege upon this commitment and burn the bondholders in Anglo, or in any other bank covered by the systemic support, except where contractually permitted.

If the Irish Government breaks its commitments to support Anglo senior bondholders, or retroactively changes the law with respect to its other creditors, why would investors believe its similar commitments given to Allied Irish Bank, Bank of Ireland or indeed with respect to the sovereign state itself?

The consequence of allowing Anglo Irish to “burn” its senior bondholders now – having explicitly promised not to – would be that the credibility of the entire support package would be placed at risk.

No one would believe the commitments given to the other Irish banks. Neither Ireland nor its banks would then be able to satisfy its borrowing requirements from private capital markets. This would be catastrophic.

In the bigger picture, Ireland has acted with commendable clarity of purpose thus far in formulating a strategy to address the current banking sector problems. It has sought to prevent a repeat of a Lehman-style crisis of confidence by guaranteeing the liquidity of the Irish financial system and putting in place measures to restore the banking system’s solvency.

Many parts of this support package have been copied subsequently by other countries. However, the task has arguably been made harder by some of the specific tactical decisions taken, one of which was the decision that Anglo Irish was systemically critical and that its senior creditors thus needed to be supported.

Whether Anglo was systemically critical and whether its senior creditors needed to be supported is beyond the scope of this article, but having defined it as being so, and having stated that its senior creditors will be supported, it would be extremely risky to now burn these bondholders. Doing so would risk threatening the entire recovery plan.

Damian Chunilal is managing director of the Hong Kong-based investment firm Ocean Capital Management. He has invested in Irish bank bonds in the past. The firm holds no investment in Anglo bonds

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