You might recall from your secondary school days, Pythagoras’ theorem on right angled triangles that the square of the hypotenuse (the longest side) is equal to the sum of the squares on the other two sides. So a^2 + b^2 = c^2 where a and b are the two smaller sides and c is the hypotenuse. Is it all coming back? And then in the seventeenth century, a bored Frenchman suggested that a^n+b^n=c^n could never be true if n>2. Legend has it that the Frenchman, Perre de Fermat wrote the proof of his theorem in the side margins of a book but alas, it got lost. And so for 350 years, mathematicians tried to prove Fermat’s theorem, which was to have been his last theorem as he died soon after he developed it. The quest to prove the theorem ended in the 1980s when the geeks finally cracked it. All for what you might ask. Well, it gives us an introduction for examining some maths which is very relevant to us inIrelandtoday – Patrick Honohan’s Calculations (“the Calculations”), and it’s particularly relevant as we are all now geeks in the wilderness trying desperately to understood the Calculations .
The Calculations are those referred to by Patrick Honohan, governor of the Central Bank of Ireland (CBI) in March 2011 on the occasion of the publication of the AIB/Bank of Ireland/Irish Life and Permanent stress tests and banking restructuring. On the night of the announcements, the Governor was interviewed by veteran journalist Vincent Browne and the interview is still available here. Vincent repeatedly homed in on the commitment to repay senior bondholders which the CBI had shown as follows in April (following a correction to figures first shown in March 2011)
And what do the Calculations look like? Probably
A < B
Where A is the total cost of repaying bondholders in Irish banks and B is the total cost of not repaying the bondholders. Simple so far, but alas A and B are merely the top level costs and need to be broken down further – much, much further. The cost of repaying the bondholders A, is probably the easier to calculate – after all, we know the figures and the interest rate on the borrowings we need to repay the bondholders.
Now at this point, you might be tempted to introduce other costs such as the damage to Irish society from repaying the debt, the increased class sizes, the reduced healthy life expectancy, the fear and fact of crime for examples; and perhaps also the impact of the decision on the psyche of Irish society. After all, if what is perceived as a grossly unfair course of action is imposed on society, there will be damage to trust, respect and the integrity of society. How do you measure these? Well, thankfully you wouldn’t have to concern yourself with such considerations to understand the Calculations because Governor Honohan stated that his calculations ended when he arrived at the total “fiscal account”. So if A was €70bn and B was €80bn then the Governor didn’t explore the consequences further. Presumably he would have concluded that because A is €10bn less than B, then the social damage will be less than if we pursue B. There is logic to that approach. Please think about it, it’s not the Governor saying these considerations are not important, it’s him saying that these considerations will flow from the financial calculation of the net fiscal position. So I might offer you a salary of €100k and a 10% shareholding in the company or a total salary of €200k. Your calculation is how much the shareholding is worth – you’re not considering what you can buy with the money or how it will improve your life, at this stage you’re just comparing the financial (or “fiscal accounts”, in the Governor’s terms) position. Fair enough.
But what about the cost of not repaying the bondholders? Now this would appear to be quite a complex calculation and although not at all privy to the Calculations, I would expect a mixture of costs and probabilities; probabilities because there are so many unknowns which depend on assessments of legal, political, reputational, economic, financial system and other issues. The calculation would probably take account of the following
(a) Legal issues. As we are seeing today with the withdrawal of a subordinated debt offer in the UK by Bank of Ireland, on the eve of the hearing in London’s High Court where a group of bondholders was challenging Bank of Ireland, we are seeing that there is legal uncertainty with adopting certain courses of action. We might be able to control matters inIreland, for example through the draconian provisions of the December 2010-enacted Credit Institutions (Stabilisation) Act, and even here there can be constitutional challenges. Overseas, the setting aside of contracts, regardless of the emergency that gives rise to the intereference, might be met with hostility in foreign courts.
(b) State’s finances and banks’ finances : Irish banks are in receipt of €156bn of central bank funding at the end of May 2011. Most, €102.3bn came directly from the ECB where the interest rate charged is understood to be its main rate of 1.25%. In addition, the CBI lent €53.7bn, under the auspices of the ECB, at 3% reportedly. Although Bank of Ireland was able to issue a €750m State-guaranteed bond last October 2010 at 5.9%, the feeling is that today the market would demand 10%-plus if it would lend at all. And as the State owns most of the banking system, there would be a substantial annual cost if the ECB were to withdraw its funding. The Governor referred to the State’s finances as well in his interview, and he was perhaps referring to possible difficulty in returning to the markets.
(c) Spill-over on other banking markets and the consequences for our relationship with the rest ofEurope. The Governor was presumably referring to the perceived fact that it is mostly French, German and British banks that hold senior debt and that should our banks default on those debts, then other banks would suffer losses, and those banks in turn might default on their own bonds, and you might have a damaging domino effect and possibly banks that were borderline surviving going under which might lead to a spiralling banking crisis. Who knows, Irish banks themselves may be exposed to losses from their holdings of bonds. As for our “relationship withEurope”, how would you place a value on that?
(d) If the ECB were to withdraw funding then our banks would fail, and putting aside the contagion effects of our bank failures throughout Europe, inIrelandour banking system would be jeopardised. And given that there was no alternative funding available, it is likely we would need exit the euro. Which would lead to inflation as whatever new currency we introduced would devalue against the euro, so imports would increase in price. Savings would suffer again as a result of inflation. There might be social and political unrest as people lose money, experience inflation and possibly increased unemployment. Foreign investment would suffer as companies would no longer viewIrelandas stable, that there would be foreign exchange risk by locating here, and consequently Foreign Direct Investment would decline and that would impact jobs, taxes and investment generally.
(e) “Known unknowns”. There might have been all sorts of other considerations not accounted for above. There might also have been allowance for “unknown unknowns”
(f) Probabilities. What probability was attached to the ECB withdrawing its funding from Irish banks if there was default on senior bondholder debt? 100%, 50%? What probabilities were attached to legal opinion.
So why can’t we see the Calculations?
Presumably they might expose sensitive political and economic considerations. A 100% probability of the ECB withdrawing funding in retaliation at our burning of senior bondholders might be considered sensitive, especially considering the fact that we are at pains to deny the ECB ever threatened us. Attaching probability to legal opinion might also be sensitive. Arguably however, these concerns are irrelevant in a democracy. And any decision that entails such significant financial outlay should be presented openly so that society can understand the reasoning behind decisions. Adopting the Men-in-Black (“A person is smart. People are stupid”) or A-Few-Good-Men (“The truth. You can’t handle the truth”) mentalities is not acceptable when so much (of our) money is at stake.Irelandis not a dictatorship or oligarchy or technocracy – it’s a republican democracy. That should be respected, and if it is not it should be demanded.
Another argument that might be advanced regarding the concealment from the public of the Calculations is that the people who prepared the Calculations were expert and therefore there is no need to share the Calculations with the general public. Governor Honohan is held in very high personal and professional opinion on here. Remember that alongside the president, he’s about the only public servant that volunteered, without prompting, a 20% reduction in salary last year. At a time when the role of CBI governor is so demanding and all-consuming, that was a major act of sacrifice and stands to the credit of the man personally. And professionally, he took over in September 2009 after most of the damage had been done to Irish banking and hasn’t shied away from confronting difficulties; he enjoys professional respect for his application and intellect. But for all that, the stress tests in March 2011 were not accurate in light of later revelations such as NAMA losses, and you could argue Governor Honohan should have validated the testing more. He repeatedly got the recapitalisation needed at the banks wrong, in the sense that later estimates tended to balloon. He believed we would need no more than €10bn of the €35bn-bank-earmarked element of the bailout whereas the actual requirement appears to be double that (and we are still to confront the credit unions and INBS and Anglo – these latter two have not gone away and the recent stress tests left unanswered the quantum of additional capital required). Against the above, you could say that the economy has continued to deteriorate as have property prices and the international financial situation has not been kind. But still, Governor Honohan and his experts are far from infallible. And let’s not forget that EBS miscalculated its €2.5bn of bonds by €1bn in March 2011 which resulted in an embarrassing correction by the CBI.
So when can we see the Calculations? Must a society that will, regardless of the equation, suffer painful adjustment, spend 350 years having a stab at why in 2011, Ireland decided that repaying senior bondholder debt was a better course of action than not repaying it?
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