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Archive for November 7th, 2010

During the week there was the usual fervent debate on the irisheconomy.ie blog following the publication by the Department of Finance (DoF) of what it called an “Information Note” in advance of the four-year plan which will now be published at the end of this month and the Budget debate on 7th December 2010. The Information Note made reference to the “promissory notes” which are being used to bail out the banks. One commenter on irisheconomy.ie, understood to have a background that makes them familiar with the bond market, frankly admitted “btw, i f***ing hate those promissory notes, seriously confusing”. This, just a couple of weeks after Labour finance spokesperson Joan Burton told the Minister for Finance, Brian Lenihan, in a heated Dail exchange that in relation to the operation of the promissory notes  “we need a Powerpoint presentation on this” and got the curt reply from Minister Lenihan “we do not” which prompted an Opposition deputy, Jim O’Keeffe, to chip in with “we need lots of money for this”. This entry examines the operation of promissory notes in the bailout of our banks and in particular the note of explanation produced by the Department of Finance on Friday morning last. It will conclude that the timing of the cash-flows appears optimistic in the early years and that as an aside the figures appear to not add up.

The background – promissory notes for Anglo, INBS and EBS

In December 2008, DoF informally informed the EU of its intention to inject €1.5bn into Anglo. On 8th January, 2009 DoF formally notified the EU of this intention.On 14th January, 2009 the EU gave its approval to the injection but it was never carried through. In May 2009, Minister for Finance Brian Lenihan announced the first State injection of €4bn into Anglo.  On 26th June, 2009, the EU gave its approval to inject the €4bn in Anglo and noted “Anglo will use part of the proposed €4 billion recapitalisation to buy back at a significant discount certain outstanding subordinated loans it had issued in previous years, which will lead to a further increase in its Core Tier 1 capital”. In July 2009, Brian Lenihan replied to a written question in the Oireachtas to say that €3bn of the €4bn had been paid to Anglo from the Central Fund in June and “the balance of up to €1bn will be provided subject to agreement on a proposed buyback of Anglo debt aimed at improving the Bank’s Core Tier 1 capital position”. In August 2009, €827.72m was injected into Anglo and in September 2009 the remaining €172.28m was injected to bring the overall injected at the end of September 2009 to €4bn. So that was the €4bn in cash that Anglo received in 2009 – all simple and straightforward and it came from the Central Fund. Ireland’s deficit in 2009 was €24.6bn and the national debt grew from €50.4bn in December 2008 to €75.2bn in December 2009 so you could argue that the €4bn was borrowed and added to national debt.

In 2010, the “injections” into Anglo have been using promissory notes and it’s worth remembering that a promissory note is a promise by the government to inject real cash into Anglo at a point in the future. It is a commitment and no cash actually changes hands when the commitment is given. The Financial Regulator regards these promises as sufficient to bolster Tier 1 capital – he’ll have egg on his face if the State can’t honour these promises because of an inability to secure borrowing. Anglo does not pay interest on the promissory notes (paragraph 26 of the EU Decision granting use of the instrument – “The promissory note is not remunerated by Anglo. The Irish authorities will not obtain any further rights in Anglo and repayment of the principal by Anglo is not foreseen.”) On 30st March 2010, Minister Lenihan announced the first promissory note to Anglo for €8.3bn – “The bank’s capital support is being provided by the State in a way which spreads the cash requirements over an extended period of time. I am injecting the capital this week in the form of a promissory note, payable over a number of years into the future. In essence this means the amount will be paid over a period of 10 to 15 years, thereby reducing the impact on the Exchequer this year and stretching the payments into the future.” No further details were given. The full terms for the operation of the promissory notes are set out in the EU Decision on 10th Augist, 2010 and are examined below – as far as I can see there has been zero debate on the terms in the Oireachtas – and Joan Burton’s request for a Powerpoint presentation seems appropriate. The initial promissory note of €8.3bn was increased on 28th May 2010 (ministerial announcement here) to €10.3bn. “At the end of June, Ireland notified a capital injection of €8.581 billion in favour of Anglo Irish Bank” according to the August 2010 EU announcement of the Decision to approve further capital support and “this amount can be increased to €10.054 billion, depending on the actual valuation of the bonds issued by the National Agency for Asset Management (NAMA) in the accounts of Anglo Irish Bank”. This would bring the cumulative promissory note injection into Anglo to €20.354bn and the intention would appear to be to increase this by a further €5bn (which will presumably require yet another EU Decision) to bring the promissory note total injection into Anglo to €25.3bn (€25.354bn to be precise). When added to the €4bn cash injection in 2009 that gives you the €29.3bn being touted by DoF as the “best estimate” of Anglo’s costs though a claimed worst scenario puts the estimated cost at €34.3bn.

Irish Nationwide Building Society (INBS) has a less convoluted history. In March 2010, Minister Lenihan announced a €2.7bn injection into INBS, of which €2.6bn was via a promissory note and €100m in cash – “I intend to inject the necessary capital through a combination of €100 million in Special Investment Shares in the society and a Promissory Note for €2.6 billion issued to the Society, giving INBS a small buffer”. In September 2010, the Minister announced his proposal to increase the promissory note to €5.3bn (plus the previous €0.1bn injection in cash).

The Educational Building Society (EBS) is even more straight-forward. In June 2010, Minister Lenihan made a €0.35bn injection into EBS, of which €0.25bn was via a promissory note and €100m in cash. EBS is presently up for sale and the government has indicated that it may need make an additional €0.5bn available via an increase in the promissory note value.

So there you have it, at the present time three Irish financial institutions are supported to the tune of €25.9bn (Anglo €20.354bn, INBS €5.3bn with the assumption that the announcement in September of an additional €2.7bn has been effected and EBS €0.25bn) by the magic that is a promissory note. This figure is set to increase by €5bn with a further promissory note for Anglo to bring the total Anglo capitalization to €29.3bn (€25.354bn in promissory notes and €4bn in cash). A further €0.5bn may be needed for EBS and a further €5bn may be needed for Anglo in a “worst case scenario”. This could mean that these three Irish financial institutions are supported by €36.2bn of promissory notes. I wonder what nice people will lend the State these sums?

The announcement by DoF on Friday last

According to the EU Decision in August 2010 in Anglo’s case (and this entry is going to restrict itself to Anglo) the promissory note “will be paid out to Anglo in annual payments of a maximum of 10% of the principal over a ten-year period. The principal amount of the instrument shall therefore amortise over time. The Irish authorities will pay every year a fixed annual coupon on the average principal amount during the preceding year (in other words, on the still unpaid part of the promissory note). The coupon rate will be set on the date of issue of the promissory note. The Irish authorities intend to accumulate the coupon and pay it after the payment of the principal amount. This will have as a consequence that the duration of the payments made to Anglo is increased by four years to fourteen years in total.”

Clear as muck then! Here’s what I think happens. DoF give Anglo a promissory note. When Anglo needs cash they come to DoF with their request. DoF borrows the money and gives it to Anglo. DoF repays the principal plus interest to the nice lender.  So when will Anglo need the cash? Take a look at page 28 of the Interim Report for Anglo for the six month period ending 30th June 2010 (the latest accounts available) and you will see that Anglo has liabilities of €80bn. It also has assets of €87bn (including at that point €10.3bn of a promissory note). When does Anglo need repay the €80bn of liabilities? Notes 24-27 on pages 55 onwards should help but don’t very much. €33bn is payable to other banks (including the Irish Central Bank and one imagines, the ECB – both of whom might be tolerant). €23bn is repayable to customers and represents customer accounts. This could be repayable immediately. €17bn are bonds with maturities up to five years and there is a note to say that €7.9bn matured in September 2010. There’s €2.4bn of subordinated debt which is presently the subject of a negotiation at 20c in the euro. There’s €4bn of “derivative instruments” and note 16 on page 46 offers some explanation for these. But the point is what certainty DoF can have that only 1/10th of the cash will be needed in 2011. What happens for example if deposits of €10bn are withdrawn early?

The announcement on Friday includes a key table (which might be adaptable as a Powerpoint presentation). I have transferred the figures in spreadsheet format which is available here. The spreadsheet shows the totals – column one shows total repayments on the €30.854bn of promissory notes and €0.2bn of cash injected  plus interest. The interest payable is calculated in column four and totals €13.3bn. And guess what? The interest payable and the promissory note/€0.2bn cash injections in EBS/INBS total €44.3bn, yet the table adds up to €43.3bn. How did DoF magic away €0.8bn of principal/interest? I’d guess it might be in the year 2026 which isn’t shown but the fact that the figures don’t add up doesn’t inspire confidence. Here’s the table which is taken from the announcement.

So why is the scheme as outlined cockamamie?

(1) It assumes that there will be an even call on the promissory notes by the banks in the early years. Yet given that €23bn is payable on customer accounts on demand, and with an unknown profile for the other liabilities, that may be so over-optimistic as to be reckless.

(2) It assumes the State can borrow at these levels in forthcoming years to honour the promissory note

(3) It assumes that we don’t need fund the worst case scenario for Anglo (an additional €5bn if you believe DoF estimates) or the remaining capital shortfall at EBS (€0.5bn) or any other unexpected loss at INBS.

(4) It’s obvious that interest accrues in 2010 and 2011 and all we’re doing is adding it to the principal so that we repay more in future years at the expense of recognizing zero interest payments in 2010 and 2011.

(5) The interest payable plus the principal (promissory notes and €0.2bn in cash to INBS/EBS) do not appear to add up to the total shown.

(6) Our Financial Regulator is prepared to accept a promise (that the State might have some difficulty honouring) as sufficient to bolster Tier 1 capital. Welcome to the Wild West of Europe indeed.

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Every country throws up its own share of comedic stories in the “you couldn’t make it up category”. Maybe on the world stage the Irish, Poles, Belgians (mostly in France) have come to be stereotypes but in truth they’re present in every country. But take our own in the last week:

Of the of the main stories occupying the media is the Cork-based provocative and opinionated radio broadcaster, Neil Prendeville, who is alleged to have exposed, and then masturbated himself beneath the inflight magazine Cara (meaning “friend” in Gaelic) in the middle seat of the front row between two shocked passengers on either side (one male and one female who happened to be a journalist) and facing two female stewardesses, on an Aer Lingus flight from London to Cork on 19th October. Neil Prendeville release a statement in which he claimed he couldn’t remember the incident as he had taken painkillers and alcohol, though if it had happened he said, then he expressed his sincere apologies. Gardai are investigating the matter and according to the Irish Examiner “their investigation will take several weeks before a file is prepared and sent to the Director of Public Prosecutions.” The public won’t be surprised that it will take the Gardai a few weeks to investigate a wank – after all they have been investigating for nearly two years a €450m share-support scheme, €7bn loan carouselling at year-end to avoid adverse financial reporting and the concealment of €80m+ director loans at Anglo Irish Bank. Despite Anglo’s HQ being raided by Gardai in February 2009 and two high-profile arrests – on 18th March 2010 (Sean Fitzpatrick, the former chairman and CEO of Anglo) & on 24th March, 2010 (Willie McAteer, former finance director of Anglo), both men were released without charge after 24 hours – no apparent progress has been made with the investigation though recent reporting has suggested that the Gardai might try to present their case to the DPP by the end of this year.

On Friday, the Minister for Agriculture, Fisheries and Food, Brendan Smith announced a scheme to provide assistance in the form of cheddar cheese to hard up families (there are a lot here with 450,000 people on our Live Register representing about 275,000 unemployed and the remainder in receipt of some form of income support). The scheme is not new – up until recently the State used provide some 350,000 kg of butter per annum to the needy. It was decided that cheddar cheese was easier to store and distribute so now we distribute 167,000 kg each year and the announcement on Friday was to confirm that 53,000 of this 167,000 kg would be distributed before Christmas.  Cheddar typically sells for about €10 a kilo in our supermarkets so the one-size 12 x 1kg pack available from five distribution centres throughout the country will have a value of some €120 per household lucky enough to qualify for the permits. In total some 53,000 kg are now being made available for distribution (worth €530,000 in the shops and capable of supplying 4,417 families). The Minister defended the scheme which is supported by charitable organisations but with an expected €6bn of budgetary cuts expected in weeks (with €4.5bn coming from public services and capital spending and €1.5bn in new or increased taxes and levies), the initiative attracted widespread public and political ridicule for being ad-hoc and not part of joined-up thinking.

Of far greater significance was the bizarre announcement by the Minister for Health and Children, Mary Harney, of a one-time offer open for 17 days only of a redundancy/early retirement scheme for the health service – the scheme is to allow 5,000 to take early retirement (if they’re over 50) or voluntary redundancy (no restriction whatsoever) and the projected cost is €80,000 per person (€400m in total). The “offer” will close on 19th November, 2010 and the offer was roundly criticised not least because it was making a blunt and random cut in the health service (annual budget is 2011 is €15bn out of government current spending of €55bn – appendix 1) without regard for the nature of services that would be cut by a departure of people from unpredictable departments (be they frontline or managerial). The offer lacked any planning of the future service and was a worrying augur for what the forthcoming Budget will contain.

And so to the Budget itself. The Information Note released on Thursday last has had a mixed response. There seems to be broad agreement, though with notable exceptions, that a fiscal cut of the order of €6bn is required in 2011 to help us along the road to restoring our finances to a 3% budgetary deficit in 2014 (from an estimated 11.9% in 2010 – that’s after stripping out the one-off bank bailout costs which otherwise would see us at 32% in 2010). The financing of the bank bailout promissory notes (subject of a separate entry on here later today) caused confusion and resulted in an additional release from the Department of Finance of Friday which showed how the interest and capital repayments on the notes would work. The two-year interest free period (from a Eurostat accounting perspective) amused many and fooled no-one, it was a device to defer €2-3bn of interest into 2013 and beyond. The statement released doesn’t even seem to add up as the total interest shown on the promissory notes is €13.1bn and the total repayment of promissory note and interest is €43.3bn but the promissory notes (including the €0.2bn special shares in INBS and EBS) come to €31.05bn – so it seems that €1bn of debt has disappeared someplace. The DoF has deferred the publication of the four-year plan to the end of this month apparently with many calling foul that this is a device to spancel debate on the detail of how we’re to tax and cut our way to fiscal stability. And just to muddy the water further, there is now a higher degree of political instability where one government supporter has resigned his seat and the government has been dragged through the courts (at a reported cost of €100,000) to allow a seat vacant for 17 months to finally hold a bye-election (in which it is likely to lose as no incumbent political party has won a bye-election since 1982 and the current administration is deeply unpopular). The recent unabashed pork-barreling extortion for votes from Independents will amuse some overseas viewers (see here for Independent deputy Jackie Healy-Rae’s list of demands and here and here for Independent deputy Michael Lowry’s casino dream). Approval of the Budget is far form certain.

But why the IMF? Firstly it’s not as if the idea is totally alien, even if the Minister for Finance denied that his trip to the IMF in Washington last month (his first since becoming MfF in May 2008) was anything but routine. It would be tantamount to gross incompetence if the DoF was not at least contingency planning for a bailout by the IMF even if they remain tight-lipped about the possibility, no doubt not wanting to undermine confidence in the country.

Without the IMF, would a different administration with a change of political parties help? I don’t think so. As unpopular as the ruling Fianna Fail party is, the MfF, Brian Lenihan, still retains relative popularity even if his management of the crisis has been anything but sure-footed. The two main Opposition parties don’t give the impression of having candidates for the job that would be much better, the Fine Gael Finance spokesperson Michael Noonan is a (here’s my own view) fine politician and a gifted orator but he is hardly the most talented financial operator, their erstwhile finance spokesperson Richard Bruton would probably be a better choice but he ended his chances when he launched an unsuccessful “heave” (coup) to remove party leader, Enda Kenny during the past summer. The Labour Finance spokesperson Joan Burton has been the most vociferous opponent of government policy during the crisis but my personal view is that she would not be the order of magnitude better than the present incumbent needed to get us out of this mess. Regardless of the political party with its name on the minister’s door, it will be the same civil service in support – the civil service that has been seen to be inept during much of the current crisis, unable to research accurate information or produce credible forecasts. There seems to be a dreadful lethargy in the civil service which appears obsessed with process yet unconcerned about end results – a good example would be the rambling and incoherent report by the Comptroller and Auditor General into NAMA during the week.

The best reason for inviting the IMF in is that they will conduct a root and branch investigation into taxation and spending – we stand a better chance that the weeds will not just be cut, they will be rooted out. Our Taoiseach is unlikely to remain in the top five highest paid prime ministers in the world. Former Taosigh might lose benefits (I was saddened at the recent interview of former Taoiseach Garret Fitzgerald on the under-rated Vincent Browne show on TV3 where he said he wouldn’t be giving up his ministerial car “that is a situation and I have no control over that [Vincent Browne – do you think that is ridiculous?] I can understand people being unhappy with it, the expenditure but I can’t intervene in that matter”). These are high profile though low value examples of what many perceive as excess and waste, but hopefully the IMF would not stop before any sacred cow in considering cuts.

Of greater significance is that at the start of this year, the government entered into a deal with the unions representing the 350,000 (20% of the total employed workforce) public sector employees and effectively took compulsory redundancy and salary reductions off the table as future options. There was supposed to be a quid pro quo of industrial relations peace and reform which might see services being delivered more effectively – whilst the former has happened in the sense there has been no industrial action, there has been no apparent movement on the latter. Ireland is still seen in terms of insiders and outsiders where tribal connection is seen as vital to advance and with a population of 4.5m the country is still a small place where everyone knows everyone else. There are too many sacred cows, be it the minimum wage (generally €8.65 per hour), unemployment benefits (€196 per week or GBP 170), State pensions (state contributory pension of €230 per week and the state non-contributory pension of €219 per week, which together are paid to a total of 368,000 pensioners), archaic and protected allowances, quangos stuffed with political appointees, ministerial pay expenses and pensions, lack of transparency on spending and salaries, the 12.5% corporation tax rate, the list goes on and on. IMF intervention would see adjustments that were efficient, timely and in my view “fair”.

The IMF would not be a panacea and they will not be entirely peopled with world-class staff and they will make mistakes and they will be summary in some of their decisions. But they wouldn’t completely control the changes needed to bring the country back to fiscal stability – there would be choices and there would be some debate. So if the 12.5% corporation tax rate is seen as vital to Ireland’s competitiveness, then presumably we can produce a Laffer Curve to justify the 12.5% rate and debate that with the IMF. The IMF will however be broadly competent, will be capable of producing plans based on accurate information which will be credible and can pursue common-sense policies with a degree of independence not available to any political party.

Our bond rates still seem to suggest that a default or intervention is expected. It might be that the four-year plan later this month offers more credibility to our chances of managing our destiny without intervention. I don’t think it will.

Will somebody get that door?

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