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?
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.