Burning bondholders versus concessions on bailout interest rates

At the time of writing this morning, it seems far from being a done deal at the European finance ministers meeting in Hungary, that Ireland will secure a reduction in the interest rate charged on the European element of the bailout. This entry follows on from two recent entries (here for part 1 and here for part 2) which examined the effect of a 1% cut in the European bailout. Since those two entries two weeks ago, there have been some developments

(1) the current expectation is that our banks will only need €24bn of the €35bn allotted to them in the bailout – a “saving” of €11bn

(2) we received some information on Thursday this week on the existing drawn-downs

(3) the Central Bank issued a correction to its bondholder information following the uncovering of a €1bn under-reporting by EBS of its bondholder position.

(4) the ECB has increased its interest rates this week, including its main operations refinancing rate from 1% to 1.25%. Although not confirmed by the NTMA, it seems to me that the interest rates on the EU element of our bailout will rise proportionately, as the interest rate is set at the time the advances are drawn down.

The effect of a 1% drop in interest rates on the EU element of the bailout
A couple of weeks ago, it was estimated on here that a 1% reduction in the EU element of the bailout would reduce our interest bill by between €4-5bn. In Net Present Value (NPV) terms, the gain would probably be less than €4bn but that would depend on the discount rate. The reason NPV is significant is because if you are burning bondholders today, then the saving is presented in present day terms.

I am assuming that the revelation that we will only need €24bn of the €35bn bailout for the banks means that we will reduce our borrowings from the most expensive source. Today that is the EFSF which charges us 6.05% but the hope is that this will reduce by 1% as will the EFSM/bilateral advances. That will mean that the IMF which charges us 5.5% will become the most expensive source of funds so it would be logical to reduce the €11bn “saving” from the banks stress tests from the IMF’s total of €22.5bn. Which would mean that our external bailout would fall to €56.5bn and would be composed of the following.

Remember that Ireland is contributing €17.5bn of its own funds to the bailout, which originally had a headline value of €85bn (€67.5bn external plus €17.5bn domestic).

Here are the key results

(1) A 1% reduction in EU interest rates is still worth €4.2bn in nominal terms and still worth only €3.2bn in Net Present Value terms using a 6% discount rate. The reason there is no change from the calculations on here two weeks ago is because the €11bn saving on the stress tests is likely to reduce the IMF contribution which presently looks more expensive. To place that €3.2bn in context, our unguaranteed senior bondholders total €36bn today.

(2) If we are entitled to 100% burn unguaranteed senior bondholders which are presently worth €36bn, then we could afford to pay 13%+ on our EU bailout. Or indeed, given our 10-year bond was trading at 9.25% mid-point at close yesterday, to forget the EU altogether. Indeed on an NPV basis which is arguably more apt, we could afford to pay almost 20% on the EU €45bn bailout.

(3) If the funds borrowed by our creditors to provide our bailout are still charged at 2.6% to them then at a 4.8% interest rate to us, our creditors will still generate a profit to them of €7bn over the life of the loans.

The above results are crudely derived making the same assumptions as in the entry on here two weeks ago. A full and accurate analysis would require details of the amounts, terms of time and repayment schedule to calculate the effect of different interest rates.

The ECB
My knowledge of central banking comes from a few academic outings in life, so I readily admit that it’s not an area of expertise at all. Having said that, I am aghast at the apparent behaviour of the ECB at present. It’s akin to the fire brigade turning up to tackle a major fire in your home. You’re standing outside and are initially impressed at the application and competence of the fire crews. But five minutes after arriving, the fire captain comes up to you to say that the fire is more serious than they first thought but that you should rest assured the fire crews will do everything they can to save your home. But – and here’s the kicker – the fire captain wants you to agree to give up your weekends for the next five years to provide cover to crews at the local fire station. You’re thinking “hang on there, my house is burning down, I pay my taxes, you turn up to do your job and now you want me to give you five years of my free time or you’ll let my house burn to the ground”. Of course, you might understand that it would be charitable to give some of your time to help your neighbours, but you’d still be furious that you were being extorted at the worst possible time by someone whose support is mandated in law.

And it seems to me that this is how the ECB is treating Ireland at present. We joined the euro system accepting that we ceded a degree of sovereignty for perceived benefits. If you wanted more proof of this surrender of sovereignty, then look to the statement by president of the ECB, Jean-Claude Trichet this week when he confirmed that the decision to raise interest rates by the 23-member Governing Council of the ECB was “unanimous”. The 23 members include 17 governors of national central banks, including our own Patrick Honohan, Governor of the Central Bank of Ireland. It seems accepted that an interest rate rise at this juncture hurts Ireland but presumably Patrick acted in the interests of the 331m, not the 4m at home (mind you does this mean that he will support the preservation of bondholders in the greater European good also?). But with the disadvantages of membership came advantages which included a colossus of a central bank – well capitalised, supported by Germany, France and Italy. And like any central bank, the ECB provides a lender of last resort service to domestic banks. Indeed in the ECB’s case, it publishes in some detail the eligibility of bank assets that it will lend on. At home, economist and broadcaster David McWilliams might claim the ECB is advancing loans on collateral which he describes as “rubbish” but the truth is these assets are audited and rated and haircuts are applied before loans are advanced. And as the CBI confirmed yesterday, the ECB is still advancing more than €100bn at any one time to banks operating in Ireland (including those that don’t service the domestic economy). And that funding is necessary because banks aren’t able to secure it on the market.

So here we are with our banks on fire and the ECB has turned up to help those banks in the way we understood it would when we joined the euro with all its attractions and disadvantages. But now they are intimating that not only will they not guarantee the provision of a lender of last resort service but they are insisting that creditors to banks which are insolvent must be paid in full, and that shortfalls must be provided by citizens. And I am aghast that we are accepting this position. I really wonder if those in our CBI or Department of Finance who deal with the ECB, have become overwhelmed by the exotic apparent civility of old European money, where property estates are in families for generations, where marriages are semi-arranged and where surnames often begin with “von”. Why is it that our domestic representatives can’t simply turn around to the ECB and tell it to do its fucking job. And it may need to be expressed in those vulgar terms because the current accommodating niceties are bankrupting the nation. And observe the communication style of our creditors who are understandably ruthless in their insistence that we get our fiscal budget – what the government collects in taxes versus what it spends on services including public sector employees – in order; we need to be equally ruthless in ensuring private sector creditors (that is, bondholders) are not attached to our sovereign financial standing and we should not entertain the ECB making extraneous demands in return for simply doing its job.

Guaranteed bondholders
There is a small but significant domestic controversy here at present with the proposal to allow downward reviews of commercial rents in Upward Only Rent Review commercial leases. During the week, our soporific Minister for Justice, Equality and Defence, Alan Shatter appeared on RTE’s Frontline programme where he gave an assurance that legislation to effect the changes – allowing downward reviews in UORR commercial lease contracts – would be presented to the Dail either before the Summer recess or soon thereafter and the legislation would be operational by the end of the year. There is a difficult debate being had domestically on the proposed changes and those against the changes cite the unconstitutionality of retrospective legislation as a significant argument. Addressing this specific objection, the Minister, talking on the Frontline programme, referred us to Article 43 of the Irish Constitution which says

“43.2.2 The State, accordingly, may as occasion requires delimit by law the exercise of the said rights with a view to reconciling their exercise with the exigencies of the common good.”

Now Article 43 specifically deals with property rights in the State but that is not the only occurrence of the term “common good” in our Constitution. Article 6 for example says

“All powers of government, legislative, executive and judicial, derive, under God, from the people, whose right it is to designate the rulers of the State and, in final appeal, to decide all questions of national policy, according to the requirements of the common good.”

So if it possible, as seems the case given the tangible commitments being given by the Minister for Justice, that property contracts can be retrospectively altered “in the common good”, why is it that the disastrous banking guarantee can’t be similarly unpicked. And if it is unpicked, an additional €21bn of senior bond-holdings will come into play.

To conclude, it is probably the case that a 1% interest rate cut will be secured, if not this weekend then soon. However in the context of €36bn of unguaranteed bondholders it is hardly significant. In the context of €51bn of bondholders, guaranteed and unguaranteed, it is practically insulting.