World Leaders in Moral Hazard?

Today’s Irish Times reports the Minister for Finance as delivering comments along the following lines yesterday:

There was an ideological view that certain banks should be let fail and that bondholders and investors in that bank should take the hit. However, if Governments were to allow this happen, the result would be a ‘‘staggering loss of confidence in whole economic system of a country’’ and therefore ‘‘governments have to prevent banks failing and stabilise them’’, he said.

The implication of these comments is that no bondholder of an Irish bank should ever take a hit, no matter how badly the bank fails, as long as the Irish taxpayer is capable of bailing them out. In other words, Irish bank bonds should now be interpreted as having the same risk as Irish sovereign debt. The Minister also ruled out any further nationalisation, which in the absence of any kind of debt-for-equity swap (which I discussed here but would be ruled out by the Minister’s bond-holder comments) means that he is imposing a de facto lower limit on the value of shares in our major banks.

I reckon these comments place Minister Lenihan on the international cutting edge of moral hazard. Yes, the international reaction to the current crisis, with implicit safety nets made explicit and lots of new safety nets introduced, has made this a difficult contest to win. Maybe I’m being parochial here in singling out the Minister for this award, so perhaps our readers can highlight for me another government that deserves the award.

Incidentally, I would also argue that ideology is largely in the eye of the beholder. From my position, Minister Lenihan’s no-bondholder-left-behind approach appears far more ideological than the positions of those who argue that losses should be shared between the state and the various providers of risk capital.

24 thoughts on “World Leaders in Moral Hazard?”

  1. Are you sure the Minister is going that far? I would paraphrase him as something like: “We all know who should take the hit but we destroy them without destroying the whole system. Unfortunately, ideology is out the window for the moment.” Is he reflecting a principled approach or reflecting a logical approach to a fait accompli?

    It appears that the reason the Minister cannot afford to default on bonds for one bank is becasue the other banks are totally illiquid and are possibly insolvent. It is not because investors might think the banks are broke and lose confidence. The investors already know the banks are broke. It is because the investors might think the State was broke.

    It is surely up to the State to manage that perception, i.e. the State with the help of the EU must say that it can contemplate bondholders being punished for their profligacy without fear of people thinking the state is insolvent. The state cannot convince the market for the moment because of its has a huge fiscal gap. That confidence the Minister refers to is funding 40% of public expenditure.

    The State should not have to worry about bond defaults when our finances are back on an even keel and Anglo’s carcass is no longer systemic (provided all non-guaranteed sub-debt has not been repurchased by then). At that stage one would expect that some bond-holders would be left behind.

  2. Whatever about moral hazard, its time that Lenihan gave up making dire economic predictions. He’s out of his depth and damaging international confidence in the Irish economy by doing so. As he is a solicitor and wouldn’t be capable of making economic forecasts himself, I assume he’s just repeating what Alan Aheane tells him.

    In the IT article referenced, he predicts that GDP will fall by 13% between 2008 and 2012. How does he know? Answer: he doesn’t. Its just a wild guess. It might prove accurate, or it might prove hopelessly inaccurate. It obviously depends on how soon and how quickly the global economy recovers. At present, the greatest minds in the world, of whom Lenihan is not one, are totally divided on the likely future course of the global economy. Some say that we’re now at the bottom and that the global economy will grow in the second half of 2009 and that this growth will accelerate from 2010 on. Others say its a mirage, that we’ll have a ‘W’ shaped recession, with hardly any global growth for several years. If these people don’t know, how does Lenihan know that GDP will fall by 13% between 2008 and 2012? In no other country are the Prime Minister and Minister for Finance going around claiming to know the GDP growth rates between now and 2012. In all other countries they accept that the situation is extremely uncertain and that anything (including significant GDP growth) is possible between now and 2012.

    Even ESRI do not support Lenihan’s forecast. In their recent mid-term analysis, ESRI forecast a fall in GDP of about 13% between 2008 and 2010, but GDP growth of close to 6% in 2011 and 2012, which would leave cumulative growth between 2008 and 2012 at close to zero, rather than the 13% fall Lenihan is predicting.

  3. Perhaps Minister Lenihan’s comments may be interpreted in the form of a co-ordination game? The strategies available to the government and investors are {Support, NoSupp} and {Invest, NoInv}, respectively. The payoffs in the game are as follows:
    (Support,Invest) = (VH,H) (Support, NoInv) = (VL,M)
    (NoSupp,Invest) = (M,VL) (NoSupp, NoInv) = (L,L), where VH>H>M>L>VL.
    The two pure strategy Nash Equilibria in this simplified version of the game are (Support,Invest) and (NoSupp,NoInv). Minister Lenihan’s declaration seems like a commitment device to encourage the former outcome. In which case, it makes perfect sense for him to declare that the Irish government will back the banks to the hilt.
    Maybe he’s a world leader in game theoretic reasoning?

  4. But surely by committing to support the banks, he is deterring investors from buying government bonds, since the more the government supports the banks, the greater the likelihood of a government default?

  5. I was referring to investment in the banks, but you raise a valid point. The government has probably decided that the increased cost in government debt is justified if it boosts international confidence in Irish banks. Their support must be trenchant in the face of criticism if this strategy is to work successfully.

  6. @zhou
    “It is because the investors might think the State was broke.”
    The state is spending twice as much as it is taking in this year.
    Any investor would know this. The state is broke!

  7. @Antoin, that is when the game moves onto the next level. As the effectiveness of the (support/invest) strategy starts to wane with increased investor awareness of the governments debt commitments, then it falls on the EU and the ECB to continue to support Ireland Teo.
    In six months Brian Lenihan may be in Brussels selling that Ireland is Systematically Important to the EU and the Euro. A government default within the Eurozone would spook international dealers and put downward pressure on the Euro etc etc..

  8. Here is a simple theory: our current Irish finance minister is not competent for the job and his statements have no logical consistency.

    Trying to interpret his statements in terms of a logically consistent perspective on the current market environment is an exercise in futility.

  9. “In other words, Irish bank bonds should now be interpreted as having the same risk as Irish sovereign debt.” is that not really the case given the parameters of the guarantee? We could call it something else but that is what it boils down to (unfortunately).

  10. Is it not true to say that in the current climate the Minister has a point and a very fair one at that. However if conditions were to improve and a bank were to underperform it would then be allowed to go out of existence and the consequences would not be as dire as if that were to happen now? I think the situation is very complex and economists (even those turned politicians) don’t agree with what action should be taken. Economists seem to think they can make sweeping statements without any regard for the consequences of their words much in the same way as banks lent their money. These economists do not seem to have to take any responsibility for their comments which many of the public deem to be gospel and without flaw. We need much more informed discussion from all perspectives and not sound bytes which lead to even more hysteria.

  11. If those damn, now insovent, financials were (or is that, are) of fundamental systemic importance, why were they left un-regulated? The minister is spouting political gibberish – God knows who he (or his mentors) are attempting to impress. Dreadful stuff. It was an act of unparalleled financial and economic madness to have given the guarantees he did give. Public traded companies, operating in a public marketplace, cannot be given a sovereign guarantee – you are effectively transferring their income source from the competitive market to the private citizens of the state. I find the whole episode deeply worrying. The state can enact legislation to seize private property. Private property does not enjoy an unfettered blanket protection under our constitution – see, Art 43.2.2.

    Brian P

  12. The time to present a negotiating position to the EU is now, before Lisbon II. We get bubkiss after!

    Lenihan and Biffo presided over the bank collapse and watched it happen. The regulator knew. All the banks knew, they took it in turns to lend to AngIB. Why trust these people?

    Do we have a choice? What would force an election?
    Is it worth taking 20Bn Euro so seriously? Hell, yes!

  13. Irish bank debt now has the same risk as Irish sovereign bonds yet yield 250bps more. What rational investor would buy Irish debt when the banks have about €100bn to refinance over the next few years?

  14. Can anybody tell us where we find the text of the original speech? The Irish Times paraphrases the Minister in part. I always prefer to read the original text.
    Indeed I cannot believe such an able and well-advised Minister could make such a statement.
    Politicians usually appreciate wide and accurate dissemination of their views. So in many countries, every ministerial speech of any consequence finds itself onto a website.

    So am I missing something? Or maybe someone who attended the InterTradeIreland All-Island Economic Forum at Farmleigh got a copy of the speech?

    As for the substance of the Minister’s comments, it is patently clear now that there was a massive transfer of risk from the banks to the taxpayer over the past nine months. Irish government credit led the move in the eurozone. Of late, Ireland has possibly least benefited from a global easing of fears for banking.

    Effectively this just might reflect ministerial sympathy for the equity and bondholders, less for the taxpayer. Bu what of the long term solvency of the taxpayer to bear such a burden, rather than the unfortunate circumstances of the financial creditors, and still rich debtors?

    A sharing of the burden of bank losses between the taxpayer and the creditor could effectively lead to some reputational costs. They would however be limited I believe. And exaggerated by the powers that be. But why?

    More than the Ministerial comments, I am astounded by the meekness of the Irish taxpayer. There may be outrage, but that does not change the financial or political reality.

    Determined action to defend the public interest could do wonders for reducing the size of public debt, and the cost of its servicing. Indeed some foreign investors – those that buy Irish government bonds at least – could even welcome such action.

    The upcoming constitutional referendum in October now provides an opportunity to pose questions relating to the appropriation of property by the State (and not just a token cut in the salaries of judges). Indeed that’d be a sure way of getting out the vote on Lisbon, and a step towards restoring confidence…

  15. @ Brian
    I agree they are mad but I was trying to think what kind of mad.

    Admitting that you have made a mistake is not easy.
    Admitting that you have made a list of linked mistakes (the guarantee, nama, the lengthining of the guarantee) that may empovorish a couple of generations is probobly close to impossible.
    Then I remembered two terms from my limited knowledge of Psychology. Dissonance and Rationalisation.
    From Wikipedia
    ‘A powerful cause of dissonance is an idea in conflict with a fundamental element of the self-concept, such as “I am a good person” or “I made the right decision.” The anxiety that comes with the possibility of having made a bad decision can lead to rationalization, the tendency to create additional reasons or justifications to support one’s choices. A person who just spent too much money on a new car might decide that the new vehicle is much less likely to break down than his or her old car. This belief may or may not be true, but it would likely reduce dissonance and make the person feel better. Dissonance can also lead to confirmation bias, the denial of disconfirming evidence, and other ego defense mechanisms.’

    Therefore with regard to the current government I think its time to call in the men in white coats and have them removed to Dundrum mental hospital.

  16. Essentially the Banks’ Bonds are now zero risk (moral hazard).
    The face value of the bond is fully protected and the yield is guaranteed.

    Recently the banks busied themselves buying their own debt at vastly reduced prices.The guarantees will be extended by the government so in essence the par value of those bonds will be redeemed by the banks with a hefty 60 to 70% profit which the Irish taxpayer is paying.

    My understanding is that NAMA will value assets such as development land and finished contsruction projects which are in trouble and the taxpayer will be on the hook for the difference between that valuation and the banks book price for those assets.

    So the Irish taxpayer is gutted on both sides of the balance sheet .

    Irish Sovereign Bonds are carrying the increased risks for the banks all along the yield curve.This is also reflected in NTMA’s strategy of high issuance of shorter securites such as Treasury Bills and shorter issue bonds of smaller amounts.Irish sovereign bonds are now trading with wider spreads than Greece.

    Interesting to note is that prior to EMU the profile of investors in Irish sovereign bonds was 80% Irish as compared to 20% invested by foreigners.
    Today this profile is reversed.
    One wonders if the profile of Irish investors had held at 80% would more scrutiny of risks within the country (i.e. reckless bank lending) occurred.

    Likewise who in Ireland would now front up to buy the majority of sovereign debt here knowing what we know now? I would think most individual and institutional investors here reckon there is now a high probability of default.So how long before those outside of Ireland also lose the faith?

  17. @Eamonn M
    Its the quote from Keynes…The full quote is “Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”
    My point is this : Since, oh, Feb or so, Lenihan has been much more “active” economically, it seems to me. I suspect that he is listening carefully to good quality advice then doing what he thinks politically best at the moment. Thats not a criticisim, its what politicians do. But another quote comes to mind from JMK “There is no harm in being sometimes wrong — especially if one is promptly found out” .

  18. I think he believes that if he tries to do the right things by the international investors, the markets will give him more money later.

    he is wrong. Markets invest in a country on the basis of it’s ability to repay, not based on whether it has a reputation for doing the right thing.

  19. I think P. Honohan’s statement that existing non-guaranteed subordinated bondholders should take little comfort from the proposed statutory provision which gives the Minister the option to extend the guarantee indicates that there is a limit to what the Govt will guarantee. This means we should avoid the moral hazard of non-guaranteed bondholders holding on to their investments in the expectation that the State will bear the risk. Subject to correction, I think this is what KW fears.

    Is there a moral hazard for new debt? I don’t think so. If people act on this latest “moral hazard” then they will lend money to irish banks allowing them to lend to the Irish people. The damage would be if it caused another credit bubble. Does anyone think that is going to happen any time soon??

    @Eamon Moran

    The State does appear to be broke. That is a precisely why it makes sense not to allow defaults. That is factor which I see constraining the Minister.

  20. @Alan Holland
    “The great proof of madness is the disproportion of one’s designs to one’s means” N Bonapart, esq…..

  21. If only the Brians had talked down the likelihood of repaying the bond holders…..then Somers could have done an Amherst, buying up the cheap debt.

    All of this is to come to pass……in September, 2009.
    When the world will be a different, colder place! Let’s see if any of this is relevant then?

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