Promissory Notes, Real Money and Borrowing

This is hardly the most important issue right now with so much going on but it’s a two cents I’d like to toss out there all the same.

Last year, I regularly heard the following argument on this blog, in the media and in private. “Overpaying for assets via NAMA is actually the best way to recapitalise the banks. This is because we can purchase the property assets with “NAMA bonds” that we can just print off. They’re not real money, just IOUs. But if we paid a low price and had to recapitalise nationalised banks, we couldn’t do this. We’d have to borrow the money expensively on sovereign debt markets and then hand over real money to the banks.”

A typical example of this philosophy was this Brendan Keenan column from last August:

The budget crisis makes Mr Lenihan reluctant to put capital into the banks. For that he needs real money, whereas he is buying the loans with a huge IOU, to be paid at some unknown date in the future.

I pointed out at the time that this argument made no sense. Specifically, I argued out that the same type of government bonds – IOUs as the phrase went last year – that were issued by NAMA could also be issued to recapitalise banks. An example was this post:

Why would anybody think that the same banks that are happy to exchange property loans for government NAMA bonds will somehow refuse to accept these same bonds in return for an equity stake?

I was regularly told by commenters on this blog that I was wrong. Indeed, on this site and on some other less reputable sites, this idea – we can pay for property assets with NAMA bonds but can’t recapitalise with bonds like this – was often suggested as THE key explanation for the government’s approach.

Often it was suggested that somehow the ECB had a role in ruling out NAMA-type bonds for re-capitalising state-owned banks (though without an articulation of what business of the ECB’s this was.)  As far as I can tell, when this kind of thing happens—lots of people suddenly  making the same, completely wrong, point—it usually comes from inside sources leaking a talking point to journalists.

Fast forward to March 30, 2010. Nationalised Anglo Irish Bank needs to be recapitalised. How is this being done? The Minister’s speech informed us that

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.

In other words, we are recapitalising Anglo (and EBS and INBS) by printing off IOUs and directly placing them with the banks, just like the NAMA bonds. No “real money”, no new borrowing on sovereign bond markets.

Update: In a bizzare twist, we now see that one of the key people pushing the argument that you had to use “real money” to recapitalise the banks, Mr. Keenan, now turns around when we do exactly what he said we couldn’t do and praises it as a brilliant wheeze.

Today he wrote:

The scale of the Anglo losses makes it necessary to devise ways to keep costs off the Exchequer while Mr Lenihan wrestles with the budget deficit itself. The “promissory notes” mean the bank may call on the taxpayer for its losses over 10-15 years.

It appears that, for Mr. Keenan, whatever Brian Lenihan is planning to do is brilliant and ingenious. Even if it’s the exact opposite of his previous brilliant and ingenious plan.

20 thoughts on “Promissory Notes, Real Money and Borrowing”

  1. If everything else in the government’s projections held, the additional provision of €8.3 billion to Anglo will increase the Exchequer Deficit to €27 billion (€18.7 billion prediction + €8.3 billion). This would mean Exchequer borrowings of 16.7% of GDP this year!

    But we won’t say that because we’re cooking the books.

  2. @KW

    The Sovereign was; the Sovereign is; the Sovereign will be. All is now Sovereign. Sovereign IOUs OK. OK

    This economic war is ‘not yet’ over. Stay fit.

  3. Real money is valuable. Borrowed money cab less costly if fiat currency is devalued and the money used to buy commodities. But I understand the money is to be spent keeping banks the same size, even though the real economy has shrunk…?

    In a deflationary environment, the cost of borrowed money is greater than real money, unless the fiat is devalued faster.

    Better talk down the Euro, Brendan Keenan, otherwise you look like a loon!

  4. @ Karl

    isnt the whole idea of the use of promisory notes in this situation to do with one arm of the state lending to another, due to their nationalisation, and that as such its non monetary and non cumulative to the national debt as calculated by the EU/Ecostat and generally referred to by bank/analysts? I don’t think we could undertake the same process with a privately operated and owned bank like AIB or BOI, could we?

    Yes, you know what the “real” debt of the nation is, but as discussed elsewhere on this site yesterday, most of the markets only look at certain metrics which are unaffected by this type of transaction. I don’t think its fair to completely gloss over that element of this.

  5. Karl, I was one of those arguing that NAMA bonds were different to hard cash and I stand over that. If this government had to go to the market to raise 50Bn in order to buy loans it would dramatically impact on our ability to raise finance in general at anything like a reasonable cost. I agree that there seems inconsistencies in these matters and I am not entirely able to explain them away but my instinct tells me there is a significant difference in sourcing funds in the following ways:

    1. Raising cash in the bond markets

    2. Printing NAMA bonds which the ECB says it will accept IF NECESSARY at its window

    3. Investing assets from the Pension Reserve Fund

    4. Issuing promissory notes

    It seems to me all to do with “the rules of the game” and these are set by the ECB. Consider for example if the government were to try this NAMA bond trick to finance the fiscal deficit. It would issue 20Bn of NAMA Bonds to the banks in return for a 20bn credit to its current account with those banks. As it blew this credit on the fiscal deficit the banks would be forced to the ECB window. In such a way the government could finance its deficit without being subject to the disciplines of the market. Wouldn’t be allowed of course which brings me back to a main difference between us: the feasibility of the NAMA bond trick is entirely because the ECB has acquiesced and agreed to accept them at their window provided we abide by the conditions set by the ECB.

  6. Karl, on a different topic which has got too full for posting on.

    You observe that if AIB needs 7.4Bn of equity to meet a capital requirement of the same order then its existing equity must effectively be nil. The observation seems formally correct but in economic substance it is falwed.

    This because of another rather inconsistent discipline – that of accounting values.

    We are painfully aware of one of these inconsistencies, the values it places on toxic loans. This is being addressed by NAMA. It does seem that after that inconsistency is eradicated that AIB would have negative equity.

    But there are other inconsistencies. Long term sub debt is valued at par despite standing at large discounts in the market. AIB have already tapped this inconsistency, I don’t know whether there is any more water in that well.

    Then we come to the remaining main inconsistency. The fair value of its overseas subs appears to be considerably in excess of their accounting value. The plan seems to be to eradicate this inconsistency as well. We finish with a balance sheet of cash or near cash items and on these, account values and fair vales approximatley coincide. After all this crystallisation there should be a reasonable positive existing equity. Unlikey to be enough for the 7% ratio and it will have to be topped up by either private or public equity injections. The basic point is that existing shareholders are, on a fair value look through basis, in positive territory (I’m assuming NAMA prices are fair).

  7. @ BW2

    Agreed that the AIB issue is a bit more complex. I’ve been meaning to write a short post about where things stand on AIB but haven’t gotten around to it yet.

  8. At end 2010, AIB had net equity of c. 6 bn. The reason it has to raise €7.4 bn is because the NAMA people and Regulator have now told it to Assume that the NAMA discount over all its loans, including performing loans, will average c. 43% or c. €6bn more than was provided for; and on top of that the Regulator has decided it must not only have core tier 1 capital ratio of 8%- which it had at end-2009- but it must have core Equity capital of 7%, (c. €7 bn). (It had provisions of c. € 4bn against NAMA assets and another €1.3 bn against other loans, on top of the €6 bn equity)

    In my blog I described (more accurately I should say”opined” ) how they can do that this year. AIB is far from insolvent, as some professors continue to claim- some commentators even use the word “bust”- its outrageous !- and barring some major unexpected development, the State shreholding in it, if any, will be a minority one

    NAMA issues a bond, a promise to pay the holder (??- I assume, but is it tradeable, doea anyone know?-) or the banks some real money in the future sometime. NAMA is technically a borrowing from the banks by the State/taxpayer. The government tried hard to obfuscate that fact, but the EU refused to accept the spin. Hence SPVs , etc…

    In this day and age, and keeping in mind Basel III, bonds, loans and promissory notes will not add up to “core equity capital”. So, I dont know what the Regulator is at, if he imposes a stringent core equity capital ratio on AIB/BOI, but ‘permits the owners of Anglo to get away with promises !

    If NAMA bonds are acceptable to ECB–which it seems they are- then as far as I understand it, that would only be useable for raising “real money” loans from ECB by our banks on the ECB’s increasingly short term basis. I think the last one year loan was made yesterday and from now on only 6 month loans are available. So, what are the banks to do with these NAMA bonds after that?

    If they are tradeable in the financial markets, as BL once said they would be, then, in order to trade at par value they would have to carry a coupon comparable to the sovereign guarantor’s current borrowing rate, currently c. 4.5%. If it is only 1.5%, – I dont know, can someone please advise?-then , based on the repayment schedule foreseen in the original NAMA Business plan, €50 bn of bonds face value would be worth, at NPV, something in the region of €10 bn less than otherwise. (Discount at 1.5% instead of 4.5%). ‘(This is extra real profit that the State is taking for itself, from bank shareholders, including itself, of course )

    I suspect, though, that these bonds are unusual in that they are, for one reason or another, effectively not tradeable in the market. I just have that feeling. (Does anyone know for sure?). It may be why Eugene Sheehy was unwilling to confirm that AIB would cash in these bonds, when asked by a Dail committee. I admit I could be very wrong there…But I think journalists have not focussed enough on this aspect of NAMA. We simply have not asked the questions properly. (Another aspect we have let slip by is : What will the State do with all the NAMA cash, including property sale proceeds, which it will have available to it for years, before repayments begin to the banks?) (The idea that it will have to pay an average of €240 mn a year on lawyers fees is simply more obfuscation…Amazing how much you can fool, intelligent peoiple!). That extra NAMA cash which it will hold is effectively a cash loan from the banks to the taxpayer, and at a steal of an interest rate– a scraping of the faces of the elderly bank shareholders ! (But maybe the interest rate has been adjusted since 1.5% was first indicated…?)

    Sorry for the long comment

  9. BoD, I can’t answer all your questions but NAMA bonds are “floaters”. They are paying the correct market floating rate. Over time the market expects this to rise so this is not cheap funding it is funding at the martket rate. The real trick is that the government was simply allowed to issue these, it did not have to sell them to the market. In the words of Moodys, quite ingenious.

  10. @BWII
    By “floaters”, I presume you mean they are tradeable freely…OK…but what coupon do they carry – or offered- when issued as “payment” to the banks for the “purchase” of the banks assets?

    For example, a bond is usually issued in denominatioons of €1000 euros, say. “The Holder will receive 1000 euros on December 31, 2014, signed, The government”

    So, they are bought at a discount to that, “floating” in the market at a price reflecting that discount, which normally reflects the risk perceived in the promise of the signatory, as well as general market rates. Today, that risk is perceieved at 4.5%…So, a bond due in a years time should sell for c. 950 euros.

    But, the problem is that the government issues these bonds to the banks at a discount of only 1.5% approx. (That might be expressed as an interest rate of 1.5% , but the effect is the same) (That’s taking for themselves, with a little add on, the special interest rate offered to banks- only !- by the ECB)
    If I am right–and I don’t know for sure because the details have not been demanded by the media or examined and reported by qualified commentators- of whicjh I am not one- it seems to me that the government/NAMA is forcing the banks to provide it cheap funding–enormous billions worth over a ten year period- and NAMA is a LOAN , remember–while the banks, if they wish to turn these bonds into cash any time soon, in the open market, must accept their true value which is much lower than they must pay for them, the price being face value less c. 4.5% per annum until maturity)

    As I have said for a longtime in my blog, NAMA, while it suits the banks because it enables them to offload many illiquid assets of uncertain value and get on with banking and re-funding existing loans- also suits the taxpayer/government, very much, because it provides substantial assets- in the form of cash flow as well as property of uncertain value- to the State, to sell at its convenience (and to pocket/use the proceeds until it decides to redeem the bonds to the banks) This is quite a massive loan TO the government, which is not being acknowledged. (Instead, the banks ordinary shareholders- tens of thousands of Momas and Pops- are sometimes vilified in the media and some politiciians and academics would see them “rightfully” thrown on the rocks totally (i.e nationalised))

    Then it seems- as I have read elsewhere in this blog- that the government proposes to recapitalise Anglo with promissory notes !. So, what’ll the Basel II lads say about that? They want banks to have more EQUITY in their core tier 1 capital and, if Preference shares do not any more qualify as equity, then Promissory notes certainly do not.

    (AIB, incidentally, began the year 2010 with the original Basel captial ratio target of 8% core tier 1 capital: the problem is that our Regulator now wants the percentage of own equity in that capital – which was 5% in AIB’s case- to be increased to 7%…something most international banks are still objecting to. )

    Maybe the comments in this blog about BL financing Anglo with promissory notes is inaccurate. If its true its outrageous that the CB Governor and the Regulator should le them away with it. And it would be a major distortion of the Irish banking market–to force higher standards on AIB/BOI and then expect them to compete with Anglo…The more I think about it, the more I find it unbelievable The EU Competition Directorate would have to spike those plans.

  11. @BWII

    OK, since my last comment I have found the NAMA Bond term sheet. I see that NAMA will take the six month euribor rate and then proposes to roll over the bonds every six months. Indeed, it reserves the right to extend the maturity unilaterally.

    We all know that there’s no way our Government can pay real cash for the banks’ property for many years to come. Even when they sell on the property, they plan to keep the proceeds for some unspecified (??) period. Or loans that are repaid to NAMA, by former borrowers from the banks…that’s cash flow that our government will use for its day to day purposes.

    So, why the pretence in issuing six month bonds? The only reason is to get lowest possible interest rates–indeed, rates at which the banks lend to each other… This looks like a bit of a scam to me…I’m not sure that there even IS a six month rate for sovereign borrowing, but if there is, then the holders of the bonds can surely demand cash from the sovereign at the end of the period

    But not in the case of NAMA…They will issue six month bonds but without a guarantee that the buyer gets his money bask in six months time!. In fact, they indicate the opposite.

    Is this the real world? Can our banks take these bonds and discount them at euribor rates and pocket the cash? Are there really investors out there who’ll pay money for these bonds and be happy to wait years for the Irish Government to redeem them at the Irish government’s discretion, and be happy to see them earning six month inter-bank rates in tbe meantime??

    Mr. Honohan, Central Bank Governor and protector of our banking industry…I ask you…is this a proper way for our government to treat our banks?

    Btw, our sovereign long term of borrowing rate is c. 4.5% (ten year). I don’t know if we have a six month borrowing rate. But I see that the rating agency S&P gives Ireland an “AA” long term rating and an “A-1+” short term rating…Makes you think !

  12. @BoD By “floaters” I meant they pay a floating rate of interest, i.e. a rate of interest based on 6 month money. Because of ECB policy, short term interest rates are very low compared to long term, but over time this is expected to even out. We have a so called “steep yield curve”. The “value” of these bonds should be their face value + half a year’s coupon discounted at 6 month money rates. The coupon is based on 6 month money rates so that should give a par value.

    However, the market will want to extract a bit more for liquidity and credit risk. It will be interesting to see what the market value of NAMA bonds is. It is slightly irrelevant though as their face value can be used for determining regulatory capital and for presentation at the ECB window.

  13. @BWII
    Thanks, Brian
    So, that floating rate is currently c. 1%, just under, I think (and is anyway a rate normally confined to inter-banks)..But the government (NAMA) is borrowing long term- in that it does not intend to repay the borrowings fully for at least ten years. Therefore it should be paying a rate closer to the Ireland sovereign ten year rate, currently c. 4.5% or so. If the banks try to cash these in by selling them in to the market, they will probably have to accept a discount closer to the latter figure. Thats the interest rate opportunity cost I refer to, currently over 3%. ‘

    Actually, the NPV, net present value of c. €50 bn received back in part payments, as per the NAMA Business Plan, for example, at 4.5% is lower than at 1.5% by approx. €10 bn. However, the real opportunity cost for the banks and their shareholders is less than that in the NAMA case and depends on the bank and its percentage of performing assets taken by NAMA and how quickly the NAMA value of other property could have been turned into cash by the bank. But, in total, over all of NAMA, it should run into some billions (of extra benefit to the State/ loss to the shareholders)

  14. @BOD

    Owning 100% of an asset that loses 95% of its value is not the same as losing 95% of the ownership of the asset.

    The shareholders maximum loss is 100% of the asset. The assets (the banks) market capitalisation is the maximum loss the shareholder can have. Without government support I believe the current market capitalisation would be lower than it currently is.

    NAMA will make a loss. The cleansed banks will have value. Giving part of that value away would be a very kind gesture, however, the Irish state does not have the money to give away nor should (my opinion) the Irish government have a mandate to give away public money to risk taking investors.

  15. @BoD

    Think mortgages. Mortgages are very long term but the interest rate is variable or at most a short fixed rate. If mortgagees had to pay an interest rate related to 30 year fixed rate loans it would be very considerably higher. NAMA bonds are in effect variable rate loans with the interets rate set every six months based on the new six monthly rate, or it might be the ECB rate.

  16. @ Karl

    Please, if it’s wrong, do correct “Brian O’Doherty’s musings on promissory notes and equity capital”, we wish to be informed, avoid mis-understandings, isn’t that (part of) what this site is about?

  17. @ Peadar

    The basic point is as explained in a later thread

    http://www.irisheconomy.ie/index.php/2010/04/02/the-world%E2%80%99s-slowest-recap-a-cunning-plan/#comment-43435

    In response to another commenter, I wrote:

    “I don’t think you’re right about the idea that there was some complication in getting any type of government bonds, promissory notes or whatever counting towards Tier 1 capital. It seems there’s a general confusion here about regulatory capital — it’s not one specific instrument, it’s essentially the gap between assets and liabilities. Give a bank sufficient assets and it’s well capitalised.”

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