The September 2008 Guarantee

The media have decided that one of the headline conclusions of the Honohan report was that “Honohan supported the September 2008 guarantee” and the government have been very keen to consistently repeat that line.

I think the truth is that the report says that some kind of guarantee was required but that it asks very serious questions about the nature of the guarantee put in place. The only issue I have heard discussed in relation to the report’s questioning of the guarantee is the inclusion of subordinated debt. Indeed, the Taoiseach’s speech in the Dail this afternoon also mentioned the inclusion of subordinated debt as the only quibble that the report had with the guarantee.

In fact, my reading of the relevant section is that the report questions the essential nature of the type of guarantee that was introduced here. Here, I want to highlight the relevant discussion in the report and to flesh out its implications.

Here’s the relevant section (8.39 in the report):

The scope of the Irish guarantee was exceptionally broad. Not only did it cover all deposits, including corporate and even interbank deposits, as well as certain asset backed bonds (covered bonds) and senior debt it also included, as noted already, certain subordinated debt. The inclusion of existing long-term bonds and some subordinated debt (which, as part of the capital structure of a bank is intended to act as a buffer against losses) was not necessary in order to protect the immediate liquidity position. These investments were in effect locked-in. Their inclusion complicated eventual loss allocation and resolution options. Arguments voiced in favour of this decision, namely, that many holders of these instruments were also holders of Irish bonds and that a guarantee in respect of them would help banks raise new bonds are open to question: after all, extending a Government guarantee to non-Government bonds has the effect of stressing the sovereign to the disadvantage of existing holders of Government bonds; besides, new bonds could have been guaranteed separately. The argument for simplicity also is weakened significantly by the fact that an actual dividing line between covered and non-covered liabilities was drawn at as least an equally arbitrary point; moreover, such instruments were held only by sophisticated investors.

The key point here is not that subordinated bonds were included (this decision is singled out in the short paragraph 8.40 that followed and later in 8.50 as “not easy to defend”). Rather the point was that the guarantee applied to existing bonds rather than new debt issues. While most of the discussion of the guarantee in Ireland has focused on the very broad range of instruments covered, this distinction between existing and new debt is at least as important.

Irish banks, like many banks during this period, hit a liquidity crisis (based on concerns about their long-run solvency). Government guarantees were required if they were to be able to go into the market and raise new funds to pay off existing debts. So a government guarantee of some sort was required if the liquidity problems were not to trigger widespread defaults. However, the guarantee of almost the entire stock of existing debt was, as the report notes, “not necessary in order to protect the immediate liquidity position.”

We have heard time and again that guarantees were provided in lots of countries. However, the Irish decision to guarantee the full stock of existing debt, rather than new issues, was followed by hardly anyone. Here’s a link to an ECB document from last summer that outlined the various measures taken by European governments: You won’t find many guarantees of existing debt, you’ll find plenty of guarantees of new issues.

This decision to underwrite the full stock of debt of the Irish banks rather than assist them with new borrowing had profound implications. As the above paragraph noted, it “complicated eventual loss allocation and resolution options.” Of course, there’s a sense in which it made things pretty simple: It put the taxpayer on the hook for almost all losses.

The decision was motivated by a view that any failure of Irish banks to repay debts could not be countenanced. As Sections 8.48 and 8.49 of the report notes, this decision:

was an oversimplification which short-circuited decisions that deserved closer scrutiny. Under the circumstances of the extraordinary international financial market environment of those weeks, it was an understandable position. But it could not be a permanent policy if severe moral hazard was to be avoided. And it was also conducive to downplaying the importance of developing an appropriate legal framework for a special bank resolution regime scheme.

The “no failure” policy also took the question of optimal loss-sharing off the table. In contrast to most of the interventions by other countries, in which more or less complicated risk-sharing mechanisms of one sort or another were introduced, the blanket cover offered by the Irish guarantee pre-judged that all losses in any bank becoming insolvent during the guarantee period – beyond those absorbed by some of the providers of capital – would fall on the State.

To be concrete, consider an alternative decision in September 2008 to fully guarantee deposits and guarantee new issues. These new issues could be guaranteed out to some maximum maturity with the agreement of the Department of Finance and the policy of guaranteeing new issues could be reviewed in three or six months.

Such a policy would have allowed for a review that could have deemed Anglo Irish Bank to be no longer covered by the guarantee. This would have given real teeth to the later plan to split Anglo into a good bank and bad bank because the bad bank could have ended up with debt that has since been paid off by an Irish government unwilling to dishonour its guarantee.

The failure to focus on new issues, and to instead guarantee all debt up to September 2010, has also lead to the potentially serious problem we now face in rolling over bank debt over the next few months.

The government was slow to introduce a new scheme that focused on guaranteeing new issues out to maturity. The ELG scheme was passed in December 2009 and did not start operating until earlier this year. For this reason, the banks issued very large amounts of debt after October 2008 that mature prior to October 2010: €57.8 billion in senior debt and €16.4 billion in interbank deposits. The introduction of a scheme that focused only on new issues could have been designed in a way that avoided the single “wall of cash” moment that we have descending upon us.

Governor Honohan is more than capable of speaking for himself on these issues, so I don’t want to get into the question of the importance he places on the qualifications he has aired (i.e. whether it is the case, as I heard on the radio last Friday from a political commentator, that he was 97% in favour of the guarantee!)

However, speaking for myself, I think these flaws in the original formulation of the guarantee are extremely serious and may prove to be very costly.

15 thoughts on “The September 2008 Guarantee”

  1. Another point I think deserves attention is the idea of addiction to the kind of foreign capital whose flow the extended guarantee was designed to preserve.

    In a closed capital market, banks would only have been able to lend on the basis of (Irish) creditors – mostly depositors. Hence, the volume of loans would have been curtailed and the housing boom stemmed.

    Once the drug of cheap foreign money is made available, the bubble starts to swell. And then it popped.

    So why on earth would we want to put in place (costly) measures to ensure this flow of cheap money could continue?

    That’s like when you find someone with a drug overdose, and instead of giving him emergency treatment, the A&E crew hooks him up to some more heroine…

  2. Hi Karl, I can see where you are coming from and I agree with alot of what you say. I don’t think anyone can say that the guarantee was a perfect scheme. However, I think it is worth noting that even though other Countries may not have come out and explicity guaranteed bank’s liabilities, many Countries pretty much did the same thing through their actions. Senior bondholders have not suffered a loss in any European Country despite huge amounts of money being used to bail out banks in the UK and Germany for example.

  3. @Gavis S.: And look how great their economies are doing! Just because other countries did something similar doesn’t mean it was the right thing to do. Moreover, no other country’s banks were as exposed so their governments were explicitly or implicitly guaranteeing much smaller amount in proportion to GDP.

  4. @Gavin S
    “Senior bondholders have not suffered a loss in any European Country despite huge amounts of money being used to bail out banks in the UK and Germany for example.”

    I would say none of the other countries have banks that are as hopelessly insolvent as Anglo, INBS and maybe even AIB.

    Besides the decision to guarantee subordinated bonds which I don’t think we will find a single person willing to defend, the biggest mistake as pointed out by Honohan was guaranteeing existing bonds.

    It added nothing to the stability of the system and has cost the country very dearly.

  5. @ Dreaded Estate

    I think Hypo and IKB to name but two could be comparable.

    How has the guarantee of the exisiting bonds cost the Country dearly? Even if the guarantee was not in place, it is unlikely that senior bondholders would have been asked to take losses due to the absence of a resolution scheme for the same reasons that they weren’t made take losses in other countries.

  6. I don’t think any come close to the level of insolvency of Anglo.

    And what justification is there for still not having the legislation to deal with hopeleslly insolvent banks?

  7. @GS

    Sure there would have been problems forcing losses on senior bond holders even if they weren’t guaranteed, but it is likely that, particularly in the case of anglo (+INBS?), that buy backs below par for some of this debt would have been easier to achieve.

    Together with the fact that anglo was (arguably) not essential to the payments system, the gov’s negotiating position would have been strengthened, and significantly so.

  8. @Gavin S
    “How has the guarantee of the exisiting bonds cost the Country dearly? Even if the guarantee was not in place, it is unlikely that senior bondholders would have been asked to take losses due to the absence of a resolution scheme for the same reasons that they weren’t made take losses in other countries.”

    Ah, the easy ones first! Without the guarantee of existing debt, the government pumps a recap of a few billion into Anglo says grand now off you go. In the meantime the government pushes through a resolution scheme. Meanwhile, Anglo goes TU anyway, as it is more baskety than a woven reeds thing on the arm of an old lady. In the meantime, the markets and everyone else have adjusted to the fact that Anglo is reeking. Anglo goes bust. Everyone goes “ho hum, well that was unexpected”. The new resolution scheme kicks in – there’s 22 bn saved.

    Thanks very much, I’ll have a sweet sherry.

  9. @yog

    I take your point but pumping a few billion recap into Anglo would have meant the bank being on state ownership anyway so even at that stage it is unlikely the government would have forced losses onto senior debt holders even with a resolution scheme in place. In the same way that even now, the UK government is still protecting senior bond holders even though they have s resolution scheme in place.

  10. @Gavin s
    Only if the state took equity. If it took preference shares, it could happily throw up its hands and say “oh deary me, we lost everything” while at the same time thanking its stars that it was not on the hook for more.

    Letting Anglo limp along until it was safe and possible to dismember it was an option that should have been explored.

  11. @Yoganmahew

    Fair point but are you not looking at this with the benefit of hindsight? To be fair to the politicians, right up to the night of the Guarantee, they were being told by their experts in the FR and Central bank that they were dealing with a liquidty crisis and not a solvency crisis. Preference shares wouldn’t have saved Anglo at that stage as they had zero liquidity. They would not have seen close of business the next day.

    I am not saying the Guarantee scheme was perfect or even ideal but it is important to note the conditions that the decision was made under. Ireland may have went further than other European Countries but I can’t argue when I think back to those days that something decisive like this shouldn’t have been done. Like I say, other Countries had done similar things. Northern Rock was not systemically important. It was roughly the same size as Anglo so was only a medium sized bank in the UK. By saving NR at that time, the UK Government basically committed itself to not allowing any bank debt defaults. The Germans did the same with Hypo, IKB and Sachsen LB. There is little doubt that at that time, no European Country was going to allow a bank default on it’s debt if at all possible.
    Saying that the Guarantee in Ireland is a bigger percentage of GDP than other Countries is not a valid argument. Ireland can’t afford the Guarantee and the markets know that. If they believed that Ireland faced an actual liability of €400 billion, we would be bankrupt by now so it doesn’t come into it.
    The only way you can say that the Guarantee has cost this Country very dearly is if you believe that Anglo should have been allowed fail and senior debt holders made pay. I don’t see how that was possible and I don’t think even Patrick Honohan suggests that is what should have been done.
    The banking bailout has cost this Country dearly but the Guarantee is not the reason.

  12. @Gavin S
    Ah, but you see I was am not saying these things with hindsight. I was saying them at the time. As were others. Others who had been right before.

    Liquidity would have been maintained in Anglo by the unlimited deposit guarantee. This is what the Swedes did to keep their banking system going.

    The problem is that we already knew that bad banks with shoddy business models would be expensive to resolve. Hypo, Sachsen and Northern Rock had already proved that point. Only Sachsen has significant subprime exposure.

    Mr Honohan for sure makes that point. Otherwise he would not comment on how unusual it was to guarantee existing bond debt.

    The guarantee is the only reason. At least, the only reason that doesn’t have the words “fraudulent” or “crony” in it. And then only by virtue of it being a step removed by the veneer of Parliament.

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