Irish Times Article on September 2008 Guarantee

Following on from my post last week on the September 2008 guarantee, here‘s an article I wrote for today’s Irish Times on the same subject.

52 replies on “Irish Times Article on September 2008 Guarantee”

Good article Karl insofaras it states the obvious but only to those bothered enough to look at Honohan’s report rather than listen to incredibly misleading Government spinning (deception?).

The best construct that can be given to this mess is that the DoF thought it was only a liquidity problem it was dealing with rather than a solvency issue and applied a sloppy solution thereto.

In the private sector if you got something wrong by 20 billion or so (with or without hindsight) you would be “pursuing other interests” by now….

First article I’ve read that actually reports Honohan’s report accurately.

@PA Bandit – “you would be “pursuing other interests” by now….”

I came across another version of this the other day… “He was resigned.”

Good article.

Can I ask a question though? – Let me see if I have me bearings right here.

1) The original Guarantee in 2008 which backed all outstanding debt

2) The ELG in 2009 which backed new debt

Did the originsl guarantee back Irish banks’ in their attempts to secure ‘new’ funding on the market or was it only for outstanding debt and hence the need for the ELG a year later?

Also:

“The so-called ELG scheme was not passed until December 2009. In the meantime, the existing guarantee for all debt applied only up to September 2010.

For this reason, the banks issued very large amounts of debt after October 2008”

Why on earth did banks go crazy issuing new debt after the initial guarantee if it wasn’t yet backed by the state?

@ Rob

it’s a bit of a muddle trying to seperate the blanket guarantee (BG), the ELG and the deposit protection scheme (DPS, ie up to 100k). I think the BG guaranteed all existing debt AND all future debt up to Sept 30th 2010, regardless of the actual maturity of the debt, so thats why the banks issued a good bit of debt with a shortish maturity (ie on or before 30/9/10). The g’tee was set up this way primarily to protect deposit funding and short term debt issuance, which are key components of a banks liquidity. The ELG was then set up to allow for longer term funding to be put in place out to 5 yrs.

So the BG helped with shorter term funding (sub 2yrs) and the ELG allowed them to add a bit of term maturity to it, while the ongoing DPS will protect smaller consumer depositors.

@ Rob S

The September 2008 guarantee applied to all types of debt — existing and new — untill end of September 2010. So the new debt was covered but only until September of this year — a default after that date did not have to be covered by the Irish state, hence the debt that was issued had maturity dates before the expiry of the guarantee.

Only after the ELG scheme came into place could the banks issue debt backed by government that expired beyond September 2010.

Note that the “very large amounts of debt” is intended to apply to the €54 billion figure for bonds to be rolled over this year, a large figure in anyone’s book. The phrase “very large” wasn’t intended to conjure up the idea of banks doing anything crazy.

Let’s talk real world. Of course, we could have left out existing debt and subbies. Lenny probably will do that on the renewal of this guarantee. Prof Honohan’s criticism is somewhat theoretical, i.e. that the blanket cover ruled out potential resolution options.

But the reality is that (Anglo aside for the moment) the blanket guarantee has not and will not (during the guaranteed period) cost us a single cent. Unless one argues that it increased borrowing costs, but weren’t these recouped from the banks?

On Anglo, I don’t think we would be any better off if we had only guaranteed depositors and new bonds, they (including Prof H) would still have made the call to fully support that cesspit.

Is there a possibility that the Government will be able to access the €750 billion EZ stabilisation fund to support the rollover of this €54 billion – assuming investors aren’t queueing up?

@ BW2

I suppose you want to leave INBS aside for the moment as well.

If your point is that this discussion doesn’t matter because the government would always have made the wrong calls at the crucial time no matter what, well perhaps you’re right but I still think it’s worthwhile learning from our past mistakes.

As for Prof. H, you’re free to imagine someone else will support your position in some hypothetical alternative situation. However, the wording in the report was pretty carefully chosen to suggest that a different outcome from what is happening would have been preferable.

@ Paul

We don’t know much about how the stabilisation fund might work or the conditions under which we might have to access it. Presumably, it happens when\if the sovereign debt markets close on the Irish government.

In relation to what happens to the bank debt in that scenario, well we’d have to see. For what it’s worth, I suspect a purely IMF-sponsored program would not lend us the funds to keep pouring into Anglo. However, an EU-IMF fund may well give us enough rope to allow us to continue supporting the banks.

To what extent can we now remedy the situation of too much being guaranteed?

Presumably the guarantee will not be extended for any debt maturing after Oct 2010 which is not covered by the ELG. Anything maturing before that end of the guarantee will have to be repaid or refinanced (with ELGs and the extension of the guarantee).

What is our net position then?

@BWII
“But the reality is that (Anglo aside for the moment) the blanket guarantee has not and will not (during the guaranteed period) cost us a single cent. Unless one argues that it increased borrowing costs, but weren’t these recouped from the banks?”
The Guarantee led to NAMA. It led to preference shares. It led to recapitalisation. It led to nationalisation of Anglo, INBS and EBS.

What have we lost? Yes, increased borrowing costs (look at the Finnish spread for a differential – we started from roughly the same position…). No, these weren’t recouped from the banks – they are paying less for the guarantee than the difference.

Preference shares? Well, we get near-worthless equity that is immediately diluted by 95% in the case of BoI. Then we buy more near-worthless equity and dilute ourselves. Then we sell the warrants off for a song. The result? We got stiffed. Wanna bet something different happens with the 7.4bn that AIB needs to find? We will shortly be told that the money ‘invested’ in AIB and BoI (7 bn remember) is as gone as the 22 bn+ we put into Anglo, the 6 bn that will be put into INBS.

NAMA? Who knows. The bailout mechanism for the banks has switched to bailing out management at the expense of existing shareholders and the state. The haircuts may be sufficiently large to mean that NAMA can break even. Or then again, after 55% from peak off at Carrickmines and still unsold units, maybe not…

@Karl,

Thank you. Despite the lack of specifics, you appear to share my suspicion that some mechanism will be developed at the EU/IMF level to keep AIB/BoI afloat. As to Anglo and the rest of the dross, I think there is broad agreement that the state – and, ultimately, all citizens – will have to take these continuing hits on the chin without a possibility of respite only in the very long term.

@ yogan

When did the NPRF buy equity and get diluted by 95%
If we sold the warrants for a song…what price was that at? Would it have been above the current market price?

@ Yog

I agree that the guarantee, Nama and the recap all come as a package. But that package would not have changed had we simply guaranteed deposits and new bonds. And I reiterate, the blanket guarantee of itself has cost nuffin’.

How long before this can is too heavy to kick down the road?

Does anyone know if all the Irish banks are to be ‘Stress tested’?

@ Celtic

They were stress tested by the new regulator. BOI has raised the requisitie capital to comply with that stress test. AIB is in the process of raising the capital through asset sales and capital raising.

@YM

I understand the extension of the Guarantee will not be for everything covered under the original guarantee.

@ BW2

You say “the blanket guarantee of itself has cost nuffin’.”

Earlier, you said “(Anglo aside for the moment) the blanket guarantee has not and will not (during the guaranteed period) cost us a single cent.”

This seemed to concede (correctly) that the guarantee had implications for the options available to deal with Anglo, with the government forced to put money in or else dishonour the guarantee.

@Karl

The BWII jury is still out on Anglo. The official line still seems to be that the alternative is to lose over 40Bn. If that is because of a botched guarantee then I hope the forthcoming enquiry will name and shame. My sense though is that the treatment of Anglo has always been a least worst option and that irrespective of whether the guarantee covered existing bonds we would still be where we are. However, I stand to be ejected on this.

@tull
“When did the NPRF buy equity and get diluted by 95%
If we sold the warrants for a song…what price was that at? Would it have been above the current market price?”
When they converted preference shares into common equity at 1.80 in part 1 of the capital raise. Part 2 of the capital raise then diluted this and the existing portion of ownership as a result of the payment in kind of the dividends. The state then converted more preference shares to restrict its dilution in Part 2 of the capital raise.

The warrants were sold at above the pre dilution market price. But as they could not be diluted, this matters little – the pre-dilution (capital raise) value of the bank was much lower than the post-dilution value. Do you really think that the current share price of BoI represents anything other than a distressed level? So the future value of the warrants would be greater given the inevitable recovery.

That is what I mean by a song – either the value of the shares is going to increase as a result of the recapitalisation being successful (in which case the warrants are valuable) or it is not (in which case the preference shares are more valuation with 8% dividends).

@BWII
If the guarantee has cost us nothing, why did we nationalise Anglo, EBS and INBS? Half of the banks covered by the guarantee! Why does Mr. Lenihan want to extend it to cover 74 bn of refinancings this year? I’ll tell you why, because the state has to sink every borrowed penny it has into not letting the guarantee be called upon. You are being disingenuous if you do not see this.

The CEO and the CFO of Anglo both say that 22 bn that has been paid into it will never be returned. That not cost enough for you?

Mr Dukes said in March that the wind-down cost would be 20 bn. http://www.rte.ie/news/2010/0312/anglo.html

It has since ballooned to 49 bn. All based on makey-uppy double-secret figures. It is a steaming pile of nonsense to suggest these figures without given some detail on how this can be the case and how supposedly smart people can be 150% out on their figures in just three months. How much less then zero can Anglo really cost?

@zhou
“I understand the extension of the Guarantee will not be for everything covered under the original guarantee.”
It matters little as 74 bn will be added to the liabilities of the ELG. The bits that aren’t included aren’t important… otherwise they’d be included 😀

@Paul Hunt

…. ‘some mechanism will be developed at the EU/IMF level to keep AIB/BoI afloat. As to Anglo and the rest of the dross, I think there is broad agreement that the state – and, ultimately, all citizens – will have to take these continuing hits on the chin without a possibility of respite only in the very long term’

Everything suggests that a little state has stood, perhaps patriotically, or at least politically, over a number of ‘its’ insolvent banks, whose balance sheets are of the same order as the finances of that same state.

You can use a VW Golf to tow a big trailer, but you will be sniffing asbestos on the uphills. Any EU/IMF mechanism which is planned for purposes of bank rescue will also come in handy when there are no funds to pay public sector salaries. But the EU side will be far too polite to mention that.

@ Yog I know what you are saying. The recaps are necessary because of the guarantee. But the guarantee per se and in particular the guarantee of existing bonds has not cost a cent. It is a theoretical nicety that we should have left out existing bonds. How would we be in a better place today if we had left out existing bonds but guaranteed deposits and new bonds? That is the main thrust of Karl’s IT OP.

@ Yogan,
I still don’t see where the state suffered immediate dilution of 95%, whatever that means. Perhaps you could explain with numbers.
For what its worth, I calculate that the state has ended up switching about 1.7bn of its prefs into ordinary equity and received shares in lieu of coupon to the value of 250m. All told the total consideration seems to be around 1.9bn. At current market value, this stake is worth 1.55bn euros at the current price of 85p.

In addition the state received just under 500m in cash for cancelling the warrants.
Prior to the recap, the NPRF had 15% of the equity and warrants exercisable in five (?) years to buy another 25%. It now has about 35% of the ordinary shares. Where does 95% dilution appear out of all that number crunching.

@ Karl Whelan,

I’m of the opinion that Honohan’s comment on guaranteeing existing means that he can’t agree with the guarantee as implemented. Aside from increasing the losses to the taxpayer, it also pushed up the cost of Irish sovereign debt. It makes absolute sense not to cover bonds that couldn’t move. The only scenario I can think of where covering existing debt makes sense is where Irish banks were holding each other’s bonds. In such an event, not guaranteeing existing bonds would cause ratings downgrades and balance sheet markdowns across the board.

I suspect the “97% agrees with” is the percentage guaranteed that wasn’t subordinate debt. This was the impression I got from an interview with Michael Martin on Vincent Browne last week. The unfortunate Mr Martin doesn’t appear to understand tiering risk.

I’d like to draw out Governor Honohan’s comments that the cost of fixing the banks was “manageable”. Is it a nuanced “in isolation” the cost is manageable?

@ALL

Honohan’s point that subbies and existing bonds should have been excluded is of course technically correct and I think he is delighted to be seen to have at least one point which is anti the official line.

But let us not overegg it, which I think Karl does in his IT piece.

We would be in no different place today if we had excluded these and Lenny will exclude them next time round.

@tull
The 95% figure is from the prospectus and related to the dilution an ordinary shareholder would suffer if they didn’t take up their options. So the states original stake as a result of the dividends.

Let me put it another way. According to the prospectus – if the state had kept the warrants and exercised them post recap, the state would have ended up with 34.3% of the bank (assuming it paid to avoid dilution on the dividend stake).

Instead, the state received overall a 36% stake and 491 mn in cash at the cost of 1,036 in preference shares and the warrants.

So the state has increased its stake by 1.7% points for 545 mn euro cash equivalent (the preference shares). This would value BoI at 32 bn euro… At current price it is worth 4.4 bn…

You don’t see anything bad, wrong, illogical, inefficient about that?

@BWII
Well Brian, oil hasn’t run out yet, so I guess it never will? Global warming is clearly costless as we haven’t paid anything for it yet? That cancerous lump you have isn’t dangerous, “per se”, as it hasn’t killed you yet.

Really.

@ Yog

You are being so incredibly stubborn here that I am going to agree with you so as to get my point across.

The guarantee is a disaster, we are all doomed.

BUT IT DOESN’T MATTER A WIT THAT WE DIDN’T EXCLUDE SUBBIES AND EXISTING BONDS.

@ YOGAN,

The state owned 184m shares from the coupon and had warrants to buy another 230m shares (roughly) so it had close on 40% of the pre recap share issue.

Now lets assume that the state did not particiapte in the rights issue and somebody else too up the shares. the share count rises from 1.2bn shares roughly to 5.2bn shares approx. In which casre the state’s share holding drops from close on 40% to around 4% ex warrants or 8% including the warrants which of course were not exercisble for a number of years.

The NPRF took up its rights and therefore was not diluted. Is still do not understand your logic. Clearly my brain is not as big as yours.

@BWII
“But the reality is that (Anglo aside for the moment) the blanket guarantee has not and will not (during the guaranteed period) cost us a single cent. ”

remind me of “apart from that, Mrs Lincoln, how was the play?”

@BWII
Me, stubborn? I’m not the one arguing that the continued existence of Anglo, INBS and EBS is not the result of the guarantee. INBS in particular, it would have been cheaper to pay the depositors off and close the place down.

“IT DOESN’T MATTER A WIT THAT WE DIDN’T EXCLUDE SUBBIES AND EXISTING BONDS.”
Now that is a more interesting argument.

I don’t think we could have let an uncontrolled collapse of the banks take place.
I don’t think we could have excluded any bank from the guarantee.
However, we could now be in a position of talking to the Anglo and INBS bondholders and doing debt for equity swaps with them, taking a plain haircut etc.

About the only thing an abrupt collapse would have given us would have been a death to the derivatives monster, as derivative payouts are senior to everything else. But who is on the other side of the IRS swaps?

Derivative payouts are not senior to everything else. A derivative counterparty is an unsecured creditor like depositors and senior bondholders hence the use of ISDA’s and CSA’s to minimise counterpaty risk risk.

Ireland has a massive stimulus program in the form of low taxes, currently resulting in a 15% deficit. This deficit will worsen as bank employees are let go and their taxes are no longer paid to the state from money borrowed by the state. Re-read that!

How many “jobs” are now fully funded by state borrowing? What happens when the state no longer borrows?

The true economy cannot support such low taxes! We need a small government surplus and we need it now!

@Tull,
The warrants contain standard anti-dilution measures and were for 25% of the bank as it existed. You may go on about the size of your brain, clearly you are professional in these matters. I accept your corrections:
– a 96% dilution on the original stake
– close to 40% pre-dilution

My brain is of a simple taxpayer wondering how an increase in shares outstanding of 400% (from circa 1.2 bn to circa 5.2 bn) could result in a 96% dilution – surely that is less than 80% dilutive?

How 25% of a bank ‘worth’ 2 bn was worth 491 mn pre-dilution, but the same figure now would be 25% of a bank ‘worth’ 4.4bn? I don’t see that the sale of the warrants was anything other than the sale of the century.

Am I missing something about how warrants work? They permit you to buy a fixed proportion of the bank at a set price. They cannot be diluted. You have to wait until a certain date to exercise them. 😕

The banks are no longer rel;evant. I have said this for years. They were the money machine. It is now broken. They did their job too well. People no longer want debt.

PEOPLE NO LONGER WANT DEBT!

The banks are now expensive forms of workfare for the unemployed. They will slim down when the government ceases to borrow to pay for the jobs.

The banks are ZOMBIES! They feed off the living. Only those who read this are alive. The banks are not.

We hear the banks will have to pay for regulation. The state will have to pay. You and I will pay through our taxes! The banks are nationalized. They now belong to the state. We do not need the employees nor the offices. We only need 10% or so of the branches.

@ yogan

The warrants gave you the right to buy a certain number of shares which represented 25 % of the bank at the time of issue. At the time of their issue there were around 1bn shares in issue. The complicating factor is that the warrant owned did not actually own the shares now. It was a right to buy at a strike price 5 years hence. How he could actually participate in a rights issue to recap without actually owning the shares now is above my paygrade.
The warrants were not possessed of majic powers. If there was a new share issue and the warrant owner did not participate he would have been diluted from a 25% ownership position prior to recap to a c. 5% ownership position when he exercised in five years time.

The bottom line is that the state switched 1.7bn of 8% prefs to an equivalent of ords plus it got the 185m shares in lieu of dividend. The total consideration was about 1.9bn. These are now worth about 1.5bn at current market prices. In addition the state received 490m cash for cancelling the warrants. State ownership went from 38% or so of an undercapitalised entity to 36% or so of a properly recapped entity (according to the FR). I just cannot make out where 95% dilution comes from.

@tull
The 95% is the 96% you yourself identified?

I still don’t see how it is that much given the number of shares increased from 1.2 bn to 5.2bn. Not a 25 fold increase, but a less than 5 fold increase.

“The warrants were not possessed of majic powers. If there was a new share issue and the warrant owner did not participate he would have been diluted from a 25% ownership position prior to recap to a c. 5% ownership position when he exercised in five years time.”
But the warrants contain a “standard anti-dilution” clause. I understood this to mean full-ratchet anti-dilution ( http://papers.ssrn.com/sol3/papers.cfm?abstract_id=702581 ), whereby if the warrants were issued for 25% of stock pre-dilution, they would still be worth 25% of stock post-dilution.

“Form: On purchase of the New Preference Shares, the State will receive an option (the “Warrants”) to purchase 25% of the existing ordinary shares in each bank (calculated on a post-dilution basis). The State may exercise this option from the fifth to the tenth anniversary of the purchase of the New Preference Shares.

Early redemption: If the bank redeems up to €1.5bn in New Preference Shares from privately sourced Core Tier 1 capital prior to 31 December 2009, then the Warrants will be reduced pro rata to that redemption to an amount representing not less than 15% (the “Core Tranche”) of the existing ordinary shares of the bank.

Strike Price: The strike price of the Core Tranche of the Warrants shall be €0.975 for Allied Irish Banks and €0.52 for Bank of Ireland. The strike price of the balance of the Warrants granted to the State shall be €0.375 for Allied Irish Banks and €0.20 for Bank of Ireland.

Anti-dilution: Market standard anti-dilution protection will apply. ”
http://www.finance.gov.ie/viewdoc.asp?DocID=5669&UserLang=GA&StartDate=1+January+2010

@Gavin S
“Derivative payouts are not senior to everything else. A derivative counterparty is an unsecured creditor like depositors and senior bondholders hence the use of ISDA’s and CSA’s to minimise counterpaty risk risk.”
Sorry I wasn’t really clear – as I understand it, close-out netting is a preferred creditor if the liquidated partner owes on the swap. No?

@ KW,

Kathleen Barrington published one of her Insider articles in the Sunday Business Post on June 13th, although I hadn’t a chance to read it properly until this morning. I quite liked the article, because it fits together a couple of more pieces of the jigsaw puzzle about property and banking in Ireland. A couple of more crucial pieces, which I believe had not been widely studied until I read Ms. Barrington’s piece from June 13th 2010, Cowen’s Act fuelled banks’ folly.

But the legislation also included a provision that allowed banks to issue certain bonds – known as ‘covered bonds’ – backed solely by commercial mortgages. Under the previous 2001 Act, the bonds could only be backed by residential mortgages or public sector debt.
The 2007 move was music to the ears of commercial mortgage lenders, particularly Anglo Irish Bank, as it meant they could raise new money by issuing securities backed by commercial mortgages.

http://kathleenbarrington.blogspot.com/2010/06/cowens-act-fuelled-banks-folly.html

Hi Yoganmahew

Close out netting just allows in-the-money swaps be offsetted against out- of-the-money swaps. Therefore if Anglo owe AIB €100m on swap contracts and AIB owe Anglo €50m, AIB has an exposure to Anglo of €50m in the event of liquidation. This is simply an unsecured claim and ranks pari passu with other claims from depositors and bondholders etc.
I suppose close-out netting could be seen as a preferential payment to certain creditors (as the €50m owed by AIB could be used to satisfy all claims instead of being just used to reduce AIB’s exposure) but this is permitted under Irish and English law and is usually covered under ISDA Agreements between the parties.

What was the effect of guaranteeing subordinated and long term debt in Sept 2008 that was not due to mature until after the expiry of the Guarantee??

Would the guarantee only kick in if the bank was liquidated or forced into resolution?

That is my (cursory) reading of S.I. No. 411 of 2008.

If that is the case then the restriction on policy imposed by an over-inclusive guarantee can be alleviated to the extent that the guarantee is not extended in respect of certain debt.

Thus, if we can break through “the wall of cash” we should be able to improve our position somewhat.

A question arises as to whether the existing guarantee makes it more costly to break through the wall of cash.

On the one hand, the owners of debt maturing before the guarantee ends have a gun to our head in that if an act of default takes place on the covered institutions part then the other bonds which fall due outside the guarantee period may become payable.

On the other hand, the debt-holders would need to adopt a pretty unified position to create such a problem. Furthermore, whilst some debt-holders may wish to get out, there ay well be others willing to take their place under the ELG scheme.

In the meantime, it appears that we are adopting a staggered approach to escaping the guarantee. The first to be jettisoned will be the subbies and possibly others. It is not clear how covered bonds and longer term bonds are treated.

It would be interesting to have Colm McCarthy’s views on how we might best exit the Guarantee.

@Gavin S
Thanks for the info. I had it that the other 50 mn would have to be paid over aswell as the netted amount. I agree with you that the netting amounts to a preference as it is a set of contracts, not, for example, an insurance policy.

Where does cash collateral fit into this? (Yes, not really to do with IRS, more CDS? Although perhaps with the owing bank downgraded cash cover could also be required for IRS?). Say bank A has a losing position of 200 mn to bank B and has put up cash to cover this, but there is some time to go before the contract matures. Bank A then goes bust. Does bank B get to collect its 200 mn and pass Go?

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