The Debt Net Post author By Philip Lane Post date February 21, 2011 The FT has a long article on the pros and cons of bailing in of senior bondholders here. Categories In Banking Crisis Tags bail ins 24 Comments on The Debt Net ← More Black Holes? The Curious Case of the Missing €700 Million → Münchau on misdiagnoses 24 replies on “The Debt Net” Choices are commonly presented as if there are no costs — keep things simple and avoid the hassle of considering the downsides. The bail-in for senior bondholders from 2013, is mainly politically motivated but it would be stupid to dismiss that. The anger against the TARP program in the US was a factor in the rise of the flat-earther Tea Partiers and every society has its populist bandwagon jumpers seeking to exploit the market for simple answers. Bond yields for countries like Ireland will have a high risk premium for many years. Last week’s downgrade of some debt of even Deutsche Bank, in response to new German legislation, shows that no one is immune from higher costs. Furthermore, senior bank bonds are typically held not by hedge funds but by pension funds, insurers and other asset managers – the plodding pedestrians of the investment universe – attracted by the apparent safety and reliability of bank bonds. If that safety goes, there is a knock-on risk that the ultimate cost will be borne by those behind the insurers and pension funds: the general public. The Government has made it easier for Irish funds to buy Irish sovereign bonds but for the minority of private sector workers with a pension, most funds are already in the red and real annual returns for 3, 5 and 10 year periods from managed funds are negative. Over a 20-year period, people may be lucky to end up with some net advantage from the tax break, if they are lucky. Economists will surely have much fun in future years with the Law of Unintended Consequences. I agree with Michael H. that populsit calls to “burn the bondholders” will likely backfire. But the fact that the EU will permit discounting of senior debt claims post 2015 but opposes it now shows that the current official stance is political in nature rather than financial. I have lent senior debt. The very title “senior” presupposes liquidiation events where the claims of senior debt rank ahead of those of junior or subordinated debt. And the fact that credits which I proposed were subject to pretty rigorous credit analysis indicated a real and present fear that the bank for which I worked mightn’t get fully repaid if we didn’t do our work properly. So in my mind, there is no question but that providers of senior debt should face discounting in the sort of conditions now facing Irish banks. But there are clearly two problems with this: a. the risk of contagion as Irish bank debt write-downs generate knock-on effects across Europe. (British and German banks are each owed over €100 billion from the Irish banking system). If the Europeans want to avoid this, let them pay us a price to do so. It is a simple matter of negotiating the price. Sadly, our negotiating team (why do we still not know who was on it?) doesn’t appear to have done a great job on this. b. the risk that bank depositors get hit together with providers of senior debt. The political temptation is to change the rules so that the gambling, speculative and foreign bond investors take a hit but the sober, decent and domestic depositors are made whole. Taking this approach would certainly increase the risk premium for any bonds issued in the future (as Michael H. points out). Indeed, fear of such a move has probably played a huge role in the large outflow of deposits seen since last summer. Good article. I have a comment on the following para: “But bondholders and many bank executives warn that such moves could have negative consequences for the wider economy. Banks finance most of their customer lending through bonds. Raise the risks of bond investors losing money, and they will charge more in interest.” It is remarkable that such sentiments are not being more vigorously opposed. I would argue that most of the world was addicted to cheap money over the past decade and that is a big reason – but not the only one – for the crisis. If money gets more expensive people will think twice about where to deploy it and we may get a better allocation of capital than we have seen in the past decade. Bankers obviously stand to gain if money remains cheap – more deals and bigger bonuses – but for the rest of us, we should not support burdening the taxpayer to keep the cost of money artificially low. The cost of money MUST reflect the real danger of loss. Te present situation is unsustainable and would only lead to an even bigger bust down the road. The case against bail-ins in the article is a thinly disguised plea for the public to subsidise banking by taking on one of its significant costs – the cost of insuring against default. Most of us will oppose subsidies for almost all industries, and banking is not an obvious candidate for sympathy. On the discussion of concerns about what happens to different classes of creditors, I think one of the issues must be that if there is an event of this nature the government may simply not have access to the cash required to settle claims in a timely manner. It might be obliged to settle with some form of paper rather than cash, even if it has a credible strategy to repay the liability over time. @Garo: “The present situation is unsustainable and will (would only) lead to an even bigger bust down the road.” I have amended your last sentence slightly. The bust is a mathematically positive event, with probability 1.01! “Its the Model dear chap, the Model!” Linear economic growth meets exponential debt growth. When these plot-lines cross (and they already have), then economic growth stops and its lights out! Gotta strip out that excess debt ASAP. Gordi was on Morning Irl earlier and was asked about his proposal for a Debt Jubilee: My gaelic namesake interviewer seemed clueless about money and debt. Wanted to know whether the taxpayer would have to pick up the tab for crammed down debt and also opined about Moral Hazard! Gordi’s response was blunt and deathly. Hands up all who think that persons with less disposable incomes than they had, or worse, have to ask for state welfare transfers can actually repay debts which are growing exponentially, every second, of every day of every week, of every . . . Words fail me! BpW Apologies for going slightly off topic. However as many members of the diaspora read this site they may be interested to note that they can cas a “symbolic” vote for thir constituency by using Ballotbox.ie As I am currently working on the (European) continent I cannot vote so I have just used this opportunity to cast a “symbolic” vote in my Longford Westmeath constituency after I satisfied myself of their respect for privacy when accepting basic personal details. IMHO it is a great idea and, as this site demonstrates, social media enables the diaspora to have an opportunity to follow, participate, contribute to and (to a certain extent) have a “say” in Irish affairs. While it is a great idea it is important to note that “polls” close tomorrow. Once again, Philip, please accept my apologies for going slightly off topic but I am sure you will understand. @Livonian Getting ready for the European Court of Human Rights …. at the mo, only political party which explicitly addresses this is Sinn Fein – but I expect more …. need to move to be ready for next general election within 12 months ….. This battle is WINNABLE – and imho, key to political reform ………… in-bred crony insider conservatism exports young, savvy, well educated dangers to its continuance ….. This ‘VOTE’ needs to be ‘REAL’ …. @Garo +1 Your excellent point about the crisis being largely the result of dumping funds at low interest rates seems to have been missed completely by the author. Another comment: “According to a client survey by JPMorgan, a quarter of senior bondholders said they would not buy bonds that could be bailed-in.” Which of course implies that 3/4 of them are quite willing to buy them. Maybe that is because like most other people they were unaware that they were backed by state guarantees when they bought bonds previously. In Irelands case these guarantees simply didn’t exist – unless you buy the myth that they were always there but implicit. Of course if the implicit guarantees did in some vague way, exist and were of some value, which some commenters in here believe, the question would change to: why then were further explicit guarantees needed? The article also seems to confuse senior and subordinate debt – since when that was reported last week it was quite clear that Fir Tree bonds were sub. The basis of the lawsuit was that it was New York law and not Irish which applied in their case. One of the arguments in favour of beiling out senior bondholders is that if you destroy “wealth” which has been prudently disbursed and investment then you will do severe long term damage to growth prospects. This is true. However, the question then arises as to the consequences of destroying wealth which was disbursed relatively imprudently. We know from the disappeared Merril Lynch note criticising Irish banks’ aggressive lending before the crash that this could be applied to knowledgable investors in Irish Banks. Here you have two types of wealth being destroyed. On the one hand, you have wealth which turns out to be illusory but which was based on proper sustainable economic behaviour of humans (“Sustainable Wealth”). On the other hand, you have wealth which was illusory but which was not based on proper sustainable economic behaviour of humans. (“Unsustainable Wealth”). It seems that QE by printing of quantums of the abstract concept of money is justified if it is done to resurrect Susainable Wealth. On the other hand, a certain amount of pain must be taken by those who behaved in an unsustainable way so as to force them to correct their behaviour and to apply resources more sustainably. A problem which Irish people to not want to face is that many individually prudent people have been handling and benefitting from Unsustainable Wealth. A farmer who sells his land for €50m and invests it in gold and german bonds is handling this wrong-type of illusory wealth. A social welfare recipient receivig a much more generous transfer payment than society can afford to pay is also in receipt of Unsustainable Wealth just as an agent, lawyer or exchequer which makes fees on transactions funded with Unsustainable Wealth (and perhaps buys a generous pension with said unsustainable wealth). Therefore, the application of pain and relief in the appropriate measure is a very difficult, if not impossible, job. Ultimately, people act on the basis that one must err on the side of pain for the sake of the credibility of the financial system and the civilisation it underpins. However, that pain must be applied in a politically sustainable manner and all must share the burden. Therefore, it is imperative that senior debt takes some pain, particularly where it was invested in visibly recklessly run banks. It is also imperative that the acquisition of senior debt is date stamped. If it has been acquired second hand then the purchaser must have to answer for the knowledge they should have had at the time of acquisition. This should reduce the scope for opportunistic hold-outs. (The principle of a bone fide purchaser for value without notice is already enshrined in the law.) A register of bank debt centrally administered and regulated is therefore necessary. In this way, the Taxpayers (Irish and EU for example) who missed what was going on might share the pain equally with investors who missed it at the same time. However, an investor who bought when all knew it had gone pear-shaped should be treated less favourably. @Zhou, “..the application of pain and relief in the appropriate measure is a very difficult, if not impossible, job.” You have described the challenge facing the EU’s Grand Panjandrums extremely well. Since the EU is governed by rules and laws I don’t see any cavalier retrospective changes in existing rules and laws – any changes will be prospective. But some political discretion will be exercised to enforce limited burden-sharing. And when discretion is exercised the disposition of political and economic power will determine the outcome. Any political or economic capital that Ireland might have built up has been spent. We are totally reliant on the mercy of others. But we can be assured that the current generation of EU Grand Panjandrums will be determined not have it on their record that their actions (or inaction) occasioned the collapse of the EU project. The contest between low politics and the pursuit of national self-interest, on one side, and the preservation of a (reformed) EU, on the other, will be a close run thing. But the EU will survive. Ireland has successfully evaded paying full membership fees up to now – and has benefitted significantly and continuously. It is unfortunate that the bill is being presented when we are least able to pay them. Do we have the sense to see where our long term interests reside? @Paul Hunt Accepting responsibility for portion of the blame has to be the first step. Whereas, I said in a previous that there was no moral or legal basis for making taxpayers responsible for private bank debt, it has to be understood that there is an economic basis for inflicting pain on voters as citizens must know that their country cannot take the benefits of bubbles (e.g. high stamp duty and income tax receipts) and at the same time avoid any consequences when the bubble bursts. With that said, the sharing must be fair. I think Irish people are very pragmatic when it comes to the economy and cutting our cloth to measure as necessary. There has been great solidarity amongst Irish people up to now despite the attacks on public sector workers by some commentators. However, if Irish taxpayers are treated in an unfair way vis-a-vos the bondholders (whether people like Bini-Smaghi think it is fair or not) then things will go seriously wrong and not just in Ireland but also in other peripheral countries. We are heading for that point. I am not an FG supporter but Michael Noonan was right to remind people that we are in a terrible fix. Accepting that openly and telling the Irish people that even the best case scenario will be painful is the starting point in any renegotiation. We cannot approach the rest of the EU or the markets on the basis that we could not be expected to know that our economy was unsustainable and therefore we should not be rescued from our banks’ mistakes. We should also remember that we got a lot out of our boom in terms of infrastructure and access to education. Even though many will say they got nothing and have no responsibility, our country is a more equal and egalitarian society than it was and it has a better infrastructure than ever to re-build on. I don’t want to deny the dire situations some people are in which will force them to emigrate and will cause great pain. However, it is not all doom and gloom for the future. EDIT Substitute “…therefore we should be rescued from…” for “…therefore we should not be rescued from…” @Zhou, Your last paragraph highlights how much better shape we are in when compared to the other peripherals. We need to leverage this – as I keep harping on about – by reducing net sovereign debt via a sensible programme of privatisation and pursuing structural refroms in the domestic economy to enhance sovereign debt service capacity. It’s understandable, but disappointing, that voters are not being confronted with these issues before the election. The likelihood is that these reforms will be whipped through the Oireachtas as part of the EU/IMF deal – and these parties will be blamed. This is neither healthy in a democracy nor wise. What about the passport gig – 100bn for a passport and being sneaked in on the next return cattle boat from Libia? One of the sources of the current crisis was the under-pricing of credit risks at all levels through the financial system. The risk of bank insolvency was grossly under-priced and senior banks bonds didn’t yield enough maybe because the implicit guarantee existed in many investors minds. This allowed banks to take greater and greater risks because the riskiest weren’t punished for taking on too much risk or inappropriate risk. The risk adverse banks were then punished by the market for not following the crowd to chance the returns. Arguing that we should retain implicit/explicit guarantees long-term misses the source of the crisis IMO. In fact it is worse than missing the source, it is attempting to patch over the problem with policies that worsen the problem long-term. I agree that the cost of banks funding will increase if senior bonds are “bailed in” but I think this is exactly what is needed to fix the system. Banks that have a risky balance sheet will have to pay more to obtain funding, investors who invest in riskier banks will get more for their funding and borrowers from the banks will have to pay an appropriate rate for their loans to compensate the banks for the added risk on their balance sheet. Further to my previous comment of slightly dubious taste, it would be interesting to know how much of the Gaddafi slush fund is in the IFSC – and how liquid it might be? Don’t know where it is these days but first line of enquiry would be hedge fund of any Franco-Arab banking subsidiary. I have asked about this before: Could you all resist the use of, ‘pain’, burn’ and other unnecessary and inappropriate adjectives, please. Thanks. What we have is a debt repayment predicament. This predicament is perhaps 3 or 4 decades in gestation. The recent property bubble mania in Irl was the logical endgame. Hence we have a set of options, and very unpleasant ones at that. 1. We ‘kick the can down the road’:Predicament remains, it is merely being given the psychological ‘displacement’ treatment. Debt is real and increases exponentially. 2. We change bankrupcy laws and procedures: Allow for orderly writedowns of all personal debts (mortgages would have to be dealt with separately) to levels that can actually be repaid with our about-to-be significantly diminished disposable incomes. Professional financial managers and traders, many with very wide experiences, chose to ignore all the prudent rules of lending (like making sure the borrower could actually repay – like probably, as opposed to possibly. This stupidity of ever incrementing levels of credit creation has been going on for a long time – decades. Eventually the math catches up with you:Its default time. Generally, real incomes have barely kept pace with real productive output, so credit was substituted (there’s one for the econs to ponder over) as additional income. Problem was (is) Dr Credit metamorphosed into Mr Debt. Is it Silver Bullets or Wooden Stakes we need? How about a Referendum of the citizens? We (the citizens of this state) will/will not honour the debts incurred by Irish financial institutions and instruct our government to act accordingly. We ARE a democracy? I think we are. A decisive No vote might just concentrate some arrogant minds. BpW “Pain” is an appropriate adjective as financial, physical and psychological pain are real consequences of insolvency. I don’t like the idea of having a referendum where you wish that something beyond your control was other than it was. We already had a referenda on european treaties that banned bail-outs. Dreaded_Estate Says: “Arguing that we should retain implicit/explicit guarantees long-term misses the source of the crisis IMO. In fact it is worse than missing the source, it is attempting to patch over the problem with policies that worsen the problem long-term.” THIS. Whatever the increase in cost of banks funding it’s orders of magnitude less than a guarantee which misallocates capital, inflates asset prices and imposes debt deflation on the real economy while making creditors and speculators whole. @ Zhou ‘However, an investor who bought when all knew it had gone pear-shaped should be treated less favourably.’ You are surely jesting. Things have not gone pear shaped enough yet, which is why mobile capital is waiting in the wings for further falls in asset values, individual and coprorate bankruptcy, emigration etc. Busts are just as profitable as booms for the dominant players. ‘I don’t want to deny the dire situations some people are in which will force them to emigrate and will cause great pain. However, it is not all doom and gloom for the future’ What many people are saying is that the course of action which we are about to endorse can result only in the breakup of the existing infrastructure and the loss of those gains to which you refer. I don’t always see it Fintan O’Toole’s way, but he has put his finger on something in our national character in the IT today. @postmodernprimate/dreaded_estate It is an excellent point that we cannot expect capital to be properly allocated unless we allow losses. We should not still have to be in fear of contagion 3 years down the line. One wonders does the possibility of contagion favour some countries as well as banks? On the other hand, it appears that private and public debt are often aggregated when it comes to assessing the creditworthiness of a country. It is further arguable that we all agree that investors should lose money but then we all suffer by a lack of credit and collapsing economy. However, this argument is wearing thin. As far as I can see there is close to zero credit out there in any event. This lack of credit or capital is the only thing stopping more liquidations and fire sales. The market for deliquent borrowers’ assets is nil. @paul quigley I am clear as to what your point is. My point is that there should certainly be no bail-out or subsidisation of investors who came in when things were bad (/when regulation was no longer non-existent) as they knew the full facts took their chances. By all means let them profit if their investment turns out to have been propitious. EDIT: I am NOT clear as to what your point is. !! @all Next ‘Dear Leader’ here – note his response to the Death .. er.. Debt Issue: http://www.tv3.ie/shows.php?request=tonightwithvincentbrowne&tv3_preview=&video=32768 @postmodernprimate .. er .. would premodern primate not be more appropriate – with present policy Irish are regressing to the condition of the Fir Bolg? Comments are closed.