The Black Hole Grows

It has been apparent for some time that proposed design of the post-2013 ESM — notably preferred official creditor status and arrangements for creditor bail-ins — is undermining peripheral country creditworthiness. The so-called bailout mechanisms have the rather grotesque feature that they can suck a country in once it begins to show enough vulnerability.  

At the moment, markets do not want to lend to Portugal in large part because markets expect Portugal will enter the bailout mechanisms, increasing the risk they will be caught up as junior creditors in later accelerated bail-ins.  This could end up happening well before 2013; hence the surge in our 2-year yields. These fears are likely to be self-fulfilling, despite the resistance of the Portuguese government (no doubt informed by watching what happened to Ireland).  As we are learning more by the day, once in, it is damn hard to get out.   Peripheral yields have shot up every time the ESM became that bit more certain (latest news on the agreement here).   With the evidence so clear, it is hard to understand how European leaders persist with a solution that could end up destroying the Eurozone.   The interest rate issue appears a sideshow by comparison.

The FT has a couple of good articles that nicely capture that damage being done to our and others’ creditworthiness (see here and here).  A flavour:

Investors warned they could boycott peripheral eurozone bond markets as reform of the region’s bail-out fund sparked fears of a sovereign default in Europe.

Irish three-year bond yields leapt close to a full percentage point at one point on Tuesday, while the cost of borrowing for Portugal and Greece also shot up on worries that one of these countries would have to restructure their bonds.

European finance ministers finally drew up plans to make investors share the burden of potential sovereign defaults beyond the summer of 2013 in a deal hammered out on Monday night. Concerns centre on the preferred creditor status given to European Stability Mechanism, the permanent eurozone rescue fund, which takes up the reins from the temporary fund, in the middle of 2013.

Investors warn that this will mean they will be the last in the queue for the recovery of money in the event of a default. One fund manager said: “We will definitely not buy peripheral bonds now, not with the uncertainty this has created.”

Tamara Burnell, head of sovereign and financials analysis, M&G Investments, said: “This agreement will not do anything further to encourage investors to buy peripheral bonds.

30 replies on “The Black Hole Grows”

Does this mean that after June 2013 our bailout of 85b will become super preferential and if we sell them bonds under the proposed terms of the ESM will these also be super preferential and if so what value existing paper?

S&P have run their own stress tests and come up with a capital requirement of 200 to 250billion euro for European banks.
“S&P said there would be three phases to its scenario: firstly, bond yields rise; then access to debt refinancing deteriorates, especially in peripheral euro-zone economies; and finally a severe downturn would follow, hitting Greece, Ireland, Portugal and Spain particularly hard. ”

We are already through stage two so lets hope we don’t get to stage three/\.

Ceteris paribus
Those numbers are probably true and the more I think about it, the more I am convinced that, in most scenarios Ireland is toast without some really creative action. If the worked economy grows, and rates increase, then we get more exports but asset prices correct and blond markets stay firmly shut ( the 94 to 2000 defaults in Latin America and Asia were the rolling after effects of the rate increases in 1993)

Ireland needs to act or it will default. Why not raise debt directly from the Irish diaspora? It would take effort and creativity but it is not possible for a population of 3+ million with a culture of emigration to carry the levels of debt that our previous geniuses assumed.

I was wondering if the government launched a 1% bond with a link to gold prices and targeted Irish people living in the US, Europe, Australia or wherever they are. The bind would carry a ten year tenor and part of the proceeds would be used to buy options on gold. This way, the interest rate is reduced (one percent is better than the yield on gold) , the government would have to hedge against rises in the gold price (they could set a strike price at 10% above current spot gold prices and hedge that).

Of course the bond would have to be launched with a series of policy commitments. First, the passive attitude to emigration has to change, a country carrying huge debt cannot afford to lose population. Second, they could offer Irish born emigrants a vote to ensure that they get a say.

With the proceeds, Ireland could do two things, first repay the IMF EU facility. Then the set a ceiling on the Irish government guarantee and let other countries go hang for the rest. Finally they LOWER CT rates (up yours Zarkozy) to maximize revenues.

Once all of that is done, there is at least a chance that cash flows are stabilized and the government will have options. They would have to use that time to lower public spending, to re finance any debt maturing in the next five years and finally, to stabilize the mortgage market.

Finally, they would have to pass a constitutional amendment that forbids government from assuming private sector liabilities without a referendum on each specific transaction above say 1% of GDP (that includes bank and church liabilities incidentally)

They would also be free to tackle the massive headwinds to ireland’s economy. First they could demolish the excess housing sitting in quarter filled estates. Offer house swaps to those that live in a quarter full estate for a house in a half full one and then demolish the empty ones and rezone the land for agriculture.

These may be crazy ideas, but I would be willing to invest if I thought that there was real desire to fix the problem and ensure it never happens again.

Ireland may have come to a watershed. Consider the following interpretation of events:

1. The EU /ECB effectively prevented Ireland from reaching an accommodation (or rescheduling or whatever) with its banks’ creditors during negotiations in November. Instead, we got a vague promise of temporary support for our banks from the ECB. The vague nature of this promise (that included a planned reduction in ECB exposure over time) resulted in the private sector running even further away (from Irish banks) and the required ECB financing became even larger (as the months went on). But the ECB has (crucially) stayed the course and has continued to support Irish banks.
2. Moreover, because of the vague nature of the official support in the IMF agreement (think about it!), and the associated failure to clarify Ireland’s relations with private sector creditors, it has become increasingly obvious that the broad outlines of the programme are not sustainable. The ECB cannot be repaid right now and it never intended to extend such credit in the first place. The private sector suspects that it will not be repaid before the ECB and, as a result, sovereign bond yields have continued to rise. Therefore, it has become increasingly obvious that the private sector will not be involved in financing the recovery in Ireland in 2012 and this further undermines the programme assumptions. (The Irish programme is highly unlikely to have any private-sector involvement and, therefore, cannot be executed as planned).
3. So let’s face it; Ireland no longer cares too much (for the moment) about the yield on its old bonds!
4. And, at the same time, bond yields on the periphery (including Ireland’s) seem to have begun to respond to actions by the EU/ECB rather than to developments in the individual nations. In other words, the markets seem to think that the bonds have become a problem for Europe as a whole–they have become a matter of EU/ECB credibility.

This all seems to suggest that the markets think that a debt restructuring/rescheduling is inevitable but that it will be negotiated at the EU/ECB level. This, as noted by John, is dangerous for the euro-zone but may represent some relief for Ireland … and we can begin to end this silly debate about unilateral default.

@Bklyn_rntr Says:
That is a big ask. Cannot see anyone buying 1% that not gold plated. I don’t think we have any in the vaults.

@Gary O’Callaghan Says:
“This, as noted by John, is dangerous for the euro-zone but may represent some relief for Ireland … and we can begin to end this silly debate about unilateral default.”

Yes …The closer we draw them into the net the better.

I just hope JtO purchased the Irish 2 year about a year ago when it was under 2%. I would suggest he double up.

@Gary O’Callaghan

Thanks for that. Very helpful.

It seems to me that there is a danger of being caught in a no-man’s-land: trapped outside the markets but without external support.

One potentially feasible option would be to move quickly to funder-supported private sector involvement; involvement that imposes losses retrospectively on existing bondholders and does not just threaten future bondholders. This does not appear to be on offer.

A second potentially feasible option is to have a firmer commitment to external support (very much including the ECB) based on strong conditionality, and take the latent (and not so latent) threat of private sector involvement off the table. From the funders perspective, of course this creates risks of both debtor and creditor moral hazard. Hopefully, the first could be dealt with by credible conditionality; the second by strong commitments to improvements in regulatory discipline in place of weakened market discipline (strengthened financial regulation, independent fiscal councils, “debt brakes”, etc). Again this does not appear to be on offer in a form that can work.

Instead we get a combination of official support (which of course has been invaluable) but with limited commitment to its continuance, and a threat of future private-sector involvement. This has turned out to be a toxic mix in terms of countries’ market creditworthiness.

I do not think that the behaviour of the bond markets can be explained other than by setting the issues in their broader European political context. At the beginning of the crisis, Germany was caught unprepared both by the extent of the losses incurred by its inefficient banking system but also by the realisation that there were a number of costly cuckoos in the euro nest (first Greece, then Ireland). Hence, the intemperate language such as forcing Greece out of the euro, selling Greek islands etc.

However, the German establishment has since recovered its sangfroid and we now have the definitive solution in the form of the ESM designed and made in Germany. To assume that it cannot work is to assume that the Germans do not know what they are doing which would be a very courageous assumption. There are three essential elements in its foundation (i) Germany will not abandon the euro (it would be idiotic for it to do so in any case given the benefits the country derives from the single currency area) (ii) the euroarea must stay as wide as possible and (iii) the cuckoos will not be evicted but they will not be given a free ride.

The approach solves the trilemma identified by Wolfgang Munchau of (i) no default (ii) no bailout and (iii) no exit. Germany accepts that the no bailout element is the one that has to give. But it is the “ultima ratio” and only to be conceded, as of 2013, when the pips squeak and the private investors and banks – with whom the German populace is deeply angry, as in Ireland – who contributed to the situation will have to pay.

The cuckoos are effectively placed in quarantine until it is established that they will not recover on their own and then some treatment can be contemplated. Adjustments have already been made for Greece.

The German approach is not necessarily viewed as the best by the ECB but then Germany did not think that the decision by the Governing Council to decide against the wishes of its German members to start buying government bonds was a good one and that decision has not turned out very well.

The Irish policy stance, insofar as it can be established, could be interpreted as seeking more money while threatening not to repay what has already been received. This has clearly got to be clarified. Saying a deal you signed up to a few months ago cannot work is very different from saying that one has doubts about its feasibility but intend sticking to one’s last until this has been clearly established. (If the report by Arthur Beesley in toady’s IT is any guide, this is now happening).

The academic community in Ireland should stop worrying about the future of the euro. It is in good hands. Ireland’s economy, on the other hand, is a case for attention.

P.S. For the view of Smaghi cf. his recent speech and this extract in particular.

“The proposal was based on the assumption that the best way to discipline governments and to ensure sounder public finances is to make it easier for a country to declare bankruptcy. As soon as a country has problems with its public finances, it should seek a restructuring of its debts or automatically extend its bond maturities as a necessary condition for receiving help from European and international institutions.

This idea is mistaken for several reasons. Firstly, it attributes the main task of disciplining governments to the financial markets. The markets – according to its proponents – work better if the conditions under which a state may fail are more explicit. This hypothesis – dear to many academics – does not however reflect reality. In the private sector bankruptcies are possible and are subject to regulation, but markets often incorrectly assess the risk of securities issued by the private sector. The markets were wrong both before and after the crisis, and continue to make mistakes, even with regard to sovereign risk. Moreover, they often behave inefficiently and facilitate collusion, especially when it is possible to buy derivatives that allow you to ‘bet’ on a country’s bankruptcy, even without having invested in it. Giving the market the exclusive power to decide the fate of millions of people seems to me quite irresponsible. The recent European decision to limit the possibility of buying derivatives to hedge sovereign risk without the underlying security is therefore justified”.

Events will decide.


In terms of regaining creditworthiness, I don’t think it is case of putting the emphasis on domestic policy measures or on the bailout mechanisms. Both are critical. The joint movement of peripheral bond spreads suggests something more than the problem being a failure of country-level adjustments, though these are clearly critical as well. While I do agree that markets sometimes get things wrong, it is a mistake to put our heads in the sand, and to assume that countries can’t default because European policy makers say so. Policy makers are getting a strong signal that the proposed crisis resolution mechanisms are not working — and failure is not in anyone’s interests. I think our negotiators should be hammering on this point.

A QE-style programme should be a key element to solving this Eurozone mess. It’s understandable that each state doesn’t want to pay the losses of another state. It makes getting reelected a little tougher. However something less tangible to voters and, perhaps of greater consequence, is the drag failed states will have on the rest of the Eurozone.

@ Johm McHale

I agree with your point about the need to place the emphasis equally on domestic policy measures and bailout mechanisms. The problem is that they are on different timelines and especially in Ireland’s case. They will only coalesce in our case if Portugal also has to fall into the black hole of the EFSF.

The main players are simply not too concerned about the problem of peripheral debt. It is the countries involved that are between a rock and a hard place, not the euro. And if the holders of their bonds are getting their fingers burnt, so what! This is where the German vision of the ESM parts company with that of the ECB. We will see who is right.

There is also an unholy row brewing in the governing coalition in Germany about the extra cash that Germany has to put up and how this is to be financed cf.

The besettiing sin of national media and commentators, and this far from being confined to Ireland, is that they tend to view events in Europe through a national prism. This distorts the overall picture.

@John McHale

I completely agree that we are in no-man’s land. We have been there since November. But the markets now seem to have decided that there will eventually be an EU/ECB negotiated rescheduling. Recognition of this reality has yet to crystallise in Europe, but the current market push on rates may be the catalyst we needed.

The EU/ECB fumbled around in the china shop and, in the process, broke Ireland’s (fragile) credibility. Now, the markets have decided to apply the age-old dictum that “if you broke it, you own it.” But the lads have yet to come up to the cash register and accept responsibility.

@Ahura Mazda

I agree, but don’t hold your breath.


(iii) the cuckoos will not be evicted but they will not be given a free ride.

One could contend in this case that Ireland is not the cuckoo. Au contraire, Ireland could be described as the hapless female that was not vigilant enough to mind her own nest from well feathered parasites.

There is another aspect of the ESM that is causing problems – the fact that control is intergovernmental and not by the Community/Union method. Both the Commission and the ECB wanted the ESM to be an EU institution run under the Union method (using QMV), but instead it is essentially a Luxemboug bank where every participating country can veto any decision.

Barroso has admitted that the EFSF would already have been changed to be more flexible under QMV, but as it is now any country can easily throw up any roadblock or insist on any policy under conditionality, for domestic purposes. France is blocking lowering the interest rate for Ireland and Finland is blocking expanding the EFSF to €500bn. The ESM now indefinitely institutionalizes this flawed decision making system – what are the chances that at any given time there will be at least one government facing a “difficult upcoming election” and will want to show how tough they are to a segment of their domestic electorate? Pretty high I would think.

Just last week the EFSM raised €4.6bn and lent on €3.4bn to Ireland and €1.2bn to Romania. The former had a 3% margin attached and the latter did not. Where’s the logic in this?

The markets can see that common-sense has left the building and there is no sign yet that he is about to return any time soon.

@ Bryan G

On your first point, the text states clearly that the agreement will be by way of treaty governed by international public law. No doubt, this is because only the Euroarea countries are participating and any decision to establish the ESM under EU law would have been a long-drawn out affair and probably have created difficulties for the UK. There are also precedents such as the Schengen Treaty (abolishing controls on persons at borders for initially a limited number of EU countries).

On your second point, key decisions on any basis other than unanimity would have been politically impossible for Germany.

On your third point, the difference is obvious. Ireland is in a financial hole and Romania is not. The two programmes, as far as the Commission is concerned, are entirely different and based on different articles in the treaties.

@ David O’Donnell

For a court jester, he is exceptionally well paid. The point about the intervention that I quoted is that it raises the intriguing question: does the ECB think that any form of explicit provision for a sovereign default, e.g. the proposed ESM, is in itself likely to precipitate such an event? There is a school of thought – to which I belong – that believes this to be the case. Given the difficulties that have arisen for Merkel domestically, which seem likely to delay any decision until June (nicely timed to coincide with the outcome of the bank stress tests), one wonders if this school does not have many more adherents than her advisers imagined?


… build a road — and someone is sure to use it. I agree. It ups the probability … and in some cases, becomes a certainty.

@ David O’Donnell

This then raises the further intriguing possibility; that Merkel’s mania for “making the wicked bankers pay” may be the equivalent of the poll tax for Margaret Thatcher, to whom she is beginning to bear a startling resemblence with her unfortunate finance minister in the role of Sir Geoffrey Howe. Thatcher, however, knew that “you cannot buck the markets”.

There is also the little noted event of the recent decision by the highest German appleals court to make one of the self-same bankers do just what Dr. Merkel has ordered.


Her analysis is sound enough – and she has plenty local empirics on under and uncapitalised german banks – but she blew the TIMING with tango in Deauville with her pet_nicky … her local bank logic may be summed up with the manta of the joyful sinner: make me chaste lord – but not yet! so she quarantined the greeks and the irish …. & portugese….. while she has a few yrs to recapitalise locally – she might yet get away with it – if she does we’re toast! She could also get tossed out by her own before the year is out ………..

We need to ruthlessly look after ourselves …….. quarantined pawns in glass jars on a continuously reduced diet of bread and water ………. only serfs … hibernian upper-echelons and special interests to be protected at all costs …….


On your third point, the difference is obvious. Ireland is in a financial hole and Romania is not. The two programmes, as far as the Commission is concerned, are entirely different and based on different articles in the treaties.

The difference is not obvious. Romania cannot raise money on the markets at reasonable rates; has declining GDP and a significant budget deficit; is subject to an IMF program with conditionality that includes fiscal targets, structural reform, public sector cuts, tax increases and measures to improve the financial sector; the EU Commission and ECB are involved in the review process for disbursements. Seem familiar?

Of course Romania is one of the poorest countries in the EU, and Ireland was one of the richest, and Ireland’s program is far bigger, but the reasons for the funding and the way the program operates are similar.

The reason for the different margin has little to do with logic and everything to do with politics.


“On your third point, the difference is obvious. Ireland is in a financial hole and Romania is not. The two programmes, as far as the Commission is concerned, are entirely different and based on different articles in the treaties.”

So the EU thinking is that higher rates are required to get overly-indebted nations out of their financial hole? Isn’t this what loan sharks do?

@ Bryan G and BEB

I put the point badly. Ireland is excluded from the bond markets for the moment, Romania, as far as I know, is not cf. an item picked at random from Google.

Romania is one of the poorest countries in Europe and the idea of comparing the situation of Ireland with it is untenable. The two programmes are totally distinct and the IMF is taking the lead role with regard to Romania.

The EFSF was designed to be punitive to dissuade wealthy Euroarea countries from using it and to force them to take the measures to avoid having to do so. The previous Irish government studiously avoided taking these measures and seemingly drifted through the summer of 2010 in blissful ignorance, or willful denial, of what was coming down the road.

If one takes the full-page coverage at page 12 of the Irish Times today as a guide, the new government is finally beginning to join up the dots. What the rest of the Euroarea is seeking, through the reported comments from Berlin and Paris, could not be clearer than if it was written in six foot letters on a barn door; and it is not an increase in corporation tax.

It is a clear and unambiguous statement that Ireland intends to stick to the agree IMF/Commission/ECB programme. Difficulties along the way can then be discussed (probably in the company of Portuguese colleagues).


Romania is still in the markets, but was forced to abandon a 7% yield cap. It raises money in the 7%-8% range. I still maintain the difference between Ireland’s situation and Romania’s is quantitative not qualitative.

The problem with the EFSF, and pretty much all the EU rescue mechanisms, is that they are predicated on the assumption that the problem is profligate government spending, and not huge banking-system insolvency. If the problem is misdiagnosed (whether by accident or design), then the treatment will be inappropriate. It was the banking problems that led to the bailout, not a dispute with the EU or concern by the markets over the size of the fiscal adjustment for 2011, or whether the 3% target was to be hit in 2014 or 2015, for example.

Unfortunately I don’t have access to the print edition of the Irish Times – are Paris and Berlin backing off from the CT demands and/or is some substitute quid pro quo being floated? The IMF-EU plan implicitly assumed unbounded sovereign exposure to all future bank recap costs. This should never have been agreed to. In combination with the fact that the bailout agreement was silent on a number of key points, such as the conditionality of ECB bank funding, I think the agreement received the treatment by the markets that it deserved. The pieces of the bailout plan that are broken need to be fixed, before they can be adhered to. On the fiscal/non-banking side, the plan is being implemented as far as I’m aware, with perhaps the odd planned policy substitution here and there.

Leaving Romania aside, I venture to say that everyone knows by now that it is the banks in Ireland that have caused the problem. Just as in Iceland. And, when push comes to shove, the experience since Lehmans is that every nation state ends up with the responsibility for carrying the losses of, and recapitalising, its own banks. After all, the systemic risk is to each state, not other states. (This, of course, underlines once again the question of whether or not the failure of Anglo-Irish would have constituted a systemic risk. In my view, the answer is yes not because of Anglo-Irish but because of the behaviour of the other financial institutions in imitating its lending policies).

The difficulty with the position that you adopt, and many others on this blog, is that it is assumed that the problem of the banks is for other member states to solve. They will not accept this and neither would we if the situations were reversed. The problem then becomes one of addressing the question of whether or not it is actually possible for the country affected to provide the necessary capital. This is the stage we are at now.

The most pertinent report from the IT is that on the statement by the Minister for Finance in the Dáil yesterday.

The most pertinent sentence is the following;

“Ireland, he said, must move in the context of a bailout agreement being in place with the agreement of the IMF, the European Central Bank, the European Commission and the Government.

The contract, said Mr Noonan, was not with the previous Fianna Fáil-Green Party government but with the Irish Republic and “one must remember that when considering those issues”.


There are a number of post-Lehman cases where banks have been allowed to fail with bondholders taking loses e.g. WaMu, the Icelandic banks (the government only covered what it had guaranteed), Amagerbanken etc. As the EU/ECB is preventing any losses being imposed where those losses rightfully and legally fall (i.e. private parties in private transactions, that are not guaranteed) then I would argue that, at least for those portions of the losses, there should be corresponding compensation, since other countries are benefiting directly from this corporate welfare. I recognize that this only amounts to 10% of the overall debt burden, but its political resonance in Ireland is huge, and in my view this is preventing other issues being effectively addressed, since everyone can hide behind the shield of this obvious injustice.

I do believe the ECB should be prepared to act as a lender of last resort to banks in the inevitable bank run that would follow such loss imposition, and that some QE (effectively imposing an inflation tax on all Euro-holders, rather than member-state tax-payers) should be used to solve the problem (as it has been used in the USA and UK), on the basis that the credit bubble was a systems failure reflecting design problems in the Euro architecture, rather than a component failure reflecting a localized implementation problem, to use an engineering analogy.

@ Bryan G

All very valid arguments and which will undoubtedly figure in any eventual compromise. (Iceland was not a member of a single currency area). But this is a far cry from the election campaign slogan of Fine Gael about “not another penny for Irish banks”.

And the capital gap has still to be filled. This can only be achieved by putting state assets on the line (as in the case of Greece).

This is not about banking but politics. I do not know that much about the first (but a lot more than I did three years ago) but everybody can easily grasp the second.

P.S. I do not think that a bank run is on the cards. The “auction” of the deposits of Anglo and Nationwide went without a hitch.

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